During the years when our economy is booming people invest in the stock market with wild abandon. You can put your money in almost any kind of mutual fund and it will surely grow. Either the value of the mutual fund shares grows, or the fund pays dividends that build your stake, or both. But what happens when the stock market starts descending and keeps going down? Where can you put your money? If you know what a hedge fund is you could try shifting your investments in that direction but investment experts say that you cannot time the market. Most people lose money when they start moving it around.
Here are Brad’s Rules for Growing Your Wealth In Stages.
1. Always Keep Cash In the Bank
I mean this literally. Before I buy any new stocks or mutual funds I ensure my bank accounts have minimum balances in them. I like to keep a couple hundred dollars in my checking account. After all the bills are paid and I have budgeted my gas and groceries and entertainment for the month, I aim to have about $200 extra in the checking account.
Past that I like to keep about $1000 in savings. There are months when I dip into savings but I restore my balance from the next paycheck. If I had to drain the savings for an emergency I increase my savings budget to rebuild the balance quickly.
I never buy investments from my checking or savings account. Instead I transfer money to a money market fund. Now here is things get interesting. That money market fund represents my liquidity. I aim to keep a few thousand dollars there in case I need some cash to take advantage of a good deal. And by the same token if I have a financial emergency I can hit the money market fund before I have to sell hard core investments.
So finally when I have reached a threshold in liquidity I move money into stocks or mutual funds. I don’t spread myself too thin but I cover a couple of different sectors. This way I’ve avoided selling stocks when I run into occasional unexpected expenses.
2. Buy Dividend-paying Stocks or Mutual Funds
Some people are “value investors”. They want buy shares in stocks at low prices and sell when they reach a profitable margin. You’ll end up paying short-term capital gains tax that way, and I don’t like the tax rate. I’d rather keep a stock for at least 5 years and pay long-term capital gains. It’s a much better tax rate.
But there is another reason why I like to hold on to investments for a few years. Those dividends build up value in your portfolio. The more shares of a cheap dividend-paying stock you can buy the more dividends you earn.
I’m not saying I don’t want the price of my shares to grow. If after 5-10 years my shares have doubled in value, I’ll gladly accept the profit. But I’m not counting on that. The value I want is regular income that can be plowed back into investments. The more predictable my investment returns are the happier I am.
As long as you don’t need the money to meet daily expenses, let it build up. Just remember that you have to pay taxes on those dividends every year. I can live with that because in a pinch I can get at least some of my money back without having to deal with a lot of bureaucratic and tax rules.
3. Buy When the Market is Down
If the market is in a long period of growth then go ahead and “average up” on the costs of your shares. Value investors make a profit anyway so they are all for averaging up. You won’t find a good value investor who recommends averaging down.
To “average up” means you keep buying the stock as the price increases. Most stocks and mutual funds sit in what are called “trading ranges”. Their prices move slowly back and forth behind high and low values. Averaging up in this trading range is usually a good thing for dividend-based investments. But value investors are looking for stocks that break out of the trading ranges.
You want to avoid buying a stock if its price is moving down while the rest of the market is stable or moving up. You should only buy cheap stocks after they have begun climbing in value in again. If a stock falls out of its trading range the investors who are selling those shares may know something you don’t. It’s better to miss some opportunities and wait until the market has confidence in the stock again.
So if the stock market goes through a correction the time to start buying stocks again is after the correction has ended. You’ll know within a few days that it’s over because the indexes start climbing in value again.
If you’re building up your cash value the way I described above, you can afford to wait until the market has corrected itself. That usually happens once or twice a year. Corrections last from about 30 to 60 days. You don’t have to rush into the market at any time.
Why Not Use a 401(k) Plan to Do This?
I hate 401(k) plans. I have lost way too much money in them.
401(k) plans were adopted by companies that saw the eventual failure of pension plans coming their ways. By shifting the burden of managing your retirement to you, your employer gets out from under the obligation to keep investing money in its pension fund.
The average American worker doesn’t know enough about investing in the stock market to make good decisions. Even if you follow the advice I outline above to the letter, did I tell you which stocks or mutual funds to buy? I can’t do that. You have to identify the opportunities yourself, just like I do. That’s why I like to take my time. If an investment is only worth buying for a short time then it’s worth buying at all.
You could do everything I explain above through your 401(k) plan. Just have your paycheck contribution deposited directly into a money market fund. Wait until you build up a few thousand dollars in the money market fund and then use it to buy a good stake in a mutual fund that shows promise. That way if you have to take an emergency loan you don’t sell any shares. You just pull the money out of the money market fund.
But you have to pay that loan back. And there is the administration fee associated with the loan. Worse, if you lose or leave your job you have to pull your money out of the 401(k) plan. You could roll it over into a new plan or an IRA, but you may lose a lot of value when you sell those mutual fund shares.
I hate 401(k) plans because they take away control over my money, force me to pay fees and penalties I wouldn’t have to pay otherwise, and force me to sell shares when I’m not ready to.
Keep your 401(k) plans. I’m done with all that.