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Investing for Beginners: 6 Steps to Building Wealth

/ INVESTING FOR BEGINNERS / 88

 

Copyright © 2015 by Nathan Winklepleck

 

All rights reserved. No part of this publication may be reproduced, distributed, or transmitted in any form or by any means, including photocopying, recording, or other electronic or mechanical methods, without the prior written permission of the publisher, except in the case of brief quotations embodied in critical reviews and certain other noncommercial uses permitted by copyright law.

 

ISBN ___ (EPUB)

 

 

Names, characters, businesses, places, events and incidents are either the products of the author’s imagination or used in a fictitious manner. Any resemblance to actual persons, living or dead, or actual events is purely coincidental.

 

Although the author and publisher have made every effort to ensure that the information in this book was correct at press time, the author and publisher do not assume and hereby disclaim any liability to any party for any loss, damage, or disruption caused by errors or omissions, whether such errors or omissions result from negligence, accident, or any other cause.

 

No patent liability is assumed with respect to the use of the information contained herein. Although every precaution has been taken in the preparation of this publication, the publisher and author assume no responsibility for errors or omissions. Neither is any liability assumed for damages resulting from the use of information contained herein.

 

This book is for entertainment purposes only. It is not intended as a substitute for professional advice. The material contained herein is not investment advice. Individuals should carefully research their own investment decisions and seek the advice of a Registered Investment Advisor or other financial professional where appropriate.

[_ Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it. -Peter Lynch, widely regarded as the greatest mutual fund manager of all time _]

 

If you’re like most people, investing is extremely intimidating. You know its something you should be doing, but it’s hard to know where to even begin. What is a stock? How do I buy one? What on Earth is an “equity”? And isn’t “asset allocation” something reserved for a high school locker room? Every time you try to educate yourself, you are met with nothing but confusing articles and cryptic financial mumbo jumbo. At this point, you’re probably asking yourself…

 

Can I really learn how to invest?

 

The sheer volume of information and varying opinions is enough to cause most people to give up. They assume that investing is just way over their head so they pay a financial advisor or put it off.

 

The reality is that you can learn how to become a successful investor. Once you learn a few of the basics, you’ll find that it’s really not that complicated after all. By following a few simple techniques, you can have more success than your friends who hire “experts” to help them.

 

You don’t need a PhD in finance to become knowledgeable about what investing is, how to do it, and why it’s important. That’s what I’m here to show you!

 

What am I going to learn from reading this book?

 

When you finish reading this book, you will have the basic tools necessary to open your first investment account and get started. Will we cover everything? Of course not. But you don’t need to know everything. You might be pleasantly surprised how little you actually do need to know. Here are some common questions that we will cover:

 

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p<>{color:#000;}. Why is investing necessary?

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p<>{color:#000;}. How is investing different from gambling?

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p<>{color:#000;}. What is a stock?

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p<>{color:#000;}. How does a stock make money?

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p<>{color:#000;}. How can I buy stocks?

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p<>{color:#000;}. What is a bond?

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p<>{color:#000;}. Should I invest in gold?

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p<>{color:#000;}. What is an index fund?

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p<>{color:#000;}. Which index funds should I buy?

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p<>{color:#000;}. What is asset allocation?

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p<>{color:#000;}. Who should I open an account with?

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p<>{color:#000;}. What type of account should I open?

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p<>{color:#000;}. What is the difference between a Roth IRA and a Traditional IRA?

 

Who should read this book?

 

This book is written with the beginner in mind. If you’ve tried to learn about investing before, but have been frustrated by all of the complicated terms – this book is for you! Everything you need to know to get started investing is laid out in a logical, easy-to-follow format. Rather than bombard you with financial buzz words, we’ll relate investment concepts to everyday activities… like grocery shopping!

 

How is this book structured?

 

This book is broken down into a few parts:

 

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p<>{color:#000;}. Part One: Why Invest? Without a “why”, it’s often difficult to get motivated to take action. We’ll answer the “why” behind investing. What’s the point? Why is it beneficial? And what can you expect?

 

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p<>{color:#000;}. Part Two: What Should I Invest In? Here’s where we’ll get into the details. We’ll follow along with “Alex’s Lemonade Stand” to explore what exactly a “stock” is and how it can build wealth for its owners (you). Here we will also take a look at some other forms of investments such as bonds, real estate, precious metals, and other alternatives. We’ll also explore the different ways to buy investments.

 

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p<>{color:#000;}. Part Three: The Investment Decision Process Once you’ve got the basic concepts down, we’ll follow the five decisions you need to make before you get started. We’ll relate the process to grocery shopping as we explore where to open an account, which type of account to open, and what you should buy within that account.

 

You can succeed at investing. I hope this book will help you get started!

 

 

 

 

 

 

 

 

PART ONE

Part One: Why Should You Invest?

 

 

 

 

 

 

Chapter 1: How Will Investing Benefit Me?

 

“[_ He who has a why to live can bear almost any how.” -Friedrich Nietzsche, German philosopher _]

 

Everything you do in life must have a “why” behind it. Why do you brush your teeth? Why do you go to work? Why do you want to learn about investing?

 

Many of these “why” answers are obvious. You brush your teeth because you know the negative repercussions of not brushing your teeth. You go to work because you have bills to pay.

 

But why do you want to learn more about investing? Before we get into the meat of this book, we need to take a step back and look at the “why”. Only then can we look at the “how”.

 

Investing will benefit your life in the following ways:

 

1. Grow Your Wealth

 

I’d like to make a hypothetical proposal to you. Option #1: I’ll give you $5 million today. Option #2: I’ll give you $0.01 today, but it will double every day for the next 30 days. Which would your rather have?

 

Believe it or not, you would be better off taking the penny.

 

After 1 day, your $0.01 doubles to $0.02. In day #2, $0.02 doubles to $0.04. Then $0.08. After 10 days, you have $5.12. After 20 days, you’d have $5,242. On day #30, your penny has doubled its way to $10.8 million.

 

How is that possible? The miracle of compound interest.

 

At first, the initial gains were too small to notice. 1 penny, then 2 pennies, then 4 pennies. Over time, however, each penny started to earn its own interest. That interest then went on to earn its own interest. And so on it went until those pennies turned into dollars, which turned into thousands of dollars, which turned into hundreds of thousands, which turned into millions.

 

You may not have the opportunity to earn 100% return, but by following the principles I’ll show you in this book, you can likely earn 8% or more per year over the long-term. Even that “small” rate of return adds up over time.

 

If you can just invest $10 per day at 8%, you would have over $1 million after 40 years. Learn how to invest and you’ll put the power of compound interest on your side.

 

2. Create “Passive Income”

 

Most people assume the only way they can earn money is by working at a traditional 8-to-5 job. But that’s not the only way.

 

Investing in income-producing assets such as stocks, bonds, and real estate (more on those later) will produce “passive income” in the form of interest, dividends, and rent income. It’s called passive income because you don’t actually have to do anything to earn it. The income shows up in your account while you eat, while you sleep… all the time!

 

If you invest consistently, your investment portfolio can eventually replace your paycheck and eliminate your need to work for pay. We’ll explore this concept further in a later chapter.

 

3. Grow Your Confidence

 

Imagine something for a second. Let’s say you have a $1 million investment account that provides more than $30,000 to you per year. You never have to buy or sell any stocks, it just pays you $30,000 ever year without fail. How would that change how you live your life? How would it change what you think about your job?

 

Imagine how confident you would be if you could walk into your place of employment and really not care if you suddenly were fired that day. How free would you feel to share your real opinions at work? Would you still feel pressure to impress your boss? Is losing a client really the end of the world? Probably not…

 

You may not have $1 million (yet), but no matter how much you do have – the more you grow your investment portfolio, the less dependent you are on other areas of your life to provide for your needs. That creates space for you to pursue your true passions in life.

 

4. Promote Discipline

 

Investing is like losing weight. It’s not hard to know what to do, but it is difficult to actually do it.

 

If you commit to investing $1,000 per month into an investment account, that’s $1,000 that you can’t spend on a flat screen TV or at the mall. You’re exchanging what you want today for more wealth and peace of mind in the future. That takes discipline.

 

By investing, you are not only doing the best thing financially – but you are proving that you have the mental and emotional fortitude to deny yourself for future benefit. You do not succumb to your petty human emotions and desires. You have the strength of character to do what you need to do today, so that you can do what you want to do tomorrow.

 

5. Benefit Your Loved Ones

 

By building up your investment portfolio, you are providing a future for those you love dearly. It can be a source of income for your family if something were to happen to you.

 

6. Give to Others

 

Yes, I know this one’s cliche. But it’s true. If you have financial abundance, you can give generously to other people. Not just with money, but with your time.

 

Conclusion

 

There are few things you can do right now that will improve your current and future life more than starting an investment portfolio and contributing to it regularly. We’ll talk more about how to do that here in a few chapters.

 

Before we do, I’d like to address one particular issue that most people have with investing: Isn’t it just like gambling?

 

 

 

 

 

 

Chapter 2: Isn’t Investing Like Gambling?

 

“[_ Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” -Paul Samuelson, first American to win the Nobel Prize in Economics _]

 

There are many skeptics who believe that investing is a just another form of gambling. This perception has kept thousands of people from reaping the handsome rewards provided by investing in the U.S. stock market.

 

Investing and gambling are not the same thing. Not even close. Here’s why.

 

1. The odds are on your side

Casinos make so much money because the odds are on their side in every single game. The “house edge” represents the casino’s expected profit for each game. The best odds you have are on Blackjack (0.28% house edge). The worst is for Sic-Bo (33% house edge).

 

The casino’s exact profit is unknown, but it’s a virtual guarantee that the casino will win at the expense of the gamblers. For every $100 played on Blackjack, the casino will earn a $0.28 profit. For every $100 played on Sic-Bo, the casino would earn a $33 profit.

 

That’s why you have never met someone who works as a full-time gambler. You’ve also probably never met anyone who built any wealth from gambling over a long period of time. The longer you gamble, the more certain you will end up losing more money than you win.

 

Investing in stocks puts the odds squarely in your favor. If you invest consistently for a long period of time, the chance that you will make money investing in stocks over the long-term is incredibly high. From 1950-2013, there has never been a 20-year period where stocks have lost money.

 

Even in the absolute worst 20-year period, a $1,000 initial investment would have grown to $1,600. In just an average 20-year period, that same $1,000 would have grown to more than $4,000.

 

[* If you spend 20 years gambling, there is a virtual 100% certainty that you will lose. If you spend that same 20 years investing in stocks, you will earn a profit with near certainty… and a pretty healthy one at that! *]

 

2. You own a tangible asset

 

If you owned your own business, wouldn’t you consider that to be an asset? The same thing applies to when you own a stock. When you buy a stock, you are actually buying a small piece of a business. That stock is more than just a piece of paper. It is an asset just as tangible as the ground you walk on. If the business does well in the future, you will profit through dividend payments and price growth.

 

When you plop down $10 on a blackjack hand, you don’t own anything tangible. Those cards don’t employ other people nor do they create any products or services. Those cards won’t pay you a dividend or grow in value. If they happen to be the lucky cards, they might make you a quick buck. But over time, the blackjack table will result in a net loss.

 

3. Three winners vs. just one

When you invest in stocks, you literally create wealth out of thin air. How is that possible?

 

Let’s assume you have $1,000 in cash. If you put that money under your mattress, it does no good for anyone. It just sits there becoming worth less and less.

 

That same $1,000 in the stock market is used for something productive. Companies use the proceed they receive from selling stock to fund business operations, which includes researching and developing new products and services. Those products will benefit everyone who buys them. Not only that, but the employees of the business will earn a paycheck. That paycheck can be invested in more companies to make more products and employ even more people. This virtuous cycle is made possible by investors like you and me.

 

Consider Microsoft for a moment. Many years ago, there were some investors that put money into Microsoft. This money allowed Bill Gates and his partners to develop Windows software. Through the creation of Windows, nearly every single person on the planet has benefitted. This truly revolutionary product has led to unfathomable technological progress.

 

The initial investment helped three segments of people:

 

1) The initial investors in Microsoft have earned a lot of profits from their investment.

2) Microsoft has employed thousands of people and paid out billion of dollars worth of wages.

3) Society benefitted from improved productivity and amazing technological progress.

 

Gambling, on the other hand, does not create wealth. It merely transfers it from one party to another (usually from the gambler to the casino). The only real value added would be wages to the employees and entertainment value for the players. As a general rule, however, gambling creates addictions that destroy lives and increases crime in areas. Little wealth is created and society ends with a net loss.

 

Investing creates wealth. Gambling merely transfers it.

 

4. Lasting pride in accomplishment

 

Consider two 16-year-olds who both just got their driver’s license. One just got a brand new Mercedes Benz that morning given to him by his wealthy father. The other just purchased a 20-year-old high-mileage Toyota Camry for $1,500 with the money he earned from his summer job.

 

Who is more proud of their vehicle? Paradoxically, it’s probably the kid that had to work for it. The spoiled rich kid did nothing to deserve his car. He might show it off to his friends, but the newness will wear off. He probably will neglect to take care of it and he will be on to the next new thing. There is no lasting satisfaction from having something that you didn’t work for.

 

Now consider which person is more proud of their accomplishment: the $1 million lottery winner or the person that worked to accumulate $1 million over the course of many years? The person that put in the work and slowly built wealth will be far more satisfied with their accomplishment than the gambler.

 

The lottery winner might be on a short-term high from their newfound wealth, but it won’t leave them with lasting satisfaction. Despite winning millions of dollars, 65% of lottery winners go bankrupt within 15 years. Divorce rates are 4x higher for lottery winners than the average person. And many winners have led significantly worse lives after they won than before. Why? They didn’t work for their money.

 

Can investing ever be like gambling?

 

Investing can be abused just like any other good thing in life.

 

The technology bubble is a perfect example. In the late 1990s, people were doubling, tripling, even quadrupling their wealth over just a few months by investing in “dot-com” technology stocks. If it had the word “.com” at the end of its name, investors couldn’t get enough of it. It didn’t matter if the company made any real products. All that mattered was that they were a part of the new internet revolution.

