Chapter 5
IN THIS CHAPTER
Knowing what you should do before investing
Understanding how your financial plan translates into your investing plan
Investing is exciting.
Most folks love to pick an investment, put their money into it, and then enjoy seeing it increase in value. Of course, as I discuss in this book, investing isn’t that easy. You can do your homework and make a good decision but then see your well-chosen investment fall in value and test your nerves.
But that’s putting the cart before the horse. Before you make any great, wealth-building investments, you should get your financial house in order. Understanding and implementing some simple personal financial management concepts can pay off big for you in the decades ahead.
In this chapter, I explain what financial housekeeping you should do before you invest, as well as how to translate your overall personal and financial plans into an investment plan.
Plenty of younger folks have debts to pay and lack an emergency reserve of money for unexpected expenses. High-cost debts, such as on a credit card, can be a major impediment to investing, in particular, and accomplishing your future personal and financial goals, in a broader sense. A high interest rate keeps the debt growing and can cause your debt to spiral out of control, which is why I discuss dealing with this debt as your first priority, just before establishing an emergency reserve.
Paying down debts isn’t nearly as exciting as investing, but it does make your investment decisions less difficult. Rather than spending your time investigating specific investments, paying off your debts with new money you’re able to save may indeed be your best investment.
Consumer debt includes borrowing on credit cards, auto loans, and the like, which are often costly ways to borrow. Banks and other lenders charge higher interest rates for consumer debt than for debt for investments, such as real estate and business, because consumer loans are the riskiest type of loans for a lender. Risk means the chance of the borrower’s defaulting and being unable to pay back all that he or she borrowed.
Many folks have credit card debt that costs 18 percent or more per year in interest. Some credit cards levy interest rates well above 20 percent if you make a late payment or two. Reducing and eventually eliminating this debt with your savings is like putting your money in an investment with a guaranteed tax-free return equal to the rate that you pay on your debt.
For example, if you have outstanding credit card debt at 18 percent interest, paying off that debt is the same as putting your money to work in an investment with a guaranteed 18 percent tax-free annual return. Because the interest on consumer debt isn’t tax-deductible, you would need to earn more than 18 percent by investing your money elsewhere to net 18 percent after paying taxes. Earning such high investing returns is highly unlikely, and to earn those returns, you’d be forced to take great risk.
You never know what life will bring, so having an accessible reserve of cash to meet unexpected expenses makes good financial sense. If you have generous parents or dear relatives, you can certainly consider using them as your emergency reserve. Just be sure that you ask them in advance how they feel about that before you count on receiving funding from them. If you don’t have a financially flush family member, the onus is on you to establish a reserve.
If you don’t have a financial safety net, you may be forced, under duress, to sell an investment that you’ve worked hard for. And selling some investments, such as real estate, can take time and cost significant money (transaction costs, taxes, and so on).
Getting out from under 18 percent interest rate credit card debt is clearly a priority and a bit of a no-brainer. But what should you do about other debts that carry a more reasonable interest rate? This section talks you through some common examples: student loans and mortgage debt.
If you’re one of many young adults with lingering student loan debt, you’re probably wondering whether you should focus your efforts on paying down that debt or instead invest the extra cash you have.
The best choice hinges upon the interest rate on this debt (after factoring in any tax breaks) and how that compares with the expected return from investing. Of course, you must be reasonable and not pie-in-the-sky about the rate of return you expect from your investments.
Under current tax laws, with student loans, you can deduct up to $2,500 in student loan interest annually on your federal 1040 income tax return. So this deduction can lower the effective interest rate you’re paying on your student loans. This deduction is available to single taxpayers with adjusted gross incomes (before subtracting the student loan interest) of $60,000 or less and married couples filing jointly with such incomes of $120,000 or less. Partial deductions are allowed for incomes up to 20 percent above these amounts. Another requirement for taking this deduction is that you and your spouse, if filing jointly, cannot be claimed as dependents on someone else’s income tax return.
