Financial Literacy

Investing - what is it, and how can it help you achieve financial independence?

Virtually everyone has heard stories like this - if you had invested a small amount of money in "Company X" years before its stock price took off, you'd be a millionaire today. Apple was one of the most famous examples: An investment of just $1,000 in 1980 is worth nearly $2,000,000 today.

While the average investor doesn't often experience this kind of stock market gain, the numbers don't lie - investing can be very profitable, and it's a cornerstone strategy of virtually all retirement plans. It can also be quite daunting for beginners and younger investors - sometimes so much so that it's challenging to get started. In that case, procrastination (or foregoing investing altogether) can cost you considerably over the long term.

With that in mind, let's talk about the fundamentals of investing.

Basics for New Investors

The basic idea behind investing is simple - making your money earn more for you. You can do this in various ways, but one of the most common methods is purchasing stocks, bonds, mutual funds, or real estate. In the investment world, these four things are called asset classes. Let's review the basics of each asset.

• Stocks, sometimes called equities, are simply a way to own a piece of a company and its assets and earnings. If the company does well, its stock price usually goes up, making your share of the company more valuable. If a company struggles, however, the value of your investment may decline.

• Bonds are an investment where you loan money to a business or governmental agency in exchange for interest payments. They are more predictable and less volatile than stocks, making them a better choice for those not in a position to risk significant losses. The drawback is that while bonds are generally safer, the returns are typically far lower.

• Mutual funds are collections of stocks and bonds, generally speaking. Rather than risking a large amount of money on a single investment, mutual fund investors diversify their holdings by owning pieces of various individual stocks or bonds held within a single fund. This difference typically makes investment performance less risky and more predictable.

• Real estate is as simple as it sounds. You purchase property as an investment rather than as housing. The goal is to buy property that appreciates, or you can rent out the property you purchase to create a passive income stream. There are also real estate investment vehicles called REITs (Real Estate Investment Trusts), which allow you to invest in property much in the same way as stocks.

How to Get Started

The most common investment method for most people is a standard employer-run 401k retirement plan. You determine how much of your salary you'd like diverted into your 401k investments, and the company typically matches that amount. If your employer doesn't offer a 401k, you can opt for an Individual Retirement Account (IRA) or Roth IRA. Both provide significant tax breaks from the federal government. 

If you'd like to be more hands-on with your investments or expand your holdings, you can hire a broker or open an account at one of the many self-service online brokerages. While brokers can offer critical advice for investing neophytes, their fees will lower your returns.

Generally speaking, most experts suggest that new investors consider low-cost mutual funds tied to the performance of broad stock indexes like the S&P 500 (the 500 largest publicly traded companies in the country) or a similar index. The index funds typically offer fairly reliable performance at a reasonable cost. The average annual return for the S&P 500 over the last 90 years is around seven percent, adjusted for inflation.

The Takeaway

Investing your money wisely is one of the most important things you can do to secure your future financial independence. By following some basic principles, you can confidently begin your investing journey. And like any decisions you may make about money, if you need help with how to proceed, seek the help of a qualified financial advisor.

Investing in the stock market can feel like navigating a roller coaster of ups and downs. For "buy and hold" investors looking at long-term appreciation in the market, dollar-cost averaging presents a strategic method to mitigate market volatility and reduces the guesswork of trying to time investments.

By consistently investing a fixed amount into an investment at regular intervals, dollar-cost averaging allows investors to purchase more shares when prices are low and fewer when prices are high, averaging the investment cost over time.

This approach eliminates the temptation of trying to "time the market" - guessing when prices are low and offering the greatest chance for appreciation. By purchasing a fixed amount of a stock fund, for example, regularly, the price you pay is averaged.

An Automatic Approach 

Dollar-cost averaging is about making regular, disciplined investments regardless of market conditions. This approach can particularly appeal to those wary of market fluctuations or who procrastinate over finding the "perfect" time to invest. Automating investments at regular intervals (for example, each pay period) ensures continuous market participation, which can lead to potential long-term growth and profit accumulation.

Especially for those who may worry about choosing the right time to invest, this automatic approach means less stress and less second-guessing of your investing decisions.

Yes, dollar cost averaging means you may buy when prices are high. But you will also purchase a portion if the price falls - lowering your overall investment cost. The philosophy here is to buy smaller amounts over time at regular intervals rather than investing, for example, an entire year's worth of savings at once.

