Protecting Your Assets

You may be at risk of making a catastrophic investing mistake: not protecting
your assets properly due to a lack of various insurance coverages. Manny,
a successful entrepreneur, made this exact error. Starting from scratch, he
built up a successful million-dollar business. He invested a lot of his own personal money and sweat into building the business over 15 years.
One day, catastrophe struck: An explosion ripped through his building, and
the ensuing fire destroyed virtually all the firm’s equipment and inventory,
none of which was insured. The explosion also seriously injured several
workers, including Manny, who didn’t carry disability insurance. Ultimately,
Manny had to file for bankruptcy.
Decisions regarding what amount of insurance you need to carry are, to some
extent, a matter of your desire and ability to accept financial risk. But some
risks aren’t worth taking. Don’t overestimate your ability to predict what accidents and other bad luck may befall you.
Here’s what you need to protect yourself and your assets:
✓ Major medical health insurance: I’m not talking about one of those policies that pays $100 a day if you need to go into the hospital, or cancer
insurance, or that $5,000 medical expense rider on your auto insurance
policy. I know it’s unpleasant to consider, but you need a policy that
pays for all types of major illnesses and major medical expenditures.
Consider taking a health plan with a high deductible, which can minimize your premiums. Also consider channeling extra money into a
Health Savings Account (HSA), which provides tremendous tax breaks.
As with a retirement account, contributions provide an upfront tax
break, and money can grow over the years in an HSA without taxation.
You can also tap HSA funds without penalty or taxation for a wide range
of current health expenses.
✓ Adequate liability insurance on your home and car to guard your
assets against lawsuits: You should have at least enough liability insurance to protect your net worth (assets minus your liabilities/debts) or,
ideally, twice your net worth. If you run your own business, get insurance for your business assets if they’re substantial, such as in Manny’s
case. Also consider professional liability insurance to protect against
a lawsuit. You may also want to consider incorporating your business.
✓ Long-term disability insurance: What would you (and your family) do
to replace your income if a major disability prevents you from working?
Even if you don’t have dependents, odds are that you are dependent on
you. Most larger employers offer group plans that have good benefits
and are much less expensive than coverage you’d buy on your own.
Also, check with your professional association for a competitive
group plan.
✓ Life insurance, if others are dependent on your income: If you’re single
or your loved ones can live without your income, skip life insurance. If
you need coverage, buy term insurance that, like your auto and home
insurance, is pure insurance protection. The amount of term insurance
you need to buy largely depends on how much of your income you want
to replace.
✓ Estate planning: At a minimum, most people need a simple will to delineate to whom they would like to leave all their worldly possessions. If
you hold significant assets outside retirement accounts, you may also
benefit from establishing a living trust, which keeps your money from
filtering through the hands of probate lawyers. Living wills and medical powers of attorney are useful to have in case you’re ever in a medically incapacitated situation. If you have substantial assets, doing more
involved estate planning is wise to minimize estate taxes and ensure the
orderly passing of your assets to your heirs.
In my experience as a financial counselor, I’ve seen that although many
people lack particular types of insurance, others possess unnecessary policies. Many people also keep very low deductibles. Remember to insure
against potential losses that would be financially catastrophic for you —
don’t waste your money to protect against smaller losses. (See the latest
edition of my book Personal Finance For Dummies, published by John Wiley
& Sons, Inc., to discover the right and wrong ways to buy insurance, what to
look for in policies, and where to get good policies.)

Allocating college investments

If you keep up to 80 percent of your investment money in stocks (diversified
worldwide) with the remainder in bonds when your child is young, you can
maximize the money’s growth potential without taking extraordinary risk. As
your child makes his way through the later years of elementary school, you
need to begin to make the mix more conservative — scale back the stock percentage to 50 or 60 percent. Finally, in the years just before entering college,
whittle the stock portion down to no more than 20 percent or so.

How to pay for college

If you keep stashing away money in retirement
accounts, it’s reasonable for you to wonder
how you’ll actually pay for education expenses
when the momentous occasion arises. Even
if you have some liquid assets that can be
directed to your child’s college bill, you will, in
all likelihood, need to borrow some money. Only
the affluent can truly afford to pay for college
with cash.
One good source of money is your home’s
equity. You can borrow against your home at
a relatively low interest rate, and the interest is
generally tax-deductible. Some company retirement plans — 401(k)s, for example — allow
borrowing as well.
A plethora of financial aid programs allow
you to borrow at reasonable interest rates.
The Unsubsidized Stafford Loans and Parent
Loans for Undergraduate Students (PLUS), for
example, are available, even when your family
isn’t deemed financially needy. In addition to
loans, a number of grant programs are available
through schools and the government as well as
through independent sources.
Complete the Free Application for Federal
Student Aid (FAFSA) to apply for the federal
government programs. Grants available through

state government programs may require a separate application. Specific colleges and other
private organizations, including employers,
banks, credit unions, and community groups,
also offer grants and scholarships.
Many scholarships and grants don’t require
any work on your part — simply apply for such
financial aid through your college. However,
you may need to seek out other programs as
well — check directories and databases at
your local library, your kid’s school counseling
department, and college financial aid offices.
Also try local organizations, churches, employers, and so on, because you have a better
chance of getting scholarship money through
these avenues than through countrywide scholarship and grant databases.
Your child also can work and save money
during high school and college for school. In
fact, if your child qualifies for financial aid,
she’s generally expected to contribute a certain amount to education costs from employment (both during the school year and summer
breaks) and from savings. Besides giving your
gangly teen a stake in her own future, this training encourages sound personal financial management down the road.

Section 529 plans

Also known as qualified state tuition plans, Section 529 plans offer a taxadvantaged way to save and invest more than $100,000 per child toward
college costs (some states allow upward of $300,000 per student). After you
contribute to one of these state-based accounts, the invested funds grow
without taxation. Withdrawals are also tax free so long as the funds are used
to pay for qualifying higher educational costs (which include college, graduate school, and certain additional expenses of special-needs students). The
schools need not be in the same state as the state administering the Section
529 plan.
As I discuss in the previous section dealing with Education Savings Accounts,
Section 529 plan balances can harm your child’s financial aid chances. Thus,
such accounts make the most sense for affluent families who are sure that
they won’t qualify for any type of financial aid. If you do opt for an ESA and
intend to apply for financial aid, you should be the owner of the accounts (not
your child) to maximize qualifying for financial aid.

Education Savings Accounts

Be careful about funding an Education Savings Account (ESA), a relatively new
savings vehicle. In theory, an ESA sounds like a great place to park some college savings. You can make nondeductible contributions of up to $2,000 per
child per year, and investment earnings and account withdrawals are free of
tax as long as you use the funds to pay for elementary and secondary school
or college costs. However, funding an ESA can undermine your child’s ability
to qualify for financial aid. It’s best to keep the parents as the owners of such
an account for financial aid purposes, but be forewarned that some schools
may treat money in an ESA as a student’s asset.

Treading Carefully When Investing for College

Many well-intentioned parents want to save for their children’s future educational expenses. The mistake they often make, however, is putting money in
accounts in their child’s name (in so-called custodial accounts) or saving outside of retirement accounts in general.
The more money you accumulate outside tax-sheltered retirement accounts,
the less assistance you’re likely to qualify for from federal and state financial
aid sources. Don’t make the additional error of assuming that financial aid
is only for the poor. Many middle-income and even some modestly affluent
families qualify for some aid, which can include grants and loans available,
even if you’re not deemed financially needy.
Under the current financial needs analysis that most colleges use in awarding financial aid, the value of your retirement plan is not considered an asset.
Money that you save outside of retirement accounts, including money in the
child’s name, is counted as an asset and reduces eligibility for financial aid.
Also, be aware that your family’s assets, for purposes of financial aid determination, also generally include equity in real estate and businesses that you
own. Although the federal financial aid analysis no longer counts equity in
your primary residence as an asset, many private (independent) schools continue to ask parents for this information when they make their own financial
aid determinations. Thus, paying down your home mortgage more quickly
instead of funding retirement accounts can harm you financially. You may
end up with less financial aid and pay more in taxes.
Don’t forgo contributing to your own retirement savings plan(s) in order to
save money in a non-retirement account for your children’s college expenses.
When you do, you pay higher taxes both on your current income and on the
interest and growth of this money. In addition to paying higher taxes, you’re
expected to contribute more to your child’s educational expenses (because
you’ll receive less financial aid).
If you plan to apply for financial aid, it’s a good idea to save non-retirement
account money in your name rather than in your child’s name (as a custodial
account). Colleges expect a greater percentage of money in your child’s name
(35 percent) to be used for college costs than money in your name (6 percent). Remember, though, that from the standpoint of getting financial aid,
you’re better off saving inside retirement accounts.
However, if you’re affluent enough that you expect to pay for your cherub’s
full educational costs without applying for financial aid, you can save a bit
on taxes if you invest through custodial accounts. Prior to your child reaching age 19, the first $1,900 of interest and dividend income is taxed at your
child’s income tax rate rather than yours. After age 19 (for full-time students,
it’s those under the age of 24), all income that the investments in your child’s
name generate is taxed at your child’s rate.

