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A Primer On Savings & Investing
If you look at the people who are successful savers and investors,
you will find they share a number of common denominators in their
planning, timing, and implementation. The thought here is to share
these "secrets to savings success" with you. This is not an attempt
to provide investment advice, or usurp the authority of any
investment or financial adviser you may be using. In fact, if they
were to read this primer, they would probably agree with it
wholeheartedly.
First Step: Get Your Ducks In Order
Before you consider any significant investing plan, you should first
make sure your "financial basics" are covered in related areas
because they are investments in their own right.
Make sure you are adequately covered with the right kind and amounts
of insurance for you and your family. Do you have the proper amount
of life insurance? How about disability insurance? In fact, you are
statistically 5 times more likely to become disabled than to die. If
you own vehicles or property, are they properly covered in case of
accidents, and lawsuits?
Next, do you have any emergency money on hand? A common rule of
thumb is to have the equivalent of 3 months of living expenses in an
account that you can liquidate at a moment’s notice. That doesn’t
mean you need to put this money under your mattress, or in a
checking/savings account. You can put the money into higher yielding
investments as long as you can get the principal out immediately.
Third, are you comfortable with your home ownership(or lack of it)
situation? For qualitative as well as quantitative reasons, you
should be satisfied here. If not, it is a very significant
foundation to get in order first. In this topsy turvy world, it’s
important that you feel secure about your shelter.
Fourth, how is your overall debt structure? Do you have a lot of
consumer-type loans outstanding with high interest rates? If so,
paying them down is actually a good investment. If you have $3000
outstanding on a credit card that is charging you 18% annualized,
non-tax deductible interest, by paying it off you are actually
making nearly 18% on your moneywith no risk. So you should compare
the amount of interest you are paying on debts to the amount of
return you will make on your money to determine how much debt to
retain vs. pay off.
Finally, should you be investing in any extra education for
yourself? The proper kind of advanced learning for your job can pay
for itself many times over. In fact, it is probably the best overall
investment you can make for yourself.
Step Two: Establish Your Specific Investment Goals
The secret to success in anything is to know your strengths and
weaknesses. For investing, the strongest point is to HAVE A SPECIFIC
GOAL! What are you trying to achieve? Retirement? College? A Big
Purchase like a house, boat, or wedding? Or extra income? Knowing
this sets the stage for everything else. It tells you whether your
objective is income vs. appreciation, and it sets up a strategy that
is used in conjunction with your life cycle and risk tolerances.
Next, try to QUANTIFY THE GOAL. This allows you to make reasonable
estimates as to how much you will need to invest, for how long, and
at what rate of return in order to reach the goal. This helps you to
understand and quantify your risk/reward factors, and gives you the
"trade off" figure that is, the amount of money you must put away
today instead of spending it on something else in order to reach a
goal down the road. In short, you are trading off a short term
pleasure for a long term one, and investing the proper amount to get
there.
Step Three: Understand Your Risk/Reward Tolerances
Everyone is different. Some are conservative by nature, some are
high risk takers. Some enjoy working with numbers, others hate it.
It’s the same for investing. Successful investors understand their
tradeoffs in achieving investment rewards against the appropriate
risks. It’s how they arrive at their investment style.
But what are these various risks? Coming to grips with them, and
establishing boundaries for your individual personality and goals is
the issue. Bottom line is that you should have a good feel for your
risk tolerances, because every type of investment comes with a
price. That price is how much risk you are willing to take for a
given return. The most common factors to understand your risk
tolerance level are as follows:
1. Ease of Management: This determines how much of the investment
process you will be doing as opposed to using a professional. If you
enjoy doing hands on work, if you have a considerable amount of free
time to do the research, selections, and management, your overall
gameplan will differ from one who elects to "farm out" the work to a
financial advisor. Similarly, the types of investments, and the
volatility of them are related to one’s available time budget.
