You probably already know how important it is to invest. But this overview guide explains why investing is so important for you in ways you may not have considered. This will help you understand inflation and risk in way you can put to use and improve your life. It will also help you differentiate between the variety of buckets of money you need to have and how best to invest each one. Finally, by having clearly defined investment buckets, it makes it easier to invest each bucket appropriately.
What is investing?
When you put money into the bank, buy bonds, stocks, mutual funds, ETFs, real estate a business, gold, art, antiques etc. with the goal of getting your money back plus earning a profit or interest, that’s investing.
Why do people invest? Everyone has their own reasons. But mostly people invest because they want their money to grow in order to help them achieve their financial goals both long and short term. When people are successful growing their money, they enjoy the benefit of having their money work for them instead of them having to work for their money.
Are Women or Men Better Investors?
There is no doubt about it. Research proves that women and wealth are a better match than men and money. Women are simply better investors than men. Professors Brad Barber and Terrance Odean published a paper a few years ago that found women less likely to be overconfident when it comes to investing. As a result, they trade less often and that in turn increases investment results.
Odean and Barber found that men earn about 1% less per year compared to women because of their undisciplined trading. And when it comes to bachelors and bachelorettes the problem is even worse. According to the Journal of Economics, single men trade 67% more than single women. That reduces the men’s returns by 1.44% year.
The Investor’s Business Daily speculates that men are overconfident traders. They wrote that men who are successful in their careers often become overly optimistic. Many times that optimism spills over to investing. As a result they allow their feelings and “gut” to guide their investments. When this happens their investment strategy and discipline go out the window – along with their returns.
What you can learn from this?
It doesn’t really matter if you are male or female. It pays to find an investment strategy that fits your needs and emotional make up, and then stick to that strategy. Rather than convince yourself “it’s different this time” or “this stock has simply got to ________”, keep in mind that you truly can’t predict the future. Don’t speculate.
My experience tells me that there are many people out there who continually override their own investment rules (or investment manager) to their own detriment. Just because you think you know what’s going to happen to the price of:
……realize that you don’t.
Should You Borrow To Invest?
Some of the wealthiest people you know became that way because they were willing to borrow to invest. But does that mean it’s the right thing for you to do? At times…yes. But the circumstances under which this maneuver makes sense are very limited.
Keep in mind that I’m talking about investing – not taking a mortgage to buy a home. That’s an entirely different mater.
The good news it’s not a difficult problem to work out. If you take the time to answer the following 5 questions, you’ll know if it makes sense to take a loan to make an investment or not.
1. What will it cost you to borrow the money?
Think about your cost after tax and think about your cost of borrowing over time as well. The after tax calculation isn’t difficult. Let’s say you are considering refinancing your home for example. If the interest rate is 4% but you are in the 40% tax bracket, your actual cost is 4% less 40% of 4% or 2.4%. Simple. If the interest expense isn’t deductible than your after tax cost is the same as the before tax cost – 4% in this example.
The “over time” element is important as well but easy to overlook. What is your real cost of borrowing over the life of the investment? Can the interest rate change at some time or is it fixed for the entire period? Even if the rate is fixed, if your income changes and/or the tax code is updated, your after-tax cost of funds might change as well. Some of these costs are predictable and some can only be guessed at. But all of them should be considered.
2. How much will you earn on your investment?
Sometimes it’s very difficult to foresee how much you are going to make on an investment. This is especially true when you are looking at long term investments. The greater the time-span the more difficult it is to accurately predict. But in order to make an informed decision you have to make some assumptions about future returns.
This is why I am very much against borrowing money to invest in the stock market. The returns might look great long-term (which is still a gamble) but they are completely unpredictable over the short-term. Of course I am optimistic about the long-term prospects for equity investments. But I would never borrow money to put into the market and I strongly encourage you to follow my lead.
When it comes to borrowing money to invest, it only makes sense to do so if the returns are somewhat predictable – and that boils it down to buying bonds, real estate or maybe a business. Look at the after-tax cash flow from these investments. If that return is greater than the cost, it makes sense to continue your analysis. If not, don’t waste your time.
If you carry high-cost debt, it can be brilliant to borrow to pay it off. Think of this as refinancing your debt. It can be smart if the refinanced cost is lower than the existing debt.
3. When will you receive the earnings?
We don’t have the time to discuss present value discounted cash flows, and it’s an extremely boring topic anyway. But talk to your CPA or financial advisor about the expected cash flows of your proposed investment and ask them to run a quick analysis on it for you. It’s important to consider the time value of money and they can show you how this works without too much problem.
4. How risky are the investments?
How much risk can you take with your money? This question might be the most important question of all. Here’s why. When you take on debt, you are fully obligated to make those payments. Using our example above, you can be absolutely sure that your cost is 4% less the tax benefits of borrowing the money.
But you can’t be so sure about your returns. When you make an investment, there are always risks that things won’t turn out as planned. Before I invest, I look at the worst-case scenario and only go forward if I can live with this pessimistic outcome. I’ve rarely experienced anything so horrible as the worst-possible result. But because I’m ready for it, I’m always pleasantly surprised by what actually unfolds. Always get clarity on the worst-case and make sure you can live with it before proceeding.
