blake johnson

Over break a friend was asking me questions about investing, specifically about 401k’s and Roth IRAs. By no means am I an expert on these subjects, but I have given my own financial planning a fair bit of thought, so I thought I’d write down my own advice for others that are interested. In large part I am just repeating advice which you can find on most financial planning websites.

1. Get a high-yield savings account. Right now you can get savings accounts with no fees and no minimum balance from a number of companies, including Emigrant Direct, Ing Direct, and E*Trade (I use E*Trade because I also have my Roth IRA and brokerage account with E*Trade). You may also be able to find a local bank offering a competitive product, but what you want is something with at least a 4.5% APY and an automatic deposit program. You should try to have 9-18 months of living expenses in your savings. This is your cushion should you lose your job, or for less drastic (but no less inconvenient) expenses like a car accident or a health problem which requires expensive treatment.
2. Make regular contributions to your savings. In fact, I highly recommend drawing up a budget and listing your savings as an expense. Try to save at least 15% of your paycheck. Your “extra” money for entertainment, gadgets, etc. should come from what’s left over after you have paid yourself.
3. After you have built a suitable cushion, it is time to think about other investments. Investing in the stock market is a poor idea unless your investment horizon (when you plan to start withdrawing the money) is at least five years. Besides saving money for more near-term goals like buying a first house, retirement accounts like 401k’s and Roth IRAs are incredibly good deals. Many companies will offer a program to match contributions to a 401k. This is free money that no one should refuse. If you have already filled up your 401k, or your company does not offer a matching program, of if, like me, your don’t work for a company that offers 401k’s, then you should open a Roth IRA. You can open a Roth IRA account at any investment house (like E*Trade, TD Ameritrade, Fidelity, Vanguard, etc.). A Roth IRA has the amazing tax benefit of the interest being tax-free upon withdrawal. Honestly, get one before the US government changes their minds about this.
4. Once you have opened a 401k or Roth IRA account, you have to choose how to invest your money. I’m not entirely sure how much flexibility you have with 401k’s, but with a Roth IRA absolutely any stock, bond, or mutual fund is available to you. You can safely ignore most of these, because I highly recommend that you invest in index funds. Why index funds? Because if you are more interested in doing well over the long run and you aren’t a trader that spends almost every waking hour researching companies, you simply can’t do better than index funds. Sure, there are mutual funds which will occasionally outperform the market, but even a very good mutual fund will lose out in the end because of the very large fees associated with active trading and the large salaries of the fund managers. Index funds have ridiculously low costs (to the tune of less than 0.20%) which will make a big difference in the long-run. Most financial websites have tools which will suggest a portfolio of index funds to match your expected return and tolerance for risk.

5. An especially easy way to get started is with a company called Sharebuilder. They have an automatic contribution program which will automatically purchase a portfolio of funds every month based on your selections. Every portfolio should include a mix of index funds that cover various asset classes such as large cap (e.g S&P 500), small cap (Russell 2000), and international corporations. The minimum initial investment in most funds is $3000, which means that given the $4000/year contribution limit, it will take several years to build a proper portfolio if you use a traditional brokerage service.

   If you want something even easier than that, Vanguard has a number of target retirement date funds which will automatically invest in a diversified portfolio of low-cost index funds and bonds and automatically adjust your stocks/bonds ratio as you approach retirement.

Well, I think that is enough to get started. I hope this is useful to someone.