Category: Investing

A Kick-in-the-teeth Guide to Investing

Most people aren’t rocket scientists when it comes to investing. I’m not either, but I know enough about it that hopefully I can teach you something about it in the next five minutes.

You need to know why you’re investing.

The first thing you need to do is develop a purpose for investing. Without this you’re just going to sock away money for no apparent reason. By developing a purpose you’ll provide yourself with motivation by knowing what you’ll get when you’re ready to start making withdrawals.

  • Do you want to retire decades before your peers?
  • Do you want to travel the world?
  • Do you want to start your own business?
  • Do you want to put your kids through college?
  • Do you want to sleep on a bed made of money?

Then, you need to develop a timeline. A timeline will help you understand when you’ll actually achieve your financial goals. Make sure they’re realistic and within your reach. You could then apply your timeline to each of your investing goals. “I want to retire in 10 years with $1,000,000″. This is a properly formed goal. Now you have to figure out how you’re going to get that Million bucks.

How much of your income should you invest?

I’m not going to answer this question. Instead, we can explore it a little bit, then you can make your own determination.

Let’s say your goal is to save $1 Million and you’ve decided that your timeline is 10 years. The market grows at about 8% per year (on average). And inflation eats about 3% of your money. This means that your money will grow at an inflation-adjusted rate of 5% per year on average.

By plugging in a few numbers into the MoneyChimp compound interest calculator you can see that you would need to invest $75,718.65 annually to reach your goal of $1Million within 10 years. Realistic or not, that’s for you to decide.

I will say that 20% of your take home pay is a good number to start with, but over time you should increase this amount as you become more efficient with your money. For example, I can safely invest 70% of my income every month, because I constantly exercise my ability to optimize my finances.

How to invest.

When I became debt-free I was pretty confused when it came to investing. There’s almost too much information out there and no one to simplify it. I’ll make it as simple as possible. If you’re a pro investor then feel free to not read this.

You’ve heard of stocks, bonds and mutual funds before. These may just sound like words with no meaning, but each of them has their specific purpose. Stocks are tiny portions of companies. If you own stock in a company then you own part of a company. Bonds are money that you lend organizations or governments who then pay you back over time for your investment.

I invest all of my money in either mutual funds or ETFs. These two things are pretty much the same thing, but have slightly different tax structures. Mutual funds and ETFs are ways of investing in many companies at once. They reduce volatility (extreme gains or losses), because your money is spread loaded to hundreds or thousands of companies.

Kick-Ass places to invest.

The following are my suggestions of where you should be investing your money.

  1. The first and least obvious place to invest is your 401k. This is an investment! You can invest $17,500 into your 401k this year which will shelter your money from taxes. You’ll have to pay taxes when you withdraw money, but your money will grow tax free. Pretty slick.
  2. Vanguard. Vanguard is the mecca of investing. All of their funds have extremely low expense ratios (explained in the next section). They have many index mutual funds and ETFs, as well. This means a computer picks the allocation rather than a human, which means you pay less over time. Open a Vanguard account today.
  3. Betterment. Betterment is great because they make investing extremely easy. They automatically allocate your money and create an instantly diverse portfolio for you. You don’t have to know anything to use Betterment. I’ve had an account with them for over a year now and it performs just as well as my Vanguard account. My personal Betterment returns since February 2013: 10.0% Open a Betterment account today.
  4. Prosper. Prosper is a way to crowd-source loans for people. Someone may want a $10,000 loan. As an investor I can buy a $25, $50, $100, etc portion of that loan. The borrower then pays back the loan plus interest. While this shouldn’t be the foundation of your portfolio, it can add some nice diversity. My personal Prosper returns since July 2013: 9.38%. Open a Prosper account today

Terms you should know.

There is a very limited portion of investor lingo that you need to concern yourself with. Most of the other stuff is meant to confuse you and to make Wall Street employees feel good about themselves.

