Contrary to the impression you may get watching all-day TV stock market shows, investing is not a sport. It’s a serious endeavor – specifically, a means to a better life for you and your family. If you invest wisely, you can acquire wealth for goals such as a down payment on a house, college tuition for the kids or a nest egg for a comfortable retirement.
Whether times are good or bad, financial health always begins with this simple idea: Your goals determine your investments – not the other way around. If you want to build up wealth for a goal far into the future, you invest with one strategy; if your goal is two years away, you invest with another.
The underlying principle derives from 200 years of stock market history. Stocks produce far higher returns than bonds and “cash” (that is, Treasury bills, money-market funds and short-term certificates of deposit). In the short term, stocks are far more risky than bonds – but not in the long term.
Thus, the principle: The longer you can keep your money at work before you need it, the more stocks you can own. Now, let’s look at the specifics – how to invest for three representative goals.
Down Payment on a House
As enthusiastic as I am about stocks, I believe the best investment any young family can make is a house. Residential real estate offers tax advantages that stocks can’t match: Mortgage payments are deductible, and profits (when you sell) of up to $500,000 are exempt from capital gains taxes.
Also, bear in mind that a house you own is an asset whose “income” (that is, the annual value it provides you each year in living space) isn’t taxable. By contrast, if you invest $200,000 in bonds and use the interest income to pay your rent, that income is taxable at ordinary rates – up to 40 percent and more, including state taxes.
So go buy a house or a condo. In most cases, you’ll need a down payment, and my strong suggestion is not to take foolish risks in accumulating it. Say you have managed to save $15,000 and expect, by squirreling away a small amount each month for the next three to five years, to have enough for a down payment – say, $25,000. What should you do with the $15,000?
Do not put it in the stock market.
The future, of course, is utterly unknown, but history provides strong clues, and the history of stock performance over short periods is frightening. Look at each of the 77 calendar years since 1926 and you’ll find that the benchmark Standard & Poor’s 500-stock index has declined 23 times. (I am using statistics gathered by Ibbotson Associates, the Chicago research firm.) That’s nearly one-third of the years!
Now, look at each of the 73 overlapping five-year periods during that time (1926-31, 1927-32, etc.). The S&P has dropped in eight of them – or about one-ninth of the years. I don’t like those odds. My strict rule is that investments of less than five years should be concentrated in bonds, not stocks.
When you buy a bond, you make a loan to a government agency or corporation, which promises to repay you on a specific date and cough up interest in between. The interest rate is set by the market at the time you buy the bond, and right now rates are extremely low. For example, on Dec. 31, two-year U.S. Treasury bonds (or, more precisely, “notes”) were paying only 1.6 percent interest; five-year notes, 2.7 percent. Bonds issued by federal agencies or quasi-public corporations with implied government guarantees such as Farmer Mac or Fannie Mae generally pay an extra quarter- to half-point.
With Treasury securities, you don’t have to worry about being repaid, but there are alternatives that are almost as safe. Top-rated five-year corporate bonds, for example, were paying 3.9 percent at year-end, and certificates of deposit issued by federally insured banks can be even higher. (A CD is a loan you make to a bank.) Capital One of Richmond, for example, was recently offering 21/2-year CDs at 3.4 percent and five-year CDs at 4.3 percent.
If the economy picks up, rates will almost certainly rise for new bonds and CDs, and you will feel awfully silly holding five-year notes paying less than 3 percent. My advice is to own a mix of bonds and CDs with “laddered” maturities – that is, they come due over several years, serially. For instance, a one-year bank CD might pay 2 percent for 2003, but when it matures in 2004, you may be able to take the cash and invest in a higher-rate one-year CD. There are no guarantees, of course. Rates might fall but, at these levels, they won’t fall very much.
My favorite bonds are TIPS, or Treasury Inflation-Protection Securities. These are T-bonds that pay a fixed “real” interest rate plus an inflation bonus based on the rise in the consumer price index each year. At year-end, the TIPS series that matures in January 2008 was yielding 1.7 percent. If inflation averages 3 percent over that period, you’ll be collecting interest at a 4.7 percent rate – compared with just 2.7 percent for a standard five-year T-note.
My strong preference in accumulating a down payment is to stick to Treasury, U.S. agency or federally insured investments. There’s no sense in assuming what’s called “credit risk” for an extra percentage point. Similarly, for short-term investments, I don’t like bond mutual funds, whose managers could be taking more chances with your money than you would on your own. Bonds mature; that is, you know when you are going to get the principal back. Mutual funds don’t.
So here’s a sample portfolio for $15,000 invested over the next five years: $5,000 in TIPS maturing in 2008 (paying 3.7 percent, assuming 2 percent inflation); $5,000 in a T-note maturing in 2006 (paying 2.2 percent); $3,000 in a bank CD maturing in 2005 (paying 2.5 percent); and $2,000 in a bank CD maturing in 2004 (paying 2 percent).
