Over the years I’ve gotten a lot of questions from people on how to create some basic investments and get started on building a stock portfolio. While I am not a stockbroker/financial planner/accountant/etc… I’ve read voraciously on the subject and have been investing since I turned 18 and could legally do so. I have made some practical moves over the years and right now am seeing between a 30-35% return on my portfolio and barring any major future recessions/depressions I am hoping to retire well before the age of 65. I’ll share with you some information that I’ve uncovered and some keys to getting started so that you too can be on this path:
1) Debt:
I have never in my life carried any kind of credit card debt or monthly balance. This is the first roadblock to becoming financially independent and building wealth and if you have a habit of let’s say carrying over debt and taking care of it with tax refunds every year you are in the worst possible position you can be in. The interest adds up and your credit score is negatively affected. Your credit score is your lifeline and without having a strong credit score you end up paying more for everything for the rest of your life. It’s really a catch 22 that people can enter into and its of utmost importance to knock off any type of high-interest debt (outside of good debt meaning student loan, mortgage, or lower auto loans) as soon as possible before you even consider socking away money in investments. The general rule of thumb here is debt that is above 7% should be paid down or refinanced as soon as possible before anything else.
2) Emergency Fund:
After taking care of debt, you should be sure to at least have your primary bases covered in event of flood/loss of job/car crash/etc… There are some varying schools of thought on what an emergency fund looks like, but the typical consensus is around 6 months saved up to cover all of your monthly expenses. I think this fund especially applies to those who are living paycheck to paycheck as in some cases you will be able to get away with 3 months if your monthly income outweighs your expenses enough and you have some of the other financial basics below covered.
3) 401k:
If your company offers a match on your 401k it would be stupid not to take advantage of that as it really is “free” money. You should always contribute up to the amount that your company will match (i.e. if they match 100% up to 3% and 50% up to 5% you should be aiming towards that 5%). Some people think that doing just this step is the extent of their retirement planning, which is not nearly enough.
4) Roth IRA:
The Roth IRA differs from the traditional IRA as it allows you to withdraw the earnings completely tax free after you turn 59 1/2. This means that the money you put into your Roth IRA is already taxed from your earnings and you are limited to contributing $5,500 a year. In a traditional IRA, the money you contribute is before-tax earnings, but when you go to withdraw any time after 59 1/2 you’ll be taxed at the marginal tax rate that you are in at that time. Most of us will be at a higher tax rate or the government will have increased taxes enough in the future where we’ll end up paying more taxes on earnings in a traditional IRA, where your Roth through the magic of compounding interest will be all yours with no tax worries.
5) Funds
Now that you’ve covered your bases by paying off debt and opening up your emergency fund, you’re going to have to figure out where to actually put your money when choosing your 401k funds and your IRA funds. I am a big fan of vanguard.com as they have the lowest expense ratio’s (fees that are charged for managing your fund) and waive all administrative costs if you opt in to their electronic statements. Vanguard also has an excellent history of returns in almost all of their funds. If your 401k doesn’t allow for any Vanguard funds, you can check out the ticker symbols on Morningstar.com to find ratings.
6) Asset Allocation
Now that you’ve chosen where to put your money, you need to figure out what to actually buy. Traditionally the rule of thumb for people under the age of 40 is to be heavy on equities (subtract your age from 100 and thats the % of your portfolio that should be stocks).
The easiest fund to get is a Target Retirement Fund or LifeStrategy fund which basically will change the asset allocation as you get older from heavy on stocks (equities) to more conservative with greater holdings on bonds. This is a “set it and forget it” method where you buy into a fund and it is passively managed as you age. To find the right Target Retirement Fund for you just look at the age where you will be 65 (i.e. 2050) and buy the Target Retirement Fund that applies to that age group (i.e. VFIFX — Vanguard Target Retirement 2050 Fund).
The other option is to buy an index fund that tracks the S&P 500 (VFINX) so that you get broad exposure to the US Stock Market. If you’re going this approach, I would recommend a Total Stock Market Index (VTSMX) fund as it diversifies some risk by also carrying small and mid cap stocks. About 30% of your stock allocation should be International stock to further diversify your portfolio to emerging markets and global markets. Vanguard’s version of this is the Total International Stock Index Fund (VGTSX). If you’re under the age of 35, I would stay heavy in equities with maybe 10% for bond’s at most as people are living much longer and retiring later and you’ll benefit from the few extra years of more aggressive investing.
7) Individual Stocks
Notice that I don’t focus heavily on individual stocks here as if you are not investing with much (less than $100,000) the gains from holding shares in individual stocks are minimal compared to the fluctuation risks in the market. Individual stocks also require greater research based on factors such as P/E Ratio’s to predict performance. A mutual fund mitigates the risk by diversifying it’s holding across a wide range of stocks.
If you are inclined to buy individual stocks, I would recommend filling out your portfolio with blue chip stocks (i.e. Johnson & Johnson, Disney, Verizon, Coca-Cola, Microsoft, Wal-Mart) as they all pay great dividends (blue chip companies that are large cap’s and don’t anticipate the type of growth trajectory of smaller companies keep their investors happy by paying out bigger quarterly dividends). This is a great way to get current income generated from your portfolio and blue chip stocks don’t tank in recessions as their businesses are more fundamentally sound.
These basic steps will allow you to set yourself up with all of the essentials of a portfolio. As you find yourself with more and more money to invest you can start to buy other types of funds to further diversify your holdings in a taxable account. The key to low cost investing is tax sheltering as much as you can in a 401k and Roth IRA and then keeping tax efficient funds in your taxable accounts outside of these to keep your yearly tax costs low. Future funds to move on to could include growth index funds, dividend growth funds, and emerging market funds. Foreign stock holdings provide yearly tax deductions, while your bond funds should perferably be in a tax sheltered account as they are taxed at a higher rate.
If you have any questions or would even like to see more information in a future column you can tweet me @adiraval.
