I originally wrote this 12-part series on ryanwaggoner.com, but I've organized it somewhat and I'll be releasing an ebook PDF version soon. Please let me know if you have any comments or questions. Thanks!
I'm pleased to announce that for the month of April, RyanWaggoner.com will be running a series called $3.1 Million in 30 Days and 12 Easy Steps: an Investing Primer for Young Adults. I know this is launching on April 1st, but this is not a prank. However, I should apologize for the title, as it's a little misleading. There's no practical way to make $3.1 million in 30 days and 12 easy steps, but you can lay the foundation to do so in that timeframe. The goal of this series is to take you on a journey towards financial peace and security. The series has been structured around 12 action steps that take place over 30 days. I've tried to break things down as much as possible and not get too complicated with each step, and the end goal of the series is to help you setup a solid financial foundation that will enable you to accomplish your goals going forward.
Note: The $3.1 million figure was derived as follows: a 25 year-old investor making $50,000 / year invests 10% of her salary each year and earns 10% per year on her investments. Her salary increases by 3% each year. At age 65, she will have $3,159,929.
Why I'm Doing This
In my conversations with friends and acquaintances in their twenties, I've come to the realization that many young adults are missing out on a fantastic opportunity to build a solid foundation for their future. While it will still be possible to do so after a decade or so, it will never be as easy as it is today. There's a lot of information out there, and some of it is even geared towards young people, but I wanted to do something very focused and action-oriented. I'll be referencing a lot of those other resources and materials where appropriate so you can dig deeper where you want to.
Who It's For
This series has been written for those in their twenties who know they should be investing and planning for the future, but are confused and overwhelmed by the options and don't know where to start. To keep things simple, my examples will revolve around someone 25 years old and making $50,000 / year in household income. This may not fit you exactly, but the principles remain the same, and I'll point to my sources of information so you can crunch the numbers for your situation.
What We'll Cover
We'll cover a bunch of personal finance and investing topics, including investing for retirement, budgeting, where to save a little extra money, the types of retirement accounts out there, setting up a financial plan, and more. I've tried to break the topics up into logical chunks so that things don't get too overwhelming.
How It'll Work
Starting April 2nd, I'll be posting 3 posts per week (Mon, Wed, Fri) for the next 4 weeks, for a total of 12 posts. Each post will have an action at the end that should be completed before you read the next one. I would love for readers with questions, comments, or suggestions to post in the comments for each post. I will do my best to answer any comments quickly and thoroughly.
What This Can Do For You
My goal for this series was to create something that would help make investing more understandable, approachable, and manageable. By following this plan, you can build a solid financial foundation for the future with money that you may not even miss each month. You can retire with millions of dollars in investments that will pay you an annual income for the rest of your life. Best of all, after the next 30 days, you can do all this with very little time or energy. A few hours a year may be all that's necessary to manage your investments.
What You Need
In order to effectively finish this plan, you'll need 3 things: commitment, discipline, and most of all, honesty. You'll need to do some soul-searching and really take a hard look at yourself. If you're not going to follow this plan out to completion, I'd advise you to not even start. Procrastinating in this area of your life can be very tempting, especially since you're planning for something that's four decades away. However, every day that you wait to begin investing is lost forever, and as we'll see in the first post, the magic of compound interest means that these next ten years are more valuable than the following thirty combined. Thinking about putting money aside when you're struggling to pay the bills can be tough, but I urge you to make a commitment right now to finding a way to make it happen. Someday you'll be glad you did.
Check back tomorrow for Part 1: Financial Goals.
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
If you aim at nothing, you'll hit it every time. ~Author Unknown
You must have long-range goals to keep you from being frustrated by short-range failures. ~Charles C. Noble
Welcome to Part 1 of the April blog series: Investing For Young Adults. If you missed the introduction, you can check it out here. After you read Part 1, please leave any comments or suggestions. In particular, please let me know if this is useful information and anything I can do to make it better. Thanks!
Compound Interest
The underlying focus of this first post is the absolute importance of setting financial goals and immediately getting started towards those goals, but I'd like to start off with a discussion of one of the fundamental principles of investing: compound interest. This may sound like an odd place for such a discussion, but my purpose here is to get you motivated and excited about investing, and nothing is quite as exciting as compound interest, despite the decidedly unexciting name. Albert Einstein reportedly called it the greatest mathematical discovery in history, and after you become familiar with it, you probably will too.
But first, let's talk about you. Maybe you know a little about investing, and you feel like you should be doing something, but you're not sure what, and you don't know where to start. It's true that personal finance and all the options for investing can be overwhelming for someone just graduating from college. In addition, retirement seems so far away that it doesn't seem that urgent and you assume you can always worry about it later. Big mistake. While you may be able to make up for lost time in the future, it will never be as easy as it is right now. You may not have much money to invest, but the younger you start, the less money you need to put aside each month and still meet your goals. Consider the following example:
Jack and Jill both graduate college at age 22 and get decent jobs. Jill decides that she can spare $200 / month to save for retirement. Every year for 10 years, she adds $2400 to her retirement account, which earns 10% annually. After 10 years, she decides she's tired of investing that $200/month and stops, leaving the account as-is.
Jack decides at the age of 22 that $200 / month can buy a lot of fun. He uses the money to buy sports equipment and beer. However, by the time Jack is 32, he's married and starting to think seriously about the future. He decides he better start setting some money aside and begins to put $200 / month into a retirement account, also earning 10% annually.
For the next 30 years, Jack faithfully puts $200 / month into his retirement account and Jill completely ignores hers. After 40 years, at age 62, their balances are as follows:
Jack's total investment of $72,000 has grown to $392,386.
Jill's investment of $24,000 has grown to $667,436.
Jack would have needed to contribute $340 / month for those 30 years to match Jill's earnings from just $200 / month for 10 years. If Jill had decided to keep contributing $200 / month for the entire 40 years, she would have ended up with more than $1 million.
This apparent mathematical oddity is explained through the miracle of compound interest, which sounds more complicated than it really is. Compound interest essentially means that over time, you earn interest on your original investment (called principal) and you earn money on any interest from earlier periods. For example, if you deposit $1000 into an account earning 10%, after a year, you'll have your original, plus $100 in earnings, for a total of $1100. But at the end of the second year, you won't have $1200. You'll have $1210, because you earned 10% not only on the original $1000, but also on the $100 that you earned in year 1. That $10 may seem insignificant, but as the example above shows, it adds up over time.
What you really need to know about compound interest is that your investments grow much more in the later years than in the early years, so if you start earlier rather than later, you will make a LOT more from your investments.
Here's a last example. Suppose you put $1000 into an account bearing 10% interest. After 40 years, that $1000 will have grown to $45,259. Pretty amazing. However, what's really interesting is the value of the account at the end of each decade:
As you can see, almost 2/3rds of the increase from $1000 to $45,000 came in the last 10 years. If you left it invested for another 10 years, for a total of 50 years, you would have $117,391. Sixty years would get you to $304,482. All from that original $1000.
The bottom line here is that every day you wait to start investing for the future, you're wasting some of that tremendous earning power. You may not make much money in your twenties, but you have an unstoppable force behind you that gives you a distinct advantage over those who are older and make a lot more money: time. Don't waste it.
When you're in your twenties, it can be tempting to go out and "enjoy your youth," spending all of what you make. My goal here is to help you realize that the sooner you start, the less you have to put aside for the future (because of compound interest) and the more you'll be able to enjoy your youth and the years to come.
Task 1: Write a prioritized list of financial goals
When it comes to getting started with something, nothing helps like goals. So our first action is going to be to write a list of financial goals. This is not meant to be a full financial plan. Our purpose here is to come up with a list of rough financial goals that you would like to achieve. You don't need to attach numbers or times to these goals yet, though you may want to. Here are a few examples to get your creative juices flowing:
Sample Financial Goals
Once you have all of these goals written down, prioritize them by asking yourself the following question: "If I could only accomplish one of these goals, which would it be?" After you select a goal, write #1 next to it and ask the question again for the remaining goals, until they're all gone. I'll give you a hint: retirement and buying a house should almost certainly be first on the list. It can be tempting to put kids' college above those goals, but if your kids have no money to pay for school, they can always apply for scholarships and/or borrow money. There are no retirement loans or scholarships, so make saving for retirement your first priority. In fact, because preparing for retirement will take up such a large chunk of your investment dollars, we'll tend to focus on it more through the rest of the series.
