Basics of Investing - Part 2 - Bonds

Let's return today to our Basics of Investing Series.

In our last installment, "Basics of Investing - Part 1", we answered the questions: "Why Invest?", "What is Stock?", "What is the stock market?" and "What is the difference between saving and investing?".  In this post, we will explain what a bond is and how bonds work.

Fundamentally, a bond is a loan to a company or government (city, state or federal).  You are the lender, or "bond holder".  The company or government agency is the "bond issuer".  A bond typically has a fixed interest rate and a maturity date.  If you hold the bond until the maturity date, you will be paid back the original loan amount plus interest.  Some types of bonds pay regular interest payments during the period you hold the bond.

There are many types of bonds.  Here are a few.

Treasury Bills, Bonds and Notes - issued by the U.S. government and are considered the safest of bonds.  Different bond types have different number of years before they mature and slightly different terms.

EE Savings Bonds are issued by the federal government and earn a fixed-rate of interest and can be redeemed after a year (though you lose three-months interest if you hold them less than five years).  They can be held up to 30 years.   They can be bought for any amount starting at $25.

I Savings Bonds are similar to EE savings bonds, except the interest rate you earn rises and falls with inflation. - Also issued by the US government.

Agency bonds are not quite as safe as Treasury issued bonds, but they are often safer than corporate bonds. They’re issued by government-sponsored companies.  They are not backed by the “full faith and credit” of the U.S. government like Treasurys.


Municipal bonds, or Munis, as they’re commonly known, are issued by states, cities and local governments to fund various projects. Municipals aren’t subject to federal taxes, and if you live where the bonds are issued, they may also be exempt from state taxes. Some municipal bonds are more credit-worthy than others, though some munis are insured. If the issuer defaults, the insurance company will have to cover the tab.


Corporate bonds are bonds issued by companies. Corporate debt can range from extremely safe to super risky.

Most investment professionals agree that bonds help to dampen out the volatility of stocks and add a measure of protection against stock losses.  Dave Ramsey disagrees.  Here is a link to a very informative video clip wherein Dave explains why he does not advocate holding bonds.   Virtually every other financial professional I follow online and 100% of the investors I have discussed this subject with has advocated some percentage of your portfolio be dedicated to some type of bonds. The list of people I have found to be at odds with Dave on this subject include Russ Carroll - Dave Ramsey's recently retired right hand man and one of the most knowledgeable financial people on the planet as far as I'm concerned.  I discussed the subject of holding bonds with Russ personally at an investment training class he taught at Financial Peace Plaza years ago.

For further reading, here are some links to really good and in-depth bond explanations. Enjoy!

• Sound Mind Investing articles on bond investing.  This is a list of very well-written and easy to understand articles.  You can delve as deeply into the subject as you want at this site.

• Wall Street Journal personal finance pages - http://guides.wsj.com/personal-finance/investing/what-is-a-bond/

Next up, in our Basics of Investing - Part 3, we will explain what a Certificate of Deposit, or CD, is.  See you then!

Jim

Danger! Stay Away!

In this installment, I'd like to take a minute to warn readers about some potential pitfalls.  Don't fall in these traps!

• Payday loans, title pawn - even with the Federal laws that were recently put in place these predatory lenders are horrible rip offs.  They can still legally charge up to 17.5% Interest on a 30-day loan amount.  That's equivalent to 210% interest per year.

• Lotto, powerball, etc. - these institutions are a tax on the poor and those who can't do math.  The odds are better that you will walk outside and have a flying pig land on your head than the odds of you winning the lottery.  The average person that plays the lottery regularly spends over $100 per month.  That much money invested wisely over a lifetime would make you very wealthy.  Stay away from gambling of any kind.  People say "I just gamble for entertainment".  If you want some entertainment, walk down the street throwing $20 bills on the ground.  Pretty soon there will be people scrambling all around you.  You'll probably cause at least one traffic jam and a heck of a lot of commotion.  Now that would be entertaining!

• Car lease - Smart Money magazine, Consumer Reports and Dave Ramsey all agree a car lease is the most expensive way to drive a vehicle.

• Credit Cards - Unbelievably large pitfall.  It's amazing to me after so many people's lives have been ruined by out-of-control spending and the resultant interest and late payment fees on credit cards that they are still considered a perfectly normal part of everyday life by so many.