5. How much experience do you have with these kinds of investments?
This is a question that few people ask themselves yet it’s vital to successful investing. The more experience you have with a given investment the more you know what to expect and the less risk you have. That experience helps you make better decisions. And that means you won’t bail out at the first sign of trouble. And because you know what to expect, your risk is reduced.
If you are seasoned real estate investors, your pro forma cash flow statements are more reliable. That also mutes your risk.
But let’s take a look at the other side of the coin. Let’s say you want to borrow money to invest in a business that you know nothing about like a restaurant or laundromat. This is probably the riskiest thing you could possibly do because there is so much that might go wrong. You have no idea what to expect because it’s a road you’ve never traveled. As a result, it’s more difficult to predict cash flows. This is an example when it’s probably a very bad idea to borrow money to invest.
If you take a loan to make an investment, you take on more risk. The best way to mitigate those risks is by having experience with that kind of investment so you can more accurately predict future cash flows. That’s the bottom line.
With that in mind, let’s now discuss the rules that can help you be more successful.
Rules of Investment Success That Make Money
There are 5 rules that, if followed, will lead you to financial success. My 30 years of experience in the financial professional tells me that if you follow them you will absolutely make a great deal of money. To make this even better, let me share that you can implement them yourself. You don’t need to hire a financial guru. In fact, a financial advisor can’t really help you here. You’re going to have to get these implemented by yourself. Let’s get down to business and let the wealth flow.
1. Create Cash
If you want to see investment results you have to first create capital. And you create capital by simply paying yourself first. That’s right. Before spending a dime, set up an automatic investment plan and you’ll see astounding results.
I read an article on FreeMoneyFinance a few days ago highlighting the secret of having over $1,000,000 in your retirement account. According to the article, less than 2% of the population has been able to save that much. In fact, the average 401k savings is just a bit over $60,000. That’s barely enough to provide for a year of retirement.
How do some people sock away a million? By maximizing monthly contributions over many years no matter what. Do this and the magic happens. This in effect is paying yourself first. I want you to do this in and out of your retirement accounts. Set up automatic investments and make it a priority. If you work with an advisor, call her and get this going this week please. If you are a DIY investor, open an account with a good online broker and make it happen. Either way you can get this set up in less than 15 minutes.
If you are like most people I know, you might find it difficult to get out of the starting blocks when it comes to saving and investing. Sometimes it’s hard enough just to pay the bills without going into debt. It’s tough to imagine having enough extra money to put aside for the future. You know it’s important to put a plan together, but how do you begin?
Note: The following pertains to those people who are out of debt. If you still have high-cost debt and/or don’t have an emergency fund set aside, you should probably take care of those items before you start to invest.
How To Create The Cash You Need To Start Investing
In order to power ahead, what you need is a spending and investing plan. A spending plan lays out the broad parameters of how much you plan on spending, on average, each month. An investment plan tells you how much to invest and how to invest it in order to achieve your long-term goals.
The reason it’s important to have one plan that puts both these numbers together is because investing is indeed a monthly expense. Here’s why.
If you are like most other people, you invest now in order to have money available in the future. Why do you need to have money available in the future?
Because when you retire, your income will likely be diminished. In other words, you are putting money aside today to pay for your future expenses. Investing then isn’t really a luxury – it’s a necessity. At least it’s a necessity for anyone who wants to retire one day.
How To Build Your Spending And Investment Plan
There are a few different approaches that work. But in my opinion, there is one tactic that really gives investors the highest chances of reaching their financial potential. That winning idea is to save first and spend second. What I mean by this is to first determine what you need to put aside each month in order to reach your financial goals, set up an auto debit process whereby the money is automatically taken out of your checking and deposited into your investment account, invest that money correctly and then only spend (at most) what is left over.
This strategy is known as “paying yourself first” and it really increases the likelihood of you reaching your goals because it forces you to save first and wrap your spending around it. If you spend first and save what’s left over you probably won’t have much left over to save if you are like most people I know.
I hate to break it to you – this is probably the approach you’ve been using up until now, and it isn’t working. If it was working, you wouldn’t have read this far.
What If You Can’t Save As Much As Required?
Don’t worry if you can’t hit your savings number right from the get go. Life is a process and the important thing to do is just get that process off the ground. If you figure that you need to save $1,000 a month in order to reach your goal, start with $100, $50 or even $25. It doesn’t matter what you start with – what matters is that you get started.
If you are like most people I know, you’ll find ways to build up your monthly savings figure by either cutting back on spending, finding ways to earn extra money or a combination of the two.
If your run your projections and learn that you need to save an impossible amount each month, you still have options. You can plan on working longer, working part-time after you retire, cutting back on your retirement lifestyle or (again) a combination of all of the above.
Make investing a monthly expense that you pay before paying any other bill except after you’ve gotten out of debt. By doing so you’ll automate your success and systematically reduce any unnecessary spending – a win-win in anyone’s book.
