One of the most puzzling things about money is knowing where to begin. You get out of college and suddenly find yourself in the real world, with a job, with rent, with student loans, and wonder how you’re going to make ends meet, let alone save for retirement. Retirement seems so far away. It’s easy to just forget about it.
Ignoring retirement could be one of the biggest financial mistakes you’ll ever make. Compound returns favor the young. Time is money. Invest now and your 40-year-old self will be grateful. But where do you start?
Frances Leonard’s 1995 book, Time is Money, is an excellent introduction to retirement for people in their twenties and early thirties. Leonard preaches the important message: start now.
If you start soon enough, your dinky little monthly investment will take care of your golden years. You won’t have to worry about retirement for the rest of your life. The hundreds of dollars per month that late starters need to save for retirement will be all yours — yours to do all the things you’re dreaming about, instead of having to deny yourself all the good things just because you missed your best chance to amass a fortune mostly made of money you’ll get for free.
At the heart of this book is Leonard’s “four steps to a fortune”, a simple program which, if followed, can enlist time as an ally to help you build your retirement nest egg. The four steps are:
Find your number.Time is Money provides several tables to help you determine how much you need to save now in order to retire with the money you need. For example, if you’re 27 years old and believe you can achieve a 10% investment return, then you need to save $143 each month for the next forty years in order to have a million dollars upon retirement.
Invest at 10 to 12 percent. This may seem like a rosy assumption, but over the long-term, the U.S. stock market has offered these sorts of returns. The key, says Leonard, is to invest in an index fund.
Invest in a tax-deferred account. Taxes can take a huge chunk out of compounded returns. Take advantage of tax-deferred retirement accounts and other breaks. (This book was written before the advent of Roth IRAs. I believe Leonard would now advocate putting your money into a Roth first.)
Protect your fortune from inflation. Leonard recommends that at the beginning of each year, you track down the Consumer Price Index from the year before (free from the government), and adjust your monthly contributions by that amount. Using the $143 example cited earlier, if prices have risen 4%, then the new contribution would be roughly $149/month.
Time is Money features chapters on mitigating risk, types of retirement accounts, fighting inflation, starting from “zero minus” (i.e. a position of debt), and more. There’s a great chapter that defines financial terms like annuities, derivatives, and leverage. (Stay tuned to GRS in April for a series that will help to de-mystify financial concepts like these.)
This book is a clear introduction to the power of compound returns, and offers strong motivation to begin saving now, no matter how old you are.The only major drawback is that it’s twelve years old. Because it was published in 1995, it doesn’t have information on Roth IRAs and other recent developments.
If you’re just out of school and looking for guidance to set up retirement savings, this is a great place to start. Look for it at your public library, a local used book store, or from Amazon (which has 25+ used copies for under five bucks).
(While preparing this review, I found that Nickel wrote about Time is Money two years ago. He liked it too, calling it the: “personal finance book that forever changed the way I think about money.”)
The series on Roth Individual Retirement Arrangements (Roth IRAs) has covered a number of topics — what they are, how (and where) to open one, and which investments are best. Now, in the final part, we turn to some of your questions. Remember: I am not a financial adviser. I’m just a regular guy trying to gather information to help you. If you need more specific answers, please consult a CPA or an investment professional.
All of the questions below were submitted by Get Rich Slowly readers via comment or email. If your question isn’t here, please drop us a line so we can research an answer and add it to the list. If you are new to Roth IRAs, this article is not the place to begin. Start here, instead.
Types of Accounts and How Much You Can Contribute
Which is better: Investing in a Roth IRA with after-tax dollars or investing in a 401(k) with pre-tax dollars?
Also, does it make a difference if there is an employer match?
And if I already have a 401(k) through work, then why would I want to add to a Roth IRA?
There are a lot of variables here, so the answer for your situation may be different. But the traditional answer to this question is to…
Invest in the Following Order:
If your job offers a 401(k), contribute to that each year until you’ve reached the limit of the employer match. Never turn down free money!
If you still have money to invest, contribute to your Roth IRA.
If you still have money to invest, then max out your 401(k).
Once you’ve contributed all you can to these investments, then invest however you see fit in regular, taxable accounts.
Some people like to have all their accounts in one place. If you’re this sort of person, you may benefit from simply putting all your money into a 401(k) and not worrying about a Roth IRA.
However, there is another wrinkle to consider: When debating whether to invest in a 401(k) versus a Roth IRA, why not check with your employer to see if they offer a Roth 401(k) which allows you to invest with after-tax dollars (and withdraw tax-free in retirement)?
Also note that you can actually invest in both a 401(k) and a Roth IRA as long as you meet the requirements for both programs.
Is It Possible to Roll a 401(k) Into a Roth IRA?
It is possible, but you have to be careful. It is not a one-step process. Also, it’s difficult to do with an active 401(k) account. A mistake along the way could cost you a lot of money, so it’s a good idea to consult a financial adviser for help.
Here’s a discussion of the subject in the forum.
Can I have more than one Roth IRA? For example, can I have one at USAA and another at Vanguard?
To understand the answer, let’s step back and look at what an IRA is exactly: The “A” in IRA does not stand for “account.” If you look on the IRS website, you will see that the official definition of “IRA” is “Individual Retirement Arrangement.”
Every taxpayer can have only one Roth arrangement, but you can have multiple accounts as part of that arrangement. You can have as many Roth IRA accounts as you’d like.
Contribution Limits for Roth IRAs (and Traditional IRAs)
Contribution limits for 2015 and 2016:
Under 50 years of age: $5,500
Age 50 and over: $6,500
Note that your contribution limit applies to all of your IRA accounts (Roth and traditional) collectively; they don’t each get a $5,500 limit. In other words, you can contribute $100 each to 40 different Roth IRA accounts, but not $1,000 to each of them.
Who Can Invest and are There Limitations?
Can legal U.S. residents who are not citizens open an IRA?
Is it a good idea?
What if I don’t plan to be in the U.S. at retirement age?
Anyone with earned income in the U.S. can contribute to a Roth IRA — citizenship is not required. However, for greater flexibility, you may want to consider a traditional IRA or other investment accounts, depending on your goals.
Be sure to check with a tax professional to see which solution best fits your exact situation.
How does the IRS know that you contributed to a Roth IRA?
How does it know if you contributed more than you were allowed?
At the end of the year, the investment company submits Form 5498 to the IRS, which reports the amount that you invested. For example, it might show that, in 2015, you invested $5,000 in a Roth IRA. The IRS computers then match this form electronically to your tax return to check for discrepancies. If you are over the income limit, your return will be flagged.
What happens if I contribute too much to a Roth IRA?
If you contribute more than allowed, you are subject to a 6 percent excess-contribution penalty. However, you have until the annual contribution deadline (generally April 15th) to withdraw any overage from the account before the penalty is assessed.
What options are there if I earn too much to contribute to a Roth IRA?
Your Contribution May Be Affected by Your Modified AGI
These tables show whether your contribution to a Roth IRA is affected by the amount of your modified AGI as computed for Roth IRA purposes. They show how to determine the amount of Roth IRA contributions that you can make for …
If you make too much to contribute to a Roth IRA, be sure you’re maxing out your 401(k), if you have one. You can also contribute to a traditional IRA.
