This is the perfect guide for you if you have the feeling (or you know) you should invest but you don’t know how, where or why. You might be confused and worried right now but don’t worry. By the time you complete studying this guide, you’ll know how to avoid the mistakes that permanently damage your financial future, you’ll understand your options and you’ll know exactly what needs to happen next in order for you to start building your financial future. It’s pretty cool stuff……right? It gets better.
Now, 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 ways you can put to use and improve your financial 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, buy real estate or a business, gold, art, antiques etc. with the goal of getting your money back plus earning a profit or interest, that’s invest. These different investment options are known as asset classes and it will help you tremendously if you understand this topic a little more thoroughly.
Understanding Asset Classes
An asset class is a group of assets that react in a similar fashion to a variety of financial forces. This is very important as asset classes come with unique risks and opportunities and you need to understand them both. What are examples of asset classes?
- Stocks or equities
- Bonds or fixed income
- Cash or cash equivalents
- Real estate or businesses interests
- Tangibles such as commodities
How an Asset Class Works
Consider stocks as an asset class. If all stocks are part of the equity asset class, that means they are all subject to similar forces. Of course not all stocks go up or down in lock-step fashion. But if (for example) the economy heats up, that improvement is going to help most stocks. The outcome will be far different depending on the stock (or mutual fund that holds stocks). But an improving economy will move most stocks in a similarly positive direction.
That’s not the case with the other asset classes. An improving economy might hurt bond prices because interest rates might rise (and when that happens, bond prices drop). That’s part of how bonds work – and they work very differently than equities do. That’s why they are a different asset class. Now, if interest rates rise, it doesn’t mean that every bond is going to drop in value. But it means that most bonds will be negatively impacted.
So as the economy shifts, different forces will be unleashed on each of the asset classes. Those forces will nudge the different asset classes in different directions. But most assets within an asset class will be moved in a similar direction. Again, there may be competing forces that move the particular stock or fund. That individual stock might move against the market. For example, XYZ Company comes out with a cancer cure the same day the market drops 200 points. XYZ could still do really well that day but maybe not quite as well as they would have had the market been in an uptrend. Capiche?
Now that you understand what an asset class is, what’s the next important thing to understand?
The next really important step for you to take is to understand how different asset classes work. What are positive factors for each asset class? What hurts each asset class? I gave you a brief introduction on how bonds work. Equities are very different. They tend to rise over time as earnings rise. But over the short term, it’s very difficult to know how a particular stock is going to perform. Real estate markets behave differently based on local economies, but they are also impacted by national and international economics. Can you see how knowing a great deal about equity asset class investments won’t help you the least if you invest in real estate?
You can get an understanding of how these asset classes work for free on this and many other blogs. Before you invest, I strongly encourage you to master this understanding.
Why is it so important to understand how each asset class works?
If investing didn’t entail risk, it wouldn’t be important. You could just invest in the asset class with the greatest potential return and be done with it. But investing does have risk. And people lose a ton of money when they buy the wrong investment for the wrong reason, and they become very disappointed. Let me use an analogy.
If I went to the store and bought a hammer but started using it as a screwdriver, you’d probably think I was silly, and you’d be right. Well that’s exactly what happens with investments. People often buy one particular asset class, like an equity mutual fund, and expect it to perform like something else, such as cash or a cash equivalent. Then when the market dips, they freak and sell. Sound familiar? Another problem is when you buy a fund expecting to get one asset class, but you end up with an entirely different portfolio. That’s why it’s so important to read and understand a mutual fund prospectus.
Have you ever heard someone complain about their investment performance? Have you ever heard someone say, “Oh…I shouldn’t have bought that fund. I could have done better in the bank.” Of course you’ve heard this. Maybe you were the one saying this.
While I can appreciate the sentiment, the statement belies a misunderstanding of how investments really work.
The bottom line is clear. If you understand how each of these asset classes work, you’ll make smarter investments. You’ll buy them for the right reasons, and you’ll sell them for the right reasons. Understand how these asset classes work, and then make sure they fit your investment strategy.