Easing into risk: Dollar cost averaging

Dollar cost averaging (DCA) is the practice of investing a regular amount
of money at set time intervals, such as monthly or quarterly, into volatile
investments, such as stocks and stock mutual funds. If you’ve ever deducted
money from a paycheck and pumped it into a retirement savings plan investment account that holds stocks and bonds, you’ve done DCA.
Most people invest a portion of their employment compensation as they earn
it, but if you have extra cash sitting around, you can choose to invest that
money in one fell swoop or to invest it gradually via DCA. The biggest appeal
of gradually feeding money into the market via DCA is that you don’t dump all
your money into a potentially overheated investment just before a major drop.
Thus, DCA helps shy investors psychologically ease into riskier investments.
DCA is made to order for skittish investors with large lump sums of money sitting in safe investments like CDs or savings accounts. For example, using DCA,
an investor with $100,000 to invest in stock funds can feed her money into
investments gradually — say, at the rate of $12,500 or so quarterly over two
years — instead of investing her entire $100,000 in stocks at once and possibly
buying all of her shares at a market peak. Most large investment companies,
especially mutual funds, allow investors to establish automatic investment
plans so the DCA occurs without an investor’s ongoing involvement.
Of course, like any risk-reducing investment strategy, DCA has drawbacks.
If growth investments appreciate (as they’re supposed to), a DCA investor
misses out on earning higher returns on his money awaiting investment.
Finance professors Richard E. Williams and Peter W. Bacon found that
approximately two-thirds of the time, a lump-sum stock market investor
earned higher first-year returns than an investor who fed the money in
monthly over the first year. (They studied data from the U.S. market over the
past seven decades.)
However, knowing that you’ll probably be ahead most of the time if you
dump a lump sum into the stock market is little solace if you happen to invest
just before a major plunge in prices. In the fall of 1987, the U.S. stock market,
as measured by the Dow Jones Industrial Average, plummeted 36 percent,
and from late 2007 to early 2009, the market shed 55 percent of its value.
So investors who fear that stocks are due for such a major correction should
practice DCA, right? Well, not so fast. Apprehensive investors who shun
lump-sum investments and use DCA are more likely to stop the DCA investment process if prices plunge, thereby defeating the benefit of doing DCA
during a declining market.
So what’s an investor with a lump sum of money to do?
✓ First, weigh the significance of the lump sum to you. Although $100,000
is a big chunk of most people’s net worth, it’s only 10 percent if your
net worth is $1,000,000. It’s not worth a millionaire’s time to use DCA
for $100,000. If the cash that you have to invest is less than a quarter of
your net worth, you may not want to bother with DCA.
✓ Second, consider how aggressively you invest (or invested) your
money. For example, if you aggressively invested your money through
an employer’s retirement plan that you roll over, don’t waste your time
on DCA.
DCA makes sense for investors with a large chunk of their net worth in cash
who want to minimize the risk of transferring that cash to riskier investments, such as stocks. If you fancy yourself a market prognosticator, you can
also assess the current valuation of stocks. Thinking that stocks are pricey
(and thus riper for a fall) increases the appeal of DCA.
If you use DCA too quickly, you may not give the market sufficient time for a
correction to unfold, during and after which some of the DCA purchases may
take place. If you practice DCA over too long of a period of time, you may miss
a major upswing in stock prices. I suggest using DCA over one to two years to
strike a balance.
As for the times of the year that you should use DCA, mutual fund investors
should use DCA early in each calendar quarter because mutual funds that
make taxable distributions tend to do so late in the quarter.
Your money that awaits investment in DCA should have a suitable parking
place. Select a high-yielding money market fund that’s appropriate for your
tax situation.
One last critical point: When you use DCA, establish an automatic investment
plan so you’re less likely to chicken out. And for the more courageous, you may
want to try an alternative strategy to DCA — value averaging, which allows you
to invest more if prices are falling and invest less if prices are rising.
Suppose, for example, that you want to value average $500 per quarter into
an aggressive stock mutual fund. After your first quarterly $500 investment,
the fund drops 10 percent, reducing your account balance to $450. Value
averaging suggests that you invest $500 the next quarter plus another $50 to
make up the shortfall. (Conversely, if the fund value had increased to $550
after your first investment, you would invest only $450 in the second round.)
Increasing the amount that you invest requires confidence when prices fall,
but doing so magnifies your returns when prices ultimately turn around.

Making the most of your investment options

No hard-and-fast rules dictate how to allocate the percentage that you’ve
earmarked for growth among specific investments like stocks and real estate.
Part of how you decide to allocate your investments depends on the types of
investments that you want to focus on. As I discuss, diversifying
in stocks worldwide can be prudent as well as profitable.
Here are some general guidelines to keep in mind:
✓ Take advantage of your retirement accounts. Unless you need accessible money for shorter-term non-retirement goals, why pass up the free
extra returns from the tax benefits of retirement accounts?
✓ Don’t pile your money into investments that gain lots of attention.
Many investors make this mistake, especially those who lack a thoughtout plan to buy stocks.  I provide numerous illustrations of
the perils of buying attention-grabbing stocks.
✓ Have the courage to be a contrarian. No one likes to feel that he is
jumping on board a sinking ship or supporting a losing cause. However,
just like shopping for something at retail stores, the best time to buy
something of quality is when its price is reduced.
✓ Diversify.the values of different investments
don’t move in tandem. So when you invest in growth investments, such
as stocks or real estate, your portfolio’s value will have a smoother ride
if you diversify properly.
✓ Invest more in what you know. Over the years, I’ve met successful
investors who have built substantial wealth without spending gobs of
their free time researching, selecting, and monitoring investments. Some
investors, for example, concentrate more on real estate because that’s
what they best understand and feel comfortable with. Others put more
money in stocks for the same reason. No one-size-fits-all code exists for
successful investors. Just be careful that you don’t put all your investing eggs in the same basket (for example, don’t load up on stocks in the
same industry that you believe you know a lot about).

Considering your age

When you’re younger and have more years until you plan to use your money,
you should keep larger amounts of your long-term investment money in
growth (ownership) vehicles, such as stocks, real estate, and small business.
As I discuss in Chapter 2, the attraction of these types of investments is the
potential to really grow your money. The risk: The value of your portfolio can
fall from time to time.
The younger you are, the more time your investments have to recover from
a bad fall. In this respect, investments are a bit like people. If a 30-year-old
and an 80-year-old both fall on a concrete sidewalk, odds are higher that the
younger person will fully recover and the older person may not. Such falls
sometimes disable older people.
A long-held guiding principle says to subtract your age from 110 and invest the
resulting number as a percentage of money to place in growth (ownership)
investments. So if you’re 35 years old:
110 – 35 = 75 percent of your investment money can be in growth
investments.
If you want to be more aggressive, subtract your age from 120:
120 – 35 = 85 percent of your investment money can be in growth
investments.
Note that even retired people should still have a healthy chunk of their
investment dollars in growth vehicles like stocks. A 70-year-old person may
want to totally avoid risk, but doing so is generally a mistake. Such a person
can live another two or three decades. If you live longer than anticipated, you
can run out of money if it doesn’t continue to grow.

These tips are only general guidelines and apply to money that you invest for

the long term (ideally for ten years or more). For money that you need to use

in the shorter term, such as within the next several years, more-aggressive

growth investments aren’t appropriate. See Chapters 7 and 8 for short-term

investment ideas.

Knowing what’s taxed and when to worry

Interest you receive from bank accounts and corporate bonds is generally
taxable. U.S. Treasury bonds pay interest that’s state-tax-free. Municipal
bonds, which state and local governments issue, pay interest that’s federaltax-free and also state-tax-free to residents in the state where the bond is
issued.
Taxation on your capital gains, which is the profit (sales minus purchase
price) on an investment, works under a unique system. Investments held
less than one year generate short-term capital gains, which are taxed at your
normal marginal rate. Profits from investments that you hold longer than 12
months are long-term capital gains. These long-term gains cap at 15 percent,
except for those in the two lowest tax brackets of 10 and 15 percent. For
these folks, the long-term capital gains tax rate is just 5 percent.
Use these strategies to reduce the taxes you pay on investments that are
exposed to taxation:
✓ Opt for tax-free money markets and bonds. If you’re in a high enough
tax bracket, you may find that you come out ahead with tax-free investments. Tax-free investments yield less than comparable investments
that produce taxable earnings, but because of the tax differences, the
earnings from tax-free investments can end up being greater than what
taxable investments leave you with. In order to compare properly, subtract what you’ll pay in federal as well as state taxes from the taxable
investment to see which investment nets you more.
✓ Invest in tax-friendly stock funds. Mutual funds that tend to trade less
tend to produce lower capital gains distributions. For mutual funds
held outside tax-sheltered retirement accounts, this reduced trading
effectively increases an investor’s total rate of return. Index funds are
mutual funds that invest in a relatively static portfolio of securities, such
as stocks and bonds (this is also true of some exchange-traded funds).
They don’t attempt to beat the market. Rather, they invest in the securities to mirror or match the performance of an underlying index, such as
the Standard & Poor’s 500 (which I discuss in Chapter 5). Although
index funds can’t beat the market, the typical actively managed fund
doesn’t either, and index funds have several advantages over actively
managed funds. See Chapter 8 to find out more about tax-friendly stock
mutual funds, which includes some non-index funds, and exchangetraded funds.
✓ Invest in small business and real estate. The growth in value of business and real estate assets isn’t taxed until you sell the asset. Even then,
with investment real estate, you often can roll over the gain into another
property as long as you comply with tax laws. However, the current
income that small business and real estate assets produce is taxed as
ordinary income.
Short-term capital gains (investments held one year or less) are taxed at your
ordinary income tax rate. This fact is another reason that you shouldn’t trade
your investments quickly (within 12 months).