  • Expense ratio – The cost of operation for a mutual fund or ETF. The lower the expense ratio the better. Vanguard’s average expense ratio is 0.19%. That means they take a small cut of your money every day. The industry average is 1.11%. That means other companies charge nearly 600% of what Vanguard charges you.
  • Active vs. Index – Active management requires a human being — or a team of human beings — to decide the allocation of a fund. It costs money to pay these people, who are essentially throwing darts and making educated guesses with your money. Index funds use spiders, or robots, to decide the proper allocation. It costs less because there’s no one expecting a paycheck. Index funds reflect the market more accurately.
  • Dividend – This is free money that is distributed to you for owning shares of a fund. Think of it like a thank you. This money then gets reinvested into the fund, which provides you more shares — shares that you didn’t have to pay for. You do have to pay taxes on dividends every year.

Taxable vs. Tax-Advantaged.

There are three main categories that I’ll cover here. They are the three that I currently use, and the ones that I personally recommend.

  • 401k / TSP / 403b – These three investment options are pretty much the same thing. You can invest up to $17,500 per year of your pre-tax money here. You can access this money when you’re 59 and 1/2 penalty free. You can access your money earlier, but you’ll pay heavy fees, so I don’t recommend it. You’ll pay taxes when you withdraw from these accounts.
  • Roth IRA – This is a way to shelter an additional $5,500 per year from taxes. You use post-tax money (money that you’ve earned that’s already been deposited into your bank account), and you never have to pay taxes on this money again. It grows tax-free and you can withdraw it tax-free. The same rule applies that you have to be 59 and 1/2 to withdraw penalty free. However, you may withdraw the contributions you’ve made penalty-free at any point.
  • Taxable investing – This is where you invest the money you want to touch before you’re 59 and 1/2. You’ll use post-tax money to invest. You’ll pay taxes on the dividends and interest they generate, AND you’ll pay taxes on any capital gains or losses (these are generated when you SELL shares).

How to apply these principles.

At this point you may still not know how to invest and that’s fine. Here’s an example so you it will become clearer:

You decided you wanted to start investing $500/month so you could reach your goal of having $75,000 in 10 years. You know that in 10 years you’ll still be under 59 and 1/2, so you decided to open a TAXABLE account with Betterment.

Betterment only asks you one question: What percentage of your portfolio will be stocks and how much will be bonds? You answer by saying 100% stocks, because you’re young and you can afford short-term losses.

You set up an automatic $500/month withdrawal from your checking account every month and BOOM, you’re an investor. That’s it. Since you can reasonably expect your account to earn 5% (inflation-adjusted) per year you should easily reach your goal.

How to track your investments.

The only thing that I use to track my investments is Personal Capital. They have a streamlined interface that shows the growth of your accounts and your net worth over time. It isn’t a budgeting site like Mint, although they do track your purchases automatically which is nice.

Personal Capital is a powerful tool that can help you find hidden fees in your investment accounts — especially the tricky ones that hide in your 401k.

 

Crap that I avoid.

  • I don’t listen to people who try to convince me they have a way to get rich by buying or selling stocks.
  • Penny stocks. The people that buy them are misguided, and are subsequently throwing away their money.
  • Up-and-coming sectors. I don’t buy into hype, and you shouldn’t either. Broad-based index funds ONLY.
  • Sensationalism. The market goes up and down. Big media blows this out of proportion in whatever direction it’s moving. Don’t listen to these people, they’re just sensationalizing the market for ratings.
  • Emotional investing. If you let your emotions get in the way of your investing, you’ll be heartbroken when your holdings slide and excited when they climb. Leave your emotions out of it, and let the stock market happen.

Not so Kick-Ass disclaimer.

You’re ready to start investing. You know what an index mutual fund is and what expense ratios are. You know that you’ll earn money in dividends and you know you should avoid penny stocks. Blah blah blah.

Now you need to understand that you might LOSE money when you invest. Like I said, the market goes up AND down. Be conscious of this from the beginning. This doesn’t mean you should be fearful. It means that you should remain confident even during market turbulence. Recessions are eminent, but don’t let that scare you — especially if you aren’t withdrawing your money for a few years.

