Tuesday, March 17, 2009

I'm in the High-Fidelity First Class Traveling Set

After you have paid off your debt and built up your emergency fund, the next step will have you entering the elite high-roller class: the investor. It's a little intimidating; you see those business people reading the Wall Street Journal and money magazines, and wonder how you're ever going to understand what stocks to buy and what to skip.

The good news is, you don't have to! It's actually a simple process. First, ask yourself whether you should be in stocks and bonds to begin with. If you're reading this post in the future, remember 2008: will you be OK if you lose half of your money in a year? If you're like me and have many years until retirement, then the answer is "yes". If the answer is "no," then consider putting less money into stocks. If the answer is "absolutely not," then steer clear.

After deciding that you want to go in, then just remember this: never buy an individual stock. Never buy an individual bond. It's easy to focus on the Microsofts and the Googles out there, and daydream about how rich we'd be if we invested in them at the beginning. But we don't think about the hundreds and thousands of companies that went bankrupt, leaving their shareholders nothing.

What you want to do is buy a mutual fund: a collection of stocks or bonds that is managed by another company. A mutual fund can still go up and down, but it won't become totally worthless: some companies will do well, others will do poorly, and the fund as a whole will average out.

There are a dizzying number of mutual funds out there. Almost every one has a focus, which might be an abstract investment strategy like "Growth" or "Value", or might be related to a particular area of the economy like Energy or Health Care.

Personally, I'm a big fan of "Index Funds." These are mutual funds that are designed to reflect the performance of a particular stock index, like the S&P 500, or the entire stock market. In other words, the people who run these funds don't try to guess which individual stocks will do well or poorly: they buy everything in the market. This has two benefits. First, your results will be in line with how the market as a whole goes. By definition, half of the investors will do better than the average and half will do worse than the average, so you're in a relatively safe place. Second, account fees are generally much lower for index funds than they are for actively managed funds. Because other people are paying higher fees than you, you're actually doing better than the average! In a field that's notorious for its unpredictability, that's an enviable position to be in.

Stocks are sometimes referred to as "equities". This means that when you buy stock, you actually OWN part of a company. Over the long run, you'll probably earn more from owning a range of companies than you will lending to them. Historically, the long-term average return of the stock market has been around 8%. If your investment timeframe is very long, it'll be hard to find any other investment that can offer you that kind of return.

That being said, even if you have several decades until retirement, you shouldn't just buy the Total Stock Market Index Fund and be done with it. (There are far worse decisions, but it isn't the best.) The key is diversification. By picking a stock index fund, you've diversified the specific stocks you've picked. By picking a bond index fund as well, you can diversify the type of investment you're making.

In some ways, bonds are a little bit like a certificate of deposit. You lend some money to a company or a government, instead of to a bank, and in return will earn a fixed amount of interest for a specified number of years, after which time you will get your money back. The biggest difference between the two is that CDs are federally insured, while bonds are not. If a city or company goes bankrupt, their bonds may become worthless. (Bondholders are paid before shareholders, though.) Because of this risk, they need to pay more money than CDs do in order to attract investors. Additionally, government bonds may allow you to deduct money on your taxes.

As with stocks, you don't want to buy in individual bond; it would be horrible to loan money to the next Enron or Circuit City. Instead, get a bond fund. This is a giant collection of money that invests in bonds. Unlike individual bonds, you can buy or sell the fund at any time. Like a stock index fund, the bond index fund will be an average of every bond's performance.

Bonds aren't a totally safe investment; even an index bond fund can go down, and most did in 2008. But in general they are much safer than stocks. They don't earn as much money, and at the same time, they won't lose as much money. As you get closer to retirement age, and start shifting to be a more conservative investor, you should start taking on more bonds and fewer stocks.

