The following is a guest post from Tom Cleveland of Forex Traders.
It is often said that there are three simple steps towards building financial security for the future: start saving, save enough for emergencies, and then invest the rest.
Investing is all about managing risk, and in this day and age, that task is daunting at best, and overly complex for anyone new to the world of investing.
There are three key factors required for investment success. These are knowledge, experience, and a disciplined approach to the market. You must be willing to invest time learning each area.
There are no shortcuts to success. Studies, time and again, confirm that impatience and inexperience will lead to failure in any one of the many trading markets around the globe. Stocks and bonds require careful study and research to determine if value is present, and whether it will grow in the future.
Investment vehicles, however, can be organized according to the level of risk that they present. Generally, an item of higher risk offers the potential for a higher return, but also a higher potential for a large loss. For the beginning investor, who has embraced frugality and saved enough for an emergency fund, your focus should be on the lower risk items at the base of the following pyramid:
The first step is to grow accustomed to setting aside 10% of every paycheck into a savings account or money market account that’s roughly 3-6 months of net pay for an emergency fund. The emergency fund is there for unexpected medical bills, car repairs, or anything else that hits when Life comes at you fast. You never want to be forced to sell an investment security since you may suffer early withdrawal penalties or hit the market at the worst possible time to sell. The most important thing to remember with an emergency fund is to keep it “liquid”, or easily transferred into cash. Storing your emergency fund in a savings account or money market account will keep it liquid as well as mitigate the effects of inflation.
Now that you are ready to invest, you must learn to avoid a few of the common pitfalls that face beginners. Avoid commissioned salesmen, whether they are selling special insurance products or are broker/dealers with special securities to unload. Heavy commissions mean small returns. Never buy whole life insurance, and beware of variable annuities – they are rarely right for anyone. Timeshares are not good investments, and real estate requires specialized training to discern true value.
The “safest” items are at the bottom of the risk pyramid. However, that does not mean that there is no risk. Certificates of Deposit are the acknowledged leader in this sector of investment types. CD’s, also known as “time deposits”, are issued by banks and savings and loans for different periods of time, typically three months to five years. They earn a higher interest rate when you choose to tie up your money for a longer time period. They are FDIC protected up to a certain limit, but when funds are withdrawn early, penalties may apply. Bankrate.com is a good source of information on issuers and on rates in the marketplace.
Safe implies that returns will also be low. Most all of long-term CD’s pay less than 3% on an annual basis. Your banker can instruct you on how to set up an Individual Retirement Account (IRA) in order to shield your savings income from current applicable tax rates. With an IRA in place, whether at work or with your banker or broker, the rule of compounding will work better for you.
When interest is allowed to accumulate over time, it produces a “multiplier” effect as shown above. If you had invested $10,000 at 6% for 20 years, your principal would have grown to $32,000. Eliminating the reduction of taxes until later will ensure that these calculations hold in the long run. If you wish to preserve your purchasing power, then you must also protect yourself from the ravages of inflation.
Inflation has average 2.5% for the past decade. Government bonds may help, but when interest rates rise, the value of a bond declines. Do not buy Gold coins or bullion as inflation hedges either. They are too difficult to control or sell, but Gold Exchange Traded Funds may meet your risk threshold and serve your interest. Check with your broker first.
Frugality and savings are excellent first steps to financial security. The next step is to secure an emergency fund of 3 to 6 months of income in a savings or money market account. Once you have your safety net in place, learn prudent investing disciplines, and the next steps will come easier for you.
Tom Cleveland is a market analyst for Forex Traders, an online resource for the foreign exchange market and currency trading.