- Getting Started (rule #1)
- Getting Started (rule #2)
- Good Debt and Bad Debt
- The Prerequisites to Investing
- Selecting a Broker
- The 50 Percent Rule - A Simple Investing Strategy
- Dollar Cost Averaging
Thursday, January 12, 2012
Index of Financial Advice Posts
Since the organization of posts by date isn't that convenient, here's a handy index of all my posts so far on financial advice. The posts are meant to be read in order:
Wednesday, January 11, 2012
Dollar Cost Averaging
One of the best ways to invest is to put in a fixed amount of money at regular intervals. This style of investing is naturally available to you if your work has a 401K program, or something similar. With a 401K program, a fixed amount is taken out of each paycheck and invested in the fund that you choose. If you don't have this kind of program at work, then you can create the same effect by choosing a set amount of money to invest each month. Of course, you should have met the prerequisites of investing before starting such a program.
Why is this a good way to invest? Well, suppose you are buying a stock, and you decide to purchase 10 shares a month for a year. At the end of the year, you will have 120 shares. The stock price fluctuates during the year, lets say in the range $25 to $40. To make this example concrete, suppose the price goes like this during the year:
This was a pretty good investment! You put in a total of $3,600 and at the end of the year it was worth 120 * $35 = $4,200. But is this the best you can do?
Suppose instead of buying 10 shares each month, you invested $300 each month. Your total amount invested would be the same as in the previous example, but what would be the value of the investment at the end of the year? Using the same price history, your investment would accumulate like this:
Actually, since I only allowed an integer number of shares to be purchased each month, you invested less than in the previous example. But you ended up with more shares than before! You invested a total of $3,540 and ended up with an investment worth 121 * $35 = $4,235.
How is this possible? Well if you look at the details, you can see what is happening. Each month you put in the same amount of money. So if the price is low that month you buy more shares. If the price is high you buy fewer shares. That means on average you are getting a better price, since you are buying more shares at the lower price. This is called Dollar Cost Averaging, hence the title of this column.
So, for your next investment, whatever it may be, put the power of Dollar Cost Averaging to work for you!
Why is this a good way to invest? Well, suppose you are buying a stock, and you decide to purchase 10 shares a month for a year. At the end of the year, you will have 120 shares. The stock price fluctuates during the year, lets say in the range $25 to $40. To make this example concrete, suppose the price goes like this during the year:
| Price | Shares | Investment | |
| $25 | 10 | $250.00 | |
| $25 | 10 | $250.00 | |
| $30 | 10 | $300.00 | |
| $25 | 10 | $250.00 | |
| $30 | 10 | $300.00 | |
| $35 | 10 | $350.00 | |
| $40 | 10 | $400.00 | |
| $30 | 10 | $300.00 | |
| $30 | 10 | $300.00 | |
| $25 | 10 | $250.00 | |
| $30 | 10 | $300.00 | |
| $35 | 10 | $350.00 | |
| Total | 120 | $3,600.00 |
This was a pretty good investment! You put in a total of $3,600 and at the end of the year it was worth 120 * $35 = $4,200. But is this the best you can do?
Suppose instead of buying 10 shares each month, you invested $300 each month. Your total amount invested would be the same as in the previous example, but what would be the value of the investment at the end of the year? Using the same price history, your investment would accumulate like this:
| Price | Shares | Investment | |
| $25 | 12 | $300.00 | |
| $25 | 12 | $300.00 | |
| $30 | 10 | $300.00 | |
| $25 | 12 | $300.00 | |
| $30 | 10 | $300.00 | |
| $35 | 8 | $280.00 | |
| $40 | 7 | $280.00 | |
| $30 | 10 | $300.00 | |
| $30 | 10 | $300.00 | |
| $25 | 12 | $300.00 | |
| $30 | 10 | $300.00 | |
| $35 | 8 | $280.00 | |
| Total | 121 | $3,540.00 |
Actually, since I only allowed an integer number of shares to be purchased each month, you invested less than in the previous example. But you ended up with more shares than before! You invested a total of $3,540 and ended up with an investment worth 121 * $35 = $4,235.
