Twenty basic rules for intelligent money management

post by James_Miller · 2015-03-19T17:57:22.558Z · LW · GW · Legacy · 55 comments

Contents

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1.  Start investing early in life.
 

The power of compound interest means you will have much more money at retirement if you start investing early in your career.  For example, imagine that at age eighteen you invest $1,000 and earn an 8% return per year.  At age seventy you will have $54,706.  In contrast, if you make the same investment at age fifty you will have a paltry $4,661 when you turn seventy.
 
Many people who haven't saved for retirement panic upon reaching middle age.  So if you are young don't think that saving today will help you only when you retire, but know that such savings will give you greater peace of mind when you turn forty.
 
When evaluating  potential marriage partners give bonus points to those who have a history of saving.  Do this not because you want to marry into wealth, but because you should want to marry someone who has discipline, intelligence and foresight.
 
 2.  Maintain a diversified portfolio.

By purchasing many different types of investments you reduce your financial risk.  Even a single seemingly stable stock can easily fall by 70% in a single year.  In contrast, a broad investment portfolio is extremely unlikely to decline in value by such a gigantic amount unless something truly horrible happens to the entire world's economy.  As the saying goes, "don't put all of your eggs in one basket."

 
3.  Consider buying an index fund.
 
Index funds provide cheap and easy ways to acquire a diversified stock portfolio.  An index fund is a mutual fund that invests in every stock in its index.  So, for example, an S&P 500 index fund will purchase all 500 stocks in the S&P 500 index, which consists of the 500 largest publicly traded stocks in the United States. 
 

4.  Don't forget about foreign stocks.
 
To achieve optimal portfolio diversification you need to invest in foreign stocks.  The bigger a nation's economy, the more money you should put in its stock market.  You can buy index funds that invest in foreign stocks.  By investing in diverse foreign securities from many nations you will probably reduce the chance that your portfolio will suffer a sudden huge decline. 
 
 
5.  Don't try to out-guess the market.
 
Ordinary investors, and indeed even most professional investors, are horrible at figuring out which individual stocks will outperform the entire market.  For reasons I won't go into, economists have overwhelming evidence that without inside information not available to the general public an investor can't accurately predict which stocks will do well.
 
If you try to out-guess the market you might get lucky and earn a superior return.  But on average you will do worse compared to someone who holds a diversified portfolio.  Furthermore, by placing a large bet on a few stocks you will necessarily violate many of the other investing rules listed here and so will most likely pay a financial penalty.  True, it can be fun to take a chance and gamble on one stock.  But you probably shouldn't allow the excitement of gambling to infect your investment decisions.  If you want to gamble bet a few dollars on blackjack, but stick to a sound, diversified, investment strategy.
 
You may know people who brag about how they made a killing in the stock market by calculating which stocks would do well.  Keep in mind, however, that they might be telling you only about their profitable stock choices and not their losses.  Furthermore, even if someone has on average beaten the market, he probably just got lucky.  After all, although people do win lotteries, such winners don't really have any special abilities at guessing which lotto numbers will come up.
 
A few professional investors, such as multi-billion-dollar hedge funds, might well have means of earning superior returns by investing in just a few financial securities.   But if they do possess financial superpowers they won't share them with you for less than a lot of money.  Also, such investors probably earn their above-average returns by investing in exotic financial instruments, such as derivative securities, that you don't have access to.
 
 
6.  Don't take on "stupid" risks.
 
You may have heard that financial markets compensate investors for taking on risks. This is true, but it doesn't apply to stupid risks.
 
Imagine you work for a construction company.  You learn that the owner pays higher wages for employees who do work on the top of tall, unfinished buildings because such work is extremely risky.  Construction companies have to pay more to workers who undertake the most perilous tasks or else no laborer would be willing to do such dangerous work.
 
This week, say, you want to make a lot of money.  You understand that the construction company pays the highest wages to workers who do the most dangerous jobs.  So you intend to work on the top of the tallest skyscraper while drunk!  You figure that since this is extremely risky you should get a large bonus.  But of course management pays only for risks it needs someone to undertake, and they obviously don't need anyone to labor while under the influence.
 
