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How Do You Know When You’re Financially Ready To Start Investing?

2013 June 3
by Kyle Bumpus

The simple answer to this question is “as soon as you have money.” Ideally, you should start investing whenever you have money to invest. Time is on your side and those who start young will be very richly rewarded. That said, life sometimes happens. Not everybody is in a position to invest for retirement, perhaps because they have other more immediate obligations (medical emergency, family issue, high-interest debt, etc) or maybe they just plain don’t make enough money at the moment to save money after buying the necessities.

At the risk of wading uncomfortably deep into Dave Ramsey territory I’m going to lay out a few basic guidelines for when you should definitely start investing for long-term goals.

You’re Ready To Start Investing When…

You’re consumer-debt free

While there are some exceptions (you should definitely invest at least enough to get the full 401k employer match regardless of your other obligations, for example) you will get more bang for your buck from concentrating on paying down high-interest consumer debt than investing in the stock market. Over the long term, stocks have averaged in the 8-10% per year range. Credit card interest rates, on the other hand, are usually in the 13%+ range. It would take an incredible amount of skill to earn more in the stock market (or even with real estate) than your credit card charges. Warren Buffett can probably get away with taking out a cash advance on his credit card in order to invest in stocks, but you and I sure as hell can’t.

You don’t have to cut corners on your health to come up with money

I am a very firm believer that your health is your most important asset. While I’m not saying you have to be able to afford organic everything and belong to a fancy gym before you start to invest, you definitely shouldn’t be cutting corners on your health. If the only way you can come up with extra cash to invest is to skimp on your health insurance coverage, skip doctor visits, or eat processed junk rather than fresh vegetables, you should seriously reconsider opening that Roth IRA. That’s right: I’m telling you not to start a Roth IRA if you can’t afford to eat well. First things first.

You have an emergency fund

Some people argue a credit card or home equity line of credit (HELOC) can function as an emergency fund and while that’s probably true for people with substantial assets, there’s really no substitute for having a cash emergency fund, in my opinion. Some gurus recommend you have 3 months worth of expenses in an emergency fund, others 6 months – I’m personally more comfortable with 12 months – but however much you decide is sufficient for your situation, build up your emergency fund in full before you start investing for retirement. I find myself having to use my emergency fund far more often than I would have thought possible when I first started one. This goes doubly for homeowners. Sh!t is always breaking.

You have realistic expectations about investing

It’s quite sad how many people I come across on the interwebs with insanely unrealistic expectations about investing. In fact, it appears this describes a sizable minority of the general public. Why else would the “earn 20% per month investing in xyz” scams be so prevalent? Somebody must be buying into that crap. If it sounds too good to be true, it probably is. You aren’t going to earn more than 8-10% per year with a properly diversified portfolio. You’re just not. If you’re expecting more than that, you probably shouldn’t be investing because odds are good you’ll fall victim to a scam and lose all your money eventually. You are Madoff’s wet dream.

You understand the basics

I don’t care if you aren’t interested in investing. You probably aren’t all that  interested in brushing your teeth or flossing either, but you do it. Why? Because it’s good for you. It’s just something you have to do. It’s the same with learning about personal finance. Not being interested isn’t an excuse. Man (or woman) up and learn the basics. There are a billion good personal finance blogs on the internet, tons of good books on the subject, and some great internet forums like Bogleheads.org to help you along the way. You aren’t alone. The information is out there and investing isn’t difficult. Just do it. No excuses.

5 Fatal Investing Mistakes You Must Avoid

2013 May 7
by Kyle Bumpus

Warren Buffett once said the key to successful investing is to avoid making major mistakes. Kinda. He actually said “don’t lose money,” but I think my paraphrase is more useful. You don’t need any big wins as long as you avoid the big, fatal losses. Which is good, since very few people have the skill to score big wins consistently.

Luckily, avoiding fatal losses isn’t overly complicated. In fact, I can think of just 5 fatal mistakes. Avoid those and you’ve got an excellent chance of funding a comfortable retirement.

5 Fatal Investing Mistakes You Must Avoid

1. ) Not saving enough

This is mistake numero uno. If you aren’t saving enough for retirement it almost doesn’t matter what else you do. Chances are if you’re under the age of 40, you won’t have a pension. And while I think claims that Social Security won’t be around in 30 years are mostly BS, there’s a real chance it might be somewhat less generous than it is now.

The old rule-of-thumb is that you should save 10% of your income for retirement. That made sense when pensions were more mainstream, but today’s young worker probably needs to save more like 15% of her income to really guarantee a good shot at a comfortable retirement.

