Investments 101: Why should you save for your future?

An investment is money set aside for the future.  So why make investments?  When should people start planning for the future?

A current TV ad for an investment firm shows a man asking various people how much cash they have in their wallets.  Some have $15, some have $50, some have more or less, you get the picture.  The point of the ad is that even the person with the smallest amount of cash on hand has an amount-- that when invested steadily & regularly over time-- can grow to actually make a difference in the person's financial future.

I like this ad because it shows that cash we might spend frivolously does make a difference when set aside on a monthly basis for the long run. The first thing to look at when anyone is starting out is a budget.  You should budget for necessities like rent, food, utility bills (water, electricity, gas for heat & cooking), clothing, car payments & insurance, medical bills & prescriptions, basic furniture and payments on loans.  You might even budget for 'necessities' like eating out at restaurants a couple times a month, vacations, pedicures, getting a salted caramel mocha macchiatto at  Starbucks on the way to work, popcorn at the movie theater-- well, again-- you get the picture.

Necessities, in other words, are not always created equal. Some are more necessary than others, to be sure.

I am not saying not to have fun. Living like a miser is not exactly what I have in mind! When Lewis & I were first married, we did go out to eat on occasion, and we did take a vacation here and there.  But watching the kind of impulse buys you make tells a lot about your spending habits. If you can only have fun by spending money, well, that may be a problem.  What I am suggesting is that you keep track of where you spend your money, keep credit card debt in check, and try to live within your means if at all possible.

Of course if you are a student and paying your own way to go to school, you may be in debt.  This does not make you frivolous with money, it makes you mindful about your future.  You may be spending more than you take in for the time being, but hold onto the thought that this will change!  There are few better investments to make for your future than an education.

In general, living within your means means not spending more money than you make.  It means living within your own personal budget.  Americans in general are not known for doing this well, at least in recent years. I think back to another TV commercial from about 6 years ago that just drove me nuts.  It showed a man in a huge electronics store spotting a big screen TV from across a crowded room that he just HAD to have-- his eyes glazed over, his jaw dropped, and a chorus of angels in his head burst into  song chanting, "I want it NOW!" in heavenly tones.  Needless to say, the ad was run by a big bank's credit card department.  

"I want it NOW!" is not a problem if you're living within your means.  It is a problem if you outspend your income.  It is also a problem if you are not thinking about your future. I wish I could tell you that Lewis & I started investing for our future back in our 20s.  The reality is that we did not, nor did we have family members helping us out financially.  We lived within our means in one sense (including sharing one car for the first 4 years we were married) but did not save much for the future.  Since hindsight is a beautiful thing, I can say now what a mistake that was.

To illustrate that point, and the point that the TV commercial I talked about at the start of this article makes, go on a website with an investment calculator. They are fascinating!  But just in case you don't have the time or inclination, let me share a few scenarios that knocked my socks off.

Let's say you are in your 20s and starting at ground zero. You have no initial investment to make.  You are starting with no cash whatsoever.  Aaagh!  But you sock away $25 a month, which is roughly the price of a no-frills pedicure OR 2 bottles of inexpensive wine OR the price of a medium bucket of popcorn, a large Coke & a box of Junior Mints at the movie theater (actual movie tickets not included). Say you do this for 40 years at a 7% average return.  Do you know what you will have at the end of those 40 years?  Approximately??

$62,000.00. 

Not bad, right??  So in case you are wondering WHY I decided to pick a 7% return on your investment, I'll tell you.  I was born in 1959, so I picked that as my year to start tracking the average return of the S&P 500 (which is a stock index that tracks 500 of the most traded stocks in the US market).  If you average out the return on these stocks from 1959 through December 2013 (or 54 years), the average return over this span of time is 7.33%.  

Were there years that did better than that??  Yes, of course!  Were there years that tanked??  Without a doubt!  But over time, the S&P 500 increased 7%, adjusting for inflation and adding in dividends.

