Legal disclaimer. I am not a financial advisor, and don't have any special training in what I am talking about. Not knowing what I am talking about has never stopped me before, so if you read on, you have been warned - proceed at your own risk, and seek competent financial advice before you follow any of my suggestions. However, as we near the end of our working life, we have ended up in an enviable financial condition - far better than most expensive financial advisors said they could do for us.
One kind of savings is for retirement or major purchases like the downpayment on your first house. Another kind is saving for a vacation or a car (yes you can pay for these without a time payment plan after the purchase). But the most important type of savings is to cover your living expenses if you suddenly are without a job. You might be laid off because of business circumstances, but more important for professionals is to be able to say to your boss, "I don't feel what you are asking me to do is right (legal, ethical, moral, decent, whatever), so if you insist, I quit." Does that ever happen? Yes. There have been multiple times when we were ready to quit, but things worked out or we found a different job before just walking out. But there were a couple times when we had to pull the trigger and actually quit.
How much do you need in the "go to hell" fund? Your first job may not pay very much, and a replacement job is probably fairly easy to find - if you lose your job parking cars, McDonald's probably will hire you, even though the tips are lower. Cash to cover expenses for a few weeks is probably enough. As my career advanced, my salary increased, as did my mortgage and other expenses. And the time to find a comparable replacement job rose as well. First we had to plan on a few months, then 6 months, then a year or more. That doesn't mean you have to have a full year of gross salary saved, but you need enough (now it is a smaller amount of after tax money) to cover your necessary expenses (no vacation, no eating out, no parties, no memberships, etc.) for the year.
Each time I changed jobs, I figured "I gave up my old job, but what if the new job doesn't work out? How long could we last?" By my last job change, the answer was a revelation... we could last forever. I wasn't retirement age, and I wouldn't like to live the rest of my life at the level our savings would support, but we would survive without my job. So you could say that my last job - the last 10 years of work - was to improve our lifestyle for the last 35-50 years of our life. That was a wonderful feeling.
One of our self-imposed rules was that we wouldn't let our basic expenses exceed what either one of us could cover... we didn't do anything that required both of our salaries. If one lost their job (or returned to school or got sick) the other could cover our expenses - the savings in the "go to hell" fund would still be there if needed to cover a problem in the second person's job.
It would be nice to save enough that your kids or grandkids could go to the college of their dreams without worrying about money, but if you have to choose between college for them or retirement for you, choose retirement.
Why am I being so harsh on the kids? There are lots of ways to finance college, even loans at attractive interest rates. There is no way to finance your retirement. And early savings towards retirement has much Much MUCH more impact on the total than late career attempts to save. If you can keep a good retirement plan going, and can help the kids, great. If they have to borrow money, and you can help them pay it off, great. But your retirement has to be top priority.
In my first job, my boss called me in, and said "You aren't putting any money in your retirement plan (what today would be called a 401k, but they hadn't been invented yet)." "Of course not," I replied, "I live in a cheap apartment with Salvation Army furniture, drive a ratty car, and have a ton of college debt." I don't know what he said next, but before I left his office, I had signed up for the retirement plan. 50% of the money went into interest based investments - at pretty respectable but not great interest rates. The other 50% went into equities - stocks.
Over the next 12 years, working at two different Universities, I continued the plan. The total amount I invested over those 12 years was well under $10,000. The low University salaries were supplemented by other benefits - they did contribute a little more to my retirement than I did. The total amount invested by me or my employers (40 years ago) wouldn't buy a decent car today, but has grown tremendously over the years. I am not going to share the actual amount that the early investment yielded, but note that we could survive on just those funds - not a comfortable retirement from only 12 years work, but enough to live on. Lesson 1: Invest early in your career. The earlier the better.
Lesson 2: Diversify. Not knowing any better, I split the investment 50%-50% between fixed income and stocks. I was really tempted to move the money from stock to fixed income during the period when interest rates skyrocketed and home mortgage interest reached 21%, but I held firm. During each stock market boom, I was tempted to move from fixed income to stocks, but I held firm. Forty years later, the money had grown to ¾ in the stocks, ¼ in the fixed income accounts. The volatile and slightly risky stock investments made 3 times as much as the "safe" investments. General advice, when you are young and aren't going to withdraw the money soon, put more in stocks - despite the ups and downs, the long term trend is up, far more than conservative investments. When you are closer to retirement, and need more stable income, gradually shift the investments to the more conservative, less risky, less volatile choices.
Lesson 3: Don't panic. We lost a ton of money when the dot com bubble burst. We were patient, left our investments in place, and more than recovered in remarkably short time. Then we lost a ton of money in each of the recent recessions (market dips). We have more than recovered from each dip. Our savings are back above the boom-time peak. They are three times the level they were when we moved to Austin 15 years ago.
This is how our net worth (everything we own, minus everything we owe) has changed over the last 25 years. It grew both from investment income and from our extra savings after our house and cars were paid off, and as our income increased over our careers. It started low - we were poor and had college debt, there were no big inheritances. We lived frugally and saved consistently, but most of the money is the result of investments like IRAs and those started with that retirement fund with my first job.
