To Roth or not to Roth

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As you enter the world of investing, one of the first decisions you need to make it whether to open a Traditional IRA or a Roth IRA.  Of course, I’m taking for granted that you’re using an IRA to save money, because we know that being smart with taxes is one of the most important things you can do.  As you read this, remember that I’m not a tax expert, but here is how I look at this issue.

These IRA cousins are both tax advantaged, but they go about it in different ways.  With a Traditional IRA, you are allowed deduct your contribution from your taxes that year; however you pay taxes on the money when you withdraw it in retirement.  Conversely, with a Roth IRA you contribute with after-tax dollars but then when you withdraw the money in retirement it’s tax free.

So basically with Traditional and Roth IRAs, you’re making a choice between paying taxes now or later.  If you lived in a world where your tax rate didn’t change over time, there would be no financial implications in the choice between the two IRA types.  The math would work out the exact same.  However, we don’t live in that world.  We live in a world where your tax rate goes up the more money you make.  In this world, we want to pay taxes when our tax rate is at its lowest.  So where does that leave us?

I did some quick estimates of what someone’s marginal tax rate would be in a high tax state (California—where the Foxes live) and a low tax state like Florida.  I did this at three different income levels: $50,000 (when you’re just starting out), $100,000 (after you’ve been working for a while), and $20,000 (when you’re in retirement—remember you’ll spend more than that but only $20k will be taxed as income).

MARGINAL TAX RATES

High-tax state

Low-tax state

$50,000 (early working career)

33%

25%

$100,000 (later working career)

37%

28%

$20,000 (retirement)

17%

15%

Wow!!!  Look at that.   We all knew that we would have the highest tax rate when our income peaked.  But did we really expect that we’d be paying double the tax rate when we were starting out compared to when we were retired?  That’s a huge difference.

Now, remember that the major difference between a Traditional IRA and a Roth is when you pay your taxes.  For a Traditional IRA, you’re getting a deduction while you’re working so that $5000 you contribute in your early years gives you a $1667 tax deduction ($5000 x 33% tax rate), and a $1850 deduction ($5000 x 37% tax rate) in your middle years.  Of course you’ll have to pay taxes on that money when you retire, which would be about $850 ($5000 x 17%).  Compare that to a Roth IRA where you’re paying taxes on that $5000 during your early years ($1667) and your middle years ($1850) in order to avoid paying taxes in retirement ($850).

In a world where we want to maximize our portfolio by minimizing our taxes (legally, of course), the answer seems clear—GO WITH A TRADITIONAL IRA.  The back of the envelop math says that going with a Traditional IRA will save you about $1000 per year that you contribute.  Remember that $1000 per year over a working career of 40 years, adds up to about $150,000.  Those are pretty high stakes for what seems like a pretty innocuous choice.

So why do so many people instead go with a Roth IRA?  Why did Stocky Fox himself open up a Roth IRA instead of a Traditional IRA?

  • Don’t understand rules: A major culprit is that many investors don’t understand the tax rules all that well.  Because of that they don’t have a strong opinion on which type of IRA to pick so they go with the one that others tell them is better (which leads to the next reason).
  • Roth IRAs are marketed better: For some reason it seems that Roth IRAs are marketed better than Traditional IRAs.  I don’t know if it’s because “Roth” sounds like an actual name and that draws investors, or what.  But my experience tells me that the average investor would pick a Roth just because that “feels right”.
  • Uncertain tax future: As my loyal readers Mike and Rich have pointed out in the past, the future tax rates are uncertain.  Today we know that a current tax rates make a Traditional IRA a better option, but what if those tax rates change in the future?  It could definitely impact the decision, but who really knows what will happen?  If I could predict the future I would own my own Caribbean island next to Johnny Depp.
  • Get the pain done with: As a kid I used to eat cupcakes upside down; start with the cake and finish with the best part, the frosting.  Some use my cupcake strategy to get the “hard part” over and done with.  They choose a Roth IRA because they get the taxes out of the way and then it’s smooth sailing.  This is following your heart instead of your head which may not make sense financially but we all do it.
  • Bad advice: You’ve heard me rail about investment advisers who maybe aren’t all that good.  A lot of people might take advice on which IRA to choose from someone who really hasn’t done the analysis, so they say “yeah, go with the Roth.  Just as good as any.”

I’m sure there are many more reasons but that’s my list.  At the end of the day I think Traditional IRAs are the best choice for most people just because with them, when you do finally pay taxes in retirement you’re probably paying at a lower rate than any time during your working career.  And that choice can be of the six-digit variety.  Yikes!!!

Of course, you there are special circumstances where maybe a Roth IRA works better.  Maybe you’re a kid with really low income (less than $10,000 like from a summer job), but those are probably more the exception.

Let me know what you think in the comments section.

Should you use an investment adviser?

I started writing this blog because I wanted to share my own experiences with investing, including how to navigate the complex world of investing on your own.  I am a firm believer in DIY financial management.  That is what worked for me, and I believe all people can get really great results doing it on their own.  That said, many readers ask about using a broker or investment adviser or financial planner.  Here’s my take.

Quick disclosure: I am an investment adviser.  I passed my Series 65 and work with a small number of friends, helping them with their finances.

 

Are financial professionals worth it?

As with any purchase you make, you need to evaluate a investment adviser on the basis of how much she costs, and how much value you get in return.  On the surface I would say “no, it probably isn’t worth it,” however there are definitely some factors which may reverse that decision.

First, let’s look at how much investment advisers cost.  The rates range widely.  Plus there isn’t a lot of transparency in the marketplace so it’s not always easy to know what the going rate is.  My experience says that 1-2% is typical.  This can come in many forms—typically brokers get paid fees from the mutual funds they suggest for you or from the transaction costs for trades.  Advisers tend to charge a percentage of your portfolio.  We know that 1% coupons are really valuable, so those fees are a lot.  Over an investing career they can add up to hundreds of thousands of dollars.  That’s a pretty big deal.

