Archives for Investment Pyramid category
6
Mar
Posted in Investment Pyramid by Roger |
Up to this point, we’ve been talking about the how of investing, from getting yourself ready financially to starting to build up some diverse investments to expanding into other investment opportunities. This is all important to know, but it doesn’t touch on the broader question of why we invest. The short answer is, we invest to help us fulfill our hopes and dreams.
The longer answer goes like this: investing gives us more money, and more money (as well as alternative ways to get it) lead to more options. The main reason to invest is that by diverting some of your money from current consumption (that is, not spending all the money you earn), you can help to secure a more stable future.
The money you have, determines the possibilities that are available to you. If you want to retire early (or retire at all), travel the world, engage in philanthropic endeavours, or simply want the flexibility to shift your career without panicking about your income, investing can help you to achieve your goals. There are just a few things to consider as you work toward your goals:
1) Be realistic about your goals – If you’re twenty now, making $40,000 a year and don’t have any money invested yet, being a millionaire by the age of thirty just isn’t realistic. Having $80,000 in investments by thirty is possible, though. Understand what is possible, what’s impossible, and how to understand the difference between the two, and you will go far with your investments.
2) Be willing to sacrifice – All investments entail some short-term sacrifice. The money you are putting into stocks or mutual funds could be spent on entertainment now. Being able to say no to going out every night or spending money on a new television is necessary to be a successful investor.
3) Be confident – It’s easy to find times when staying in your investments seems risky, or even stupid. As I write this, in March 2009, we are in one of the most volatile markets in decades. It’s easy to find people panicking over market volatility, pulling their money out and keeping it in savings accounts or Treasuries.
These actions might make you feel safe in the short term, but it becomes nearly impossible to meet your long term goals with such low growth. Achieving your goals requires taking some (smart) risks, and being confident that investing for the long term will yield positive growth.
With these words of advice, I know you’ll do well with your investments. Keep your goals in mind, work towards them every day, and you’ll achieve them in the end. Good Luck!
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5
Mar
Posted in Investment Pyramid by Roger |
If you’ve spent any time reading through investment literature, you’ve probably noticed that there are many, MANY possible ways to invest that we haven’t mentioned in our discussions of mutual funds and stocks. Most of these methods actually are really speculation; taking substantial risks in the hopes of generating even greater returns.
Speculation is inherently risky; unlike investing (at least, passively investing in index funds or similar investments), it involves significant work, research, and frankly, more than a little luck, in most cases. My best advice regarding speculation is simply to limit your exposure. Keep at most 10% of your portfolio in speculative ventures, and then, only if you can afford to lose that money with no effect on your retirement and other long term plans.
If you decide to engage in some speculation (and again, there is no requirement that you must), there are plenty of ways you can go about speculating. Day trading stocks is one method, but of course, you run the risk of mixing your investments with your speculatory stocks. There are numerous other financial instruments that are used only for speculation:
Futures - Futures are contracts to secure the price of some commodities for a future date (hence the term, futures). The underlying goods can range from agricultural products (corn, cattle, soybeans) to raw building materials like lumber and steel. For producers and consumers, futures can serve to decrease the volatility of the market and help to limit future price risk. Selling a futures contract allows the producer to lock in their profit, and buying one enables the consumers to ensure their expenses.
For most investors, though, investing in the futures market involves trading contracts without intending to take physical delivery of the underlying goods. Depending on how the prices of the commodites change, the value of the futures contracts will change, leading to profit or loss for the investors.
Options - Options are financial instruments similar to futures. They enable you to lock in a price on a stock, bond, or other asset for a future date. Options come in two flavors, calls and puts: calls give you the right to buy the asset at a pre-arranged price (the strike price), while puts permit you to sell an underlying asset at the strike price.
Buying options is a method of hedging, enabling investors to ensure the future price they’ll be able to buy or sell an asset in which they are interested. Buying an option doesn’t compell the buyer to exercise the option (that is, buy or sell the underlying asset at the strike price), so the only money at risk is the cost of buying or selling the option. Selling options can be a way of generating funds (the price of the options), but there is the risk that you could be compelled to buy or sell the underlying assets at prices much worse than the current market prices.
