Become An Owner Instead of a Worker


When we’re young, we trade our health for money.  We work long hours.  We lift heavy things and wear down our tendons. We spend hours typing or doing other repetitive motions that cause carpal tunnel syndrome.  We spend hours on our feet and wear down the disks in our backs and develop heel spurs.

We trade this wonderful gift of youth and health that we’ve been given, the ability to keep pushing it for may hours, to bounce back when we fall down and heal fast when we get cut, for cash by working way too many hours.  We go in before dawn and leave after dark, never getting out to see the sun and the woods and the oceans.  We work hard to go on a vacation, which is then rushed and filled with work thoughts and emails back to the office the whole time.  We buy large, beautiful homes that we spend all of our free time maintaining and cleaning when we aren’t working to pay the mortgage.  We buy things on credit and then spend a quarter to half of our time working to pay interest payments.

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While we’re young we can make extra money by just pushing it a little harder.  We can make that car payment if we work overtime on weekends so we can drive that shiny new car to work and have it sit in the parking lot all day, slowly decaying away.   We can take on that second job and get all of the cable packages and five different web streaming services.  We can keep buying clothes to impress people we don’t like and buying all of the latest gadgets to look good for people we don’t even know.

When we get old, we trade our money for health.  Any money we’ve saved up through those long hours of work goes to treatments, surgeries, and drugs to reduce the pain our weary bodies feel.  We spend money to try to have the ability to walk and run and jump and heal like we did so easily while we were young.  We get surgeries to be able to walk after long hours of carrying heavy loads have destroyed our knees.  We buy prescriptions to lower our blood pressure after years of sitting idle at a desk, eating poorly, and letting our health decay.

Stop.  Stop today.  Stop right this minute and change your life.

Become an owner instead of a worker.  Instead of getting that new car, drive your old one for a few more years and send those car payments you would have made into a stock mutual fund and become an owner in a group of companies.  Buy a smaller house for cash and invest the money you save on interest.  Stop buying things to impress people and just buy what you need so that you can spend time with your family who don’t care what the label on your blouse or jeans says.

Start building a portfolio so that you will be getting dividend payments and capital gains instead of paying interest payments and penalties.  Let others work for you so that you don’t need to work those extra hours.  Expand your lifestyle by waiting a little while to buy things, instead investing the money in mutual funds, then using the distributions from those mutual funds to add to your income.  Direct some of that money back into buy more mutual funds, and your income will expand on its own.

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Everybody can become an owner.  You can start a mutual fund account with Schwab for only $1.  You can start investing through Vanguard funds for only $3,000 ($1,000 if you start a retirement account).  Start an account and start sending a little of your paycheck in each month to build your wealth.  Own things.  Build things.  Stop just using all of your effort to generate entropy.  Stop having your money flow into your back account through direct deposit and then back out again to bills through auto pay without your even seeing it.

The next SmallIvy book, Cash Flow Your Way to Wealth, will be coming out in about a month.  It gives the game plan to go from worker to owner.  Subscribe to this blog to make sure you get your copy when the time comes and don’t miss out.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Are Your Parents Likely to Move In? If So, How Should You Prepare?


Don’t look now, but if your parents are in their late fifties or sixties, chances are pretty good that they’ll be moving back home – to your home – in ten to fifteen years.  They’ll still be healthy.  The issue will be that they’ll be out of money since many people in their late fifties and even early sixties have just a fraction of the amount of money needed to make it through a 20-30 year retirement.  Many just have enough to make it five years or less.

There are a couple of things you could do.  You could just ignore the issue and believe it won’t happen.  You could move away and leave no forwarding address, hoping to hide somewhere.  Or you could take on the issue head-on, figuring out if you are likely to need to take your parents in, perhaps help them take steps to delay the inevitable, and make choices now to be ready when the day arrives.  Here are some steps to take:

Have the talk

People say that the two conversations parents and children find most difficult are those about sex and money.  But if your parents are heading into retirement in the next ten or twenty years, now is the time to get a gage on how they are doing.  You may not be able to get them to talk about specific numbers, but maybe you can find out things like 1)Do they have a pension plan at work or a 401k?   2) If they have a 401k, have they been putting away 10% or more right along (if not, suggest they start putting away 15% now) 3)If they have they have a 401k, have they let it build up their whole career or have they pulled money out?  4)Are they planning to stay in their home in retirement or downsize and use the savings for living expenses?  5)Have they talked to a financial planner about their readiness for retirement?

Hopefully, they have a pension plan or they have been regularly contributing to their 401k with no withdrawals.  If they are planning to sell their home and downsize, they may be able to stretch their retirement savings a bit.  If they have gone to a financial planner, hopefully he/she has started to help them realize whether or not they have saved enough.  If from the answers to these questions it does not look like they have done much planning, brace yourself for the worst.  At the very least, see if you can set up a meeting with a financial planner to discuss their status and look at options.

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If you do get specific numbers, you can calculate the amount they have total in retirement accounts and other savings/investments (their net worth) to determine how much money they have available to generate income for retirement.  (Do not count their home value in the total unless they plan to sell.)  Once you have their net worth, subtract $400,000 for a couple or $250,000 for a single from the total to account for medical expenses in retirement, then divide by 25.  That is the yearly amount they’ll have available to withdraw each year to fund their retirement and probably make it through without running out-of-money.

For example, if they have $500,000 saved:

Yearly Amount = ($500,000 – $400,000)/25 = $4000/year

In the case above, they would be able to generate about $4,000 per year before starting to deplete their savings.  Add that to maybe $12,000 from Social Security, and they would have about $16,000 per year to spend.  That would not be a good lifestyle for most people and they would need help with bills and expenses.

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Set a Target

If you figure out that they need to be saving more, figure out how much they will need to pay for yearly expenses, and then figure out how much they need to save up to reach that target.  Assuming they’ll receive $12,000 per year from Social Security, here’s how much they would need to save up to generate different yearly income levels:

Monthly Income Yearly Income Single Account Value Couple Account Value
$2,500.00 $30,000 $700,000.00 $850,000.00
$3,333.33 $40,000 $950,000.00 $1,100,000.00
$4,166.67 $50,000 $1,200,000.00 $1,350,000.00
$5,000.00 $60,000 $1,450,000.00 $1,600,000.00
$5,833.33 $70,000 $1,700,000.00 $1,850,000.00
$6,666.67 $80,000 $1,950,000.00 $2,100,000.00
$7,500.00 $90,000 $2,200,000.00 $2,350,000.00
$8,333.33 $100,000 $2,450,000.00 $2,600,000.00

Realize that without the expenses of work clothes, maintaining a car for work, and things like professional dues and meals out, the amount needed in retirement will be less than their income while they are working.  If they pay off their home and cars, this will lower the amount needed even more.  They might therefore be able to set their retirement income target at 70% of their current take-home pay or so.  Of course, setting the target high reduces their risk in retirement.

