Investing For Your Future

Unit 8: Investing with $mall Dollar Amount$

Earlier units in this course have discussed specific types of investment products (e.g., mutual funds) and various investment prerequisites. Unfortunately, and erroneously, many people think that they need a substantial sum of money to start investing. This is simply not the case. The objective of this unit is to demonstrate that investing is possible, even on a "shoestring" budget. Investing can be done with as little as $25 (e.g., a U.S. savings bond), and a variety of investments (e.g., Treasury securities, unit investment trusts, and many mutual funds) are available for an initial outlay of $1,000 or less. Once you’ve taken care of "the basics" (e.g., reduced household debt, purchased adequate insurance, and set aside an emergency reserve of at least 3 months’ expenses), you are ready to explore affordable investment options. This way, your money will earn a higher rate of return over time than a certificate of deposit or passbook savings account to help you achieve important financial goals. This unit will discuss investments that can be purchased for a thousand dollars or less and are suitable for beginning investors whose largest asset is their future earning ability.

Retirement Confidence Surveys conducted annually in recent years have found that over half of American workers said it was "reasonably possible" to set aside $20 a week for retirement. While this may not sound like a lot of money, over time it really adds up. At a 5% annual real rate of return, an investor would have $36,100 more than they would otherwise have in 20 years ($65,500 with a 10% return), according to the Employee Benefit Research Institute. In 30 years, the figures for 5% and 10% returns are $72,600 and $188,200, respectively, and, in 40 years, the figures are even more dramatic: $131,900 with a 5% return and $506,300 when $20 per week is invested to earn 10%. The take home message: small-dollar investments matter!

Getting Started: Investing Tax-Deferred

If saving for retirement is one of your financial goals, a good place to start investing is a tax-deferred employer retirement plan [e.g., 401(k)s and 403(b)s]. (See Unit 7, Tax-Deferred Investing, for more information.) Many employers require only a minimum deposit amount (e.g., $10) per paycheck or a low percentage (e.g., 1 or 2%) of pay to enroll.

In addition, almost 80% of 401(k) plans and about 30% of 403(b)s provide employer matching. For every dollar a worker contributes, an employer might contribute a quarter, fifty cents, or even a dollar. This is "free money" that should not be passed up, if at all possible.

If you’re already investing in an employer plan, consider increasing the amount contributed by 1% (or more) of pay. The most painless time to do this is when you receive a promotion or raise because you’re already accustomed to living on less and won’t miss the extra contribution. The extra savings (e.g., 2% of pay), combined with a pay raise, should be more or less "a wash." As chef Emeril Lagasse of the Food Network would say, "Kick it up a notch!" Over time, the extra amount of savings that will accumulate is impressive, especially for younger workers and workers at higher salary levels. According to Boston-based Advantage Publications, a company that produces financial education materials including a slide rule-type chart called the 401(k) Booster Calculator (1-800-323-6809), investing just 1% more of your pay can translate into tens of thousands of extra dollars by retirement age.

As an example, 1% of a $30,000 salary is $300 ($5.77 weekly). According to Advantage Publications, if a 35-year-old worker earning a $30,000 salary increases his/her contribution to an employer plan by 1%, he/she would have an additional $55,680 at age 65. This example assumes an 8% average annual investment return and 4% average annual pay increases. If the extra 1% increase also triggers an additional 1% match by their employer, this figure can be doubled to $111,360.

The beauty of investing in employer plans is that you are using pre-tax dollars. For every dollar you invest, Uncle Sam subsidizes this investment by that amount multiplied by your tax bracket. For example, if you contribute $1,000 to an employer plan and are in the 15% marginal tax bracket, your after-tax cost is only $850 ($1,000 - ($1,000 x 0.15)). In the 27% marginal tax bracket (decreasing to 26% in 2004-05 and 25% in 2006), the out-of-pocket cost is even less: $730 ($1,000 - ($1,000 x 0.27)). Most employers adjust workers’ withholding to reflect this tax savings, thereby freeing up more money in each paycheck to invest. In addition, taxes are deferred on investment earnings, which provides increased growth of principal over time.