The several year peak about 2/3 of the way up the curve was the dot com boom. The dip after that peak was the dot com bust - little more than giving back the gains of the boom. There are a couple smaller recessions moving up the curve - each followed by a recovery that put us back on track. Don't be afraid of the market!
If stocks are so good, we must have all our money in the stock market. Right? NO! I might generalize that there are several ways people invest in stocks.
A few years ago (as in 20+ years ago) we used our 300 bps dial up modem to automatically call every 15 minutes to pick up stock prices that we were following. We had some analysis programs that could spot trends, and were able to make a significant amount of money trading stocks. Some stocks we held for days, most for weeks or months. We were Traders. People would ask what stock we recommended, then would say they wanted to think about our suggestion and might buy the stock next month. Sorry, as traders, our recommendations might have been valid for a few hours. With today's high speed communications and lots of professional traders, by the time you spot a trend, somebody else has already used it to their profit, and the price or market has changed. It is hard to stay ahead of people who do this full time. We don't recommend being a trader any more.
In those days, there were people who bought and sold stocks after they had held them a few hours rather than days or weeks. Using borrowed money, they would buy very large quantities of stocks, but sell them before the end of the day (so they didn't have to pay back the loan). More frequent trades, larger numbers of shares in each trade, so a change in price of a few cents could be profitable. In general, these "day traders" did not hold any stock at the end of the day. Their business was to buy and sell within the day. There were a few times that we sold the stock the same day we bought it, but that was not our plan. With evolving technology and computer triggered trades, the day traders now hold stocks for minutes... or seconds... or even fractions of a second. (We know someone who does this kind of trading, and with large volumes of stock can make - or lose - hundreds of dollars in seconds, many times per day.)
As an investor, you buy a stock in a specific company. Generally you should choose that company because you understand it's business, because you believe they have a solid business plan, good management, that there is a market for their product or service, that they have a competitive advantage - their product will be more attractive than some other company entering the field. You should be more concerned about the company than about what the stock market thinks about that company on any particular day - if the stock price drops 10% you should rejoice that you can buy more at a bargain price, not panic that you have lost 10% of your investment. If you are looking for a stock tip from us, as an investment, look at Berkshire Hathaway. BRK-B .
With frequent fluctuations in stock prices, it may be tempting to wait for a low to buy and a high to sell. This is called market timing - it has lost money for us as often as it has helped. The real experts speak very harshly about trying to do market timing - they insist that it doesn't work. It hurts me to agree that it doesn't work.
If you don't want to be a trader, and it is a lot of work to be an investor, how can you get into stocks? Mutual funds. There are countless types of funds, from those that focus on a mix of fixed income investments (Money Market Funds) to tax exempt municipal bonds (Bond Funds), to European business, to worldwide manufacturing to gold and gold mining equipment... and more. Instead of picking a single business, you pick the market segment that interests you.
Ten or more years ago, you could buy a mutual fund that was Actively Managed by a wizard who could handle short term investments (trading) and make money. Of course the fund operating expenses (deducted from your profits) were higher to pay for the wizard and staff, but if it made more money, who cares! As the funds became large, the investments became large - one fund we like has over $13 Billion invested, typically about $250 million in each company whose stock they hold. Active management can no longer move quickly to change their holdings - buy or sell ten million shares of a company's stock without impacting the stock price. Therefore it now pays to look at the long term performance, in a fund with lower operating expenses, since the "actively managed" funds with high operating expense are too large to move fast enough to have a significant advantage. If you want a mutual fund company recommendation from us, we like Vanguard Funds.
Most mutual funds use the market closing price (4 pm in New York) to calculate the total value of the shares held, then divide by the number of mutual fund shares issued, giving the price-per-share of the mutual fund. Those prices don't change during the day - it is a calculation done each evening. If you deposit money in a fund, the number of shares you get will be calculated that evening. If you want to "redeem" shares in a fund, the value will be determined that evening. Money market funds work almost the same way, but they try to keep the value per share at $1. Gains (and losses) are accumulated and paid periodically as if it were interest earned on the holdings. You buy or sell these funds through the fund company, with little or no sales charges.
Waiting for the end of the day to sell a mutual fund or determine it's value bothers enough people that a new product is emerging, called an ETF, or Exchange Traded Fund. These are mutual funds whose shares are bought and sold throughout the day (traded on the stock exchange) so you don't have to wait for the end of the day to complete the transaction. The value of the ETF is calculated frequently, based on the market price of the holdings of the ETF - sometimes figured multiple times per minute. An ETF is traded like a stock, so you can sell short, buy on margin, give a stop-loss order, or other trading techniques. However, they are often bought and sold through a stock brokerage, typically with a sales charge similar to buying or selling an individual stock.
Hedge Funds are somewhat like mutual funds, but take higher risks in the hope of achieving higher gains. They are far less regulated (allowing the risky investments) but may only be sold to accredited investors - basically those wealthy enough that they can afford to lose their entire investment. They cannot be sold to the general public. We do not invest in these.
