Invest and prosper

I recently ran across a comprehensive retirement planning tutorial. It is free and available on The Motley Fool right here. The covered topics include:

1. Choosing retirement date
2. Sources of retirement income
3. Saving and investing for retirement
4. Calculating retirement income needs
5. Calculating how much one needs to save
6. Tax issues

The material is presented very clearly and I found the tutorial easy to navigate. I have not yet found a better source of retirement information that is free, easy to read and assembled in one place. I highly recommend it.

This website focuses mainly on independent investing. Yet, there are instances when one may want to hire a financial professional.

Why hire a financial professional? One’s portfolio may be too big to effectively self-manage. Perhaps one is too busy to devote the necessary time to portfolio self-management. One may also want to have professional experience on his or her side.

But whom does one hire? John G. Wells, in his book “Kiss Your Stockbroker Goodbye: A Guide to Independent Investing,” suggests working exclusively with fee-only advisers. The reasons for this are as follows:

1. The fee-only adviser has no ulterior motive in making investment transactions, since transactions themselves do not affect the fee-only adviser’s income.
2. The fee-only adviser has a vested interest in making money for clients, since the fee-only adviser’s income is directly affected by the performance of the client’s portfolio.

A fee-only adviser typically charges a percentage of the value of the portfolio that he or she manages. Therefore, if a client’s portfolio grows in value, a fee-only adviser is rewarded with a higher fee. Conversely, if a client’s portfolio diminishes in value, a fee-only adviser is penalized with a lower fee.

On the other hand, a commission-based adviser generates his or her income by making transactions. This means that whenever a client (you) purchases or sells investment products, the commission-based advisor makes money. Thus, a commission-based adviser gets paid regardless of whether or not he or she makes you money. This seems far from ideal.

Working with professionals -part 2 will follow shortly.

I think that one should start investing as early as possible. What happens if you delay investing for just one year? You miss the growth of the money you would have invested that year for the entire duration of your investment. Therefore, even if you are earning a fairly low income, it may still be worth the hassle to find a few extra bucks to invest.

Let’s consider the following scenarios.

In 2008, the maximum you can invest in a Roth IRA is $5,000. Let’s say you invest this entire amount in a Roth IRA (which is tax-exempt), put it in an index fund earning 11% annually, and never contribute anything again. You will, based on past market performance, had approximately $114,461 in 30 years.

If you leave the money in the bank savings account at 5% interest, which is then taxed at 25% every year, you will end up with only $15,087 in 30 years. Please keep in mind that 5% interest in the savings account is most likely not sustainable for 30 years!

If you realize your mistake quickly and after 1 year, take this money out of your savings account and put it in a Roth IRA for the remaining 29 years, you will have only $106,996 at the end of 30 years. That’s a $7,465 or more than 6.5% difference!

Do you have your emergency cash fund set up? Are your high-interest credit card and other loans paid off? Are all your bills paid as well? Barring some unforeseen circumstance and if you fit eligibility requirements, you may want to consider investing some of your remaining money in a Roth IRA.

I think that most beginning investors should start by investing in an index fund. There are several reasons for this:

1. Diversification - it is not easy to assemble a well-diversified portfolio by collecting individual stocks. An index fund, on the other hand, is already extremely diversified. For instance, Vanguard 500 Index fund (VFINX) tracks the persormance of the S&P 500 index, which includes - you guessed it - 500 stocks. Standard & Poor has already done the job of picking 500 excellent large US companies, so you wouldn’t have to.
2. Tax efficiency - index funds very rarely sell stock; companies do not get kicked out of S&P 500 too often. Therefore, the chance that an index fund will distribute capital gains to you is very small. On the other hand, some actively managed mutual funds will sell stock often; if they sell stocks at a profit, the capital gains will be distributed to you, sticking you with a tax bill.
3. Ease of administration - this one is easy. Watching an index fund is not as labor-intensive as watching a portfolio of 10 different stocks. In addition, you do not have to follow an index fund as closely. The net result is that you save time, effort and possibly money that your occasional lapses in attention could cost you.
4. Low transaction costs - if you buy a number of shares of an index fund, you pay one commission charge. If you buy 10 different stocks, you pay 10 commission charges. Enough said.
5. Returns - Only one in three actively managed stock funds in operation since 1976 has beaten the Vanguard 500. You can be in the top third of the returns of all professional money managers by simply owning an S&P 500 index fund!
6. Low volatility - an index fund is extremely unlikely to plummet in value with the same speed than any individual stock or even a 5-10 stock portfolio. Sure, it can’t increase in value with the same speed either - but to most people, losing money quickly is of more concern than missing out on making even more money.

Short answer: stocks. Here’s why.

Over the long run, stocks massively outperform real estate. To see a chart of the performance of S&P 500 vs. the real estate market in 10 largest US metropolitan areas, from 1980 to 2005, on Forbes.com, click here.

Performance is not the only reason why stocks are a much better long term investment than real estate. Stocks (and ETFs and mutual funds) are much less expensive to buy, sell and own (discount brokers now charge very low commissions without any annual or inactivity fees). In addition, a stock portfolio can be diversified; real estate, since it represents a single asset class, lacks diversification. The time and effort one needs to expend to own real estate can be tremendous - think finding, inspecting, negotiating for and buying the property, maintenance and repairs, dealing with tenants if a property is a rental, as well as the hassle of selling it.

References (which are also suggested reading):

1. Stocks vs. Real Estate, CNNMoney.com
2. Real Estate Vs. Stocks, Forbes.com