Figuring your tax bracket

You may not know it, but the government charges you different tax rates for
different parts of your annual income. You pay less tax on the first dollars of
your earnings and more tax on the last dollars of your earnings. For example,
if you’re single and your taxable income totaled $50,000 during 2011, you
paid federal tax at the rate of 10 percent on the first $8,500, 15 percent on the
taxable income above $8,500 up to $34,500, and 25 percent on income above
$34,500 up to $50,000.
Your marginal tax rate is the rate of tax that you pay on your last, or so-called
highest, dollars of income. In the example of a single person with taxable
income of $50,000, that person’s federal marginal tax rate is 25 percent. In
other words, he effectively pays a 25 percent federal tax on his last dollars of
income — those dollars earned between $34,500 and $50,000. (Don’t forget to
factor in the state income taxes that most states assess.)
Knowing your marginal tax rate allows you to quickly calculate the following:
✓ Any additional taxes that you would pay on additional income
✓ The amount of taxes that you save if you contribute more money into
retirement accounts or reduce your taxable income (for example, if you
choose investments that produce tax-free income)

Choosing retirement account investments

When you establish a retirement account, you may not realize that the retirement account is simply a shell or shield that keeps the federal, state, and
local governments from taxing your investment earnings each year. You
still must choose what investments you want to hold inside your retirement
account shell.
You may invest your IRA or self-employed plan retirement account (SEP-IRAs,
Keoghs) money into stocks, bonds, mutual funds, and even bank accounts.
Mutual funds (offered in most employer-based plans), are an ideal choice because they offer diversification and professional management. After you decide which financial institution you want
to invest through, simply obtain and complete the appropriate paperwork for
establishing the specific type of account you want. (Flip to the later section
“Choosing the Right Investment Mix” for more information.)

Taming Your Taxes in NonRetirement Accounts
When you invest outside of tax-sheltered retirement accounts, the profits and
distributions on your money are subject to taxation. So the non-retirement
account investments that make sense for you depend (at least partly) on
your tax situation.
If you have money to invest, or if you’re considering selling current investments that you hold, taxes should factor into your decision. But tax considerations alone shouldn’t dictate how and where you invest your money. You
should also weigh investment choices, your desire and the necessity to take risk, personal likes and dislikes, and the number of years you plan to hold the
investment (see the “Choosing the Right Investment Mix” section, later in the
chapter, for more information on these other factors).

Annuities

If you’ve contributed all you’re legally allowed to contribute to your IRA
accounts and still want to put away more money for retirement, consider annuities. Annuities are contracts that insurance companies back. If you, the annuity
holder (investor), should die during the so-called accumulation phase (that is,
prior to receiving payments from the annuity), your designated beneficiary is
guaranteed reimbursement of the amount of your original investment.
Annuities, like IRAs, allow your capital to grow and compound tax deferred.
You defer taxes until you withdraw the money. However, unlike an IRA that
has an annual contribution limit of a few thousand dollars, you can deposit
as much as you want in any year to an annuity — even millions of dollars, if
you’ve got it! However, as with a Roth IRA, you get no upfront tax deduction
for your contributions.
Because annuity contributions aren’t tax-deductible, and because annuities
carry higher annual operating fees to pay for the small amount of insurance
that comes with them, don’t consider contributing to one until you’ve fully
exhausted your other retirement account investing options. Because of their
higher annual expenses, annuities generally make sense only if you have 15 or
more years to wait until you need the money.

IRAs

If you work for a company that doesn’t offer a retirement savings plan, or
if you’ve exhausted contributing to your company’s plan, consider an individual retirement account (IRA). Anyone with employment income (or who
receives alimony) may contribute up to $5,000 each year to an IRA (or the
amount of your employment or alimony income if it’s less than $5,000 in a
year). If you’re a nonworking spouse, you’re eligible to put up to $5,000 per
year into a spousal IRA. Those age 50 and older can put away up to $6,000 per
year (effective in 2011).
Your contributions to an IRA may or may not be tax-deductible. For tax year
2011, if you’re single and your adjusted gross income is $56,000 or less for the
year, you can deduct your full IRA contribution. If you’re married and you file
your taxes jointly, you’re entitled to a full IRA deduction if your AGI is $90,000
per year or less.
If you can’t deduct your contribution to a standard IRA account, consider
making a contribution to a nondeductible IRA account called the Roth IRA.
Single taxpayers with an AGI less than $107,000 and joint filers with an AGI less
than $169,000 can contribute up to $5,000 per year to a Roth IRA. Those age 50
and older can contribute $6,000. Although the contribution isn’t deductible,
earnings inside the account are shielded from taxes, and, unlike a standard
IRA, qualified withdrawals from the account are free from income tax.

Company-based plans

If you work for a for-profit company, you may have access to a 401(k) plan,
which typically allows you to save up to $16,500 per year (for tax year 2011).
Many nonprofit organizations offer 403(b) plans to their employees. As with
a 401(k), your contributions to 403(b) plans are deductible on both your federal and state taxes in the year that you make them. Nonprofit employees can
generally contribute up to 20 percent or $16,500 of their salaries, whichever
is less. In addition to the upfront and ongoing tax benefits of these retirement
savings plans, some employers match your contributions.
Older employees (defined as being at least age 50) can contribute even more
into these company-based plans — up to $22,000 in 2011. Of course, the challenge for many people is to reduce their spending enough to be able to sock
away these kinds of contributions.
If you’re self-employed, you can establish your own retirement savings
plans for yourself and any employees that you have. In fact, with all types
of self-employment retirement plans, business owners need to cover their
employees as well. Simplified employee pension individual retirement accounts
(SEP-IRA) and Keogh plans allow you to sock away about 20 percent of your
self-employment income (business revenue minus expenses), up to an annual
maximum of $49,000 (for tax year 2011). Each year, you decide the amount
you want to contribute — no minimums exist (unless you do a Money
Purchase Pension Plan type of Keogh).
Keogh plans require a bit more paperwork to set up and administer than
SEP-IRAs. Unlike SEP-IRAs, Keogh plans allow vesting schedules that require
employees to remain with the company a number of years before they earn
the right to their retirement account balances. (If you’re an employee in a
small business, you can’t establish your own SEP-IRA or Keogh — that’s up to
your employer.) Many plans also allow business owners to exclude employees
from receiving contributions until they complete a year or two of service.

If an employee leaves prior to being fully vested, his unvested balance
reverts to the remaining Keogh plan participants. Keogh plans also allow for
Social Security integration, which effectively allows those in the company who
earn high incomes (usually the owners) to receive larger-percentage contributions for their accounts than the less highly compensated employees.
The logic behind this idea is that Social Security taxes and benefits top out
after you earn $106,800 (for tax year 2011). Social Security integration allows
higher-income earners to make up for this ceiling.
Owners of small businesses shouldn’t deter themselves from doing a retirement plan because employees may receive contributions, too. If business
owners take the time to educate employees about the value and importance
of these plans in saving for the future and reducing taxes, they’ll see it as a
rightful part of their total compensation package.

Checking out retirement account options

If you earn employment income (or receive alimony), you have options for
putting money away in a retirement account that compounds without taxation until you withdraw the money. In most cases, your contributions to
these retirement accounts are tax-deductible.

Starting your savings sooner

The common mistake that many investors make is neglecting to take advantage of retirement accounts because of their enthusiasm to spend or invest in
non-retirement accounts. Not investing in tax-sheltered retirement accounts
can cost you hundreds, perhaps thousands, of dollars per year in lost tax savings. Add that loss up over the many years that you work and save, and not
taking advantage of these tax reduction accounts can easily cost you tens of
thousands to hundreds of thousands of dollars in the long term. Ouch!
To take advantage of retirement savings plans and the tax savings that
accompany them, you must first spend less than you earn. Only then can you
afford to contribute to these retirement savings plans (unless you already
happen to have a stash of cash from previous savings or inheritance).
The sooner you start to save, the less painful it is each year to save enough
to reach your goals. Why? Because your contributions have more years to
compound.
Each decade you delay saving approximately doubles the percentage of your
earnings that you need to save to meet your goals. For example, if saving 5
percent per year in your early 20s gets you to your retirement goal, waiting
until your 30s to start may mean socking away 10 percent to reach that same
goal; waiting until your 40s, 20 percent. Beyond that, the numbers get truly
daunting.

If you enjoy spending money and living for today, you should be more motivated to start saving sooner. The longer that you wait to save, the more you

ultimately need to save and, therefore, the less you can spend today!

