The Basics of Investing
Preface:
You can work hard all your life, put lots of money into your savings, but can still be poor in retirement if you don't invest well.
You will learn three things from this article: how much to invest, how often, and where.
How much money do you need to retire?
The Four Percent Rule. Let's start at the end. How much money do you need to retire? The rule of thumb is that you can take out 4% of your money every year for your retirement. So if you need $40,000 dollars a year from your savings (in addition to Social Security), you will have to save one million dollars by retirement age. That's a lot of money and it doesn't just happen.How much to save?
As a general rule you should try to save 10-15% of your salary for retirement. This 10-15% includes what your employer contributes. The following table shows how far along you should be at a particular age to be on track.| Age | What multiple of your salary should you have already saved |
|---|---|
| 30 | 1x |
| 40 | 3x |
| 50 | 6x |
| 60 | 8x |
| 67 | 10x |
Basics of Investing - Risk
You get paid for taking risks. Since inflation historically runs about 2% a year, if you put your money in the bank in a risk-free FDIC insured account at 0.05% interest, you are losing 1.95% every year. You need to take more risk to earn more money.What is the stock market?
When you own a stock, you own a little piece of the company. When the company makes a profit for the year they will pay you a tiny part of that profit which is called a dividend. If a company has a million stock shares, and you own one stock, you will get one-millionth of their profits for the year. (Although some companies don't pay dividends, but let their stock price rise instead. Either way you can make money).Stocks are risky.
If the company does not do well, your stock value can go down. If the company goes bankrupt you can lose all the value of your stock. But with greater risk comes great reward. The US stock market averages about 8% returns a year.What are stock funds?
Stock funds are composed of other stocks. It's like a basket of stocks; when you buy a stock fund, you buy a small piece of multiple stocks.
Managed and Index Funds
Two types of funds exist, managed and indexed. Managed funds buy stocks based on the opinion of a highly paid stock picker and have a high fees (0.5-2%). Index funds buy stocks based on an list, like the 500 biggest companies in the stock market (the S&P 500 list) and have a low fee (0.03%).Index funds will almost always beat managed funds because managed funds have a higher expense. Over the decades this tiny difference can amount to tens of thousand of dollars.
Don't invest in individual stocks, buy index stock funds.
Individual stocks are fun to play with, but they're too risky to invest serious money.What are bonds?
Companies borrow money from investors by selling bonds. They are like government savings bonds - you buy them now and can redeem them later with interest and sometimes with quarterly payments. While bonds earn interest and are safer than stocks, they don't earn as much potential profit.When a company goes bankrupt the bond holders get their money before stock owners, less risk so less reward. Government bonds are the safest investment, but only pay about 2-3% returns.
The biggest risk with bonds is that inflation will rise, making your bonds worth less.
How to Mitigate Risk: Diversify
You should own a mix of stock index funds and bonds in case the stock market goes way down.What percentage in stocks? One rule of thumb is to have the percentage of stocks the same as 120-your age. So at age 50 you should have 70% of your savings in stocks, both domestic and foreign. When you are 20 you should be 100% in stocks, since you have a lot of time to ride out the ups and downs in the market.
John Bogle, founder of the Vanguard Group which champions low cost index funds, recommends this proportion of funds:
40% in the Vanguard Total U.S. Stock Market Index Fund
20% in the Vanguard Total International Stock Market Index Fund
40% in the Vanguard Total Bond Market Index Fund
20% in the Vanguard Total International Stock Market Index Fund
40% in the Vanguard Total Bond Market Index Fund
Dollar cost averaging and beating the market.
Trying to invest money in the stock market when you think it is low, and selling when you think it is high almost never works. Instead, invest a little every month and ride out the storms.
Real Estate.
You can invest in real estate, but it takes time to manage. Your own home is typically good investment. Another way to invent in real estate is a Real Estate Investment Trust (REIT), which is like a stock, but it invests in real estate like apartments, shopping malls, office buildings, and homes. This is the simplest way to own real estate.Invest in ways that minimize your taxes.
Your work will typically have a Retirement 401(K) plan that will allow you to invest money without it first being taxed. They will typically match a part of your investment, like the first 4% of your salary. You get to deduct the amount you invest from your income so you don't have to pay taxes on it, yet. When you retire you will pay taxes when you pull money out, but the money has grown for 30 years without paying taxes.If your company doesn't offer a 401K, you can invest in an IRA, or a ROTH account. If you invest in an IRA, it is untaxed going in, allowing for compounding interest on the full amount you put in, but taxed when you withdraw money from the account. If you invest in a ROTH account, money is taxed going in, but considered non-taxable income when withdrawn.
In Summary
Miscellaneous Tips:
- Don't buy toys on credit. Credit cards carry a huge interest rate and you will be losing money every time you have a balance at the end of the month. Pay your credit cards off at the end of the month. Buy clothes at Goodwill, eat frugally, take local vacations, drive an old car, use a Windows computer - do what you must, but never carry a balance on your credit cards.
- Watch your expenses.
- Use a Credit Union
- Beware your broker and financial advisor
Your home and cars are the only things you should normally buy on credit. Save up your money so you don't have to buy cars on credit.
Do you really need a $5 cup of coffee every morning, a $10 lunch and a $20 dinner?
Banks are made to provide profits for their owners, the stockholders. Banks try to wring every last cent from you. Credit Unions belong to the depositors and hence try to serve you, the depositor. That being said, sometimes banks can provide services like ATMs everywhere that make them worth a second look, but remember banks live to make other people money.
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| Bankers circling to figure out ways to charge you more fees |
Your stockbroker or financial advisor (unless they are fiduciaries) may not have your best interest at heart. They may steer you towards funds that are not as good as other funds, but pay a commission to your advisor.
Don't let your broker run up trading fees that make her money, but cost you money. This shouldn't be a problem since you are invest in index funds. Right?
After saving 15% of you income every year for 40 years in an Index stock fund, you will have a fortune in the stock market.
