2006 Makeover, Step #3: Thinking about Investing

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This is step 3 of my 2006 financial makeover (see step 1 & step 2).

Today, we’re going to start the process of investing. I’m also going to try to give you some ammo to tell your friends who are earning money–but aren’t investing any of it. So by the end of the article, you’ll know how to get started investing and you’ll be able to mock your friends. Happy Friday!!

The Final Word on Budgeting
But first, let’s finish doing our budgets. I’ve spent a lot of time on budgets in these articles because they’re really important. In step 1, I talked about figuring out how much money you’re spending. In step 2, we went in-depth on the budget, adding irregular events and more details. By now, you should understand your spending a lot better–in fact, you should be able to take the top-down approach of saying “I’m going to spend $300 on food this month” as opposed to “I guess I spent $850 on food last month” (sob).

This is the last time I’m going to talk about budgets for a while. But before we move onto opening an investment account, I want you to make one small change to your budget. You know how much you need to live every month; this includes not only necessities like rent, but also money for going out, etc. It’s fine to add a little extra until you get a more exact monthly amount. Now, you need to decide how much you’ll save every month (“savings” here includes mid-term savings and long-term investing money).

For example, let’s pretend you make $4,000/month (I’m completely avoiding taxes in this example). If it costs you $2,500/month to live, you have to decide what to do with the rest of your money. Remember, earlier I urged everyone who’s single to save at least 20-30%, and more if possible. Now here’s what you do:

Pay yourself first. Figure out how much you’re going to save each month, and treat it like just another bill. Seriously, in your budget, add an extra expense called “Saving” and pay yourself. If you can’t pay yourself that month, then you have to either cut some costs or earn more money. This is easier than you think: You can instruct your bank to automatically withdraw a certain amount out every month.

This is why I had you open a savings account last week.

If you want more information on the logistics of doing Pay Yourself, the author of Stackbacks.com has a great PDF with details of how to set this up.

Summary: In your budget, add an extra expense called “Saving.” Figure out how much you want to save (be aggressive) and pay yourself every month. Ideally, for easy tracking, your savings account should be in a different place than your checking account.

Result: At the end of every month, your bills are paid, your savings account has grown, and you know exactly how much you can afford to spend on every category in your budget. Congratulations.

Why Becoming a Millionaire Isn’t That Hard
Investing in the stock market is a fantastic way to make money over the long term (even better than real estate). But it takes a few hours of thinking and some deep research, so a lot of people get scared off.

One of the biggest myths about investing is that you have to be supersmart to make money. This drives me nuts. The 3 most important factors are these: Do your research (yes, you have to read some numbers), be disciplined (consistently put money away), and start early. Starting early is a monster advantage. Here’s why:

If you’re 25 years old and you save $100/month until you’re 35 (for only 10 years, then you never save money again), and your dumb friend starts later–saving $100/month from age 35 to 65 (that’s 35 years compared to your 10 years)–you will have way more money (over $50,000 more) than him at age 65. Start early and you’ll be rich.

It’s not hard to become rich. But it takes work and consistent saving, and so it’s easier for a lot of people to shrug their shoulders and put it off for another day. Unfortunately, every extra year you wait to start investing makes it dramatically harder to make the same amount of money. Also note: The $300 you spend on that iPod is actually worth many thousands of future dollars. See for yourself how it works (check the chart at the end of the page).

Next Steps: Read a Little, Open an Investment Account
1. Read a few articles I’ve written about stocks, bonds, and mutual funds, where I talk about which asset classes are good and bad for us, and how to pick them. They’ll help next week when we start looking at how to invest. Post any questions you have and I’ll try to answer them here.

2. Open an investment account at a discount brokerage. I don’t care which one you choose (try Googling “discount brokerage” for the most popular ones). How do you tell which one you should get? Make sure you can get someone on the phone; that’s really important, especially when you’re starting out. Just give each of them a call and tell them you’re looking for a discount brokerage, and why are they good compared to others?

Also note that they have varying trading fees. Yes, you should compare them, but if it’s a $10 difference, don’t worry about it–go with which one makes you comfortable. However, the trading fees are important for one thing: Many of you will start investing with smaller amounts, so you don’t want to invest $100 and have 25% eaten up by trading fees. When you call them, ask them if they have student accounts or if they’ll waive fees if you automatically send a consistent amount every month (many will).