Does all this seem complicated? It is, kinda. Fortunately, there's an excellent solution out there. Funds called "Target Date" or "Lifecycle" funds are sort of meta-mutual funds: funds that are made up of mutual funds representing stocks, bonds, and other investments like TIPS. Each fund is oriented towards a specific "retirement date". So, if you plan on retiring in 2025, you can invest in the 2025 target date fund. Over the years, the fund will automatically shift investments from a more aggressive to a more conservative mix. And, since they're generally made up of low-cost index funds, the charges are usually very low. You don't need to worry about anything; just make your contributions, and let the fund do its work.

In the interest of full disclosure, here is my current setup. I'm a fairly young professional with a few decades until retirement. In my rollover IRA and Roth IRA, I am 100% invested in my Target Date Retirement Fund (from Vanguard). My 401(k) does not offer this fund. There, I am 80% invested in the S&P 500 Index Fund, and 20% invested in an international mutual fund. If my 401(k) offered a Total Stock Market Index Fund, I'd be in that instead, but the S&P 500 is still pretty good. I really should include a bond fund - the rule of thumb is to have a percentage of bonds equal to your age in years - but I have a very high tolerance for risk, so I'm going all out for maximum long-term earning.

Outside my retirement accounts, I do have some discretionary savings invested in a Vanguard Total Stock Market Index Fund. I bought into it over a period of about a year, when I was thinking that my next major expense would be a down payment for a house, and that it would be more than five years before I would be purchasing. Now, I am starting to look at possibly purchasing within the next year, but will most likely not be tapping that account, just because of how far it has declined.

There! Hopefully that sheds a bit of light on the world of equity investment. And frankly, a little light is all you need. The less you try to be clever about stuff, the more successful you will be.

And that, ladies and gentlemen, concludes the primary portion of this series on money management! It was a lot of fun to write. I doubt it was nearly as much fun to read, but thanks for sticking with it! I have a few one-off topics in mind for the next few weeks, after which time I will write as things occur to me or upon request.

In review, here are the take-away messages I hope everyone got.
0. Before you start even thinking about money, decide what is most important in your life.
1. Your career is probably the largest contributor to your income, so carefully consider whether it will help you achieve your goals.
2. Take control of your spending by keeping track of where your money goes and making decisions about your priorities.
3. Keep your money in a checking account, paying bills off as they come in.
4. Focus on paying down your debt and building up an emergency savings account. Then try signing up for a retirement account, start funding that, and begin putting aside money for future purchases.
5. Debt is bad. Unavoidable, but bad.
6. Keep money that you will need in the next few years in a safe investment.
7. Keep money that you won't need for many years in more lucrative, but well-known, investments.

The best part of all is, after you get the hang of it, you don't even need to think about it any more. Stuff runs on auto-pilot, and you'll be pleasantly surprised at how the money you never really looked at amasses over time.


I have absolutely no formal training whatsoever in money matters. The last financial class I took was a semester on micro- and macro-economics back in high school. I scored a 5 on the AP exam, for whatever that's worth. (Nothing!) Like I said at the beginning, take all money advice with a grain of salt, and consult a true professional before making important decisions.

Any expertise I may have, assumed or actual, comes partly from my real-life experiences, and even more from a few sources that I really trust. If you're interested and want to dive deeper into this world, I highly recommend the following.

"Smart and Simple Financial Strategies for Busy People." This really nails all the actual things we need to worry about. Not whether a particular stock is "Hot" or "Tired", but how to automatically transfer money to a retirement account, how to tell whether it's a good idea to buy a house, etc. This may be the only personal finance book you'll ever need to read.

"Marketplace Money." Man, I love this show. They're incredibly smart, humorous, wise, and timely. The show combines expert question-and-answer sessions, snapshots of various careers, in-depth (yet comprehensible) investigations into the economy, summaries of political and business news, and more. It has a permanent spot on my iPod podcast roll.

Kathleen Pender. I'm a bit biased - she's local - but she may be my favorite economic columnist. (Unless you count Paul Krugman, who I probably shouldn't.)

Go forth, save, and enjoy!

No comments:

Post a Comment