Thursday, July 31, 2008

An introduction to mutual funds

Stocks and bonds are both great investments. However, if you are investing in stocks, and most people should be, you need to diversify your holdings by investing in many different stocks. If you don’t diversify, you face the prospect of losing a great deal of your investment if the few stocks you own all decline. In yesterday’s example, the losses for the investment in Krispy Kreme were offset by the gains from Crocs. Imagine if all of your money had been in Krispy Kreme.

Generally, brokers charge a fee every time you buy and sell a stock. Many online brokers charge around $10 per transaction. If you are adding to your investment every month (the recommended minimum) or more often and spreading that investment between different stocks and bonds, those trading expenses could eat up most of your investment.

It is also very difficult to identify promising stocks. There are many highly paid professionals whose job is to look over the stock market and pick the best stocks for their clients. While some of these analysts consistently do well, as an industry, the results are not impressive. In fact, many studies have shown that, once you account for the fees that these professional money managers charge, the majority of them deliver returns that are worse then the average of the entire stock market. If the experts with their training, experience, and reams of data have a rough time predicting which individual stocks will be big winners, you can bet that you’ll face the same difficulties.

Stocks are a great investment, but it is very difficult, even for professionals, to separate the winners from the losers. Stocks also can be expensive to purchase if you make regular investments. This is exactly why you need to invest in mutual funds.

A mutual fund is essentially a large pool of money from many different investors. Imagine how much easier it would be to create a cost-effective diversified portfolio of hundreds of stocks using millions of dollars pooled together by thousands of investors than it would be to create a cost effective diversified portfolio by yourself. Purchases of mutual funds also have a different cost structure than purchases of stocks. When you buy shares of a mutual fund you generally pay either no fee or a fee based on a percentage of the money that you are investing. Mutual funds charge an annual fee, which is also a percentage of the money that you have invested in the fund. So rather than go through the expensive and difficult process of creating a well diversified portfolio on your own, you can simply invest in a cost effective mutual fund and own a fraction of a very large diversified portfolio.

There are as many kinds of mutual funds out there as there are flavors of ice cream. Tomorrow I will cover some of the basic types of funds and explain how you can pick funds that are right for you.

I should note that if you are interested in picking and investing in individual stocks, there is a place for them in your portfolio. I very much enjoy picking out and investing in stocks. I treat it as a hobby – the bulk of my investments are in low cost mutual funds. If you are just starting out investing, not interested in stock picking, or seeking to make your investing as easy as possible there is no reason that you would need to invest in individual stocks.

Wednesday, July 30, 2008

Investing basics - stocks

Yesterday, we learned that investors who buy bonds are essentially lenders.  Stocks work differently.  Investors who purchase stock in a company become partial owners of the company.  A share of stock represents ownership of a very small fraction of a company.  There is no predictable rate of return for a stock.  If the company does well over time, the stock tends to do well over time.  If the company does poorly over time you can probably guess what happens.

Stock holders make money in two ways - through dividend income and through the increase of the share price.

Some - but not all  - stocks pay a dividend.  This dividend payment is a cash payment made to anyone who owns a share of the stock.  Dividend payments from stocks tend to be at much lower rates than bonds.  However, stock dividend payments, unlike bonds, are not fixed.  Stock dividends can be increased, decreased, or eliminated.

Stock holders also make - or lose - money based on the price of the shares of stock that they own.  If the company that they own shares of does well or is predicted to do well, the share price will rise.  If the company does poorly or is predicted to do poorly, the share price will fall.  From 1900 - 2000, U.S. stocks provided investors with an average annual return of 10.1% (this includes the dividend).  For that same time period, U.S. Government bonds provided an annual return of 4.8%.  It is very, very important to keep in mind that these examples assume that all dividends and income from these investments is reinvested, not spent elsewhere.

While these returns may sound small, over time they really add up.  Hypothetically, if you invested $1,000 in government bonds in 1900 and your investment grew at 4.8% every year, in 2000 your investment would be worth $103,000 .  Not bad - you now have over one hundred times what you started out with.  However, an investment in the stock market over the same time period which returned 10.1% every year would be worth $15 million.   Sadly, you would probably be dead at this point.

