Sunday, November 23, 2008

Getting Started with Investing

How do you get started investing?

Many young people are interested in getting started in investing, but have little or no idea how to get started. Everyone, it seems, advises them to invest, but how do you get started?

When I was in my 20's, I faced this same problem. I talked with an investment counselor, and his advice was, "Well, if you've got $5,000 to $10,000 to start with, I can set you up with a mutual fund..."

Of course, I didn't have $5,000 to $10,000 to start with. If I did, I wouldn't need his advice. The problem with investment counselors or advisers, is that they are working on commission. So they want to "sell" you an investment, usually with a certain fee (as high as 5%) as their sales commission. If you don't have money to invest, they aren't interested in talking to you.

Fortunately, there are many ways for a novice to start out investing, without having to use an investment counselor or having a lot of money up-front to invest. For most folks, setting aside small amounts of money in after-tax and before-tax investments is not hard to do.

So what are after-tax and before-tax investments, anyway? You should know the difference between the two before you start.


After-tax investments are investments you make with money from your pocketbook, after you have already paid taxes on it. This is the money in your pocket. So any cash you have in a savings account, for example, is an after-tax investment. You have already paid taxes on the amount you've put in. You only need to pay taxes on the interest you earn.

After-tax investments primarily are for immediate needs. Most money gurus suggest that you have anywhere from 6 months to 1 year's salary in after-tax investments, to cover emergencies and other contingencies, such as losing a job, or a major health crises. If that amount scares you, don't feel bad - most Americans have little or nothing in the way of after-tax investments or savings, and as a result, when they lose their jobs or experience other financial difficulties, they are often out on the street in short order.

The problem most people have (and that I had) was that if there is money in the checking account, it gets spent pretty much the week it is earned. Like most Americans, I was a spendthrift, and if I got a pay raise, I simply expanded my lifestyle by spending more money. While this is typical of the spending habits of teens and 20-somethings, if you are still doing this well into your 30's and beyond, you are headed for financial ruin.

The secret, I found, was to squirrel away money in different accounts - some being hard to access, so that I would not be tempted to spend right away. There are different ways of doing this that can be setup to automatically save money from your accounts.

For example, many corporations have shareholder savings plans. If you purchase one share of stock in, for example, Virginia Power, you can have a certain amount of money per month (e.g., $50) deducted from your checking account and used to purchase stock. Over a year, this amounts to $600 in stock, and after several years, you may have a few thousand dollars of stock, without much difficulty.

The magazine The Money Paper has (or had) a service that allowed you to purchase single shares of stock in companies that participate in shareholder savings programs. You'd be surprised how $50 here and $50 there can add up to a small portfolio of stock.

The only problem with this approach is that it requires you to keep track of all these different stocks and what you paid for them ($50 at a time) so you can calculate your capital gains when you sell.
Most online brokerages (etrade, Ameritrade) allow you to transfer money on a regular basis (e.g., monthly) into your online account, so you can then use that money to invest in stocks and bonds. You can setup an account with etrade or Ameritrade using an initial deposit of cash or stocks, and then have money automatically deposited into that account. Once a certain balance has built up, you can then purchase stocks. The only problem with that approach is that even at their low trading fees, the purchase price for small lots of stock can be high, and the temptation to "trade" (buy and sell and lose your shirt) can be high. After accumulating a number of stocks, I transferred the shares to an Ameritrade account for easier management.

Back in the old days, we used to have something called the Payroll Savings Plan, where a certain amount of money (e.g., $25) would be taken out of your paycheck each week and used to purchase U.S. Savings Bonds. Most companies have dropped the Payroll Savings Plan, but you can still participate in automatic deduction in which allows you to have automatically deducted from your checking account, every month, a certain amount (e.g., $50) and put into U.S. Savings Bonds. Again, after a few years, you'd be pleasantly surprised to discover that you now have a few grand in that account, which might come in handy down the road.

UPDATE:  While bonds used to pay 3.5% or more, in recent years, the return has been fractional.  They will go up, shortly, I suspect.  Again, this is not a "main thing" to invest in, but a way of squirreling away cash so you don't spend it. The biggest problem investing and saving isn't "what do I invest in?" but "stop spending money on crap!"

