Join Friends on the Road to Financial Freedom

As many Americans plunge deeper into debt, some are looking for ways to educate themselves about investing and at the same time make some money. There may be no better way to achieve both goals than to gather friends and relatives and set up an investment club.

National statistics regarding savings and investing reveal a grim picture for the level of wealth building in the United States. In fact, according to the Bureau of Economic Analysis, the personal savings rate is negative -- meaning we are spending more money than we are saving. Additionally, only 49.7 percent of American families had a retirement account in 2004. However, the silver lining in this picture is a growing interest in investment clubs, especially over the last three years as stock market indexes have been steadily on the rise.

Today there are more than 35,000 investment clubs nationwide. Belonging to an investment club is not only a good way to educate yourself about investing, but it may actually result in higher investment returns. According to Consumer Reports, over the past 10 years investment clubs have equaled or outperformed the Standard & Poor's 500 index 80 percent of the time on average.

What Are Investment Clubs? How Do They Work?

An investment club is a group of people, usually 10 to 20 members, who pool their money together to make joint investments in the stock market. While the monthly contribution amount will vary club by club, the average is $84 per member, according to BetterInvesting, a nonprofit investment education organization that offers instructions on starting investment clubs.

Generally, investment clubs hold monthly meetings during which one or two people present a formal research report on a single stock or mutual fund for the club to consider. To move forward with an investment, members of the club vote. Usually, at least two-thirds of a club's members need to be present to vote on an investment, and a vote of 50 percent or more results in a "yes" for the investment.

What Are the Benefits of Investment Clubs?

One of the biggest benefits of an investment club is dollar-cost averaging, which is the practice of consistently investing money over time regardless of market conditions, thereby reducing your risk.

Additional benefits include:

  • Increased financial literacy
  • Access to more investment choices
  • Lower fees/commissions due to the larger size of purchases
  • Investment diversification
  • Wonderful way to spend time with friends and family

What Is the Best Way to Set Up a Club?

If you are interested in starting an investment club, you are probably not alone, so start networking with friends, family and colleagues to determine who might share a similar interest. Your goal should be to gather a group of at least six people but no more than 20. If your group is too small, you may not have enough money to pool together each month for a diverse set of investments. If the group is too big, you may have trouble reaching consensus regarding investment options.

Once you have a good group, get together for a preliminary meeting to discuss your goals, investment interests and guidelines for how the club will be run. Factors to consider include monthly contribution amount; meeting frequency and format; club officers and responsibilities; club name..

BetterInvesting is a great resource for information (www.betterinvesting.org). BetterInvesting currently has 161,670 members and more than 16,174 investment clubs, with a total portfolio value of $117 billion. The organization provides administrative services and excellent educational material for investors, as well as a low-cost stock purchase plan to further ease the purchase of common stock.

Once your club guidelines have been agreed upon, you will need to select a broker. Whether you choose a full-service brokerage firm or a discount brokerage firm will depend on your club's objectives and needs. Once a brokerage account is established in the name of the club, you will need to make an initial lump sum contribution to get the account rolling.

Are There Any Legal or Tax Issues to Consider?

You must absolutely consider tax issues. First, every club must have an employer identification number (EIN) to use when filing its tax return. To apply for an EIN, you need to complete Form SS-4 (Application for Employer Identification Number), which can be obtained online at www.irs.gov or by calling 800-TAX-FORM (800-829-3676).

How the club is structured also plays an important role in how taxes will be paid. Generally, investment clubs are set up as a legal partnership or corporation. In a partnership, the club itself is not liable for taxes; rather, the individual members are. But with a corporation both the members and the club are responsible for taxes. For this reason, many clubs opt for the partnership route, with each individual member of the club sharing equal responsibility of the management, profits and/or losses. In the eyes of the Internal Revenue Service, the partnership is seen as its own entity and therefore must file a special form, Form 1065 (also known as a Schedule K-1), with the IRS. Each member of the club must report on their individual tax return their share of the club's income or losses.

There are other tax nuances to consider as well, so consulting with a tax adviser may help to ensure you are filing taxes appropriately.

Mellody's 5 Tips for Starting an Investment Club:

1. Set guidelines upfront. It is critical to establish rules regarding club governance -- such as how much each individual member will pay; responsibilities for each member as it relates to investment research, taxes, administration; the process of researching and deciding upon a stock or mutual fund for investment; and the schedule of meetings -- from the start. Keep in mind this is not a book club. All members need to be fully committed to the purpose of the club, not fudge their way through the meetings like you might with a book club discussion.

2. Enroll with BetterInvesting. BetterInvesting offers an easy and safe way to manage all the back office administration. It also provides useful resources for individual investors and investment clubs alike.

3. Choose wisely. It is not only important to choose your investments wisely but also to select the members of the club with just as much caution. You want to make sure that all are equally committed and on the same page regarding their expectations of what they hope to gain from the club. While you do not need an entire club of Warren Buffet disciples, it is critical that everyone is active and engaged in investing.

4. Keep at it. Investing is a long-term pursuit. It is impossible to time the market and to pick winners all the time, so make sure your club agrees to stay the course and weather the market's ups and downs.

5. Learn, learn, learn. The greatest benefit of an investment club is not necessarily the return on your investment but the gains you can make in terms of financial literacy. Use the club as a learning opportunity -- with real-world lessons you can pass down to your own children to encourage them to save and invest.

Mellody Hobson, president of Ariel Capital Management in Chicago (www.arielmutualfunds.com) is "Good Morning America's" personal finance expert.

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