Principles 1: Not rocket science Principles 2: Relax Principles 3: Caveat Investor

Sensible-Investor: Principles -- Part 1  

You can understand personal finance

The basics of personal finance aren't all that complicated -- they can be understood by almost anyone. While the fine points of personal finance can be mind-bogglingly complex, the fundamentals are much simpler and less time-consuming than they are typically believed to be.silverbullion

In part, personal finance seems complex because much of what's written about investments focuses on complicated but dispensable topics, including picking stocks that are about to rise, guessing which way the markets will go next, and finding market-beating mutual fund managers. All that is unnecessary. If you are an experienced investor, you may be convinced that such matters are crucial to your success. (In that case, you may want to skip immediately to a discussion of why you're wrong.) If you are a newcomer to the world of investing, you would do better to start with the next step-by-step advice for first-time investors.

For beginners, one step at a time

Many people cower before the daunting prospect of beginning an investment program. The task seems monumental. They don't know where to start, so they don't start at all. Instead, they feel guilty and inadequate. If  this describes you, there are a few relatively simple, but quite important, steps you can take.

First, some preliminaries. Before you make your initial investments, you should make sure you have enough money saved in an emergency reserve so investing is prudent rather than foolhardy. If you don't, you are gambling that no unexpected occurrences will force you to withdraw funds from your investments at an inopportune (money-losing) moment. Take your pick as to how you define your emergency reserve. You might take a less traditional approach -- by simply thinking through how you would cope in case of a financial crisis. Even if you are laid off and fell ill simultaneously, perhaps your family support network is so strong that you would be provided for without any financial drain. Or, in such an emergency you might need your own funds, which you keep tucked away in a money market fund. In case you take the traditional approach, here are two traditional definitions of an emergency reserve fund from two personal finance writers:

    "(U)ntil you have at least $5,000 or $10,000 someplace safe and liquid, like a savings account – unless you are so wealthy you don't have to worry about the contingencies of everyday living – you are crazy even to consider making riskier investments." (Andrew Tobias, The Only Investment Guide You'll Ever Need, Harcourt Brace & Co., New York, 1996, p. 60)

    If you are running a balance on your credit cards, "your first priority should be getting rid of that debt. Then build a reserve fund of 3 to 6 months' living expenses in a bank or money-market mutual fund. With a fully funded reserve, you can start putting extra money into … longer-term savings and investments." (Jane Bryant Quinn, Making the Most of Your Money, Simon & Schuster, New York, 1997, p. 172)

If you have difficulty establishing an emergency reserve fund because your spending is out of control, those personal finance books by Tobias and Quinn, among others, can help you with budgeting and trimming unnecessary expenses, The following Web sites also might help: Ask Cash Flo, Kiplinger.com (Search for “budget”), and Quicken.com (the Saving and Spending section).

Step 1: Lining up money to invest

You’re now ready to select which money you will invest. If you can only invest chunks of cash sporadically, as they become available, do so, if that's the best you can manage. But you would be better off if you made your investments in regular installments. Even better, your employer may let you invcoinlineest  in regular installments that are deducted automatically from your paycheck. Best of all, your employer might match some of what you deduct. If your company offers this benefit, take advantage of it. Regarding employers' matching funds for employees' retirement accounts, heed what Tobias says: "This is free money. If your employer offers a deal like this and you're not taking full advantage of it, you're an idiot. (Well, I'm sorry, but c'mon: if your local bank decided to give out free money to attract deposits – say, $500 for each new $1,000 – there would be riots in the streets, so eager would people be to get in on it.)" (Only Investment Guide, p. 90.

Step 2: Setting your goals

Define the specific goal or goals you are investing to achieve – a house, your child's college education, retirement? The appropriate type of investment will vary, depending on how much time will elapse before you need the money. If you have several investment goals, you should make separate investment decisions for each and keep track of each block separately.

Step 3: How much risk can you stand?

