Time
Once you have earnings coming in, expenses under control, emergency funds in place, and risk management addressed, it’s time for investment. You have your foundation. Now, build on it. Begin treating excess income as your future, not your present. Take advantage of employer retirement contributions. Treat substantial gifts and inheritances as investments, not as windfalls to promptly spend to improve your lifestyle. You can think about investing before you have your financial foundation in place. But once the foundation is there, build your future.
⤠ Bad money drives out good.⤟
Principles
Successful investing depends on following the right principles. As Opportunity may present itself through an employer retirement contribution, substantial gift, or inheritance. But you usually make your own opportunity by laying a sound financial foundation. The first principle of investing, then, is to consistently put yourself in a position to do so. Investing doesn’t just happen. You make it happen by executing a thoughtful investment plan built on your solid financial foundation. Then, invest early and often, as soon and often as you are able. The race goes to the tortoise, not the hare. And take the long view when investing. While the term for your individual investments like certificates of deposit may be six months to one year, treat every investment as part of your long-range goals. Take the long view of investing. Here are other principles that the book Warren Buffett Invests Like a Girl—And Why You Should, Too recommends:
avoid overconfidence in investing;
instead, exercise suspicion and even pessimism;
especially identify and manage investment risks;
constantly investigate, research, learn, and adjust;
avoid responding to peer pressure and herd behavior;
learn from your mistakes rather than repeat them;
don’t chase large short-term gains;
instead seek consistent gains over the long term;
make fewer and wiser transactions rather than more;
question the experts both to test opinions and learn; and
always act with integrity while expecting advisors to do the same.
⤠ Money in heaps disappears but gathered little by little grows. ⤟
Risk
Know the difference between investment risk and planning risk. Investments carry different degrees of risk, from high to low and everything in between. Diversification and allocation, discussed below, can help manage investment risks. Yet the larger risk is that our plans will not reach our investment goals. Investments go up and down. That market risk, though, is not the biggest risk you face. Your bigger risk is not to plan effectively, implement plans consistently, and assess and adjust those plans periodically to achieve your investment goals. The market is not your biggest challenge. You are your biggest challenge. Control that bigger planning risk. You are doing so by reading this book.
Capital
Do not treat investing as a necessary evil. Instead, celebrate that you are acquiring and directing capital to its higher and better uses. Earnest retirement saving and investment by individuals has subtly transformed and democratized the control and direction of capital. We are slaves to the whims of others until we own the means of our own production. Starting your business is one way of doing so, but saving and investment is another way. Individual investors now own about one third of total U.S. capital, largely through retirement accounts. That figure is on its way to one half or higher. Do a good thing for yourself, your family, and others. Work diligently, spend cautiously, give generously, save much, and invest wisely.
Diversification
Diversify your investments within and across asset classes. Hold a wide enough range of investments that you spread the risks of any single one of them. Diversify especially in asset classes. Asset classes include cash or its equivalents, stocks, bonds, precious metals, and alternatives like real estate and commodities. Diversifying asset classes helps you weather economic cycles, decreasing both volatility and risk. When one asset class goes down, another asset class goes up. Also diversify within asset classes. Don’t hold more than 5% of stocks or bonds in any single security. You might have wanted all your money in Apple stock when it went way up but not when it went way down. Diversify stocks. Yet also diversify market sectors. Technology, energy, manufacturing, transportation, utilities, banking, and other sectors perform differently at different times. Don’t get caught in sector cycles. Also diversify investment advisors, managers, and the timing of investments. Think of your total investment portfolio as a collage or kaleidoscope, not a monotone picture.
Allocation
Allocate your investments thoughtfully between asset classes. Diversification reduces risk. Allocation helps you achieve your investment goals through the best mix of different-performing asset classes. Your allocation should depend on your age and other circumstances. When you are young and able to earn a solid income over a long term, assume greater investment risk for greater growth, allocating to higher-growth, higher-risk assets like stocks. When you approach retirement or otherwise face short-term, uncertain, or declining future income, avoid investment risk by allocating to lower-growth, lower-risk assets like bonds. A common guideline is to invest your age in bonds and the remaining in stocks. At age 30, you would invest 30% in bonds and 70% in stocks, but at age 60, you would invest 60% in bonds and 40% in stocks. Gradually reduce risk as you approach retirement age. Reducing risk reduces growth but moves you toward a secure fixed income. Fixed-income assets include shorter-term bonds (especially stable corporate and government bonds), dividend-paying stocks (especially stable utility and similar stocks), and annuities.
