Your Investments [ Edited ]

[BookClubEditor]

What Have You Done So Far?

Investing is about building a foundation for today and the future, and it is a lot like cardiovascular training. Cardiovascular work boosts your heart and respiration rates and, as a result, your capacity for energy and wellness. Similarly, investing ultimately drives your wealth. No other quadrant in the Net Worth Workout has this great an impact. Just using your current paycheck sensibly won't do it. You need a measure of intensity.

If you're serious about fitness, you don't just work your heart and lungs -- you mix it up. An investment portfolio does the same thing. Even better, a properly aligned portfolio can protect you from the pain of taxes and fluctuations in the market.

Your Investment Inventory

It's time to write down exactly what you own. It's important to look at your investments in the aggregate. Yours may be just one half of a larger portfolio. Are you married or the legal or emotional equivalent? If so, do you think of your investments collectively? If you have a 401(k) with your employer and a Roth IRA, do you manage these as a whole? Don't feel bad if you don't; most people follow the same pattern. Behavioral finance calls this "Mental Accounting," an unconscious habit of segregating dollars by source, location, or use. We tend to divide our money into "mental" accounts, each with a different importance. As a result we value some dollars less than others and waste or underutilize them.

Another pattern is that people tend to divide their chores, and finances usually fall to one person, increasing the likelihood that you're "strengthening the strong and weakening the weak" as one person becomes more proficient in handling investments and the other defers to the more involved party.

Page 152 of The Net Worth Workout can help you complete your Investment Inventory. What investments do you have? Make a list of your retirement accounts, brokerage accounts, annuities, and savings beyond your three-to-six month emergency reserve. Also, what is your annual return in each of these accounts? You can find the rate of return on your investments by looking them up on www.morningstar.com.

A Few Capacity Building Drills

When it comes to investing, there are five capacity-building drills. We'll focus on compound interest, dollar-cost averaging, tax reduction, and diversification. (You can learn about the fifth by turning to page 163 of The Net Worth Workout.) It's exactly like cross training: Relying on some of each gives you better performance than relying on one or two.

Compound Interest: Einstein's Favorite

Albert Einstein famously quipped, "The most powerful force in the universe is compound interest." He was right: Investments build empires. We also have more time than we think. If you start working at age 22 and live until 83, that's 61 years. Let's say you're 43 years old: You might have another 40 years of compound interest. This is exactly why you do yourself (and your blood pressure) a disservice by worrying about the market performance every single day. Here's an example of how powerful compound interest can be.

It's 1960 and your mom puts $1,000 a year into the S&P for 44 years. In 2004, she'd have $717,905 since the S&P averaged 10% a year. What's so striking is at her 22-year mark, halfway through her 44 years, her $22,000 of contributions were worth $78,000 - a very nice $56,000 profit. But the real power occurred in the next 22 years. She added another $22,000 as she did in the first half but her account grew from $78,000 to over $717,000! Compound interest created well over $600,000 of profit!

You also have more time than you think. Visit www.dinkytown.net and try it for yourself. Click "Investment Returns" under the investments section.

Dollar-Cost Averaging

Dollar-cost averaging is one of the best investing habits you can build. Instead of investing your assets in a lump sum, you work your way into buying funds by buying smaller amounts over a longer period of time. You buy a certain amount of your investment on a regular schedule, regardless of what the market does. More shares are bought when prices are low, and fewer shares are bought when prices are high. Page 157 in The Net Worth Workout provides an overview of how this really works.

Tax Reduction

Here, Uncle Sam gives you a hand. It involves investing in a way that shrinks your taxable income. You can do this by participating in a retirement plan: either a 401(k), 403(b), or traditional IRA. For example, if you're 49 years old and earn $100,000 a year and don't participate in a 401(k), then if you are in the 31% tax bracket you'll pay $31,000 in taxes. Now let's suppose you contribute $15,000 to that 401(k). Uncle Sam taxes you as if you made $85,000 and if you're in the 31% tax bracket you paid $26,350 in taxes, saving over $4,650 in taxes and you socked away $15,000 toward your retirement! Pages 160-161 in The Net Worth Workout discusses this pre-tax investment.

Diversification

Many investors think that picking the right stock or timing the market to buy at the best time is the way to success. A Nobel-Prize winning study in Economics called "The Determinants of Portfolio Performance" found that neither of these determined performance, and that more than 90% of your return comes from how your assets are diversified.

