Wednesday, October 23, 2013

Investing 101

Earlier this month I presented posts on the first two steps to financial freedom, escaping the debt trap and saving. Now let’s assume you have dumped your most toxic debt or at least have it under control and let’s assume you have at least three months take home pay or three months expenses in a boring federally insured account somewhere. As soon as you have an extra $3,000 in your pocket you are ready to start separating yourself from the average American. There is one exception to these general guidelines. If your employer offers any matching money with your 401-K or equivalent, grab it as soon as possible even if you have to sacrifice lifestyle or get a part time temporary job. You simply can not beat 100% guaranteed instantaneous tax free return on your money, anywhere.

Just do it. Don’t worry about making mistakes. I assure you. You will make mistakes.

If you start early in life or even in your middle years, time and compound interest are working in your favor. There are only two mistakes that are really dangerous, investing too much money in any one vehicle or investing too much money at one time. I have written so much about diversification I get tired thinking about it. One more time, if you have no more than 2% or 3% of your liquid net worth invested in any one company, losing 50% of your money in that one company doesn’t really matter in the long run. Likewise, don’t put all your money in the market (or anything else for that matter) at one time. Invest small amounts systematically over the entire course of your working lifetime. Leave it alone. Reinvest the dividends. Let time and the miracle of compound interest work for you instead of against you.

Let’s assume you start with your tax favored 401-K. Most likely you will be offered a selection of bond and stock funds. More recently lifecycle funds have been added to the menu.

My former employer the Department of the Navy offers.

G Fund – Government Bonds
F Fund – A mix of Government Bonds Corporate Bonds and Mortgage Based Securities

C Fund – Shares of Medium to Large U.S. Companies
S Fund – Shares of Small to Medium U.S. Companies
I Fund – Shares of International Companies (22 Developed Countries)

Put your money in all five. The old rule of thumb would have your age split between the G and F funds. Hence put 30% of your money in G and F if you are thirty years old. The new rule of thumb suggests 15% less than your age due to inflation risk. Hence 15% if you are thirty years old. Split the rest between the C, S, and I funds. Again, if you are younger put more of your money in the more risky S and I funds, less in the C fund. Rebalance your holdings to maintain your desired distribution percentages about once a year or more often if the market does something strange.

If you don’t want to worry about distribution percentages, just put it all in the appropriate lifecycle fund for your age. As you gain knowledge and experience you will become more comfortable making your own decisions, but start an investment program today.

Starting a taxable account is no different. Begin building a base of LOW COST mutual funds or their more modern brothers, the Exchange Traded Fund. If you mimic the offerings in the list above in your investment account or invest in a commercial lifecycle fund that would be a good start.

Do not pay a salesman a commission to invest your money, ever.

Do not pay 12B-1 fees, ever.

Pay very close attention to the total expense ratios associated with any of these investments. Generally speaking, the less you pay the better. Vanguard is no longer the only low cost player in town, but always check out their products before making a decision. Fidelity, Schwab, BlackRock, and I-Shares are some competitors with decent offerings.

If you have already paid a salesman a commission on any of your investments, that money is lost forever, just don’t repeat that mistake. Depending on how the fees are structured it may be better to leave that money alone or it may be better to sell those shares and move the money into a low cost equivalent. That can be a hard call, because the fees are hidden in pages of fine print crafted by attorneys who are paid large sums of money to protect the mutual fund company’s interest.

Yes, some managed retail mutual fund with sales commissions and fees will beat its equivalent index over a given ten year period. The problem is picking the winner in advance. In any given year only 1 in 4 mutual funds beat the index. Over the course of ten or twenty years that number becomes diminishingly small, much less than 1%. You have a much better chance of picking the 2025 Super Bowl Winner out of a hat than picking a retail mutual fund that will beat its low cost index equivalent.

Once you have a solid foundation of low cost fees, you are ready to start investing in individual stocks. For most people these funds would be in a tax favored account of some sort. When you buy shares in individual companies, do as Warren Buffet does. Tell yourself, “My preferred holding time is forever.” Of course, if your shares tank, sell them. Take the tax loss and move on. If they go up so fast you can’t sleep at night because you are afraid they will fall just as fast, sell your shares. It is said that God put over half the bones in the human body in the hands and feet so that we can take the money and run. Warren Buffet also suggests that you tell yourself that you are only allowed to make 20 stock buys in your entire life. Do extensive research before you put your money down.

And please, “Let’s be careful out there.”

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