When I drive my car, I don’t know how the internal mechanics work. I know if I push on the accelerator, the car speeds up. If I hit the break, the car slows down and stops. If I turn the wheel one way or the other, the car will turn in that direction. Investing is very much the same. A typical investor does not need to know the beta or alpha of a mutual fund. They just need to know the basics of investing to grow wealth. During my career as a financial advisor, I have met with thousands of investors. I have observed clients that have made mistakes based on emotional decisions and I have met with clients that have made lucky decisions. However, I noticed a trend with the habits and decisions made by many people with wealth.
Build and Maintain an Emergency Fund
The foundation of every financial plan starts with an emergency fund of 3 to 6 months worth of living expenses. An emergency may include events such as job loss, disability, or appliance failure. I like to call this “life”. When “life” happens, an emergency fund allows you to cover those costs without using a credit card or accessing other long-term investments. An emergency fund is the foundation of an individual’s wealth. Many money markets are available with little to no accumulation to start. A money market account provides the potential for a slightly higher return than a checking or savings account.
Keep Fund Expenses Low
Assume that you have to go to the grocery store to buy some oranges. Two stores offer very similar oranges at the same price. Store A charges $5 just to get into the store before you can buy the oranges. Store B allows you to walk in at no cost to buy the oranges. Any rational consumer would choose Store B over Store A. In the mutual fund industry, Store A is called a front-end load mutual fund and Store B is considered a no-load mutual fund. In this scenario, the correct choice seems obvious. However, investors on a daily basis are being charged front-end loads, back-end loads, and high internal expenses that are unnecessary and erode returns. Let’s take a minute to discuss the types of charges that may be incurred by a mutual fund investor. The first charge that may be incurred is a front-end charge or a back-end charge. A “loaded” mutual fund will charge a percentage, often 5%, off the top of the contribution. This leaves an investor with a $95 investment in a mutual fund assuming the contribution amount was $100. This means the investor has a smaller amount invested which will lead to a smaller accumulation compared to the full contribution being invested at the same rate of return. In contrast, a back-end charge is the cost for leaving a fund within a certain time frame. A prudent investor should never pay a front-end load or back-end load for investing in a mutual fund. There are thousands of no-load funds that offer similar or superior returns to loaded funds. When you look at purchasing a mutual fund the same as the grocery store example above, it makes perfect sense to purchase the fund with no front-end charge. The second charge that you may incur is an annual expense. This is sometimes called an internal expense ratio.Both loaded and no-load funds charge an annual expense. However, the annual expense can vary widely. These expenses can be found in the prospectus of the fund and may be hard to find. Keeping with the grocery store example above, this would be similar to paying less for oranges in one grocery store compared to another. The less you pay at the grocery store for oranges, the more money you are left with in your pocket. Investing in mutual funds with a low internal expense ratio will lead to higher accumulations than a similar fund that has higher charges. Many companies such as TIAA-CREF and Vanguard offer no-load mutual funds with low internal expenses. The third charge that you may incur is a maintenance charge. These are the irritating small deductions that you may see on a quarterly statement. These charges can be hard to avoid if you have a small balance. Usually, these charges can be avoided with a balance over $10,000. Maintenance charges will vary between mutual fund families.
Systematically Save in a Tax Efficient Manner
Rome wasn’t built in a day and unless you win the lottery or your rich Uncle Jed leaves his oil money to you, your wealth will take years to build. In a society that wants instant gratification, saving a small amount on a monthly basis can be frustrating. Many of my wealthy clients have been saving monthly into a retirement plan, Roth IRA, and mutual funds for thirty years or more. In addition to taking a disciplined approach to systematically investing, making sure you are using the correct vehicle according to your goals is extremely important. Vehicles such as 401(k)s, 403(b)s, SEP IRAs, Roth IRAs, Traditional IRAs, and 529 College Savings Plans are examples of investment vehicles that can save investors money in taxes immediately or in the future.
A diversified portfolio means investing in multiple asset classes that are going to react differently in various economic conditions. Many clients I have with wealth found an appropriate allocation based on their risk tolerance and time horizon to their goals. A diversified portfolio can help investors smooth out some of the volatility associated with the markets.
Money causes emotion and makes investors act in irrational ways. I have seen investors move money out of stocks at the bottom of a bear market to turn around and place it back in the stock market after a 50% run up. The stock market is going to be volatile and it is important that investors realize that they should not panic. Decisions to move money out of stocks based on emotion may lead to bad decisions and opportunities lost when the stock market recovers.
While many of the habits referenced above may be more complex than I have covered in this article, these basic concepts provide a framework for most investors. Following these basic habits will provide a guideline to become a successful investor. It is also the responsibility of the investor to educate themselves to understand these basics concepts.Many investors feel overwhelmed by the prospect of researching financial information. However, there are many resources available to help you navigate through the research process. These resources include a mentor that has recently retired, magazines, websites, mutual fund company phone centers, and financial advisors. Just remember, investing is like driving a car.