Both of these are excellent options. But note that, if you have a 401(k) at work, your contributions to a traditional IRA may not be tax deductible. Another option for high-income individuals to consider is to contribute to an annuity.
Here are two more forum discussions about Backdoor Roth and 401(k) rollover strategies and What to do when Roth IRA isn’t an option.
My wife is a stay-at-home mom and doesn’t have any earned income. Does this mean she cannot have a Roth IRA?
To every rule, there is an exception. If you are married and filing a joint return, then both spouses can max out IRAs from a single income (so long as the other Roth IRA requirements are met).
I’m self-employed and I make more than the maximum allowable for a Roth IRA. Does a SEP-IRA make sense?
A SEP-IRA may make sense, but that will depend on your individual circumstances. Basically, self-employed people can contribute roughly 20 percent of their first $200,000 of pre-tax earnings to a SEP-IRA. However, they must contribute the same percentage for all employees. If you are the only employee, or if you don’t mind giving all employees the same retirement benefits, then this may be a good choice. This is another case in which you should consult a financial adviser.
Types of Roth IRA Investments
I want to open a Roth IRA, but I’m confused by the mutual funds offered by different companies.
For example, ING Direct (now Capital One 360) offers six funds, and another bank offers only five. What’s the difference?
Which should I choose?
Only you can answer that question. Here’s how I would approach this problem: I would first locate the investment I want to purchase. Is it an individual stock? Is it real estate? Or is it, as I encourage, an index fund?
Once you’ve decided on an investment, then find a company that will let you buy the investment from within a Roth IRA at the lowest cost. This shouldn’t take too much effort. If, like me, you decide you like Vanguard’s mutual funds, then open an account directly with Vanguard.
Can I really use my Roth IRA to buy a house?
Sort of. There’s an animal called a self-directed IRA which allows you to invest in real estate. However, you cannot invest in anything directly related to you, like your company or your primary residence. This is definitely a topic you should take up with a tax professional if you have a strong interest in doing something like this.
In many cases, complex Roth IRA questions are best answered by a qualified financial professional. Each person’s situation is different. It is difficult to give one-size-fits-all advice in the context of this blog. Use the National Association of Personal Financial Advisors to find an independent, fee-only adviser.
I opened a Roth IRA at a local bank, but I noticed that I’m only getting a 1.98% return. This seems unusually low. Should I withdraw my money and move it to Vanguard, Fidelity, or T. Rowe Price?
Your money is probably in a savings account or certificate of deposit. Your bank may offer additional financial services — check with them to see where else you can put the money. Barring that, yes, absolutely move the money to a different location. You may have to pay a transfer fee, but it’s worth it.
As Mandy writes in the forums, “Traditionally, banks are one of the worst places to invest because they typically offer high-load/high-fee or very conservative investments and charge higher service fees than most other brokerages. Banks are for banking, not investing.”
(See Which investments are best for a Roth IRA? for ideas on where to put the money.)
Withdrawing From a Roth IRA
Can I really withdraw money from my Roth IRA without penalty?
That depends on what you would consider a penalty. Here is a direct quote from the IRS website:
“You can take distributions from your IRA (including your SEP-IRA or SIMPLE-IRA) at any time. There is no need to show a hardship to take a distribution. However, your distribution will be includible in your taxable income and it may be subject to a 10% additional tax if you’re under age 59 1/2. The additional tax is 25% if you take a distribution from your SIMPLE-IRA in the first 2 years you participate in the SIMPLE IRA plan. There is no exception to the 10% additional tax specifically for hardships. See chart of exceptions to the 10% additional tax.”
A couple of readers have mentioned that they’re nervous about the stock market’s recent volatility. I’ve read similar concerns on other blogs and financial news sites. People are worried that the stock market’s performance over the last month portends an impending bear market, and they don’t know what to do.
Reading these concerns reminded me of Why Smart People Make Big Money Mistakes, which I reviewed last week. In the book, the authors discuss panic selling as a common financial pitfall. When people suffer from loss aversion, short-term losses cause them to sell investments prematurely, which can lead to greater pain:
One of the most obvious and important areas in which loss aversion skews judgment is in investing. In the short term, being especially sensitive to losses contributes to the panic selling that accompanies stock market crashes. The Dow Jones Industrial Average tumbles (along with stock prices and mutual fund shares in general), and the pain of these losses makes many investors overreact: the injured want to stop the bleeding. The problem, of course, is that pulling your money out of the stock market on such a willy-nilly basis leaves you vulnerable to a different sort of pain — the pangs you’ll feel when stock prices rise while you’re licking your wounds.
But what can you do if being in the market makes you nervous? You don’t want to lose your money — what happens if the market continues to fall? If you feel trepidation about stocks, assess your risk tolerance. There are several online tools that can help you with this:
If your risk tolerance is low, then the stock market may not be right for you. Perhaps you should consider less volatile investments until you’ve researched the market’s historic performance.
If you have a decent tolerance for risk and still feel nervous, pay less attention to market news. Again, Why Smart People Make Big Money Mistakes offers excellent advice:
Pay less attention to your investments. Horrors! How can we think such heresy. Don’t worry, we’re not advocating turning a totally blind eye to your hard-earned savings, mostly because nobody would listen: a recent American Stock Exchange study indicated that nearly 40 percent of young, middle-class investors check their investment returns once a week! And that’s simply too often. The more frequently you check your investments, the more you’ll notice — and feel the urge to react to — the ups and downs that are an inevitable part of the stock and bond markets. For most investors — frankly, for all investors who don’t trade professionally — a yearly review of your portfolio is frequent enough to make necessary adjustments in your allocation of assets.
One strategy for minimizing fears is to buy and hold low-cost stock market index funds. Reduce the effect of market fluctuations by making systematic regular investments. This is what I intend to do when I’ve eliminated my debt — I’ll schedule a regular monthly purchase of QQQQ (or similar index fund), automate the process, and forget about it.
In The Little Book of Common Sense Investing, John C. Bogle, the great pioneer of index funds, warns against attaching too much meaning to what he terms the “expectations market”, the guessing that investors — amateur and professional — make when trying to predict the market’s direction. When we begin to focus on the short-term noise, we’re speculating and not investing. Bogle writes:
There are bumps along the way in [investment returns]. Sometimes, as in the Great Depression of the early 1930s, these bumps are large. But we get over them. So, if you stand back from [a chart of stock market returns since 1900], the trend of business fundamentals looks almost like a straight line sloping gently upward, and those periodic bumps are barely visible.
The entire text of Common Sense Investing is a treatise on the virtues of index funds. Bogle states that “the case for the success of indexing in the past is compelling and unarguable”. He believes overall market returns may be lower in the coming decade, but that this actually makes index funds (with their low costs) more attractive, not less attractive.
If the road to investment success is filled with dangerous turns and and giant potholes, never forget that simple arithmetic can enable you to moderate those turns and avoid those potholes. So do your best to diversify to the nth degree; minimize your investment expenses; and focus your emotions where they cannot wreak the kind of havoc that most people experience in their investment programs. Rely on your own common sense. Emphasize all-stock-market index funds. Carefully consider your risk tolerance and the portion of your investments you allocate to equities. Then stay the course.
