Don't forget about inflation risk

While the stock market has rebounded quite a bit in the past five months, it is still down significantly from its 2007 highs. That makes it an easy target for critics to attack, such as this comparison (via Bargaineering). Some people have attempted to refute these criticisms, however others continue to fuel the fire.

With the run up in value in the mid 2000's, I think people have conveniently forgotten that the stock market can be extremely volatile over the short term. Conservative investment vehicles such as CDs are definitely more appropriate for short term savings, but anyone thinking about using them for long term investing should definitely consider inflation risk.

According to some predictions, inflation may make a strong come back as early as 2010. So if you have a CD earning 2-3% (which is not that uncommon these days), it is quite possible that it will barely keep up with inflation over the long haul.

While my investment allocation may seem aggressive to most people, I think I am actually pretty risk averse thanks to a deep rooted fear of inflation eroding the value of my money. As I have written before, I plan to slowly shift my assets into more conservative investments as I reach closer to retirement age, so that I can reduce my exposure to market risk.

3 steps to achieve financial success

I believe that most Americans can achieve financial success. I am living proof that it's possible. Granted, I have a well paying job, but I don't make an obscene income. Besides, I know plenty of people in my income range that have little to show for their years of working. And I think that even if my income was more modest, I would still be well on my way to financial independence; I just wouldn't have accumulated as much.

Here are the three steps that I feel are necessary to achieve financial success:

1. Live below your means. I realized that to make money, I needed capital, and to generate it I had two options: reduce my expenses or increase my income. I increased my income by gaining valuable work skills and hopping jobs, but that may not always be possible depending on the stage of your career. I also kept my overhead low, and that is something that everyone can do.

For one thing, I never tried to keep up with the Joneses. I knew from reading "The Millionaire Next Door" that self-made millionaires lead pretty modest lives, and people who flaunt extravagant lifestyles are financing those lifestyles at enormous opportunity cost. I kept my focus on becoming debt free and saving for early retirement.

I differentiated my needs from my wants, and carefully evaluated each expense that fell into the "wants" category. If it didn't match my priorities, then I opted to forgo it or found cheaper alternatives. That meant no luxuries like designer clothing, Starbucks, BMWs, concerts, etc., but I really didn't care about those things anyway. That doesn't mean I always deprived myself, I just made sure that any money spent on non-necessities was used to buy things that brought real, lasting happiness. I bargain shopped to find the best deals, and I made sure that I could pay off the credit card bills when they arrived. I also understood the eroding effect of taxes on my money: the combined impact of income tax and sales tax meant that only about half of every dollar I earned was available for me to use, so I spent them very sparingly.

2. Save. I knew my ability to work was finite, and I wanted to have the option of not having to work as soon as possible, so I treated my earnings like lottery winnings. I socked away the max into my 401(k) plan immediately upon starting my first job, and continued to do so as I changed jobs (and never cashed out). I figured I wouldn't miss 15% of my salary, and even if I did I could always scale it back. I survived just fine though, and because I kept my expenses low, I was able to save a significant portion of my take home pay and use it to pay off my first house early. I also started a ROTH IRA as soon as I was eligible, and maxed it out every year.

3. Invest.I learned about the amazing power of compounding, and the risk of inflation. Because I started early and had a long time horizon, I was able to invest aggressively. So far it has worked out pretty well for me.

There you have it, the three key steps to building wealth. These aren't new ideas, and it takes time and patience to see the results, but as someone who has done it I can confirm that they will work for you--unlike most get rich quick schemes. I think the most difficult part is the first step, where you have to make the paradigm shift from instant gratification to delayed gratification. Think of robbing your future self when you spend your money in the present, and perhaps that will help you resist the temptation to buy stuff you don't really need.

So if you want to do something to get started on the road to wealth, here is a simple action you can take now: log into your employer's 401(k) plan, and bump up your contribution amount. Remember, if you find that you can't live without the reduction in take home pay, you can always change it back, but I'm betting that you'll learn to live without it, and you'll be thanking yourself later.

Making money in stocks: The only 6 things you need to know

I recently ran across an old issue of Family Money Magazine from 2000 that I saved. It featured an article (the title of this post) on investing in the stock market, and I think the advice is still pretty valid today.

Here are the six principles discussed in the article:

1. Systematic investing can improve your results dramatically. The author says that investing on a regular basis helps you to develop the discipline to stay in the market for the long term. She also mentions dollar cost averaging, which enables you to buy more shares when prices are low, and fewer shares when prices are high, but it's a strategy not without criticisms. I think simply getting started can often be the most challenging step, and systematic (or automatic) investing can lessen the pain because you are buying a little chunk of the market at a time, rather than taking a big bite at once. If you do decide to use the DCA approach and choose to invest in index funds, be aware of the impact that trading fees can have on your investments.