When the market hits a downturn (and it always does), traditional investors tend to sell off shares that are losing ground and look for better deals elsewhere. This strategy is the exact opposite of dollar cost averaging. When using this strategy, investors don't look at market downturns as something to worry about but rather as an opportunity for growth. When prices are down, your set investment amount will buy more.

Timing the Market Versus Dollar-Cost Averaging

Let's compare the two investment philosophies: trying to time the market and dollar-cost averaging in a period of market decline.

When trying to time the market, investors try to wait for the "right" time when prices are low. The investor, for example, would purchase $10,000 worth of stock at $100 per share. But if the price slides to $70 a share over the coming months, the investor would lose 30% or $3,000.

On the other hand, let's say an investor takes that $10,000 and purchases the same stock over an entire year. Over time, the stock price fluctuates (some will cost $100 a share, some $70 a share, and a few at prices in between). This approach means that the "average" cost of your shares will be lower than it would have been if purchased all at once - potentially resulting in higher buying power depending on how stock prices move over time.

When you use a dollar-cost averaging approach to buying stock, you spend the same amount during a calendar year. But if prices decline or fluctuate in a range, you may own more shares for the same investment. Then, when the price of the shares increases, you will have more shares and may experience higher gains.

If prices continuously increase without a temporary decline, making one purchase could be the better strategy. The problem is that it's impossible to say what will happen in the stock market over the short term. But over the long term, studies have shown that the most important thing is to be "in" the market without taking money in and out.

Who Benefits the Most From Dollar Cost Averaging?

The dollar cost averaging approach is a solid option for those who invest a portion of each paycheck, and for those who come into a large sum of money they'd like to invest while protecting against the possibility of a sudden price decline.

It's also a promising approach for investing in broad market indexes versus one individual stock. While broad averages have continuously increased over the long term, some individual stocks lose all their value. In the latter case, buying more of a stock that goes to zero wouldn't be the best idea!

The Takeaway

While dollar cost averaging is not a one-size-fits-all solution, its disciplined approach can be a practical component of a diversified investment strategy, suitable for a wide range of financial goals and risk tolerances.

Long-term investments offer a bigger reward than trading in and out of the market. Just ask Warren Buffet - many of the "Oracle of Omaha's" investments have been held for decades. While watching your investment portfolio decrease in value without taking action can be challenging, the key to a buy-and-hold investing strategy is having the patience to withstand the inevitable ups and downs of a volatile market.

In other words, getting caught up in market swings can send many inexperienced investors to the selling table. And, by selling and waiting for the right time to reinvest, there is the chance of participating in the long-term appreciation of the market.

What Are Buy and Hold Stocks?

Buy-and-hold stocks are long-term investments that you feel comfortable keeping for at least one year – but preferable for several. By holding stocks through several market cycles, you have a much better chance of walking away with more significant profits. And keep in mind that when we say "stock," we're also referring to not only high-quality individual stocks but stock indexes and mutual funds.

But how do you know which stocks are suitable for long-term investing? The best strategy is to use a combination of fundamental and contrarian indicators to make your decisions.

Fundamental Indicators

The key tools in long-term trading are fundamental indicators. They tell you if a stock, industry group, or index (such as the S&P 500) is undervalued or overvalued. Fundamental indicators include things like:

• Earnings, cash flow, and debt
• Industry benchmarks
• Financial plans
• Future growth potential
• History of the industry/company

When looking at a particular company, for example, comparing its earnings, debt, cash flow, and potential growth, you can estimate the company's current financial health and whether or not its potential for future growth is strong enough to warrant you holding your investment for years – or even decades.

Contrarian Indicators

Unlike fundamental indicators, which help to prove a company's strength, contrarian indicators go against standard analysis. This means that you see potential in a stock you think is being overlooked at the time and are willing to take a chance investing in an up-and-coming company or industry.

Short and pull-call stock option ratios are all contrarian indicators that may make you take notice of a particular stock. Keep in mind, however, that using contrarian indicators does make your purchase riskier, although the benefits of a successful buy can be quite profitable when you hit the mark.

Buying and holding stocks for the long term takes a certain amount of faith, patience, and the ability to see the big picture. Long-term investing is not for the weak or skittish, and it is certainly not for those out to make a quick profit. The ability to foresee future opportunities and the calmness to stick it out when the market experiences unexpected lows can all work towards more significant investment returns. 

