“The economy, as measured by gross domestic product, can be expected to grow at an annual rate of about 3 percent over the long term, and inflation of 2 percent would push nominal GDP growth to 5 percent, Buffett said. Stocks will probably rise at about that rate and dividend payments will boost total returns to 6 percent to 7 percent, he said.”

Let’s assume that Buffett is exactly right with his predictions. What does that mean for retirement savings?

First, we have to make a few assumptions. Let’s assume that you’re going to want to be able to withdraw 60% of your salary each year for 25 years out of your retirement savings when you retire, so we’ll use that as a target amount.

We’ll also assume, for convenience, that you’re going to be invested entirely in a broad-based index fund until the day you retire and then you’ll switch everything to more secure investments that will just match inflation.

We’re also going to assume that the return Buffett describes is steady. The stock market is volatile year over year, but over a very long term, it’s not that terrible. I’m also going to assume that you get half of the return during the year you invest it because it’s so steady (since most people contribute throughout the year, not in one lump sum at the end).

We’ll also rip inflation out of the question. Buffett states that a stock market investment will earn about 3% per year outside of inflation plus an additional 1.5% in dividends, so let’s use that. We’ll ignore inflation and assume that the stock market will rise faster if inflation goes up to match it, as Buffett predicts.

So, what we’re left with is that every dollar we put into retirement is going to earn a 4.5% annual return beyond inflation in the stock market – the 3% growth plus 1.5% dividends that Buffett predicts. However, we don’t have to worry about inflation at all – we’re just going to try to match our current salary in retirement.

Let’s say Bob is making $50,000 a year. In order to be able to pull out 60% of that per year for 25 years, Bob will need to have $750,000 in retirement savings. What will Bob have to save each year to make his dream of retiring at age 65 with long-term security come true?

What if Bob is 50? That means he has fifteen years to reach that $750,000 target. To reach that target in that timeframe, Bob would have to sock away $33,000 per year. This would give him $766,607.22 over the course of those fifteen years. Bob would have to put away almost all of his take-home pay into retirement to make that goal, so that’s probably unrealistic.

Let’s back off a bit and say that Bob is 40. That means he has twenty five years to reach that $750,000 target. To reach his target in that timeframe, Bob needs to save $15,500 per year, or about 30% of his annual salary, to make that target. This would give him $753,935.25 after those twenty five years.

What if Bob is 35? To reach that target, Bob needs to save $11,300 per year, giving him $748,165.28 after those thirty years.

What if Bob is 30? To reach the big $750,000 target, Bob merely needs to save $8,500 per year, giving him $748,872.57 at retirement.

Even at age 25, the savings are intense. To reach that target at retirement, Bob needs to sock away $6,500 per year, giving him $750,007.30 at retirement. That’s still 13% of Bob’s salary.

In other words, if you believe in Buffett’s numbers instead some of the more rosy projections, you should be saving as much as possible for retirement.

Why such a different picture than the 10% or 15% suggestions that investment managers often give? Those managers are using overoptimistic approaches, as noted in that article:

“The Standard & Poor’s 500 Index, a benchmark for U.S. stocks, surged 18 percent a year on average from 1982 to 1999. The bull market tainted investor expectations, Buffett said. Polls in the late 1990s showed some investors expected stocks to gain 14 percent to 15 percent a year, he said.

“‘Thinking that in a low-inflation environment is dreaming,’ he said.”

Retirement advice that indicates that you’ll be fine by just saving 10% of your income starting at age 40 is using unrealistic assumptions, at least from Buffett’s perspective.

Save plenty for retirement, and start saving now.

The post Applying Warren Buffett’s 7% Figure to Your Retirement appeared first on The Simple Dollar.

Let’s say, for calculation’s sake, that a car has a life span of 200,000 miles before the maintenance issues catch up with it. For the last 40,000 miles of that drive, the reliability of the car is going to be seriously slipping, but up to that point, the car will be pretty reliable. We’re simply using this example for conversation’s sake. At the end of that life span, we’ll say the car is worthless, just for calculation’s sake.

You can go to a car dealer and buy a new car for $25,000. At this rate, every single mile you put on that car is going to cost you twelve and a half cents in car depreciation. We’ll call this Car A.

Alternately, you can go to a car dealer and buy a car with 100,000 miles on it for $8,000. In this situation, every single mile that you put on that car is going to cost you eight cents in car depreciation. At the 100,000 mile mark, you buy a replacement car for another $8,000, bringing your total car cost to $16,000 over that stretch. We’ll call this Car B.

Clearly, Car B is going to be the best value in this situation. For 200,000 miles of driving, you’re going to save $7,000.

Here’s where it gets trickier, though. In the second situation, you’re going to spend twice as many miles in the “danger zone” of reliability. 40% of the time, your car is going to have questionable reliability in the second scenario, whereas in the first scenario, it’s only in that “danger zone” 20% of the time.

Let’s add in another comparison. Let’s say you just sold off that $25,000 car at the 160,000 mile mark, which is the first time your car repairman told you that your car was starting to wear out. In this situation, your car would depreciate fifteen and five-eights cents every mile. Over the course of 200,000 miles, this plan would cost you $31,250. We’ll call this Car C.

In terms of pure dollars, Car C is going to be the most expensive option and thus the worst investment. If you view the value of a car as being strictly a means of getting from one place to another, Car C is a terrible option.

However, Car C spends no time at all in that reliability “danger zone.” It is constantly reliable.

So, for $31,250, you can have a car that gives you 200,000 with perfect reliability. For $25,000, you can have a car that gives you 200,000 miles with only the last 20% of those miles with poor reliability. Or, for $16,000, you can have a car that gives you 200,000 miles but it’s unreliable 40% of that time. We’re not counting any of the extra costs that occur when the cars are unreliable, either.

Which is the best deal? From a pure dollars and cents perspective, the $16,000 option is going to be the best deal. However, it’s not a reliable deal. It’s the one that’s going to give you the most failure in getting to your destination reliability.

What this decision really turns into is how much do you value reliability? How much more are you willing to spend to increase the reliability of your car and provide more assurance that it will get you to where you want to go over a long period?

Eventually, we always end up attempting to put a dollar sign on something that doesn’t have an exact dollar value.

All of us are in different situations. A single mother with three children, no relatives nearby, and only one car is going to value car reliability a lot more than a married couple with two cars, no children, and family members in town. Our income levels are also going to influence how much money we’re willing to put forth for some attribute that we value.

The biggest key to personal finance success is knowing what attributes are actually worth paying for in your life and which ones are not.

A name brand logo on a non-perishable item at the grocery store is probably not worth paying for (not without the product itself having real advantages). A fast food sandwich might be saving you time, but it’s costing you in food quality – so why not keep a bag of trail mix in your car (it’s faster and probably higher quality food at the same time)?

If you’re paying money for something – particularly when you’re paying more than another option – can you actually explain what you’re paying for? What are you getting that’s worth the extra money?

Sometimes, there’s a great answer to that question, and when you know that answer, it makes the more expensive purchase worthwhile. It’s also the reason why every purchase can’t always be examined through pure dollars and cents.

On the other hand, every time you can’t come up with a reasonable answer to that question immediately, it’s worth rethinking that purchase.

The post Is Every Purchase Merely an Investment? appeared first on The Simple Dollar.

First, I’m assuming that you’re investing for longer than ten years. That’s because in a given year, the stock market is very volatile. Some years see an enormous dip in the stock market, like 2008, when many investments saw a 40% loss. Other years see gains much larger than 7%. It’s only over a longer period that you begin to approach that steady 7% average.

Second, I’m assuming that you’re investing in something that’s very broad-based, like the Vanguard Total Stock Market Index. That 7% return doesn’t apply if you’re just invested in the stocks of one company or just a few companies. Those investments are simply far too volatile.

But where does that 7% number come from?

