Investing

Most medium- and long-term goals require more than saving—they require investing. Our culture has become used to borrowing to reach goals, but if you borrow for everything you can't afford, you will be using future income to repay loans and credit card debt. You can't borrow for everything. You will still need a substantial down payment to purchase a home or buy a car. And borrowing for some things, like retirement, doesn't make sense.

Saving and investing allow you to make your hard-earned money work for you. Interest, dividends and capital gains build wealth over time. For example, $1000 invested in the stock market at an average rate of 10.4 percent (Ibbotson Associates) will grow to:

• $2,690 in 10 years
• $4,411 in 15 years
• $7.234 in 20 years
• $19,457 in 30 years

• Investments—Compounding
• Regular Investing Adds Up
• Compounding for Mathematicians
• Your Investment Strategy
• Investment Basics
• Investment Basics Plus
• Investing for Education
• Investing Your Retirement Account Money
• Ways to Fund Your Retirement

Investments—Compounding

Compounding was once called Compound Interest, because its appeal comes from the interest your account earns, which is added to your account total and earns more interest. Investing is one way to make sure your money compounds over time.

The Power of Compounding
The power of compounding is visible as your money earns interest. The interest increases the total in your account, and that larger total earns more interest. You profit from what mathematicians call exponential returns. When this happens over and over, our savings and investments grow and wealth is accumulated.

Even at today's low interest rates, compounding makes a big difference over time. A $1,000 savings deposit at 3 percent compounded daily will grow to $2,460 in 30 years. Without compounding, the same deposit will be worth only $1,900 in 30 years. That's $560 extra!

Interest is determined by the amount we have saved or invested (principal), the rate we earn, and the length of time we can leave the amount invested.

To build maximum wealth to achieve your goals, you should:

• seek the highest rate available for the amount of risk you can tolerate (more information in the Investment section)
• seek the most frequent compounding period
• hold your investments for the long term (more information in Investing)

If you love math, you can see how compounding works.

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Regular Investing Adds Up

Instead of waiting until you have a lump sum of money, it's better—and easier—to invest smaller sums regularly. Most people wait until the end of the year—or even until April 15th of the next year—to make a contribution to an Individual Retirement Account (IRA). If you wait until the end of the year to put $5,000 in your IRA account, after 30 years it will be worth $590,677 (assuming an average return on equities of 8%). That sounds pretty good, but if you invest that $5,000 in equal installments of $417 each month over a year, and keep it invested for the same 30 years, your IRA will be worth $769,145! The extra $178,468 that you will have at retirement is your reward—thanks to the power of compounding—for putting your money to work earlier.

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Compounding for Mathematicians

How Compounding Works Magic
Interest (I) is determined by the amount we have saved or invested principal (p) , the rate (r) we earn, and the length of time (t) we can leave the amount invested, as expressed by the following equation:

I = p x r x t

Compounding means that every so often we calculate the interest, add it to the principal, and use the higher principal for the next calculation of interest to arrive at a future value. To get from the original principal—or present value—to the future value, we use the following equation (where i is the interest rate per period and n is the number of compounding periods):

FV = PV (1+i)ⁿ

What does all this mean? It means that the future value of your investment depends on what you set aside today (present value), what rate you earn (i), and the number of times the rate is compounded (n).

Doing the Math for an Annuity
A series of equal periodic payments is called an annuity. To get from the future value of the annuity (FVA) to the periodic payment (PMT), we use the following equation (where i is the interest rate per period and n is the number of periods):

This means that the periodic payment or annuity investment you must make depends on the future value (or amount of your goal), what rate you earn i, and the number of payments you make n. Therefore, to keep your payments (delayed consumption) to a minimum, you should:

• seek the highest rate available for the amount of risk you can tolerate make a habit of regular savings and investments
• hold your investments for the long term

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Your Investment Strategy

Every person invests differently based on goals, timing considerations, risk tolerance, willingness to delegate and knowledge. There is no "best" approach to investing that guarantees success.