3. By next week, have your investment account set up. Bonus points if you’re ahead of the game and you already electronically transferred some investment money there (it will just sit there, earning a little interest, until you decide where to invest).

Post your questions here and I’ll try to help.

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40 Comments

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  1. First off, I’m 22, I want an IRA. Secondly, while I can contribute regularly (a couple hundred a month) I can’t contribute large amounts.

    Would it be a good idea to (after some research) pick out some no load stock index fund such as Vanguard’s S&P 500, and just put it on monthly automatic deduction every month? Let that be my entire investment for a few years and let it build up? I know there are higher fees for lower balances, so investing in lots of different index funds seems a little silly.

  2. You’re thinking the right things. I’ll cover Roth IRAs soon, so stay tuned.

  3. Good writeup. The only qualm I have is with the idea that the stock market has better returns than real estate. The referenced article gives a 10% return rate that only counts capital gains. Two important aspects of RE investment that it ignores is the current income produced by either charging rent to tenants or by saving money on rent yourself and the effect of being leveraged. When taking into account these two effects real estate provides a much higher rate of return.

  4. Your website has inspired me to work on my budgetting skills, I have made a budget/expence tracking for personal and another for bussiness purposes.

    Im interested in getting into stock, Can you recommend some good sources to learn Stock Research

  5. Also, what do you do if you are dead sure your parents aren’t saving enough and won’t ever be saving enough for a good retirement and you may well be the main support? I figured step 1 would be fund up your own retirement as fast as possible so that if you’re forced to cut back on contributions later it’s not a problem, but what would step 2 be?

    P

  6. As far as discount brokerages go, I would recommend IZone, a subsidiary of Ameritrade. Though this is for experienced investors, if you answer the questions intelligently while opening an account, you should have no problem opening an account with them. Its a bare bone service and they charge only $5 per trade. I think its necessary that we try and minimize the amount one pays towards brokerage fees thus maximizing your profit.

    http://www.izone.com

  7. http://www.izone.com says…
    “You maintain an account value of at least $5,000″ under “In Exchange For” on http://www.izone.com/savings.html

  8. Your site is now my default homepage; keep up the good work.

    I have read many articles that discuss the power of compound interest, and I am always put off by the fact that a certain rate of growth is ASSUMED. What guarantees that 6%, 8%, or 10% growth will actually occur over the long haul? If you have a timeframe of 30 years or so, what is to say that we can’t have a 30 year bear market, or at least a bearish enough market for a long enough period of time to wipe out gains?

  9. Should one think about which company/area they’re going to invest before openning an investment account at a discount brokerage?

  10. You posted a great article Ramit. What actually constitutes a “discount broker”? Is it the amount they charge per trade? I currently have an account with scottrades, they charge $7 a trade, no minimum balance.

    Question number 2; can a person have more than 1 retirement account if they can contribute to it? Can I have both a 401k, IRA, and another retirement account? What about 2 IRA’s?

  11. I have a simular question as Johnathan. I have a 401K at work but my company does not match. I have been contributing to it, but I also started a Roth IRA with Etrade. Should I favor one over the other since I don’t get matching with the 401k?
    My guess is that the 401k is still good since it’s pre-tax and the IRA is good because I can kind of “play” with it?

  12. For thos of us reading from outside the US, would anyone care to briefly explain what an IRA is?

    A lot of the principles you talk about would be useful in most industrialised countries — maybe explaining some of the US-centric terms will widen your audience?

  13. Guys, I’ll talk about IRAs and 401(k)s in detail in a future article. Stay tuned.

  14. I use scottrader as well, but for people are are only investing small amounts of money in stocks, ensure that you pick a brokerage firm with the smallest possible commision. ShareBuilder for example only chargers $4.00 to buy, but charges quite a bit more to sell, enforcing the idea that you should buy and hold, but Ramit will have more on that later.

  15. I can’t wait to read about IRAs!

  16. #12 matt, an IRA is an Individual Retirement Account. There are 2 main types, Traditional and Roth, I’m sure the future article will explain all you need to know.

  17. IRA is the Irish Republican Army…oh wait sorry I’m not it Poli Sci. Anyways an IRA is as stated above an Individual Reitrement Account, Traditional IRA’s are taxed when you take money out, Roth are when you put money. I’m not going to tell you the advantages or disadvantages of either because that is Ramits job. Check out rothira.com for some info on them.