In other words: your best choice is to invest in low-cost index funds that mirror market performance, even during rough patches. If you are risk averse, then shift some of your portfolio to bond-market index funds. Maintain your investment strategy, no matter which way the market is moving.
Benjamin Graham once wrote: “The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances.” It’s not the short-term that matters; it’s the long-term that’s important.
Addendum: In the comments, Ogden points to recent commentary from Ben Stein on this subject. Also, Free Money Finance recently wrote about going against the flow. And here’s more on the subject from Andrew Tobias.
My short life as a daytrader In my second year of college, I decided to take out $10,000 in student loans and become a daytrader. I could earn far more than the low 4% rate the loans came with, and I planned to finance my education with the winnings.
Sounds like a great idea, right?
There I was, hanging out in the school library, taking up two or three monitors with stock tickers running across the screen and Excel spreadsheets tracking my trades. A copy of Barron’s would be spread out beside me, and the Wall Street Journal wasn’t far away.
So how did it go? Well, there were a couple of problems.
Real-time trading was hard to do in 1997. Back then, the internet was up and running well, and Datek Online had just launched, but real-time trading was still restricted to people with a lot faster connections than my school library had.
Apparently, the school library was not designed for my exclusive use. For some reason, the library staff grew weary of my hanging out in the library all day, taking up three computers. I tried to play it cool when they asked me about it — “Oh, is there a problem?”— but in the end I was put on library restriction: I could use only one computer at a time, and if others were waiting to do academic work, the stock trading would have to stop. Not wanting to pay for a better computer and connection at home, I finally gave it up.
Fast-forward ten years, and I haven’t done any stock trading since then, but I’ve managed to choose unusual paths most of that time:
I lived in West Africa for four years, working as a volunteer for a charity without taking any salary.
I’ve worked as an entrepreneur for most of my adult life — ten years and counting without the dreaded “real job”.
After spending so much time overseas, I’ve found that I really enjoy traveling to places most North Americans never go to, so I recently set a goal of traveling to every country in the world before my 35th birthday in 2013
Each of these experiences has taught me a lot about personal finance, and in a few important ways, my belief in unconventional living has carried over to how I handle money. I’ve made a lot of mistakes along the way, but I’ve also done a few things right.
With that in mind, I’ve written a two-part summary to explain more about how I handle my finances. While I don’t expect that anyone will adopt my own system in full, I do hope that this summary may help others who see the world similar to the way that I do. My thanks to J.D. for providing a forum for this summary here at Get Rich Slowly.
Back to basics First of all, I’d like to think that most of what the GRS site advocates — and what GRS readers consistently practice — represents a great start to a nonconformist approach to personal finance. Sadly, the majority of North Americans are woefully under-informed about financial matters and do not set savings goals.
Simply by planning and taking deliberate action with your finances, you are already in a league of your own.
Further, as different as I may be, I am an advocate of most of the basic financial advice presented here on GRS and in other like-minded publications. Some financial advice is fairly generic, but there really are some good principles that are true for everyone.
For example, I believe in:
I think of these things as The Basics. Simply following The Basics will put most of us far above the curve.
Also, I am generally skeptical about retirement as it’s commonly defined (more on that later), but I am even more skeptical about Social Security. If you’re under 50 years old, I don’t recommend you count on Social Security for anything. Consider those payments you make each month as a parent or grandparent tax.
Where I diverge from the conventional wisdom is over the issues of debt, focused spending, home ownership, traditional employment, retirement, and charitable giving.
Here are a few of my principles — and please, feel free to take them or leave them for yourself as you see fit. I don’t make judgments about the choices of others; I only think it’s reasonable that each of us should carefully consider our own motivations and priorities. As J.D. says, “Do what works for you.”
#1 — There is no such thing as “good debt.” Finance books and magazines often talk about “good debt,” in the sense that a long-term mortgage is considered a good thing to have. Depending on your perspective, a car loan or education loans may also be “good.”
Well, this is probably the only thing in the world I am conservative and old-fashioned about, but I happen to believe that all debt is something to worry about. While watching many friends accumulate huge levels of debt buying cars and houses, I have lived my entire adult life debt-free.
This has occasionally meant going without something or not buying an expensive car (I don’t own any car at all now), but the real secret is that choosing to live debt-free is no sacrifice at all. Even though I work as an entrepreneur and have never had a stable income, I also don’t have to worry about falling behind on mortgage payments or watching credit card finance charges rise every month.
#2 — Student loans? No thanks! Aside from the short experience of daytrading with my undergraduate loan money (I actually came out a little ahead, but I wouldn’t recommend trying that), I’ve financed the rest of my education without debt as well.
Two years ago I came to Seattle and began an expensive graduate program, and since that time I have met a lot of students who have gone into debt to finance their undergraduate and graduate education. It’s fair to say that some of them are happy with this choice, and there are certain professions (such as medicine) where it is very difficult to get an education without taking on serious debt.
However, it is also fair to say that I know a lot of people who have truly regretted taking on so much debt to go to school, especially if they enrolled in a program that does not lead to a high-paying job after graduation.
I’m simply not comfortable borrowing large sums of money. I was able to pay for my University of Washington Master’s Degree on my own. But now that I’m writing during the day instead of building businesses, I really can’t afford to continue paying for my education. Earlier this year I was accepted to a competitive Ph.D. program on the east coast, but the offer didn’t come with financial support, so I had to make a tough decision.
I could have started the program by taking loans or using long-term savings, hoping that more financial support would come along later. To be honest, I briefly considered taking the loans. But in the end I made the right choice, at least for me: I’m not going. I don’t value it that much.
#3 — A house is a liability, not an asset I am currently living in one of the most expensive housing markets in North America (Seattle, Washington), and I have no interest in buying a home here. I am quite happy that my landlords are responsible for maintenance, and that I pay no homeowners’ dues or property taxes. (Yes, I realize that some of those costs are factored in the price of rent, but I think we still come out ahead.)
In the long-term, you do have to live somewhere, and if you’re staying put for the next 30 years and want a home of your own, ownership can make sense. But for many of the rest of us, renting is becoming less of a stigma now that people have begun to realize that taking out huge mortgages isn’t usually a good idea.
Invest in yourself My wife Jolie and I made a decision several years ago that guides most of our spending choices. We try not to spend money on “stuff” — physical items that all of us end up accumulating over time — and instead focus our spending on life experiences that we value.
Jolie is an artist, so we invest a lot in her art education and supplies. For me, world travel is my highest personal expense category. On a train ride from Hungary to the Czech Republic a few years back, I worked out the cost of visiting 100 countries. I had already been to a lot of countries, and I figured that to get to the remaining 60 or so and stay for a few days in each would cost roughly $30,000, or the cost of a large SUV.
I prefer to use public transport and don’t own a car in Seattle, so I thought, wow, that’s cheap. I could have a large vehicle and complain to everyone about the cost of fuel, or I could have the world. For me, it was an easy choice.