A haphazard approach to investing may work when the whole market is on the way up. Consistent success comes more often from a strategic, deliberate approach. Your strategy may be different from anyone else's, but you should develop a set of rules to guide your investment decisions. You should have a very good reason to break your rule. More important, you should test your rules over time and be willing to change them when your circumstances (or the whole world's) change.

If you want to learn about strategies that others have used and see if they apply to your own situation, check out the Motley Fool at http://www.fool.com or browse the investment section in a bookstore.

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Investment Basics

Investing is a topic that you can study for a long time before running out of new material. You don't have to be an expert to get started, but it helps to know the basics before you set a strategy for investing.

1. Beware of the "Sure Tip"
   Investment ideas often sound tempting, particularly if they come from a professional. Some companies pay their sales staff a commission to sell certain investments. Do your homework before investing. Never rely on a "tip" without checking it out first. There are companies and mutual funds on the Yahoo! Finance site. At the very least, if you prefer to delegate the research work, get a second opinion from someone who has nothing to gain from your decision.

2. Understand Risk and Reward
   Investment risk means you can tolerate some losses while waiting for some gains. When you invest in the stock market, risk is a given. There are many levels of risk, from the relative safety of cash (e.g., bank savings accounts) to the high-risk world of stock futures. The amount of risk you can stand is the amount that will let you sleep at night while your money is invested.

   Generally, the longer you have to recover from a loss, the higher the risk you can afford. But the overall risk tolerance varies from person to person and is something you must know before you start investing.

3. Know Your Risk Tolerance
   Determine your tolerance for risk by completing any of the questionnaires available at financial publications such as Kiplinger's. Keep in mind that if you decide to risk more than you normally would, you will most likely manage that investment emotionally rather than intellectually. You may panic at the first sign of trouble and sell when you should be buying.
   

4. Spread Your Risk
   Don't put all your eggs in one basket. Take advantage of the benefits of diversification (spreading out your risk) and asset allocation (investing in a variety of funds). Your Thrift Savings Plan, which may be invested in index funds, provides plenty of opportunities for diversification. Mutual funds, in particular Life Cycle funds, can achieve diversification and asset allocation for your investments outside the TSP. Learn more about these at Morningstar.
   

5. Don't Believe in Market Timing
   Research has shown that attempts to "buy low and sell high" often fail. Big market moves often happen within a short time frame. By the time most people decide that the market is "going up," most of the money has been made. Rather, consistent investment over long periods of time has generally paid off. Refer to the sections on Dollar Cost Averaging and Share Purchase Plans and Dividend Reinvestment Plans.

6. Do Your Research
   Finance experts disagree on whether it's possible to "beat the market." Those who say that you can beat the market recommend extensive research to uncover information about stocks that are under- and overvalued. Others say that market movements are random and stocks are always priced correctly. This debate will not be resolved soon—perhaps never.

   You will be a calmer (and maybe richer) investor if you do your homework. Researching stocks and mutual funds before you buy has many benefits, whatever you believe about the market. It may not enable you to uncover hidden gems, but at the very least, it will focus your decisions, provide information about the costs of investing, and provide some protection from being victimized by financial predators.

7. Keep Your Costs Low
   Do your own research at Morningstar and Yahoo! Finance to find quality no-load mutual funds with low expense ratios. If you purchase stocks on your own, consider buying through Share Purchase Plans (Sharebuilder), a deep-discount brokerage (TD Ameritrade), or directly from the company (determine whether you can do it by reviewing the Investors section of the company's Web site).

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Investment Basics Plus

Risk

In investing, risk is the chance of losing money.
People ordinarily do not take a financial risk unless there is also a chance of making money or being rewarded. If you make an investment that has a real chance of a high return—such as in the equities market—then you are also taking a chance of a low return, or a loss of your money. If you invest in a lower-risk, short-term, fixed-income security—such as a bank savings account—both your risk and your returns will be lower.