• Television - Yes.  I said it.  One of the most effective things you can do to help you be successful with money is walk over to your television set and turn it off.  It's a statistical fact that people who watch more television spend more money.  It's because of the constant barrage of ads that we get hit with when we watch.  I believe that there might be as much or more more ad time than content nowadays.  Spending more is just one side effect of TV watching.  TV watching throws your brain and body into neutral.  Not only is it an incredible time waster, it contributes to our increasing health problems caused by lack of physical activity.  Health problems that will eventually cost you (or hard working taxpayers) lots of money.  All the health and financial side effects aside, do you really care to watch tv any more given the constant immorality displayed there?  Turn it off.  It will do you good.

Some Basic Truths about Money

Here are some basic truths I've learned about money and money management over the years.  

1. Managed money goes farther.  Unmanaged money disappears.

2. There are really only three things you can do with money:  save it, spend it or give it away

3. Financial success can be achieved in three easy steps:  live on less than you make, save for the future, don't borrow money.

4. It is commonly thought that the more money you make the better money manager you must be.  In reality, a high income earner has much more room for mistakes and sloppy living.  A low income earner has less room for mistakes and therefore must be more diligent and a better money manager.

5. Everyone wants our money.  Some out there are very good at getting it from us.  We must be alert, educated and diligent to keep our hard earned money out of other people's hands.

6.  God owns everything including us, our families, our income and our possessions.  We are not owners, we are managers of His possessions.  We save, spend and give differently when we keep that in mind.

7. In the children's story "the tortoise and the hare", the tortoise wins the race.  Likewise in investing, slow steady plodding beats get rich quick every time.

Hope this helps!

Traditional IRA vs. Roth IRA Comparison

Joe and Suzy make $56,000 per year household income ($4,667 per month)

Following Dave Ramsey’s baby steps, once Joe and Suzy are debt free other than their home mortgage and have 3-6 months emergency fund saved, they are ready to invest 15% towards retirement.  They will invest $8,400 per year.  Over 30 years, their total contribution to the retirement account is $252,000.

Using a Traditional IRA or by making pre-tax contributions to their company-sponsored 401K, Joe and Suzy can defer paying taxes on the $8,400 per year IRA contributions.  At a tax rate of 20%, the total taxes they would defer over 30 years are $50,400.  At 8% growth rate, their retirement account would grow to $951,549 which would all be subject to taxes when the money is withdrawn.  At 20%, their taxes would be: $190,316.

In a Roth IRA or Roth 401K, Joe and Suzy would pay 20% taxes on $8,400 more income per year for a total of $50,400 over 30 years.  At 8%, their retirement account would grow to $951,549, of which None is subject to taxes.  

The Roth option provides more and more advantage to Joe and Suzy as the rate of growth on their investments increases.  Further, if their tax rate increases over time, the Roth option provides more benefit when compared to the Traditional IRA.

Alternatively, as the rate of return on Joe and Suzy’s investments decreases, it lessens the advantage of the Roth IRA/Roth 401Kover the Traditional IRA/401K.  This is also true if Joe and Suzy’s tax rate goes down over time, as the favor would beshifted toward the Traditional IRA option which defers tax payments on both contributions and earnings.

Keep in mind in the above example, Joe and Susy would pay almost 4 times as much in taxes using a Traditional IRA/401K than they would if they saved using a Roth IRA/Roth 401K.  

Back from Hiding

It's been a long while since I posted.  Thank you for your patience.  I hope to continue on with my Basics of Investing series very soon.  However today I would like to point you to a fantastic Christian investment web site.  I may have referred you to them before.  If so, all the better.

SoundMindInvesting.com - check them out for the best of the web common sense investment advice and outstanding educational articles and commentary.  Over the recent 13-year period, Sound Mind Investing has outperformed the market (as measured by the Dow Jones Wilshire 5000) by nearly two-to-one.  The mutual funds based on the newsletter's unusually successful investing technique, manage over $300 million.

SoundMindInvesting was founded in 1990 by Austin Pryor, personal friend of the late Larry Burkett and author of the book "The Sound Mind Investing Handbook: A Step-By-Step Guide to Managing Your Money from a Biblical Perspective".

Basics of Investing - Part 1

What is Investing?
Investing is to purchase an asset with the expectation of capital appreciation, dividends, and/or interest earnings.  Investments can be made in anything that appreciates over time such as real estate, antique cars, coins, art, etc.