My primary source for that number comes from Warren Buffett, who claims point-blank in this Bloomberg article that you should expect a 6-7% annual return in the stock market over the long term. In that article, Buffett describes the analysis that led him to that kind of conclusion:

“The economy, as measured by gross domestic product, can be expected to grow at an annual rate of about 3 percent over the long term, and inflation of 2 percent would push nominal GDP growth to 5 percent, Buffett said. Stocks will probably rise at about that rate and dividend payments will boost total returns to 6 percent to 7 percent, he said.”

Didn’t the stock market do far better than that in the past?

“The Standard & Poor’s 500 Index, a benchmark for U.S. stocks, surged 18 percent a year on average from 1982 to 1999. The bull market tainted investor expectations, Buffett said. Polls in the late 1990s showed some investors expected stocks to gain 14 percent to 15 percent a year, he said.

“‘Thinking that in a low-inflation environment is dreaming,’ he said.”

Beyond that, the long-term data for the stock market points to that 7% number as well. For the period 1950 to 2009, if you adjust the S&P 500 for inflation and account for dividends, the average annual return comes out to exactly 7.0%. Check the data for yourself.

Based on these two things – the raw historical data and the analysis of Warren Buffett – I’m willing to use 7% as an estimate of long-term stock market returns.

Still, there’s one big problem. Past performance is no indication of future results. That simple statement is true of any investment. It’s true of almost anything in life.

We can’t anticipate what the future holds. Some people project the latter part of this decade holding an American economic renaissance thanks to our burgeoning energy independence and our long period of low interest loans funding rapid business growth. Others see economic doom in our future.

Nothing is a sure bet. All we can do is put ourselves in the best position we can. For me, that means diversification, with part of that diversification coming in the form of index funds held over the long term.

The post Where Does 7% Come From When It Comes to Long-Term Stock Returns? appeared first on The Simple Dollar.

Everything you need to know about financial planning

Make a will.
Pay off your credit cards.
Get term life insurance if you have a family to support.
Fund your 401(k) to the maximum.
Fund your IRA to the maximum.
Buy a house if you want to live in a house and you can afford it.
Put six months’ expenses in a money market fund.
Take whatever money is left over and invest 70% in a stock index fund and 30% in a bond fund through any discount broker and never touch it until retirement.

If any of this confuses you, or you have something special going on (retirement, college planning, tax issues) hire a fee-based financial planner, not one who charges a percentage of your portfolio.

I largely agree with the ideas presented here and I think that, if your primary goal is to save for early retirement above all else, this is a great plan.

I have just a few small problems with this plan.

First of all, there’s no encouragement to cut out unnecessary expenses. The broad stroke of “take whatever money is left over and invest it” doesn’t point people toward one of the most powerful tools there is for improving their financial state – taking a serious look at their life and cutting back where it makes sense.

It is very easy for anyone to slip into a routine of spending money without any real benefit. We’ll start a Netflix subscription, for example, and keep paying for it even though we rarely use it. Taking a regular hard look at one’s expenses can provide quite a lot of money for investment.

Second, the money market fund idea isn’t a good idea for most people right now. At this point in time, having money in a money market fund is like having money in a savings account that returns only a tiny fraction of a percent and isn’t FDIC insured. There are times when a money market fund is a decent place to store your cash. Right now isn’t one of those times. Use a savings account.

Finally, it doesn’t look at non-retirement goals. Like I said earlier, this is a great plan if you’re saving for early retirement. If you’re not saving for early retirement, you’re going to want to take a different approach to the “money left over” investment and you might not necessarily want to be maxing both your 401(k) and your Roth IRA.

If you have non-retirement goals, I’d say it’s a good goal to be saving 10% of your income for retirement and throw everything else you can toward that non-retirement goal. If that goal is farther off than eight or ten years, then you might want to follow the investment advice above. Otherwise, you’ll probably want to be more conservative than that because stock market volatility makes stock investments much less of a sure thing over a term shorter than eight years. The stock market has leaped and fallen and leaped again like a hyperactive gymnast over the last eight years and over some shorter periods it has seen some devastating losses.

Aside from those quibbles, if you’re looking for a very straightforward plan for financial success, this is a pretty sensible one.

The post Is This Everything You Need To Know About Financial Planning? appeared first on The Simple Dollar.

Many of you pointed me toward this op-ed piece from Forbes Magazine in which the author, Steve Forbes, offered up opinions like this:

Holders of Roth IRAs may be in for a rude shock. Their contributions have been made with aftertax dollars, with the promise that the ensuing benefits would be exempt from federal income tax. Slapping a special “emergency” levy on these assets will become an irresistible temptation for politicians as the pot of assets gets bigger. Impossible? Your Social Security “contributions” are made with aftertax dollars, and it was promised that those benefits would be tax free, but Washington started chipping away at that vow back in the 1980s. Today millions of Social Security recipients find a portion of their benefits subject to the IRS.

and this:

The sobering truth is that there is no safe hiding place to stash your cash, gold or silver other than stuffing ’em under your mattress (and pray that the boxes or bags in which you store the cash can withstand the assaults of rats or mice).

and this:

There are other ways, of course, for governments to get your money—the age-old one being inflation. The Federal Reserve has already stated that it wants to get inflation up to 2.5%. Put aside for the moment the impossibility of concocting a true price index—the Consumer Price Index, for example, allocates less than 1% of the cost of living to health insurance! Inflation, as John Maynard Keynes wrote nine decades ago, is a form of taxation—and, in this case, taxation without representation. Especially invidious is the fact that inflation hits lower-income earners disproportionately hard, as they spend a higher percentage of their income on fuel, electricity and other necessities. If you ever run into a Federal Reserve official, ask him how taxing the American people like this helps stimulate sustainable long-term growth. I’ve done it, and the official always gets flustered.

In one respect, the Forbes article is right: there is nothing that is absolutely secure in this world. There is nothing you can invest in that you can be sure will have any value tomorrow. Your investments could be derailed by terrorist acts, technological innovation, seizure of land by eminent domain, an inflationary spiral, or countless other events.

The best thing you can do as an individual to protect yourself in an uncertain world is to diversify. Don’t put all your eggs in one basket, ever.

From a purely financial angle, that means don’t invest everything you have in any one thing. Split it up widely. Own little bits of everything. Have some cash, have some domestic stocks, have some international stocks, have some bonds, have some real estate, have some precious metals. Don’t have everything in the same kind of account, either, particularly when your investment plan relies on some specific tax benefits.

For most Americans, when we’re talking about investing, we’re often talking about retirement accounts. The easiest way to add diversity to your retirement account is to put your money in a target retirement fund. This will split up your retirement savings among many different investment types, with more risk exposure when you’re younger and less when you’re older. It’s all handled automatically. If you can, have some of your money in a 401(k) and some in a Roth IRA to hedge your bets against an uncertain tax future.

However, diversification doesn’t just refer to one’s investments. Diversification should play a role in many aspects of your life.

Diversify your skills. Build a strong set of transferable skills that will help you no matter what happens to the economy. Work on your communication, your leadership, your project management, your time management, and your information management skills. Those will help you almost everywhere you go in almost any field.

Diversify your relationships. Build lots of relationships in your field, but also outside of your field. Be known as a dependable person and work to build deep connections with people from all walks of life. When things become problematic, you’re going to need to draw on those personal relationships.

Personal skills help with both of these areas. Can you make minor repairs and maintenance on your car? Can you fix a broken toilet or a broken lawnmower? Can you grow your own food? Can you replace a light fixture? Would you know where to start when it comes to fixing a leaky roof? Could you jump right in if someone needed your help with these kinds of tasks?

Personal skills not only build relationships, but they can provide avenues for earning money in many situations.

The events in Cyprus should be a clear signal that diversification is very valuable. However, financial diversification is just the first part of it. Beyond financial diversification (which is quite useful), the more skills you have and the more relationships you have, the better off you’re going to be weathering any storm that comes your way.

The post Could Cyprus Happen Here? What Can We Do? appeared first on The Simple Dollar.

The first factor is risk. How likely is it that you’re going to get the return you expect over the next year, or the next five years? Generally, lower risk is better.

The second factor is liquidity. How easy is it for you to get money out of that investment? The easier it is, the greater that investment’s liquidity. Generally, higher liquidity is better.

