Investing in securities
After you've decided on whether or not you need an advisor, you're ready to start thinking about investing in securities. When you invest in securities, you'll almost always want to invest through tax-advantaged retirement accounts like 401(k)s, IRAs and 403(b)s.
I give detailed information about these accounts in my tape on retirement planning, but most plans offer two or three advantages that make them far superior to almost any other investment.
Advantages of retirement accounts
First, these plans immediately cut your income taxes. With most retirement plans, the government is paying you to save. If you're a middle-income taxpayer, each $1,000 you put into a retirement account will reduce your taxes by about $300.
In addition, the money you've stashed into retirement accounts grows tax deferred.
Finally, many retirement accounts like 401(k)s offer an employer match. This is the best investment you'll ever find because your employer's match means you're making an immediate 50 to 100 percent return on your investment.
Drawbacks to retirement accounts
Of course, the government has a few strings attached to these great plans. The biggest string is you usually can't withdraw the money without penalty until age 59.5.
If you're saving through an IRA, you can put your retirement money in just about anything, including mutual funds. If you're using a company-sponsored 401(k), you'll have fewer options, but mutual funds probably will be included.
To learn how to manage your mutual funds and minimize your taxes both inside and outside of retirement accounts, check out my tape on mutual funds.
And you should fund your retirement before you save for your kid's college. No one wants to stiff their kids, but you aren't doing your children a favor if you save to send them to an expensive college only to burden them later when you're retired.
Plus, money saved inside a retirement account usually isn't counted as an asset for financial aid reasons. This is another good reason to fund your retirement accounts first, and then worry about college funding.
After you've gotten out of debt, built up an emergency fund, and saved the maximum deductible amount in your retirement accounts, you might want to consider investing in annuities.
But note that annuities are pretty low on the totem pole, and the majority of people shouldn't even consider investing in annuities. I'd recommend that you not think about investing in annuities until you've saved the maximum possible through conventional retirement accounts.
If you want more information about annuities, listen to my tape on bond investing for fixed annuities, and my tape on stock investing for variable annuities.
Buying individual stocks
Aside from annuities, there are other investments available, but for the most part you want to steer clear of them.
You can invest in individual stocks and bonds, but I'd suggest you stick with mutual funds. Take advantage of the reduced risks and low-cost, professional management that mutual funds offer. Listen to my tape on mutual funds to hear the benefits of funds over individual securities.
Limited partnerships are another type of investment, but you probably want to avoid these as well. Limited partnerships had their day in the 1970s and early 1980s when they were a vehicle used to generate tax losses.
However, after the Tax Reform Act of 1986 limited partnerships lost most of their luster, and partnerships now are basically illiquid dogs that are sold with high commissions and high ongoing expenses. Avoid them.
You can avoid limited partnerships and a lot of other poor investments by following two simple rules. First, if you can't find the price for a security in the business section of your local newspaper, you probably shouldn't buy it unless you know what you're doing.
The second rule is don't buy any investment unless you understand it. People lose the most money when they get in over their heads. I'm not against making small mistakes as you learn your way along, but don't put a lot of money into something you don't understand or don't have experience with.
Finally, derivative securities like options and futures also should be avoided by most people. These securities have their place, but they're really a form of insurance for large institutions and aren't suitable as investments for individuals.
Investing in derivatives is somewhat akin to buying an insurance policy and then cashing in big after making only a few premium payments. You can get a large payoff if you guess right, but derivatives are a zero sum game where trading commissions will eat you alive over time.
Copyright 1997 by David Luhman