Investing Basics
Most important aspects to being a successful investor (from the Boglehead Wiki page):
The US Stock Market has historically been a good place to invest. Although year to year the market can swing up and down pretty dramatically (+50% to -35%), over the long run (20-30 years), the historical compound returns have been positive (roughly 10% not adjusted for inflation).
Bonds behave differently than stocks and have historically been a "safer" investment. In most cases, when prevailing interest rates fall, bond prices rise (in other words, bonds have a low correlation to stocks). Bonds have earned around 6-7% per year not adjusted for inflation.
Both stocks and bonds and cash reserves are a necessary part of any successful investment portfolio. Stocks are the heavy earners, but can also crash hard if a major event occurs (remember 2008?). Bonds help stabilize the portfolio in the event of a market downfall and also create a more reliable stream of income in retirement. Selecting the right stocks or bonds are not as daunting as you think. Since no one knows which stocks/bonds will be next year's winners or losers, it's best to own the entire market and earn our fair share at the lowest possible cost.
Mutual Funds are probably the best investment vehicle for any individual that isn't a Wall Street broker. Mutual Funds are lumped by family (Vanguard, Fidelity, Schwab) and purchase stocks and bonds that match the specific fund's objectives. There are large cap funds buying stock in large corporations, mid cap, small cap, bond funds, international funds, sector funds such as real estate and health care stocks, and commodity funds (precious metals, etc.). There are also funds that buy the entire US stock market, International stock market and US/International bond market at very low cost (explained in Index Funds).
COSTS MATTER MOST. Ignore fund performance. This is sometimes difficult to understand and counter-intuitive, but research shows that the only predictor of a fund's performance is its COSTS (lower cost, better performance). High advisor fees and annual maintenance expenses can be hazardous to your wealth. 1% fees may not sound that high, but considering the fact that the lifetime Compound Annual Growth Rate of the stock market is 10%, a 1% fee reduction per year compounded over your lifetime is huge. Choose mutual funds that carry NO LOAD and the lowest possible expense ratio. A fund with an expense ratio of over 1% is extremely high, .5% is moderate, and less than .2% is ideal. Index funds are the cheapest funds there are, and are discussed here.
The most important decision an investor must make is their Asset Allocation, not what funds to pick. Since you should choose index funds that own the entire market, it really doesn't matter what mutual funds you pick, just pick the cheapest, most broadly diversified fund. The most important aspect, Asset Allocation, is simply how much you wish to allocate to stocks and how much to allocate to bonds. This is a personal decision that aligns with your own risk tolerance (click to take a risk questionnaire). Since stocks are a riskier asset than bonds, a 20-year old single person would do well with a mostly stock portfolio. A person with a family, a mortgage, a lower projected income, and small pension might want to be more conservative (hold more bonds). Nearly everyone should own more bonds as they age since they are a more conservative investment than stocks and you have less risk of losing your money. An old rule of thumb was to "Own your Age in Bonds" (age 40 - 40% bonds, etc.), but since life expectancy has risen considerably since this "rule" was established, it may be more prudent to own your age minus 10, 15 or even 20. I am going to go with "Age - 15" in bonds and will hold a 50/50 allocation of stocks and bonds in retirement.
Your savings rate and investment time-frame are crucial. Investing too little or starting much later in life will leave you with a considerably smaller nest egg. The performance of your mutual funds are not as important as investing more and starting earlier!
Myths to dispel:
1) The stock market is evil. Truth - the news does a great job of portraying this, but the reality is that the stock market is a representation of all publicly traded companies, some bad, but most are good American companies that care about their stock holders and customers.
2) Investing is greedy. Truth - it can be if looked at through the wrong lens. If you are giving person, you will probably use your money for giving to charity and leaving a legacy through an inheritance. Supplementing one's income to keep from eating dog food in retirement isn't greedy... it's being responsible. I feel that relying on the state for food, income and insurance is much more greedy than building a good nest egg and becoming self-reliant.