The third factor is return. How much do you expect to earn off of your investment over the next year? This is, of course, heavily tied into risk. Generally, higher returns are better.

Everything you invest in is going to require a sacrifice in one of these areas.

If you want high liquidity and low risk, you’re going to have a low return. You’re probably going to be putting your money into something like a savings account.

If you want low risk and high return, you’re going to have to give up liquidity. You’re probably going to be putting your money into something like real estate.

If you want high liquidity and high return, you’re going to have to take on some significant risk. You’re probably going to be putting your money into something like stocks.

There are different life situations that call on different investment options.

For example, if you want to have an emergency fund that will help you get through painful situations in your life without having to dive into debt or touch your retirement, you’re looking at something that’s high liquidity and low risk, which means you’ll have to accept a low return. Thus, it makes sense to keep an emergency fund in a savings account.

If you want to buy something and sit on that investment for a very long period while it earns you a fairly steady income, you’re going to want something with a low risk and a high return, which means you’ll have to sacrifice some liquidity. Thus, it makes sense for people to invest in rental properties to generate a steady income.

On the other hand, if you want to be able to invest in something that provides a great return, but also want the freedom to jump out of that investment quickly if something in your life changes or if something about that investment changes, you’re going to need something with high liquidity and a high return, which means you’re going to be adding risk to the mix. For many people, it makes sense to invest in stocks for the ease of rebalancing and selling them off.

These descriptions are very broad strokes, of course. Different people may have different opinions on how to specifically invest and so on.

The key thing to remember here is that your life is in the lead. You make investments based on what you actually need in your life above all else. The situation you’re in and what you need out of the investment will lead you to what you should be doing with your money.

Yes, it takes research and time, and yes, you’ll sometimes find contrasting viewpoints, but without a plan for your life before you invest, you’re likely to make a giant mistake, one that will cause you to have your money locked up tight when you need it or be facing a severe loss when you least expect it or be facing very small growth over a long period.

Figure out your life before you figure out your investments. If you know your goals first, the right investment becomes much more clear.

The post The Investment Trinity appeared first on The Simple Dollar.

My brother has argued with me that I shouldn’t make any extra payments on our mortgage because we’re losing money over the long term by making early payments. He says that with inflation at 3% and our money able to earn 1% at minimum in a savings account and more if we do other things, we’re losing money by making early payments on our 3.75% mortgage. What do you think?

From a purely financial perspective, your brother does have a good point. However, your brother’s case has a bunch of implied assumptions that don’t necessarily apply to your situation.

First, let’s look at the math of the situation. Let’s say that you get a raise at work that equals the rate of inflation. Since your mortgage payment stays the same (assuming it’s a fixed rate mortgage), that means that your mortgage payment will take up a smaller and smaller percentage of your income over time. With the percentages expressed by your brother, your mortgage payment will take up only about a third as much of your income by percentage during the last year of your mortgage compared to the first year of your mortgage.

Want real numbers? Let’s say your monthly mortgage payment is $1,000 and you bring home $30,000 a year. Right now, you’re paying $12,000 a year in mortgage payments, which is 40% of your take-home pay. Each year, though, you’re getting a 3% raise. After ten years, you’re making a little over $40,000 a year, dropping your mortgage payments down to only 30% of your take-home pay. After twenty years, you’re bringing home around $54,000 per year, dropping your mortgage payments down to about 22% of your take-home pay. During the last year of your mortgage, you’re bringing home $72,800 per year, making your mortgage payments around 16% of your take-home pay.

The argument against early payments is that at the point where mortgage payments make up 40% of your take-home pay, it doesn’t make sense to pay even more just so that you eliminate payments at a later date where the payment is only taking up 16% of your take-home pay.

That’s a pretty powerful argument. It forgets a few things, though.

First, it assumes your income steadily increases at the rate of inflation or better. The truth of the matter is that wage growth isn’t keeping up with inflation in most industries and, in many industries, wages are actually seeing negative growth.

Most Americans can’t rely on the idea that their wages will routinely go up. That’s just not reality for the majority of people out there. Yes, there are people who are smart and work hard and have an entrepreneurial bent and a big pile of transferable skills who can keep increasing their wages, but that’s not something you can plan on unless you’re exhibiting confidence bordering on arrogance.

Second, it assumes that you can earn a sizeable steady return from a small investment. If you have $500,000 sitting in the bank, you can probably find some ways to invest it that can earn a nice return on that money, better than the 4% or so return you might get from other things. It’s much harder to do that with $1,000 in the bank.

Most Americans do not have the capital on hand to buy a rental property. Many Americans struggle to have an emergency fund. With an extra mortgage payment, a person can get a steady 3.75% return (in the mortgage example above) from every single dollar they pay ahead on their mortgage.

Third, it assumes an inflation rate. The Consumer Price Index, which is likely the best tool for estimating inflation, has only touched 3% once in the last several years and is usually around 1.5 to 2%. Some people debate whether CPI is a good measure of inflation and some argue for other rates, but CPI is a pretty solid benchmark for inflation.

Inflation does vary over time, but we’re currently in a period of very low inflation. Most inflation-based arguments rely on an inflation rate of at least 3% for people to make financial moves based on the inflation rate.

Finally, it assumes inflexibility. If you’re in a position where inflation is at 5% and savings accounts are paying a 6% return, it makes a lot of sense to put money into a savings account and make minimum payments on a 3.75% mortgage. On the other hand, when we’re in the position we’re at now, with savings accounts paying 1% and inflation somewhere around 2%, you’re going to want different solutions. Just because you choose to make early payments now doesn’t mean you can’t choose to do something differently later on.

In the end, the decision to make early mortgage payments or invest in something else is a minor point compared to the real issue. As long as you are spending less than you earn, you’re getting ahead. If you’re spending $100 less than you’re earning each month, you blow away any investment returns you might get on that $100 by instead figuring out how to spend $150 less than you earn each month. Spending less than you earn is the real key to financial success, regardless of how you invest it.

The post How Does Inflation Affect a Mortgage? appeared first on The Simple Dollar.

What would you do if you won the lottery?

Since I don’t play the lottery, I’ll answer this question under the assumption that instead I’m just receiving a very big inheritance from my unknown Uncle Rockefeller and Aunt Vanderbilt.

The first step I’d take is to make absolutely sure all taxes on that income were paid. I would immediately hire a tax attorney to make sure that every single I was dotted and T was crossed so that I could be very, very confident that the money remaining was mine, free and clear.

Once I had cleared all of the taxes out of the way, I would give a one-time gift to several of my family members. I would not give them enough so that they could simply stop working, but I would give them enough to pay off all of their debts and have a significant amount in the bank. I would make sure all taxes on those gifts were fully paid, and I’d encourage them to invest in something that would pay them a steady income. I would be extremely clear that this was a one-time gift, however. There would be no lending of money at any point in the future and I’d make that fact clear as well. That’s how I’d handle family issues with the money.

I would also give some one-time gifts to a few charities that are near to my heart. For example, the community food pantry in my local town is a wonderful charity run by some wonderful people, but they constantly struggle with things like keeping their doors open. I would love to give them enough so that they were endowed to cover their basic expenses in perpetuity.

With the remaining money, I would invest every single dime of it. I would not keep even a dime of the balance for anything fun.

“That sounds boring!” Well, really, it’s not.

Let’s say that I had $20 million left over after taxes and gifts to family and charity, hypothetically. Let’s say I invested all of it in about twenty five different blue chip stocks that paid a 3% annual dividend on average. That simple move would earn me $600,000 a year for the rest of my life in income. I would never have to worry about anything financially ever again. I can’t conceive of my lifestyle expanding to the point where I would even use a majority of that income.

I would diversify more than that, of course, but my focus would be on making sure that I was earning a very healthy investment income that didn’t touch the principal.

What would I do with my life with a large, stable income like that? I’d travel with my family. I would expose my children to the wide world in an incredible way. I’d spend significant periods in several different countries with them. I’d also make sure that my children could go to any institution of higher learning that they wished.

