Investing for Dummies Excerpt

Aug 19, 2014 by

Investing for DummiesIf you do much reading on personal finance, you’ve likely come across the work of Eric Tyson, author of “Investing for Dummies,” 7th Edition. Here’s an extended excerpt from Eric’s Dummy book focused on what you need to do to prepare to start investing.

Getting Your Financial House in Order before You Invest

By Eric Tyson, author of Investing For Dummies, 7th Edition

Before you make any great, wealth-building investments, you must get your financial house in order. Understanding and implementing some simple personal financial management concepts can pay off big for you in the decades ahead.

You want to know how to earn healthy returns on your investments without getting clobbered, right? Who doesn’t? Although you generally must accept greater risk to have the potential for earning higher returns, I can tell you about some high-return, low-risk investments. Here, I point out some of the easy-to-tap opportunities for managing your money that you may have overlooked.

Establishing an Emergency Reserve

You never know what life will bring, so having a readily accessible reserve of cash to meet unexpected expenses makes good financial sense. If you have a sister who works on Wall Street as an investment banker or a wealthy and understanding parent, you can use one of them as your emergency reserve. (Although you should ask them how they feel about that before you count on receiving funding from them!) If you don’t have a wealthy family member, the ball’s in your court to establish a reserve.

Make sure you have quick access to at least three months’ to as much as six months’ worth of living expenses. Keep this emergency money in a savings account or a money market fund. You may also be able to borrow against your employer-based retirement account or against your home equity should you find yourself in a bind, but these options are much less desirable.

If you don’t have a financial safety net, you may be forced into selling an investment that you’ve worked hard for. And selling some investments, such as real estate, costs big money (because of transaction costs, taxes, and so on).

Consider the case of Warren, who owned his home and rented an investment property in the Pacific Northwest. He felt, and appeared to be, financially successful. But then Warren lost his job, accumulated sizable medical expenses, and had to sell his investment property to come up with cash for living expenses. Warren didn’t have enough equity in his home to borrow. He didn’t have other sources — a wealthy relative, for example — to borrow from, either, so he was stuck selling his investment property. Warren wasn’t able to purchase another investment property and missed out on the large appreciation the property earned over the subsequent two decades. Between the costs of selling and taxes, getting rid of the investment property cost Warren about 15 percent of its sales price. Ouch!

Evaluating Your Debts

Yes, paying down debts is boring, but it makes your investment decisions less difficult. Rather than spending so much of your time investigating specific investments, paying off your debts (if you have them and your cash coming in exceeds the cash going out) may be your best high-return, low-risk investment. Consider the interest rate you pay and your investing alternatives to determine which debts you should pay off.

Borrowing via credit cards, auto loans, and the like is an expensive way to borrow. Banks and other lenders charge higher interest rates for consumer debt than for debt for investments, such as real estate and business. The reason: Consumer loans are the riskiest type of loan for a lender.

Many folks have credit card or other consumer debt, such as an auto loan, that costs 8, 10, 12, or perhaps as much as 18-plus percent per year in interest (some credit cards whack you with interest rates exceeding 20 percent if you make a late payment). Reducing and eventually eliminating this debt with your savings is like putting your money in an investment with a guaranteed tax-free return equal to the rate that you pay on your debt.

For example, if you have outstanding credit card debt at 15 percent interest, paying off that debt is the same as putting your money to work in an investment with a guaranteed 15 percent tax-free annual return. Because the interest on consumer debt isn’t tax-deductible, you need to earn more than 15 percent by investing your money elsewhere in order to net 15 percent after paying taxes. Earning such high investing returns is highly unlikely, and in order to earn those returns, you’d be forced to take great risk.

Consumer debt is hazardous to your long-term financial health (not to mention damaging to your credit score and future ability to borrow for a home or other wise investments) because it encourages you to borrow against your future earnings. I often hear people say things like “I can’t afford to buy most new cars for cash — look at how expensive they are!” That’s true, new cars are expensive, so you need to set your sights lower and buy a good used car that you can afford. You can then invest the money that you’d otherwise spend on your auto loan.

Using consumer debt may make sense if you’re financing a business. If you don’t have home equity, personal loans (through a credit card or auto loan) may actually be your lowest-cost source of small-business financing.

