Should You Buy Individual Stocks or Mutual Funds


 

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Many people say you should not buy individual stocks, and maybe they are right.  Buying individual stocks is radically different from buying mutual funds.  It takes a different mindset and it carries a completely different set of risks.  So what is the difference?

When you buy into a mutual fund, you are buying a large number of different stocks.  One of the most concentrated mutual funds you can buy is one that tracks the Dow Jones Industrial average (such as the DIA, or “diamonds”). which trades on the American Exchange.  In this case you are only buying into the Dow Jones Industrial Average, which includes 30 large, household-name companies.  There is also the Janus Twenty Fund that invests in just 20 stocks that the managers pick.  Otherwise, you’ll probably find that a listing of the holdings in your mutual fund will cover a few pages in the prospectus (a booklet that describes a mutual fund).   

Because you are buying so many stocks, your return over long periods of time will essentially equal that of the market in general, minus expenses, regardless of the mutual fund you pick.  Your return will be between 8-20% before expenses if you hold for ten or more years, and if you hold for more than  fifteen years, your return will narrow to between about 10-15%.  There will be years when you make 30 or 40% returns, and others where you’ll lose 20 or 30%.  On really bad years, you might lose 50% or more.  On great years, you might make 100%.

With a mutual fund, you’re protected against a single CEO making a big mistake and causing the company stock to lose 90% of its value.  You’re protected against choosing the wrong company and seeing your investment tread water while others are charging ahead.  You don’t need to spend a huge amount of time pouring over annual reports or earnings sheets.

Individual stocks are different.  Individual stocks routinely double in value or drop 50% in a year.  If you have only a few stocks, you may see your portfolio value change by  ten or twenty percent in a day.  There are also times when your stocks will fall in price even though everything seems fine at the company, or continue to rise for days on end without a clear reason why.  You might also see a company take on too much debt, misread the customers, or just become no longer needed and disappear entirely.  This doesn’t happen with mutual funds.

So why would someone buy individual stocks?  Again, most people shouldn’t.  Most people who try to trade individual stocks end up making much lower returns than the markets.  They buy too late, chasing the latest fads after the run-up has occurred, then hold on way to long as their stocks crash back down to earth.  Then they sell out, right at the bottom, when they should have been buying. 

Look at average returns, and you may see 3-4% when the market was making 15%.  For most people, if they would just buy index mutual funds (funds with low fees since they just buy whatever is in a particular stock index) and forget they own them, they would do much better.  In fact, everyone should do this for a portion of their portfolio if they have a portfolio of reasonable size (greater than $20,000, say).

There is a way to use individual stocks, however, for a portion of your investing that can allow you to beat the markets.  This is the way that Warren Buffett and Bill Gates made their billions.  You do it buy buying companies, rather than trading stocks.  Rather than worrying about the price of the shares and trying to time buys and sales to make a small profit, you find great companies and buy in for the long-term.  You plan to own them for the good times and the bad times as they grow and mature.  Twenty years down the road, they may be paying out as much in dividends each year as you paid for the shares.

This type of investing is very simple mechanically, but very difficult emotionally.  You need to be willing to sit there as your shares lose half of their value, perhaps buying more at the bottom.  There may be years when the markets go up 30%, but your company’s stock sits and does nothing.  The big gains are made in short bursts, with a lot of waiting in between.

Individual stock investing isn’t for everyone.  But for some, it can be the path to life-changing gains.  The secrets are patience, stock selection, and proper risk management.  Plus control of your emotions and a willingness to buy when everyone else is selling.  

Got an investing question?  Write to me at VTSIoriginal@yahoo.com or leave a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

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.

A Financial Mistake Wealthy People Don’t Make and You Shouldn’t Either


Probably reading no phrase causes me to shout out into the room and bother my wife and sleeping cats more than, “I cashed out the 401k.”  I usually see this in Money magazine when they have a story about a reader starting a business at age 50 as a second career.  (The worst one was in 2009 from a lady who added speaking about the money in her 401k, “It wasn’t doing anything anyway.”  I wonder if she ever looked back after 2010 or the years since then, during the period where she probably would have seen her 401k double, and realized mow much she gave up.)  I’ve also read it in blogs when people are talking about getting out of debt.  Thankfully I haven’t heard it in real life or I might commit homicide, shaking them and yelling, “WHAT WERE YOU THINKING?!!”

