Basic Investment Vehicles, Part I: The What, How, and When of Investments

Below is a comprehensive (but certainly not exhaustive) choices of where you can put your money. I’ve also listed a time-horizon for when you should place your money in these investment vehicles. I also tried to talk a little bit about risk. Most young investors (under 40) should probably be heavily invested the last three choices.

Low-Yield Savings Accounts

The first interest-bearing account most people learn about. Most banks offer a small percentage of interest (usually no more than 2%). It’s also the lowest risk. Local bank Savings Accounts should actually be the place to store the majority your next-day funds if it is directly connected to your checking account (meaning if you have a Wachovia savings account attached to your Wachovia checking account). That way instant transfers are available and you can get the money quickly.

Note – notice I didn’t start with checking accounts—this is because the majority of checking accounts are NOT investment vehicles. In fact, you should only keep enough money in your checking account to stay above minimum-balance requirements and to cover everyday expense. Large balances in checking accounts do NOT help you.

Money market Accounts (MMAs), High Yield Savings and CDs

For the savvy folks out there these options are the superior place to put the majority of your money for the short-term (under 5 years). To repeat, these options present the SUPERIOR place to park your SHORT-TERM savings. If you plan to use your savings in the next 5 years, consider the following:

High Yield Savings (HYS) accounts (generally online) have little or no overhead and so are able to offer higher rates. You should generally only stick to rates with low or no balance requirements. In fact, many people associate/interchange MMAs with HYS accounts HYS are just glorified versions of MMAs (and usually, a more attractive option). The top 5 $1-or-less-minimum, no fee HYS accounts and their interest rates, according to this writing as of October 3, 2006 appear below:

1. UFB Direct (5.27%)

2. Amboy Direct (5.15%)

3. Grand Yield Direct (5.25)

4. Emigrant Direct (5.05%)

5. Citibank Direct (5.00%)

There is a lead time of about 2 business days to transfer your money. You should keep this in mind when allocating savings from everyday spending.

CDs (Certificates of Deposit) are like lending agreements. Basically you lend the bank some money for a certain period of time. After that time period is up, they give you the money back with interest. Generally (but not all the time), CDs offer the highest interest rate among low-risk investments. However (and this is big) the “risk” involved is more on you than it is with the bank. In a CD, once you put the money in it is agreed that you can’t take it out before the agreed-upon time period. If you do, there is a penalty that may even leave you with less money that you put in the account in the first place.

401(k)/IRAs

Finally, for long-term saving (more than 5 years), its best to consider the higher-risk, higher reward option that comes with your job. Most employers have a 401(k), which is a deferred-payment program and is a good introduction to investing. I highly recommend it. Many major companies require it and will auto-enroll you into their 401(k). Once you’ve set up your budget, this should be your primary investment vehicle. The earlier you start contributing to this program, the better off you’ll be.

So how does it work? You simply elect to set aside a portion of your gross pay into a series of mutual funds or company stock (or a mix of both). Usually the company leaves the allocation to you, but usually will have someone offer investment advice. However, they will leave the final decision up to you.

The 401(k) is tied to your place of employment. When you leave that particular company to work for another company (or yourself), you have some options. If you are satisfied with the investment holdings that company has (and you have more than 5,000 invested) you can leave it with the company, especially if the holdings your new company owns are not as attractive.

The other advisable option is to roll over that money into an IRA (Individual Retirement Account). Think of as a 401(k) that is not attached to the company. You get more freedom in how your money is allocated and to what funds are included. When you change jobs, the IRA can go with you, and no more rolling is needed.

What is NOT advised though, is to take the “cash option”—this is where people elect to simply take a check from the company they’re leaving. This is very bad because it will be subject to absurdly high taxes which can cut your savings SIGNIFICANTLY. First, there will be a 10% penalty if you take out the money before you’re 59 and a half. Then, you’re taxed in whatever bracket your income is in—so if the income is enough to be taxed at the 28% tax bracket, then that’s 10+28=38% of your money gone when you get your check. And unless you live in Texas, Florida, or any other no-income tax state, you will be subject to state taxes as well!

So save yourself the trouble. By rolling the money into an IRA, there’s no loss.

Some of the best reading and tips explaining the IRA in detail can be found at fool.com. Go here to find info on 401(k)s, and here to find info on IRAs.