3) Investing isn't safe at all so I'm not going to do it. Truth - nothing in this world is completely safe. Being a wise investor (not speculator) is reasonably safe over a long period of time. Remember, there are only 2 rolling decades in the stock market's history that haven't made money. Every other decade's average is about 10%. There are no 20-year periods of the market seeing a loss. Put in a slightly different way - you have a much stronger chance of being in a serious car accident (or two) than you do losing your money over a 20-year investment window. If you allocate your investments to stocks and bonds, your money is virtually guaranteed to make some kind of return over a long-term horizon. The only way the entire stock market closes down is if every company it represents closes down (your bank CD's would be gone in that scenario, too and you're better off buying a gun and some ammo).
4) There are too many investment rip-offs and people trying to steal my money, so I'm not going to do it. Truth - it is definitely true that there are rip-offs and folks who would love to pinch your pennies. You probably have a stronger risk of losing most of your money through high expenses than you do in market losses. Learn about investing through index funds, develop a buy-and-hold strategy (don't sell when the market plummets), use proper Asset Allocation, and you will save a ton of money in commissions, expenses and taxes.
5) I can't do this on my own, it's too complicated. Truth - opening up a Roth IRA through Vanguard, Fidelity, Schwab or an online discount brokerage firm like E-Trade, TD-Ameritrade or Scottrade is fairly easy. All you need is the minimum required investment, your checking account information to set up automatic withdrawals each month, and your choice of funds to invest in (I suggest Target Retirement or Vanguard LifeStrategy as the easiest and some of the cheapest funds to own). There is some paperwork and time involved with setting it up, but the investing will be done automatically thereafter.
6) I don't have enough income to invest every month. Truth - freeing up your income by paying off all of your debts quickly and aggressively allows you to have more disposable income to save for the future. Check out Dave Ramsey on this issue - it's the best!
7) Fund performance has to be part of the equation as to which investments I purchase. Truth - this is probably the most difficult myth to dispel for anyone that has any sort of investment knowledge. This myth is also perpetuated by people like Dave Ramsey. The truth is that 70-80% of investors fail to earn basic market index returns. In other words, while we see charts on Morningstar or Google Finance that show that your mutual fund is outperforming the S&P 500, the truth is that after your front-end loads and high expense ratios, your money invested is actually not keeping up with a simple S&P 500 index fund. The advertising dollars are enormous to make you to believe that actively managed funds consistently outperform their benchmark index. There are also several other factors that allow most investors to fail to keep up with benchmark indexes - higher taxes, higher commissions, trying to time the market by selling low or buying at the peak, and picking a previous year's winner that will almost always be the following year's loser. Even active funds with 15 or 20-year top performance have no guarantee of being the top performer for the next 15-20 years (this has a less than 3% chance of actually happening). All of this research has been done by John Bogle and the Vanguard Investment Group and is discussed in Boglehead's Guide to Investing and the Boglehead's Wiki page.
Bad investment ideas:
Annuities - these are investments with an insurance company. These are more conservative (and more expensive), but have guaranteed (modest) returns and some estate planning advantages. Unless you receive a large inheritance and need to invest it in an annuity to protect it from yearly taxes, I would not use annuities for your long-term investment plan. You can make more on your money and incur considerably less cost with purchasing index mutual funds in a tax-deferred retirement account like a Roth IRA, Traditional IRA or 403(b) (explained on next few pages). Beware - the 403(b) is actually nick-named an "Annuity" account because this was the main investment vehicle for many years. Annuities are fraught with high fees and lower returns than index funds in a Roth IRA.
Cash Value Life Insurance (Whole Life, Variable Life, Universal Life) - designed for uneducated, ill-informed consumers and play on emotions. These are HORRIBLE rip-offs and are not a good place for retirement investing or kids' college funds. Purchase Term Life insurance (if your family cannot self-insure upon your death) and invest your dollars in mutual funds.