  18. >>>$300 you spend on that iPod is actually worth many thousands of future dollars.<
    assuming ceteris paribus. Reality is that your CDs will scratch, decay get ruined. etc. IPOD back up your music and you don’t have to buy CDs if they go to the crapper.
    IPOD sound investment. Should I buy new CDs every 5 years?

  19. Wow. An iPod is now an investment?

  20. >>>Open an investment account at a discount brokerage. <
    I beleive most have a minimum deposit of $2,000.

  21. If there’s a 30-year bear market coming, I’m going to stock up on can food and duct tape. I’ll get rich by hording them and then selling them at 4000% their current value.

    If there’s a 15 year bear market coming, prudentbear.com advises buying gold or gold etfs/index funds.

    If there’s a 5 year bear market coming, I believe the standard advice is to invest overseas until the US market rides out the downward funk. Then buy buy buy when you think we’re as low as we can possibly be. You’ll make money via regression to the mean.

    If the economy is going completely sideways, look for investments with a yeild that is greater than the interest rate of a cd/t-bill. If you can’t find any, build a short-term cd/t-bill ladder and defer buying stocks to a time when you think the economy has decided where it want to go.

    There are methods of approximating atleast 4-5% no matter what type of economy we are in.

  22. Jennifer, just one question: How will you know what’s going to happen?

  23. Ramit, are you going to discuss student loan payoff in a future post? In particular, what are the pros and cons of paying more than your minium loan payment vs putting that money into an investment/retirement account?

  24. Graham Lathrop Link to this comment

    For those that can get access (military and grandfathered military), USAA has excellent investment services with low rates. An all around good organization that many people do not think of.

  25. Ramit, I have no idea what is going to happen. But if I wake up some day with the gripping irrational fear that “la vida goldilocks” is about to crumble, I’ll have a plan and feel somewhat empowered.

    Ramit, did you mention that you did consulting work as a student? Do you still do consulting work? In that future IRA/401k article could you say a few words about consulting/odd jobs and opening SEP IRAs or Simple IRAs for anyone under 21?

  26. Jennifer: I dunno, my investing strategy is not about feeling empowered…it’s about making money. Same as when I pointed out that investing isn’t about being sexy (lots of derivatives, shorts, arbitrage, etc), it’s about getting rich.

    Yeah, I still do consulting once in a while. But I’m not an expert on SEP IRAs enough to write about them!

  27. I have a relatively small amount of money that I will be investing regularly. Since even the lowest fees will factor significantly into my long term earnings, I’ve been comparing ShareBuilder.com and Scottrade.com, both with the lowest fees.

    Sharebuilder’s fees jump from $4 to $16 unless you use their automatic system, which only makes purchases on Tuesdays (so no live trading).

    Scottrade charges $7 for a pseudo-real-time trade (and sale).

    Up front, it seems logical to go with ShareBuilder. Is this really true? It seems like a huge advantage to be able to purchase stock in near real-time. For the pricier stocks (like Google) picking the right time to buy can save you more than the $3 difference in trade fees.

    With the fee being negligible, Scottrade seems to have more advantages than Sharebuilder.
    Also, in order to fund an account, it appears I have to use a wire transfer. My bank charges $20 for an outgoing domestic wire transfer. Does anyone know how to minimize wire transfer fees? Are these negotiable with your bank?

  28. Jason, great questions.

    It seems like timing your stock purchasing would be important, and to a certain degree, it is. But over the long term, saving consistently is far more important than guessing whether a stock is high or low. Remember, although a stock may seem like it’s suddenly low, it’s all relative and you’ll only know that in retrospect. It’s generally a losing strategy. Try searching for timing the market to see what I mean.

    Personally, I would opt for consistency over a guessing game.

    As for the wire-transfer fees, they just suck. Sadly, the fees are high and you can’t negotiate them (I’ve tried). But most online brokerages don’t use wire tranfers, they use electronic transfers, which are free. Call them and look into this.

    In the worst case, you can mail them a check and avoid paying the stupid wire-transfer fee.