For myself? Honestly, the security of that money would mean more than anything else. Sarah and I would probably buy a piece of land in the country and build a home on it. We’d probably involve ourselves in volunteer work, mostly apolitical but not always. I would love to go back to graduate school in the areas that I studied in college, but be able to do it for the sheer joy of learning and researching and not have a cutthroat push for a job that often exists in the postsecondary science.

I don’t really have expensive dreams. I’d just enjoy the security and lack of stress that such a gift would provide.

Upon my death, I’d leave a small portion of the balance to my children and other descendants, not enough to allow them to live vicariously, but enough so that they could secure a strong financial future for themselves if they work at it. Most of it, however, would go to form a nonprofit foundation with strict directives on how the money should be used.

This is my gameplan if I were to suddenly receive a large gift. It’s not glamorous, but it fulfills everything I want from life.

The post My Plan for Handling a Big Windfall appeared first on The Simple Dollar.

My local bank offers an interesting account each year. It starts on the first Saturday in January and the deal is that if you deposit the same amount each week for 49 weeks, they will make the 50th deposit for you and give you the money at the end of the year just before Christmas. You can’t take the money out of the account and if you miss any payments you don’t get the free 50th payment but they do set it up so you can pay in automatically out of your checking account. It seems worthwhile, but is it worth it?

I’ve heard of this type of savings product before. It’s also been called a “Christmas club,” among other things. Let’s walk through this step by step.

I calculated the interest rate on this account as being roughly 4.15% I calculated this based on an account that you deposit money in each week and that compounds weekly, and on the fiftieth week you don’t make a payment and instead receive the total value of the account at the end of the week. In other words, the money you put into this account earns interest at a rate that’s pretty close to 4.15% per year.

That amount blows away pretty much every savings account available right now. There are some catches, however.

First, this account has a lot more in common with a CD than with a savings account. The biggest difference between a CD and a savings account is that you can’t withdraw the balance of a CD before it matures without suffering a penalty. The same thing is true here – if you withdraw the money before it matures (after fifty weeks), you lose that “free” payment at the end, which reduces the interest rate you earn down to 0%.

There’s also the caveat of having to make a payment every week. If you can’t make that payment each week, then you suffer the same penalty as an early withdrawal – your interest rate essentially drops to 0%.

Not only do you have the money tied into the account, you essentially have to have the next payment tied to the account at least a day or two in advance (and even longer unless you’re really micromanaging things).

What about the return on your money, though? Given the restrictions on deposits and withdrawals, you should expect a return that’s similar to a CD and substantially better than a savings account.

Right now, savings accounts are earning at a rate below 1% in most places. You can find accounts that pay out 1% or, in a few cases, even a bit better than that, but they’re unusual cases.

12 month CDs, on the other hand, pay out somewhere between 1% and 1.5% at the moment, depending on the exact CD you find.

Naturally, both savings and CD rates vary over time. In a few years, when overall interest rates begin to rebound, the rates on both savings accounts and CDs will go up, making this type of “savings club” a bit less lucrative.

For now, though, it’s a very good deal. If you have the chance to get into one of these clubs and can easily afford the weekly contribution, it’s definitely worthwhile. In future years, you’ll want to compare the return to savings accounts and checking accounts to be sure you’re getting your money’s worth, though.

The post Does a “Savings Club” Account Work? appeared first on The Simple Dollar.

The only way this even looks like a good idea at all is if you’re looking only at the very, very short term. If you look beyond that, making this move is pretty clearly worse than using a high-interest credit card to pay your bills. In fact, if we’re comparing disastrously bad financial moves, I’d actually prefer to use a credit card cash advance to pay a bill than pull money out of my 401(k) early.

Why is it so bad to tap into your 401(k) early? Let’s use this 401(k) early withdrawal calculator to see how big the disaster is.

Let’s make a few reasonable assumptions first.

First of all, let’s say we want to take $20,000 out of our 401(k). We’re in the 33% federal income tax bracket, and we pay 5% in state income taxes. We’re 45 years old and don’t plan on retiring for 20 years at least. If we left our money in there, we’d get an average of a 7% return each year until retirement – the long term return that Warren Buffett suggests people will get from the broad stock market.

On that $20,000, you’ll have to pay a $2,000 early withdrawal penalty, $6,600 in federal taxes, and an additional $1,000 in state taxes. Thus, out of the $20,000, you’ll only keep $10,400 of it. Between federal and state taxes, you’re going to lose just about half of your money instantly. Poof.

Let’s say that instead you left it there where it earns a 7% annual return. In twenty years, your investment will be worth $77,394. That’s the start of a pretty nice nest egg, one that will probably give you $3,000 or so a year take-home all throughout retirement.

So, just to get $10,400 now, you’re sacrificing $3,000 a year for years and years and years when you retire. That is an incredibly bad trade.

Then there’s the flip side of that coin.

Let’s assume the average person pulling money out of their 401(k) is making $50,000 a year. That’s a little higher than the average American salary, but many of the low-end salaries don’t have a 401(k) involved, so we’ll assume a bit higher average income.

If that person can find a way to come up with just 20% of their annual income to fix their financial situation, they don’t have to pillage their retirement.

Clean out your closet and sell the junk you don’t use. Write a grocery list when you go to the grocery store and stick to it. Even better, don’t go to the grocery store on an empty stomach. Have some friends over to your house instead of going out. Stop using your credit card for purchases and live off of cash so that you’re paying less credit card interest every month. Call up your creditors and negotiate a lower interest rate or a payment plan.

If you’ve been reading The Simple Dollar for long at all, you get the idea. Here’s a hundred more.

Fixing a short term problem by pillaging your long term savings is never a good idea. If you’re eyeing your retirement savings in order to keep your head above water or to enjoy some life “treat,” turn your eyes instead to the multitude of tools you already have in your life for coming up with some quick cash or trimming back your spending for a while.

The post More Than 25 Percent of Americans Are Making a Huge Financial Mistake appeared first on The Simple Dollar.

Assuming I’m not so altruistic as to just give away that knowledge, what would I do with it?

Logically, I’d use it to secure my family’s wealth. Then, if I could demonstrate the results to others, I might privately start a hedge fund or something to make more money from my newfound talent. I could make far more money doing these two things than pretty much anything else I might come up with.

One might argue that I could make a lot of money writing a book outlining my methods. Sure, that might work, and I’d probably sell a bunch of copies of that book. After the secret was out, though, everyone on Wall Street would begin using my “secret” and I’d no longer have an edge of any kind.

In fact, as soon as I shared that knowledge with anyone I didn’t have absolute trust in, I would essentially no longer be able to get those great returns (at least, not after a very short period) because everyone else would be doing it, driving up the prices on those stocks and making it so I couldn’t actually earn money. By letting the cat out of the bag, I would be seriously damaging the financial future of my family.

What if I were being altruistic? Let’s say, for some reaon, I just want to let the world know this secret. Whichever investment banker sees the value and capitalizes on it first will hit the jackpot and few other people will earn much of anything on it. In essence, I’d give up my own family’s financial future to make some very wealthy person much, much richer without anything in return.

Would you tell anyone that secret if you had it? I’d be willing to bet you wouldn’t. There’d be no good reason for you to do so. Given that, why would you ever put much value at all in someone telling you they have the secret to beating the market?

Let’s say the secret that someone is trying to sell to you actually is real. If that’s the case, they’d make far more money by keeping it to themselves and making a quiet mint. If their secret is real and they tell many people, then their investment advantage goes away and they’re back where they started.

It is extremely unlikely that the person offering to sell you financial tips actually is selling you anything that will give you any sort of advantage, let alone a lasting one.

What about the guy giving away tips for free? Again, if there was a real advantage to what the person was saying, you wouldn’t be able to get near it. The big investment banks would beat you to that advantage before you could even blink.

There is no specific investment advice that someone would give to an “average joe” that will actually beat the stock market. For that pitch to be true, the person selling the tip would have to have the faultiest business model of all time, because they’re selling you an asset at a pittance that would be worth a gold mine. You would have to assume the person selling you the tip is extremely dumb, and if they’re that dumb, why would they have been able to break the stock market when the big banks could not?