2. Understand Your True Timeframe
The second rule of investment success is to have the proper time frame. Sure everyone wants to make an overnight killing but it just doesn’t work that way. If you have a long-term goal (like retirement) your best bet is to take advantage of long-term growth investments like equity ETFs and mutual funds.
Once you are clear on your long-term objectives don’t get excited about short-term results. If you do get wrapped up in short-term volatility you’re bound to make huge investment mistakes like getting too aggressive or conservative at exactly the wrong time.
Please don’t misunderstand me. I am not suggesting that you buy investments and then forget about them. There are a variety of investment strategies for long-term growth – not just buy and hold. But the reality is that no matter which strategy you use, there are going to be times when you are going to be disappointed. Expect that. Stick to your long-term goals and forget about short-term results.
3. Watch Expenses
In order to stick to the first two rules, you’re going to have to get your spending under control. And don’t underestimate how spending impacts your investments. When people overspend, they often try to make up for it with very aggressive investments. And there are other problems with overspending.
Obviously, if you overspend you may not have the ability to “pay yourself first”. In fact, spend enough, and you won’t ever be able to save.
4. Keep it Super Simple
It is important for you to get a proper education. But once you set your course on a given investment strategy, don’t go on a continuous search for the perfect mousetrap unless you want to lose money on your investments big time. Again, there will be times when the strategy you use is absolutely going to underperform.
During those times, you’ll be tempted to try something new. I know people who make a career out of investigating and tinkering with investment approaches. Don’t do it. Understand that every dog has its day and it makes absolutely no sense to hop around. The grass may seem greener…but it usually isn’t.
5. Be Careful Who You Take Advice From
This tip is akin to previous tips. If you have friends, they’ll be more than willing to offer “investment tips” on an ongoing basis. Don’t listen. Sure there is a slight chance that you might miss an Apple or Google. But you’ll more than make up for it by side stepping the investment landmines that are just waiting to blow up in your face.
While we’re on the subject, lets talk about how to immunize yourself against investment scams. You may remember Bernard Madoff and how he stole billions of dollars from individuals over the last several decades. It’s the biggest investment scam ever and it’s a great lesson for all of us.
You are probably asking yourself how could anyone get away with stealing so much for so long? What is the real story of Bernie Madoff? How could intelligent people invest their hard-earned dollars and not know what they were getting into? How could those same people not know what was going on with their money over years and years and years? And more important, are you doing the same thing right now?
I ask myself a different question – or maybe the same question, but from a different perspective. I wonder if an investor could have avoided the problem entirely. Lets consider that now and use those lessons to protect your money going forward.
First, remember that if it sounds to good to be true, it isn’t. Had investors simply respected that rule of thumb, they would have been safe. Mr. Madoff reported great returns year after year regardless of what the market did. And that should have been the first red flag. But many people just saw those big numbers and invested based on that alone.
Some people fail to take the time to understand how investment strategies work. Had they done so, they would have known that such results are not possible. Other people are kind of lazy and they don’t get a second opinion. Obviously, the heady returns that Mr. Madoff reported fed the greed which fed the laziness. It all works together. So the first tip is to ask yourself if you are being greedy and/0r lazy. If so, slow down.
Next, lets talk about your advisors. I wonder where all these investors’ CPAs were. This is especially troubling. These clients were not getting third-party statements confirming the existence of the investments from established custodians.
For example, you may have a lousy broker, but it’s nice to know that your investment is for real. You know this if you get monthly statements from either the brokerage house or the custodian (Schwab, Fidelity, TD Ameritrade, etc.)
But these accounts never existed. The clients and their CPAs never got statements from the third-party custodian. Again, the greed fed the sloth and that led to the result. The clients and CPAs should have seen this as a huge red flag too. The take-away is, don’t rely on anybody to spot a shiester. Keep alert at all times.
Insist on third-party statements and verify them yourself. In addition, make sure you understand the returns you are getting and if it looks too good, dig deeper.
Another important reminder; never make a check payable to the person who sold you the investment.
As I said, investments are held by third party custodians.Examples of custodians are TD Waterhouse, Fidelity, Charles Schwab, etc. When you invest, that’s where your money goes. That’s who you should make your check payable to. If your adviser ever asks you to make the check payable to them, I want you to do two things:
Call the SEC
Also, always check out your advisor. Call the SEC and FINRA to make sure your financial planner has a clean record. I wouldn’t do business with anyone who had a blemish on their record – I don’t care how long ago it was.
Also, be wary of certain investments. Certain investments are very attractive to rip-off artists. Hedge funds and limited partnerships (two of Bernie Madoff’s favorites) are stars among these.
Because they aren’t transparent. It’s very difficult for investors to know what’s held within those investments. It’s also very difficult to know what the investment managers are doing with the investor’s money within these types of investments.
I’m not saying that all hedge funds and limited partnerships are destined to land you in the poor house. I’m only saying that these types of investments expose you to lots more risk.
What To Focus On
As you can see, investment success is much more a function of your behavior than it is a result of one particular fund or stock you pick. Which investments you choose is important but your investing behavior is far more important. If you have the wrong financial behavior it will have a multiplier effect. If you get any of these rules wrong, the negative results will be visited on you time and time again.