How is this possible? Well if you look at the details, you can see what is happening. Each month you put in the same amount of money. So if the price is low that month you buy more shares. If the price is high you buy fewer shares. That means on average you are getting a better price, since you are buying more shares at the lower price. This is called Dollar Cost Averaging, hence the title of this column.
So, for your next investment, whatever it may be, put the power of Dollar Cost Averaging to work for you!
Tuesday, August 30, 2011
The 50 Percent Rule - A Simple Investing Strategy
OK. Here is the promised simple strategy for investing. In this column, I'll just give the recipe for the strategy, and I'll devote future columns to explaining how it works and how to modify it for different purposes.
The purpose of this simple strategy is to grow your investment at a reasonable rate, while reducing the chance of catastrophic losses. The first part of this strategy has to do with asset allocation. Take all of the money that you have to invest, and divide it into three piles:
Keep in mind that you should always have six months worth of salary in cash (see my earlier column on the prerequisites to investing). The 10% kept in cash here can count towards that six month salary total.
The second part of this strategy is to use exchange traded funds (ETFs) to minimize the risk involved in purchasing individual stocks and bonds.
Once a year, you should correct the allocations to bring them back to the recommended percentages. For example, if the stock market has declined, and the bond market has rallied slightly, after a year your allocation might look like this:
This rebalancing should be done once a year. I do it at the end of January or beginning of February each year, because that is when most companies report their annual results.
So that's the whole strategy. As you save money, you can add it to cash, and let it be rebalanced into other investments annually. If you need to raise money, take it out of cash. Don't let the cash level drop too low, however. If it falls to 5%, you should do a rebalancing to bring it back to the 10% level.
The purpose of this simple strategy is to grow your investment at a reasonable rate, while reducing the chance of catastrophic losses. The first part of this strategy has to do with asset allocation. Take all of the money that you have to invest, and divide it into three piles:
- 50% for investing in stocks
- 40% for investing in bonds
- 10% to keep in cash
Keep in mind that you should always have six months worth of salary in cash (see my earlier column on the prerequisites to investing). The 10% kept in cash here can count towards that six month salary total.
The second part of this strategy is to use exchange traded funds (ETFs) to minimize the risk involved in purchasing individual stocks and bonds.
- With the money designated for investing in stocks, purchase SPY. SPY is a fund that mimics the performance of the Standard and Poor's index of 500 large cap domestic stocks. It is a broad index that will rise and fall with the overall stock market. It also pays a dividend that is currently running around 1.9%.
- With the money designated for investing in bonds, purchase AGG. AGG is a fund that tracks the performance of the total bond market. Since bonds pay interest, AGG also pays a dividend, which is currently yielding around 3.3%.
- The money that is kept in cash will be automatically invested in a money market fund by your broker (see Selecting a Broker).
Once a year, you should correct the allocations to bring them back to the recommended percentages. For example, if the stock market has declined, and the bond market has rallied slightly, after a year your allocation might look like this:
- 45% SPY
- 41% AGG
- 14% cash
This rebalancing should be done once a year. I do it at the end of January or beginning of February each year, because that is when most companies report their annual results.
So that's the whole strategy. As you save money, you can add it to cash, and let it be rebalanced into other investments annually. If you need to raise money, take it out of cash. Don't let the cash level drop too low, however. If it falls to 5%, you should do a rebalancing to bring it back to the 10% level.
Tuesday, May 10, 2011
Selecting a Broker
OK, if you've met the requirements for beginning to invest (see my previous entry on the prerequisites to investing), the first step is to select a broker and open an account with them. When I'm choosing a broker, the things I look for are: online trading, low fees, good execution, and a nearby office. It's useful to check out articles like the annual Smart Money list of top brokers. You can also google for "Top rated online brokers", and get lots of similar articles.
By coincidence, the top three brokers on the list this year (2011) were all brokers that I currently use. They are Fidelity Investments, Scottrade, and TD Ameritrade. These all have offices nearby, and they all support online trading. Their fees range from $7.00 to $10.00 per trade.
