Sunday, April 15, 2012
Investing Does Not Have to be Brain Surgery
So many people are intimidated when they hear the term investing. Many find it to be a complex subject, or even a boring one. It does not have to be complex or boring. If you have ever watched Jim Cramer's show on CNBC, you know that people can make it exciting. It is complex if you are looking to be a day trader and buy and sell throughout the day, tracking even the smallest movement of individual stocks. But most are not planning on doing that. Often times, over thinking our investment choices leads to "analysis paralysis". In that case, people get so overwhelmed that they fail to make any changes to their portfolio, fearing that they will do something wrong. We need to find a happy medium when it comes to monitoring our investments. Here are a few rules of thumb that I follow.
1. Decide your level of risk. If you want to play it safe with investments, that is fine. There are choices ranging from mutual funds, to exchange traded funds (ETFs), to certificates of deposit (CDs), to index funds, which will track the performance of a particular fund, such as the Dow Jones Industrial Average or the S&P 500. But, not every investment is created equal. All mutual funds are not winners. Track their average returns from the past few years and see how that fund has performed. Also look at the expenses and fees that are associated with that investment. If your local bank is selling CDs and they only will generate 1 or 2% per year, then that is not a wise investment. Playing it too safe means you will have a small return on your money, if you have any return at all. If inflation is at 3% per year and your investment is returning 3% per year, then you are not ahead of the game. Individual stocks can generate big gains, but they are risky. You could always have a portion of your portfolio set aside for individual stocks, but don't invest money here that you cannot afford to lose. Some tech stocks tend to be volatile, meaning they move up and down rapidly from day to day. These can be bought and sold for short term gains. The first rule of investing is to buy low and sell high. Maybe a stock could be bought for $10 per share, then sold a week later at $20 per share. That is good, but you have not actually doubled your money since you need to consider brokerage fees and tax implications that occur when you sell. So, think before you buy, and think again before you sell.
2. Are you investing for the short term or the long term? Investing for the long term is often accomplished through a 401k plan that includes an employer match. Many 401k plans will allow you to choose from several mutual funds that will comprise your retirement fund. A 401k plan will grow in a tax deferred environment, so that is a big advantage. A Roth IRA is a good choice too, since you pay taxes when it is bought, but then do not need to pay taxes when it is withdrawn, as long as you are past age 59.5. Young people can afford to take more risks than older people since young people can have time available to make back their losses. If you are investing for the short term, individual stocks will often not be a good choice, but they tend to do well over the long haul. Stocks that pay dividends can be a good choice. They are often paid by companies with a long track record of good, stable, financial performance, such as is the case with Procter and Gamble. Dividend stocks often do not have the rapid growth of a company like Google, but they do well over time, and re-investing dividends can add up to a lot of money.
3. Don't put all of your eggs in one basket. In other words, diversify. If you want to buy Apple stock, for example, that is fine, but don't put 100% of your investing funds into one stock. Maybe buy a tech stock and an auto stock and a retailer along with a pharmaceutical stock. Many financial experts recommend spreading around your investments so that each sector has no more than 20% of your money. Diversify your choice of investment vehicles as well as your individual choices. Those who are successful might invest in real estate, stocks, bonds, mutual funds, cash, savings bonds, treasury bills and an IRA. Don't overlook the international funds, since we are in a global economy and significant gains can be made by investing in overseas funds. We have experienced how the debt crisis in Europe has had a ripple effect on US markets.
4. Start early. How early? As early as possible. I wish that I had bought stocks as a teenager. If I did, I would have 25-30 years of growth behind me. Those who start investing early can build a bigger retirement nest egg to protect against financial hurdles that so many face during their golden years. People are living longer. If a person retires at age 65, they might live to 85, so they need 20 years of funds available. Don't assume that social security will still exist 15 or 20 years from now. It might, but don't assume that social security will be a part of your retirement income, since it might not be. It is best to err on the side of caution and save as if social security will not be there. If it is, great, you will do even better financially than you once thought. Also, if social security is solvent, there will be a higher payout if you retire at age 65 versus age 62, and even more of a payout if you can hold on until 70. Someone who starts investing at age 25 versus age 35 will make a lot more to go towards retirement. Time is the best friend of investing. Compounding interest multiplies faster than you think.$1 million dollars at retirement with 6% growth will give you $60,000 per year to live on without touching the principal. $60,000 is good now, but if retirement is 25 years away, the real spending power of that amount will be a lot less. Financial expert Suze Orman recommends taking out no more than 4% of the total value of your nest egg each year during retirement. At age 70.5, it is a requirement to start taking a minimum amount of money out of the 401k and/or traditional IRA. Otherwise, a 50% penalty plus normal income tax will be accrued.
5. Don't get sucked in by fads that you hear about through the media. An example of this is investing in gold. Recently when the commodity of gold reached an all time high, there were commercials and media pundits recommending that people invest a portion of their portfolio in gold. What is the cardinal rule of investing? Buy low, sell high. Why would one want to buy something when it is at an all time high? If you go to a department store and see a sweater that is normally $20, and it is marked up to $50, will you want to buy it? Of course not. Now, selling gold at an all time high would make sense, but not buying it. Financial experts will vary in their advice regarding commodities. Most will say that if you want to invest in commodities, make it a small percentage of your portfolio, maybe 5%. Then again, some suggest zero percent.
* Some information from The Money Class, by Suze Orman