2. Time Horizon: The amount of time you have in order to achieve
your financial goals is critical. It affects the type of
investments, the rate of return you must shoot for, the actual
portfolio mix, and the general risk factor. If you have a long time
to reach your goal, you can use more conservative investments with
lower yields since the power of compounding is working for you.
3. Liquidity Needs: Liquidity is the amount of money you should have
available for unforeseen changes in your financial situation. If you
are 100% certain you will not need to liquidate the investment over
the amount of time in question, you have no liquidity need. On the
other hand, if there is substantial uncertainty, you have
significant liquidity needs. This affects the type of investments
you will make, and when you will make them. If you are considering
stocks, and you will not need the money for 5 years, then this is an
acceptable type of investment. A 5 year time span in the market
reduces the volatility aspect significantly compared to a 1 year
time frame.
4. Inflation: This is a critical factor if you are investing for
income as many retirees do. You must account for the potential
ravages of inflation when you invest. If you invest in a $10,000
bond that will pay you 7% per year in today’s dollars($700), and
inflation averages 5% per year, then in real terms you are clearing
$200 for year one. It gets less and less in real terms over the
years, so this investment will deteriorate over time. So the longer
you are investing, the more you should consider the inflation factor
in choosing the type of investment, and the types of fixed yields.
5. Your Tax Bracket: With today’s 2000 federal tax rates as high as
39.6%, this is a very important factor since it affects the actual
yield you will make. The higher your bracket, the less you make and
the more the government makes. So it can have a crucial role in how
long it will take you to reach your goals. Also, it is one of the
key factors in deciding whether to use tax-free investments or
taxable investments. As a general rule of thumb, the lower your
overall tax bracket is, the less attractive tax free
investments(such as municipal bonds) are. Also, the more volatile
your tax bracket will be over the investment timeframe, the harder
it is to decide on the proper mix of taxable vs. tax-free
selections.
6. Temperament: It doesn’t do any good to put your money in
investments that will drive you crazy. The overall plan must be
coordinated with your overall personality. If you are ultra
conservative, you may not wish to invest in aggressive issues even
if they are good. It may eventually eat you alive from an anxiety
standpoint. You should always invest within an appropriate comfort
level from both a quantitative and a QUALITATIVE standpoint. After
all, life is more than just investing, isn’t it?
Step Four: Use Appropriate Investing Techniques
There are 12 tried-and-true techniques that can literally mean the
difference between average success and stellar performance when it
comes to investing.
DIVERSIFICATION: Study after study indicates that 90% of the
potential total return on investments comes from the broad
allocation of assets, and only 10% comes from the individual
selections over the long run! This is the Modern Portfolio Theory
set forth by the Nobel Prize winner, Professor Markowitz. In
layperson’s terms, it means it’s more important to decide how to
place your money within various asset classes, rather than which
individual investment to pick. Buying IBM stock is secondary to
deciding how much money to put into stocks vs. bonds in general.
Why is this? Because, at various times one type of investment will
outperform another type. If you look at some historical examples,
you can understand more clearly.
From 1975 to 1980 Gold took off like a rocket, going from $195/ounce
to $800/ounce, while stocks languished. From 1980 to 1987, real
estate was the "wonder" investment, and gold hit the skids. From
1987 through 1999 stocks have had a great run, while real estate
cooled considerably. So, unless you got very lucky in picking the
right single asset group over this span, and knew when to sell it as
well, you would have done much better by diversifying among all
these groups so one could pick up the slack for the other.
In effect, diversification increases your chance for returns while
reducing the volatility. Here’s an example: Choice One: You can
invest in a $10,000 bond paying 10% per year for 25 years. OR,
Choice Two: You can put the money in 10 other diversified
investments at $1,000 apiece, each with the potential to make 25%
per year, or to lose everything over the same 25 year period. Now,
assume 9 out of the 10 investments go completely bankrupt, and only
1 makes the grade.