The Bottom Line 

The buy-and-hold strategy can work in building future wealth, but the ups and downs of the market may tax the nerves of the less experienced investor. However, when the goal is long-term appreciation, the buy-and-hold strategy offers a history of success - primarily when investing in a broad index of stocks. Please consult a qualified financial professional if you need clarification on whether any investment or strategy is suitable for you.

You may hear interviews with them on the radio, see their infomercials on television, or even follow them on social media. Today's financial gurus are everywhere, and they have a lot to say about your money - and how you spend it. 

These modern mavens blend expertise with showmanship, offering a mix of entertainment and (perhaps) financial wisdom. Their advice may seem solid, but the question remains: do these people really know what they're talking about?  Is it smart to trust what they have to say? 

Financial gurus often share their wisdom from personal trials, including past financial struggles, which humanizes them and makes their advice seem more credible. For example, Suze Orman and Dave Ramsey have openly shared their financial ups and downs, potentially making their guidance feel more authentic and tested. But remember, while their experiences may resonate with you, their advice might not be right for you.

No single financial plan can universally apply to everyone's unique circumstances. For example, strategies like selling off assets to eliminate debt works well if you have assets to sell. But what if your financial challenges come from situations you didn't create or can't control, like a health crisis or job loss? In these cases, the broad-brush advice from celebrity financial experts may be less than helpful.

Or consider Jim Cramer, a well-known television personality and former hedge fund manager who gives stock recommendations on his CNBC show. Based on his background, it could be tempting to apply his stock recommendations to your investment portfolio. There's just one problem - the performance of his stock picks rarely beats that of the market as a whole. And some suggestions, such as the recommendation to buy Silicon Valley Bank, failed dramatically when the bank went out of business just one month later.

Finding Advice That's Right for You

Instead of putting too much faith in a financial entertainer, consider extracting relevant tips from various experts and stitching them into a personalized financial plan. Dave Ramsey's methods may help you spot and correct poor spending habits. At the same time, Suze Orman's advice could guide you toward financial accountability, and David Bach's expertise might assist in expense tracking.

However, it's important to recognize the business model behind these gurus. Their livelihoods depend on selling you their financial philosophies through books, workshops, and website memberships. Their success is also due to compelling delivery – they're entertainers as much as experts. They can't provide advice that's personalized to your life.

True financial wisdom often lies in the mundane and the practical, not just the bold proclamations delivered with 100% certainty. Sometimes it's the small, consistent changes, such as increasing your retirement savings rate or paying off credit card debt, that build a solid foundation for financial well-being - no guru required.

Seeking Professional Guidance When Necessary

While self-education is valuable, there are instances when professional advice is indispensable. Complex financial situations that involve investing, tax planning, estate planning, or dealing with unmanageable debt often require personalized help. 

When selecting a financial advisor, look for credentials such as a Certified Financial Planner or Chartered Financial Analyst, and ensure they have a fiduciary duty to act in your best interests. When selecting a credit counselor, consider nonprofit agencies approved by the U.S. Department of Justice's Trustee Program.

The Takeaway

Finding financial freedom is not a sprint; it's a marathon. When you hear these financial gurus' quick tips and tricks, consider using their insights as a launching pad rather than an entire roadmap. Creating a financial plan can be complex, and a one-size-fits-all approach that works for some people may not always be right for you.

Retirement planning is a critical aspect of financial health, requiring strategic thinking about how much to save, where to invest, and how much to withdraw. Adhering to time-tested financial rules of thumb can provide a starting point for crafting a retirement plan that aligns with your goals, lifestyle aspirations, and financial status. While no rule of thumb is a solution for every situation, here are some rules of thumb to consider in the context of retirement planning.

The 20 Times Income Rule

A widely accepted rule of thumb is to aim for a retirement nest egg at least 20 times your annual salary. This benchmark provides a general target, suggesting that saving and investing a portion of your income over your working years can offer a sustainable withdrawal rate during retirement and minimize the risk of depleting your savings too early.

However, this rule doesn't account for variables like long-term care needs or lifestyle changes, which could significantly affect your financial requirements in retirement. Adapting your savings strategy to include potential future healthcare costs or lifestyle aspirations is crucial for a comprehensive retirement plan.

