Here are our free financial plans. Review the basics of building wealth. Then choose one of the five model plans for yourself, or adapt them to suit your purposes.
Model Plan 1: Getting Started. Getting started is the hardest step for a lot of people. Here is a suggested plan for taking the first few steps: start a retirement account, establish a modest cash reserve, and pay off high interest debt.
Model Plan 2: Lifecycle Funds, the essence of simplicity. Use lifecycle funds if you want to minimize the work of managing your assets. The fund managers diversify your investments and change the mix of investments to become more conservative as you grow older. This will leave you more time to improve your golf game.
Model Plan 3: Do It Yourself with Mutual Funds. If you’re a bit of a finance aficionado and want to personalize your financial strategy without spending hours each week researching investments, invest in a diversified group of mutual funds. We suggest allocations for your investments, so that your portfolio will be appropriately diversified. We also present suggested changes in your asset allocation as you get older.
Model Plan 4: Do It Yourself with Stocks and Bonds. This is the plan for the person who enjoys finance and financial research. If you like to spend time thinking about investment strategies and selecting stocks and bonds, this plan may be for you. Don’t underestimate the effort it will take. You’ll have to monitor your investments regularly, sell off the dogs, and reinvest dividends and other gains, all while maintaining appropriate diversification--you can use our suggested asset allocations. If finance is a hobby for you, doing it yourself with stocks and bonds may provide enjoyment as well as financial security.
Model Plan 5: Do Whatever You Like. If all this talk of stocks, bonds, mutual funds, ETFs, risk management, diversification, asset allocation, compounding, reinvestment of gains, etc. gives you the mother of all headaches, then save any way that feels comfortable. If you like, put the money in plain old bank or credit union accounts. Or try money market funds or U.S. Savings Bonds. Financial planners with alphabet soup credentials wouldn't give you this advice. But we will, because the most important way for you to build wealth is to save. And that’s true regardless of where you put the money. You might not keep up with inflation with very conservative investments. But if the only way you’ll have the confidence to save is to put your hard earned nickels into no-lose (but low gain) investments, then just do that and the @#$%! with someone else’s opinion. It’s your money. But be diligent. If you are ultra-conservative with your investments, then put away a large percentage of your income (e.g., 15%, 20% or more). That way, you’ll end up with a pretty decent nest egg after 30 or 40 years. Indeed, you’ll almost surely end up better off than a person who invests 2% of his or her income in a well-diversified way.
You are entering the innermost sanctum of the Den, where we reveal the model financial plans that you can use to build your estate. There is no magic to these plans—we didn’t pull them out of a boiling cauldron filled with newts, toads, snakes, worms, bats and frogs. And we don’t claim that they are based on statistical studies run on supercomputers using massive databases and linear and non-linear regression analyses that attained a 99% confidence level. They reflect our opinion of what’s a good place for most ordinary investors to start. We won’t promise you riches. Each of you must decide whether any of these plans is right for you. Uncle Leo’s Den does not give personalized advice, and these plans may not be appropriate for everyone. But it costs you nothing to keep reading, and you can accept or reject our suggestions—or tailor them for your individual needs and wants--as you choose.
Basic Principles of Building Wealth
When considering these plans, bear in mind the following basic principles for building wealth. If you’ve read preceding sections of this website, you’ll find us repeating ourselves a bit. But these are points that bear repetition.
Anyone can build wealth by saving steadily. How the savings are invested is less important than the act of saving something every month. Habitual savers do well. Serial savers do better. Very few people become wealthy from windfalls or jack pots. Not many inherit wealth. Those who save regularly are the most likely to end up well off.
It’s never too late to build wealth. While you don't always get a second chance in life, every day gives you a new chance to save. You’re better off starting young. But starting later in life is a lot better than never starting. If you never start, you’ll never have anything. Even modest savings will give you, if nothing else, an emergency fund that can be an alternative to the food bank at the end of the month.
Boost Your Benefits. Work as long as possible to boost your Social Security benefits. If you are lucky enough to have a pension, working longer will probably increase your pension benefits as well. Boosting your benefits isn't the same as saving. Social Security and pensions won't provide you with luxuries--you need savings for that. But the predictable arrival of an electronic deposit in your bank account each month will aid your digestion. And the longer you work, the more opportunity you will have to save. For more detail, go to our discussion of boosting your benefits.
