Family Finances V – Investing I: Learn your ABCs

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Family Finances V – Investing I: Learn your ABCs

Postby WiseNLucky » Sat 04 Nov, 2006 06:34 am

Family Finances V – Investing I: Learn your ABCs

William Bernstein, the author of one of the source books I’ve referenced at the end of this post, famously said “If you really want to become proficient at [investing] you are going to have to log off the net, turn off your computer, and go to the bookstore or library and spend several dozen hours reading books.”

I concur with Mr. Bernstein, at least in part. The interesting thing is that you don’t need to read very many books, not nearly as many as you would think. In fact, if you were to read all of the books I’ve referenced, you would be better prepared to handle your own investments than the vast majority of the US population. I’ll make a few points in this post that I hope will encourage you to engage in the behavior that will give you the investing results you will need to retire comfortably when that time comes.

I would like to preface my remarks by pointing out that I am a financial professional. Despite that, my college education and subsequent work career provided me with absolutely none of the skills I’ve developed in personal and family finance. Everything I’ve learned has come about through personal experience and by reading the books I’m recommending to you. But I can tell you that the principles provided actually work! So on with our investing primer.

There are essentially three things that will determine the net return in total dollars of any long-term portfolio of investments. They are, in order of importance:

1) Time
2) The cost of investing
3) The allocation of invested assets among available investment vehicles

We began our discussion of the importance of time on our final investment results in the last lesson. We will continue that discussion in this lesson and provide some instruction on the bones of personal financial investing. Lessons VI and VII will discuss the costs of investing and the allocation of your invested assets, respectively.

For an additional object lesson about the impact of time on the final balance in an investment portfolio, let’s start with a couple of teenagers. Teen 1 decides to begin working a summer job at age 16. Each birthday, beginning with her 17th birthday, Teen 1 deposits $2,000 into a Roth IRA. She does so for each birthday until her 24th birthday, after which she no longer has the resources to continue her saving and investing plan. She invests her Roth money in the S&P 500 index which, over the 50 years of her investing lifetime earns its historical return over the last 75 years of approximately 13%. Edited to add: I do not believe such a rate of return is possible in the future. I have no idea what future returns will be. For my own portfolio assumptions, I use 7%, but your guess is as good as mine what the final answer will be when I die or deplete my portfolio. I will tell you then what I should have invested in!! :D She sets her initial account up to reinvest all dividends and she never opens a statement until she sits down to assess her retirement options on her 65th birthday.

Teen 2 does a lot of stuff between age 16 and age 24, but none of those things involves saving any money for retirement. Still, at the comparatively young age of 24, Teen 2 gets serious about saving and investing and deposits $2,000 per year in his Roth IRA beginning on his 25th birthday. He continues to make these deposits every year of his entire working career and his last deposit is on his 64th birthday. Again, he reinvests all his dividends and doesn’t open his statements until his 65th birthday.

Teen 1 will have saved and invested a total of $16,000, or $2,000 per year for eight years. Teen 2 will have saved and invested a total of $80,000. As you might imagine, both of our former teens will end up with a rather nice retirement portfolio. But, as you also might have guessed given the nature of this object lesson, Teen 1 will end up with much more money than Teen 2. Teen 1 will have $3,828,000 at retirement, a full $1.5 million more than Teen 2’s $2,290,000. So Teen 1 invested only 20% as much money as Teen 2, but by starting eight years sooner Teen 1 harvested 67% more money at the end.

This is the biggest message I have to give. If you aren’t getting it, I can’t help you. Time is literally money in the investing world. Your money!

As a reminder from our previous lesson, if you have entered the world of employment and if your employer has a 401(k) plan option with any sort of match at all, you must begin using that plan today. That’s true regardless of your age. That means that you must resolve your financial equation around the fact that you need to take a portion of your pre-tax income and put it into your employer’s 401(k) plan. You must not turn down this opportunity to receive free money and to allow your funds to grow for the absolute longest time possible.

In my discussion about the time value of money in the previous lesson, I used an average return of 9% to determine the outcome of the example portfolio. In the example above, I used 13%. You probably are asking yourself where those return figures came from. You are probably aware that money market accounts and bank savings accounts provide returns far below those figures. So where do we invest our money to get higher returns?

In order to obtain higher returns than bank or money market rates, we must put our funds at risk. I won’t go into a long dissertation about risk but will point out a few types of risk for which we get paid and some for which we don’t. Obviously, we want to take on only that type of risk for which we will be compensated in the long run.

