Three Principles of Personal Finance: #2 Make The Money You Have Work For You

This is the second part of a series entitled: “Three Principles of Personal Finance.” To read the first installment on Principal #1: Spend Less Than You Earn, please click here.

If you saved $10,000 a year for the next 40 years and earned no interest, you would have $400,000. If you invested $10,000 a year and earned a 10% return each year, you would have $5,267,155. Why the difference? Because your interest earns interest, and its interest earns interest, and so on. The result is exponential growth. Remember calculus? This time it actually works for you.

To obtain real wealth, you need to redeploy your money. And that means investment. It’s how capitalism works. You can invest in stocks where you own a part of a corporation; bonds where you loan your money out and earn interest in return; invest in real estate; or start your own business.

Managing real estate can be a full time job, and owning your own business certainly is. Since both of these may require radical changes in life style, we’ll ignore them to focus on investments open to everyone: stocks and bonds.

Stocks vs. Bonds:

Over the last 200 years, stocks have consistently and reliably outperformed bonds. Not counting inflation, stocks have averaged 10% a year; and 14% for the past 20 years. Accounting for inflation, stocks have provided a “real” return of 7% annually, doubling their value every 7 years. By contrast, bonds have produced an average real return of 4.5%, doubling only every 16 years¹.

For money you need in the next four years, stocks may not be the right choice. In the short term, the market may swing widely up or down. You can lose money. In the long term, however, a portfolio weighted heavily in stocks has consistently outperformed one weighted towards bonds or other fixed-income investments (such as CDs or money market funds).

Individual stocks are risky. Any one company might go out of business, suffer an accounting scandal, or miss their quarterly earnings. To distribute your risk (or in investment terms “diversify your portfolio”), invest in a mutual fund. But be aware of the big differences between those that are “actively managed” vs. “indexed”.

Some mutual funds are actively managed by professionals. This active trading comes with a cost: management fees, administrative fees, and transaction costs can eat up to 2% of your investment each year. Active trading also means more taxes in the form of short term capital gains. Are they worth the cost? Often, they’re not: 80% of mutual funds under-perform the S&P 500 index. You should also be aware that choosing the right mutual fund is nearly as hard as choosing the right stock.

By contrast, index funds are “passive” – these funds invest in specific set of stocks designed to simply mirror the market instead of trying to out-guess it. The result: fees at index funds like the Vanguard S&P 500 are less than 0.20% annually.

Pay Yourself First:

You pay the government. You pay your rent (or mortgage). You pay your bills. How about paying your (future) self for change? They key is to do it automatically, every paycheck, before you get a chance to spend or even see the money.

If your company has a 401kplan, start contributing. This money comes out of gross-pay and is not taxed. Even better, companies often “match” employee contributions. You put in $1, they put in $1; it’s like doubling your money immediately. Even if you company matches only $0.50 to the dollar, that’s still an instant 50% return.

If your company does not have a 401k (or you’ve maxed it out), you can setup “automatic” investments with E*Trade, Fidelity, Vanguard, and most major brokerages. Each month, they’ll take $1,000 from your checking account, and put it towards the investment (hopefully an index fund!) of your choosing.

The Magic of Compound Interest:

The end result of automatic monthly investments: wealth that grows year after year.

You can run the numbers yourself by clicking here.

Think you’ll be a millionaire? Be wary of taxes. Instead of a 10% return, taxes knock it back to 7%. If you’re 30, that means your $500 a month investment drops from $1,898,319 to $900,527. But there is a way to avoid taxes; it’s called an IRA (Individual Retirement Account).

Like a 401k, an IRA allows your money to grow tax-free until you take it out for retirement. Unfortunately, if you need to money before retirement, you’ll be hit with penalties and be forced to pay the extra taxes. A better alternative, especially if you’re young, may be a Roth IRA. Contributions to a Roth IRA are made from after-tax income. As a result, you can withdraw your original contributions at any time, penalty and tax-free.

By “avoiding taxes” and investing small amounts every month, anyone can achieve financial security. Check in tomorrow for the final part of this series and the last principal: “Prepare for the unexpected.”

Takeaways:

• Weigh your long term portfolio heavily towards stocks.
• For money needed in less than four years, keep it in a high-yield savings account, money market fund, or CD.
• Invest $100-$1,000 a month automatically into index funds or the closest alternative offered by your company’s 401k plan.

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Notes:

1. See “Stocks for the Long Run” by Jeremy Siegel, Chapter 1.