March 26, 2014 | Posted in: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.
- 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.
- 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.
- 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.
- 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.
Open a Personal Capital account today. It’s free and secure (and pretty to look at).
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.
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