Gaining tax benefits

Retirement accounts should be called “tax-reduction accounts” — if they
were, people may be more motivated to contribute to them. Contributions
to these plans are generally deductible on both your federal and state taxes.
Suppose that you pay about 35 percent between federal and state income
taxes on your last dollars of income. (See the section “Determining your tax
bracket” later in this chapter.) With most of the retirement accounts that I
describe in this chapter, you can save yourself about $350 in taxes for every
$1,000 that you contribute in the year that you make your contribution.

After your money is in a retirement account, any interest, dividends, and
appreciation grow inside the account without taxation. With most retirement
accounts, you defer taxes on all the accumulating gains and profits until you
withdraw your money down the road, which you can do without penalty after
age 591⁄2. In the meantime, more of your money works for you over a long
period of time. In some cases, such as with the Roth IRAs described later in
this chapter, withdrawals are tax free, too.
The good, old U.S. government now provides a tax credit for lower-income
earners who contribute up to $2,000 into retirement accounts. The maximum
credit of 50 percent applies to the first $2,000 contributed for single taxpayers with an adjusted gross income (AGI) of no more than $17,000 and married couples filing jointly with an AGI of $34,000 or less. Singles with an AGI
of between $17,000 and $18,250 and married couples with an AGI between
$34,000 and $36,500 are eligible for a 20 percent tax credit. Single taxpayers
with an AGI of more than $18,250 but no more than $28,250 and married couples with an AGI between $36,500 and $56,500 can get a 10 percent tax credit.

Funding Your Retirement Accounts

Saving money is difficult for most people. Don’t make a tough job impossible
by forsaking the tax benefits that come from investing through most retirement accounts.

Determining your investment tastes

Many good investing choices exist: You can invest in real estate, the stock
market, mutual funds, exchange-traded funds, or your own or some else’s
small business. Or you can pay down mortgage debt more quickly. What
makes sense for you depends on your goals as well as your personal preferences. If you detest risk-taking and volatile investments, paying down your
mortgage, as recommended earlier in this chapter, may make better sense
than investing in the stock market.
To determine your general investment tastes, think about how you would
deal with an investment that plunges 20 percent, 40 percent, or more in a
few years or less. Some aggressive investments can fall fast. You shouldn’t go into the stock market, real estate, or smallbusiness investment arena if such a drop is likely to cause you to sell low or
make you a miserable, anxious wreck. If you haven’t tried riskier investments
yet, you may want to experiment a bit to see how you feel with your money
invested in them.
A simple way to “mask” the risk of volatile investments is to diversify your
portfolio — that is, to put your money into different investments. Not watching prices too closely helps, too — that’s one of the reasons real estate investors are less likely to bail out when the market declines. Stock market
investors, unfortunately from my perspective, can get daily and even minuteby-minute price updates. Add that fact to the quick phone call or click of your
computer mouse that it takes to dump a stock in a flash, and you have all the
ingredients for short-sighted investing — and potential financial disaster.

Investing as couples

You’ve probably learned over the years how
challenging it is just for you to navigate the
investment maze and make sound investing
decisions. When you have to consider someone else, dealing with these issues becomes
doubly hard given the typically different money
personalities and emotions that come into play.
In most couples with whom I’ve worked as a
financial counselor, usually one person takes primary responsibility for managing the household
finances, including investments. As with most
marital issues, the couples that do the best job
with their investments are those who communicate well, plan ahead, and compromise.
Here are a couple of examples to illustrate my
point. Martha and Alex scheduled meetings
with each other every three to six months to discuss financial issues. With investments, Martha
came prepared with a list of ideas, and Alex
would listen and explain what he liked or disliked about each option. Alex would lean toward
more aggressive, growth-oriented investments,
whereas Martha preferred conservative, less
volatile investments. Inevitably, they would
compromise and develop a diversified portfolio that was moderately aggressive. Martha
and Alex worked as a team, discussed options,
compromised, and made decisions they were
both comfortable with. Ideas that made one of
them very uncomfortable were nixed.
Henry and Melissa didn’t do so well. The only
times they managed to discuss investments

were in heated arguments. Melissa often criticized what Henry was doing with their money.
Henry got defensive and counter-criticized
Melissa for other issues. Much of their money
lay dormant in a low-interest bank account, and
they did little long-term planning and decision
making. Melissa and Henry saw each other
as adversaries, argued and criticized rather
than discussed, and were plagued with inaction because they couldn’t agree and compromise. They needed a motivation to change their
behavior toward each other and some counseling (or a few advice guides for couples) to make
progress with investing their money.
Aren’t your long-term financial health and marital harmony important? Don’t allow your problems to fester! Remember what the famous
psychologist Dr. Phil McGraw says about problems and making changes: “You can’t change
what you don’t acknowledge.” I couldn’t agree
more with this assessment when it comes to
money problems, including investing issues.
In my work as a financial counselor, one of the
most valuable and difficult things I did for couples stuck in unproductive patterns of behavior
was to help them get the issue out on the table.
For these couples, the biggest step was making
an appointment to discuss their financial management. Once they did, I could get them to
explain their different points of view and then
offer compromises.

If you don’t know how to evaluate and reduce your spending or haven’t
thought about your retirement goals, looked into what you can expect from
Social Security, or calculated how much you should save for retirement,
now’s the time to do so. Pick up the latest edition of my book Personal
Finance For Dummies (John Wiley & Sons, Inc.) to find out all the necessary
details for retirement planning and much more.

Establishing Your Financial Goals

You may have just one purpose for investing money, or you may desire to
invest money for several different purposes simultaneously. Either way, you
should establish your financial goals before you begin investing. Otherwise,
you won’t know how much to save.
For example, when I was in my 20s, I put away some money for retirement,
but I also saved a stash so I could hit the eject button from my job in management consulting. I knew that I wanted to pursue an entrepreneurial path and
that in the early years of starting my own business, I couldn’t count on an
income as stable or as large as the one I made from consulting.
I invested my two “pots” of money — one for retirement and the other for
my small-business cushion — quite differently. As I discuss in the section
“Choosing the Right Investment Mix” later in this chapter, you can afford
to take more risk with the money that you plan on using longer term. So I
invested the bulk of my retirement nest egg in stock mutual funds.
With the money I saved for the start-up of my small business, I took an
entirely different track. I had no desire to put this money in risky stocks —
what if the market plummeted just as I was ready to leave the security of my
full-time job? Thus, I kept this money safely invested in a money market fund
that had a decent yield but didn’t fluctuate in value.

Consider your investment opportunities

When evaluating whether to pay down your mortgage faster, you need to
compare your mortgage interest rate with your investments’ rates of return. Suppose you have a fixed-rate mortgage with an
interest rate of 6 percent. If you decide to make investments instead of paying
down your mortgage more quickly, your investments need to produce an average annual rate of return, before taxes, of about 6 percent to come out ahead
financially. (This comparison, technically, should be done on an after-tax
basis, but the outcome is unlikely to change.)
Besides the most common reason of lacking the money to do so, other good
reasons not to pay off your mortgage any quicker than necessary include
the following:

✓ You instead contribute to your retirement accounts, such as a 401(k),
an IRA, or a Keogh plan (especially if your employer offers matching
money). Paying off your mortgage faster has no tax benefit. By contrast,
putting additional money into a retirement plan can immediately reduce
your federal and state income tax burdens. The more years you have
until retirement, the greater the benefit you receive if you invest in your
retirement accounts. Thanks to the compounding of your retirement
account investments without the drain of taxes, you can actually earn a
lower rate of return on your investments than you pay on your mortgage
and still come out ahead. (I discuss the various retirement accounts in
detail in the “Funding Your Retirement Accounts” section later in this
chapter.)
✓ You’re willing to invest in growth-oriented, volatile investments,
such as stocks and real estate. In order to have a reasonable chance of
earning more on your investments than it costs you to borrow on your
mortgage, you must be aggressive with your investments. As I discuss
in Chapter 2, stocks and real estate have produced annual average rates
of return of about 8 to 10 percent. You can earn even more by creating
your own small business or by investing in others’ businesses. Paying
down a mortgage ties up more of your capital, and thus reduces your
ability to make other attractive investments. To more aggressive investors, paying off the house seems downright boring — the financial equivalent of watching paint dry.
You have no guarantee of earning high returns from growth-type investments, which can easily drop 20 percent or more in value over a year
or two.
✓ Paying down the mortgage depletes your emergency reserves.
Psychologically, some people feel uncomfortable paying off debt more
quickly if it diminishes their savings and investments. You probably
don’t want to pay down your debt if doing so depletes your financial
safety cushion. Make sure that you have access — through a money
market fund or other sources (a family member, for example) — to at
least three months’ worth of living expenses (as I explain in the earlier
section “Establishing an Emergency Reserve”).
Don’t be tripped up by the misconception that somehow a real estate market
downturn, such as the one that most areas experienced in the mid- to late
2000s, will harm you more if you pay down your mortgage. Your home is
worth what it’s worth — its value has nothing to do with your debt load.
Unless you’re willing to walk away from your home and send the keys to
the bank (also known as default), you suffer the full effect of a price decline,
regardless of your mortgage size, if real estate prices drop.