⤠ Don’t be greedy for money. It’ll cost you everything. ⤟
Bonds
A bond is simply the issuer’s promise to periodically pay specific sums in interest plus a specific sum in principal at the maturity date. Because the bond has its own fixed principal amount and maturity date, you know how much you will get back and when. You could always hold the bond to maturity and get its face principal amount. If you wanted to sell it in the meantime, its price would depend on how its interest rate compares to market interest rates. When market interest rates rise, bond values go down, while when market interest rates decline, bond values go up.
Types
Both governmental entities and private corporations issue bonds. Investors once thought governmental bonds, known as municipal bonds or munis, to be the safer of the two bond classes. Governments have tax revenues and other revenues such as highway tolls and utility charges to back their obligations. In theory, the government can always tax more to pay accumulated debt, whereas private corporations must profit to repay debt, and private corporations have no profit guarantee. Yet some governmental entities today hold such massive debt that they make poor risks, in some cases receiving junk-bond ratings. Some municipal bonds also carry call risk (that the issuer will refinance due to declining interest rates and repay the bonds) or liquidity risk (that the holder will find no market to sell the bonds and will have to hold to maturity). Municipal bonds can nonetheless carry significant investment advantages because of tax-favored status. The federal government does not tax the interest on qualifying municipal bonds. Depending on state and local law, you may also avoid state and local income taxes on your municipal-bond earnings, particularly if they are from the state or locale in which you pay state and local income taxes. Their tax-favored status gives municipal bonds a natural advantage over corporate bonds and other investments on which you must pay federal, state, and local income taxes.
⤠ Both are good, but better to be wise than rich. ⤟
Rebalancing
Rebalancing means to adjust your portfolio as investments change. Rebalancing can increase investment returns while managing portfolio risk. Rebalance your asset allocation at least annually. Investors tend to buy investments that have already performed well for them. That practice over-concentrates investments in assets and asset classes. It also leads to buying high rather than low. If the asset has already performed well, then it may have appreciated above its value line and may soon fall, making further purchases of it unwise. Rebalancing naturally encourages investors to sell high and buy low over the long term. Rebalancing can be among your best investment tools. Do not procrastinate. Act consistently and decisively, and then go enjoy other things.
Erin had begun to accumulate funds in her 401(k) retirement plan both from her payroll deductions and her employer’s year-end contribution. One evening, she and Pat sat down to look at how they had invested those funds. The statement that had come in the mail that day showed 80% of her funds held in stocks and the other 20% in bonds. Erin was pretty sure that she had chosen a better balance, more like 70% stocks and 30% bonds, when she first opened the account at age 27. She and Pat checked their earlier statements, which confirmed that Erin’s stocks had made significant gains while her bond funds had fallen, throwing her portfolio out of balance. Time to rebalance and reap the reward of some of those gains, Erin and Pat decided. The financial-services company’s website showed evening hours. Following the age-in-bonds rule, Erin immediately called the toll-free number to redirect 35% of her total portfolio into bonds and 65% into stocks. The whole process took them about a half an hour, and they still had time for their evening walk.
Averaging
Another principle known as dollar cost averaging is that periodic small purchases of investments outperform one large investment purchase at one time, when the total amount invested is the same. Periodic purchases buy investments at their higher and lower price as their markets fluctuate up and down over time. Smoothing out or averaging the highs and lows with periodic purchases keeps you from buying in one lump sum at a high price and thus losing the appreciation. You eliminate the risk of timing market fluctuations, at which few of us are any good. When you set aside a monthly amount for investing, complete the investment purchase each month so that you gain the benefit of dollar cost averaging. Don’t accumulate funds to make a single lump-sum purchase. Instead, spread the purchase over several spaced transactions.