Why does this simple phrase give me so much frustration?  Three reasons:

1.  By cashing out before retirement, these people are going to give away about half of the money to the government for taxes and penalties.

2.  More importantly, they are giving up about $8 for each dollar they cash out.  If they had held the money in their 401k from age 50 and retired at about age 70, that $150,000 they took to start a coffee shop would be worth about $1.2 M – enough to finance a good portion of their retirement.  Instead it all now rests on the fortunes of a small business that very well may fail as most do.

3.  Now, when they reach retirement, they’ll probably get there with no money and everyone else will need to support them because they decided to leave a six-figure job to “pursue their dream” or because they used their retirement savings to pay off credit cards that they’ll probably run the balance right back up again within a year because their behavior hasn’t changed.

Don’t get me wrong – I think it is great to pursue your dream or to get out of debt and stop paying credit card companies 18% interest.  It is just that using your 401k to do so means that you’re throwing away the one thing that, no matter how badly you screwed up your budgeting and savings while you were working, would nearly ensure you have a comfortable retirement.  If you want to start a business, start living like a college student and direct some of that six-figure income into a savings account until you save up enough money.  If you want to get out of debt, change your spending and start down Dave Ramsey’s “debt snowball.”  If things really are impossible – like you have $100,000 in medical bills and $50,000 in credit card debt but you only have a $60,000 per year salary, maybe a bankruptcy is the right path for you (not something I say lightly).   Don’t give up your retirement assets.

This brings us to the next item in the list provided in 10 Dirt Simple Rules of Money Management.   (Note, as always, you can find all of the posts in this series by choosing Dirt Simple from the category list in the sidebar or searching for Dirt Simple in the site.) Today we cover the eighth rule:

8.  Once money becomes an asset, it stays an asset unless an emergency happens.  This is especially true with money in retirement accounts.  Never borrow against a 401K or take money out unless you are retired or facing homelessness.

As discussed in the seventh rule, you should spend part of your money building up assets.  These are things like stocks and bonds, a reasonable personal residence for your needs, and maybe a rental property or two.  These are your “pipelines” that will keep you from needing to carry buckets for all of your life.  They are hard to build and it takes some sacrifice to build them, so don’t go ripping them out on a whim just when they are starting to flow water.  

A huge, critical asset everyone should have is a 401K account, with maybe an IRA account on the side.  If you work for the government or are self-employed so that you don’t have a 401k option, use whatever options you do have, even if it is an account at a mutual fund invested in index funds called “Sam’s Retirement Account.”  People talk about how wonderful pensions were while they bad-mouth 401k plans, yet you were never able to go up to the pension fund manager and ask to take out your portion at 45 to start a doughnut shop.  It wasn’t happening.  Leave your 401k alone and compare the outcome with that of a defined benefit plan and you’ll find the 401k isn’t such a bad route after all.

Beyond the 401k, if you want to become financially independent, you need to be building up assets.  As discussed in the 7th rule, Rich People Buy Assets,  you should always be putting some of your paycheck away into investments since those investments will add to your income.  When you have enough assets that your investment income equals your work income, you’ve become financially independent.  

You should also be looking at buying assets to pay for things rather than pay for them directly with your salary.  For example, rather than just paying for a vacation each year from your salary, start putting money away regularly into a mutual fund designated for vacation funding and then use a portion of the proceeds from that mutual fund for vacations each year.  You can do this for car purchases, meals out, and even donations to charities.  You then scale your spending based on the revenues generated by your assets.  As your assets grow, so does your lifestyle.

The beauty of this technique is that you get to have your cake and eat it too.  You get to go on the vacation, but then you come back and instead of having a big credit card bill to pay off, you still have the assets, producing more income and replacing the money you used.  You work to pay for your vacation once and then you’re done.  You never have to work to pay for vacations again.  Kind of like growing an apple tree and then getting apples every fall for the rest of your life with little work on your part once you’ve done the work of digging the hole, conditioning the soil, and training and pruning the tree as it grows until it is fully established.

But you don’t take out a saw and start cutting off limbs from the tree for firewood.  If you start selling off assets and using your principle instead of the interest you’re generating, you will reduce the amount you get next year.  This builds on itself, requiring you sell more assets to pay for things because you reduce the number of assets you have and the income they provide.   