If you can deduct student loan interest on your tax return, to determine the value of that deduction, please see Chapter 4 to understand what tax bracket you’re in (what your marginal tax rate is). For most moderate income earners, 25 percent is a reasonable number to work with.
Suppose that you have student loans outstanding at the attractive interest rate of just 3.5 percent. Assume that you’re able to deduct all this interest and that your tax bracket is 25 percent. So after taxes, the effective interest rate on your student loan is 3.5 percent – (0.25 × 3.5 percent) = 2.63 percent.
Now, the question to consider is this: Can you reasonably expect to earn an average annual rate of return from your investments of more than this 2.63 percent? If you invest your money in a sleepy bank account, the answer will probably be no. If you instead invest in things like stocks and bonds, over the long term, you should come out with a higher return.
If you have student loans at a higher interest rate — say, 7.5 percent — it may make more sense to pay those loans down faster with your extra cash than to invest that money elsewhere. To get a higher return than that from investments, you need to take a fair amount of risk, and of course there’s no guarantee that you’ll actually make a high enough return to make it worth your while.
When deciding whether you should pay down student loans faster, there are some factors to consider besides the cost of your student loans and comparing this cost to the expected return on your investments. Other good reasons not to pay off your student loans any quicker than necessary include the following:
You’re willing to invest in growth-oriented, volatile investments, such as stocks and real estate. To have a reasonable chance of earning more on your investments than it costs you to borrow on your student loans, you must be aggressive with your investments. As I discuss in Chapter 3, stocks and real estate have produced annual average rates of return of about 9 percent. You may be able to earn even more by creating your own small business or by investing in others’ businesses.
Keep in mind that you have no guarantee of earning high returns from growth-type investments, which can easily drop 20 percent or more in value over a year or two.
Paying off your mortgage more quickly is an “investment” for your spare cash that may make sense for your financial situation. However, the wisdom of making this financial move isn’t as clear as is paying off high-interest consumer debt; mortgage interest rates are generally lower, and the interest is typically tax-deductible.
As with the decision to pay off a student loan faster (review the previous section), when evaluating whether to pay down your mortgage quicker than necessary, you need to compare your mortgage interest rate with your investments’ rates of return. Suppose that you have a fixed-rate mortgage with an interest rate of 5 percent. If you decide to make investments instead of paying down your mortgage more quickly, your investments need to produce an average annual rate of return, before taxes, of more than 5 percent for you to come out ahead financially.
You may want to invest money for several goals, or you may have just one purpose. When I was in my 20s, I put some money away toward retirement, but my bigger priority at that time was to save money so that I could hit the eject button from my management consulting job. I knew that I wanted to start my own business and that in the early years of my entrepreneurial endeavors, I couldn’t count on an income as stable or as large as the one I had in consulting.
I invested these two chunks of money quite differently. I kept the money I saved for the start-up of my small business, which was a shorter-term goal, safely invested in a money market fund that had a decent yield but didn’t fluctuate in value. By contrast, my retirement was a longer-term goal, so I invested the bulk of my retirement money in stock mutual funds. If these funds fluctuated and declined in value, that was okay in the short term, because I wouldn’t be tapping that money.
Many good investing choices exist: You can invest in real estate, the stock market, mutual funds, exchange-traded funds, or your own business or someone else’s. Or you can pay down debts such as on your student loans, credit cards, auto loan, or mortgage debt more quickly.
What makes sense for you depends on your goals as well as your personal preferences. If you detest risk-taking and volatile investments, paying down some debts, as recommended earlier in this chapter, may make better sense than investing in the stock market.
To determine your general investment desires, think about how you would deal with an investment that plunges 20 percent, 40 percent, or more in a few years or less. Some aggressive investments can fall fast. You shouldn’t go into the stock market, real estate, or small-business investment arena if such a drop is likely to cause you to sell or make you a miserable wreck. If you haven’t tried riskier investments yet, you may want to experiment a bit to see how you feel with your money invested in them.