Take some time with these goals. Think about your attitude towards money and what is a good fit for you. Think about what you would like your financial life to be like. I understand that you may have no idea what you want in some areas of life, but do your best to come up with some rough directions and then put them on paper. This will give you a starting point for understanding what your financial plan should look like. Now go do it.
Check back on Wednesday, April 4th for Part 2: Financial Health
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
If you missed Part 1 of this series on Investing for Young Adults, you may want to check it out before you read Part 2. I would greatly appreciate any comments, suggestions, criticisms, or questions that you may have. Please post in the comments or use the contact form to get in touch with me. Thanks!
For our second lesson, we're going to cover general financial health. I think we all know a lot of people who live a lifestyle that they can't afford, and these types of people are often asking me how to get started with investing. I always start by telling them to examine their general financial health.
Imagine personal finance as a pyramid. Investing is not the bottom level of the pyramid. I know it's not always fun to hear, but you shouldn't necessarily jump right into investing for the future. There are some more foundational things that you need to make sure you have right first. These things aren't necessarily fun, but they are absolutely vital. I'll try and cover them broadly so you have a sense of where you should focus your attention.
Keep as Much as You Can
The first thing I want to emphasize is that building wealth is not just about how much you make, it's also about how much you keep. The person who makes $30k per year and spends $28k is building wealth faster than someone who makes $300k and spends $299k. The focus of this post will be to help you build a solid foundation that will help you keep more dollars each month and reduce your overall financial stress.
Maximize Your Income
Even though how much you make isn't everything, it's obviously still an important piece of the puzzle. Especially when you're young, you should focus on maximizing your earning potential. Why do I say especially when you're young? Well, as we saw in Part 1, the longer a dollar is invested, the more it will earn for you, with the really spectacular earnings coming in the later years. By increasing your earnings early in your career, you can front-load your investments with a decent chunk of cash and end up with far more in the long run, even if you end up making the same amount of total money over the course of your career.
Live Below Your Means
The foundation of all wealth-building is this: spend less than you earn and invest the difference wisely. It is impossible to increase your net worth and provide for the future if you spend everything you make, or more.
Many young people scrape through college, eating Ramen noodles and spaghetti, and then land a good job soon after graduation. For the first time, they're making decent money. They begin to look around at all the things they can do with that money, instead of being conservative and looking at what they actually need and building a game plan. Pretty soon, they're spending everything they're making, or more. When they get raises, they bump their lifestyle up a little bit more to match. This may be you. If so, don't despair.
It's tough reducing your lifestyle, but it's absolutely vital that you get your spending below your income in order to build wealth.
Budget
If the financial goals that you wrote down yesterday are the stops on your financial journey, a budget is like GPS, showing you exactly where you are and giving you turn-by-turn directions to get to the next goal on your financial road map. Living by a budget is absolutely critical to building wealth and you'll find it almost impossible to manage your finances with any degree of clarity and precision without one. It's so important that we'll be dedicating an entire lesson to the subject. For now, all you need to know is that if you don't have a budget, you need one.
Build an Emergency Fund
You need to have an emergency fund, for when your car breaks down, you need to fly home for a funeral, you need to cover an insurance deductible, you lose your job, etc. Many financial experts recommend 3 - 6 months of expenses, which is great, but that takes time. If you're trying to reduce debt, I recommend Dave Ramsey's plan:
* There is at least one circumstance in which you'll want to invest before you have eliminated all debt and have a fully-funded emergency fund: the 401k match. We'll cover that in a later lesson.
Two additional comments about the emergency fund:
Eliminate Consumer Debt
If you remember nothing else from this entire series, remember this: consumer debt is financial cancer. Consumer debt includes credit cards, payday loans, auto loans, and basically any debt used to finance anything other than an investment. It may seem innocent enough to finance that new car for just $300 / month, but when you go into debt, you're betting your future. The borrower is slave to the lender. If you can't afford to pay cash, don't buy it. This is a simple rule to grasp, but very difficult to follow, especially in our current frenzy of consumerism.
If you are already in debt, I cannot recommend highly enough that you pay off all your debt before starting to invest (with a few exceptions). It won't be much fun or very exciting, but it's very important. One exception may be debt with an interest rate of below 6% or so, such as a mortgage, student loans, etc.
If you're paying 19% on a credit card and investing your money at 10%, you're losing money each month in spite of your investments. You're better off plowing as much money into your debts as possible to get rid of them ASAP. The recommended method to eliminate debts is called the debt snowball method and there are two variations: by order of highest balance and by order of highest interest rate. Here's how it works:
As to whether to pay off in order from highest interest rate or lowest balance, there's a lot of debate out there. Basically, highest interest rate first is the mathematically correct way to go, because you end up paying less interest over the life of all your debts. However, there's a psychological benefit to paying off a debt, and you'll usually get to that first milestone faster by paying off the smallest debt first, making it less likely that you'll give up before eliminating all your debt. Everyone's situation is different. The important thing is to pick a method and devise a gameplan for eliminating all your debt and then stick with it until all the debts are gone and never become a slave to debt again.
Automatic Investment
Once you get to the point where it makes sense for you to start investing, it's a good idea to setup an automatic investment process to transfer money into your investments without any action on your part so that you never even see the money you're putting aside each month.
You don't need to worry about this too much right now, as we'll talk about specific ways that you can accomplish this in a later post. I just wanted to mention it here because disciplined investing on a regular basis is a basic financial habit that will reap tremendous rewards in the long run and put your far ahead of your peers.
Task: Find someone to keep you accountable
The first task from Part 1 wasn't too difficult and this one hopefully won't be either. You need to find someone to keep you accountable as you try and improve your financial health. Don't travel this road alone if you can help it.
In many cultures debt was (and still is) something to be ashamed of. Not anymore, at least in America. If you follow this plan, everywhere you look, there will be people your age living a better lifestyle than you, at least for the next few years. Most of them are probably financing that lifestyle with credit and it will catch up with them someday. Don't worry about keeping up with them. They'll find out soon enough that the years they wasted spending money recklessly can never be recovered.
The best way to ensure that you don't get caught up in the frenzy is to find someone else who shares your convictions and keep each other motivated. If you're married, this could be your spouse, but I recommend finding someone outside your marriage who can keep you accountable. When it comes to spending money that you don't have for something you want to do, such as a vacation, your spouse will often have the same motivation as you and may not kick your butt as much as a friend will.
Either way, find someone and commit together that you'll keep each other accountable for maintaining good financial health. Don't go it alone.
Don't forget to check back on Friday for Part 3: Budgeting.
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
"A budget tells us what we can't afford, but it doesn't keep us from buying it." ~William Feather
Welcome to Part 3 of Investing For Young Adults. If you haven't read Parts 1 & 2, you may find it helpful to do so before tackling this topic. Please leave any comments or suggestions at the bottom of each post or send me an email via the contact form. Thanks!
In this post, we're going to talk about budgeting as a young adult. We'll cover what it can do for you, what the different methods of budgeting are, and some tips and tricks to get you started in the right direction.
What a budget can do for you
I would be lying if I said that this is going to be fun. Budgeting is a necessary evil. A very necessary evil. It's really the only way to get (and keep) your spending under control. Even if you become a millionaire, you should still stick to a budget.
For years I avoided setting up a budget and sticking to it. I usually had a rough idea of how much money was in my account and I made decisions on whether to buy something or not based on that rough figure. The problem was that I often wasn't thinking about all the upcoming expenses, nor was I aware of how much I spent on different categories. After several years of paying ridiculous overdraft fees, I finally decided that I was going to solve this problem once and for all and I started budgeting. I tried a few methods until I found the one that works for me. The difference in my financial peace and control is striking. More than anything else, including making more money, budgeting has completely revolutionized my financial life.