Of course, if you’re getting a lot of value from your investment adviser, maybe it’s worth it.  One of the main missions of this blog is to show you how you can invest successfully on your own, and I think most people can do that without having to hire a professional.  Sure you have to make decisions on asset allocation, which accounts to use, what investments to make; but those aren’t really all that complex.  Also, thanks to the efficient market lessons from A Random Walk Down Wall Street we know that you’re as good a stock picker as anyone.

So my general feeling is that investment professionals aren’t worth the money; a motivated investor can do just as well on their own and pocket the fees.  Wait, what???  You said “motivated”.  As it turns out, a lot of people, despite their best intentions, aren’t able to put their financial plan in motion.  If you’re one of those people, and if an investment adviser can help motivate you to do the right things, then I do think they are more than worth it.

In this way, investment advisers are a lot like personal trainers.  Most of us know that exercise is good for us, and most of us know how to run on the treadmill and lift weights properly (or you can find out by watching a 3-minute video on Youtube).  But if a trainer can motivate you to actually hit the treadmill and the weights, they’re definitely worth the money, right?  How much is your physical health worth to you?  Same thing with finances.  If you know what you should be doing, but for one of a million reasons you never end up actually doing it, maybe you should get an investment adviser to help you out.

Nearly every post I’ve done shows that there is a ton of value out there if you invest properly, taking into account things like time horizon, taxes, etc.  But if you don’t do anything, you’re losing ALL that value.  If an investment adviser helps you in ways you won’t or can’t, then you’ll probably end up ahead of the game, even after you take his fees into account.

 

How would you pick a financial professional?

So let’s say you’ve decided that an investment adviser makes sense for you.  How do you pick a good one?  This is one of the biggest challenges, and in my opinion one of the reasons a lot of people don’t get investment advisers: They don’t know a good one they can trust.  The problem is there are a ton of them and the quality varies greatly.  Sadly, there are a lot of unskilled people in the industry who don’t know what they’re doing.  Even worse, there are some real shysters who might take your money, either overtly steal it or use other schemes to siphon away your money and put it in their pockets.  It’s a legitimate concern.

First, you need to find someone you can trust.  Ideally, this would come from a personal reference.  Today you also have things like yelp.com or Angie’s List that gives ratings.  Additionally, there are government agencies like FINRA.org that track these people so you can look them up to see how long they have been around and any complaints that have been files against them, etc.  These are okay, but for my money, nothing beats a personal reference from someone you trust.  Of course, it’s not always easy to have those conversations with friends: “So Mary, who is helping you with your money, and can I talk to them?”

Second, you need to find someone who is good.  Of course, knowing this isn’t always easy.  Using that same personal trainer analogy, you probably wouldn’t hire an obese trainer.  You’d want someone who is ripped, someone who has shown they have been successful at physical fitness themselves (like my totally buff friends Christel and Tobias).

Tobias
If you have a personal trainer, he should be ripped like Tobias here. Similarly, if you have an investment adviser, that person should be somewhat wealthy.

 

Similarly, you want a rich investment adviser.  You want someone who has been successful creating wealth for themselves.  But this is where the challenge comes in: if the investment adviser is wealthy then why is he working with you?  Seriously.  You have a lot of young kids who are doing this (let’s say less than 30).  I’m sure there are some good ones, but I’m not trusting my family’s financial wellbeing to someone without a lot of experience.  You also have a lot of people who just aren’t that good.  If someone has been an investment adviser for 10 or 20 years and they aren’t a multi-millionaire, how good can they really be?  I’m not trying to be mean, but shouldn’t that be more than enough time to accumulate some serious wealth?

 

Questions to ask:

If you do decide to go with a investment adviser, make sure you ask a lot, A LOT, of questions.  Beyond your doctor or minister/rabbi, this person will probably have the biggest impact on your wellbeing.  Take the time to make sure you find a good one.

How long have you been doing this?  This is an area where experience definitely matters.  In particular, you want her to have lived through a few bear markets.  At a minimum she should have been doing advising people since 2008 and even better if she’s been doing it since 2001.

What did you do during 2001 and 2008?  Investing is a lot easier when things are going well.  You prove your mettle during the tough times.  Figure out how he handled himself when everyone thought the world was coming to an end.

What are you paid?  This should be answered in excruciating detail.  Does he get paid by you (how is the amount determined, when is it paid), by others like mutual fund companies (how much, how do you make sure you serve my interests ahead of theirs)?

What is your personal financial situation?  No point sugar-coating it.  Find what his financial situation is like.  As mentioned above, if he isn’t pretty well off, how good is he really?  Also, the relationship you have with him needs to be based on trust because you’re going to be sharing everything with him.  If he isn’t willing to reciprocate in some way, that might tell you something.

How will you ensure you serve my best interests?  This is a biggie.  Ideally you want her to have a fiduciary relationship which is a legal standard where she serves your interests ahead of anyone else’s, including her own.  No matter how this turns out, you’re going to need to trust this person, but you should get a sense of how she will ensure that you are #1.

What is your investing strategy?  Obviously, there are a lot of nuisances to this, especially as he customizes it to your specific situation.  But he should definitely have an approach and a philosophy that he can articulate clearly and understandably.

What type of power will you have over my money?  Will she be able to make trades and move money between accounts with your express permission, on her own, or not at all?  This is a tricky one because maybe you want to offload these activities completely, so her having a ton of control may be okay.  No matter, you should definitely understand this completely.

How will you take into account other assets that you won’t manage?  Most situations will have him managing an account like your IRA or brokerage account but not others like your 401k, mortgage, pension, etc.  Most times, he’s only paid on the accounts he manages, but to do his job well he’ll need to take into consideration those other accounts as well.