 

Eventually, the bubble burst. Companies like “Webvan.com” saw their stocks fall from $30 down to just $0.06. Yes, that’s 6 cents. If you had put $10,000 in the company at its peak and ridden it all the way down to the bottom, your stock would have been worth just $20. Ouch.

 

There are people that use the stock market like a casino. The following methods are all ways that people “gamble” with the stock market:

 

1. Investing in “hot” stock tips they heard from a friend or saw on TV. If you buy a stock hoping to double and triple their investments based upon no real research or knowledge about the company, you are gambling not investing.

 

2. Buying “penny stocks”. There are all kinds of scams out there trying to hook investors into buying penny stocks. The idea is enticing. If a penny stock were to increase from $0.01 to even $0.03, you would triple your investment. The reality is that these stocks are trading for pennies for a reason. Most of the businesses are barely worth the paper their legal documents are printed on.

 

3. Trying to “time the market”. If you’ve ever sold all of your stocks because “stocks are too high right now” or sold them because the market is down by 10% and you think it is going lower, you are trying to time the market. Most investors try it, but few (if any) are successful at it.

 

4. Jumping in and out of the latest hot stocks or mutual funds. When deciding which mutual funds to buy, most investors and financial advisors look at Morningstar’s “5-star funds”. These are the best performing mutual funds over the past 1, 5, and 10 years. The problem with buying based upon past performance is that it ignores what really matters: future performance. Research shows that the best past performers usually end up being the worst future performers.

 

Is Investing Like Gambling? No!

 

While the stock market can be treated like a casino, the reality is that true investing over a long period of time is nothing like gambling. Investing is one of the most proven ways to build wealth over the long-term, while gambling is one of the most proven ways to destroy it.

 

 

 

 

 

 

 

 

PART TWO

Part Two: What To Invest In

 

 

 

 

 

 

Chapter 3: What Is A Stock and How Does It Make Money?

 

“[_ Investing is most intelligent when it is most businesslike.” -Warren Buffett, CEO of Berkshire Hathaway and widely considered to be the greatest investor of all time _]

 

Why does the stock market continue to go up? Where does this money come from?

 

Before you understand how a stock makes money, we first must answer the fundamental question about what a stock is in the first place. To illustrate, we’ll follow 12-year-old Johnny as he sets out to start his own business.

 

Johnny’s Lemonade Stand

 

Johnny is an enterprising young man that would like to start earning some money. He watches his mom make some lemonade one day and decides he wants to start a lemonade business. The problem is that Johnny doesn’t have any money. He needs $200 to build a stand and buy a one-month supply of lemons and sugar, but his penny bank is dry.

 

To raise the money needed for his business, Johnny has three options:

 

1) He could borrow the money.

 

Johnny has two friends named Jim and Tim. Johnny could go across the street and ask to borrow the money he needs.

 

Jim and Tim may agree to lend Johnny the money, but they wouldn’t do it for free. Jim and Tim are taking a risk that Johnny may not pay them back. Since there is risk involved, Jim and Tim would require Johnny to pay them interest to compensate them for lending him the money.

 

The amount of interest Jim and Tim would ask for depends on the rate of return they could get from putting their money in other places. Say, for example, the bank was offering 5% interest. Jim and Tim would not lend this money to Johnny if he was only going to pay 5%.

 

Why? They could get the same interest at the bank and take a lot less risk to get it! Risk and return go hand-in-hand. As a whole, investors will require a higher rate of return to compensate them for taking on additional risk. We’ll talk more about risk and reward in a later chapter.

 

Jim and Tim would probably consider lending Johnny money to be a pretty risky idea. Johnny’s venture is just getting off the ground and he has no real experience making or selling lemonade. Since more risk is involved, Jim and Tim might require twice as much interest as the bank is offering (10%).

 

Once Johnny, Jim, and Tim agree on the terms, they would each loan Johnny $100. Johnny would give both of them a document (called a “bond”) that acted as a contract between them.

 

Periodically, Johnny would send Jim and Tim each an interest payment. If the agreement was to pay interest bi-annually, Johnny would send Jim and Tim each $5 once every 6 months. In total, both Jim and Tim would get $10 interest each year, which would be 10% of their original investment.

 

At the end of the pre-determined time period (1 year, 2 years, 5 years, 10 years, 30 years, whatever), Johnny would pay both Jim and Tim the original $100 back.

 

The primary risk for the investors (Jim and Tim) is that Johnny’s lemonade stand will be a flop and won’t be able to pay its bills. If Johnny’s lemonade goes bankrupt, Jim and Tim may only get a portion of their $100 back or none at all.

 

2) He could sell ownership in his future business.

 

Instead of borrowing the money, Johnny could go to those same friends (Jim and Tim) and offer to sell them “stock” in his business. Under this arrangement, Jim and Tim would purchase ownership “shares” in Johnny’s business. As part owners, they would be entitled to a portion of the future profits that business earned.

 

The risk for the investors is that Johnny’s lemonade stand wouldn’t make any profits. If the business went under, Jim and Tim would each be out $100. Once again, the principle of risk vs. reward holds here. When Jim and Tim purchase stock, they are taking a larger chance that they won’t get their money back. Stockholders do not earn interest like bondholders do. Stockholders are also the last to be paid if the company goes out of business, which makes owning stock more risky than owning bonds.

 

With more risk, however, comes greater opportunity for reward. Bonds offer a fixed rate of return, which is 10% in this case. If Johnny’s lemonade stand earns a profit, Jim and Tim have unlimited potential for return with their stock purchase.

 

3) He could give up his dream.

 

Johnny’s last option is to simply give up. If he can’t find the money to start his business, Johnny will resort to playing video games with his friends instead of adding a valuable product to society.

 

This is one of the key principles of the financial markets: They move extra cash that’s just lying around and put it to use in productive places. Without the opportunity to sell bonds or stock, Johnny’s lemonade stand would never exist. Neither would Ford, Southwest Airlines, Apple, or any other business you can think of.

 

Without the financial markets, the economy would be significantly harmed and many products would have never been added to the shelves. You are not only making money with your investment, but are playing a key role in the benefit of the economy. Investing is incredibly beneficial for society as a whole. Don’t let anyone tell you otherwise.

 

How Does a Stock Make Money for Me?

 

You now know that a stock is simply part ownership in a real business. But how does this “stock” make you money? And where does that money come from?

 

Let’s say Johnny decides to sell stock to fund his new business. He divides the ownership stake into four pieces and sells one of those pieces each to Tim and one to Jim. Since there are four shares, we can say that each share is worth 25% of the overall business. Here is the current share structure:

 

Jim - 1 share (25% of the business)

Tim – 1 share (25%)

Johnny – 2 shares (50%)

 

Year #1

 

In the first year, Johnny uses the investors’ $200 to build his lemonade stand and buy lemons and sugar. As he starts to get some sales (also called “revenue”), he pays for some advertising around town to boost awareness about the new business. All-in-all, the costs add up to $500 for year #1. Johnny also sells $500 worth of lemonade. After subtracting for his expenses, Johnny’s lemonade stand earned $0 profit.

 

Year #2

 

In the second year, Johnny’s lemonade becomes more popular. His sales increase by 2x up to $1,000. His raw material (sugar/lemon) expenses also increase, but he doesn’t have to pay to build a stand this year. Total expenses in year #2 are only $800, which leaves him with “net income” of $200.

 

Decision Time: Re-invest in the Business or Pay a Dividend?

 

Johnny now faces a decision. He has $200 profit that he needs to decide what to do with. He can either (1) re-invest that money back into the business or (2) pay it out to his shareholders as a “dividend”. Johnny decides to re-invest the $200 back into the business and build a second lemonade stand across town.

 

Side Note: Even if a company is making profits, that doesn’t necessarily mean it will (or even should) pay a dividend. In this case, Johnny believed he could put the $200 to better use inside of the business than outside of it. If he can double his profits, Johnny’s shareholders will be benefited by the re-investment as it makes the business worth more in the future. More on that in a minute.

 

Year #3

 

In the third year, Johnny builds a second location and doubles his sales up to $2,000. Now that Johnny is selling more lemonade, he strikes a deal with local grocery stores to sell him lemons and sugar for 10% off. This decrease in the cost of his raw materials allows Johnny to earn even more per cup of lemonade sold. His expenses increased to $1,600 in year #3, which left him with a $400 profit in year #3.

 

Decision Time (Again): Dividend or No Dividend?

 

Once again, Johnny is faced with a decision. He has $400 profit that he needs to decide what to do with. Should he pay it out to shareholders as a dividend or put it back into the business?

 

Johnny decides to re-invest half of the money back into the business ($200) and the other half he will pay out to his shareholders as a dividend.

 

Way Stocks Make You Money #1: Dividend Payments

 

The $200 dividend payment is divided by the total number of shares, which is four. $200 divided by four = $50 per share.

 

Jim gets $50 × 1 share = $50

Tim gets $50 × 1 share = $50

Johnny gets $50 × 2 shares = $100

 

Johnny’s lemonade would write a check to each shareholder for the amount of shares they own. If Jim and Tim held Johnny’s Lemonade Stock in their investment account, their $50 dividend payments would show up on their investment statement. They could then take that $50 out to buy a new bike or keep it in there to invest in more stocks.

 

Dividends are one way that a stock makes you money. If you invest in a company that pays a dividend, you will periodically receive cash in your investment account.

 

Take Apple (AAPL) as an example. Apple is currently paying $0.52 per share to shareholders each quarter (4 times per year). For each share of Apple’s stock you own, you receive $0.52 × 4 = $2.08 per year in dividends. If Apple makes more money in the future, those dividend payments will continue to increase.

 

Ways Stocks Make You Money #2: Price Changes

 

Most people don’t think much about dividends when it comes to investing in stocks. The big hoorah surrounds fluctuations in the value of a stock on the open market. These fluctuations happen every day. Sometimes stocks go up, sometimes they go down.

 

Over the long run, they will likely go up. Why is that? Let’s check back in with Johnny and his lemonade stand to find out.

 

Let’s say 10 years have gone by and Johnny’s lemonade stand has continued to increase its profits year-after-year. Johnny’s lemonade now has a presence in multiple cities with many lemonade stands. Johnny has partnerships with several restaurants in these cities that all sell his products. In the most recent year, Johnny sold $5,000 worth of lemonade and earned profits of $1,000.

 

How Much Could Tim Sell His Stock For?

 

Now let’s assume that one of the investors, Tim, decides he would like to sell his shares. Tim approaches “Big Mike” from across town. How much do you think Big Mike will offer to pay Tim for his shares? That depends on several different factors:

 

1) How much could Big Mike earn on other investment opportunities? If the bank is offering a 5% rate of return, Big Mike will certainly require a higher rate of return from Johnny’s Lemonade Stand since it represents a bigger risk than the bank.

 

2) What is the future outlook of the company? Will Johnny’s Lemonade Stand continue to expand and sell more lemonade? Is there a threat that a competitor might come in and take some of Johnny’s business? All of these are factors Big Mike will consider.

 

3) The financial stability of the company. Would you rather own a company that makes $1,000 per year with $0 in debt or $1,000 per year with $10,000 in debt? Of course, you would prefer a company with lower debt. A company with strong finances is more valuable.

 

Let’s say Big Mike has done his homework on Johnny’s Lemonade Stand and he expects the company will continue to earn profits of $1,000 or more each year for the forseeable future. Big Mike has some other investment opportunities that are offering him an 8% return, so he believes if he can buy stock in Johnny’s Lemonade Stand and earn a 10% rate of return, that would be a good deal for him.

 

Johnny’s lemonade currently earns $1,000 total, but those profits are divided up by the number of shares. Since there are four shares, Big Mike would simply take the total “net profit” of $1,000 and divide by 4 (the number of shares outstanding) to get $250 “earnings per share”.

 

Side Note: If you follow stock investing for very long, you’ll hear the word “earnings per share” thrown around a lot. This is simply the amount of earnings that each share is technically entitled to. In this case, each shareholder in Johnny’s Lemonade Stand was entitled to $250 per share.

 

Big Mike would probably be willing to pay Tim right around $2,500 in exchange for his one share. Why would he be willing to pay so much? If Johnny’s lemonade earns another $250 per share next year, Big Mike would get a 10% rate of return ($250 / $2,500 = 10%).

 

Remember our point about risk vs. reward. Let’s say there was a lemon shortage and the price of lemons was increasing dramatically. Since there is now more risk for buying Johnny’s lemonade, Big Mike might require a larger rate of return to compensate for the bigger risk. If Big Mike wanted to earn a 20% rate of return, he would only be willing to pay half as much for Tim’s shares ($1,250). $250 earnings per share divided by $1,250 = 20%.

 

Now let’s say there is a major tea shortage that drives up the price of tea. More people are buying lemonade as an alternative. In this case, the outlook for lemonade sales increases so Big Mike would be willing to pay a premium for Tim’s shares of Johnny’s lemonade. If Big Mike thought Johnny’s lemonade had a bright future and that the $250 earnings would increase in the future, he might be willing to pay twice as much for the shares (or even more).

 

Side Note: How much you sell your shares for depends on the outlook of a particular company at a particular point in time. If the outlook is rosy (economy is good, etc.), then other investors will be willing to pay more for your shares. If the outlook is not so good (economy is in a recession, there is some bad news, etc.), then other investors won’t be willing to pay as much for your shares.

 

How Much Did Jim Earn?

 

Let’s say Jim accepted Big Mike’s offer of $2,500. Big Mike gained access to all future earnings of Johnny’s lemonade and Jim gladly accepted Mike’s $2,500 check.

 

How much did Jim earn on his investment? As you know, there are two parts to earning money in an investment: (1) the increase in price and (2) the dividend payment.

 

Over the entire lifetime that Jim owned his share of the business, Johnny’s lemonade paid him $1,000 in total dividends. He sold the stock for $2,500. That brings the total to $1,000 + $2,500 = $3,500. Jim originally paid only $100 for the business, which means his profit was $3,400 over a 10 year period. Not bad!

 

However, that’s not the end of the story for Jim. Since he earned a profit of $3,400, the U.S. Government would like to also earn a profit. Chances are that Johnny will have to pay “capital gains tax” on his profits. [* Depending on which tax bracket Johnny is in, he will likely pay the Internal Revenue Service 15% to 25% of his profits. *] Johnny would pay at least $510 in taxes, which would leave him with a “net profit” of $2,890.