Some people would say that world travel is a frivolous luxury, and not something that should be such a prominent item in a graduate student’s budget. I’ll try to consider that point the next time I’m flying off to Hong Kong or Johannesburg.
Because travel is so important to me, my working budget includes funds for at least one Round-the-World trip each year. I realize that I don’t need this trip in the same way that I need to buy groceries, but I do need it in the sense that it is one of my highest priorities, and I would rather eliminate other expenses before cutting into it.
A lot of GRS readers may not be as interested in travel as I am, but that’s OK — it’s more important to find your own “life experience” priorities. What do you get excited about? What are you truly passionate about? I believe these items should be your spending priorities, right after groceries, savings, and investing in others — the next area in this short guide to unconventional personal finance.
Invest in others For many affluent people, charitable giving is an afterthought. It’s something we do once in a while to feel better, or at the end of the year for a tax write-off.
I have a problem with that mindset. Done well, charitable giving is essentially an investment in those less fortunate than us. I don’t view investing in others as a luxury or an afterthought; I consider it as essential as taking care of our own savings.
Money doesn’t solve all the problems of the world, and it’s important to give to the right causes. For example, because far more people give to short-term relief than to long-term development, the money spent on disaster relief is often highly inefficient and poorly used.
But when you create a strategy for your investment in others, you can have a positive impact on far more people, and the quality of that impact will be greatly optimized.
If you’re not sure where to start and are looking for good causes to increase your own giving, consider the following organizations. I personally know the people who run each of these groups and give them my highest recommendations:
Kiva.org — This great organization has the objective of democratizing microlending by matching small donors (like you and me) with promising entrepreneurs in the developing world who need small loans to improve their businesses.
CharityIs — My friend Scott Harrison started this project to bypass government foreign aid (most of which does not go to the poorest people in poor countries) and directly provide access to clean water and sanitation throughout Africa and Asia.
Care — One of the larger, more traditional charities, Care has managed to keep administrative expenses down even as they have expanded to projects in 71 countries
What I’m Doing Right now I’m beginning a writing career while my wife works as an artist, so we have definitely had to cut back on both giving and savings, but I still try to pay attention to the overall percentages. I also believe that if you don’t “miss” the money you give — if there is no real sense of sacrifice — you’re not really being challenged by the giving.
Therefore, I have a stated goal of investing at least 15% of our income every year in charitable giving. I feel a little strange about writing that here for 50,000 people to read, because this is something that is very personal, and I have previously shared the number with only a few people.
To those who say that it’s hard to give to others when you don’t have much money yourself, part of me wants to sympathize, but another part remembers that we chose to adopt this principle when we were living on about $12,000 a year. In the end, all I can say is that every year we have given more money away, and we have rarely lacked for anything.
To be continued… By getting the basics under control, rejecting conventional beliefs about debt, choosing to spend freely on life experiences instead of “stuff,” and creating a giving plan to invest in others, I’ve built a personal finance system that is aligned with my values.
There are just a few important parts left, including where the income comes from. I’ll discuss that in the next update, which will be published at Get Rich Slowly next week. In that article, I’ll discuss alternative forms of work, the financial independence goal, and a few mistakes I’ve made on my nonconformist finance journey.
Thanks for reading this far! I welcome feedback, questions, or disagreements in the comments below.
Are you stuck in a rut feeling like nothing is exciting left to do? Think again! If you were lucky enough to inherit $100,000 suddenly, what would be the first thing on your bucket list? Redditors had plenty of ideas for how they’d spend their newfound fortune. From purchasing exotic vacations, high-end home renovations, virtual reality headsets, and dream weddings to community sculpture gardens to more practical investments in college tuition grants—there are plenty of ways to imagine how you’d spend a large inheritance!
1. Attend the Funeral
One user pointed out, “Attend funerals.”
Another user replied, “It took me a second, but yep.”
One commenter responded, “Goes without saying.”
“First, I would attend the funerals of the deceased. Then I would think about what to do with the money. Just a matter of respect,” another Redditor shared.
2. Pay Off Debt
“Become debt free!” exclaimed one user.
Another user added, “Become debt free, stash the rest in savings and CDs for sure. I’ll even get adventurous and go out and have a nice dinner.”
One commenter shared, “You know you’re an elderly millennial when you see the term CDs and start thinking about replacing your beloved but heavily scratched pop-punk and hardcore punk collection from the early and mid-2000s.”
3. Pay Bills
One user posted, “Pay bills.”
Another user confirmed, “100% this. Pay bills. Pay off debt. Bank the rest against a rainy day.”
One replied, “Smart.”
4. Plan Ahead
One user shared his own story, “I inherited a little more, roughly $150k total, than that after my mom passed away a few years ago. My dad [had been] a doctor, and she didn’t have to worry about money for her remaining 21 years. When they sold their rental duplex (they never raised the rent in the 30 years they had it), I used my share to open an investment account for both of my kids and used the rest to pay off one credit card.
“With the cash I received from the trust, I paid off the other cards and started my own investment account. I’m 50, and for the first time in my adult life, I don’t have debt other than a student loan (that will hopefully get discharged under the borrower’s defense for false advertising) and our house.
“Before doing that, though, I booked a family vacation to Riviera Maya. I mentioned Dad was a doctor; well, he and Mom traveled the world going to dads medical conferences and just seeing the world. They lived to see new places and do new things. So, to honor and thank them, I spent a small amount and took the family on our first trip outside the US. I cried on the plane, I cried on the beach, I cried when I saw apple pie at the resort like mom made, and I cried when we came home. At one dinner, we talked about Grandma and what we miss most about her. Dad passed before I met my future bride, so only I mentioned him.
“So if I inherited that again, I’d probably do the same thing again. I remembered where it came from, and I prepared for those it would eventually go to.”
One user replied, “This is beautiful, thank you for sharing your incredible story with me.”
“For a person who is not from the US, it’s mind-blowing that you are 50 years old (not that far away from retirement age), and you still have student loans,” one user commented.
5. Make Sure it’s Not a Scam
Another user posted, “You know how generational wealth is kind of a thing—well, so is generational poverty, as it turns out. So if I suddenly inherited 100k, the first thing I would do is make sure this wasn’t a prank or a scam.”
One confirmed, “Yes, fortunately, it’s not a scam, as my aunt passed away.”
Another user added, “I missed that part. Condolences and congratulations in whichever order you feel is more appropriate. Take the sincere advice of a generational poor person for what it is—but if I were in your shoes, I would act conservatively. I imagine there are a lot of people with a lot of enticing pitches for the newly rich. Just keep pulling in a regular paycheck for your day-to-day if you can, and make sure you have found a well-regarded accountant before the next tax season. Start inquiring into a money manager that can provide a realistic plan to ensure your long-term retirement.
“(Edit: Also, think of ONE affordable extravagance you could never financially justify before but might have been able to pull off and give to yourself as a gift. For me, that would be a 3-day weekend in some major city.)”
“Sending condolences, I was put in a similar situation when my dad passed away. The best advice I can give is to not rush into any decisions financially, take your time, and the money isn’t going anywhere!” shared one user.
6. Fully Exhale
“For the first time in my adult life, I could fully exhale,” one user confirmed.
One user pointed, “THIS.”