If you don’t have an employer plan, or have "maxed out" contributions to an employer plan and are looking for another tax-deferred investment, consider an individual retirement account (IRA). The good news for IRA investors with small dollar amounts is that you don’t have to invest the maximum allowable contribution ( $4,000 in 2005-2007 and $5,000 in 2008 and thereafter, to be adjusted for inflation in $500 increments. Additional catch-up contributions are available for persons age 50 and older) all at once. You simply need to meet the minimum amounts (e.g., $250 or $500) required for the investments you select (e.g., a zero-coupon bond or mutual fund).

One way accumulate IRA money, for example, $2,000, by year-end is to open a "Holiday Club" at a local bank.  Simply deposit $40 weekly in a club plan throughout the year and you'll have $2,000 ($40 x 50 weeks) for an IRA deposit when the last coupon is clipped.  By 2008, you can put $5,000 a year in an IRA or $100 a week ($100 x 50 weeks).  As discussed in Unit 7, there are two types of IRAs: a traditional (deductible or non-deductible) IRA and a Roth IRA. To choose the IRA that will provide the highest amount of after-tax income, consult one or more "IRA calculators" on the Web site <www.rothira.com> or check with a financial advisor.

Buying Stocks With Small Dollar Amounts

Not too long ago, to build a diversified portfolio of stocks, you may have needed $30,000 to $50,000 or more. That was the cost to purchase a round lot of 100 shares of each of 10 or 12 different stocks at an average cost of $30 to $50 per share. Today, thanks to the popularity of investment clubs and the increase in both online trading and stocks that can be purchased directly from sponsoring companies, you can make a purchase for far fewer dollars. Making small stock purchases no longer has to be costly or embarrassing (e.g., asking a broker to trade a few shares), as it used to be. Direct stock investing today is easy and affordable.

As described in detail in Unit 9, Investing Resources, investment clubs generally assess members from $25 to $100 monthly, which is pooled to make club stock purchases. The amount of "dues" is decided by individual clubs based on the preferences of their members. Some investment club members also choose to invest additional dollars above the required amount. As for online trading (also discussed in Unit 9), several of more than 100 electronic brokerage firms in existence today require $1,000 or less to open an account, although a minimum of between $2,500 and $15,000 is typical. Stocks that can be purchased directly from participating companies often require initial investments of $1,000 or less, with subsequent investments (called OCPs or optional cash payments) of as little as $25.

Adequate diversification in a portfolio of individual stocks can, therefore, be achieved without spending a fortune. According to the National Association of Investors Corporation (NAIC), stocks can be grouped into 12 industry sectors. Consider the following example of an investment club stock portfolio that incorporates these sectors. The initial purchase of a diversified stock portfolio costs less than $3,000.

In this example, the total cost of these shares is $2,700. Add on the fees that most companies with stock purchase plans charge (e.g., enrollment fees and fees to reinvest dividends or buy and sell shares) and the cost is undoubtedly higher, maybe $3,000.

Finding quality companies with affordable minimum investment amounts can be a challenge for individual investors, as well as investment clubs. It may also take several years to develop a diversified portfolio like the one described above if minimum amounts of $500 or more are required. Fortunately, the number of companies that allow investors to purchase shares directly has increased in recent years. Well over 1,000 companies offer shareholder investment plans where dividends are invested in additional shares. Of these, dividend reinvestment plans (DRIPs) allow investors to make direct stock purchases only after they acquire an initial share elsewhere. Some companies offer direct-purchase plans (DPPs or "no-load stocks") where even the first share of stock can be purchased from the sponsoring company.

In addition to their affordability, another advantage of DRIPs and DPPs is a discount on the price of shares, which can help stretch limited investment dollars. Approximately one in 10 companies that sell shares directly to investors offer a 3% to 5% discount on initial purchases and/or OCPs. Of course, the quality of a company, and not a discount on its stock, should be your primary consideration. If you’re picking a quality company, however, it’s nice to be able to purchase stock on sale. An increasing number of DRIPs and DPPs also allow investors to set up IRAs, although an annual fee of $25 or $50 is generally charged.

