Mutual Funds Best Option for Most Investors

Jane Young, CFP, EA

Jane Young, CFP, EA

There are three primary ways to invest in the stock market; mutual funds, exchange traded funds (ETFs) and individual stocks.   With mutual funds and ETFs your money is pooled together with money from other investors and is professionally managed in accordance with a predefined objective.   Some major benefits of investing in mutual funds and ETFs include diversification, professional management and time savings.  Some disadvantages of mutual funds may include management fees and less control on when gains become taxable.

An essential factor in effectively managing your portfolio is diversification and it’s difficult to maintain a diversified portfolio without investing a significant amount of money.  A diversified portfolio should be comprised of a combination of fixed income investments and stock market based investments.  The stock based investments should be comprised of small, medium and large companies in a variety of different industries in both the United States and abroad.    Investing in a wide variety of companies and industries can spread out your risk.  Mutual funds allow you to easily diversify your portfolio by pooling your funds with those of other investors.  Instead of buying 10 individual stocks you can by 5 to 10 mutual funds in different areas of the market, each of which may contain hundreds of companies.

Although managing your finances should be a priority, most investors lead busy lives and don’t have the time to research and monitor individual stocks.   Mutual funds can be a good alternative to doing your own research.   Most mutual fund companies have entire teams of highly skilled analysts who visit companies, analyze data, assess the competition and monitor industry trends.  It would be difficult to attain this level of knowledge and understanding on your own.  Additionally, professional management provides the methodology and discipline to keep emotions out of investment decisions.  When investing in individual stock, investors can become emotionally attached to a company whose stock has performed well.  This can result in dangerously high concentrations in a few individual companies.

Mutual funds and ETFs use a broad approach that generally tracks more closely to the entire stock market or a specific index.  Individual stocks, on the other hand, can provide the opportunity to break away from market performance to make a significant profit, if you select a winner.  However, you many also experience a significant loss if the stock is a loser.

Some potential disadvantages of mutual funds in comparison to individual stocks include management fees and less control over when you pay capital gains tax, within non-retirement accounts. With individual stocks and ETFs you don’t pay capital gains until you sell your shares.  However, when a mutual fund manager sells stock within a fund, gains earned on the stock are passed through to the shareholder as a taxable gain.  This gain is added to the investor’s basis in the mutual fund to avoid double taxation when the fund is eventually sold.

Defending Yourself Against a Market Correction

Jane Young, CFP, EA

Jane Young, CFP, EA

The recent increase in the stock market is making a lot of investors nervous about the possibility of a significant correction.  I am frequently asked what the market will do over the next few months.  In reality, no one can predict market performance, especially in the short term. Your best defense against a volatile stock market is to create a financial plan and an asset allocation that is appropriate for your financial situation and time horizon.

If your current asset allocation is in line with your financial goals, there’s probably no need to make major adjustments to your current portfolio.  Your asset allocation defines the percentage of different types of investments such as U.S. stock mutual funds, international funds, bond funds and CDs that are held in your portfolio.  You should establish an asset allocation that corresponds with the timeframe of when your money will be needed.   Investments in the stock market should be limited to money that isn’t needed for at least 5 to 10 years.  Keep money that may be needed for emergencies and short term expenses in safe, fixed income investments like bank accounts, CDs or short term bond funds.

The stock market is inherently volatile and there will be years with negative returns.  However, over long periods of time the market has trended upward with average annual returns on the S&P 500 exceeding 9% (approximately 7% when adjusted for inflation).  It’s important to consider your emotional risk tolerance in establishing your asset allocation.   You may have the time horizon to have a significant portion of your portfolio in stocks but you may not have the emotional tolerance.  Your asset allocation may be too risky if you are tempted to sell whenever the market goes down or you are continually worried about your investments in the stock market.

Establishing an asset allocation that meets your situation can help your ride out fluctuations in the stock market more effectively than trying to anticipate movements in the market.  It’s impossible to time the market and a short term increase is just as likely to occur as a drop in the market.   Although you want to avoid timing the market, you should rebalance your portfolio on an annual basis to maintain your target asset allocation.  Additionally, you will want to adjust your target allocation over time as your financial situation changes and you move through different phases of life.

Keeping other areas of your financial life in order can also help you through a major market adjustment.   It’s essential to maintain an emergency fund of at least 3 to 6 months of expenses,  make a habit of spending less than you earn, and  save at least 10 -15% of your income.

Rather than focusing on where the market is headed and what the financial pundits are predicting, maintain an appropriate asset allocation and keep your financial affairs in order.