This is a process. You build a diversified portfolio by mixing the three basic asset classes: cash, bonds, and stocks. Your risk tolerance, age, time horizon, and a few other factors will determine the ratios. Pages 171-173 of The Net Worth Workout feature a helpful chart of the different asset classes.

It's important to find out which asset classes define your investments. It may take a bit of sleuthing, but the additional returns are well worth it. Many of you will be focusing on your 401(k)s, IRAs, Roth IRAs, and other retirement plans. That's where most people end up with their assets.

If you have a mutual fund, look up the ticker symbol on www.morningstar.com. It will tell you the various asset classes of your fund. Or go by the fund's title (though this isn't as accurate). If it says international in the title, you can probably guess it's a foreign fund. If the fund is called Growth and Income or Equity Income, it's probably a value fund. The purpose of this exercise is to make sure you don't own two, three, or more funds that you think are "diversified" and really all come under the same asset class.

If you're really feeling ambitious at this point, the next step is to categorize the percentage you have in each asset class. How much do you own of cash, bonds, and stocks? Dig deeper and identify if your stock is large-cap growth, large-cap value, or international. For the investment allocations below, write down how much is invested, and what percentage of your total investments it is.

Naïve Diversification and Other Pitfalls

Naïve diversification means letting the investment choices presented dictate your asset allocation. If someone is offered more equity funds, say in their 401(k) plan, they tend to own more equity funds. On the other hand, if the choices presented have more bond funds they'll skew more towards owning bond funds.

Another pitfall is company stock. A study by Richard Thaler from the University of Chicago found that employees who were offered company stock typically had 42% in their retirement plan and then split the balance (the other 58%) between bonds and stocks. If company stock wasn't an option, then employees typically chose 50% stocks and 50% bonds. The point is that if company stock is an option you're pre-disposed to be more aggressive than if it wasn't a choice. A good rule of thumb is to avoid having more than 10& in any one company stock.

Benefits of Diversifying

The Callan Investment Chart on page 213 of The Net Worth Workout shows the best-performing asset class along the top, and the worst performing asset class along the bottom, over the last 20 years.

Let's imagine every year you need to decide where to invest your $10,000 for your 401(k) contribution. Your best friend at work tells you he's a contrarian and he invests in the worst performing sector. By the end of 20 years your investment of $200,000 would grow to $514,684. It sounded like a pretty good strategy but then you talked to your boss and she said her strategy was to invest her $10,000 to the best-performing category, and in that scenario you would have accumulated $550,966. After mulling this over, you decided your best course of action is to say, "I really don't know what will be the best so I'm going to divide my $10,000 equally between all the asset classes." How brilliant! Your $10,000 every year for 20 years mushroomed to over $694,633. That's the real power of diversification!

Women and Investing

For years, women have been perceived as supplementary income earners and homemakers with typically less interest than their husbands in financial matters. Today, the story is much different. In 1970, 43% of women (ages 16 and older) worked outside of the home. By 2000, this had grown to over 60%. Denmark leads the world with over 74.5% working outside of the home. Meanwhile, over 3.4 million women broke the ranks of top wealth holders (those with gross assets of $675,000 or more). In 1981, about 14% of women out earned their husbands. Today, it's over 30%. Never before has there been greater opportunity to build financial independence and wealth for women.

But women still have their work cut out for them. Women tend to live longer and tend to be a few years younger than their husbands. They are also out of the workforce for longer, taking care of children and/or elderly parents, for usually about 11 years. This alone has quite an impact on social security and pension benefits. Another reason is that as a whole, women are still earning less than their male counterparts. Finally, women tend to take less risk than men with their investments. (Though this isn't always a negative!)

So, what are some of the things women can do to protect themselves? First, if you're changing jobs (women usually change jobs more often than men, typically every 4.8 years), thoroughly compare the benefits your present company is offering versus the new company. Maybe your present company has an attractive pension plan that gives you a higher income payment the longer you accrue time with them. Or maybe you have to be at the new company for five years before they'll match your 401(k) contribution. New jobs and opportunities are exciting, but don't let the excitement of something new cloud your thinking. Even better, if you are sacrificing any benefit, be sure to ask for its equivalent in the new position before you accept the offer.

Divorce has a tremendous impact on how women live. A divorce's financial impact is usually far greater for women than for men. Immediately following a divorce, women age 50 and older experience a 39% decline in their income. That's nearly triple the decline men experience, which is about 14%. One year after a divorce, 40% of men have regained their pre-divorce incomes, while only 21% of women have. It's important to be involved in your household's finances. If anything should happen -- divorce, loss of a spouse, etc. -- you're much more likely to regain your pre-divorce income quickly if you know how your finances work.