Another user commented, “YES.”
One Redditor added, “Hell yeah, just to breathe easy is a luxury.”
7. Add It to the Rest
One user shared, “Throw it on the pile.”
One user added, “New paint job for the jet.”
“Ya know, my old boss traded in his propeller plane for a jet and got $100,000 in tax write-offs…” a user commented.
One user commented, “I get it… sometimes it’s just super exhausting just thinking of all the money I have.”
8. Invest
“Invest,” one user shared.
Another user replied, “All in SPY 0DTE 0.5% OTM calls.”
One user commented, “Invest half, and with the other half, live pretty much the same life, stay at my job, etc., but with complete financial security.”
Another user said, “Invest, invest, invest.”
The OP asked, “What would you invest in?”
The user answered, “The reality is 100k is just the starting point to getting anywhere financially. If you did inherit 100k like you say you did in another comment, it’s worth knowing that if you’re still young (30 or under), you have a huge head start in a secure financial future. I’ll get crap for this, but only spend up to 15% or so of the actual money you get from this. For the rest of it, you should first look to invest in a tax-advantaged account like a Roth IRA. If you max out that annual limit ($6500 for 2023), then either open up high-yield savings (if you’re in a place to buy a house soon) or put it in something simple like the S&P 500 index fund (if you can put this money away for a long time you’ll be shocked at how much it’s grown in 20 years). But most importantly, if you have any high-interest debt, pay that off first.”
9. Buy Lottery Tickets
One user shared, “50,000 lottery tickets.”
The OP commented, “Love this, thanks for a laugh.”
Another user shared, “Laugh?”
One user commented, “And then you get $70k back if the MrBeast videos are any indication.”
10. Pay Off Mortgage
A user shared, “Pay off my mortgage and other debts, then go back to living as normal, just with more disposable income since I won’t be making repayments anymore. It’s such a boring adult answer, but it’s accurate.”
Another user replied, ‘I agree with it; I would do the same.”
11. Save As a Safety Net
One user shared, “Wife and I inherited around $175k. What we did was largely just keep living life, exhale finally, and catch up on some… debts we had. Used the money as a safety net to get out of construction and into something else, and now our lives are, without a shred of doubt, 100x easier than they were before.”
The OP of the thread replied, “This is my hope.”
12. Ask a Financial Advisor
One user posted, “I’m 50F on a disability pension with high rent and living costs. It’s an unexpected windfall, and I am not financially literate. I don’t want to blow it. Yes, I am going to get a financial advisor!”
One user commented, “Go to a personal finance Reddit or something and ask how to choose a good advisor. Some are shady!”
“It’s honestly not that much these days, a down payment on a house at most. Pay off any debt, but otherwise, live as you have been. Hopefully, with a safety net for the next financial speedbump,” replied one user.
13. Trucks and Good Times
One user freely posted, “Trucks and H–kers. It would be best if I didn’t get 100k.”
Another user replied, “That’s like 1 of each, lol”
One replied, “Each? You must have gotten a cheap truck.”
14. Government Bonds
One user commented, “After potentially paying estate/ inheritance tax, Spend [40k] on settling debts (I don’t have much, so there’s going to be leftovers, but I will put them in government bonds as savings $. Spend [10k] on online courses and career certifications. Spend [10k] on buying stuff I’ve wanted for a while. Spend [10k] on new tech. Spend [5k] on a mini solo budget vacation to somewhere random. Keep [5k] as pocket cash. Save [20k] in a high-interest account or maybe split into government bonds, high-interest accounts, green tech stock options, etc. ( I am hesitant investing real estate because of the obvious market bubble).”
“Love this detail; much appreciated. No tax and I’m debt free. I’ll be making a list off this,” replied one user.
15. Donate
“Help out a lot of people,” one user shared.
Another user replied, “Yes. I’ve already decided who I’m going to help and how much. Giving back is important. I couldn’t imagine not sharing my blessing with those closest to me. I also need help as I have been living on the disability pension, so I’d also like to be out of poverty if at all possible, lol.”
Do you agree with the things listed above? Comment below!
Source: Reddit.
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So you are in the market for a Roth IRA, that popular, flexible, tax-advantaged vehicle that can be used to save for retirement — smart choice — but here comes the next question: which investments are best for a Roth IRA?
Roth IRA Mutual Fund Options For Investment
There are three basic options for your Roth IRA investments:
Index funds
Exchange traded funds (or ETFs)
Managed mutual funds
It’s essential whatever you choose it has as low an expense ratio as possible. Small fees can really add up. The expense ratio is what the fund charges you to run it, reflecting operating expenses such as compliance and other administrative costs. Even the cost of marketing the fund to you is passed down in some way through the expense ratio.
One very popular investment vehicle, The Vanguard Fund, has an average fund expense ratio of 0.18% and many investors see it as a low-cost leader. Regardless of what you choose, make sure you know the fund expense ratio and it’s as low as possible, for sure under 1%.
Here’s more about each:
Index Funds
A mutual fund that invests in indexes which are compiled and calculated independently, such as the Standard & Poor’s 500.
Two main attractions with index funds:
Index funds typically offer the lowest cost to manage your investments. (Since you are not doing it yourself, there’s no escaping having to pay someone else. The goal, of course, is to keep that amount as low as possible.)
Index funds generally outperform managed funds. You would think a paid professional who runs a mutual fund would do better than a market average, but history has consistently proven that to be a false expectation.
Related >> How to Start a Roth IRA
By far, the most popular index funds mimic the S&P 500 stock market index. There are other funds which purport to be index funds; however, they don’t track an actual index. (Bond funds, for example, are called index funds simply because they offer the low management costs commonly associated with index funds.)
Exchange Traded Funds (ETFs)
One of the benefits of investing for your retirement through a Roth IRA (or a traditional IRA, for that matter) is the fact that you are not restricted solely to mutual funds. Through an IRA, you can invest in individual stocks, which opens the door to ETFs, which are nothing more than mutual funds which trade on a stock exchange just like stocks.
Related >> Considering EFTs
Most ETFs are index funds, but they offer a wider array of specialized investments. For instance, if you want to invest in gold, there are several ETFs which allow you to do that. One such ETF (which uses the GLD symbol) owns the actual gold bars, and they hold more gold than all national governments except the big three.
ETFs offer low costs, but not always quite as low and the index funds referred to above. If cost is an important consideration for you — and it should be take the time to check out all the costs of anything you want to invest in before you take the plunge.
Managed Mutual Funds
Although somewhat maligned recently, managed mutual funds still account for more than 70 percent of all retirement investment funds. There are a few reasons for that:
Convenience. Managed mutual funds are usually the most convenient way to invest as an employee.
Low risk. They are the oldest of the three options listed here, and have proven themselves to be pretty safe in terms of risk.
Variety. They offer by far the widest variety of specialized investment options. For instance, if you don’t want any investment dealing with GMO, tobacco, or other issues, you are more likely to find a managed mutual fund to meet your needs than an ETF or index fund.