 

At this point, Johnny is probably kicking himself. Why? He could have avoided paying taxes completely if he would have purchased his stock within a tax-advantaged retirement account (such as a 401(k) or IRA). We’ll talk more about that in a later chapter.

 

KEY POINTS

 

*
p<>{color:#000;}. Stocks represent ownership stake in a business. As an owner of a company’s stock, you own all of that company’s assets (building, land, machines) and are entitled to the future production of that business.

*
p<>{color:#000;}. When a company earns a profit, it re-invests some of that money back into the business to keep it running and growing. The rest of the money can be used to pay a “dividend” to investors. Dividends are essentially the investors’ slice of the earnings. When earnings go up, so do dividends.

*
p<>{color:#000;}. Bonds are basically IOUs. When you own a bond, you lend money to a company or government in exchange for periodic interest payments and the promise that they will pay you back. There is less chance that your investment will fall to $0, but you are limiting your future return to whatever interest you receive.

*
p<>{color:#000;}. How much you earn on your stock investment depends on two factors: (1) how much the stock increases (or decreases) in price and (2) the total amount of dividends you receive.

*
p<>{color:#000;}. The price of a stock tends to follow its earnings over a long period of time. In the short-term, however, price changes are largely impacted by how optimistic or pessimistic other investors are about that particular company or the economy as a whole.

*
p<>{color:#000;}. Taxes take a large chunk out of your investment profits.

 

 

 

 

 

 

Chapter 4: How Do You Buy Stocks and Other Investments?

 

In this chapter, we’ll talk about the different ways you can buy stocks including mutual funds, index funds, and buying them individually. We’ll also talk about where investment advisors fit into the equation.

 

How can you purchase shares in stock?

 

Buying shares in a stock is much easier than you might think. It’s really not much different than purchasing something on Amazon. The shipping is even faster (at least for now)!

 

You can buy shares in any company as long as it is a “public” company. Some examples of publicly traded companies are: Apple, Walmart, Procter & Gamble, Amazon, General Electric, Wells Fargo, and Starbucks. Johnny’s Lemonade stand is what we would call a “private company”. You cannot purchase shares in a private company on the open market. The only way to buy a private company is to negotiate directly with a current owner of the stock.

 

A private company goes “public” when it issues an “initial public offering” or “IPO” and begins to trade on a stock exchange. One of the more recent initial public offerings was for social media company Twitter, who sold shares in their company to the public and began trading on the Nasdaq stock exchange under the ticker symbol “TWTR”. You can think of the stock exchanges just like any other market. It’s a place where buyers and sellers gather to exchange stocks, just like you would gather at a farmer’s market to exchange apples. The most well-known is the “New York Stock Exchange”.

 

Companies are identified on these markets by their “ticket symbols”, which are unique 3-5 digit letters. For example, Apple trades under the ticker symbol “AAPL”, Starbucks trades under “SBUX”, and Southwest Airlines uses “LUV”. If you want to purchase shares in a particular company, you can with just a few clicks of your mouse. All you need is an online investment account, a couple hundred dollars, and the unique ticker symbol for the company (or companies) you want to buy.

 

Before you go out and start buying shares in your favorite companies, you should understand some other options for buying stocks.

 

Mutual Funds: An Easier Way to Buy

 

In the last chapter, we saw that Jim and Tim bought stock in Johnny’s Lemonade Stand and ended up making an impressive profit. Jim turned his $100 initial investment into $3,500 over a 10 year period. If he could duplicate those results over the next 10 years, he could turn $3,500 into $122,500!

 

Jim thinks he can make more smart investments in the future, so he decides to leverage his investing skills to make a nice profit for himself. Jim goes around town and asks people to pool their money together into what he calls a “mutual fund”. Jim finds 100 people that each give him $1,000 to invest. Jim pools the entire $100,000 together into one mutual fund that he will use to buy and sell different stocks.

 

Think of the mutual fund like a giant pie. Each mutual fund investor owns a piece of that pie. Jim does not own any of the pie, but he does manage it and the mutual fund investors pay him for it. Every year, Jim takes a small chunk of the overall pie. The amount Jim charges is up to him. He will probably charge as much as the investors will let him get away with. We’ll assume 1%, which is slightly less than the industry average.

 

With the $100,000 gathered in the mutual fund, Jim will purchase stock in several different businesses that he believes will do well in the future. He may buy again buy some shares in Johnny’s Lemonade, but he also could put some of the mutual fund’s money in Andy’s Automobiles, Homer’s Hacky Sacks, and Gibbo’s Gadgets. Each investor owns a slice of the overall mutual fund, which means they each own a portion of all of these different companies.

 

The profits for the mutual fund and all of its investors will depend on how the stocks inside of it perform. Let’s say in a given year, the performance of each business is shown below:

 

Johnny’s Lemonade +40%

Andy’s Automobiles -10%

Gibbo’s Gadgets +5%

Homer’s Hack Sacks -20%

 

As a whole, the mutual fund would have increased in value by 15% before Jim took his 1% fee. The “net profit” after fees would have been 14% for each investor. Since each person put in $1,000, everyone’s mutual fund value would now be $1,140. Not bad!

 

This illustrates one of the primary benefits of owning a mutual fund: diversification. You’ve surely heard the phrase: “Don’t put all your eggs in one basket.” If you were to put all of your money into just one stock, that stock could have a really bad year. If it did, all of your money would also have a really bad year. If you owned that stock in addition to many other stocks, your portfolio would still be impacted – but not nearly as much. A mutual fund allows you to buy shares in many different stocks all with just one mutual fund purchase. If one stock has a particularly bad year – your portfolio will be balanced out by other investments that have good years.

 

Side Note: Diversification is a bit of a two-edged sword. The more stocks you own in your portfolio, the less of a loss you will bear from one particular rotten egg. However, owning hundreds of different stocks reduces the benefit you will get from making a few really good picks. Many of the world’s best investors (including Warren Buffett, Charlie Munger, and Benjamin Graham) have earned outsized returns by owning a “concentrated portfolio” of 5-10 of their favorite companies. As a rule of thumb, however, most investors should try to diversify their portfolios as much as possible.

 

What’s the Catch?

 

Back to Jim. In exchange for his investment services, Jim charges the investors 1% of the total value of the fund each year. If the fund grows, Jim will increase the fees he earns from managing the mutual fund. Jim makes a nice profit and the townspeople gain access to a skilled investor without having to do all of the work to find investments for themselves. It’s a win-win, right?

 

Not so fast. It turns out that Jim’s mutual fund starts to attract the attention of other investors in town who start mutual funds of their own. Pretty soon, there are hundreds of other mutual funds all competing against each other.

 

Before the other mutual funds came into town, Jim had a pretty easy time finding good investments. Now, there are many more equally skilled investors all snatching up these deals before Jim can get to them. As a result, the performance of Jim’s mutual fund starts to suffer. The townspeople who originally bought into Jim’s mutual fund start hearing about other mutual funds that are doing better than their fund – so they start to sell out of Jim’s mutual fund and move to the other mutual funds. Jim doesn’t like this one bit. As Jim’s mutual fund gets smaller, so do the fees he collects.

 

To counter this problem, Jim decides to hire some of his friends to go around town recommending his mutual fund to the townspeople. To motivate his friends to bring money to his fund, Jim offers them a cut of the fees for each person that moves money to his mutual fund. Jim’s friends call themselves “investment advisors” and go around town taking people out to dinner, going out golfing, and general schmoozing.

 

The number of mutual funds now available is overwhelming, so the townspeople decide they need to hire these “advisors” to choose which mutual fund is best. In exchange for their “help”, the investment advisors also charge the townspeople a 1% fee in addition to the 1% fee they were already paying to Jim and the other mutual fund managers.

 

Key Point: There are now two layers of fees the townspeople are paying. The first 1% goes to Jim’s mutual fund and another 1% goes to the investment advisors. That is a total of 2% per year. And this fee comes every year, no matter whether the townspeople make money in their accounts or not.

 

With an army of investment advisors now selling (I mean… “recommending”) his fund to their clients, Jim’s mutual fund starts to grow again. This happens until the investment advisors start to get competing offers from other mutual funds who want them to bring the townpeople’s money to their mutual funds. So each investment advisor now gets kickbacks from all of the mutual funds and begins choosing mutual funds for the townspeople based upon short-term (1-5 year) performance.

 

Now that the mutual funds know they are being evaluated on short-term performance, they begin making decisions to boost 3 month performance at the expense of 10+ year performance. This ends up in reduced overall returns for the townspeople over a long period of time.

 

The obsession with short-term results leads to the creation of a news station in town that starts to track the financial markets and performance of various mutual funds in town. The news station soon figures out that they get a lot more viewers by creating sensational news stories about “how to triple your return in just 1 year” and “why an impending stock crash is coming”. They interview different mutual fund managers (like Jim) and ask them for their opinion about the stock market and the economy.

 

The townspeople are already confused about the number of mutual fund choices. Their investment advisors use all of these big words that they don’t understand. And on top of that, they watch the news station that warns them about the upcoming stock market boom or crash. This causes panic amongst the townspeople, who call their investment advisors and want to sell their investments at the worst possible time and buy into them at their highest point.

 

Enter Index Funds

 

One of the town’s most savvy investors (Jack) saw the chaos caused by all of the actively managed mutual funds in town. He decides that the townspeople need a better option. Jack decides to start a mutual fund that simply owns all of the town’s businesses based upon their size. Jack didn’t try to figure out which companies were going to do better than others, his mutual fund just owned them all. When a company comes into town, he buys them. When a company leaves town, he sells them.

 

At first glance, Jack’s index fund seems like a downgrade to the actively managed mutual funds. After all, Jack wasn’t doing any research or buying and selling stocks. His index fund was content to simply own all of the companies in town. Doesn’t it make more sense to strategically buy and sell stocks?

 

The key advantage for Jack’s index fund is the incredibly low cost. Since his mutual fund takes basically no time on his part, Jack charges the townspeople who buy his index fund a much lower fee. He only charges 0.1%, which is 10 times less than the average actively managed mutual fund.

 

By offering a fund with lower fees that owned every stock in town, Jack guarantees that his index fund will outperform the average mutual fund every single year. There will be some of the town’s mutual funds that do better than Jack’s index fund, but it’s mathematically impossible that more than 50% of the mutual funds can beat his index fund. How is that possible?

 

At the end of each year, all the townspeople tally up their returns. On average, the townspeople will earn exactly what the town’s businesses earned. We’ll assume that total return was 10%. But that’s before fees. Less fees mean more profits for the townspeople as a whole.

 

If the businesses in town all increased their values by 10%, the townspeople who invested in the average mutual fund would have only earned 9% after the mutual funds take their cut. And the townspeople who hired an investment advisor would have only earned 8% after paying both 1% mutual fund and 1% advisor fee. The townspeople who put their money in Jack’s index fund would have earned 9.9% after paying the 0.1% index fund fee.

 

[* Is 1% Really That Big of a Deal? *]

 

The difference between earning 9% and 9.9% doesn’t sound like much, does it? Let’s see just how much it adds up. Losing out on 0.9% per year means your $100 only grows to $109 instead of $109.90. That’s $0.90 less cents to compound the next year. And then $1.89 less the next year. And on and on…

 

Over a 50 year period, a $10,000 investment growing at 9.9% per year would grow to $1,121,700.

 

That same $10,000 invested in a mutual fund averaging only 9% per year would only grow to $743,500.

 

And that same $10,000 invested in a mutual fund with an advisor would only grow to $469,000. Ouch.

 

There are some that would argue that a mutual fund could earn more than average in a given year. That’s true, but over the long-term - research has shown that mutual funds consistently underperform index funds over a long period of time (10+ years). The best way for you to make sure you keep your cut of the stock market’s profits over the long-term is to buy index funds. I’ll show you some of the best index funds in the business in a later chapter.

 

A Quick Note on Investment Advisors

 

I’ve been a little rough on the investment industry in this chapter. And not without reason. Time and time again, they have proven their inability to put their own clients above themselves. The temptation to put clients in actively managed mutual funds is obviously too great for many advisors to stand.

 

While most investment advisors do their clients a disservice, it is important to note that not all investment advisors are bad. In fact, having a good financial advisor on your side can be one of the best “investments” you can make, particularly if you find that you make bad investment decisions. A quality advisor should add value in the following ways:

 

*
p<>{color:#000;}. Offer financial planning services including retirement planning, tax planning, and college planning.

*
p<>{color:#000;}. Help keep you invested during the inevitable bumps in the markets. In other words, your advisor stands between you and a dumb decision.

*
p<>{color:#000;}. Provide a sound investment strategy matches up with your specific goals and needs.

*
p<>{color:#000;}.

*
p<>{color:#000;}. Before you hire an advisor, you should always be sure that they have a legal fiduciary duty to put your needs ahead of theirs. Any potential advisor should be completely transparent about how they are paid. They should also disclose exactly what commissions and fees that you would be paying (both to them and to any mutual funds you are invested in).

 

If you have an investment advisor and he or she has been recommending actively managed mutual funds to you, they are doing you a great disservice! Either (1) they are putting their fees above your gains or (2) they aren’t aware of just how much better index funds are. Both scenarios are bad. Fire that person and either do it yourself or hire someone else.

 

KEY POINTS

 

There are basically two ways to purchase stocks:

 

1. Select Individual Stocks

 

You could go out and buy the individual stocks yourself. You may stumble upon the next Johnny’s Lemonade, but you also might invest in a bust. Most investors should avoid buying their own individual stocks.

 

2. Buy Mutual Funds

 

Mutual funds solve the problem of investing in individual stocks. Rather than having to commit time to researching investments, people can simply buy a mutual fund and own hundreds (if not thousands) of different stocks with just one mouse click. This provides instant diversification (not putting all your eggs in one basket) and is a much easier for most investors.

 

The performance of a mutual fund depends on the performance of the stocks it holds. Mutual funds come in two varieties: actively managed and passively managed.

 

Professional investors are in charge of managing actively managed mutual funds . They are actively buying and selling stocks based upon which they think will do better in the future. This sounds great, but it comes at a cost. Active mutual funds charge their clients an average of 1% per year. Research has shown that the vast majority of actively managed mutual funds do worse than their passively managed counterparts.

