Understanding Investments

This week we listened to Dave Ramsey discuss various types of long-term investments.  For long-term wealth building, putting your money in a standard bank account is just not going to cut it.  You need to use some other vehicle that will outpace inflation and enable you to end up with more money than you start with.  If you dont need access to your money for at least five years, then that money can be invested instead of just saved.

Keep it simple, stupid!

Besides the statement directly above, Ramsey provided a few more rules for investing:

• Never invest purely for tax savings
• Never invest using borrowed money (that certainly should not shock anyone!)

Diversification is the most important tip

Diversification means to spread around and it lowers your overall risk.  Ramsey presented an interesting example in the workbook.  Imagine two different investors.  The first puts $10,000 into a investment that earns 7% interest for 25 years.  The second puts $2,000 dollars into five different investments and earns the following returns over the 25 years: loses all $2,000, 0% (under mattress), 5%, 10%, 15%.  Maybe surprisingly, at the end of 25 years the second investor will have almost $59,000 more!!

A (very) basic primer on investments

Remember that all investments carry different degrees of risk and that as risk increases so does the potential rate of return.  Liquidity is the ease with which you can access your money (cash is very liquid while equity in a house is not very liquid at all).  Conversely to risk, as there is more liquidity, there is typically less potential return.  Finally, remember that there are two types of risk to consider for an investment the investment risk itself (if I buy that Enron stock, is there a chance it will go down in value?) and inflation risk as it eats away at your money over time.

Different types of investments

Ramsey spent the remainder of the class touching on a few of the various types of investments out there.  I will just highlight some of those he mentioned.

• Single Stocks This is small piece of a company that you own.  You gain a return when the value of the company increases or when they pay you some of their profit (dividend).  These are extremely risky and should be kept to less than 10% of your net worth.  Ramsey does not own any individual stocks.
• Bonds — This is debt that you lend to a company.  Your return is the interest rate that the company pays you and the fluctuation in the price of the bond.  Ramsey does not own any individual bonds either.
• Mutual Funds An investment where many people put money into a pool to buy a bunch of different stocks providing diversification.  The pool is is usually managed by a professional portfolio manager.  Mutual funds are a good long-term investment and Ramsey does own shares of a number of funds.
• Rental Real Estate This is a good investment (Ramsey does own paid-for rental real estate) but he suggests that you have a lot of cash before getting involved with real estate investing.  His recommendation is to buy slowly with cash only.  Also, a reminder from him is that your money is made at the purchase so be patient and only buy big bargains.

Bad Investments

Ramsey does not recommend the following investment vehicles (in fact, he warns to stay far away from them):

• Gold
• Commodities & Futures
• Day Trading
• Viaticals

Daves suggested mutual fund portfolio

Ramsey suggested creating a diversified long-term portfolio by purchasing different mutual funds in the following proportions:

• 25% Large-cap mutual funds (growth & income)
• 25% Mid-cap mutual funds (growth)
• 25% Small-cap mutual funds (aggressive growth)
• 25% International mutual funds

Cap means the capitalization of a company which means how big the company is.  So, a large-cap mutual fund owns companies like IBM and/or GE.  By purchasing a few different mutual funds to create a similar portfolio, you are able to reduce your risk (relatively).  To recap: putting all your money into some shares in a single company is very risky, purchasing a mutual fund is much less risky, and purchasing a diversified set of multiple mutual funds is even less risky.  Again, the term risky is all relative as we have seen over the past year as all types of funds decreased in value.  So, remember that investing in stocks and mutual funds is a long-term endeavor!

A good tip or two

Ramsey concluded the class by giving out the following two tips:

• If you dont understand the workings of an investment well enough to be able to teach it to someone else, then you dont understand it well enough to buy it!
• Build wealth slowly Dont look for short-cuts; remember who wins in the tortoise and the hare story (hint its the turtle).

One other point out of our discussion

Right at the end of class during our discussion, someone asked the following question When was this video made? I couldnt really hear what he asked and his comments after the question (everyone was starting to pack up and leave) during class, so I asked my wife. His point was to insinuate that Ramsey would have changed the video after what happened in the US stock market since late 2008. I remarked to her, So he kinda missed the entire point of the lesson then?

Heres a reminder from me (not Dave Ramsey though he might say the same thing): You dont change long-term strategy based on transient short-term events. Ramsey tried to explain this during class when he took a number of events that caused a significant market drop and showed that in almost every case the market had recovered within a year of the triggering event.  Remember, the market does go up and it does go down too; thus it is possible that your investments will also go down (not just up).  That is why it is important to view investing as a long-term process.  If you need that money in the near-term, the market is not a good place to put it (Remember the five-year rule).

Check out my previous FPU posts:

www.borrowfromnone.com/2009/12/financial-peace-university-lesson-8-thats-not-good-enough/