More Details About The Different Asset Classes
1. Bonds and Bond Funds
Bonds are simply loans you make to companies and governmental agencies. They promise to pay you interest every six months and repay the principal some time in the future. You can either buy bonds individually or through mutual funds. I’ve written an extensive guide on bonds which you can and probably should review.
Bonds are usually for conservative investors but you can actually get very aggressive with bonds. I say that because there are a number of mutual funds that buy bonds and, at the same time, sell bonds they don’t even own. This is known as “shorting”. Not all bond funds do this but those that do 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 bond alternative 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 may 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 and returns.
Understanding Long-Term Historical Returns
If you could achieve your financial goals by plunking all your money into risk-free investments, you would do so of course. So why do people buy anything other than guaranteed investments? Because usually, they have to if they want to achieve their goals. The returns offered by “guaranteed” investments historically aren’t there. Let’s consider the stock market to illustrate the point while keeping in mind that returns go up and down regardless of what you invest in.
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 annual 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 consider 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. To give you perspective, for the 10 years ending 2010, the S&P 500 lost about 1% on average per year (including dividends). That’s a very unusual result but it’s important to know that the potential is there to lose money even after 10 years. The chart above provides important perspective but that’s still no guarantee.
Let’s explore this topic a little more.
I understand that 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.
Risk is a big reason why people invest, why people don’t invest, why people invest correctly and why others invest incorrectly. It’s important stuff. Let’s talk about the most important risks that investors face; risk to their capital and inflation.
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 (on average) 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 at first, 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.
Other Risks – Losing Money On Your Investments
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 and diversify.
Risk To Your Capital
Nobody likes losing money. You can minimize the risk by really understanding every investment thoroughly before investing but no matter how you invest, your capital is almost always at risk. You quantify risk by asking these questions:
- What could go wrong?
- What are the chances of this happening?
- What happens to my money if it does happen?
- Can I accept that?
- What risks do I take if I don’t invest and what are the odds of that happening?
If you invest you must ask these questions and accept the answers. If not, don’t move ahead.
Truth be told, if you could avoid taking 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 risk along the way. The question is, how much is enough investment risk? How much is too much?
The questions I posed above are intellectual questions. But you are human which means you also have 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 running at 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 I didn’t know I was right at the time. I was just looking at the historical trends to get perspective and that perspective was very helpful. But back in 2009, most people were too busy licking their wounds to have that perspective. 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. This is important to do regardless of what you invest in. Almost all investments carry risk and that means your feelings are going to get triggered. It’s no good to wait until another crisis happens before you hammer out your strategy so let’s get to it.
Identify Your Financial and Emotional Needs
In order to navigate your financial life despite conflicting financial and emotional 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. It is also absolutely mandates that she create a financial plan.
Many times people who have a strong need for short-term security allow that need to influence long-term investment decisions. If that happens to this person, 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 you lack certainty.
How To Put Your Logic Back In Charge
When the value of your investments tumble, it’s only natural to be griped by fear. I understand that of course. But it’s important not to become a victim of yourself. To avoid that, you need to get your head back in the game Pilgrim. 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 as it was 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 which 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.
Rules of Investment Success That Make Money
Now that you understand the playing field, let’s discuss XX investment rules that will lay your foundation of a successful financial future. The good news is, you don’t need to hire anyone in order to implement these rules for success. The bad news is, even if you do hire someone, they can’t help you if you aren’t willing to implement the rules yourself.
Let’s get down to business and let the wealth flow.
1. Understand that investing is not gambling.
Some people feel that investing is like gambling. You put your money down and you take your chances. Right? Well…….it can feel like that. And it can actually be like that. But it does not have to actually be that way.
Like gambling, investing entails risk. This is true whether you invest passively or actively. Nobody eliminate risk. But if you are an investor, you have a distinct advantage over gamblers. If you play your cards right (get it?) you can be the “house” and stack the odds squarely in your favor.
I’ll explain exactly how to do that in a minute. But first, let’s get our terms straight. Here is the definition of gambling according to Wikipedia:
“Gambling is the wagering on an event with an uncertain outcome. Typically, the outcome of the wager is evident within a short period.”