 

Passive mutual funds (also known as “index funds”) don’t try to pick the right stocks. They simply own every stock available. Passively managed index funds charge far less than actively managed mutual funds – typically 5-10x less. Over time, the lower fees add up to more profits for investors and less for the financial industry.

 

 

 

 

 

 

Chapter 5: Other Investment Options

 

At this point, you know about what a stock is and how it makes you money. We also touched on the basics of a bond. Stocks and bonds are just a couple forms of investment. There are several others, but most fall under one of the following three categories:

 

Real Estate

 

If you’ve ever lived in an apartment or rental house, you paid rent each month. That rent went to the owner of the property – a real estate investor.

 

Real estate extends beyond owning rental homes. Most shopping malls are owned by real estate investors who charge their tenants (stores) a certain monthly amount.

 

Traditional real estate investing involves purchasing a home or property yourself and then renting that out to other people. If you’re like me, the idea of dealing with renters and waking up at 2 AM to unclog a toilet doesn’t sound appealing at all. Fortunately, you can indirectly invest money into real estate through a “real estate investment trust” or “REIT” for short.

 

A REIT is basically like a stock, except rather than manufacture goods and services, REITs manufacture and purchase properties that they rent and sell for profit. As long as they distribute at least 90% of their income to investors, REITs do not pay taxes. That means more income for investors like you and me!

 

REITs can be a great way to get exposure to the real estate market without dealing with finding tenants and uncloggings toilets They also provide juicy dividend income, which is particularly attractive if you are getting close to retirement or want an investment that puts more cash in your pocket today.

 

Commodities

 

A commodity is a good or service that has no distinguishable difference no matter where its sold or who sells it. Oil and gas are examples of commodities. You don’t go to one station because it has better gas. They all sell the same thing. A t-shirt, on the other hand, is not a commodity because there are differences between types of clothes, materials, brands, and designs.

 

Many investment experts recommend that you own some commodities in your portfolio. One popular commodity investment are precious metals such as gold, silver, and copper. Adding diversification to your portfolio through commodities sounds like a good idea, but it’s not. Here’s why.

 

Let’s say you are given the option to buy $100 worth of gold vs. $100 worth of Apple stock. The only catch is that you can’t sell either of them. You must hold them for the rest of your life. Which would you rather have?

 

The Apple stock, of course. Why? Apple will continue to earn money for many years to come, which means they will likely continue paying a divided to you every year. Even if they went out of business, they would have some assets they could sell and you would also benefit from that.

 

What would the gold have done for you? Nothing.

 

The last time I checked, gold wasn’t doing anything productive for society. Gold isn’t creating new products or researching the next technological breakthrough. Gold wasn’t employing anyone. It wasn’t earning a profit. Gold was just sitting in a safe somewhere not doing anything for anyone. In fact, it was actually causing harm to society because it must be stored, cleaned, transported, and protected.

 

When you buy gold, you are merely converting one storage of wealth (money) into another (gold). Over time, gold cannot be a good investment because it is not doing anything productive. Remember: in a capitalist system you are rewarded with money if you do good for society. Gold does not do any good for society, therefore, it cannot reap rewards in a capitalist system.

 

Sure, gold may increase in value. But the only reason it increases in value is because someone else is willing to pay more for it in the future than you were today. In other words, gold is purely speculative. You buy gold if you believe (or hope) that someone else will pay you more for it in the future.

 

Commodities like gold or anything else don’t belong in your investment portfolio. That money is better used to buy productive assets like stocks, real estate, and bonds.

 

Alternative Investments

 

The basic concept of a hedge fund is that they attempt to satisfy a certain objective using any means possible (often complex financial tools) to accomplish them. The problem is that the fees are quite ridiculous. Typically they charge 2% plus 20% of all profits above a certain amount. That’s climbing into borderline asinine territory.

 

Private equity funds are similar to mutual funds except they invest in private companies rather than public companies. A private equity firm might purchase a local manufacturer, then carve out all of the “fat” (in other words: fire everyone) to make the company more profitable. They would then re-sell the company at a handsome profit. At least, that’s the idea.

 

Actually, the main idea of both is to earn a high profit for the managers of the funds. If you’re considering investing in hedge funds or private equity funds, you are treading into some pretty murky water. Stay away from both.

 

 

 

 

 

 

Chapter 6: Balancing Risk vs. Reward

 

One of the most important concepts in investing is the relationship between risk and reward. When it comes to investing, the two are intertwined. If you want to earn a high rate of return, you cannot do it without also taking higher risk. This must be true.

 

Consider a society that has only two jobs offered. The first job is installing and maintaining electrical wires. The other job is filing papers. Both jobs pay $30,000 per year with equal benefits and time commitment. Which job do you think you would apply for? Of course, you and every other sane person would apply for the filing job. Why? Because it is far less risky and offers the same reward as the electrical job.

 

In order to attract people to take more risk, the reward must also increase. How much can depend on lots of factors, but the reality is that the more risky job must pay a higher reward. This society would have to increase the pay for the electrical job to the point where someone is willing to take the additional risk in order to get the additional reward.

 

The same thing applies to investments.

 

Imagine that there are two investment options. Both investments cost $1,000 initially and both are expected to pay 5% per year over the next 10 years. Now assume that Investment A comes with a guaranteed 5% return. Investment B has no such guarantee. In fact, there is a 50% chance that Investment B will be completely worthless in 10 years.

 

Which investment would you prefer? Obviously, you and everyone else would buy into Investment A. There is no point in taking extra risk to still get the same 5% reward.

 

The extra demand to buy Investment A would drive the price of Investment A higher and the price of Investment B lower. Eventually, the price to buy Investment A would be high enough that it would no longer be offering a 5% return. On the other hand, the price of Investment B would fall to the point where it would return more than 5%.

 

Let’s say now that the other investors have bid up the cost of Investment A from $1,000 to, say, $2,000. At this point, it would provide a future return of just 2.5% per year. Investment B’s price has fallen from $1,000 down to just $500, which has made the future expected return increase from 5% to 10%.

 

Now which would you prefer? A guaranteed 2.5% return or a 50/50 chance of earning 10%? It depends on what your needs are.

 

If you’re getting ready to put a down payment on a new house in the next 1-2 years, you’d probably prefer the guaranteed 2.5%. You know you would be sacrificing the potential to earn a higher rate of return, but that’s something you’re willing to do so you can be sure to have the money when you need it.

 

On the other hand, you would probably be willing to take a higher risk if you’re saving for a longer term goal such as retirement. Losing $1,000 wouldn’t be a huge deal since you’ve got plenty of time to make up for it, so it might be worth the extra risk to you to get the 10% return.

 

What you choose also depends on your personality. Some people are more comfortable taking risks, while others tend to shy away. Both need and risk tolerance are important considerations.

 

The Two Form of Investment Risks

 

What is the definition of “risk” when it comes to investing? There are basically two forms of risk.

 

(1) Risk of negative price changes

 

When most people talk about investment risk, they are referring to the potential fluctuation in prices. This is the risk that you took if you invested in Investment B. You had the chance to make a 10% profit, but you also took a chance that your $1,000 could fall in value to $0.

 

It is typically rare for an investment to truly fall to $0. The real “risk” is the reality that the market value of your investments will change. Sometimes dramatically. From October 15, 2007 to March 2, 2009, the S&P 500 dropped in value by 53%. As a general rule, the market can fluctuate by as much as 20% over a 6-month period.

 

The investment world calls this fluctuation in price “volatility”. A stock or collection of stocks whose price change wildly would be considered a “volatile” stock. The more volatile the swings in price, the more “risk” that stock (or group of stocks) would be. Other stocks don’t change much in price. These would be considered to have “low volatility” and, therefore, “low risk”. Since we know risk vs. reward are linked, we can say that stocks with low volatility will probably earn a lower return. As a general rule, this is correct.

 

Volatility gets a bad rap in the investment world, but it’s not always a bad thing. If you are a young person that will be investing money over the next 20 years, fluctuations in stock prices could actually benefit you. If you had money to invest from 2007 through 2009, you were able to buy stocks at an extreme discount while the market was low. Since March 2009, the S&P 500 stock index has returned approximately 250%. If you are going to be buying stocks in the future, you should actually hope that stocks fall in value so that you can buy more in the future at lower prices.

 

Price volatility presents a problem in situations where you need the money in a shorter period of time. For example, if you are wanting to buy a $10,000 car one year from now, price volatility would be a bad thing. If stocks fell by 50% over the course of 1 year, you would then have less than $5,000 to buy your car with.

 

A retired person has a similar problem. Since they no longer have an income, they need to either live only on the dividends produced by their investments or sell small chunks of their stocks to pay for their expenses. In the latter scenario, a retired person spending more than the dividend produced by their portfolio would be forced to sell their stocks at a discount.

 

Fortunately, there are ways to reduce the volatility of your investment portfolio. We’ll talk more about that in the next part of the book.

 

(2) Risk that you won’t meet your goals.

 

People often look at price volatility and get scared about investing. They don’t want to put their money “at risk” and face the reality that their account value might fall by 20% or more in a given year. However, there is a second type of risk that most people fail to consider. And this risk is even greater than the first. It’s the risk that you won’t take enough risk and end up with a reward that is too low.

 

Wait… it’s a risk if I don’t take enough risk? Exactly.

 

Let’s say you’ve done some calculations and figure that you need $1 million to be able to retire. You have 30 years to get there. It’s going to be extremely difficult to save $1 million if all you do is hide money under your mattress or stick it in the bank. Starting with $0 today, you’ll have to contribute more than $33,000 per year for 30 years to end up with $1 million. That’s a tough job.

 

Even tougher would be trying to survive on that $1 million without earning any interest in retirement. If your retirement lasts 30 years, you’ll only have $33,000 per year to spend in retirement. That’s probably not going to be enough to cut it. Especially considering inflation will likely double the cost of all your bills twice over your lifetime.

 

Now let’s say you decide to take some additional risk and, therefore, increase your expected return from 0% to 7%. If you can earn 7% on your investments, your job of saving $1 million becomes much easier. You would only have to contribute $10,500 per year for 30 years compared to $33,000 per year. And since your investments continue to earn more money even after you have quit your job, you would be able to spend $80,000 per year in retirement instead of just $33,000!

 

One of the biggest risks you face is that you won’t take enough risk with your investments to get the kind of return you need to reach your goals. In other words, you have to be sure that you take enough risk. If you don’t, you’ll fall short of your goals every time.

 

How Can You Reduce These Risks?

 

You can design your investment portfolio so that both of these risks are reduced.

 

1. Diversification

 

Diversification is essentially the idea that you shouldn’t put all of your eggs in one basket.

 

There are two types of diversification: (1) within asset classes and (2) between asset classes. To help illustrate the difference, we’ll use the major food groups as an example. You know, the food pyramid with fruits, meats, dairy, junk food, and grain? Yeah, that one!

 

Diversify Between Assets

 

When you go grocery shopping, you naturally diversify between food groups. You wouldn’t go to the store and stock up on 100% fruits or 100% dairy products. You would likely get a mix a few different food groups.

 

The concept applies to investing as well. Over the long-term, stocks and real estate will likely be the best performing asset class with bonds coming in a distant third. But that doesn’t necessarily mean that everyone should own all stocks or all real estate. Consider the 65-year-old retiree who needs to start taking withdraws from their investment portfolio. This person can’t afford for stocks to fall by 50% because they need that money to live on. This person should have some in stocks, but also some in more safe assets such as bonds and some cash in their checking account.

 

A young person, on the other hand, doesn’t need to diversify between asset classes nearly as much. Since they have a longer period of time to let their investments grow, they can afford to take more risk in search of a higher long-term return. That’s why a 25-year-old should probably be in 90-100% stocks.

 

Diversify Within Assets

 

Ok, so your grocery cart is now diversified with different food groups. We’ll say you decided to buy 25% meats, 25% dairy, 25% fruit, and 25% grains. You wouldn’t just buy ribeye steaks, cottage cheese, raspberries, and oatmeal. You would diversify within each group as well. Within the fruit category, you might buy some apples, bananas, blueberries, apples, and a mango.

 

Investing is the same way. You may set out to buy some of the “stocks” asset class. But you wouldn’t want to stop with buying just one stock, would you? Of course not. Why? If you just buy into one single stock (let’s say, Apple), you are taking a lot of risk. If Apple were to stop selling as many iPhones or face a large lawsuit, your investment portfolio would be hurt quite badly. If you owned Apple’s stock as well as stock in Walmart, Google, Microsoft, Procter & Gamble, Johnson & Johnson, and Exxon Mobil, your investment portfolio would be protected in case one of these companies experienced hard times.

 

As we talked about in an earlier chapter, the easiest way to diversify within asset classes is by owning index funds. In Part Three of this book, I’ll share with you some of the best index funds available today.

 

2. Change Your Investments With Your Goals

 

The second way to reduce your investment risk is by modifying your goals as you get older. This is no different than your diet needs changing as you get older and as your life goals change.

 

As you progress through life, you’ll need to eat different proportions of different food groups. A young person trying to build muscle would eat more protein. A long distance runner would need more carbs to provide energy. A person looking to lose weight would eat less carbs. An older person trying to keep their joints healthy would probably lean towards more healthy fats.

 

Again, this concept applies to your investments. Your investment portfolio will look different as your goals change. For shorter-term goals, you should put more of your money in safer investments like bonds, cash, and CDs. For longer-term goals, more money should be in stocks and real estate. Consider the following examples:

 

*
p<>{color:#000;}. An 85-year-old widow is currently living on social security checks and her investment portfolio of about $250,000. She needs money over the next 10-15 years to pay her bills. She should keep some of her money in stocks, but a decent chunk should be in bonds. Why? Bonds are much less volatile than stocks. So if the stock market were to fall by 50%, her portfolio would still be relatively safe.

 

*
p<>{color:#000;}. A 24-year-old college graduate just accepted her first job. She’s got some student loans, but she also wants to start saving for retirement. Since she isn’t going to touch her investments for at least another 20+ years, she should basically have 100% of her money in stocks. Why? Over a long-term period, there is basically no chance that bonds will provide a higher rate of return than stocks. In fact, there has never been a 20-year period in history that stocks have had a negative return.