How Risk Varies
For example, the historical average monthly return on equities (e.g. stocks) has been a gain of 0.85 percent (10.2 percent annually). At the same time, these returns varied, on average, from a loss of 0.61 percent (7.28 percent annually) to a gain of about 2.6 percent (31.32 percent annually). In other words, $1,000 invested in equities at the beginning of a month could be worth, at the end of the month, as much as $1,026 or as little as $994. At these rates over a year, your $1,000 might grow to $1,313 or decline to $927. [Siegel, Jeremy, Stocks for the Long Run, ©2002, McGraw-Hill.]

Keep in mind that all these returns are averages. Any single stock in any single year could gain or lose a much greater amount. For example, in 2001 Enron lost 95 percent of its value ($1,000 invested in this stock became just $50). In 2002, ICG Communications gained 3400 percent of its value ($1,000 became $35,000)! [Reference: Denver Post, July 23, 2003 ]

Systematic Risk
Risk that the overall equities market will decline is called systematic risk. There is nothing you can do to reduce this risk except to completely avoid investing in equities. But remember that you are giving up the chance of making an average return of as much as 31 percent in a year while avoiding an average possible loss of only 7 percent. Financial professionals would call this a bad trade-off, and they advise most people to invest at least some of their long-term funds in the equities market.

Non-systematic Risk
Risk that any single stock will lose money (or go to zero) is called nonsystematic risk. The good news is that this risk can be minimized. Overall, nonsystematic risk may be diversified by owning several stocks. This is referred to as holding a portfolio, and it relates to the old saying, "Don't put all your eggs in one basket." The chance that a single stock will lose money is offset by the chances of your other stocks making money.

Controlling Risk through Diversification
Equity investors can build a diversified portfolio by buying several stocks that have different risks. This generally means owning stocks of companies in different businesses. Some, like retailers, will do better when the economy is growing and inflation is low. Others, like gold-mining companies, will perform better in times of high inflation or political instability. Another way to diversify is to own stocks of companies that operate in different parts of the world.

Transaction costs
Charges such as brokerage commissions, associated with creating and rebalancing a diversified portfolio can add up and reduce your returns. For example, $2,000 invested at the end of each year for 30 years earning 12 percent per year will grow to $482,665 if there is no sales charge on the investment. A front-end load of 8 percent will bring the value of the same investment to $444,052. In other words, the front-end load (e.g. a sales expense charged on each contribution/deposit) will cost you $38,613! To obtain a diversified portfolio at a lower cost, you can invest through your Thrift Savings Plan, dividend reinvestment plans (DRIPs), and mutual funds.

Asset allocation is another way to diversify overall investment risk. Portions of an investor's assets are invested in equities (both United States and international), fixed income (various types of bonds), commodities (such as gold), and real estate. The percentage invested in each type of asset is determined by your stage in life. Once again, you can achieve an effective asset allocation using mutual funds and real estate investment trusts (REITs).

Dollar cost averaging is the process of purchasing stocks or mutual funds periodically at different market prices. You must commit to investing the same amount of money each time, regardless of what happens to the market price of the stock or mutual fund.

Here's how it works:

• When the price of the stock or mutual fund goes down, you purchase more shares with the same amount of money. It is as if the investment is "on sale."
• When the price of the stock or mutual fund goes up, you purchase fewer shares, but the shares you bought before are now worth more, too!
• Over long periods of time, the average cost of your shares tends to be less than the current market price.

Let's look at an example (refer to the table below):

• Assume that you commit to invest $50 per month in a no-load mutual fund for one year.
• The market price of the fund starts out at $10 per share. At the end of the year it is also $10 per share.
• In months 2 through 5, the market price of the fund declines by $1 per month. The number of shares you buy in each of these months is $50 divided by the market price. Column 5 shows that you are buying more shares with your $50 than in previous months.
• There is no change in price during month 6.
• In months 7 through 10, the market price of the fund increases by $1 per month. The number of shares you buy in each of these months is $50 divided by the market price. Column 5 shows that you are buying fewer shares with your $50 than in previous months.
• In months 11 and 12, the market price of the fund remains unchanged at $10.

Now let's analyze the results.

