Thursday, October 11, 2007

Financial Advice for Folks in Their 20s and 30s in 10 Easy Questions

I recently switched jobs and now am doing investment education for a big US union. Since i took the job (and before) people have been asking me lots of questions about how to invest, different kinds of investments, retirement, etc. I hope the post below will offers some simple and useful guidance to folks. I am, of course, happy to provide more specific answers and update the post to reflect concerns left out--just make comments, i'll be reading them actively. This is a draft and I hope that through your recommendations it will get substantially better over time. Dig in.

1) Why Is Advice Different For People In Their 20s and 30s?

I am primarily referring to folks who are working and not anticipating retiring in the next 30-40 years. The length of time that money will be invested impacts substantially how it should be invested. Someone who was 40 and anticipate working until age 72, would probably find this information useful, perhaps even if they planned to retire at age 62.

2) What If I Have Lots of Debt?

If you have credit card debt, it multiplies at an astonishing rate. Do whatever you can to eliminate it as soon as possible. If you need to, move in with your parents and get it axed, don't eat out again until it's gone. Come up with a strategy to avoid carrying a credit card balance. Many credit cards trick you into making "minimum payments". These payments allow your debt to grow and compound (sometimes at a rate of 20% or more). The bank is getting more than a 20% return and you are paying them for it. Square things with them immediately.

If you have student loans, however, since they tend to charge less interest you don't have to take as aggressive approaches as with credit card debt. You might be able to invest less as you pay them off but the money you invest will outperform the rate you have to pay for student loans.

3) Do You Have Some Secrets Which Will Enable Me To Amass great Riches?

Not really. If you eventually want to stop working (retire) then sometime before that point you must start spending less money than you earn (saving). Not saving likely leads to no retirement.
When asked about the most important invention of the 19th century, Einstein is often said to have given it significant thought and then replied compound interest.

Insofar as there is a secret to retirement savings it is called the power of compounding interest. Let's say you invested $1 today and received a 10% per year return. That return is somewhat less than the 11.86% average annual return of the Dow Jones Industrial Average (DJIA) over the last twenty years. After one year that $1 will be worth $1.10. The next year you would have $1.21 (because you received interest on last years interest). After five years the dollar would have turned into $1.61, after 10 years--$2.59, 20--$6.73, 30--$17.45, and after 40 years, that original dollar would be worth $45.26. From year 39 to 40 the $1 initial investment yielded $4.12 in annual interest.

Now imagine that instead of investing $1 initially, you invested $1,000 and were 25. At age 65 that money would be worth $45,260.

4) But I'll Be Making More Money When I'm 45. Shouldn't I Just Put Money Away Then?

In our example above you invested $1 at age 25 and ended up with about $45 at age 65. Now, assume you didn't start investing until age 45. You would have needed to invest $6.43 to have the same $45 at the end. Do you really think you will be making 6.43 times as much money in twenty years? At that point you may have several children, mortgage payments etc, to worry about and you'll probably not be making much more than double or triple what you are making now. If you invest 10% of your income every year for retirement starting at age 20 it will be worth a huge amount more than if you invest 30% starting at age 45. Over the course of your life, 10% will be doable. 20% would have you living a rich life in your later years.

5) Where Should I Invest This Money Between Now and When I Retire?

Let me take a second and say something very important. Where exactly you invest isn't nearly important as that you make the decision to invest. You will make a solid decision of where to put your money and, if you are smart, you will pretty much leave it alone. Dr. Dichev, of the UMich B-School studied investors and found that the returns of most investors was less than the markets they invested in. The Wilson Quarterly has a great (brief) writeup of that study:

“Buy and hold” is the mantra of many investment gurus. Rather than try to time the market or pick win­ners and losers, they say, indi­vidual investors should put their money into a representative basket of stocks and forget about it. Good advice, says Ilia D. Dichev, an economist at the Uni­versity of Michi­gan’s Stephen M. Ross School of ­Business. What a pity it’s too simple for most people to follow.

The NASDAQ market, the main crash site of the Internet boom of the 1990s, would have produced handsome returns (9.6 percent annually) for a person who invested in 1973 and did nothing until 2002.

But even committed “passive” investors have a hard time sitting tight. People tend to put more money into stocks when the market soars and pull it out when it turns south. Most wind up buying high and selling low. In order to find out how investors actually fared, Dichev adjusted historical market returns to reflect the flows of money in and out of the market. That juicy 9.6 percent return on the NASDAQ? In fact, inves­tors reaped only 4.3 percent on average. Results were better in other markets. A ­capitalization-­weighted basket of stocks on the New York and American stock exchanges held from 1926 to 2002 returned an average of 9.9 percent annually. Investors who tried to outsmart the market saw an 8.6 percent annual ­increase.

