Start saving. Starting to save is the hardest step, but it’s the most valuable.
A little financial virtue is much better than none. Saving even a little bit regularly is much better than not saving, because your wealth will build up over time.
Use retirement accounts. They’re the best legal tax shelter.
Take advantage of payroll deduction. Save automatically and you’ll eventually save a lot.
Stock market basics. Here's some basic information to help you get started.
Invest in what you understand. Your greatest chance of making a mistake or being cheated is when you don't understand what you're getting into.
Invest in an asset, not a person. The nicest people sometimes turn out to be crooks. Don’t invest just because the investment is offered by a likeable person, or because your friends or family have invested. Check the investment out thoroughly. Beware of glowing promises: if the investment sounds too good to be true, it probably isn’t true. Before investing, make sure you understand how an investment could lose money. All investments have a risk of loss. You need to find out what it is.
Keep your emotions under control. The financial markets are driven by greed, on the one hand, and fear on the other. Both emotions tend to work against your long term financial interests, leading you to buy high and sell low. You should be dispassionate, analytical and objective about investments.
Don’t borrow to invest. Investments may or may not pay off, but debts are a certainty. Ordinary investors shouldn’t borrow to invest.
Invest for the long term. A long term investment strategy based on a diversified low-cost portfolio moderates risk, minimizes transaction costs, and has a good chance of producing wealth in the end.
Keep commissions, fees and other costs down when saving and investing because that will help you build wealth. Fees and expenses have a negative compounding effect that builds up significantly over the years. If an investment’s total expenses—management fees and other costs—are less than 0.5% of asset value, they are pretty low. If they are 0.5% or higher, do some comparison shopping. If they are 1.0% or higher, do some serious comparison shopping.
Expect turbulence. Building wealth is like an airplane flight. There is usually some turbulence. As you save for retirement, be prepared for ups and downs in the financial markets. Soften the turbulence by working as long as possible to boost your Social Security benefits and any pension benefits you might have. A predictable electronic deposit in your bank account every month makes the flight through retirement a lot smoother. Work longer to make that deposit larger. We provide more details in our discussion of boosting your benefits.
Getting the basics right is the key to success in many walks of life. Building wealth is no different. Here, we discuss basic points for ordinary investors.
A. Start saving. Somewhere around a third or more of all Americans don’t have any savings at all. So if you just start, however modestly, you’ve won much of the battle. Anyone can build wealth by saving regularly. That means you can build wealth, if you don’t sell yourself short.
B. A little financial virtue is much better than none. Saving even a bit is much better than saving nothing. If you save a little bit regularly, it will build up. Give up two café lattes each week, and save $10. Eat at home rather than going out for dinner one fewer night a week. That saves $30 or more (the food may not be that expensive, but what about the couple of beers or glasses of wine that you have with dinner?). That’s a total of $40 a week, or $2,000 a year. After ten years, you’ve saved $20,000 plus whatever interest and investment gains you might have earned. That's easily the price of a nice car, and you didn’t give up much to have it.
C. Use retirement accounts. The best legal tax shelters for most Americans are retirement accounts. Most of them let you defer taxes on the money you save. In other words, if you normally pay 30% of each pre-tax dollar of earned income in federal and state income taxes, you can delay paying those taxes, perhaps for decades, by saving that dollar in a retirement account. Another kind of retirement account, the Roth account, requires you to pay taxes initially on the money that is contributed. But then, if you hold the Roth account for at least 5 years and don't make withdrawals until you are 59 1/2, you don't have to pay income taxes on the earnings. Retirement accounts come in a variety of colors and models, but the most important ones are the 401(k) account and its public sector and nonprofit clones, the 403(b) and 457 accounts. IRA accounts are also popular. The next section discusses retirement accounts in greater detail.
D. Take advantage of payroll deduction or automatic payment. Put your retirement plan on autopilot. Employer sponsored plans like the 401(k) are based on payroll deduction—your contribution is simply taken out of your paycheck and funneled into your account before you can spend it on jelly beans and processed cheese food. Your wealth, not your waistline, will grow.
You can arrange for regular automatic payment from your checking account into IRAs or taxable investment accounts. Mutual fund managers, stock brokerage firms, and banks would be glad to help you arrange for monthly additions to your wealth. You’ll learn to live without the money that’s siphoned into savings. And you’ll be glad to live with it when you retire.
E. Stock Market Basics. Here are the basics of the U.S. stock and bond markets (the financial markets of other nations can be quite different, so research them separately). For more detail about the terminology, please look at our Glossary. There’s much more to learn if you want to become an active investor. But you can get an idea of the concepts here.