Which was the better choice? The $10,000 bond would have returned
$108,000 to you. But, the one successful $1,000 investment would
have returned $265,000 to you! That’s an example of what
diversification can do in real terms.
So, you should mix your investments among a number of asset groups,
including Equities(Stocks), Fixed Instruments(Bonds, CD’s), Cash
Equivalents(Bank accounts, Money market accounts), and Inflation
Hedges(Real Estate, Precious metals, and the use of Bond "Ladders").
Further diversification is recommended within these groups. Buy
stocks in small, medium, and large companies, buy stocks in
different industries and sectors, and have a group of thesenot just
one stock in your portfolio. Some financial experts believe that if
you are a moderate risk taker, and you can’t afford to buy at least
11 different individual stocks as your Equity portion, then opt for
mutual funds instead.
For the Fixed Instruments, buy various maturities ranging from 2
years up to 30 years to hedge your risk against interest rate
changes. Also, buy different types of these investments: US
Treasuries, GNMA’s, Corporate Bonds, Savings Bonds, and Floating
Rate Funds to name a few. Again, unless you have a significant
portfolio where you can buy individual issues, consider using bond
funds to further diversify among issues and maturities.
What percentage of your money should you put into each group? That
depends on many factors we have already mentioned, such as your risk
tolerance, your time horizon, and so forth. You must carefully make
this decision. Some time-honored tips: The longer you have to
invest, the higher the percentage should be in Equities; the more
conservative you are, the less should be in equities. But, even the
most conservative should have some equity investments for long-term
planning according to the experts.
USE DOLLAR COST AVERAGING: This is a long term technique in
which you buy into an investment periodically instead of in a lump
sum. You buy equal amounts over stated periods(such as monthly). If
the investment performs according to historical statistics, this
will lower your purchase price. Why? Because investments don’t tend
to increase in value in a straight line; rather, they go down
sometimes, and up others. In fact, statistics show that an average
stock can change in value up to 50% in a given year. A $10 stock can
decline to $8 or rise to $12. So, by purchasing periodically, you
buy on the downside as well as the upside, thus lowering your
average cost per share. Naturally, this assumes the investment will
eventually increase in value over your time horizon.
ENJOY THE MAGIC OF COMPOUNDING: Investments that allow you to
reinvest the income automatically are "compounding" themselves. You
are getting interest on your interest. As a guide to see how
powerful this is, use the so-called "Rule of 72" to calculate its
effect. Divide an investment’s expected yearly rate of return into
the number "72" to see how fast it will double in value. Thus, an
investment returning 6% compounded will double in 12 years. A 12%
yield compounded will double your investment in just 6 years!
INVEST FOR THE LONG TERM: When it comes to the equity portion
of your investment mix, think long termat least 3 years. If you
can’t maintain your equity position for at least that long, then
don’t do it(unless you are an aggressive player). The longer you
hold equities, the more you reduce the volatility risk, a major
factor.
DON’T TRY TO TIME THE MARKET: If you are investing for the
long run, then don’t worry about short-term fluctuations, and short
term machinations of the market. People who try to time the market
lose 70% of the time. Why? For the average investor(even the
above-average investor!), the market is always 2 steps ahead in
information, performance, and projections. An average investor waits
"until the market gets better" to invest, thus insuring that he will
be buying "at the top," or at the highest price. Besides, who knows
when or where the "top" or "bottom" of a market will occur? A savvy
investor who believes in the investments made for the long run
understands this, and will buy steadily in good and bad markets.
Leave market timing to the so-called "experts!"
KEEP EMOTIONS OUT OF THIS: Take a tip from the professionals.
Look at the entire exercise from a quantitative, cold-calculating
approach. This allows you to invest for the long haul, use
dollar-cost averaging effectively, and avoid getting caught trying
to time the market, to name a few.