Stocks on average pay higher returns than government bonds because otherwise everyone would buy the bonds and no one would take the risk of owning stocks.  Since markets need people to buy stocks, they must compensate those who do by giving them, on average, higher returns.  But the market doesn't need anyone to hold an undiversified portfolio.  If you do, you are taking on risks that benefit no one and so you won't get paid for it.  Holding an undiversified portfolio and expecting to get a high average return because of all the risk you are taking on is analogous to working on a skyscraper while drunk and expecting your employer to pay you a premium because you are increasing the riskiness of your job.
 
 
7.  Understand the dangers of actively managed mutual funds.
 
7(A)  On average, actively managed funds do worse than passively managed funds do.
 
Index funds are passively managed because the funds don't try to guess which stocks will do well.  In contrast, actively managed mutual funds do try to identify stocks that will outperform the market.  Most actively managed mutual funds, however, do much worse than broad-based index funds such as S&P 500 index funds.  
 
7(B).   Actively managed mutual funds have high fees.
 
Mutual fund fees have a tremendous impact on long-term investment performance.  Imagine that the market goes up by 8% a year.  One mutual fund charges fees of .2% a year; another charges fees of 1.5% per year.  Pretend that you invest $1,000 in both funds.  After thirty years you will have $9,518 in the first fund but only $6,614 in the second.
 
Mutual funds often charge high fees to pay expensive MBAs to pick stocks.  But MBAs are not on average, any good at out-guessing the stock market.  So when you buy a high fee mutual fund you are wasting money on MBAs.
 
Index funds often have the lowest fees because these funds don't try to out-guess the market and so don't need to hire expensive (and useless) stock guessing MBAs.  Still, some index funds do charge high fees and so should be avoided at all costs. 
 
7(C).  Survivorship bias artificially inflates the mutual fund industry's past performance.
 
Let's say I start 100 mutual funds.  Each fund will randomly select a few stocks to invest in.  Almost certainly at least one of my funds will get lucky and earn a high return.  After a few years I will identify the one that did the best and market this fund to consumers.  I will quietly close down the other 99 funds.  When attracting customers for my one surviving fund I will claim that its fantastic past performance proves I'm an investment genius.  Of course, since all my stock picks were random I have not demonstrated any investment skill.  If you evaluate only the mutual fund that survives it will indeed appear that I'm an investment wizard.  But such "survivorship bias" corrupts the evaluation.
 
Mutual funds that do very poorly shut down.  Consequently, if we just take the average past returns of mutual funds that exist today we would get an estimate of performance that overstates the overall investment skills of the mutual fund industry.
 
 
8.  Don't engage in much stock trading.
 
When you trade a stock you pay a fee.  And as a previous investment tip explains, in the long run fees decimate investment performance.  Furthermore, when you trade stocks that are not in a tax-preferred plan (such as a 401(k) plan) you often pay extra taxes.
 
 
9.  Invest in tax-preferred vehicles such as 401K plans.
 
The U.S. government gives tremendous tax benefits to those who invest in certain tax-advantaged vehicles such as 401(k), 403(b), or IRA plans.  (Restated:  The U.S. government imposes a "stupidity tax" on investors who don't take advantage of tax preferred plans.) These plans have yearly contribution limits, so a wise investment strategy is to put as much as the government allows into the plans you are eligible to contribute to.
 
 
10.  Avoid credit card debt.
 
High interest rate credit card debt is financial cancer.  Each month you should pay off your full credit card balance to avoid such financial sickness.  If you can't, however, call your credit card company to negotiate a better rate. 
 
Credit card companies love customers who (a) have lots of debt, but (b) make only their minimum payment each month.  If you are such a customer then call your credit card provider and tell it that because of the high interest rates it charges you want to transfer your balance to a card from another company.  Chances are your credit card provider will offer you a lower rate to keep you as a customer.  The credit card industry is highly competitive.  Use this to your advantage if you can't pay off your total balance each month.
 
 
11.  Always take full advantage of matching contribution pension plans.
 
Some employers will match a worker's contribution to his retirement account.  These matching plans always have some upper limit after which the employer will no longer match contributions.  For example, an employer might deposit fifty cents into your 401(k) account for every dollar you put in as long as you have put in less than $6,000.  After you have put in $6,000 your employer won't match any additional money you put into your retirement account.
 
