EMS From a Distance: Investing 101
Defined-contribution plans, mutual funds and less-risky ways to accumulate savings
In a recent column, I covered budgeting as an uncomplicated, effective way to align expenses with income. Next, we’ll discuss how to augment that income by investing it safely. If you’re looking for a primer on penny stocks, junk bonds, loans to Liberian princes, or any other dubious uses of discretionary funds, you’ve come to the wrong place. All you need here is curiosity about less-risky ways to accumulate savings.
Give yourself a raise
There’s a saying that it takes money to make money. That can’t be true; I could go to work today with an empty wallet and still earn a paycheck. But the money I’d make would be limited to my salary. Or would it?
Many companies offer employees ridiculously easy ways to increase their earnings through defined-contribution plans with cryptic labels like 401K and 403B. “Defined contribution” just means the plan is funded mostly by workers, as opposed to “defined benefit” pension plans financed by employers. There aren’t too many of the latter anymore.
Most 401K-type plans require predetermined deductions from each paycheck before or after taxes (before taxes is often better; more on that later). All that salary goes into an account you own. Bosses can’t take it back, even if you leave.
Defined-contribution plans usually allow staff to decide how their money will be invested – so much in stocks, so much in bonds, etc.
Some employers also match portions of employees’ contributions – half of the first 4% you kick in, for example, which would be 2% of your before-tax wages. We’re talking free money, folks. The best advice I can offer is to withhold as much as you must to maximize your company’s contribution. You’ll thank me someday, but you’ll have to visit the Old Medics’ Home to do so.
“Before tax” means Uncle Sam’s share is deferred. Until when? Possibly forever, but at least until you withdraw contributions or turn 70½. It takes a long time to reach 70½ unless you’re ... uh ... 66.
You may be able to defer even more taxes by combining a conventional (not Roth) IRA with your 401K. That depends on your age, income, marital status and favorite color. Just checking to see if you’re paying attention.
Money in the bank
The most important skill I’ve acquired in EMS isn’t patient assessment, airway maintenance, or where to find good Chinese food; it’s risk management. You’ll need that and a willingness to keep up with current events if you want to make money without betting the ranch.
Why are current events important? Because reputable newsfeeds include clues about which investments might make sense at any time. Changes in interest rates, for example, are pretty good predictors of stock and bond prices. There isn’t room here to cover that topic in detail, but generally, stocks and bonds move in the opposite direction of interest rates.
So how do experienced risk managers like us with modest resources take control of our finances? Begin by recognizing the limitations of banks.
When I was a kid, I had a savings account at my neighborhood bank. It paid something like 5% interest – a generous amount today, but pretty much the norm in the ’60s. Today, banks are just as safe, thanks to FDIC insurance, but 5% yields on savings accounts haven’t been around since the Reagan administration. And checking accounts, if they include any interest at all, probably won’t pay you more than pennies a month.
Sometimes, banks offer money-market accounts, which combine savings and checking. Teaser rates may be as high as 2-3%, but they often drop below 1% within a year. Just walk away, Renee.
If you’re willing to leave funds untouched for six months or more, you can earn higher interest through certificates of deposit – low-risk investments that offer fixed returns for a number of months or years. Every bank I do business with sells CDs; however, rates have varied by several percentage points from one place to another. Shop around.
In general, the longer a CD’s term, the higher its yield. This is where a knowledge of current events can help. Are interest rates high or low? Are they headed up or down? Locking in attractive rates long-term is something we should all be trying to do.
Mutual funds: balancing risk and return
Money-market accounts and CDs are available through financial-services firms like Fidelity and Putnam, too, often with higher rates, but those huge money-management companies specialize in mutual funds – diversified, uninsured investments similar to stock, in that you buy or sell shares at prices that go up and down. Most funds pay dividends, too.
The chief advantages to mutual funds are:
You don’t have to pick individual stocks or bonds; professional investors will do that for you
You’re spreading risk over many securities
Here are three popular classes of mutual funds:
Stocks. The Dow Jones Industrial Average, a bellwether of stocks, has gained over 1,500% since the crash of 1987. That’s hard to beat. However, stock markets tend to be cyclical, which means the amount you’ll make depends very much on the timing of your investments and the number of years you can afford to wait for bad times to get better. Ideally, you’d buy stock or stock funds when prices are low and sell when they’re high. People tend to do the opposite.
Bonds. The value of existing bonds goes down as interest rates on newer issues go up; however, higher rates also mean new bonds will pay more interest than older bonds. Those factors moving in opposite directions mean bond funds often provide steadier but smaller returns than stocks.
Cash. These are similar to bank money-market funds, but with higher yields (usually) and no insurance. Large investment firms with billions or even trillions of dollars in assets are as dependable as banks.
Another safe but underrated investment is Series I Savings Bonds. Their payoff is tied to inflation – 0.7% to 3% during the past 10 years – and interest is tax-deferred. Plus, I Bonds are guaranteed by the U.S. government, which makes them as reliable as the cash in your wallet.
EMS is risky. Investing doesn’t have to be. Set goals, know your options, and don’t jump into anything that sounds too good to be true.
You worked hard for your money; now let it work for you.
[Read: EMS From a Distance: Money matters. Playing give and take with the government with tax prep, social security and retirement planning]