Encourage them to save/invest if needed

If it looks like your parents aren’t ready, you’ll need to help them get into the best position they can.  Have them pull together a budget using the income you expect them to have in retirement if things don’t change.  Perhaps seeing what their life will be like if they head into retirement with $50,000 will cause them to decide to get passionate about saving.

You can then help them develop a savings plan to reach their goal.  If they are five years or less away from retirement, just subtract the amount they have from what they need, then divide by the number of years they have left until retirement to determine how much they need to put away per year.  Divide that number by 12 to determine how much they need to put away each month.

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 If they have more than five years until retirement, Multiply their monthly savings rate by the factor from the table below to estimate how much they’ll need to save each month since they’ll be able to invest to enhance their savings.

Years to Retirement Multiply Monthly Amount by
5 0.9
10 0.81
15 0.4
20 0.27

So, for example, if you calculate that they’ll need to raise about $2,000 per month to reach their goal and they have ten years until they will retire, they will actually only need to put away $2,000 x 0.81 = $1620 per month.  This assumes that they invest the money in a diversified set of stock and bond mutual funds or a target date fund appropriate for their retirement date.

Note that they will only need to save 27% as much if they start 20 years early – their investments will make up the rest.  If they are only five years away, they’ll need to raise about 90% of the difference through hard work and saving.  There is good reason to start saving early.  It may be too late for your parents, but you still have a chance.

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Encourage them to work longer

If they don’t have enough saved up and it is clear that they will not be able to do so before their expected retirement date, encourage them to think about working longer.  Not only will this allow them to pile up more money, but it will also reduce the number of years they’ll be drawing an income from their savings, reducing the amount they will need to have.  As long as they are healthy and don’t have enough saved up to live comfortably, they should continue to work, even if it is only part-time near the end.

New to investing? Want to learn how to use investing to supercharge your road to financial freedom?  Get the book: SmallIvy Book of Investing: Book1: Investing to Grow Wealthy

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

401K Changes that Would Work


IMG_0120401k plans are better than traditional pensions and way better than Social Security, if they are used correctly.  The issue is that they are not used correctly.  People are too timid and leave all of their money in the money market or treasury fund their entire careers, missing out of the growth they could have had if they had invested.  They don’t enter the plan until they are in their forties or fifties, or contribute far too little.  They are too aggressive when they are nearing retirement, usually because they are trying to make up time, and see a market crash wipe out half of their portfolio value right when they were ready to head out-the-door.  They borrow against their 401k plan, or take the money out entirely, and lose the effects of compounding.

These issues could be easily solved.  The reason they occur is the rules behind 401k plans that allow or even encourage behaviors that are destructive to the employees retirement.  People have no choice in the amount they contribute to Social Security or pension plans.  The employer or the government dictates how much of the employee’s pay is contributed and how much they provide.  And at least with Social Security, you have no choice but to participate.  You are enrolled whether you like it or not.  Employees can choose not to enter the pension plan at some companies, but most realize that they should and they do enroll.  Likewise, you can’t borrow against your pension plan or Social Security or take it out early.  In the case of pension plans, they are invested in a mix of stocks and income investments in a manner that is appropriate for the goals of the plan and the payouts that must be made.

The sad part is, if people were to put all of the money they are putting into Social Security (about 13% of their paycheck) into a 401k plan and invested it properly, everyone who worked their whole life would be set for retirement.  There would be no issue paying for living expenses and medical bills.  The senior discount would vanish since most seniors would be multi-millionaires.  Unfortunately, people don’t think about their futures and plan.  They either see the big pile of cash they’ll need to build up to have  comfortable retirement as being either too difficult to achieve or retirement too far out in the future, so they sabotage themselves.  Much as I hate to see central government planing and control, some regulation is needed to nudge people in the right direction.  Unlike Social Security, where the government has proven that they’ll just squander any money given to them, however, government involvement should only extend to preventing people from drawing the money out to soon, not enrolling at all or not contributing enough,  or investing the money in a way that is too timid early or too aggressive late.  Here are some regulations that would make 401k plans the path to comfortable retirement for all:

1.  Required enrollment.

Employees should be required to contribute at least 5% of their pay to a 401k plan to ensure they’re putting enough away for at least a basic retirement.  While I hate to force people to do anything, it is for the good of society to not have a group of destitute retirees.  As an incentive to contribute more, the rules could eliminate the need to make a Social Security contribution if at least 10% of an employee’s paycheck is being contributed to a 401k, between the employee’s contribution and the employer’s.

2.  Forbid withdrawals until age 62, then limit withdrawals until age 70.

There is no good reason for people to be pulling their retirement savings out early, and again, doing so subjects society to the burden of carrying a lot of destitute old people.  No withdrawals should be allowed until the employee has reached at least the age of 62 (which also encourages people to work longer and reduce the number of years they’ll need to be supporting themselves with their savings).  To prevent people from pulling all of the money out at age 62 and blowing it, they should only be able to pull out a portion, like 5%, each year until they are age 70.  Hopefully by that point they will have learned that it is a good thing to take the money out slowly since then the account has the ability to recover and generate more money and they’ll continue that behavior from then into old age.

3.  Eliminate borrowing of funds.

Just as funds should not be withdrawn, they should not be borrowed.  If people want to pay down credit cards, start a business, or upgrade their home, they should find the money elsewhere than their retirement savings.  People shouldn’t live beyond their means at the expense of their retirement funds.

4.  Remove the money market option for those under age 58.

There is zero reason for anyone to have a dime in a money market fund within a 401k account until they are getting close to using the money.  Removing this option would force employees to invest the money, which would allow the money to grow and prevent inflation from reducing their spending power in retirement.