Before I started budgeting, I hated seeing bills come in the mail, because I never was sure if I'd have the money to pay them on time. Every single purchase I made carried a little bit of guilt, because I never knew if I was overspending and if this money should be earmarked for rent or the electric bill. When multiple overdraft fees of $30 each would hit my account, I would be overwhelmed with frustration and anger.
Now that I budget, I hardly even notice when bills arrive. Paying bills doesn't bother me, and spending $20 for a book doesn't worry me at all if I know that I have the money left in that category. I haven't had a single overdraft charge since I started budgeting. I feel more in control and at peace about my finances. And best of all, I now have money to save and invest for the future. I no longer plan on just saving whatever is left at the end of the month, usually nothing. I now include savings and investments as a part of my budget and pay it each month just as if it were another bill.
You will find it difficult or impossible to reach your financial goals if you do not implement some kind of budget. Saving for retirement, kids college funds, vacation, a down-payment on a house, etc. just can't be managed well without a budget, in 99% of cases. If you're one of those 1% out there who doesn't have a budget and thinks you're doing just fine, I encourage you to give budgeting a try for a few months. You may indeed be doing ok without a budget, but you'll likely do far better with one.
What a budget is not
It's not helpful to think of a budget as a financial diet. It's simply a tracking tool that lets you measure your monthly spending against your planned spending for that month to ensure that you don't spend more than you should in a certain category. If you plan on spending $200 for groceries this month, a budget helps you make sure that you don't spend more than that $200.
Methods of budgeting
There are several methods of budgeting that different people find works best for them. You should evaluate each one and determine what might work best in your particular case. Budgeting can be split into two different activities: building your spending plan and tracking your income and expenses. All three of the methods utilize these activities; only their implementation differs.
Paper budgeting
This is the bare-bones version of budgeting: just you and a piece of paper. The first thing you'll need to do is setup your spending plan. In the simplest variation, you write your income at the top of a sheet of paper and list your expense categories (groceries, insurance, savings, food, etc) below that. Next to each expense category, you write the monthly amount that you plan to spend in that category. Then you add all the expense amounts together and ensure that they match the income at the top of the page (meaning that the budget is balanced).
The difficult part with this budgeting method is tracking your expenses on a daily basis, since you'll need to record each transaction under the appropriate category and add it to the running total for that category to ensure that you're not overspending in that category. Depending on your volume of transactions each month, this can be difficult to keep up with.
Advantages
Disadvantages
Envelope budgeting
This method of budgeting starts with the paper spending plan, just like the paper budget above, but for tracking, you use cash in actual envelopes for each spending category. At the beginning of the month, you put cash in the envelopes to correspond with the spending plan for that category. For example, you have an envelope for groceries. On the first of the month, you put $250 into that envelope, or whatever your spending plan calls for. When you buy groceries, you take the money out of the grocery envelope. When the envelope is empty, that's it. It's very simple, but very effective, and you don't need to write down each transaction.
Advantages
Disadvantages
Software budgeting
Technology has improved many areas of our life, and budgeting is no exception. Budgeting software typically walks you through the creation of your spending plan and helps automate the tracking process. Most budgeting programs download your transactions daily from your bank and other financial institutions. Then you'll just need to assign those transactions to the appropriate categories. Budgeting with software can have a slightly steeper learning curve, but offers greater convenience and tracking capabilities.
Some of the most popular budgeting programs include:
Advantages
Disadvantages
Tips and tricks for getting started
Include your spouse in the process, if applicable
Adjusting to a budget can be difficult, especially at first. If you're married, you'll need the full cooperation of your spouse to make it work. The best way to minimize argument and tension over your budget is to make your spouse a part of the planning process, giving each person a voice in the decisions that are made.
Customize your categories
Part of the art of budgeting is determining what categories to include in your spending plan. You shouldn't necessarily use the default categories provided in any sample budgets or software packages. Determine the best categories for your particular situation. Also, you want to make your categories specific enough to be useful, but not so detailed that categorization becomes too tedious and cumbersome. As a general rule of thumb, if you have more than 20-25 spending categories, you may want to consider combining a few into more general categories.
Record your expenses for at least a couple days before starting
Get a notebook and write down every penny you spend for at least a few days to get an idea of where you spend your money now. This will give you a good baseline from which to construct your first spending plan.
Expect changes for the first couple months
When you first start budgeting, you probably will need to do it for a couple months to get a handle for where you actually spend money and what kinds of things you under-budgeted or over-budgeted for. This is natural and you shouldn't be discouraged by it. Just make sure that your budget still balances after each adjustment to your spending plan.
Be realistic
It may be tempting to put down $50 / month for food, but try and be realistic. It's probably a good idea to not stray too far from the numbers you came up while recording your spending, at least for the first spending plan. After the first month or two, you can look at ways to trim your budget and put more towards savings and investment.
Don't forget savings
Don't forget to budget for savings, just as if it were another bill you had to pay. If you're still paying off debts, that money will go towards your debt snowball until your debt is eliminated. By setting that money aside each month in your budget, you'll be more likely to follow through and meet your goals. Just as a rough guide, although everyone's situation is different, most people should budget to save at least 10% of their income. We'll cover investment targets in more detail in Part 4.
Task: setup a budget
If you don't have a budget, start by creating a spending plan on paper using the method described above. Then pick a budgeting method and get started with it right away. Don't get frustrated if things are difficult at first. Stick with it and you'll soon reap the benefits of greater financial control and peace in your life.
Don't forget to check back on Monday for Part 4: Investment Targets
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
If you haven't read Parts 1 - 3 of this series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
This is going to be a relatively short post. Now that you've put together a budget and come up with an idea of how much you can save each month, it's time to compare that number with how much you need to be saving and see whether you need to make some lifestyle changes to reach your goal.
Priorities, priorities
As we talked about in part 1, there are a variety of things to save for later in life, such as a down payment for a house, vehicles, vacations, college funds for the kids, etc. All of those things are important, and you should absolutely plan ahead and save for them. But retirement is the most important thing for you to focus on when you think about saving money. Nothing else that you need to save for will cost you as much as retirement, and nothing else will put you at greater risk should you choose to ignore it. Because of our increasing lifespans, you could spend as much time in retirement as you do in the workforce. I know 65 seems a long way off to you right now, but if you live to be 100 (and many of you will), you'll have thirty-five years left after you retire. Building a nest egg that can support you for that long is a difficult goal, and the sooner you get started, the better. Because of this, I recommend that you make retirement savings your top priority. I also recommend that you commit to saving as much as you reasonably can for the next few years. Getting those retirement account balances up early will pay off big time in the long run, as we saw in Part 1.
The New Retirement
Four or five decades ago, planning for retirement wasn't something that most people needed to worry about. Many people went to work for the same company for their entire career, and at retirement, your company would provide a pension that would pay you a set benefit for the rest of your life. For a variety of reasons, those types of plans started dying in the 70s and 80s and have all but completely disappeared today. Today, the vast majority of companies expect their employees to plan for their own retirement and fund their own retirement accounts. Retirement is now your responsibility. Also, if you're counting on Social Security to be your security, you've probably got some disappointment coming up. It's out of the scope of this series, but for a variety of reasons, Social Security is in peril and will exhaust its surplus sometime between 2042 and 2052, or about the time many of the readers of this series will be retiring. There are options to fix the problem, and it probably will be "fixed" eventually, but your benefits may be reduced or eliminated as part of the solution. The bottom line is that you can't count on the government to take care of you in retirement. You have to take of you in retirement.
What lifestyle do you want at retirement?
This is a good time to take a few minutes and think about your retirement and what you want it to look like. Do you want to buy a rustic cabin in a rural area and lead a simple life? Do you want to sell it all, buy a boat, and sail the world? Do you want to live in a high-rise condo in a major metropolis? If you have no idea of what you want, don't despair. You've got plenty of time to figure it out. Ultimately, your retirement income will be provided by your investments, and that income will determine the type of lifestyle you can afford in retirement. The more you save now, the more options you'll have later.