So once you buy an asset, do all you can to avoid using the principle.  Instead, limit your spending to the income produced, minus a little bit to allow your assets to reinvest and grow bigger while your net worth is still fairly small.  Especially leave your most important asset alone – your retirement funds.  The time when you will not be able to work anymore is coming, and you owe it to yourself and everyone else to be prepared.

Got an investing question?  Write to me at VTSIoriginal@yahoo.com or leave a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

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.

Buy Your Roof Before the Rainy Day


Ask SmallIvy

Most people are able to at least tread water financially.  They learn to cut coupons, get pizza a few nights instead of more expensive meals as take-out, and eat lunch at their desks a few days a week instead of going out every day.  No matter their income, they come to an equilibrium where they are spending the same amount each month as they are taking in.  They then use things like the “extra” paychecks a year – those months where you get 3 paychecks instead of two – or tax refunds to  buy luxuries like vacations and toys.

Still, most people get into debt and when that happens, they end up spending a lot of their money on interest instead of putting their whole paycheck toward things like retirement and college savings.  The reason they get into debt despite being able to handle the usual monthly expenses is the unusual events that cost a lot of money and seem to come up “suddenly.”  Since everything that comes in through salary goes out each month in expenses, they have no savings to take care of things like the new roof or the car repair.

This brings us to the next item in the list provided in 10 Dirt Simple Rules of Money Management, a series I hope my regular readers are enjoying and finding useful.   (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list in the right sidebar.) Today we cover the sixth rule:

6.  Put money away until you can buy a new roof and a good used car for cash, then invest it in diversified mutual funds until you need the money.  Automate as much as possible.

Eventually you will need to replace your roof.  Eventually you’ll need a new air conditioner.  Eventually that car you’re driving will need to be replaced.  When these things happen, you can’t just cut back on expenses and start saving up the money needed at that point because the things are needed now, not five years from now.  You need to be putting money away each month as if you are making a car payment, a roof payment, or an air conditioner payment.  (Otherwise, you’ll end up taking out a loan to pay for these things and you will be making payments, with interest.)  These are things that should be in your cash-flow plan and you should be putting money aside for them each month.  Remember that it is more difficult to cut back on spending to save than it is to never have spent all of your paycheck in the first place.

So, right from the first paycheck, open a savings account that you call the “Home and Car Fund” or the “Big Items Fund” or maybe the “Murphy Repellent Fund” and start putting money away.  Just figure out the things you’ll need to replace, the approximate cost, and the number of years between replacements.  For example, your list may look like this:

      Cost  
Item Cost Replace In(years) Per Year Per Month
Car (4-year old) $10,000 5 $2,000 $167
Roof $10,000 20 $500 $42
Air Conditioner $5,000 15 $333 $28
Flooring $5,000 10 $500 $42
Lawn Mower $500 10 $50 $4
Refrigerator $2,000 12 $167 $14
Washer/dryer $1,000 12 $83 $7
         
    Totals $3,633 $303

So now to be ready for when the next disaster strikes, all you need to do is put away $303 per month (maybe round it up to $310) into a savings account.  Ideally you should do this as a direct deposit from your paycheck so that you will remember to do it.

Note that everything goes into the same account instead of putting money into a roof fund, a car fund, and so on.  This is the better approach since it helps you get ready for any one of the expenses happening in any given month that much faster.  If you were only putting $167 away in a car fund to be ready to replace your car in 5 years, but then the car died in 3 years, you wouldn’t have the money needed.  Because you’re putting away $303 a month, you’ll have the money you need to replace the car in two years and seven months if you needed to do so.  In this way you’re acting like your own insurance company where you put all of the money into one pot and then pay out “claims” as they come up.   The only thing to be careful of is taking out money before you really need it because the balance becomes large.  Remember that those expenses will come eventually and you’ll need the money when they do.

Of course, most of these things will not happen in any given month, so the balance in the account will build.  Eventually you will want to start to invest at least a portion of the money so that you can get a better return and not see money lost to inflation each year.  In fact, once the fund reaches a critical mass and is invested, it may sustain itself and you won’t even need to contribute anymore, leaving you free to save your money for other things like a vacation fund, increases in your retirement fund, home upgrades, or whatever else is important to you.   