As you all know, gambling your money places it at risk and there is a chance of payoff for taking that risk. But gambling is not an acceptable form of investing because it is set up for the ultimate payoff to go, long-term, to the house or bank. In other words, gambling games and rules are set up so that the totality of players will lose. Its attraction is that, over the course of the game, some of the players will win. Those potential winners draw in others that will not win so that the house comes out in the end. You would be wise not to gamble with your investments.

There are a number of ways that people can invest; that is, ways they can place their funds at risk but obtain an acceptable return on their investment for taking on that risk. We will focus on only two – the purchase of stocks and bonds. If you develop an interest in other forms of investment vehicles, you can learn how they work and take a portion of your investing capital and try them out. I have been quite successful in my investing activity and have found no personal need to use any more exotic investments than stocks and bonds.

Investment options beyond stocks and bonds are much riskier and require knowledge about investing far beyond what the average investor will ever be able to acquire. There are no magic formulas for mitigating that risk. It is notable that the most successful investors of the last century have limited their investments to stock and bond types of vehicles with some real estate thrown in.

So, what exactly are stocks and bonds?

A bond is a debt instrument. You essentially loan your money to someone else when you buy a bond. In return, they agree to pay you back the money you have loaned them at some specific date in the future and to pay you interest on the money you have loaned them in the meantime. The interest rate they will pay you is most often set at the time the bond is sold although there are investments out there where the interest rate fluctuates over the bond period.

There are two significant forms of risk that come into play in a debt investment; you have risk that your debtor will not pay you either the interest or principal (or both!) they have agreed to pay and you have risk that interest rates will change between when you loan the money and when you get the money paid back to you. The first risk is obvious while the second is not. If interest rates go up after you have loaned your money to someone, then you lose the higher interest you could have earned if you had waited to invest your money until after those rates rose. The value of your investment has therefore gone down; if you were to sell your bond after interest rates had risen, you would get less than the face value of the bond. This is because the potential investor who would buy your bond would have the option of going out into the marketplace and buying a different bond at the prevailing rates. The reverse would be true if interest rates were to go down. Since you are still getting the same amount of interest, you are earning higher than the prevailing rate. If you were to sell your bond, you would get more than the face value of the bond.

The longer term your bond is, meaning the longer your debtor has before they have to pay back the money you have loaned them, the more risk there is of a change in creditworthiness or interest rates. As a result, long-term bond interest rates should be higher than short-term rates. This has not always been the case. There have been times during which short-term and intermediate term bond interest rates have been higher than long-term bond interest rates. This means that you may not be compensated for the additional risk you take on by buying long-term bonds. For this reason, many investment advisors recommend using only short or intermediate term bonds in an investment portfolio.

The more creditworthy your debtor is, the less risk you take on. For instance, you can lend money to the US government at very low risk. In exchange, you will receive a lower interest rate return from more creditworthy debtors. They have many sources of borrowed capital and need not pay as much to borrow money. As you may have experienced being on the other side of the equation, when you needed to borrow money, the more you need the money and the less able you are to repay it, the more you have to pay to borrow it if you can even get someone to lend it to you in the first place. Businesses face this same dilemma; bonds sold by businesses of low creditworthiness are often referred to as “junk” bonds which pay a high interest rate compared to prevailing rates. You should probably avoid junk bonds when putting together your first investment portfolio.

The advantage to bond investments is that, if you get the interest and principal payments on time, you know exactly how much money you will get in the future and when you will get that money. That is the downside of bond investing as well. The company you loaned the money to would not have borrowed it if they did not have an idea of how to take your money and make even more money with it than what they have to pay you. If the company that borrowed your money is wildly successful, you receive no additional compensation for having provided the funding in the first place. Because of this, returns on bond investments have historically been lower than returns on stock investments.

A stock investment is an ownership instrument. When you buy stock in a company, you become a fractional owner in that business. If the business is successful, you share in the success of the business along with all of the other owners. If you get in on the ground floor of a company that is wildly successful, you will be wildly successful with your investment. There are many Apple, Microsoft and Wal-Mart millionaires out there. The flip side is that, if the business is not successful, you almost always lose your entire investment in stock. This is a very real and substantial risk. Any assets of a company that goes out of business must go toward its creditors; owners of stock are last in line when it comes to distributing assets. There are former stockholders of Enron and WorldCom out there who have learned this lesson all too well.