A million ain't what it used to be
Having a million dollars in the bank sounds like a fortune, and it is for some, but a cool million isn't what it used to be, thanks to inflation. In fact, you'd need about $20 million today to buy what $1 million would have bought you in 1907. And in another 100 years, inflation will likely erode the value of your money so that you'd need $369 million to match the $1 million from 1907. The causes for inflation are beyond the scope of this post, but the essential point is that inflation erodes the value of money over time. When you watch old black & white TV shows and they talk about buying a hamburger for a nickel or a ticket to the movies for fifty cents, you're seeing inflation at work. Over time, inflation causes the price of goods and services to increase. Inflation has averaged around 3% for most of the last century, so 3% is usually a fairly standard estimate of future inflation. What this means for you is that making $100,000 / year might sound great now, but inflation will likely make that sound not nearly as good in the future. If it stays at 3% for the next 40 years, $100,000 / year will be the equivalent of making a little over $30,000 in today's dollars. The bottom line is that you'll need to adjust your desired retirement income for inflation, but we'll cover that in more detail in a bit.
How much will you need at retirement?
It's difficult to know how much retirement income you'll need in four decades, but a good rule of thumb is to use 75 to 85% of your pre-retirement income. So, if you make $100,000 the year before you retire, you'll want to plan for $75,000 to $85,000 per year once you've retired.
To determine a rough idea of the total amount you'll need in retirement, take the amount you plan on spending in the first year of retirement and multiply by 25. In the example above, you might take $80,000 and multiply by 25 to come up with $2 million. This is roughly what you would need in your combined retirement accounts when you retire. This does not take income from Social Security or other pension-type benefits into account.
How much should you save?
Once we've determined roughly how much income we need in retirement and roughly what our goal is for our retirement account balances, we can determine how much we should be saving now. There are a couple ways to do this:
Go by the 15% rule
This varies depending on who you talk to and what your goals are, but many financial advisers recommend saving 15% of your income for retirement, including any matching that your employer may offer (we'll cover employer matching in a later post). If you're having a hard time deciding what kind of retirement you want to have, are not sure how your income is going to increase over the course of your career, etc, then the 15% rule may be just the thing for you for now. Saving 15% of your income while you're young may be difficult, but will put you in an excellent position later on.
Use a retirement calculator
If you're a little more numbers-oriented, you may want to use a retirement calculator to determine how much you should be saving. I recommend one from Bloomberg.com, located here. I'm sure there are other good ones out there, so please leave suggestions in the comments.
Task: calculate retirement savings targets
You need to calculate 3 things:
I highly recommend that you use the financial calculator from Bloomberg.com. I recommend starting with the default values, changing only your age, income, current level of retirement savings, and current contribution amount. The calculator will then tell you whether you're saving enough. If you need to save more, try gradually increasing the contribution percentage. The calculator will estimate what amount you'll make the year before you retire, how much your investments will pay you in retirement, and when the money will run out, if ever. This should give you a good sense of how you're doing and what you may need to change in order to reach your goals.
Don't forget to check back Wednesday for Part 5!
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
If you haven’t read Parts 1 - 4 of this series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
Many of you probably read Part 4 of the series and after running the numbers on how much you need to save, thought "How can I possibly save that much? I'm already having trouble making ends meet." This post is designed to help you deal with that problem. We're going to talk about financial streamlining, and finding places to save money. Hopefully we can uncover some relatively easy and painless ways to find the money you need to reach your long-term financial goals. These measures may not get you all the way to where you need to be, but hopefully they'll be a good starting point. Please keep in mind that most of these suggestions come from my own personal experience or those of friends and family, and are not meant to be comprehensive. They're just some general ideas to get your creative juices flowing. Post any additional ways that you've found to streamline your own life and I'll revise the post and add them as appropriate.
Some general suggestions for everyone:
If you still find that you're not able to meet your investing goals, consider the following:
That last one sounds a little sinister, but you shouldn't worry too much just yet. Most people will be able to find the money they need in steps 1 – 3, or possibly step 4. Also, remember that you can take these steps now or you can take them later, but if you do it now, it will be much easier. According to MoneyCentral, people in their forties have a median balance of just $40,000 in their retirement accounts. These people will need to save huge amounts of money over the next twenty years just to catch up to where they need to be. Don't let that be you. Make it easier on yourself by starting now.
Let's take a look at each of the above in more detail.
Budgeting
We discussed budgeting in detail in Part 3, but I wanted to mention it here again in the context of saving money. Since I have started budgeting, I have reduced my expenses by 10 - 20%. The really unexpected part of that is that I don't really feel the pinch. Part of what budgeting helps you do is get control over the way in which you spend money. You start to see all these little here-and-there expenses and realize how much they're actually costing you. This prompts minor lifestyle adjustments, sometimes even subconsciously. It's hard to explain, but I think anyone who has been budgeting for awhile will understand what I'm talking about. Give it a try for a few months and you'll see what I'm talking about.
Take advantage of free or low-impact ways to save money
Coming up with money to invest doesn't always mean drastic lifestyle changes or cutting out things that you enjoy. Sometimes you can find investment money just by making some minor "tweaks" to your lifestyle that won't really cost you much in terms of time or depriving yourself of things you want. Let's run through a few examples:
Save your change
It might seem trivial, but just tossing your change into a jar at the end of every day can add up. If you're married and you each have around $1 in change at the end of the day, that's over $700 at the end of the year. Toss that money into a good index fund every year and watch it grow. Do this for 40 years at a 10% return and you'll have almost $380,000. Not bad for some spare change you'll probably never miss anyway.
If you find that you rarely use cash and thus don't have much change, a variation on this idea is Bank of America's Keep the Change program, where each debit card transaction you make is rounded up to the next dollar and the difference is deposited in a savings account automatically.
Review your insurance
Insurance is one of those necessary evils in life. It sucks to pay those premiums every month, but if you ever really need insurance, you'll be glad you have it. However, like anything else, insurance providers are not equal. Once every couple years or so, review your insurance coverage to see if you can optimize your protection. In particular, you're looking for three things:
In general, you don't want to skimp on the insurance, but make sure that you're not overpaying for what you're getting. Cutting $50 / month from your combined insurance premiums and investing the money for 40 years at 10% adds up to more than $316,000. Not bad for a few minutes of hassle every couple years.
Review monthly subscriptions and accounts and close those you no longer use
Subscribe to magazines that just end up stacks? Have an old gym subscription that hasn't been used for months? Maybe you paid for some kind of online service that you don't use often, or have a club membership and don't attend anymore. Write down a list of all of these types of things that you can think of and be honest with yourself about whether it's something you still need. While you're at it, review your utilities, cell phone plan, and internet service. Make sure everything you're paying for is really needed and cancel all the rest.
Avoid ATM and other useless banking fees
When you stop and think about it, it's a little preposterous to pay $2 to get $20 out of the ATM. You're paying a 10% fee to access your own money. Try to use your bank's ATMs or carry some spare cash to avoid that ATM fee. Also, there is very rarely a good reason to pay for a checking account. Most major national banks offer free checking with no minimum balance. If your bank currently charges you for a checking account, you should consider switching to one that doesn't.
Pay off your consumer debt before you start investing
Once you've identified some money that you can invest every month, it's time to determine whether you're ready to start investing. As I discussed in Part 2, you should pay off any consumer debt before you start investing. Once you get rid of that high-interest debt, you'll have more free cash each month to invest in your future, instead of throwing it away on interest. And speaking of interest, while you're paying off that debt, it's a good idea to call your credit card company and attempt to negotiate a lower interest rate. If you've been paying on time for awhile and you let them know that you'll be switching to a lower-interest card if they don't work with you, they'll often lower your rate, which can save you a lot over the course of the repayment. If they still refuse, transfer your balance to a lower rate card, which you can find here.