Of course in general people don't start investing with $25 a month without having an initial starting amount of cash to get going with.  Since trading on stocks involves some expense and buying into mutual funds usually has a minimum investment, I suggest saving up a small chunk of untouchable change in your checking or savings account until you are ready to make your move into the world of investing.  

Where to start? A $1,000 opening investment can buy you into an account such as Vanguard's STAR fund, a relatively tame risk vs return mutual fund (actually it's a fund of funds, but more on that down the road) that has returned 9.77% since its inception in 1985. (Of course that is before taxes and sale of fund shares, but that topic is for another day entirely as well!!)  That's just one example of so many available it's hard to believe the choices that are out there!  

Inflation, Taxes and Fees

There are many kinds of investments.  Investments can be in the stock market, bond market, real estate, precious metals, certificates of deposit (CDs) or small businesses. Investments can also be in mutual funds and exchange traded funds (ETFs). 

Mutual funds are investment opportunities that are comprised of a grouping of stocks and/or bonds as well as a little cash in some instances. Money market accounts and savings accounts are also investments in one sense, but the yield (or interest rate) paid to you for these accounts-- while stable and possibly even FDIC insured-- is also very low.  So beware: not every place you can place your hard-earned income is a money maker over time, and some can even be money losers.

A word about collecting--  whether it be art, antiques, cool cars, stamps, jewelry or baseball cards-- is not investing.  It's a hobby, where something you love owning may-- or may not-- become more valuable over time than what you spent on it.  For the most part, when we tune in to Antiques Roadshow, we are seeing the occasional person who brings in the rare and elusive treasure we all dream of finding hidden in the attic!  You are not seeing all the hundreds of people who are not being filmed, the ones who brought in the painting of white-jump-suited Elvis on black velvet that Aunt Wilma got on a road trip through the Smoky Mountains in 1969.  So collect what you love and enjoy what you have, but do not count on these items to have any monetary value.

Inflation: it's not just for balloons

Back to money! Right now, the average money market account, savings account and CD are making close to no money whatsoever.  Considering the inflation rate so far for 2014 (even at a relatively low 1.7%), keeping money in a money market account will actually lose money over time.  Personally, we have a Vanguard money market account that is used as a parking area for liquid assets ('liquid' means those particular assets are available to be converted to actual cash for immediate use). We have some liquid assets which we may need to pay bills. This account is electronically linked to our bank's checking account so that cash can easily be transferred from one place to the other quickly if need be.

Inflation occurs when there's an increase in what we pay for goods and services over time. When I was a child in the 1960s, I remember candy bars going up in price from 5 cents to 10 cents-- now that's inflation!  Inflation calculators show the buying power of our money over time.  So that same candy bar which was a dime in 1967 is now on average 71 cents.  The cumulative inflation rate in that span of time was 612.7 for candy bars%.

Not all goods and services have the same inflation rate, though.  Inflation on college education tuition has increased disproportionately compared to inflation rates on goods like food, clothing, gas, etc.  From 2003-2013 alone, college tuition went up by nearly 80%, almost 2 times faster than even a pricey area like medical care.

According to a NY Times interactive college cost calculator, the average 4 year in-state public school student living on campus paid just over $18,000 per year in 2009 for college, room & board.  If the cost of college inflation stays at an annual rate of 1.7% per year, a baby born in 2009 can expect to pay over $56,000 per year (in 2009 dollars) for her freshman year tuition of the exact same kind in 2027.  Ouch!

So when making investments, inflation should always be taken into account.  Inflation, taxes, and brokerage fees are all insidious places where we may be losing money when making investments.

I'm not writing this to scare anyone, but these are facts worth considering when deciding how to invest money for your future.  Whether you're saving for a big event, buying a home,  your child's college education, or for retirement, it's a good idea for you to get a real feel for how much money you are really making on your investments.