1. The corporation is an organization. It sells pieces of itself, called “stock,” in order to raise money to conduct business. (In other words, it takes money to make money, for corporations as well as people.) People who buy stock become owners (collectively with all the other stockholders) of the corporation.
2. Stock. When you buy a share of stock, you own a tiny portion of the corporation. The stock will increase in value if the corporation does well, and it will decrease in value if the corporation does poorly. Many people refer to stock as “shares” (as in shares of stock). If you want to invest in a particular stock, research it carefully.
3. Bonds. A bond is a way that corporations and governments borrow money. An investor lends them a fixed amount of money (e.g., $10,000), which is called the “principal.” They pay interest on the bond for a stated amount of time (e.g., 10 years), and then, if all goes well, they repay the principal (i.e., the money originally invested in the bond). Corporate bonds have “credit risk,” meaning the risk that the corporation might be unable to pay them. Government bonds are less likely to have this problem if they are issued by the governments of wealthy nations. But government bonds of less well-off nations can have significant credit risk. The riskier a bond, the higher the interest rate it will have. Be careful investing in bonds that offer a high return—the return reflects a higher risk that you won’t be repaid.
4. Mutual Funds. Mutual funds are a type of corporation used for investment purposes. Their business consists of investing in stocks and/or bonds. When you invest in a mutual fund, you are buying shares of the mutual fund. That gives you an interest in the fund’s holdings of stocks and/or bonds. The value of your mutual fund shares is based on the values of the fund’s holdings of stocks and/or bonds, and will increase or decrease as they increase or decrease in value. Most mutual fund shares are bought or sold at prices based on the values of their holdings of stocks and/or bonds at the close of the financial markets for the day. You usually buy or sell mutual fund shares by directly contacting the company that manages the fund.
Mutual funds can be index funds or actively managed funds. Index funds invest in a way that copies, or mimics, a financial market index, like the Standard & Poor’s 500 or the Nasdaq 100. Index funds have low costs and fees because they don’t have to pay professional money managers to strategize for them. Actively managed funds hire professional money managers to select stocks and/or bonds for them to invest in. These funds have higher costs and fees, because the professionals have to be paid to do the investment strategizing. Some actively managed funds are quite successful. But most do no better, or even worse, than index funds. An investor who is just starting out has relatively little, or nothing, to gain by investing in an actively managed mutual fund,
An exchange traded fund (ETF) is a special kind of mutual fund that can be bought or sold during the hours the stock market is open, at a price that normally reflects the most recent prices for its holdings of stocks and/or bonds. ETFs are bought or sold through stockbrokers.
5. The stock market and bond market are the principal financial markets for investors. They are open for normal trading from 9:30 a.m. to 4:00 p.m., East Coast Time. You can buy or sell stocks, bonds or exchange traded funds during these times. It is possible to buy or sell some U.S. stocks and bonds in other markets at other times. But the prices you get may be less favorable.
6. Stockbrokers are people and firms that serve as intermediaries in the process of buying and selling stocks. You can’t personally call or e-mail a stock market to buy or sell. You have to go through a stockbroker. (However, you can directly invest in or sell mutual funds--except ETFs--by contacting the company that manages the fund.) Stockbrokers charge commissions and/or other fees for their services.
7. Risks. You’ll probably have very little trouble getting information about the potential rewards offered by investments. You’ll probably have a harder time getting information about the risks (because people selling you investments tend not to emphasize their bad points). However, risk and reward walk hand-in-hand down Wall Street. The greater the potential reward, the greater the risk of loss. If you’re getting a glowing story about how great an investment is, but very little detail about the risk of loss, you will be at an informational disadvantage. You might be tempted to invest because you don’t know how bad the investment could be. Go back to cigarette ads from the early 1960’s. They’ll tell you that it’s enjoyable and sophisticated to smoke. But they’re rather short on information about heart disease, cancer and emphysema. Makes it tempting to light up—and that’s the idea. Make sure you know how an investment can go wrong before investing.
8. Investment Strategies. There are about eight and one-half zillion investment strategies. The large majority of them are (a) inconsequential (i.e., they won’t give you much of an advantage, or any, in the long term), (b) expensive (i.e., they require you to buy and sell investments often, which means large transaction costs that can significantly reduce your returns), (c) bunk (i.e., stupid, also referred to as dumb), or (d) fraudulent (i.e., a way to steal your money). Are there investment strategies that will prove superior in the future? Possibly, but you’ll have a hard time separating them from (a) through (d) above. Most professional money managers do not get returns higher than the stock markets as a whole and some do worse. That’s why investing for a return around stock market averages is a rational strategy. In general, most investors should stick to a simple strategy of investing on a diversified basis for the long term.
