Again, your knowledge of investing is just about nil. You’ve heard about mutual funds through some of the TV ads, and you’ve heard about stock investing from that guy at work who is always bragging about his day trading but always seems to be borrowing money from you to put into the coffee fund. Is there an easy way to invest and keep that money for the future without needing to spend a lot of time reading and learning all of the nuances? Luckily, there is, thanks to mutual funds and their streamlined cousins, the ETFs. Here’s the minimum you need to know:
The first thing to do is to pay off your high interest bills and get a good emergency fund in place:
There are no investments that will provide a big enough return to overcome the 18%-24% that a credit card will charge. The first thing to do with a windfall is to pay off those bills and then cut up the cards so you won’t rack up a balance again. Then, put $10,000 in a checking account with a debit card attached. Use the account to cover the float (the money needed for the time between when you pay for things and when your paycheck comes in. This is what you used to cover with your credit card between the time you made the charges and paid the bill). If you ever find yourself spending down the account and not paying it back, cut back on lifestyle and save like crazy until it is replenished.
You need to invest where your money can grow:
While the bank is a great place to keep your emergency funds, you need to put your money in places where it will grow faster than inflation if you want to have that money around for all of your life while still deriving some income from it. When you invest, you put your money at risk, meaning that there will be times when the value of your investments will be less than the amount you paid for them, but if done right your investments will grow with time. This will ensure inflation doesn’t make the $1.00 you started with be worth $0.50 in twenty years, plus allow you to take some money out from time-to-time to do things to make your life better.
Time reduces risk:
If you were to simply buy a stock at random and hold it for a day, you would be taking the same risk as if you went into a casino and put the money on red or black. About 50-50. Because companies in general grow with time, because they attract more customers, grow more efficient at what they do, and add on outlets and product lines, if you hold for a long period of time you will generally see the value of your investment rise. The way to deal with the risk of random fluctuations in the price of investments and the many events that occur that you cannot predict, known as timing risk. is to invest for long periods of time. Just like waiting for a bus, you can’t always predict when it will come, but you know that if you wait long enough, a bus will eventually come along.
Diversification reduces risk:
While time reduces timing risk, meaning that if you wait long enough the random fluctuations that occur won’t matter, there is still the chance that a given investment will fail and disappear. Sometimes bad things happen to specific investments that are unique to that investment and the investment becomes worthless. This is called special situation risk. Last I checked, few people were using buggy whips, so holding shares of a buggy whip company for the last 150 years wouldn’t have done you much good even though you used time to eliminate timing risk. To guard against special situation risk, you need to diversify what you hold. This means having several different investments in several different things. Ideally these investments will be uncorrelated, meaning that just because one goes down does not mean that the others will do the same. For example, you could own an apartment in new York city that you rent out, a pizza restaurant in Tucson, and a set of bank bonds. Commonly for simplicity one would just buy different kinds of mutual funds, but to each his own.
Minimize your costs:
Costs must be paid whether your investment increases in value of decreases. Account fees must be paid. Taxes on income must be paid. Property taxes must be paid. Storage fees must be paid. The best investments are those where you minimize these drains that suck away your cash year-after-year.
So, the best investment plans will include an emergency fund and pay off credit cards, put your money where it can grow faster than inflation, utilize time to reduce eliminate timing risk, utilize diversification to eliminate special situation risk, and minimize costs. Here are some example investment plans to do just that:
Plan 1: Simple Growth: This is a plan that will put you on stable financial footing by putting an emergency fund in place and paying off risky debts, then allow your money to grow long-term at a high rate compared to almost anything else. Expect fluctuations in portfolio value from year-to-year, meaning there are years where it will decline in value (sometimes by 20-40%), but returns approaching 10-15% annualized for periods greater than ten years, meaning the value will double about every five to seven years.
Emergency fund: Put $7,000 into a money market fund and $5,000 into a 1-year bank CD.
Debt reduction: Pay off all credit cards, HELOCs, and second mortgages.
Investments: Place the remainder in the Vanguard Total Stock Market Index Fund.
Maintenance: Sell off shares of the fund periodically to pay taxes as needed, which should not be much. If desired, use up to 3% of the account value each year to add to your income. Note, this is the simplest of the portfolios to maintain and will generate the lowest tax bills unless you start selling off shares for income.
Plan 2: Current Income: Again it all starts by putting an emergency fund in place and paying off risky debts. The portfolio is then designed to provide current income to pay for day-to-day expenses. This portfolio gives up growth, meaning the income it produces will remain fairly stable and not grow with time in inflation-adjusted dollars. Expect fluctuations in portfolio value from year-to-year as well, with declines when interest rates rise of inflation spikes, but not as great as with the 100% stock portfolio. Returns approaching 6-8% annualized can be expected, meaning the value will double about every nine to twelve years if you don’t spend the income and reinvest it instead.
Emergency fund: Put $7,000 into a money market fund and $5,000 into a 1-year bank CD.
Debt reduction: Pay off all credit cards, HELOCs, and second mortgages.
Investments: Place 70% in the Vanguard Total Stock Bond Market Index Fund and 30% in the Vanguard Total Stock Market Index Fund.
Maintenance: Periodically (about once per year or two) shift money as needed to maintain the 30%/70% ratio (realize any gains will generate taxes here). Utilize the income from the bonds as desired, remembering to hold back enough to pay taxes on the income and any capital gains. The stock portion helps keep pace with inflation.
Plan 3: Moderate growth with moderate volatility: As always it all starts by putting an emergency fund in place and paying off risky debts. The portfolio is then designed to provide growth, but uses diversification into fixed income assets to reduce volatility and make returns more consistent. Adding an REIT (real estate) fund adds diversification. This portfolio gives up some growth for stability, but will still grow faster than inflation and produce more available income with time. Expect fluctuations in portfolio value from year-to-year, but not as big as with Plan 1. Declines of 10-30% are still possible, but on some years when the market is down into bear territory this portfolio will be down only a few percentage points. Returns approaching 8-10% annualized can be expected, meaning the value will double about every seven to nine years if you reinvest the income, only taking out enough to pay taxes.
Emergency fund: Put $7,000 into a money market fund and $5,000 into a 1-year bank CD.
Debt reduction: Pay off all credit cards, HELOCs, and second mortgages.
Investments: Place 70% in the Vanguard Total Stock Bond Market Index Fund, and 20% in the Vanguard Total Stock Market Index Fund, and 10% in the Vanguard REIT fund.
Maintenance: Periodically (about once per year or two) shift money among the funds, selling the winners and buying the losers to maintain the 70%/20%/10% ratio. Reinvest most of the income, only holding enough back to pay taxes on the income and capital gains. The stock portion will generate growth over time.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.