5.  Require a professional money management option.

Most people know little about investing.  An option where a professional money manager just invests the money for employees should be included.  This would be similar to a traditional pension plan, except the money manager could invest for groups of employees separated into different age brackets instead of investing everything as one big account.  Because there would just be a few, large accounts (maybe three), instead of a lot of little accounts to manage, and because the manager would be investing in mutual funds instead of individual stocks, the cost would not be very much.

6.  Limit the contribution of company stock by employers.

Some employers like to issue company stock as their contribution instead of giving cash because cash is more precious.  This puts an employee in a risky position since he/she then has a big position in one company – their employer’s.  They could both lose a job and see their 401k decimated should the company misread market conditions.   A reasonable limit, such as 1% of salary, should be placed on the amount of company stock that can be issued by a company for a 401k contribution.  Alternatively, require a company match at least 5% of salary with cash before issuing stock so that the employee at least has 10% of his/her salary going into the 401k in a diversified manner before concentrating in company stock.  Employees should also be able to sell shares that a company distributes to them immediately and shift the money into mutual funds where it will be appropriately diversified.

7.  Require low-cost index fund options in each plan.

Research has shown that low-cost, passive funds will beat out high cost, actively managed funds over time.  Unfortunately, some employers only have high cost funds available.  Every 401k plan should at least have the choice of a large cap, small cap, international, and bond index fund in their investment mix.

8.  Auto-enroll employees in a target date retirement fund.

Even when they do enroll (usually through automated enrollment), many employees tend to wait to get into their 401k plans and make their investment choices, sometimes for years.  Currently, many 401k plans auto-enroll employees in a money market fund, meaning they are losing money to inflation until they shift the money somewhere better.  Instead, they should be auti enrolled in a target date retirement fund so that at least they’ll have a reasonably good investment plan until they get the time and motivation to take a little more active role.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

Good HSA Investing Can Let You Retire Early


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If you are fortunate enough to have a Health Savings Account, or HSA, you might be able to retire earlier than a lot of your peers.  Many people have the money to retire by their late fifties, but they hold out a few more years because they’re worried about losing their health insurance before they become eligible for Medicare.  If you invest properly in an HSA starting when you’re young, you might have the cash needed to carry you through to the time you’re eligible for Medicare and beyond, allowing you to retire on your timetable.

This is even assuming Medicare will still be there when you’re ready to retire.  The actuaries for Medicare have been warning for years that the system is running out of money and will either need an infusion from Congress/taxpayers or it will need to start cutting benefits.  This makes even the more reason to beef up your HSA.

So let’s look at the basics of an HSA and then talk about how to contribute and invest in an HSA to have the money you’ll need for medical expenses later in life.

What is an HSA?

A Health Savings Account, or HSA, is a private account that you can use for medical expenses, including paying the doctor, paying for labs and x-rays, and paying for prescription drugs.  You can also use an HSA to pay for COBRA continuation of insurance if you lose a job.  This means that if you are laid off or see your hours drastically cut, you can continue to get the same healthcare insurance for a period of time (currently 18 months, but always check this since it can change) so long as you are willing to pay both your part and the portion your employer was paying before.  So, having a well-funded HSA can help protect you from an unexpected job loss even years before you retire by providing the money needed to pay for COBRA coverage.  Unfortunately, it cannot (at this time) be used to pay for private insurance.

When you use your HSA to pay for qualified medical expenses (things like those listed above), you don’t need to pay taxes on the withdrawals from the HSA.  If you buy other things, you may need to pay some taxes.

Who can start an HSA?

Basically you can start an HSA if you have an employer who provides one, which means that your employer offers a high-deductible health insurance plan option.  The idea is to encourage employees to choose a plan with a high deductible by also having an account from which they can pay for expenses before meeting their deductible.

How does an HSA get funded?

Many employers fund part of the HSA for you as further incentive to choose the option.   In addition, you are able to contribute some of your own money from your paycheck to fund the HSA.  There are limits on how much you can contribute, so check the laws before proceeding.

Why would you want to contribute to an HSA?

If you pay for medical expenses out-of-pocket, you’ll be spending money on which you will have already paid taxes.  You can deduct medical expenses from your taxes, but only above a really high threshold that most people do not meet.  If you instead put the money into an HSA, then pay for medical expenses out of the HSA, you will not pay taxes on the money deposited from the first dollar.  So, if you are in the 15% tax bracket, this is like the government paying for 15% of your medical bills.  In fact, you don’t have to spend the money on medical bills during the year in which you make the contributions to see the savings.  As soon as you put the money into your HSA, you can deduct the contribution from your taxes, while letting the money stay in the HSA until you need it.

Why would you want to invest in an HSA?

In addition not paying taxes on the money you put in, money from interest or capital gains earned inside of the HSA will be tax-free if used on qualified medical expenses.  This means that you can put $2,000 in an HSA today, invest it in stock mutual funds for 20 years, and maybe then have $16,000 or so that you can spend on medical expenses, all tax-free.  Put in $10,000 today and you might have $80,000 later, and so on.  That $10,000 invested in your early twenties for 40 years might provide around $650,000 in your early sixties, which is enough to pay for some significant medical events even without insurance.  Double the amount you contribute and you’ll have over a million dollars available.

And that’s the part that might help you retire early.  If you have enough saved up in an account to self-insure for the unlikely event that you’ll have a major medical event during the three or four years between retirement and Medicare, you may be able to take the risk.  If before you retire the requirement in the Affordable Care Act is repealed that prevents the sale of catastrophic, major medical insurance , that would be even better since then you could buy inexpensive insurance to pay for the unlikely event that a major surgery will be needed and just self-insure for the more minor events.   The nice part about investing money for medical expenses in an HSA instead of just putting money into an IRA for retirement is that you can spend it tax-free on medical expenses before retirement age.  This provides protection and options for you that an IRA will not.

How should you invest the money inside an HSA?

In investing, you need to look at how soon you’ll need the money.  Money you’ll need (or have a reasonable chance of needing) within the next three years or so should be kept in cash.  Money that may be needed in 3-10 years you should be invested in a mix of stocks and bonds.  The higher the percentage of bonds (up to 80%), the more stable your account balance will be but the lower your return.  Money you don’t need for ten, fifteen, or twenty years or more should probably be invested almost entirely in stocks since they’ll offer the best return and protect your money from inflation.