REDUCE TRADING COSTS: If you are doing your own selections,
consider using discount brokerage services, or non-commissioned
funds and financial advisors. Trading costs can put a big dent in
your profits, especially if you can’t follow the previously
mentioned techniques. Everything else being equal, a "buy and hold"
strategy for equities may be betterand cheaperthan trading and
timing.
LADDER YOUR FIXED INSTRUMENTS: When you buy interest yielding
issues such as Bonds, or CD’s, it is important to mix up the
maturity dates to avoid interest rate and inflation risks. Don’t put
all your fixed instrument investments into a singular maturity date
schedule. Keep in mind that most fixed instruments will change in
value after you buy them when the interest rates change in the
market. If you buy a bond with a 20 year maturity date today, and
interest rates increase 1% next week, the value of your bond
declines by 9%(or vice versa).
So unless you are omnipotent and know what interest rates will be
doing over the next 30 years or so, play it safe and stagger your
maturity dates. This is called "Laddering." That way, you don’t get
"locked in." If you need to cash in, you can cash in a shorter term
bond, or one that is maturing, and avoid loss of capital if interest
rates have moved against you. Use maturity dates ranging from 2
years, 5 years, 10 years, 20 years, and 30 years. Also use floating
rate bond funds for safety.
USE MUTUAL FUNDS FOR SMALL PORTFOLIO: If you don’t have
enough money to set up a balanced portfolio of individual stocks and
bonds, consider using mutual funds. There are thousands available in
all areasequities, bonds, international, precious metals, you name
it. Pay attention to the fund’s track record, both short-term and
long-term. Research how it has done in various types of markets,
i.e. "bull vs. bear" markets. Finally, evaluate the costs of using
two general types of funds: "Load" vs. "No-load," that is, a
commission-charging vs. non-commission fund.
BONDS VS STOCKS: A BENCHMARK: When do bonds make a better
investment than stocks? As we mentioned, your overall investment
strategy should have both. However, keep in mind an important
historical average. According to research company Ibbotson
Associates, over the past 65 years the S&P 500 stocks have risen an
average of 10% a year. So, from a long-term perspective, if you can
make more than that on bonds(in after tax dollars), have a higher
percentage in bonds. If not, have a higher percentage in stocks.
THE SECRET TO MARKET PERFORMANCE: Remember this: Investment
markets are fueled by emotions in the short term, and value in the
long term. Even the biggest of players follow this axiom. That means
you should use the short term emotional angle to buy in at the lower
end and hold it for the value. It also means if you are going to try
to "play the market" you are at the mercy of these emotions(the
market’s and yours), and it can be quite a roller coaster.
BALANCE & RE-EVALUATE YOUR INVESTMENT PLAN: Once you have set
up your plan, coordinating the investments with your financial goals
and situation, don’t go to sleep. You should balance the mix of
equities and bonds periodically. If the mix percentage changes from
your original plan because of the change in valuation of the
investments, adjust these investments accordingly by either selling
or adding to the mix to bring the percentages back in line. This
technique forces you to sell at the top and buy at the bottom, to
increase your chance of success. As a rule of thumb, once you do
this periodic check(for most people it is once a year), if the
ratios have changed by 10% or more, you should make the necessary
moves to restore the balance.
Also, you should re-evaluate your personal financial situation to
see if things have changed. Has your overall monetary situation
improved dramatically due to job change, inheritance, etc? How about
your investment philosophy? Or other value systems? If so, maybe you
should re-structure your financial goals accordingly. We all change
over time. Make sure you are periodically re-balancing to increase
your overall success rate.
Conclusions
As you can see, saving and investing can be done in a step by step
procedure. There are no "hidden secrets." But successful investing
does depend on putting in the time, either by yourself if you are
going to handle your own money or a financial advisor who will be
doing it for you. If a fundamental, diversified, long-term approach
is used, with periodic balancing to take into account your changing
financial situation, and if the 12 time-honored investment tactics &
techniques that we discussed are used, you will be well on your way
to becoming a very successful investor.