Please keep in mind that the returns above are averages.  The performance of individual stocks is very different form the average performance of the market as a whole.  Lets look at two extreme examples and pretend that on January 1, 2007 you invested $1,000 in Crocs, the company that makes brightly colored foam shoes, and $1,000 in Krispy Kreme.  Hindsight is 20/20, and apparently, in 2007, people just couldn't buy enough colored foam shoes.  Crocs stock rose 168% in 2007.  This means that after only one year, your investment in Crocs is worth $2,680.  That would make anyone happy.  Krispy Kreme, however, had a tough year and the stock lost 72% of its value.  Your $1,000 investment is the doughnut maker is now worth only $280.  You probably would have been happier if you had spent your $1,000 on Krispy Kreme doughnuts rather than stock.  However, between the two investments you still came out alright.  You started with $2,000 and ended the year with $2,960.

Generally speaking, stocks are a risker investment than bonds.  Not only is a stockholder more likely than a bondholder to lose money on his investment, but that stockholder will also experience more volatility.  In the financial world risk generally refers to an investment's volatility.  Historically, given a long enough time frame, stocks have out performed bonds time and time again.  However, over shorter periods of time stocks can take a real dive while bonds chug along making money.  Because of these volatility differences, even if you believe (as I do) that stocks will continue to outperform bonds in the long run, there is still a place for bonds in an investors portfolio.

Tuesday, July 29, 2008

Investing basics - bonds

You know that you need to invest, and you know what types of accounts you should be investing in, but what actual investments should you make inside of those accounts?

Most of your investment will be stocks, bonds, or a combination of the two.  Often, you will be able to invest in stocks and bonds through a mutual fund.  Mutual funds are a great way to invest and I will talk more about them in coming days.  Because stocks and bonds are the building blocks of mutual funds I first want to make sure that you understand what they are and how they work.  Today, I will cover what bonds are and how they work.  Like most of my posts, this is a quick overview designed to give you enough information to make wise decisions about your money.  If you want to go more in depth on this or any other topic, there is much more information out there.  If you leave me a comment or send me an email, I would be happy to help you find it.

Bonds are loans.  When governments or corporations need to raise money, they often issue bonds.  When an investor like you purchases the bond, you are loaning your money to the government or company in exchange for a regular fixed payment.  The interest rate of the bond determines the payment that you will get for owning the bond.  For most types of bonds, this interest rate can never change.  Bonds are issued for a set period of time, generally thirty years or less.  At the end of that time period, the issuer of the bond will repay the loan to the investor.

For example: ABC Corporation needs to raise money to expand their business.  You purchase a 30 year bond with a 5% interest rate from ABC for $1,000.  Every year, for the next thirty years, ABC Corporation will pay you $50 in exchange for the $1,000 loan you gave them by purchasing the bond.  At the end of the thirty years, you will have received $1500 in payments and ABC will return your $1,000 to you.  So this bond turned your $1,000 into $2,500 over the course of thirty years.  Not bad, eh?

While you can choose to own the bond for the entire 30 years, you can also sell it to another investor should you choose.  If you sell the bond from ABC, it might be worth more or less than the $1,000 you paid for it.  Investors will look at other bonds that are available.  If the 5% interest rate on your bond is better than the interest rate that similar bonds are paying, then your bond might sell for more than $1,000.  However, if other similar bonds are paying interest rates that are higher than 5%, then your bond will not be an attractive investment, and will be worth less than $1,000.  This price fluctuation only matters of you sell the bond.

Bonds are not risk free.  If ABC's business goes poorly (think Enron) and ABC goes bankrupt, you could lose some or all of your money.  Therefore, in order to encourage investors to purchase bonds from less financially sound organizations, these organizations need to offer higher interest rates to investors.  So the riskier the bond is, the higher its interest rate will be, and the safer a bond is, the lower its interest rate will be.

