If you have $500 left over at the end of every month, you can easily achieve millionaire status with a simple investing approach and a little bit of patience. If you simply match the historic stock market returns over the past 90 years -- returns that averaged 10% per year -- investing $500 per month will net you over $1 million in 30 years.
But it's one thing to understand the power of compound interest and dollar-cost averaging (we'll talk more about both later); it's another to develop a plan for how to take advantage of them. In this article, you'll learn some strategies for investing $500 a month and becoming a millionaire by the time you're ready to retire.
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Some prerequisites to investing $500 a month
Before you start investing your money in the stock market, there are a few things you should have in place.
Pay off your high-interest debt
Credit card debt, unpaid medical bills, and even some student loans can be a big drag on your finances, especially if the interest rates are in the double digits. The definition of "high-interest" debt will be different for everyone, but I'd consider anything above 6% worth paying off before you start investing.
The reason for paying off debt first is simple: It's basically a guaranteed return on investment. Furthermore, after paying off your debts, you'll have more money to invest every month since you won't be tied to making interest payments.
Here's the best way to put your $500 per month toward paying down your debts:
Organize all your debts from the smallest balance to the largest.
Pay the minimum amount on all debts.
Put whatever cash you have left over toward paying off the smallest balance.
Once you've paid off the smallest balance, start making bigger payments on the next-smallest balance.
Repeat until all of your debt is gone.
This is called the "snowball method." It's not mathematically optimal, but the psychological boost of paying off those smaller balances keeps people motivated to keep paying off their debt.
Set up an emergency fund
If you don't have anything saved for emergencies, it probably makes sense for you to establish some sort of emergency fund. It doesn't have to be big. You could start with just $1000 to handle common occurrences like unexpected car or home repairs, or unplanned but necessary travel. Most experts recommend three to six months' worth of living expenses, depending on your circumstances and risk profile.
The safest place to keep your emergency fund is in a savings account. It won't earn much return at today's interest rates, but it will provide the safety needed to reduce the risk of falling into debt or having to liquidate investments at an inopportune time.
It's worth taking the time to establish a solid financial footing before you start investing your savings.
Compound interest -- the most powerful force in the universe?
If you're interested in investing, you probably already know something about compound interest. But to make sure we're all on the same page, here's a simple example of how investing today will allow compound interest to grow your money tremendously over the next 30-plus years.
If you invested $500 and earned 10% over the next year, you'd have $550. That math is simple: 10% of $500 is $50.
Compounding interest means leaving that interest in the account, so that money you earned from interest last year can itself earn interest this year. So, in the second year, your $500 would earn $50 again, and the $50 in interest you earned the previous year would earn another $5, for a total of $55. You'd end the second year with $605. You'd earn another $60 the next year, and $66 the year after that.
Things really start to ramp up when interest is compounded more frequently. If instead of getting one big $50 interest payment at the end of the year, you got an interest payment every month, those payments could start accumulating interest sooner; you'd end up with even more money after a year.
Each compounding period, your cash pile will earn more and more interest. In the 30th year of our example above, your original $500 investment would earn you $793. That's more than the original investment! It's no wonder Albert Einstein supposedly declared compound interest the most powerful force in the universe.
While it would be great if you could count on 10% interest year in and year out from the stock market, the real world doesn't work like that. The market has its ups and downs every day, month, and year.
While the long-term trend in the market is to increase in value, it's impossible to know whether the market will go up or down in any given month or year. Using a simple strategy called dollar-cost averaging can help you navigate the ups and downs of the market.
Dollar-cost averaging simply involves investing a fixed dollar amount -- say, $500 -- on a regular schedule -- perhaps every month. That way you buy more shares when the market is down and fewer shares when the price goes up. In the end, your average cost basis will be below the market average, since you'll end up buying more shares at the lower price and fewer shares at higher prices.
Dollar-cost averaging can reduce the emotional response to investing. It's a simple plan to follow, and becomes relatively mechanical after some time. Some brokerage accounts even allow you to invest on autopilot, so you don't even have to think about it. Investors using dollar-cost averaging aren't constantly looking for a good entry point or second-guessing their purchases. They just repeat the process every month.
Developing a simple system that works is the key to sticking with a financial plan. Dollar-cost averaging is as simple as it gets.