  29. But Ramit, isn’t “personal entrepreneurship” a big part of “getting rich?” Aren’t “barriers” your enemies? Isn’t lack of “empowerment” (ie the inability to DO anything due to fear or minutae overload) the #1 enemy?

    My point is if someone really thinks that we’re due for a 30 year bear market, there’s a game plan out there for them. They have no excuse to sit on their hands and moan about inflation.

  30. Oh I agree, Jennifer. My point is just that nobody knows what’s going to happen in 5 years, much less 30.

    But you’re right. Anyone who sits stricken by indecision is going to lose lots of potential gains. There’s always an option.

  31. i totally disagree that the stock market is a better investment than real estate. I’ve been invested in the stock since 1999 with pretty lousy returns. I’ve started investing in Real Estate since 2003 with spectacular returns. Real Estate offers tremendous leverage, tax-deferred gains, phantom losses against regular income and there’s just no comparison. The only people who tout stocks as a better investment are stock-brokers and financial planners. Thats not to say that its not difficult. I do not own my own home and my closest rental is 976 miles away. [Which is good. I don't want my tenants calling me to fix something!]

    In real estate you can get an easy 30-50% return on your money every year. i’ve gotten 16,500% returns on some investments and have sheltered the gains from taxes. try making that in the stock market and not paying taxes!

    also recommended reading – ben stein’s “yes, you can time the market”.

  32. Empty Spaces: Sounds great, but who DO your tenants call when something breaks? I’m assuming you had to enter into some kind of agreement with a maintenance company, which is eating into your profits? Also, the problem with real estate, as far as I’m aware, is that you need a sizeable initial investment. If I want to invest $1000, or even $10000 right now, I can buy lots of shares of stock, but there’s not much (if anything) I can do real-estate-wise, right? Please correct me if I’m wrong – I would very much like to be wrong in that statement.

  33. http://www.interactivebrokers.com is a great deep discount brokerage. As low as $.005 per share, and they do IRA’s. $2k minimum deposit.

    If you’re looking for someone more local Scottrade is good. Great customer service, local brokers to talk to if you’re not sure of stuff. They don’t give investing advise, though, being a deep discount brokerage. $7 trades limit or market. This fixed fee is good when you start getting into larger amounts of shares.

    There’s always going to be debates between the market vs real estate. Both are great investments with their own barriers to entry and success. Real estate happens to generate passive income as well as potential for appreciation. Stocks for example also have the potential for appreciation, as well as passive (dividends). They’re not mutually exclusive investment vehicles either, so there’s no point in debating about it…

  34. Ok, so my wife and I have read the articles you listed in step 3 here (about stocks, bonds, mutual funds, and asset allocation). We’re totally psyched. We’ve been following along with your first 2 articles, and we’re now officially in new waters, financially speaking.

    So I have some questions: Do you have articles explaining options or margins? These are terms I’ve heard associated with stocks, but I haven’t found any good explanations of these.

  35. Dan: Thanks for reading. No, I don’t (intentionally). I’m writing about the simple, long-term steps to get rich–not the advanced, cool hand-waving things that most beginners shouldn’t care about.

    If you really want to learn about that stuff at this stage (I can’t imagine why), check out Investopedia dictionary.

  36. Ah — good to know that I shouldn’t be worried about options and margins now! That’s why I asked :-)

  37. Thanks for all the good advice. I’ve referenced your blog on my blog. The Good Life.

    ~Maria Palma

  38. I’ve just been reading up on your site – great! Thanks!
    To those wanting to learn more about investing, I’ve been learning a lot about stocks and funds over at fool.com aka the Motley Fool.

  39. Just had to comment about the ipod as an investment post… Ipods usually don’t last for more than 5 years, they are running off of a hard disk drive. Hard disk drives do wear out and can wear out very fast if exposed to lots of vibrations. Plus cost of proprietary batteries can take a serious chunk of change to replace every year or two when they get worn out so bad that they barely can play 1 cd’s worth of music before dying.

    As for CD’s, a CD can easily last 25+ years if taken good care of.

  40. Re the whole iPod as investment question: an iPod isn’t an investment. I think Ramit’s intention in mentioning it was to say that you should think about the other things you could do with that $300, instead of buying an iPod. To me, it said that the $300 was worth thousands in the future, not the iPod! Sorry, Ramit, if I’m putting words in your mouth. Please correct me if I’m wrong.