by David Bach
FOR SHORT-TERM DREAMS (LESS THAN TWO YEARS)
It doesn’t get simpler than this. If you’re saving for a short-term dream, such as going on a vacation or redoing the kitchen—anything you can achieve in two years or less—you need to invest conservatively and keep your money liquid (meaning easily accessible).
In my opinion, there is only one sensible investment that meets these criteria: your money should go into a money-market account. I discussed money-market checking accounts in Step Six as the smart alternative to regular bank checking accounts. In this case, you don’t necessarily need the checking feature because you’re not going to be using this money until you’re ready to realize your dream. So what we call a “plain vanilla” money-market account—that is, one without any frills or features—may be all you need.
A money-market account is a mutual fund that typically invests in very liquid, very safe, very short-term government securities. As I noted earlier, money-market accounts can be opened at most brokerage firms with relatively small initial deposits. Indeed, in many cases, if you set up an automatic investment plan, you can fund them with as little as $50 a month.
These accounts are not only incredibly safe (to my knowledge, there has never been a money-market default), they are also quite stable. In recent years, they’ve generally offered an average annual interest rate around 1 percent (in the original version of this book they were 4 to 7 percent; as interest rates go up, these rates may someday return but don’t hold your breath).
In many cases, you can find money-market accounts that pay as much or more than a one- or two-year certificate of deposit. What’s more, money-market accounts are liquid, which means you can pull your funds out at any time without ever having to pay a penalty fee. With rates as low as they are today, money markets are simply a safe place to put your money for the short-term dream.
If you don’t yet have a financial advisor, opening a money-market account can be a great way to begin a relationship with one. Get a referral from a friend or visit the local branch of a major brokerage company and ask to meet with an advisor. Explain that you’re looking to open a money-market account and that you would like to set up a systematic investment plan to fund it. By the way, there are no commissions on money-market accounts, so you don’t need to worry about the cost of setting one up. There isn’t any.
FOR MID-TERM DREAMS (TWO TO FOUR YEARS)
In this time frame, things are a little trickier. If you happen to be ultraconservative and don’t want to risk your dream money, I’d recommend going with a short-term bond fund. However, if you’re looking for more of a return—and can handle a little more risk—you should consider what’s known as a balanced fund.
Short-term bond funds invest in really short-term government bonds, typically Treasury bills with maturities ranging from six months to four years. These types of bond fund are very safe and relatively stable (meaning the price won’t fluctuate much).
Balanced funds are mutual funds that invest in both stocks and bonds. A typical balanced fund will have about 60 to 70 percent of its assets in stocks and the remainder in bonds (usually Treasuries). Because it’s so well diversified, this type of fund is less risky than a pure stock fund. And while it normally won’t outperform the stock market, it should come close to matching it. Typically, a balanced fund will generate about 75 percent of the returns you would get from a similar-sized investment in the stock market. Indeed, over the last decade, balanced funds have generated annualized returns of about 8 percent over the past 20 years. These are not guaranteed returns; the returns are based on the market’s returns, and past performance does not guarantee future performance.
Comparing balanced funds to straight stock funds is like comparing the tortoise to the hare. Balanced funds are slow and steady, but they will get you to where you want to go. These are by far my favorite “starter” investment. These are also good for long-term investment dreams.
FOR LONG-TERM DREAMS (FOUR TO TEN YEARS)
Once you get to dreams that are going to take you more than four years to save for, you should really consider putting your dream-basket money into growth-oriented investments. Because you’ve got more time, you can afford to take more risk to get a bigger return. To my mind, that means investing in stock-based mutual funds.
WHERE DO WE START?
As far as I’m concerned, the first place you should put your long-term dream-basket money is in an index fund. Index funds are simple, inexpensive, easy to set up, and they work. What more could you ask?
Index funds are stock mutual funds that mimic a specific index. In recent years, the most popular of these have been S&P 500 index funds. These funds invest in the 500 stocks that make up the Standard & Poor’s index. Next to the Dow Jones Industrial Average (which consists of 30 or so “blue chip” stocks), the S&P 500 is one of the most commonly quoted stock-market indicators. That’s because the performance of the S&P 500 pretty much matches the performance of the overall market.
The main reason index investing has become so popular is that it costs less than investing in other kinds of funds. The cost of an average index fund may be 80 percent less than that of an actively managed fund. What’s more, index funds offer real tax advantages. Because index fund managers move in or out of particular stocks only when those stocks are added to or dropped from the index they’re mimicking (something that happens relatively infrequently), there is barely any trading that results in taxable capital gains. In addition, while index funds may have lagged behind some actively managed funds in the go-go years of the late 1990s, historically they have tended to do better than most other funds. (Over the last 20 years or so, index funds have outperformed roughly 75 percent of the actively managed funds.)
If you want even broader exposure to the stock market than an S&P 500 index fund, you might consider a Wilshire 5000 Index Fund. As the number suggests, the Wilshire 5000 tracks the performance of 5,000 separate stocks, and as a result represents one of the most diversified market gauges you can find.
Here is a list of some popular index funds. Remember, they all represent investments in the stock market—meaning there is risk involved. So read their prospectuses before you invest any money.