Related >> A primer on mutual funds
The popularity and wide variety of managed mutual funds come with two penalties, though:
High cost. Of the three options, managed funds usually are by far the most expensive. You may see rates which look low, e.g., 1.5 percent. Remember, though, that your long-term return is unlikely to be more than 7 or 8 percent. That means they will take 20 to 50 percent of your annual growth. That’s a steep price for many.
Bewilderment. It is not easy to distinguish between the bewildering arrays of managed mutual funds. They all seem to offer things like value and growth, and you never know which buzzwords are simply marketing gimmicks to get you to pick their fund.
When you consider that index funds and ETFs are generally simpler and cheaper, it’s easy to understand why they have grown much more in recent years at the expense of managed funds.
Conclusion
Most people consider the best way to invest through a Roth IRA is by putting your money every month into index funds. They typify the get-rich-slowly ideology. Some of you will want to purchase individual stocks in your Roth IRA. Some will want to purchase real estate or invest in precious metals. If you make educated decisions, these can be excellent moves. However, for most investors, index funds are a smart way to own a piece of the market while mitigating risk.
Part 1: The extraordinary power of compound interest Part 2: What is a Roth IRA and why should you care? Part 3: How to open a Roth IRA (and where to do it) Part 4: Which investments are best for a Roth IRA? Part 5: Questions and answers about Roth IRAs
Learn More:
Safety – the Main Objective for Retirement Investments
The main objective of any investment for retirement is safety: You don’t want to invest in anything risky. You may enjoy investing in things like individual stocks or property, but we all know those can be risky investments. When it comes to your retirement funds, you want to stay away from things with inordinate risk.
Flexibility is a Good Thing (Unless It’s a Bad Thing)
The fact that you can use a Roth IRA to hold a variety of investments is good news – it offers flexibility. What’s good about it is that you can invest in pretty much any type of investment through your Roth IRA – stocks, bonds, exchange-traded funds (ETFs), mutual funds (including index funds), and even real estate.
The bad news is that you can invest in pretty much anything – including things which might not work for you. For instance, if you thought Twitter was going to be a good stock to invest in, you would be banging your head against a wall right now.
Consider This When Selecting an Investment
With a clear understanding of the purpose of an IRA – a tax-advantaged vehicle designed to help you save for retirement – we can begin to answer the question about which investments are best for a Roth IRA. Here’s what to consider:
Funding
By far, the majority of the population earns their living from a job, which typically gives them two paychecks every month. The Roth IRA is perfect for that since you can easily put away a certain amount every month, a little bit at a time. But investing in rental property is quite a bit more difficult (effectively precluding that type of investment for many) because it requires a big chunk of money at a time.
Automation
If you’re like most people, setting time aside to make investment decisions is a challenge because your life is a daily whirl of activity. The tactic most successful people use is automation: They have a set amount deducted from every paycheck which is then automatically deposited into their Roth IRA account. For automation to work, you want to pick an investment which lends itself to a set amount invested every two weeks or so.
Basic Investing Concepts
It’s a mistake to jump into investing and make your decisions blindly. Before you begin any investment program, it’s important to have an understanding of basic concepts. Here are a few posts on some important topics:
This is a guest post from Dong, who writes about personal economy at Ask Dong.
Who can forget their first time? I certainly can’t. I was 22 and fresh out of school. The NASDAQ was around 4000, and young turks like myself were getting jobs that we had no business holding. The times were good. Even if I couldn’t work for a dot-com, there was no reason for me not to invest in them. The world was my oyster.
I opened my first real brokerage account with only one in thing in mind — I wanted the cheapest trades possible. At the time, Datek offered the best price at $9.99 a trade. This wasn’t my first account, but it was my first account as an adult.
Important Factors
While my choice of Datek back in 1999 wasn’t a bad one, I realize in hindsight that I didn’t go about choosing a broker in a particularly systematic manner. Today, the options are more numerous, and the services provided more comprehensive, but there are still the same factors to keep in mind, including:
Cost: Trading costs, account maintenance costs.
Mutual fund selection: Number and variety of no-load mutual funds.
Investor research: Access to different analyst reports, robust graphing options.
Customer service: Are service representatives easily reachable and well-informed? Does it cost extra to talk to someone?
User interface: Easy to use?Easy to navigate?
Customer reports: Profits and losses are easy to discern. Reports are up to date.
How one weighs each of these factors is a matter of personal preference and need. In my view, there are basically four types of investors. I’ve listed them below and ranked in order the factors to consider, from most important to least important.
Completely Clueless Investors
A clueless individual isn’t an investor per se, but rather someone who needs access to a lot of educational resources. Even if someone decides to be a relatively basic investor, and invest only in index funds, that someone should understand the decision to do so. I think it’s great to follow a tried-and-true method of investing like using index funds exclusively. But to do so without any education is still foolish.
Important factors for new investors are: customer service, user interface, cost, investor research, mutual fund selection, customer reports.
Passive Index Fund Investors
This type of investor doesn’t need much out his brokerage company — mainly free access to cheap index funds. Because someone who subscribes to the Bogle way of thought is all about reducing costs, index mutual fund trades must be free, but other trading costs might be irrelevant. Some of these investors may employ the use of ETFs (exchange-traded funds), and therefore would want low-cost stock trades. Other than investments made on a regular periodic schedule, which would likely be done via a free mutual fund, the overall level of trading on such an account should be minimal.
Index fund investors would rank the factors like this: mutual fund selection, customer service, cost, user interface, customer reports, investor research.
Value Investors
Value investors buy individuals stocks and mutuals funds, but are not active traders. They buy and hold, but not forever. Fundamental research is important, but fancy graphs and technical indicators are not. Reporting is important but trends are measured in quarters and years, not days. Trading costs are important but not as important as they would be for an active trader.
For value investors, the factors in choosing a brokerage are: cost, mutual fund selection, investor research, customer reports, user interface, customer service.
Active Traders
Active traders don’t hold positions for extended periods. What’s important to them is the ability to trade different products, and to do so cheaply. A good and easy-to-use interface is important. Also, reporting features, especially ones that measure daily performance, are important.
Active traders consider the following important: cost, user interface, investor research, customer reports, customer service, mutual fund selection.
Know Thyself
Like anything else, it’s important to know thyself. Know what kind of investor you are and what kind of investor you might become. Opening a brokerage account isn’t unlike investing; read what the experts have to say and still do your own research.
The options today are more numerous and varied than they were for me in 1999. Some brokerages, like Zecco, offer “free” trades for most small investors. Others, such as Bank of America and Wells Fargo, offer free trades for customers who do substantial business with the bank. However, as I’ve learned, trading costs aren’t everything — knowing what you want and need is.
“What’s the safest possible thing that I can do with my money?” wonders Afroblanco over at Ask Metafilter:
I take bearishness to an extreme. Having witnessed the 2000 tech crash, I have no faith in the stock market or the US economy. I keep all of my money (USD) in a savings account. However, with the recent financial turmoil, I have a few questions:
Is it conceivable for the FDIC to fail?
If so, is there a place where I can put my money that will be safer than a savings account?
What’s the safest, most risk-free way for me to save money and not get killed by inflation and the tanking US dollar?
If there is a safe way for me to save money and not be punished by inflation and the depreciating dollar, is there a way that I can do this without having to stress out and micromanage my finances? I don’t want to be checking the finance page and making adjustments every day.