P.S. Enclosed you will find some guidesheets to provide you with
insights in 3 important areas:
1. Questions To Ask Financial Advisors;
2. Investment Options Available; and,
3. The 9 Most Common Errors An Investor Makes.
Here’s hoping you find them helpful...
Questions To Ask Financial Advisors
If you are considering using a professional to help you with your
investing, make sure the person you select fits into your overall
game plan. To help you in this selection process, here are 11 issues
to discuss:
1. Investment philosophy.
2. Services to be provided and types of investment options
available.
3. Past investment performances: 1 year, 5 years, 10 years.
4. Will advisor have discretionary powers over the account?
5. Can anyone other than yourself remove funds from the account?
6. Licenses, educational background, overall experience, references.
7. Will your account be typical or will it be bigger or smaller than
an average account managed by the advisor?
8. How will financial advisor be compensated? Commissions vs. fees
or a combination of both?
9. Get copy of fee structure and Parts I and II of Form ADV.
10. Is advisor or advisor’s firm affiliated with any of them
investments that are recommended?
11. What would happen to your account if the advisor left, or you
wanted another advisor?
Keep in mind that you will be working with this person over a
relatively long period of time. It should be a person with whom you
feel comfortable and confident. This is a high priority issue, so do
your homework first. Spend at least as much time in selecting a
financial advisor as you do in buying a new car. While this analogy
may seem ridiculous, statistics show that it isn’t the case! So
stand out from the crowd and give yourself a chance to be a
successful investor. After all, this is your future and your
family’s future at stake.
Investment Options Available
Since most successful investors use a diversified approach where the
portfolio consists of a mixture of bonds, stocks, and cash
equivalents, you should have a knowledge of what investment options
exist within these areas, and the pluses and minuses of each as
well. Whether you will be buying individual issues within these
groups, or using mutual funds instead depends on your temperament,
and budget. In either case, the general categories of mutual funds
respond the same way as do individual issues.
Stocks & Stock Funds
Statistics have shown that, over the long run, the best investment
performers have been equities, or stocks. Stocks can be further
divided into three main categories: Large Cap, Mid Cap, and Small
Cap, the difference being how much capitalization exists. A Small
Cap stock means a company with capitalization of less than $500
million. A Mid Cap is one with more than $500 million, but less than
2 Billion; and a Large Cap has in excess of $2 Billion in market
value of its outstanding stock. These differences affect such
investment concerns as volatility, potential for growth, and base of
ownership, to name a few.
There are numerous ways stocks can be further defined. You can buy
preferred vs. common. There are growth-oriented stocks, there are
value-oriented stocks. How about high dividend stocks, or low
dividend stocks. You can also buy so-called "Blue Chip" issues. Each
has its own purpose, advantage and disadvantage according to the
goals you have set.
Instead of buying individual stocks, you can buy into a stock mutual
fund. These funds hold a number of different stocks so there is more
diversity. The theory here is that an investor can reduce risk
and/or increase diversity by using a fund instead of buying
individual stocks. In fact, most financial advisors would agree that
an individual should never rely on just buying one stock issue. To
reduce risk, a portfolio should have a number of stocks. Hence, the
possible advantage of a mutual fund.
Funds have other advantages in that investors can also buy in
smaller amounts, have the returns reinvested(or compounded), and
supposedly rely on the fund to manage the market changes. Funds cost
money in that there is a commission to buy in or out if the fund is
a "Load(commission based)" fund, and there is a yearly management
fee(both load and no-load funds charge this). Another disadvantage
is that funds must follow their charter as to how much stock to own
at any given time, which may not always be the right amount in
certain market conditions. This is called being "Fully Invested."
