What You Need to Know About Finance and Investing

I first got into finance and investing almost 20 years ago, when I opened my first brokerage account and read the book One Up on Wall Street by Peter Lynch. Since then, I’ve read countless books on the subject, took many classes and helped individuals and families with their finances. Most of what you need to do to create wealth is contained in the principles below. While these shouldn’t be earth shattering, they are simple to understand and execute, however difficult to maintain.

We Don’t Save Enough

The paradigm in the United States needs to be shifted from spending first and saving what’s left over, to saving first and spending later. One of my favorite books on creating wealth is The Millionaire Next Door by Thomas Stanley. Stanley studied millionaires and multimillionaires in the US and found that on average, they saved 20% of their income. The personal savings rate in the U.S currently sits at 4.4%, which means that millionaires are saving nearly 16% more than the average person.

That extra 16% is enormous when it comes time to retire. As an example, a 30-year-old making $75k a year that saves 20% in their 401k, earning 6%, would have $1.67 million in their plan at age 65. Contrast that with the average saver, who is looking at $368k when they retire.

Before we look at the remaining principles 2-5 below, which focus on investing, it is critical that you start saving more. The best place to start is by looking at your purchases — then, the leaks in your spending habits will become evident.

Invest In What You Know

Investing can be intimidating. From newspaper articles and media coverage detailing how millions will no longer be able to retire, to the angry man on television yelling “BOOYAH!,” it’s no wonder that so many people are hesitant to take the leap into investing. For many otherwise intelligent, confident people, the idea of risking hard-earned cash in a market they don’t truly understand just doesn’t make sense. Often people feel more comfortable sitting down at a blackjack table! The truth is you may have an advantage over Wall Street when it comes to investing — your personal area of expertise.

There are countless strategies and philosophies when it comes to investing. Two of the most successful investors of all time — Warren Buffet and Peter Lynch — have the same simple philosophy. They find good investments by spending a couple of months tracking where every dollar they spend goes, then investing in those companies. By taking this disciplined approach, you are less likely to make impulse decisions.

When doing your own research, Lynch highlights five positive signs to look for in a company.

1. A low price-to-earnings ratio, especially as compared to similar companies.
2. A low percentage of institutional investors.
3. Insiders buying the company’s stock.
4. The company buying back it’s own stock.
5. A low debt-to-equity ratio, especially as compared to similar companies.

Additionally, I advise not to invest in a stock just because of the numbers. I think it’s important to be able to describe why the business is worth investing in — and the fact that the stock is going up is not a good enough reason alone.

However, this simple strategy is not infallible. Sometimes you may find a good company with a great story, but the markets in general move against you.

Avoid Being A Bandwagon Investor

Studies show that investors who try to time the market end up selling at the wrong time — when the market is down — reducing their overall returns. Sticking to a strategy, especially when the when the markets are down, is extremely challenging.

Fidelity analyzed participant actions from October 1, 2008 through the second quarter of 2011. Their findings revealed that 401k investors who moved their assets to cash during the 2008-2009 downturn and stayed invested in cash achieved a 2% gain as of June 30, 2011. Those who stayed fully invested, achieved an increase of 50% during the same time period. Investors who sought “help,” ended up having average returns, almost 3% higher than those that didn’t.

When trying to time the market, most people make the same mistake over and over again: They buy high — out of greed — and sell low — out of fear — despite knowing, on an intellectual level, that it is a very bad idea.

Fees Matter

Everything in finance (and just about every other industry) requires fees and expenses. Sometimes they are hard, if not impossible to uncover, but they are there. Over time, they add up, and can take a chunk out of your portfolio.

To illustrate, let’s focus on fees and expenses in mutual funds, since there is about $23.9 trillion invested in them country-wide.

In the world of mutual funds, costs are measured by the mutual fund expense ratio. All mutual funds must, by law, disclose the expense ratio to existing and potential investors. But what is the ratio, what makes up the costs that it includes and how does it compare to other types of investments?

A Breakdown of the Costs Included in the Mutual Fund Expense Ratio

• Management Fee: A fee paid to the portfolio management company for investing the money according to the funds objectives. This is often the biggest component cost of the mutual fund expense ratio. Typical management fees run from 0.50% to 2.00%.
• Transaction Costs: A mutual fund must pay stock brokers a commission, as do individual investors. Some funds have high turnover (they are always buying and selling investments). In addition, high turnover in a fund’s investment portfolio can generate higher capital gains taxes and other expenses.
• Custody Costs: Mutual fund companies are required to have their investments held by a custodian bank. These banks are responsible for registering the stocks, bonds or other securities on behalf of the fund.
• 12b-1 Marketing Fees: These annual marketing and advertising fees are taken from fund shareholders and used to promote the fund for the purpose of raising money. The more money the fund has, the more money the portfolio managers make from their management fee. A 12b-1 fee does absolutely nothing for you as an investor so one piece of advice would be to stay away from funds charging these fees.
• Legal Expenses: Funds must file paperwork to the SEC and other regulators, file incorporation papers and many other things that require legal expertise.
• Transfer Agent Fees: When a mutual fund shareholder buys or sells part of his investment in the fund, the transfer agent has to deal with the paperwork, money and account statements. Transfer agents handle the day-to-day work of keeping records for shareholder who own the fund, processing redemption and purchase requests and other responsibilities that are vital to the nuts-and-bolts functioning of the capital markets.

The other large expenses not included in the Mutual Fund Expense Ratio are Mutual Fund Sales Load. This is nothing more than a commission that goes to the person or institution that convinced you to invest your money.

The lesson of this is to pay attention to the mutual fund expense ratio. It represents real money coming directly out of your own pocket. Ensure the fees you are paying are worth what you are getting from them.

The Importance of Diversification

This lesson is brought to you by the employees of Lehman Brothers and Worldcom, two high-profile examples of high-flying stocks going bankrupt and their investors losing everything.

I see this scenario all too often. You work for a public company. They offer you a 10-15% discount on the company stock. No one likes to pass up free money, so many people select the company stock as their sole investment in their retirement plan. You work for the same company for many years, and over time, you build up a nice sized retirement account — into the hundreds of thousands. But, it’s still tied up in your company’s stock.

You are essentially playing Russian roulette with your retirement, because the company going bankrupt will change that stock price to $0/share.

A lot of times it is not easy to see the pending bankruptcy because it happens so fast. After all, a company does not send out a notice to employees saying, “Hey guys, we are going to go bankrupt so you should sell all of your stock.”

Simply stated, if you put too many eggs in one basket, you can expose yourself to significant risk. In financial terms, you are under-diversified: you have too much of your holdings tied to a single investment — your company’s stock.

There are some other principles that I think are worthy of discussion, such as carrying high-interest debt, starting planning too late in life, not planning for the unexpected and automating your savings plan. But the five that I covered in this article are a great place to start with getting your financials in order.