We will focus on securities - debt (bonds), equities (stocks), but not derivatives (options).

What are stocks?

One share of stock represents a fractional ownership in a company.  The value a share of stock has is based on the value of the company and the number of outstanding shares.

Stock is bought and sold privately and/or publicly, in a stock exchange.  In the US, the NASDAQ or NYSE.

To purchase or sell on an exchange, you must go through a broker with a seat on the exchange.  Online trading software makes this easy and relatively inexpensive.

Investors can invest in individual stocks by purchasing shares in companies they believe will increase in value over time.  Alternatively, investors can invest broadly in the U.S. and foreign markets using mutual funds.

The Stock Market
As shown in the chart below, the U.S. stock market is generally increasing in value when viewed over a period of many years.

However, when viewed on a short term basis such as a day, a month or a year, the stock market can be seen to fluctuate up and down.  No surprise.

The point I would like to make at this time is that investing should be considered a long term endeavor.  Short term investing, such as day trading is risky business and very few succeed at it.






Savings vs. Investments

Saving
Generally, less than five years is saving.  Use savings accounts, CDs, money market accounts, piggy banks, etc. for saving.  For savings, our goal is to preserve our money.







Investing
Five years or more is investing.  My favorite investment vehicles are stocks, mutual funds and/or real estate.   When investing, our goal is growth.

Why Invest?
We harness the power of investing to achieve goals not possible with savings vehicles.  Consider the following chart.

18-Year College Savings vs. Investments Example

In the chart above, we assume a $120 per month contribution for 18 years and an average annual market growth rate of 8%.  The blue shaded area represents the savings growth over the 18 years which would come to roughly $30,000.  Look at the orange shaded area, which represents the investment growth.  Over time, the investment begins to significantly overshadow the savings growth.  That's the power of investing in the market.

Next up:  In "Basics of Investing - Part 2", we'll begin to cover a new types of investment vehicle: bonds.

See you soon!

How to Get Out of Debt

In this fifth entry in our Financial Freedom series, we will discuss how to get out of debt.

• First things first.  So that we don't fall back into debt while we're trying to pay it off, first we have to start with an Emergency Fund.

• Next, we need to get and stay on a budget (see Annual and Monthly Budgeting)

• Now.  Let me have your undivided attention for just one second.  Yes you.   Thank you.  Now pay close attention.  This is very important.   Stop borrowing money. You'll never pay off your debt if you keep signing up for more.

• To get out of debt we need to apply focused intensity.  Shut off all discretionary services and expenses.  Someone mowing your lawn and washing your car?  If so, do those things for yourself at least until you get the consumer debt paid off.   Paying for expensive cable TV service?  Cut it out temporarily.  Nowadays, a cheap antennae will get you several HD quality channels in most areas.  Make that work for a while.    Eating out a lot?  Nip it in the bud.  The idea is to free up as much income as possible so that you can pay off your debt rapidly.

• Temporarily, stop retirement and all other savings and investments outside of your emergency fund.  If you have debt other than your house, there's no better place for you to invest than in your own debt.

Use Dave Ramsey's Debt Snowball Method
The Debt Snowball is a technique for paying off debts from smallest to largest balance, not based on interest rate.  Paying debts off from smallest to largest balance allows you to get a quick win when you knock out a small debt and free up cash to apply to the payoff of the larger ones.

Your debt payments are the snowball.  They start smaller, but when a debt is paid off, the payment that you were making on that debt is added to any extra cash you have and applied to the next larger debt.  Thus, as the snowball rolls downhill, it gets larger.  Here's the steps...

1. List debts in order of smallest to largest balance

2. Each month, prepare your monthly budget paying only the minimum required payments to each creditor.

3. Pay every extra dollar you can scrape up on the debt with the smallest balance

4. When the smallest debt is paid off, use the payment you were making on it to pay extra on the next largest debt in subsequent months.

5. Repeat steps 2 - 4 until all your debts except the house are paid off.  Most families can do this in 1 or 2 years.   Wouldn't it be awesome if you did too?!

For an example, see this site.  Also, try Dave Ramsey's Debt Snowball tool.



That's it!  See that wasn't hard was it?

Next up in this series, Basics of Investing.  See you soon!