There are a variety of investment options for a reason: they are not all suitable for all circumstances. In general, investments that may achieve higher rates of return come with greater risk of loss. In the instance of the stock market, those greater risks can be tempered, though not eliminated, by diversification and expanding your time-frame.
The easiest way for someone just starting out to diversify an investment in the stock market is through a mutual fund. A mutual fund is actively managed by professional investment experts who take a pool of investors money and buy several different stocks, and thereby reduce the investors risk of loss from one individual stock crashing. If you attempt to buy several different stocks on your own with only a few thousand dollars, the individual brokerage commissions that you pay for each transaction will significantly reduce the return on your investment, since those costs are proportionately much higher for small investments. On the other hand, if you have a great deal of money to invest, the commissions will not be a substantial fraction of your return, and mutual funds may have a lower return because the money managers charge annual fees, as well as transaction and short-term selling fees in some instances.
As with any investment, research the fund carefully. You may wish to invest in a few funds, to further diversify your investment among different market sectors. Beyond that, you are looking for a Morningstar rating above four (4), and historic returns over the past ten years of greater than 12 percent. A fund that does not achieve those standards is, generally speaking, not keeping up with the market as a whole, and you would be better off buying an “Index Fund” – a mutual fund that simply mirrors a leading industrial average, such as the Dow Jones or S&P 500. Of course, past investment is no guarantee of the same return in the future, and you should also evaluate whether a sector is “overheated” explaining high prior returns. For example, a fund of real estate companies may have excellent returns due to the housing bubble, but what are the odds that those returns will continue?
Given an investment horizon of greater than five years, a diversified investment in the stock market historically achieves the greatest safe rate of return – even if you have timed the market badly (buying during a peak, and selling during a market set back). A diversified investment in smaller capitalization stocks historically achieves the highest rate of return within the stock market – even on a risk-adjusted basis. The reason for this is simple – well-run smaller companies have more growth potential. G.E. is a great company, but it cannot double in value over two years because it is simply too large to do that – it would have to upset the world economy to do so. A smaller computer company, like Apple, by contrast, can multiply its value dozens of times over before reaching those physical limits.
The stock market can fluctuate greatly in the short-term. If you will need the money that you seek to invest in less than five years, a stock market investment comes with a substantial risk of loss, though also with a chance for greater gains. Whether you can weather those risks, seeking a higher rate of return, is a personal question that no investment advisor can fully answer for you. Your decision will depend on your own risk aversion and relative need for the principal at a given time. If you are saving for your child who will attend college next year, for example, the risk of losing necessary principal may outweigh the potential higher gains that you might achieve in the market.
Some alternatives to the stock market are each more reliable in the short-term, but come with greatly reduced returns. Bonds, Money Market funds, CDs and T-Bills are common examples. A good rate of return here is on the order of 4%, which is slightly above inflation – the hidden scourge to such investments. Each year, the power of a Dollar or Euro is eroded by inflation, so it is not enough to feel secure in your “safe” 4% return, thinking that 12% in the stock market is not much better. Because of inflation, the real difference is closer to a 1% return for fixed instruments versus 10% for the stock market. Over thirty years, a regular $10,000 per year investment will generally differ by hundreds of thousands of dollars between these two investment vehicles.
Finally, you should consider the tax consequences of the investment account, and, in some instances, the specific investment that you choose. In the United States, if your time to retirement is greater than 30 years, a Roth IRA will provide the best tax shelter and ultimate yield. With a time horizon less than that, an ordinary IRA or 401K plan (if offered by your employer) generally will be superior,and will reduce your current tax bite. If you can spare the money, you may wish to do both – but your circumstances may be such that you need the money now. IRAs lock the money away until you are 65, unless you are willing to pay severe penalties for early withdrawal. Again, no tax advisor can answer the question of your current need for capital. If you are investing in fixed instruments, municipal money market funds may be tax free and, though they offer lower pretax returns, their post-tax returns are greater.
Parents may also take advantage of a tax free college savings plan (a.k.a. a “QTIP plan”), under section 529 of the IRS code, to invest for their children’s future.
For further reading, see http://www.irs.gov/publications/p970/ch08.html.