Even though I follow finance news, I’ve never done any investing or money management other than socking money away in my savings account. I’m a n00b, I admit it.
Afroblanco is willing to forego potential market gains so long as he does not lose money. He is risk-averse. He’s not alone. A rocky economy makes many people nervous. You can assess your risk tolerance with one of several online tools:
If your risk tolerance is low, then the stock market may not be right for you. You should consider less volatile investments until you’ve researched the market’s historical performance. In response to Afroblanco’s question, AskMetafilter member Pastabagel wrote:
The best thing you can do with your money is invest it in yourself of your children, if you have any. Go to school, get new training, start a business, etc. After that, the next best thing to do with it is to eliminate your debt (excluding mortgage). Typically people have formulae for determining how much savings you should spend to pay down debt, but I think you’d be a happier person if you just eliminated all credit card debt, car payments, etc. you have outstanding.
Barring those things, here’s the basic story:
Your money in a savings account is insured up to $100,000, but earns little interest and may actually result in your losing money to inflation. Certificates of Deposit pay more, but you can’t touch your money for the duration of the CD.
Bonds are safe, but you have to know which ones to buy, what to watch for, etc. And bonds fluctuate in price.
The rule-of-thumb is that the more interest, or yield, something offers, the more risk is involved. Interest is essentially what is exchanged for you risking your money. Also, low-risk equals low-reward. But you sound like you want something extremely safe, so I’m not going to preach to you about the S&P 500’s long-term performance.
Gold and commodities are not so good, because while a two-year chart looks great now, a two-year chart two years from now might look like a nightmare. Gold lost $100/ounce since Monday — about 10%. Did anybody call that? So not exactly a rock solid investment.
You want safe, here is safe:
What you really want is some kind of short-term bond mutual fund (the “short-term” refers to the kind of bonds it holds). Mutual funds are great because you can put in and take out your money whenever you want, unlike bonds and CDs. I would recommend VFSTX from Vanguard. It has a decent yield (which is sort of like interest) and also can appreciate in value. This particular fund has had one down year in the last 24 years, and that year it was only down 0.08%.
In the alternative, you can get a fund that invests in inflation-protected treasuries (TIPS), like VIPSX from Vanguard.
These two funds are very much buy-and-forget. You talk about the economic turmoil, VFSTX fluctuated less than 1% from October to January (when the shit really hit the fan) and VIPSX fluctuated by no more than about 4%. They are very very safe, but won’t appreciate much, but it sounds like that would be okay for you. Keep in mind that these funds also pay you interest along the way, which is typically reinvested, so the charts you see on Yahoo!, which track price only, don’t show you the full story.
When you pick a mutual fund, however, you need to be very careful because different fund companies fund often charge expenses, loads and fees, which are basically ways for the fund company to take your money out of your investment. Vanguard has built its entire company and every one of the hundreds of funds they manage on the principle of no-load, and rock-bottom expense ratios. All of the money I cannot afford to lose for the rest of my life I keep there. This is not a slick Wall Street operation — Vanguard will collapse when the world ends, not a moment sooner.
The people who started and who ran that company are very old-school personalities — they personally live frugally, invest very conservatively, and their business model is based on lifetime relationships with their investors, not on clever financial wizardry. You don’t see Vanguard people on TV as much as Warren Buffet because these people aren’t the type to have publicists. This is the place where your crusty great-grandfather who grew up in the Depression would keep his money. Slow and temperate. They also offer very low-cost financial advisory services, which you might need if/when you ever get married, have kids, etc and don’t feel like trying to figure out how to buy life insurance.
On a psychological note, though, I would encourage you to read The Millionaire Next Door. The book is not really about personal finance, though it does discuss it a little. What the book will do is reset your social attitudes about money and wealth, and how wealth is accumulated.
These recommendations are appropriate for somebody who is very conservative and risk-averse. If you’re more worried about losing money than eager to gain it, then consider these tips. Via e-mail, Pastabagel suggested that those with slightly more risk tolerance should consider a total-market index fund (such as VTSMX) as part of an IRA.
Pastabagel also notes — correctly — that it’s difficult to answer a question like, “How should I invest?” The answer depends more on psychology than finance. “The only answer,” he writes, “is to take as much risk as you can stand before you start losing sleep over it.”
This is a guest post from John Forman from The Essentials of Trading. Forman is the author of a book by the same name. He has been a trader of the stock and other markets for over 20 years, and is a professional stock market analyst for Thomson Reuters.
The wealth building potential of the stock market is enormous. I think we all realize that. The long-running debate, though, is whether one is better off investing in individual stocks (or funds that do just that), or whether it’s best to just put your money in an index fund. Most funds fail to beat the market, so it would seem index funds are the better choice.
While it is certainly true that index investing has some advantages, and some mutual funds do perform better than the indices, no index or fund will ever offer the upside potential of investing in individual stocks. It’s a matter of math.
Indices and funds include many stocks which move in all different directions. One of those stocks could double in price for the year, but because most others in the collection will do much less well, the index’s or fund’s performance will be much lower than that one stock’s gain. An investor who held that stock by itself, though, would have done quite well.
Of course you need to be able to find the stocks that will beat the indices and funds.
How Do I Find Good Stocks? The requirements for success in the stock market are much like the requirements for success in any other undertaking. Proper preparation is one of them — potentially the biggest — and a major part of preparation is having a firm objective in mind. As an investor, that normally means either seeking capital appreciation or pursuing income, or some combination. For the purposes of the discussion here, I will focus on the capital appreciation.
Another part of the equation is timeframe. I’m not talking about how long you have to retirement. There’s plenty of literature in financial planning circles about how you should structure your investments from that perspective. What I’m referring to here is how long you will expect to hold any given stock position in your portfolio.
Are you a patient long-term buy-and-hold investor who will have no problem sitting through the inevitable ups and downs of the market? Or are you someone who wants more action, doesn’t have the patience to hold stocks for years at a time, and/or cannot stomach the idea that at points your positions could go well against you for long periods of time?
You may not always be one or the other. It is, however, important to know which mode you are in when you are looking to pick good stocks. A lot of stock market players get themselves in trouble because they go into a position thinking they are one type of player only to change their minds once prices start moving.
Fundamental Analysis If you are in the first category, then your focus in trying to find good investment stocks is to look at the big picture. You are Warren Buffett. You look at the company and its management team. You look at its business and, in many cases, the broader economy. What you are trying to identify is a company which will steadily increase in value over time.
How do you do that? By thinking about what it takes for a company to grow and profit in a sustained fashion.
What do companies like that have? They have strong management teams who know what they are doing, who have a long term view and who aren’t worried about the quarter-to-quarter results or stock price fluctuations. They are in growing business sectors (or niches) where the competition isn’t so intense that no one can really make any money.
This sort of approach to looking at companies is generally referred to as fundamental analysis. Fundamentals are the underlying elements that determine the long-term growth and profitability of a company.