2.) Not taking personal responsibility for your finances

For many, the temptation is strong to throw up their hands and proclaim “I just don’t get this stuff. I’ll let a professional handle it.” There’s nothing wrong with seeking professional help, but blindly trusting somebody else to handle your money is a recipe for disaster. Nobody cares about your finances as much as you do.

The world is full of people who handed off responsibility for their money to some “highly qualified professional” and lost it all. Plenty of celebrities, professional athletes, and lottery winners who made more than enough money to provide for themselves and their children for a hundred years have ended up bankrupt. Why? Because they weren’t paying attention. And when the fit finally hit the shan, what was their excuse? That they trusted somebody else to handle their money and they were betrayed. Screw that. Even if you trust somebody else with your money, it’s still up to you to monitor their actions. Do you think those people who were betrayed by others kept tabs on their advisors? Nope. That’s the opposite of taking personal responsibility for your money. Don’t be that person.

3.) Investing without a plan

Investing without a plan all too often leads to emotional decision-making. If you have a well thought-out plan, you’re more likely to stay the course when the market hits a rough patch. My advice: come up with a reasonable asset allocation according to your willingness and ability to take risk and write it down along with your reasoning for choosing that particular allocation. Whenever you feel panicky, read back to yourself what you wrote. Often, that will be enough to convince you to stay the course.

4.) Neglecting to educate yourself about  money

This is an absolute necessity. Even if you decide to invest with a competent financial advisor, you need to know the basics of investing. How would you ever be able to figure out which advisors were competent and which weren’t if you didn’t?

5.) Getting too cocky

Everybody thinks they’re a genius in a bull market. How many ordinary, everyday people turned day traders thought they were stockmarket geniuses during the late 90′s when tech stocks were setting new records daily? Tons. How many still thought they were geniuses a few years later after the crash? Almost none. Don’t buy into your own hype. Everybody looks good in a bull market.

If Everybody Indexed, Would It Stop Working?

2013 April 29
by Kyle Bumpus

It’s difficult to get into an “active vs passive investing” discussion on the internet without somebody throwing out the “yeah, but if everybody indexed it would stop working” argument. Yeah, that’s true. But that’s also true of just about everything, everywhere.  If everybody invested in real estate, there’d be no renters. If everybody was an electrician, there’d be no plumbing, etc. You’re not everybody and shouldn’t invest as though you are. Is there currently an advantage to preferring index funds to actively managed funds? Yes, there is. Might this advantage disappear in the future? Possibly. But until it does…

Here’s Why “Everybody” Will Never Index

The aforementioned objection is stupid for a lot of reason, but let’s take a moment to think about why it will never be an issue in the real world.

  1. The market is inherently efficient – The public stock and bond markets are extraordinarily efficient, which is what makes indexing such a smart strategy to begin with. But what if everybody suddenly started indexing tomorrow. What would happen? Huge pricing errors would quickly arise. Eventually, these pricing errors would grow so large that even investors of modest skill would be able to profit from active management without much effort. Once that happened the pendulum would swing in the opposite direction and everybody would become an active investor because it would be, by far, the most profitable thing to do.
  2. People are greedy – Unless you believe people will knowingly avoid acting on what they believe to be easy profit opportunities for long periods of time, you’ll never have to worry about the pricing errors mentioned in item #1 above going unexploited for long. If I see $100 on the ground in front of me, I’m going to pick it up. Likewise, if some mutual fund manager sees an obvious mis-pricing, she’s going to act on it. It’s what she’s paid to do, after all.
  3. Prices are set at the margin – Market prices are set at the margin, which means the market only requires a relatively small percentage of investors to be actively trading in order to remain efficient. The market doesn’t need 95% of market participants to be active in order to set prices accurately. It can get by on much less. What’s the real number? I have no idea, but I’m going to wildly speculate that it’s probably around 50%. I very much doubt indexing will ever comprise anywhere near 50% of the market. Fama and French actually wrote a paper on the topic. Their conclusion? It depends on who goes passive. Not very helpful, I’m afraid.
  4. Stock picking is fun – Passive investing is horribly boring. I would know: I have to find a way to write about it on a weekly basis.
  5. Passive indexers are poor owners – There is a class of investor out there, called activist investors, whose raison d’être is to unlock shareholder value by provoking management to take actions they otherwise wouldn’t be apt to take. In other words, they attempt to stir the pot for their own benefit. You can’t do that via an index fund. Corporate governance fanatics, likewise, find index investing to be untenable. Unless those types of investors disappear, indexing will never take over completely.
  6. Most people don’t care and would rather just have somebody else do it – The vast majority of people just don’t care enough to learn about investing in general and indexing in particular. Those people will continue employing active managers because intuitively, active managers should be able to add value. That they don’t will go unnoticed. I don’t see this ever changing.

