Monday, March 19, 2007

Make it Easy - Your Financial Plan, Part 2

Let's review the 5 steps to a solid financial plan that were discussed in Part 1 of this article. The 5 steps in order are:

1) Eliminate all credit card debt

2) Contribute to a 401 K plan if possible up to the limit of the match

3) Save some money

4) Build an emergency fund

5) Invest in a one Stock Index Fund and one Bond Fund

Now, let's explore these 5 steps in a little more detail:

(1) Eliminate all credit card debt – Average credit card debt costs for interest are over 13 % for a standard credit card. If you pay off this debt, you essentially guarantee yourself on average a return on 13 %. Guaranteed! I would gladly accept this guaranteed rate of return on my investments. I think a certain peace of mind will also be obtained.

(2) Contribute to a 401 K plan if possible up to the limit of the match – If you are fortunate to get a match on your 401K, this is a great deal. Many companies will match something such as half on the first 6 % that you put in from your paycheck. This match equates to a 50 % return right off the bat. Most likely, you may also make your paycheck contribution as a pre tax deduction and saves some taxes also. If this option is not available to you, skip to the next step.

(3) Save some money - If you want a solid financial plan, you have to find a way to save some money. Those savings can be the 401K Plan discussed above. Or it can be a number of other things such as a Christmas Club, an automatic mutual fund monthly deduction or hiding money in the mattress (not my preference but if it works for you and you save, it is far better than no savings). Many articles are available of how to save and ways to save. But the message is – find a way to save.

(4) Build an Emergency Fund – This step goes hand in hand with items 2 and 3. It would be good if the emergency fund could be separate from the 401K. But if that is not practical, the 401 K could serve as the emergency fund. Note that you will pay a tax penalty for a withdrawal from a 401 K plan if your are less that 59 ½ years old. The emergency fund would cover about 6 months expenses and be in something like short term Certificate of Deposits (CDs) or a money market fund that can be readily turned into cash in your pocket. Many money market funds are available that are currently paying over 5 % interest.

(5) Invest in a one Stock Index Fund and one Bond Fund – If you have made it this far, you are now ready for an investment in a stock and bond mutual fund. I think that you can do very well with just 2 funds (one stock and one bond fund). For the stock fund, I would recommend a no load, low cost mutual fund that tracks the total stock market index or Wilshire 5000 Index. The cost annually is only about 0.25% (that is right, about ¼ of 1 percent). This cost equates annually to $2.50 (yes, two dollars and 50 cents) for every one thousand dollars invested. This Index fund will essentially give you the same return as the stock market in any given year with miniscule effort and cost on your part. A good no load bond fund will give you a smaller return on average than the stock fund but with less ups and downs (known as volatility). Now, there are lots of investment choices (probably too many) but all your really need are these two investments. Now many people spend their career attempting to beat the market and some do. However, in any given year, about 70 % of mutual funds fail to beat the stock market average return. Now if you love to study the stock market and companies and are willing to study for many hours, you can be more complicated with no guarantee of a better result. However, in terms of the return on your investment for the amount of time invested it is hard to beat a stock index fund and a simple bond fund. For the large majority of investors, this approach is clearly superior in my mind and allows you to minimize costs thus keeping more in your pocket or account. This approach does require patience to just put the money in the fund and leave it there. While Ibbotson Associates tells us that stocks have returned about 11% on average over the past 80 years, we also know that the majority of investors are unable to achieve this level of performance. Why is that? Because they trade far too often, moving in and out of the market in reaction to all kinds of news, rumors and emotions.

A simple way to determine the percentage to put in each fund is to subtract your age from 110 and put that amount in the stock fund. For example, if you are 40 years old, then put 70% (110-40) into the stock index fund and the remaining 30% in the bond fund. I particularly like the Vanguard family of funds. Now many experts may disagree with my approach but think about their motives. Many of these experts are making commissions off your investing activity and there is nothing for them to gain in my approach.

The steps are easy. The discipline may be harder. But with one step at a time, you can build a solid yet simple financial plan for now and for your future. There is no time like the present, why not start today? If not now, then when?

No comments: