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Getting started investing

Dear Dr. Don,
I am interested in investing in mutual funds. I am currently in college, and have been saving money to put into a mutual fund. However, I have no idea where to start and don't know when and if it's too early to start investing.

I plan on this being a long-term investment for my future, like for my children's college or a down payment on a house. Please point the way to get me started.
Thank you,
Amber Accumulate

Dear Amber,
It's not too early to start investing. The earlier you start, the easier it is to reach your financial goals.

First, decide what your financial goals are. You can have multiple goals -- most people do -- but you need to be specific about listing those goals. From a financial planning perspective it's important because you invest for short-term goals differently than you do for long-term goals. From a behavioral perspective, it's hard to reach a goal that you haven't defined.

Investing in financial assets means that you're choosing between investing in cash, stocks and bonds. The term cash is shorthand for liquid investments such as money market accounts and investments that mature in a year or less.

Stock investing is buying fractional ownership of a corporation. You can own shares of a company's stock or own shares in a mutual fund that owns the company's stock.

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When you invest in bonds you're lending money. With Treasury securities you're lending to the federal government. With corporate debt you're lending to companies, with savings accounts (such as CDs) you're lending to banks, and with municipal debt you're lending to state and local governments.

In general, invest in cash to meet your short-term goals. With long-term goals you can extend your investment horizon to include stocks and bonds. Saving for the down payment on a house can be a short-term to intermediate-term goal depending on the price of the house and how much you are able to invest.

You also have to decide between investing in taxable accounts or tax advantaged accounts. In a taxable account you pay taxes each year on the account's investment earnings while in a tax advantaged account the tax treatment of investment earnings depends on the provisions in the tax law for that type of account.

Coverdell Education Savings Accounts (CESA) and Section 529 College Savings plans are two tax-advantaged ways to save for your children's education.

Individual Retirement Arrangements (IRAs) are also a tax-advantaged way to invest. You'll need earned income to qualify for the IRA accounts or CESA and can't exceed income limits to contribute to these accounts. See IRS Publication 590, Individual Retirement Arrangements, for more information.

If you qualify, a Roth IRA would be a good place to start investing. With a Roth IRA you invest with after-tax dollars but qualified distributions are tax-free. These accounts allow you to take qualified distributions prior to retirement for education expenses and withdraw up to $10,000 for first-time home buyers.

The account has to be established for at least five years before you can use the first-time home buyer provision without paying the penalty tax on investment earnings. Talk to a tax adviser to make sure this approach is right for you.

Just starting out, transaction costs and administrative fees can really eat into your investment returns. If you have $3,000 to invest and the account has a $35 annual account fee, that fee will reduce the yield on your investment by more than 1 percent.

Avoid paying sales loads on mutual fund investments by investing in a no-load fund. Even when investing in no-load funds you need to know what the fund's annual expense ratio is because that will reduce the yield on your investment. Contact the funds directly to set up an account and you'll remove a layer of management (and expenses) by avoiding the need for a brokerage account.

A common mistake for people just starting out investing in mutual funds is to think that they need to invest in several funds. By choosing a diversified mutual fund you don't need to diversify across mutual funds.

A domestic hybrid fund can be a good choice as an investor's first mutual fund. A hybrid fund invests in stocks and bonds. The fund manager allocates between these two asset classes.

The fund selector on Morningstar's Web site can help you shop for mutual funds. That site also has free investing tutorials that will help you learn more about investing.

-- Posted: May 31, 2002

Read more Dr. Don columns
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See Also
Basics of Coverdell savings accounts
Setting up a Section 529 savings plan
More Dr. Don stories

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