And here’s how they define investing:
“Investing is putting money into an asset with the expectation of capital appreciation, dividends, and/or interest earnings.”
When you read that, what differentiates investing from gambling? Here’s my take:
1. When you gamble, you bet on a one-off event and you have no reasonable expectation of gain. Your money is not safe. You only have hope. You haven’t done any work and you haven’t purchased an asset. Your potential gain is purely a function of chance. And in most cases, your chances of winning are pretty low. Last, you learn the results of your gamble almost immediately.
2. Investing is nothing like gambling. When you invest you do have an expectation of gain over a long period of time. And if you are realistic, you understand that you have to do your homework in order to have that expectation. There is an element of chance of course. But you can shave down those risks by investing strategically (based on a solid investment strategy and good research) in assets.
Now that we’ve defined our terms, let’s look at tactics that can help you load the dice to always come up 7 or 11:
2. . Continue to Learn
Every January I give a presentation about the economy and the market. Although I don’t have a crystal ball, I talk about the forces at work in the economy and market and how those forces may manifest over the coming 12 months.
Again, my goal isn’t to predict the market. My objective is to help people understand what the various economic forces are and how they might play out during the year.
Ever since I started doing these talks, I’ve noticed that the people who attend are far less anxious about their money during the year. That’s because they understand what is happening. When the market drops and you have no idea why, it can be frightening and it can lead to emotional reactions. But if the market drops and you have some idea as to what is going on, it’s easier to stay the course.
So the first order of business for you is to learn a little about what is happening in the economy and stay up on it. One easy way to do that is to subscribe to this blog but it’s clearly not the only solution. There are plenty of great resources available on the net. Just give yourself about 15 minutes a day and you’ll be a regular Milton Freedman in no time.
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.
3. Expect The Unexpected
There are always positive and negative surprises that are just impossible to anticipate. Don’t let those surprises shake you out of your investment strategy. If you are a buy and hold investor, stay with the program. If you adjust your portfolio based on market conditions, employ your strategy. We’ll talk more about how to pick the right investment strategy in later guides.
4. Have the Right Time Frame In Mind
If you have ever been on a casino floor, you already know that there are no clocks on the walls. That’s because the House wants you to keep on playing as long as possible. Since the odds are in their favor, they’ll clean you out if you play enough hands.
If you want to switch places with the casino owner, you’ve got to pull your clocks off the wall too. A good investing strategy will pay off over the long run. But if you are looking for quick wins, you are speculating and gambling. That’s not to say you won’t throw down a full house once in a while. But that kind of strategy isn’t investing and it isn’t a long-term winning hand.
Off course it would be great if you 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.
5. Expect Losses
You can’t win them all Pilgrim. You won’t make money on every investment you make. You have to accept and anticipate losses.
As you can see, gambling and investing are very different. Gambling “success” depends almost entirely on chance. When you invest properly and over the appropriate time frame, chance has almost nothing to do with your results.
6. If you aren’t a woman, start investing like one.
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.
7. In most cases, don’t 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. My experience tells me that buying the right property or business could justify borrowing but few other situations do.
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.
8. Be Methodical About Creating The Cash To Invest
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.
Once you implement this rule you may have to cut spending or get a side gig in order to maintain your current lifestyle and save enough too. This is a far better approach than the alternative which is to try to make up for insufficient savings by making very aggressive investments. If you want to be a successful investor, don’t overlook the issue of spending and/or income.
9. Don’t Freak Out 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.
10. 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.
11. Have The right amount of short term cash set aside.
Wealthy investors know that they must set aside enough cash in liquid, safe bank accounts for short-term needs and unexpected problems. You need to take that page out of their book and adopt the same strategy 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.
12. Set up the buckets for your mid-term needs.
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.
13. Stick to your long-term plan even if the world goes nuts.
When the world gets extra turbulent and you think everything is about to fall apart, slow down and breathe. It’s true that the past is no guarantee of the future but in order to invest rationally, you have to make some assumptions. The market has survived terrible wars, famines, earthquakes, terrorism, assassinations, etc. You name it. But somehow the earth continued to spin and markets kept going.