Cash:  So first look at your deductible and multiply by three to estimate how much money you may need to pay out-of-pocket for medical expenses in the next three years.  Then look at your income and free cash flow and decide how much of those expenses you could cover from your paychecks if needed.  Plan to keep the amount beyond what you could cover from your income in cash so that you’ll be ready for near-term medical needs.  For example, if you have a $5,000 deductible and plan to cover $2500 per year from your salary, you’d need to keep 3 x $2500 = $7500 in cash inside the HSA.  For the first couple of years after you open the HSA, you’ll probably just be building up cash.  Investing comes a little later.

Bonds/fixed income assets: Figure out next what your deductible will be for seven years.  When doing this, assume that your deductible will increase by 10% each year for each of those seven years.  For example, if you have a $5,000 deductible now, use that value for the first year, then multiply by 1.1 for each year afterwards to get $5,500, $6050, $6655, $7320, $8052, and $8858, for a total of about $47,500 over the seven-year period.   Plan to keep about half this amount in bonds and the other half in stocks.  This will result in that portion of your portfolio being fairly stable in value while enjoying modest growth.  In years when the market really falls like 2008, this portion of your account may fall about 15% while the stock market as a whole falls 40%.  In years like 2009 when stocks go up 30%, this portion of your portfolio might gain 15-20%.  This will nearly ensure that you’ll be able to generate the cash you’ll need to meet your deductible in the period 3-10 years from now.

For the first ten years or so after you start an HSA,  you’ll probably not have this much to invest.  Just start by building up the amount of cash you’ll need from the section above,  Once you’ve got enough cash, start buying half bonds and income funds/half stocks and growth funds as you contribute more money.  As far as selecting particular funds goes, you’ll want to just buy an income fund that buys the whole market –  all types of bonds and some dividend paying stocks if possible.  For the stock portion, split between funds that invest in large and small caps 50/50 or just buy a whole market stock fund.  When choosing funds, get the ones with the lowest fees you can find.  If you can find passive funds – those that invest based on a strategy rather than hiring managers to choose investments – that is normally the lowest-cost option.

Stocks/growth assets:  Once you’ve invested enough to cover yourself for ten years out, you’re ready to invest any additional funds for long-term growth.  Here you’ll want to buy a mixture of large cap and small cap stocks, while skewing slightly towards small caps.  For example, you could put 40% in a large growth stock fund and 60% in a small growth stock fund.  If you have the option to buy into an REIT fund, which invests in real estate, you could add this to the mix with maybe a 20% REIT, 50% small cap, 30% large cap allocation.

As with everything, this will start slow with only a small amount invested in your HSA.  After sticking to the plan for many years, however, suddenly the value will explode.  You’ll be surprised at how much money your investments are generating and how easy it is to cover your deductible and medical expenses each year.  Before you know it, you’ll have plenty of money to cover medical expenses.  You’ll then have a lot more freedom and a lot more options.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

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

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Is a Roth 401k Better than a Traditional 401k?


IMG_0120We’ve all heard the conventional wisdom.  If you have an old, stodgy traditional IRA you should convert to a snazzy new Roth IRA.  There is now even a new Roth 401k.  Sure, you’ll need to pay all of the taxes since the money was initially invested tax-deferred and the conversion requires that the taxes be paid immediately.  For an account of $100,000 this could mean a tax bill of $20,000 or more.  But it will be worth it in the long-term, right?

Well, maybe.  It is true in general that if you are investing for a long time before retirement, the mathematics show that a Roth IRA , where after-tax funds grow tax-free, will do better than investing in a traditional IRA where funds are not taxed until withdrawn from the account at retirement.  This is true even if you invest the tax savings (the money that would have gone to taxes) in a taxable investment account rather than spend it.  This is because the large amount of growth in the IRA will not be taxed, so when you are withdrawing your millions later, because you paid the taxes on the thousands you put into it now, you will end up with more money.

But those making the above calculations leave out some important factors.  First of all, they assume that you are investing for a long time period, such that the money you put into the Roth IRA will have years to grow, compounding ad nosiuem such that the amount gained from interest and capital gains will far exceed the funds deposited.  If you are putting funds into an IRA for a shorter period of time — 10 years before retirement, for example — it may be better to put the funds into a traditional IRA.  This is because the money has little time to grow (15 years or so), and if your withdrawals are small enough, you may be in a higher tax bracket when you are making the money than when you are withdrawing it.  It may therefore make sense to make tax-free Roth IRA contributions early in one’s career when in a lower tax bracket and with many years before retirement, and then make increased tax-deferred contributions into a 401K or Traditional IRA when near retirement.

The second big factor that is left out of the calculation is politics and all of the things that can happen in thirty or forty years.  Because the rules can be changed at any time at the whim of the legislature, your calculations may be meaningless.  This is particularly true with the current demographics.  We have a large percentage of the population who have saved nothing for retirement, and a few people who have saved a great deal through IRAs and Roth IRAs.  This has led to a situation where some individuals have millions of dollars, and others have almost nothing (or negative balances, in some case).

Given that the nothing-savers far outnumber the big savers, it could be very popular to establish some sort of wealth tax (as the inheritance tax is already) or change the rules on the Roth IRA withdrawals, charging a “distribution fee” or some other form of tax.  After all, “how is it fair that some people have lots of money, and others have none”, the thinking will go.  Even if the rules are not changed, the taxes on dividends and interest as funds from the Roth IRA are pulled out and put into fixed-income securities could rise to high levels as governments try to balance their books.

Another possibility is that the income tax could be abolished or radically changed.  For example, the Fair Tax idea has been around for years.  In this scheme, income taxes would be eliminated entirely and replaced with a national sales tax.  To make things “fair” each individual would receive a prefund (beginning of the year refund) such that those who make little would pay essentially nothing in taxes, while the larger spenders would pay more.  If such a tax scheme were enacted, the Roth IRA tax-free growth would evaporate.  There has also been talk about eliminating the income tax and replacing it with a Value Added Tax (VAT), which is similar to a sales tax.  Here again, the Roth tax-free growth would be eliminated.