 

Those are what I came up with off the top of my head.  At the end of the day, if you do go with an investment adviser make sure you find someone who has demonstrated they have the skills to build your wealth.  Just as importantly, make sure you find someone who you can trust completely.

 

Debt is a four-letter word

“Never a borrower . . . be”—Hamlet by William Shakespeare

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People generally think of debt as a bad thing, and for good reason.  Debt can devastate national economies at it is currently doing to Greece and has done to countless others (Russia—1998, Argentina—2005, Mexico—1982, to name a very few).  At a personal level, it can hamper individuals with a burden that takes years to relieve, if they ever are able to pay it off.  Many people offer the sage advice to avoid debt as much as possible: “take on as little debt as you can, and if you have to borrow money for something then pay it off as soon as you can.”

In recent years the issue of debt has become raw meat for rabid politicians.  The explosion of college debt, the predatory lending practices on mortgages leading up to the sub-prime crisis, credit card debt in a world where credit card marketing is ubiquitous—all those are real issues that can affect anyone.  And the difference between getting this one right or wrong can lead to tens or even hundreds of thousands of dollars.

Quick note: This is an investing blog, not a personal spending blog, so I don’t want to get too much into the question of “should you incur debt?”  There are hundreds of blogs out there already that do that much better than I (my personal favorite is www.mrmoneymustache.com).  This post is going to be focused on looking at debt from an investment perspective.

 

Good debt and bad debt

Some people think of debt as either good or bad, like it is the good cholesterol or bad cholesterol you see on your annual blood test.  I think that glosses over some of the most important points.  Instead I look at debt solely by how expensive it is.  What is its interest rate?  Basically, if you can invest your excess cash at a higher return than the interest rate on your debt, then you should invest; if you can’t, then you should pay off your debt.  That seems pretty reasonable, right?  Based on that, the higher the interest rate on your debt, the more quickly you should pay that off.

If you make a list of common debts and associated interest rates, you get a bit of a hierarchy that looks something like this:

Debt type

Typical interest rate

Credit card

20%

Car loan

8%

Student loan

5%

Mortgage

4%

 

Obviously those are just examples, and they can vary a lot, but that’s a good starting point.  When you think about paying off debt, basically you’re getting a “guaranteed return” on your investment of the interest rate you were paying.  Right now, US bonds tend to have an average return in the 4-5% range; that certainly isn’t guaranteed, but that gives you a sense of what a “safe investment” can yield.  Stocks tend to have an average return in the 6-8% range, but sometimes it’s much higher and other times it’s much lower.

Now think about paying off debt.  Let’s say you own money on a loan that has 10% interest, and you have $1000 that you could either invest in stocks or use to pay off your loan.  If you invested it, let’s say you bought stocks; on average you would get 6-8% but that could really vary from year to year.  On the other hand, if you put the $1000 towards that loan, you would be guaranteeing yourself a 10% return because you wouldn’t be charged interest on that money.  This seems like a no-brainer, right?  A 10% sure-thing is much, MUCH better than investing in the stock market.  So this is the approach we’re going to use when we look at debt.

 

Credit card debt is pretty universally terrible for one’s personal finances.  The interest rates are usurious and there is no investment that can come close to the double-digit interest rates on most cards.  Some cards offer low introductory rates which change the calculations, but those are temporary.  As a general rule, paying off all your credit card debt should be the highest priority.

Auto loans throw in an added complication.  Some auto loans are on the high side, let’s say anything over 5%.  If you pay those off, you’re getting a guaranteed 5% return which is better than any other “guaranteed” return, so that makes sense.  This is the case with many new car loans and nearly all used car loans.  However, some car companies offer “below-market” interest rates auto loans to induce you to buy.  Last year, the Fox family bought a new Honda Fit, and we were offered a 0.9% interest rate to finance the car for 5 years.  If you compare 0.9% to what we could expect on average with stocks or bonds, we’re much better off taking the loan and investing the money we would have used to buy the car outright.

Also, you can think of a subsidized loan as something of value that the car company is offering.  If you don’t use it, you’re passing up that value.  However, if you do use it, even if you have the money to pay off the car in full, the value of that “subsidy” might be worth a few thousand dollars.  The Fox family has very little debt, but we do have an auto loan.  We had the money to buy the car outright, but we’ve taken advantage of the really low interest rate because we’re getting more by investing that money in the market.

Student loans get a little more complicated because the interest on them is tax deductible, and that’s an important consideration.  So for example, if your student loan is at 5% (current rate for new Stafford loans) while your marginal tax rate is 40%, you’re effectively paying only 3% (5% *(1-40%)).  Obviously the decision to pay off your loan right away or invest that money is significantly impacted by that difference.  You’d probably want to pay off a 5% loan right away, but a 3% loan might be low enough to make it worthwhile to invest the money.  There is a lot of gray area here, but I would generally choose to invest the money and just make the regular loan payments.

Mortgage is usually the biggest loan people have (as we covered here).  Similar to student loans, interest on mortgages is usually tax deductible, so really lowers your effective rate.  Also, mortgages tend to be subsidized by the government, so they often have interest rates that are lower than any other type of loan.  30-year fixed loans are currently at about 3.7% which is super low.  Add on the tax-deductibility benefit and your effective rate can drop as low as 2%.  If you’re paying 2% on a loan that will last decades, the math and historical averages definitely say that you should pay off the loan over time and invest any excess cash.

Of course, you can take this to the extreme and get an I/O loan (an “interest only” loan where your payment is only interest and your principal never goes down).  Some people do the calculations above and decide “if a little is good a lot is better”.  Mathematically, I think they’re right.  However, the Fox family doesn’t do this, less because of logical reasons (the logic says pay off as little as you can), but more because of emotional reasons.  I like the idea that over time I am paying off the loan and when our tails turn from red to gray, our house will be paid off.