So let's take a look at how certain factors take a bite out of your investments. In the chart below, you can see the historic rate of return on 5 different types on investments. The least risky investment paid just under 4% per year. The riskiest paid just under 12% per year. 

Historically, the inflation rate has averaged out to be about 3% over the past 85 years.  How does this-- and the taxes we pay-- affect your purchasing power (financial ability to buy stuff)?

Taxes join inflation for a good time

Well, let's say you go for a fund of large US stocks as an investment.  Our chart above says that the historic rate of return on this option is 9.8%.  Historic charts often illustrate what the past 10 years have revealed, and they like the nice round number of $10K to be their initial investment. 

So if you invest $10,000 in large US stock companies (without any additional contributions), you may end up with about $25,500 in just 10 years!  That is, until you factor in the following very real considerations:

• your state marginal tax bracket (ours is around 6.65%; yours may be more or less)
• your federal marginal tax bracket (anywhere from 10%-39.6%)
• an estimated annual inflation rate of 3% (remember this varies from year to year; this year's inflation rate is considerably lower)

For Lewis & me, after taking inflation & taxes into account and figuring the average inflation rate of 3%, the purchasing power of this exact same investment is reduced to just $14,500.  These factors reduce the return to a much lower  3.7%. 

If we decided to go with the more conservative (less risky, but less return than the stock funds) investment of taxable long-term government bonds (which has a 5.7% historical return), the outcome is lower still.  No surprise there! Our investment after inflation & taxes are factored in would be approximately 1%.  Yes, most likely it's safe, solid and dependable, but awe-inspiring??  Not so much. But it still beats a savings or money market account, not to mention stuffing cash into our mattress.

Taxes are one of the very best reasons for you to invest in your retirement account NOW!!! 

• First, contributions to retirement accounts such as 401Ks , 403bs (retirement savings programs offered by many employers) and traditional IRAs (individual retirement accounts) are actually subtracted from your taxable income when you file your tax return, which  may put you in a lower bracket than you would be if you didn't invest your money. That is a good thing!!
• Second, money you tuck away in retirement accounts AND the money you earn on the investment is not taxed until you withdraw from it upon retirement.
• Third, the tax-rate on your saved investments will probably be considerably lower in retirement than it is while you are working, as it is unlikely you will be making as much money.  So you may very well be in a lower tax bracket and get to keep more of your investment return!!  Yahoo!

Fees: yes, someone else also wants a cut of your money!

I haven't even touched on fees yet, another area where someone has their hand out to take a chunk of your investment money.  Buying and selling individual stocks has a price tag which can vary enormously depending on where you choose to do business. As for a mutual fund, you will indirectly pay for its  manager, as well as legal expenses, accounting & auditing fees among others. These people make money whether or not the stock market goes up or down.  On another day I'll talk about load vs no-load funds, another fee to be aware of while investing. If someone tries to sell you a 'loaded' mutual fund, do not buy it without first truly understanding what the deal is!!  In fact I recommend steering clear of loaded funds entirely.

Not all mutual funds of comparable investing categories charge the same amount, either. For example, Vanguard, T. Rowe Price and Fidelity all have retirement funds for the target date of 2030.  Year-to-date (as December 2014), they have made 4.74%, 4.20% and 3.53% respectively. 

Their fees, however, are interesting to see: Vanguard's expense ratio is the lowest at  0.17%.  Next comes T. Rowe Price at 0.73%, and finally Fidelity's is 1.02%.  A fund's expense ratio is the amount your account is charged per year for the pleasure of doing business together.  If the mutual fund losses money, guess what??  You still pay.  Looking at these numbers makes the Vanguard account the most attractive-- in this particular case.

In this example, the fund with the lowest return of 2014 also has the highest fees.  This is not always the case, however, so it pays to look into returns over time and expenses in several places.  Magazines like Kilplinger's and websites like Morningstar can give insight into investments which can be very helpful. So can each brokerage house's websites, which are often a fountain of information.