The bottom line is to not get too enamored with mathematical calculations when it comes to finances.  One must always remember that the rules can change and the risk of rules changes affecting results, particularly when large time periods are involved, must be taken into consideration.  As the old saying goes, a bird in the hand is worth two in the bush, and perhaps sometimes it is better to save the taxes now than save the taxes later.  So go ahead and save up for retirement, putting away at least 10-15%, but think about spreading it out between tax-deferred and tax-free growth, just to play both sides of the table.  Also, think long and hard before converting a traditional IRA to a Roth IRA, particularly if it is a large account.  In particular, if you do not have the funds available to pay the taxes without touching the balances of the IRA, it may not be worth it.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

Simple Choices to Become Wealthy


jellyfish

Most people think they can never become financially independent – that state where you have enough money to live the rest of your life without a job.  Instead, they decide that they’ll need to labor away the rest of their lives, always have a car payment, a mortgage, and a HELOC.  They figure they’ll retire someday, somehow, but have no idea how they’ll pay for things then.  Maybe the government will take care of them.  Maybe they’ll move in with their kids.  Maybe they’ll just work until they die.

The thing is, it doesn’t need to be that way.  If you’re in your twenties, thirties, or early forties and reading this post, simple choices you make today will get you financially independent by the time you’re in your forties or fifties.  If you’re in your fifties, you might not end up financially independent before retirement, but at least you can put yourself in a position where you’ll be able to make it through most of your retirement on savings and then perhaps get some help from family at the end.  Here are some really simple things that people who become wealthy do:

Choose the right career

It starts while you’re in college.  You might really like the ancient Egyptians and want to spend your time studying them.  But what then?  In a free enterprise society, you make money in by doing things that people need.  Do you know many people who need someone with knowledge of the Ancient Egyptians?  Maybe you’ll sell a couple of hundred copies of a book or do a couple of talks per year, but certainly not enough to sustain yourself.

In a free enterprise society, you make money in by doing things that people need.  

People need engineers to design and build things.  They need computer programmers to make the things engineers build think.  They need people to manage their business for them.  They need people to create artwork for their marketing and presentations.  They need people to prepare food for them.  They need people to clean-up their homes and offices.  They need people to write articles for newspapers.  They need people to get them home from the airport.

This doesn’t mean you can’t have a career that you enjoy.  It just means you need to find something you like doing that other people need you to do.  Maybe you can take a few elective classes on ancient Egyptian writing while you pursue an accounting degree and then visit Egyptian museums as a hobby.  Don’t expect people to pay you for something just because you like doing it and you need money.  Remember that you need people to do things like grow food and make things for you, which they do in return for you’re doing something they need.  You can’t get your needs met if people were just doing things they enjoy, so you shouldn’t expect to make a living doing what you enjoy but which does not have value to others.

Buy used cars for cash

The mantra of those who will stay in the middle class all of their lives is that they will always have a car payment.  Buying a new car on payments every five years will cost you anywhere from $2,500 to $5,000 extra in losses due to depreciation when compared to buying a new car, and between $3,000 and $7,000 in interest over the life of the loan when you buy new cars using payments every five years.  That’s $3,100 to $6,200 you could be investing each year instead – enough to fund college savings accounts or put a good amount into an IRA.

Buying new cars, you’re spending $3,100 to $6,200 extra each year that you could be investing each year instead – enough to fund college savings accounts or put a good amount into an IRA.

Instead, save up and buy used cars that you can afford to buy for cash.  If you work a few extra hours or save up for a few months and scrape together $2,000, you can get a perfectly adequate car to get you where you need to go reliably for cash from a private owner.  Even if you put $1,000 in repairs into it each year, you’ll still be saving over $2,000 per year.  Save that up for three years, and you can move up to a four-year-old used car that will look nicer.  You can then start putting half of your savings away for the next car, moving up in car at least one more time, and invest the rest.  Keep this up over your working lifetime and you’ll have over a million dollars from the money you save on cars and invest alone.

Learn to cook

Eating out is costly, even eating fast food.  Meals in a fast food place will cost you two times as much as an equivalent meal at home.  Meals in nicer places will cost you four times as much.  You can easily find ten thousand dollars a year or more to invest if you currently eat out all of the time if you start cooking and eating most meals at home.  This is enough money to allow you to become financially independent in your mid-forties. Even heating up boxed meals will cost you significantly more than cooking from scratch, plus meals you cook yourself will be healthier and taste better.

You can easily find ten thousand dollars a year or more to invest if you currently eat out all of the time if you start cooking and eating most meals at home.

The reason many people give up cooking when they first try is that they pick recipes that are way too complicated, involve way too many steps, force them to buy lots of ingredients where they use a little and throw the rest out, and dirty every pot and pan in the house.  Instead, get an all-purpose cookbook like Betty Crocker or The Joy of Cooking and learn the basic preparation of things like chicken, roasts, and fish.  Also, find cookbooks with recipes designed for using only one pot and/or five or fewer ingredients.  You can venture into more complicated recipes if you enjoy cooking and have more time to cook some nights, but you need the easy, quick recipes to just get dinner on the table.

You can venture into more complicated recipes if you enjoy cooking and have more time to cook some nights, but you need the easy, quick recipes to just get dinner on the table.

You can also use some time savers to make things easier for when you’re busy.  Buy frozen vegetables that you just need to steam and serve as sides.  Make a big pot of soup or chilli on the weekend, then add a small serving to your dinners throughout the week.  Likewise, make a bowl of salad greens (lettuce and carrots) when you have time and then add fruits like tomatoes and peppers at dinner time.

For the ultimate in easy dinners, get a book of crockpot recipes.  When you’re going to be rushed the next day or get home late, you can put together dinner for the next night the evening before in the crockpot and refrigerate, then just start it going before you leave for work the next day.  When you get home, you’ll have a hot meal waiting for you.

Buy a smaller house

Many people take the bad advice to buy the biggest home for which they can get a loan.  This leaves you house-poor, where you have a good income but you’re spending so much on your mortgage payments that you can’t save and invest.  You then end up taking out a HELOC or a second mortgage when you need to pay for something like college, a home repair, or even a vacation.  Plus, big homes come with big maintenance bills.

To avoid feeling house-poor, you should be able to pay the mortgage using no more than 25% of your gross pay.

Instead, buy the home that you can afford and the size that you need.  To avoid feeling house-poor, you should be able to pay the mortgage using no more than 25% of your gross pay.  Plus, save up at least a 20% down payment to reduce the risk that you’ll end up owing more on the home than it’s worth and to save the cost of mortgage insurance.  If that means you need to start with a smaller home and then add-on or upgrade in ten years, that’s better than buying a McMansion to start and possibly going through a bankruptcy in a few years or not being able to put money away for retirement.