 

*
p<>{color:#000;}. A 40-year-old is saving money for his children’s college education. His first daughter will be going to college in 5 years. What should he do with this money? He can afford to have a small amount in stocks, but the majority should be in bonds or short-term investments. Why? Even though this person is also very young, his goals are different for this particular pot of money. He will need it in 5 years, so he can’t afford to take a lot of risk with it. His retirement money, on the other hand, should be mostly in stocks. Why? He probably won’t need that particular pot of money for another 20 or more years.

 

So how much of your money should you put in stocks and how much should you have in bonds? We’ll talk about that more in the next chapter.

 

KEY POINTS

 

Risk and reward are linked at the hip. You can’t expect to take little risk and achieve a high return.

 

There are two main “risks” involved with investing:

 

*
p<>{color:#000;}. The first is the fluctuation in the market value of your investments. In any given day, the stock market can move up or down by 1%. Over just a few months, it can move up or down by as much as 25%. If your investments falls in value right before you need to buy something, you’re going to be out of luck.

*
p<>{color:#000;}. The second risk is that you won’t earn a high enough rate of return to reach your long-term goals. In other words, it’s the risk that you won’t take enough risk! Saving for retirement will be virtually impossible if you only earn 3% on your investments. You’ve got to earn more. You’ve got to take risk.

 

You can reduce both of these risks by diversifying your investments. There are two types of diversification:

 

*
p<>{color:#000;}. The first is diversifying within an asset class. In other words, you should own a lot of different stocks – not just one or two.

*
p<>{color:#000;}. The second is diversifying between asset classes. In other words, you should own different types of assets including stocks and bonds (and real estate, if you prefer).

*
p<>{color:#000;}.

 

 

 

 

 

 

 

 

PART THREE

Part Three: The Investment Decision Process

 

At this point, you know all of the building blocks for creating your investment portfolio. You understand what a stock is and how it makes you money. You understand that there are different types of investments available. And you know that risk and reward are linked together. Now, it’s time to put that knowledge into action.

 

In the final part of the book, we will explore the process of creating an investment portfolio for yourself. You may have been intimidated by idea of building your own portfolio, but it’s not as bad as you might think! Over the next few chapters, we’ll continue with the grocery shopping analogies from the last chapter. Each step in the grocery shopping process will align with each step in the investment process.

 

Let’s say you’re needing groceries for the upcoming week. What is the process you go through? It probably looks something like this:

 

1. Examine your food needs.

2. Select where you will do your shopping.

3. Select your shopping cart.

4. Know how much of each food group you want.

5. Select the specific food items.

 

The investment process also basically involves 5 steps:

 

1. Examine your financial needs

2. Choose your “store” (where you will open an account)

3. Select your “cart” (which type of account you should open)

4. Choose your asset “groups” (stocks vs. bonds vs. others)

5. Choose your investment “items” (what you will specifically invest in)

 

Each chapter will dig into one specific part of the investment process in more detail. After reading all five chapters, you should have a basic understanding of everything you need to do to open your investment account and get started!

 

 

 

 

 

 

Chapter 7: Examine Your Needs

 

“[_ If you don’t know where you are going, any road will get you there.” -Lewis Carroll, mathematician and author of Alice In Wonderland _]

 

Before you set out to do grocery shopping, you probably spend some time thinking about which meals you want for the upcoming week. Maybe you want chicken and broccoli for dinner on Monday and snack on some popcorn in the middle of the week. Creating a grocery list ensures that you will purchase what you need, not what you don’t.

 

If you skip this step, chances are pretty high that you will either: (1) not have everything you need when you need it or (2) you’ll buy more than you need and things will spoil. Both scenarios are bad, which is why you’re always better to spend the time now to save both time and money later.

 

Your investments are no different. Without a basic plan in place, you are unlikely to end up where you want. The unfortunate reality is that most people will spend more time planning their vacation this year than planning their long-term financial future.

 

Coming up with an “investment plan” sounds intimidating, but it’s really not. There are basically two types of goals: retirement savings and non-retirement savings.

 

Goals, Part #1: Non-Retirement Savings

 

These are the big ticket items that you know you will buy in the future (say, 12 or more months from now) and need to save up for today so you will have enough when the time comes. This could include things like a house down payment, summer vacation, college savings, replacing an old car, and building up an emergency fund.

 

None of these funds are pressing needs for you today, but they will be. If the transmission in your car were to go out tomorrow, you may be faced with a $1,000+ repair. Without some money set aside for car maintenance/repair, you would have to dip into your emergency fund. Without an emergency fund, you’ll put it on a credit card. Not a good picture.

 

You’re better off to do some forward thinking today and start saving for these numerous expenses before they happen.

 

How do you do this?

 

1. Brainstorm all of your longer term savings goals (1-5 years from now). Mine include: buying a safer commuter car for myself, fully funding an emergency fund, and buying a van for our growing family.

 

2. Write down how much you estimate each will cost. I’m looking at a 2000-ish Toyota Camry with high miles. Estimated cost is about $2,000. The van will probably be around $8,000. And 3 months worth of expenses will be about $7,000.

 

3. Estimate when you will need to have the money by for each item. The commuter car is needed in about 2 months. We won’t need the van for another 3 years or so. And the emergency fund is already funded.

 

4. Plan how much you will need to set aside each month to reach your goal. Simply take the amount in step #2 and divide by the number of months in step #3. $2,000 / 2 months = $1,000 per month for the Camry. The van will be $8,000 / 36 months = roughly $220 per month.

 

I would regularly fund both of these savings accounts until they reached my savings goal. At that point, I could stop contributing to them and put that money elsewhere.

 

Where Should You Keep the Money?

 

As a general rule, money that you’ll need over the next 1-5 years should be kept in a high-yield savings account or extremely conservative investments such as certificates of deposits (CDs) or short-term government bonds.

 

My personal recommendation is to open an account with the online bank Ally. They currently offer the best interest rate of any bank at 1% per year on a checking account. Another great feature with Ally is that they allow you to open sub-accounts within your primary bank account.

 

Why is that awesome? You can name each goal and know that money in that sub-account is dedicated for a specific reason. For example, I can label one of my sub-accounts “Van for My Growing Family” and set $220 per month to be deposited into that account. In 3 years, I’ll have really done no special work or kept track of any Excel spreadsheets, but the $8,000 will be there when I need it. If I want to take some exotic vacation, I’ll think twice before pulling the money out of that account because it has a specific purpose.

 

If you have longer-term savings goals (5-15 years), you will want to get a higher rate of return than 1%. We’ll talk more about how to handle this situation later in the book.

 

Retirement Savings

 

Earning interest on your short-term savings is nice, but it isn’t how you’re going to build real wealth. At just 1% per year, my van savings account will only generate $240 worth of interest over 3 years. That’s nice, but it’s not going to sustain me for life or help me fund retirement.

 

Where investing really shows off its power is in saving for long-term goals. The most obvious and common long-term savings goal that we all share is saving for retirement or “financial independence”. The objective is to build up enough wealth that we don’t have to rely on a paycheck from work.

 

How Much Do You Need to Retire?

 

Ask a room full of people how much they’ll need to retire and you’ll be greeted by a bunch of blank stares. The sad reality is that not many people have any clue what they’ll need. Retirement savings are a mystery to most people.

 

How much will you need to retire?

 

The answer is surprisingly simple. All you need to do is take your current spending and multiply by 25. At that amount, you would have enough money that you could take 4% each year and not likely ever run out of money.

 

Why 4%?

 

Over the long-term, a well constructed investment portfolio should be able to earn a 4% return each year, on average. So by only taking 4% each year, you’re removing the profits only and not touching your “principal” (what you started out with).

 

For example, let’s say you have a $1 million investment portfolio. In the first year, your investments produced dividends and investment gains of 4%. That would be a profit of $40,000. If you were to re-invest that $40,000, the $1 million account would be $1,040,000 at the end of the year.

 

If you were to take the $40,000 out to pay your bills, the investment account would remain at $1 million. If you kept repeating this over time, you would basically be able to take out $40,000 year after year and always have $1 million in your account.

 

Why 25?

 

The number 25 is simply the inverse of 4%. In the last example, we took out $40,000 per year. $40,000 times 25 = $1 million. And 4% of $1 million is equal to $40,000.

 

To calculate what you need for retirement, simply take whatever you spend today and multiply it by 25. That will tell you how large of an investment account that you need to be able to reach financial independence.

 

The more you spend, the larger of an investment account you will eventually need to retire. A person who spends $0 per year doesn’t need an income, so they can retire today. And a person who spends every dime they ever earn will never be able to retire.

 

What how the amount you need to retire continues to increase with higher spending:

 

$10,000 spending x 25 = $250,000

$20,000 spending x 25 = $500,000

$30,000 spending x 25 = $750,000

$40,000 spending x 25 = $1,000,000

$100,000 spending x 25 = $2,500,000

 

So you see that there is a double benefit of spending less. Not only do you need less in the future, but you have more cash to invest today.

 

Teacher vs. Doctor: Who Retires First?

 

Consider that a teacher earns $30,000 per year and invests 30% of that or about $10,000 per year. She only spends $20,000 per year on groceries, rent, clothes, and her other expenses. Using our “Rule of 25”, we can calculate that she needs a retirement account of $500,000. If she can earn a 5% rate of return (after inflation) between now and retirement, it will only take her about 28 years to reach financial independence.

 

On the other hand, a doctor earns $300,000 per year but only invests 20% of that or $60,000 per year. Even though the doctor is investing 6x as much as the teacher, they won’t be able to retire as quickly. Why? They spend $240,000 per year. We know that using the “Rule of 25” that the doctor will need $6 million, which will take them 37 years to accumulate if they can manage to earn 5% per year (after inflation).

 

This example illustrates a surprising truth: When you reach financial independence has nothing to do with how much money you make. It is completely a function of how much you invest today as a percentage of your income.

 

When Can You Retire?

 

The more you invest as a percentage of your take home income, the sooner you can retire. The table below shows how long it would take you to retire investing different percentages of your salary. If you want to retire in…

 

Never… invest 0% per year

66 years from now, invest 5% per year

51 years from now, invest 10% per year

43 years from now, invest 15% per year

37 years from now, invest 20% per year

32 years from now, invest 25% per year

28 years from now, invest 30% per year

25 years from now, invest 35% per year

22 years from now, invest 40% per year

19 years from now, invest 45% per year

16 years from now, invest 50% per year

14 years from now, invest 55% per year

12 years from now, invest 60% per year

10 years from now, invest 65% per year

 

The above calculations all assume you can earn a 5% rate of return (after inflation) and withdraw 4% per year in retirement. If you want to do your own calculations, check out this free retirement calculator.

 

Take Aways

 

*
p<>{color:#000;}. Creating a simple investment plan isn’t as difficult as most people believe.

*
p<>{color:#000;}. For short-term savings (1-5 years), contribute a certain amount each month into a separate savings account (Ally Bank is my personal favorite) until you reach your goal.

*
p<>{color:#000;}. For long-term savings goals (5-15 years), you might consider opening an investment account with a small percentage towards stocks.

*
p<>{color:#000;}. You need roughly 25 times your current annual spending in order to “retire” (in other words, not have to earn a paycheck).

*
p<>{color:#000;}. When you can retire has nothing to do with how much you make. It has everything to do with how much you invest as a percentage of what you make. If you invest 50% of your income each year, you can retire 16 years from now.

 

 

 

 

 

 

Chapter 8: Choose Your Store

 

How do you determine where you will do your grocery shopping? It probably depends a lot on their selection, prices, and how quickly/easily you can get to the store.

 

How do you determine where you will open an investment account? It also depends on their selection, prices, and ease of use.

 

There are basically X types of investing “stores”:

 

*
p<>{color:#000;}. Mutual fund company – A mutual fund company creates and sells mutual funds to investors such as yourself. You can open an account directly with a mutual fund company and purchase their mutual funds. The mutual fund companies often require a minimum initial investment of $1,000 to $3,000. Most companies also allow you to make automatic contributions, which is nice when you don’t have a lot of time that you can or want to commit to managing your investment account.

 

*
p<>{color:#000;}. Discount brokerage - These companies allow you to purchase individual stocks or exchange traded funds (ETFs). They make money by charging a commission each time you buy or sell. The amount is usually $4 to $10. That may seem like a small amount, but paying $10 per month to invest $100 ends up eating away at 10% of your return right off the bat! Before using a discount broker, be sure you have at least $1,000 to invest per trade so you can keep costs within 1%.

 

*
p<>{color:#000;}. Full-service brokerage – These companies are basically the same as a discount brokerage, except you get “service” (meaning hot stock tips, etc.). As a general rule, these aren’t worth the extra commission charge ($20+). Avoid them.

 

If you’re reading this book, I would highly recommend opening an account with either Folio or Vanguard.

 

Vanguard is a non-profit investment firm, which allows them to offer mutual funds and exchange-traded funds at the lowest possible cost. Vanguard is a pioneer of passively managed index funds, which tend to outperform actively managed mutual funds over a long period of time. By opening an account directly with them, you can purchase into their funds for free and also set up automatic investment and re-investment, which saves you time.

 

Folio, on the other hand, is one of the most unique discount brokers out there. They allow you to create your own “Folio”, which includes up to 100 individual stocks or exchange traded funds (ETFs). Like Vanguard, Folio also allows you to set up automatic investment and re-investment. The primary advantage that Folio offers over Vanguard is that they do not require a minimum investment of $3,000. You can invest as little as $100 per month. Folio also lets you purchase unlimited individual stocks for $25 per month or individual stocks/ETFs for just $4 per trade. That’s 60% less than most other discount brokers.

 

What about Betterment? Lately, there have been a number of so-called “robo-advisors” that have emerged. Their platforms are extremely slick and easy-to-use. In exchange for 0.25% per year, you can get access to a pre-diversified portfolio. Betterment is good for those who really have no idea what they are doing, but you can end up doing better on your own if you take the time to learn a little bit about investing. The advantage of choosing your own ETFs rather than buying into a pre-built portfolio are:

 

(1) Lower fees. +0.25% fees on top of the ETF fees add up to between 0.35% and 0.40% cost per year. Over a long time period, that can add up to several thousand dollars in fees.