Keep in mind...

Also-- in case you missed it on the Morningstar chart above, "Past performance is no guarantee of future results."

Just because historically the stock market has behaved in certain ways does not mean it will remain a steady slope aiming upwards.  In reality, it has been more or less a pretty wavy line, but in general  aiming up!  Investing is a long-term activity. Day trading is not too different from gambling in my humble opinion.

Much of investing comes down to risk vs reward.  That speaks to your comfort level in tolerating risk & the unknown of the future. It also comes to diversification.  That means not having all your eggs in one basket.

Stocks: For the Long Term

"Buy good companies. Don't pay a lot for them. Hold them for a long time."

Where is this quote from? It is paraphrased from something Warren Buffet once said. The original quote is actually this:  S

 "Build a snowball on top of a very long hill, start very young and live a long time. Keep expenses low."

That snowball has to roll down the hill to grow bigger & bigger.  Obviously. Good advice from the 2nd wealthiest person in America (fellow philanthropist Bill Gates is #1 for 2014).

So what does Warren Buffet mean when they say to buy good companies??  They don't mean go out and literally buy the whole business, they mean to buy ownership shares of a corporation.  They mean to buy stock.

When you buy stock, you are literally becoming a partial owner of the company.  Stocks are traded in what are called exchanges. These exchanges are located worldwide. For example, the NYSE (New York Stock Exchange) is one of the most famous of these.

Companies sell stocks to raise money.  When you buy a stake in a company, you pay whatever the shares cost.  This gives the company more money to invest and I'll say it again-- makes you a partial owner.

Companies can also raise money by borrowing.  Bonds are essentially loans  that a company or the government will pay back over time, with interest. Bonds do have their place in investing, but in general, stocks perform better than bonds.   

I will go into more detail about bonds on another day, but for now let's focus on stocks.  Which brings me to a few more Warren Buffet quotes:

"Price is what you pay.  Value is what you get."  

"Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

"You can't buy what is popular and do well."

“Never invest in a business you can’t understand.”

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

“Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.”

So in general we are seeing some pretty sound advice:

What something costs and what it is worth are often 2 different things.

Buy good, solid quality items on sale rather than buying over-priced and/or poorly constructed stuff that may fall apart after a few years.

What's hot today may not be so hot tomorrow. Buy what you can live with comfortably, whether it's a comfortable, well-made couch or a safe, solid dependable car.  It's your money, so choose wisely!

Know what you're buying and ask yourself, will people still be interested in 20,30, 40 years?  Coca Cola has been around since 1886 (with a few notable ingredient modifications to its mainstay product). Clearly people have stayed interested for the long haul.

Beware of bank savings accounts or any money market account.  They have their place, but are for one thing and one thing only in my opinion: a parking place for money you intend to spend on life's necessities. It's the money you use to pay bills or have on hand in an emergency.

So with these concepts in mind, we can start to weed through the over 6,000 publicly traded stocks!!  

Embarrassing moments and more...buying my 1st stock!

My first adventure with the stock market was in 2006 at the age of 46 years old.  Well, better late than never, right?  Of course Lewis & I already had stock exposure in the form of mutual funds.  But I wanted to learn to pick & buy individual stocks, and I spent some time cautiously exploring my options.

At that time I primarily relied on advice from a premium subscription to Morningstar. This subscription costs around $199/year now, and while I am unsure I will ever subscribe again, it was a good move for me at that particular time.  Now I use other tools to help me make decisions, but I really learned a great deal from Morningstar and found it an invaluable resource.

So after a great deal of time and a few mild anxiety attacks, on April 27th, 2006  I took the plunge into uncharted territory: I bought our first single stock: Microsoft.

                                                                                                                                                   Getting feet wet!

