The Amateur Financier

(Hello again, my dear readers.  It’s time once again to head back to class, in order to learn some interesting and helpful facts about the investing world.  After all, if we’re hoping to be educated investors and stewards of our money, we first have to be educated.  Today, we’re going to start veering a bit away from the different types of investments available, and towards some of the finer points of business and the economy.  To start with, it’s one of the defining features of the modern business world: corporations.)

Q: So, what exactly is a corporation?

A: A corporation is legal entity that is distinct from the shareholders, workers, or anyone else involved in its function.  It’s considered for purposes of law to be a separate individual from the shareholders or other owners, and can be involved in legal proceedings as either a plaintiff or a defendant.  One of the major features of corporations is the concept of limited liability.

Q: Alright, what’s this limited liability all about?

A: Let’s go through a little thought experiment.  You own a small business and run into a small snafu legally.  Perhaps a worker ran over a poodle or something similar.  (No offense intended to any poodle lovers, of course.)  If you owned the company outright, as a sole proprietorship in your own name, the poodle owner could sue you and take not only the assets associated with the company, but any personal assets you happen to own, as well (car, house, pets, etc).  If the company is arranged as a corporation with limited liability, though, then the only money you can lose is the money that was already put into the corporation.  You can lose the money you put into your business, as well as the value of any corporate stock you own (assuming you’ve gone public with the company), but beyond that, all your other assets are safe.

Q: Reasonable enough; but doesn’t that make corporations just a way for the wealthy to dodge responsibility?

A: Well, that’s one criticism that’s leveled at them, sure.  Limited liability is one of the biggest (if not THE biggest) selling point of corporations, but it benefits everyone involved; owners and shareholders (which include most of us, at least for larger companies) can invest without fearing that a mistake made by the corporation will cost them everything.  By limiting the potential to the invested amount (and ONLY the invested amount), investing becomes safer and companies can draw in more investment dollars.  If you own any stock, you’re benefiting from the corporate structure.

Q: I guess I’ll accept that; what are some of the other benefits of a corporation?

A: Besides a possible sense of pride in being able to call your business a ‘corporation’, there are several more tangible benefits, as noted on Find Law.  Many of them have to do with issuing stock; once your company is a corporation, you’ll be able to sell of tiny portions of it as stock, either to raise money or to give to employees.  The corporate structure also sets up a number of positions: the directors, who provide direction to the company; the officers, such as CEOs and COOs, who oversee the business’s daily activities; and shareholders, who hold stock, have an ownership interest in the company, and elect the directors.

Q: I’ve done this enough to know what comes now: what are the downsides of corporations?

A: Yup, corporations aren’t all peaches and cream; they do have a few negatives, as noted in the above Find Law article.  It mentions both the costs of setting up a corporation (which can be substantial) in terms of time and effort, as well as the rules that corporations have to follow in order to preserve its existence as an independent entity (and keep that limited liability in place).  One of the most griped about problems, though, is the possible ‘double-taxation’ within the corporate structure, where profits are taxed first when they accrue to the corporation, and second, when they are distributed to the shareholders as dividends.  (The logic behind this is that, as corporations are separate persons, the money they make should be taxed as their income, and then also taxed when the money is transferred to other people (the investors).  It’s similar to you paying your mechanic out of your own paycheck; the money is taxed when each one of you receives it as income.  The only trick is here is that one person in our corporate example is not actually a person, but a legally created entity.)  There are ways around this double taxation, mainly by choosing a different type of corporation.

Q: Wait, there’s more than one type of corporation?

A: Yes, indeed.  In fact, if we go to Wikipedia’s Companies Law page and look at the index over on the right, we can see that there are a great number of different types of corporations, all with different governing rules and regulations.  Depending on your needs, any number might meet your purposes, although you’d have to do careful research and consideration in order to be sure.  I’ll try to cover some of the types more in depth during the coming weeks.

That’s all for now; hopefully, you’re a little better informed on just what a corporation is, and how it can affect you.

• What Subjects Should You Cover?
• Ethical Investing is Gaining Popularity
• Can Small Businesses Teach Blue Chip Corporations Something About Paying Profits?
• Life Insurance and Annuities may be Right for Retirement Despite Money Magazine
• Basic Info About The Benefits Of Brochure Printing

(It’s Tuesday, and you know what that means: Investing 101 day!  Today we look at compound interest, one of the most basic concepts in investing, and indebtness, for that matter.  So, for a closer view of the concept that Albert Einstein is said to have called ‘the most powerful force in the universe’, let’s journey together, shall we?)

Q: What is compound interest?