EVERY YEAR, INCREASE THE AMOUNT YOU SAVE BY THE INFLATION RATE. This is very important. Inflation is the retiree’s financial archenemy. If you begin your savings plan by putting away $500 a month, the true growth of your savings will slow over time as inflation reduces the value of $500. Increase the amount of your savings by the rate of inflation (or more) each year. Most people will find that their incomes more or less keep up with inflation. Even if your income doesn’t entirely keep up every year, try your best to increase your savings by the inflation rate. That way, your wealth accumulation will automatically adjust for inflation and you’ll have enough money for groceries when bread costs $12 a loaf (which it will within the lifetimes of many of our readers; you can count on it).
Invest in what you know and understand. Ordinary investors should stick to straightforward investments, such as mutual funds, CD’s, money market funds, stocks and bonds. Keep your investments simple. That helps to keep your investment risk levels reasonable. Diving into esoteric and complex investments is likely to involve high risk. Ordinary investors may have trouble understanding these puppies and don’t have the resources to easily recover from losses.
Invest in an asset, not a person. Don’t turn your money over to people or organizations that aren’t familiar to you. Also, don’t turn money over to someone simply because he or she appears decent and honest. Many fraudsters are charming and likeable people, and appear trustworthy. Don’t think that you can spot a crook.
Beware of glowing promises. If an investment sounds too good to be true, it probably isn't true.
Don’t invest in something simply because your family or friends have invested in it. Those close to you may have been deceived by con artists, and could unknowingly rope you into a scam. The fact that their intentions may be good doesn’t protect your money.
Always be dispassionate, analytical, and objective about investments. Don’t worry about hurting someone’s feelings. It’s your money, and you don’t owe it to anyone to risk your hard earned savings.
Use retirement accounts such as 401(k)’s as much as possible. Start with any account where there is an employer match—that would be in the 401(k) type accounts. Use Roth or traditional IRAs as well—certainly, use them if nothing else is available. If you’re self-employed, look into SEP-IRAs and SIMPLE IRAs, or consult with a tax accountant about more sophisticated retirement plans. (For more detail, see our discussion of retirement accounts).
Look for low costs. Low cost providers of mutual funds include firms such as Vanguard and, for some funds, Fidelity. Vanguard has made low costs its hallmark. Fidelity is not always a low cost provider, but has some funds that are relatively inexpensive (such as its index funds; Fidelity's actively managed funds are not so much of a bargain). It’s important to check out the fees and expenses of each fund you consider, as well as its performance. Low cost funds may be found in other mutual fund families as well; feel free to investigate elsewhere. However, Vanguard and Fidelity are good places to start if you’re looking for low cost money market funds and index funds. Vanguard also has low cost lifecycle funds. If you invest in individual stocks and bonds, look for a discount broker. Some online brokerage firms have very low costs.
Compound the growth of your investments. Whether you invest in mutual funds, individual stocks and bonds, money market funds, or bank or credit union accounts, be sure to reinvest the interest, dividends and other gains. Reinvestment is crucial to the compounding effect of your investments. The advantageous returns that stocks have offered (approximately 9% per year since 1926 or 7% since 1900) assume that you reinvest dividends. If you don’t reinvest, your returns will probably be lower than you expected. Remember, if you love compounding, compounding will love you.
Now, let's turn to the Model Plans.
Model Plan 1: Getting Started.
If you're just getting started with building wealth, and maybe recently got the brush off from a financial planner, we'll give you a few ideas for starting out.
1. Open a Retirement Account. Get into the habit of saving by opening a retirement account. If you have access to a 401(k) plan at work (or the small business equivalents, SIMPLE IRAs or SEP-IRAs), open an account. If your employer doesn't offer retirement accounts, open an individual IRA. If you're relatively young (under 45), open a Roth IRA if you can. Otherwise, open a traditional IRA. If you have an employer sponsored account, contribute at least enough to get the full employer match, if there is one. If there is no employer match, contribute at least 5% of your salary. For individual IRAs, try to contribute the maximum permitted ($4,000 in 2007; $5,000 if you're 50 or over), whether or not you can deduct it. Invest the money in a lifecycle fund, if possible. If you don't have a lifecycle fund as an investment option, choose index funds. Put 70% of your contributions into an index fund that mimics the S&P 500 stock index and 30% of your contributions into an index fund that mimics the bond markets as a whole. While you'll want to think about diversifying your investments in a way that is suitable for your age (see Plan 3 below), the 70%/30% ratio is a good place to start if you have no real understanding of investment and finance.