Mitigating Your Mortgage

Paying off your mortgage more quickly is an “investment” for your spare cash that may make sense for your financial situation. However, the wisdom of making this financial move isn’t as clear as paying off high-interest consumer debt; mortgage interest rates are generally lower, and the interest is typically tax-deductible.

When used properly, debt can help you accomplish your goals — such as buying a home or starting a business — and make you money in the long run. Borrowing to buy a home generally makes sense. Over the long term, homes generally appreciate in value.

If your financial situation has changed or improved since you first needed to borrow mortgage money, reconsider how much mortgage debt you need or want. Even if your income hasn’t escalated or you haven’t inherited vast wealth, your frugality may allow you to pay down some of your debt sooner than the lender requires. Whether paying down your debt sooner makes sense for you depends on a number of factors, including your other investment options and goals.

When evaluating whether to pay down your mortgage faster, compare your mortgage interest rate with your investments’ rates of return. Suppose you have a fixed-rate mortgage with an interest rate of 5 percent. If you decide to make investments instead of paying down your mortgage more quickly, your investments need to produce an average annual rate of return, before taxes, of about 5 percent to come out ahead financially. (Technically, this comparison should be done on an after-tax basis, but the outcome is unlikely to change.)

Besides lacking the money to do so (the most common reason), other good reasons not to pay off your mortgage any quicker than necessary include the following:

  1. You instead contribute to your retirement accounts, such as a 401(k), an IRA, or a Keogh plan (especially if your employer offers matching money). Paying off your mortgage faster has no tax benefit. By contrast, putting additional money into a retirement plan can immediately reduce your federal and state income tax burdens. The more years you have until retirement, the greater the benefit you receive if you invest in your retirement accounts. Thanks to the compounding of your retirement account investments without the drain of taxes, you can actually earn a lower rate of return on your investments than you pay on your mortgage and still come out ahead.
  2. You’re willing to invest in growth-oriented, volatile investments, such as stocks and real estate. To have a reasonable chance of earning a greater return on your investments than it costs you to borrow on your mortgage, you must be aggressive with your investments. Stocks and real estate have produced annual average rates of return of about 8 to 9 percent. You can earn even more by creating your own small business or by investing in others’ businesses. Paying down a mortgage ties up more of your capital and thus reduces your ability to make other attractive investments. To more aggressive investors, paying off the house seems downright boring — the financial equivalent of watching paint dry. You have no guarantee of earning high returns from growth-type investments, which can easily drop 20 percent or more in value over a year or two.
  3. Paying down the mortgage depletes your emergency reserves. Psychologically, some people feel uncomfortable paying off debt more quickly if it diminishes their savings and investments. You probably don’t want to pay down your debt if doing so depletes your financial safety cushion. Make sure that you have access — through a money market fund or other sources (a family member, for example) — to at least three months’ worth of living expenses. Don’t be tripped up by the misconception that somehow a real estate market downturn, such as the one that most areas experienced in the mid-to late 2000s, will harm you more if you pay down your mortgage. Your home is worth what it’s worth — its value has nothing to do with your debt load. Unless you’re willing to walk away from your home and send the keys to the bank (also known as default, which damages your credit report and score), you suffer the full effect of a price decline, regardless of your mortgage size, if real estate prices drop.

Establishing Your Financial Goals

You may have just one purpose for investing money, or you may desire to invest money for several different purposes simultaneously. Either way, you should establish your financial goals before you begin investing. Otherwise, you won’t know how much to save.

For example, when I was in my 20s, I put away some money for retirement, but I also saved a stash so I could hit the eject button from my job in management consulting. I knew that I wanted to pursue an entrepreneurial path and that in the early years of starting my own business, I couldn’t count on an income as stable or as large as the one I made from consulting.

I invested my two pots of money — one for retirement and the other for my small-business cushion — quite differently. You can take more risk with the “longer-term” money, so I invested the bulk of my retirement nest egg in stock mutual funds. With the money I saved for the startup of my small business, I took an entirely different track. I had no desire to put this money in risky stocks — what if the market plummeted just as I was ready to leave the security of my full-time job? Thus, I kept this money safely invested in a money market fund that had a decent yield but didn’t fluctuate in value.