When making the decision to start to invest, keep in mind that this is money that you need to have available when you need it.  You therefore cannot lock money up that you’ll need in the next few years away in things like individual stocks that will have unpredictable values from year-to-year.  I would therefore do the following:

1.  Keep the money in a savings account to start, then shift some of the money to 1 year CDs as the balance built up.

2.  Once the balance built to the point that I could do the biggest item on my list (in this case, replace the car or the roof), I would hold that amount in CDs and start to shift new monies into an index mutual fund.  I would probably pick a large-cap fund like an S&P500 fund or maybe a total market fund since the fluctuations for these funds would be less than that for small caps or other funds.  I might also consider REITS (real estate funds).  

3.  Once I got to the point that I had 150% of my largest purchase, I might start to shift a bit more into the mutual fund.  For example, I might keep enough for 50% of the purchase in bank CDs and the rest in the mutual fund.  The reason is that it is very unlikely that I would see more than a 50% drop in a mutual fund, so chances are very good that as long as I had 50% in a bank CD, I’d have enough in the mutual fund to cover the rest of the purchase.  Once the value of the fund exceeded about 15 times my annual contribution (about $55,000 for the case above), I might shift the money entirely into the index funds, but raise cash as needed for expenses that I knew were about to occur (see item 4. below).

4.  If I saw one of the purchases coming up in the next 2-3 years, I’d start shifting money to bank CDs, and reducing the term of those as needed to have the cash available when needed.  For example, if I knew that the roof would need to be replaced in 2-3 years, I’d start selling the mutual fund off at opportunistic times, such as after large run-ups in the market, to raise cash.  When I knew I was within a year of needing to replace the roof, I’d shift the money from 1-year CDs into perhaps 6-month or 3-month CDs, eventually just putting the money into a money market fund when I was starting to line up a contractor.

5.  I would keep contributing to the fund until the value of the fund was at least 30 times my yearly payment.  For example, if my payment were $3,633 as shown above, I would contribute until I had at least $110,000 in the fund.  After that, I would be reasonably assured that the fund would be able to sustain itself, with capital gains and dividends from my mutual funds replenishing money as it is spent on expenses.  If the balance dropped below that level, I would resume payments into the fund again to bring the balance back up.

Got an investing question?  Write to me at VTSIoriginal@yahoo.com or leave a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

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.

Which is Safer – Cash or Stocks?


I’m sure there are many out there who are saying the answer to the questions is obviously cash.  Stocks go up and down in value, and you could lose all of your money if you are in individual stocks.  Cash just sits there and waits for you to spend it.  As long as you are safe from robbery, if you have physical cash, or fraud or a bank run, if the cash is sitting in the bank, then obviously cash is safer than stocks, right?  Not exactly.

Put a dollar ten-dollar bill on the table in front of you and stare at it.  Not doing anything, is it?  Believe it or not, that ten dollars is being stolen right before your eyes.  Don’t believe it?  Put the ten-dollar bill away and put a one-dollar bill in its place.  If you kept that ten-dollar bill in your mattress from the time you started working until retirement, the one-dollar bill would be what you would be pulling out when you retired.  It would still look like the ten-dollar bill, but it would buy a soda in some vending machines or maybe a half-gallon of gasoline.   Because of inflation, the value of cash money is being stolen all of the time, even if the bills are physically safe.

And this leads us into the next item in the list provided in 10 Dirt Simple Rules of Money Management, where I provided 10 rules to follow to maintain a healthy and happy financial life.   (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list in the sidebar.) Today we cover the fifth rule:

5.  If you need it in five years or less, save in cash.  If it is ten years or more, invest.  If you’re in between, invest but only if you have a back-up plan.

The returns of stocks over one, two, or three years are unpredictable.  You could end up with more money or less.  If you invest in a diversified basket of stocks (for example, you invest in a three different index funds that cover different segments of the market), over most five-year periods, you’ll end up with more (maybe a lot more, maybe just a little more).  Over ten-year periods you’re almost assured of ending up with more and earning a return of maybe 8-20% annualized per year.  Over a fifteen year period of time, things start to settle in and you can almost count on an annualized return of 12-15%.  For periods longer than that, your return will remain in the 12-15% range.