2. Establish an emergency cash reserve. Open an account separate from your regular checking account to serve as your emergency cash reserve. This account can be at a bank or a credit union. Or, if you satisfy the minimum deposit requirements for a money market fund (usually a few thousand dollars), you'll be able to get a higher interest rate. Some online banks also pay relatively high interest rates. Ideally, this account should hold 3 to 6 months of living expenses. If you're just starting out and have some high interest debt (like credit card debt), try to get at least 1 to 2 months worth in the emergency fund while using other funds to pay off the high interest rate debt. Even though high interest rate debt is a financial drain, you should have some cash available as a buffer against life's unexpected U-turns.
3. Pay down high interest rate debt. Pay down credit card balances and other high interest rate debt. Once these debts are paid off, don't carry a balance from month to month. Pay off any new balance at the end of each month.
4. Build up your savings. After getting rid of your high interest rate debt, beef up the emergency cash reserve to 3 to 6 months of living expenses and then increase your retirement fund contributions to the maximum allowed. Use other funds to pay down longer term debt like student loans. After you've gotten your debt levels down, you'll be able to devote more cash flow to saving and investing. Think about transitioning to one of our other model plans. Or you can develop your own financial plan.
What would Plan 1 look like in action? Let's assume we have a single person in his or her late 20's, making $40,000 a year.
1. Retirement Account. This person contributes 5% of his or her salary to a 401(k) account (or $2,000 a year). The employer provides a 3% match, so the account grows by 8% per year (that's an immediate $3,200 for an investment of $2,000!) plus investment returns. The account assets are invested in a lifecycle fund, which takes care of diversification.
2. Emergency cash reserve. Even though life as a single person in his or her 20s has a lot of financial demands, our saver has directed his or her bank to automatically transfer $100 a month into a savings account, which serves as an emergency cash reserve. After a few months, this account starts to look pretty good. After a year, this account will feel warm and fuzzy.
3. Pay off credit card debt. Our saver has cut back on mindless spending, and is gradually reducing credit card balances. Our saver had two credit cards, one with a small balance and one with a large balance. The small balance is paid off first, an early triumph against poverty in old age.
4.Build up savings. When our saver has finished paying off high interest rate debt, he or she will build up the emergency cash fund, increase contributions to the retirement account to the maximum allowed, and look for suitable ways to use additional savings. Paying off student loans early would be a good idea. A lifecycle fund is a good place for long term investment. A money market fund is a good place for a downpayment on a house.
5. Insurance. Our saver has health insurance coverage through work, or an individual policy, if his or her employer doesn't provide health insurance. Our saver also has substantial liability coverage on his or her car (like $500,000 or $1,000,000--the premiums for increased liability coverage are cheap if your driving record is good), and a tenants policy (or homeowners coverage if he or she owns a home). Disability coverage isn't really necessary at this age and stage of life, but is a decent idea if you can afford it.
Plan 1 is really just an interim measure for digging yourself out of debt and setting the stage for long term financial growth. Once you've got your spending under control, your high interest rate debt paid off, and are ready to build wealth for the long term, consider one of the following plans.
Model Plan 2: Lifecycle Funds, the Essence of Simplicity
If you want to minimize the amount of work required to manage your investments, follow this plan.
Invest in Lifecycle Funds. As we covered in our discussion of managing investment risk, lifecycle funds manage your money for you. They invest in a diversified portfolio of mutual funds holding stocks or bonds, and perhaps put a small portion of their assets in money market funds. Then, as you grow older, they alter the portfolio toward a more conservative mix of investments in order to gradually reduce your risks and lock in your gains. Change toward a more conservative investment mix is what people should do themselves as they approach retirement. With a lifecycle fund, the managers of the fund do the work for you.
Lifecycle funds have “target dates,” which is the year in or near which its investors expect to retire. In that year, the fund managers will shift the fund’s assets into a conservative mix of assets they believe to be suitable for retirement. Most mutual fund managers offering lifecycle funds have several funds to choose from, each with a different target date. What you do is pick a fund with a target date at or near the year when you expect to retire, and invest your money.
If you choose a lifecycle fund, you should monitor the fund’s asset allocation to make sure you are satisfied with it. Different lifecycle funds have moderate differences in asset allocation and investment philosophies. Some may be too conservative for you and others may be too aggressive. Some have higher levels of expenses and fees than others, and you should pay close attention to these costs because they have a direct impact on your return. Some lifecycle funds may invest only in index funds with low expense and fees, which keeps the lifecycle fund’s overall costs down. Others may invest in actively managed mutual funds, which will generally raise the expenses of the lifecycle fund. In general, there is no reason to expect that actively managed funds will do better than index funds. So you should lean toward the low cost alternative.
