Let's say that you have $1,000 set aside, and you're ready to enter the world of investing. In this article, we'll walk you through getting started as an investor and show you how to maximize your returns while minimizing your costs.
What Kind of Investor Are You?
Before you commit your money, you need to answer the question, what kind of investor am I? When opening a brokerage account, a broker like Charles Schwab or Fidelity will ask you about your investment goals and how much risk you're willing to take on. Some investors want to take an active hand in managing their money's growth, and some prefer to "set it and forget it." More "traditional" online brokers, like the two mentioned above, allow you to invest in stocks, bonds, ETFs, index funds and mutual funds. Investopedia's broker reviews will show you which brokers are best for every investor. Investopedia's The Complete Guide to Choosing an Online Stock Broker will give you step-by-step instructions on how to open and fund an account once you've decided which one is right for you.
Brokers are either full-service or "discount." Full-service brokers, as the name implies, give the full range of traditional brokerage services, including financial advice for retirement, healthcare and everything related to money. They usually only deal with higher net-worth clients, and they can charge substantial fees, including a percent of your transactions, a percent of your assets they manage and a yearly membership fee. It's common to see minimum account sizes of $25,000 and up at full-service brokerages.
Discount brokers used to be the exception, but now they're the norm. According to a report by Charles Schwab, 58% of Americans say they will use some sort of roboadvice by 2025. As the space of financial services has progressed in the 21st century, online brokers have added more features including educational materials on their sites and mobile apps. Still, traditional brokers earn their high fees by giving advice detailed to your needs.
In addition, although there are a number of discount brokers with no (or very low) minimum deposit restrictions, you will be faced with other restrictions, and certain fees are charged to accounts that don't have a minimum deposit. This is something an investor should take into account if he or she wants to invest in stocks.
After the 2008 Financial Crisis, a new breed of investment advisors was born: the roboadvisor. Jon Stein and Eli Broverman of Betterment are often credited as the first in the space. Their mission was to use technology to lower costs for investors and streamline investment advice.
Since Betterment launched, other robo-first companies have been founded, and established online brokers like Charles Schwab have added robo-like advisory services. If you want an algorithm to make investment decisions for you, including tax-loss harvesting and rebalancing, a roboadvisor may be for you. And as the success of index investing has shown, if you're goal is long-term wealth building, you might do better with a roboadvisor.
Learn the Costs of Investing
As economists like to say, there's no free lunch. Though recently many brokers have been racing to lower or eliminate commissions on trades, and ETFs offer index investing to everyone who can trade with a bare-bones brokerage account, all brokers have to make money from their customers one way or another.
Opening an Account: What Are the Minimums?
Many financial institutions have minimum deposit requirements. In other words, they won't accept your account application unless you deposit a certain amount of money. Some firms won't even allow you to open an account with a sum as small as $1,000. Some newcomers don't require minimum deposits, but often they lower other costs, like trading fees and account management fees, if you have a balance above a certain threshhold.
Investing in stocks can be very costly if you trade frequently, especially with a small amount of money available to invest. If you're broker charges commission fees, every time that you trade stock, either through buying or selling, you will spend extra money. Trading fees range from the low end of $5 per trade, but can be as high as $10 for some discount brokers.
Remember, a trade is an order to purchase shares in one company – if you want to purchase five different stocks at the same time, this is seen as five separate trades and you will be charged for each one.
Now, imagine that you decide to buy the stocks of those five companies with your $1,000. To do this, you will incur $50 in trading costs, which is equivalent to 5% of your $1,000. If you were to fully invest the $1,000, your account would be reduced to $950 after trading costs. This represents a 5% loss before your investments even have a chance to earn a cent!
If you were to sell these five stocks, you would once again incur the costs of the trades, which would be another $50. To make the round trip (buying and selling) on these five stocks would cost you $100, or 10% of your initial deposit amount of $1,000. If your investments don't earn enough to cover this, you have lost money by just entering and exiting positions.
Mutual Fund Fees
There are many fees an investor will incur when investing in mutual funds. One of the most important fees to focus on is the management expense ratio (MER), which is charged by the management team each year, based on the amount of assets in the fund. The MER ranges from 0.05% to 0.7% annually and varies depending on the type of fund. But the higher the MER, the worse it is for the fund's investors.
It doesn't end there, however. You'll also see a number of sales charges called "loads" when you buy mutual funds.
In terms of the beginning investor, the mutual fund fees are actually an advantage relative to the commissions on stocks. The reason for this is that the fees are the same, regardless of the amount you invest. Therefore, as long as you meet the minimum requirement to open an account, you can invest as little as $50 or $100 per month in a mutual fund. The term for this is called dollar cost averaging (DCA), and it can be a great way to start investing.
Reduce Risk with Diversification
Diversification is considered to be the only free lunch in investing. In a nutshell, by investing in a range of assets, you reduce the risk of one investment's performance severely hurting the return of your overall investment. You could think of it as financial jargon for "don't put all of your eggs in one basket."
In terms of diversification, the greatest amount of difficulty in doing this will come from investments in stocks. This was illustrated in the commissions section of the article, where we discussed how the costs of investing in a large number of stocks could be detrimental to the portfolio. With a $1,000 deposit, it is nearly impossible to have a well-diversified portfolio, so be aware that you may need to invest in one or two companies (at the most) to begin with. This will increase your risk.
This is where the major benefit of mutual funds or exchange-traded funds (ETFs) come into focus. Both types of securities tend to have a large number of stocks and other investments within the fund, which makes them more diversified than a single stock.
A Small Step Toward a Large Future
It is possible to invest if you are just starting out with a small amount of money. It's more complicated than just selecting the right investment (a feat that is difficult enough in itself) and you have to be aware of the restrictions that you face as a new investor.
The Bottom Line
You'll have to do your homework to find the minimum deposit requirements and then compare the commissions to other brokers. Chances are, you won't be able to cost-effectively buy individual stocks and still be diversified with a small amount of money. You will also need to make a choice on which broker you would like to open an account with. To make sense of all the different platforms, browse the different online broker and roboadvisor options in Investopedia's broker center.