Diversification Rules of Thumb

"Diversification" is more than just investment jargon; it's essential advice that means spreading your investments across various asset classes to reduce risk. The rule of not putting all your eggs in one basket holds true, especially when planning for retirement. When you concentrate all your capital on a single investment, you're gambling on a single outcome. Should that investment underperform, your entire retirement fund will also underperform.

A mix of stocks, bonds, and other investments can help protect your retirement savings from market volatility and ensure consistent growth. Employer-sponsored plans like a 401(k) offer a straightforward way to diversify through mutual funds, with potential employer matching a significant plus. Taking full advantage of these plans can significantly impact your retirement savings, thanks to compound interest and tax advantages.

Age-Based Rules

One of the critical aspects of diversification is managing risks - and how your age may influence your risk tolerance. As investors age, many experts suggest a gradual shift from higher-risk investments like stocks to more stable options such as bonds. The age-based formulas come into play in this situation, providing a simple yet effective guideline for adjusting your investment strategy over time.

The first of these rules of thumb involves subtracting your current age from 100 to determine the percentage of your investment portfolio that should be allocated to stocks. For example, if you're 40 years old, according to this formula, 60% of your portfolio should be invested in stocks, with the remaining portion in bonds and other less volatile investments. This traditional approach is designed to gradually reduce your exposure to risk as you get closer to retirement, aligning with the principle that younger investors have a longer time horizon to recover from market volatility, whereas older investors might not.

However, recognizing that life expectancies are increasing and many individuals are working and staying active well beyond traditional retirement ages, a modified version of this rule suggests subtracting your age from 120. This adjustment allows for a slightly more aggressive investment stance, reflecting the need for your portfolio to grow over a more extended period. For example, a 40-year-old would allocate 80% of their portfolio to stocks using this revised formula. This approach acknowledges that with longer life expectancies, the fear of outliving one's savings becomes more pronounced, necessitating a strategy that emphasizes growth for a prolonged period.

Both rules of thumb are starting points for tailoring your investment approach to match your risk tolerance. It's important to note that these guidelines are not one-size-fits-all solutions. Individual financial goals, income levels, and personal circumstances are crucial in determining the most appropriate allocation strategy. For some, a more conservative approach may be warranted due to specific financial obligations or risk aversion. In contrast, others may opt for a more aggressive strategy to achieve their financial goals.

The 4% Withdrawal Rule

The 4% withdrawal rule is a widely recognized guideline used by retirees to manage their retirement savings. It suggests that you can withdraw 4% of your retirement portfolio's total value in the first year of retirement and then adjust that amount for inflation in subsequent years to sustain a steady income stream for at least 30 years without depleting your nest egg. 

To apply the 4% rule, you first calculate 4% of your retirement portfolio's total value at the time of retirement. For example, if you have a $1 million portfolio, you would withdraw $40,000 in the first year. In the second year, you adjust the $40,000 by the previous year's inflation rate to maintain your purchasing power. This process repeats annually, theoretically allowing your savings to last through a 30-year retirement.

While the 4% withdrawal rule offers simplicity and accessibility, it's essential to be aware of its limitations. It relies on historical market returns, which may not accurately predict future conditions. It also may not fully account for individual circumstances such as varying lifespans, unexpected healthcare costs, or significant changes in personal expenses. Additionally, periods of high inflation or poor market performance early in retirement can erode the purchasing power of withdrawals.

While the 4% rule is a valuable guideline, it's important to remember that it's not a rigid rule. Financial planners often recommend using it as a starting point, but it's crucial to remain flexible. 

The Takeaway

While the rules of thumb for retirement savings offer valuable guidance, tailoring your plan to your unique circumstances is vital. Regularly revisiting your investment strategy to adjust for life changes and evolving retirement goals will help ensure your retirement planning is robust and responsive to your needs.

No single strategy fits everyone, highlighting the importance of informed, flexible planning and, when necessary, consulting with a financial advisor to adapt these general guidelines to your specific situation. 

Planning for retirement is a journey that evolves with every phase of life, and there's no one-size-fits-all approach to securing your financial future. Whether you're laying the foundation of your career in your 20s or navigating the complexities of mid-life financial planning, every step taken brings you closer to a more secure retirement.