 

Obviously there are a lot of considerations when it comes to what to do with debt.  Pretty universally everyone agrees that credit card debt and most auto loans are way too expensive and should be paid off as soon as possible.  However, as you move down the spectrum to student loans and definitely home mortgages, it becomes more complicated.

Some people have the attitude that a healthy portfolio has no debt, and you should focus on debt reduction before starting investments.  They set goals for themselves to be mortgage free ASAP.  That’s a noble goal, and one I totally get.  If you don’t have debt you feel more secure, you own your stuff outright, etc.  Those are very valid emotional responses, but the math says that’s the wrong thing to do.  I take the middle ground on this—the only debt we have is a subsidized car loan and a mortgage.

The car loan is pretty small, so let’s not even count that.  For the mortgage (currently we owe about $500k) we could have paid it off over the past 5 years by scrapping together every penny we had and pretty much saved nothing (including not doing things like our 401k—yikes!!!).  Today we wouldn’t have a mortgage which would be nice, but we wouldn’t have been able to take advantage of a pretty nice bull run the last five years.  Taking all that money and investing it has probably netted us a $400k profit.  That’s almost double what we would have had otherwise.

Of course, the past five years have been a really good time to be an investor, plus interest rates have been at historic lows, so that makes a perfect storm for it being to your advantage to invest rather than pay off your mortgage.  But remember that it’s a numbers game, and over the long term stocks return more than what you’re paying with today’s interest rates.

Rental properties

For Rent Real Estate Sign

Up to this point, the main way I have discussed investing for the future is with stocks and bonds.  That leaves out one of the major vehicles that people use for investing—owning real estate.  Actually, stocks, bonds, and mutual funds are newcomers to the world of investing when you compare that to owning property.  Being a landlord has been around for millennia, while trading stocks and bonds as we know is about 100 years old.

Full disclosure: Foxy Lady loves the idea of investing in rental properties while I am opposed.  We talk about it all the time and at this point we have not jumped in the pool yet.  So what is my take on it all?

 

The pros

There are a ton of really great reasons to invest in rental properties.  I had a coworker who once told me: “real estate is the only way to build real wealth.  Stocks and stuff are great, but to really become wealthy, you need to buy property.”  I don’t really agree with that, but there are a lot of people who do, and there are a lot of people who have become super wealthy following that line of thinking.

Rental income:  Obviously the main reason to go into rental properties is for the rental income.  Of course this will vary greatly depending on a ton of factors, but I just did some quick research on www.zillow.com and you can get about 7-10% of the property value in rent each year.  That tends to be lower for more expensive markets (LA or Chicago compared to St Louis or Birmingham) and it tends to be lower for more expensive properties (free-standing homes compared to condos).  And of course, any expenses you incur come out of that, but 7-10% is an awesome return for an investment.

Property appreciation:  In addition to that 7-10% rental income, you’ll also enjoy the potential for the property to increase in value.  This similarly varies greatly, with periods of huge price appreciation and other times where the market crashes, but on average home prices do tend to go up.  So this is an added bonus.  If you’re savvy about which properties you buy with an eye towards which neighborhoods will become popular or buying fixer-uppers, this can be a major portion of your profits.

Leverage:  With rental properties, you often buy the home with a mortgage.  This gives you leverage which can really juice up your profitability.  Take for example a home that costs $300,000 and you can rent for $2000 per month.  Using the basic calculation, you would have a return of 8% ($2000 rental per month x 12 months / $300,000).  But what if you bought the property for $50,000 down and then financed the remaining $250,000 with a 5% mortgage?  The calculation is a little more complex—your revenue is $11,500 ($24,000 annual rent – 12,500 interest on mortgage), but then you divide that by your $50,000 investment.  That’s a 23% return!!!

Tax advantages:  In the US the tax code can be tricky on this (and I’m not an accountant) but in some circumstances, the interest you’re paying on the mortgage can be tax deductible.  That 23% return from above can be even higher because Uncle Sam is letting you deduct some of that interest from your taxes.

Economies of scale:  All these calculations on returns are assuming you have no expenses.  Of course, you will have some (finding renters, maintenance on the property, improvements on the property, etc.) so that 23% return will definitely be lower when you take those expenses into account.  But as you do more and more rentals, you will start to have serious economies of scale.  Especially if you do some of the handyman work yourself, you’ll learn to do these things like fixing plumbing and electrical, installing appliances, etc.  That can lead to lower costs for each property unit you have, and that can make a major impact on your returns.

Best option:  I’ve always said you should be investing your money, but what if you live in a country where investing in stocks isn’t very easy (as we saw was the case in Russia)?  Without those other options, that makes real estate investing even more attractive.  After all, you need to invest your money somehow.

 

The cons

Wow!!!  A 23% return plus property appreciation and tax benefits.  All that seems pretty sweet, and there’s no way you’re matching those returns with the stock market.  So what’s the downside?  Stocky Fox, why aren’t you seeing with wisdom of what Lady Fox wants to do and start buying rental properties?

It’s a job:  Make no mistake that owning rental properties is a job.  If you own mutual funds you literally have no work for your investment.  When you manage rental properties, there is real work involved—finding renters, getting documents signed, fixing the place, dealing with renters, etc.  Maybe you set it up so it’s not much work, but it’s still always some work.  Also, you can have a property management company do all that work for you, but then they’re eating into your profits.

It could be a nightmare:  This is what keeps me from wanting to get into the rental property business.  If things are working well the returns for rental properties are super attractive, but that can all go up in flames in a hurry, and there seem to be so many things that could go bad.  What if you tenant is a real pain in the butt and is constantly badgering you to fix things or upgrade things?  What if they trash your place and you need to do major repairs (you could take them to court, but then that’s a whole other headache)?  What if they stop paying rent (you could evict them but there are a lot of laws protecting renters so that could be a really long and painful process)?  Any one of those things could cancel out months or years of rental profits.

