When our parents were killed in a traffic accident in 1956, Jay and I were 16. The other vehicle was clearly at fault and had a significant insurance policy. The result was that although our parents were not very well off financially, there was enough money for “us kids” to go to college. Uncle Gene was appointed our guardian. Then a year of college cost maybe $2000 if you lived well, as I did. After I graduated from college I had about $2000 left. Uncle Gene seemed to be pretty well off, and made his living from investments in the oil business, etc., so I asked how I should invest. He would not give me advice. I took his reluctance to advise me to mean that providing someone investment advice was heavy business. Maybe that is why I have answered Jay’s simple suggestion to provide some advice to his kids, with a long answer. Anyway, what follows is my advice concerning investments.
- Basics first. If you haven’t accomplished the basics from the last chapter, that is put aside enough money to have what you consider enough financial flexibility to handle life’s normal crises, then you are not ready for investing. Do not forget this, no matter how tempting the investment opportunity! You can start planning, however, so read on. I also suggest some homework, starting now. I cannot make you a wise investor, you must do it.
It seems to me as the two most common motivations for selling someone something are; (1) get their ego involved, i. e. the Marlboro Man, and (2) convince them it is a good investment, i. e. you cannot afford to miss this opportunity! If something is such a good investment, why is the salesman selling it? Be cautious of “investment counselors” selling things, but if you have the time, listen to their advice, for the information and ideas. Only you can make the decision of what is a good investment for you, and it is not an easy decision. Mostly what stands in your way is not stupidity but ignorance. And there is a difference between the two; one is correctable with effort, the other is not.
- Risk versus Profit. Someone once told me that “in Engineering the rules are very complicated but applying them is simple, and in Law the rules are simple but applying them is very complicated.” In financial matters there almost seem to be no laws. As close as you get to a law is; the higher the risk the more the profit and loss potential. With this in mind, most personal finance primers draw an “investment pyramid” and tell you to start at the bottom with low risk investments and after you have a substantial base, you can move up toward higher risks (and profits). That idea is good, but it is not very specific. However some of the first things you need to do are in the low risk category; save some money for a rainy day, start buying a house, have the insurance you need, and those kinds of things. How wide you make the base of the pyramid, and even what you consider risks are open to interpretation. There are recent books you can read about “what to do during the coming depression,” and “how to make millions in the coming boom.” Boom or bust? If you think the future for America (and the world) is not very bright, your investment strategy should be different than if you think the good times are just around the corner. You must live with your judgments. Some people buy gold because it will always be good. It does not earn interest, however. I have friends who purchased gold at $600 and $800 an ounce, and have held it for 10 years, so far. It now sells for less than $400. I’ll continue this later, but for now remember profit and risk seem to go together.
- Taxes assist some Investments. In physics there is a law that says (roughly) that one cannot measure something without changing it. Something similar is true in US tax laws. Every time the US Government makes an addendum to the tax laws (usually well intentioned, to help some segment of the economy) all kinds of things change. I knew a man who bought a medium sized sailboat, leased it to a “rental company” who made it available for people to rent. The man’s deprecation tax deductions were larger than the payments, so every year he made money and in five years he owned a five-year old boat and had money in his pocket. (He did take some risks, but basically he ripped off the rest of us.) The Tax Reform Act of 1986 closed most of the worst tax loop holes, and left basically two tax schemes available for most people. (Glee and I have a couple more working, but that is another story.) The two schemes are home mortgages and retirement accounts. These will not make you rich, but they will give you a 28% advantage over other investments, if you earn income. Of course you still must consider the risks associated with the investments of your choice.
The reason a house is a good investment is that the interest you pay on the mortgage is deductible from your income taxes. That means it actually costs you 28% less than what you pay out in interest on a monthly basis, if you have income and itemize your deductions on your income tax return. That does not mean paying interest is better than earning it, just less painful if it’s for a house. People who think that paying more interest is better because they can deduct more, are 72% wrong.There are two kinds of retirement accounts which are “tax advantaged,” Individual Retirement Accounts and 401(k) plans. An IRA is a good deal because, under certain conditions (which you can learn about by reading the Federal Income Tax package) you can deduct from your gross income, up to $2000 that you invest in an IRA (so investing $2000 saves you $560 in taxes, if you are in the 28% bracket) and you do not have to pay taxes on the investment’s earnings each year. You do not pay until you withdraw the money. So called 401(k) accounts are investment accounts which are usually arranged through your employer. A 401(k) puts some of your pay into a tax protected investment before you actually receive it and you do not have to report it as income on your Income Tax Return. 401(k) accounts also earn interest that you do not have to report, or pay taxes on, until you withdraw the money.