Choose a low-cost area in which to live

A lot of people will say that there is no way they can do the things I’ve described because things just cost too much where they live or they are not practical.  Well, move somewhere else.  There are a lot of great places to live that cost a lot less than New York or San Francisco.  You can get a bigger house; land; safe, high-quality public schools; and pay a lot less for insurance, food and practically everything else.  Obviously, some people have a really strong reason for living in the big cities and it is worth it for them to pay out all of their income to do so.  If there is not, look around.  It is a lot easier to become financially independent if you lower your cost of living.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

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

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Take Risks when You’re Young, Sleep Easy when You’re Old


Clingdome2Proper investing is all about taking appropriate risks.  An appropriate risk is one where the reward justifies the risk you are taking.  Basically, you want to maximize your reward to risk potential.  Unfortunately, some people severely limit their reward potential because they don’t properly understand how risk works – in particular, how volatility works.  Probably one of the worst mistakes people make is to stay entirely in low volatility investments like back CDs their whole careers, totally missing out on the wealth growing potential of stocks because they’re afraid of seeing their account balances drop.

And volatility can be scary if you’re focused on your account value from day-to-day. Stocks are more volatile than bonds, which in turn are more volatile than money market funds and savings accounts.  By volatile, I mean that the price goes up and down more rapidly.  With a savings account, you can basically predict what your account will be worth tomorrow, next week, and next month.  With bonds, they will change in price from time to time, particularly when interest rates are changing or people are scared by inflation or deflation, but the extent of their fluctuations are normally limited.  Common stocks can change in price by huge amounts over short periods of time.  A single stock can easily double in price or drop to half of its value over a given year or even a month or a week.  Even a basket of stocks in an index can go up or down by 30-40% in a year.  This means that you may look at your mutual fund portfolio one month and see that it is worth less than it was a month before.  For some people, this is very disturbing.

Measurement of risk, however, is more than just volatility.

Risk = Volatility/Time

If you buy a stock mutual fund today and are planning to sell in a week or two, you are taking a huge amount of risk and would have been better off just leaving the money in a money market fund or even in cash if you really need the money in a week since you have very little time and stocks are very volatile.  If you hold an investment like a stock or a bond for a long time, however, the risk decreases essentially to zero since the volatility is constant but time grows, causing risk to approach zero.  (Look at the equation above and plug in 1 for volatility and 10, 100, and 1000 for time.  The larger time grows, the smaller risk gets.)

Higher volatility investments like stocks, however, have a higher rate of return. Basically, because they are taking on more risk by putting their money into a company with no guaranteed rate of return, people require a better return on their money when things do work out with stocks than they do with bonds.  If you buy just one stock, things may not work out and you may lose money.  If you buy several stocks, however, those that do well will make up for the losses in those that don’t.  And because they are priced for the risk you are taking, you’ll earn a better return investing in a portfolio of stocks than a portfolio of bonds.  You’ll make a much better return than you will putting your money in bank CDs and money market funds.

If you are investing for five years or less, it makes sense to invest in bonds and cash investments like bank CDs since the risk of investing in stocks will be too great.  You might end up with a good gain in stocks over a five-year period, but you might also end up with a loss.  You might end up just about back where you started.  With bonds, at least you’ll get an interest payment twice per year.  Bonds also mature and pay you back a fixed amount when they do, so if you hold them to maturity by buying only bonds that mature within five years, assuming the company or government issuing the bonds doesn’t go bankrupt, you’ll know how much money you’ll have.  This also makes the volatility for bonds less.

Now this is assuming you really need the money at the end of the five years.  If it would be nice to have the money, but you could wait out a market downturn if one occurred, you might choose to invest in stocks anyway for the possible higher gain. During that time period if there were a big run-up in stocks before the five years were up, you would take advantage and cash out.  If you ended up with less than you started at the end of the period, you’d go to plan B, using money from another source or just waiting longer to get whatever it was for which you were investing.

Retirement Investing

So how can you apply your newly minted knowledge about volatility and time?  Well, let’s look at retirement investing.  I invest for retirement through both a 401k at work and a personal IRA that I’ve had even since I was working as a lab assistant, making $5 per hour, in college.  In my 401k, because I’m only in my forties, I have only stock funds and one REIT fund.  The stock funds are scattered among large- cap, mid-cap, and small-cap index funds, a value fund and a growth fund, and an international fund.  I tilt towards the small and mid caps since those will grow faster than the large caps over long periods of time.

 In my IRA I have a few large positions in some select individual stocks and a few stock ETFs.  I concentrate mainly on growth securities – those that offer little or no dividend – because I want them to put extra money back into growing their business rather than sending me a check four times per year that I’d just need to reinvest.  These stocks are more volatile, but more volatility results in higher returns over long periods of time.

So what is my thinking behind these selections?  Well, I’m planning to work until I’m at least 65, and maybe to age 70.  I therefore have about a quarter century before I plan to tap my retirement funds.  It might be even longer than that since I have other investments that I could use for daily living expenses for several years into retirement.  This means I have a lot of time on my side, reducing the risk of holding mainly stocks and more even volatile stocks like small-cap growth stocks. I’m really not worried about a 40% drop in the markets like we saw in 2008 because  I would expect the markets to recover over a few years afterwards if one did occur.  As you saw in 2008, such events usually correct themselves within a year or two, as long as the government doesn’t try to “fix things.”

With stocks I can get a much better return than I will with bonds and fixed income assets, so I’m willing to accept the higher volatility over shorter periods of time. It will not matter ten or fifteen years from now if my portfolio value is cut in half next year.  In fact, market downturns just mean I get to buy stocks cheaper, which will help me be even better off wen I’m ready to use the money.  As I get closer to retirement – say within ten years – I’ll start to figure out how much money I’ll need and convert a portion of my portfolio to cash and buy some fixed income securities.