Note you can use the rule of 72 to estimate how much your portfolio will be worth in periods of time more than 10 years.  Simply divide 72 by the annualized return and that will tell you how long it will take for your portfolio value to double.  For example, if you earn 12% annualized, your portfolio will double about every 6 years.  This means in 12 years your portfolio will be about four times what you started with ($10,000 will be $40,000).  In 18 years, you’ll have eight times as much ($10,000 will be $80,000).

If you have money that you absolutely need in a few years, investing in stocks would be very risky unless you have a lot more money than you need.  For example, if you are planning to go to college in two years and need $20,000 for the first year, you would not want to have the money invested if you only had $25,000 saved.  You could just as easily have $15,000 in two years as you could have $30,000.  If you kept the money in cash, your money might only buy what $24,000 bought two years before – meaning college costs may have gone from $20,000 to $21,000 or $22,000, say – but at least you would be assured of at least having that much spending power.

For money not needed for ten or more years, you really need to invest because otherwise not only will you miss out on a much better return on your money than you’ll find in savings accounts or even bank CDs, but you will also see the spending power of your money decline if you don’t.  This decline will probably be fairly gradual, maybe 1-4% per year, but it could be very rapid should we see hyperinflation again as was seen in the 1970’s.

For periods of five to ten years, it really is a crap shoot, although the odds are somewhat in your favor if you invest.  If I really needed $20,000 in seven years and I had $25,000 saved, I might choose to keep it in a five-year bank CD and just work and save more to fight inflation.  If I had $40,000, I would probably invest it, figuring that even if I saw a loss of 50% I would still have the money I needed.  I would invest in mutual funds instead of individual stocks in this case since I could well see a 100% loss in an individual stocks, while even a 50% loss in mutual funds would be unlikely.   I could also put $20,000 away in a bank CD and invest the other $20,000.  That would be the best option because then I’d be assured of having at least $18,000 after inflation, and I’d probably more than the $20,000 I initially invested in the investment account.

So for money that you won’t need for a long time, like children’s college funds when they’re infants or retirement funds when you’re younger than fifty, invest the money.  For money you absolutely need in a few years, put it in a bank and get the best return you can while still staying in safe bank products with assured returns.  For things in between, invest if you have more than enough, and save if you have just enough.  

Got an investing question?  Write to me at VTSIoriginal@yahoo.com or leave a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

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.

How and How Much to Save For Retirement


This is the next item in the list provided in 10 Dirt Simple Rules of Money Management, where I provided 10 rules to follow to maintain a healthy and happy financial life.   (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list in the right sidebar.) Today we cover the fifth rule:

4.  Put away 15% of your paycheck for retirement as the first thing you do.  Automate all you can.

Retirement.  The word evokes images of sitting in a rocking chair, travelling the world, or sitting on the beach.  For many it is extended visits for time with grandchildren, many of whom are in other states, or perhaps getting time to work on some projects you’ve been putting off.  Few people have images of sitting around, stressing over how to get the next meal or pay for important prescriptions, and yet that is what retirement holds for many who don’t start to save and invest until it is too late.

Saving enough for retirement is a huge hurdle.  If you’re retiring this year, you’d want to have more than a million dollars saved up – closer to $2M would be better.  If you are twenty years old and reading this, you’ll probably need around $4M – $6M saved to afford a comfortable and secure retirement.  This may seem an impossible amount, but it really doesn’t take a great sacrifice if you do a little at a time.  If you wait until you can see retirement around the corner, it is next to impossible.

People long for the days of pensions since they saw it as a much more secure and guaranteed source of income in retirement.  The truth is, you’ll do a lot better in a modern 401k plan, or simply saving and investing for retirement on your own, than you will with a pension.   The reason is that pensions are invested in a manner suitable mainly for people who are going to retire in five or ten years all of the time, instead of investing for long term growth while people are young and then becoming more conservative as they near retirement.  This is because pension plan managers need to be sure that the money will be there for people in the company who will retire soon.  This means that your return from your pension plan will be a lot less than it would have been if you had invested it properly yourself.   Someone who is in her twenties, thirties, or forties should be heavily in stocks and growth assets rather than perhaps half in income and half in growth as are pension plans.  Companies also set payouts low relative to the returns they expect from their investments to build in another margin of safety.  Of course, many pension plans are still underfunded since companies tend to fund the minimum required by regulators and then save their money for other things.  The pension plan investments are also the first thing cut when economic times get tough since they are competing with keeping the lights on and researching for the next products.

