I've set some ambitious financial goals for this year.
- One of them I have met already</li>
- One is in progress</li>
- and one is met but also partially in progress.</li>
The last one there, was maxing out my 403(b). Technically I signed the paperwork to do that, but it will take the entire year to actually max it out.
One goal I accomplished already was to max out my Roth IRA. Roth's are one of those funny things because there is a limit of $5000 for 2009 that you can put in them. Now, since I'm a fan of dollar/cost averaging investments, I personally think it would be foolish to just stick all 5000 into a stock account and then pray for a year. So I came up with a little plan.
There are several things I like in relation to investing
- index funds</li>
- dollar cost averaging</li>
- cash accounts</li>
The first bullet there offers a convenient way to "be" the market. For the average Joe, investing in individual stocks can be risky. You don't know what to pick, and if you pick the wrong thing, well, heaven help you.
Index funds are like a mutual fund in that they invest in a broad number of, in my case, stocks. There are index funds of many things though; you're not limited to stocks.
They are in many cases less expensive than mutual funds though, for reasons explained below.
1. They are not actively managed
This means humans don't sit there are choose what stocks go in them. Humans incur a cost on your investments called "load". A load is an expense that the broker charges you so that he or she can make a living, feed the family, etc.
While I understand that brokers need to eat, I'm also very selfish; i.e. I don't want to pay them. Loads cut into your bottom line.
Besides, for every person like me</strong> in the world, there is at least one person like my mom</strong>. What I mean by this is that there are people that will feed the brokers. My mom is not financially saavy. She has no desire to be personally responsible for her finances. She refuses to learn about how money works. In a nutshell, she is ignorant by choice.
This is not necessarily a bad thing. For instance, I am ignorant by choice in regards to plumbing. I have no interest in it. So I will pay a plumber to do the work. A consequence of her choice though is that she does not understand enough about investing to be able to comfortably embark on her own. So she must pay a broker to invest for her. That broker charges a load, and that load eats into her bottom line.
2. They are generally tax efficient
When people say this referring to a comparison between mutual funds and index funds, they usually are referring to how much selling is going on under the hood of the fund.
Remember, mutual funds and index funds simply act as a layer of abstraction. Instead of you, personally, investing in 100 stocks, you instead invest in a single mutual or index fund which splits your money out into those 100 stocks.
Remember that mutual funds are actively managed by humans though. Even the best humans have emotions, and emotions can rein terror on your investments. Consider what happens when a mutual fund start performing poorly. The manager of the fund, in the hopes of saving face, may start selling off the bad assets in the fund.
This selling can do two things.
- If portions of the underlying investments that are being sold have risen in value since they were purchased, you incur what is called a gain, and you are taxed on that; a capital gain</li>
- Just the act of selling incurs fees; this cuts into your bottom line</li>
Index funds on the other hand are not human. They are more like algorithms; math. If an index goes down, there is no emotion, except your own personal emotion, that would influence a sale of the underlying funds.
Indexes are efficient in this way. You can think of them as being the market. If the market goes up, your index goes up. If it goes down, your index goes down.
A consequence of all this emotion is another thing that mutual fund managers are hard pressed to beat. Managers get this idea in their head that they are good; really good. They get to thinking that they can "beat the market" (ie if the market returns 5% for the year, they can return >5%)
All too often though, they are simply wrong. Very few managers can do this (perhaps 1 in 10). And who are you</strong> to think that you're so special that you can pick that 1 magical manager. You're not special; you're human just like the rest of us. And that 1 special manager may only beat the market once. Consistently beating the market is darn near impossible, unless you cheat</a>.
So, as the saying goes, "if you can't beat em, join em". By buying the index fund, you buy the market. So the worst you can do is "the market". Yes, sometimes that can be pretty bad, but more often than not it's not as bad as if a human were trying to keep pace.
Ok ok ok. So all this talk about investment stuff has caused me to be like Joe and drone on and on and on about a single topic. What's my plan that I was touting above.
In my Roth I have 2 funds; a money market fund and a target retirement fund.
My target retirement fund is composed of all index funds; think about that. Where an index fund is an abstraction on top of individual stocks, this target fund is a further abstraction on top of those indexes. Yikes.
The target fund automatically re-balances it's self over the years. This means that at time passes, a larger portion of the account invests in bonds and less in stocks. Currently, it invests largely in stocks and not so much in bonds. The 2045 aspect of the fund essentially is telling the fund that "Your owner wants to retire in the year 2045". Based on this, the fund will re-balance appropriately.
Cool, so I send money to 1 place, and I, literally, own the world. The underlying index funds are things like the "total stock index" and "total bond index" as well as "emerging markets" (think new countries) and "total european market" and "total pacific market". So I own quite a breadth of the world.
So how does dollar cost averaging makes it's way into my idea? Well, that's where the money market fund comes in. Money market funds are like a high yield savings account. Every month, they typically pay a portion of interest. I re-invest that interest back into the Money market fund. While in theory they can go down, it's considered a rare event.
So here's the plan.
At the start of the calendar year, I immediately max out my Roth IRA by contributing the full amount to the money market fund.
Then, I have automatic exchanges configured so that every week $100 is exchanged from the money market fund, into the 2045 fund; that is the dollar cost averaging.
At the end of the month, the money market fund turns a profit and bears interest. This goes back into the MM fund. Over the course of a year, ~$5200 gradually makes it's way into the 2045 fund. By investing during the peaks and lulls of the market, I effectively average out.
I'm interested to see how this all pans out. To me it seems like a simple, effective way, to save for retirement while mitigating quite a bit of risk. And, since it is a Roth, all my gains (including that monthly interest) can be withdrawn tax free when I turn 59 1/2. This is in start contrast to the 403(b) which will be taxed when I make withdrawls far into the future.
So yeah, I hope that got your brain thinking about money. I don't claim that it's a perfect strategy, but it is a</strong> strategy. Enjoy.