F. Invest in what you understand. Make sure you understand any investment that interests you. People are most likely to be defrauded or disappointed when they invest in something they didn’t fully understand. The most important thing to understand is how the investment can lose money. The person trying to sell you the investment will tell all about how wonderful it is. You need to work hard to find out about its leaky roof or cracked foundation. This may limit you initially to dull, conservative investments. That’s okay. Wealth is built first and foremost by saving regularly, not by gambling on complex and confusing investment strategies.
G. Invest in an asset, not a person. Never invest in something because the broker or other person who is selling it is likeable, charming, or socially prominent; or a neighbor, a member of your congregation or an acquaintance. Invest in the asset itself, and if it’s not a good asset, don’t invest. One trait that con artists almost always have was that they are very likeable people. They can be charming, witty, and fun--just the kind of person you’d like to have a drink with. That’s why they’re effective crooks. They appear trustworthy, and no one would suspect that they are dishonest.
Beware of glowing promises. If an investment sounds too good to be true, it probably isn't true. Just because you need money doesn't mean that a get rich quick scheme is a idea. Beware of the risks of wanting too much.
Don’t invest in something simply because your family or friends have invested. Those close to you may have been deceived by a con artist, and could unknowingly rope you into the scam. The fact that their intentions may be good doesn’t protect your money. Don’t worry if your decision against an investment hurts someone’s feelings. It’s your money that is at risk, and you don’t owe it to anyone to risk your hard earned savings.
H. Keep your emotions under control. The markets are driven by greed, on the one hand, and fear on the other. Both emotions tend to work against your long term financial interests, leading you to buy high and sell low. You should be dispassionate, analytical, and objective about investments. Never fall in love with an investment, because you may hold onto it too long. Unlike relationships, love never made an investment more valuable. The financial markets don't care how you feel or what you need. Stay calm. Stay loose.
I. Don’t borrow to invest. Avoid borrowing money to invest. People sometimes take out a home equity loan and invest the proceeds in stocks or other investments. Some investors have a margin account at a stock brokerage firm, where you borrow up to 50% of the purchase price of the stocks or bonds that you buy, and use the assets in your account as collateral for the loans. The idea is that if the investment provides a profit greater than the interest charges on the loan, you can leverage the investment’s profitability by using borrowed money. But you can’t pay interest with a failed expectation. Borrowing to invest is a bad idea for ordinary investors, because it involves too much risk. Stocks and bonds go up and down in value, but the debt is a certainty and interest charges accrue every month whether the investments blossom or turn sour. People who have substantial financial strength, such as a net worth of $500,000 or $1,000,000 in financial assets (apart from home equity), may be able to justify a moderate level of borrowing to invest. But they have the means to bail themselves out if their investments go sour. Ordinary investors should avoid leveraging their investments.
J. Invest for the long term. Investing for retirement should be focused on the long term. In other words, buy investments that have long term potential without unusual risk, and hold them. Buying and selling investments after relatively short terms of times—such as a period of days, weeks, months or even a few years—has generally been less rewarding than buying and holding for longer periods of time. It is difficult to know when the stock market has bottomed out or peaked. Therefore, you can’t easily tell if your timing to sell or buy is right. “Chasing returns” by investing in assets that have recently been increasing in value causes many investors to buy just as prices are peaking and sell when prices are bottoming out. Buying high and selling low isn’t the way to make money.
Also, frequent trading of investments increases transaction costs such as commissions, markups and other charges. These charges erode the long term gains you might get. Many of the compensation arrangements in the financial services industry are commission-based, and some financial services professionals may try to persuade you to trade on a short term basis, rather than investing long term, because they receive more income if you become a short term trader. Remember that the goal is to enrich yourself, not someone else.
Don’t bolt for the exits the moment the stock market begins to decline. The market has always had ups and downs, and always will. Getting out of stocks to avoid a decline can often backfire, not because you don’t avoid the decline—you may succeed in that if you move quickly enough. But many people are leery of jumping back in during or after a market decline, and miss subsequent upswings. The stock market ultimately reflects trends in the U.S. and world economy. Even though the economy coughs and sneezes from time to time, it has been fundamentally healthy since World War II and has grown well. Investing for the long term allows you to participate in this growth.
Of course, if you invest in individual stocks and bonds, you must monitor each investment you hold and perhaps sell if you are dissatisfied with its performance. Investing long term in the stock market doesn’t mean investing long term in every stock or bond you buy. Not all individual stocks and bonds are good long term bets.