Social Security is a form of national pension plan, but it is on even shakier footing than corporate pension plans and the rate of return is absolutely dismal (it may be positive, but it is about on par with a savings account).  The trustees for Social Security (and Medicare) have reported to Congress numerous times that the program will run out of money in a few years and serious decisions will then need to be made.  Unlike a corporate pension plan where at least your contributions are invested, Social Security is a system where everything going in that is not paid out immediately to current retirees is spent on other things, just like other taxes.  Like a Ponzi scheme, this worked fine as long as there were many more people working than drawing benefits, but now that the ratio of payees to payers is changing, something will need to be done over the next ten to twenty years – even sooner perhaps depending on how things go.  This means payouts will be cut and perhaps taxes will be raised.

So why is it that pension plans are seen as safe and secure, and 401ks are seen as risky?  And why are many people not as well off with a 401k as with a pension?  The reason is our own behavior.  With a pension plan, you’re forced to contribute from every paycheck and you cannot take the money out before retirement no matter what.  (Note, even if the company pays for the pension, you’re really the one contributing since they could pay you more if they didn’t need to fund the pension plan.  The money that goes into that pension plan is created through your labor, not some other source of corporate funds that magically appear.) This allows the money time to compound and grow.  Even in retirement, unless the plan offers a lump sum payout, you are forced to leave the money there and take just a small amount out at a time with a pension plan.

With a 401k plan, conversely, people treat it like a giant piggy bank.  They don’t contribute enough, perhaps just putting in whatever the company will match, if that.  They then take loans out against their investments, which effectively become early withdrawals if not paid back soon after leaving a company or being laid off.  Finally, when they get into their forties or fifties and they finally start to see some investment income coming in as their 401k starts to build into that multi-million dollar account they’ll need in retirement, they get the whim to start a business, pay for a wedding or college, or simply pay off debt and break into that piggy bank despite the huge tax penalties.  They then approach retirement and bad-mouth 401k plans.

If you want to have a safe retirement, you need to treat your 401k just as you would a company pension plan.  This means you need to contribute enough and you need to not touch it for any reason until you are retired.  Even then, you need to withdraw the money out responsibly to preserve the balance and let it grow to cover the higher expenses you’ll face later in retirement as inflation and medical bills take their toll.  With a 401k plan you need to:

1.  Contribute at least 10% of your paycheck every month.  15% would be even better.  If it won’t all fit in a 401k, invest in an IRA and then taxable accounts as well.

2.  Make sure you capture all of the company match.  Unless you have a crazy-generous company, investing 10% will do this, but even if you decide not to invest the full 10%, make sure you’re at least investing enough to get everything your company is willing to give.

3.  Automate the investments, right from the start.  As soon as you get home with the paperwork from the HR office, fill out the form for the 401k and setup for your 10-15% contribution.  If you do this right away when you start, you’ll never miss the money.   It is much more difficult to cut lifestyle later.

4.  Select the lowest cost funds you can find in different sectors of the market.  Go with index funds and other unmanaged funds where possible since they will have the lowest costs.  Splitting money between large caps, small caps, and International is a good way to go.  You can also split between growth and value funds.  When you’re young, you have no reason for any significant amount of income investments.

Got an investing question?  Write to me at VTSIoriginal@yahoo.com or leave a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

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.

The Start of the Debt Spiral – Not Having an Emergency Fund


Cash Flow for Normal People
Cash Flow for Normal People – Don’t be Normal!

People don’t plan to get into credit card debt and other consumer debt.  They start out thinking that they will just use the card to earn cash back or points for an airline seat.  They figure it is just like buying things with cash since they’ll pay off the balance each month.  Or maybe they keep one in case of an emergency, where they need cash fast and a credit card seems like a good way to be ready.

And then the car breaks down and they need a $1000 repair.  They whip out the credit card, even though they don’t have enough money to pay it off in addition to their other bills since their monthly spending equals their monthly earnings.  (Call it the law of the cash flow equilibrium, where your spending will always grow to equal your income, no matter how high your income is.)  They figure, however, that it’s an emergency – they need their car – and they’ll just pay it off over a few months.  Maybe they do, maybe they don’t, but eventually their air conditioner goes, or they need to go to the emergency room, or the car breaks again, or their friends ask them to go on vacation with them, and the balance reappears on their credit card statement, bigger than ever.

