Make Your Money Work for You

Since savings accounts are backed by the FDIC, they are basically risk free.  However, the average return rate for a savings account is 0.06% – basically nothing.  In fact, if inflation is around 2%, you’re actually “losing” money, since it’s losing spending power.  But for now, I wouldn’t really consider this an investment, since at that rate, your little green employees are hardly working to generate additional cash.

Similar to savings account – usually backed by the FDIC up to a certain amount and basically risk free.  These offer a slightly better return (~0.5% – 2.5%).  The return may vary based on current interest rates, which (almost) always stay positive, but are currently pretty low.  Some restrictions may also be placed on how often you can access money, but they’re usually not a big deal.  If you know you’ll need a large sum of cash for something in the near future, this option is better than nothing.

When you invest in a bond, you’re acting like a bank to loan either the government or a company money.  In return, they will pay you back a higher amount in the future.

US Government bonds (i.e. series I and EE) are guaranteed by the government and basically risk free.  Returns are usually slightly higher than CDs/high interest savings accounts. 

Series EE bonds offer a small annual interest rate (currently only 0.1%).  However, if you keep the bond for 20 years, you can redeem it for double what you paid for it (the equivalent of a 3.5% annual return).  In other words, if you buy a bond for $100, it will be worth slightly more than $100 for most of its life, until magically at 20 years, it’s worth $200.  I know, this sounds weird (the link above explains more).  Bottom line is these can be a good option if you’re looking for a guaranteed amount in 20 years, but if you have that kind of timeline you’re probably better off with stocks or real estate.

Series I bonds offer a fixed rate on top of whatever the calculated inflation rate is over 6 month periods.  So if the current fixed rate is 0.1%, and the inflation rate for this 6 month period is 1.5%, your bond would earn 1.6% over that period.  If next period, inflation is 2%, your bond would earn 2.1% over that period.  Currently, for new series I bonds offered today, the fixed rate is 0% and for all series I bonds no matter what the fixed rate was when you got it, inflation for the current 6 month period is 1.06%.  

Corporate bonds are a little riskier – if company goes under, you might not get paid (corporate bonds usually fall into the unsecured debt category).  Since each company’s risk varies, so does return.  Over the past 5 years, the highest rated (safest) companies were in the 2 – 4% range (slightly above government bond rates).  To reduce your risk, instead of investing a certain amount in a bond for one company, you could invest that same amount in bonds from a variety of companies.  While one may go under, it is much more unlikely multiple companies will.  There are also bond index funds that will do this for you, but they charge an expense rate that lowers your return.

If you’re investing over a period of 5 years or more and diversifying with quality, low cost index funds, stocks are probably your best bang for your buck.

How Do Stocks Work?

Ever notice how a lot of rich people are business owners?  Ever wish you could be a business owner, but without all the work that goes into running a business?  You can, with stocks!  Stocks are literally buying a piece of ownership in a company.  In return, you are entitled to a share of the companies profits (in the form of dividends) for as long as you own the stock. You can even participate in shareholder meetings and cast votes for company leadership.  In addition, as the company grows and earns more, the value of the business increases, their profits increase, and so does the value of your stock and the dividends it pays.

Minimizing Risk

If you’re trying to put all your investments in only a few stocks, or short term trading, risk can be high.  If one of those companies goes under, or you’re investing money you need one year from now and the market tanks, you could lose a lot.  However, both of these risks can be mitigated by investing in a wide variety of companies (ideally no more than 2% in any one company) and by investing for the long term.  If you do this, your risk is quite low.  Investing low cost index funds (diversifying which stocks you own) for a period of longer than 5 years could even be less risky than holding it in a savings account!

This chart shows the returns of the S&P500 various holding periods over time. Notice how if you were to only buy and hold this index for a year (red line), your returns could be anywhere from -39% to +53%. However, as you increase your holding period to 20 years or more (i.e. green and blue lines), historical returns have always been positive (ranging from ~4 – 17%, and averaging a little over 9%.)*

Maximizing Returns

Set your account to automatically reinvest dividends! Some accounts might do this for you by default, but if you’re not sure, spend 5 minutes right now to set this up – you’ll be glad you did!** Doing this can increase your return by a few percentage points, which is HUGE over time (green, aqua, blue, and purple lines on the chart below). If you don’t reinvest dividends, all the extra money the stocks pay you just sits in a savings account, doing basically nothing. Put it to work as soon as you get it, so your earnings can also earn you more! Harness the full power of compound interest!