Making investing decisions and determining your likes and dislikes is challenging just when you consider your own concerns. When you have to consider someone else, dealing with these issues becomes doubly hard, given the typically different money personalities and emotions that come into play. In most couples with whom I’ve worked as a financial counselor, usually one person takes primary responsibility for managing the household finances, including investments. In my observation, the couples that do the best job with their investments are those who communicate well, plan ahead, and compromise.
To accomplish your financial goals, you need to save money, and you also need to know your savings rate. Your savings rate is the percentage of your past year’s income that you saved and didn’t spend.
Part of being a smart investor involves figuring out how much you need to save to reach your goals. Not knowing what you want to do a decade or more from now is perfectly normal; after all, your goals and needs evolve over the years. But that doesn’t mean that you should just throw your hands in the air and not make an effort to see where you stand today and think about where you want to be in the future.
An important benefit of knowing your savings rate is that you can better assess how much risk you need to take to accomplish your goals. Seeing the amount that you need to save to achieve your dreams may encourage you to take more risk with your investments.
If you’re one of the many people who don’t save enough, you need to do some homework. To save more, you need to reduce your spending, increase your income, or both. For most people, reducing spending is the more feasible way to save.
To reduce your spending, first figure out where your money goes. You may have some general idea, but to make changes, you need to have facts. Get out your checkbook register, examine your online bill-paying records, and review your credit card bills and any other documentation that shows your spending history. Tally up how much you spend on dining out, operating your car(s), paying your taxes, and everything else. After you have this information, you can begin to prioritize and make the necessary trade-offs to reduce your spending and increase your savings rate. Earning more income may help boost your savings rate as well. Perhaps you can get a higher-paying job or increase the number of hours that you work. But if you already work a lot, reining in your spending is usually better for your emotional and economic well-being.
If you don’t know how to evaluate and reduce your spending or haven’t thought about your retirement goals, looked into what you can expect from Social Security, or calculated how much you should save for retirement, now’s the time to do so. Pick up the latest edition of my book Personal Finance For Dummies (Wiley) to find out all the necessary details for retirement planning and much more.
Regularly investing money at set time intervals, such as monthly or quarterly, in volatile investments such as stocks, stock mutual funds, or exchange-traded funds is called dollar cost averaging (DCA). If you’ve ever had money regularly deducted from your paycheck and contributed to a retirement savings plan investment account, you’ve done DCA.
Most folks invest a portion of their employment compensation as they earn it, but if you have extra cash sitting around, you can choose to invest that money in one fell swoop or to invest it gradually via DCA. The biggest appeal of gradually feeding money into the market via DCA is that you don’t dump all your money into a potentially overheated investment just before a major drop. No one has a crystal ball and can predict which direction investments will move next in the short term. DCA helps shy investors psychologically ease into riskier investments.
DCA is made to order for skittish investors with larger lump sums of money sitting in safe investments like CDs or savings accounts. It also makes sense for investors with a large chunk of their net worth in cash who want to minimize the risk of transferring that cash to riskier investments, such as stocks.
As with any risk-reducing investment strategy, DCA has its drawbacks. If growth investments appreciate (as they’re supposed to), a DCA investor misses out on earning higher returns on his money awaiting investment. Studying U.S. stock market data over seven decades, finance professors Richard E. Williams and Peter W. Bacon found that approximately two-thirds of the time, a lump-sum stock market investor earned higher first-year returns than an investor who fed the money in monthly over the first year.
However, knowing that you’ll probably be ahead most of the time if you dump a lump sum into the stock market is little solace if you happen to invest just before a major drop in prices. For example, from late 2007 to early 2009, global stocks shed about half of their value.
If you use DCA too quickly, you may not give the market sufficient time for a correction to unfold, during and after which some of the DCA purchases may take place. If you practice DCA over too long a period of time, you may miss a major upswing in stock prices. I suggest using DCA over one to two years to strike a balance.