That covers the basics of how bonds work.  Tomorrow, we can learn about stocks.

Monday, July 28, 2008

Your Accounts

OK, you are tracking your spending and are making sure that your life insurance needs are met.  You are off to a great start.

However, I am sure that you are wondering what to do with the piles and piles of cash you have sitting around, right?  Today, I would like to share with you the basic banking and investment accounts that I believe everyone should have.  In later posts, I will discuss each account in more detail.  I have listed them in the order I would recommend establishing them:

1.  Checking Account.  You just can't get by without one.  However, make sure that you are smart about how you use it.  Try to find one that pays you at least a little bit of interest and does not charge any fees just to have the account.  Both E*Trade Bank and INGDirect tend to offer very competitive services.  If you are willing to bank online they are well worth checking out.

2.  Savings Account.  You need a place to build up cash for large expenses both planned (your trip to Costa Rica) and unplanned (your furnace breaking down).  Many experts advise that you should keep three to six months living expenses in your savings account.  I find that I don't need to keep that much cash on hand and generally have about two months of living expenses in the bank.  I do this because (a) I like to keep my money working for me harder than it does in a savings account, (b) I have a very stable job and a regular income, (c) in a worst case scenario I would be able to pull money out of my brokerage account or use credit.

3.  Credit Card.  A credit card can get you into real trouble.  However, if you can use it responsibly it can also be a great tool and safety net.  You should only carry and use a credit card if you are able to pay off your balance every month.  If not, your cards are hurting you, not helping you.  If you are in that situation something needs to change.  I will discuss paying off debt in a later post.  However, if you pay off your balance every month (or just keep it on hand for emergencies) a credit card can be a great tool to helping you manage your money well.

4. (tie)  401(k), 403(b), TSP, or other employer-sponsored retirement account.  If you are working you should be contributing to your retirement account.  For-profit companies can offer 401(k) plans, not-for-profit companies can offer 403(b) plans, and the Federal Government offers a plan called the Thrift Savings Plan to federal workers.  All of these plans offer employees the opportunity to invest a portion of your salary into a retirement account without paying taxes on the money you invest, or the money that your investments produce, until you withdraw your money from this account.

4. (tie) Roth IRA.  In addition to your employer-sponsored plan you should also have a Roth IRA.  A Roth IRA does not give you any tax benefits today when you put money into the account.  However, when you withdraw your money everything that comes out of the account is completely tax free.

6. Brokerage Account.  Once you have established all of the other accounts, you should have an investment account other than your retirement accounts.  This account will not have tax advantages but it will be more flexible in how you can use the money invested in it.

And if your situation requires it:

 - 529 Plan.  A 529 plan is one of the best ways to save money for your child's college education.

 - Rollover IRA.  If you leave your job to work elsewhere you need a rollover IRA.  You can "rollover" your 401(k) from your previous job into this account.

For most people, that should do it.

Sunday, July 27, 2008

Keep it simple

As I mentioned yesterday, in any aspect of your financial life, when given the choice between simple and complex, it almost always is better to go the simple route.

Few investment and banking accounts tend to be better than more accounts.  The more accounts that you spread your money into, the less likely your money is efficiently working for you.  Fewer credit cards are probably better than more credit cards.  The more cards you have, the more likely you are to rack up debt or miss a payment - both of which are detrimental to your financial goals.  Straight-forward investments are almost certainly better for you than more complicated investments.  The more complicated a financial product is, the more likely that it is a better deal for the seller of the product than for you.  This rule tends to apply across the board to investments, insurance, mortgages, you name it.

One of the best parts of this philosophy is that it means you don't need to have a PhD in economics or keep up all all of the latest trends in finance to meet your goals and to be successful.  Consider the millions of Americans with interest-only or any of the other new and complicated home loans.  How many of them would wish to go back and choose a simpler loan if given the chance?

The simpler your finances are, the easier it will be for you assess your own progress, stick to your plan, meet your goals, and keep fees down. 