Hold your stocks in tax free accounts (i.e. 401k, IRAs) whenever possible. Not only do you get a gigantic tax write off when you invest or sell (depending on the type of account), the dividends you get over time are also tax free so you have more money to reinvest. The tax savings on dividends alone can boost you by ~0.5% or more (the difference between the purple and blue lines on the chart below). This doesn’t even include the thousands of dollars you can save each year when investing using a tax free account.

Use low cost index funds and avoid trade commissions. Many investment firms make money by pushing mutual/hedge funds that they “actively manage” to “beat the market” and charge you a fee for. Not only have most failed to beat the market, their high fees you pay each year also work against you. These fees are often charged as an “expense ratio,” which is what % of your portfolio you lose to them each year. For example, if have $100,000 invested in a fund with a 1% expense ratio, that means they’re taking $1,000 that year. Next year, if your investment goes up to $110,000, they’ll take $1,100. See the purple and aqua lines on the chart below to see the difference avoiding even 1% in fees can make.

Most brokerage firms now offer free commission on most stocks and index funds too, so if your account charges you every time you make a contribution to buy more stock, it’s probably time to use a different firm.

Buy and hold for long term gains. If you buy and sell within a year, not only is it riskier, the taxes you pay on the gains will be higher. If you are still tempted to make short term trades, at least do it in a tax free account (i.e. 401k, IRA) to avoid the short term capital gains taxes (and don’t withdraw the money until you’re 60, to avoid tax penalties).

Invest sooner, rather than later. Since the market tends to trend up over time, if you have money to invest now, usually, the sooner you invest it, the better. Making regular monthly contributions can also give you an edge over those who save money for one time annual contributions, since you’re putting your money to work sooner. It may also help reduce risk.

For more information on stocks, this series is a great read.

Ways to Invest in Real Estate

There are many different ways to invest in real estate, and your returns, risk, and amount of work will vary depending on which method you pursue.

Flipping Properties

This method usually involves buying a run down property and spending time and money to fix it up and sell it, hoping for a better price. If you have contractor experience or are pretty handy, this could be a decent option. A family friend who does this averages returns around 4 – 20% over a 6-8 month period (~6 – 44% annualized), so it can pay off if you know what you’re doing. However, if you need to pay others to do the work, mistime the market, or don’t know what you’re getting into, you can lose a lot of money on unforeseen expenses.

If you’re interested but not sure where to start, find someone who does this already that you could shadow. They may also be looking for investors, and if you have the money and trust them, this could be a way to invest without needing to put in the extra work or knowledge.

Without doing your research and making value added improvements, just buying a property and speculating that it’s value will go up so you can sell it in the future is usually not a great way to “invest.”

Property Rentals

Rentals do take a decent amount of money upfront to purchase, but can be fairly low risk with a decent return if you do your homework and are in them for the long haul. Owning property, in addition to index funds, will also help you diversify, decreasing your overall investment risk.

Before you invest, you can figure out almost exactly what your rental income and expenses will be. A good rental property will get ~7 – 10% return, and bring in enough in rent each month to generate positive cash flow (cover all expenses, including mortgage). Sure you might run into an occasional vacancy or large expenses (i.e. replacing a furnace on New Year’s Day***), but if you incorporate these expenses into your projections, they’re not a surprise. If you’re in it for the long term, you don’t really care what happens to the property value in the short term, as long as rent doesn’t fall significantly too. If the property does appreciate, it’s a nice boost to help offset inflation.

You can also increase your return by leveraging a loan to purchase your property. For example, if you pay $100,000 in cash for a rental, you might expect to make $7,000/year in rent (a 7% return). If you only put down 20% ($20,000) and use a loan for the other 80%, your expenses will go up some, since you’re now also paying interest to pay back the loan. Let’s say you pay $3,000 that first year in interest expense. Your net income is now only $4,000, but $4,000 on a $20,000 investment is a 20% return.

While the income from a rental is taxed, you can write off depreciation, deferring some taxes to the future when you sell, where you will likely pay a lower capital gains tax. And if you end up living in the property yourself at least 2 years before selling, you could end up avoiding capital gains taxes altogether.

REITs and Crowdfunding

Real Estate Investment Trusts (REITs) are companies that own, operate, and finance income producing properties. They are probably the easiest way to invest in real estate since they are often publicly traded, like stocks. Their risk/return has been roughly similar too.

Crowdfunding properties is a relatively new way for the average individual to invest in real estate. It is sort of like investing in a “start up” REIT. A non-publicly traded company develops plans for an investment property, then funds it from a group of interested investors, usually in exchange for some form of ownership and a share of future income. Returns can be high, but since your investment isn’t publicly traded, it’s not very “liquid” – meaning it’s hard to sell your share, and you probably have to wait a while for returns.