If you want to learn about investing and figure out what you should be buying, visit your local library and start digging around in the personal finance and investing section. Read several books, compare what they’re saying, and figure out which elements are consistent and make sense. The advice in those books is public knowledge, so the big investors already know it. The goal of reading them is to know what they know and try to match what they can do.

From what I’ve read, the best thing that I can do as an independent stock market investor is to mostly just buy broad-based stock index funds with the lowest annual costs so I can essentially ride the stock market. Aside from that, there is some sense in buying stocks in very stable companies that pay a nice dividend, like Coca Cola. The rest of your money should be in real estate or cash to protect yourself against a stock market failure.

There aren’t any secrets to investing success, in other words. If there is, it’s something that’s buried inside a hedge fund somewhere and, if the knowledge did get out, it would be completely dominated by someone who studies this information far more than you or I.

Play it safe. Don’t fall for people trying to sell you investment strategies or tips. Learn the basics of what you’re doing, understand why they work, and stick with them.

The post Why I Never Use Stock Market Predictions to Invest My Money appeared first on The Simple Dollar.

My husband and I are in great financial shape thanks to living well below our means for many years. We are in our mid 40s and have $300,000 in the bank along with no personal debts.

We’ve been thinking about buying an apartment building in our area. There’s a person who may be selling a six unit apartment building for about $400,000. We talked to him and looked at the books and it looks like it would generate about $25,000 a year in profit provided we keep at least four of the units occupied. There’s a property management company already in place.

So, we’re considering going into debt to buy this building. Do you think this is a good idea?

This is an interesting problem that deserves a longer answer than the typical reader mailbag response. While this situation doesn’t really apply to the life of many of my readers, it does provide some potential goals and some insight as to how this might work.

First of all, I don’t really view this as personal debt. If you do this purchase correctly, you’ll set up a corporation to own all of these properties. I won’t guide you through this, as I couldn’t possibly write a guide that would take you through the nuances of this for every local area in the country. You can figure out the process by stopping at your local library or by contacting a lawyer.

So, let’s say you set up a corporation to handle all of this. Is it still okay to go into debt for this?

I think it is, with a few big caveats.

First of all, you have no personal debt when you start this business. Connie does not. Her personal finances are in great shape. It doesn’t matter what interest rates are like – I am never comfortable leveraging my personal life in the hopes of earning more money through a non-guaranteed investment.

Second, you’re maintaining a very large emergency fund for yourself. This means I wouldn’t put nearly all of that $300,000 into this endeavor.

Third, any debt your corporation incurs is merely to buy an asset that retains value. With the purchase of a property like this, the corporation you’ve started can theoretically sell it pretty easily to recoup all of the debt at the very least and ideally can extract a large portion of the money you invested.

In other words, I wouldn’t go into very much debt for my corporation, but I would be more willing to go into debt to buy a property.

Fourth, the lowest reasonable expected income from the asset you’re purchasing will cover the interest on that debt. In other words, take a look at the lowest number of tenants that the apartment has had over the past several years. How much income did that generate? Would that income be enough to pay the interest on the debt and all costs associated with the property?

In other words, does the corporate debt turn this corporation into a personal money drain? You do not want this corporation to be draining any money from your personal state after the initial investment. If you keep having to add more of your personal money to the corporation, it’s not a winning proposition for you.

Fifth, I’d want to know exactly why this person wanted to sell the building, and I’d have it fully and carefully inspected before purchase. Make absolutely sure you’re not stepping into some kind of trap here where there are deep faults with the building.

A final question: why not just pay cash for this building by waiting until you can pay cash for it? That is absolutely the safest stance here.

However, the debt incurred by this corporation is wholly collateralized, meaning that if you sell the property, you can recoup the mortgage amount. The property is also not your home, meaning that if you do have to sell the property, you’re not homeless – you still have your house. You won’t devastate your personal way of life if the corporation sells the property. This isn’t personal debt, it’s corporation debt, and as long as that corporation has a positive balance sheet and a positive cash flow, it’s not a personal issue.

So, let’s take a look at how this might work. Connie and her husband form a corporation and seed it with $200,000 of their money. This money is basically investment money. This leaves them with $100,000 in personal savings for an emergency fund and other purposes.

The corporation buys the property with their $200,000 in seed money, along with a $200,000 thirty year term mortgage at 3.75%. Since they can sell this property at any time to easily recoup that $200,000 in mortgage debt and the debt isn’t covering anything they need in their life, they’re in good shape. The monthly mortgage payment for this debt is $926.23.

It’s worth noting that this plan works reasonably well because of the incredibly low interest rates available right now. If you double that interest rate to 7.5%, you bump that monthly payment up to about $1,800 a month, and you make this entire proposition much more challenging.

The apartment building costs $25,000 a year in property taxes and building upkeep, or $2,000 a month.

Each of the apartments in the building rents for $900 a month. If four of the six apartments are occupied, that’s $3,600 a month. With the expenses totaling $3,000 a month, that’s $600 in income to the business each month. Every additional apartment that’s rented generates another $900 a month.

The problem comes in if there are fewer than four apartments rented. If only three are rented, this doesn’t cover the monthly expenses on the building – $2,700 versus a hair under $3,000 in expenses. (On the other hand, if the building is paid for in cash, three apartments will generate about $800 or so in income per month, with additional rentals generating even more.)

The exact numbers here will depend on the research Connie does. They may find that the rent they can charge is higher or that the tenant rate is really variable or that the expenses are lower. They need to see the history of the building. They need to run the numbers for themselves.

For this to work, Connie and her husband need to make absolutely sure that (a) their personal finances are strong regardless of what happens with the corporation and (b) the corporation is extremely likely to maintain a positive balance sheet and a positive monthly income. If it fails to maintain a positive monthly income and a positive balance sheet, they need to sell out and get out because it’s not a good investment.

This isn’t a labor of love – it’s here to make money. If there’s even the slightest indication in the property’s history that it won’t make money, then they shouldn’t do this.

A final thought: I would never take on personal debt to invest and I would never feel comfortable running a business that didn’t have positive cash flow and a positive balance sheet. I wouldn’t even try this unless I were debt free, I could start the corporation with enough of an initial investment to ensure stability, and that initial investment wouldn’t destabilize my personal finances in any way. If any of these things ceased to be true, I would sell things off until it became true. I’m pretty conservative with my money, after all.

The post Financing to Make Money appeared first on The Simple Dollar.

First, a few caveats.

Dividend stock investing is something I do with only a small part of our investments. It’s not my primary investment strategy, which is actually buying index funds through Vanguard. (Index funds are essentially single investments you can buy that are made up of small amounts of tons and tons of other investments – for example, some index funds just own tiny amounts of every publicly-traded stock in the United States.)

Dividend stock investing also requires that you pay attention to diversity. Buying tons of one company’s stock, no matter how strong that company is, is a bad idea because it lacks diversity. If that one company were to get into some sort of trouble and their stock begins to tank, you’ll lose much of what you have very quickly.

The example I’m going to describe below follows investment in only one company. You would want to invest in at least ten different companies in ten different industries, for diversity’s sake.

Also, you’ll want to focus on companies that have been stable and paying dividends for a long time. Your focus is going to be on rock-solid companies that understand their business top to bottom and have been executing effectively through ups and downs for a very long time. They’re about as stable as you’re going to get. Dividend.com provides a great list of such companies.

For this example, we’re going to look at Coca-Cola (stock symbol KO). We’re going to start off in January 2002 with a person saving $25 a week in a savings account that earns a 1% return (we’ll just figure annual interest at the end of year to keep things simple). That person buys stocks only once a year on January 1 at a fee of $10 per buy. All buys are going to be whole shares, with the fractional money staying in the savings account. All dividends from their stocks are going to flow into their checking account for next year’s purchases. We’re going to see what that person winds up with at the end of five years. I’m pulling the data for KO from this history, which automatically adjusts for stock splits so we don’t have to worry about them in this example, and I’m sticking with purchases of whole shares so that the math isn’t fractional and easier to follow.

