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Questions for New Investors

Mike’s note: I get a lot of questions from new investors. Often, the person is somewhat bewildered about investing in general and is having trouble figuring out where to start.

To that end, I invited my friend Matt–who was in a similar position just a few years ago–to share some of the questions he had when he was new, as well as the answers that he’s settled on as he’s gotten started investing.

Should I pay off debt or invest?

As a general rule of thumb, if the interest rate on your debt is higher than what you expect to earn by investing, pay off that debt as your first investment. Eliminating high-interest debt is a no-risk, high-return investment.

In fact, it might even be reasonable to work on wiping out all debt ASAP. For example, I consider myself to be particularly debt averse: I look at paying off debt as an investment in security. If I lose my income, the less debt I have, the less pressure I’m under. I’m willing to accept somewhat lower returns in exchange for that security.

Should I contribute to my 401(k) while in debt?

Contributing toward your employer-matched retirement plan is a special circumstance when it comes to investing. Think about it this way: If someone approached you on the street and offered to match the dollar amount currently in your wallet if you promise to save it, would you let them do it or would you tell them you can’t because that money is going toward debt?

It’s good to pay yourself first, but it’s even better to let others pay you first.

After you’ve contributed enough to get the maximum employer match, then go ahead and use any surplus to get out of debt. (Paying off debts in order from highest to lowest interest rate.)

Should I buy individual stocks?

Investing in individual stocks is tempting. There’s the possibility of striking it rich–a possibility that just doesn’t exist with broadly diversified index funds.

Still, I’ve chosen to build my portfolio using index funds and ETFs. Two good reasons for choosing index funds and ETFs over individual stocks are:

  • Easy diversification: Just a few funds gives me a diversified portfolio. With individual stocks, diversification requires many more holdings.
  • Less work: There’s no need to watch for news about the companies I own.

But what about stock tips?

If the tip is legit, unless you’re a market insider, chances are pretty good that the info has already been exploited by the time it gets around to you. I advise leaving individual stock ownership to day traders and professionals and sticking to something simpler and easier to understand.

Should I buy bonds?

Given that stocks have historically earned higher returns than bonds, many new investors wonder whether it makes sense to hold any bonds at all. The answer: Yes. Bonds are more secure than stocks, and even a small amount can significantly reduce volatility in a stock-heavy portfolio.

Because I am 35 I hold a fairly aggressive portfolio: 80% stock index funds, 10% bond index funds, and 10% physical precious metals. For my bond position I’ve chosen to use a Treasury bond fund because Treasury bonds are very secure. Using a Total Market bond fund would also be a reasonable choice. Just understand that if you do that, you will be investing in some higher-risk bonds as well.

If you are closer to retirement or more risk averse, it’s probably wise to hold a greater percentage of bonds than the 10% position I presently hold.

Should I buy precious metals?

Precious metals look quite appealing given the returns they’ve earned over the last couple years. But past isn’t always prologue when it comes to investing.

That said, I do actually hold physical silver with a small portion of my portfolio. But it’s not because I’m hoping to get lucky with amazing returns. Rather, I own silver as a sort of insurance policy against a collapse scenario for our debt-based fiat currencies. I prefer physical silver to precious metal ETFs or gold, neither of which would be as useful in such a scenario.

In closing…

If there is something I missed–and I’m sure there is–leave your question in the comments. I’ll answer to the best of my ability.

Matt Jabs set out on a passionate adventure to get out of debt back in January of 2009. He writes about personal finance at DebtFreeAdventure.com and about healthy self-reliance at diyNatural.com. Subscribe to his blog here.

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Comments

  1. Regarding paying off high interest credit first, yes, paying them off first does make the best financial sense. But there is also the school of thought that you should pay off the smaller credit card debts first, giving you the psychological satisfaction of paying off those smaller debts which will keep you motivated through the process. It worked for my sister, who had more than one year’s salary worth of debt.

    Today is my first day debt free – the final house payment was dropped in the mail, twenty years ahead of schedule. Being totally debt free is a GREAT feeling!!!

  2. @bcarney – Correct. Some people have better results paying debts off in order of size, but the most stands to be saved by paying in order of interest rate. Individuals should examine themselves, set their preference, and get about paying off debt. Congrats on being debt free! I am so happy for you (and a little envious.) 🙂

  3. Congratulations, bcarney! 🙂

  4. When you say you hold physical silver, does that mean you have a stock of, say, silver dollars in your possession?

  5. @Tara C – The physical silver I hold is a collection of dimes that date 1964 or older. US Minted dimes, quarters, half dollar and dollars prior to 1965 are 90% silver. I like the dimes because they are smaller denominations and easier to use/barter with if need be. The nickels are not made of silver, with the exception of 1942-45 “war nickels” that are only 35% silver.

  6. Great advice to pay down your debt first before you invest…unless your company offers a matching program for your retirement. Usually you can’t beat paying down a credit card at 19% interest, but 100% return on your money is tough to turn down (although many do).

    I manage my own portfolio of individual stocks, but if you are just starting out it is probably better to buy an index fund or ETF that tracks the broad market. You’ll save on fees and will probably avoid making a mistake on any one particular stock.

    Focus on increasing your own savings rate and contributions rather than trying to hit a home run on any one particular investment.

  7. @Echo – Based on your comment I’m assuming you didn’t read the entire post which suggests taking advantage of the employer match.

  8. @Matt – Ha-ha, I did read the entire post and was just re-iterating and agreeing with your point about paying off debt unless you get an employer match.

  9. @Echo – Good deal, it really is the best way to go.

  10. “If you are closer to retirement or more risk averse, it’s probably wise to hold a greater percentage of bonds than the 10% position I presently hold.”

