Saving and Investing - Real Life Scenarios
After paying down debt, how should you allocate any remaining money you have? The first thing to think about is how soon you will need the money. The sooner you will need the money, the less risk you will want to assume. So, if you are saving for a down payment on your first home and you would like to purchase a home in the next 5 years, you will want a low risk investment, like CDs, short term bonds or short term US Treasury Notes. On the other hand, if you are saving for retirement 30 years from now, you can invest in asset classes with higher risk (and long term higher return), like stocks and longer term bonds. The higher risk asset classes, such as stocks, may go up or down in any given year, but over the long term will typically earn a higher return than lower risk assets like CDs.
OK, so once you decide when you’ll need the money, how should you invest it. If it’s not needed for a long time, should you invest it all in high risk / high reward investments like stocks? Not necessarily. Most investment professionals will tell it’s a bit safer to invest in a mix of asset classes to counter balance each other when one type of asset declines in value. For example, bonds or real estate may go up in value as stock come down, but not always. In general, it is desirable to diversify your investments across multiple asset classes to reduce risk. For example, allocate your savings to some bonds, some stocks, some real estate. Ok, but how much and which ones to select? Let’s start with some typical scenarios and investment strategies.
Saving for your Child’s College Education:
Since your child will attend college most likely around age 18, you don’t want to start saving for college when he or she is 15. It doesn’t leave you enough time to save enough money. The best approach is to start when they are born – even if you only save a little each year. The value of interest year on top of year (called compounding) can generate a lot of earnings. Furthermore, if you place the money in a Section 529 College savings plan (offered by large investing firms like Fidelity, Vanguard, T Rowe Price, etc.), you will not pay any federal or state income tax on the earnings. Instead, you can use all of that interest and saved tax to pay for major college expense like room, board and tuition. These type of funds usually charge a low management fee and offer age appropriate funds based on birth year. To maximize earnings and minimize risk, they typically are made up of high stock percentage (e.g. 95%) in early years and gradually reduce stock and increase more liquid asset types (CDs, US Treasuries, short term bonds) as your child grows older. This allows you to have the comfort of knowing a stock market dip or recession wont impact your availability of funds when your child starts college. Another risk reduction strategy is that these types of funds will diversify their investments of stocks and bonds across many companies to avoid the risk that one company’s financial failure or bankruptcy does not cause disaster for you. Normally they will create funds that track a basket of stocks – like S&P 500, Dow Jones Industrial average or Russell 2000 stock indexes.
Saving for Your First Home:
We discussed this a little earlier, but let’s dig in some more. For most people, a home is the single biggest investment you will make in your entire life. That sounds a little scary, but with a little common sense approach, it can also be the most valuable investment you ever make. While home prices do tend to go up in the long run, they also tend to fluctuate up and down significantly. Be patient and time your home price right - when prices are down. It’s easy to panic when you see home prices rising rapidly, but remember what physicist Isaac Newton said – what goes up must come down. Surges in home prices are often triggered by drops in interest rates. This often happens when the economy is in or headed for a recession. The US Federal Reserve bank lowers interest rates to stimulate borrowing by companies that will in turn invest in new plants and equipment and hire workers. The problem for home buyers is that sellers figure that if you pay less to borrow mortgage money (lower interest rates), you can afford to pay more for the home. So, they raise the price of homes. A prospective buyer can still afford to pay the same monthly amount, but that payment is going to pay off the now higher priced home (since the lower interest rates reduce the amount of interest payable each month). Normally, it’s a good thing to pay less interest, but in this case you are also having to pay more for the home itself. Let’s take an example. Let’s say a home cost $100,000 and you will pay $20,000 cash down payment and need to borrow $80,000 at 7% interest rate (via a home mortgage). Suddenly interest rates go down to 4% due to an impending recession and the home price jumps 50% to $150,000. You’ll pay $30,000 cash and borrow $120,000. It would have been better to pay the higher 7% interest rate on only $80,000 than it would be to now have to pay off $120,000 in debt. So, it’s best to try to time your home purchase when home prices are relatively depressed due to a recession or other reasons. Also, even if you have a higher interest rate, you can typically refinance to a lower rate (when interest rates go down) or even pay off your mortgage earlier and avoid the interest altogether. Some other suggestions regarding home purchases are:
- Don’t get emotionally attached to a prospective new home because you like some feature about it or are just excited to be buying your first home. Always be ready to walk away form the opportunity if it does not make financial sense.
- First 3 rules of home purchase are Location, Location, Location. A home in a desirable location near school, park, easy commute, quiet street, easy access to food shopping, etc.) will tend to retain and increase value much more than another home.
Saving to buy a car:
There are entire books devoted to this topic, but let me share a few basic financial thoughts. Use these as a starting guide to do more research on your particular situation.
- Think of buying a car as an investment. Will the car help me travel to a job that allows me to earn more money? Will the make / model of car I want to buy retain its value or does it have a poor reputation? Does the car get good gas mileage? Am I buying a car that is practical (seats my whole family, relatively inexpensive, good mileage) or am I buying a toy? Do I really need a truck that has poor gas mileage and only seats 3 people? Do I really need a luxury model sports car that costs a lot initially and to maintain? Many people buy a car for psychological reasons – to improve their image / status. Don’t fool yourself.
- Do you need a car or is it a “nice to have”? If you live in an urban area, the cost of parking, insurance, garage can be high. If you can use public transportation to get to work / school, consider renting a car when you need to go out of town.