You should always take full advantage of matching pension plans because they offer the best rate of return of any investment.  For example, with the 50% plan described above you get an immediate and risk free 50% return on your investment.  Putting less than $6,000 in this hypothetical plan is the equivalent to telling your employer that it should keep some of the money it was prepared to give you.
 
Many employers don't offer matching contribution pension plans.
 
 
12.  Be cautious about investing in your employer's stock.
 
Companies love for employees to buy lots of their stock because such stock-owning laborers care more about the company's profitability.  But it's financially perilous to buy your firm's stock because if the firm goes under you lose not only your job but also part of your savings.
 
Some companies, however, offer significant financial enticements to employees who do buy their stock.  If these enticements are large enough you should seriously consider giving in.  But understand that by buying your company's stock you are taking on significant risk.
 
 
13.  Remember that your home is a very risky asset.
 
 It's temping to think that your home is a much more solid investment than your stocks because you can actually touch your home.  But as with individual stocks, the value of a single home can fall rapidly .  This is especially true if you have a mortgage. 
 
Imagine, for example, that you buy a $400,000 home and pay for it with $40,000 in cash and a $360,000 mortgage.  So you have a $360,000 debt on a home worth $400,000, meaning that you have $40,000 in home equity.  Now assume that the value of your home falls by 10% and becomes worth $360,000.  Since you still owe $360,000 on the home, your equity in it has fallen to zero!  A 10% fall in the value of your home has obliterated your home equity. 
 
A home is inherently risky because it's an undiversified asset.  Mortgage debt magnifies this risk.
 
This doesn't mean you shouldn't buy a home.  The favorable tax treatment of mortgage interest makes it worthwhile for most adult Americans to be home owners.
 
 
14.  Learn how your financial advisor gets paid.
 
People respond to incentives.  If, for example, your stock broker receives a fee every time you make a stock trade then he may well advise you to make more trades then you should.  If your real estate agent gets paid the same whether you buy after looking at five or twenty-five houses then she has an incentive to get you to make a quick home buying decision.
 
 
15.  Buy life insurance if your family relies on your income or time.
 
If your family relies on your income you owe it to them to buy life insurance.  No one likes to think that he could die but, alas, all men are mortal.  If you rely on your spouse's income make sure that he/she has life insurance.  A husband should get life insurance before his wife becomes pregnant in case the worst happens.  Homemakers who don't earn any income but have dependent children should still buy life insurance because if they die their spouses may have to hire someone to do many of the tasks that the homemaker had previously done.
 
 
16.  You and your spouse should have disability insurance.
 
You might well impose a greater financial burden on your family if you become seriously disabled than if you die.  If you die you stop bringing in income, but you also (after your funeral) stop consuming.  If, however, you can't work because of a disability, you not only won't be earning money but you will also require a significant amount of financial support from your family.  To (partially) protect your family from this burden you should purchase disability insurance.  Most people get such insurance through their employer, so speak to your company's human resources department about getting disability insurance.
 
 
17.  As you approach retirement consider putting much of your new savings into safe government bonds.

Sudden falls in the stock market have a greater impact on those close to retirement than on younger investors who can ride out the inevitable ups and downs of the market.  So as you approach retirement you should consider putting much of your new savings into safe government bonds.  
 
 
18.  Women usually live longer than men and so need to save more for retirement.
 
Since women live about six years longer than men do, they will on average need more money to finance a comfortable retirement.
 
 
19.  Keep in mind that you might live a lot longer than your grandparents will/did.
 
Over the next forty years scientists might develop many successful anti-aging treatments.  Because of the possibility of such technologies, a forty-year-old alive today has a non-trivial chance of still being alive one hundred years from now.  So when deciding how much to save for retirement take into account that you might spend a heck of a lot more time in retirement than any of your grandparents will/did.
 
 
20.  Determine how much people in your job make.
 
Your employer knows how much people in your position are paid.  If you don't you're at a disadvantage in salary negotiations.  Many people are uncomfortable discussing salaries with co-workers.  Overcome such discomfort to find out if you deserve a raise.

 Originally published on Google's Knol

 

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