Don’t get hung up on mortgage tax deductions
Although it’s true that mortgage interest is usually tax-deductible, don’t
forget that you must also pay taxes on investment profits generated outside
of retirement accounts (if you do forget, you’re sure to end up in trouble with
the IRS). You can purchase tax-free investments like municipal bonds , but over the long haul, such bonds and other types of lending
investments (bank savings accounts, CDs, and other bonds) are unlikely to
earn a rate of return that’s higher than the cost of your mortgage.
And don’t assume that those mortgage interest deductions are that great.
Just for being a living, breathing human being, you automatically qualify for
the so-called “standard deduction” on your federal tax return. In 2011, this
standard deduction was worth $5,800 for single filers and $11,600 for married
people filing jointly. If you have no mortgage interest deductions — or have
fewer than you used to — you may not be missing out on as much of a writeoff as you think. (Plus, it’s a joy having one less schedule to complete on your
tax return!)

Mitigating your mortgage

Paying off your mortgage more quickly is an “investment” for your spare
cash that may make sense for your financial situation. However, the wisdom
of making this financial move isn’t as clear as paying off high-interest consumer debt; mortgage interest rates are generally lower, and the interest is
typically tax-deductible. When used properly, debt can help you accomplish
your goals — such as buying a home or starting a business — and make you
money in the long run. Borrowing to buy a home generally makes sense. Over
the long term, homes generally appreciate in value.
If your financial situation has changed or improved since you first needed to
borrow mortgage money, you need to reconsider how much mortgage debt
you need or want. Even if your income hasn’t escalated or you haven’t inherited vast wealth, your frugality may allow you to pay down some of your debt
sooner than the lender requires. Whether paying down your debt sooner
makes sense for you depends on a number of factors, including your other
investment options and goals.

Conquering consumer debt

Borrowing via credit cards, auto loans, and the like is an expensive way to
borrow. Banks and other lenders charge higher interest rates for consumer
debt than for debt for investments, such as real estate and business. The
reason: Consumer loans are the riskiest type of loan for a lender.
Many folks have credit card or other consumer debt, such as an auto loan,
that costs 8, 10, 12, or perhaps as much as 18-plus percent per year in interest
(some credit cards whack you with interest rates exceeding 20 percent if you
make a late payment). Reducing and eventually eliminating this debt with your
savings is like putting your money in an investment with a guaranteed tax-free
return equal to the rate that you pay on your debt.
For example, if you have outstanding credit card debt at 15 percent interest,
paying off that debt is the same as putting your money to work in an investment with a guaranteed 15 percent tax-free annual return. Because the interest on consumer debt isn’t tax-deductible, you need to earn more than 15
percent by investing your money elsewhere in order to net 15 percent after
paying taxes. Earning such high investing returns is highly unlikely, and in
order to earn those returns, you’d be forced to take great risk.
Consumer debt is hazardous to your long-term financial health (not to mention damaging to your credit score and future ability to borrow for a home or other wise investments) because it encourages you to borrow against your
future earnings. I often hear people say such things as “I can’t afford to buy
most new cars for cash — look at how expensive they are!” That’s true, new
cars are expensive, so you need to set your sights lower and buy a good used
car that you can afford. You can then invest the money that you’d otherwise
spend on your auto loan.
However, using consumer debt may make sense if you’re financing a business.
If you don’t have home equity, personal loans (through a credit card or auto
loan) may actually be your lowest-cost source of small-business financing.

Evaluating Your Debts

Yes, paying down debts is boring, but it makes your investment decisions
less difficult. Rather than spending so much of your time investigating specific investments, paying off your debts (if you have them and your cash
coming in exceeds the cash going out) may be your best high-return, low-risk
investment. Consider the interest rate you pay and your investing alternatives to determine which debts you should pay off.

Establishing an Emergency Reserve

You never know what life will bring, so having a readily accessible reserve of
cash to meet unexpected expenses makes good financial sense. If you have
a sister who works on Wall Street as an investment banker or a wealthy and
understanding parent, you can use one of them as your emergency reserve.
(Although you should ask them how they feel about that before you count on
receiving funding from them!) If you don’t have a wealthy family member, the
ball’s in your court to establish a reserve.

Should you invest emergency money in stocks?

As interest rates drifted lower during the 1990s,

keeping emergency money in money market

accounts became less and less rewarding.

When interest rates were 8 or 10 percent,

fewer people questioned the wisdom of an

emergency reserve. However, in the late 1990s,

which had low money market interest rates and

stock market returns of 20 percent per year,

more investors balked at the idea of keeping a

low-interest stash of cash.

I began seeing articles that suggested you

simply keep your emergency reserve in stocks.

After all, you can easily sell stocks (especially

those of larger companies) any day the financial markets are open. Why not treat yourself to

the 20 percent annual returns that stock market

investors enjoyed during the 1990s rather than

earning a paltry few percent?

Stocks can drop and have dropped 20, 30, or

50 percent or more over relatively short periods of time. Consider what happened to stock

prices in the early 2000s and then again in the

late 2000s. Suppose that such a drop coincides

with an emergency — such as the loss of your

job, major medical bills, and so on. Your situation may force you to sell at a loss, perhaps a

substantial one.

Here’s another reason not to keep emergency

money in stocks: If your stocks appreciate and

you need to sell some of them for emergency

cash, you get stuck paying taxes on your gains.

I suggest that you invest your emergency

money in stocks (ideally through well-diversified mutual funds) only if you have a relative

or some other resource to tap for money in

an emergency. Having a backup resource for

money minimizes your need to sell your stock

holdings on short notice. As I discuss in Chapter

5, stocks are intended to be a longer-term

investment, not an investment that you expect

(or need) to sell in the near future.

Make sure you have quick access to at least three months’ to as much as six

months’ worth of living expenses. Keep this emergency money in a money

market fund. You may also be able to borrow against your

employer-based retirement account or against your home equity should you

find yourself in a bind, but these options are much less desirable.

If you don’t have a financial safety net, you may be forced into selling an

investment that you’ve worked hard for. And selling some investments,

such as real estate, costs big money (because of transaction costs, taxes,

and so on).

Consider the case of Warren, who owned his home and rented an investment

property in the Pacific Northwest. He felt, and appeared to be, financially successful. But then Warren lost his job, accumulated sizable medical expenses, in Order before You Invest

and had to sell his investment property to come up with cash for living

expenses. Warren didn’t have enough equity in his home to borrow. He didn’t

have other sources — a wealthy relative, for example — to borrow from

either, so he was stuck selling his investment property. Warren wasn’t able

to purchase another investment property and missed out on the large appreciation the property earned over the subsequent two decades. Between the

costs of selling and taxes, getting rid of the investment property cost Warren

about 15 percent of its sales price. Ouch!

Considering Your Goals

How much do you need or want to earn? That may seem like an extraordinarily stupid question for me to ask you! Who doesn’t want to earn a high
return? However, although investing in stocks, real estate, or a small business can produce high long-term returns, investing in these vehicles comes
with greater risk, especially over the short term.

Some people can’t stomach the risk. Others are at a time in their lives when

they can’t afford to take great risk. If you’re near or in retirement, your

portfolio and nerves may not be able to wait a decade for your riskier investments to recover after a major stumble. Perhaps you have sufficient assets to

accomplish your financial goals and are concerned with preserving what you

do have rather than risking it to grow more wealth.

If you work for a living, odds are that you need and want to make your investments grow at a healthy clip. If your investments grow slowly, you may fall

short of your goals of owning a home or retiring or changing careers.

Are smaller-company stock returns higher?

Stocks are generally classified by the size of the

company. Small-company stocks aren’t stocks

that physically small companies issue — they’re

simply stocks issued by companies that haven’t

reached the size of corporate behemoths such

as IBM, AT&T, or Coca-Cola. The Standard &

Poor’s 500 index tracks the performance of 500

large-company stocks in the United States. The

Russell 2000 index tracks the performance of

2,000 smaller-company U.S. stocks.

Small-company stocks have outperformed

larger-company stocks during the past seven

decades. Historically, small-company stocks

have produced slightly higher compounded

annual returns than large-company stocks.

However, nearly all this extra performance is

due to just one high-performance time period,

from the mid-1970s to the early 1980s. If you

eliminate this time period from the data, small

stocks have had virtually identical returns to

those of larger-company stocks.

Also, be aware that small-company stocks can

get hammered in down markets. For example,

during the Great Depression, small-company

stocks plunged more than 85 percent between

1929 and 1932, while the S&P 500 fell 64 percent. In 1937, small-company stocks plummeted

58 percent, while the S&P 500 fell 35 percent.

And in 1969 to 1970, small-company stocks fell

38 percent, while the S&P 500 fell just 5 percent.

Small-business returns

If you have the drive and
determination, you can start your own small business. Or perhaps you have
what it takes to buy an existing small business. If you obtain the necessary
capital and skills to assess opportunities and risk, you can invest in someone
else’s small business.
What potential returns can you get from small business? Small-business
owners like me who do something they really enjoy will tell you that the
nonfinancial returns can be major! But the financial rewards can be attractive
as well.