The exception to the rule that you should pay off your debt first is the 401k match. We'll talk more specifically about 401k's and what they can do for you in a later post, but what you need to know now is that many employers offer free matching on any funds you choose to put aside for retirement. A common matching formula is $0.50 for every $1 you invest, up to 6% of your pay. For example, let's suppose that someone making $30,000 per year decides that they'll set aside 6% of their pay each month, or $1800 per year. If their employer offers matching like the example above, the employer would contribute an additional $0.50 for every dollar of the first 6% that the employee contributes, meaning that the employer would contribute an additional $900, for an annual total of $2700. These matching funds cost the employee nothing and are essentially free money. If your employer offers matching on 401k contributions and you're not yet signed up, stop reading this and go sign up immediately. You're throwing away free cash every day that you're not taking advantage of such an offer.
Examine ways to make bigger cuts
Stop smoking, drinking coffee or soda, and hitting the vending machine
When you're looking at the vending machine, $.75 doesn't seem like much for a bag of chips or a can of soda. However, if you buy a couple of items every day that you're working, your spouse and you can together save $60 / month just by avoiding the vending machine. None of that crap in there is good for you anyway. Bring some healthy snacks to work from home and drink water instead of soda.
A latte at Starbucks will set you back $3 or so. Hit this a couple times a week with your spouse and you're looking at $50 / month. Make coffee at home or work, or cut it out of your diet completely.
Finally, quitting smoking is definitely one of the highest-yield improvements you can make in your life. Not only could it save you hundreds of dollars each month from not buying cigarettes, you'll save money on insurance premiums and medical costs. And most importantly, it could save your life.
Bring lunch to work
Eating out is awesome. I love it, and I do it way too much. Home-cooked meals are great, as long as I don't have to cook them or clean up after them. Also, packing a lunch in the morning is such a pain. However, eating lunch out 5 times per week for $6 / lunch is $120 per month. If your spouse does the same thing, you're looking at almost $250 / month. Ouch. If you and your spouse switch to bringing lunch from home just 3 days a week, you'll save $150 / month.
There are many other examples of ways you can alter your lifestyle and save money. Post some of your tips in the comments and I'll add them to the body of the post.
Task: Streamline your financial situation
Now that you've put your budget together and come up with a rough idea of what you should be saving each month, it's time to compare and see if the two match. If not, use the ideas above, your own brainstorming and budget review, and Google to come up with some ways to trim the fat from your budget until you're able to set aside the target amount each month.
Check back Wednesday for Part 6.
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
If you haven’t read Parts 1 - 5 of this series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
Now that you've figured out what your goals are and what you're going to need to do to accomplish those goals, it's time to look at the options you have in terms of where to put your money. If you're whipping out your newspaper to check the stock quotes of your favorite companies, hold up a second. Before we can even talk about what to invest in, we need to talk about the different account types through which you can invest. This is probably one of the most confusing areas of investing for many people, so let me see if I can break it down some.
In general, the types of investment accounts you can open fall into two categories: tax-advantaged and non-tax-advantaged. Tax-advantaged account types offer the benefit of reducing your tax liability in some way, though certain limitations usually apply. Non-tax-advantaged accounts usually have fewer restrictions but offer no tax benefits.
Tax-Advantaged Accounts
Generally speaking, most tax-advantaged accounts fall into one of three categories:
We'll spend most of our time talking about retirement accounts, but I hope to cover education savings and medical savings in future posts or series.
Retirement savings account types
Brace yourself, it's a long list (and this isn't even all of them):
Never fear, though the list above may seem daunting, here's what you need to know:
Don't worry if you don't know what any of the above means, we're going to cover each of these in more detail, but before we do, let's briefly take a look at:
Non-tax-advantaged Accounts
Generally, any place to stash your cash that doesn't offer any tax benefit falls into this category. This would include:
Generally, what you need to remember is this: your bank probably pays you about 1-2% (if that) on your savings account, which isn't enough to keep pace with inflation. However, online banks right now are offering savings account rates of 4-5%, which makes them a great place to stash your cash for shorter periods (anything less than 5-7 years). Beyond that time period, you'll want to look at opening a normal brokerage account. Don't worry...it's relatively painless and really cheap (or free). In general, you'll want to make sure you're meeting your retirement goals first (and then some) before packing money into a non-tax-advantaged account, as you'll have to pay taxes on your earnings from these types of accounts. Because this series is aimed at young investors, many of whom have debts to eliminate and may struggle initially with just meeting their retirement savings goals, we'll spend most our time focusing on retirement accounts. However, if you want to open an online savings account, I recommend HSBC Direct or ING Direct. You can compare rates from a host of institutions here. If you want to open a brokerage account, I recommend ETrade or Sharebuilder (more on this later).
Individual Retirement Accounts (IRA)
An IRA is a special type of account that comes in a few flavors, but for now, we're going to focus on the two most common: traditional and Roth.
Traditional IRA
The traditional IRA allows you to invest a certain amount of your income and deduct those contributions from your taxable income (you invest with pre-tax dollars). In an extremely simple example, if you make $50k per year and you invest $4k in an IRA, your taxable income is reduced by $4k, to $46k. However, there are a few catches:
Roth IRA
A Roth IRA is similar to the traditional IRA, but the taxation works in reverse: instead of not paying taxes on the initial contributions and paying taxes on the withdrawals when you retire, as with a traditional IRA, a Roth IRA allows you to pay taxes on your initial contributions and withdraw your earnings at retirement tax-free. There are several other advantages as well:
Which to choose?
This is a very complicated question that depends on future variables for the optimal answer, but in general, you should invest in a Roth IRA if you expect that you will be in a higher tax bracket at retirement than you are now. My personal opinion on the subject is that with the unfunded liabilities our government is currently incurring, they'll have to raise taxes severely in the future to compensate. I like the peace of mind that the Roth IRA offers because I know that I've already paid my taxes on that money and anything I withdraw at retirement is mine to keep. This particular subject (traditional vs. Roth, both for IRAs and for 401k's) is worth delving into deeper in a future post.
What can you invest in with these accounts?
Pretty much anything, provided that the place where you open the account offers it. You can invest in stocks, bonds, mutual funds, index funds, hedge funds, money market funds, real estate, options, etc. Keep in mind that I'm not recommending most of these asset classes, especially when you're just starting out. But it's nice to know that you can choose the best investments for your situation, including down the road when your investing prowess has increased.
The 401(k)
The 401(k) (or 401k, as I'll be calling it) is an extremely common type of investment account, offered through your employer. It's named after the section of the IRS code where it originated. Just as with IRAs, the 401k comes in two main flavors: traditional and Roth.
Traditional 401k
For the purposes of taxation, the traditional 401k works just like the traditional IRA: you invest with pre-tax dollars and are taxed on your savings and future earnings upon withdrawal at retirement. Just like with the IRA, there are restrictions:
However, there are benefits to this account over the IRA:
Roth 401k
The Roth 401k functions exactly like it sounds like it would: contributions are made with after-tax dollars and savings and earnings are withdrawn tax-free at retirement. Generally, the same pros / cons that apply to the traditional 401k apply to the Roth 401k. This account has only been around for a couple years, so a lot of employers don't yet offer it, but if you bug your HR department, they may be able to make it happen.
Matching funds
Many employers offer some kind of matching on 401k contributions. This generally works something like a 50 - 100% match on the first 6% of an employee's contributions, where 6% is a percentage of the employee's salary. So for example, if you gross $4000 / month and you contribute 10% to your 401k (good for you!), that's $400 / month. If your employer offers a 50% match on the first 6% of your contributions, that means that 6% of the 10% you contribute will get a 50% match. In this case, 6% is $240 and 50% of $240 is $120, so your employer kicks in another $120, so your 401k actually gets the $400 + $120 = $520 / month, which is like getting a free 30% return on your first year of investing, plus whatever the market returns. Not bad. There are, however, a couple of things to keep in mind:
Contribution limits
Just as with the IRAs, the contribution limits for both 401k account types is the limit of contributions for both together, not for each. In other words, if you contribute $15,500 to your traditional 401k in 2007, the grand total you can contribute to your Roth 401k in 2007 is $0.