Saturday, July 26, 2008

Purchasing life insurance

Now that you have given some thought to why you need life insurance, you are ready to figure out exactly how much you need and comparison shop for the best price.

There are three components to calculating the dollar amount of insurance that you need.
  1. Any lump sum amount.  For example, $150,000 to pay off the remaining balance on your mortgage.
  2. Any income that you will need for a specific period of time.  For example, $12,000 annually  for a period of five years to pay for childcare.
  3. Any income that you will need indefinitely.  For example, $20,000 annually to replace lost income.
It's not hard to turn these numbers into a specific dollar amount. The first category is by definition a dollar amount.  In order to calculate the dollar amount of insurance needed for the second category, simply multiply the dollar amount needed annually by the number of years needed.  In our above example, that would be $60,000.  For the third category, multiple the annual need by 20.  If you have 20 times the amount of annual income you need, you should be able to invest it so that it will produce the income you need indefinitely.  I will tell you how to do this in a later post.  In this example, $400,000 of life insurance would meet the needs in category three.  Therefore, the person in the example would need a total of $610,000 of life insurance to meet her family's needs.

The next step is to figure out what kind of insurance to get.  There are two basic categories: term insurance, which is temporary, and permanent insurance such as whole life or variable universal life.  This is an easy decision.  Buy term.  Here's why:

Whole life and variable universal life insurance policies never expire.  As long as you keep paying the premiums, the policy will stay in force, and when you die, your beneficiary will receive the proceeds.  In addition, these policies have a complicated investment component wrapped up inside the life insurance policy.  This means that some of the money you pay as premiums is invested on your behalf as a part of the life insurance policy.  Should you choose to cancel that policy, you will be able to turn the money in that investment into a stream of income if you choose.

Term life insurance is much more straight forward.  A term policy will cover you for a specific period of time, or term -- usually, 10, 20, or 30 years.  The premiums are much cheaper than premiums for a permanent policy.  If you die while the policy is in force, your beneficiaries will receive the proceeds.  If you live past the end of the term (which is a good thing - you're still alive, after all) or stop paying the premiums, the policy ends with no payout.

Term is almost always the best option because it is cheaper and it is simpler.  Once of my rules of thumb for financial planning is that simpler is almost always better.  If you need insurance, buy insurance.  If you need to invest, invest.  For most people, there is no real benefit to the added investment component of a permanent policy.  Most people would be better off buying the cheaper term policy and investing the difference in a dedicated investment account.

When financial products are complicated, the seller of the product usually comes out ahead.  When I was a financial advisor, I knew of some permanent life insurance policies that paid 50% of the first year's premiums to the salesperson as a commission.  If the commissions are that generous, do you really think that the product is always a good deal for the client?  I don't.

If you buy term insurance you will need to decide how long of a term you need.  If there is a specific event in your future that you think will reduce your need for life insurance - retirement, a spouse returning to work, or kids moving out of the house for example - choose a term long enough to last through that transition.

The internet is a great place to shop for life insurance.  For the most part, term insurance is term insurance.  All you need to do is price shop.  Sites like www.intelliquote.com are a great place to start.

Insurance policies are technical and can be complicated.  This post only covers the basics.  If you want to learn more, there are plenty of great resources out there, including this one from CNN Money: Money 101 - Life Insurance

Thursday, July 24, 2008

The first step in your financial plan

I hope that you are still tracking your expenses -- it is vital step in handling your finances.  After you have tracked your expenses for 30 days, I will discuss how you can use that information to personalize your spending and budgeting decisions.  For the next few weeks though, I will cover some of the other basics of creating a personal financial plan for you and your family.  

The first step in any financial plan is to have adequate life insurance.

I know, I know, it's not an exciting way to start, and paying an insurance bill is probably not the liberating, rewarding experience that you came to this blog looking for.  But hands down, this is the most important thing for you to do right now.  This is one of the only steps of the financial planning process that is not gradual.  Either you are appropriately insured or you are not. There is no middle ground.  The good news is that once you decide to address your insurance needs you can immediately accomplish your goal, check it off your list, and forget about it for a few years.