Tracking Your Savings Rate

In order to accomplish your financial goals (and some personal goals), you need to save money, and you also need to know your savings rate. Your savings rate is the percentage of your past year’s income that you saved and didn’t spend. Without even doing the calculations, you may already know that your rate of savings is low, nonexistent, or negative and that you need to save more. Part of being a smart investor involves figuring out how much you need to save to reach your goals. Not knowing what you want to do a decade or more from now is perfectly normal — after all, your goals and needs evolve over the years. But that doesn’t mean you should just throw your hands in the air and not make an effort to see where you stand today and think about where you want to be in the future.

An important benefit of knowing your savings rate is that you can better assess how much risk you need to take to accomplish your goals. Seeing the amount that you need to save to achieve your dreams may encourage you to take more risk with your investments.

During your working years, if you consistently save about 10 percent of your annual income, you’re probably saving enough to meet your goals (unless you want to retire at a relatively young age). On average, most people need about 75 percent of their pre-retirement income throughout retirement to maintain their standard of living.

If you’re one of the many people who don’t save enough, you need to do some homework. To save more, you need to reduce your spending, increase your income, or both. For most people, reducing spending is the more feasible way to save.

To reduce your spending, first figure out where your money goes. You may have some general idea, but you need to have facts. Get out your checking account history, examine your online bill-paying records, and review your credit card bills and any other documentation that shows your spending history. Tally up how much you spend on dining out, operating your car(s), paying your taxes, and everything else. After you have this information, you can begin to prioritize and make the necessary trade-offs to reduce your spending and increase your savings rate. Earning more income may help boost your savings rate as well. Perhaps you can get a higher-paying job or increase the number of hours that you work. But if you already work a lot, reining in your spending is usually better for your emotional and economic well being.

If you don’t know how to evaluate and reduce your spending or haven’t thought about your retirement goals, looked into what you can expect from Social Security, or calculated how much you should save for retirement, now’s the time to do so.

Determining Your Investment Tastes

Many good investing choices exist: You can invest in real estate, the stock market, mutual funds, exchange-traded funds, or your own or someone else’s small business. Or you can pay down mortgage debt more quickly. What makes sense for you depends on your goals as well as your personal preferences.

To determine your general investment tastes, think about how you would deal with an investment that plunges 20 percent, 40 percent, or more in a few years or less. Some aggressive investments can fall fast. You shouldn’t go into the stock market, real estate, or small- business investment arena if such a drop is likely to cause you to sell low or make you a miserable, anxious wreck. If you haven’t tried riskier investments yet, you may want to experiment a bit to see how you feel with your money invested in them.

A simple way to mask the risk of volatile investments is to diversify your portfolio — that is, to put your money into different investments. Not watching prices too closely helps, too — that’s one of the reasons real estate investors are less likely to bail out when the property market declines. Stock market investors, unfortunately, can get daily and even minute-by-minute price updates. Add that fact to the quick phone call or click of your computer mouse that it takes to dump a stock in a flash, and you have all the ingredients for short-sighted investing — and potential financial disaster.

Just a few comments:

  • The 3-month to 6-month rule-of-thumb Eric cites for your emergency savings could be much improved if you actually took a few minutes to assess your own family’s circumstances. Depending on a lot of things, you may not need a reserve at all or a 2-year reserve might be most prudent for your family. Read How Much Emergency Savings. Eric makes a fantastic point that you do not want to be forced to sell an investment to meet your expenses. You want the freedom to choose the moment in time when you’ll sell an investment.
  • Paying down debts is boring? I think not! But maybe that’s because I’m a nerd. But watching financial freedom move closer and closer is very exciting!
  • “Reducing and eventually eliminating this debt with your savings is like putting your money in an investment with a guaranteed tax-free return equal to the rate that you pay on your debt.” Right on, Eric! And that’s why we should consider your debts as an investment opportunity, not as an alternative to investing.

Excerpted with permission from the publisher, Wiley, from Investing For Dummies, 7th Edition, by Eric Tyson. Copyright © 2014

Image By Rept0n1x (Own work) [GFDL or CC-BY-SA-3.0-2.5-2.0-1.0], via Wikimedia Commons

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