However, accounts of another type are fair game, so you can max out your 401k and a Roth IRA, for example, or a Roth 401k and a Roth IRA. Just keep within the limits for each type (IRA vs. 401k).
Also, keep in mind that the 401k limits apply only to the employee's contributions. Employer contributions can push total contributions above that limit, provided the total does not go above 100% of the employee's total compensation, or $45,000 / year ($46k for 2008), whichever is less. If your employer is piling enough cash in your 401k that this is a problem, please let me know if they're hiring ;-)
Bringing it all together
So now you now about the most basic options for retirement accounts. Which should you choose? Instead of giving you some nonsense about how it depends on your situation and leaving you with more questions than answers, here's some ideas, in order of priority:
Task: Find out what your employer offers and make sure you're taking advantage of any matching offered.
As discussed above, those matching funds are like free money and it's there to encourage you to invest for your future. Take advantage of it. Your HR department will be able to help you determine what your options are and help you sign up. Don't wait. If you're reading this at work, send HR an email RIGHT NOW. If you're reading this in the evening or on the weekend, write yourself a note, send yourself an email, or whatever you need to do to make sure you take care of this next time you're at work. Will you miss the couple hundred bucks per month? Probably. Will you be glad you did this someday? Absolutely.
Note: Now that I'm self-employed, I'm seeing all this investment advice through new eyes. However, I'm going to continue to write this 12-part series for someone with a job. I'll touch on some of the areas that may differ for self-employed folks, those employed by the government, etc. Hopefully in the future I'll be able to dedicate a post or two to investing for those situations.
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
If you haven’t read Parts 1 - 6 of this series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
This post is going to be relatively short, leaving you plenty of time to go out and take some action. Now that you know what type of account(s) you're going to open, it's time to decide where to open them. I personally hate reading posts like this that never actually point you to a company in particular, but instead tell you what to look for. I'll talk about what to look for, but I'm also going to give you my recommendations on which companies to go with for the most common scenarios.
Assuming that you've decided to open an IRA or a traditional brokerage account (non-tax-advantaged), you've got about 17,000 options. Probably not quite, but close enough. The choice of what's best for you depends on a few things:
What to look for
Vanguard and Fidelity
In general, my feeling is that the best option is an account at Vanguard or Fidelity. Both companies are rock solid with a focus on index investing (which we'll cover in detail later). The fees are very low and you'll have plenty of solid options on what to invest in. However, they do have account minimums, so if you're unable to come up with the cash right away (usually $1 - 3k per fund, and you'll need 3 - 5 funds), consider going with one of the options below and transfering to these guys in the future when you've built up the necessary amounts.
This post used to be longer and more complicated, but I've recently discovered that Fidelity waives their minimums if you setup automatic monthly contributions of at least $200. This is a fantastic deal that I highly recommend. If there's any way at all to swing that $200 / month, do so. Hopefully Vanguard will offer a similar deal soon.
Sharebuilder
Sharebuilder allows you to setup an automatic monthly investment plan that transfers money from your bank account each month and invests it in your chosen stocks and funds. The interface is easy to use and they have a very good selection of investments, at least for our purposes. The downside is that you'll pay a monthly fee for this service of $8 - 20. This may not sound like much, but if you're investing smaller amounts, it can be a relatively large percentage. If you only have $100 / month to invest, $12 means that you're losing 12% right off the bat. Ouch! In general, I would only use this service if I could keep my monthly fee below 2-3% of the amount I'm investing.
Bringing it all together
In general, here's what I would do:
Task: Open your accounts, setup your direct deposit, and create your automatic investment plan.
If you absolutely can't invest $200 / month, I would honestly just open an online savings account at HSBC Direct or ING Direct and stash the cash in there while I figured out how to increase my income or cut my expenses enough to be able to afford that $200 / month. If you're only investing $100 / month or something, the $15 or $20 / month fee is going to cut into your investments too much if you go with Sharebuilder. You're better off going with a high-interest savings account while you try and get your monthly investing budget to $200.
If you can come up with the $200 / month, call Fidelity today (or if you have the required minimum balances, Vanguard). Tell them you want to open an IRA and setup automatic monthly deposits. I don't get paid anything to recommend these companies and I have specifically NOT recommended other companies in this post because I don't feel that they are trustworthy enough. However, these two will take very good care of you. Don't wait.
When you setup the account, don't choose what funds or investments that you want to put your contributions into just yet. We'll cover that in later posts. For now, just get the account opened and the contributions flowing into it.
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
If you haven’t read Parts 1 - 7 of this series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
This is a good time to talk about diversification in your investments. In general, you want to avoid putting all your proverbial eggs in one basket, spreading your risk among several different types of investments. Deciding exactly how to spread this risk is called asset allocation and is a large part of what financial planners are paid to do. Asset allocation can be an extremely complicated subject, but hopefully we can simplify it somewhat so you can make some decisions.
This is a good time to point out that this post is going to focus on diversification of asset classes, but diversification also means buying multiple assets within that class, whether that means stocks, bonds, real estate properties, etc. One of the easiest and most popular ways to diversify is through the use of mutual funds. We'll talk more about mutual funds and index funds in the next section.
The basic idea behind diversification is that the best-performing type of investment is extremely difficult to predict because it may vary from year to year, or even month to month. Real estate may be a great investment vehicle one year and a terrible choice next year. American stocks may do well this year while overseas stocks suffer, and large financial services companies in Brazil may outperform Chinese manufacturing this year, but the reverse may be true next year. Therefore, diversification strives to choose asset classes that will balance each other out and reduce the volatility of market returns. Certain types of asset classes tend to move in opposite directions. For example, when stock returns suffer, bond returns usually increase. Therefore, an investor can theoretically reduce the volatility of their overall portfolio by choosing some bonds and some stocks.
The difficulty then becomes how to choose what asset classes to invest in and how much to invest in each. In general, there are two main variables that you need to consider when determining your asset allocation:
Although there are many different types of asset classes, we're going to keep it simple and stick with three major ones. These asset classes are easy to invest in and are passive investments:
Over the last hundred years or so, stocks have outperformed bonds and most experts recommend making stocks the backbone of your portfolio.
I'm going to now make some recommendations based on lots of information that I've read and things I've assimilated over time. Because asset allocation is such a complicated subject, many out there may disagree with me on these recommendations, and I would welcome any comments or suggestions. My goal here is to get people to start investing as soon as possible, as every single day counts in investing. You're not going to have a perfect asset allocation plan from this article, but you'll have a pretty good start, and in a few years, you can dig deeper into the subject. I think most investment experts would agree that it's better to start investing with a simplified asset allocation plan than to not start at all.
If you're still not convinced, there's a few decent asset allocation calculators out there that may help you decide what a good mix is for you:
Recommendations
I'm going to assume that this investment is for retirement. In general, the shorter your timeframe, the more conservative you'll want to be with your investments. If you're planning on using this money in less than 5-7 years, I would stick with cash or cash equivalents, like a high-yield online savings account.
For retirement savings, start by subtracting your age from 110. This is the percentage that you should hold in stocks, with the remainder held in bonds. So if you're 25, you should hold 85% of your portfolio in stocks and 15% in bonds. Pretty simple, but you'll want to rebalance your portfolio every year to adjust for changes (we'll go over this in more detail in a later lesson). If you're more comfortable with risk, subtract your age from 120. If you're less comfortable with risk, subtract from 100.
Within the stock category, I would choose something like the following:
The first number for each asset class is the percentage that risk-averse investors should allocate to that class. The second number is for those more risk-neutral, and the third number is for those that are more risk-tolerant. So for example, if you're relatively risk-averse, you would want 60% in large American stocks (which tend to be more stable), 10% in small American stocks (which tend to have higher volatility), and 30% in international stocks (which also tend to have higher volatility).
Task: Calculate your asset allocation.