Before they know it, that $1000 balance goes to $2000, then $10,000.  Suddenly that silly little $10 per month interest payment becomes $100 or $200.  After a while, debt begets debt and they’re doing everything you can to just pay the debt each month.  Each little event causes them to go deeper and deeper into debt.  This is the debt spiral.  At first, everything is easy and manageable, but as things get worse it gets harder and harder to pull yourself out.  Eventually it becomes impossible and sending in a check to the credit card companies feels like trying to empty a lake with a teaspoon.

The way to prevent heading down this spiral is to be ready for emergencies so that you can handle them without going into debt.  This is the next item in the list provided in 10 Dirt Simple Rules of Money Management, where I provided 10 rules to follow to maintain a healthy and happy financial life.   (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list in the right sidebar.) Today we cover the third rule:

3.  Have a store of cash for a rainy day.  It will rain at some point.

If you were a farmer, you probably wouldn’t sell or eat all of the food you grew.  You would know that some years you’ll have a great harvest, but others the locusts will come, or it won’t rain, or it will rain too much, or you’ll see a hail storm right as the wheat gets ready to pick.  So you would store some in the silos or preserve it in mason jars in your root cellar. And yet most people spend every dime they earn each month, and even get so many loans and subscriptions for things that they couldn’t cut their spending if they wanted to, as if they will never face a financial storm.  This means that they need to go into debt if something happens (anything happens) and they have an unusual expense one month.  Often this is credit card debt, probably the worst kind second only, perhaps, to payday loans.

If instead you put aside some money to handle these issues, what would have been a financial emergency turns into an inconvenience.  Break a leg and need to go to the emergency room?  You just dip into your emergency fund to pay the deductible.  Need a car repair?  The money is sitting there, waiting for you in your emergency fund.  You get out of these potholes in life without taking on debt.  And staying out of debt means you’ll pay a lot less for things since you’ll typically pay about twice as much for things you buy with debt than things you buy with cash.

Some facts about your Rainy Day Fund or your Emergency Fund:

1.  It should be about 3-6 month’s worth of expenses.  Figure out how much it would take to meet expenses for three to six months if you really cut back to the minimum needed, and then save that much up.  This will give you time to find a new job should you lose your current one.  If you have other sources of money like an investment account, you can save less.  If you don’t, then save up for 6 months.

2.  Your emergency fund should be in a combination of a bank money market account and bank CDs.  You need to have your emergency fund available when you need it, which means it can’t be invested in stocks or other things that go up and down in price.  Start out with cash and see how low you tend to dip in your emergency fund when you need it for a couple of years.  Keep that amount, plus maybe another $1000 in a money market fund so you can access it as needed.  Put the rest in a bank CD since you’ll still be able to access the cash if needed, perhaps paying an interest penalty, but you’ll earn a bit more on the money you’ll probably never access unless you have a life event like a long job loss.

3.  If you dip into it, save like a mad man (or woman).  If you deplete your emergency fund for something, you’re now vulnerable should something else happen.  If you need to dip into your fund for any reason, cut way back on spending and investing until the fund balances are back to where they need to be.  

4.  Emergency means emergency.  You don’t dip into your emergency fund to go on vacation or a night out on the town.  This could literally be the food in your children’s mouths should you lose your job.  It is also the only thing between you and the debt spiral.  Guard it jealously and only spend money from it for real emergencies.  If there is a way to leave it alone, do so.

Follow on Twitter to get news about new articles. @SmallIvy_SI

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.

A Simple Analysis that Can Save You Big Time


OLYMPUS DIGITAL CAMERAToday I continue down the list provided in 10 Dirt Simple Rules of Money Management, where I provided 10 rules to follow to basically ensure a great financial future.   (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list in the right sidebar.) Today we cover the second rule:

2.  Before you buy something to “save you money,” figure out how long it will take to recoup your costs.

 

There are always people telling us about all of the money we’ll save by buying their product.  Before you take the plunge and buy into something, however, you should spend a little bit of time doing a simple analysis to figure out how long it will take for you to make your money back and then actually start saving money.  By doing so, you might find that some ideas make a lot of sense, while others are really not that much of a bargain after all.  