2. How you diversify is the most important determinant of your investment return. Yahoo! Finance featured an article before Halloween about personal finance horror stories, and one of the tales involved an investor who, over the course of four years, lost 98% of an $8 million portfolio that was invested in seven or eight stocks. Clearly diversification is important, and I would add that including international stocks in your investment portfolio is a good diversification strategy as well.

3. No money manager can beat the market over the long run. Neglecting the fact that even pros are unable to consistently predict how the market will move, the author points out that trading costs erode returns by about 0.81% a year, and management expenses further eats into returns. Large company funds have an average expense ratio of 1.23% a year, compared to 0.43% for the average index fund (according to Morningstar, 2000). If you think of money managers as middlemen who take their cut of the profit, and it's easy to understand why they have to outperform the market just to break even. I usually prefer ETFs or index funds to actively managed funds for this reason.

4. Over the years, growth stocks are your best bet. The author says you want to buy companies that are growing consistently and steadily, and that it's harder for investors to predict which value stocks (whose shares are cheap compared to the company's current earnings) are going to take off. I suppose from a risk perspective, it makes sense to buy companies that have proven track records than to gamble on newcomers, although I think owning value stocks can be part of a diversified portfolio.

5. A good stock is a bad investment if it's overpriced. Look at the P/E (price-to-earnings) ratio. If the stock is trading at a high P/E compared to historical values, you may want to wait, according to the author. I think there's more to determining the worth of a company or stock than simply looking at its P/E ratio, but it's certainly one factor to consider.

6. Trying to time the market is futile. Market timing is an investment strategy that never pays off in the long run, because the likelihood that you'll enter and exit at the right time is slim. It's better to buy and hold, which also prevents commissions and taxes from eroding your returns.

If you're a beginner investor, these six simple rules may help you to get started in the right direction.

Source:
Karen Cheney
Family Money Magazine
October 2000 issue

My retirement plan investment strategy

I just read a recent interview with famed economist and lawyer Ben Stein. I've gained a lot of respect for him lately, especially after a piece he wrote for CNN Money about sticking with long term investment goals instead of following short term market trends. I am definitely all about investing for the long term, and it's reflected in my investment strategy.

Because I have a long-term horizon (I don't plan to touch my retirement funds for at least 30 years), I am almost completely invested in stock funds. My 401(k) plan offers the following stock fund choices (next to them are how my contributions are allocated):


The Aggressive Asset Allocation Portfolio fund is comprised of 20% bonds, 24% international equity, and the remainder is split between the S&P 500 index, large caps, and small cap funds. It is similar to a target retirement fund in that it invests according to my risk tolerance level, only it doesn't adjust the portfolio mix over time.

How did I arrive at this particular investment mix? My primary goal was to be invested in stock funds, however within that I wanted diversify amongst the various fund choices, so I decided to put an equal amount (25%) into each fund type: an index fund, an international fund, a managed portfolio fund, and US stocks. This allows me to see how the fund types perform over time compared to one other, and as you can tell from the chart below the international equity fund is kicking butt at the moment:



Ben Stein believes in foreign stocks, and so do I. 25% of my contributions are directly earmarked for the international equity fund, and another 24% within the Aggressive Asset Allocation Portfolio fund, making my total foreign investment a hefty 31% of my incoming contributions. Note that unlike a global fund, an international equity fund does not invest in US stocks. If I only had access to a global fund, I would raise my contribution allocation accordingly to increase my exposure to foreign stocks.

A lot of experts advocate regular rebalancing of retirement portfolios, usually on an annual basis, to bring investments back in line with the target asset allocation. However, like Ben Stein, I don't believe in rebalancing--at least not for myself at this time. Why would I want to sell off assets that are doing well to invest in underperforming (relatively speaking) funds? Not to mention the detrimental effect the sales fees will have on my portfolio. If I was nearing retirement, I could see an argument for using rebalancing as a tool to control my risk exposure, but until I start shifting a significant portion of my investments out of stocks it makes little sense.

I am fortunate that my current 401(k) plan offers funds with extremely low expense ratios. Most of them are at 0.50% or lower, except for the small cap fund, which is still at a reasonable 0.80%. Because of this, and the fact that I like the fund choices available to me, I was comfortable with rolling over my 401(k) accounts from previous employers. It makes managing my retirement funds easier, and reduces the amount of paperwork I have to file. I only wish I could use the same custodian for my ROTH IRA, which is invested elsewhere in a S&P 500 type index fund.