How To Eat Cat Food In Retirement (In 8 Easy Steps)

2013 April 22
by Kyle Bumpus

Ed: First of all, it should be noted this title is only half sarcastic. Have you seen some of the stuff rich people feed their pets? We should be so lucky.

Regular readers of this blog already know the truth: investing isn’t particularly difficult or complicated. Why, then, do so many intelligent and seemingly rational individuals regularly make such idiotic mistakes with their money (I’m looking at you, doctors and lawyers!)? Why do we read headlines like “Paycheck to Paycheck on $300k per Year?” on a semi-regular basis? Other than the obvious answer that it’s just really, really awesome to make fun of rich people, I believe its a combination of over-confidence and the fact that skills necessary to climb the corporate ladder just don’t translate well to money management. In most aspects of life, style over substance works out okay. Not so with investing!

market timer

Awesome photo by: DonkeyHotey

Want to be one of those people who blows through her lottery winnings in 3 years or the NBA superstar who declares bankruptcy before the age of 40? Well pull up a chair! I’ve got a few tips for you.

How To Eat Cat Food In Retirement (In 8 Easy Steps)

1.) Blindly trust somebody else with your money

Got money? Who better to manage it than your cousin’s best friend’s sister who went through a weekend course in financial planning down at the local community college?!? You’ll be cruising down easy street in your new yacht in no time with all those huge financial gains that are sure to come your way as a result of giving somebody else responsibility for your money. You have better things to do than rebalancing your portfolio once a year and monitoring your financial progress, after all. Like bocce. Bocce is fun. What could possibly go wrong? It’s not like there are greedy people out there looking to line their own pockets at your expense or anything.

2.) Invest in a business you know nothing about

Have you ever worked in a restaurant before? Managed a clothing boutique? No? What better way to learn the business than invest vast sums of your own money to start your own?!? Nine out of 10 restaurants go on to make their owners quadrillionaires, so there’s very little risk involved. Who do you know who lost money starting their own business? Okay, besides Jim, who do you know? Okay, but Karla doesn’t really count, though. Who ELSE do you know? Didn’t think so.

3.) Buy the best-performing funds

Everybody knows past performance is the best and only predictor of future results. All you have to do, then, is buy the funds with the best returns last year and you should be able to afford that island in French Polynesia by 35. 40, max.

4.) Ignore costs, because it’s returns that matter

This one is a no-brainer after the point above. Why would you care what your investments cost so long as they are the highest-performing investments? Costs aren’t good predictors of future performance, after all. Past returns are. Everybody on Wall Street who wants your money knows and will tell you that.

5.) Watch CNBC religiously

Nobody knows what’s going to happen in the markets better than a guy in a suit wearing makeup who doesn’t even actually trade stocks for a living. It’s very important that you only take financial advice from guys wearing makeup on TV, because they know best. Sorry Morgan Stanley.

6.) Always drive a nicer car than Bob

Did Bob just bring  home a new Porsche? Better man up and get a Ferrari, even if you can’t quite afford it. Your portfolio knows what car you drive and will punish you by going down if it’s not nicer than Bob’s. Seriously.

7.) Borrow money to buy your Ferrari

That’ll show Bob! He’s such a pissant. (Why don’t more people use the word “pissant?” It’s such a cool word.)

8.) Develop an insanely expensive habit and pretend it makes you sophisticated

Sure, you could go the traditional route and collect original Matisse paintings, but I urge you to be creative here. Did a random drunk hipster once tell you original-pressing vinyl records played on rare 19th century phonographs have better sound quality than CDs? Collect those! Your friends will be amazed how sophisticated you are and your net worth will, almost as if by magic, go up as a result.

 

Bond Prices May Drop If Rates Rise, But How Bad Could It Get?

2013 April 1
by Kyle Bumpus

Current conventional wisdom holds that interest rates are at unsustainably low levels and have nowhere to go but up. Neverminding the fact that people have been saying this for several years now, they have a point: interest rates are very low and they probably will rise in the next few years, although that’s by no means guaranteed (for instance, if the economy slips into recession again, rates will probably remain low). But so what if they do?

Assume Interest Rates Rise: Then What?