S&P 500 Index Funds
Vanguard Index 500 (symbol: VFINX)
(800) 992–8327
www.vanguard.com
Minimum investment required for a regular account: $3,000/For IRA: $3,000
Systematic Investment Plan: No minimum required.
Schwab S&P 500 Fund (symbol: SWPPX)
(866) 855–9102
www.schwab.com
Minimum investment required for a regular account: $1/For IRA: $1
Systematic Investment Plan: $100 minimum for additional investments
Fidelity Spartan 500 Index (symbol: FUSEX)
(800) 343–3548
www.fidelity.com
Minimum investment required for a regular account: $2,500/For IRA: $2,500
Systematic Investment Plan: Must first meet minimum investment/$10 minimum for additional investments
Wilshire 5000 Index Funds
Vanguard Total Stock Market (symbol: VTSMX)
(800) 992–8327
www.vanguard.com
Minimum investment required for a regular account: $3,000/For IRA: $3,000
Systematic Investment Plan: No minimum required.
Schwab Total Stock Market Index Fund (symbol: SWTSX)
(800) 225–8570
www.schwab.com
Minimum investment required for a regular account: $1
Systematic Investment Plan: Must first meet minimum investment/$100 minimum for additional investments
EXCHANGE-TRADED FUNDS (ETFS)
In the last decade and a half, a new class of index funds has become increasingly popular. Since I wrote this book in 2000, exchange-traded funds have exploded and changed the investment landscape. There are more than 4,779 ETFs now, and the number is growing, according to Statistica.com. Ther
e is nearly $4 trillion in ETFs globally, according to research firm ETFGI. ETFs are basically mutual funds that trade like stocks, meaning you can buy and sell them during market hours just as you can buy and sell common stock. What makes these funds so exciting to investors is that they are incredibly liquid, incredibly tax efficient, and extremely low cost. The average ETF has an expense ratio of about 0.20 percent, and sometimes less. And most of these funds sell for less than $100 a share. How’s that for ease of investing and diversification with very little money?
Some of the most popular ETFs are the S&P 500 Index Depositary Receipts (known as Spiders, because their trading symbol is SPY), iShares Core S&P 500 (trading symbol IVV), Vanguard Total Stock Market ETF (trading symbol VTI), the Dow Jones Industrial Average Model Depositary Shares (or Diamonds; trading symbol: DIA), the NASDAQ 100 Trust (known as Cubes, after its QQQ symbol), and the S&P MidCap 400 Depositary Receipts (symbol MDY).
ETFs can be purchased through virtually any brokerage firm or online trading company. For more details on this exciting new investment vehicle, go to www.ishares.com or visit www.etf.com.
MOVING BEYOND THE “GETTING STARTED” PHASE
Balanced funds and index funds are great places to start, but once your dream basket reaches a really large size—say, when it contains $25,000 or more—it’s time for the two of you to consider building a diversified portfolio of mutual funds.
BUILD YOUR PORTFOLIO AROUND “CORE” FUNDS
I’m a huge believer in building a portfolio that consists of what I call “core-type” mutual funds. I’m also of the philosophy that the key to successful investing is to keep the process relatively simple and straightforward. With this in mind, here are the six types of funds I believe you should consider when building a mutual-fund portfolio. They are listed in the order of what I consider most conservative to most aggressive.
Target Date Funds If you use a target dated mutual or an asset allocation fund then you don’t need the funds I am listing next (because they will more than likely already be included in the fund). I covered the target dated mutual fund concept early in Step 5 on this page. Go back to that page for the details again. Target dated mutual funds do all the work of selecting the funds and do the asset allocation for you. They are much like a balanced fund but more advanced. As a result, you could easily decide to use a target dated fund for your dreams. For example, if it’s 2018 when you read this and your dream is going to take five years to fund, then you could pick a fund coming due in five years (2023) close to that date. Target dated funds are not just for retirement.
Large-Capitalization Value Funds A large-cap value fund invests in companies with large market capitalizations—that is, companies whose outstanding stock has a total market value of $10 billion or more. Companies of this magnitude tend to be more secure and established than most, and, as a rule, they pay quarterly dividends to shareholders. The “value” part of the name reflects the basic strategy these kinds of funds pursue. Generally speaking, the manager of a value fund looks for high-yielding large-cap stocks that sell at low price-earnings multiples. (That’s a fancy way of saying that these funds like to invest in solid companies whose stock is selling at bargain prices.) By investing in these types of stocks, you can often get consistent returns with relatively lower volatility. I’m a big fan of value investing. With that said, you need to diversify and not just go with one fund style or market cap weight.
Large-Capitalization Growth Funds These types of funds invest in what are commonly referred to as “growth stocks.” Large-cap funds typically look for stocks with a market value greater than $10 billion. Typically, growth stocks do not pay dividends because growth companies prefer to invest their profits in research, development, and expansion. Some great examples of large-cap growth companies are Apple, Microsoft, Facebook, Google, Oracle, Intel, and Amazon.com. These companies are huge, but they are not yet focusing on paying dividends because they are focused on powering their earnings into areas that they believe will grow the value of the company.