• The market price of the fund at the end of 12 months is exactly the same as at the beginning of the year, $10 (column 2).
• If, instead of dollar cost averaging, you had invested the entire $600 at the beginning of the year and held on to the fund for 12 months, it would still be worth only $600 at the end of the year.
• Your $50 per month, however, bought more than 5 shares in months 2 through 9 (column 5). Over the 12 months, you bought 74.5635 shares (column 6) for $600, resulting in an average cost per share of $8.05 ($600 ÷ 74.5635 shares; column 7).
• If you sold all of your shares in month 12 at $10, you would receive $745.64 (74.5635 shares × $10 per share), a gain of $145.64 ($745.64 received - $600 cost)! See the table below for an illustration.

Some words of caution:

• Dollar cost averaging requires discipline. You must commit to buying shares even when the market is going down and your emotions tell you to "cut your losses."
• The price movements in the above illustration, while possible, are exaggerated to make a point. Your results will vary.

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Investing for Education

College tuition costs have risen faster than the rate of inflation for many years. Today it is not uncommon for parents to pay more for their child's four-year college education than they spent to buy their first home.

Public colleges—including community colleges and state universities—are supported by taxes on residents, so tuition is usually much less than private colleges. Most public colleges charge out-of-state residents higher tuition. Because members of the military may be deployed anywhere in the world, they are not eligible for in-state tuition everywhere. When you plan for college, be sure to ask whether you will qualify for in-state tuition.

For more details on investing for education, visit Education Planning.

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Investing Your Retirement Account Money

You have an ownership interest in your retirement accounts. You will probably have investment choices with your thrift savings account, and you certainly have choices with your IRA account. Rely on your financial advisor to the extent that you are comfortable; but as the account owner, you will pay the price or benefit from whatever happens. Learn at least the basics:

• How much money must you save to meet your financial goals?
• How much time do you have to save for retirement?
• How much risk are you willing to take?

The investment terminology might be new to you, but the facts won't be. There are different kinds of investments you can buy with your retirement dollars. You will want to choose a certain mix of investments for your account that reflects the amount of risk that you are willing to take. Remember that as the rate of return you want to achieve goes up, so does the risk. You will want a balance that gets you to your goal with a risk factor that you can live (and sleep) with. The main categories of investment opportunities are:

• stocks
• bonds
• cash and cash equivalents

Stocks—High Return and High Risk
Stocks, also called equities, represent ownership rights in a corporation. You might receive dividends and share in the company's growth. There's no guarantee that the company will grow and do well, so you could lose value rather than gain value. Over the long run, stocks in general have always brought the highest return. If you've got time to recoup from down periods in the market, you should be able to tolerate the higher risk of stocks.

Cash and Cash Equivalents—Lowest Return with Lowest Risk
If you keep your money in certificates of deposit (CDs) and money market funds, you'll preserve the dollars with which you started but earn a low income on those dollars.

Think about how you would like to allocate your assets. It's the most important decision you have to make about your retirement accounts. Investment selections and timing within the allocations are other factors. Consider your specific investment goals, financial resources, time frame and risk tolerance. Some financial advisors suggest that you subtract your age from 120 to determine the percentage of your assets to invest in stocks. The remainder would be invested in bonds and cash or cash equivalents. For example:

• If you are 30 years old, invest 90 percent in stocks and 10 percent in cash and cash equivalents.
• If you are 50 years old, invest 70 percent in stocks and 30 percent in cash and cash equivalents.

You can get decision assistance from online calculators with graphics. If you visit http://money.cnn.com and click on "Calculators," you will find an asset-allocator calculator that you can use to try different asset mixes. You will find a mix that is comfortable to your risk tolerance. If you need additional help or want professional guidance, ask a certified financial planner (CFP).

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Ways to Fund Your Retirement

Thrift Savings Plan

The TSP is designed to supplement your retirement benefits in a tax-effective manner. Contributions from taxable income are invested on a tax-deferred basis, while contributions from tax-free income (such as combat-zone pay) remain tax-free status. When you arrange to have a portion of your taxable income invested in the TSP, you immediately save money on taxes. In other words, when you contribute $100, your net paycheck may be reduced by only $85, because the contribution isn't taxed until you use it when you retire. Yet you will be able to invest the entire $100. You'll pay tax on the amount that the $100 becomes in the future. TSP information is subject to change, so check for updates at http://www.tsp.gov.