Every year, Forbes magazine publishes a list of the world’s wealthiest individuals. Perusing this list shows that most of these people built their wealth

by taking a significant ownership stake and starting a small business that

became large. These individuals achieved extraordinarily high returns (often

in excess of hundreds of percent per year) on the amounts they invested to

get their companies off the ground.

You may also achieve potentially high returns from buying and improving an

existing small business. As I discuss in Part IV, such small-business investment returns may be a good deal lower than the returns you may gain from

starting a business from scratch.

Unlike the stock market, where plenty of historic rate-of-return data exists,

data on the success, or lack thereof, that investors have had with investing

in small private companies is harder to come by. Smart venture capitalist

firms operate a fun and lucrative business: They identify and invest money in

smaller start-up companies that they hope will grow rapidly and eventually

go public. Venture capitalists allow outsiders to invest with them via limited

partnerships. To gain entry, you generally need $1 million to invest. (I never

said this was an equal-opportunity investment club!)

Venture capitalists, also known as general partners, typically skim off 20 percent of the profits and also charge limited partnership investors a hefty 2 to

3 percent annual fee on the amount that they’ve invested. The return that’s

left over for the limited partnership investors isn’t stupendous. According to

Venture Economics, venture funds have averaged comparable annual returns

to what stock market investors have earned on average over this same

period. The general partners that run venture capital funds make more than

the limited partners do.

You can attempt to do what the general partners do in venture capital

firms and invest directly in small, private companies. But you’re likely to be

investing in much smaller and simpler companies. Earning venture capitalist

returns isn’t easy to do. If you think that you’re up to the challenge.

Real estate returns

Over the years, real estate has proved to be about as lucrative as investing in
the stock market. Whenever the U.S. has a real estate downturn, folks question this historic fact. However, just as stock
prices have down periods, so too do real estate markets.
The fact that real estate offers solid long-term returns makes sense because
growth in the economy, in jobs, and in population ultimately fuels the
demand for real estate.
Consider what has happened to the U.S. population over the past two centuries. In 1800, a mere 5 million people lived within U.S. borders. In 1900, that
figure grew to 76.1 million, and today, it’s more than 310 million. All these
people need places to live, and as long as jobs exist, the income from jobs
largely fuels the demand for housing.
Businesses and people have an understandable tendency to cluster in major
cities and suburban towns. Although some people commute, most people
and businesses locate near major highways, airports, and so on. Thus, real
estate prices in and near major metropolises and suburbs generally appreciate the most. Consider the areas of the world that have the most expensive
real estate prices: Hong Kong, San Francisco, Los Angeles, New York, and
Boston. What these areas have in common are lots of businesses and people
and limited land.
Contrast these areas with the many rural parts of the United States where the
price of real estate is relatively low because of the abundant supply of buildable land and the relatively lower demand for housing.

Stock returns

Investors expect a fair return on investment. If one investment doesn’t offer
a high enough rate of return, investors can choose to move their money into
other investments that they believe will perform better. Instead of buying a
diversified basket of stocks and holding, some investors frequently buy and
sell, hoping to cash in on the latest hot investment. This tactic seldom works
in the long run.
Unfortunately, some of these investors use a rearview mirror when they purchase their stocks, chasing after investments that have recently performed
strongly on the assumption (and the hope) that those investments will
continue to earn strong returns. But chasing after the strongest performing
investments can be dangerous if you catch the stock at its peak, ready to
begin a downward spiral. You may have heard that the goal of investing is to
buy low and sell high. Chasing high-flying investments can lead you to buy
high, with the prospect of having to sell low if the stock runs out of steam.
Even though stocks as a whole have proved to be a good long-term investment, picking individual stocks is a risky endeavor.arket returns. In fact, in
the U.S. markets, data going back more than two centuries documents the fact
that stocks have been a terrific long-term investment. The long-term returns
from stocks that investors have enjoyed, and continue to enjoy, have been
remarkably constant from one generation to the next.
Going all the way back to 1802, the U.S. stock market has produced an annual
return of 8.3 percent, while inflation has grown at 1.4 percent per year. Thus,
after subtracting for inflation, stocks have appreciated about 6.9 percent
faster annually than the rate of inflation. The U.S. stock market returns have
consistently and substantially beaten the rate of inflation over the years
Stocks don’t exist only in the United States, of course . More
than a few U.S. investors seem to forget this fact, especially during the sizzling performance of the U.S. stock market during the late 1990s. As I discuss
in the earlier section “Diversify for a gentler ride,” one advantage of buying
and holding overseas stocks is that they don’t always move in tandem with
U.S. stocks. As a result, overseas stocks help diversify your portfolio.
In addition to enabling U.S. investors to diversify, investing overseas has
proved to be profitable. The investment banking firm Morgan Stanley tracks
the performance of stocks in both economically established countries and socalled emerging economies. As the name suggests, countries with emerging
economies (for example, Brazil, China, India, Malaysia, Mexico, Russia, South
Korea, and Taiwan) are “behind” economically but show high rates of growth
and progress.

Psychological returns

Profits and tax avoidance can powerfully motivate your investment selections. However, like with other life decisions, you need to consider more than
the bottom line. Some people want to have fun with their investments. Of
course, they don’t want to lose money or sacrifice a lot of potential returns.
Fortunately, less expensive ways to have fun do exist!
Psychological rewards compel some investors to choose particular investment vehicles such as individual stocks, real estate, or a small business.
Why? Because compared with other investments, such as managed mutual
funds, they see these investments as more tangible and . . . well, more fun.
Be honest with yourself about why you choose the investments that you do.
Allowing your ego to get in the way can be dangerous. Do you want to invest
in individual stocks because you really believe that you can do better than
the best full-time professional money managers? Chances are high that you
won’t. Do you like investing in real estate more
because of the gratification you get from driving by and showing off your properties to others than because of their investment rewards? Such questions are
worth considering as you contemplate what investments you want to make.

Bond returns

When you buy a bond, you lend your money to the issuer of that bond (borrower), which is generally the federal government or a corporation, for a specific period of time. When you buy a bond, you expect to earn a higher yield
than you can with a money market or savings account. You’re taking more
risk, after all. Companies can and do go bankrupt, in which case you may lose
some or all of your investment.
Generally, you can expect to earn a higher yield when you buy bonds that
✓ Are issued for a longer term: The bond issuer is tying up your money at
a fixed rate for a longer period of time.
✓ Have lower credit quality: The bond issuer may not be able to repay
the principal.
Wharton School of Business professor Jeremy Siegel has tracked the performance of bonds and stocks back to 1802. Although you may say that what
happened in the 19th century has little relevance to the financial markets and
economy of today, the decades since the Great Depression, which most other
return data track, are a relatively small slice of time.

Savings and money market account returns

You need to keep your extra cash that awaits investment (or an emergency)
in a safe place, preferably one that doesn’t get hammered by the sea of
changes in the financial markets. By default and for convenience, many
people keep their extra cash in a bank savings account. Although the bank
offers the U.S. government’s backing via the Federal Deposit Insurance
Corporation (FDIC), it comes at a high price. Most banks pay a low interest
rate on their savings accounts.
Another place to keep your liquid savings is in a money market mutual fund.
These are the safest types of mutual funds around and, for all intents and
purposes, equal a bank savings account’s safety. The best money market
funds generally pay higher yields than most bank savings accounts. Unlike a
bank, money market mutual funds tell you how much they deduct for the service of managing your money. If you’re in a higher tax bracket, tax-free versions of money market funds exist as well. See Chapter 8 for more on money
market funds.
If you don’t need immediate access to your money, consider using Treasury
bills (T-bills) or bank certificates of deposit (CDs), which are usually issued
for terms such as 3, 6, or 12 months. Your money will surely earn more in one
of these vehicles than in a bank savings account. As rates vary by institution,
it is essential to shop around. The drawback to T-bills and bank certificates of
deposit is that you incur a penalty (with CDs) or a transaction fee (with T-bills)
if you withdraw your investment before the term expires

After-tax returns

Although you may be happy that your stock has given you an 11 percent
return on your invested dollars, remember that unless you held your investment in a tax-sheltered retirement account, you owe taxes on your return.
Specifically, the dividends and investment appreciation that you realize
upon selling are taxed, although often at relatively low rates. The tax rates
on so-called long-term capital gains and stock dividends are lower than the
tax rates on other income. In Chapter 3, I discuss the different tax rates that
affect your investments and explain how to make tax-wise investment decisions that fit with your overall personal financial situation and goals.
If you’ve invested in savings accounts, money market accounts, or bonds,
you owe Uncle Sam taxes on the interest.
Often, people make investing decisions without considering the tax consequences of their moves. This is a big mistake. What good is making money if
the federal and state governments take away a substantial portion of it?
If you’re in a moderate tax bracket, taxes on your investment probably run in the
neighborhood of 30 percent (federal and state). So if your investment returned 7
percent before taxes, you’re left with a return of 4.9 percent after taxes.

Analyzing Returns

When you make investments, you have the potential to make money in a variety of ways. Each type of investment has its own mix of associated risks that
you take when you part with your investment dollar and, likewise, offers a
different potential rate of return. In this section, I cover the returns you
can expect with each of the common investing avenues. But first, I walk
you through the different components of calculating the total return on an
investment.

