Practical investing

Concepts: Impractical investing is the riskiest, often expensive, way of saving money for future use. Practical investing is the safest way to save money. The most practical investments are savings accounts, bonds, and brokerage accounts.

Practical investing is the long, slow process of saving money for future use.  Not by stashing it at home, but by giving it to a trustworthy person outside of home who will protect it, and better yet, put it to work earning extra money on your behalf.  ‘Protected money’ helps defend against future emergencies.  ‘Extra money’ helps pay for expensive things, caring for family members, and retiring from work.  The most practical investments are savings accounts, bonds, and brokerage accounts.  

Savings accounts are available in banks and credit unions.  Shop around to find the best deal for you and when you apply for an account, be sure it is FDIC insured (FDIC stands for the Federal Deposit Insurance Corporation). The FDIC insures against accidental or criminal loss of all the money held in your account up to the limit of $250,000 per account holder, per bank.  

  • ADVANTAGE- Money is easily deposited and withdrawn.
  • DISADVANTAGE- The interest rate is very low, usually below our national rate of inflation.
  • RECOMMENDATION- Use your savings account as an emergency fund to pay for catastrophes such as job loss, medical bills, and other overwhelming events. Try to save 3-9 months of wages in your emergency fund for the rest of your life. 

Bonds and CDs (CDs are certificates of deposit) usually pay more interest (interest is ‘extra money’) than savings accounts.  Bonds sold by the U.S. Government are guaranteed to be fully repaid with interest after a specific period of time.  Bonds sold by companies are fully repaid with interest unless the company is unable to make the payment.  CDs are sold by banks and credit unions, and insured by the FDIC.  

  • ADVANTAGE- The seller promises to repay you the full amount of the bond plus interest. 
  • DISADVANTAGES- The full amount plus interest is not repaid until the maturity date.   “Investment grade” bonds are usually repaid, but “junk bonds” may not be repaid.
  • RECOMMENDATION- Purchase bonds and CDs with maturity dates at or below 5 years in order to save for startup projects such as buying a car, new business, or new house.

Brokerage accounts sell securities such as stocks and stock-index funds.  The accounts are “SIPC insured” if the broker is a member of the SIPC (SIPC stands for the Securities Investor Protection Corporation).  The SIPC insures against financial failure of the broker and unusual loss of securities by the broker.  The SIPC insurance limit is $500,000 per customer, including no more than $250,000 cash, for all of the customer’s accounts combined. SIPC insurance does not protect against investment losses.

‘Extra money’ from stocks and stock-index funds might exceed the interest rates of bonds and CDs, and also exceed the rate of inflation.  But stocks and stock-index funds are riskier investments than bonds and CDs because you could lose money in the stock market.  

Three good ways of earning money in the stock market are 1) buying shares of a reputable stock-index fund, 2) holding the shares for a long time, and 3) reinvesting stock dividends.  All three ways are illustrated in the following graph:

dividend reinvestment

The graph shows 33 years of growth-in-value of a stock-index fund that was invested in a group of stocks measured by the Standard & Poors 500 Index (the “S&P 500″).  The stock-index fund earned ‘extra income’ in 2 ways: 1) from stock dividends and 2) from growth-in-value of the fund.  When all dividends were reinvested by buying additional shares of the fund (blue line), the final fund value of $6,000 was twice what it would be, $3,000, when the original number of shares were held without reinvestments (red line) for the entire time.  The blue line represents compounded growth.

Impractical investing is a very risky, often expensive way to save money.  The very risky investments include junk bonds, initial public offerings, partnerships, leveraged funds, commodities, currencies, collectibles, options, derivatives, hedge funds, and property ownership.  The possible expenses are high commissions, high tax rates, tax accountant fees, illiquidity (tied-up money), and costly mistakes.   

Useful references

FDIC. https://www.fdic.gov 

SIPC. https://www.sipc.org 

Introduction to Treasury Securities.  https://www.investopedia.com/articles/investing/073113/introduction-treasury-securities.asp 

TreasuryDirect®. https://www.treasurydirect.gov/ 

The Index Card.  Why Personal Finance Doesn’t Have to be Complicated. {http://wp.me/p1LlDo-KQ} Helaine Olen, Harold Pollack. Penguin Publishing, New York, 2013.

roadmap to investing.  https://www.sec.gov/reportspubs/investor-publications/investorpubsroadmaphtm.html 

Copyright © 2020 Douglas R. Knight 

 

Saving for Unemployment

An emergency fund is used to pay 3-9 months of living expenses during unemployment. Keep it for retirement.  