One of the themes of this blog is that you need to be responsible for your own investing. You can ask a broker for advice, but the sad fact is that no one cares as much about your investments as you do. When you get advice from a broker, that advice is influenced by the products that the broker's company is selling. Another problem with financial advice is that it is often generic, rather than tailored to your specific situation. A third problem with financial advisors is that some of them are incompetent or outright crooks.
If you don't understand enough to do your own investing, then how can you tell the good advice from the bad advice? That's why I recommend opening an account that supports online trading, so you can make your own trades without going through a broker.
Of course, the big question is, how do you get the knowledge to do your own investing? That's what I'll be talking about in the future. For now, one resource you can use is Investopedia. It's got a handy dictionary of investment terms, and regular articles on different topics.
In the next few entries in this blog, I will describe a simple investing strategy that works in all different kinds of market conditions.
By coincidence, the top three brokers on the list this year (2011) were all brokers that I currently use. They are Fidelity Investments, Scottrade, and TD Ameritrade. These all have offices nearby, and they all support online trading. Their fees range from $7.00 to $10.00 per trade.
One of the themes of this blog is that you need to be responsible for your own investing. You can ask a broker for advice, but the sad fact is that no one cares as much about your investments as you do. When you get advice from a broker, that advice is influenced by the products that the broker's company is selling. Another problem with financial advice is that it is often generic, rather than tailored to your specific situation. A third problem with financial advisors is that some of them are incompetent or outright crooks.
If you don't understand enough to do your own investing, then how can you tell the good advice from the bad advice? That's why I recommend opening an account that supports online trading, so you can make your own trades without going through a broker.
Of course, the big question is, how do you get the knowledge to do your own investing? That's what I'll be talking about in the future. For now, one resource you can use is Investopedia. It's got a handy dictionary of investment terms, and regular articles on different topics.
In the next few entries in this blog, I will describe a simple investing strategy that works in all different kinds of market conditions.
Tuesday, April 12, 2011
The Prerequisites to Investing
You might think that all you need to start investing is some money. But it's not that simple. When you invest, you put money at risk. That's a fancy way of saying you might lose the money. For example, if you buy stocks or bonds, those investments can become completely worthless if the company goes bankrupt. Even a company that is doing OK can see its stock dramatically drop when the business climate changes.
So when is it safe (and worthwhile) to take this kind of risk? That's what these prerequisites are really about. Here's the list of what you should have before you begin investing:
The insurance prerequisites are necessary to cover unexpected but potentially catastrophic events. Without health insurance, for example, your entire savings and investments could be wiped out by a sudden illness. Many jobs provide insurance as one of the employee benefits, but if you are self employed, or your job doesn't provide insurance, then you should purchase insurance for yourself (and your family) before even considering investing.
This brings us to the home. Why own a home before starting to invest? The reason is that a home is really your first and your best investment. It not only provides you a return on your investment, it also gives you a place to stay, and saves you the rent you would otherwise pay. On top of that, the government subsidizes your investment by giving you a tax break on the interest payments on your mortgage.
Your equity in a home is the value of the home minus the amount of the mortgage. So if you bought a $300,000 home, and borrowed $250,000 to buy it, then your equity is $50,000. Over time your equity increases as you pay off the mortgage. Substantial equity is at least 20%. So in the example of a $300,000 home, you should have at least $60,000 in equity before considering investing.
There are lots of things to consider when buying a home, I could write another column just on that topic. But there is one thing which is so vital to your financial health, that I have to mention it here. Never buy a home using a variable rate mortgage. The standard mortgage is a 30 year fixed rate, and that is the way to go (or a 15 year fixed rate if you can afford it).
With a fixed rate, you know what your costs are in advance, and you can determine if you can afford the home. As long as the payments are within your means, and you plan to stay in the area for a while (five to ten years), the home should be an excellent investment. The equity in your home provides you with a margin of safety against the normal fluctuations in home value.