The components of total return
To figure out exactly how much money you’ve made (or lost) on your investment, you need to calculate the total return. To come up with this figure, you
need to determine how much money you originally invested and then factor
in the other components, such as interest, dividends, and appreciation (or
depreciation).
If you’ve ever had money in a bank account that pays interest, you know that
the bank pays you a small amount of interest when you allow it to keep your
money. The bank then turns around and lends your money to some other
person or organization at a much higher rate of interest. The rate of interest
is also known as the yield. So if a bank tells you that its savings account pays
2 percent interest, the bank may also say that the account yields 2 percent.
Banks usually quote interest rates or yields on an annual basis. Interest that
you receive is one component of the return you receive on your investment.
If a bank pays monthly interest, the bank also likely quotes a compounded
effective annual yield. After the first month’s interest is credited to your
account, that interest starts earning interest as well. So the bank may say
that the account pays 2 percent, which compounds to an effective annual
yield of 2.04 percent.
When you lend your money directly to a company — which is what you do
when you invest in a bond that a corporation issues — you also receive interest. Bonds, as well as stocks (which are shares of ownership in a company),
fluctuate in value after they’re issued.

Inflation ragin’ outta control

You think 6, 8, or 10 percent annual inflation
rates are bad? How would you like to live in a
country that experienced that rate of inflation
in a day? As I discuss in Chapter 4, too much
money in circulation chasing after too few
goods causes high rates of inflation.

reichsmarks. People had to cart around so
much currency that at times they needed
wheelbarrows to haul it! Ultimately, this inflationary burden was too much for the German
society, creating a social climate that fueled the
rise of the Nazi party and Adolf Hitler.

A government that runs amok with the nation’s
currency and money supply usually causes
excessive rates of inflation — dubbed hyperinflation. Over the decades and centuries, hyperinflation has wreaked havoc in more than a few
countries.

During the 1990s, a number of countries, especially many that made up the former U.S.S.R.
and others such as Brazil and Lithuania, got
themselves into a hyperinflationary mess with
inflation rates of several hundred percent per
year. In the mid-1980s, Bolivia’s yearly inflation
rate exceeded 10,000 percent.

What happened in Germany in the late 1910s
and early 1920s demonstrates how bad hyperinflation can get. Consider that during this time
period, prices increased nearly one-billionfold!
What cost 1 reichsmark (the German currency in those days) at the beginning of this
mess eventually cost nearly 1,000,000,000

Governments often try to slap on price controls
to prevent runaway inflation (President Richard
Nixon did this in the United States in the 1970s),
but the underground economy, known as the
black market, usually prevails.

If you don’t continually invest in your education, you risk losing your competitive edge. Your skills and perspectives can become dated and obsolete.
Although that doesn’t mean you should work 80 hours a week and never
do anything fun, it does mean that part of your “work” time should involve
upgrading your skills.
The best organizations are those that recognize the need for continual knowledge and invest in their workforce through training and career development.
Just remember to look at your own career objectives, which may not be the
same as your company’s.

Purchasing-power risk

Increases in the cost of living (that is, inflation) can erode the value of your
retirement resources and what you can buy with that money — also known
as its purchasing power. When Teri retired at the age of 60, she was pleased
with her retirement income. She was receiving an $800-per-month pension
and $1,200 per month from money that she had invested in long-term bonds.
Her monthly expenditures amounted to about $1,500, so she was able to save
a little money for an occasional trip.
Fast-forward 15 years. Teri still receives $800 per month from her pension,
but now she gets only $900 per month of investment income, which comes
from some certificates of deposit. Teri bailed out of bonds after she lost sleep
over the sometimes roller-coaster-like price movements in the bond market.
Her monthly expenditures now amount to approximately $2,400, and she
uses some of her investment principal (original investment). She’s terrified of
outliving her money.
Teri has reason to worry. She has 100 percent of her money invested without
protection against increases in the cost of living. Although her income felt
comfortable in the beginning of her retirement, it doesn’t at age 75, and Teri
may easily live another 15 or more years.

The lowdown on liquidity

The term liquidity refers to how long and at
what cost it takes to convert an investment into
cash. The money in your wallet is considered
perfectly liquid — it’s already cash.
Suppose that you invested money in a handful
of stocks. Although you can’t easily sell these
stocks on a Saturday night, you can sell most
stocks quickly through a broker for a nominal
fee any day that the financial markets are open
(normal working days). You pay a higher percentage to sell your stocks if you use a highcost broker or if you have a small amount of
stock to sell.
Real estate is generally much less liquid than
stock. Preparing your property for sale takes
time, and if you want to get fair market value for
your property, finding a buyer may take weeks

or months. Selling costs (agent commissions,
fix-up expenses, and closing costs) can easily
approach 10 percent of the home’s value.
A privately run small business is among the
least liquid of the better growth investments
that you can make. Selling such a business typically takes longer than selling most real estate.
So that you’re not forced to sell one of your
investments that you intend to hold for longterm purposes, keep an emergency reserve of
three to six months’ worth of living expenses
in a money market account. Also consider
investing some money in highly rated bonds, which pay higher than money
market yields without the high risk or volatility
that comes with the stock market.

Weighing Risks and Returns

Just as individual stock prices can plummet, so can individual real estate
property prices. In California during the 1990s, for example, earthquakes
rocked the prices of properties built on landfills. These quakes highlighted
the dangers of building on poor soil. In the early 1980s, real estate values
in the communities of Times Beach, Missouri, and Love Canal, New York,
plunged because of carcinogenic toxic waste contamination. (Ultimately,
many property owners in these areas received compensation for their losses
from the federal government, as well as from some real estate agencies that
didn’t disclose these known contaminants.)
Here are some simple steps you can take to lower the risk of individual investments that can upset your goals:
✓ Do your homework. When you purchase real estate, a whole host of
inspections can save you from buying a money pit. With stocks, you can
examine some measures of value and the company’s financial condition
and business strategy to reduce your chances of buying into an overpriced company or one on the verge of major problems. Parts II, III, and IV
of this book give you more information on researching your investment.
✓ Diversify. Investors who seek growth invest in securities such as stocks.
Placing significant amounts of your capital in one or a handful of securities is risky, particularly if the stocks are in the same industry or closely
related industries. To reduce this risk, purchase stocks in a variety of
industries and companies within each industry. (See Part II for details.)
✓ Hire someone to invest for you. The best mutual funds (see Chapter 8)
offer low-cost, professional management and oversight as well as diversification. Stock mutual funds typically own 25 or more securities in a
variety of companies in different industries. The best exchange-traded
funds offer similar benefits at low cost. In Part III, I explain how you can
invest in real estate in a similar way (that is, by leaving the driving to
someone else).

Individual-investment risk

A downdraft can put an entire investment market on a roller-coaster ride, but
healthy markets also have their share of individual losers. For example, from
the early 1980s through the late 1990s, the U.S. stock market had one of the
greatest appreciating markets in history. You’d never know it, though, if you
held one of the great losers of that period.
Consider a company now called Navistar, which has undergone enormous
transformations in the past two decades. This company used to be called
International Harvester and manufactured farm equipment, trucks, and
construction and other industrial equipment. Today, Navistar makes
mostly trucks.
In late 1983, this company’s stock traded at more than $140 per share. It then
plunged more than 90 percent over the ensuing decade (as shown in Figure
2-3). Even with a rally in recent years, Navistar stock still trades at less than
$50 per share (after dipping below $10 per share). Lest you think that’s a big
drop, this company’s stock traded as high as $455 per share in the late 1970s!
If a worker retired from this company in the late 1970s with $200,000 invested
in the company stock, the retiree’s investment would be worth about $25,000
today! On the other hand, if the retiree had simply swapped his stock at
retirement for a diversified portfolio of stocks, which I explain how to build in
Part II, his $200,000 nest egg would’ve instead grown to more than $2,800,000!

Tracking your savings rate

In order to accomplish your financial goals (and some personal goals), you
need to save money, and you also need to know your savings rate. Your savings rate is the percentage of your past year’s income that you saved and
didn’t spend. Without even doing the calculations, you may already know
that your rate of savings is low, nonexistent, or negative and that you need to
save more.
Part of being a smart investor involves figuring out how much you need to
save to reach your goals. Not knowing what you want to do a decade or more
from now is perfectly normal — after all, your goals and needs evolve over the
years. But that doesn’t mean you should just throw your hands in the air and
not make an effort to see where you stand today and think about where you
want to be in the future.
An important benefit of knowing your savings rate is that you can better
assess how much risk you need to take to accomplish your goals. Seeing the
amount that you need to save to achieve your dreams may encourage you to
take more risk with your investments.
During your working years, if you consistently save about 10 percent of your
annual income, you’re probably saving enough to meet your goals (unless
you want to retire at a relatively young age). On average, most people need
about 75 percent of their pre-retirement income throughout retirement to
maintain their standards of living.
If you’re one of the many people who don’t save enough, you need to do
some homework. To save more, you need to reduce your spending, increase
your income, or both. For most people, reducing spending is the more feasible way to save.
To reduce your spending, first figure out where your money goes. You may
have some general idea, but you need to have facts. Get out your checkbook
register, examine your online bill-paying records, and review your credit card
bills and any other documentation that shows your spending history. Tally
up how much you spend on dining out, operating your car(s), paying your
taxes, and on everything else. After you have this information, you can begin
to prioritize and make the necessary trade-offs to reduce your spending and
increase your savings rate. Earning more income may help boost your savings
rate as well. Perhaps you can get a higher-paying job or increase the number
of hours that you work. But if you already work a lot, reining in your spending
is usually better for your emotional and economic well-being.