Thrift for Retirement
Investing in the Thrift Savings Plan (TSP) for your retirement is a no-brainer! Quite simply, you should invest as much as you can afford in the TSP because:

• You save money on income taxes.

• 100 percent of the money you have deducted from your pay goes into your investment account, and no income tax is deducted. If, for example, you are in a 10 percent tax bracket and you contribute $100, your net pay goes down by only $90.

• All of the earnings on your account are tax-deferred. You don't pay the tax until you withdraw money, usually during retirement.

• Contributions of your tax-exempt combat or hazardous-duty pay retain their tax-exempt status, so you won't pay tax on this money, even when you withdraw it. (Earnings on your tax-exempt contributions are tax-deferred until they are withdrawn. There is also pro-ration of amounts-see below.)

• You may be eligible for matching contributions if you serve in a critical specialty.

• This is free money that results in an immediate return of as much as 100 percent on your contributions. If you don't contribute, however, you can't earn the match—even if you work in a critical specialty.

• If you need access to your money, you can borrow from your TSP at a low rate of interest.

• Personal loans can be for up to five years.

• Loans to purchase your residence can be for up to 15 years.

• Your loan is repaid through payroll deductions; it's like borrowing from yourself.

Start Contributing Now
The first step is to complete a TSP election form (TSP-U-1), using these guidelines:

• To calculate your contribution (per paycheck) to the TSP, use and multiply that amount by 1.111. Figure out how much to contribute.

• If you can do without $40 per paycheck, put in for a contribution of $44.44. Your TSA account will get the full $44.44, and your net pay will go down only $40!

• Put your incentive pay or special pay (including bonus pay) into the TSP.

• You can earmark a portion (up to 100 percent) of these extra pays to go directly to the TSP. It's a smart use of extra money. If you can't put it all in, consider putting in half.

• You cannot participate with your extra pay unless you also have some contribution coming out of your base pay, so consider starting with just $10 per week, or $40 per month.

• If your account earns 7 percent per year, your $40 per month will grow to nearly $21,000 in 40 years. Compound Calculator.

Allocate Your Investments for the Long Haul
All of the investment choices available in the TSP offer diversification to reduce risk, but only the Government Securities fund (G) guarantees that you won't lose money. It would be prudent to invest any TSP funds that you anticipate withdrawing within five years in the G fund. You will earn a medium-term (four-year-plus), government-securities return on your money in an investment that you can turn to cash at any time.

Higher Returns Mean Higher Risk
The more risk you take, the better the chance of making more money. You should take a look at how your investments are allocated every year or two. Investment performance (gains and losses) will change the percentages over time. You can rebalance your asset allocation by making transfers among your different investments groups.

Don't Touch Your Money Before Retirement
Any time you take money from your fund, you are taking money out of your retirement. The best plan is to never touch the money until you retire. Sometimes you find yourself in financial trouble. Before you take out money, consider taking a loan from the plan-borrowing money and paying yourself back.

• You must pay taxes and possibly penalties on your withdrawals. Loans let you pay yourself back over time, and all your money keeps working for you. But the interest you pay yourself back may be less than you would have earned if you hadn't touched the money.

• Wait until you reach age 59-1/2 to withdraw money penalty-free from your TSP.

• You will have to pay tax on the money you withdraw (except for any tax-free funds from combat or hazardous-duty pay), but you won't have to pay an additional 10-percent penalty.

• If you are younger than 59-1/2, consider an annuity.

• If money is needed for income, you can withdraw substantially equal amounts over your lifetime, without paying the 10-percent penalty.

• The calculations are quite complex, so seek advice from a tax professional.

• Note that if some of your TSP is tax-exempt, you cannot withdraw only the tax-exempt portion. The IRS forces you to prorate the amount taken out. As a result you will pay tax on some of your withdrawal, and you also may owe a penalty. Again, consult a tax professional.

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