Exactly which investments to buy is what we'll cover in the next lesson, but for now, just think about how much tolerance for risk you have and how long you'll be investing these funds for and come up with some idea of what asset classes you'll be investing in and how much. Remember that you can always change your asset allocation later (though you should minimize this). In fact, in a few years, once your portfolio begins to grow in size, it's probably a good idea to visit a financial adviser for more tailored advice, but we'll cover that in a later lesson, too.
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
If you haven’t read Parts 1 - 8 of this series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
Mutual Funds
We talked about diversification between asset classes in the last lesson, but now we should talk about diversification within asset classes. The idea here is to buy several investments within each investment class to protect yourself against major losses by one of your investments. Because diversification within each asset class can be a real pain in the butt to do by buying individual stocks or bonds, most investors use mutual funds to easily diversify. A mutual fund is just a basket of several hundred or thousand stocks (or bonds). Buying one share of that fund means that you're actually buying a tiny fraction of a share in each of the stocks held in that fund, making diversification much easier. Funds come in two flavors:
Some of you may be wondering when we'll start talking about stock-picking and how to evaluate that "hot stock tip" that your friend passed you at a party. In short, we're not. The reason is simple: you're not good at picking stocks. A few of you might be, but the dirty secret of the financial services industry is that something like 75% of all actively-managed mutual funds UNDERPERFORM the market. Keep in mind that the managers of these funds are usually paid six and seven figures (or more) and have spent their entire professional lives trying to learn how to beat the market. If 75% of them can't do it, you probably can't either. Not to mention the fact that picking stocks is time-consuming and complicated. Fortunately, there's a better alternative: index funds.
Oh, one more thing: if you know someone who tries to insist that they consistently beat the market picking individual stocks, it's extremely likely that they either haven't been investing long enough to see a market correction (3 - 5 years or longer) or they don't keep very good track of their gains and losses. Just like gambling, we tend to subconsciously downplay our losses and enhance our gains in our mind, leaving us with a feeling that we did better than we really did.
Before we dig into index investing, let me suggest that if you really want to pick individual stocks, you set aside a certain portion of your portfolio for that purpose (no more than 10%). Keep careful records of your gains and losses for the stocks you pick. If after 10 - 15 years you've consistently beat the market, think seriously about a second career in finance :-)
Index Investing
An index is a basket of stocks designed to help track the performance of market sectors, or the market as a whole. For example, the S&P500 is one of the most common stock indexes and is composed of 500 of the largest publicly-traded American companies. The Dow Jones Industrial Average ("the Dow") is another common index and is composed of 30 of the largest and most stable American companies from different sectors of the economy.
Index funds buy and sell stocks to match the stocks that make up an index. So an index fund that tracked the S&P500 would buy the 500 companies that make up the S&P500. Why is this important? For a few reasons:
You might be wondering just how big of a difference a percentage or two makes. After all, if you make 9% instead of 11%, is it really that big of a deal? Here's an example scenario:
That 2% of interest cost you $2 million over 40 years. There is an entire industry out there that thrives on people's ignorance of this point and how much turning your money over to a professional money manager will end up costing you in the long run. To those that work in this industry, or hope to, let me encourage you to either be honest and tell people that you'll likely underperform the market, or be one of the 25% that doesn't ;-).
Which Index Funds?
Index funds come in tons of different sizes and shapes. There are index funds for different market sectors (energy, telecom, etc), different market capitalizations (small cap, large cap, etc), and different parts of the world. However, I'm again going to eschew the traditional approach of making you sort it out for yourself and give you my opinion of what you should invest in. The following are indexes for the different sectors that you might wish to invest in, with the symbol of an index fund that tracks that index in parentheses.
All of the funds above are ETFs, or exchange-traded funds. This just means that you can buy them through pretty much any broker. A couple of notes:
Task: Setup your automatic investment plan in the index funds of your choice.
Take your asset allocation plan that you created in the last chapter and match each category to the appropriate fund above. Then log into your broker of choice (Fidelity, Vanguard, Sharebuilder, etc) and create an automatic investing plan. You should be able to specify a certain amount to pull from your bank account each month and what percentage of that money to invest in what stocks or funds. Once you're all set, you'll just need to remember to ensure you have money in the account. I've always found it helpful to set my automatic investing plan to pull money from my bank account the day after payday, to ensure that the money comes out before I have a chance to spend it on other things. You may also want to set a reminder on your calendar.
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
If you haven’t read Parts 1 - 9 of this series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
Congratulations! If you've followed the plan this far, you're an investor now. Your money is working for you, and over time, you can reap enormous benefits from this. The rest of these posts will be pretty short and are designed to help you keep your investments healthy and hard at work.
Plant a tree because you'll be using them up now
Now that you've an investor, get ready for the deluge of paperwork about to come your way. In general, you're going to see several different types of things:
*Note: I know full well that most of you are NOT going to read the 180-page annual report with the size 4 font that comes every year for each of the 5 funds that you invest in. Most investment writers implore you to read every single one cover to cover, as you're now an owner of the company. It's true, but I doubt most of them go through and read the annual reports for every company held by their mutual or index funds, despite the fact that they own a tiny sliver of each of those companies now. Skim the executive summary and financial statements, check the fees and expenses to ensure they haven't doubled them or anything, and keep on truckin'. If you have a different opinion, I'd love to hear it. What's the best way for a 25-year-old investor to handle this?
Also, you can usually elect to receive a LOT of your paperwork online now. It's definitely more about saving the company money than it is about your convenience, but you may be able to save or print a PDF of your monthly statement instead of getting it in the mail.
What to keep
My original goal here was to break down all the different types of documents you should keep, for how long, etc. But to be honest, it's a huge pain. Here's the truth: unless you get audited, you won't need 98% of what you end up keeping. However, if you do get audited (and if you're wealthy and successful, your chances of an audit increase), you'll wish you had kept EVERYTHING. So here's my recommendation: keep it all (almost). Here's what I do:
If the thought of boxes full of basically un-filed and disorganized paperwork makes you recoil in disgust, by all means go through and setup an archival filing system so you can spend 30 seconds to find the March 1957 savings account statement, just in case. In my case, I have found that the time necessary to setup and maintain such a system is not worth it. It may take me 10 minutes to find the same document (in the extremely rare event that I need to), but I'll have saved countless hours by not maintaining such a system over the last 50 years. Just my preference.
Annual Review
Now that you've got everything setup and running smoothly, you're not completely off the hook. This account will likely represent the bulk of your net worth within a few years, so you need to protect it. Every year, you need to set aside at least a day or two This process should only take a few hours. I recommend choosing a day or two that you'll remember easily, such as January 1st and July 4th, or your birthday. You should evaluate your asset allocation to ensure that it still meets your situation and rebalance your portfolio to make sure it still meets your asset allocation plan. I'll devote an entire article to the annual review at a later date.
Task: Setup a filing system.
See my remarks above, but this is really up to you. It doesn't matter how you keep the stuff or in what system of organization (or lack thereof). Just come up with some kind of system and make it happen.
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
If you haven’t read Parts 1 - 10 of this 12-part series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
I know what you're thinking: why did we wait until step 11 to write a financial plan? The reason is that I wanted to encourage you to dive in and just get started with investing and see how painless it can be. You should now have a good grasp of the basics of investing and be more prepared to write a financial plan that actually makes sense.
Momentum vs. Perfection
I think people sometimes get too caught up in the idea that you have to have a complete and perfect plan before you can start investing. That's just not true. While the details absolutely do matter over a long period of time (as demonstrated by our example of the effects of a 2% interest rate difference), you can always adjust your plan as you go, and probably should! Your optimal asset allocation plan is likely to change over time, and hopefully as your income increases, you'll be able to contribute more to your financial goals. The most important thing right now is just getting some forward momentum, which is what most people struggle with. My view is that if you start saving money AT ALL, you're doing well and you should be proud of yourself. Just make sure you're reviewing your financial plans and goals on a regular basis and looking for ways to improve. Just like the fable of the tortoise and the hare, early momentum and consistent forward motion counts for a lot, as demonstrated by this example:
Julie starts investing at age 22, putting $300 / month into her 401k. She doesn't really understand investing but she knows she should, so she just invests in whatever options her HR department tells her to. However, because she doesn't invest wisely, she ends up under-performing the market with an 8% return for the next ten years, at which point she decides that she needs to really start taking this seriously and revises her investment strategy. She's now 32 years old. She continues funding her retirement accounts with just $300 / month for the next 30 years, but now she matches the market at gets a return of 11%. At age 62, she'll have about $2.3 million.