Diversify for a gentler ride

If you worry about the health of the U.S. economy, the government, and the
dollar, you can reduce your investment risk by investing overseas. Most
large U.S. companies do business overseas, so when you invest in larger U.S.
company stocks, you get some international investment exposure. You
can also invest in international company stocks, ideally via mutual funds.
Of course, investing overseas can’t totally protect you. You can’t do much
about a global economic catastrophe. If you worry about the risk of such a
calamity, you should probably also worry about a huge meteor crashing into
Earth. Maybe there’s a way to colonize outer space. . . .
Diversifying your investments can involve more than just your stock portfolio.
You can also hold some real estate investments to diversify your investment
portfolio. Many real estate markets actually appreciated in the early 2000s
while the U.S. stock market was in the doghouse. Conversely, when U.S. real
estate entered a multiyear slump in the mid-2000s, stocks performed well
during that period. In the late 2000s, stock prices fell sharply while real estate
prices in most areas declined, but then stocks came roaring back.

Counting Out Collectibles

The term collectibles is a catchall category for antiques, art, autographs,
baseball cards, clocks, coins, comic books, diamonds, dolls, gems, photographs, rare books, rugs, stamps, vintage wine, writing utensils, and a whole
host of other items.
Although connoisseurs of fine art, antiques, and vintage wine wouldn’t like
the comparison of their pastime with buying old playing cards or chamber
pots, the bottom line is that collectibles are all objects with little intrinsic
value. Wine is just a bunch of old mushed-up grapes. A painting is simply a
canvas and some paint that at retail would set you back a few bucks. Stamps
are small pieces of paper, usually less than an inch square. What about baseball cards? Heck, my childhood friends and I used to stick these between our
bike spokes!
I’m not trying to diminish contributions that artists and others make to the
world’s culture. And I know that some people place a high value on some
of these collectibles. But true investments that can make your money grow,
such as stocks, real estate, or a small business, are assets that can produce
income and profits. Collectibles have little intrinsic value and are thus fully
exposed to the whims and speculations of buyers and sellers. (Of course, as
history has shown and as I discuss elsewhere in this book, the prices of particular stocks, real estate, and businesses can be subject to the whims and
speculations of buyers and sellers, especially in the short-term. Over the
longer-term, however, market prices return to reality and sensible valuations.)
Here are some other major problems with collectibles:
✓ Markups are huge. The spread between the price that a dealer pays for
an object and the price he then sells the same object for is often around
100 percent. Sometimes the difference is even greater, particularly if a
dealer is the second or third middleman in the chain of purchase. So at
a minimum, your purchase must typically double in value just to get you
back to even. And a value may not double for 10 to 20 years or more!
✓ Lots of other costs add up. If the markups aren’t bad enough, some collectibles incur all sorts of other costs. If you buy more-expensive pieces,
for example, you may need to have them appraised. You may have to
pay storage and insurance costs as well. And unlike the markup, you pay
some of these fees year after year of ownership.
✓ You can get stuck with a pig in a poke. Sometimes you may overpay
even more for a collectible because you don’t realize some imperfection
or inferiority of an item. Worse, you may buy a forgery. Even reputable
dealers have been duped by forgeries.
✓ Your pride and joy can deteriorate over time. Damage from sunlight,
humidity, temperatures that are too high or too low, and a whole host of
vagaries can ruin the quality of your collectible. Insurance doesn’t cover
this type of damage or negligence on your part.
✓ The returns stink. Even if you ignore the substantial costs of buying,
holding, and selling, the average returns that investors earn from collectibles rarely keep ahead of inflation, and they’re generally inferior to
stock market, real estate, and small-business investing. Objective collectible return data are hard to come by. Never, ever trust “data” that
dealers or the many collectible trade publications provide.
The best returns that collectible investors reap come from the ability to identify, years in advance, items that will become popular. Do you think you can
do that? You may be the smartest person in the world, but you should know
that most dealers can’t tell what’s going to rocket to popularity in the coming
decades. Dealers make their profits the same way other retailers do — from
the spread or markup on the merchandise that they sell. The public and collectors have fickle, quirky tastes that no one can predict. Did you know that
Beanie Babies, Furbies, Pet Rocks, or Cabbage Patch Kids were going to be
such hits?
You can find out enough about a specific type of collectible to become a
better investor than the average person, but you’re going to have to be among
the best — perhaps among the top 10 percent of such collectors — to have a
shot at earning decent returns. To get to this level of expertise, you need to
invest hundreds if not thousands of hours reading, researching, and educating
yourself about your specific type of collectible.
Nothing is wrong with spending money on collectibles. Just don’t fool yourself into thinking that they’re investments. You can sink lots of your money
into these non-income-producing, poor-return “investments.” At their best
as investments, collectibles give the wealthy a way to buy quality stuff that
doesn’t depreciate.
If you buy collectibles, here are some tips to keep in mind:
✓ Collect for your love of the collectible, your desire to enjoy it, or your
interest in finding out about or mastering a subject. In other words,
don’t collect these items because you expect high investment returns,
because you probably won’t get them.
✓ Keep quality items that you and your family have purchased and hope
that someday they’re worth something. Keeping these quality items is
the simplest way to break into the collectible business. The complete
sets of baseball cards I gathered as a youngster are now (30-plus years
later) worth hundreds of dollars to, in one case, $1,000!
✓ Buy from the source and cut out the middlemen whenever possible. In
some cases, you may be able to buy directly from the artist. My brother,
for example, purchases pottery directly from artists.
✓ Check collectibles that are comparable to the one you have your eye
on, shop around, and don’t be afraid to negotiate. An effective way to
negotiate, after you decide what you like, is to make your offer to the
dealer or artist by phone. Because the seller isn’t standing right next to
you, you don’t feel pressure to decide immediately.
✓ Get a buyback guarantee. Ask the dealer (who thinks that the item is
such a great investment) for a written guarantee to buy back the item
from you, if you opt to sell, for at least the same price you paid or higher
within five years.
✓ Do your homework. Use a comprehensive resource, such as the books
by Ralph and Terry Kovel or their website at www.kovels.com, to
research, buy, sell, maintain, and improve your collectible.

Passing Up Precious Metals

Over the millennia, gold and silver have served as mediums of exchange or
currency because they have intrinsic value and can’t be debased the way
that paper currencies can (by printing more money). These precious metals
are used in jewelry and manufacturing.
As investments, gold and silver perform well during bouts of inflation. For
example, from 1972 to 1980, when inflation zoomed into the double-digit range
in the United States and stocks and bonds went into the tank, gold and silver
prices skyrocketed more than 500 percent. With precious metals pricing zooming upward again since 2000, some have feared the return of inflation.
Over the long term, precious metals are lousy investments. They don’t pay
any dividends, and their price increases may, at best, just keep up with, but
not ahead of, increases in the cost of living. Although investing in precious
metals is better than keeping cash in a piggy bank or stuffing it in a mattress,
the long-term investment returns aren’t nearly as good as bonds, stocks, and
real estate.
One way to earn better long-term returns is to invest in a mutual fund containing the stocks of gold and precious metals companies

Career risk

Your ability to earn money is most likely your single biggest asset, or at least
one of your biggest assets. Most people achieve what they do in the working
world through education and hard work. By education, I’m not simply talking
about what one learns in formal schooling. Education is a lifelong process.
I’ve learned far more about business from my own front-line experiences and
those of others than I’ve learned in educational settings. I also read a lot.

Consider your time horizon

Investors who worry that the stock market may take a dive and take their
money down with it need to consider the length of time that they plan to
invest. In a one-year period in the stock and bond markets, anything can
happen (as shown in Figure 2-1). History shows that you lose money about
once in every three years that you invest in the stock and bond markets.
However, stock market investors have made money (sometimes substantial
amounts) approximately two-thirds of the time over a one-year period. (Bond
investors made money about two-thirds of the time, too, although they made
a good deal less on average.)
Although the stock market is more volatile in the short term than the bond
market, stock market investors have earned far better long-term returns than
bond investors have. (See the “Stock returns” section later in this chapter
for more details.) Why? Because stock investors bear risks that bond investors don’t bear, and they can reasonably expect to be compensated for those
risks. Remember, however, that bonds generally outperform a boring old
bank account.
History has shown that the risk of a stock or bond market fall becomes less of
a concern the longer the period that you plan to invest. As Figure 2-2 shows,
as the holding period for owning stocks increases from 1 year to 3 years to
5 years to 10 years and then to 20 years, the likelihood of stocks increasing
in value increases. In fact, over any 20-year time span, the U.S. stock market,
as measured by the S&P 500 index of larger company stocks, has never lost
money, even after you subtract for the effects of inflation.