Thus, it is not hard for the "little guy" to invest in both Stocks and Bonds without having a huge wad of cash to start with. You can start an investment portfolio with as little as $50 and go from there. The secret is to have the discipline to keep at it and the patience to wait over time for money to accumulate.

You can also play other games to trick yourself into not spending money. For example, I had an account with a Credit Union in another State, where I had a job (Credit Unions, by the way, ROCK. If you can join one, do it!). Rather than closing the account when I moved, I put aside $50 each month and deposited it into a savings account there. If I wanted to get at the money, I would have to write to them and ask for a check to be mailed, so it prevented me from using that as a source of "easy money." Once a balance had accrued, I converted the savings account into a Certificate of Deposit (CD) which is even harder to tap into on a moment's notice.

You can see there is a pattern here - $50 here, $100 there, no big chunks of money going into any one thing. I started small and worked my way up as I made more money over time (if you can resist the impulse to SPEND every pay raise you get, you will become wealthier instead of spinning that gerbil wheel faster and faster).

The only problems I see with this approach is that some folks bite off more than they can chew. They assume that if putting $50 a month aside is a good idea, then putting $500 a month aside is even a better idea. While this may sound good in theory, if you try to save too much, too fast, you'll end up starving yourself for money and then be tempted to "tap in" to your new savings plan, defeating the whole purpose of the thing. Once you've "tapped in" to it, you'll start doing it again, get discouraged at the progress of the whole thing, and probably quit.

So, if you have no savings and don't know how to get started, start slow and work your way up. I started with one stock at $50 a month. After a year, I added another, and so forth. As a result, I didn't miss the money much, and after several years, I had a portfolio worth quite a few thousand dollars.


Before-tax investments, as the name implies, are investments made with money you haven't yet paid taxes on. These are long-term investments that are designed to fund your retirement. The most common of these are 401(k) plans, IRA, SEP plans, and the like. If you work for the government or are the military, you may know these as the FERS plan or some other moniker.

While the details on each type of plan differ slightly, the basic premise is the same: You have a certain amount of money taken out of your paycheck each week, and that amount is invested in stocks, bonds, or mutual funds (usually the latter) through some investment management company. Your income tax is calculated on the amount of your paycheck AFTER the deduction is made, so the money invested has not been taxed at all.

Someday, when you make it to retirement, you'll have to pay taxes on that money. But that is a long way off, and as we say in tax law, a tax deferred is a tax denied. Retirees usually pay lower rates of income taxes, so not only do you delay paying the tax, you end up paying less. It is a sweet deal, to be sure.

If your place of employment has a 401(k) plan of some sort, you should participate in it as much as you can. In many cases, it can be literally free money. Although fewer and fewer employers are doing it anymore, many used to "match" contributions dollar for dollar. So right off the bat, you make 100% return on your investment.

Most financial advisers will tell you to participate to the maximum amount allowed in your 401(k) plan or the like. This is good advice, but can be difficult for many young people who are just starting out. The cost of rent, car payments, insurance, and the like can make it seem hard to save.

But bear in mind that contributing to your 401(k) plan REDUCES YOUR INCOME TAXES. So in addition to any "matching" funds you may get from your employer, you may also get nearly 50 cents knocked off your taxes for every dollar you invest. This is on top of all the interest you earn on the money as well or any matching funds your employer provides. So you can see, a 401(k) is the best opportunity for the average working Joe. You can make money three ways!

How does the tax thing work? Simple. If you make $100,000 a year (I am choosing this only because it is a nice round number) you are in the highest marginal tax rate of 36% (soon to be 39.5%). If you put $10,000 in your 401(k), your "taxable income" will drop $10,000, but your taxes will also drop $3600. So in effect, the net cost to you is only $6400 to make a $10,000 investment.

So you see, it is a heck of a deal for the investor. Why don't more people take advantage of it? Well, they are taking the short-sighted "weekly paycheck" view of things. If they take money out for a 401(k) they feel they won't have enough to spend on food and beer. Of course, they aren't taking the longer view - or taking into account that their taxes will be lower (larger refund check at the end of the year).

Bear in mind that while a 401(k) is designed for retirement funds (age 59-1/2 or later) the money can be accessed for other needs. For example, if you are buying a first home or going to school, you can often borrow against the 401(k) or take money out in some instances. And in a worst-case scenario, you can always take money out and pay the tax and penalty if you had to.