DRIPs and DPPs appeal to investors who are willing to do their own research rather than consult a broker. There are several helpful references available for investors who wish to learn more about purchasing stock directly from issuing companies. Among them are the books No-Load Stocks and Buying Stocks Without a Broker by Charles B. Carlson and the Web sites <www.dripinvestor.com> and <www.dripcentral.com>.

Buying Fixed Income Investments
With Small Dollar Amounts

Fixed-income investments are securities that provide regular interest or dividend payments and, in many cases, a return of principal at maturity. Their primary objective is income with limited, if any, growth potential. As noted in Unit 5, Fixed-Income Investing, the rate of return on a fixed-income investment can be fixed throughout its holding period (e.g., bonds) or can fluctuate with the general movement of interest rates (e.g., Series EE U.S. savings bonds and money market mutual funds).

Most fixed-income investments, including all marketable U.S. Treasury securities (See Unit 5.) purchased since August 1998, require a minimum purchase of $1,000 or less. Formerly, $10,000 was required to purchase Treasury bills and $5,000 for Treasury notes with less than a 5-year maturity. Treasury bills are issued with maturities of 3 and 6 months and Treasury notes with maturities of 2, 5 and 10 years. All Treasury securities are backed by the "full faith and credit" of the U.S. government and can be sold prior to maturity in secondary markets. Periodic government Treasury auctions determine the interest rate earned by investors. Generally, the longer the maturity date, the higher the rate of interest a Treasury security (and all bonds) pay, because an investor’s money is "tied up" (subject to interest rate fluctuations and unavailable to invest elsewhere) for a longer period of time.

Interest earned on Treasury securities is exempt from state and local income taxes. Another characteristic is that, like all bonds, Treasuries are subject to interest rate risk (when interest rates rise, bond prices decrease and vice versa). Treasury securities can be purchased from a bank or brokerage firm with a $50 to $75 fee or directly from the Federal Reserve System’s "Treasury Direct" program at no charge. For additional information, contact the Bureau of the Public Debt at 202-874-4000 for the location of the nearest Federal Reserve Bank or the Web site <www.treasurydirect.gov/indiv/products.htm.

Corporate bonds are IOUs issued by for-profit companies and can also be purchased in denominations of $1,000.  (In the secondary market, corporate bonds can cost more or less than $1,000).  Like Treasury securities, investors deposit a sum of $1,000 or more and receive a fixed amount of interest at regular intervals, generally every 6 months. For example, an investor holding a corporate bond paying 7% interest would receive $70 in two semi-annual payments of $35. Barring any problems with company finances, bond payments continue until bonds are called or principal is returned at maturity (e.g., 30 years). Conservative investors should select "investment grade" bonds issued by corporations rated BBB or higher by a major rating service such as Moody’s or Standard and Poor’s.

Another type of fixed-income investment that can be purchased with a small dollar amount is a zero-coupon bond (a.k.a., zeros). These are bonds issued by certain levels of government (local, state, and federal) or corporations at a deep discount to face value. Unlike other bonds that pay semi-annual interest, zero-coupon bonds don’t pay out anything until maturity, at which time an investor receives the face value, generally $1,000. The table below illustrates the amount of money required initially to purchase a zero-coupon bond that will mature to $1,000 at different yields and maturities:

Table 1. Amounts Required to Purchase a Zero Coupon Bond With $1,000 Face Value

Note that, the longer the time horizon to maturity and the higher the investment yield, the less an investor needs to deposit up front to guarantee a return of $1,000 at a future date. Brokers often require a transaction with a $5,000 face value, however, so the amounts in the chart would need to be multiplied by five to determine the amount needed to invest initially. For example, a purchase of five 25-year zero-coupon bonds earning 8% would require an up-front deposit of $705 ($141x5), which would increase in value to $5,000 in 25 years. A disadvantage of zeros is that the "phantom income" (interest that increases the amount originally invested to full face value) is taxable each year even though this interest is not received until maturity. For this reason, zeros are often recommended for tax-deferred accounts (e.g., IRAs and Keoghs or SEPs for the self-employed).