Medium-Capitalization Funds Otherwise known as “mid-caps,” these funds invest in medium-sized companies—that is, those with a market capitalization of $2 billion to $10 billion, such as Domino’s Pizza, ResMed, and Packaging Corporation of America. The potential for great returns here is high, but so is the risk. As a result, even though you find a lot of volatility in this sector, I think most portfolios benefit from containing some exposure to mid-cap stocks.
Small-Capitalization Funds It’s getting harder to classify these funds because some small new company can go public these days with no earnings and overnight see its market capitalization suddenly spike to $1 billion or more. Typically, small-cap funds invest in companies with market caps that range from about $250 million to $3 billion. This reflects an ultra-aggressive approach, which can potentially produce great returns. Small-cap investing is a lot like betting on the hare instead of the tortoise. The younger you are—which is to say, the more time you have to recover from a potential downturn in the stock market—the more you can afford to invest in this way. Because of its aggressiveness, I don’t recommend putting more than 20 percent of your assets into this type of a fund.
International or Global Funds As the name implies, these funds invest in stocks from foreign countries. While an international stock fund invests solely in foreign stocks, a global fund will usually have only about 60 percent of its assets invested abroad; the remaining 40 percent will be in domestic stocks. Remember, as big as it is, the United States represents only about a third of the total world economy, and if you invest only in domestic stocks, you’re missing out on a lot of opportunities. I usually recommend that investors keep about 10 to 20 percent of their portfolio in international or global mutual funds. If the European economy really starts to take off, you might want to increase this percentage, but for now I wouldn’t put more than 20 percent of your assets into this type of fund.
Created by Sterling Capital
Source: Morningstar
The DJ Industrial Average and S&P 500 Index represent returns of passive indexes, while the “Morningstar” portfolios represent the average return of investment managers in the respective strategy.
WHO SAYS YOU CAN’T EARN 10 PERCENT ANYMORE?
One of the most common things I hear is that it’s impossible to earn 10 percent in the stock market now. Really? Says who? I intentionally gave you the first chart to show you a long-term perspective of the market returns. Now let’s look at the last eight years. You could have basically thrown a dart into the market and picked nearly any stock-based index fund and had double-digit returns. This is why when I wrote Start Over, Finish Rich my mantra was “Recessions make millionaires.” Recessions always create the next generation of millionaires if you invest and buy things that are “on sale.” As I write this, the market is up nearly 300 percent from the low in 2009. I have no idea when you will read this. The market could be going through a correction or continuing its bull market run up. What I know is this, the next time the market has a significant correction, don’t believe people who tell you, “This time it’s not going to recover—this time is different.” The markets have always recovered. A correction is not fun to go through, but if you don’t panic, you can live through it and thrive.
Created by Sterling Capital
Source: Morningstar
The DJ Industrial Average and S&P 500 Index represent returns of passive indexes, while the “Morningstar” portfolios represent the average return of investment managers in the respective strategy.
WITH 9,500 FUNDS TO CHOOSE FROM, HOW DO WE KNOW WHICH ONE IS RIGHT FOR US?
Let’s face it, even mutual-fund investing has become pretty complicated in recent years. There are so many different funds, (9,500 at last count, down from 13,000 when I first wrote this book). And now, as previously discussed, there are nearly 5,000 ETFs. So many ads screaming about performance. So many books, magazines, websites, television shows—all of them with their own sugge
stions on how to pick a mutual fund. It’s enough to get a Smart Couple confused to the point of not taking action.
The good news is that a competent financial advisor can help you build a diversified portfolio on a fee basis. I cover how to hire a financial advisor in Step Eight, the next chapter (so keep reading). A good one will discuss your goals and risk tolerance with you and then build a professionally managed portfolio of funds, oversee it, and rebalance it as necessary. Many financial advisors use both actively managed mutual funds and ETFs, and many of them today will do this for you with accounts that start at $25,000 (sometimes less). Additionally, virtually every single major financial service firm now offers a managed portfolio option. It may seem complicated, but you’ve already learned more by reading this book than most people will ever learn about investing. You can do this. And you don’t need to do it alone.
FOR REALLY LONG-TERM DREAMS (TEN YEARS OR MORE)
There are long-term dreams and then there are really long-term dreams. Say your dream is to build a second home in Hawaii, but you know it won’t be possible until your kids are out of college, which is at least ten years away. Where should you put your dream-basket money in the meantime? The mutual fund options I discussed in the previous section work fantastically well for long-term dreams, and I could simply leave it at that, but I want to provide you with all the major investment options, which is why we’re now going to cover annuities. They may be right for you, and they may not. The fact is that annuities are a major part of the investment landscape, so let’s learn about them. Over $220 billion was invested in annuities in 2016. There are lots of people who bash annuities, and usually that’s because they are marketing a competitive product (for example, a managed stock account). Annuities can be used for dreams accounts and also for retirement investing. There are really two major types of annuities for long-term dream investing: fixed indexed annuities and variable annuities. Let’s take a look and try to understand the basics of them.