- Can I afford a new car or should I buy a used car? New cars have the benefit or never having been abused by a previous owner, but cost more. If you can’t afford a new car, or if you have a trusted friend, relative or neighbor who you know has regularly maintained the vehicle (and may even give you good price), consider buying from them. Cars of elderly people often have very low mileage and have been regularly maintained. Elderly people, unfortunately reach a point where it is no longer safe for them to drive. Often in the preceding immediately, years, they drive very little (< 5,000 miles per year).
- If you do buy a used car, make sure it you have it thoroughly inspected by a mechanic you trust.
- Buying a used car from a car dealer should come with a multi-year warranty for any major repair. You will pay extra to buy from a dealer, but it could be worth peace of mind. Make sure it is a reputable dealer.
- Should I buy or lease a car. Understanding the complexity of car leasing arrangements is beyond the majority of many car buyers. Lease are designed to get you to buy or pay more than you should, but it seems like less because it’s a lower monthly payment. The more likely situation is that you will be paying more money in the long run. If you can’t afford to buy the car all at once, as most people can’t, consider taking a loan from the dealer, your employer or bank. In times when automobile purchases are slow, auto manufacturers often provide low to no interest loans. Also, auto manufacturers often offer rebates on new cars to improve their sales. Make sure you know what incentives the manufacturer is providing before you start negotiating with a dealer. Often the dealer will make it look like they are giving you really good price, but they are in fact just passing a long a manufacturer’s rebate you are going to get anyway.
- All car purchases are negotiable. Auto manufacturers publish a MSRP (Manufacturer’s Suggested Retail Price) as a starting [price. In hard economic times, you can usually purchase below MSRP and get manufacturers rebates. In better times, you may have to pay a premium above the MSRP. Ask the dealer to tell you the price first. Don’t answer the question “how much are you willing to pay?” He’s the seller and should name the price. Always be willing to walk away. Ask for a lower price at least 3 times. You can find out the dealers cost of the car (“Invoice price”) on internet web sites like Kelly’s Blue Book, Edmunds or others. Offer the dealer invoice price + a small profit ($400 – $800) – minus the manufacturers rebates. Try buying the same car at multiple dealers. See who offers the best price.
- If you have an older car to trade in, try selling your trade in separately / privately on ypur own. While it is convenient to trade in the old car, the dealer will be looking to take advantage of you by paying you less for the trade in than the car is worth. Another typical trick si for the dealer to offer you a great trade in price, but then build a higher profit into the lease of the new car.
- If you are going to lease a car, make sure you understand “residual value” (how much it will cost you to buy out the lease (you own the car) at the end of the lease period. Also, how many miles are you allowed to drive each year, and how much will it cost if you exceed the allowed miles? The key comparison to make is the “final total price to buy the car” vs the total lease cost (down payment + (monthly cost x the number of months) + residual buy out price.
Saving for Retirement:
The most important thing to know about saving for retirement is that you should do it early – no matter how small the amount. The time value of multiple years of interest over your natural working lifespan will generate a surprisingly large sum of money when you are ready to retire.
The next best thing to know is that if you save for retirement under the umbrella of tax deferred IRA or 401k savings plan, you will earn interest on the deferred federal taxes. Also, when you do finally pay the tax (upon withdrawal when you are retired), there is a good chance you will be in a lower tax bracket and therefore pay less taxes. You can open an IRA (Individual Retirement Account) as an individual –-provided you have taxable income. You don’t need your employer to create a plan that you can join. Many employers do, however, have employee 401k savings plans, that allow you to say a certain portion of your salary each month. In many cases, the employer will also match your contribution typically up to 6%. If you don’t take advantage of these plans, you are literally throwing money away.
Ok, so you are going to save for retirement and you will save under a tax deferred IRA or 401k. The next question is what type of investment should I invest in – stocks, bonds, high yield money market?
The most typical advice you will hear is that if you are young, allocate a larger percent of your savings into stocks – perhaps, 70-90%. Don’t invest in single stocks because it is too risky of that company does poorly or goes bankrupt. Instead, invest in a portfolio of stocks such as an S%P 500 index fund – typically offered in all employer 401k funds and also available from large investment firms such as Fidelity Investments, Vanguard, Charles Schwab, T. Rowe Price. Make sure you invest in an IRA to take advantage of earnings on the deferred federal taxes. Invest the other 10-30% of your savings in more liquid (immediately available with no loss of original investment) funds like intermediate bond funds or US Treasuries (also typically available for purchase on major investment firms). Bonds can also be bought through bond funds made up of the bonds of multiple companies in order to reduce the risk of an individual company failure. Bond funds are typically sold as short term (1-3 years), intermediate (4-6 years) or long term funds (7+ years). Some state or municipal bond funds are also designed to offer immunity from state or local taxes as the underlying companies are typically cities or states that can exempt you from local income taxes. Whether you invest in stock or bond funds, make sure you read the fund’s prospectus, which describes the objectives, types of investments, management fees and risks.
As you get older, move your savings to a more liquid investment like bonds and US Treasuries. A good rule of thumb is approximately, 60% stock / 40% bonds by the time you retire. You’ll need to start spending some of this money once you no longer are working and receiving a pay check. After retirement as you approach your golden years, higher liquid percentage is typically recommended since your fund balance is low and you normally need the money sooner.
So, these are some initial thoughts and strategies to give you foundation for exploring more on your own. Hopefully, you found them useful and can put them to use to improve your family’s financial future.
Written by Francis Daly. Fran is a Life Science Business Technology Executive. He earned a Bachelor of Science degree in Business and Spanish from the State University of New York - Oneonta, and a Master’s of Business Administration in Finance from Fairleigh-Dickinson University. Fran is a Certified Public Accountant and has extensive experience working in the pharmaceutical and life sciences industry over the last 40 years, working for Schering-Plough Pharmaceuticals, Revlon, and Apps Associates.