Series EE and Series I U.S. Savings Bonds (See Unit 5.) are also well suited to those with small dollar amounts. Series I bonds are an inflation-adjusted savings bond introduced by the Treasury Department in September 1998. Like inflation-adjusted marketable Treasury securities that were introduced in 1997, the principal amount of Series I Bonds is adjusted semi-annually for inflation. I Bonds are available at most commercial banks and many other financial institutions.

Like Treasury securities, savings bonds are a debt instrument of the U.S. government and income earned is completely exempt from state and local taxes. They can be purchased in denominations ranging from $50 to $10,000. Series EE Bonds cost one-half their face value (e.g., $25 for a $50 bond) and I Bonds are sold at par (e.g., $50 for a $50 bond). Many employers also offer savings bond purchase programs via payroll savings, where bonds can be purchased with as little as $5 or $10 per paycheck.

Effective May 1, 2005, Series EE bonds pay a fixed rate of interest for the life of the bond based on interest rates in effect at the time of purchase.  Bonds must be held one year before being eligible for redemption and those cashed in before 5 years are subject to a 3-month penalty. For example, if an investor redeems a bond after 18 months, they will earn 15 months of interest.

Savings bond rates are announced each May and November for the following 6 months. Thus, the 6-month earning period for rates announced on May 1 is from May through October and, for rates announced on November 1, from November through April. Series EE bonds and I bonds earn interest for 30 years that is exempt from state and local income taxes. Special tax benefits are also available for Series EE bonds and I bonds cashed in for education expenses by qualified taxpayers.

Unit Investment Trusts:
Diversification For $1,000

Unit Investment Trusts (UITs) are a low-cost diversified investment product that can include either fixed-income securities (e.g., municipal bonds, Ginnie Maes) or stock. UITs are sold to investors by brokerage firms in small denominations called units. The cost of a unit is generally $1,000. The securities that comprise a UIT are professionally selected and of a similar type (e.g., investment grade municipal bonds with 30-year maturities). Unlike mutual funds, however, UITs are not professionally managed. Instead, the securities in the portfolio are simply held to maturity to generate interest or dividends, which are periodically distributed proportionately to investors. If a UIT includes bonds that are called (redeemed by the issuer prior to maturity), investors get back part of their principal early. When the last security in a UIT portfolio is redeemed, the trust ceases to exist.

UITs offer diversification at a low cost. For just $1,000, an investor can become part-owner of a portfolio of, perhaps, 30 municipal bonds that would sell individually for $5,000 and would require a total of $150,000 to purchase. UITs can also be used to purchase units of Ginnie Maes, which are portfolios of VA (Veterans Administration) and FHA (Federal Housing Authority) mortgage securities packaged by the Government National Mortgage Association (GNMA).

Ginnie Maes typically sell in minimum denominations of $25,000 so investing in them directly through a UIT makes them affordable for small investors. Investors in Ginnie Maes and Ginnie Mae UITs receive both interest and a return of principal as homeowners repay their mortgages. Distributions are generally paid monthly and the interest portion is taxable.

While originally developed as a vehicle to sell fixed-income securities, UITs have also been used to sell stocks. Common UIT stock investments are trusts that buy equal shares of the 10 highest yielding stocks that make up the widely quoted Dow Jones Industrial Average (DJIA) stock index (a.k.a., "The Dow Ten" or "Dogs of the Dow"). The "Dogs of the Dow" is considered a "value investing" strategy because it invests in out-of-favor stocks that offer better bargains among the 30 large company stocks that comprise the DJIA.