The simplest way to invest $500 a month
For those who don't want to worry about things like asset allocation, rebalancing a portfolio, or the ability to access funds, there's a simple way to invest $500 a month. (Fair warning, this isn't the most efficient way of investing, but it's possibly the easiest.)
You can put that $500 each month into a target-date fund at any mutual-fund company like Vanguard, Fidelity, or T. Rowe Price. A mutual fund is a collection of stocks and bonds, typically controlled by a designated portfolio manager. Buying a share of a mutual fund means you're buying a portion of that fund's portfolio.
Target-date funds are special mutual funds with a target asset allocation based on your planned retirement date. The fund manager will automatically rebalance the portfolio to fit that allocation, with no need for the shareholders to make any changes. These funds can be great for people with time constraints, or who don't want to conduct more research than necessary.
To start investing in a target-date fund, just open a brokerage account and select the fund that corresponds with your target retirement date. Link your bank account information to fund the account, and you can even commit to automatically investing $500 per month in the same fund.
Some funds do have minimum investment requirements, but setting up automatic monthly investments usually drops those minimums well below $500 per month.
Investing in this way is dead simple, but you could end up paying more in taxes in the long run due to capital gains. Capital gains are the profits made on the sale of an investment -- and just as with the profit you make from your job, the government wants a share. In target-date funds, the portfolio manager may end up selling highly appreciated assets in order to rebalance the portfolio, creating capital gains. You'll likely be better off using a tax-advantaged retirement account for your investments.
A company-sponsored retirement plan could help you save even more
Many companies offer a 401(k) retirement plan for their employees, and some even offer an incentive for contributing. Often a company will provide a matching contribution to an employee's 401(k), equal to a percentage of the employee's salary.
For example, if you earn $50,000 and your company offers a 4% matching contribution, the company will match the first $2,000 you contribute to your 401(k). The percentage of your contribution that an employer will match typically ranges from 50% to 200%.
The 401(k) match is something you should be sure you never pass up. It's free money.
A 401(k) account usually has limited investment choices and relatively high fees. While those can cut into your returns over the years, a matching contribution will more than make up for the higher fees associated with the account. Such accounts usually include several target-date funds that should fit your goals, too.
You fund your 401(k) through payroll deductions. Simply talk to your human resources department and tell them you want to contribute $500 per month (or whatever amount you prefer); that money will go straight into your 401(k). This can make investing $500 per month a lot easier, since it removes a step for you once you have everything set up.
On top of the potential free money from an employer, 401(k) accounts are tax-advantaged. You can deduct contributions from your income taxes, so you'll actually be able to save even more, since the government will put some extra money in your pocket as well. Additionally, the funds in a traditional 401(k) grow tax-free, so if you end up buying or selling shares or the fund you invest in distributes capital gains, you don't have to worry about paying taxes on the growth of your shares. You'll only pay taxes when you withdraw funds.
Your employer might also offer a Roth 401(k). With a Roth, instead of taking a tax deduction on your income taxes for your 401(k) contributions, you pay taxes now, but then don't have to pay taxes on your withdrawals.
Which one is right for you -- traditional or Roth -- depends on your personal situation and expectations for the future. Practically speaking, if you expect your effective tax rate in retirement to be higher than your marginal tax rate today, you should use a Roth. Otherwise, choose a traditional 401(k). Traditional will work best for most people.
Use an IRA for more control
An individual retirement account (IRA) can provide even more control over your investments. IRAs also come in traditional and Roth flavors, and have the same tax advantages as a 401(k). Unlike 401(k)s, however, IRAs have a lot more investment options. Most things you can invest in within a typical brokerage account are fair game in an IRA as well; that means you'll have your choice of funds.
If you're planning to save $500 per month, however, you'll run into a slight issue. The maximum contribution to an IRA in 2018 is just $5,500. You'll have $500 left over at the end of every year that won't fit into your IRA unless you qualify for an extra $1,000 in catch-up contributions (for investors age 50 or older).
The extra $500 can go into a regular brokerage account, but it adds a bit more complexity to the plan. The IRS does occasionally raise the contribution limits on retirement accounts to account for inflation, so you may be able to eventually contribute the full $6,000 per year to your IRA.
