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Retire Early: Seven tips for successful saving and investing.


Seven tips for successful saving and investing?

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Several readers have asked for Retire Early's investment tips. While no individual stock or mutual funds are recommended on this site, I can offer a few thoughts that can increase the chances that you'll be able to Retire Early like your author.

1. Eliminate all credit card debt.

I'm not talking about cutting up all your credit cards. It's O.K. to use them as long as you pay the bill in full each month. But if you are paying 12% to 20% interest on your credit card debt, your banker is more likely to retire early than you are.

Paying off a credit card with a 20% interest rate is like getting a 20% return on your money. You're not going to get anything near that in the stock market over long periods of time.

2. Know the "bid" and "asked" price on everything you buy.

If you've ever bought individual stocks on the exchange, you probably already know about bid and asked prices. Savvy investors know that they're getting the best deal when there is a small spread between the bid and asked price and their commission costs are low. But, I'll bet you never thought about applying the same logic to other purchases like a home, a car or a consumer product.

Let's take the example of buying 1,000 shares of IBM at $100 per share. You call your deep discount stock broker and find out that IBM is 100 asked, 99 7/8 bid. You decide to buy at market, pay the $100 per share asked price, and send your broker a check for $100,018.00 to cover the amount due including commission. If you decided to sell 5 minutes later, and the bid and asked price remained the same, you could accept the 99 7/8 bid price. Your broker would then credit $99,857.00 to your account. A round trip for 1,000 shares of IBM cost you $161.00 in the "spread" and commissions. If you buy and sell large cap stocks and use a discount broker, the stock market is remarkably efficient.

Now let's look at buying a $100,000 home. You would probably pay $3,000 in closing costs in addition to the $100,000 sales price for a total of $103,000. One month later you decide to move and you can still get $100,000 for the home. A real estate agent typically gets a 6% commission and seller's closing costs add $1,000 to the cost of sale. At the closing you receive a check for $93,000. Our "round trip" for the purchase and sale of a $100,000 home cost us $10,000 versus $161 for our stock example. Real estate markets aren't nearly as efficient as the stock market.

There are countless other examples. A new car loses thousands of dollars in value when you drive it off the dealer's lot. A $1,200 suit isn't worth nearly that much at the second hand store, even if it was never worn. If you minimize the "bid/asked spread" in all your purchases you can save thousands while still maintaining your lifestyle.

3. Make a "rent vs. buy" calculation before buying a home.

Buying a home is the largest purchase most people make. Conventional wisdom tells folks to buy a home as soon as they've saved money for the down payment. The logic here is to build equity and avoid "wasting money" on rent. Some "experts" even advised buying the largest, most expensive home a family could afford. All the better to "cash in" as real estate prices increased year after year.

This strategy might have worked during the '70's and early '80's when inflation was high, but it's not necessarily true today. In most parts of the country today a home isn't an investment - it's a consumer purchase just like a stove or a blender.

The smart thing to do is to consider the smallest, least expensive home that will meet your needs and then save and invest the balance of the funds you would have otherwise spent on housing. You should also carefully analyze the "rent vs. buy" question. We've already discussed the fact that the inefficiencies of the real estate market make it very expensive to buy and sell a home. If you're in a low tax bracket, the widely publicized "tax advantages of home ownership" really don't amount to much. Also, homeowners are responsible for many costs included in your apartment rent such as: garbage collection, lawn maintenance, snow removal, etc. You may still want to purchase a home - just make sure you've evaluated it as both an "expense" as well as an "investment."

4. Don't put your entire 401k account in company stock.

One of the main reasons I was able to Retire Early was that I sold most of the Exxon stock in my 401k account while I was still working for Exxon. No, I didn't have a premonition that the Exxon Valdez was going to run aground years later. Nor did I think that Exxon was a particularly poor investment. I decided I should diversify my investments and not have my entire net worth at risk to the price of oil.

Having worked for five different Fortune 500 companies, I've met many people who have their entire 401k account in company stock. I've seen folks with 85-90% of their net worth in one investment. Many regard it as a badge of patriotism that they've put all their eggs in the company basket. It may work for Bill Gates, but it's risky for you.

Remember, more than 50% of the companies in the S&P 500 underperform the average. The odds are that you don't work for Microsoft or Intel. (And even if you do, the next 15 years won't see the same 100-fold increase in share price you've enjoyed in the previous 15 years. The immutable law of large numbers won't allow it.) For most people, 25-30% of your net worth in one company's stock is plenty. And you should only have that much if you truly believe it's a good investment, not because you work there.

5. Find the lowest management fees and "never pay a sales load."

The money you pay to financial advisors and mutual fund managers in the form of fees and commissions reduces your investment return. You probably won't get any of them to admit it, but it does.

Your best bet is to choose mutual funds with the lowest management fee. Use Morningstar, Value Line, or some other financial reference to research your invesments. Choose funds that are "no load" and make sure they don't levy a 12b-1 fee. Then contact the mutual fund directly using their toll-free telephone number. Eliminating sales loads and marketing fees adds a "risk-free" boost to your investment return. (Note: Beware of mutual funds offered through "no transaction fee" mutual fund supermarkets. There may be no transaction fee, but there surely is a 12b-1 fee. Amazingly, even if you call these mutual funds directly on their toll-free line, you still pay the 12b-1 fee designed to compensate operations such as Charles Schwab or Fidelity. Yes, that's right. Even if you don't buy the mutual fund through a broker you still pay the marketing fee. See, "How much should I pay in fees ?" )

6. Match your maturites to your future obligations.

This means you should decide when you need your money and then buy securities that will return the money to you more or less on schedule.

If your saving to buy a car in one year, a money market fund would probably be the best investment. Need a down payment on a house in five years? Try 2-Year to 5-Year US Treasury notes which will mature by the time you need the money. Saving for retirement in twenty years? The stock market has the best returns over extended periods of time.

When I was working, I put almost all of my IRA and 401k accounts in a diversified portfolio of US stocks. I never let any one security account for more than 30% of my net worth. Now that I'm retired, I've put two year's worth of living expenses in a money market fund, five year's worth in 2-Year to 5-Year US Treasury notes, and the balance in stocks. I've decided that you should only put money in the stock market that you won't need for at least 7 years.

7. You'll need to accept some risk, but make sure you can sleep at night.

People invariably lose money when they act irrationally. If trouble in Asian markets and large swings on the Dow average unnerve you, put less money in stocks and more in Treasury securities. The last thing you want to do is sell everything at the bottom of the market.

But be forewarned, over the long term (say more than 10 years) the stock market has historically offered the highest returns and been the best hedge against inflation. You should have some exposure to stocks in your retirement portfolio. You're unlikely to Retire Early with all your retirement savings in CDs or a money market fund.

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Copyright 1997 John P. Greaney, All rights reserved.

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