The single biggest mistake that mutual fund investors make
is investing in funds before they’re even ready to. It’s like trying to build
the walls of a house without a proper foundation. You have to get your
financial ship in shape — sailing out of port with leaks in the hull is sure to
lead to an early, unpleasant end to your journey. And you have to figure out
what you’re trying to accomplish with your investing. Let me emphasize that mutual funds are specialized tools for specific jobs. I don’t
want you to pick up a tool that you don’t know how to use. This post covers
the most important financial steps for you to take before you invest so you get
the most from your mutual fund investments.
Pay off your consumer debts best investments
Consumer debts include balances on such items as credit
cards and auto loans. If you carry these types of debts, do not invest in
mutual funds until these consumer debts are paid off. I realize that investing
money may make you feel like you’re making progress; paying off debt, on the
other hand, just feels like you’re treading water. Shatter this illusion.
Paying credit card interest at 14 or 18 percent while making an investment that
generates only an 8 percent return isn’t even treading water; it’s sinking!
You won’t be able to earn a consistently high enough rate of
return in mutual funds to exceed the interest rate you’re paying on consumer
debt. Although some financial gurus claim that they can make you 15 to 20
percent per year, they can’t — not year after year. Besides, in order to try
and earn these high returns, you have to take great risk. If you have consumer
debt and little savings, you’re not in a position to take that much risk.
I go a step further on this issue: Not only should you delay
any investing until your consumer debts are paid off, but also you should
seriously consider tapping into any existing savings (presuming you’d still
have adequate emergency funds at your disposal) to pay off your debts.
Review your insurance coverage
Saving and investing is psychologically rewarding and makes
many people feel more secure. But, ironically, even some good savers and
investors are in precarious positions because they have major gaps in their
insurance coverage.
Consider the following questions: best investments
- Do you have adequate
life insurance to provide for your dependents if you die?
- Do you carry
long-term disability insurance to replace your income in case a disability
prevents you from working?
- Do you have
comprehensive health insurance coverage to pay for major medical expenses?
- [Have you purchased
sufficient liability protection on your home and car to guard your assets
against lawsuits?
Without adequate insurance coverage, a catastrophe could
quickly wipe out your mutual funds and other investments. The point of
insurance is to eliminate the financial downside of such a disaster and protect
your investments.
In reviewing your insurance, you may also discover
unnecessary policies or ways to spend less on insurance, freeing up more money
to invest in mutual funds.
Figure out your financial goals best investments
Mutual funds are goal-specific tools and humans are
goal-driven animals, which is perhaps why the two make such a good match. Most
people find that saving money is easier when they save with a purpose or goal
in mind — even if their goal is as undefined as a “rainy day.” Because mutual
funds tend to be pretty specific in what they’re designed to do, the more
defined your goal, the more capable you are to make the most of your mutual
fund money.
Granted, your goals and needs will change over time, so
these determinations don’t have to be carved in stone. But unless you have a
general idea of what you’re going to do with the savings down the road, you
won’t really be able to thoughtfully choose suitable mutual funds. Common
financial goals include saving for retirement, a home purchase, an emergency
reserve, and stuff like that. In the second half of this chapter, I talk more
about the goals mutual funds can help you to accomplish.
Another benefit of pondering your goals is that you better
understand how much risk you need to take to accomplish your goals. Seeing the
amount you need to save to achieve your dreams may encourage you to invest in
more growth-oriented funds. Conversely, if you find that your nest egg is
substantial, given what your aspirations are, you may scale back on the
riskiness of your fund investments.
Determine how much you’re saving best investments
The vast majority of us haven’t a clue what our savings rate is. By savings rate, I mean, over a calendar year, how did your
spending compare with your income? For example, if you earned $40,000 last
year, and $38,000 of it got spent on taxes, food, clothing, rent, insurance,
and other fun things, you saved $2,000. Your savings rate then would be 5
percent ($2,000 of savings divided by your income of $40,000).
If you already know that your rate is low, nonexistent, or
negative, you can safely skip this step because you also already know that you
need to save much more. But figuring out your savings rate can be a real
eye-opener and wallet closer.
Examine your spending and income best investments
If you’re saving enough to meet your goals, you can skip
this step and move ahead. For the rest of you, however, you need to do some
additional work. To save more, reduce your spending, increase your income, or
both. This isn’t rocket science, but it’s easier said than done.
For most people, reducing spending is the more feasible
option. But where do you begin? First, figure out where your money is going.
You may have some general idea, but you need to have facts. Get out your
checkbook register, credit card bills, and any other documentation of your
spending history and tally up how much you spend on dining out, operating your
car(s), paying your taxes, and everything else. When you have this information,
you can begin to prioritize and make the necessary trade-offs to reduce your
spending and increase your savings rate.
Earning more income may help you save more to invest if you
can get a higher-paying job or increase the number of hours you’re willing to
work.
Watch out, though: Many people’s spending has a nasty habit
of soaking up increases in income. If you’re already working many hours,
tightening the belt on your spending is better for your emotional and social
well-being.
Maximize tax-deferred retirement account savings best investments
Saving money is difficult for most people. Don’t make a tough
job impossible by forsaking the terrific tax benefits that come from investing
through retirement savings accounts. Employer-based 401(k) and 403(b)
retirement plans offer substantial tax benefits.
Contributions into these plans are generally federal- and
state-tax-deductible. And after the money is invested inside these plans, the
growth on your contributions is tax-sheltered as well. Furthermore, some
employers will match a portion of your contributions.
Some investors make the common mistake of neglecting to take
advantage of retirement accounts in their enthusiasm to invest in nonretirement
accounts.
Doing so can cost you hundreds of thousands of dollars over
the years.
Fund companies are happy to encourage this financially
detrimental behavior, too. They lure you into their funds without educating you
about using your employer’s retirement plan first because the more you invest
through your employer’s plan, the less you have available to invest in their
mutual funds.
Determine your tax bracket best investments
When you’re investing in mutual funds outside of
tax-sheltered retirement accounts, the profits and distributions that your
funds produce are subject to taxation. So the type of fund that makes sense for
you depends, at least partially, on your tax situation.
If you’re in a high bracket, give preference to mutual funds
such as tax-free bond funds and stock funds with low levels of distributions
(especially highly taxed capital gains). In other words, focus more on stock
funds that derive more of their expected returns from appreciation rather than
from distributions.
If you’re in a low bracket, avoid tax-free bond funds
because you end up with a lower return than in taxable bond funds.
Assess the risk you’re comfortable with best investments
Think back over your investing career. You may not be a star
money manager, but you’ve already made some investing decisions. For instance,
leaving your excess money in a bank savings or checking account is a decision —
it may indicate that you’re afraid of volatile investments.
How would you deal with an investment that dropped 10 to 50
percent in a year? Some of the more aggressive mutual funds that specialize in
volatile securities like growth stocks, small company stocks, emerging market
stocks, and long-term and low-quality bonds can quickly fall. If you can’t
stomach big waves in the financial markets, don’t get in a small boat that
you’ll want to bail out of in a big storm. Selling after a big drop is the
equivalent of jumping into the frothing sea at the peak of a pounding storm.
You can invest in the riskier types of securities by
selecting well-diversified mutual funds that mix a dash of riskier securities
with a healthy helping of more stable investments. For example, you can
purchase an international fund that invests the bulk of its money in companies
of varying sizes in established economies and that has a small portion invested
in riskier, emerging economies. That would be safer than investing the same
chunk in a fund that invests solely in small companies that are just in
emerging countries.
Review current investment holdings best investments
Many people have a tendency to compartmentalize their
investments: IRA money here, 401(k) there, brokerage account somewhere else.
Part of making sound investment decisions is to examine how the pieces fit
together to make up the whole. That’s where jargon like asset allocation comes
into play. Asset allocation simply means how your investments are divvied up
among the major types of securities or funds, such as money market, bond, stock, international stock, and so on.
Another reason to review your current investments before you
buy into new mutual funds is that some housecleaning may be in order. You may
discover investments that don’t fit with your objectives or tax situation.
Perhaps you’ll decide to clear out some of the individual securities that you
know you can’t adequately follow and that clutter your life.
Consider other “investment” possibilities best investments
Mutual funds are a fine way to invest your money but hardly
the only way. You can also invest in real estate, invest in your own business
or someone else’s, or pay down mortgage debt more quickly. Again, what makes
sense for you depends on your goals and personal preferences. If you dislike
taking risks and detest volatile investments, paying down your mortgage may
make better sense than investing in mutual funds.