So when is it safe (and worthwhile) to take this kind of risk? That's what these prerequisites are really about. Here's the list of what you should have before you begin investing:
- A steady income that provides you with enough to live on plus a little more. See Getting Started (rule #1).
- No credit card debt, or other "bad" debt. See Getting Started (rule #2) and Good Debt and Bad Debt. It's OK to use a credit card as long as you pay off the balance each month. Then you aren't really incurring debt.
- Substantial equity in a home. I'll say some more about this below.
- Savings that amount to six months of your income (your combined income if you are married).
- Health insurance, and also Life insurance if you are married.
The insurance prerequisites are necessary to cover unexpected but potentially catastrophic events. Without health insurance, for example, your entire savings and investments could be wiped out by a sudden illness. Many jobs provide insurance as one of the employee benefits, but if you are self employed, or your job doesn't provide insurance, then you should purchase insurance for yourself (and your family) before even considering investing.
This brings us to the home. Why own a home before starting to invest? The reason is that a home is really your first and your best investment. It not only provides you a return on your investment, it also gives you a place to stay, and saves you the rent you would otherwise pay. On top of that, the government subsidizes your investment by giving you a tax break on the interest payments on your mortgage.
Your equity in a home is the value of the home minus the amount of the mortgage. So if you bought a $300,000 home, and borrowed $250,000 to buy it, then your equity is $50,000. Over time your equity increases as you pay off the mortgage. Substantial equity is at least 20%. So in the example of a $300,000 home, you should have at least $60,000 in equity before considering investing.
There are lots of things to consider when buying a home, I could write another column just on that topic. But there is one thing which is so vital to your financial health, that I have to mention it here. Never buy a home using a variable rate mortgage. The standard mortgage is a 30 year fixed rate, and that is the way to go (or a 15 year fixed rate if you can afford it).
With a fixed rate, you know what your costs are in advance, and you can determine if you can afford the home. As long as the payments are within your means, and you plan to stay in the area for a while (five to ten years), the home should be an excellent investment. The equity in your home provides you with a margin of safety against the normal fluctuations in home value.
Friday, December 17, 2010
Good Debt and Bad Debt
You might think from my last post (see Getting Started - Rule #2) that I believe that all debt is bad. But that's not the case. Sometimes it's OK, and even a good thing to go into debt. How can you tell good debt from bad debt?
The difference between good debt and bad debt lies in what you plan to do with the money. If you are borrowing money to pay for ordinary expenses, like food and clothing, then that is a bad thing. On the other hand, borrowing money to buy a house can be a good thing.
What's the difference between these two cases? For one thing, the house has a long term value that generally goes up over time at about the rate of inflation. The last 10 years have been an exception to this rule, where the prices have shot up and then fallen, but in general this is true. A second difference is that a house provides a service to you over the long term. It gives you shelter and saves you from having to pay rent.
When you put up money today to receive something of value in the future, then this can be an example of good debt. I say "can be" since it all depends on the cost of the loan and the amount of value you expect to receive. You have to do the math to figure out if it is really worth it or not.
Another example of potentially good debt is when you borrow money to go to college (or for any type of education or training). If the training you receive provides you with more income in the future, then you can use that extra income to pay off the debt.
The last example is buying a car. If you can't afford to buy a car, and you need one to get to work, then taking out a loan to buy a car makes sense. The car also provides a service to you, while it lasts, but unlike a house, the value of the car declines over time. In cases like this, you need to make sure that you will have the loan paid off before the car's useful life is over. The other thing about cars is that they will start to cost you money for maintenance as they get older. So it's best to pay off a car loan over a 3-5 year period (for a new car), so that when the big ticket maintenance items start to happen, you will already be paid off.
So, to sum it up, debt isn't good and it isn't bad. It's what you do with the money that counts.
The difference between good debt and bad debt lies in what you plan to do with the money. If you are borrowing money to pay for ordinary expenses, like food and clothing, then that is a bad thing. On the other hand, borrowing money to buy a house can be a good thing.