6) So, Nu? Where should I Invest My Money?

A lot of folks like to pay other people a lot of money to manage their money. This is usually a bad idea. Most folks aren't better than the market and they charge you money for their advice. The Motley Fool has an excellent piece on why Index Funds are better than anything else. Here are
two excerpts:
There's a reason that all these magazines don't tell you how simple mutual fund investing really is. Scientific marketing surveys and focus group testing have determined that magazines with covers that read "Index Funds: Still The Best Choice!!!" every single month really wouldn't sell as well as magazines that promise "Our BRAND NEW 10 Best Mutual Funds To Buy RIGHT NOW!" Sad, but true.
During the 1990s, the S&P 500 has provided an annualized return of 17.3%, compared with just 13.9% for the average diversified mutual fund. This 3.4% is explained first by understanding the fact that during the 1990s the S&P 500 (essentially an index of the 500 largest companies in America) has produced returns that are better than the rest of the market....S&P index funds have garnered a lot of attention over the last couple of years for good reason. The Vanguard S&P 500 fund has outperformed over 90% of all domestic equity mutual funds over the past three and five years (and a much higher number if you include bond and international equity funds). But S&P index funds certainly aren't the only index funds -- and in fact may not even be the best.

Basically, it will cost you anywhere from 1-2% to have an actively managed mutual fund. Sometimes even more when sneaky fees are introduced. Vanguard's total US market index fund [Vanguard: VTSMX, ETF: VTI] is an example of a diverse, low-cost option. It will likely outperform 90%+ of other investments and costs only 0.19%. If you want to live a very simple investment life, this is a good choice for your one mutual fund.

7) The Simple One Index Fund Approach Looks Good but What is the Next Step?

Dave Swenson, the guy who manages money for Yale, is generally regarded as a financial super-genius. Here is a post on a great financial blog discussing his recommendation. It is very close to what a smart 20/30-something investor might do.

Here is a modified version suited to a younger investor:
  • Domestic Equity (42.5 percent): Refers to stocks in U.S.-based companies listed on U.S. exchanges. [Vanguard: VTSMX, ETF: VTI]
  • Emerging Market Equity (12.5 percent): Refers to stocks from emerging markets around the world, such as Brazil, Russia, India and China. [Vanguard: VEIEX, ETF: VWO]
  • Foreign Developed Equity (20 percent): Refers to stocks listed on major foreign markets in developed countries, such as the United Kingdom, Germany, France and Japan. [Vanguard: VGTSX, ETF: VEU]
  • Real Estate Investment Trusts (25 percent): Refers to stocks of companies that invest directly in real estate through ownership of property. [Vanguard: VGSIX, ETF: VNQ]
I have removed Bonds and TIPS and concentrated on equities. Basically, over several decades stocks almost always do better than bonds. If you are nearing retirement or about to buy a house then you need more stability and are willing to lose upside. If you want to maximize money down-the-road, you are better off taking more of a risk. Retirement investments for young folks should be somewhat risky in the short run to make them richer in the long run.

The reason that this system has a few more funds than the one fund solution is to diversify more broadly to make is a safer and more lucrative system. This will cover you much better if foreign companies come to reign supreme in the next few decades.

8) But I want to buy a house?

Generally speaking, real estate doesn't do as well as the market. Here is an excerpt from a Forbes piece on the subject:
Where's a better place to put your money: the stock market or real estate? These days the accepted wisdom (at least at cocktail parties) says to pick real estate. But is the accepted wisdom right?

It is--in the short term. U.S. real estate sale prices increased more than 56% from the beginning of 1999 to the end of 2004, as tracked by the Office of Federal Housing Enterprise Oversight, part of the U.S. Department of Housing and Urban Development. The S&P 500 index dipped nearly 6% during that same period.

But if you take a longer view--say 25 years--you'll find that the S&P 500 has actually stomped the real estate market, from Boston to Detroit to Dallas. From the start of 1980 to the end of 2004, home sale prices increased 247%. A pretty sweet deal, it would seem. Over the same period, however, the S&P 500 shot up more than 1,000%.
The other big problem with real estate is that it causes a large portion of your assets to be tied up in a single entity. It is very hard to diversify if 90% of your net worth is in a single property as is often the case with young investors. That said, if you are a brilliant real estate investor you may be able to realize short terms gains enough that your share of a nice home is less than renting used to cost. In general though, if rent prices are good, as they are in DC at the moment, the financial incentive to buy is not very good.