Currencies - More commonly known by the term forex, currency trading involves currency pairs. Large international banks need to convert from one currency to another in the course of their business dealing. The market for these exchanges is the interbank or spot market.
Speculators in this market try to determine how the exchange rates of currencies will change, usually over short periods of time. They buy or sell pairs of currencies, representing the exchange rates between two different monetary systems. Profit or loss results from the movement of currency rates and the particular bet the investors have made.
(Beware of leverage with regards to these investments, particularly with options and currencies. Leverage essentially translates to borrowing money with the hopes of investing it and generating profit, enabling you to repay the loan and generate a larger profit than possible with your money alone. The advantage is that relatively little money can be used to generate a large profit; however, the disadvantage is that a bad investment can lose more money than you initially invested. Be very, very careful about the investments you choose, and be sure you know the largest amount of money you could end up losing if your speculation fails.)
Finally, I’d like to remind you that there’s no reason to engage in speculation if you don’t want to do so. It is certainly possible to create a complete and comprehensive investment plan without touching upon speculatory investments at all. Only engage in speculation if you have the funds available, can lose them without affecting your investment goals, and understand exactly what you’re doing. If you don’t meet all these qualifications, stick with investments lower on the pyramid.
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4
Mar
Posted in Investment Pyramid by Roger |
When we left off last time, we were looking at the joy and wonder of investing in mutual funds. For most people, this is about as far as they need to go in building up an investment pyramid. It might be a flat-topped pyramid if you are following my little diagram below, but there’s nothing wrong with that. But, if want to keep building up your pyramid, the next step is to look into individual stocks or bonds.
I like to call these ‘concentrated investments’ because they aren’t diversified (and I’m a chemistry dork, so I think in terms of concentrated and dilute). This can be a good thing; if your investment goes up, you’ll make much greater profit by holding a single stock than owning it as part of a diverse mutual fund. The flip side, of course, is that if the stock goes down, or if the company goes bankrupt, you’ll be take a much greater loss holding the stock directly compared to having hundreds of stocks in a mutual fund.
Try to limit how much money you put into stocks; it’s easier, much easier, to lose all the money invested in individual stocks than it is to lose the money that’s in mutual funds. Start with a small portion of your portfolio in stocks (10% to begin with), and then, as you gain experience, you can expand that amount upwards, should you desire. If you’re going to invest directly in stocks and bonds, be sure to keep a few things in mind:
1) Be sure to do lots of research – individual stocks and bonds require a lot more attention than mutual funds (especially if you stick with index funds). If you invest in individual stocks, you need to closely watch the company in which you are investing, or you might end up holding another Lehman Brothers as it takes down a large portion of your portfolio. If you aren’t willing or able to look over your stocks weekly, investing a significant amount of time studying the companies in which you are investing, you simply will not do well.
2) Learn to read financial statements – in the same vein, understanding how to read the numerous financial filings that companies need to make with the Securities and Exchange Commission (SEC) is important when you want to invest in individual companies. Being able to read and understand a 10-Q or 10-K form (to say nothing of knowing what they are) is vital for investing in individual companies. If you haven’t learned how to read financial statement, the SEC can show you the way.
3) Consider your asset allocation – if you’re investing in American, large company stocks (’blue chips’, as they are frequently called), you should probably cut back on the US stock funds you hold. That way, you’ll remain diversified, even as you expand your holdings into individual stocks.
4) Know your risk tolerance – investing in securities can be a harrowing experience; stocks go up and down daily, sometimes for fundamental reasons (the company itself is doing well or doing poorly) and sometimes for emotional reasons (stocks are bought and sold by people, and people react emotionally). As a result, there will be movements in the stock price, sometimes dramatic, and there could be times when it seems like the company might go under. If you aren’t prepared for this, if you haven’t thoroughly studied the stock and have the stomach to face harrowing drops in the stock price, you’re going to be much better off investing in safe index funds and letting your investments ride.
