In fact, the most important things you can do relate to the way you go about investing, not the specific investments you pick. Here, I offer five secrets that can help you become a smart investor.
The First Secret: Compound Interest
Compound interest represents the first secret. Does that seem strange? Compound interest doesn’t seem very powerful at first blush. You put, say, $1,000 into an investment that returns a 10 percent profit. The first year, the $1,000 earns $100. Let’s say you leave the $100 in the savings account and add another $1,000. The second year, you earn $210. If you continue saving this way (every year putting $1,000 into the account), you earn $330 in the third year.
Compound interest produces a very interesting result. Your interest earnings grow because you continue to add to your investment. Some of the addition comes from additional savings. But more and more of the interest earnings come from the interest you’re earning on the interest—what’s called compound interest.
By year seven, for example, you typically earn more in interest than the regular amount you annually save. And the interest earnings continue to grow and grow.
After 25 years, you earn around $10,000 a year in interest. After 35 years, you earn around $27,000 a year in interest. After 45 years, you earn around $72,000 a year in interest. And all of this from a $1,000-per-year savings plan.
Nothing is tricky about compound interest. You need to be able to save some money and then reinvest the interest. And you need to be able to earn a decent interest rate, or investment rate of return (which is basically the same thing).
By meeting these simple requirements, you can grow rich. How quickly you grow rich depends on the interest rate and your savings. The higher the interest rate and the bigger the savings, the faster and more impressive the compounding.
The Second Secret: Opt for Tax-Deductible, Tax-Deferred Investment Choices
You need to use tax-deductible, tax-deferred investment vehicles such as IRAs or, even better, an employer’s 401(k) or 403(b) plan.
Let me show you how powerful these two tools are. To provide a backdrop against which to discuss your future investing, let’s suppose that you want to save $6,000 a year. And just to make things fun, let’s also pretend that $6,000 is an absolute impossibility. Let’s say that you’re currently spending every dollar you make and you couldn’t come up with an extra $500 a month unless your life depended on it.
Here’s the secret of meeting the $6,000-per-year goal: Tax-deductible investments let you borrow a huge chunk of the money from the federal and state government.
Suppose, for example, that you’re working with an employer who provides a 401(k) plan but doesn’t contribute any matching money. You want to save $6,000 a year because that amount will ultimately allow you to become financially independent.
By using a tax-deductible investment such as a 401(k), you would, in effect, be able to borrow roughly $1,500 a year. Here’s why: If you stick $6,000 in your 401(k) plan, you will probably save about $1,500 in income taxes. Of the $6,000 in annual savings, then, $4,500 would come from your pocket and $1,500 would come from the federal and state government.
Notice what you’ve already accomplished by using the powerful concept of tax-deductible investing: You’ve cut your out-of-pocket cash by around a third.
Things get even better if you happen to work for an employer who matches a portion of your 401(k) contribution. Let’s say, for example, that your employer matches your contributions by contributing $0.50 to your savings for every $1.00 you contribute.
The math gets a little tricky in this case. If you contribute $4,000, you get another $2,000 from your employer. You also get roughly $1,000 in government contributions in the form of tax savings.
The bottom line is that you need to come up with only about $3,000 of your own money to reach your $6,000-per-year savings goal. So half the money comes from your pocket. And half comes from the government or your employer. That’s pretty good.
And the economics can get ever better. If you work for an employer who generously matches a portion of your 401(k) contributions or you have high income, most of the money you need to achieve financial independence may come from your employer and the government.
But that’s only part of the beauty of tax-deferred investments. In a tax-deferred investment vehicle like a 401(k) or an IRA, income taxes on your interest or investment profits are deferred. For this reason, you effectively earn a much higher rate of interest inside a tax-deferred account.
The reason is that the federal and state income taxes you pay on interest and investment income wipe out anywhere from 10 to more than 40 percent of your profit, with most people paying about a 25 percent tax on their profits.
Inside a tax-deferred investment vehicle like a 401(k) or an IRA, you might earn compound interest at the annual rate of 10 percent. Outside a tax-deferred investment vehicle, on the other hand, you might earn around 7.5 percent.
