More Free Financial Advice for 2017 Part II

In my last post I talked a little about paying off debt and creating a budget. I also went over some basic rules about credit and possibly applying for a mortgage. But in this post I am going to talk about saving and investing, and most importantly automating your savings I will explain what I mean.

Before we get into in the intricacies of investing let’s talk about automating you savings. I read this somewhere and though it was somewhat of a silly notion, but believe me it works. Take a look at your budget and determine what you can afford to invest. Once you have that number you should automate your savings accounts to withdrawal that amount from your checking every paycheck. This takes the dollars out of your hands before you can spend it, which is a good thing, and it also holds you to your budget. Both of these issues are important, what good is your budget if you do not stick to it? So I recommend doing this as eventually you will get to a point where you have learned to live on just a few dollars every month while the rest is going either to pay off your debts or toward your retirement. Speaking of retirement let’s take a look at a few investment options.

First, let’s talk about the 401K or 403B for those in the nonprofit sector, or an IRA if your company does not offer a 401K. Again this is where your budget comes into play, and see how important that budget is! You will again need to see what you can invest in terms of your salary. Most companies offer a match of about 6% or so. At first I was told that at the very least put in what the company will match so in this case contribute 6% of your salary to your 401K account. This is the very least you can do, and as always something is better than nothing when it comes to investing. Also, this is automated so this will automatically come out of your check before you can get your grubby meat hooks on the cash and spend it. So that is always nice.

But once you get some of your debts paid off you need to increase that contribution amount accordingly. Again see what you can afford, maybe 8% or 9%. My advice is try to get as close to 15% as you can. The goal is to try and get to $10,000 contributed per year to you 401K that you personally contribute. If you do that for 30 years that is $300,000 which is not a bad next egg to retire on, and that is not even counting the return on your investments. Obviously it would be nice to max out your contribution, but that is not usually possible, and even the 15% mark may be a stretch, but again it is all about what you can afford. So if you get a small increase or raise every year, be sure to adjust your budget and gradually increase your contribution maybe 1% a year. That is a good rule of thumb or if you are still paying off debts increase a payment by $10 or $20 if you get a raise. Also it is important to remember that you can adjust your 401K contribution amount throughout the year. So if you get a raise mid year go into your account and increase your contribution amount. Or if you had a large car repair or house repair it is okay to lower that percentage and have a bit more cash available, just try not to make this the norm. Remember you have your emergency fund for things like that.

If you are maxed out at this point and have no extra money to spare that is totally ok, you are in a good position and I would not change anything, just keep on keeping on. We will talk about what funds to look at in a minute. But now let’s talk about if you still have additional income and don’t know what to do with it. So you are at the 10%-15% contribution on your 401K and still have dollars left over after your bills are paid. Hoarding that extra cash is ok, but not ideal. $1,000 invested at 0% will get you a return of $0.00, you will get that exact same return with $10,000 or $1,000,000, hopefully you see my point.

What I would suggest is to open a Roth IRA and start contributing to that. This will reduce your overall tax liability when it comes to retirement, as this money has already been taxed, and when you withdraw it you will not be taxed. You can contribute $5,500 to this account for the year which is about $211 per paycheck, if you get paid every two weeks. I highly recommend that if you are able to get to 10% or more on your 401K contribution and still have money leftover then contributing to a Roth is a great idea. Now there are arguments as to if you should focus all your efforts on maximizing your 401K contribution of about $18K per year before contributing to a Roth. Honestly, I am not sure it makes a ton of difference, and like I said it could help diversify your taxes splitting you dollars to a Roth and 401K. So I think if you can get to about 10%-15% for your 401K and max out your Roth, that is a great game plan. If you do that, that is an additional $165K after 30 years in your Roth, but again that is not considering any sort of compounding interest in your Roth. So just by doing these simple steps you could potentially save around half a million dollars from just your contributions, but what is really cool is what happens when you invest it. But we will talk about that in a second. So if you get to the 10% mark in your 401K and max out the $5,500 contribution per year for your Roth and you do this for 30 years you will have near half a million dollars (10,000*30)+(5500*30)=$465K. That is enough to fully fund your retirement so long as you do not try to live like a king. And again that is not counting any sort of return, if you say a 5% return over 30 years you are probably looking at $700K or more. (By the way 5% is very conservative as a return.)

Another interesting thing to remember is that by increasing your 401K percent you are also reducing your current taxable income. Dollars put into your 401K are pretax dollars so essentially you will pay less taxes next year because you had less income. Everyone likes paying less taxes, so there is another reason to save more. But in the end you still have to pay taxes on those dollars just not till you retire, so essentially you are just deferring your taxes till retirement. But that is where the Roth comes into play as again those dollars are tax free. Death and taxes!