A: In a nutshell, compound interest is interest that is earned on interest.  For example, let’s say you have $100 in a bank account that earns 5% interest.  After one year, you will have earned a total of $5 in interest.  If you add no more money to the account, after the second year, you will have earned $5.25, five percent of your new total of $105.

Q: An extra $0.25; how’s that supposed to impress me?

A: It’s not where you start but where you end up that matters.  After five years, you’ll have over $120 in your account and be earning over $6 a year in interest (an increase of twenty percent).  After ten years, you’ll have $155 in the bank and earn nearly $8.  If you keep the money in there for thirty years, you’ll have $411 in the bank (more than four times the money you started with) and will be earning over $20 each year.  All of that is possible with a tiny starting balance and only a moderate level of return; if you start with $10,000 and get a 10% return (a frequently cited average for the return from the stock market), you will have nest egg worth $158,000 in thirty years, and will receive over $15,000 each year in returns, without investing another dollar.  Not a bad start to funding your retirement.

Q: Okay, that’s more exciting; are there any disadvantages to compound interest?

A: Well, yes.  While compound interest is your best friend when you have money in the bank, if you are in debt, compound interest can be a killer.  A debt of $5000 can grow to more than $10,000 in five years if you are being charged 20% interest on your debt (a rather low rate, among credit card interest rates).  If you’re paying only the minimum charges (usually only two to three percent of your outstanding total), there’s no way to ever get ahead on your debt.

Q: Alright, fair enough; how can I take advantage of compound interest, without letting it take advantage of me?

A: There are some pretty simple rules when it comes to your investments and debts so that compound interest works for you.  First, starting saving early, and consider putting aside a little more than you initially planned.  The three factors that determine how much you will gain in compound interest are the starting amount, the interest or return rate, and the time you allow the investment to grow.  How much you invest and how long you allow the money to grow are within your control.

Second, try not too be too cautious in your investments, especially when you are young.  It’s tempting, especially when the investment world seems to be falling apart (as it did at times last year), to flee to the safest investments you can find.  But, money market funds, Treasuries and even bond funds will all yield less over the long run than stocks or real estate.  Attempt to avoid the risk of falling account values, and you can find yourself facing the risk of not having enough to retire or meet your other needs.

Finally, if you owe money, do your best to pay off the debt by paying more money than you owe.  If you are paying only or predominantly interest, your debt will just continue to grow and grow.  Paying down some of the principle of your debts, be they your mortgage or credit card loans, will only save you money in the long run.

That’s all there really is to it; pay down debts (particularly the principle), give your money time to grow, and take some smart risks with your money as long as you have time to recover.  Do that, and compound interest will be your best friend (and will all but pay for your retirement).

• Only Paying the Minimums Payment on Your Credit Card? Prepare To Be in Debt for 42 Years!
• Planning for Your Retirement The Smart Way
• Understanding Investment Returns for Retirement Planning
• Comparing The 401k Vs Traditional IRA
• Finance 101: Good Debt vs. Bad Debt

(Welcome once again to my ongoing feature, Investing 101.  This week, we’re looking at indexes, those things whose prices you hear quoted at the end of most business news reports.  But what are they, how do they work, and why does everyone seem so concerned about this ‘Dow Jones’ guy?  Read on for the exciting answers to these and other questions of vital importance!)

Q: So what is an index, anyway?

A: An index is simply a collection of stocks, bonds, or other individual investments.  Depending on the particular index, it can represent the entire market or some smaller portion, divided up according to index creator’s criteria.  You can think of them as imaginary portfolios holding the particular investments that it tracks.

Q: Alright, why should I care about indexes?

A: Well, if you are investing in index funds, where the mutual fund company attempts to own all of the stocks in the index (or a representative portion, in some cases), then indexes should be quite familiar to you.  They serve as the basis of your funds’ holdings.  You can thus use the performance of the index (which are frequently reported in newspapers) as a proxy for your investment performance.  (Although, it’s worth mentioning that your index fund will (almost) always lag the performance of your index; real mutual funds have expenses while indexes themselves do not.  Still, your fund should perform roughly the same as the underlying index, making the index a useful tool.)

Q: That’s fine for index investors, but I buy actively managed funds and individual stocks.  How do indexes help me?

A: Well, indexes serve as a benchmark for your actively selected investments.  If you own an actively managed fund (or attempt to manage your own money), you should compare your returns to an appropriate index.  If your fund is not outperforming the index (or an index fund, to take into account the aforementioned mutual fund fees) that holds the same type of investments, you should consider switching to an index fund and being done with it.  You’re paying higher fees (or trading commissions) to achieve worse results than you could get with an index fund.  (Now, of course, be reasonable with your comparisons; dropping a fund for one year of under-performance is not usually justified.  But do be sure to watch how your active investments perform compared to an appropriate index.)