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The disadvantages of retirement accounts
The biggest drawback of investing all of your money in a retirement account like an IRA or a 401(k) is that you'll have limited access to your funds. IRAs don't allow you to withdraw your funds without penalty until age 59 1/2. While 401(k)s have a similar rule, they could allow you to access your funds as early as age 54 if you separate from service during the calendar year you turn 55 or later.
There are some ways around the withdrawal rules, such as using substantially equal periodic payments, or just paying the 10% early withdrawal penalty. But for the most part, you shouldn't expect to access those funds before retirement age.
Roth accounts are a little different. You can withdraw your contributions to Roth accounts at any time, penalty-free. The gains on your investment are still locked up until you're 59 1/2, though. If you convert funds from a traditional IRA to a Roth IRA, the amount converted is available for withdrawal after five years.
Another potential disadvantage of 401(k) accounts is that yours may have a poor selection of funds to choose from, and the fees on the account may be relatively high. Still, it's worth investing in them for the employer match, and you can roll over the funds into an IRA when you separate from service.
For the optimizers
For those who want to go beyond target-date funds, choosing a few index funds yourself can save a little money in the form of reduced expense ratios. The expense ratio is the percentage of your investment the fund company keeps for itself in exchange for managing the funds. The average expense ratio on a target-date fund is 0.44%, compared to 0.09% for simple index funds. And that 0.35-percentage-point difference compounds heavily over time.
Target-date funds are simply made up of several index funds that get rebalanced on a regular schedule, so each fund accounts for a certain target percentage of the portfolio. An index fund is a simple mutual fund that tracks an index by buying every security in the index. For example, an S&P 500 index fund will own shares of the 500 U.S. companies listed in the S&P 500 index.
Each target-date fund will tell you what index funds it's investing in and what the target allocations are. You should also be able to find the fund company's planned glide path for its target-date funds. A "glide path" is the plan for changing the asset allocation over time as you move closer and into retirement.
Since you'll be adding money to your account every month, you can allocate it in such a way that your portfolio remains closer to the target asset allocation, without having to sell shares of one fund to buy shares of another and rebalance. That will minimize your capital gains taxes, on top of saving you from the higher expense ratios associated with target-date funds versus standard index funds.
If you want to do even more research, and develop a proper asset allocation for yourself and your personal risk profile, you might achieve better results than the cookie-cutter plan for people retiring in 30 or 40 years that you'd get with target-date fund allocations. It's up to you to determine if a fraction of a percentage point in additional returns is worth the time it takes to do additional research.
A step-by-step plan
Now that you understand the basics of compound interest and dollar-cost averaging, the types of accounts available to you, and your investment options, here's a step-by-step guide for how to start investing $500 a month:
Open a brokerage account with the fund company of your choice, or enroll in your company's 401(k) plan. Do some research to find the target-date or index funds that best suit your style and have the lowest fees.
Provide your bank information to your broker, or fill out some paperwork at your company, and set up automatic $500 deposits every month.
Select the fund(s) in which you want to invest. If you're investing in a target-date fund, you can set up the $500 to automatically buy more shares of your fund of choice. If you're handling the asset allocation yourself, you probably want to buy shares manually every month anyway, so you can keep your portfolio balanced with your target allocation.
Investing doesn't have to be more complicated than that.
How much will $500 a month turn into?
At the beginning of this article, I told you investing $500 a month with an average return of 10% per year will result in a portfolio worth $1.14 million after 30 years. But the market might not continue to return 10%, and if you're investing in several different asset classes to reduce volatility, your results will, in all likelihood, fall short of the total stock-market returns over a 30-year period.
Here's how much you can expect to have at various levels of return (compounded monthly) by investing $500 per month.
Rate of return
After 10 years
Data source: Calculations by author.
It's also important to keep in mind that these numbers are in today's dollars. In 30 years, thanks to inflation, $1 million won't be worth as much as it is today.
Consistently putting money into the market on a regular basis -- even just $500 a month -- and investing in low-cost index funds is the simplest path to becoming a millionaire. Even starting from nothing, you can reach millionaire status within 30 years. And if you can ramp up that $500 per month over time to keep up with inflation, you'll get there even faster.
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