5) Be sure to buy and hold – investing is all about the long term; it’s about where you end up, not what happens along the way. Buy stocks with the idea of keeping them for the long term. You can invest for capital growth or for dividend payments (or both), but look toward the long term. Trading weekly, or even daily, will drive up your commissions with your brokerage firm but will be very unlikely to lead to higher profits for you.
6) Tune out the noise – one of the biggest obstacles to simply buying and holding is the sheer amount of chatter you will encounter, whether on TV, in newspapers, or online. Learn to tune it out; finding, buying, and holding quality stocks for the long term is the best way to make money from individual stocks. At best, shows on CNBC or online stock pickers can be sources of ideas as to where to begin your investing, but you shouldn’t buy or sell without doing hours of your own research.
7) Consider sector-specific funds – finally, if you’re looking to get more exposure to a particular subsection of the economy, there are ways to get it without buying individual stocks. A mutual fund (or ETF) that invests in a particular sector of the economy can give you a way to invest in financial stocks, for example, without having to invest in individual stocks. These sector-specific fund give you a greater margin of safety, while still letting you participate in the weakness or strength of a particular part of the greater economy.
Following these rules should help you to expand your holdings beyond mutual funds. If you still need more excitement in your investing life, though, you can always look into speculation. And by sheer coincidence, that’s the subject of tomorrow’s blog article!
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3
Mar
Posted in Investment Pyramid by Roger |
Welcome to the second part of our week -long look at building an investment pyramid. Yesterday, I shared some advice to help secure your finances and get yourself ready. If you took all the steps I recommended, you are now in good shape to begin investing. But, where to start?
Your first steps into investing should be as broad-based as possible; the market can be volatile, and having wide-ranging holdings is the best way to minimize just how much risk you take on. In other words, diversify, diversify, diversify!
The best method to diversify your holdings is by using mutual funds. Mutual funds are essentially collections of investments, such as stocks, bonds, or other assets, that are held by the mutual fund company. The fund, in turn, sells shares to investors. Buying shares of a mutual fund gives partial ownership of all the assets held by the fund; if a mutual fund you invest in owns stock in one hundred companies, you will own a small portion of each of those company’s stock.
At LEAST 70% of your investment money should be invested into broad-based mutual funds; if you’re conservative or just don’t want to be bothered with lots of research, you can go all in on mutual funds, and your investments will work out fine. There’s no need to get any more complicated than mutual funds if you don’t want; mutual fund companies make mutual fund investing complex enough already. There are thousands of mutual funds currently in existence, divided into numerous categories and groups based on what assets they hold. Some of the broad categories used by mutual fund companies are:
-US Stocks – One of the biggest and broadest categories is mutual funds that own stock (partial ownership stakes) in companies based in the US. There are numerous ways that these stocks are divided up: on the basis of company size, growth-oriented (that is, companies that are increasing in size) vs. value-oriented (companies that are selling for less than their intrinsic value), and those that are managed by humans as opposed to those that simply buy all the stocks in a particular index (called index funds, appropriately enough).
US Stock funds will typically form the bulk of your portfolio, especially if you’re young. The growth potential of stocks is among the highest you can get from investments, and making sure your holdings take advantage of that growth will help to meet your investment goals. If you don’t have the time (or the interest) to do in-depth study on the many, many US stock funds that exist, you can simply buy a total market index fund, like Vanguard’s VTSMX, and essentially own the entire market.
-Foreign Stocks – There are companies located in countries other than the United States, of course, and foreign market funds invest in stocks based around the world. Frequently, these stocks are divided up based on the home country of the company (into European or Pacific Rim companies, for example) or how developed the country’s economy is currently (into developed or emerging markets).
Foreign stock funds add more diversity to your holdings; if you’re entirely in US stocks, troubles with the domestic economy could drop your portfolio, as well. Holding foreign stocks lessens (but, does not eliminate) the possibility of all your investments being down at the same time. Again, a broad-based, whole foreign market fund, like the VGTSX from Vanguard, provides an easy way to get your desired foreign exposure.