It is easier for most people to invest for the long term if they put their money in mutual funds. That way, you can avoid the hassle of keeping track of individual stocks and bonds. When you’re starting out, stay away from actively managed mutual funds. They are harder for ordinary investors to understand. Poor performance of an actively managed mutual fund might be due to investment misjudgments by the portfolio managers, a downturn in the industry group(s) on which the fund focuses, a general downturn in the market, or a combination of these factors. Until you have some experience, you may have trouble figuring out why the investment went sour, and you may sell for the wrong reasons at the wrong time.
Focus instead on easy to understand mutual funds, like index funds and lifecycle funds. These funds can be held long term without the need for close monitoring. You can’t altogether ignore them, either—you need to have an appropriately diversified mix of index funds. Or, if you choose lifecycle funds, you need to be satisfied with the lifecycle fund’s investment philosophy. But these mutual funds aren’t high maintenance like individual stocks or most actively managed mutual funds.
K. Keep Commissions, Fees and Other Costs Down. Do you like vacations in distant places? Okay, but will you pay a lot for air fare? If not, that means you like to keep your transaction costs down. You may consider the vacation important, but you don’t want to pay an arm and a leg to get there. The same principle applies to retirement investing. Transaction costs, such as commissions, markups, management fees and other charges (always read the fine print) are like air fares. The more you spend flying somewhere, the less money you’ll have to enjoy your destination. The more you spend to save for retirement, the less money you’ll have to enjoy your retirement.
Here's why. Transaction costs reduce the amount of profit that your assets earn, and thereby reduce the compounding of your portfolio. In other words, transaction costs have a negative impact on compounding. Commissions and other costs that you pay this year are forever unavailable to compound and grow in your portfolio. If you love compounding, you’ll hate transaction costs.
For example, let’s say you have an IRA in which you save $4,000 a year for 35 years. Its assets are invested in index funds that earn 7% per year on average, and the earnings are reinvested. The fees and expenses for the IRA and the index funds together total 0.5% per year of the account’s assets, which would be a pretty low level of expenses. Your net return each year, after taking out the 0.5% in fees and expenses, is 6.5% on average. At the end of 35 years, you’ll have $496,138 in the account.
But what if the fees and expenses are a relatively high 1.5% per year? Then, your net return would be 5.5% per year on average. Does 1% a year really matter much? Here’s the answer. After 35 years of higher fees and expenses, the account would have $401,005. The difference between the two returns is $95,133. Even in a time when people think nothing of spending $4 or $5 on a cup of coffee, that’s real money. Fees and expenses matter; they are like a private tax on your wealth and earnings. If you don't like taxes, you shouldn't like fees and expenses.
Look for mutual funds with low management fees and expenses. If you’re going to invest in individual stocks, use discount brokers. So-called “full service” brokerage firms may be fine for people who have hundreds of thousands or millions of dollars to invest, because they might benefit from the extra services these firms provide. Even then, transactions costs are also a consideration for the well-to-do; if they don’t get comparatively higher rates of return from their relationships with higher cost firms, they, too, will suffer an erosion of profits from transaction costs.
Stock market returns are expected to be modest in the foreseeable future. The exuberance of the late 1990’s took a lot of energy, and the market has struggled to recover the losses of the first few years of the 2000’s. If you pay 2% or 3% per year of your assets for management fees and other expenses, you may end up with little or no gain after taxes and inflation. If you can find an investment (like a low cost mutual fund) with total fees and other costs less than 0.5% of your assets, think hard about investing in it. If an investment’s fees and expenses are 0.5% or higher, do some comparison shopping, because you might do better. If they are 1.0% or higher, do some serious comparison shopping. Amidst the uncertainties and volatility of the financial markets, fees and expenses are a certainty. That is why you should minimize them..
L. Expect turbulence . Saving and investing for retirement is like an airplane flight. In order to take you to your destination, the process will involve travelling through some of the ups and downs of the financial markets. Investment portfolios, like just about everything else in life, have good days and bad days. You won’t like what you see in your portfolio on a bad day. But if you ride through the turbulence, you'll have a good chance to build wealth.
Soften the turbulence by working as long as possible to boost your Social Security benefits and any pension benefits you might have. A predictable electronic deposit in your bank account every month makes the flight through retirement a lot smoother. Work longer to make that deposit larger. We provide more details in our discussion of boosting your benefits.
Let’s turn next to our discussion of retirement accounts, the most important investment vehicle for the ordinary investor.