If your 401(k) plan offers lifecycle funds, invest in the one that has a target date closest to your planned retirement date (assuming its management fees and expenses are reasonable). If your 401(k) plan does not offer lifecycle funds, lobby for them. While they aren’t for everyone, they should be an option.
Model Plan 2.a. Multiple Lifecycle Funds. Keep in mind the possibility of investing in more than one lifecycle fund. While some financial professionals might argue that this undermines the purpose of the lifecycle fund—which is to have one place that is complete in itself and manages your portfolio in a way that targets your anticipated retirement age—life sometimes is more complicated than that. If you aren’t sure how long you will work and want to hedge your bets, invest some money in a lifecycle fund with an early target date (e.g., when you’ll reach 62) and some more money in another lifecycle fund with a later target date (e.g., when you’ll reach 67). That way, the money in the earlier fund will be handled in a suitably conservative way if you retire earlier. You can roll it over into a fund with the later target date if you choose to keep on working. But all along, you will have had some money in the fund with the later target date, so you’d be partially prepared for retirement around 67. If you do retire at 62, you can transfer the funds in the later fund to the earlier fund.
Another possibility is that if you want to fund a child’s or grandchild’s college education, you could select a lifecycle fund with a target date around the time the child reaches 18. At the same time, you could have an account with another lifecycle fund that has a target date approximating the year you expect to retire. This way, you can fund education expenses in a way that makes the assets ripe for use at the time your child (or grandchild) reaches college age, and you can also fund your retirement without having to devote a lot of effort to investment strategizing. Educational account such as a 529 Plan or a Coverdell accounts may not offer lifecycle funds as an investment option. However, these special college savings plans sometimes have high fees and expenses. As is detailed in our discussion of saving for college, a low cost taxable investment can provide returns as good or better than some college savings plans. Thus, a low cost lifecycle plan may be a suitable place for college savings.
What would Plan 2 look like in action? Let’s assume we have a married couple in their 30’s with one child. One parent works, making $60,000 a year, and the other stays at home with the child. They have monthly expenses (after taxes, savings and the costs of health, disability and life insurance) of $3,200. For about the last ten years, they have contributed $500 a month to a 401(k) account and $100 a month to a money market account. They come from modest backgrounds and have not inherited anything, nor have they received much financial assistance from their parents. Here’s a look at their financial picture:
1. Emergency cash fund: $10,000 in a money market account serves as an emergency cash fund. It covers only 3 months of expenses; 6 months worth would be a better buffer. But they have done well to set aside this much.
2. Insurance: health, disability, life, homeowners and auto policies. They have a lot of their risks covered. They don’t have enough wealth to justify having an umbrella policy. A long term care policy might be worth thinking about, because it’s inexpensive if one buys in one's 30’s (look for a policy whose premiums don’t increase over time). But long term care coverage is not important for this couple unless they are fairly sure they’ll have substantial wealth in retirement.
3. 401(k) account: $60,000 invested in a lifecycle fund with a target date 30 years in the future. Since the money is in a lifecycle fund, they don't need to worry about asset allocation, rebalancing or other portfolio maintenance.
If you have several retirement accounts, like an old employer’s 401(k), a new employer’s 401(k), a traditional IRA, and a Roth IRA, be sure to coordinate the diversification of all these accounts. Your collective retirement portfolio should be all invested in lifecycle funds, or should have the profile described below for Model Plan 3 that is suitable for your age.
Model Plan 3: Do It Yourself with Mutual Funds
Some people like to decide for themselves how to invest. Their goals in life and tolerance for investment risk may not be accommodated by the choices between vanilla, chocolate and strawberry offered by lifecycle funds. They may wish to retire relatively young (say, at 55), yet would keep a lot of money in stocks to cover a potentially long retirement. That could require an investment allocation that would separate one’s portfolio into two segments—one that is invested conservatively to provide income for current living expenses and another that is invested aggressively for long term growth. The asset mixes used by lifecycle funds might not be suitable for such a goal.
To have more control over how your portfolio is invested, yet avoid having to do a lot of work researching investments, select a small group of mutual funds to achieve the diversification you desire. You should be careful about using lifecycle funds if you are a do-it-yourselfer, because you can’t control the diversification in lifecycle funds. Their diversification is controlled by the mutual fund management company.