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. If you want to succeed, you have to fire your emotions as hard as that can be at times.
14. Acknowledge that you probably need to invest a portion of your money in long-term equity growth.
If you have long-term goals, what is most important is to achieve them. It would be nice if the 20-year ride could be as smooth as silk but that’s not always possible. And as nice as it would be, it’s far more important to achieve your goals 20 years from now. That should be more important than eliminating all short-term volatility. As we saw above, after inflation and taxes, if you stick with guaranteed investments you may find it very hard to achieve those financial goals.
If you invest some of your money in equity or real estate to achieve those long-term goals, you’ll likely have an easier time getting over the finishing line. That’s no guarantee of course, but we have to make decisions today based on some experience….right? Sure, 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 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.
Investing Is NOT Just About Making More Money
Smart investors know that investing is not just about getting the highest return possible. What you want to do is balance your financial goals with your emotional well-being. It makes no sense to invest super-aggressively if it keeps you up at night. On the other hand, if you invest too conservatively, you may not reach your financial goals.
How do you find the balance?
My suggestion is to first get an objective assessment of your risk tolerance. One way to do that is to take this or another risk survey. This will provide an introspective look of what kind of investment mix you might feel comfortable with.
Then, test your comfort zone against your financial plan. Does this kind of asset mix have a high likelihood of helping you achieve your goals? You will only know this if you run your retirement projections – and that’s why it’s a must.
This takes a little work. Most DIY investors skip this step and in my experience, it’s the reason many fail. Please don’t repeat their mistake. What good is it having a portfolio you feel comfortable with if it doesn’t have a high likelihood of getting you where you want to be? Let me show you a crazy analogy to prove the point.
I might feel really safe sitting in a tank. But if I can’t use it to drive down to the Food Mart to pick up groceries (or anything else) what good is it? You get the picture. Investing is all about compromise.
Once you test your risk appetite and run it against your financial plan, you’re just about ready. I want to offer one piece of advice; I suggest that you start off being a little more conservative than you think you should be and monitor yourself over a period of time. In fact, stay tad conservative until the market goes through a rough patch or two.
You really know what your risk tolerance is once the market turns ugly. If you can stomach it, that’s fine. You might consider becoming even a little more aggressive. But if you can’t tolerate the swings, lighten up on the equities and put a heavier emphasis on fixed income as long as the renewed allocation jives with your long-term goals.
The Last Filter
Now that you know what your risk tolerance is and what your long-term goals are, the next thing you should think about are your priorities. Are you in debt? Are you going to buy a house or spend a lot of money in the short term? How far away are you from retirement? As you’ll see, your investment plan should be customized to accommodate these very unique circumstances:
How to invest if you are in debt.
If you have significant credit card or personal debt, address that problem before worrying about investing. This is important for two reasons. First, the interest you are paying on those debts is likely far higher than any guaranteed return you could make by investing. And second, if you don’t take care of the debt problem, it will probably grow. And if it grows, you may have to liquidate your investments at some point to pay off that debt anyway.
If you have mortgage debt, car and/or student loans, you might be OK investing while paying those debts off but if the rates on any of these debts are higher than 4% – I would personally pay them off before investing. That’s because when you pay off a debt it’s a guaranteed return.
In other words, if you pay off a creditor that is charging you 4%, that means you’ll be saving a guaranteed 4% . That’s the same as earning a guaranteed 4%. The higher the rate on debt, the more profitable it is for you to pay it off before doing anything else.
How to invest if you are just starting to put money away
.Let’s assume you have no substantial debt, you’ve already set up your emergency fund, and you’ve got money to spare each money that you want to invest. Let’s further assume that your main financial goal at this time is to save for retirement (we’ll talk about other goals and how to invest to achieve those goals in the retirement guide).
If that describes you and you have retirement plans at work or are able to set up your own IRA or other retirement plan, that’s where you want to sock that cash away. You benefit most by adding as much money as possible to retirement plans because of the tax benefits of doing so and because these plans keep your money safely invested so you can’t spend it. (When we get to the retirement guide, we’ll discuss the differences between the types of plans.)