The Coolness of Getting This Right
Let’s say you invest $10,000 every year for 20 years. If the money earned nothing, it would grow to only $200,000 ($10,000 x 20 years). But if the money earns 5%, the account value actually grows to almost $350,000. Impressive, right? You have almost twice as much and you didn’t have to lift a finger. That’s the power of compound interest and time and I’ll explain that in detail shortly.
The point is, you now have $350,000 because you invested $10,000 every year for 20 years and earned 5% on the money. Had you invested the money without earning a return, you’d have $200,000 after 20 years as I said. And if you spent that $10,000 every year instead of investing it, you’d have nothing. Simple stuff – but if you put that idea to work, it will change your life. And the sooner you get with the program, the cooler your life will be.
Let’s look at the difference in two portfolios with one starting now and one delaying 5 years. The former will be invested for 40 years while the latter for just 35. We’ll assume the first investor got started at age 25 and retired at 65 while the latter started at age 30.
All other variables will be the same:
$5,000 investment per year at the beginning of the year
7% average growth annually
Here are the portfolio totals at the end of the investing period, when our investor retires:
- Invested for 40 years: $1,068,047.85
- Invested for 35 years: $796,687.01
The difference is a staggering $271,360.84. The first investor only contributed an extra $25,000 total ($5,000 per year for five years) yet came out hundreds of thousands of dollars ahead. The second investor would need an average growth rate of 8.23% to make up for waiting 5 years. Starting investing late is costly. And it also means the investor who delayed will have to take on more risk in order to catch up to his friend who started earlier. Waiting is costly and risky.
That is the power of compounding. The earlier you start investing the better. Agreed?
How much will my investments make?
Before you make an investment the first question you likely ask yourself is what the return will be. It’s a very reasonable question.
And it’s very easy to know the answer with some short-term investments like CDs. You deposit your money for a specific time with a bank. And the day you do so you know exactly when you’ll get your money back and how much you’re going to earn. Better still, it’s all guaranteed.
With stocks, bonds and real estate it isn’t that easy. Let’s consider bonds first. When you buy a bond, you lend your money to a company or government and they promise to pay you a fixed interest amount and they also obligate themselves to pay you back your principal at a fixed date.
Sometimes your investment in the bonds is guaranteed. When the agency standing behind your bonds is the U.S. government for example, you can rest assured that if you hold on to your bonds to maturity, you’re going to get your money back. Of course if you sell the bonds before maturity, even U.S. government bonds, you may get more or less than you invested. All of this will be explained in great detail below. Let’s get back to it.
If your bonds are not backed by Uncle Sam you’ve got an entirely different situation and a lot more to be concerned about. If the organization you make the loan to goes belly up, you may not get your interest payments or your principal back. Obviously if either of these unfortunate events comes to pass it’s going to put a big dent in your returns. You might buy a bond that “guarantees” to pay you 6% for example- and that’s great. But it’s only great if you get your interest and principal payments as promised and when you first buy your bond there is simply no way to know it is going to work out or not.
The profits you potentially could make with stocks and real estate are even more difficult to foretell. Here’s a chart that shows what the S&P 500 did year-by-year from 2000 through 2013:
You can see that returns are over the map.* If you add up all the numbers and calculate the simple average it comes out to a shade over 5.46%.
Does that mean you can be highly certain that you’ll earn 5.46% each year in the stock market from here on? No way. Next year the returns could be anything. Look at the chart above one more time.
The best year gave investors a sweet 32.15% return. The worst lost them 36.55%.
In any one year, the market could return far more or far less. That’s a pretty broad spectrum.
Real estate returns vary widely also and are simply impossible to predict on a year-by-year basis.
How Can You Possibly Invest In Something If You Don’t Know What The Returns Are Going To Be?
If the only investments that offer guaranteed returns are bank CDs and government bonds, why would anyone invest in something else?
If you could earn as much with CDs and/or U.S. government securities as you could in real estate or in the stock market, you would forego the risks of the later. Unfortunately, over the long-run, the statistics say you can’t.
Take a look at the chart below:
The column on the extreme left shows different time periods. The column to the immediate right shows the average returns over that period for the S&P 500 (which cannot be invested in directly). The next column over shows the average returns of 3-month T bills and the column on the far right shows the average return of the 10 year Treasury bonds. You can see that during each of the periods presented above, the S&P500 beat the alternatives handily. That is of course no guarantee of future results and is not saying that market beat the bonds over any and all time periods.
But you can see that if you are thinking long-term (10 years or longer) it’s reasonable to invest in equities. The other conclusion we have to draw is, it’s just impossible to know what an investment in the market is going to do any in any one year.
Bottom line? If you ask me what your investments are going to earn I wish I could tell you. The truth is that the answer is unknown for the best investments.
Inflation – Another Reason People Invest
We invest in order to have a better future. But the reality is, we also have to invest just to maintain the purchasing power of our money. In other words, your money has to grow at least as fast as prices go up every year or you will fall behind.