How do you make money when the stock price is falling? Lets say company XYZ is selling for $10 per share, but you don't want to own it since you are convinced it will soon be selling for only $8 per share. If your credit is good, you could tell your broker to sell 100 shares even though you don't own them. You get $1000 (less fees) but you have only borrowed the shares that you sold. If XYZ company declares a dividend, you must produce the cash so that the owner who bought the shares from you gets the dividend like all the other owners of that stock. You receive the cash from the sale of the stock, but you are "short" the stock. If the stock later drops to $8 as you predicted you buy 100 shares, paying $800 plus fees. You "covered" your short position (gave back the stock you borrowed) and pocket about $180 ($200 less fees). Of course if you were wrong and the stock price rises, you eventually have to buy the stock to cover your short, perhaps at $11 per share, costing you $1,100 plus fees, so your bad bet on the stock falling cost you $120.
If selling a stock you don't have is called a short position, what do you call buying a stock (that you do have). You got it. You will hear analysts talk about being long (owning) a stock, or that they are long 500 shares of XYZ.
Buy your home. Pay it off as soon as you can. Don't buy more house than you can easily afford (no tiny downpayments, or loans that bet on the value of the house increasing, or count on being able to refinance someday). The argument that a home mortgage is good because the interest is tax deductible is weak - the tax savings are far less than you think. You may be paying 3-5% on the mortgage, but only earning a fraction of a percent on your cash; the tax savings are generally far from enough to cover that difference.
There is another reason to own your home (or car) without a mortgage. If you have an insurance claim, the insurance company pays your mortgage company - they need to have the house fixed, and have to be sure you don't just pocket the money and disappear, leaving them with a broken house and no cash to repair it. The bank's promises of how quick and easy they will make the process of repairing your home may disappear if they are swamped by a disaster.
Hurricane Sandy devastated the Northeast coast a few years ago. One homeowner was interviewed on TV - just back in his home 4 month after the storm. Yes, he had insurance, and was paid the full amount almost immediately. Actually the bank was paid. Contractors were scarce - many took on too many jobs, and "did one screw per day." The homeowner finally found workers to fix his house, but the bank wouldn't pay, based on his receipts. With so many cases, they required bids (even if the homeowner was ready to proceed), and would choose the low bidder, then send the money direct to the contractor. Of course the bank was swamped, so bidding and payment took a lot of time. As the homeowner said, "If my contractor requires a box of nails, do I have to get three bids, wait two weeks for the bank to choose Home Depot, then get Home Depot to send the bank a bill so I can pick up the nails a week later?" If he had owned his home without a mortgage, he would have gotten the check, not the bank, and been able to manage the contractors and materials himself. Streamlining the bank's bidding process, his house would have been fixed faster, and perhaps more cheaply without the contractor facing the hassle of formal bidding.
For years we liked investing in rental properties. There were tax advantages (largely because you could depreciate the house, and if the value of the house increased over time, what would have been taxable "ordinary" income became capital gains, taxed later, and at a lower capital gains rate). However, the laws to protect the tenants have become so biased in favor of the tenants that it has become a risky investment... just try to evict someone who hasn't paid the rent. And if they don't pay the rent, do they have money to pay for the damage they can do to the house on the way out? Been there, done that, no more.
If you are a senior level employee and have to move with your job, and it isn't a good time to sell your house, it may be okay to rent your high end home to an arriving businessman with a similar problem, but buying a house just to rent as an investment is not in our future.
If you house burns down or is blown away by a tornado, do you have the cash to replace it without impacting your retirement savings or "Go to Hell" (emergency) fund? Probably not, so it pays to have homeowner insurance.
If you hit someone with your car, and that person is crippled and will need lifetime care, do you have the funds available to pay? Guess you should have auto insurance.
You sign up for Medicare, and as the TV ads say, "it sometimes only pays 80% of the cost." Can you afford a 20% copay on your doctor visits? Hint: they reason they want to sell you a medicare supplement policy for $100 per month is that your copay, covered by their policy, is likely to be far less than the premiums. You don't need that insurance if you manage your money well enough that you have the cash available to cover the copay.
As you get old, you may need someone to prepare your meals, clean your room, etc., generally called assisted living. A nice place may cost $100,000 per year or more. If you have a few million in savings, you don't need to buy a frightfully expensive long term care policy that may pay a lifetime limit of up to a million dollars. Instead of a retirement home you can go on a cruise, or multiple back-to-back cruises, with free meals, free housekeeping, free medical care, free entertainment, that likely costs less than $100,000 per year. Doesn't that sound better than insurance paying your tab in a nursing home?
The dirty secret. Insurance companies have expenses that they call the underwriting expense ratio, that is the cost of advertising, selling you a policy, issuing the policy, sending you bills, answering the phone when you call, and so forth, an a percent of the premiums they collect. That expense ratio is 20% to 30% of the premium that you pay. So they only have ¾ of the money you sent to them to pay for your losses. If you can manage your money so you can handle those expenses without help, you are far better off without insurance.
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