If you do withdraw money from either type of retirement account, except for certain circumstances, you will pay a penalty, however. So read the rules. These are great long term investment vehicles, because the gains are not taxed until long after they have compounded. All investments for these types of accounts are not the same, you can have a fixed dollar, interest earning account all the way (in risk) to a leveraged, aggressive growth mutual fund account. The levels of risk are obviously different. You need to know quite a bit about investments to make good long term decisions concerning which types are for you. Read on.
- Informed Judgment. Above I brought up the idea that you need to have an opinion about where our nation is going to have an informed judgment on how to invest. Let me give you a start with a 25 cent history of American economics.
Until this century the US government left the “market place” alone. When the economic engine had almost gone out during the late 1920’s, President Roosevelt (and Congress) started spending money the government did not have to give people jobs. The economic advisors of the time suggested that a depression was as natural a state of economic affairs as a boom, and to change the conditions, a stimulus had to come from somewhere. Roosevelt took the challenge. To a large degree it worked, and the depression began to lift. World War II also helped get people back to work. The government then borrowed more money to fight the war. After the war balanced budgets returned. In the 1960’s President Johnson did not want to stop President Kennedy’s social programs or raise taxes to pay for the Viet Nam war, so he (and Congress) kept raising the national debt and borrowing to pay for the bombs, bullets and social programs. Substantial inflation occurred during this period as a result. (The house we owned in Virginia sold new for $36,000 in 1972. We purchased it for $63,000 in 1975, and sold it for $110,000 in 1982. Lots of the increase was inflation.) The national debt really got out of hand when some economists convinced Presidential Candidate Reagan that economic activity could be moved to a “sustained, higher level” by more government spending with no more taxes. Many businesses caught the fever and spent money they did not have. (Believe me when I say there seem to be no rules in economics!) To some extent these “supply side” economists were correct, but inflation also stayed with us. The Federal Reserve Board, which is independent from the President and Congress, finally stepped in and raised interest levels to cool inflation, which unfortunately also slowed down economic activity. So now we are left with a mountain of debt, lots of empty office buildings and insolvent S&L’s (because about all they own is empty office buildings). (The USA has enough available office capacity for the rest of the decade.) So, what do we do now? And further, how do we invest now? Well, what do you think is going to happen now? (Incidentally during this period all of the news was not bad, we did cause the “evil empire” to collapse. Recently I read that the “cold war” cost US taxpayers $5 trillion.)Lets look at some numbers. The US economy is about $6 trillion per year (Gross National Product – you need to learn what that means, if you do not know). The Federal budget is a little over $1 trillion per year, 30 to 40% of which is borrowed and adds to the national debt. The Defense Department gets about 30%, which is no longer as big a slice as the interest on the national debt. The national debt now stands at about four years total Federal Governmental expenditures, or $4 trillion. Time for hand-wringing? Yes, or at least considerable concern. Some people think that Ross Perot pulled out of the Presidential race after learning that there is no easy way out of the mess that we are in. You cannot have an informed opinion unless you understand all of these numbers, including how many zeros there are in a trillion, what our debt is in relationship to our GNP, and items like that. Compare it to your own budget situation; if you did not know what your income, debt and expenses were, how could you make informed budget decisions? So learn! (I also urge you to vote, someone said that “Every nation has the government it deserves.”)
My opinion is that regardless of who wins in November, we are going to have elected a rather fiscally conservative President. Both Bush and Clinton have gotten the word that the American people are mad and want sound fiscal policy, not more smoke and mirrors. Who ever wins will slowly begin to bring the annual deficit down and that will be something of a drag on the economy. They will not balance the budget for a number of years. To balance the budget now, every individual US taxpayer would have to increase their tax payment by $3364. To do that would cause a depression. And the only reason that the increasing interest payments on the national debt will not strangle the US economy is because creeping inflation (3 to 6% a year) will lower the real value of the debt. (That is, in my considered opinion, we are and will continue paying our debt off by making our money worth less.) If 3 to 6% inflation continues, fixed dollar savings, like credit unions, CD’s and S&L’s are not where you want your long term savings, money that is above the pyramid’s base. What is? I recommend mutual funds. Read on.