Don’t get caught up in investment analysis paralysis

After Mrs. Moneyseed and I got married (about three years ago), we started aggressively paying off our debts. We owed about $60,000 between student loans, car loans, etc. We carefully mapped out a debt repayment plan, and figured out, pretty accurately, the date that we’d be debt-free. Once our debts were almost completely paid off I had a mini-meltdown, because I knew I wanted to, but didn’t know how to invest money. I understood the concept of investing, but I didn’t understand what the actual process entailed.

I was in a state of “investment analysis paralysis” that so many people are affected by, that leaves them penniless after long careers, because they didn’t know how to invest. What causes this state of do-nothing-ness? Confusion, for one. You’ll hear people throw around investment options like 401k, 403b, Roth IRA, Traditional IRA, 529 College Plan. You’ll hear other jargon like “Tax-Deferred” or “Tax-Advantaged”, and you’re supposed to know what any of this crap means? It’s about as confusing as trying to figure out the Matrix first-hand.

Investment analysis paralysis begins when you know you want to, or should be, investing money, but the sheer amount of investment options keep you from purchasing anything. What’s the best investment option for you? Who the hell knows! You could talk to 10 financial advisers and they’d tell you 10 different things. Though, there would be one similarity between all of these so-called experts, they’d all be trying to sell you something. They may want to help you succeed, but they want to line their pockets in the process.

There are also people who haven’t started investing yet, because they’re “too young to think about retirement”. I’m talking primarily about 20 and 30 somethings. Did you know that if you don’t invest your money when you’re in your 20s or 30s you’ll miss out on one of the most amazing mathematical phenomena in existence? I’m referring to compound interest, of course.

The younger you start investing, the less you’ll have to invest in your lifetime to “become rich”. Older folks in their 40s and 50s, in contrast, have to dump significant amounts of money into their investment accounts to play catch-up. Would you rather invest $100/month starting in your 20s or $1000/month starting in your 40s? The crazy thing is that you’ll end up with the same amount in the long-run, so why not take the path of least-resistance?

The two biggest misconceptions about investing are that it’s hard, and that you have to have tons of money to do it. Investing money is probably the easiest thing in the world. You log onto your investment account, click “buy” and select an amount of money to contribute. Boom. That’s seriously it. And you don’t need to be rich to invest, but it’s a good possibility you could become rich from your investments, you just need to start.

Primarily, I am an index mutual fund investor. What that means is that I don’t buy shares of companies like Apple, IBM, or Exxon individually. Instead, I’ll buy shares of a fund that may be comprised of a thousand different companies. Essentially, with mutual funds, I can invest in thousands of companies easily and pain free through one single transaction. All you have to do is figure out what sector you want to invest in, whether it be Energy, Health Care, Growth, or the S&P 500. It’s pretty standard for there to be minimum investment for purchasing a mutual fund, usually around $3,000. After that you can contribute as much or as little as you want. Pretty sweet right? It only takes $3,000 to be an investor. But, what if you don’t have $3,000?

What’s the bottom line to all of this? Doing something is better than doing nothing. You don’t need to know everything to start investing (you can learn as you go!), and you don’t need to have very much money to be an investor ($100/month). There are so many paralyzing factors that could make you hesitant to start investing, but when you realize how easy it is, you’re going to wonder why you didn’t start sooner.I can understand that most people don’t have $3,000 to put into an investment right now, so here’s something even better: Betterment.com.

With Betterment, all you need to do is pick your risk tolerance, then you can start investing with as little as $100 a month. I was pretty skeptical at first, but we opened a Betterment account to see what it was all about and so far it’s been pretty awesome. It’s completely hands-free and they barely charge anything (which is surprising for such a great service). I don’t care who you are, you can afford $100 a month. Even if you have debt, it’s a good idea to start investing, so you can take advantage of compound interest. The reason I say this is because debt isn’t affected by compound interest, but your investments are, which makes investing a much more powerful tool than debt payoff (even though you should pay down your debts as well).