Q: Alright, what sort of indexes are out there?

A: There are literally hundreds of indexes, run by numerous different companies.  There are indexes created by Standard & Poor’s, Morgan Stanley, and the Russell Investment Group, amongst others.  Three of the most commonly encountered indexes are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite Index:

• The Dow Jones Industrial Average, commonly called the Dow, is composed of 30 different stocks that are among some of the largest companies traded in America.  These companies are considered some of the leaders in their fields, and the index, although limited, is considered a good representative of how American industry is doing.  It’s also the most commonly and prominently mentioned index on financial and other news programs, and thus one that’s easy to track.  For a more complete picture of how American business is doing, we can look at:
• The Standard and Poor’s (S&P) 500 Index, which measures the performance of 500 of the largest companies in the United States.  It includes all the Dow stocks and an additional 470 stocks of large companies, making it a more complete and accurate picture of American industrial performance.  It does not include mid- and small-cap stocks, though,
• The NASDAQ Composite Index measures the performance of the more than 4,000 stocks that trade on the NASDAQ exchange.  It tends to be weighted towards technology and other ‘hipper’ stocks (one reason why it suffered a tremendous fall at the end of the tech boom).

Q: That’s quite a list; you say there are other indexes?

A: Oh yes, indeed.  There’s the DJ Wilshire 5000, which includes all the stocks in America, making it even more representative of the American economy than the S&P 500, the MSCI EAFE, which invests in European, Asian, and Far Eastern stocks, and the Russell 2000, which invests in small- and mid-cap stocks (a total of 2000 of them, to be exact).  Which index funds (and related indexes) you should invest in and how much money you put into each one will depend on your goals, financial situation, and personality.

Good luck in the wonderful, funderful world of indexes, and see you for the next edition of Investing 101!

• Target Retirement Funds Portfolio Composition And Expenses: Vanguard vs Fidelity vs T Rowe Price
• 10 Things About Funds Investors Should Know About.
• Dimensional Fund Advisors Funds (DFA Funds): Better Than Vanguard?
• Beginner's Tips for Smart Investing
• New Loan Funded — payoff current loan and new invest on business — $25,000 at 29.00% — E Credit — DTI 37%

(Once again, when it’s Tuesday, that means it is Investing 101 day!  We’re running out of individual investment vehicles to cover, so we’re going to start covering some broader investment concepts.  Today, that means asset allocation, a concept that comes up repeatedly in discussions of investing and personal finance.)

Q: What is Asset Allocation?

A: In general, asset allocation refers to how you have your money distributed among different investments.  The point of asset allocation is to view your portfolio holistically, ensuring that you aren’t taking more risk than you want, or less risk than you need, with the money and resources you have available.

Q: What’s the perfect asset allocation, then?

A: There’s no way I can answer that; no one single perfect asset allocation exists.  It’s a bit like individual investment choices; some people prefer investing in stocks, others in real estate, still others in mutual funds.  Each option could be equally effective at building wealth, it’s simply a matter of personal preference and individual needs with the investment that will dictate the best one for each person.  Similarly, the best asset allocation for you will depend on a number of personal factors.

Q: Alright, how do I determine the best asset allocation for me?

A: There are a few important factors to consider to determine how to build your asset allocation.  The first step is to consider what goal(s) you’re investing to meet.  The big one for most people is retirement, of course; besides being one of the most expensive events in your life, it’s also one of the few you can’t take out a loan to finance.  You might also find yourself investing for college (for yourself or your children) or investing in order to buy a house.  For the purpose of keeping track of your progress, it might be best to think of each of these goals as a separate portfolio, even if in practice they are co-mingled.

Second, know how long you have until you need the money.  The less time you have available to make up any shortfalls, the more conservative you’ll have to be with your investments.  In general, the advice is that any money you’ll need within five to ten years (depending on the source of the advice) should not be invested in the stock market or similar risky ventures.  (As an aside: for goals where you’ll need the money all at once, this means you should be completely invested in bonds, bond funds or cash equivalents five to ten years before the event.  For goals that occur over the space of years or decades, like retirement, you can (and should) remain invested in stocks or other growth investments at the start of your retirement, to maximize the growth of your money and help make sure it lasts through your whole retirement.)

