A question I have been pondering for awhile is “How do I become an investor?” Way back in the annals of history, I worked for an investment management firm and wondered how some people managed to accumulate so much money. It seems to me these items are related since a saver becomes an investor after a period of time and then the investor becomes wealthy if they are good at investing.
I should start with what I mean by a saver. I have divided up my savings into two objectives. The first is to accumulate enough for an emergency. I have read many books and blogs that recommend three to six months of expenses. I think each person’s level depends upon the economy and their lifestyle. If I think it will be easy to find a similar job if I were to lose my current job, then three months is likely sufficient. If it think that will be hard or I am dealing with debt that needs to be re-paid quickly, I will make that higher. As an aside, this debt is linked to the purchase of a car or something like that where I may need a loan of a few years to assist in the purchase. Any other debt should be handled as part of normal expenses.
The second objective of saving is to prepare for retirement. Nothing helps the preparation better than a long time frame. While it may be hard to think of retirement when it is forty or more years away, it is the unknown changes that will arrive over the decades that make retirement planning essential as early as possible.
My plan has been to put aside 10% of my net income into the first savings pool, the emergency fund. In addition to that, I have been putting another 10% of my net income into the second savings pool, the retirement fund. If these funds are transferred into accounts when each pay check arrives, it is psychologically easier for me since it is like the money isn’t available to spend in the first place.
Once the first pool is filled with at least three months of expenses, it is time to think about saving for other items. Typically these are big ticket items like a house or a vacation or a new car. Now that normalcy has returned to the mortgage market, the traditional 20% down payment is required. I like to think that way about each purchase where I want to put 20% down and finance the rest. Of course, by financing, I may be changing the requirements of that first pool of savings because my monthly expenses have risen.
I think we have covered that first pool of savings well enough. The concept is to save for emergencies and then to save for bigger items. Let’s move on to the retirement savings.
Becoming an investor starts with this pool of savings. Typically no one saves enough for retirement by saving 10% of their net income. They usually need help from inflation and market returns. That means it is necessary to move these savings out of cash as quickly as possible and into securities. The traditional security of the long-term investor is the stock market.
Choosing individual stocks can be quite difficult. No only does the investor need to follow the business prospects of the company, they also need to follow the management of the company, the industry the company is in, and what the market thinks of the company. For a beginning investor, following the market average is usually the best way to get into the market. The historical way has been through mutual funds with the new way being the purchase of ETFs.
Let me take a moment to describe how they are different. The one difference I want to focus on is how the transaction is charged. These purchases are not free. For the mutual fund, each individual transaction is not charged, but a percentage of your investment is taken each year. For the ETF, each transaction has an expense. So if you have no transactions or a large amount of investable money, the mutual fund can be more expensive. If you are conducting many transactions, the ETF is more expensive. That leads to the easy way to minimize expenses by limiting the number of transactions.
For example, if I am receiving 24 pay checks per year, I do not need to perform 24 purchases. I could make that 12 purchases and cut the amount paid in transaction fees by half.
The next decision becomes what to invest in. There is not a shortage of ETFs to invest in so is it advisable to simply choose a fund that mimics the market? While the answer is yes, how the fund performs that mimicry matters. The traditional method is the S&P 500 fund. This captures the price movement of the 500 largest companies in the market.
That description leads to the problem I have with the fund — following the price movement also means I am buying more of the higher priced companies and less of the lower priced companies. That usually leads to a high amount of volatility as prices correct. Shouldn’t we be investing based on how a company is performing?
There are three funds that invest based on several fundamental factors of a company (like sales growth). I like the concept of these funds since they are not price weighted. These three funds split up the investment universe into the United States, the Developed Markets (except the United States), and the Emerging Markets. For myself, I have placed 45% of my investment into the U.S. fund, 45% into the Developed Market fund, and 10% into the Emerging Market fund. Which fund I invest in each month depends on which fund is furthest away from its target level.
So there is the plan. From my experience, an investor becomes wealthy through time, persistence of staying with a well-constructed plan, and choosing well. The ideas I have mentioned here are good to begin with but will need refinement as assets and experience grows.