Finding the right mix of stocks and bonds is a common question among beginners. As a conservative investor, it is a must that I find a good mix to mitigate risk. Most conservative investors go with a mix of 75% stocks and 25% bonds to help lessen any risk of loss. But as a younger investor, we argue that going 100% stocks is a better way to go.
- Pros and cons of 401k/IRA accounts for beginners
- Pros and cons of Robo-Advisors
- Advantages to Roth IRA
- Best Allocation strategy for young investors
- Dollar Cost Averaging for those just starting out
- Better to do it yourself or have someone manage your money? Or a Robo-advisors?
- Any advice for where to start for beginners?
Welcome to Session number 5 of the Investing for Beginners Podcast show notes. Today’s session includes our guest, Phillip. He is a beginner that subscribes to Andrew’s eletter and he asked us some really awesome questions today.
So let’s get to it!
For a beginner where should you start investing? A 401k or an IRA?
Andrew: First off, a big difference between the 401k and an IRA is that usually, the 401k is pretty limited in what you can invest in. Just from experience and talking to other people. Of course, not every 401k will be like this but a lot of them will have different mutual funds you can choose from. Sometimes they will have ETFs that you will be able to choose from.
But most 401ks you will not be able to buy individual stocks inside of them. As far as an IRA, that is on the opposite side and you can buy mutual funds, etf and you can also buy individual stocks.
There is also different tax implications on each of those. Most 401ks are like the Traditional IRA in which you can contribute the money before the government taxes you. And basically, it’s not taxed until you withdraw it.
You can also have a Traditional IRA which works the exact same way. They also have a Roth 401k, which is not as common. That one they will withdraw the taxes from your paycheck and then put it into the 401k after the taxes. And you can do the same with the Roth IRA.
Which is what I recommend for most young people. You are paying the taxes up front but the money will grow tax-free for the rest of your life. So being an optimist you really that the tax rate you will have in the future will be much higher than it is now because you are hoping that your salary goes up with time.
That is why we sacrifice taxes now because you don’t have as big of an income now as you will when you get older. So why not take the hit now and let it grow. And when you withdraw it in the future you don’t have to pay taxes at that time.
So that is why I recommend the Roth IRA, and why I personally have one.
There are different allocations you can do for a 401k and an IRA. There are limits to what you can contribute to an IRA. For both the Roth and Traditional it is $5500 a year and if you are over 50 it grows to $6500.
But with the 401k you can invest up to $18,000 a year and if over 50 you can add an additional $6000.
For my individual IRA, I choose a Roth and have a Robo Advisor handling the investing. I like the fact that I have access to these funds before retirement age of 59 if I ever need them. Should I focus on my Roth IRA as opposed to my 401k?
Andrew: This is something that I have been giving a lot of thought too lately. So it is really cool that you are asking this now.
The idea of having a regular taxable brokerage account and being able to take that money out sooner without paying a hefty fee. I know there are some details in the tax laws that say that you can take money out of a Roth IRA if it’s going towards a first-time home purchase. Or some medical expenses.
But mostly there could be substantial tax liabilities if you do take the money out, or a big hit. Something that I like to think about is that nobody lives forever and you can’t take it with you. You don’t know if you’re going to live tomorrow and you want to enjoy your abundance.
At the same time, you want to balance it. Because you want to prepare for retirement. And be financially independent as soon as you possibly can. It gives you the freedom to never have to go to work. In reality, having financial independence means you don’t have to go to work. You don’t have a job and basically, your investment portfolio is sustaining you through income.
That will give you a lot more freedom than having a bigger emergency fund would.
So, I think you obviously want to have an emergency fund. And there is a debate about how much you should have just started out. I mean having a $1000 saved to start is great. Every time I tend to get to $1000 I always have something come up. I am always replenishing that which is really frustrating.
As you go along, some people like to recommend three to six months which is kind of beyond the scope of this show.
I like to have money in a taxable account and see that money come in and actually be able to enjoy it. Not having to wait 30 or 40 years. So I kind of like the idea of having a fun money account. Where you can reap the rewards of the stock market now.
And I ran some numbers and as the years go on and you’re contributing regularly to a taxable account. Your income checks are going to grow pretty fast.
You are talking about most dividend stocks have a 3% yield. So I put $100 and I get a $3 check for the year. Woo hoo, right?
But if you are doing $150 a month and doing it every single month for years. By the time you get around to year twelve or fifteen. Even without reinvesting the dividends and having a dividend stock that is growing their dividend payment. Year after year after year.
That is the big goal of these dividend stocks. If you think about it. The average growth for a stock in the stock market is 10% a year.
