Some basic financial advice . . .

This post is a product of a discussion I had with my bro Ben the other day regarding some financial planning. It’s written from the point of view of a young couple with a lot of years of saving ahead of them. Hopefully some of you find it helpful. It’s long.

There are four basic financial accounts that every family should have. They are primarily based on liquidity.

For the sake of this discussion, think of liquidity as the speed at which you can turn your money into goods. A quick example: cash is the most liquid form of money as you can give it to almost anyone in exchange for almost anything. An 18-month certificate of deposit (CD) is much less liquid: you can’t turn it into an exchangeable form of money, such as cash, until it matures (without paying a penalty).

The only good reason to give up liquidity is if someone pays you more than it costs you to not have your money for that period of time. Interest is effectively the price of money and the laws of supply and demand determine that price. If money is scarce or in high demand, the interest rate will increase; if there is plenty of money available relative to how much people want to spend it, its price will decrease. Economic factors influence supply and demand, which in turn influence the interest rate. It would be a bad idea to lock your money up in a 12-month CD at 5% interest if you can get the liquidity of an online savings account with a 5% return. Similarly, it would be a really bad idea to commit your money to a CD that pays 5% if you are carrying a balance on a credit card that charges you 20%!

The logic above results in a general relationship between liquidity and return; namely, the less liquid an account is, the higher the return will be. So, the first principle applicable here: trade liquidity for return when there is no material cost of doing so. The next general rule that applies to this discussion is simple and needs no explanation: taxes suck and it is your moral responsibility to avoid paying them whenever possible. The last rule can get more complex (and has a substantial literature behind it that does): the best investment policy for anyone reading this is to diversify and hold. For now, I will rely on some age-old advice: “Don’t put all of your eggs in one basket” and “Patience is a virtue.”

Before we go on to the accounts, some more terminology:

Stocks, or equities, are ownership. When you buy a stock you are buying a small part of a company. As the value of the company increases, the value of the stock increases. This is the primary way people make money though equity investment, but often times, stocks will give a portion of their earnings to the owners of the company. As a (very small) part owner of the company, you will get a (very small) part of the earnings. These payouts are called dividends, and, in some larger and well established companies, is the primary benefit of ownership.

While equity is ownership of a company, a bond represents a company’s debt. As a bondholder of a company (or government entity) you have effectively loaned money to the company in return for interest payments that are determined in the contract. Another general rule in finance is that, as risk increases, the return you get on your money must also increase to provide incentive for you so take on the added risk. The interest rate a bond issue pays is determined by the risk of the company or entity defaulting on your loan. Therefore, US government bonds are rightly considered almost risk-free since a government can meet its debt obligations through its powers of taxation (which is does). A corporate bond from a small and fledgling company would be considered more risky and would pay a higher interest rate than a risk-free government bond. Municipal bonds are more risky than government bonds, but are still relatively secure and have the added benefit of being free from federal taxation. Thus, many very wealthy people invest in “munis” to secure a fixed income and reduce the ridiculous amount of taxes they pay.

Mutual funds are made up of many individuals contributing money into a pool that is then invested in various financial instruments. Most funds are made up of various arrangements of stocks, but there are funds that consist of bonds, as well as a mix of both. There are also many types of equity index funds. Growth funds are made of up the stocks of small companies which, while increasing the volatility of your return, have a greater chance of experiencing significant growth. Large cap funds consist of the larger companies in the country, which have lower but less volatile returns. There are emerging market funds that specialize in companies in growing countries, there are regional or sectoral companies, real estate trust, etc.

Index funds are a type of mutual fund. They differ from mutual funds in that the assets that make up the fund are chosen to mimic an index. The first index fund was an S&P 500 index fund from Vanguard. The S&P 500 is an index that tracks the 500 largest companies in America. The advantage of an index fund is that they are not actively managed, meaning there isn’t active buying and selling of the assets in the portfolio. Since index funds are passively managed, you don’t have to pay anyone to manage it. The difference in the fees you pay for active management vs. a passive fund, measured as a percent of the returns and called expense ratios, is very significant over the long term. The reason individuals invest in actively managed funds is to receive a higher return on their money, thinking that the manager of the fund knows enough about the market and various stocks in the market to beat the average returns from the market. Empirical evidence disagrees with this thinking; 70% of actively managed funds under-perform when compared to the S&P 500. A typical actively managed mutual fund expense ratio is around 2%; the Vanguard S&P Index Fund charges expenses ratios of .18%. This difference, multiplied across 40 years of Roth-IRA investing, will cost you over $700,000 (assuming a 10% return and annual contributions of $4000).

So, from most to least liquid, here are the four accounts you should have:

Cash-back credit card for daily expenditures: As with most things monetary, a responsible individual can benefit greatly due to the fact that people are irresponsible. Credit card companies make such bank on those who carry balances that they will offer huge incentives to get people to sign up for their card, knowing that enough people will end up paying extremely high interest that they will make it back and more. Thus, there are credit cards that pay over 1.5% cash back on every purchase. Often, you can use your credit card for rent, utilities, insurance, and most other daily purchases, and 1.8% back on $5000 a month is over $1000 a year. Put the savings in a high-yield savings account, and that’s another $55. Of course, you must commit to never carry a balance, or your savings will get eaten up pretty quickly. Credit cards also bring convenience, are actually safer (for you) than writing checks, and will help build a credit history.