So when you’re developing your savings and investment plans, tilt more towards stocks when you have a long time to invest.  The extra gains you make will give you more money and security when you need it later.  If you really need the money soon, put the money in cash.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

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

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Not Lose Money when Investing, Part 2


River2In the last post we talked about how you can use bonds to provide a steady income and to provide stability while using stocks to participate in the markets and get some growth.   You buy enough in bonds such that the interest you receive from the bonds will be enough to offset any losses you may see in the stock portion of your portfolio.  This is how you create the “risk-free” portfolios you see some companies promote.  The difference is that if you do it yourself you’re not limited to the 5% maximum returns in the stock markets that they advertise.  You also don’t have the big company backing you up, however, meaning you don’t have a company able to pay out some money in the down years so that you don’t see a drop in your portfolio value during those years like you will if you create the portfolio yourself.  In the long run, however, you’ll be better off going it on your own, but you’ll have a little more volatility over short periods of time.

Today we’ll go into the strategy more fully and see how to put things into practice.  First, let’s talk about the behavior of stocks and bonds.

Stocks:  As stated previously, when you buy a stock, you are taking an ownership position in a company.  After you buy it, it’s value is determined by what someone else is willing to pay you for it in the future.  While you can look at the long-term return for stocks and draw some conclusions about how they will probably perform in the future, there is no guarantee of any rate of return over a given period.  Furthermore, the shorter your time period, the more unpredictable your returns will be.  Almost all periods of five years have positive returns, while 1-year returns are about 70% positive and 30% negative.

Despite the uncertainty involved (or really, because of it), stocks are an important part of a portfolio.  Stocks provide a long-term return that is better than bonds and other fixed-income assets, and holding stocks will allow you to protect your money from inflation.  While single stocks can (and do) become worthless from time to time, it would be very unlikely that you could lose everything if you held several different stocks.  If you have money you need in a short period of time (five years or less), it should be in cash assets.  If you have money that you don’t need for ten years or more, it should be in stocks to protect against inflation and increase returns.

Bonds:  Because bonds provide a fixed income, their return is more predictable than that of stocks.  This is not to say that the total return of a bond can be predicted exactly, and in fact the price of a bond can change dramatically if interest rates change or if a company gets into financial difficulty.  Losses can therefore still occur if the price declines and the investor sells out of the position.  Provided bonds are held until they mature, the fluctuations in price of bonds is not important since you’ll get the full coupon price of the bond when it matures.  In fact, you can gain a little extra return by buying bonds that are at a price less than their maturity price and then holding to maturity.

Holding single bonds can result in a loss of your entire investment if the company goes bankrupt and is unable to repay the loan.  Because of this, several bonds should be bought at once to reduce the damage caused by the loss of any single bond.  Again, buying bonds through mutual funds is a good way to accomplish this.  Also, bonds should be held for long periods of time, as should bond funds, so that the interest paid by the bonds and the effect of bonds maturing has the ability to reduce or eliminate short-term losses caused by price fluctuations.

Setting up a (nearly) limited risk portfolio:  Now that we’ve discussed the behaviours of bonds and stocks, let’s see how to use them to make gains when the stock market goes up but limit or eliminate losses when the market declines.  The trick is to use bonds to provide income and stability, while using stocks to benefit from market gains.  The more bonds you buy, the less declines in the market will decrease your portfolio value, but the less gains you’ll make when the markets go up.

You should therefore use a percentage of bonds tied to the amount of risk you’re willing to take and the amount of time you have to invest.  For example, let’s say that bond funds were paying an interest rate of 5% and you had $100,000 to invest.  You want to take almost no risk of a decline in your portfolio value, but you want to participate if the stock market increases in value.  Let’s also assume that you don’t need the money for at least five years.  (If you have a shorter time period and you really need the money, you should just be in CDs because even bond portfolios can decline given less than five years).

If you put 60% of your portfolio in bonds through a bond mutual fund, you would get a return of $3000 per year from your bonds in interest.  If you then invested the remaining 40% ($40,000) in stocks through a stock mutual fund, the interest from the bonds would make up for almost an 8% decline in the value of your stock portfolio.  If the stock portfolio increased 10%, you would gain $4,000 from the stock gains and still have the $3,000 from the bond interest, providing a $7,000 total return, or a 7% overall return.

Now if stocks fell more than 8%, or if interest rates went up and your bond portfolio went down in price, you would see a loss temporarily.  You would not see this from the commercial products because the company covers these losses.  (Note, they also generally require you to hold for a specified period of time since they know it is very unlikely that you will see a loss in either the bond or the stock portfolio if you holld for at least five years.)  When there are big gains in the portfolio, however, they keep a good portion of that gain.  You would therefore do better on your own since your gains will more, but you may need to see an account value decline a little in a given year, especially really bad years.

Note that you’ll often do much better than an investor who is fully in the stock market during down years if you hold bonds as well.  For example, in 2008, many pure stock investors saw 30% declines in the value of their portfolios.  Bond investors actually saw the price of their bonds go up as stock investors sold and bought bonds to try to gain safety (note, this is exactly the wrong thing to do, but we’ll talk about that another time).  If you had the portfolio described in the example above, you would have seen maybe a 5% gain on your bond portfolio just due to the price going up (+$3,000), a 30% loss in the value of your stock portfolio(-$12,000), and then your normal 5% interest return on from your bonds (+$3000).   You would therefore have seen a decline of only $6,000 in your portfolio, or about 6%, when others were seeing a 30% decline.  Most years are not that bad, so even a 6% loss would be rare.

If you had then held the portfolio for another year, allowing stocks to recover, you would have ended up gaining about 20% on your stock portfolio (+$5600), plus another $3,000 in interest from your bonds in the next year.  After year two, you would actually be up $2400 from where you started at the beginning of 2008.

The issue with increasing bond percentage further is that you are giving up return.  And if you go to an all bond portfolio, in fact, you end up increasing risk since now you’ll not have a counterbalance to a decline in bond prices due to rising interest rates.

Your investing questions are wanted. Please leave them in a comment.

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

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

 

How to Not Lose Money when Investing, Part 1


Coffee money

Ever see those ads where you can invest and get returns from the stock market, but you’re guaranteed to never lose money and wonder how they could offer such a product?  If you wanted to, you could do the same things with your portfolio by using the right mix of stocks and bonds, and holding your investments for a long enough time period.  You’ll actually make more that way than you will with one of the “guaranteed” investment products because you won’t be paying out a lot of money in fees.

Let me first say, despite the claims, there is absolutely no way that you can never lose money when investing.  You can just make the chances of losing money very low by making the right investment choices.  The companies may claim that you can never lose money, but they would simply go bankrupt or look for a government bailout if everything went bad at once.  They also have a little more protection than you do when investing on your own since they have a larger pool of money to work with.  As long as everyone doesn’t want their money back at once (and they’ll usually protect against this by charging huge fees if you redeem early), they can usually wait for the stock market to recover.  This is actually what you should do as well, but you’ll see a loss for a while until it does.