Like bond and Ginnie Mae trusts, "Dow Ten" UITs are packaged and sold through brokerage firms, generally in units of $1,000 each. Instead of having to spend upwards of $50,000 to buy 100 shares of the Dow 10 stocks, ownership can be achieved at a fraction of this cost. Of course, there is "no free lunch," and UITs of all types (stocks and fixed-income securities) also have their downside. The first drawback is brokerage commissions, which are generally 3% to 5% of the initial purchase. To amortize this expense over time, it generally makes sense to "buy and hold" a UIT until it is dissolved. UITs containing bonds that can be called also are subject to unpredictable distributions and reinvestment risk (the risk of having to reinvest principal at a lower interest rate).

Mutual Funds: A Shoestring Investor’s Friend

Mutual funds are a professionally managed portfolio of securities such as stocks, bonds, and real estate investment trusts that are sold to investors in units called shares (See Unit 6, Mutual Fund Investing, which deals exclusively with mutual funds.). The market price of fund shares fluctuates daily in response to market conditions and the performance of securities within a fund. Unlike UITs, mutual fund portfolios are always in a state of flux as securities are bought and sold. Unless they are closed to new investors, mutual funds are constantly receiving "new money" from investors and also must meet shareholder redemptions upon request.

The amount of money required to purchase shares in a mutual fund varies considerably. Some funds require an initial investment of $250 or $500 (or less), while others require $10,000, or even $25,000, to open an account. Like banks, mutual funds are free to set their own purchase and redemption policies. Unfortunately, many mutual funds with low initial minimums also have high expense ratios (the percentage of fund assets deducted annually for management and operational expenses). Therefore, in addition to the initial investment amount, fund expenses, objectives, and historical performance also need to be considered when making a selection.

What happens if you find a great fund but it requires more money than you have available? Don’t despair! In three instances, mutual funds typically reduce their entrance requirements to a more "shoestring" level. The first exception is for retirement accounts such as simplified employee pensions (SEPs) and IRAs. Some fund families lower the required deposit amount in order to build a long-term relationship with investors.

A second instance where initial fund purchase requirements are lowered are Uniform Gifts/Transfers to Minors Act (a.k.a., UGMA/UTMA or "custodial" accounts). These are accounts established for a minor child, generally for college savings. Once a child reaches the age of majority in their state (age 18 or 21), this money is theirs to do with as they please. Again, mutual funds that charge several thousand dollars to open a regular account may accept less for minors’ accounts. One well known mutual fund family, for example, typically requires a $2,500 minimum initial investment but only $1,000 for UGMA/UTMA accounts and retirement plans.

The third way to purchase shares in an otherwise "out-of-reach" mutual fund is to open an automatic investment plan (a.k.a., "sharebuilder" or "asset builder" account). Typically, this is done through direct deposit. On the application form, an investor authorizes a mutual fund to deduct a certain amount (often a minimum of $25 or $50) periodically from his/her bank account or paycheck, which is used to purchase fund shares. In addition to the convenience of not having to remember to write a check, this strategy also avoids the temptation of spending the money first (out of sight, out of mind).

Mutual funds, recognizing that they are encouraging a long-term relationship, generally provide a price break or waive their minimum account requirements completely for automatic investment programs. For example, one well-known fund family requires $2,500 to open an account and $250 for subsequent deposits. Investors who enroll in its "Automatic Account Builder"^SM investment plan still need $2,500 for a regular account, and $500 for retirement accounts, but only $100 for subsequent deposits, which can be made monthly or quarterly.

All-In-One Mutual Funds

What if you have money for only one fund and want to include several asset classes (e.g., stocks, bonds, cash)? Not a problem. This, too, can be done on a shoestring budget. The trick is to select a fund that invests in several asset classes and also has an affordable minimum. Three types of "hybrid" funds that combine asset classes are balanced, asset allocation, and life-cycle funds.

The key difference between a life-cycle fund and an asset allocation fund is that life-cycle funds include three or four "portfolios" with varying percentages of funds in each asset class. These portfolios are designed to fit investors of various ages or risk tolerance levels. An example is the Vanguard Group’s "LifeStrategy Portfolios." Investors have a choice of four asset mixes ranging from income (60% bonds, 20% stock, and 20% cash) to growth (80% stock and 20% bonds). Some life-cycle funds follow an asset allocation strategy indefinitely, while others (usually those with a future date in their title such as 2030) gradually become more conservative over time as investors get older. Some mutual fund families also offer "funds of funds" that invest in a combination of funds within their family. Two examples are Vanguard STAR ($1,000 minimum) and T. Rowe Price Spectrum ($2,500 minimum; $1,000 for IRAs; no minimum for automatic investment accounts).

