What's the key to making good personal finance and investment choices? It isn't necessary to understand the inner workings of the securities markets or the mathematical economies underlying investment theory.
Instead, let AAII's 10 axioms of effective investing provide the critical cornerstone for guiding your investment philosophy and your personal finance decision making process. This will ensure that you meet the universal goal of creating financial wealth for retirement.
Unfortunately, these personal finance principles are easier to understand than to implement. For many individuals, it is easier to plan to save and invest next month rather than to begin immediately. However, visualizing the peace of mind and security that comes with maintaining a disciplined, successful savings program can help you get started.
By investing early, you are using the greatest tool available to an investor-the power of compounding, where invested money grows exponentially, not algebraically.
Consider two young investors, both age 35 and both of whom want to retire at age 70; therefore, each has a 35-year investment horizon. They both also have a personal finance goal of accumulating $1 million by retirement. But they have devised different strategies for attaining that goal:
Let's assume that both earn 11% annually on their savings. Where do the two investors stand at age 70? Investor A will realize his goal—by age 70, he will have $1,022,293, even though he actually put away money for only 10 years. Poor Investor B, however, does not reach his personal finance goal—he has only $514,860 at age 70, even though he invested two and one-half times that of Investor A. He simply started too late.
You can see even more clearly the effect of compounding on ultimate retirement value by examining the graph in Figure 1, which shows the amount that would be accumulated by investing an initial amount of $1,000 over a 35-year period. By reviewing the graph, you can see the exponential nature of compounding-that is, the graphed line representing the amount saved increases at an increasing rate, especially in the later years.
The basic personal finance principle: START NOW, NOT LATER.
Being frugal should be the cornerstone of any personal finance plan. Those individuals who gain financial independence do so by budgeting, controlling expenses and saving a reasonable portion of their income. They value thrift and discipline. They understand that the keys to being a successful investor are having a smart personal finance plan and adopting an attitude of conservation and stewardship. The route to financial independence is a slow accumulation of wealth versus a fantasy of get-rich-quick investing.
The key to wealth accumulation is to set reasonable savings goals and then to "pay yourself first" by setting aside that savings amount with each paycheck you receive. Each time you get a pay raise, increase your monthly savings by an amount with which you are comfortable.
The amount you save need not be large, but if you pay yourself first each time you receive a paycheck, the magic of compounding will help you build wealth.
When developing any personal finance plan, there are many places where individuals can and should invest. What rates of return should you expect? The word "expect" is important here, because seldom do investments provide us with the exact rate of return we thought they would. Therefore, looking at average rates of return over long periods of time is extremely helpful in setting expectations.
Table 1 reports the rates of return, as well as how much $1 would have grown to, for four different types of investments, as well as the inflation rate, from 1926 through 2006.
You can see from the table that stock investors have fared much better in the past decades than other investors. But it was not without considerable uncertainty as to what could happen. This is illustrated by the volatility figure that appears in the last column of Table 1. This volatility figure indicates the amount by which actual returns each year varied around the average; the greater the variation, the greater the risk.
The annual returns of small stocks varied the most, while the returns of large-company stocks came in a close second; both of these areas also produced the highest returns over the long term. The annual returns of Treasury bills varied the least, and at the same time they produced the lowest returns.
You can see from Table 1 that rewards tend to go hand-in-hand with risk—managing the risk/return relationship will be crucial to the success of your personal finance plan.
Investment risk has two important components: volatility risk and inflation risk.
Volatility risk is the risk that actual returns vary compared to expected returns over time; in general, higher returns go hand-in-hand with greater volatility risk.
Inflation risk relates to a loss in purchasing power through general price inflation. For example, from the inflation rate in Table 1 you can see that between January 1, 1926, and December 31, 2006, the dollar lost more than 90% of its purchasing power. At the end of 2006 it took $11 to purchase a basket of goods similar to what could have been purchased for $1 at the beginning of 1926.
While you cannot eliminate either volatility risk or inflation risk in your personal finance plan, you can minimize both by understanding the nature of investment risk and selecting investments suitable for your investment time horizon. For shorter-term time horizons, volatility risk is more of a concern; for longer-term time horizons, inflation risk becomes a greater concern.
For this reason, money invested for short-term personal finance needs should be invested differently than money earmarked as part of your long-term plans. The common error among many individuals who are saving for retirement is to reduce their average earning rate significantly, and thus their accumulated savings, by attempting to avoid short-term earnings volatility. This approach exposes their personal finance plan fully to inflation risk.
For short-term investment periods, the returns from stocks are clearly more volatile (or risky) than from Treasury bills or bonds. However, for longer-term holding periods, the returns from stocks are both less risky and higher than for bonds after adjusting for inflation.
Portfolios should be diversified at all levels. By allocating among the major asset categories (stocks, bonds and cash), you minimize the two kinds of investment risk that we identified in Axiom 4.
