The Money Equation (Part II Your Investments)

∫ (Money In) d/dt = ∫ (Money Stored + Money Spent) d/dt
(This equation is integrated over your lifetime)

Let’s look at the other half of “Money Stored,” where the magic of compound interest works for you instead of against you. The first step in investment is savings. Dave Ramsey’s seven baby steps are a good way to prioritize this process.

1)$1,000 in a insured emergency fund (a bank account).
2)Pay off all unsecured debt (credit cards)
3)Three to six months total household expenses in that emergency fund.
4)15% of your household income in Roth IRAs and pretax accounts (for most of us that would be a 401K)

I would quibble as to when to start savings in your 401K if your employer offers matching money. For example, if your company offers a dollar for dollar match on the first 3% you contribute, for heaven’s sake take the free money. There is nowhere else where you can get an instantaneous 100% tax free return on your money! You don’t need to start at the 15% level to contribute to your retirement accounts. As time passes, build up to that number, but start as soon as possible.

Now what to do with your savings once you have established a firm foundation to your personal financial condition? I believe that there are a number of proven strategies that will work for you. The key is finding one that matches your personality then holding to that plan with patience and perseverance through good times and bad.

The number one investment mistake is never starting to invest.
The number two investment mistake is getting out of the game at the wrong time.

I am learning how to be a value investor. It is a philosophy that works for me. Somewhere along the line, I decided that I would buy stocks like I bought any other major purchase. I would look for the best value at the lowest cost. That has worked pretty well, but it does have it limitations. The text on value investing is The Intelligent Investor by Benjamin Graham. Warren Buffet believes it is the only book on investing you ever need to read.

There is a certain amount of risk involved in owning individual stocks. However, if you keep each holding under 2% or 3% of your liquid net worth, you are probably going to be OK. I think there is a greater danger, buying actively managed mutual funds from a commission salesman. Yes, there are funds that will out perform the market. Proponents of actively managed funds argue that every year there are funds that beat the market. True, but picking them before the fact is the problem. Picking the Super Bowl winner after the game is over is pretty easy. Picking next year’s winner, well that’s a bit of a trick, isn’t it?

Studies indicate that at least 75% of these money managers will underperform the market. In addition a 6% or 7% sales commission means you need 7.5% growth before you break even. There go your first year’s returns. These funds also have annual fees that can run 1% or more of the total value of your account. Numerous studies by John C. Bogle, founder of the Vanguard group and other heavyweights in academia and the industry have demonstrated the near impossibility of an actively managed fund beating the major market averages over the long haul. In addition these studies have proven that those commissions and fees are simply not worth the value of the “professional” management that is playing with your money.

As I mentioned there are inherent limits to buying individual stocks. Picking out stocks like Chevron, Coca Cola, and Proctor & Gamble didn’t require a lot of research on my part. However, the key to safe investment is diversification across many asset categories. Starting with companies like Chevron is easy, but what Brazilian tree farm should I buy? This is where low cost index funds and their younger siblings, the exchange traded fund come into play. I bought Vanguard’s exchange traded fund for developing markets to own a piece of the action in countries like Brazil, Russia, India, and China.

Buying and selling individual bonds can be laborious. In addition individual bonds can be, at a given point in time, illiquid. Perhaps you own a Frederick County Municipal Sewer Bond. To sell this instrument you need to find someone who wants to buy that exact item. In order to attract a buyer you might need to sell at a pretty steep discount. Low cost bond funds can be bought and sold any day of the week for a well understood and relatively stable price.

Finally, I want to own some gold as disaster insurance. What am I going to do with physical gold? Bury it in my back yard? An exchanged traded fund sector fund like GLD (SPDR Gold Trust) solves that problem. For a very small fee my gold sits safely in a bank vault in London. I can buy or sell it like any other stock.

For the record, I hold something on the order of 15% (or a little more) of my liquid net worth in individual shares. The rest is held in low cost index funds, exchange traded funds, or simple cash vehicles like money market funds or certificates of deposit.

Bottom line. You want the safest strategy for your investments? Numerous studies indicate that an age appropriate mix of low cost index funds is the best bet.

Maybe something like this for someone of my age (62)?

Total Stock Funds 45% distributed in index funds something like this:

20% U.S. Large Cap
5% U.S. Mid Cap
5% U.S. Small Cap
10% Developed Markets Foreign Stocks
5% Developing Market Foreign Stocks

Total Bond Funds 35% distributed in index funds something like this:

10% U.S. Treasury Notes
10% Investment Grade Commercial Bonds
10% Tax Free Municipal Bonds
5% Treasury Inflation Protected (TIPS) bonds

15% Cash: This is not as stupid as it sounds. Even if you are young, you will need working capital to pay your monthly bills, an insured emergency fund, and something to take advantage of opportunities that will appear from time to time. Besides that, there are (uninsured) commercial Certificates of Deposit and similar vehicles that offer a pretty good return with a minimum of risk.

5% Precious Metals: Maybe now is not the best time to buy very much gold, silver, or platinum, but long term I would keep a little money in this sector.

Remember, as your stocks fall in value you are selling bonds to buy more stock, thus maintaining your target balance. As your stocks rise in value you are selling shares to buy more bonds. As you continue to work you are adding more money in a manner that maintains your balance.

If all that seems like too much work, just buy a low cost lifecycle fund. A computer will maintain an age appropriate mix of stocks and bonds on your behalf while you sleep or play computer games.

One word of caution about the “experts,” always investigate how they actually invest their own money. If they are not following their own advice, ask why.

The Japanese have a saying about eating the potentially lethal, poisonous dishes prepared from the puffer fish, "Only a fool would want to eat Fugu fish, but only a fool will not taste the delicious Fugu fish." It is both the most notorious and celebrated dish in Japanese cuisine. Perhaps investing in the American markets is the most notorious and celebrated function of life in America. Always start small. If you are frightened by a new method of evaluating stocks open a practice portfolio without using your own money on a website like Google Financial before you invest real money. Be careful. Take your time.

Never stop learning.

* In the interest of accuracy let me add that I have three positions that are neither this nor that a closed end fund and two hybrid (bond/stock) funds. All of them invest primarily in conservative dividend paying stocks or conservative dividend paying stocks and investment grade bonds, just like me. I do not yet have a position in TIPS but I am thinking about it.