What's the difference between these two cases? For one thing, the house has a long term value that generally goes up over time at about the rate of inflation. The last 10 years have been an exception to this rule, where the prices have shot up and then fallen, but in general this is true. A second difference is that a house provides a service to you over the long term. It gives you shelter and saves you from having to pay rent.
When you put up money today to receive something of value in the future, then this can be an example of good debt. I say "can be" since it all depends on the cost of the loan and the amount of value you expect to receive. You have to do the math to figure out if it is really worth it or not.
Another example of potentially good debt is when you borrow money to go to college (or for any type of education or training). If the training you receive provides you with more income in the future, then you can use that extra income to pay off the debt.
The last example is buying a car. If you can't afford to buy a car, and you need one to get to work, then taking out a loan to buy a car makes sense. The car also provides a service to you, while it lasts, but unlike a house, the value of the car declines over time. In cases like this, you need to make sure that you will have the loan paid off before the car's useful life is over. The other thing about cars is that they will start to cost you money for maintenance as they get older. So it's best to pay off a car loan over a 3-5 year period (for a new car), so that when the big ticket maintenance items start to happen, you will already be paid off.
So, to sum it up, debt isn't good and it isn't bad. It's what you do with the money that counts.
Sunday, August 29, 2010
Getting Started (rule #2)
The first rule was aimed at getting you started on the road to having some money to invest. The second rule is aimed at keeping you on track.
(2) You should never carry credit card debt
It's OK to have a credit card, and to use it. Credit cards are very handy things to have, and you should have at least one. But you should always pay the full balance on the card each month. If you do this, then you will never be charged any fees or interest.
If you treat your credit card like this, then you aren't really going into debt, you are just paying your bills on a monthly basis. If your credit card charges an annual or monthly fee anyway, then you should cancel that card and get one with no fees.
Interest and fees seem like little things at first, but they add up over time. Think of them as little vampires sucking away at your money. Just like a little savings can add up to a lot of money over time, these recurring fees add up. And these fees are coming right out of your disposable income.
Disposable income is the money you have left over after you have paid for your necessities, like food and rent. This is the money that is available to you to spend on things that you enjoy, like music and movies. Savings also have to come from your disposable income. So anything else that is coming from your disposable income is an evil that should be eradicated. If it's not fun, and it's not helping you save then why tolerate it?
While we are on the topic of fees and interest, it is also a good idea to get a no fee checking account, for the same reason. Most banks will give you some way to avoid fees, either by maintaining a minimum balance in the account, or by setting up an automatic deposit into a saving account.
One other type of scam to avoid is the so called "free credit report" service. These services may be free to start with, but they all convert to a service that charges a monthly fee. If this happens to you, cancel the service immediately.
(2) You should never carry credit card debt
It's OK to have a credit card, and to use it. Credit cards are very handy things to have, and you should have at least one. But you should always pay the full balance on the card each month. If you do this, then you will never be charged any fees or interest.
If you treat your credit card like this, then you aren't really going into debt, you are just paying your bills on a monthly basis. If your credit card charges an annual or monthly fee anyway, then you should cancel that card and get one with no fees.
Interest and fees seem like little things at first, but they add up over time. Think of them as little vampires sucking away at your money. Just like a little savings can add up to a lot of money over time, these recurring fees add up. And these fees are coming right out of your disposable income.
Disposable income is the money you have left over after you have paid for your necessities, like food and rent. This is the money that is available to you to spend on things that you enjoy, like music and movies. Savings also have to come from your disposable income. So anything else that is coming from your disposable income is an evil that should be eradicated. If it's not fun, and it's not helping you save then why tolerate it?
While we are on the topic of fees and interest, it is also a good idea to get a no fee checking account, for the same reason. Most banks will give you some way to avoid fees, either by maintaining a minimum balance in the account, or by setting up an automatic deposit into a saving account.
One other type of scam to avoid is the so called "free credit report" service. These services may be free to start with, but they all convert to a service that charges a monthly fee. If this happens to you, cancel the service immediately.
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