When approaching this kind of analysis, you should start out simple with gross assumptions, just to see if the numbers are close or tilted far one way or another.  If you do so and the results are really convincing, like it would take you 40 years to make your money back, there is not a reason to continue.  If things are close, however, like you estimate that it will take you three years to make your money back but you will probably only own the thing for 2 1/2 years, then you should improve your assumptions and try again.  This would be referred to as “sharpening the pencil” in engineering and accounting circles. 

For example, let’s say you are looking at refinancing your home and you see that you can cut your interest rate by 1/2 of a percent.  Is this a good deal?  What is a simple analysis that you could do to estimate the amount of time required to make your money back (your break-even time)?

Well, if you have a $200,000 loan, saving 1/2% per year would save you (1/2% * $200,000) plus a little more.  As a first estimate, just assume you save (1/2% * $200,000) = $1000 per year.  Looking on the internet, you might find that closing costs for such a loan would be somewhere between $2000 and $4000.  You might just pick $3000 as a first-cut estimate.  Your time to break even would be:

$3000/($1000 per year) = 3 years.

So, if you are planning to be in your home for 15 years, this would be a no-brainer.  After about 3 or 4 years, you would have made the money back that you had paid in closing costs and you would be saving a thousand dollars per year after that.  If you were only planning to be in your home for a year, you would obviously lose money and should just stick it out with your current mortgage.  If you were planning to be in your home for four years, you would be right ont he line and would need to improve your analysis.  You could improve your analysis by using an online calculator to calculate your payments and to get better information on closing costs, since it could go either way.

You can also do the same sort of analysis if you’re looking at doing something to earn more money.  For example, let’s say that you are looking at going to a technical school and get a drafting degree.  The school costs roughly $15,000 per year and it would take you two years to get the degree.  You are currently making $10 per hour and think you could make $20 per hour as a draftsman from a brief internet search.  

The cost of the education would be: (2 years) * ($15,000 per year) = $30,000.  If you needed to take out loans to go to school, double the estimated costs to $60,000.  If you needed to leave your job to go to school, add ($10/hour)*(2000 hours/year)*(2 years) = $40,000.  So, you education would cost you about $100,000 if you took out loans and went full time.

Once you finished the degree and found a job, you would make ($10/hour)*(2000 hours/year) = $20,000 more per year that you were making before you went back to school.  Based on these numbers, it would take you $100,000/$20,000 = five years to make back your money.  If you are looking at a 20 year career, this would be a great move since you would make around $300,000 more than you would have without the degree.  If you were planning to work for a few years and then stay home to raise children, however, you might want to think about waiting until the kids were out of the home to get the degree since it might be more attractive to employers.

I can guarantee that on certain purchases you will almost never break even.  These include:

1.  Buying a time share, or even a vacation home.  You may think that you’ll get a “free vacation” each year after you make these purchases, but you’ll find that the payback will take forever and little costs you haven’t considered will keep you in the red.

2.  Going to an elite college, especially on loans.  With very few exceptions, such as becoming a partner in a law firm that only hires people who go to Princeton, you will never make the additional money back that you pay for an elite private school versus just going to your local state school.

3.  Buying an electric car or even a hybrid car.    You really won’t save that much money in gas, especially when compared to a comparable diesel car, and you won’t make enough to overcome the higher price tag before you’re looking at an expensive battery replacement.

4.  Any sort of home improvement.  You’ll only get maybe 75% of your money back on even the best projects, such as a kitchen or bathroom upgrade, and it will all disappear in five or ten years as your upgrades become dated.

So what about cases where you will never break even, or at least not break even during a time frame that matters?  In these cases, you should look at it as a purchase and treat it the same way you would treat any other luxury.  If you have a couple million dollars in the bank, you can afford to send a child or two to Harvard so they can proudly wear a maroon sweatshirt the rest of their lives.  If you are willing to eat in most lunches and save up the cash, you can buy a Prius to make all of your eco-elite friends jealous.  Just realize that you are spending money and not saving money.  You are buying a liability, not acquiring an asset, and people who do well financially acquire more assets than liabilities.  Like many other things, it’s about balance.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

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.