The third consideration is how much growth you need.  If you can save enough money to meet the goal through your own efforts, you can focus on keeping that money safe rather than growing it, by putting it aside in a savings account or other secure cash equivalent.  You won’t see much return, but the money you save will be safe and secure for when you need it.  If you need a great deal of growth (for a huge event such as retirement), you’ll have to put your money into riskier but higher average growth investments like stocks.  (Of course, you still need to balance your need for growth of your money with your time frame; if you try to make up for a short time frame by investing in highly risky ventures, you put yourself at risk of losing even more money and falling even further behind in meeting your goal.  If you have limited time, you should try to boost your savings to make up the difference, not upping your investment risk.)

A fourth consideration is your own tolerance for risk.  Depending on how well you can stomach the ups and downs of the market, you can tweak your portfolio to be slightly less risky or slightly more risky (with a higher average return).  Note that I say tweak; you shouldn’t take a huge amount of risk if you only have a few years left to make up your losses, regardless of how ‘risk-tolerant’ you are, nor should you hide from any risk if you have a long investment horizon and a large amount of money that you need to gain through investing.  While much is made about risk tolerance, ultimately it has to take a back seat to more practical concerns of time and needed growth.  At most, you could shift ten to twenty percent of your portfolio to a more or less risky investment according to your tolerance; that should moderate your returns while still allowing a reasonable level of growth.

Q: Whoa, that’s a lot to think about; care to run through an example asset allocation?

A: Sure, here’s an example of an investment portfolio for retirement, showing how to start, how to shift the investment over time, and where to end up:

1. Start with stock mutual funds, approximately one-third in a total foreign fund and the rest in a total US stock fund.  (Consider adding more funds to cover other investment classes, like REITs or commodities, but don’t worry about getting too complex.)  Rebalance whenever the ratio gets too far from your desired allocation.  (A five percent threshold before selling off part of the portfolio will keep you from constantly buying and selling within your portfolio.)
2. About twenty-five years before your intended retirement, switch ten percent of your portfolio over to a bond mutual fund, either a total bond market or total short term bond fund.  Keep the same proportion of US and foreign funds in your stock allocation.  (Ideally, make the switch within a retirement account to avoid paying any capital gains taxes on the growth of your stock funds.)  Rebalance between the three funds as needed, ideally by directing new investment money towards the laggards in your portfolio.
3. Every five years, continue to build up the bond portion of your portfolio, ten percent each time.  In this way, you’ll slowly scale back on the risk that a bad stock market will deplete your retirement reserves.  Continue to rebalance if your actual allocation gets too far out of proportion.
4. At ten years to go, start putting the new bond money into a TIPS fund, to provide you with an inflation hedge.  With ten years until retirement, you should have 40% in US stocks, 20% in foreign stocks, 30% in bonds and 10% in TIPS.  Have I mentioned that you should rebalance your portfolio if it gets too far from this allocation?
5. With five years to go before retirement, ensure that your cash reserves equal three to four years worth of expenses, to give you a buffer if your investments decrease in value.  Add more TIPS to your portfolio, giving you a final portfolio allocation of 33% US stocks, 17% foreign stocks, 30% bonds, and 20% TIPS.  Rebalance when needed.
6. At retirement, start to live off your cash reserves (as well as any pensions, Social Security payments, or annuities you happen to have).  Put the dividends from your investments into your cash accounts, and when selling your investments (if the dividend income is not enough to meet your needs), try to maintain the same asset allocation you had before you retired (in that way, you’ll automatically be rebalancing your portfolio as you progress).  With a large enough investment portfolio, this method should enable you to live quite well in retirement.

Q: Wow, that’s kind of complicated.  Is this the only asset allocation I should use?

A: Far from it.  This is just a simple, off the cuff allocation progression.  With some effort and a little research, you can probably come up with an even better investment plan of your own, or at least tweak this one enough to meet your personal needs.  It does illustrate some key points about your own asset allocation plan, though.  First, when you have plenty of time to invest, you should invest agressively, using a lot of stocks and other growth investments.  Second, when you are approaching your goal, you should scale down your risk, starting to focus more on preserving what you’ve gained rather than gaining still more.  Lastly, there should be a ‘flight path’, a slow, gradual progression from agressive to safe investments, which you follow over the course of your investment career.

There you have it, some basics on creating an asset allocation and altering it over the course of a lifetime.  Hopefully, these tips will help you as you begin your own investing career.  Good luck, and happy investing!

• 10 Things About Funds Investors Should Know About.
• Why Do You Invest?
• A Lazy Portfolio
• My IRA’s Asset Allocation (March '10 Update)
• Successful Investing Tips and Techniques