If you have $3,000 to start investing today check out Vanguard. They have some of the lowest fees for mutual funds in the industry. If you don’t have $3,000 either save for a few months until you do, or head over to Betterment and set up an account.

Would you rather work 1920 hours per year or 8?

Preface by J. L. Moneyseed: When I thought to myself, “if I could have any other Financial Independence blogger do a guest post for my site, who would it be?” I really didn’t have to look very far, as I had been chatting it up with Mr. 1500 on Twitter for the past month or two now. He’s like the future version of myself. Him and his wife are both hysterical, and strive for what so many people will never really understand: Early retirement.

They may be pretty new on the Personal Finance blog-scene, but they are in no way newcomers to understanding how money works. Their out-of-the-box thinking is going to secure their rightful place as early retirees at the ripe old age of 43… No, I didn’t say 63. I said 43. Most people are just warming up in their early 40s, but the 1500s will be able to take a step back from the Rat Race and really live the life they deserve.

Now, open your minds (and hearts) to Mr. 1500 from 1500days.com himself:

I’m frequently asked about my investing moves and how I manage my portfolio, but there isn’t really much to say. At heart, I’ve always been a “buy and hold” guy. I put money in investments and then sit on them. At the beginning of every year, I set my 401(k) contributions at 75%. At that rate, it quickly maxes out and I don’t have to worry about it anymore.

Now that I share my finances with the world, I keep a tight record of all things financial. In the past, I wasn’t as diligent. I would enter my investment balances every January 1st. I’d make a couple entries during the year when something interesting happened and that was about it. I didn’t think much about it.

A couple weeks ago, I was going over some old records and discovered something that nearly made me fall out of my chair. I started 2012 with $391,000 and ended with $586,000, for a gain of $195,000. About $75,000 of this was from new contributions, so after accounting for that, my portfolio appreciated by more than $120,000. For the first time in my life, my earnings from investing surpassed the net income from my job.

I was amazed and have some quick thoughts about it before I get to the bigger lesson.

  • This didn’t happen overnight. I’ve been in the workforce now for about 15 years, consistently saving that entire time.
  • 2012 was a very good year for the markets, with the S&P 500 returning almost 16%. It’s much easier to go fast when you have a strong tailwind.

1920 hours or 8?
The really cool and important point is this: In 2012, I worked at my day job 1920 hours. Contrast that to the 8 hours I spent working on my portfolio. At least 7 of these were random checks of Mint to see how things were going. My money was working very, very hard for me.

I believe that Joe Average plans to spend 40 hours per week or a couple thousand hours per year working at his 9-5 until he hits the ripe old age of 62 or 67 or maybe even 70 if he is a bad saver and social security isn’t around in its present form. It is a way of thinking that the populace buys into that is sold to them with fear tactics from the mainstream financial media. Our consumer culture, encouraging people to buy, buy, buy, certainly isn’t helping either. However, it doesn’t have to be this way.

Go grab a dollar and look at it. What do you think of when you see George Washington or the Loon? I’m encouraging you right now to start thinking about that dollar in a different way. Every dollar has potential. Don’t think of it in terms of what it can do for you today; think about what it can do for you in a decade. If you spend that dollar on something, it is gone forever. However, put that dollar to work and just like rabbits or Tribbles, it will make more dollars. Put enough of them to work and in time, you will have a big pile of dollars making new piles of dollars. When those dollars produce enough new ones to account for your expenses, you are free. If you work from that point on, it is because you choose to.

When I discovered what my portfolio had done, I was so excited, I jumped out of my chair and told Mrs. 1500 about it. After discussing it for a while, she said something which I thought framed the situation perfectly:

Would your rather work for your money or have your money work for you?

I’ll take the latter any day of the week.

For me, it all comes down to freedom. I don’t have enough money to last for the rest of my life, so I have to give up almost 2000 hours every year to a job. However, it won’t be that way forever. I can almost hear my dollar pile getting bigger as I type. Soon, very soon, those little dollars are going to be doing all of the work. And I won’t have to.