A lot of my friends have approached me lately about investing - I guess word got out that I'm obsessed with personal finance. They want to know what to buy, which firm to use, what accounts to open. You get the idea. You might be wondering the same things.
Before I get tactical with them, though, I always point out that this is a MAJOR ACCOMPLISHMENT! Deciding to invest extra money means two things: first, it means they have extra money, derived from spending less than they earn. And second, it means they're thinking about the long term. These are the building blocks of wealth; people who think this way tend to become wealthy. So props for having some extra cash.
So now they're smiling, they're feeling good. They want to jump right into which broker they should use or which stocks they should buy. <smh> At this point, I have to stop the whole conversation again, and ask two simple questions:
1) Are you sure you should invest?
2) What are you investing for?
The answers to these two questions will have a much, much bigger impact on their investing success than any brokerage choice or stock tips I could share (which I actually can't, because someone starting out should never buy individual stocks). Anyway, let's dig into those two questions:
1) Are you sure you should invest? This one's huge. So you've saved up ten grand and are ready to put it to work. But are you sure you should invest it? I mean, have you already reviewed your Personal Balance Sheet? If you've paid off your credit cards, stashed away some cash for an emergency, and don't anticipate any big expenses for a few years, ok - maybe you should invest.
2) What are you investing for? Investing for retirement, a child's college tuition, or a down payment on a house each has a different time horizon. The last thing you want to do is pull money out of an investment account a year into a big market downturn. Once you know your time horizon, you can figure out which accounts to use, how much to allocate toward stocks or bonds, and even which broker to choose. Seems like a simple question, but it'll get you thinking.
So imagine we're friends. You might be a little peeved I didn't recommend buying AMZN, but you'll be glad I asked these questions. Take a day or two to think them over - review your Personal Balance Sheet and write down your long term goals. Then let's talk shop about when, how, and where to put that extra money.
Investors have more options than ever these days. Thousands of stocks, mutual funds and ETFs are available in hundreds of assets classes – some are specific (small cap domestic energy sector stocks, or large cap technology growth stocks) while some are broad (all US stocks or all global bonds).
While choosing the right asset mix is most important, choosing the right assets is a close second. Many mutual funds charge high fees – some charge sales fees as high as 5% – and they all charge an ongoing “management fee” of up to 2% each year. Most people consider funds with fees of over 1% to be expensive.
Now you might think 1% or 2% doesn’t seem like a lot of money. If you were buying a cup of coffee and were charged a 2% convenience fee, you might not care. But when it comes to investments, even a 1% fee can take a big cut of your return.
Stocks have returned about 10% annually over the last 80 years. After inflation, the real return has been about 7%.
Now consider paying 1% in fund fees on your investments earning 7%. That’s over 14% of your expected return each year (1/7 ~ 14%)! 1% doesn’t seem like a lot, but a 14% fee seems crazy. And that’s for a 1% fund in one year. A fund with a 5% sales fee could eat almost your entire return that year. And don’t even get me started about the impact of compounding that return.
Always remember to watch those fees!
You may have come across the term “asset allocation” as you read about investing. It’s one of the most important concepts to understand, and isn’t as complicated as it sounds.
Even though almost anything we own is an asset (furniture, cars, education, art), the assets we’re addressing here are stocks, bonds, and cash.
Each asset type carries a certain amount of risk and reward (called return). Cash is the lowest risk – a $100 bill won’t turn into $50 if you put it in your sock drawer for a month. But it’s also the lowest return – that $100 bill won’t magically turn into $200, either. Stocks are the other end of the spectrum: high risk, high return.
If you’re not thinking “how can I get the highest return while taking the lowest risk?” you may be asleep at your desk. Pay attention! The goal is to maximize return while minimizing risk. Since there are virtually unlimited combinations of assets in a portfolio, you can choose the risk/return scenario that you feel most comfortable with.
Generally, the younger you are, the more stocks you should own. In fact, there’s a simple formula for calculating the percentage of stocks to own: 130 (or 120) minus your age. For most millennials saving for retirement, stocks are the way to go, with perhaps a minor allocation to bonds and cash.
Until next time,
We all like lists, so I put this one together to highlight what I've found to be the Best 8 Rules of Investing.
Consider each of these when thinking about your investment goals. Did I miss any?