 

(2) Lower returns. In my experience, Betterment’s portfolios tilt investors a little on the conservative side. They tend to put too much emphasis on bonds, which will hurt long-term performance. I believe you can do better deciding an asset allocation that’s just right for your situation.

 

At the end of the day, both Folio and Vanguard are fantastic options. You really can’t go wrong with either one!

 

 

 

 

 

 

Chapter 9: Choose Your Shopping Cart

 

When you walk into the grocery store, one of the first things you do is pick out a shopping cart. The kind of cart you choose depends on what your needs are for that particular trip. If you’re only picking up a few items, one of those hand baskets might work. On the other hand, you’re definitely going to need a cart if you plan on walking out with two weeks worth of groceries.

 

When it comes to investing, your “shopping cart” represents which type of account you will open. There are basically two types of accounts: retirement and non-retirement. To illustrate the difference, let’s use a ridiculous example.

 

Let’s say that every time you go to the grocery store, someone steals food out of your cart. Not in the store. After you’ve already paid for it. Rude, right? Eventually, you get tired of people stealing food from you, so you construct a shopping cart with a metal cage around it. This eliminates your problem with stealing, however, it also is a giant pain to have to unlock and re-lock your cart every time you go to put something in it. It takes you a few extra minutes to shop just because of this nuisance.

 

Your investments are like the food in your grocery cart. Unless you protect them, some of the goods will get stolen. By who, you ask? Uncle Sam! That’s right. Your friendly neighborhood tax man is going to want a portion of all the profits you make on your investments. That includes dividends and any time you sell an investment at a profit (incurring what is called a “capital gain”). If you invest in a non-retirement account, your investments are subject to these taxes.

 

The only way to protect yourself from Uncle Sam is to build a wall around your investments to keep the tax man away. The barrier between you and the IRS is called a “retirement account”. Keeping your money in a retirement account makes sure the government can’t get to your investment profits.

 

The downside to a retirement account is the same as your caged shopping cart: it’s more difficult to get access to your food if you need it. You’re also limited in how much you can put in a retirement in any given year. We’ll talk about that more in the next section.

 

Here is a basic summary of retirement vs. non-retirement accounts:

 

(1) Retirement Accounts

*
p<>{color:#000;}. You do not pay taxes on any dividends or capital gains.

*
p<>{color:#000;}. There are limits on how much you can add to a retirement account in one year.

*
p<>{color:#000;}. You can’t access the money before age 59 1/2 without incurring some penalties.

 

(2) Non-Retirement Accounts

*
p<>{color:#000;}. You have to pay taxes anytime you make money (get paid a dividend or sell a stock at a profit and earn a “capital gain”).

*
p<>{color:#000;}. You are able to access the funds at any point in time.

 

IRA, 401(k), 403(b)… Oh My!

 

The world of retirement accounts can get confusing pretty quickly. There are a lot of acronyms thrown out there that may sound intimidating at first. Let’s review the primary types. There are a few different retirement accounts available, but most fall into two categories.

 

1. Employer-sponsored accounts

 

These accounts are opened by employers on behalf of their employees. One of the most common types of employer-sponsored retirement accounts is the 401(k). Employees of non-profits may have 403(b) accounts. These employer-sponsored accounts have a few distinct advantages and disadvantages:

 

*
p<>{color:#000;}. In most cases, employers will match a certain percentage of money contributed to a 401(k) or 403(b). Let’s say your employer matches up to 4%. If you made $50,000, you could contribute 4% of that and your employer would put in another 4%. In this case, you would contribute $2,000 and your employer would contribute $2,000 for a total of $4,000. Always, always, always take full advantage of your employer’s match ! That’s an instant 100% return, which is even better than paying off high interest credit cards, student loans, or just about any other investment opportunity available.

 

*
p<>{color:#000;}. Another benefit of employer-sponsored accounts is that they come with higher contribution amounts than the Individual Retirement Agreements (or “IRA”s) that we’ll get to next. In a 401(k), you can contribute a maximum of $18,000 in one year or $24,000 if you are over age 50.

 

*
p<>{color:#000;}. While these two benefits are substantial, one thing to keep in mind about employer-sponsored accounts is that they often come with lots of fees. A 401(k) plan administrator will track how much each person is contributing each paycheck. That costs money, which is paid by the 401(k) plan participants through an “administrative fee”. Usually, this fee is around 1% per year.

 

*
p<>{color:#000;}. Another downside to 401(k) plans is that you are limited to the investment options offered by the company you work for. In many cases, the choices are limited to 6-12 mutual funds. Unfortunately, most 401(k) plan providers are no better at picking mutual funds than the average person. Many times, these mutual funds are actively managed (read: high fees). If your company is smart enough to offer index funds, you’re lucky!

 

So while 401(k) and 403(b) plans are great for getting an employer match, they aren’t so great for any money above and beyond that because of the high fees and limited investment options. You should always get the maximum offered by your employer (4%, 5%, 6%… whatever), but any money that you want to invest above and beyond that should go into an…

 

2. Individual Retirement Agreement (IRA)

 

An employer-sponsored retirement account is opened by an employer. Can you guess who opens an Individual Retirement Agreement (IRA)? That’s right. It’s you! An IRA is something that every person should have. It’s key advantages and disadvantages are:

 

*
p<>{color:#000;}. Since it’s not sponsored by anyone but you, there will be no employer contributions. Sorry! Everything will have to come from you.

 

*
p<>{color:#000;}. IRA accounts have lower maximum contribution levels than employer-sponsored accounts. In 2015, the most you could contribute to an IRA was $5,500 in one year. If you’re over age 50, that increases to $6,500 per year.

 

*
p<>{color:#000;}. There are no “administrative fees” involved with IRA accounts, which will likely save you 1% annually.

 

*
p<>{color:#000;}. You can open an IRA account with any brokerage firm or mutual fund company. That means the number of investment options available to you are limitless! In a later chapter, I’ll show you the only 3 index funds that you need to build a well-diversified, low-cost portfolio. The likely difference between most employer-sponsored mutual funds and these index funds is probably somewhere between 0.5% and 1.5% per year.

 

Having money in an IRA rather than a 401(k) or 403(b) account will probably save you somewhere between 1.5% and 2.5% per year in fees! That may not sound like a big deal, but it is. For every $100,000 you have invested (and you will end up with far more… trust me), you’ll save $1,500 to $2,500 per year. Once you build up to your $1 million portfolio, you can tack on another zero to both numbers. That’s a nice savings!

 

That’s why you should always do what is called an “IRA rollover” anytime you leave an employer. Basically you are transferring money from a high-fee 401(k) account into an IRA. The process is pretty simple. All you need to do is look on your 401(k) statement and call the number you find. Tell them you want to do an “IRA rollover”. A couple weeks later, they’ll send you a check made payable to “Your Name Here IRA”. Then all you need to do is deposit that check into an IRA account (either new or existing, it doesn’t matter) that you have with Vanguard, Folio, TD Ameritrade, Fidelity, Charles Schwab, or any other discount broker.

 

Got it? Good! Before we leave the retirement account discussion, we need to go over an important distinction between the two forms that retirement accounts can come in: Traditional vs. Roth.

 

Retirement Accounts: Traditional vs. Roth

 

Retirement accounts such as IRAs and 401(k) plans used to all be treated the same for tax purposes. In 1989, two Senators proposed a new idea for retirement accounts, which is now named after Delaware Senator William Roth: the “Roth” retirement account.

 

Both “Traditional” and “Roth” options are available for IRA accounts. All employers offer Traditional 401(k) options, but many are option to also offer Roth plans. The accounts are independent from one another, so you could have both a Roth IRA and a Traditional 401(k) or a Traditional IRA and a Roth 401(k) or any combination of the two.

 

Like all retirement accounts, investment profits earned within both Traditional and Roth IRA or 401(k) accounts are not taxed. So what’s the difference between the two? The only difference is whether you pay taxes on money contributed vs. withdrawn. Why is that relevant? Let’s go over an example.

 

In a Traditional IRA, you pay no taxes on any money contributed. Let’s say you earn $50,000 in a year. Normally, the government would take roughly 15% of that in taxes or $7,500. Now let’s say you earn $50,000 and contribute $5,000 to a Traditional IRA. In this case, the money you contributed to the IRA would be taken off of your taxable income. The government would only tax you on $45,000 ($50,000 minus $5,000). That would save you 15% of $5,000 or $750. By putting in $5,000 into a Traditional IRA, you paid $750 less in taxes during the year you contribute money to the account.

 

If you had put that same $5,000 into a Roth IRA, you would have had to pay taxes on that $5,000 in the year you contributed. So why would you want to put money into a Roth IRA? All money in a Roth IRA is not taxed when you take it out (as long as you are at least 59 1/2). That’s the magic of a Roth!

 

In other words, let’s say this same $5,000 that you contributed in 2015 grows to $50,000 by your retirement in 2035. If you had put that money in a Traditional IRA, you would then have to pay taxes each time you take money out of your account. So if you withdrew $10,000 in 2035, you would owe tax on that amount. If the tax rate was still 15%, you would owe $1,500.

 

If that $50,000 were held in a Roth IRA, you could take every penny out and not pay a single cent in tax. Why? Because you already paid taxes on it when you put it into the account. Every dollar you put into a Roth IRA will never be taxed again. Even if that $5,000 grows to $5 million, it doesn’t matter. The government can’t touch a cent of it.

 

Another benefit of contributing to a Roth IRA is a subtle one, but can be beneficial particularly if you are a young person. If you contribute money to a Traditional IRA, you cannot access money held in a retirement account until you turn 59 1/2. In a Roth, however, there is one exception. You can take money out at any age as long as you only take out what you originally put in.

 

In our example above, you contributed $5,000 to the account. If you fast forward a few years and have an emergency come up, you can take out what you put in ($5,000). You just can’t take any more than that. So if your $5,000 grew to $50,000, you could take out $5,000 at any time. You just couldn’t touch the remaining $45,000 until age 59 1/2.

 

Which Account Should You Choose?

 

So which accounts are best for you? 401(k) or IRA? Retirement or non-retirement? Roth or Traditional?

 

Some people really overcomplicate the issue of which account they should open. It can be a complicated issue, but it doesn’t need to be. Don’t worry about making the optimal decision. That’s impossible without knowing what the future holds (and none of us do). Just do what makes sense for your situation and move on!

 

The following guide will help you decide how much to put in a retirement vs. taxable account.

 

(1) Do you need the money before age 59 1/2? If yes, then choose a non-retirement account (either individual or joint). If no, then move on to #2.

 

(2) Does your work match contributions in a 401(k) or 403(b) plan? If yes, then you should contribute up to the match they give you. In most cases, it’s 4%. If your work does not offer a match, you should skip the 401(k) (at least for now) and move on to an IRA.

 

(3) Do you think your tax bracket will be higher during your working years than during retirement? In other words, do you plan on making more money in your working years or retirement? If you think you’ll make more in your working years, then you’re better off to choose a Roth IRA over a Traditional IRA. If in doubt, I’d go with the Roth.

 

(4) After putting the minimum to get the match in your 401(k) and after maxing out your Roth/Traditional IRA, do you still have more money left over to invest? If yes, then you should contribute more to your 401(k). You won’t get a match on this money, but you will be able to protect your investments from taxes.

 

(5) Have you already fully maxed out both your 401(k) and IRA? At this point, you’re out of tax-advantaged options. Anything you have to invest above this should be put into a non-retirement account.

 

And that’s about it! If you understand everything we’ve discussed here, you know just about 80% of everything you’ll ever need to know about the different types of investment accounts available. And the ones we did not cover here, you can find out more about online. In any case, the basic principles will remain the same.

 

 

 

 

 

 

Chapter 10: The Investment “Food Groups”

 

Everyone has seen the food groups chart published by the government. Recent research has questioned the validity of the food pyramid, but it’s a good analogy for how you should think about investing. Just like there are different food groups such as meats, dairy, bread, junk food, fruits, and vegetables, there are different investment groups.

 

Let’s take a look at each type of investment and relate it to one of the food groups.

 

The Investment “Food Groups”

 

Cash = water. Without water, you will die. You must drink water constantly to stay hydrated and keep your body functioning at peak condition.

 

In the same way, you must keep cash flowing into your investment account so that it can compound over time. You can be the greatest investor of all time, but it’s going to be impossible to accumulate wealth without consistently creating cash from a job or business and not squandering it on fancy clothes, new cars, or oversized houses.

 

Cash is the water to your investment portfolio. Keep it flowing into your investment account (not out) and you will grow wealth.

 

Bonds = whole grains. What is the first thing people buy when a big storm is on the way? Bread and milk. There is something about bread that we associate with survival. Grains aren’t exciting, but they keep your stomach full and don’t expire quickly. You could survive on oatmeal and bread in an emergency, but you wouldn’t thrive over an extended period of time.

 

In the same way, the “bread” of your investment portfolio are bonds and other fixed income investments such as your savings account, certificates of deposit (CDs), and Treasury bills. They don’t fluctuate in value nearly as much as stocks, so people feel comfortable holding them.

 

However, remember that you cannot earn high returns without taking higher risks to get it. Since bonds are lower risk, don’t expect a great return. An investment portfolio made up 100% of fixed income assets will likely keep up with inflation and serve you well in a time of emergency, but it isn’t going to create real wealth over the long-term.

 

To create wealth, you must own stocks.

 

Stocks = protein. Proteins are the building block of muscle. After you go to the gym, it’s highly recommended that you eat (or drink) protein to help your body repair itself. Protein is also essential for brain function. Without protein, you cannot grow physically or mentally.

 

Without stocks in your investment portfolio, you cannot grow wealth over the long-term. Research shows that stocks have historically outperformed bonds by somewhere between 3% and 13%. ^^1^^ As long as you have a longer term investment horizon (5 or more years), stocks absolutely must be a part of your investment portfolio. We’ll talk about how much of your portfolio should be in stocks in the next chapter.

Alternative investments = junk food. The flashiest items in the grocery are the processed junk foods that lower your energy levels and make you fat, but taste oh so good! Having a little junk food here and there isn’t going to kill you, but there basically is nothing desirable about it. If you could go your entire life without putting it in your body, you’d be better off for it.