Checking account for bill-paying: The first attribute this account should have is that it should be free. Everything, including the checks, can be free. Competition from the advent of online banking and higher interest rates have eliminated most all fees associated with checking accounts. There are many incentives, including reasonable interest rates, IPOD Nanos, and cash rewards for opening accounts. You will also want this account to have a local branch so that you can make physical deposits. The third service your checking account must allow is the ability for online savings accounts to transfer money in and out of your checking account with no fees. USBank has free checking with great online services, including free bill pay services and easy transfers between other savings accounts.

High-Yield online savings account: There are a few online banks that provide 4.5% + interest savings accounts. I use ING Direct, as they were the first. I’ve been very happy with them as they are convenient, probably more secure than your local branch, and pay 4.5% right now. Citibank also has a savings account that pays around 5%; Chase pays around that as well. HSBC offers over 5%. These accounts are easy to establish and often provide incentives as well. They work by “attaching” themselves electronically to your checking account via a routing and account number. You can move money back and forth within 2-3 days. Thus, you get a great return and great liquidity. A little planning allows you to keep almost all of your day-to-day money earning interest. And seeing real money show up at the end of every month encourages saving.

Roth Individual Retirement Account and long-term saving: The Roth IRA is where the “taxes suck” principle comes in. Individual Retirement Accounts, or IRA’s, are an effort by the government to provide tax incentives to save. They do this by allowing you to either: 1) in the case of the traditional IRA, invest your pre-tax income and pay interest on the principle at retirement, or 2) invest taxed earnings and realize the earnings tax-free. Either way you pay taxes on the earnings, but you don’t pay taxes on the gains from your investment. If you are worth less now (financially) than you will be at retirement, a Roth is the way to go because you will pay taxes according to your tax bracket at the time you realize the gain. If you are in school right now, you probably don’t pay any income tax. This is a great time to sock money away in a Roth. Of course, our good government’s generosity with our money has limits—as of 2007, you can only invest 4000 annually in your IRA. However, your spouse can also own an IRA and put an additional 4000 in it. This works out to 333.33 per account per month, and a great way to save is to set up an automatic withdrawal from your checking or savings account.

IRA’s are just tax arrangements; they aren’t actually “investments” as they are only accounts. The “investment” is the purchase of an asset that you plan to hold, in the case of an IRA account, until retirement. You can put most all financial instruments into an IRA account. What to invest in can seem like a daunting question, but it need not be. This is where the third rule comes in: diversify your investment portfolio and buy and hold. Determine what your goal is. If you want to get rich quick and easy, you will need more information than you will find here (or almost anywhere). While it is true that some professionals make a ridiculous amount of money engaging in what could be called “active” investing (I watch them make literally hundreds of thousands a day) you are not one of those people! If you want to buy and sell individual securities, do it as part of a larger, diversified investing strategies. If you really want to speculate, make sure it is with money you aren’t particularly attached to.

If your goal is financial security at the latter end of your career and a comfortable retirement, look no further than index funds and, depending on how many years you have until retirement, fixed-income securities like treasury bonds. The S&P 500 has provided an average annual return of 12% over the last 40 years. If you max out your IRA for both you and your spouse over 40 years of saving (8000 per year total), and the market performs like it did over the last 40, you will retire with $6,136, 731.26. Not too shabby. Once you have this much money, you can live extremely comfortably on the interest from your savings. When you retire, you should shift your investment vehicle over to municipal bonds. Expect a return of around 5% at this point. That will provide an annual income of over $300,000 that you can spend on whatever you want. But until then, don’t touch it.

I’ve heard some respond to this plan negatively, claiming that inflation will eat up their returns. This is foolish. If you don’t invest, you will have no money in 40 years regardless of the inflation rate. Some retirement is better than none. It is true that if you don’t continually contribute at an inflated rate, inflation will reduce your real annual return by the inflation rate. Historically, we’ve had inflation of 3-4%, so, if you are assuming inflation of 4% annually, you should also plan on increasing your savings by that amount. You will be no worse off in real terms, because your income will increase proportionately.

I recommend going to www.vanguard.com and looking around at your investment options. Start off with an S&P Index Fund and set up an automatic withdrawal from your savings. Had you done this last year at this time, and invested 333 per month for only the first half of the year, you would have made $800 by years end. That’s the awesome thing about saving; you see the benefits surprisingly quickly. I would also recommend getting some kind of financial software such as Quicken and track all of your accounts, including credit cards and cash. It will calculate your net worth and give you a benchmark to measure yourself against. This becomes your measure of financial security. It will control all aspects of your spending and saving and keep you from falling into the “plastic trap” of not realizing that you are getting poorer every time you swipe your card. Set a yearly net-worth goal through your retirement. At first, this might be depressing. But, it is reality, and ignoring it won’t help you.