Those differences may not seem very big, but over time they have a cumulative impact on compound interest calculations. For example, suppose that you are a 20-year-old adult just entering the work force and you’re trying to decide how to invest $2,000 a year for retirement at age 65. If you compound interest using a 7.5 percent annual rate, you end up with around $664,000 by the time you retire. If you instead compound interest using a 10 percent annual rate, you end up with around $1,400,000—roughly twice as much.
To sum things up, tax-deductible, tax-deferred investment vehicles are the best and most effective method of accumulating wealth. There is no better method for moving toward financial independence—none. You can save up to roughly $12,000 a year by using a 401(k) or 403(b) plan.
Now, what if you’re unlucky and your employer doesn’t offer a 401(k) plan, 403(b) plan, or an equivalent tax-deductible, tax-deferred savings program. Is this whole tax-deductible, tax-deferred investing business such a big deal that you should consider switching employers? First, if you’re serious about achieving financial independence, I recommend moving to a new employer with a 401(k) or equivalent, tax-deductible, tax-deferred investment plan. The wealth creation benefits are just too enormous to pass up. Likewise, if your employer does offer a matching plan, well, free money is free money. I’m not saying that you should keep a job you hate, but I would think long and hard about leaving an employer who has put you on a fast track toward financial independence.
And if you are working where there isn’t a 401(k)? Talk to other employees and gauge their interest. Assuming you’re not alone in your feelings, I would approach management. A simple 401(k) plan or SIMPLE-IRA is very easy to set up. As you know now, such a plan delivers enormous benefits. If it were me, I would rather have a 401(k) plan than a fancy holiday party or a summer picnic. If the truth be told, I would even forgo part of my next raise.
I should note here, too, that you may be eligible to contribute $3,000 or even $3,500 a year in a tax-deductible IRA. (IRA earnings on allowable contributions are always tax-deferred.) If you’re married, you and your spouse together may even be able to contribute $6,000 or $7,000 a year.
Even if your employer doesn’t provide a 401(k) plan, you may be able to save you need to save using a traditional IRA. And IRA may be all you need to progress toward your wealth target.
The Third Secret: Work Your Money Hard
Most people don’t make their money work very hard. Not surprisingly, their profits reflect this. They earn returns of 3 or 5 percent. By working their money harder, they could double or triple their returns and earn 9 percent, 10 percent, or more.
You make your money work harder by investing in riskier investments. If the idea of investing in, say, the stock market, scares the living daylights out of you, you’ve made way too big a deal out of stock market risks—or you’ve been making investment mistakes (perhaps by day-trading).
Let’s start by discussing the concept of risk. What you mean by risk, I’ll venture, is really two things: volatility and the fear of losing your investment.
As for the volatility of the stock market, some days the market is up, and some days the market is down. Up and down, up and down. It’s enough to make some people sick. However, people make way too big a deal over day-to-day fluctuations in the weather. Stock prices are like the weather. Some days it’s warmer, and some days it’s colder. Some days the market is up, and some days the market is down.
This up and down business gives the nightly news anchor something to talk about, but it’s only so much blather. It’s pseudo-news. You don’t let day-to-day temperature fluctuations bother you. The fact that it was two degrees colder last Thursday doesn’t matter. Neither should you let day-to-day stock market fluctuations bother you. It’s just plain silly. The only thing that really matters is the change in price between the time you buy a stock and the time you sell it.
The other feeling about risk, based on the fear of volatility, is that what you buy today for, say, $1,000, won’t be worth $1,000 when you sell it. You have only to look at day-to-day fluctuations in the market to realize that. However, if you take the long view, you will see that the general trend in the stock market is always up.
You can’t buy a handful of stocks today and be certain that they will increase in value over the next few weeks, months or even years. But you can be certain that they will grow in value over a decade or, even better, over two or three decades.
“Well, even so,” you’re thinking, “I’ll still stick with something a little safer. All that bouncing about makes me nauseous.”