 

Consider that if you had invested $10,000 into bonds 200 years ago, it would have grown to $8 million. That same $10,000 in stocks would have grown to $5.6 billion with a B. Gold? It would have grown to $26,000. If you would have invested in gold instead of stocks, you would have missed out on $5,599,974,000 in investment gains over the past 200 years.

 

Alternative investments may “diversify” your portfolio, but they certainly don’t do much for it’s long-term returns. Steer clear.

 

Now that you have a knowledge of all the different food groups, it’s time to select exactly what you want in your investing “shopping cart”. What specific stocks, bonds, real estate, or other assets should you include? And how much of each should you get? We’ll cover all of that in the next two chapters.

 

 

 

 

 

 

Chapter 11: The Only 3 Index Funds You’ll Ever Need

 

In this chapter, we’ll talk about 3 specific index funds that are some of the best in the business. You can’t go wrong with any of these index funds. As a whole, they will cover every single investment you really need. Ever.

 

All three index funds are managed by the king of index funds and low-cost investing: Vanguard. Vanguard is a non-for-profit investment company, which means all of the funds are offered to you at cost. You don’t have to worry about anyone trying to make extra profits off of your accounts.

 

The Million Dollar Question

 

As a result of this fee structure, these three Vanguard funds are approximately 90% cheaper than their competitors. Think of Vanguard vs. other mutual funds like this: If Vanguard were to go into competition with Starbucks, a cup of coffee would cost just $0.20 compared to $2.00. This savings may not sound like much. And it isn’t when you’re talking about small purchases like coffee. However, these charges are significant when you’re talking about your investment portfolio.

 

Just how much can fees hurt your portfolio? Consider that the average mutual fund charges 1.25% per year. The average Vanguard fund below charges just 0.10% per year. Let’s assume that you’re going to invest $10,000 each year for 30 years. Over that time period, the stock market returns an average of 7% per year. In the mutual fund, you would get 7% minus fees (1.25%) = 5.75% per year. With Vanguard’s index funds, you would earn 7% minus fees (0.10%) = 6.90% per year.

 

That 1.15% difference may not sound like much, but it’s substantial. Your investments with Vanguard’s index funds would grow to $927,782. Your investments with the mutual funds would grow to just $756,645. That’s a difference of $171,137 or $5,704 per year.

 

If you kept investing for another 20 years after that, the difference would be $2,672,848 in the mutual fund vs. $3,929,215 in Vanguard’s index funds. I’ll do the math for you: $1,256,367 or $25,127 per year.

 

So… the million dollar question (literally) is this: Will you invest in mutual funds charging you 1.25% per year or Vanguard index funds only charging you 0.10% per year? That’s what I thought…

 

On to the only 3 index funds you’ll ever need!

 

1. Vanguard Total Stock Market Index Fund

 

I love this index fund because when you own it, you literally own every single public stock in the U.S. If you’re a young person with 20+ years until you plan to need the money, this index fund is all you really need.

 

You don’t need to buy a separate fund for “small caps” or “mid caps” like many advisors will tell you that you should. Buying this one fund gives you exposure to companies of all sizes:

 

72% of VTI is invested in large cap stocks

19% is invested in mid cap stocks

9% is invested in small cap stocks

 

VTI also removes your need to buy many different funds for each sector of the market. By owning VTI, you own stocks within all of these different stock market sectors and industries:

 

17.34% in Technology (Apple, Facebook, Netflix)

15.55% in Healthcare (Johnson & Johnson, Pfizer, Eli Lilly)

14.77% in Financials (Wells Fargo, JPMorgan Chase, Berkshire Hathaway)

11.90% in Consumer Cyclical (Starbucks, TJ Maxx, Target)

11.53% in Industrials (Deere, Caterpillar, Boeing)

8.24% in Consumer Defensive (General Mills, Procter & Gamble)

7.24% in Energy (Exxon Mobil, Chevron)

3.66% in Real Estate (the REITs we talked about earlier)

3.61% in Telecommunication (AT&T, Verizon)

3.32% in Basic Materials (Dow Chemical, Monsanto, Praxair)

 

In other words, if you own this fund… you don’t need to own anything else (at least U.S. Stocks)!

 

Just what exactly would you own? For every $1,000 you invested as of July 2015, you would own approximately:

 

$3.18 worth of Apple

$1.53 worth of Exxon Mobil

$1.42 worth of Microsoft

$1.19 worth of Johnson & Johnson

$1.18 worth of General Electric

$1.15 worth of Wells Fargo

$1.11 worth of JPMorgan & Chase

$1.06 worth of Berkshire Hathaway

$0.93 worth of Procter & Gamble

$0.91 worth of Pfizer

$0.84 worth of Verizon

$0.81 worth of AT&T

$0.81 worth of Facebook

… And smaller amounts of over 2,000 other stocks!

 

Recognize any of those companies? As an owner of VTI, you are now part owner in the future profits of all of them! And all you had to do was buy one fund.

 

A $100,000 investment in VTI would have grown to $212,120 over the past 5 years. That’s a rate of 16.23% per year, which soundly destroyed the average index fund. According to Morningstar, the average mutual fund would have grown $100,000 to just $194,750 over the past 5 years. That’s a rate of 14.26% per year. Don’t try to pick winning mutual funds.

 

A big reason why VTI outperforms the average index fund is cost. VTI only costs 0.05% per year or $0.05 for every $1,000 you invest in it. That’s 95% cheaper than the average mutual fund and could save you literally hundreds of thousands of dollars in fees over your investment lifetime.

 

You can purchase this ETF through your Folio investment account (my top pick) or any other discount brokerage account (TD Ameritrade, Fidelity, Charles Schwab, etc.) by typing in the ticker symbol “VTI”. As of this moment, one share costs $108.27. So if you invest $1,000, you would be able to purchase roughly 9 shares of VTI.

 

You don’t need to own 20 different high-cost mutual funds to be fully diversified and earn a high return over the long-run. All you need is VTI!

 

2. Vanguard Total Bond Market Index Fund

 

This index fund is the exact same as the one above except instead of stocks, you own nearly every single bond available. Again, this saves you from having to decide whether to own this percentage of municipal bonds or this percentage of corporate bonds. Save yourself the trouble and just buy this index fund!

 

This one is a bit more expensive than the stock fund at 0.07% per year. However, that’s still 92% cheaper than the average bond mutual fund. And since bonds typically offer a lower return than stocks, a lower fee is even more important!

 

Over the past 5 years, BND has grown $10,000 to $11,694. That’s 3.18% per year over the past 5 years. Again, the lower fees mean higher performance compared to mutual funds. The average intermediate government bond mutual fund earned just 2.31% per year over these 5 years.

 

You can purchase this ETF by typing in the ticker symbol “BND”. As of this moment, one share costs $81.55. So if you invest $1,000, you would be able to purchase roughly 12 shares of BND.

 

3. Vanguard Total International Stock Index Fund

 

And last but not least, the international index fund. If you’re interested in gaining exposure to developed and emerging markets outside of the good ol’ US of A, this is the cheapest way to do it.

 

At just 0.14% per year, you’ll save 88% compared to other international mutual funds.

 

Again, the lower fees translate to higher returns. VEU has soundly crushed the average international stock mutual fund over the past 5 years. It has grown $10,000 to $14,871. That’s 8.26% per year.

 

The average international mutual fund has grown $10,000 to $13,325. That’s 5.91% per year.

 

You can purchase this ETF by typing in the ticker symbol “VEU” on your discount broker’s website. As of this moment, one share costs $48.22. So if you invest $1,000, you would be able to purchase roughly 20 shares of VEU.

 

And… That’s It!

 

There are some investment advisors out there that will try to convince you that you need to own 20-30 mutual funds to be “adequately diversified”. The reality is that the quantity of funds you own does nothing for your diversification. If you owned all three of the index funds I mentioned above, you would own nearly every single possible investment security on the face of the planet. It doesn’t get more diversified than that!

 

What your investment advisor is actually saying is that these three index funds aren’t “adequately profitable” (for them, that is). Most of them will try to pull the sheet over your face with a laundry list of “5-star mutual funds”. The reality is that a portfolio of these three index funds will beat the pants, shoes, shirts, and socks off of their mutual funds over the long-term. And that’s not even considering the fee that your advisor is charging you.

 

Don’t fall for it. These three index funds are all you really need to achieve impressive investment returns. The only question that’s left for you to answer is how much of each index fund should you own? We’ll cover that in the next chapter.

 

 

 

 

 

 

Chapter 12: The Bucket System: How to Design Your Portfolio

 

How do you decide how much fruit to buy at the store? You may create a list of everything you plan to eat the coming week. Or maybe you just know in your mind roughly how much you’ll need.

 

Either way, you choose how much of each food group to buy based upon what your needs are. If you don’t buy enough, you risk running out of food and having to go back out to the store. If you buy too much, you risk that the food might go bad before you eat it. That’s a waste of money. Both are not good!

 

You face similar risks when you invest. If you go too conservative (too many bonds and not enough stocks), you risk running out of money when you need it later on in retirement. If you go too aggressive (too much stocks and not enough bonds), you risk a market downturn wiping out your investments right when you need them most.

 

Asset Allocation: The Key to Your Investments!

 

In the investment world, the term “asset allocation” describes what percentage of stocks vs. bonds you have in your investment portfolio. Over the long-term, 88% of your investment returns are a result of the allocation between different types of assets (source: Wallick et. al 2012).

 

For example, if you had put 100% of your portfolio in bonds, your rate of return would have been 5.5% each year from 1926-2013. If you had went with 100% stocks, your portfolio would have earned 10.2% per year. The difference between 5.5% and 10.2% over an 87-year period is staggering. The 100% bond portfolio would have turned $10,000 into just over $1 million. Pretty good, right?

 

That’s nothing compared to earning 10.2% per year in stocks. The 100% stock portfolio would have turned $10,000 into more than $46 million. $46,751,841 to be exact.

 

Then… Why Use Bonds?

 

So if stocks always do so well, why doesn’t everyone just put everything in stocks? What’s the point of owning bonds?

 

Stocks have been and will likely always be the best way to grow your wealth. The problem with owning only stocks is that they can go through extreme fluctuations in value.

 

From 1926 through 2013, the best 1-year return for stocks was 54.2%. The worst? -43.1%. To put that into context, a $100,000 portfolio would have fallen to $56,900. Ouch.

 

The best period for bonds was only +32.6%. The worst was -8.1%. That means the same $100,000 portfolio would have only fallen to $91,900 in even the worst time period.

 

Like a Race Car

 

Think of stocks like a red sports car. It’s going to get you where you want to go a lot faster, but it also rides a lot lower to the ground and absorbs a lot more bumps in the road along the way.

 

Think of bonds like a 4×4 truck with huge tires and shocks. Even if you hit a massive bump in the road, bonds are going to be able to handle it. In other words, it’s a much smoother ride!

 

So what if you want to get there quickly, but also don’t want to experience all the bumps along the way? That’s where asset allocation comes in!

 

“ Asset allocation” is just a fancy word for how much stocks and bonds you own. A person that owns just stocks has a “100% stock allocation”.

 

Your asset allocation determines two things: (1) how high your returns will be and (2) how rough the ride will be. Keeping with the car analogy, let’s see how different “rides” have performed from 1926-2013.

 

Lamborghini Diablo (red, of course) : 100% stock portfolio. +10.2% average return. As we mentioned earlier, turned a $10,000 initial investment into $47 million. Ah, the power of compound interest… This aggressive allocation should be reserved for money you don’t need for 20+ years.

 

Toyota Camry: 80% stocks and 20% bonds. It will get you up to traffic speed, but it’s not going to blow the doors off of anyone. At the same time, it offers a much smoother ride than the Lamborghini. Average return +9.4% per year. Worst year -34.9% and the best +45.4%. A good “moderate-aggressive” portfolio. Ideal for 15-20 year time frame.

 

Honda CR-V: 50% stocks and 50% bonds. It’s the perfect mix between getting you there in a reasonable time frame, but also protecting you from the bumps. +8.3% per year. The worst year was -22.5%. The best year was +32.3%. Ideal for money you need in about 10 years or so.

 

Chevy Suburban: 20% stocks and 80% bonds. A good mix for money you need in 5 years. You’ll likely get a better return than your bank (+6.7% historically), but also limit the downside. +29.8% in the best year and -10.1% in the worst.

 

Ford F-350 with mudding tires and all jacked up : 100% bonds. Aside from cash or certificates of deposit (CDs), this is the most conservative you can get. OK if you need money within 3 or so years and just want to keep up with inflation, but this portfolio is more for holding onto the money you already have (not building it). Average return +5.5% with the best at +32.6% and the worst at -8.1%.

 

Below is a more detailed breakdown of different portfolio allocations and how they have historically performed. The widest bands (and most red) represent the riskiest portfolios, but also offer the highest returns. The narrowest bands (blue) represent the most conservative portfolios (source: Vanguard).

 

 

 

 

What “Asset Allocation” Is Right For You?

 

There are a lot of people out there that take a simplified approach to determining how much money you should have in stocks. Most recommend that you take your age and put that in bonds. The rest should be in stocks. So if you are a 30-year-old, you should put 30% in bonds and 70% in stocks.

 

Others recommend that you be a little more aggressive with this and add an extra 20% to stocks. So a 30-year-old would have 10% in bonds and 90% in stocks.

 

This technique is simple, but it’s certainly not ideal. The age-based asset allocation fails to take into account each person’s unique situation. Consider a 60-year-old that spends $40,000 per year and will be getting a $60,000 pension from their company. This person doesn’t need anything from their investment portfolio since all of their expenses are covered by their pension. Yet, according to the age-based system, this investor would have somewhere between 40-60% of their investments in bonds. That’s ridiculous!

 

The “bucket system” takes a little extra work, but it does a much better job in helping you get the absolute most out of your investments while still providing for your shorter-term needs. All you have to do is create 3 “buckets” (hence the name). Each bucket represents the amount of money that you’ll need over that time period that is not covered by other income sources (a job, pension, etc.). Each bucket of money requires a different investment style. The three buckets are:

 

0-2 years – The money you need over the next 2 years should not be invested at all. It should be in cash or some other low-risk investment like certificates of deposit (CDs) at your local bank. You can also get decent interest rates in online banks such as Ally.