In general, use funds like index funds, lifestyle funds, and bond funds. Index funds hold baskets of the stocks that comprise stock market indexes, like the Standard & Poor’s 500. They tend to increase or decrease in value in line with changes in the index they mimic. Lifestyle funds (as distinguished from lifecycle funds) are diversified funds that usually contain a mix of stocks and bonds. They can have conservative or aggressive investment philosophies, or something in between. Unlike lifecycle funds, however, lifestyle funds do not change their asset mix as you get older. If they start out conservative, they will always be conservative. If they start out aggressive, they will always be aggressive. It’s up to you to alter your asset mix as you get older.
We now turn to a key question: what mix of assets should you have, and how should it change as you grow older?
You can choose your own mix or consult a financial planner. Or you could use the following benchmarks (which assume that you will retire around 65 and have a normal life expectancy):
| Age up to 29: | 90% stocks and 10% bonds |
| Age 30 to 39: | 80% stocks and 20% bonds |
| Age 40 to 49: | 70% stocks and 30% bonds |
| Age 50 to 59: | 60% stocks and 40% bonds |
| Age 60 to 69: | 50% stocks, 40% bonds and 10% money market funds or CDs |
| Age 70 to 79: | 40% stocks, 40% bonds and 20% money market funds or CDs |
| Age 80 plus: | 30% stocks, 40% bonds and 30% money markets or CDs |
Note: It would probably be a good idea to make foreign stock funds about one-quarter of the stock component of your portfolio (not one-quarter of the entire portfolio). It would also probably be a good idea to make "small cap" stocks about one-quarter of the stock component of your portfolio. (Small caps are stocks of smaller companies.) Investing some money in foreign stocks and small caps is prudent for diversification purposes.
There is nothing magical about these benchmarks, and you should feel free to vary them if you wish. We won’t tell you they will generate greater profits than someone else’s benchmarks. But they are easy to understand and relatively easy to use. You may have noticed that the recommended amount of cash, in the form of money market funds or accounts, and bank CD’s, increases noticeably in the retirement years. That’s because your cash needs tend to increase, and sometimes dramatically, in old age. You don’t want stock market fluctuations to take away your ability to pay for necessary medical care or other important expenses. Having a significant cash cushion is important.
You may have also noticed that the recommendations for 80 and above included 30% in stocks, and wondered why someone that old should hold relatively speculative investments. Not that many people reach 80, but if they do, their life expectancies average around 9 years. That’s only an average, which means many of them live into their 90’s. Having a significant portion of an 80 year old’s assets in stocks is prudent to provide the potential for growth in case she or he keeps on chugging along for 10 or 15 more years.
What mutual funds should you invest in? That’s where the do-it-yourself part comes in. We don’t recommend particular mutual funds for this purpose, since each individual could have different needs and different tolerances for risk. If you want to do it yourself, start learning about mutual funds. The more you learn, the better off you’ll be. If you want to keep things simple at first, consider using mutual funds that more or less replicate the performance of entire asset classes. For example, the Vanguard Total Bond Market Index Fund or the Fidelity U.S. Bond Index Fund are designed to produce results approximating those of the U.S. bond markets. Examples of funds that more or less replicate the U.S. stock markets are the Vanguard Total Stock Market Index Fund and the Fidelity Spartan Total Market Index Fund. To add international stocks as further diversification, consider the Vanguard Total International Stock Index Fund or the Fidelity Spartan International Index Fund. While these funds may not be ideal for everyone, they give you a place to begin your evaluation of funds.
What would Plan 3 look like in action? Let’s again assume we have a married couple in their 30’s with one child. One parent works, making $60,000 a year, and the other stays at home with the child. They have monthly expenses (after taxes, savings and the costs of health, disability and life insurance) of $3,200. For about the last ten years, they have contributed $500 a month to a 401(k) account and $100 a month to a money market account. They come from modest backgrounds and have not inherited anything, nor have they received much financial assistance from their parents. Here’s a look at their financial picture:
1. Emergency cash fund: $10,000 in a money market account serves as an emergency cash fund. It covers only 3 months of expenses; 6 months worth would be a better buffer. But they have done well to set aside this much.
2. Insurance: health, disability, life, homeowners and auto policies. They have a lot of their risks covered. They don’t have enough wealth to justify having an umbrella policy. A long term care policy might be worth thinking about, because it’s inexpensive if one buys in one's 30’s (look for a policy whose premiums don’t increase over time). But it’s not important for this couple unless they are fairly sure they’ll have substantial wealth in retirement.
3. 401(k) account: $60,000 invested index mutual funds. The total is allocated as follows: (a) 80%, or $48,000, in stocks, with $36,000 in a U.S. market-wide stock fund (they picked the fund) and $12,000 in a diversified foreign stock fund (also their pick); and (b) $12,000 in a bond fund that mimics the U.S. bond market (again, their pick).