-Bonds – Bonds are essentially IOUs, pieces of debt from companies or government that need to borrow money and agree to pay it back, with interest. They come in a variety of flavors, from US government bonds (Treasuries, essentially your own little piece of the national debt) and municipal bonds (used by cities to meet their expenses) to corporate debt. The latter is rated and grouped according to the estimated risk of default, and grouped into investment grade (the ones that are unlikely to default) and ‘junk’ (bonds that are quite likely to default, and thus pose a significant risk).
Bonds are primarily used to help stabilize your portfolio; because they aren’t as volatile as stocks, holding a portion of your assets in bonds will tend to blunt the pain of downturns in stock prices. Unfortunately, the same holds true on the upswing; high bond holdings will limit how much your investments can grow. As a result, if you have a significant time before retirement, more than twenty years to go, for example, you’re probably best served with an all stock portfolio. When you’re approaching retirement, slowly adding to your bond holdings, in a short-term bond fund like VBISX from Vanguard, will cushion your portfolio and make your investment life a little less harrowing.
-Money Market – money market funds invest in short term debts, and offer fairly low dividend payments to their investors. They are designed to keep a stable price of $1 a share, and are considered exceedingly safe (last year, the Primary Reserve Fund created waves when it was the second money market fund in history to decline in value). These funds typically generate interest rates in the same neighborhood as that available from online savings accounts.
While you’re young, money market funds are probably used for storing your emergency fund. They’re very stable, but offer almost no growth; most of the time, you’ll barely keep up with the rate of inflation. When you are approaching retirement, though, increasing the amount of money you have in ultra-safe investments will give you somewhere to start drawing the income you’ll need in retirement. Having three or four years worth of expenses in a money market fund like VMMXX from, yes, Vanguard, will give you a nice cushion to wait out a market downturn, while limiting the need to sell your other assets until they recover.
Simple Mutual Fund Plan – If we put together all the features we’ve been discussing to this point, we can come up with a simple, fairly conservative investment plan for a lifetime. When you start investing, put 30-50% of your money in a foreign total market fund, the rest into a total US market fund. When you’re about twenty years from retirement, start to transfer money (using new money as much as possible, to avoid selling off your stock funds) into a short term bond fund, increasing the portion of money in the bond fund each year. So, 10% in bonds with twenty years to go, 20% five years later, 30% at ten years to retirement, and 40% with five years before we get to retirement. With less than five years to go, start to add to your money market funds, building up a sizable cash cushion for when you need to start drawing down your funds, and you should have a smooth retirement.
That’s essentially my plan for my investments (although, being the nerd I am, I couldn’t resist complicating it just a bit). It’s pretty simple, but the best plans usually are. If you do want to look into other investments, you’re in luck: we’ll be covering those in the next few days.
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2
Mar
Posted in Investment Pyramid by Roger |
This week, I’m going to share my thoughts on creating an investment pyramid for the rest of the week. Because nothing makes investing fun like adding pyramids; if it works for nutrition, it should work for money-management!
All this week, we’re going to be building an investment pyramid. Building on a solid foundation, creating an appropriate set of investments, and working towards your hopes and dreams are good steps for anyone to take, and now, I’m going to share my thoughts on creating an investment pyramid of your very own. We’re going to start by creating a solid base on which to add our investments:
Building an investment pyramid is like building any large structure; if you don’t build on a solid foundation, it’s going to sink into the ground, leaving you with no pyramid and a great big hole. And nobody wants to spend their retirement in a huge hole in the ground.
There are many things you may need to do to get your financial foundation in order, enough to fill an entire week of posts (which is a nice thought for the next time I’m out of town for the week), but here are a few basics. If you can take care of all of the following, you should be in good shape to start investing. You’ll also be in pretty good shape for life:
1) Have a reliable source of income - If you don’t know whether there will be any money coming in next week, then your first priority has to be to SAVE, not to invest. Yes, you will miss out on some of the benefits of compounded earnings over time. But if you end up selling off your investments to pay the bills, you might end up taking a double hit: not only won’t that money be working for you, but you could lock in short-term losses, and have less money available for the expenses. If you don’t have a ready source of income, whether from a steady job, freelance work, or unemployment, your first task is to save until you acquire a regular money stream.