Fixed Instruments & Funds
Fixed instruments, commonly referred to as Bonds, are basically an
obligation issued by a borrower who agrees to pay back the full
amount plus interest at a set future "due date." These bonds can
range in due date(maturity) from very shortless than one yearto very
longup to 30-40 years. As a general statement, bonds are used more
by the average investor for creating income than for creating
appreciation.
Bonds are also rated according to the ability of the issuer to pay
them back; this is called their "credit quality." It is very
important to understand that the rate of return a bond pays relates
to credit quality. Thus, everything else being equal in the
analysis, the higher the rate of return promised, the lower its
credit quality. Investors must pay attention to this axiom and
integrate it with their risk tolerances and overall goals.
A bond may fluctuate in value until it reaches its maturity date,
since its value relates to changes in interest rates after purchase.
Thus, if you buy a bond today paying 7% interest, and interest rates
rise, the value of your bond will decline. Why would anyone want to
buy yours at full price when they can get a new one paying a higher
interest rate. So you would have to "discount" the bond, and sell it
at a lower price than you paid for it to get someone interested.
This is a point of which many people are unaware, and it can cause
trouble(and loss of investment money). The only way you can
guarantee the face value of this type of bond is to hold it to
maturity. However, there are "floating rate" bonds around which tend
to hedge this risk. With these investments, the principal tends to
stay constant, but the yield changes with interest rates.
Thus, when you consider buying bonds, the maturity date is as
important a consideration as is the yield. In fact, the longer the
maturity date, the more the bond price will vary before maturity as
interest rates change. Bonds are categorized according to the
purpose and the issuer. The main categories are:
US Government Obligation Bonds: Backed by the U.S., these are issues
such as US Treasuries, and Savings Bonds.
US Backed Bonds: These are issues backed by various US Government
agencies such as GNMA, FNMA, Sallie Mae. Most of them are based on
an agency guaranteeing value of mortgages.
Corporate Bonds: These corporate obligations are rated according to
credit worthiness, with AAA the highest, declining according to the
alphabet. BBB is more risky, etc.
Municipal Obligations: These are bonds issued by municipalities such
as states, cities, revenue authorities. Like corporate bonds, they
are rated according to risk. Unlike corporates, many municipal bonds
can have tax exempt status, meaning you pay no income tax on the
interest received. But not all municipal bonds are alike in either
taxability or risk.
Similar to stocks, there are numerous Bond Funds which have pooled
together a number of different issues, to diversify your risk. These
funds usually categorize themselves according to the type of bonds
they buyMunicipal bond fund, GNMA Bond Fund, Corporate bond fund,
and so forth.
Cash Equivalents & Funds
These are very short term investments that tend to be readily
converted into cash with less volatility and loss of principal.
Short term CD’s from banks, savings accounts, money market accounts,
and short-term US Treasuries are the main examples.
The advantage to these cash equivalents is that your principal can
stay relatively constant, and you can cash in immediately even if
interest rates have moved against you quickly compared to longer
term fixed instruments. Naturally, the trade off is that the yield
on these investments tends to be substantially lower than bonds with
longer maturities. As we have seen with every type of investment,
there is a price for everything, and everything has its price!
The 9 Most Common Errors An Investor Makes
Without a doubt, a good investor has the ability to minimize risk
and maximize returnanother way of saying reduce errors. If you can
avoid the following errors, you are well on your way to reaching the
upper percentile of successful investors. DON’T MAKE THESE ERRORS:
1. Putting all your eggs in one basket. Not diversifying properly.
2. Investing without a quantifiable goal, and without understanding
your individual investment persona.
3. Not considering the effects your tax bracket will have on the
investments especially with these 2000 rates.
4. Waiting for the market to get better before investing. Trying to
"time" the market -
(30% succeed and 70% fail!).
5. Failing to use equities, especially for long-term investing.
6. Relying on hot tips and emotions.
7. Over use of short-term trading vs "buy and hold" strategy.
8. Paying too much in commissions, or fees for investment
transactions.
9. Not balancing the investment mix periodically.
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