If you have several retirement accounts, like an old employer’s 401(k), a new employer’s 401(k), a traditional IRA and a Roth IRA, you should coordinate the diversification of all these accounts. Your collective retirement portfolio should have the profile described above. It’s okay to have one account invested entirely in, say, a low cost bond fund, as long the funds in other accounts are invested in stock funds or other investments that provide appropriate overall diversification for your portfolio as a who.
You may find that you enjoy dabbling in the financial markets; and the more you enjoy investing, the better you are likely to do.
As a do-it-yourselfer, be sure to rebalance the portfolio periodically. The one thing you can expect the financial markets to do is fluctuate. Sometimes, the stock market will boom. Other times, it will sink. The bond market also has good and bad times, although its fluctuations tend to be quantitatively smaller than the stock market’s gyrations. These oscillations will alter the asset allocation of your portfolio. For example, let’s say you are in your 40's and started with 70% of your portfolio in stock funds and 30% in bond funds. Then, the stock market booms. That may increase the value of the stock portion of your portfolio such that your asset allocation becomes 80% stock funds and 20% bond funds. If so, your exposure to the risks of stocks is too high, and you should rebalance the portfolio. To do this, sell off a portion of the stock funds and invest the proceeds in bond funds, enough so that you bring the portfolio allocation back to its original 70/30 ratio. Similarly, if stocks fall and the percentage of the portfolio in stock funds drops to 65% stocks and 35% bonds, sell off a portion of the bond funds and invest it in stock funds, enough to bring the stock fund portion back up to 70%. Rebalance about once a year. Rebalancing more often may have you chasing short term fluctuations in the market that ultimately wash out. You might just end up doing a lot of work and incurring lots of transaction costs for little or no benefit. On the other hand, rebalancing less often than a year may mean that you stay out of balance too long.
If all this talk of research and rebalancing makes you think you’d rather mop floors and take out the trash, stick to Plan 2 and use lifecycle funds.
Model Plan 4: Do It Yourself with Stocks and Bonds
You can also build a portfolio by investing in individual stocks and bonds. Back in the days when the Internet didn’t exist and most pop songs were about love rather than disillusionment, this was how almost everyone invested. If you want to go down this road, you can use the asset mixes recommended for Plan 3 above. Or, you can tweak the percentages as you like. But remember that you’re putting yourself in the driver’s seat, and you’ll have to do the driving.
Be sure you think about your investments. The business of picking stocks and bonds can be enormously complex and we won’t do more than touch upon a few basic principles:
One, make sure you understand what a company is about. If you don’t understand it, you can’t rationally decide whether or not to buy its stock, or when to sell.
Two, make sure you have intelligent reasons for buying or selling the company’s stock. You should have a thought process that justifies buying or selling. Don’t blindly follow someone else’s lead or recommendation, no matter how smart or knowledgeable you consider that person to be. Make an independent decision yourself.
Third, diversify. This is harder with individual stocks, because you won’t be able to personally buy the hundreds of stocks that many mutual funds hold. You’ll have to choose carefully, making sure that you aren’t heavily concentrated in any one industry, region or type of stock (such as large capitalization stocks vs. small capitalization stocks, value stocks vs. growth stocks, interest rate sensitive stocks, stocks sensitive to energy prices, etc.). Diversifying on your own can take a lot of work, not because you’ll be buying many stocks; you probably won’t. But you’ll have to choose from among many stocks, and that takes a lot of work. Avoid putting more than 10% of your portfolio in any one stock. (That's generally what mutual funds do, and it's a good rule of thumb.)
Fourth, monitor your stocks regularly. Check up on them at least once a week. Every day isn’t too often, since things can happen quickly in the stock markets. (We weren’t kidding when we said this takes work.)
Fifth, understand that deciding to sell is probably a harder decision than deciding to buy. There is no easy way to know when to sell. A stock doesn’t flash yellow warning lights when its price is about to peak and start falling. Sometimes, circumstances will tell you when to sell—the arrival of a child’s tuition bill, the need for a larger house, or retirement expenses. But even then, which of your stocks do you sell? There’s no simple answer. Selling is usually a harder decision than buying.
In addition to thinking about your stocks, avoid rapid fire trading. In general, buying and selling stocks and bonds within a short period of time—such as a few days, weeks or even months—is less likely to be profitable than buying and holding for years. That’s because the transaction costs of rapid fire trading--commissions and fees--can build up quickly and eat away at your profits. However, don't blindly buy and never sell a stock. Some stocks turn out to be dogs, and you shouldn't keep the ones that aren't keepers.