 

3-10 years – Any money you may need 3-10 years from now represent more medium-term savings goals. You don’t want to be earning nothing on these investments, but it’s still a short enough time period that investing it all in stocks doesn’t make sense. For money in this bucket, I would recommend a 50/50 split between stocks and bonds. The bonds will give you enough cushion to lesson the blow from any major downturn. In even the worst 5-year rolling period since the 1950s, a 50/50 portfolio still earned a positive rate of return.

 

[* 10+ years *] - Anything you don’t need for another 10 years should be primarily invested in income-producing assets such as stocks and real estate. Over a 10-year period, the chances of you losing money in the stock market is extremely low. In even the worst 10-year period, a 100% stock portfolio only lost a total of 1% per year. The best was +19% per year.

 

A “Real Life” Example

 

Let’s see how this comes out for a real life example. Tom is a 55-year-old that wants to retire in 5 years. He currently has a $500,000 investment portfolio and will get $30,000 per year from a pension. He also expects that he will need $10,000 in a year to buy a used car to replace the one he has now. His annual spending is $50,000 per year and he earns $75,000 from his job.

 

0-2 years

 

He will be spending a total of $100,000 over this time period, but will earn approximately $150,000 from his job. That means he doesn’t need any money from his investments to cover his spending. It’s probably still a good idea for him to keep at least 3-6 months worth of expenses in an emergency fund, but he probably wouldn’t need it as long as he kept his job over that time. $0 needed in this investment bucket.

 

3-10 years

 

He will be spending a total of $50,000 × 7 years or $350,000 over this time period. In years 3 and 4, he will be earning his normal $75,000 salary. He will also be getting some money from his pension. When he retires in year 5, he will be getting the $30,000 per year from his pension from years 5-10. The total earnings over this period would be $150,000 from his salary and $150,000 from his pension for a total of $300,000. That leaves $50,000 that he will end up needing to take from his investment account over this time period. This amount goes in the 3-10 year investment bucket.

 

[* 10+ years *]

 

After putting $50,000 in his 3-10 year bucket, he would put the rest of his money into the 10+ year bucket. Since he won’t be needing this money for another 10 or more years, he will be safe to put the majority of this into stocks and real estate. 100% stocks would be OK for this if he wanted higher returns, but we’ll say he’s conservative and decides to put 90% in stocks and 10% in bonds. [* $450,000 in the 10+ year bucket. *]

 

In total, here’s what he would have in each bucket:

 

0-2 years: $0. He might keep 3-6 months worth of expenses for a day-to-day emergency fund.

3-10 years: $50,000. Half of this would go into stocks and the other half would go into bonds. $25,000 into each.

10+ years: $450,000. He would put 90% of this into stocks (about $400,000) and the other $50,000 in bonds.

 

Overall, he would have $425,000 in stocks and $75,000 in bonds. If you do the math, that would be 85% in stocks and 15% in bonds. If he were to follow the age-based strategy, he would have somewhere between 30-50% in bonds. That is a large allocation to bonds for someone who has a pension and a lot of life ahead of them. A lot of this money would be earning a lower rate of return sitting in bonds when he really didn’t need it.

 

Over the course of his life, following the “bucket system” would likely increase his expected return by 1-2% per year and still leave him with money when he needs it. An extra 1% may not sound like much, but it would add up to another $250,000 if he lived another 40 years in retirement. That’s a big deal!

 

Each year, he would re-assess his situation. If he decided he wanted to work a little longer (or retire sooner), he could adjust his buckets accordingly. He would also calculate how much money he expected to need in each bucket. If he were expecting to take a large trip over the coming months, he could sell some from his 10+ year bucket and put it into the 0-2 year bucket to make sure he had the money when he needed it.

 

 

 

 

 

 

Chapter 13: The Top 15 Investing Myths

 

There is a lot of bad information about investing out there. Here are 15 of the most common investment myths.

 

1. A falling stock market is always bad.

 

Let’s say you were purchasing a business in your hometown. The current owner agrees to sell you shares in chunks over the next 10 years. Do you want the price of that business to increase or decrease? Decrease, of course. You would rather pay less than more.

 

So why would you want to pay more for the businesses you purchase in the stock market? If you’re planning to be a net saver over the next 10, 20, 30 years, you would actually be better off if the stock market were to fall in value. That would allow you to buy a bigger slice of each business than you would ben able to if the prices were to remain where they are now or go higher.

 

The only time a falling stock market is bad is when you plan to sell your shares. The only people this really applies to are those in retirement who are living off of more than the dividends produced by their stock portfolio. Everyone else should cheer for a falling market.

 

2. If I start investing, I need to constantly monitor my accounts.

 

When you have money invested in the stock market, it can be tempting to check your accounts every day. Please don’t torture yourself like that. Over the long-term, your account will increase in value. That’s not going to change by you checking it all of the time. The more often you check, the more likely that you are going to make a bad decision, like selling at a market bottom.

 

3. If I start investing, I need to read the Wall Street Journal and watch CNBC every night to keep up with the latest news.

 

Do you know how the financial media makes money? By getting viewers. Do you know what gets the most viewers? Sensationalist stories, bad news, and fear. You may think you need to be tuned into every second of news.

 

You don’t.

 

Just relax.

 

You don’t need to watch a single bit of news to be a good investor. In fact, you might do best if you never turned on the TV. Why? If you watch the news or financial media, you’ll probably get freaked out and make bad investment decisions. You’re better off to stay the course and continue investing throughout all environments.

 

4. I can build wealth much more quickly investing in penny stocks or the latest “hot stock tip” from [insert expert here].

 

Why do you think penny stocks trade for a penny? Because the companies underlying the stock are worth about that much…

 

You’re not going to get rich investing in penny stocks. Anyone who tells you otherwise is probably trying to sell you something. Your best bet is to invest in low-cost index funds.

 

5. With all of [insert latest worry here], now doesn’t seem like a good time to invest…

 

I’ve been investing now for going on 11 years. In every single one of those years, there was always something to worry about. It never felt like a good time to invest. It probably never will. Ever. There is always something going on in the world. If you wait for the “perfect time”, you’ll never invest a single dime.

 

If you’re worried about investing your first few dollars, the best thing you can do to help you get over the mental hurdle is to arm yourself with the facts. Since 1950, there has never been a 20-year period where stocks have not increased in value. Your account will go up and down in value. Sometimes by a lot. Keep. Investing. Looking back 20 years from now, you’ll be glad you did.

 

6. My investment advisor says index funds are boring. He or she says I can get a better rate of return investing in 5-star rated mutual funds.

 

What your advisor really means is “index funds don’t make me very much in commissions”. The reality is that mutual funds (even the “5 star” ones) will underperform over the long-term. One study published in the Journal of Finance (2009) looked at the 32-year record of 2,076 stock mutual funds. The number of mutual funds that beat the index funds over the same time period were “statistically indistinguishable from zero.”

 

There will be some mutual funds that outperform in any given 1, 5, even 10 year period. That doesn’t mean those same mutual funds will outperform in the future. Don’t look for the needle in the haystack. Just buy the haystack. Invest in index funds.

 

7. Gold is a good investment.

 

Gold does nothing productive for society. It sits there, gathers dust, requires maintaining, requires storage, and costs money. $10,000 invested in gold nearly 200 years ago grew to $26,000.

 

Companies, on the other hand, employ people, make profits, pay dividends, and continue to add value to society. That’s why stocks have dramatically outperformed gold over the long-run. The same $10,000 invested in stocks grew to $5,600,000,000. That’s $5.6 billion with a “B”.

 

If you want to invest in gold, you might as well go to the casino. The chances of making money in gold aren’t much better.

 

[* 8. If I invest in stocks, I can expect a 10-12% rate of return because that’s what has happened historically. *]

 

The past is the past. Your future returns investing depend on how high stocks were when you bought them. If you buy stocks at a high point, you may only make just 2% per year. If you buy at a low point, you may make 15% per year (or more).

 

Based upon current market levels (as of July 2015), you should make roughly 7% per year if you stick with your plan year in and year out. That assumes a 2% dividend yield plus 6% earnings growth (pacing with economic growth) minus a 1% decrease in “speculative” returns (P/Es coming back down to more normal levels).

 

9. Stocks are too risky. I’ll “stay safe” holding cash in my bank account.

 

Money in the bank is “safe” in that it doesn’t change in value. It only goes up. The problem is that it doesn’t go up by much. The biggest risk you face with keeping money in the bank is that it probably won’t grow fast enough to keep up with inflation. That means every $1 in your bank account will buy less and less each year. In other words, you risk not growing your money enough to meet your goals.

 

10. I can pick the next Apple, Microsoft, Facebook or Netflix.

 

Let’s just say you have 10 stocks you believe are the next big thing. Over a long period of time (20+ years), the odds are that maybe just 1 out of these 10 would have actually hit it big. The other 9 will probably not do much (at best). At worst, those other 9 will go out of business and be worthless.

 

Hitting a home run on one of out every 10 at bats isn’t going to build wealth. You’re better off diversifying in index funds and focusing on hitting a single 9 times out of 10. Over time, you will build wealth slowly but surely.

 

11. I (or someone else) can predict what is going to happen in the stock market.

 

Everyone makes predictions about the stock market. There is only one guarantee: no one will be right. At least, not consistently.

 

Even the greatest investor of all time (Warren Buffett) admits that he doesn’t know what the future holds. He doesn’t waste time trying to forecast the movement of the stock market. He focuses on buying high-quality companies at fair prices. You should do the same!

 

12. My 401(k) is the only thing I need to have a comfortable retirement.

 

Most people will put just enough in their 401(k) accounts to get their employer’s match. And then they stop investing.

 

The reality is that only putting in 4% into your 401(k) isn’t going to cut it. As we saw in an earlier chapter, when you retire depends on the percentage of your income that you invest. At 4%, you’re looking at working for another 70 years.

 

My recommendation is that you try to invest at least 20% of your income each year. At the absolute very least, you should be putting in 10% (not counting your employer’s match). The first bit of that should go into your 401(k) up to the full amount they will match. Anything above that should go into an IRA.

 

13. I can’t be a good investor because I know nothing about investing, the economy, interest rates, or any other financial topic.

 

The beauty of index funds is that they level the playing field between you and the top investing experts.

 

Since you own everything there is to own, that eliminates the necessity of trying to figure out which specific stocks you should move in and out of. Regardless of what happens in the future, you will ensure that you profit from the good fortunes of all businesses.

 

You don’t need an advanced degree or IQ greater than 100 to invest in index funds. If you can fog a mirror, you can have investment success. Just consistently invest month after month and your profits will rival (even beat) some of the brightest financial minds out there.

 

14. It is easy to make money investing. All you have to do is “buy low and sell high.”

 

Ahh, if it were so simple… This piece of advice has been around stock market investing for about as long as stock investing has been around.

 

The problem is that no one has actually figured out when the market is at a “high” and when it is at a “low”. The stock market appeared to be high in 1997 before it catapulted higher. The stock market appeared to be cheap in mid-2008 before it completely collapsed.

 

The problem is that we can’t know ahead of time when stocks are high and when they are low. If you invest consistently over time, you’ll buy at some good times and some bad. Over the long-term, your cumulative purchases will turn out to be good.

 

15. The stock market is only for rich people.

 

No. The stock market is one of the most reliable ways to create rich people. It’s not an exclusive club. Anyone can do it. You included.

 

This is the end of this book, but it could be the beginning of an exiting change for you! You can build wealth through investing. If you’ve stuck with me throughout this book, you probably now know more about investing than 90% of the general public. That means you are more than ready to get started.

 

Don’t wait! The time to start investing is right now. If you’re 50 years old and haven’t invested a dime, it’s not too late! You’ll never be a day younger than you are today, so get started.

 

My goal for this book is that it causes you to take a positive step in your financial life. I cannot succeed if you don’t succeed. So please don’t just read this book and put it in the back of your mind. Take action! You will make mistakes in your investment journey, but that means you’ve done something. Be a person of action. Take responsibility for your own future.

 

If you have any suggestions about how I can make this book better for future readers, I would love to hear about it! I also really enjoy connecting with readers, so please send me an e-mail.

 

If you know anyone that you think would benefit from reading this, please share. There are a lot of people that don’t know much about investing or are being led astray by unethical financial advisors – you can be the one to equip them with knowledge!

 

And before you go, I hope you’ll take the time to leave a short review on Amazon. It shouldn’t take more than a few seconds and would really benefit me and your fellow readers!

 

Thanks so much for joining me on this journey. I wish you a prosperous investment future!

 

Blessings,

Nathan Winklepleck, RP®

1 See “Where is the Market Going? Uncertain Facts and Novel Theories” published by the National Bureau of Economic Research and John H. Cochrane in February 1998.


Investing for Beginners: 6 Steps to Building Wealth

If you’re like most people, investing is extremely intimidating. You know its something you should be doing, but it’s hard to know where to even begin. What is a stock? How do I buy one? What on Earth is an “equity”? And isn’t “asset allocation” something reserved for a high school locker room? Every time you try to educate yourself, you are met with nothing but confusing articles and cryptic financial mumbo jumbo? When you finish reading this book, you will have the basic tools necessary to open your first investment account and get started. Here are some common questions that we will cover: • Why is investing necessary? • How is investing different from gambling? • What is a stock? • How does a stock make money? • How can I buy stocks? • What is a bond? • Should I invest in gold? • What is an index fund? • Which index funds should I buy? • What is asset allocation? • Who should I open an account with? • What type of account should I open? • What is the difference between a Roth IRA and a Traditional IRA? This book is written with the beginner in mind. If you’ve tried to learn about investing before, but have been frustrated by all of the complicated terms - this book is for you! Everything you need to know to get started investing is laid out in a logical, easy-to-follow format. By following these simple 6 steps, you'll be ready to build wealth investing in the stock market!

  • Author: Nathan Winklepleck
  • Published: 2015-09-19 16:20:16
  • Words: 24006
Investing for Beginners: 6 Steps to Building Wealth Investing for Beginners: 6 Steps to Building Wealth