⤠ Spending is easy; saving is hard. ⤟
Returns
You have already seen that risk relates to return. No market open to others is at once safe and at the same time high in return. If you found a low-risk, high-return investment, other investors would also find it, rush to buy it, drive up its price, and drive down its return. Generally, the higher the risk, the higher the return, and vice versa. Choose the level of risk that matches your investment goals. Generally, choose higher risk when you expect to continue to earn higher income for some time. Then lower your risk as you expect your earnings to end soon, as you approach retirement, when you should have achieved your financial goals.
Volatility
Volatility differs from risk. The distinction is an important one that many investors miss. Volatility is an investment’s value variation around its average value. If the investment swings wildly back and forth around the average value, going way up and down with market swings, then the investment has high volatility. Low volatility means that the investment simply plods along quarter after quarter, year after year, close to its expected return. Volatility, though, does not always relate to risk. Some securities have both high risk and high volatility, like a small-cap start-up stock in a volatile sector like technology. The stock shoots up and down, as the company could go bankrupt on the one hand or get bought out at a handsome premium on the other hand, at any moment. You can also have a high-volatility, low-risk asset, like a safe government bond when investors anticipate broad rate changes, swinging the price.
⤠ Beware a jealous eye. Don’t desire another’s wealth. ⤟
Stability
Beware volatility. Avoid volatile investments. Choose the more-stable investments with lower volatility, even if those investments carry higher risk and thus higher growth potential. Lower-volatility investments tend over longer terms to have higher returns than higher-volatility investments, even when the two different investments average the same annual returns. The reason is that it takes more than a 20% rise to recover from a 20% fall, even though the two-year average return of that stock would still be 0%. A stock that goes down 20% from $100 is at $80, but the same stock that goes up 20% from $80 is only at $96, not $100. If you had invested in a less-volatile stock that only went down and up 10% rather than 20%, your stock would be at $99, not $96. Favor less-volatile portfolios. Accept risk for growth potential, but avoid the more-volatile investments. It’s harder to climb back up then it is to fall back down.
Increments
Play the small game. Value increments. Small increases in investments accumulate over time to make big differences in outcomes. A couple of percentage points difference between return rates can make for large differences in investment outcomes over a period of 10, 20, or 30 years. We all want big gains quickly. That’s not generally the way it works, not without big losses. Instead, be patient, when you know that you have arranged things to work in small but steady increments in your favor. Returns compound when not withdrawn.
Management
Beware management costs. Small costs accumulate, just like small increases. Paying an investment manager even as little as a couple of percentage points each year on your portfolio value can drive down your return rate over a long period, accumulating into substantial costs. Similarly, small transaction fees repeated frequently over a long time can drive down your returns, amounting to substantial costs. Investments requiring active management, like a securities account with a stockbroker, typically have higher costs such as an annual fee of 1.5% of the portfolio. Choose lower management costs in a larger fund shared with other investors. Alternatively, choose passive management with an index or exchange-traded fund. Keep costs low and effective returns higher, with simpler, shared, passive management.
⤠ Pay what you owe quickly, lest you lose everything. ⤟
Mutuals
A mutual fund spreads management costs among many investors. Mutual funds pool the money of many investors. The larger size of mutual funds also enables greater diversification. Mutual funds can manage hundreds of different securities. They can also offer either active or passive management. Active managers pick the stocks of companies that they believe will outperform the market, although at the cost of a management fee. Yet fewer active managers beat the market net of their active-management fee. The market beaters also tend to change from year to year. And to win with active management, you must pick the best managers and accurately predict that they will have a good year. Compare mutual funds and their managers. The Financial Industry Regulatory Authority (FINRA) provides online analysis of values and fees for over 18,000 mutual funds and related products.
Index Funds
Index funds are pooled mutual investment funds benchmarked to a market index like the Dow Jones Industrials, Nasdaq Composite, or S&P 500. When you invest in an index fund, you own proportional shares of all the securities in the index. Your investment thus goes up and down precisely with the overall market index. You’ve invested in the whole market rather than any smaller collection of shares in the market. Index funds do not require active management and thus have lower costs. Index funds can make sound and secure investments.
⤠ Sound character is far better than abundant wealth. ⤟
ETFs
An exchange-traded fund or ETF is another kind of mutual fund, similar to an index fund, except that an ETF trades on a stock exchange just like a stock. An ETF may hold any collection of securities in its portfolio, even broad collections like an index fund of a major market or a mix of different markets. Yet the ETF takes the form of a security itself, like owning a share of Apple. ETFs may hold any collection of investments but are often more attractive when tracking a major index or mix of indexes. Like a passively managed, index mutual fund, an ETF can be a sound investment vehicle.