Many well-intentioned parents want to save for their children’s future educational expenses. The mistake that they often make, however, is putting money in accounts in their child’s name (in so-called custodial accounts) or saving outside retirement accounts in general. The more money you accumulate outside tax-sheltered retirement accounts, the less assistance you’re likely to qualify for from federal and state financial aid sources.
Also, be aware that your family’s assets, for purposes of financial aid determination, generally include equity in real estate and businesses that you own. Although the federal financial aid analysis no longer counts equity in your primary residence as an asset, many private (independent) schools continue to ask parents for this information when they make their own financial aid determinations. Thus, paying down your home mortgage more quickly instead of funding retirement accounts can harm you financially. You may end up with less financial aid and pay more in taxes.
If you’re sufficiently wealthy that you expect to pay for your children’s full educational costs without applying for financial aid, you can save some on taxes if you invest through custodial accounts. Prior to your child’s reaching age 19, the first $1,900 of interest and dividend income is taxed at your child’s income tax rate rather than yours. After age 19 (for full-time students, it’s those under the age of 24), all income that the investments in your child’s name generate is taxed at your child’s rate.
If the financial aid system effectively encourages you to save in your own retirement accounts, how will you pay for your kid’s education expenses? Here are some ideas and resources:
You’ll hear about various accounts you can use to invest money for your kid’s future college costs. Tread carefully with these, especially because they can affect future financial aid.
The most popular of these accounts are qualified state tuition plans, also known as Section 529 plans. These plans offer a tax-advantaged way to save and invest more than $100,000 per child toward college costs. (Some states allow upward of $300,000 per student.) After you contribute to one of these state-based accounts, the invested funds grow without taxation. Withdrawals are also tax-free so long as the funds are used to pay for qualifying higher-education costs (which include college, graduate school, and certain additional expenses of special-needs students). The schools need not be in the same state as the state administering the Section 529 plan.
Section 529 plan balances can harm your child’s financial aid chances. Thus, such accounts make the most sense for affluent families who are sure that they won’t qualify for any type of financial aid. If you do opt for a 529 plan and intend to apply for financial aid, you should be the owner of the accounts (not your child) to maximize qualifying for financial aid.
Diversified mutual funds and exchange-traded funds, which invest in stocks in the United States and internationally, as well as bonds, are ideal vehicles to use when you invest money earmarked for college. Be sure to choose funds that fit your tax situation if you invest your funds in nonretirement accounts. (See Chapter 10 for more information.)
When your child is young (preschool age), consider investing up to 80 percent of your investment money in stocks (diversified worldwide) with the remainder in bonds. Doing so can maximize the money’s growth potential without taking extraordinary risk. As your child makes his way through the later years of elementary school, you need to begin to make the mix more conservative. Scale back the stock percentage to 50 or 60 percent. Finally, in the years just before the child enters college, reduce the stock portion to no more than 20 percent or so.
Some 529s offer target-date-type funds that reduce the stock exposure as target college dates approach so that you don’t have to make the adjustments yourself.
As a financial counselor, I’ve seen that although many people lack particular types of insurance, others possess unnecessary policies. Many people also keep very low deductibles. Remember to insure against potential losses that would be financially catastrophic for you; don’t waste your money to protect against smaller losses.
You may be at risk of making a catastrophic investing mistake by not protecting your assets properly. Decisions regarding what amount of insurance you need to carry are, to some extent, a matter of your desire and ability to accept financial risk. But some risks aren’t worth taking. Don’t overestimate your ability to predict what accidents and other bad luck may befall you.
Here’s what insurance I recommend that you have to protect yourself, your loved ones, and your assets:
For all the details on the right and wrong ways to buy insurance, what to look for in policies, and where to get good policies, see the latest edition of my book Personal Finance For Dummies (Wiley), and visit my website at www.erictyson.com
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