This week was about the basics of investing. Once you’re out of debt and have your emergency fund, it’s time to move on to creating serious wealth. You do that by investing (or winning the lottery, but Dave doesn’t advocate that method). Obviously in a one-hour lecture Dave can’t touch on all of the intricacies of investing. This lesson was a good primer, though, on the basic types of investments and the theories behind successful investing. Dave admits that you need to seek additional knowledge to become a successful investor, he merely intends to set you on the right path.
His first rule of investing is to never buy something you don’t understand. Only invest in companies and products that you can explain to a seventh grader. There is no such thing as getting rich quick and most investing schemes shroud themselves in complexity so you have no idea you’re getting taken for a ride. Stick to things that are simple and easy to understand.
Dave begins by covering the basics of risk versus return. In other words, the safer and more liquid that you want your money to be (low risk), the lower the potential return will be. Safe investments are typically CD’s and money market mutual funds. Riskier investments include single stocks, bonds, mutual funds, and real estate. Real estate requires particular care because it requires a lot of money both to get in and to stay in. You not only have to buy the property, you also have to maintain it. You also have to be able to weather the times when you don’t have a renter or when the property isn’t appreciating. It’s not a liquid investment and should never be used for short term gains.
He spent a good deal of time talking about diversification, which is investing your money in many different products, industries, and sectors. You don’t want to have all of your money in one company’s stock (even if it’s the company you work for), or one mutual fund. If that product crashes, you will lose all of your money. Investing in multiple funds, stocks, and industries makes sure that even if one product tanks, your others will take up the slack. Dave’s standard mutual fund diversification is as follows:
- 25% in Growth (mid cap): These are mid-sized companies that still have a lot of room for growth.
- 25% in Growth and Income (large cap): These are big, well established companies that grow a little but mostly stay stable.
- 25% in International: These are overseas and foreign companies.
- 25% in Aggressive Growth (small cap): These are small companies and emerging markets that have a lot of potential to go big, but they may also go bust.
Dave then tells us that your money will need to earn at least a 6% return in order to compensate for inflation and taxes. He claims that if you invest in “good growth stock mutual funds” you can expect an average rate of return of 12%. This is the one piece of this class I don’t agree with. Most investing experts allow for an average 8-10% return in the market. Earning 12% consistently over many years is not common. Granted, during the boom times we just went through 12% or more was easy to achieve. However, when you factor in the down times that make up an “average” return, 8% is probably more realistic. Dave throws this 12% around in this class and on his show like it’s readily achievable, but I know no one (who’s last name isn’t Buffett), expert or average investor, who gets that kind of return consistently over a period of thirty years.
At the end he talks about some terrible investments which include gold, commodities, futures, day trading and viaticals (buying the beneficiary position on someone else’s life insurance policy, betting that they will die within a certain amount of time). These investments are either too complex or risky for all but the most experienced investors (and even they don’t always understand them). There are also a lot of scams surrounding these investments so you have to be very careful.
All in all it was a good lesson, but there was very little actionable in it. Yes, you have to invest, but how you really go about that isn’t covered here. Maybe in later lessons we get to that, I don’t know. If you want to know exactly how to go about investing and how the market works, you need a different course. This lesson is simply an overview of the most popular types of investments and some general investing theory.
Our small group didn’t really talk about much this week. I think that most people in the group are intimidated by investing and don’t really know much about it beyond their 401k options at work. We did talk a little bit about the value of educating yourself on the topic and not letting an advisor do all of the work for you. One man shared an advisor horror story. He had put about $10,000 with an advisor and it was all lost during the economic meltdown. The advisor had talked him into putting all of the money into three stocks which were all in the same industry. They all crashed in value. He was not diversified at all. He said that, at the time, he felt uncomfortable with it but thought, “This guy is the expert, so I’ll trust him.” He learned two things. First, diversification is important. Second, you can’t trust an advisor to do the right thing just because they are an advisor. The advisor might be motivated by a commission on a product or some other type of kickback, not your best interests. You have to know about investing and make your own decisions. An advisor can help, but don’t let them be the last word. Others in the group concurred, having
horror stories of their own to share.
Most people in the group agreed that investing doesn’t have to be complicated, but it can be intimidating and hard to learn. For that reason, many people just check out when the subject comes up. As one woman said, “I have so much to do everyday, I just don’t have time to learn what amounts to a foreign language to me.” Another one said, “I’m afraid of messing up and losing all my money.” These are valid concerns, but we talked about how a simple savings account will never earn enough to outpace inflation and how, if you’re well diversified, you might lose money in the short term, but you’ll gain in the long term. We tried to explain to the second woman that a loss is rarely permanent, unless you have all your money in one thing. We tried to explain to the first woman that yes, it’s time consuming to learn about investing, but you have to do it if you want to be financially successful. There just isn’t any other real way to earn the kind of returns that will protect your money from inflation and taxes. In other words, she can’t afford not to take the time to learn. Both didn’t seem convinced when class ended, so I don’t know if they’ll ever get involved in investing.
Homework roundup: This week we’re supposed to calculate how much our debt payments are taking away from our retirement. Dave provides a chart for this that shows your monthly debt payment and then how much it adds up to at 5, 10, 15, 25, and 40 years assuming a 12% annual return. For example, $600 in debt payments a month would be $49,002 in five years, all the way up to $7,058,863 in forty years. While I’ll never agree with his 12% return, the chart does illustrate the point that the money you’re paying toward debt could be used to fund your retirement (or other goals). I don’t have any debt so I can’t really do this exercise, but I’m hopeful it will come up in small group next time. I’d like to hear if anyone had a realization about just how much debt is costing them once they did this exercise.
This is a series of posts about what you will find in Dave Ramsey’s Financial Peace University course. You can find the previous posts here: week one — week two — week three — week four — week five — week six — week seven — week eight