Also, understand that the less chance you have making money, the lower your returns will be.  In investing taking prudent risk is how you make greater returns. (Note that term, “prudent” in there.  If you take stupid risks you won’t make bigger returns, except maybe for your broker.)  Part of protecting your money is to invest in some things that make a lesser return, but are more stable and have a more predictable return.

To understand how things work, you need to understand how stocks and bonds work.

Bonds:  A bond is a loan to a company.  In exchange for making the loan, they will pay you a specified amount twice a year.  At the end of the loan period, the company will pay you the money you loaned them back.  At this point, the bond is said to have “matured.”  The company can also pay you back early, which can be an issue since this normally happens during a time when interest rates are low, leaving you with few options to get a good rate of return with your money.

So with bonds, you get a specified rate of return (for example, $500 per year or a 5% initial return on a $1000 bond) and at a certain date the company should pay you your money back.  Of course, things can happen at the company and they may declare bankruptcy.  If that happens, you’ll be first in line to get paid but you’ll be lucky to get a couple of hundred dollars back for your $1000 investment.  If you’ve been collecting interest payments long enough before this happens, you’ll have made money.  If not, you’ll take a loss.  You need to therefore invest in bonds in such a way that you almost guarantee you will not take a loss.  Do this by:

  1.  Invest only in the bonds of companies that are financially strong and unlikely to go bankrupt.  These are bonds that are AAA or AA rated by the rating agencies.  You can buy a few lesser-grade bonds provided the interest rate they are paying are suitably high, but understand a percentage of these will go bankrupt before they mature.
  2. Invest in several different bonds in different companies rather than investing in just one or two.  Think of how unlikely it is that ten or twenty high-quality companies will go bankrupt within the next ten or twenty years.  Having one go bankrupt is  more likely.  Really, investing through bond mutual funds that buy a set of dozens of bonds for you is usually the way to go since you then don’t need to find all of the bonds yourself.
  3. Try to buy bonds that are below their maturity price.  The price of a bond will fluctuate during its life depending on the health of the company and interest rates.  Try to buy bonds that cost less than $1,000 per bond (most bonds are worth $1000 at maturity).  This way, you’ll get a little extra return when they mature since you’ll get paid $1000 per bond then.  If you buy bonds above their maturity price, you’ll lose a little in each bond.
  4. Buy bonds you can hold to maturity.  Your plan is to hold these bonds to maturity so that you won’t care about what happens to the price along the way.  If you have ten years, don’t buy bonds that don’t expire for twenty.

Stocks:  With common stocks, you’re buying an ownership stake in the company.  This means that if the company does well, the value of your ownership stake will increase.  There is no guarantee, however.  If your company doesn’t do well, you’ll lose money, possibly your whole position.

Stocks provide the opportunity to make a greater rate of return than you can receive with bonds.  The value of a company will also keep up with the rate of inflation.  If you invest only in bonds, you’ll see your spending power decrease over time. Remember that at the end of the life of a bond you only get the $1000 you loaned the company back – you don’t get $1100 to account for inflation.  Conversely, Over long periods of time the price of stocks will increase just because of inflation.  Even if the company you buy never makes a higher profit, the price of the shares of stock will increase just because of inflation.  Also, the company will be able to charge more when dollars are worth less, so their profit will increase in absolute dollar terms even if they don’t in real dollar terms.

So the underlying philosophy is that you buy enough in bonds such that the interest you receive from the bonds will be enough to offset any losses you may see in the stock portion of your portfolio, plus give you a little but of money each year.  That way, you “eliminate” the chance of losing money, yet still have the opportunity to make returns from the stock market.  Note that the word, “eliminate” is in quotes because there is still a chance of losing money if things go really badly or you do something silly like see your position after a drop in the markets  before it has a chance to recover.

In the next post we’ll go into the details of how to use a combination of stocks and bonds to build a “risk-free” portfolio.

Your investing questions are wanted. Please leave them in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

 

A Simple Way to Invest in your IRA


Fountain

 

Before the 401k, there was the IRA.  The simple investment account that anyone who had earned income could use to save for retirement.  For many years contributions to IRAs were held at a paltry $2000, but about a decade ago they were raised to $5500 per year .  Put away $5500 for both yourself and your spouse into IRAs each year and you really start saving up a serious amount for retirement.

One good thing about IRAs is that they let you invest in virtually anything.  One issue, however, is that they let you invest in virtually anything.  For many people who really don’t understand investing this can be a serious issue.  They just don’t know how to invest the money, so they do something foolish like:

1) Leave it in a money market fund so they lose money to inflation each year.

2) Invest in a set of high cost mutual funds recommended by their broker.

3) Put it all into a single stock, leaving open the chance that they can lose it all.

4) Trade in and out of different stocks, racking up a lot of commissions for their brokers but making little money themselves.

For those who don’t want to fool around much with investing, here is a really simple strategy for investing in your IRA:

  1. If you are younger than 45, put half of your money into a large cap index fund such as an S&P500 ETF and half of your money into a small cap index fund such as the Vanguard Small Cap ETF.
  2. If you are between 45 and 55, shift 30% of your money into a bond/income fund, the leave 35% of your money in the large cap fund and 35% in the small cap fund.
  3. If you are between 55 and 60, put 50% of your money in a bond/income fund and split the other 50% between a large cap and a small cap ETF.
  4. Assuming you’re retiring at age 65, between age 60 and 65 start to sell off some of your assets to raise cash.  Figure out how much cash you’ll need from your IRA  each year in retirement and raise that much cash each year, placing it in a CD set to mature just before you’ll need the money.  If you’ll have another source of income and won’t need to tap into your IRA just yet, just stay fully invested in the half bond/half stock portfolio.

So there you have it – real simple but really effective.  This strategy keeps your fees low, gives you plenty of diversification, has you take more risk when you’re young and can afford to wait for the market to recover, and starts to get more conservative when you start to near retirement.  The only trick now is to stick to it and not let your emotions get the best of you.  The worst thing you can do is let your emotions drive you into making a mistake.

Your investing questions are wanted. Please leave them in a comment.

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

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.