Single stocks and Day Trading - this carries high risk and are only for people who spend their life studying stocks. Warren Buffett was reading books on stock valuation starting at around age 8 and knew everything that most undergraduate finance majors know by the time he was in high school. Unless you have that kind of knowledge or time to learn, you should not speculate in single stocks. Leave that to the losers (or in Buffett's case, the super-winners). Your costs, taxes and extreme risk are much too high for your hard-earned dollars.
Gold or Precious Metals - these are commodities and have no intrinsic value (value solely based on emotions of fear and greed). Stocks and bonds actually have value based on the companies invested with and returns come with increasing value. Gold has had a very poor track record of less than 4% return in its entire lifetime. Gold did well when the market crashed in 2008, but has since done poorly again with the economic recovery. Gold is fear-based and it has not been used as an economic standard since before the 20th century. Gold also hasn't been used as a means of exchange in a fallen economy since the Roman Empire. If you remember hurricane Katrina or the 2004 tsunami of south Asia, did you ever see or hear about gold being used to buy food or water? No. People barter and trade for goods or services when catastrophe strikes... they could care less about a bar of gold when their life is in jeopardy.
"Safe" investments like Money Market accounts, CD's, Bank IRAs or other "guaranteed" return investments - these are much too conservative for long-term capital growth. Money Market accounts are ok for your emergency fund and short-term investments because unlike a CD, you can write checks against many MMA accounts. If you choose to move your retirement assets to these accounts when you are in fruition, that's probably not a horrible idea, but remember, you need stock for capital growth and to sustain your nest egg as long as you are still around.
Performance chasing - This was discussed above and is also discussed in Index Funds. Performance chasing is one of the main reasons 70-80% of investors fail to earn what the stock market earns. Investors must buy low and sell high to earn profits, and the performance chaser has a strong chance of breaking this rule by panicking when the market is down and chasing a hot fund that is already at its peak. The passive investor will simply stay the course and ride the wave up and down - staying in the market when it is down (perhaps buying more while it's on sale!!), and not become greedy when the market is hot.
- Live below your means.
- Asset Allocation (holding bonds) is essential.
- Buy low-cost funds that are widely diversified.
- Tax efficiency matters.
- Savings rate and time to invest are more important than fund performance (I added this one).
- Stay the course.
The US Stock Market has historically been a good place to invest. Although year to year the market can swing up and down pretty dramatically (+50% to -35%), over the long run (20-30 years), the historical compound returns have been positive (roughly 10% not adjusted for inflation).
Bonds behave differently than stocks and have historically been a "safer" investment. In most cases, when prevailing interest rates fall, bond prices rise (in other words, bonds have a low correlation to stocks). Bonds have earned around 6-7% per year not adjusted for inflation.
Both stocks and bonds and cash reserves are a necessary part of any successful investment portfolio. Stocks are the heavy earners, but can also crash hard if a major event occurs (remember 2008?). Bonds help stabilize the portfolio in the event of a market downfall and also create a more reliable stream of income in retirement. Selecting the right stocks or bonds are not as daunting as you think. Since no one knows which stocks/bonds will be next year's winners or losers, it's best to own the entire market and earn our fair share at the lowest possible cost.
Mutual Funds are probably the best investment vehicle for any individual that isn't a Wall Street broker. Mutual Funds are lumped by family (Vanguard, Fidelity, Schwab) and purchase stocks and bonds that match the specific fund's objectives. There are large cap funds buying stock in large corporations, mid cap, small cap, bond funds, international funds, sector funds such as real estate and health care stocks, and commodity funds (precious metals, etc.). There are also funds that buy the entire US stock market, International stock market and US/International bond market at very low cost (explained in Index Funds).
COSTS MATTER MOST. Ignore fund performance. This is sometimes difficult to understand and counter-intuitive, but research shows that the only predictor of a fund's performance is its COSTS (lower cost, better performance). High advisor fees and annual maintenance expenses can be hazardous to your wealth. 1% fees may not sound that high, but considering the fact that the lifetime Compound Annual Growth Rate of the stock market is 10%, a 1% fee reduction per year compounded over your lifetime is huge. Choose mutual funds that carry NO LOAD and the lowest possible expense ratio. A fund with an expense ratio of over 1% is extremely high, .5% is moderate, and less than .2% is ideal. Index funds are the cheapest funds there are, and are discussed here.