As a do-it-yourselfer, be sure to rebalance the portfolio periodically. Just as with mutual funds, fluctuations in the values of individual stocks and bonds may shift the proportionate value of your portfolio’s diversification away from the ideal ratios. Sell where you have too much exposure and buy where you don’t have enough, so that you bring the portfolio back to the desired ratio. Rebalance annually.
Be sure to reinvest dividends and interest. This is essential to getting the advantageous compounded long term returns that stocks have provided. It also enhances returns on bonds and money market funds. Reinvesting on a do-it-yourself basis is harder than with mutual funds (which allow you to automate reinvestment). You get dividend checks and interest payments, and the big screen TV on sale at the mall beckons. Heed not its siren call. You can enroll in an automatic stock dividend reinvestment program, if the company issuing the stock has one. In this sort of program, the dividends are automatically used to buy more of the company’s stock. You’ll still have to pay income taxes on the dividends but at least you will have the reinvestment part of the process on autopilot. If you don’t want to enroll in dividend reinvestment, or can’t because it’s not an option, then make sure you invest dividends and interest in other investments. As we've said before, if you love compounding, compounding will love you.
Use discount brokerage firms. The full service brokerage firms are geared toward people with a lot of money—they like to see at least $100,000 in an account. An ordinary investor may not have enough assets to interest the full service firms, and you might find their fees and other charges uneconomical. A discount firm will have lower fees and costs. It will not offer the full range of services of the large full service firms, but an ordinary investor isn’t likely to need all of those services. Concentrate on building your wealth, rather than spending your money for services you don’t need.
What would Plan 4 look like in action? We turn again to our hypothetical married couple in their 30’s with one child. One parent works, making $60,000 a year, and the other stays at home with the child. They have monthly expenses (after taxes, savings and the costs of health, disability and life insurance) of $3,200. For about the last ten years, they have contributed $500 a month to a 401(k) account and $100 a month to a money market account. They come from modest backgrounds and have not inherited anything, nor have they received much financial assistance from their parents. Here’s a look at their financial picture:
1. Emergency cash fund: $10,000 in a money market account serves as an emergency cash fund. It covers only 3 months of expenses; 6 months worth would be a better buffer. But they have done well to set aside this much.
2. Insurance: health, disability, life, homeowners and auto policies. They have a lot of their risks covered. They don’t have enough wealth to justify having an umbrella policy. A long term care policy would be worth thinking about, because it’s inexpensive if one buys in one's 30’s (look for a policy whose premiums do not increase over time). But it’s not important for this couple unless they are fairly sure they’ll have substantial wealth in retirement.
3. 401(k) account: $60,000 invested in stocks and bonds. Approximately $48,000 is invested in stocks (they picked them), and some of the stocks are for companies with significant overseas operations (these can be U.S. based companies or foreign companies—the point is to get some exposure to the growth potential of other countries). It's hard to avoid putting 10% of the portfolio in any one stock because $60,000 is a relatively small sum of money. A relatively young couple like our savers can afford to take the risk of a little more concentration, since they have many years to save. However, they shouldn't put more than 15% or 20% of their portfolio into any one stock. Approximately $12,000 is invested in medium term bonds (those with an average maturity around five years). Again, it’s difficult to economically invest a sum as small as $12,000 in anything approaching a diversified group of individual bonds. So the safe thing to do might be to invest all $12,000 in five-year U.S. Treasury notes, which have no credit risk.
If you have several retirement accounts, like an old employer’s 401(k), a new employer’s 401(k), a traditional IRA and a Roth IRA, you should coordinate the diversification of all these accounts. Your collective retirement portfolio should have the profile described above. It’s okay to have one account invested entirely in, say, bonds, as long the funds in other accounts are invested in stocks or other investments that provide appropriate diversification.
Assembling a portfolio of individual stocks and bonds takes work. You should research each investment carefully before buying, and then monitor it often because stocks and bonds can go bad for a variety of reasons. If the investment goes sour, you have to make the hard decision whether or not to sell. It’s generally better to cut your losses and move onto something more promising. Not every stock or bond should be held for the long term. Holding onto losing investments in the hope that they will rebound is a close cousin of the gambler’s mentality that just one more spin of the roulette wheel will turn the evening around. Don’t gamble with your retirement investment plan.