Unfortunately, there is a simple problem with so-called safe investments: They appear to be safe because their values don’t jump around, but they aren’t profitable. Your money doesn’t earn anything or much of anything.
Here are a few simple facts: Over the last eighty years, common stocks have delivered an average 10.5 percent return. Over the same period of time, long-term corporate bonds have delivered an average 5.7 percent return. U.S. Treasury Bills over the same time period have delivered an average 3.7 percent return. If you adjust the historical long-term bond return for inflation and income taxes, you just break even. If you adjust the historical U.S. Treasury Bill return for inflation and income taxes, you lose about a percent a year. These two options, remember, are so-called safer investments.
History teaches investors two lessons. One is that you profit by sticking your money in riskier investments such as stocks and real-estate-ownership investments. The other is that you don’t make any real profit by loaning your savings to the government, a corporation, or a local bank.
To profit from your investments, you need to be an owner, not a loaner.
“Now, wait a minute,” you’re thinking. “That may be true over recent history. But the world is a far more dangerous place today. We can’t be sure things will run so smoothly in the future.”
Actually, I agree with you. But I would say that the last 80 or so years haven’t been smooth. The stock market collapsed. The world suffered a global depression. A demonic madman named Adolf Hitler almost succeeded in turning the entire world into a place of darkness. We saw the first use of nuclear weapons. We had a 50-year cold war that, for peace, relied upon the threat of thermonuclear exchange.
The world is a dangerous place, but it’s been a dangerous place for a long time. And yet, despite all the terrible things that have happened, ownership investments have been profitable. For that reason, I firmly believe that the only way to achieve financial independence—the only way to accumulate any significant amount of wealth—is by investing money in ownership investments such as stocks or real estate.
The Fourth Secret: Broadly Diversify
There is one other point of which you need to be aware, and it’s a very quick point but crucially important: You need to be well-diversified. Ideally, in fact, you should have a several dozen, equal-sized investments in different areas. You should also make sure that you’re not heavily dependent on a single industry or tied to a particular geographical location.
You don’t, for example, want to own 50 rental houses in the same town. And you wouldn’t want to own 40 bank stocks. This business about broadly diversifying is a statistical truth. Unfortunately, the statistics are too daunting—and darn unpleasant—to explain here.
Suffice it to say, the only way you can hope to achieve the average returns I’ve talked about in the preceding secret is by having enough individual investments so that they average out to the historical average.
Diversification has a really interesting ramification, by the way. Even with several thousand dollars of savings a year, you need, as a practical matter, to invest in mutual funds. To own a portfolio of, say, 50 or 100 common stocks and to keep your commission costs reasonable, you would probably need to be able to invest $50,000 or $100,000 at a time. That way, you can purchase round, 100-share lots of stocks, thereby lowering your expenses.
To own a portfolio of 50 rental houses, you probably need to invest several times that much. You also have the challenge of geographically diversifying yourself. It is much harder, obviously, to own houses in many different parts of the country than it is to own stocks in many different places.
So picking a mutual fund is the way to go. And, in fact, picking an index mutual fund is the way to go.
Fortunately, picking an index stock mutual fund isn’t tough. You shop on the basis of price. But rather than try to give you a bird’s-eye view of this subject, I encourage you to read a wonderful book on the subject by Burton Malkiel, called Random Walk Guide to Investing. This short, easy-to-read book provides worthwhile and honest advice on picking mutual funds.
The Fifth Secret: You Don’t Have to Be a Rocket Scientist
None of this investment business requires anywhere near as much know-how as is needed to be a rocket scientist. All you need to know is the following, which is a summary of what I’ve explained in the preceding pages: Compound interest is a mathematical truth that says you should regularly save and reinvest your profits. Use tax-deductible and tax-deferred investment choices such as 401(k)s, SIMPLE-IRAs, and IRAs. These investment vehicles boost your savings and the interest rate you earn on your investments. The case for investing in ownership investments is simple: It’s the only real way to make money over time. Diversification is important because it increases the probability that investment profits closely match the stock market’s historical returns. However, for diversification to work, you must invest for long enough periods of time.
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