So, that, in theory, should translate to being able to grow their dividend payment by 10% a year. Because their growing earnings 10% and their stock price are going up 10%. Their dividend is going up 10%. So the reason why the income is getting so big over time is your saving money consistently. And growing it like a cushy fund that you can draw off anytime. But at the same time, it’s producing income.
That’s investing 101. That is exactly why we invest. To build income for later. We don’t invest because we want to become billionaires from the stock market. And find the next hottest pick because we want our money to work for us and to pay us income.
So not only do you get that benefit of saving money and having your income grow every year because your pile of money is getting bigger. But you also have the double effect of these companies in the stock market who are all trying to grow their dividend over time. And so you get a kind of compounding effect so your income kind of balloons.
That’s whether you want to take the money and spend it or have some fun with it. Or if you want to reinvest it and grow it even faster.
I think it’s really about finding a balance.
You need to have a balance between your financial future. Maxing out your 401k is something that I strongly recommend. And then myself personally putting something into a Roth IRA. Even if you can’t max it out if you can then great. I use a Roth IRA to invest $150 a month for my personal portfolio, which I track with my eletter to subscribers.
If you have extra income, it’s about a personal choice of how much do I want to enjoy now. Versus how much do I want to enjoy later.
You can use calculators to estimate how much you invest and what that will work out to down the road. Use a compounding interest calculator. You can find them on Google, don’t use the one from moneychimp, I feel it is garbage.
Enter the numbers into the calculator and see what comes up. You can see if I put $50 a month over a period of time, how much it will grow to. Another idea would be to track a dividend and see how much income you would have after five years. And then maybe you could spend that on yourself.
Those are the kinds of things you could do and the decisions you could make. You could also use goals to figure out how much you want to have by retirement. Everyone is different, your goal might be to one day have enough money to buy a house or to have a nice standard of living all through your retirement years. All through a dividend payment that is a 3% to 4% of your portfolio.
You can run those numbers and take some time to think about what you want. Everybody is going to be different, everybody is going to want from 0 to 100 and finding a balance is the best way.
This is so you won’t get burned out or frustrated with it. Sacrificing too much or not having enough in the future.
Phillip: I agree with all the things you are saying. I am going to match my 401k and then open a Roth IRA. Start to buy a stock with a little bit of money to practice with. You have to learn somewhere right?
Andrew: Yeah, my first pick was Microsoft (MSFT) back in 2012. I literally bought one share and I remember doing it. It was Thanksgiving and we had been up north to visit some family. It was pretty cool because I woke up the next morning and my stock had gone up a percent.
Dave: My first stock pick was Microsoft as well. I bought it three years ago, right around Thanksgiving time as well. It was one share and I was scared to death.
All I could think was “oh my gosh, what am I doing?” But it turned out great. I think it is up over 40% since I bought it, which is nice. I don’t think I would buy it again right now. But at the time it was great.
You were talking about the practice part of it. I knew nothing when I bought that stock, I really didn’t. I knew I wanted to buy a stock. In true confession, I had been reading some of Andrew’s articles and I decided I was going to buy a stock.
I didn’t know what to do, I didn’t know metrics. Knew nothing about valuation but I thought I want to buy a company. And I thought Microsoft is a good company. They have been around forever, I know who they are. They were safe and I pulled the trigger and bought the stock and it has kind of gone from there.
The learning experience is something that you only get from doing. I was listening to a podcast the other day. And the episode was an interview with Howard Marks, who is the co-founder of Oaktree Capital and author of “The Most Important Thing”. In the interview, he made a comment that I thought was profound. He said, “experience is what happens when you don’t get what you want.”
I thought that was such a wonderful comment and it illustrates that the only way to get better is to learn from your mistakes. Even the great ones like Warren Buffett, Charlie Munger and so on make mistakes. They talk about them as learning experiences and try to improve from there. We all make mistakes and we need to learn from them.
Andrew: That’s funny when I bought Microsoft I didn’t know anything either. I think I bought it because the new Xbox was going to be coming out soon. I thought that sounded like a good business thing so I bought. I think it has doubled since. I should have bought 100 shares but you don’t want to do that when you are not confident and have the skills to find a good choice.
We definitely recommend buying a stock whenever you feel it’s right. It’s a big step but it can help get your feet wet.
Do you have recommendations how to set up an asset allocation strategy for my IRA?
Andrew: Earlier we touched on robo advisors and I have never used one personally but I have seen articles about them. They mostly look at your age and then a very non-specific risk tolerance. And they’ll give you your allocation based on how much risk you are comfortable with.
It’s very automated and not personalized at all. You’re not taking into account things that are important.
If you want to make a portfolio and figure out what kind of allocation decisions you want to make within that. I think the number one thing to determine for yourself is do I want to spend the time to try to beat the market? Or am I happy with the average market return?