    Very interesting. What specific percentages of bonds do you recommend for people in or very close to retirement? Do you subscribe to age = bonds, or a less conservative formula?

  11. @Larry – I would add one other variable to the equation, how much you have invested. Historically since stocks have been higher risk and higher return than bonds, those looking to maintain existing capital when closer to retirement typically do allocate a greater portion of their portfolio toward bonds.

    Do you have a large amount invested? If so, since you’re closer to retirement, allocating a larger portion of your portfolio in bonds should, in theory, should help reduce your risk and increase the likelihood of maintaining your capital.

  12. Just wanted to step in here to say that Larry Swedroe’s discussion (in his Financial Plan book) of “need, willingness, and ability” to take on risk in an investment portfolio is likely the best I’ve ever read.

  13. @Matt: Define “how much” and “greater portion.” Are you thinking in absolute terms, or in relation to the investor’s current income and projected spending needs during retirement? (Not to mention what percentage of the portfolio the retiree draws down, which as MP has demonstrated before, may have a greater bearing on success in retirement than the allocation per se.)

    Perhaps I should look at Swedroe if he can shed more light on this subject.

  14. @Larry – As we know there is no golden number or percentage that works for everyone, so giving specifics w/o knowing circumstances is impossible really. But by “how much” I was speaking of how much in investments and by “greater portion” I meant a greater percentage than someone who is farther away from retirement.

  15. Found your blog by way of the Financial Blogger Conference! Love that Matt Jabs is doing a guest post today too. Great job both of you.

  16. Hi Jenna, glad to see you stopped by!

  17. Ditto. Looking forward to meeting everybody at the conference. 🙂

  18. Matt-
    Im 24 and my only debt is student loans which I’m paying off monthly at a low federal interest rate. I just started a job and am making about $2,000 a month and only have about $500 of expenses (because I’m still living at home). I’m looking to start investing some of the money I’m saving and want to know what types of investments I should make?
    I’d like to save up to buy a house soon (2-3 yrs) and want to know if there are any good short-term investments I should look into?
    Thanks for your help!

  19. Meghan:

    I know you asked Matt rather than me, but I’m jumping in here anyway. 🙂

    In my opinion, the only thing appropriate for such a short time frame is CDs or money market/savings accounts. Stocks or even bonds (other than very short-term bonds) have a significant possibility of loss over 2-3 years.

  20. Meghan: I should add that if you do your saving via an IRA (a CD in a Roth IRA, for instance), it’s likely that you would qualify for the Retirement Savings Contribution Credit, which would boost your returns.

    For more info on the credit, see Form 8880 and this page on irs.gov: http://www.irs.gov/newsroom/article/0,,id=107686,00.html

  21. @Meghan – For your short-term goal of 2-3 years Mike has pointed out one of the safest options. There is one other option I can think of, but it comes with increased risk… so do whatever you’re comfortable with. You could open a Betterment account and invest your liquid savings with them. I wrote a review about them today so be sure to read the review and consider how risk averse you are before making your decision.

    Also, please don’t hesitate to ask more questions as they arise.

  22. I am (both late and) new to investing and I am finding this site has really helpful content (I especially liked the 8 Lazy ETF Portfolios post).

    I followed the “3. Rick Ferri’s Core Four Portfolio” model for a taxable account recently as shown below:
    * 42% Vanguard Total Stock Market ETF (VTI)
    * 20% Vanguard FTSE All-World Ex-U.S. ETF (VEU)
    * 8% Vanguard REIT ETF (VNQ)
    * 30% Vanguard California Intermediate-Term Tax-Exempt Fund Investor Shares (VCAIX)

    But since then, I’ve read that REITs are not tax efficient and should not be held in a taxable account. :-\ If you don’t mind, I have a few questions:

    1. Were the 8 Lazy ETF Portfolios recommendations meant for taxable (non-retirement) accounts or retirement (401(k) & Roth) accounts?

    2. When investing in tax-deferred account like a 401(k), should one treat it more like a non-retirement account (because we have to pay taxes on it someday, hence keep them “tax managed”) or more like a Roth IRA (since the growth is not taxed until withdrawal)? I think it would be the latter, right?

    3. Why are there so many different model portfolios out there?! Not to mention, they barely have any funds in common (except for the Lazy 8, that is).

    Please advise if you can, thanks.

  23. Hi OC.

    The Lazy ETF portfolios article was not written with specific regard for taxable vs. tax-sheltered accounts. The assumption that I tend to operate on is that most people have some of everything–a 401(k), a Roth, and some taxable investments as well.

    My advice is to look at your investments as a whole. That is, determine what asset allocation you want (what percent stocks, what percent bonds, etc.). Then go about determining the most cost-efficient and tax-efficient way to achieve that allocation. (This is in contrast to considering each account to be a separate portfolio.)

    For purposes of asset location, you’re correct: A 401(k) should be considered a tax-sheltered account, because it is not taxed on its growth every year.

    There are a seemingly endless number of model portfolios, because reasonable people can come to different conclusions with regard to asset allocation. For example:
    -Some people use just Treasuries for their bonds. Others use a “Total Bond Market” fund. Either choice is reasonable.
    -Some people use a specific REIT allocation. Others don’t. (REITs are included in a “Total Stock Market” fund, after all.) Either choice is reasonable.
    -Some people like to overweight small-cap or value stocks in order to increase their risk and expected return.

    In short, even with all the expertise in the world, there’s no way to say what the “best” allocation will be ahead of time.

  24. Hi Mike,

    Thank you for the clarification about which accounts the asset allocation referred to and especially for the helpful “asset location” link! 🙂

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