Another way to obtain broad diversification with limited funds is to purchase an index fund. Index funds track the performance of a market benchmark such as the Standard & Poor’s 500 stock index. With limited funds for just one "core" fund, an investor might select a "total stock market" index fund that tracks over 7,000 large, medium, and small U.S. companies. Some index funds, such as those offered by Charles Schwab and ASM, can be purchased for $1,000. With extra funds, an investor can expand into additional index fund types (e.g., bonds, international securities) or into actively managed funds within these market sectors.

Let’s take a look at how a "shoestring" mutual fund portfolio might look. Let’s say that you have $2,000 to invest and your asset allocation mix is 10% cash, 30% bonds, and 60% stock. Within the 60% stock portion, you want to invest half in large company stocks and half in small company stocks. Your asset allocation might be as follows: $200 in a money market mutual fund, $600 in a bond mutual fund, and $600, respectively, in large and small company stock funds. With just $1,000 to invest, you’d place $100 in the money market fund, $300 in the bond fund, and $300 in each of the two stock funds. Of course, the trick will be finding specific funds that accept small deposits, but, as noted previously, this is often possible with automatic investing programs (i.e., DRIPs and DPPs).

Once a mutual fund account is established, resolve to add to it frequently using a strategy called dollar-cost averaging (See Unit 2 for details.). With this strategy, shares are purchased at regular intervals (e.g., monthly) with a fixed dollar amount (e.g., $100). Dollar-cost averaging takes the emotion out of investing because share purchases are made on a regular basis regardless of what is happening in the financial markets. In addition, most investors don’t have large sums to invest, but rather, small sums periodically as they earn it.

Summary

You don’t need a last name like "Gates" or "Trump" to become an investor. What you do need are investments that make it easy to get started with small dollar amounts. This unit has reviewed a variety of options ranging from tax-deferred employer retirement plans and IRAs to conservative U.S. Treasury and Series EE savings bonds to growth-oriented stocks and stock index funds. There’s no time like the present to become an investor. Follow the action steps and you’re on your way.

Shoestring Investment Comparison Worksheet

Action Steps

Check off the steps after you have completed them.

References

Carlson, G. (1998, Sept.). Budget funds. Mutual Funds, 50-51.

Clements, J. (1996, December 10). Strapped for cash? Mutual-fund firms make it easy for investors to get started. The Wall Street Journal, C1.

Clements, J. (1995, February 28). For novice investors on small budgets, there are plenty of ways to start out. The Wall Street Journal, p. C1

401(k) booster calculator (1997). Boston: Advantage Publications 1-800-323-6809.

Goetting, M. (1985). Investment alternatives for the beginning small investor ($1-$10,000). Montana State University Cooperative Extension publication 2P014.

Investing: Getting started with small amounts (1998, January). Money Matters, 2(1), 1, 7.

LaPlante, C. (1998). Wall street on a shoestring. New York: Avon Books.

No-minimum funds let you start with $1 (1995, April). Mutual Funds, 114-115.

O’Neill, B. (1998). Investing on a shoestring, class curriculum, Rutgers Cooperative Extension.

O’Neill, B. (1997). So where do I put that $2,000? Rutgers Cooperative Extension FS #883.

2002 (and 2001) Retirement Confidence Survey Summary of Findings (2002 and 2001). Washington DC: Employee Benefit Research Institute. Available online at www.ebri.org.

Updegrave, W. (1996). The right way to invest in mutual funds. New York: Warner Books.

Yakoboski, P., Ostuw, P., & Hicks, J. (1998). What is your savings personality? 1998 retirement confidence survey. Washington DC: EBRI Issue Brief Number 200.

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