So now that you have some money to do some investing, what the hell do I invest in? That is a good question and we can look at some options, and don’t get discouraged regardless of what people tell you it is not overly complicated, unless you make it so. There are a few rules of thumb and honestly you can make this as complicated as you like. The simplest and easiest thing to do is just invest in a Target Fund, which is essentially a readymade fund where you don’t have to do any thinking at all. Just pick the date you would like to retire and that is it. Simple as that, however, this may not be the best scenario. The reason you may not want to go this route is because this fund may not take as much risk as you want or give you the returns you are after. If you do not want to do anything else and are completely comfortable investing in one of these Target Funds, then by all means go for it.

If you want to take a shot at doing some of your own investing here are a few rules of thumb to keep in mind when picking your funds in your 401k. I have read that you subtract your current age from 110 and that number is what you want to put in socks the rest in bonds. So if you are 30, (110-30)= 80, so you need an 80/20 split in stocks and bonds, simple enough. Which means that every dollar you invest $0.80 goes to stocks and $0.20 goes to bonds. But that is just a rule of thumb, if you want to take on more risk by all means do so. I would recommend always, ALWAYS, ALWAYS, invest in INDEX Funds. Never invest in a Mutual Fund, they are more expensive and historically have no better returns than an Index fund. So why pay more for something that is not any better? The cost of a fund is called the Expense Ratio. This is just what the company charges to manage the fund. Anywhere from .60% to .01% is what most funds charge. Index Funds are usually closer to the .01%, so again why pay more for something that statistically has no better returns?

Of that 80% that you are going to put in stocks I would do something like 40% in large cap index funds, these are somewhat medium to low risk. So that leaves you 40%. Depending on your risk tolerance, if you want to take more risk you could do something like 20% in a small cap index fund, generally these are the most risky funds. Then also a mid-cap index fun just for some diversification, again somewhat risky but not overly so. Also I would put 5% or less in an international fund. Personally, I think the international market is in the crapper, and would not put much of my retirement in foreign stocks or bonds right now. Next you need to put about 20% in a bond fund, you can also look at an international bond fun, but again I think 10%-20% in a bond fund is plenty, but again this is to help diversify your 401K.

I know I keep using the term “risk” and I will try to explain what I mean. A large cap index fun is basically a collection of stocks from large probably international companies, like Apple, GE, and Amazon are a few. These companies are doing well and will more than likely keep doing well in the near and far future. So this type of fund is generally not that risky in terms of you losing your money. Mid Cap funds are companies that are big but not as recognizable as the Large Cap ones. This type of fund is a little more risky in terms of these companies having a greater potential to go out of business, and that would mean their stock is worth zero, and intern, your investment is also worthless. Small Cap are the most risky, again these companies are generally small startups and those have the potential to make it big or fall flat on their faces. So again if you want to take on a ton of risk you could invest in all Small Cap funds, but it is best to diversify.

Something else to keep in mind is a way to sort of hedge your losses. So if you wanted to take a bit more risk in certain stock funds you could also invest a little more in a bond fund. Generally bonds are more stable and less risky. So this is a good way to diversify your portfolio and protect against a market downturn.

As far as picking individual funds I always look at the 1yr, 3yr, and 5yr returns. It is not overly scientific. You can also see what exactly what stocks the fund is invested in. All of this info is available on your companies 401K website. Don’t get lost in the numbers, most funds have a snapshot of what they are invested in and what their returns are for the last few years. For the most part the funds that are available through your company are all probably fine to invest in. So don’t get overwhelmed with there being so many choices. I would pick one Large Cap, one Small Cap, One Bond, and put a small amount in an international. If you want to do more that is certainly ok and I would throw in another Large Cap. Depending on age, say 30 or so, I would be willing to take on a bit more risk especially with Trump now in office. I think the market outlook is much brighter in terms of returns and growth. So if you are a little younger I would take on a bit more risk. If you are 45 or older I would be a bit more conservative, and if you are nearing retirement I would be mostly trying to be risk adverse. BUT again I think the market might have a very solid year so something to keep in mind.

Let’s talk about returns now. Above I mentioned compounding interest, this is the main component that makes time and investing so powerful. It is impossible to predict what will happen in the market for the future, but historically the market has returned about 7% over the past 30 years. (Depending on which publication you read this could be as high as 10%.) So for me I think we could expect something similar for the next 30 years. However, I like to be conservative and I almost always use 5% or 4% when doing any sort of analysis for the future. If you do hire an advisor and they show you any projection of your future earnings, the first thing you should as is what rate of return are you expecting? If they say anything above 7%, you tell them thank you and leave. I will also say that you could potentially get that return, but to me I think when dealing with retirement it is better to be conservative. There is no sense in counting on large returns to supplement your retirement, because if you do not get those returns you are in some serious trouble. So just keep those ideas in mind and don’t let advisors paint the pie in the sky.