Tips from the Wealthy on How to Get Rich

Jane Young, CFP, EA

Jane Young, CFP, EA

You don’t have to be incredibly intelligent and born into the Rockefeller family to attain wealth.   Below are some pointers commonly shared by wealthy people on how to manage your life and your money to reach financial independence.  There is no magic, achieving financial security involves straight forward, common sense actions to gradually build your net worth.

  1. Write Down Your Goals: It’s great to dream about what you want to achieve but to accomplish something you need to put your goals into writing and create an action plan to attain them.
  2. Control Your Expenses: Take the time to understand and manage your expenses and create a budget that supports your goals.   Spend less than you earn and develop good saving habits.  Keep your expenses in check when things are going well and avoid automatically increasing your expenses as your income grows.
  3. Don’t Buy Status: Don’t buy things to look rich or to impress your friends.  Most wealthy people drive older model used vehicles and live in modest homes.  Use your money to save for the future and spend on what really matters.
  4. Educate Yourself: Getting a good education and selecting the right career is a huge factor in attaining wealth.  A good education can result in a more rewarding job in a field you enjoy.  If you enjoy your work you are more likely to excel and earn more money.  If you are in a dead end job or a career you don’t enjoy consider going back to school to transition into a career for which you have more passion.
  5. Be Patient and Maintain a Long Term Perspective – The key to successful investing is having the patience to ride out fluctuations in the market. Resist the temptation to chase returns and time the market.  Invest for the long term and let your portfolio grow over time.  Stay the course and avoid making decisions triggered by emotions.
  6. Manage Risk and Return – Balance your desire for high return with the risk involved. Maintain a diversified portfolio with adequate short term liquidity to get you through rough spots in the market.   Rebalance on an annual basis to keep your portfolio diversified.  Take a disciplined approach to investing and avoid high risk investments that promise a return that may be too good to be true.
  7. Start your own business – According to Forbes nearly all of the people on their list of billionaires made their money through involvement with a business they or their family had started. Owning your own business may seem too risky but it can provide you with an opportunity for higher earnings and greater control over your financial future.
  8. Avoid Complex Investments – Avoid investing in anything that seems overly complicated or that you don’t fully understand. Complex investments often come with  greater risk, a lack of control, limited marketability, limited transparency and hidden fees.

Selecting the Right Asset Allocation – Part 2

Jane Young, CFP, EA

Jane Young, CFP, EA

Your asset allocation is the basic structure of your investment portfolio defining the target percentage you want to hold in different categories of assets.   Start creating your asset allocation by deciding how much you want to invest in the two major categories, stock mutual funds and interest earning assets.  Next break your allocation down into more specific categories including cash, CDs, bonds, large cap stock, mid-cap stock, small cap stock, international stock, emerging markets stock and real estate.  Setting an appropriate, well diversified asset allocation helps you balance risk and return within your portfolio.  Your asset allocation may change over time as your financial circumstances change.  However, avoid changing your allocation too frequently based on short term fluctuations in the market.

The appropriate allocation depends on several factors including your age and investment time horizon, your financial goals, other risk factors in your life, your experience with investing and your emotional risk tolerance.  Regardless of your investment goals, you need to maintain an emergency fund of readily available funds equal to at least four months of expenses.

Your financial goals are a major determinant in setting your allocation.  Identify your major financial goals and when money is needed to support these goals.  Design an asset allocation to meet these goals.  Money needed in the short term should be held in safer, interest earning investments. The stock market should only be used for long term needs – generally at least five to seven years out.

You may be able to assume more risk in your portfolio if the timetable for your goals is flexible.  The timeframe for money to cover things like college education or your emergency fund may be firm but there may be some flexibility on when you take a major vacation, remodel your home or plan to retire.   Money needed for retirement is generally spent over twenty or thirty years.  You won’t need your entire nest egg on the first day.

Your allocation is also dependent on risks taken in other areas of your life.  For example, if you work in a volatile career with unpredictable earnings, own a small business or own rental property, you may want to reduce the risk in your investment portfolio. On the other hand, if you have a secure job and anticipate a generous pension, you may be comfortable taking more risk.

Regardless of your situation you need to feel emotionally comfortable with your allocation. If you are constantly worried about market fluctuations you may need a more conservative allocation.   Historically the stock market has trended upward, but there will be years with negative returns.  Create an allocation that gives you adequate emotional security to ride out swings in the stock market and helps you avoid selling when the market is down. If you are new to investing, start out slowly and test the water to see how you will react in a volatile market.

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