With an emphasis on the power of starting early, let's explore how to adapt your retirement planning to meet your changing needs and goals. Please keep in mind that these suggestions are general in nature – your situation may differ. If you're unsure, consult with a qualified professional before making investment decisions.

Get Started in Your 20s

You may be just starting life as an independent adult, but that doesn't mean that you should put off thinking about the future. Every decade comes with its challenges, and your 20s are no exception.

In this decade, you may have student loans to repay, your earnings may be more entry-level than executive, and the cost of establishing your first home may seem daunting. While it may appear that you don't have any money to save, starting a retirement account should be high on your to-do list. Here's why:

• The Sooner You Get Started, the More Money You Will Make. Compound interest is a beautiful thing - assuming an average annual return of 8%, saving just $100 per month beginning at age 20 would yield a balance of around $500,000 by age 65. Depending on the actual rate of return, the final balance could be higher or lower.

• Setting the Habit Now Means More Money in the Future. The savings habit isn't always an easy one to start, especially if you allow life to get in the way. By establishing a solid savings habit with your first job, you will teach yourself the importance of saving throughout your lifetime.

• You'll Get More From Your Employer. If your company offers a retirement savings match, use it as soon as you're eligible. Employer matching is essentially getting free money, but you'll be required to save to get it.

When it comes to investing in your 20s, most experts agree that this is the time to set your expectations, build lifelong savings habits, and take more risks with retirement investments (for example, by investing in stocks versus bonds). At this stage of life, you can handle some setbacks and have ample time to rebuild your portfolio in the event of a market downturn.

Investing in Your 30s

For many, this decade is filled with new expenses, such as buying a home and starting a family. But while spending often increases, it's important to continue saving for the long term.

Depending on your situation, it may be challenging to invest more, but continuing to save will pay dividends over time. Consider taking at least a small portion of any annual raises to increase your 401K contributions and avoid accruing additional debt (especially high-interest credit card debt).

Given decades until retirement, most experts suggest that your 30s are a good time to invest in stocks. With time on your side, you should be able to weather any financial storms while giving yourself ample opportunity to experience the potential for higher returns.

Investing in Your 40s

Retirement can seem far off at this stage of life, but it's closer than one may expect. If you've managed to control your debt and increase your earnings, you may see that bills don't take up quite as much of your budget as before. If so, consider allocating that "extra" money to additional retirement contributions.

Depending on your risk tolerance, this decade may be a time to consider becoming a bit more conservative in your investment approach. Some may opt for a safer (albeit lower-yielding) mix of stocks and bonds rather than an all-stock portfolio.

Investing in Your 50s and 60s

In this decade, it's time to evaluate your savings and estimate how much you'll need to retire comfortably. If your savings are less than you may need, there's some good news - people tend to save the most during their last decade of employment. For many, the fact that retirement is getting close makes savings a priority, and, in addition, many major life expenses (mortgages, children, and college tuition) are mostly behind them - freeing up more cash for saving.

As those in this decade approach retirement, a common strategy is to focus on capital preservation as well as appreciation. Remember, while the stock market has historically increased overall, there could be times of an extended decline. For example, after the NASDAQ stock index peaked in 2000, it took 15 years for it to return to the same level. So many experts would suggest a portfolio that consists of both stocks and bonds, with the balance determined by your tolerance for risk.

Other investment decisions to consider when approaching retirement include:

• Consolidating 401K Accounts. By the time you hit this stage in your career, the odds are good that you have had several employers – and several retirement accounts. Pulling all those separate accounts into one can give you more investment choices, allowing you to make more money.

• Increasing Contributions. The federal government allows older individuals the opportunity to make higher "catch-up" contributions to many savings plans. Plus, if your employer matches contributions, saving more will increase their contribution to your retirement, too.

• Opening new accounts. If you are maxing out your employer-matched retirement account, consider opening a Roth IRA to give you more savings power (and tax-free withdrawals in retirement).

The Takeaway

Each decade of life offers the chance to improve your financial future. Your 20s provide the best opportunity to take advantage of the magic of compounding, your 30s and 40s bring the opportunity to grow and protect wealth, and your 50s and beyond focus on maximizing and preserving your nest egg.

As you move through life's stages, keep revisiting your financial plan, stay informed about the evolving landscape of retirement savings, and don't hesitate to seek professional advice to tailor a plan that's right for you.