Now comes the disclaimer: this does NOT mean I am recommending that YOU rush to buy this stock!!  All I am saying is that I bought this stock, and nearly 9 years later I am happy to say we still own it.  I fully expect to own it for another 10-20 years at least.  But whatever single stocks we own and has does well for us does not mean I am recommending that you add it to your portfolio.

So moving on--

Microsoft was a good choice for us on many fronts.  I followed those Warren Buffet rules I wrote about previously: I bought something of value. Microsoft is a quality stock.  It has great name recognition, and I understood what the company did.  It was one of the stocks that comprised the Dow Jones Industrial Average.* Microsoft was not a trendy stock, but was considered a solid buy.   I knew who Bill Gates was, and it seemed to me that he did pretty well with Microsoft.  So why not me??  On an ever-so-much-smaller scale??

So what could go wrong, you may ask??  Turns out there is a learning curve for so many things in life.  It makes me laugh (now, not at the time), looking back at what I did when I bought. I want to share the error I made here. 

Let me be clear: That error had absolutely NOTHING to do with Microsoft stock itself.

So here's what I did, the ever so considerate, ever so thoughtful person I was.  When I bought 100 shares of the stock for $27.08/share, I did so with extreme caution, believing I was being responsible.  I bought with using a stop-loss order.  Fear of losing money was a real pressing issue for me, and by God I wasn't going there!  Or so I thought.

What this means is that I decided that if the stock dropped by a certain percentage, I wanted to sell my holdings to 'stop' my losses.  I felt terribly responsible that I had thought to do this ahead of time, and set up my order so that if the stock dropped by 10%, the stock would automatically sell at the lower price before it could drop any lower. 

I thought this was a really good idea.  But I had forgotten a basic Warren Buffet rule of thumb (even though I had followed every other idea to the letter!), which I will paraphrase here: Only buy something you'd be happy to own for many, many years. Buy good stock, and hold.

Because you guessed it: Five days (5!! That's IT!!!) after I purchased Microsoft, the stock price randomly dropped by 10%!!  For no reason I could discern at the time, the stock price just fell.  And my brokerage account at Vanguard did EXACTLY what I had programmed it to do: it sold all 100 shares for $24.23 each!!  Aaagh!!!

So in 5 short days, I had managed to lose nearly $300 on my first ever attempt at stock investing.  I was horrified. Not only was I horrified, but I was ridiculous enough to call up a rep at Vanguard to try to explain that I hadn't really meant it!  I wanted my original investment back, and hadn't really meant it when I'd put in the stop order!! Needless to say the very patient & incredibly kind person I talked to  thought I was pretty funny. What a way to start my investing adventures.

                                                                                                                                                        How embarrassing!

This story is brought to you by a person who learned the hard way that you don't buy high and sell low. If you can at all help yourself from doing so!

I mentioned that we still do own Microsoft. My decision to re-buy the very day of this debacle was the equivalent of getting back on the horse that had just thrown me.  I humbly re-bought at $24.19/share, and have held ever since. 

Since then, Microsoft has gone up in price, but not always.  The stock price hit a crushing low on April Fool's Day 2009, trading at $14.87.  I held.  If I had had the resources with which to do so, that point in history would have been the time to go "sale" shopping and buy more!  At the end of 2014 Microsoft hit its all time high of $50.05. It has gone down again into the mid-$40 range as I am writing today (July 2015). 

The target price for Microsoft for the next 12 months (according to Reuters, July 2, 2015) is a mean (average) of $50/share, with a low of $37/share and a high of $60/share.  That does not make this a powerhouse growth stock in any way.  But I love the current dividend of $0.31/share quarterly (4 times a year) which we reinvest into buying more Microsoft stock, and yes, I plan to hold for the long haul.

*Only 30 stocks are in Dow Jones Industrial Average index!!  Unbelievable!  It illustrates how 30 large publicly traded American companies have been bought & sold each day in the stock market.  The DJIA has existed in its most current mode since 1896, and General Electric is the only stock that been a part of this index from that time on.