Think about it; $5000 today buys a lot more than it will 20 years from now. That’s because of inflation. In fact, at nominal inflation rates (2.9%) your $5000 will only buy $2822 worth of goods and services 20 years from now. So just to stay even you have to grow your money over time. If you don’t you will be forced to tighten your belt more and more as the years go by.
Let’s look at this a different way.
Assume it generally costs you $5000 a month to live now. That includes housing, food, gas, utilities – everything. A year comes and goes and you realize you still have the same lifestyle but now it costs you about $5200 a month – a $200 a month increase. Food, cable, utilities, gas has all gone up a little in price. That $200 increase is inflation. Your cost of living went up without your standard of living changing.
In any one year, you may not feel it, but over many years this can be a huge problem. Let’s go back to our example above.
Let’s say inflation averages 4%. So, if you spend $5000 a month to live now, it will cost you $5200 a month to live exactly the same way next year. And if your income doesn’t go up, that means you’ll have to get by with less. Cutting back by $200 a month may not be that difficult, but what happens in 5 years?
What costs you $5,000 today will cost you over $6000 a month in 5 years with a mere 4% inflation. If you don’t grow your income you’ll have to cut back about 20% of your lifestyle. Ugly.
In 10 years, it will cost you $7500 a month to live and in 20 years it will be just shy of $11,000. That’s why it’s important to grow your money and your income to at least keep up with inflation. In this example, if your income stays constant, in 20 years, your income will still be $5,000 per month but you’ll have less than half of what you need to maintain your current life style. That is unacceptable and it’s the central reason why I’ve written these series of guides. To help you overcome these problems.
How is inflation measured?
In the United States, inflation is represented by changes in the Consumer Price Index (CPI). The Bureau of Labor Statistics (BLS) is the government agency responsible for collecting this data. What they do is measure the changes in prices that urban consumers pay for a market basket of consumer goods and services over a period of time.
7000 consumers take part in surveys put out by the BLS and they come from all walks of life; rich, poor, employed, unemployed and they live all around the country. The survey tracks money spent on housing, food, entertainment, travel, health care, clothing etc.
CPI vs Your Personal Inflation Number
Depending on where you and how you live, your personal inflation might be different from the government’s number. For example, if you already own your home, housing price increases don’t matter to you. But if you need expensive medicine that keeps costing more and more, that is a big part of your personal inflation rate. So your inflation rate might be higher or lower than the CPI.
And guess what? Your personal inflation rate is much more important than the government’s data because that’s the world you have to survive in. The bottom line is, inflation is a part of your life no matter what.
What Causes Inflation?
There are two main causes of inflation; demand and supply. When consumers start buying more and more goods and services, prices go up unless there is an increase in supply. Here’s why that happens. Let’s say you own a cell phone company and everyone is going berserk for your newest product. You can’t make enough of them to satisfy all your customers. Your factories are already working at full capacity and there is just no way to get more phones on the shelves.
You say to yourself – “Hey, I can raise prices and still sell all my phones. Let’s do it!” and that’s what happens. When people are willing to spend more and more in order to get “stuff”, inflation is the result.
Across the broad economy when consumers have more money in their pockets (due to pay increases at work, tax rebates or other causes) they tend to spend more. And when hundreds of millions of people start spending more, even if it’s just a little more, it sends a signal to businesses that they can charge more and still sell their wares. That’s because demand outstrips supply.er
Another cause of inflation is costs. Let’s look at oil to illustrate how this works. Let’s say the cost of oil doubles in price from $50 a barrel to $100 a barrel. That means it’s going to cost you more to drive to work and to go on vacation because of that increase. But it doesn’t stop there. It’s also going to cost the airlines more to fly you from Los Angeles to New York because their fuel costs are rising. It’s also going to cost your food store more money to ship in the groceries you want to buy.
Transportation costs are an important part of almost every business in the United States so when oil prices go up it usually means the cost of doing business goes up along with it. In most cases, businesses pass those costs along to consumers and that translates into inflation.
Is inflation good?
Inflation is both good and bad. If inflation is extreme, prices rise very quickly to the point where consumers can’t afford to buy what they want or need. When they stop buying because things are too expensive, businesses lay off workers since they don’t need to produce as much. This often leads to a slowdown in the economy, higher unemployment, lower stock and real estate prices and a possible recession.
But think about moderate inflation because it can be a good thing. In that situation, prices rise moderately. People are generally optimistic because they are making more money and it is relatively easy to find work. And when prices are generally rising consumers have an incentive to buy now (before prices go up any further) so demand keeps climbing. That in turn helps business make more profits and expand, hire more people and provide pay increases.
Inflation is also a great help to people who have mortgages or other debts. That’s because they pay back loans with dollars that are easier to come by and worth less than the dollars they borrowed.
Historical Inflation Rates
If you are planning out your finances, it’s important to have an accurate perception about inflation. Here is a graph that depicts inflation rates as measured by changes in the Consumer Price Index (CPI) since 1956.
