Finance and Investing for Everyman, by a Smart Pilot
Smart and simple investing involves three basic principles, and one important early strategy.
- Dollar cost averaging
- Compound interesting
- Tax structuring
Compound interesting is simply the effect that applying an interest-rate has to your savings.
It increases over time and in ever increasing amounts.
Do the simple exercise, take one penny and double it every day for a month and look at your total amount on day 31.
The 100% interest-rate compounded daily will yield you over $10 million on day 31!
A more reasonable interest rate would be 6% compounded monthly.
If you took a $2000 investment and added $2000 to it every year,
with the 6% compounded monthly interest,
you would have $330,000 in 40 years!
Without that compounded interest,
you would only have the $80,000 that you put in yourself.
The difference of $330,000 vs $80,000 is due to compound interest.
In the figure to the left, the blue line is your money,
the black line is the work the interest is doing,
and the green line is the total amount of money you have.
VERY POWERFUL STUFF!!!
Dollar cost averaging is simply the principle of reducing risk by investing over a long period of time.
Simply having time and taking this is the most important part of investing after compound interesting.
If you don’t have time and have to make a large amount of money in a small amount of time,
then you have to increase your risk and gamble a lot of money upfront for unsure gains.
This is where most Americans run into trouble at the retirement age when they have to make a lot of money in a hurry and have to assume high risks in doing so.
The simplest way to look at it, is the fact that over the last 150 years, the Dow Jones index has averaged 10% growth per year.
Some years it goes up 40%, some years it goes down 10 or 15% or more.
There have even been stock market crashes where the market has lost 80% of its value overnight.
But when you look at the market long-term,
the steady average growth is 10% and 10% is a great rate of return for your investment.
If you invest over a period of 40 years with the stocks in this exchange, your chance of that average return being close to 10% is excellent.
If you invest for just one year it might be a good year or a bad year and that is simply too risky.
Therefore the answer is a steady investment program over a long period of time to dampen out both the positive and negative spikes.
Pre-diversification is reducing the risk by investing in different stocks.
If you buy just one share of one stock of a company you are putting all of your proverbial eggs in one basket.
If that company does very well and you sell that share of stock you will make a good profit.
However if the company does poorly you lose money.
And if the company goes bankrupt you will lose all your money.
A way to avoid that risk is to diversify, i.e. buy a bunch of different stocks.
However that can get very expensive up front if each stock costs $100 or so per share.
But one way to diversify and do it more cheaply is to buy a mutual fund which itself buys many stocks and sells a portion of it to you.
A fund manager determines which stocks will be purchased based on his experience and charges a fee for this called a load.
You can shop for fund managers based on their experience and their past performance i.e. how well they do picking stocks!
You can also just buy a fund that just mirrors the stock market, i.e. buys a tiny portion of each company on the entire stock market.
And there are different markets to look at, for example:
- Dow Jones Industrial Average which is the collection of all the United States large industrial companies.
- NASDAQ index which is all of the up-and-coming high tech stocks.
- Standard & Poores 500 which is a sampling of 500 good companies in the United States.
All of these index funds are very inexpensive because you don’t need a genius fund manager doing a lot of research and work.
He simply picks a percentage of each company in the index fund that accurately reflects the size of the company and its proportional influence in that market.
When you buy a share of that index fund it’s like buying a tiny affordable slice of that market itself.
Cheapest Index Funds
Tax structuring is how you’re going to structure that money for tax purposes.
You make the investments with an inexpensive, low commission online brokerage firm.
You can either
invest post-tax with no limits (in a regular cash account paying either short-term or long-term capital gains).
or invest pre-tax with reasonable yearly amount limits (in a ROTH account)
If you post-tax the money, you will be able to invest money now and not pay any tax on it
but when you retire the growth on that investment will be taxed.
It will be at a lower tax bracket then during your prime earning years,
but it will all still be taxed.
But if you pre-tax the money in a ROTH retirement account,
you will pay tax at your current (higher) tax bracket.
However the good news is that, at retirement, you won’t have to pay ANY tax on the profit you’ve made on your investments.
The tax on your investment is inevitable.
A good analogy on this makes the choice clearer.
A farmer has a choice of either having to pay tax to buy seeds for his crop
or pay tax on the crop harvest itself later.
For most farmers, it’s best to pay the tax money upfront on cheep seeds, even if the tax bracket is high,
than to pay taxes on the massive crop later, even at a lower tax bracket.
Tax-structure correctly by setting up your ROTH retirement savings account online with TDAmeritrade.com (or Etrade or Schwab ect ect)
Dollar-cost-average your investment by starting early, investing $500 each month.
Diversity your investment in a stock index fund (like Fidelity's FUSEX and FNCMX Funds) with low load costs so you have no expensive fancy fund manager eating into your profits.
Your profits are growing at a compounded-interest rate as you stay in the market over the long haul.
Because of your tax-structure decision, when you retire, all of your investment can be distributed back to you completely tax-free.
You never look at your portfolio, you never stress over it, you just keep investing in a steady consistent strategy as the market rises and falls.
No work, no stress, just a guaranteed secure retirement with lots of golf and yachting.