PennyDetermine your level of risk tolerance, beginning by learning about the various types of financial risk that exist in the world, from inflation risk and default risk to the unpredictable variations of individual stock and bond prices. You may start out thinking that you'd be uncomfortable with anything riskier than a bank CD, but you may change your mind after you consider the long-term risks of such low-yield investments. As Wall Street Journal personal finance writer Jonathan Clements states, "(O)ver the long haul, … stocks actually seem safer because they are more likely to make you decent money, while bonds and money funds find it tougher to stay ahead of inflation, taxes and investment costs." (The Wall Street Journal, April 28, 1998. Page C1.) Andrew Tobias gives the same advice: "a very basic thing to know about your money is that, over the really long run, people who buy equities – stocks – will almost surely make a lot more money (if they're at all sensible in how they do it) than people who make 'safer' investments." (Only Investment Guide, p. 60) To help you think through your attitude to investment risks, Princeton University Economics Professor Burton G. Malkiel provides a risk-tolerance quiz in his book A Random Walk Down Wall Street. (W.W. Norton & Co., New York, 1996, pp. 414-415). A more accessible, though less sophisticated, risk-tolerance test is available on the MSNBC/CNBC site.

Step 4: Dividing up the money

Calculate how best to allocate your money among various types of investments, such as stocks, bonds and CDs. With properly allocated investments, you can achieve the same level of returns at a relatively lower risk than if you concentrated your investments in one category. That's because the prices of different investment categories don’t move in sync – and you can benefit from that fact. If you own some stocks and some bonds, for example, not all of your holdings will be at risk when stocks are up and bonds are down, or when the opposite is true. In the long run, you will have cut your losses without a comparable cut in your profits – a net win at a lower risk.

Don't skip this step because you’re put off by the phrase "asset allocation," which admittedly sounds mind-numbingly dull. Studies have shown that whatever decision you make about asset allocation, it will be by far the dominant factor in determining what you get out of your overall investments. Don't look for a one-size-fits-all allocation formula, such as those that some brokerages publish. The proper percentages for you will depend on your tolerance for risk and how much time you have until you need to withdraw money from your investments. For more suggestions about asset allocation, you can turn to any of several Web sites, or refer to Malkiel (p. 420 ) or Quinn (p. 595).

Step 5: Dividing up the money more finely

DimeDetermine how you will diversify your investments, which essentially means not putting all your eggs in one or two baskets. For stocks, you can accomplish this easily by investing in mutual funds. "Too many investors bet too heavily on just one or two stocks," warns Clements in The Wall Street Journal. "Sure, that may mean handsome gains. But if you bet wrong, you could suffer losses you will never recoup. The solution is simple enough. Use mutual funds to spread your money among a good number of stocks in a variety of market sectors, including large, small and foreign stocks." (WSJ, April 28, 1998, p. C1.) As Fidelity Investments veteran Peter Lynch puts it, “Diversify, diversify, diversify.” He recommends buying several different types of mutual funds for diversification beyond what one type of fund could provide.

Step 6: Taking the plunge

Start making the investments you have decided on. You'll want to make them through a reliable institution that charges low or no fees. Don't think you need to wait to invest until you find the very lowest-priced deal on an investment with the very highest expected return and absolutely the most advantageous tax consequences. The sooner you start investing, the more you’ll find that time is on your side. For children and young adults, the time advantage is astounding -- at 9 percent interest, $100 invested today will turn into $3,611 in 40 years. Using different rates and different time spans on a simple investment calculator, you can quickly convince yourself not to delay, even if you’re not confident that you’ve found the very best investment for you. You can move your money around later, as you become more savvy about the world of investments.

Step 7: Checking back later

Every 12 months or so, reassess your financial position and your progress toward your financial goals. Make adjustments, as appropriate.

Next: Relax


Principles 1: Not rocket science Principles 2: Relax Principles 3: Caveat Investor

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