You can see that the rate jumps all over the place. There were periods of very high inflation (in the late 60’s, mid 70’s and late 70’s) and other periods when inflation was rather tame. But let’s try to get a different perspective by looking at the data decade by decade:
Here we can see that inflation has been sloping down since the 70’s and the average long-term rate is 3.22% per year. (To be conservative, that is the benchmark that you might want to use when comparing investments going forward. ) This doesn’t mean inflation will continue slowing down. We’ve seen periods when inflation heats up just as well and that could very well happen.
Inflation and Other Risks
Inflation is one risk that all investors face. If you ignore the risk of inflation, you may not achieve your financial goals. In fact, you could go broke in retirement if you don’t pay attention to this as I explained above. But inflation isn’t the only risk we have to deal with.
There is also the risk of permanently losing your money as a result of making bad investments. So loss of buying power (inflation) and loss of capital (investment risk) are two major challenges investors have to deal with.
People use different investments to combat these distinct problems. As you’ll see as we go through the guides in this section together, some investments might be good at dealing with one of these risks. But none are good at solving both of these problems – at least over the short-term. Ultimately, that means good investors have to learn to compromise.
Some Ways Investors Combat Inflation
We’ll discuss all these in greater detail in other guides. For now, I just want to give you a sense of some of the alternatives you have:
1. Long and Short Bond Funds
There are a number of mutual funds that buy bonds and, at the same time, sell bonds they don’t own. This is known as “shorting” – and acts as a sort of investment insurance. They short the bonds because the fund manager thinks the values of those particular bonds will decrease. If they are right and values do decline, the manager can buy back the bonds at a lower price sometime in the future. That’s what “shorting” is all about.
So if you think rates are going to go up you might go for this kind of fund. But to be frank I don’t think this is the best way to achieve the goal of having good stable retirement income. It’s extremely risky. If you buy a long/short fund, you’re betting on the managers’ ability to predict the future, and that’s something I never suggest doing. While this is a strategy that hedge funds have used for years, it’s relatively new for mutual funds and not one recommended for risk-averse investors.
Another favorite are TIPS. TIPS stands for Treasury Inflation-Protected Securities. If inflation heats up, the principal invested in a TIPS bond increases. If deflation sets in, the principal decreases.
Once your TIPS matures, you receive the greater of what you invested or the adjusted value. These bonds pay interest twice a year at a fixed rate. And if your principal rises because of inflation, so do your interest payments. Of course they also decline with deflation. Inflation and deflation are measured against the Consumer Price Index.
I’m not a huge fan of TIPS for the long run either. Yes, TIPS are a form of US Treasury and as such are still considered one of the safest investments in the world. But as a result, they don’t pay that much interest. Basically you’ll earn the inflation rate plus a little for your trouble. Not a great way to grow your wealth or create retirement income over the long run, if you ask me. Even if you are retired now, you still need a little growth to combat inflation. TIPS investments probably won’t give you that growth Pilgrim. Sorry.
3. Real Estate
Real estate could be a great inflation-fighting investment. If you buy the right property, you’ll receive rent while you hold the property. Just the same, when you buy real estate, it’s like owning a small business. Be prepared.
Commodities are tangible goods that aren’t branded products. In other words, oil, corn, wheat, silver, platinum and gold are all examples of commodities. You don’t buy “designer” corn. You just buy corn. Commodities are considered inflation hedges because as the currency becomes weak, it costs more dollars to buy the same amount of the commodity.
Gold is one commodity that people think of when it comes to battling inflation but it isn’t the only game in town. And if you do want to buy commodities, you can find many mutual funds and ETFs that only invest in very specific commodities. Now for the bad news.
Commodities have always been an investment area known for speculation. I’ve never liked gold for this exact reason. When all hell was breaking loose in 2008 gold sailed to over $1900 an ounce. You couldn’t turn your radio on without hearing a sales pitch for the stuff. But 5 years later, the price dropped to lower than $1200 an ounce. Ouch.
All commodities are subject to market swings and, in many cases, natural forces. Cotton, wheat, sugar and coffee are all commodities, but each might be impacted significantly by weather conditions, and that could turn a wining investment strategy into a big loser. “No bueno”.
5. Growth Funds
Some people buy growth mutual funds to generate income. I like this approach very much for long-term investors. It’s not guaranteed of course. But over time, it can potentially help investors grow their income and their account values. Yummy.
But this isn’t a silver bullet. If inflation gets out of control, the market might not do that well. Remember that share values are determined by the earnings a company makes. If inflation heats up, that might result in greater profits, which would lift the value of the shares. But if it results in lower earnings because of increased costs, the shares might drop.
Inflation, when it comes, can be a threat to your investments and income if you aren’t prepared. Take time to understand your alternatives and work out a comprehensive investment plan you’ll stick to even when rates and inflation starts heating up.
Before we talk about solutions, let’s look further at investment risk.
Risk To Your Capital
Investment risk is the chance you take of getting back less money than you put into an investment. If you could avoid taking this risk, you probably would. But in order to build your wealth and beat back inflation over the long term, you’ll probably need to take some short-term risk along the way. The question is, how much is enough investment risk? How much is too much?