The idea is that you are giving your money to some really capable people and having them put it to good use in their business. Then you let them do their thing in the way they best see fit. So long as they continue to do good things and keep the business on track for positive growth in value, you stay invested. Maybe somewhere down the line you will cash out your investment. Maybe you’ll leave it to your kids or donate it to charity. Whatever the case may be, you would expect the value of your stake in the company to have grown nicely in value by that time.
Security Analysis by Benjamin Graham and David L. Dodd is the classic text for stock market fundamental analysis. You can also find a brief overview at StockCharts.com.
Technical Analysis Now, if you are in the second category where you’re not just going to buy a stock and lock it away, you need to think more specifically about your holding period. By this I don’t mean to imply that you will hold a stock for an exact period of time and that’s it. I just mean you should have an idea of how long you would expect to be in the position. That could still be years, or it could be months or weeks.
The advantage of the long-term investor is that they need not worry about the fluctuations in the price of the stock. They are investing on the basis of the long-term growth of the company with the assumption that the stock price will generally follow along at about the same pace.
Less long-term players (often referred to as traders) have to be cognizant of the intermediate and shorter-term price action. Generally speaking, the shorter your expected holding time horizon, the more you will have to focus on the price action. This is because the fundamentals mentioned above are usually slow moving elements which play out over the longer timeframes. They don’t change quickly, so they can’t really influence short-term price movements much.
What I mean by that is stock prices can move in the short-term on a great many factors. It could be news, economic data, changes in interest rates, the general market environment, and lots of other things. Just because a company is making money hand over fist doesn’t mean the stock price will be rising. If the company continues to do that, the stock will probably move higher eventually, but in the meantime other factors could cause it to go sideways or to even fall. This is something that baffles a lot of new investors.
Focusing mostly on price moves you into the realm of technical analysis. This approach seeks to identify patterns of price movement in the market for the purposes of determining likely future direction. This is also referred to as market timing, which basically means seeking to define good points at which to buy and sell. A lot of stock investors use fundamental analysis to find good companies, then use technical analysis to try to pick the best time to buy the stock.
Technical Analysis of the Financial Markets is widely considered the ultimate source on the subject. StockCharts.com offers an introduction to technical analysis.
Value Investing To this point you’ll notice that I haven’t used the term value investing yet. Many people would refer to Warren Buffett as a value investor, and as such would put value investing in the long-term investing category.
Value investing need not be a “buy it and bury it” type of approach, however. In fact, I’d guess that most people consider it the process of identifying stocks trading out of line with the value of the company in question. They use any number of metrics to determine what a company’s stock should be worth. If the stock isn’t close to that value, they will either buy it or sell it in expectation that it will eventually get back in line. In most cases, once that happens, the stock position will be exited.
This probably all sounds very familiar. You’ve no doubt heard of Wall Street analysts putting out price targets and ratings and such. They generally use fundamental analysis to come up with what they think is the value of the company right now (adjusting it for new information, of course). Then they look at current price to see how it matches up with what their valuation calculations tell them.
If you’d like to learn more about value investing, consider Benjamin Graham’s classic, The Intelligent Investor. The Motley Fool has an interview with Bruce Greenwald about the three steps of value investing.
It Takes Work Regardless which type of stock market player you are, there are no approaches which don’t require effort on your part to pick the good stocks. Even if you have someone giving you recommendations, you should still be doing your own due diligence to see if they really fit in with what you are trying to do in the market.
Also keep in mind that no matter what timeframe investing/trading you do, you should always take the longer-term view. It’s extremely unlikely that any one stock position is going to make you rich in a short period of time. If you try to score it big on any one trade you’re probably going to end up losing a lot of money. Wealth accumulation in the markets is best sought by steady growth, putting the power of compounding to work in your favor.
This is a guest post from ABCs of Investing, a new site for novice investors. ABCs of Investing offers two short and simple investing posts each week.
Personal finance bloggers are vocal proponents of passive investing in index funds and exchange-traded funds. But not everyone knows much about these, and not a lot of bloggers do a good job of explaining the basics of passive investing. This post is intended to explain the basics — along with the basics of the basics!
I was inspired to write this article because of two separate but identical conversations I recently had with friends. They went something like this:
Friend: What do you invest in? Me: I do passive investing. You know — investing in index funds and ETFs. ETFs are kind of like index funds. Friend: I see… [Blank stare.]
Me: Do you know what an index fund is? Friend: Nope. Me: It’s a fund that invests in all or most of the stocks of a stock market index and gets a return which is equal to the index return minus a small fee. Friend: I see… [Blank stare.]
Me: Do you know what a stock market index is? Friend: Nope. Me: I see….
With active investing, an investor tries to pick stocks that will outperform other stocks. With passive investing (also known as index investing or “investing in index funds”) an investor simply uses mutual funds to buy all of the stocks in the market. The basic idea is that with greater diversification and lower costs, a passive investor will generally do better than someone who buys actively-managed mutual funds.
Let’s cover some of the basic facts that my friends need to learn in order to understand passive investing.
What is a Stock Market Index?
A stock market index (or just “index”) is a number that refers to the relative value of a group of stocks. As the stocks in this group change value, the index also changes value.
For example, an index might have a value of 1000 points at the beginning of the day. If the stocks in that index rise in value by 1% during the day then the index will be at 1010 points at the end of the day. Does this sounds familiar?
The Dow Jones Industrial Average (commonly just called “the Dow”) and the S&P 500 are two examples of stock market indexes. Most people (including my friends) who think they don’t know what an index is, in fact probably have a reasonably good idea.
What are Index Funds?
An index fund is a mutual fund that invests in the same stocks that are contained in a stock index, in the same proportion as in the stock index.
Imagine a stock index — let’s call it the ABC Index — that contains two stocks: IBM and Google. Let’s say that the ABC Index is currently made up of 60% Google and 40% IBM. If an index fund is based on the ABC Index, then it too will also invest in Google and IBM — 60% of the index fund will be Google and 40% will be IBM.
These percentages will change as the values of Google and IBM change. If the price of Google stock increases and the price of IBM stock decreases then the index will change so that maybe 65% will be Google and only 35% will be IBM.
The two main arguments in favor of index funds (and passive investing) are:
Most managed mutual funds can’t beat their index over any length of time, and it is impossible to predict which ones will beat the index in any given time period.
The significantly lower costs of index funds will ensure that, on average, index fund investors will have better returns than their managed mutual fund counterparts.
If you assume that the average mutual fund will earn the same return as the stock market index minus fees, then an index fund will outperform the average mutual fund because it has lower fees.
As an example, if a managed fund XYZ earns the same 8% return as the S&P 500 in 2009 but it charges a 1% fee, then the XYZ return will be 7%. If the ABC Index fund is based on the S&P 500 and only charges a 0.25% fee then the ABC Index fund return will be 7.75% which is three-quarters of a percent higher than the average managed mutual fund.
Over time, that difference is significant. After 25 years, the investor with the lower fees will have 19% more money invested than the investor paying the higher fees.
Passive Investing is Easy
If you want to get into passive investing, then I suggest doing some more reading on the topic, as well on possible asset allocations. Some books you might consider include:
Regardless of whether you believe that index funds are better than managed funds, it’s certain that passive investing is much easier. You don’t have to analyze mutual funds or stocks — just pick some basic index funds and away you go!