These sound like minuscule returns – and they’re taxable, to boot. But they preserve your principal, so you’ll be sure of making the down payment, and they put you in a position to earn more interest if rates rise.
College Tuition
Paying for college is a daunting prospect. Four years at Harvard currently costs an estimated $144,000, and even at the University of Maryland, state residents this year will pay $15,000 for tuition, room and board. Loans are available, of course, but the least expensive way to finance college (beyond grants and scholarships) is saving and investing – especially through the new 529 plans, which allow parents, grandparents and even friends of prospective students to contribute regularly to mutual funds with major tax benefits.
“With 529s,” explains a report from the Baltimore investment firm T. Rowe Price, “assets grow tax-deferred, and withdrawals used to pay qualified education expenses are federal income tax free.”
But which assets? Say you start investing for college when your child begins first grade. With a 12-year horizon, you can adopt either of these strategies: (1) Put nearly all your money into stocks; then, as your child leaves elementary school, start moving a larger and larger proportion of the assets into bonds until they represent about half of your holdings. Or (2) divide your money roughly 60-40 between stocks and bonds for the entire 12 years. The second approach is simpler, and I like it better because it gives you a smoother ride. Stocks and bonds often move in opposite directions, as they did in 2002, so a bad year for stocks can be softened by bonds, and vice versa.
Because stocks have returned an annual average of about 10.5 percent over the past three-quarters of a century and T-bonds have returned about 5.5 percent, a 60-40 portfolio should return about 8 percent (after expenses). MSN MoneyCentral offers a nifty calculator to figure out how much you have to put away each year to have enough for college.
For example, I assumed that college currently costs $15,000 a year and costs will rise 7 percent annually, that parents will start with $5,000 and invest for 12 years at an average return of 8 percent, and that taxes will be zero (taxes could be higher, of course, depending on your own situation). The calculator determined that four years of college starting in 2015 will cost $150,000 and to have sufficient funds, parents will have to invest $7,100 a year, or about $600 a month. Ouch!
If, however, you start with your child’s birth and keep your money at work for 18 years instead of 12, then your monthly investment will be only about $300 per month. The key to accumulating a pile of money is to start as early as you can.
Put the 60 percent of the account that goes to stocks into diversified core equity mutual funds with low expenses. Good examples are the index funds offered by Fidelity and Vanguard that track the S&P 500.
Also consider funds that are managed by actual humans. One that has clobbered the S&P over the past 10 years is Clipper (CFIMX), with average annual returns of 15 percent and a modest expense ratio of 1.1 percent. William Harding of Morningstar recently cited Clipper’s team, headed by James Gipson and Michael Sandler since 1984, among the 10 best mutual fund managers.
Another five-star Morningstar fund that merits attention for an education account is San Francisco-based Dodge & Cox Stock (DODGX), whose top manager, Harry R. Hagey, has been on the job for more than 35 years. Like Clipper, Dodge & Cox leans toward large-cap value stocks such as Dow Chemical (DOW) and Schering-Plough (SGP), holding them for the long term. The fund’s average annual return for the past 10 years is 14 percent, with an expense ratio of only half a percentage point. A bargain.
Since you’re putting your money to work for a long time, it’s perfectly reasonable to own a bond mutual fund, but keep it conservative. History shows that long-term Treasury bonds (maturing in more than 10 years) return no more than intermediate-term Treasurys, and the shorter the maturity, the lower the risk. A good choice, recently cited by Morningstar for its fine performance in 2002, is Fidelity Intermediate Bond (FTHRX), whose manager owns Treasurys, federal agency securities and top-rated (AAA) corporate bonds and does not make bets on the direction of interest rates. Currently yielding 4.4 percent, the fund charges a relatively low 0.6 percent in expenses.
Another sensible bond selection for the long haul is a fund that specializes in Ginnie Maes, securities issued by the Government National Mortgage Association, an arm of the U.S. Department of Housing and Urban Development that buys mortgages from banks and other lenders and sells them to investors. USAA GNMA Trust (USGNX), with four stars from Morningstar, has a solid track record (returning an annual average of 6.75 percent since 1992) and rock-bottom expenses (0.41 percent). You can also buy Ginnie Maes (and other bonds) yourself from a broker or banker.
One warning: The funds I have picked here would have produced annual returns, in a 60-40 portfolio, of about 11 percent over the past 10 years after expenses. It could happen again, but don’t count on such robust gains. Start early and keep plugging away. If you make more than 8 percent, consider yourself lucky.
Retirement
If you’re in your twenties or thirties and planning for retirement in the next 30 or 40 years, your investment choices are simple: stocks, stocks and more stocks. Unless you are particularly risk-averse and can’t sleep at night worrying about the day-to-day (or even quarter-to-quarter) ups and downs of your portfolio, then there is no reason to put any of your retirement money into bonds until age 50 or later.
Stocks are guaranteed to give you a wild ride in the short term, but their volatility smooths out dramatically in the long term. Look at these fascinating – and reassuring – statistics on market returns (both price increases and dividends) from Ibbotson, going back to 1926:
