Things You Need To Evaluate Before You Start Investing In Mutual Funds

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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