Be sure to keep detailed and complete records. If you buy and sell individual stocks and bonds, you will be duly punished when it comes time to prepare your tax returns. Figuring out your gains or losses on a stock, particularly one that has been held for quite a few years, or has split, or has been involved in a merger or tender offer, is less fun than cleaning out a flooded basement. You can’t begin to figure out your tax basis in such a stock (which would usually be the original cost) without detailed information, some of which may date back several decades if you bought the stock a long time ago (or inherited it). The records of your brokerage firm may not be accurate, especially if your account is very old or you've moved your account around from firm to firm. Financial firms are required by law to keep records for only a few years, and then they usually destroy them. That means you have to hold onto the relevant records yourself, no matter how old they might be. Paper is the best form. (That’s right, the stuff made of trees.) If you bought stock in 1984 and kept the information about the purchase on a 5 ¼” floppy disk, how would you access that data today? There hasn’t been a PC built in years that could read a 5 ¼” floppy disk. Some younger readers of this website may not even know what a 5 ¼” floppy disk is. If such a young person receives the stock as a gift and then sells it, how would he or she know the tax basis? Moreover, your records on a 5 ¼” floppy may not, in the IRS’ view, be the best proof of a stock’s original cost. The paper confirmation slip and account statements from the brokerage firm would be much better proof of the tax basis. But you’d have to keep them in order to have them available 30 years later when the stock is sold.
Maybe the thought of keeping paper records for 30 or 40 years is unimaginable to you. If so, think again about whether or not you want to own individual stocks. If you don’t keep proper records, then reconstructing the basis of the stock can involve trips to library microfiche rooms (and that could mean travel to big city libraries if you live in a small town), hours roaming around the Internet, paying a tax accountant to do the research for you (which can easily run more than $100 an hour), or simply assuming that the cost basis was zero (in which case you’ll pay more in taxes). Actually doing this stuff is worse than it sounds.
People who enjoy the financial markets and would consider it fun to do a lot of financial research (and who can keep careful records and don’t mind serious aggravation during tax season) are probably well suited to investing in stocks and bonds directly. But if it’s all just work and more work to you, stick to Plan 2 and use lifecycle plans.
Model Plan 5: Do What Makes You Comfortable
Here’s where we really part ways with financial professionals. The reality is that some people simply don’t buy the financial planning industry’s accepted wisdom. They, too, need to save for retirement, and we encourage that.
If you don’t like the idea of investing in stocks or bonds, if you don’t feel comfortable sending your money to a mutual fund management company two thousand miles away, if you can’t stomach the ups and downs of the financial markets and just want to know exactly how much you have, then invest in whatever makes you comfortable. If that means putting 95% of your assets into credit union or bank CD’s, then go ahead. If it means you stash everything in a money market fund, so be it. Financial planners won't tell you this is okay, but we will tell you it’s okay. It’s much more important for you to save than to get the ideal asset allocation. If you can save only when your sleep isn’t disturbed by financial market gyrations, then save conservatively and sleep. You’ll be much better off with a large balance in a passbook savings account than if you don’t save at all.
If you take a cautious approach, save a large part of your earned income (like 15% or 20%,, if possible). These investments may not keep up with inflation. But, if you save a high proportion of your income, you’ll still end up with a pretty decent retirement. Later, you may begin to accept the idea of taking some investment risk to get greater gains, and can then begin to diversify your portfolio.
Now that we've gone through the model financial plans, you may be thinking, "I'm glad we got through that."
Unfortunately, we haven't gotten to the hard part. What comes later is harder. So far, we've covered basic financial planning, and it's doable if you put your mind to it. Steadily saving in one or another of these plans—or something that you tailor to your own tastes—will go a long way to building wealth. Of course, financial planning can become much more complex than this, especially for multi-millionaires. But for the ordinary investor, over-complicating the financial plan only makes it harder to get started. Keep it simple, save steadily and you'll probably do well over time. Saving may seem hard. After all, new cars and oxen-roasting backyard grills are left unbought. Oversees vacations aren’t taken. Long weekends aren’t spent being pampered at spas. Elegant restaurants staffed by snooty waiters who pretend to be French aren’t patronized. Numerous urges and wishes aren't indulged. But all of those sacrifices made your wealth grow, which feels better than receiving a retirement watch.
The hard part comes in retirement. Once you’ve accumulated a bundle for your golden years, you’ll have to make your money last in retirement. For that, turn to our discussion of finances in retirement and our discussion of making retirement money last.
If, however, you’re also concerned about paying for a child or grandchild’s college expenses, go to our discussion of saving for college.