It can come down to looking at the numbers. Using a compound interest calculator and seeing the potential difference in return.
I will tell you that you see the greats like Ben Graham, Warren Buffett, Seth Klarman who have all made double-digit returns. Some of them 20% a year, some of the 17% to 19% a year. I can tell you that Peter Lynch who earned 29% over his time with the Magellan Fund.
So Merrill Lynch did a study recently. They looked over a 90 year time period and they were comparing growth stocks and value stocks. And they saw that the average of value stocks over a 90 year time period was a 17% return. So when you compare that to a 10% return over the same time period for the market.
You can see that the difference of 7% returns from the 17% for value stocks and the 10% for the market return. This can be a huge difference in your returns.
But I will also say that buying individual stocks versus buying indexes is very time-consuming. Because you need to learn all of these what all the numbers mean. What all the jargon means. What is being told to you in the annual report.
And then also, you have to be someone who is good with numbers. I think somebody needs to be intuitive. The logic needs to be there. Basically understanding the difference between, for example, a business that is for sale for a $1000 and making $100 a year. Versus a business that is for sale for $500 but it is only making $2 a year.
I guess if that simple comparison kind of makes your brain hurt. Then definitely individual stocks would be something to stay away from.
And I think a guy like Warren Buffett is so popular and famous. Really a household name. He can be giving fully loaded automatics to people when he tells people to buy individual stocks. When he is giving advice to the general public for the average person listening. They should probably go into indexes.
I tend to get really passionate about this. I really enjoy reading about it. I enjoy doing simple math on it. That’s why I teach it but I also give the option for people that aren’t looking to buy individual stocks to find a good service that they trust. With sound principals and invest in something like that.
Or you can simply buy an ETF that covers basically the whole market. There is ticker SPY that is an ETF that tracks the S&P 500. And the S&P 500 is the thing we talk about when we talk about a 10% average annual return.
I can go further into the stock and bond allocation. But this is the first step in determining what you want to do as far as position choices.
Vanguard is the choice in ETF. They are the big name or brand in ETFs. When you talk about indexes they are THE company. I think right now they have over 50% of the index capital into their ETFS.
If you are looking at going into ETFs then Vanguard is the way to go. You can always change in the future. For the majority of people that I am talking to, I would recommend they do that. And friends and family, I would recommend that as well.
What happens when your income increases to the point that you can’t invest in a Roth IRA?
Andrew: You are happy about life.
I can be tough and a way to mitigate that would be to hold for long-term capital gains versus short-term. Basically, if you hold a position for over a year and it converts from a short-term capital gain. So let’s say you hold a stock for a year and a day. If you sell on that day after the year is up you will get taxed on the long-term capital gain percent over the short-term gain. The short-term is much higher than the long-term.
Editor’s note: Short-term capital gains are based on your current tax rate, so if you are in the 25% tax bracket, then you will be taxed at that rate.
Long-term capital gains are as following. If you fall under the 35% income tax bracket you will be taxed at 15%. If you are at 39.6% tax rate or over your long-term capital gains tax would be 20%.
So a way to mitigate taxes is to number one, not sell until you hit the long-term capital gains. What the really wealthy do like Buffett and the other guys is they will hold and never sell.
So if you hold and you never sell it’s an unrealized gain and that is never taxed until you do sell. So basically that money is compounding because the company is growing earnings year after year. So your capital is at work in the business growing. By the time you finally do sell out, however many years later. It could be big tax loss but if the money has been compounding, it could be way more than if it wasn’t.
Recently I had some tax questions with my tax guy. And he said, “you want to pay taxes because that means you’ve been successful.”
So, I think it’s a great program for people trying to get wealthy but once you do reach that point. It’s a good problem to have.
So if you reach that limit on the Roth should I keep the money in there or should I invest in a Traditional?
Andrew: Obviously I am not a tax expert and I would strongly encourage you to speak to a professional about these questions.
I know there are income limits on the IRAs and they would be able to address those for you.
Dave: I believe the tax limits apply to both the Traditional and Roth. It has to do with the way the taxes are withheld.
The income for the Roth is the restrictor if you will. Where there is no income restrictor with a Traditional.
What thoughts do you have for asset allocation. Should I go 100% stocks or have a bond mix in there as well?
Andrew: So obviously I am a stock guy and I am 100% in stocks. Even if I wasn’t a stock guy and based on the age that I am at, the mid to late 20s.
I would recommend for my peers and colleagues that they do the same thing. If they can understand the basics of how it works. If they can understand a bull and bear market. There just cycles. It can be like a relationship. You are not going to have problems with a relationship. The same with the market. You are not going to have crashes or have a bear market.
You can’t just think that you are going to just put money into it. And that it is just going to grow at this nice straight line that goes up. That you are going to always check your account and it is always growing.