Reaching Your Goals with Mutual Funds best investments
Mutual funds can help you achieve various financial goals —
saving for retirement, buying a home, paying for college costs, and so on —
that you can tackle with the help of mutual funds.
As you understand more about this process, notice that the
time horizon of your goal — in other words, how much time you have between now
and when you need the money — largely determines what kind of fund is
appropriate:
- If you need to tap
into the money within two or three years or less, a money market or short-term
bond fund may fit the bill.
- If your time horizon
falls between three and seven years, you want to focus on bond funds.
- For long-term goals,
seven or more years down the road, stock funds are probably your ticket.
But time horizon isn’t the only issue. Your tax bracket, for
example, is another important consideration in mutual fund selection. Other
variables are goal specific, so take a closer look at the goals themselves.
Remember: Mutual funds are just part of the overall picture
and a means to the end of achieving your goals.
The financial pillow — an emergency reserve
Before you save money toward anything, accumulate an amount
of money equal to about three to six months of your household’s living
expenses. This fund isn’t for keeping up on the latest consumer technology
gadgets. It’s for emergency purposes: for your living expenses when you’re
between jobs, for unexpected medical bills, for a last-minute plane ticket to
visit an ailing relative.
Basically, it’s a fund to cushion your fall when life
unexpectedly trips you up. Call it your pillow fund. You’ll be amazed how much
of a stress reducer a pillow fund is.
How much you save in this fund and how quickly you build it
up depends on the stability of your income and the depth of your family
support. If your job is steady and your folks are still there for you, then you
can keep the size of this fund on the smaller side. On the other hand, if your
income is erratic and you have no ties to benevolent family members, you may
want to consider building up this fund to a year’s worth of expenses.
The ideal savings vehicle for your emergency reserve fund is
a money market fund.
The golden egg — investing for retirement
Uncle Sam gives big tax breaks for retirement account
contributions. This deal is one you can’t afford to pass up. The mistake that
people at all income levels make with retirement accounts is not taking
advantage of them and delaying the age at which they start to sock money away.
The sooner you start to save, the less painful it is each year, because your
contributions have more years to compound.
Each decade you delay approximately doubles the percentage
of your earnings that you should save to meet your goals. For example, if
saving 5 percent per year starting in your early 20s would get you to your
retirement goal, waiting until your 30s may mean socking away 10 percent;
waiting until your 40s, 20 percent; beyond that, the numbers get troubling.
Taking advantage of saving and investing in tax-deductible
retirement accounts should be your number-one financial priority (unless you’re
still paying off high-interest consumer debt on credit cards or an auto loan).
Retirement accounts should be called tax-reduction accounts.
If they were called that, people might be more excited about contributing to
them. For many people, avoiding higher taxes is the motivating force that opens
the account and starts the contributions. Suppose you’re paying about 35
percent between federal and state income taxes on your last dollars of income. For
most of the retirement accounts described in this chapter, for every $1,000 you
contribute, you save yourself about $350 in taxes in the year that you make the
contribution. Some employers will match a portion of your contributions to
company-sponsored plans, such as 401(k) plans — getting you extra dollars for
free.
On average, most people need about 70 to 80 percent of their
annual preretirement income throughout retirement to maintain their standard of
living.
If you haven’t recently thought about what your retirement
goals are, looked into what you can expect from Social Security (okay, cease
the giggling), or calculated how much you should be saving for retirement,
now’s the time to do it.
When you earn employment income (or receive alimony), you have
the option of putting money away in a retirement account that compounds without
taxation until you withdraw the money. With many retirement accounts, you can
elect to use mutual funds as your retirement account investment option. And if
you have retirement money in some other investment option, you may be able to
transfer it into a mutual fund company.
If you have access to more than one type of retirement
account, prioritize which accounts to use by what they give you in return. Your
first contributions should be to employer-based plans that match your
contributions.
After that, contribute to any other employer or
self-employed plans that allow tax-deductible contributions. If you’ve
contributed the maximum possible to tax-deductible plans or don’t have access
to such plans, contribute to an IRA.
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