Kevin waits to start investing until he's 32, because he doesn't want to put the time and effort in to create the perfect investing plan. At age 32, he starts investing $300 / month. It turns out that Kevin is a genius and consistently beats the market for the next 30 years, returning 15% per year. At age 62, he'll have just over $2 million, or about $300,000 less than Julie.
The point is that the most important thing is to actually get started. Every single day counts. Sure, you won't make much tomorrow from your investments, and it's true that your total returns from 40 years are likely to be much different from those of 39 years and 364 days. The problem is that for many young people, the "tomorrow" in "I'll do it tomorrow" turns into next week, next month, next year, and next decade and by then you've already lost that incredible earning power. Don't let that be you.
Why write a plan?
The vast majority of people never bother to sit down and create a written financial plan, which is a big mistake. A written plan helps you stay focused and gives you something tangible to gauge your progress against. A written financial plan doesn't have to be that complicated...a single page may be enough for your situation.
What to include?
Budget
Remember that budget you created back in part 3? Go ahead and look over it again. If you've been living according to your budget for the last few weeks, it should be very familiar to you by now and you will likely have made some changes as you've began to better understand your spending patterns and how your goals match up with those patterns. Make any further refinements to your budget and file a copy with your financial plan. Thought the budget is likely to change over time, it's useful to look back at it when you review your financial plan.
Retirement goals
The majority of this series has focused on retirement savings and investment for one reason: it's the largest financial challenge that most Americans will face, though sadly, many apparently don't yet realize how big of a financial challenge this will be. Your plan should include the things we calculated throughout the series, such as when you'd like to retire, how much you'll need by then, how much you plan on investing each month to get there, etc.
Other asset classes
We focused on stocks and bonds in this series because they're extremely accessible to the average investor and are the closest thing to a truly passive investment that you'll find. However, there are lots of other asset classes out there, including real estate, private businesses, collectibles, precious metals, commodities, and more. In general, each of these asset classes are more complex and risky for the average beginning investor. However, I'm a strong believer that you can have fun investing, and after you've mastered some of the basics, you might want to try your hand at some other forms of investing. I love real estate and own three investment properties. They take a lot more time and effort than stocks, but I have a passion for real estate. Buying vacation homes can be a good investment if done correctly, and they have the added benefit of allowing you to use them for your personal enjoyment while you own them. Similarly, buying art that you enjoy and is likely to increase in value is not only a fun hobby, but can be a profitable investment as well. Think about any other types of investments you'd like to learn more about and include some goals to look into them on your financial plan.
Education / health / etc
Although we focused on retirement investments, there are other major things in life you'll want to save for, including buying a home, education savings for your kids, health care, etc. I'll have more articles about each of these later, but for now, just think about your future life goals and any other major purchases you'll want to start saving for. Remember, the sooner you start, the less you have to save each month to accomplish that goal.
Charitable giving
One of the best things about money is the opportunity to share with those less fortunate than you are. Of course, it's always your choice, but I strongly urge you to think about some ways in which you'd like to use your wealth to give back and improve the lives of others. There can be great tax benefits as well, which we'll discuss in a later article. Also, don't make the mistake of thinking that you have to be a millionaire to be generous. Start building the habit of generosity now with what you can.
Professional advice
In general, I advise people to handle their own finances when they're young and just getting started. Generally, people in their twenties have relatively uncomplicated tax situations and lack the assets necessary to justify professional portfolio management. However, one of the great things about starting investing young is that this will no longer be true at some point. Eventually, you'll have enough wealth that you'll need some professionals to help you protect, manage, and grow your assets. Add a couple goals in your financial plan to learn about this part of the financial journey, which will help you be more prepared to choose competent and honest professionals when the time comes. I'll have more articles about this in the future.
Reevaluation / Rebalancing Schedule
Finally, as we discussed in the last lesson, remember that you need to evaluate your goals, portfolio, plan, and progress once or twice each year. Pick a date or two and put it on your plan.
Task: Write your complete financial plan.
Now that we've covered everything that your plan should cover, sit down and write it. It shouldn't take long and it doesn't matter if it makes sense to anyone else, as long as it makes sense to you. Once you've finished it, make a copy that you can post somewhere visible (like on your fridge) to help keep you motivated. File the original away in your filing system. You might want to set a reminder on your calender to review your plan once per quarter, or even monthly.
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
If you haven’t read Parts 1 - 11 of this 12-part series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
Well, we're nearly done. If you've followed this series from start to finish and taken action, congratulations. You've changed your life forever. However, the journey doesn't end here. There's always more to learn and ways to improve your financial plan and performance. One of the most important things you can do is continue to educate yourself on financial topics and how best to manage your personal resources. To that end, I'm going to recommend a few books that can help you get started. Try to read one every month or two and within a few years, you'll be an expert.
Rich Dad, Poor Dad by Robert T. Kiyosaki
When I was about 19, this book changed my entire outlook on money and finances. Looking back, and reading through the book now, I see a lot that I disagree with, but it sparked my thinking about how to manage money, and what financial freedom truly means. Not a practical book, but definitely a good start if you have no “financial motivation.”
The Millionaire Next Door by Thomas J. Stanley
This book, which I read recently, is the result of years of research of America’s millionaires: how they live, what they wear, what cars they drive, how they made their money, etc. It was definitely inspiring to me, and also got me thinking about the impact of wealth on future generations, both good and bad.
Cashflow Quadrant by Robert T. Kiyosaki
This book builds on Rich Dad, Poor Dad and goes into detail about how to build multiple streams of income and gradually reduce your reliance on earned income. It contains overviews of the impact on personal finances and income of things like real estate investment, entrepreneurship, and investing in businesses.
The Richest Man in Babylon by George S. Clason
This is a deceptively simple book that contains a series of financial parables that teach the importance of always saving, the power of compound interest, investment, insurance, and other time-tested financial truths. Easy read and a good reminder of some very basic lessons. Again, good to read if you find yourself lacking that “financial motivation.”
Getting Loaded by Peter Bielagus
I haven't actually read this one yet, though it's on my list. However, I've received good reviews and it appears to be a good overview of investing for young adults.
The Little Book of Common Sense Investing by John C. Bogle
Haven't read this one either, but also got great reviews from people I trust. John Bogle is the founder of Vanguard and was the creator of the world's first index fund, so he knows what he's talking about.
Task: Get one of the recommended books and read the 1st chapter.
All of the books can be purchased by clicking on the links above and buying from Amazon, which I would really appreciate (I get a very small percentage of the transaction as an affiliate). Remember, your speed in reading these books isn't really what's important. Just get started and keep moving.
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.
If you haven’t read Parts 1 - 12 of this 12-part series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
You did it. You read through this entire series. I hope you took the actions I recommended, or at least took SOME action. In conclusion, I could offer you a bunch more examples of how crucial it is that you start investing now, scare you with statistics, or guilt you into taking action now. But the truth is, I've already done that throughout this entire series and if it hasn't sunk it by now, it's not likely to from this last post. All I can say is that I genuinely want to see other young people succeed and I'm definitely willing to do anything I can to help you along the way. Please feel free to leave any comments, suggestions, or requests for assistance in the comments or through my contact form. I'll be glad to do anything I can to help.
In conclusion, I'm going to leave with a few of my favorite quotes that I think are relevant to the topic at hand. I've repeated these quotes throughout my blog and even elsewhere in this series, but I think they deserve one more shot:
Start today and don't give up...see you at the top!
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.