- Mutual Funds. Saying “mutual funds” is like saying “vehicles.” They come in all sizes, shapes and perform all types of functions. I’ll give you a little information and some references, then you are on your own. The dominant type of mutual funds is stock funds, which take your money and invest it in a group of (common) stocks to attempt to achieve their (your) investment objectives. Most mutual funds charge a commission to join, up to 8%. These are called “load funds.” You truly pay a “load” to get in. A number do not charge a load, and they are called “no-load funds.” There is no significant difference in performance between the two, I repeat, there is no significant difference in performance between the two; it is sort of like comparing IQ’s of white and black people, for both groups they vary all over the lot. So judge each on its own merits, both people and mutual funds. The first mutual fund I purchased was from a salesman (the salesman gets the “load” in a load fund), when you are young and insecure, a salesman with confidence that you are doing the right thing can be very convincing. The fund did not perform very well and I have since sold it. All other mutual funds that I have purchased have been “no-load,” some great performers and some not so good. When I was a kid, I remember other kids saying, “If you are so smart, how come you aren’t rich?” I now know the answer is not lack of intelligence, but lack of information. You can hire managers to seek the information (full time) and to rapidly act on it in your behalf, that is why I recommend mutual funds. If they do not perform, you sell the fund (fire them) and buy (hire) another. This is capitalism at its best, working for you. An often made mistake is not selling a loser. You are not married to it, sell it.
Why not invest in stocks directly? Unless you can spend full time you will not be expert, and if you are not expert you will not do very well. Further with a small amount of money, you will not get an expert stock broker to advise you. Mutual fund managers are expert, determine your objectives and hire an appropriate expert.
- Sources of Information. If you are interested in investing in mutual funds, you should look for the Forbes (magazine) Annual Mutual Fund Survey. Usually it is the first issue in September. For it’s cost, $4, it is a very good buy for anyone interested in mutual funds. Sometimes you can find that issue in the local library, but often it has been stolen. Other sources, which are available in most public libraries are:
Wiesenberger’s. This is an annual publication that gives lots of general information about funds, the type of information newcomers need, then gives performance ratings for up through the year before its publication. A few brief remarks from the 1990 edition: There is now $1 trillion invested in mutual funds; the three steps to investing are (1) determine your goals, (2) determine funds objectives that match your goals, and (3) select a specific fund; the S&P 500 (a stock index) gained 76% 1980-90, and 143% 1970-80. The book costs $49.United Mutual Fund Selector. This twice monthly newsletter provides “news” and data, and a “recommended” list of funds for most objectives. It costs $125 per year.
Growth Fund Guide. This monthly newsletter provides information about growth mutual funds, a popular type, and has a recommended list. It costs $89 per year.
There are also other sources, such as Morningstar ($395 per year), the financial pages of your newspaper and lots of articles in “finance” magazines, but there is also lots of useless data in with the information. Keep in mind that learning about mutual funds is easier than keeping up with stocks.
- Keep up with what is going on in the world. Is this a good time to get into the market? I do not know, it is a strange point, probably not a real good time to get in, certainly not in a big way. (Glee and I are pretty much “in the market,” because interest rates are quite low and I’m pretty confident about the USA. Plus we are also pretty high on the pyramid) The Price to Earnings ratio (what a stock costs over what it pays in dividends) is at a very high point (35), which means that the market could fall 20-30% very easily. On the other hand, it was at this level before the Feds lowered the discount (interest) rate the last few times. Those lowerings of the discount rate should have stimulated the market somewhat, but didn’t, all they did was to keep it up. So what will happen? I’m not sure. My wild guess is that it will muddle along through this year (it almost never falls in a presidential election year), it may fall some and then slowly rise as economic activity picks up into the fall. Overall the 1990’s will be good for market investments. (The average market gain per decade is 78% so far this century. That is better than most other investment choices.) Other items which will influence the market are wars, oil price changes, government spending changes, the jobless rate and things like that. Uncertainty and bad news nearly always lower the market. Good news only allows it to slowly rise.