For example, if you have a 401(k) plan at work and are eligible to contribute $500 a month to that plan, do it. (If you have another $500 (or whatever amount) you are not allowed to put into that or any other retirement plan, you should invest that money for long-term growth in a non-retirement plan (non-qualified).)
How to invest if you are more than 10 years away from retirement.
If you have a decade or more before you plan to retire, you’ve got time and it’s important to use it wisely. Believe it or not, your time is just as important (if not more so) than your money.
As described above, determine what your risk tolerance level is. Then run yourself a few retirement projections to determine what you need to do in order to achieve your financial goals.
In most cases, that will likely include investing for growth – at least partially. In case you think that your investment time frame is short because it only extends to your retirement date, here’s a key success nugget that most people overlook.
You have a lot longer to invest than you think. Let me explain this by way of example. Let’s say you are 50 years old and you want to retire at 65. Do you have 15 years to invest? NO. You have decades more. That’s because if you are like most people I know, you want your money to keep working after your retirement date.
In fact, you want your money to keep working as long as you live – at least. That’s the key; when you think about investing, think about how long you want your money to last/work for you rather than your retirement date. Indeed, your retirement date isn’t that important when it comes to deciding how to invest.
If you are 50 years old today and you want to retire in 15 years, you probably still want that money to work another 25 or more years after you retire. If that’s the case, you have a 40 year time horizon, not 15.
So your first step is to be crystal clear on what you want your money to do for you and for how long. Once you know the answers to these two questions, invest accordingly. Again, balance your risk against your long-term needs and invest in a way that provides the greatest chance of you achieving your goals with the least amount of risk.
How to invest if you are less than 10 years from retirement
If you are less than 10 years from retirement, you might think you have to invest very conservatively. Well…you might. But you might not. Please read the two sections above. They are important and provide the necessary background you need. What I’ve explained above should help you hold on to the right mindset while understanding your real investment time-frame. If you read between the lines, I’m saying that your retirement date isn’t necessarily that important in determining how to invest.
Think about investing from the standpoint of how long you want your money to work for you. Remember that just because you retire, doesn’t mean you can afford to allow your money to do so. Inflation marches on regardless of what you do. That being the case, resist the temptation to become too conservative.
How to invest if you are retired
Retired people still have long investment time horizons. Focus on your expected longevity and (more important) the desired longevity of your assets. I realize that’s not always so easy to do but it is important. The problem here is that when people stop working they often become hyper sensitive to short-term fluctuations in their investment accounts.
I understand this. It’s only natural. Since you aren’t working, it becomes more important than ever to protect your capital. I get it. But as we’ve discussed, investors who become over-cautious often jeopardize the long-term safety of their retirement accounts in order to minimize the short-term risk. This is a very bad and expensive trade-off.
The solution is to revisit your risk tolerance and test again. Once you do that, re-run your retirement projections as well. Invest using an allocation that exposes you to the least amount of risk as long as you still have high probability of achieving your goals.
How to invest if you are way behind.
People who haven’t saved enough for their retirement are often anxious. They sometimes feel compelled to invest too aggressively. In their minds, they do this in order to “catch up”.
I understand this of course but I caution you against being too aggressive if you find yourself in this camp. The reason is, people who take on too much risk lose money over the long-run in my experience. They get involved with speculative schemes and risky ventures.
Remember, even if you are behind, you probably still have a number of years to make up for it. And when we speak about retirement investing, it is by nature a long-term deal.
You will take far too much risk if you speculate. Don’t give in to that impulse. Instead, slow down and breathe. Revisit your plan and consider adjustments such as delaying retirement, working part-time and/or spending reductions.
My strong recommendation is not to compromise when it comes to investment strategy. Do not get in over your head or invest aggressively. The odds are definitely not in your favor if you fall into that trap.
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 the next 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.
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 to invest 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 understanding investing and (most important) putting that understanding to work.
Now that you have the foundation, let’s continue your education by taking a deep dive into the stock market.