In 2002, this person saves $1,300 in their savings account. It earns $13 in interest.

On January 2, 2003, KO stock sells at 44.15 per share. Our friend has $1,303 to invest ($1,300 plus the $13 interest, minus the $10 in brokerage fees). He buys 29 shares of KO, leaving $22.65 in the savings account. Four times throughout the year, KO pays a 0.11 dividend, earning $12.76 in dividends over the course of the year. This person saves $1,300 in their savings account again. At the end of the year, his savings account balance is $1,335.41, plus $13.35 in interest, totaling $1,348.76.

On January 2, 2004, KO stock sells at 50.80 per share. Our friend has $1,348.76 to invest. He buys 26 more shares of KO, bringing his total to 55 shares, leaving $17.96 in the savings account. Four times throughout 2004, KO pays a 0.125 dividend, earning our friend $27.50 in dividends. This person saves $1,300 in their savings account again. At the end of the year, his savings account balance is $1,345.46, plus $13.45 in interest, totaling $1,358.91.

On January 3, 2005, KO stock sells at 41.90 per share. Our friend has $1,358.91 to invest. He buys 32 more shares of KO, bringing his total to 87 shares, leaving $8.11 in the savings account. Four times throughout 2005, KO pays a 0.14 dividend, earning our friend $48.72 in dividends. This person saves $1,300 in their savings account again. At the end of the year, his savings account balance is $1,356.83, plus $13.57 in interest, totaling $1,370.40.

On January 3, 2006, KO stock sells at 40.79 per share. Our friend has $1,370.40 to invest. He buys 33 more shares of KO, bringing his total to 120 shares, leaving $14.33 in the savings account. Four times throughout 2006, KO pays a 0.155 dividend, earning our friend $74.40 in dividends. This person saves $1,300 in their savings account again. At the end of the year, his savings account balance is $1,388.73, plus $13.88 in interest, totaling $1,402.61.

So, let’s look at this picture for a moment – five years later, on January 3, 2007.

This person has saved $25 a week – totaling up to $6,500. That person has $1,402.61 in their savings account.

That person also has 120 shares of KO stock. That stock, on January 3, 2007, is sitting at 48.36 a share. During that entire period, it has bounced back and forth between $40 and $50 a share – you’re not buying it for the gains, after all, but the investment is holding its value. If you were to sell it (with a $10 fee from the brokerage), you’d get $5,793.20 back in return. You’d actually make a small profit on that money.

However, if you were to just sit on those 149 shares (the 120 you already own plus the 29 more you could buy while basically clearing out your bank account), you’d earn $101.32 in dividends in 2007, $113.24 in dividends in 2008, $122.18 in 2009, $131.12 in 2010, $140.06 in 2011, and $151.98 in 2012. If you reinvested the dividends, those numbers would be a bit higher – if you also kept up with the $25 per week, those numbers would be far higher (approaching $400 a year). All of this happens while the value of the stock actually climbs a fair amount, though dividend stocks are usually bought for the dividends, not for the price increase.

There are some catches, though.

One, this is a proposition with risk. Coca-Cola might cut their dividends and their stock price might drop. If Coca-Cola had a major corporate crisis or a product disaster in that period, the picture wouldn’t look nearly as rosy. Such an investment is inherently tied to Coca-Cola’s long history of being a very steady company and continuing that steadiness. Less stable companies have a much more volatile picture. Even with a company as stable as Coca-Cola, you need to pay attention to what you’re doing.

Your best bet is to invest in a number of different dividend paying companies. Buy into one company one year, then put your money into another stable dividend-paying company in another industry the next year. Eventually, you’ll have yourself a portfolio.

Two, there are brokerage fees every time you buy or sell. Those fees do eat up some of the return you’ll get. You want to buy and sell sparingly.

A final note: I’m not specifically recommending or not recommending this option for investing. It’s just one route worth considering – one that I’m personally following on a small scale. Depending on your risk tolerance and your life situation, it may not be right for you, and before you make investment decisions, it’s worth talking to a fee-based investment advisor.

The post An Example of Dividend Stock Investing appeared first on The Simple Dollar.

The one thing that has kept me from diving into investing is fear of taxes. Every time I read about taxes and investments, it seems really, really complicated and I’m worried I’m going to be stuck with a big tax bill at the end of a given year even if I think I did everything smartly.

That’s an understandable worry. Investment taxes can be a bit difficult to swallow at times, but there are a few rules you can follow to make things easier for you.

My first suggestion is to use a solid tax preparation software package when you do your income taxes. A good software package like TurboTax will walk you through everything you need to do in terms of filing your taxes correctly. You’ll avoid making significant errors, so you can be confident about the taxes you file.

The second step I’d suggest is to keep careful track of every dime you invest. Note the date that you invested the money, what you invested it in, and how many shares of that investment you were able to purchase. I use a spreadsheet for this very task.

The third step – and this is probably the most important one – is to keep very careful track of every dime that’s paid out from your investments. If the investment pays out a dividend, record it. If the investment pays out a capital gains distribution, record it. Any time you receive cash as a result of an investment, you need to make absolutely sure that you write it down.

Now, for many investments, people choose to re-invest the proceeds. That’s a reasonable choice, but it’s also the choice that can get people into tax trouble.

Let’s say you have $50,000 invested in a mutual fund. The fund decides to pull out of several investments, believing them to be at their peak. The fund then has to pay out a distribution. Let’s say they’re paying out a distribution that’s worth 20% of the face value of their shares, which means you’re getting $10,000. If you just re-invest that money immediately, as many people do, you now own some more shares of the fund, but you’re also on the hook for $10,000 in additional income on your tax form, which can ding you pretty hard if you’re not prepared for it.

Investments that do this kind of distribution quite often are referred to as “high turnover” funds. If you’re investing outside of a retirement account, I’d avoid these investments like the plague. (If you’re investing inside of a retirement account, it really doesn’t matter because the taxes are all deferred.)

What’s an example of an investment with very low or no turnover? Individual stocks have no turnover, as you just own them and hold them until you sell them. Pieces of land have no turnover for the same reason. Index funds usually have very low turnover, like the Vanguard Total Stock Market Index.

Some investments earn dividends, which work much like interest in a savings account. Dividends are either taxed like ordinary income or, if you’ve held the investment for a significant period, like a long-term capital gains (meaning at a lower rate than ordinary income). Again, these are often reinvested, so you’ll need to keep track of these carefully.

My solution is that whenever I reinvest a dividend or distribution, I put a bit of money in a savings account to cover the taxes on that dividend or distribution. Usually, my investment house sends me a notice whenever a distribution is paid out and reinvested. When that happens, I’ll just move a bit of money from a checking account into a savings account to cover the taxes there. At some point, the taxes might be big enough for me to have to come up with a different solution, but I’m certainly not there yet!

When you actually sell an investment and reap more money than you paid into it, that difference is a capital gain. You’re going to owe taxes on it. If you’ve held that investment for more than a year, it’s a long-term capital gain, meaning you’ll get a lower tax rate on it than your normal income. If you’ve not held the investment for that long, then it’s a short-term gain, which means you pay normal income taxes on it.

For that, I usually put aside 40% of the proceeds from any investment I sell for taxes. If I buy something for $1,000 and sell it for $2,000, I’m going to put aside $400 for the taxes on that gain. I might not end up owing that much, but having more than enough to cover the taxes is better than not having quite enough to cover them.

Like I said at the beginning, using a good tax software package makes this all really easy, provided you kept good records along the way. I have bought and sold many investments and had many distributions and dividends come my way and I’ve never had an issue thanks to good record-keeping and a good tax preparation package.

The post Investments, Taxes, and Worry appeared first on The Simple Dollar.

I think you’re giving bad advice to people when you tell them not to put everything in stocks or real estate when making a long-term investment. Over a long period like ten years or more, you simply can’t beat the returns there.

Long-term investing relies on several assumptions, two of which hinge very strongly on personal luck and personal behavior.