To begin answering these questions, we have to consider the conflict between your financial and emotional needs.
On the one hand, you want to grow your money as quickly as possible because that could help you achieve your goals faster. But the greater potential for gain, the greater the potential for loss as well. That’s a pain everyone wants to avoid.
This issue becomes more acute during rocky financial times. Here’s a video I created during an especially troubling time some years ago. It was early 2009 – just after the financial crisis when fear was all time highs. Many people found it difficult to stick to their long-term plan as a result of their fears. The video shows the ultimate conflict between our feels and our intellect:
In hindsight, it’s easy to say I was right. But back in 2009, most people were too busy licking their wounds to be thinking about the future. Those who did however, reaped the rewards.
I’m trying to clarify that you have a financial need (to grow your capital) which conflicts with your emotional need (not to worry about your money or financial future). Now it’s time to take a closer look at the compromise I spoke about earlier. It’s no good to wait until another crisis happens before you hammer out your strategy.
How to Reconcile Your Financial and Emotional Needs
In order to navigate your financial life despite these conflicting needs, I suggest you use a chart like the one I created below:
I made this chart for a person who has financial needs which include retirement income in the long-term and stability in the short-term. She also has long-term emotional needs for retirement security and short-term emotional needs for sleep-at-night.
Let’s look closer at this person’s situation. Her short term financial and emotional needs are in synch; she needs security and low-volatility. So for this person, the solution is easy. A low-risk, low return, liquid investment should do the trick.
But her long-term needs conflict. She says she needs retirement income security. But that may require her to make investments that have short-term volatility.
Many times people who have a strong need for short-term security allow that need to influence long-term investment decisions. If that happens, she might move her long-term investments (that offer the potential for long-term growth) into shorter term investment that solve her emotional need for security. If she does that, she may end up failing to achieve those long-term goals. I’ll provide a potential solution to this shortly. For now, it’s important to recognize the potential conflict and costs.
I suggest that you create your own chart now. Separate out your long-term and short-term financial and emotional needs. Do your financial and emotional needs synch or conflict?
How to Resolve the Conflict Between Financial and Emotional Needs
It’s important to acknowledge that you have both financial and emotional needs. But at the same time, it’s important to prioritize between them using your logic.
Rationally, you probably need both stability and growth. You need security and stability for money you know you need over the short term. And you need to grow other money in order to achieve your long-term goals and overcome inflation.
If that is true, why not determine how much money you need for each goal and invest accordingly? To me, that makes most sense and is quite frankly the only way to answer the question. Moreover, by having money invested correctly and matched to the corresponding financial goal, it helps you stick with your long-term strategy.
This is easy to say and hard to do – especially when the market swoons.
How To Keep Sane In Crazy Markets
When markets tumble, it’s only natural to be griped by fear. I understand that of course. But it’s important to be become a victim of yourself. Here’s how:
1. Get present and get out of your emotion.
Do you need the capital now? Of course it’s never fun to see values drop but if you don’t need the capital now, the value doesn’t really matter. And if you do need the capital now, revisit your investment plan. That money should not have been invested in the market in the first place.
2. Don’t kid yourself.
If you think any investment is a “sure bet,” you aren’t realistic. Every investment has an element of risk. The quicker the expected investment return, the higher the risk. This is true no matter what investment you are thinking of.
3. Honestly assess what your financial needs are right now and invest accordingly.
When things are rocky, you might need to make a change or you might not.It depends on who you are and what your financial needs are. Don’t ever forget your goals, objectives and risk tolerance when you invest. Never suspend your reality because of greed or fear.
Now, let’s consider some tools to help you implement some of these solutions.
The Power of Short Term Money
The first order of business is to set aside enough cash in liquid, safe bank accounts for short-term needs and unexpected problems. This will make it easier for you to stick to long-term investing – at least from an emotional standpoint. Why? Because you know that no matter what happens in the market, you have a nice nest egg you can get to at a moment’s notice if need be. That allows you to relax a bit and focus less on short-term performance of long-term investments.
How much money should set aside for short term and emergency needs?
Some people say you always need the equivalent of 6 months’ income in your emergency fund. This could be true. But in most cases, it’s wrong. You have to dig just a bit deeper if you want to get an accurate number. This is important because there is actual danger in having too much liquid as well as having too little. Here’s how to make sure you get this right.
Understand that your emergency money set aside actually should be used for more than just emergencies. I like to think of it in 3 parts:
1. Known expenses.
To start off, do you have a specific expense that is coming up over the next 12, 24, or 36 months? This is typically for well-defined and pre-determined needs like doing major work on the house, college costs, a new car etc. They also include recurring predictable expenses such insurance and taxes.
2. Unknown Expenses
Now let’s deal with those costs you don’t know about – true emergencies. This is a little trickier but not all that tough. Break out your check book and go through the last several years making note of all the “emergencies” that came up. I’m talking about the big costs that seemed to come out of left field. What was the greatest single expense you had to deal with unexpectedly over the last several years?