Protect Yourself

Unemployment means that you aren’t paid for doing work.  People who either lose their job or retire from work are unemployed. Could you pay for living expenses during unemployment?  If not, you should start building an Emergency Fund. There are two important savings plans during life: the Emergency Fund and Retirement Account (ref. 1).  

Emergency Fund  

The emergency fund is used to pay living expenses during temporary unemployment and other unusual expenses such as big bills.  Workers should save 3-9 months worth of earned income in a secure savings account (ref. 2).  That’s a difficult task when also planning to buy expensive items such as cars and houses, or paying-off college loans.  Get a headstart in childhood by slowly saving cash in a custodial bank account.    

Retirement Account 

The retirement account is needed to pay living expenses during permanent unemployment in old age.  Contribute to your own retirement accounts as soon and often as possible (ref. 3).  Begin by opening a Roth IRA during childhood when you start reporting earned income to the Internal Revenue Service (ref. 4).  Employer-sponsored and Self-employed retirement plans should be opened at the first opportunity (ref. 5).  

About forty to fifty years of regular investing are needed to build adequate savings for retirement (ref. 3). Plan on investing in quality securities such as stock index funds and government bonds (ref 1,6).  Begin with stock index funds early in life and add the bonds late in life, finishing with a 90% investment in stock funds and 10% investment in bonds (ref. 7).  

Retirement accounts have special rules for investing money (contributions) and removing money (withdrawals).  

  • Withdrawals before age 59½ years are generally not permitted without paying a fine and taxes [check the rules for exceptions in ref. 5].  There are no fines after age 59½ years. 
  • Roth IRA. You must pay taxes on all contributions and the contribution limits are $5,500 per year [check ref. 5 for changes].  Withdrawals after age 59½ are not taxed and there are no mandatory withdrawals. 
  • Other IRAs and retirement plans. The contribution limits vary from $5,500 to $19,000 depending on the account [check ref. 5 for changes].  You don’t pay taxes on any contribution, but withdrawals are always taxed.  The government requires partial withdrawals each year after age 70½ years. 

References

1. The Index Card.  Why Personal Finance Doesn’t Have to be Complicated.  Helaine Olen, Harold Pollack. Penguin Publishing, New York, 2013.

2. Emergency Fund Calculator, MoneyUnder30 . com:  https://www.moneyunder30.com/emergency-fund-calculator.

3. Retirement Income Calculator:  https://retirementplans.vanguard.com/VGApp/pe/pubeducation/calculators/RetirementIncomeCalc.jsf

4. Video on compound interest in a Roth IRA: https://youtu.be/6dzpNd3megg 

5. Retirement plans:  https://www.irs.gov/retirement-plans 

6. Saving and Investing for Students, SEC resources for youth:  https://www.investor.gov/search/node/students

7. Warren E. Buffett, Chairman of the Board. Letter to the shareholders of Berkshire Hathaway, Inc., 2013. Page 20, 2/28/2014.

Copyright © 2019 Douglas R. Knight

Personal investments

 

personal investments

Borrow:

Secured loans are based on a collateral asset such as the borrower’s property or financial account. The lender can take ownership of the collateral asset if the borrower fails to repay the loan.
Unsecured loans are based on creditworthiness of the borrower. Lenders usually rely on credit reports to assess creditworthiness. Credit card accounts and student loans are unsecured loans. Beware: Students can incur high debt by borrowing for extra years of college or to attend an expensive school.

Short-term ownership:

The short-term investor typically lends money to an investment fund (money market fund), bank (certificate of deposit) or government (Treasury Bills) on the condition that the borrower promises to pay it back with a small reward (called “interest”) at a specified time no longer than 1 year.

Long-term ownership:

Stocks are certificates of part-ownership in a company. Stockowners earn returns from dividends and capital gains. The expected long-term rate of return is an average annual rate of 7%.
REITs are real estate investment trusts that distribute 90% of the annual profit to shareholders. REITs earn profits from rental fees and real estate investments.
Bonds are contracts that guarantee scheduled payments of interest and repayment of the invested money. The expected long-term return is an interest rate of approximately 4%.
Investment funds are pooled investments, typically in stocks or bonds, which are owned by a group of investors. Shareholders earn profits from cash distributions by the fund and by selling shares of the fund at a higher price.  Shareholders lose money if they sell shares at a lower price than paid to make the investment.
Mutual funds and ETFs are registered investment funds governed by the Securities and Exhange Commission (SEC.gov) and Internal Revenue Service (IRS.gov).
529 Plans, Coverdell ESAs and Roth accounts are portfolios of government-regulated, tax-deferred investments.
Homes are illiquid assets, meaning that they are difficult to sell quickly for cash. Owners earn a profit or loss at the time of sale.

Reference: http://www.finra.org/investors/types-investments