Low diversification:  Rental properties by their nature aren’t diversified.  When you buy a single property for let’s say $300,000 you’re putting a lot of eggs in one basket.  Maybe the neighborhood turns bad or something like that.  When you invest in mutual funds you’re buying tiny slices of thousands of different companies, but with a rental property you’re exposing yourself to much higher idiosyncratic risk.  The closing of a factory could have a devastating impact on the local rental market, but it wouldn’t register a blip on your mutual fund.

Low liquidity:  When you have rental properties you lose a lot of liquidity and flexibility.  If you needed cash for some reason (maybe an emergency) it would be super easy with mutual funds.  Sell some shares and you have the money in a few days.  With a rental property it could take months to sell it and get the cash.  Similarly, if you decided to move away from where your rental properties are that’s a monumental undertaking; once you start with rental properties you’re somewhat tied to that area.  With mutual funds, you change your address with Vanguard  and you’re done.

 

Lots of pros and lots of cons.  So where do we stand?  Certainly rental properties have tremendous upside, much more than stocks.  I always use 6% as my long-term expectation for returns on the stock market; if you do the calculations of your rent less your expenses and divide that by the property’s value and come up with a value greater than 6% you should seriously consider it.  Also, if you can avoid some of the pitfalls—you know some trustworthy people who can be renters, you’re handy and can fix things, and you don’t plan on moving for a long, long time—that makes it all the more attractive.

So what do you think?  I don’t think rental properties are a good idea for the Fox family (Lady Fox just flipped me off), but what about you?

Balancing risk and reward

“Nothing ventured, nothing gained”—Benjamin Franklin

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That Benjamin Franklin guy was pretty smart.  This is the second time one of his quotes have landed on this blog.  Now that you’ve entered the world of investing, you need to figure out how you balance the two fundamental, opposing forces of investing: risk and reward.  At its simplest, investments compensate investors who take on greater risk with higher returns.

Think of the least risky investment you could make—a savings account.  You could invest your money and know that your investment won’t lose money.  You could take out the money in a week, a month, or a year; and you would get your original money plus a very small amount of interest.  In the US, the risk of you losing money on this investment is 0%.  Unfortunately, because there’s no risk, the “reward”, the interest you make, is extremely low: less than 1% currently.

Let’s take a small step up the risk scale—short term government bonds.  The chances of you losing money investing in a 1-5 year treasury bond (let’s assume you invest in a short-term bond mutual fund like VSGBX), are extremely low, but it isn’t 0%.  There is a chance, albeit small, that changes in the market (interest rates) could decrease the value of your investment.  You’re taking on a little bit of risk (since 1988 there has never been a year where VSGBX has lost money), and to compensate for that risk these investments historically tend to return about 1-2%.  So you’re being paid a larger return than your savings account because you’re taking on more risk.

Take another step up the risk scale and you get to long-term government bonds and corporate debt (using a mutual fund like VBMFX).  These are riskier because there is some chance that you won’t get paid back; this is true for corporate, foreign, or municipal debt.  These are also riskier because like their less-risky cousins, the short-term bonds we just mentioned, long-term bonds can change in value due to changes in things like interest rates.  The difference with long-term bonds is that the effects are magnified; so if interest rates go up, that would cause the value of your short-term bonds to go down a little, but the prices on your long-term bonds would go down much more.  As you would expect, since long-term bonds are a little riskier (since 1988 VBMFX has lost money in 2 years), they tend to return a little more, historically in the 3-5% range.

Now, take a big leap up the risk curve and you get to stocks.  Stocks are extremely volatile, especially over the short-term.  Since 1930, there have been 24 years (about one-third of the time) where US stocks have decreased in value.  It’s definitely a rollercoaster ride.  Yet, by bearing the risk that in any given year your investment might go down in value, sometimes down a lot like in 2008 when stocks went down 37%, you get a significantly higher return.  Since 1930, stocks have returned on average about 8%.

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As you can clearly see in the chart, when you invest in assets with higher average returns (like stocks) you have a lot more volatility in those returns from one year to the next.  When you invest in assets with lower average returns (like bonds, especially short terms bonds or even cash), you enjoy much more stability in the value of your investments.

 

What’s your appetite for risk?

As an investor you need to determine what your appetite for risk is.  How will you balance the yin of high returns with the yang of higher risk?  At the end of the day, you need to have an investing strategy that allows you to sleep at night.  There’s no amount of money that’s worth freaking out every time the market takes a down turn, and it is certain that the market will take down turns.  Sometimes it will be a free fall like in 2008 when stocks cratered 37% or it might be a long-term grind like from 1973 to 1978 where stocks fell 23% over the course of 5 years.

That said, a long time horizon is your best friend when dealing with a volatile stock market.  While any given year might be crazy, over time there tends to be more good years than bad.  Take 2008: in 2008 stocks fell by 37%, and if you needed your money at the end of that year you were hurting.  On the other hand, if you had a longer-term investing horizon and were able to stay in the market, all your money would be made back by 2012.  In fact, while about 33% of the years have been down years for stocks since 1930, over that same period of there was only one decade, the 1930s, when stocks were down.

So how do you invest?  Well, you need to figure out your risk tolerance.  Here’s a good way to do that.  Imagine yourself as an investor at the end of 2008.  You’re in the depths of the financial crisis, stocks are down 37%, and pundits are saying we may be on the brink of financial collapse.  What do you do?

Some people like Warren Buffett and Stocky Fox (for important statements I revert to the third person) looked at that as an opportunity to continue to invest in stocks, just now we were buying them at a substantial discount compared to 2007’s prices.  In the end our faith was rewarded and we made a killing.  However, there were some times when the news just kept getting bad and Pepto-Bismol came in extremely handy.

Others felt burned by the 2008 investing bloodbath and pulled their money out of the stock market to put it in safer investments like bonds or cash.  They did so knowing their actions limited their potential for higher returns, but many were willing to accept that if it meant not having to risk their money continuing to disappear into the black hole of the financial crisis.