The most important decision an investor must make is their Asset Allocation, not what funds to pick. Since you should choose index funds that own the entire market, it really doesn't matter what mutual funds you pick, just pick the cheapest, most broadly diversified fund. The most important aspect, Asset Allocation, is simply how much you wish to allocate to stocks and how much to allocate to bonds. This is a personal decision that aligns with your own risk tolerance (click to take a risk questionnaire). Since stocks are a riskier asset than bonds, a 20-year old single person would do well with a mostly stock portfolio. A person with a family, a mortgage, a lower projected income, and small pension might want to be more conservative (hold more bonds). Nearly everyone should own more bonds as they age since they are a more conservative investment than stocks and you have less risk of losing your money. An old rule of thumb was to "Own your Age in Bonds" (age 40 - 40% bonds, etc.), but since life expectancy has risen considerably since this "rule" was established, it may be more prudent to own your age minus 10, 15 or even 20. I am going to go with "Age - 15" in bonds and will hold a 50/50 allocation of stocks and bonds in retirement.
Your savings rate and investment time-frame are crucial. Investing too little or starting much later in life will leave you with a considerably smaller nest egg. The performance of your mutual funds are not as important as investing more and starting earlier!
Myths to dispel:
1) The stock market is evil. Truth - the news does a great job of portraying this, but the reality is that the stock market is a representation of all publicly traded companies, some bad, but most are good American companies that care about their stock holders and customers.
2) Investing is greedy. Truth - it can be if looked at through the wrong lens. If you are giving person, you will probably use your money for giving to charity and leaving a legacy through an inheritance. Supplementing one's income to keep from eating dog food in retirement isn't greedy... it's being responsible. I feel that relying on the state for food, income and insurance is much more greedy than building a good nest egg and becoming self-reliant.
3) Investing isn't safe at all so I'm not going to do it. Truth - nothing in this world is completely safe. Being a wise investor (not speculator) is reasonably safe over a long period of time. Remember, there are only 2 rolling decades in the stock market's history that haven't made money. Every other decade's average is about 10%. There are no 20-year periods of the market seeing a loss. Put in a slightly different way - you have a much stronger chance of being in a serious car accident (or two) than you do losing your money over a 20-year investment window. If you allocate your investments to stocks and bonds, your money is virtually guaranteed to make some kind of return over a long-term horizon. The only way the entire stock market closes down is if every company it represents closes down (your bank CD's would be gone in that scenario, too and you're better off buying a gun and some ammo).
4) There are too many investment rip-offs and people trying to steal my money, so I'm not going to do it. Truth - it is definitely true that there are rip-offs and folks who would love to pinch your pennies. You probably have a stronger risk of losing most of your money through high expenses than you do in market losses. Learn about investing through index funds, develop a buy-and-hold strategy (don't sell when the market plummets), use proper Asset Allocation, and you will save a ton of money in commissions, expenses and taxes.
5) I can't do this on my own, it's too complicated. Truth - opening up a Roth IRA through Vanguard, Fidelity, Schwab or an online discount brokerage firm like E-Trade, TD-Ameritrade or Scottrade is fairly easy. All you need is the minimum required investment, your checking account information to set up automatic withdrawals each month, and your choice of funds to invest in (I suggest Target Retirement or Vanguard LifeStrategy as the easiest and some of the cheapest funds to own). There is some paperwork and time involved with setting it up, but the investing will be done automatically thereafter.
6) I don't have enough income to invest every month. Truth - freeing up your income by paying off all of your debts quickly and aggressively allows you to have more disposable income to save for the future. Check out Dave Ramsey on this issue - it's the best!