Pat had a rich uncle who one day called, saying that he was giving Erin and Pat each $15,000 to do whatever they wanted with it. The generous gifts so impressed them that they decided to just hold onto the money until they were certain they knew what they should do with it. Rather than let the $30,000 sit in their savings account barely earning interest, they decided to put it into an index fund. At 33 years old, they figured that they would use the age-in-bonds rule to put one third in bonds and two thirds in stocks. They found an S&P 500 Index Stock Fund with an expense ratio of just .09% into which to direct $20,000 and a U.S. Aggregate Bond ETF with an expense ratio of just .10% into which to direct the remaining $10,000. It took them just a few days to make arrangements with their local bank’s private-banking unit to make these purchases, with the bank charging only a very modest one-time fee to open an account.
Classes
Consider diversifying asset classes within stock or bond funds. Economic trends can affect large and small companies differently. A healthy asset mix includes large-cap stocks in companies over $10 billion, mid-cap stocks in companies $2 billion to $10 billion, and small-cap stocks in companies under $2 billion. Cap refers to the company’s capitalization, calculated on the market value of the company’s outstanding stock (share price times number of shares). Economic trends can also affect public and private entities differently. A healthy asset mix might include both private corporate bonds and municipal or other government bonds, and short-term bonds, intermediate bonds, and long-term bonds. Economic trends also affect the U.S. economy and foreign economies differently. A healthy asset mix may include both domestic and global investments. Investment companies offer index funds and exchange-traded funds to address these mixes. In general, the more asset classes you maintain, the less volatility and risk.
⤠ Waste time, waste money. Waste money, waste time. ⤟
Alternatives
Asset classes go beyond cash, stocks, and bonds, to include alternative classes like real estate, precious metals, and commodities. Consider expanding asset classes once your investment portfolio grows beyond a modest level such as $250,000. Expanding into real estate does not mean that you must buy rental housing or commercial property. Expanding into commodities does not mean that you must buy a warehouse of aluminum or silo of corn. Investment companies offer index funds and exchange-traded funds for both real estate and commodities. A real-estate investment trust (REIT) acts like a mutual fund for real-estate investments. Investment companies offer REITs focused around shopping centers, office buildings, apartments, industrial or warehouse space, or other real-estate sectors. Small holdings of 3% to 5% in alternative assets can further diversify your investment portfolio. Investment principles for these alternative-asset funds are the same as for stock funds and bond funds. Diversify assets and management, peg risk to your investment stage, and keep management expenses and volatility low.
Advisors
Investors often retain investment advisors to manage investments. Sound counsel can certainly be helpful, especially for wealthier investors having complex portfolios. Yet turning your entire portfolio over to a manager can also result in significant fees. Broker commissions could add to the costs, reducing your effective return rate. A less-expensive alternative could be to pay for periodic investment advice while doing your own management and directing your trades through a discount brokerage firm. Doing so would save on fees and costs but take time, even if you stuck to maintaining mutual funds holding diversified stock and bond portfolios. Know your skills, time, and limits. In no case should an unsophisticated individual investor attempt to trade in individual stocks and bonds, which takes considerable time and expertise, and significantly increases risk. Consumer investors tend to decide more emotionally than rationally while also tending not to rebalance as circumstances indicate. Get help.
⤠ Work at what you have, not for what you don’t have. ⤟
Choosing
Financial advice can come in many forms and forums. Do not underestimate the power of small groups to inform your perspective on finances. Listening to someone else discuss their financial challenges, successes, and advisors in a group can give you a helpful perspective on your own finances and financial advisors. When you are ready to choose one or more individual financial advisors, though, you should have a sound process for doing so. Do not take the first recommendation you get from a friend or family member, especially when the friend or family member has poor finances or has just started with the advisor. The Wall Street Journal Complete Retirement Guidebook recommends these steps when retaining investment advisors:
look for Certified Financial Planner (CFP), Chartered Financial Consultant (ChFC), Personal Financial Specialist (PFS), or Chartered Financial Analyst (CFA) certifications;
look for memberships in the National Association of Personal Financial Advisors, Financial Planning Association, and Certified Financial Planner Board;
distinguish brokers, who sell specific products for fees, from investment advisers and planners, whose interests are in you rather than selling an employer’s profits and products;
respect candidates from small firms, local candidates, and candidates who have long-standing relationships with family and friends;
interview the best two or three candidates;
avoid candidates who promise high returns;
check candidates using the NASD website BrokerCheck and the SEC website Investment Advisor Public Disclosure link;
compare fees including commissions on individual transactions and annual management fees as a percentage of portfolio value.