One, you’re not going to touch that balance for a very long time. The chance that you’ll touch that balance in any way over the next decade (at least) is very, very small. If there is a crisis in your life, you have other assets you can use to deal with that situation without touching your long-term investment.

Two, you are completely comfortable watching the balance of your investment drop through the floor every once in a while. It’s easy to feel good about an investment when you see it earn a 15% return over the course of a year. It’s a lot harder to feel good about it when you see a 40% drop over the course of a year.

The first issue can be resolved to a large extent through solid personal finance management. Pay off your debts, maintain an emergency fund, and you’ll go a long way toward heading off most of the crises that would interfere with your long-term investing.

The second one, however, is a bit trickier to handle.

During 2008, I witnessed several people I know make panicked moves with regards to their retirement savings and their own personal investments. They yanked their money out of stocks in the latter days of 2008, locking in enormous losses, and put their money into other investments.

With hindsight, this looks like a terribly bad decision. 2009 and 2012 were both stellar years for the stock market and stocks have regained every bit of ground that they lost in those years.

The problem is that, in the moment, it’s very hard to see that type of rebound when you’re watching your life savings dwindle away. You also don’t necessarily know how you’re going to react in that moment.

My perspective is that the key to the matter is what I call a “hardening” of one’s needs. When you’re young and retirement is a very long way off, a big loss isn’t that big of a deal. I watched 2008 flow through my retirement accounts and it didn’t seem disastrous.

However, if I watched 2008 from the perspective of my parents or my in-laws, it’s a very different picture. It’s scary because it’s much more immediate. While they may have still been outside of that ten year timeframe, a big retirement loss is much more urgent because their lives are beginning to move toward retirement.

So, what I suggest is that if you’ve reached a point where you know what your target “number” is and you know roughly when you need to reach it, you need to start moving into safer investments, even if the horizon is more than ten years off. The “firmer” the target date and target number are, regardless of the time until you reach that point, the more you need to move into safer investments like bonds and cash.

What if you need those “big gains” to reach your number? If that’s the case, then you need to look at saving more or else putting off your target date a little bit.

If you have a target date in mind and you’re gearing up your life to retire in that timeframe, a big stock market or real estate swoon becomes incredibly scary. Once that timeframe becomes pretty clear in your life, you’re making other life plans according to that timeline, and you see things progressing clearly toward that investment endpoint, you need to start preparing for it, even if it’s more than ten years out.

Don’t ride the giant roller coaster if you’re not in the right position to handle the big drops.

Again, personal finance isn’t about pure dollars and sense. It’s about managing your emotions, and it’s also about putting things in the broader context of your life. Keep that in mind with every single move you make.

The post Stomaching the Roller Coaster appeared first on The Simple Dollar.

You’ve mentioned before how a person might slowly build up income-earning investments to provide an income stream for them. How would that actually work? Let’s say I can squeeze out $100 a month for this. What would I do?

Okay, let’s do this.

First of all, you need to have selected something you’re going to invest in. You’re going to want something that gives you a direct return of some kind on a regular basis. That can be an index fund, a particular type of bond, a treasury note, or a dividend-paying stock, among other things. Each have their own particular risks and rewards that you’d want to study if you were making such a decision, but generally, investing in a company you know really well, in a very broad selection of companies (as in an index fund), or in the federal government are all good way to go.

Let’s say, for the purposes of this example, that you’re investing in Coca-Cola. Here’s the dividend history of Coca-Cola – for this example, we’ll say that Coca-Cola maintains a quarterly dividend of $0.26 for the foreseeable future. Also, here’s the stock price for Coca-Cola. We’ll say that their price per share holds steady at 38.91. I’m going to round a few numbers here and there and simplify a bit just to keep things clear.

The first thing you’d want to do is start saving that $100 per month. You would not want to buy each month, because with most brokerages you’d have to pay a fee for each purchase you made. Instead, I would recommend saving for a year and making one single purchase each year.

So, you save up $1,200. You open an account with some brokerage and spend that $1,200 on shares of Coca-Cola stock, of which you can afford 30 shares (we’ll stick with even share numbers). If your fee for buying is $9.95, that leaves you $22.65 for next time.

So, you now own 30 shares of Coca-Cola. Four times during the year, each share pays a dividend of $0.26. That’s a return of $31.20 over the course of that year.

Until you actually need the income, it’s usually wise to reinvest it. So, you take the $1,200 you saved in year two, the $22.65 you had left over from year one, and the $31.20 you earned in dividends from year one, and you use it to buy 32 more shares of Coca-Cola (with a $9.95 fee), leaving you $1.22 left over.

During the second year, you own 62 shares of Coca-Cola. The company pays a quarterly dividend of $0.26 per share, earning you $64.48 in dividends over the course of the year.

So, you reinvest again, buying 32 more shares (with your $100 a month savings and the dividends from the previous year) and leaving you with $1.90 left over. You now own 94 shares of Coca-Cola, which earns you $97.76 in dividends over the course of a year.

After the third year, you’re earning back almost $100 a year in dividends, and this will only accelerate from there.

There’s also the fact that your investment itself will retain value (and possibly gain it). You own shares of Coca-Cola, which are things you can sell if you so choose to recoup your investment. Of course, Coca-Cola shares may have gone up in value or they may have gone down in value, so you might earn more than you invested when you sell or you might earn less.

The truth is, though, that no investment will quickly recoup your income if you dump only $100 a month into it. At that rate with this investment, the dividends wouldn’t reach the $20,000 per year mark for about 250 years. In order to hit the kinds of numbers you’d need for an investment’s return to start replacing your income, you need to look at putting amounts on the order of $250 per week or $1,000 per month into this type of investment.

The post Building an Investing Future appeared first on The Simple Dollar.

Here are the five red flags I see most often with money advice.

Outrageous returns are claimed. People make statements that imply that you’re virtually guaranteed a very quick return that surpasses any legal investment. Whenever I hear an investor saying that a stock sitting at 20 is “going to 45 in the next few months,” I immediately start getting suspicious.

If someone says that they expect some degree of increase in value in a stock, I might believe that person, but over-the-top claims – particularly anything that beats a rate of about 8% annually – immediately set off warning bells for me.

Cherry-picked hindsight is used as “evidence” for their claim. When someone pulls out a specific investment pick that they made a year ago as evidence for how good they are, I immediately begin to doubt them. Sure, they probably did correctly pick that this one investment would double in price, but I’m also willing to bet that they made dozens of picks that didn’t return anything near what they predicted – and they’re choosing not to share that.

I have far more respect for investment counselors who share all of their picks and encourage people to judge them based on their whole track record. I’ll pay far more attention to someone who made 50 investment picks at the start of a year that earned 10% in a year on the whole versus someone who just points out one pick that made a 100% return. That single pick is basically worthless.

They push specific investments to the moon. This screams “conflict of interest” to me, and it’s one of the reasons I’m always wary of anyone pushing me to a specific investment without deeply understanding what I’m looking for and directly relating that to the investments they’re showing me.

Anyone who just says, “Man, this investment is hot and you need to buy in now” is welcome to join my “ignored” list.

The evidence they provide for their tip relies on chart analysis. Whenever someone pulls up a chart of the history of a stock and starts drawing vertical and horizontal lines on it to indicate where it’s going, I tune it out.

I have seen no evidence that “resistance” or “floors” or “ceilings” mean much of anything going forward. It’s easy to find patterns in a lot of old data, but it just doesn’t really pan out going forward.

The evidence they provide for their tip relies on hard-to-verify information. Sometimes, people will point to “rumors” and other weak evidence to buy a particular investment. A new building is going in down the road from this piece of land, or this company is about to launch a pretty cool product.

The problem is that most of this type of information is vapor. You can rarely track down a hard source for it. Sure, sometimes a hard source does actually appear eventually, but just because some claims do come true doesn’t validate investing your money based on unverifiable whispers.

The shocking thing to me is that investment radio, television, magazines, newspapers, and websites all do these things over and over again. If you start digging into investment news, it only takes a few clicks to start seeing these red flags going off everywhere.