7) Fund performance has to be part of the equation as to which investments I purchase. Truth - this is probably the most difficult myth to dispel for anyone that has any sort of investment knowledge. This myth is also perpetuated by people like Dave Ramsey. The truth is that 70-80% of investors fail to earn basic market index returns. In other words, while we see charts on Morningstar or Google Finance that show that your mutual fund is outperforming the S&P 500, the truth is that after your front-end loads and high expense ratios, your money invested is actually not keeping up with a simple S&P 500 index fund. The advertising dollars are enormous to make you to believe that actively managed funds consistently outperform their benchmark index. There are also several other factors that allow most investors to fail to keep up with benchmark indexes - higher taxes, higher commissions, trying to time the market by selling low or buying at the peak, and picking a previous year's winner that will almost always be the following year's loser. Even active funds with 15 or 20-year top performance have no guarantee of being the top performer for the next 15-20 years (this has a less than 3% chance of actually happening). All of this research has been done by John Bogle and the Vanguard Investment Group and is discussed in Boglehead's Guide to Investing and the Boglehead's Wiki page.
Bad investment ideas:
Annuities - these are investments with an insurance company. These are more conservative (and more expensive), but have guaranteed (modest) returns and some estate planning advantages. Unless you receive a large inheritance and need to invest it in an annuity to protect it from yearly taxes, I would not use annuities for your long-term investment plan. You can make more on your money and incur considerably less cost with purchasing index mutual funds in a tax-deferred retirement account like a Roth IRA, Traditional IRA or 403(b) (explained on next few pages). Beware - the 403(b) is actually nick-named an "Annuity" account because this was the main investment vehicle for many years. Annuities are fraught with high fees and lower returns than index funds in a Roth IRA.
Cash Value Life Insurance (Whole Life, Variable Life, Universal Life) - designed for uneducated, ill-informed consumers and play on emotions. These are HORRIBLE rip-offs and are not a good place for retirement investing or kids' college funds. Purchase Term Life insurance (if your family cannot self-insure upon your death) and invest your dollars in mutual funds.
Single stocks and Day Trading - this carries high risk and are only for people who spend their life studying stocks. Warren Buffett was reading books on stock valuation starting at around age 8 and knew everything that most undergraduate finance majors know by the time he was in high school. Unless you have that kind of knowledge or time to learn, you should not speculate in single stocks. Leave that to the losers (or in Buffett's case, the super-winners). Your costs, taxes and extreme risk are much too high for your hard-earned dollars.
Gold or Precious Metals - these are commodities and have no intrinsic value (value solely based on emotions of fear and greed). Stocks and bonds actually have value based on the companies invested with and returns come with increasing value. Gold has had a very poor track record of less than 4% return in its entire lifetime. Gold did well when the market crashed in 2008, but has since done poorly again with the economic recovery. Gold is fear-based and it has not been used as an economic standard since before the 20th century. Gold also hasn't been used as a means of exchange in a fallen economy since the Roman Empire. If you remember hurricane Katrina or the 2004 tsunami of south Asia, did you ever see or hear about gold being used to buy food or water? No. People barter and trade for goods or services when catastrophe strikes... they could care less about a bar of gold when their life is in jeopardy.
"Safe" investments like Money Market accounts, CD's, Bank IRAs or other "guaranteed" return investments - these are much too conservative for long-term capital growth. Money Market accounts are ok for your emergency fund and short-term investments because unlike a CD, you can write checks against many MMA accounts. If you choose to move your retirement assets to these accounts when you are in fruition, that's probably not a horrible idea, but remember, you need stock for capital growth and to sustain your nest egg as long as you are still around.
Performance chasing - This was discussed above and is also discussed in Index Funds. Performance chasing is one of the main reasons 70-80% of investors fail to earn what the stock market earns. Investors must buy low and sell high to earn profits, and the performance chaser has a strong chance of breaking this rule by panicking when the market is down and chasing a hot fund that is already at its peak. The passive investor will simply stay the course and ride the wave up and down - staying in the market when it is down (perhaps buying more while it's on sale!!), and not become greedy when the market is hot.