Investment Styles

One area I find lacking is that spouses typically don't coordinate their retirement accounts. This means if you have a terrific international fund and your husband has better bond funds than you, you're less likely synchronize your choices. It's really a shame because there's so much potential in making the most out of two programs rather than one.

Couples tend to adopt one investment style, with certain patterns. For instance, a woman whose husband owns more bonds than stocks tends to focus on bonds, bypassing stocks. Yet influence can flow the other way, too. Men married to women who own bonds buy more bonds than other men do. If a household owns an IRA as well as a 401(k), both husband and wife are more apt to invest in stocks. It seems that, having made retirement planning a priority, such couples come to know and appreciate the stock market.

Women really do have a lot of advantages when it comes to investments. They tend to be more careful shoppers and ask a lot of questions. Women also don't trade nearly as often as men do, which gives them quite an edge. My last piece of advice on investing is: If you're interested in taking a class on investing, look for one that focuses on asset allocation rather than timing.

Discussion

1. How would you like to improve your investment inventory?
2. Discuss your investment style. Is it similar or different to others in your family?

Message Edited by BookClubEditor on 11-30-2006 10:52 AM

[Everyman]

Discuss your investment style. Is is similar or different to others in your family?

In some forty years of investing I have tried a number of approaches to investing -- broker recommendations, tips from friends, financial magazine picks, onlike discussion boards, momentum investing, CANSLIM, short term trading, mutual funds ... you name it, I tried it. About ten years ago I realized that this was all stupid (not to mention nonproductive), and after two years of study with a group of like minded friends I concluded several things.

First, pick one approach that has been shown to work and stick with it. People who switch strategies all the time generally switch when the method they have been following is temporarily out of favor, which means their stocks aren't doing well at the moment. So have bought high, now they sell low and buy into a different approach which looks successful, which means that the stocks in that philosophy are now doing well, meaning they're expensive. So they switch to expensive stocks, then in a year or two when those stocks have not performed, they sell them (so they bought high and sold low) and switch to something else. The only people this makes happy are the brokers. Find something that works for you and stick with it.

Second, have discipline. This is essential.

Third, don't follow the market daily, or even weekly. The price of a stock in the short term is almost always unrelated to the quality of the stock or its true long term value or prospects. Short term prices are a factor of emotion in the market, reaction to world or national news, general economic factors, etc.

Fourth, and perhaps most important, don't listen to the TV pundits or financial shows or read the latest hot investing book. If those folks really knew how to get rich, they would be out there quietly doing it, not peddling their wares to others. There are a few classic texts to read (such as Peter Lynch's One Up on Wall Street, Ellis Traub's Take Stock, Graham's The Intellgent Investor, maybe Kelly's The Neatest Little Guide to Stock Market Investing (dumb title, great book). Read those four and you know all you need to know to invest wisely and successfully. If you want to read something else, read Warren Buffet's annual letters to the shareholders of Berkshire Hathaway -- they're all on the BH website.

Fifth, do your homework. Understand your stocks. You wouldn't buy car just because some salesman (and stockbrokers are salesmen and never forget it) tells you to or some half-drunk at a cocktail party touts it as a great car you gotta buy. Why buy a stock that way?

After reading and studying I settled on a process that works -- and has worked -- for me. My investing style is to invest in a portfolio of approximately fifteen diversified long term quality growth stocks purchased at reasonable values and held as long as their fundamentals continue to hold up. I use a tool called Investors Toolkit (free demo available from Iclub.com) with the Stock Central stock database. The Toolkit manual (can be downloaded free) is long and extremely worth reading; it's a whole stock investment course as well as a detailed description of how to use the program. (I have no interest in these products and get no benefit from recommending them. Don't buy them just because I say so. But look at them and decide whether they're right for you.)

My goal is to make a return that is at least five percentage points better than the market average (I use the S&P 500 as my benchmark). I'm satisfied to get rich slowly.

I will hold stocks forever as long as they keep growing their earnings and keep their fundamentals (principally their profit margin and return on equity) healthy. If a company's fundamentals fall off, I'll replace it with something better. If I find a stock that looks like a prospective winner, I'll search my portfolio for the weakest stock I have and switch.

It's simple, it's basic, it works. What more can one ask?