There’s no right or wrong answer.  You just need to figure out where you’re comfortable and invest accordingly.  If you’re willing to weather the storms then you should probably invest more in stocks.  If you’re more risk averse, then you should probably invest a larger portion of your portfolio in bonds.

Just remember, there’s no such thing as a free lunch.  With higher returns come higher risk.  If you want safer investments, you have to be willing to give up higher returns.

Individual stocks versus mutual funds

When you start investing, one of the first decisions that you’ll need to make early on is what should you invest in, individual stocks or mutual funds.  Let’s break it down, Dr Jack-style*.

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ACCESSIBILITY:  There was a time when “where” you could invest in either stocks or mutual funds was a big deal.  For stocks you had to go to a broker like E-trade or TD Waterhouse.  For mutual funds you typically worked directly with the mutual fund company like Vanguard or Fidelity.  Now days pretty much all the companies have made it so you can invest in any mutual fund you want as well as have a brokerage account to buy individual stocks.  Advantage: Push

COSTS:  A bit of an interesting question.  Over the years trading fees have really come down.  Now days you can pretty easily find a firm that will charge $5 per trade or even less (Vanguard charges me $2).  Compare that to mutual fund management fees which can range from 0.1% for index funds to 1.5% on the high end.  As an example, if you have a nestegg of $500,000 and you’re paying 1% in mutual fund management fees, that’s $5000 each year.  That would buy you 1000 trades at $5 each; unless you’re a day-trader, you’re probably not trading anywhere near that amount.  Advantage: Stocks

DIVERSIFICATION:  The major advantage of mutual funds is the diversification they give you in an easy package.  Statistics show that an investor can be fully diversified with 20 or 30 different stocks, but you have to be pretty strategic in picking those, and that means a lot of work.  Advantage: Big advantage to mutual funds

EFFORT NEEDED:  Mutual funds just seem easier.  You pick the one you want and invest in it.  There are also features like automatic investment which allows you to set it up over time.  With stocks, you have to make every purchase, and if you’re diversifying you have to make several purchases.  That just seems like more work than is necessary.  Advantage: Mutual funds

INTERNATIONAL INVESTING:  I’m not an expert here, but I don’t know if you can invest in foreign stocks easily from your domestic brokerage.  There are ADRs (American Depositary Receipts) which is another option to invest in foreign stocks, but all that starts to get a little confusing.  International mutual funds are as easy to buy as domestic mutual funds, and you don’t have to go through any of the hoops.  Advantage: Mutual funds

KNOW WHAT YOU HAVE:  One problem with mutual funds is knowing what you actually own.  Do you own Coca-Cola stock or not?  Legally, mutual funds have to disclose this to some degree, but that’s a bit of a pain and depending on the type of mutual fund it might be constantly changing.  With stocks you know exactly what you have at any given time because you own the actual stockAdvantage: Stocks

PICK WHAT YOU WANT:  Some people are particular about the stocks they own for reasons beyond getting a good return.  You had a terrible experience with AT&T so you won’t own their stock.  You have moral issues with Wal-mart’s wage policies or Exxon’s environmental record.  With mutual funds you’re a bit at the whim of the mutual fund manager, so it could very well mean you end up owning these stocks, and you may not even know it.  This isn’t the case if you buy individual stocks because you know exactly what you’re buying and if you don’t like it or you do like it, you can act accordingly.  Advantage: Stocks

BOND INVESTING:  This is about stocks, but bonds present a special problem.  If you buy bonds directly, they tend to come in large denominations like $1000 or $10,000.  If you want to invest less than that in a given transaction, it’s not very easy unless you do it with mutual funds which allow you to invest in pretty much any denomination you want.  Advantage: Mutual funds

DIVIDENDS:  Many stocks (and nearly all bonds) pay dividends .  The question is what to do with them?  With stocks (and bonds) you typically get the cash deposited in your account, and then you need to figure out where to invest that.  You have that option with mutual funds, but a nice advantage with most mutual funds is you can automatically invest it into the mutual fund.  Advantage: Mutual funds

 

For me, mutual funds are the clear winner.  I love how they make it really easy to invest and then move on.  That’s the deciding factor for me.  There certainly are disadvantages, but they aren’t that big a deal to me.  I’m not really that particular about which stocks I own from a moral perspective.  Costs are certainly important and that’s why I try to find the mutual funds with the lowest expenses by going with index mutual funds.

Actually the only stock I own is Medtronic stock that I get from my company’s stock purchase plan.  Whenever I have the choice, I always go with mutual funds and never with individual stocks.

 

What do you think?  Did I get this right, or do you think I missed something?

 

* Jack Ramsay was a coach in the Hall of Fame NBA, and he actually had a PhD from University of Pennsylvania (I guess that’s a decent school).  He was famous for breaking down match up of teams with different criteria like defense, rebounding, speed, etc.

Figure out your investment time horizon

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“Time is on my side, yes it is” –Rolling Stones, Time is on my Side

Okay, you’re ready to join me in the land of financial freedom.  One of the first things you need to figure out your time horizon for the money you’re saving.  Will you need that money in a couple months or sooner, in the next couple years, in the next ten years, or at retirement?  These answers will have the greatest impact on how you invest it.  Here is my take (and as always, I’m not an expert, and these are just my opinions; any predictions I make about the future are just based on historical trends, and you should establish your own opinion on the future).

 

Extremely short-term (tomorrow to next 6 months)

Your property tax bill, ‘Lil Fox’s preschool tuition payment, living expenses if you’re retired like Grandpa Fox.  With such a short time horizon, you really don’t have a lot of options.  For amounts less than $5,000, it’s probably easiest to keep it in your checking or savings account, even though the typical interest rates on those accounts are practically zero.  Money market accounts would offer a little more interest, but even then you’d be looking at 2% or less, so it may not be worth the $1.50 per month in interest you earn on $1000 to set something up.