Only you (and your spouse, if have one) can decide how much insurance is right for you.  Don't blindly listen to insurance salespeople and don't rely on simple calculators based on your income. Figure out why you need insurance and how much you need to cover your specific needs.  You should carefully consider what your family's financial needs will be in the event of your death.

Here are a few questions help you get started:

1. Income replacement - If something happened to you or your spouse would your family need to replace lost income?  If so, for how long?  Long enough for your kids to start attending school?  Long enough for the surviving spouse to find a job or to complete training and then find a job? For life?

2. College costs - Do you need to factor in enough money so that you know your children will be able to attend college?

3.  Housing - If you have a mortgage do you want to have enough insurance to be certain that the mortgage can be paid off or that payments can be made for a set period of time?

4.  Child care - Will you need insurance to pay for child care?  For how long?  Will the working parent need to take time off of work to in the event of their partner's death?  Will you need insurance money to fund that time off?  If so, for how long?

These few questions should get you started figuring out what the right amount of insurance is for you.  In the next post we will discuss how to buy insurance given your specific needs.

Wednesday, July 23, 2008

Money management is something that you can do

Because good money management is so important and affects virtually every aspect of your life, you, like many other people, might feel great anxiety about managing your money.   The sheer volume of books and opinions creates the sense that personal financial management is terribly complicated and best left to a professional.  It's not.  By reading this blog, you will learn what you need to know to make smart decisions about spending, managing debt, investing, buying insurance, planning for retirement, and a host of other issues.  What's more, you don't need a library of finance books or an army of experts in your service.  (There is a place for professionals and there are some great books out there if you are interested in them, but we will talk about that later.)

As you track your spending, we will cover all of the basic topics that you need to know to make smart decisions about your money.  With this knowledge, you will start down the road to becoming a smarter, savvier, more relaxed, and wealthier person.

The five most important words in personal finance

Spend less than you earn.

If you spend less than you earn you will never need to worry about money.  If you have debt, you will pay it off.  If you don't, you will never go into debt.  If you spend less than you earn, you will accumulate wealth, reduce stress, have a more harmonious marriage, and generally, improve the quality of your life.

In order to spend less than you earn, all you need to do is know two very important things:  how much you earn and how much you spend.  The first one is pretty easy - most people have a good idea of how much they earn.

This second bit of information - knowing what you spend - trips up many people.  When you consider how important money is to quality of life, it is amazing that so many people go through life without a strategy on how to spend.  If you already track your spending, great!  You are a step ahead of the game.  If not, then don't worry.  It's easy and it will definitely be worthwhile.  All you need to do is track all of  your spending for one month.  If you are not a "numbers person" and aren't really excited about this, then there will be no need for you to continue after the first month.  (Full disclosure: despite my passion for finance, investment, and economics, I do not track every expense every day.)

There are plenty of fancy programs, web sites, applications for your phone, and financial ledgers that can help you track where your money goes.  My advice, particularly if you are not terribly excited about this project, is to pick up a small pocket-sized notebook and write everything down the old fashioned way.

Remember - the goal here is to learn about how you spend money, not to pinch pennies.  Not only is it unnecessary to change your spending habits during this period, but doing so will actually make this exercise less useful.

Back when I was dispensing financial advise for a living, I advised all of my clients to track their expenses for a month.  Few of them actually did it.  However, those that did generally told me that it was the best advice that I ever gave them.

Good luck and have fun!

Some practical notes on tracking your spending:  track everything you spend and in all forms.  It does not matter if you are using cash, check, credit card, debit, or gift card - it all goes in the notebook.  However, be careful not to double count credit card purchases.  If you pay off your bill every month (good for you!), track the purchase when you make them.  Do not also add in your bill at the end of the month.  This would lead to counting these purchases twice.  If you
run a balance on your card, then track purchases as you make them and chalk up your monthly payment as debt reduction.