However, and it's a big however, there are many non-financial incentives to buy that are worth considering. You might live in a nicer place, you may like the idea of a 3-d investment, you might have help from family members, or you might want to spend money to make your home more attractive and recoil at the idea of paying for your landlord's investment to improve. I am not really in any position to evaluate the power of these non-financial arguments.

Lastly, the reason many buy real estate is that if they borrow money to do it (a mortgage) they interest payments on that borrowed money are tax deductible. Meaning that you don't pay taxes on the portion of your income you use to payoff the interest on your loan. In the early years of a 30 year fixed rather mortgage, for instance, the vast majority of your payment is interest. If you are in a very high tax bracket this break is very advantageous. Most young folks, however, are not in a very high tax bracket and those that are may want to see a tax planner or financial planner to get more personally tailored advice.

9) Okay, back to investing...Should I use a 401k? 403B? IRA? Roth IRA? What are they?

401Ks, Roth IRAs, Traditional IRAs, and 403Bs are four different tax-advantaged retirement accounts. They have several features in common:
  • All were setup by the IRS to help us save for retirement.
  • All will lead to us paying less taxes either now or later.
There are also some major differences. 401K and 403B plans are managed by employers. 401Ks are generally in private for profit companies and 403Bs are for public and non-profit firms though i understand that it can be murkier than this. These two plans work similarly. Often your boss will match your contributions up to a certain limit. Make sure you contribute up to that limit. Basically, you are getting an immediate 100% return on your investment. If your $1 is matched then 40 years later instead of being worth $45 your $1 invested will be worth $90. Don't want to miss out on that. Both 401Ks and 403Bs must be funded through payroll deductions. You can't move money from your checking account to that sort of retirement account. Money invested with a 401k/403b is tax deductible now but not later.
If you make $40,000 and you put $5,000 into your 403B you only have $35,000 worth of taxable income. The 403B (or 401K) contribution is tax exempt. IRA's are also tax excempt but aren't managed by your employer.

By contrast, Roth IRAs are not tax deductible in the here-and-now. In exchange for paying taxes now, you don't need to pay taxes when your withdraw the money later. If you are in a low tax bracket now and expect to be in a high tax bracket upon retiring, this is a better choice.

Basically, if your boss will match a contribution to a company plan, that is free money, take it. If not you are likely to be better off with an IRA, Roth IRA or both.

10) Okay, So I Want a Roth or Traditional IRA and Like Your Index Fund Idea, How Do I Do It? How Do The Mechanics Work?

Just about anyone who manages money for individuals will manage your retirement accounts. You want a firm that has lots of good, cheap, index funds and won't charge you to buy or sell their own firms funds.

Personally I like Vanguard. They invented index funds and have a very good selection including the funds i recommended earlier.*

You can open a fund with them at this site.


  • There are no tricks or secrets.
  • Start saving now and save more than you think.
  • Invest in index funds.
  • Money multiplies at an amazing rate the longer you put it away for. Start right now! Let the money invest and reinvest as long as possible.
  • If you push hard to invest enough now, you will have a much easier time later in life. It is probably worth the small sacrifice now.
  • Would you rather put away $1,000 now out of your income or need to set aside $45,000 out of your income in 40 years.

*I should say here that I have no formal certification and those funds are neither guaranteed to do as well as they have histroically nor are they guaranteed to outperform most funds as they have historically. I believe in this approach and use it myself and am reasonably confident in its simplicity but you should draw your own conclusions.


At 10/18/2007 , Blogger ZT said...

thanks you to Ari W for prompting me to include reference to the deductibility of interest payments on mortgages as a benefit of home ownership.

At 11/10/2007 , Anonymous berelnissan said...

I agree with ZT and started out his way. If you know what you are doing, after making enough to take care of retirement needs, kid's college needs, helping grandkids, and charities, you could analyse and buy individual stocks, but if you do, buy quality rather than "growth". Also have a "sell" philosophy: if your stock does beter than your expectations, ask yourself" Would I buy this stock at this price [looking at PE,PB,PCF, etc] and you say 'no', it's time to sell some and get your original stake off the table and into another "real bargain". All this with a horizon of about 5 years.


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