2) Spend less than you earn – Alright, so you’ve got money coming in on a regular basis. That’s a good start, but if you’re spending each paycheck as soon as you get it or have to stretch to make it from paycheck to paycheck, you still have some work to do. This sentiment goes double if you have to use credit cards because you’re spending MORE than you earn.
For the long stretch, you should try to increase your income, by making yourself more valuable at work, creating alternative income sources (like, say, a blog), or even working a second job, if needed. In the short term, it’s easier to trim your expenses and pocket the difference, by cutting out regular purchases such as lattes… But even when you have a little breathing room between your income and spending, you are not free yet.
3) Take care of your expensive debt – I touched upon the idea of cheap and expensive debt briefly when I talked about student loans, but the basic idea is this: paying off debt you owe to others at X% interest is the equivalent of getting an investment return of X%. If you put $1000 in an investment that grows by 10% annually, you’ll have $1100 in a year; if you pay off $1000 in debt at 10% interest, you’ll save $100 in interest over the next year. In either event, the effect on your net worth is the same: you’ll be $100 richer one year from now than you would be had you simply kept the $1000 in an envelope at your home.
In fact, paying off your debts is even better, because the return you get by paying down a debt is guaranteed, unlike most investments (especially now). Add in the high interest rates that you might be paying on credit cards (frequently in the 20-30% range), and cutting down on your consumer debt is a great investment, probably the best one you could make. If you have any debt that is charging more than you can reasonably expect to earn by investing (8% is a fairly conservative number), focus your energy and extra money paying it down first.
4) Set up an emergency fund - So, you’ve eliminated your (expensive) debt, have a regular income, and spend much less than you bring in; time to start investing, right? Not quite yet… If you run into financial trouble in the future, you need to be able to get past it without selling your investments. If you don’t have a stash of money set aside for unexpected expenses or a potential loss of income, you might have to sell when your investments have gone down or add expensive debt just to get by.
There are many different places to build and store extra money for your emergency fund; the key is that it be safe (you don’t want this money to disappear on you right when you really need it) and accessible (you should be able to get at the money if the need arises for a large, one-time expense, like car repairs). Two good options are high-yield, online savings accounts (I have accounts at ING, HSBC, and SmartyPig) and money-market mutual funds, as offered by mutual fund companies such as Vanguard.
How much to put in the emergency fund is the subject of endless conjecture from financial writers; I’ve heard suggestions ranging from two months worth of expenses (for someone with no dependents and a relatively secure job) to one year (for those with little tolerance for risk and multiple people who depend on their income). Enough money to cover six months of expenses is my goal, but if you want a more specific answer, you’ll have to ask yourself some hard hypothetical questions:
-If my car breaks down, how much would it cost to fix? How long could I get by without using my car? If I need to get another vehicle, do I have the money available to afford it?
-If there’s a problem with one of the appliances, can I afford to get it fixed? Are any of the appliances nearly the end of their lifespans? If so, can I afford to get new ones?
-Is there any part of the house that needs repair? If so, how important is the needed repair? Are there any known problems that might need to be fixed in the future? Are they structural or superficial; that is, can we still live in the house if we delay the repairs, without having to worry about our safety?
-If I lose my job, how much could I expect to get in unemployment? How much would I need on top of that to cover the monthly expenses (including COBRA or other medical, if my employer isn’t providing it anymore)? Is it reasonable to assume I’ll get another job before the unemployment benefits run out? If not, how much more should I have in the emergency fund to cover the period between running out of unemployment and getting another job?
These are all difficult questions, most going far beyond a simple matter of how many months of expenses to keep in your account. The main thrust is this: make sure you have enough money on hand to cover any costs you are likely to face, without having to float them on your credit cards. Your emergency fund is a buffer, keeping you from piling on debt or pulling money from your investments, allowing the money you’ve invested to keep working for you.
Once you’ve completed all four of these steps you should be ready to invest. You’ll have more money coming in than going out, no high-interest debt holding you down, and an emergency fund should some unexpected problem arise. The only question is, how to invest? Which, luckily for you, is the subject for tomorrow’s blog entry.
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