As an additional form of risk, investments in company stock tend to fluctuate up and down over time, often quite significantly, as the company goes through more successful and less successful periods. This risk is that, if you were to suddenly need your money during a period of downward fluctuation, you would receive a much lower return than you would normally be entitled to.

Because stock investments are inherently more risky than bond investments, they tend to provide a higher return over the long term. That’s as it should be. The problem is that this higher return is harder to turn into cash that the investor can actually use. Bank or money market investments stay very level and are almost always immediately available if the cash is needed. Bond investments tend to be very liquid as well; you can sell your bonds on the open market based on the current creditworthiness of the company and prevailing interest rates. You are getting your interest payments during the term of the bond as well. But while you can usually count on stocks to go up in value over a very long period of time, you have no idea what the price of a stock is going to be on any given day. Some companies distribute a portion of their success in the form of dividends, providing cash benefit to their owners. For the most part, however, the return on investment for a stock investment comes in an increase in stock price over time. You harvest that return only when you actually sell the stock.

For this reason, it is very important that you never take money that you may need in the near future and invest it in the stock or bond market. The risk that the value of your investment may go down between the date of the investment and the date you need the money is simply too high! Also, the tax burden on short term fluctuations in stock and bond investments is much higher than on long-term investments. It pays to avoid short term expectations in a long-term investment vehicle.

We’ll close out our primer on investing by pointing out that purchasing individual stocks and bonds can be quite expensive and often requires a significant up-front amount of capital. As a result, for many years, potential small investors were locked out of the investment world. That has changed significantly in the last few decades as discount brokers have emerged and flourished.

There is still a pretty significant risk, however, in buying a single stock or bond issue if the company goes out of business. Mathematically, over time, the risk in investing in individual issues has been proven to not pay off for average investors. For this reason, mutual funds have become quite popular. In a mutual fund, lots of people contribute comparatively small amounts of money into a pool. The money in that pool is then used to purchase a broad range of investments. The risk of having all your eggs in one basket goes away. This protection of owning very small portions of a lot of companies instead of larger positions in one or a few companies is called diversification, and is significant. In the few weeks during which many Enron millionaires went broke, those of us invested in Enron with only a fraction of our invested capital through a mutual fund saw no impact on our overall portfolios.

There is much more to learn about risk and return, and about the various forms of investment vehicles. Like I said in the beginning, there’s no way to put them in a short post on the internet. I highly recommend the resources I have identified below. These few books will teach you all you need to know about the basics of investing and the next two topics we will discuss. Please take the time to read a few of them; the payoff for you will be tremendous!

Next up: The brokerage industry and the cost of investing.

Resources (in order of helpfulness on this particular topic):

The Bogleheads’ Guide to Investing; Taylor Larimore, Mel Lindauer and Michael LeBoueuf, John Wiley & Sons, Inc., 2006. If you are able to purchase only one book out of all of these I’ve recommended, this should be the one. It deals with a wide variety of topics and gives a good primer on the entire family financial process, from spending and debt through the investing process. Disclosure: I am a Boglehead. You’ll have to read the book to find out what that is.

Common Sense on Mutual Funds; John C. Bogle, John Wiley & Sons, Inc., 1999. John Bogle has done more for the individual investor than any other human being on the planet. As the founder of Vanguard, the only true “mutual” mutual fund company out there, he made low-cost, broad-based investing possible for everyone. Forced to retire from Vanguard following a heart transplant, he continues to champion the small investor against big business, big mutual fund companies and big government. ‘Nuff said.

The Four Pillars of Investing; William Bernstein, McGraw-Hill, 2002. William Bernstein is a brain surgeon who set out to explain modern portfolio theory (MPT) to the masses. His first book, an outstanding piece entitled The Intelligent Asset Allocator was what he refers to as a “successful failure.” It explained MPT perfectly but in a way understood only by scientists, engineers or finance professionals. Still, it sold sufficiently well that his publisher was willing to take a chance on this second book that was much math friendlier; Bernstein realized that you didn’t have to understand the math of MPT in order to put together an efficient and effective portfolio. Bernstein’s second work was so successful that he was effectively forced to make investment advising his primary career instead of medicine.

Personal Finance for Dummies; Eric Tyson, IDG Books Worldwide, Inc., various (look at the latest edition you can find). A great addition to the Dummy series, this book is an encyclopedia on family finances. It contains information on all of the topics I discuss as well as on a number of very important topics that I am not going to discuss.

Horizontally gifted since . . . .

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