My 8-year-old daughter recently reminded me of a math riddle I remember from when I was a kid: "Would you rather have a million dollars right now, or one penny doubled every day for 30 days?" The answer seems pretty obvious at first blush--take the million bucks! Who wants a pile of pennies in a month?
But the math behind the penny doubling is surprising and kind of fun. On day 1 you have one penny; on day 2 you have two pennies. By day 10 you have a little over five bucks. (Is that million-dollar deal still on the table, or is it too late?) By day 20 you have around $5,000; by day 25 you have over $150,000. On the 30th day you have--wait for it--over $5 million.
Right off the bat, here's the bad news: You will almost certainly not find an investment that will compound at a 100% daily rate. But the good news is that time plus compound interest really can grow your money exponentially.
Let's say you receive $1,000 as a graduation gift. It's tempting to splurge. After all, spending $1,000 on an extravagance isn't exactly the same as squandering a fortune. But as my colleague Christine Benz advises in "7 Financial Tips for New Graduates," it pays to keep return on investment top of mind when making spending decisions.
If you had invested $1,000 in an S&P 500 index fund in May 1978, it would be worth about $78,000 today (assuming the fund was in a tax-sheltered account and you had reinvested the dividends). Though a far cry from the 100% daily gain we got with the pennies, our $1,000 investment in the S&P 500 fund gained a very respectable 11.5% annually over the 40-year period. This is where the old investing adage "save early and often" comes from: Giving your money as much time as possible to compound—even small contribution amounts—is a great way to build wealth.
I searched our fund and ETF coverage lists for great "starter" funds. If you are just beginning to dip your toes into investing and want to start out with a single fund, it's a good idea to focus on two things: broad diversification and very low expenses. We also looked for funds with low investment minimums, though if you are investing through an employer-sponsored retirement plan or via an online brokerage such as Fidelity or Schwab you may have access to share classes with higher minimum investments and lower fees.
Total Stock Market Index Funds
A fund that tracks a total market index such as the Wilshire 5000 can be a great choice for a low-maintenance core fund. Total stock market funds weight their holdings by market cap, and as a result, the portfolio tilts toward the largest U.S. stocks. Larger-cap stocks tend to be less volatile than smaller caps over a full business cycle owing to the diversification of their businesses and easier access to capital.
Total stock market index funds also have very little turnover and are tax-efficient as a result. These funds are well diversified, too; they hold over 2,000 stocks the top 10 holdings represent less than a fifth of the portfolio.
A target-date fund is really a wrapper that holds a mix of underlying funds. The underlying funds offer diversified exposure to a mix of asset classes such as equities (large caps as well as small/mid-caps), foreign stocks, bonds, foreign bonds, and maybe a small portion of cashlike securities. They are designed to be held throughout the accumulation phase, and the asset mix shifts dynamically, becoming less risky over a person's working career and into retirement. These funds achieve this by rebalancing portfolios over time to become less focused on growth (lowering their allocation to stocks) and more focused on income (raising their allocation to bonds) as the fund approaches and passes the target date. (The year in the fund's name corresponds approximately to the investor's retirement date.)
Gold-rated target-date fund series:
Karen Wallace does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.