529 Plans
Saving for your children’s college education is an important goal for many parents. The tax code’s Section 529 promotes education saving by permitting states to operate plans. Your state’s Section 529 plan would permit you to fund an account for a child or grandchild to use for college tuition, fees, books, and room and board. You do not manage the account. It grows at the same rate as other accounts in your state’s Section 529 plan. You may not deduct account contributions, but account earnings and qualifying distributions are tax free. The tax-favored status of Section 529 plans generally makes them a good vehicle for education savings. Section 529 plans generally do not limit your annual contribution amount. Yet contributions of more than the current $15,000 gift-tax limit may result in your child or grandchild owing gift tax. Don’t hold off on retirement savings in favor of college savings. Do both, not one or the other. Maximize your tax-favored retirement contributions, even while saving for your children’s education.
⤠ Give what you love, and it will return to you in heaven. ⤟
ESAs
Another type of tax-favored education account is the Education Savings Account (ESA). Your annual contributions to the ESA must be no more than $2,000 and are not tax deductible. But you retain control over investments in the account. You must designate a qualifying beneficiary for payment out of the account of tuition and other qualifying education costs. But in the case of an ESA (unlike a Section 529 account), you may designate yourself, not just children or others, as the beneficiary. You may also use the account to pay expenses not just of higher education but of primary and secondary education. Because the $2,000 annual contribution limit would make it difficult or impossible to fund a full college or graduate education for your children, many parents first fund an ESA to the annual $2,000 limit for each child and then fund Section 529 accounts to the extent necessary to accumulate full college funding, as their budget permits it.
Pat and Erin first thought seriously of saving for their two children’s college and graduate educations when both children were just entering grade school. A few other parents were already saving. That was when they decided to open two Section 529 accounts through their state’s plan. The plan’s website showed that the plan had been earning account holders reasonable returns. They learned that they could instead open $2,000 ESAs, but they wanted to do more to get the accounts started. So Pat and Erin divided the $30,000 that Pat’s uncle had given them, which through their investment had already grown to $36,000, into two accounts, one for each child. They added $2,000 out of their savings to each 529 account just for the satisfaction of starting each account with a round $20,000. They planned next year to sit down together to figure out how much they would need to add each year to fund most of their children’s education by their high school graduation. In the days and weeks that followed, Pat and Erin each realized that they felt a new bond for one another over the futures they were seeing for their children.
Target
The key to success for education savings, as elsewhere, is to fund early and often, whenever circumstances permit it. Choose the college you would like your child to attend. Determine its current tuition, room, and board. Multiply that subtotal times four years of college. That figure gives you a preliminary target. College costs may continue to rise at or above inflation. At a 4% annual rate of increase, your child’s college costs would roughly double from the child’s birth to college matriculation at age 18 years. So if you are estimating college costs at your child’s birth, then double those costs from today’s tuition, room, and board. Start saving now for that target. The sooner you save, the greater the investment return you should have on your savings, particularly if you gain the advantage of tax-free earnings through the above plans. As in so many things with finances, the earlier, the better.
Checklist
Reflect, research, investigate, and act until you are able to confirm each of the following statements summarizing the advice and counsel in this section:
I am investing or planning to invest as a means to control and benefit from more of my work productivity, to care long-term for myself and my family, and to share wealth as a legacy across generations.
I hold or plan to hold diverse investments that I allocate and rebalance intentionally to meet and secure my financial goals.
I know the costs and fees associated with the management of my investments and have favored passive management over active management to reduce those costs.
I seek out and listen to investment advice while making my own decisions on investments consistent with sound principles for long-term success and security.
I am saving or planning to save on a schedule that will pay timely for my children’s college education, taking due advantage of available tax-favored plans.