As far as a personal advisor or financial planner, to me, this is just my opinion, I think it is silly to pay someone 1% of your assests, or anything for that matter, to manage your money. It is honestly something you could do for free. But I think people want that reassurance that someone else is handling it, which is nice don’t get me wrong. I just don’t want to pay for that service, as I can do it myself. That is why I have not hired an advisor to manage my money, I find this stuff very interesting, plus with the internet you have access to unparalleled free information. But if you do not feel comfortable managing your own money, certainly get an advisor, but please do your research and make sure they are a trusted advisor. Just be sure you know how much you will be spending for this service, again 1% to 1.5% is about norm. So if you invest $100K with an advisor that is $1,000 you will pay every year for them to manage your money. Also keep in mind that some advisors will not take a new client with less that X amount of assets. That number may be $50,000 it may be $100,000, it just depends. Again all things to keep in mind when hiring someone to look after your money. Also if you don’t understand what they are wanting you to do, don’t let them do it. Or at least ask them why, or ask them how much they are making on such and such transaction. This is where I said that you should make sure that your advisor is a fiduciary. But again most importantly do not be afraid to ask why?

Why a Fiduciary, but first what is a fiduciary. A fiduciary is someone who is legally bound to act in your best interest. The reason that is important is because when it comes to investing and money an advisor does not have to do what is necessarily right for the client. This is a sticky situation when it comes to investing. An example is where an advisor tells his client to buy X stock or fund, the reason being that the advisor gets a better or higher commission, and the fund is no better than another fund. That fund may not be what is best for the client but the advisor is pushing it because he will make more money off selling it. I am not saying this is the norm, but I think it does happen. So always be careful. But nowadays this has somewhat changed and now advisors charge a flat rate of 1%-2% of total assets invested. That way the advisor will make more money if you make more money, as 1% of $150,000 is more than 1% of  $100,000. So that is a nice check but still I think it is always nice to know your advisor is a fiduciary and acting in your best interest.

Now let’s switch gears a little and look at credit cards. I don’t think there has been a device that has come under more criticism and potentially cause more trouble than these little bits of plastic. However, I think they are great and I will tell you why. Let me say, (and I want you to read this next sentence carefully, pause and reread it), I THINK THAT WHEN USED RESPONSIBILY, CREDIT CARDS ARE ONE OF THE GREATEST FINANCIAL DEVICES ON THE MARKET. I will tell you why. Where else can you borrow someone else’s money for 30 days…. wait for it …. FOR FREE! I don’t know of another financial device were you can spend a bank’s or someone else’s money and not pay them back for 30 days without paying any interest. The problem here is not everyone uses these bits of plastic responsibility, that is the problem. Paying the minimum payment and maxing out your card will destroy you financially! Buying things you cannot afford on a credit card will again destroy you financially. If you use credit cards responsibly they are a great tool to financial freedom. Also do not get sucked up in the rewards programs. You will never ever get rich from these rewards, however again if you use the credit card responsibly you could get a few free perks. So if you choose to use credit cards, do so responsibly, and make sure you pay them off in full every month as it is basically a 30 interest free loan.

The last thing I wanted to talk about was how to choose between paying off debt or using those extra dollars to invest. This is where Dave Ramsey and myself again have a fundamental disagreement. He says that no matter what you should pay off all debts before you start investing, I do not think this is the best practice for those everyone. I would say that for credit cards, so long as the balance is not on 0%, this is probably the case. You should always seek to pay off credit cards before you start investing and here is why. The average credit card is around 15%, its not impossible but very unlikely that you will get that return in any investment in the market. Remember the market average is about 7% a year. Where the situation gets a little tricky is when you have a loan interest rate of like around 5%. A good example is student loans, which are usually around 4.5% to like 7%, I think most are in that ballpark. That rate is easily attainable for an investment. So should you work to pay off your debt or invest those dollars. Ramsey says pay off your debt, but I say it depends on your personal situation. If you want to get debt free then by all means do so, there is nothing wrong with that route at all. The interest on a student loan is tax deductible as well so don’t forget about that. Personally I would do both, so long as you can afford it. I would pay a little extra on my student loan so that it gets paid off sooner, maybe put $30 or $50 more toward it a month or paycheck. Then I would use the rest of my money and put toward my Roth or 401K or both. This is maximizing every dollar you earn. Don’t forget the power of compounding interest, especially for 30 years. So putting something toward a retirement fund is better than nothing and putting little to no dollars in early could cost you big later in life. The reason this strategy works with a student loan or installment loan is because it has a term. So, again, as long as you keep paying that payment it will eventually be paid off. The sooner you pay it off, the less interest you will pay. But again you have to weigh paying off the debt vs. lost investment funds and future gains. It’s tough to balance it all but if you have a very detailed budget you can get down in the weeds and figure out where each dollar is going and reroute it if necessary.

I know we have covered a lot but these are all just things to keep in mind. Also, don’t be afraid if you don’t know something, look it up or ask someone. Never be afraid to ask a question about your financial future, and use the internet just make sure you are getting your info from a reliable source. Another point to keep in mind is that there are a million ways to achieve your financial goals, there is rarely a wrong way, but there is also more than likely a better way. So if you figure out a path to financial freedom stay on it, keep doing research and there could possibly be a better way. Hope this helps in some way.

Manik

 

 

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