Friday, May 27, 2005

Financial Advise for my friends

Since I've started my investment account I've been getting more than a few questions from my friends reguarding financial advise. So I thought I'd drop in my more or less unbiased thoughts on the matter.

401k or not?

Generally speaking, if your employer offers a 401k, with a matching contribution, not only should you take it, but you should put in at least the maximum amount they match to. This lowers your taxable income now, but on the otherhand: whenever you go to pull that money out after retirement you get taxed on it as income. Now most people tend to think that they will be making less money in retirement, personally though I think that's a bad way to look at it if you're trying not to starve when you're older. If nothing else, you want to have *more* assets when you retire don't you? As such, if you pull out from your 401k $50,000 a year, you're going to get taxed on it at about 28% according to today's current tax rates. Of course, income taxes could allways go *up* too.

However, if your employer doesn't match, or even if they do, but only to a ridiculously low amount, its probably better to open up a Roth IRA. A Roth is different from a traditional IRA in the sense that you pay taxes now, but nothing on what your money earns in interest over time. That means when you retire, and you draw out that same $50,000, you pay absolutely zero taxes. Also IRA's are different from 401k's, in that you can set them up usually with more options, and you can actively manage it yourself if you want. Also, you don't have to pull out of it at a certain age unlike a traditional IRA/401k, which requires withdrawls by the time you're 72 and 1/2.

Now, lets weigh the advantages:

Traditional IRA or 401k:
Employer Usually Matches.
Less Taxes now.
All gains are taxed later as income
No Active Management for a 401k (usually)
Employers often match your contribution in company stock.

Roth IRA:
All interest gained on money is untaxed.
Employers usually do not match a Roth IRA
You have to pay taxed on it now, which may or may not put some of your money in a higher tax bracket.

Now, lets look at some other simple options:

Savings Accounts: Are simple, but offer allmost no growth (usually well below inflation), and do your money really no good, aside from maybe keeping you from spending it. Best to be used only as a temporary account to put money allready acrued, for large short-term purchases.

Money Market: You can shop around for alot of different yeilds on these, usually the best single yeild I've found for smaller investors is They're only slightly more complicated (number of widthrawls, some require minimum balances, etc.) than savings accounts but offer much better yeilds. Do not use these are retirement accounts, their yeilds are increadibly low compared to other investments, with virtual bank topping out most of them at 3.05%

Municipal Money Market: Great places to put cash you haven't decided what to do with, make sure that the money market is reputable, and that the financial standings of the municipalities its invested in have been fairly good in the past. Municipal bonds can be tricky to directly manage yourself, as generally the safest bets offer the lowest returns, while those with the worst credit ("junk bonds"), offer the highest returns, but also the highest risk. I personally, am not into the bond market, so I won't make too many comments on it. Bonds are seen as a "safer" investmen than stocks by some investors, historically however stocks have allways out preformed bonds. I keep my uninvested cash that I don't immediately need to spend in a municipal money market fund; Why you ask? Because they're tax-free. Totally tax free.

CD's and Treasury Bonds: Long term investments, usually offering better returns the longer you give them your money, simple investments for many people with little money. Also well liked are Zero-cupon bonds (Which are bought for less than their face value) for the same reason, and inflation adjusted bonds, which are guaranteed to accrue inflation plus X amount in interest. Personally I consider the last one among the best if you're going to buy into bonds, and are not going to play the "bond market".

Mutual Funds: The advantages of a mutual fund, are that you can engage in alot of different market activities (such as option chains, and commodities), without having to know exactly how to do any of it. In otherwords, you're pooling your money with other people, and someone else is using their knowledge to play more complex investment strategies than you know, or can individually afford. On the other hand, they make money by taking a percentage of what you put in, sometimes this can total up to 2% or more of your gains, which can mean alot of money over time. Its best to shop around to find a good mutual fund (Remember, IRA's and 401ks are mutual funds too), 2% might be worth it if it's been returning 15% on average for the last 10 years or so (Hedge funds make insane amounts of money, and usually take 20% of the gains). Likewise, indexed funds (funds that are simply electronically indexed against the DJIA, S&P 500, or another index) tend to be cheaper than other mutual funds. They also, on average, tend to fair better. On the other hand, ETF (exchange traded funds) are even cheaper, and you can buy and sell them like stocks. Life-cycle mutual funds are also good for retirement as they re-adjust themselves the closer you get to retirement. One Caveat Emptor: Make sure if you have a life-cycle fund that the fund manager(s) are properly re-calibrating your investments as you get older, alot of them have been discovered to do it improperly.

Securities Accounts:By securities, I mean stock brokerages mainly. There are do-it-yourself sites like ameritrade and e-trade (I use e-trade), discount brokerages, and full service brokerages. Generally speaking, thats also the order of "how much of a cut they take". Full service brokerages offer alot of investment advice and strategies, but they may be biased toward their own investments. The advantages of brokerage accounts as a suppliment to retirement accounts are many, there's no "Tax penalty" of 10% for drawing out of them before retirement, and if you hold your stock for more than a year its taxed at 15% flat instead of income tax. Also, generally speaking you are on average going to get an increased return, usually well in excess of a money market or what-have-you, you may or may not get that raise come your annual review, but the money you've allready earned is growing, to give you a de-facto raise anyways.

Anyways, those are generally the options available to the average non-rich person. And that should serve as a quick introduction of how to get more money via investment. Also, generally speaking the best way to get more money is to get more degrees.

Finally, a few stock strategies to make things easier:

Indexing: Simply indexing your stock holdings against a economic index. Advantages are simplicity, and less risk, plus you can generally expect a good return. You can either buy stocks in equal measure to an index, buy ETF's, or buy into an indexed mutual fund.

Dogs of the Dow: Or S&P 500, or any other index. It's a variation on indexing, that basically says "Why follow the whole index, and not just the top dogs?" Historically this has been a fairly successful strategy. Buy equal amounts (say 100 shares) of the top 10 stocks on the index, and every year adjust for equal holdings, if someone drops off the top 10, sell their shares and buy the newcomers. Now, it has some drawbacks, sometimes the best preforming on a given year might all be in one sector and if that sector does poorly you may lose on all your holdings. Likewise, lets say the entire index goes down in a given year, usually the companies at the top are best readied for a general loss....on the other hand, they might be responsible for the whole downturn of the index by being in major financial trouble. Likewise, lets say the whole of the index does poorly that year, that doesn't necissarily mean that say #50 didn't do good, and move up to say #25.

Also, you can follow the purchases and long term holding strategies of the "best players" of the market like say George Soros, or Warren Buffet. Or, if you have alot of money you could allways buy into Berkshire Hathaway, ran by Warren Buffet. When he went public, it traded at $8 a share, now about 30 years or so later, preferrred shares go for around $85,000 and B shares for around $2,500. He's out preformed every last major economic index, and has had a 5,000% return over the life of the company, averaging about 30% interest per year, every year.

Of course, he's in his 70's and has no clear successor. When he dies, Berkshire Hathaway will inevitably go down in price per share, but there's a question whether or not his successor will perform as good as him...

Then again I don't have $85K sitting around, so I don't worry so much.


Anonymous andy said...

good comparison. i contribute to a 401k right now but am considering the switch.

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