If you’re talking a larger amount of money, you want something that has a very low risk of decreasing in value, but still offers an interest rate that makes the effort worthwhile.  Short-term bond funds like Vanguard Short-Term Bond Index (VBISX) may fit the bill.  There’s a pretty small chance that your investment will decrease in value (but it’s not 0% so be prepared), but you can still earn a decent ~3% interest; that’s about $25 every month for a $10,000 investment.

 

Short-term (6 months to 3 years)

Car fund because you have a 2001 Honda Civic with a bad transmission (the Fox family in June 2013), vacation you want to take to Hawaii without the kids two years from now.  Because you have extra time compared to the “extremely short-term”, it’s definitely worth it to invest for any amount more than $500.  Similar to above, you probably want a bond fund of some sort, but because of the extra time you can take on a slightly more volatile investment and grab the higher return.  Something like Vanguard Medium-Term Bond Index (VBIIX) gives a decent return, about 4% historically, with a pretty low risk that you’ll lose more than you gain over a year or two.  Just so you hear that “cha-ching” sound in your head, if you invested $1000 in a bond fund, after three years at 4% interest, you would have about $1125, a tidy little $125 profit earned for nothing more than being smart about where you put your money.  That could fund those Mia-Tias on the beach in Hawaii while you remember all the extra free time you had before the kids came along.

 

Medium-term (3 years to 10 years)

Mini Fox’s college fund, down payment on Mrs Fox’s dream vacation house down the shore.  With a longer time horizon, your options really start to open up.  A few years starts to give you the time to weather some moderate financial storms, but probably not enough to go fully into stocks (ask someone who invested money in October 1929 or November 2000).  The winner is probably some balanced fund like the Vanguard Balanced Index Fund (VBINX).  These balanced funds will have a mix of bonds, with the price stability they provide, and stocks, with the potential for higher returns those provide.  For those closer to the 10-year mark or those willing to take a little bit more risk for a higher return, you could jump into an all-equity mutual fund like Vanguard Total Stock Fund (VTSMX).

 

Long-term (10 years to retirement)

Mr Fox’s 401k, Mrs Fox’s IRA.  Once your time horizon gets past 10 years, things start to get interesting and fun.  Because this is where most of your savings for retirement should be (unless you’re Grandpa Fox, enjoying retirement), this is where I’ll focus most of my time.  Also, because this is where you have the most options, this is where there’s the biggest risk that you can screw it up and cost yourself tens or hundreds of thousands of dollars over the years.

While we can spend a ton of time discussing this (and believe me, I will) a simple starting point on where to put your money for something like this is the Vanguard Total Stock Fund (VTSMX).  In time, we’ll discuss other investment options but this is a good start.

 

In the cases of the medium-term and the long-term strategies, at this point you are truly entering the world of investing.  Welcome.  Your returns on any particular year can range from -10% or worse to 20% or better, and you can count on the fact that sometimes it will be a bumpy ride.

How to invest a windfall

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We got this letter from a reader:

Stocky,

Sadly my father passed away, but he had a $200,000 life insurance policy.  My mom spent $60,000 as a down payment on a house and $40,000 for my sister’s medical school.  That leaves $100,000 left; I was thinking about going into business with a couple shady guys to start a liquor store, but my wife talked some sense into me.  So we decided to invest the money in an S&P500 index fund (VFINX). 

My question to you is, should we invest the $100,000 all at once or spread it out in smaller investments over a couple months?

Walter Y from Chicago, IL

 

I admit I may have made this letter up as a framing device, but Walter’s problem is a pretty common one.  Maybe it’s an insurance payout, a tax refund in April, a bonus check, or a bunch of cash you’ve accumulated in your checking account.  In fact, every July the Fox family faces this exact scenario when I get my bonus check.  Let me tell you my thoughts on the matter (which of course is not an expert opinion, and which looks at historical price movements but makes no prediction on future stock movements).

When I get my bonus, and what I would have suggested to Walter, is to take the big chunk of money and invest it in equal pieces over a couple months.  Vanguard and most places will let you set up an automatic investment, so in the words of Ron Popeil “you can set it and forget it.”  So let’s imagine for Walter he would invest $10,000 per week into his mutual fund for the next 10 weeks.   Why do I do it this way?  Because I’m a spaz.

If I invested all the money at once, I would be totally freaked out that I would buy at the wrong time—either I would buy the day after stocks went up 1% or I would buy the day before stocks dropped 1%.  Using Walter’s scenario of $100,000 to invest, that would mean I could “lose” $1000 by investing at the wrong time.  That would totally tie me up in knots and I would be looking at the stock market trying to find the exact right time to jump in, like a kid on the playground playing jump-rope.  Of course we know from A Random Walk Down Wall Street, that all that stuff is random so there’s no point trying to time it, but I’m not totally rational when dealing with that much money.

For the blog, I did a little analysis and found that 12% of the time stocks* lose at least 1% in a single day; if I bought the day before that happened, I’m out at least $1000.  On the other side, about 13% of the time stocks rise 1% or more in a day; if I bought the day after that I’d similarly be out $1000.

My fragile nerves just can’t take that so I want to “diversify” the timing of my purchases to even out those big ups and big downs.  This is a strategy called “dollar cost averaging”.  So as I said, initially I would have recommended to Walter that he take the cautious path, take his $100,000 and split it into $10,000 chunks, and invest those each week for the next 10 weeks.

 

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But then using the magic of spreadsheets and the internet, I decided to see what the actual data said.  I looked at every week for the market since 1950 and did a comparison of the two scenarios:

  1. Invest your entire chunk of money all at once
  2. Spread your investment evenly over 10 weeks (dollar cost averaging)

Wouldn’t you know that on average it’s better to invest your entire chunk at once?  I’ve been doing it wrong this whole time, so thank you Stocky Fox.  In fact it’s not even close—historically it has been better to do option #1 about 61% of the time.