Guess what? That’s probably the highest amount you’ll need in the future too. I know this is just an approximation, but my experience tells me it is pretty reliable.
I’ll give you an example. Back in 2009 our pipes went on strike and flooded our home. We had to take out our entire bottom floor and redo our kitchen. The total bill was $50,000. The odds of us needing to replace our bottom floor again are pretty low but I use $50,000 as the amount I need for an emergency fund. I know this isn’t scientific, but it works pretty well.
If you have other circumstances coming up, adjust your number.
3. Loss of Income
Next, consider how long would it probably take you to find a new job if you lost your current gig. Then put aside an amount that would cover your family over that period.
When you add these numbers up you’ll have a good idea of how much you need to set aside for emergencies.
Here’s an example of what it might look like:
Upcoming roof repair $7500
Potential job loss – 6 months’ income $45,000
Largest one-time emergency over last 10 years $20,000
This is the amount this particular person might want to set aside in their emergency account. Some people might respond and say they don’t have that kind of money. That’s OK. Start with what you have and build up to it.
Others might say that since they have other liquid investments, they can just liquidate those investments should the need arise.
I understand that approach but I’m not a fan. The reason is, if things get bad, you may need to liquidate that investment at the worst possible time and have to cash in when values are low. That’s why I prefer that you set up an actual emergency account with the appropriate amount. You may not receive much interest on that money but the access and safety of that money are worth more to you than the return you give up.
Your Other Buckets
Once you build your emergency and short-term reserves, it’s time to set aside money to fund your mid-term and long-term goals.
With mid-term needs, simply identify how much you’ll need by examining expected expenditures over the next 5 years for items such as a car replacement, travel, roof repair etc. That should be very easy to calculate. This is money you want to grow but money you need to grow safely.
How to Invest For Mid-Term Goals
You want to be careful here. If you invest too conservatively, you fail to leverage the asset of time and that’s just a waste. On the other hand, if you take too much risk, you jeopardize achieving your goals. Let’s get a handle on this by looking at historical returns for different investments over that 5 year period.
JPMorgan did a study and looked at all the 5-year rolling periods from 1950 to 2013 and how a 50/50 balanced portfolio performed. The found that the maximum average annual gain was 21% per year and the worst average annual gain over any 5-year period studied was 1% per year. Most people fell somewhere in the middle.
You can see that, at least in this study, the 5-year investors never had a losing experience as long as they stuck with their 50/50 portfolio.
Just to give you a reference point, when they looked at an all equity portfolio, the numbers fluctuated from +28% to -2% per year.
This is by no means a guarantee. You could do far better or far worse. This study just shows you what happened during these periods. The past is no guarantee of future results.
Now, I’m not recommending you use a balanced portfolio to fund your mid-term goals. I would need a lot more information about you before I could make any suitability suggestions.
What I’m saying is that you might consider using some element of growth in your portfolio to fund these goals. And I’m also saying you probably should not use an all-equity approach for mid-term goals. Here’s why.
In the example above, the worst experience for a 5-year investor was a loss of 2% per year for all equity portfolios. That may not seem like a lot of risk to take in order to potentially compound your money at very high rates but think again. If you lose 2% per year for 5 years that’s an overall 10% loss. If you put $100,000 in the market that you need in five years but end up with only $90,000, you fail. You may not achieve an important financial goal and it may have a significantly negative impact on your life. You have to consider the downside of investing and the shorter-term your goals are, the more risky the market becomes.
And by the way, who’s guaranteeing that you will only lose 2% per year? Nobody. Your experience could be much worse. That’s true even if you use a balanced model.
How to Move Forward in An Uncertain World
It’s true that the past is no guarantee of the future but in order to make a rational decision, you have to use some parameters. The bottom line is, the longer you invest, the more opportunity you have to smooth out returns – to allow the good years to offset any bad years. And in the “How to Invest Using Mutual Funds” guide I’ll provide some ideas on how you may be able to protect yourself against nasty bear markets.
Next let’s examine what to do about long-term goals.
Why It Makes Sense To Invest Long Term Money Using At Least Some Growth Equity
Let’s say you have a financial goal you want to achieve twenty years or more from now. The only question that matters from a financial standpoint is, what is the best way to grow your money over long periods of time? The answer is, equity and real estate.
What is most important is to achieve your goals. It would be nice if the 20-year ride is as smooth as possible – and we’ll cover ideas on how you might try to do that. But what’s most important to you is to achieve your goal 20 years from now. That should be more important than eliminating all short-term volatility.
If you invest some of your money in equity or real estate to achieve those long-term goals, the value of your investments will fluctuate. So what? It doesn’t matter unless you make emotional decisions about your investments as a result.
Short term thinking can destroy your long-term goals.
Short-term thinking can lead to investment decisions that bring low returns. That could jeopardize your ability to reach your goals. And by the same token, short-term thoughts can lead to too much risk. Some people like to gain ground fast so they speculate on what’s going to happen to gold, tech stocks, pork bellies etc. That often ends up costing investors more than ultra conservative investments.
We’ll cover this in greater detail in the guides that explain how different investments work.