For my investments, I stick to safety. I either buy something tangible (like real estate), something with a very long provable history (like a strong blue-chip stock that pays dividends), or an index fund.

That way, I don’t have to pay attention to all of these red flags.

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My problem is that I can’t stop looking at my retirement accounts. Whenever I see an investment option that’s doing a little bit better than whatever I’m doing, I start to feel sick to my stomach and I panic and I have to switch my investments over. Then a week later I see something else that’s doing a little bit better.

There’s no tax implications for this because it’s all inside my retirement account. Still, I feel like I’m obsessing and not really gaining anything.

Your suspicion is right. With all of this switching around, you’re probably not gaining much at all and you’re likely losing compared to just sticking with a small portfolio of investments.

Here’s what I would suggest doing. Go back and see how much you earned in returns in 2012. Ideally, your investment house will help you with this kind of calculation. Then, compare that percentage return to what you would have earned just sitting in some of the investment options.

What you’ll probably find is that your annual return is pretty close to the returns on a lot of those investments. In fact, I’d bet that your returns are actually lower than most of them.

Why do I think that? The biggest reason is that when you jump from investment to investment chasing the latest bump, you’re likely “buying high,” which means that the investment isn’t going to see the same short-term returns that the investment saw over the earlier period. Also, there might be delays as well as fees in the transactions, which means that there are periods where your money’s not invested at all between the transactions and that some of the money might be swallowed up in the transaction. Many funds require you to hold your purchases for a short period or face fees.

My best advice to you is to stop looking at your retirement accounts. Delete the bookmark from your web browser and clear out your browser’s history. Limit yourself to one peek per quarter and only one change per year.

If you’re ever tempted to look, show yourself those numbers. They’re proof that obsessing over your retirement accounts is directly costing you money.

Before you do that, though, think about and settle on some sort of long-term portfolio. One good suggestion is this “bucket” portfolio that divides up one’s retirement savings into a variety of investments, each with a different risk level. This diversifies the retirement portfolio while spreading out the risk.

Once you’ve figured out the exact portfolio you want – a set of investments that’s diversified, in other words – go into your retirement account and transfer all of your holdings to match that portfolio.

Let’s say you have $200,000 in retirement and you’ve decided to put 15% in investment A, 20@ in investment B, 30% in investment C, and 35% in investment D. You’d fire up your retirement account, put $30,000 in investment A, $40,000 in investment B, $60,000 in investment C, and $70,000 in investment D.

After you do that, close your browser window and don’t look at it for a while. If you’re tempted, look at your 2012 returns and remember that tinkering costs you money, and looking makes it tempting to tinker.

Your contributions should be split up among the investments to match the various percentages you have.

Now, check it at the one year mark and rebalance it. Move the amounts around in such a way that the money is back at the percentages you want. That’s because some investments will gain more than others – but you can’t predict which ones will be the ones that gained the most.

That’s really all you need to do with your retirement accounts, and you’ll likely experience more stable returns this way. Just do this, delete your bookmark and retirement history, and keep the evidence that your activity was costing you nearby. You’ll be glad you did.

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When we look ahead, we don’t see any radical changes to this. All of our major plans for the next twenty years – the ones we’re pretty certain about – don’t require a huge pile of cash. They involve travel. They involve pre-college educational support for our children (things like buying musical instruments and paying for the costs of extracurricular activities they’re interested in).

The idea of buying a home in a rural area is still on the table, but it’s much more of a short-term goal and we have the numbers for that figured out already. We know what we want to spend and we have much of the cost of that purchase right here in the equity of our current home.

Yet, as I’ve mentioned before, we’re spending far less than we earn, which means our savings are going up.

We’re saving money without any sort of true long-term goal. I suppose that, if we had a goal, it would be to support long-term career freedom and choices for both myself and for Sarah, but as of right now and for the foreseeable future, we’re happy doing what we’re doing.

What do you do when you find yourself in that situation? The thing is, most personal finance books I’ve read never really address this head-on. Most investment books insist that you define your investing goals first, and define them clearly. Our goal, as vague as it is and if you can even call it a goal, has no real timeline at all.

So, what do we do with that money that we’re saving while we spend less than we earn? Here’s our gameplan.

First and foremost, we’re keeping our emergency fund strong. Our first priority for every dollar we bring in (after paying our bills, of course) is to keep up our emergency fund. We keep several months of living expenses in a savings account that we can quickly access if we so choose.

We use that money whenever there’s a personal emergency that we can’t easily pay for out of the unallocated portion of our budget (our budget has an unallocated line item for minor emergencies and unexpected bills). Then, we make it an extremely high priority to refill it in the coming weeks and months.

If our emergency fund is full, we split the money into several chunks. One piece of the pie is staying in cash and building up in a savings account. Another chunk goes into a pair of broad-based stock index funds at Vanguard. Yet another chunk goes into savings for an investment real estate purchase in the future. These three pieces are roughly equal. We also have a fourth piece that’s split into a few smaller things: dividend-bearing individual company stocks and foreign currency.

Why are we doing things that way? The big reason is diversification. No matter what happens, we won’t experience a huge swing in our savings, either upwards or downwards. However, because of the diversification of our money, we do see the money building at a faster rate overall than we would if it were all just sitting in savings.

Another reason is that we have flexiblity to choose to invest in things we believe in. If a company produced a product that we didn’t ethically or morally agree with, our investment future is not tied to that company. We could easily invest in other things. We can also wait to buy a property that we can control and put to good use – we plan on using whatever property we buy to provide low-cost housing to charitable groups.

Sure, that might mean a bit lower financial returns on that money, but it means much higher personal returns for us.

It’s also worth noting that our steps in each of these directions are tiny. We’re saving just a little bit each month in each of these directions. Although we’re happily spending far less than we earn, we’re not earning a mountain of money to begin with. We’re just trying to make good long-term choices with what we have.

We might not have a plan for the future set in stone, but we do have a plan for how to get there in terms of our money.

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The goal of such investments is straightforward: the person simply wants to raise more money. Now that we’re debt free and have a healthy emergency fund, quite a lot of our money is in various investments. That money is working for us and earning us a reasonable return each year – and since we’re not using the income from those investments, we’re just reinvesting it for now.

If you’re looking strictly at increasing your net worth and building toward the earliest possible “retirement” date, this is absolutely the best route to take.

However, is that your primary goal in life? For some, that is clearly the goal. For others, it might not be.

Is your goal to raise inquisitive and self-reliant children?

Is your goal to see a lot of the world?

Is your goal to dive deeply into a less-lucrative but more fascinating career?

All of these things require financial investment, both in a direct sense (they may cost money) and in an indirect sense (they may take away time and focus from other methods of making money).

All of these things result in negligible financial returns. They don’t make money, at least not directly. You might find ways to turn non-financial life goals into money makers, but many goals simply don’t earn a great return. Sure, children who are thoughtful self-starters might end up earning a great deal and helping you out in retirement… or learning a new language might open up a career path… but those are secondary effects that you can’t plan for or predict.

The lack of direct financial return doesn’t mean that such investments aren’t worthwhile, though.

For example, Sarah and I are both quite happy to invest in our children. Our oldest child is into martial arts and ice skating. Our middle child loves ballet and is just starting to get into music. We are quite happy to pay for lessons and uniforms and equipment and instruments. We fill their summer with educational opportunities that they express any interest in, from science mini-camps to museum trips.

We also intend to travel internationally as a family when our children are a bit older, perhaps near the end of the coming decade. The cost of traveling with five to another continent will be pricy, but we want our children to see that there’s more to the world than Iowa, plus we want to see many places ourselves.

These things require money and time. That invested time and money takes away from other things we might be doing, such as building our careers or saving for retirement.

The thing is, the goal of good personal finance is to achieve the goals we have for our lives, whatever they might be. It means making better smaller choices in the moment in order to have the bigger things we want out of life.

As long as you’re covering your fundamental bases – retirement savings, a healthy emergency fund, freedom from debt – you should invest your money in the life you want most, even if that means indirect (or no) financial returns.

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