The thinking is that historically, stocks have always gone up.  Sure there have been some rough patches, some of which can last a really long time, but the general trend is definitely upwards.  So if you wait to invest your money over a longer time period, you’re missing out on some of that upward trend.  I looked at every week since 1950 (if you were curious, there are about 3400 weeks) and on average you gain about 0.7% by going with option #1 instead of option #2.  0.7%!!!  Holy cow.  Remember that post on The power of a single percentage?  We just found a 1% coupon right there.

So Walter, my advice is to pick a day this week and invest it all in one fell swoop.  You might get hit with bad luck, but the odds are better that you’ll get hit with good luck to the tune of about 0.7% (which in your case is about $700).  On the day you do it, don’t even look at the stock market and have several tablets of Alka Seltzer on hand.

*For this analysis I am using the S&P 500 data going back to 1950.

How to get started saving for retirement

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So many people I talk to love the idea of investing for retirement and know they need to be doing it, but they just don’t know how to start the journey.  As a result, they don’t do anything, months and then years go by and they’re still at square one, but now they’re pissed because they missed out on the red-hot stock market that increased 50% over the past few years.  So here is what I would do in order of “Stockiness” (stockiness is a word I just made up that loosely translates to investing wisely).

 

401k or 403b

If you work for a company that offers a 401k or a 403b, that is probably the best and easiest place to start investing.  First, most companies have it set up so it’s pretty easy to sign up and get started.  Also, since they deduct the money out of your paycheck, it might be easier for some people to save the money “without having to do anything”.  Plus there’s the benefit that most of these plans don’t have any minimum amounts you have to start an account with, so you can sign up, have then deduct your 4% or 10% or whatever, and you’re set.

Of course we’ve saved the best for last—there are two MAJOR advantages of 401k and 403b accounts that really help you boost your nestegg.  First, both are tax-deferred (much more on this in a later post) which means that you don’t get taxed on your contributions.  So when you put $10,000 into your 401k this year, you don’t pay taxes on that money; had you not used your 401k then you would be taxed at normal income rates which could go all the way up to 40% or even higher, depending on what your situation is—that’s $4000 right there.  Certainly, you’ll have to pay taxes when you withdraw the money in retirement but it’s pretty likely you’ll be paying a much lower tax rate then, compared to the tax rate you’re paying while you’re working.

The other MAJOR advantage of these accounts is that most companies offer some type of matching.  It’s typically something like they will match $0.50 for every dollar you put into your 401k up to 6% of your salary.  Every company is different on their match but there is one thing they all have in common—they’re giving you free money if you’re willing to take it.  Like so many things in investing, over time this matching can add up to a lot— tens or even hundreds of thousands of dollars for this little jewel.

As with all things, if it seems too good to be true, you should probably read the fine print.  There are a lot of rules associated with 401k and 403b accounts (as I said in the disclaimer, I’m not an expert here).  The big one is when you can withdraw the money.  The government allows those great tax advantages at the cost of limiting your ability to get at the money; the idea is to have you save that money for your retirement, not your next car or next Berkin handbag (which can cost as much as a car—totally blew me away when Foxy Lady told me that).  If you’re in a pinch you can get the money sooner, but it is a major pain in the butt, and often times there are penalties.  So the general rule is: put money in your 401k or 403b that you won’t need until your late 50s.

 

Individual Retirement Accounts (IRAs)

If your job doesn’t offer a 401k or 403b, the next best thing is probably an IRA.  They are similar to 401k accounts in that they have tax advantages that can really add up over time, so that is one of the MAJOR advantages.  Unfortunately, they don’t have the matching feature which is a bummer.  Also, similar to 401k and 403b accounts, these are meant for retirement savings (and have similar penalties for early withdrawal) so it’s best to put money here that you don’t plan on needing until your 50s or 60s.

Unlike 401k and 403b accounts, you have to set these up on your own.  It’s not difficult, but it certainly isn’t as easy as if you just check a box at work.  The first thing you’ll need to do is pick between a Roth IRA or a traditional IRA.  There’s a ton of debate on which is better, but as a general rule I would go with a traditional IRA.  Ironically, when I made that decision for myself 15 years ago I went with a Roth IRA and I think I made the wrong decision.

Then you’ll need to set up an account with Vanguard or Fidelity or one of a hundred other firms.  Another unfortunate feature of IRAs compared to 401k accounts is that they tend to have a minimum amount required to open an account.  For Vanguard it tends to be about $3000, so that may take a little while to gather before you can get started, but it’s still definitely worth the effort.

But there is a nice advantage that IRAs have over 401k accounts—you have many more investment options.  With a 401k you are limited to the mutual funds that the company has set up.  My experience with 401k accounts is that you have a good variety—bond funds, domestic stock funds, international stock funds, target retirement funds—but you may only have 10 or so choices.  With an IRA you can choose from almost any mutual fund there is (just to put that in perspective, Vanguard has 100 funds to choose from).

 

Brokerage account

If neither of the above options work for you (and that would seem really odd that they wouldn’t, but I guess you have your reasons), then you can open a regular brokerage account with Vanguard or Fidelity or others.  Here you could invest in all the same mutual funds that are available to you with IRA accounts.

As you’d expect, the major drawback on these is that they don’t have the tax advantages of the 401k, 403b, or IRA accounts and that can be a pretty huge deal.  On the other hand, they do not have any of the penalties associated with early withdraws, so that might be something attractive depending on what you have on the time horizon.

 

So there you go.  Investing is a long journey, but as some poet who’s been deal a long time said, “Every journey begins with a first step.”  So the first step is opening an account so you can start investing.

 

How did you get started investing?  We’d love to hear your story.