Let’s assume for a moment that interest rates must rise. Then what? Since bond prices covary inversely with changes in interest rates, bond prices will fall if rates rise. It’s unavoidable. But is that really a big deal? Well, that depends on what kinds of bonds you own!

The Worst-Case Scenario For Bonds Isn’t That Bad

The arithmetic of bonds works out this way: for every 1% change in interest rates, a bond fund’s nav will move by the amount of its effective duration in the opposite direction. For example, a bond fund with an effective duration of 5 years will drop 5% in value for every 1% increase in interest rates. So if interest rates are currently 1%, a bond fund with a 5 year effective duration would drop by 15% were interest rates to increase from 1% to a more historically-normal 4%.

Sound bad? It’s really not. For starters, the moment rates start going up your fund will begin reinvesting the proceeds from maturing issues at higher rates. Instead of paying just 1%, the fund’s yield will rapidly increase, given you a yield cushion of an extra 3% per year. Thus, over a 3 or 4 year period, you’re looking at maximum losses in the 5-6% range. Hardly ideal, but it’s not going to cause you to start eating dog food in retirement, either.

Of course, that’s just the worst-case scenario for the total bond market (which happens to have an average duration of right around 5 years). Investors in long-term bond funds, with durations ranging anywhere from 8 years up to 20+ years, could be in for a much rougher ride. On the longer side of the maturity spectrum, investors in long-term bonds could be in for losses of 15-20% or more over a 3 or 4 year period if rates rise dramatically. Investors who have shifted their bond allocation to ever longer-maturing bonds in search of extra income could get hurt, which is one of the reasons I advise people to never reach for yield: the extra risk just isn’t worth it, in many cases.

What Are The Alternatives, Anyway?

Now that we know what the worst-case scenario for most bond investors is, and that it’s not that bad, I pose the following question to the bond-bubble rabble rousers: if not bonds, then what? After all, you’ve got to invest in something unless you think putting your money under the mattress is an acceptable investment. Let’s look at how the alternatives might fare in a rising interest rate environment.

Stocks

Rising interest rates usually  mean one of two thing:

  1. Rising inflation
  2. A booming economy

Clearly, stocks are a great place to be when the economy is booming. If you think the economy is about to take off, it might be rational to dump bonds in favor of stocks (but only if you know something the market doesn’t!). If runaway inflation is the reason rates are heading up, though, moving into stocks will likely be disastrous because, while stocks act as decent hedges against inflation over the long run, they don’t do very well at all when inflation spikes in the short term.

So as you contemplate moving out of bonds, think about which scenario seems more likely: inflation or an economic boom. I think even the most optimistic prognosticator would have a hard time predicting an economic boom. In light of our economy’s lingering systemic issues, I think the most likely scenario is a decade of moderate, not great, economic growth with perhaps a few major bumps along the way. The bond bull market may be over, but equities aren’t exactly primed for a monster bull run. Yet.

Real Estate

The real estate recovery seems to have finally begun in earnest. I don’t see a return to pre-bubble appreciation rates, but I think it’s realistic to expect real estate prices will at least keep up with inflation (or perhaps beat it slightly) in most markets going forward. Unfortunately, there’s a very direct inverse relationship between interest rates and home prices. If interest rates go up, expect real estate values to drag. Thus, real estate isn’t a good substitute for bonds if you’re afraid of a bond bubble.

Commodities

Commodities could be your best bet in the event of sudden inflation. They could also wind up being decent investments in the event of an economic boom, as demand for raw inputs tends to increase when times are good. But here’s the problem: commodities are extremely volatile – every bit as volatile as stocks, in fact. It doesn’t doesn’t make sense to sell a mostly-safe asset (bonds) because of the possibility of a small price drop in order to buy an asset with a proven history of volatility. Commodities could go up, or they could go down. The point is, if they do go down, they will probably go down far more than bonds will even in the worst-case scenario.

Stay The Course, And Shorten Your Duration If You Must

In light of the facts, it just doesn’t make sense to get out of bonds at this juncture. You’d be trading a likely small loss over the short term for a possible large loss over the intermediate term. That’s not a smart bet to make. I do think there’s an argument to be made for shortening up your bond exposure, though. If you hold long-term bonds, I wouldn’t argue against moving to short or intermediate-term bonds. If you hold intermediate-term bonds, I wouldn’t give you any flak if you chose to move into short-term bonds. But sell out completely? That’s probably the worst thing you could do!

What do you think? Are you staying the course with bonds or have you gotten out?

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