As part of your personal finance plan, risk can further be reduced by diversifying within those asset categories. For example, a stock portfolio should be built by investing in the common stock of firms in different industries. Buy only "good quality" firms that will have an increasing demand for their products. Set a goal of 15 to 20 different industries. Broad-based mutual funds offer significant diversification benefits to investors in all asset categories. A solid investment vehicle for the investor who wants to diversify broadly without attempting to purchase individual stocks is to purchase shares in a market index mutual fund, with low management fees. In particular, a single share of an S&P 500 index fund is widely diversified and represents the equity market nicely.
|Long-Term Government Bonds||72||5.4||9.2|
*As measured by standard deviation, which is the amount by which actual returns varied around the average; the greater the standard deviation, the greater the volatility.
Source: Ibbotson Associates.
If investors are rewarded for assuming some kinds of risk, then why would you not always invest in common stocks, rather than in other securities, such as bonds?
The answer relates to the length of time you are willing and able to wait for returns. An investor in common stocks must often wait longer to earn the higher returns than those provided by bonds—maybe as long as five to 10 years. In Table 1, we observed a lot more volatility in the annual returns of stocks than in the returns of bonds or Treasury bills.
What if an individual invested in a portfolio of large-company stocks for five years or even 15 years? For large-company common stocks, the average rate of return for the last 81 years was 10.4%, as shown in Table 1. However, the best year was a fantastic 54.0% return, while in the worst year it was a loss of 43.3%. But if you look at all of the five-year investment periods from 1926 through 2006 (1926-1931, 1927-1932, etc.), the best return would have been reduced to 28.6% and the worst return would not have been so drastic as before, only losing 12.5%. As you extend the investment horizon, the variability in the returns continues to decline. Yet the average return overall is still 10.4%. Thus, an investor will have maintained the same return on average, but reduced the year-to-year fluctuations by holding investments over longer time periods.
Patience is a virtue, even when investing. In the world of personal finance, the market rewards patience.
Frequently, you hear an economist or a financial consultant in the news making projections about the financial markets. However, investors, even the professionals, do not have some "super vision" when it comes to knowing the direction of the markets. If they did, implementing a sound personal finance plan would be easy and everybody would be a millionaire!
One study of large U.S. pension plans found that deciding when to get in and out of the market had little impact on the relative performance of the pension funds. The researchers estimated that market timing accounted for less than 2% of the variation explaining the relative performance of the different investment managers. This study, along with others, indicates that you simply cannot consistently identify the best time to invest.
When carrying out your personal finance plan, you cannot expect to do better by "timing" investments than if you routinely invest each and every month because the market moves in fits and starts. Missing the few good days because you are out of the market can seriously reduce your return.
Therefore, don't worry about timing your investments, instead just make regular investing a part of your personal finance plan, and always be cautious when listening to all the "experts."
Brokers, distributors and others charge a commission for putting you into mutual funds that, on average, perform below other available funds. Most load (commission) funds will also charge you a distribution fee (the shareholder is forced to give up income to pay brokers and distributors for selling shares to new shareholders).
Funds that charge these kinds of loads and fees do not necessarily have higher returns. In fact, none of those charges go to those who are actually managing the portfolio, so you are not paying extra for any kind of management expertise. Why should you pay more in continuing expenses to receive returns that are not necessarily better—particularly since your bottom line return is reduced by those expenses? As part of your personal finance plan, you should always seek out no-load funds and low broke
You may be surprised to know that you can do better than the professional money managers most of the time. Over several time periods of 10 years, an investment in a S&P index fund outperformed the great majority of the actively managed stock funds.
Individual stocks are fine, but require considerable time and expertise. Finding a good mutual fund for long-term investing takes less time and effort and reasonable success can be expected if you do not talk or listen to commissioned brokers.
As part of your personal finance plan, stick with mutual funds that have a high (four or five) Morningstar rating, no 12b-1 (distribution) fee, low expense ratios, no commission, low turnover, and have an experienced portfolio manager.
The simplest way for an investor to defer or avoid taxes is through a 401(k) retirement plan, which is available for most corporate employees. Additional tax-favored plans include regular IRAs, Roth IRAs, SEPs, and Keogh plans.
Money saved outside of tax-favored retirement plans receives more favorable tax treatment if it is invested in common stocks than in bonds or bank savings accounts or CDs. Increases in the value of common stocks due to a company's retention of earnings are not taxed until the stock is sold, which can result in the deferral of federal income tax for many years. In addition, long-term gains on the sale of common stock are typically taxed at lower rates than ordinary income.
In contrast, interest income from the ownership of bonds, savings accounts, and CDs is taxed at ordinary tax rates at the time of receipt, which is normally annually. The combination of federal income taxes and inflation sometimes operates to produce a loss in purchasing power to an investor even while an investor is receiving interest income.
The ramifications of paying taxes on your investments should play an important role in how you structure and implement your personal financial plan.