But to avoid that, I would start out with a comfortable level of investing - and work your way up. I've seen over-eager young people at low wage jobs contribute the maximum amount allowable (usually 15%) only to later drop out or borrow against the plan. This sort of defeats the purpose of the plan.

Note that for young people, time is your ultimate friend. A dollar invested at age 21 is worth maybe $20 invested at age 55. Putting off starting a 401(k) plan is foolish, as the longer you wait, the harder it will be to "catch up" later on. Participate now to the most amount you are comfortable with. Doing something as simple as giving up cable TV and investing that money in a 401(k) could put $100,000 more in your pocket by the time you are 65.

UPDATE:  Mr. See put 15% into his 401(k) for only about 15 years.  Today, his portfolio is worth over $600,000.   Rich?  No.  Comfortable?  Yes.  Beats being broke!

Note also that money in 401(k) plans and the like is usually exempt from attachment through judgments or bankruptcy. So savings in one of these before-tax plans can be a "safe" investment in more ways than one, even if you later make some financial mis-steps.

Life Insurance can be another way to invest over time. Simple term life insurance is nothing more than a gamble - you pay a premium, and they pay a death benefit if you die prematurely. If you are young and have children or other obligations, a simple term policy can be very inexpensive (shop around, they are marked-up heavily). A $100,000 term policy can be had for less than the cost of "credit insurance" on your car loan.

But term insurance is not an investment. Whole life insurance is a product that has an investment as well as insurance component. The theory is, by paying "extra" the policy accumulates funds and eventually will be "paid off" and no further premiums will be due. Upon retirement, it can be converted to an annuity, cashed out, or borrowed against, usually tax free.

Whole life insurance isn't for everyone, and it certainly should not be the main part of your portfolio. Run away from any agent who suggests putting all your eggs in this basket. About 1/3 of all people who buy whole life insurance drop out within the first few years when they don't see any big gains or returns (most policies are "upside down" for at least 5 years or more). This means, of course, more money for the folks who remain. The best companies are MUTUAL companies, where the policy holders are the owners of the company as well. STOCK companies have to pay dividends to shareholders and thus have lower returns.

I bought a $100,000 whole life policy from Northwestern Mutual when I was 29. It cost $99 a month for the policy, which was an affordable amount for me at the time. Again, picking an affordable amount insures that you will stick with it over time. If you stop making payments on the policy, you lose EVERYTHING, other than the cash value.  You could convert to a paid-up life plan (as I did with a couple of policies).  It is not for the faint of heart. At this point (20 years later) , every dollar I put into the policy increases its cash value by nearly $2, so over time, it has been a good, steady investment, and a good way to diversify a portfolio.

* * *

Starting an investment porfolio isn't hard and doesn't require a lot of up-front cash. Even spendthrifts like myself can build up savings by putting a litte away here and there over time.  The secret is to start small - make a regular monthly or bi-weekly investment in before- and after-tax accounts.  If you can cut expenses, see if you can increase this amount slightly.  And when you get a raise, consider putting more into savings before spending on a new car or toy.

The only mistake I see people make is to try to save too much right away - putting $500 a week into savings, when they are living paycheck-to-paycheck.  Such overly-ambitious schemes end up falling apart quickly, and the saver ends up cashing in his savings, and thus gets discouraged and quits.

If you can start saving $50 a week at age 20, invest it at 7.5% interest until age 65, you will end up with over a million dollars.  But you have to put away that $50 a week - you have to save.

Start out small, start early, be consistent.  You'll get there.

UPDATE: Note that the strategies I list here require you put aside a small amount every month for years on end, into relatively "safe" investments like mutual funds and the like.  Many young people (myself included) try to "jump start" their investments by listening to the shouting guy or some dubious website or discussion group hyping some obscure stock.  You'll be rich overnight!

Or maybe not.  One fellow "bet it all" (quite literally) on options on GameStop using an inheritance from his grandma.  Lost all $200,000 at it, too.

If anyone tells you to "invest" in options or some hyped stock, run away - they are trying to rob you.  How?  By using your "investment" to pump up the stock price so they make money.  It's the latest thing on social media - brigading the stock market.  Don't be someone else's bot!