That is definitely not the case.
The big gains come from hanging on during a downturn. Going from losing 50% to gaining more than what it lost.
If you continue to add to your positions via dollar-cost averaging every month. Even after a big drop of 50% and you’re going to have a recovery after that. That is why people get so excited about stocks because those are the kind of returns you can make.
We talk about having an allocation of stocks and bonds. Being young again is why I say you really have to have a time frame of like 20 to 30 years.
If you think about Japan right now. I think they are going thru a 20-year bear market. It’s probably one of the worst, if not the worst we have ever seen in the history of the stock market.
So you really want to have a long time frame and you want to understand that something like a government bond has historically averaged around 5 to 6 percent a year. And the stock market is right around 10 percent. So that difference in return is why if you are younger it is better to put more money into retirement. As you get older people tend to go more into bonds because that’s safer. And you would really be damaged if the market crashed. So you want to put more into bonds at that time.
Dave: To add a little to that. I think it comes down asking yourself what is your risk tolerance.
My thought is if you already have bonds already covered in your 401k then that can kind of cover that for you.
If you are younger you have a longer time horizon to make up for any downturns in the market so being more aggressive at an earlier age can more beneficial.
I am in a different boat. I am 50 years old so I am older and have a lot less time to go before my golden years.
But my goal at this point is to invest for my daughter’s retirement so now I have a really long time horizon. Fifty or sixty years.
So I am a 100% stocks too. Like Andrew, I am a stock guy. Bonds to me are a whole different beast and it is not something that I have really chosen to delve into a whole lot of time and resources.
I have bonds in my 401k and that covers my asset class.
I look at investing in stocks as a long-term strategy. To me, it is a marathon, not a sprint. So I am looking at it is a long-term race and I will continue to add to my positions as I go along. Find other companies I want to invest in. Sell a few here and there that are underperforming and just kind of go with it at that.
It really comes down to what are comfortable with for your risk-tolerance. What can you invest in and be able to sleep at night.
And not wake up at 2:30 in the morning worrying about how your stocks are doing.
Any advice you would like to pass along to beginners on how to get started?
Dave: Read all of Andrew’s writings!
I’ll be honest that is how I started. I started reading all these things online. I came across Andrew’s website and his writing immediately clicked with me. And I branched off from there.
I started reading the Ben Graham books, Peter Lynch books, just about anything I could get my hands on regarding value investing.
It has just blossomed from there. There are all kinds of websites, blogs, podcasts that I have immersed myself in the language. I look at investing as a language and I have immersed myself in it to try to learn the speak. How it is constructed. As you go along you will pick up influences.
Andrew wrote a great email the other day about influences. As a guitar player, I had a lot of influences but my two biggest were Jimi Hendrix and Stevie Ray Vaughan. And when you hear me play my guitar you will hear those influences come out.
When I look at investing Warren Buffett is a big hero for me. I look at a lot of things that he does and try to emulate them.
Andrew: Something that I would like to add. I kind of dip my toes into a little bit of everything.
I read “Beating the Street” and realized that reading about investing can be kind of fun.
It’s really up to anyone out there listening. However, you like to absorb this information is how you should probably proceed.
And what Dave said about this being a very long race, it is a marathon. It is not something that is going to happen overnight.
If you are a podcast learner, then slowly branch out. But also dip your toes. Not in the jargon and techniques but understanding the basic concepts whether it’s behind indexing. Even trading, trend following, growth investing, value investing, and whatever else is out there.
I kind of used that and once I found my little niche of what really spoke to me, that’s when I had the confidence that I could put serious money into this.
Because number one I had sampled what’s out there. Number two, I found what speaks to me. It is going to be different for everybody. Not everyone is going to want to spend time on this. Maybe you just want to set it and forget it.
But just dipping your toes into it and getting the basic concepts. Understanding the importance of diversification, long-term investing, and the importance of investing consistently.
Understanding those three concepts and dipping your toes into other ideas will help you.
There are a lot of great blogs, podcasts and video formats out there to learn from.
And don’t forget books.
I remember reading a “Random Walk Down Wall Street” which has a lot of contradicting ideas from what I personally believe but I think it was important for me to understand those.
Number two is “Trading Wizards” is a really cool book. He interviewed day traders and they had a lot of insightful things to say. A lot of it actually mirrors what we talk about when we talk about value investing. They just call it different things.
And then following what Dave and I teach with the value investing approach. The Warren Buffett, Peter Lynch approach and just getting the basic feel for those.
And with all of that just seeing what speaks to you and just go from there. Try to learn a little bit every day. Try to absorb a little bit every day.
Even if you make mistakes it is never a bad thing to put money aside to save. This is still going to leave you in a far better position than honestly the majority of Americans.