Finance Lesson/Personal Finance Tips

So... it's come to my attention a lot of my peers are inadequately prepared to manage their own finances and I've been helping some of them from time to time, but it's probably a good idea to put it in writing.

Now I'm not talking about not carrying a balance on their credit cards... that I believe most of my friends already know (If you do, that is probably the first priority to take care of). I'm talking about what you want to do with excess money/preparing for retirement. If you don't want to read, the gist of it is at the very least contribute enough to get the maximum contribution from your 401k plan and invest it in a very well diversified fund(s) (US & Foreign stocks, small & large). However this is probably not enough for a good retirement IMO.

I'm going to explain how stocks work as there are a lot of misconceptions out there, and you can appreciate/understand my advice rather than take it blindly or dismiss me completely.

So what is a stock? -- It is a legal right to a share of a company. This kind of doesn't make sense without some context. So if a company existed which had 1,000,000 shares and you owned 100,000 shares, you would effectively own 10% of the company. However what's the consequences of owning part of a company? Well there are two monetary ones -- dividends and rights to proceeds from liquidation in the case of bankruptcy/stopping of operations. Sometimes a company will give some of the money it makes back to shareholders which is called a dividend. In this case you get a certain amount of money (cold hard cash) per share you own. A real life example: I own 27 shares of KO(Coke), and I got a $11.07 dividend from them last quarter (That's $0.41/share). The other way you can get cash from the company is if they liquidate, in which case they sell all their assets, pay all their liabilities.. and then cover preferred shares and possibly some more exotic financial instruments. At this point if there is any cash left -- they distribute it proportionally to common shareholders. Naturally this is probably not what you want to buy a stock for -- however there are some people in Wall St. who's job is to examine bankruptcy proceedings and try to make a profit buying extremely cheap stock that will profit if the distributed proceeds/share are worth more than the share. Each share also brings with it a voting right for special shareholder votes, it works how democracies usually work. Theoretically if you owned 50% + 1 share of a company you can control its fortune (Appoint yourself CEO etc.). So fundamentally that is all a stock is. The fact that people want to buy it is a consequence of these rights.

So in effect, buying stock is like buying partial ownership of a company -- you own part of those profits -- all those workers are working partially for you, doesn't that sound enticing? However as you probably know buying stocks can be risky if a company starts doing bad -- so how do you protect yourself from this risk yet take advantage of capitalism? Well you can do as I suggested to buy a very well diversified equity fund that covers the whole world of capitalism. Real life example: my 401k account is invested 75% in FUSEX, 25% in FIISX. You can read their descriptions at their respective pages but basically FUSEX covers the US stock market and FIISX covers everything else. Apparently US stocks are worth about 42% of all the stocks(probably decreased recently) so I'm more heavily weighted in US Stocks -- I guess I trust US companies a bit more and I'm still exposed to international economies through multinational US corporations. Most 401k plans have the option to invest in something similar. Doing this you take advantage of the whole world of workers making profits for you, yeah some companies will fail but some will make billions -- overall the world's economy will keep rising barring some catastrophic event, in which case no matter where you put your money it'll probably not be worth much (except if you buy hard assets/commodities that you physically own nearby and can secure with firearms, hmm, actually i guess in this case just buy guns.) however I think that small risk is worth it.

How much can you reasonably expect to gain from this? The long term return of the stock market is about 9%/year, however Warren Buffet (The greatest proven investor) predicts around 5-6% growth in the US stock market for the future(All amounts unadjusted for inflation). The rest of the world will probably be greater as they have a lot more growth ahead of them. So lets take a rather conservative approach and assume a 5%/year growth using my strategy. If you invest 1000$ when you're 22 and don't invest anything else and look at your account when you're are 60, you will see this amount 1000*(1.05)^(60-22) = 6385.48. This is a pretty easy formula, Principal*(1 + return rate/year)^(number of years). This is a >500% return after 38 years. Not the best return.. but pretty damn safe considering you are diversified across the whole world. Again.. nothing is certain but I believe 5% return (unadjusted for inflation) is a reasonable bet. And this is just 1000$ once when you're 22, assuming a 50k salary and a 4% matching 401k, you'll be saving at least 4000$ a year (That's 50,000 * 4% * 2(for the match) ). Which is this sum series, 4000*1.05^38 + 4000*1.05^37 + ... + 4000*1.05 + 4000, there is probably a formula to do this calculation without so many operations but there are definitely computer programs out there to do this for you as well, as you can see it adds up. Keep in mind this is assuming a 5% return every year... in reality some years will be very good/very bad/mediocre ... this analysis simply states that overall your return will be similar to if you earned a 5% return rate every year.

Now I glossed over some details you should definitely consider later. Towards reaching retirement age you should invest less in stocks and more in bonds/safer assets, so this will most likely reduce your returns the last 10 years or so. Also you can invest more than your 401k matching -- in fact I believe 99% of the American Public should do just this and not try to time/play the market. Do the calculations(assume a relatively low return rate -- 4-5% is prob not a bad idea) and figure out how much you need to save each year. Don't forget to take into account inflation -- 2% is probably a good estimate. You should assume low because most likely you won't have less money than that (no bad surprises), and if it's higher you will have a nice surprise waiting for you.

There are probably some criticisms these days because the stock market has gone down so much in the past 2 years. However I don't think most people can time it right, its better to get a piece of the productivity of the world and let the ups and downs wash themselves out as you invest a little bit of each paycheck. Every time there is a major drop, people don't want to be in the stock market.. every time there is a major gain, everyone wants in.. however this precisely leads to selling(leaving) when its at the low point, and buying(entering) when its at the high point. Which doesn't make much sense, just because the market is valued less doesn't mean it actually is worth less, another way to think about it is.. would you prefer to buy an apple for 2$ or 1$? Of course 1$ it's the same apple for less money... same thing with stocks.. you can buy the same stock for less money when the market is down.. so you should be entering/buying after a major drop rather than leaving/selling as many did these past 6 months and loss out on the 30% gain since march. A company isn't going to magically lose some assets or ability to make money when their stock declines, actually it affects their ability to raise money -- however this only matters if they need financing which is usually not the case or the decline not so great to have material impact.

Now personally, I actually invest in some stocks besides my diversified funds in my 401k (thus I believe I'm in the 1% of the American people that can do it right) -- I'll explain how I do my analysis in a future post. I'm sure I missed a lot of details both intentionally/unintentionally, feel free to leave a comment if you have criticism and want a spirited debate, have any questions, or just want to comment.

Here are some sources which I believe are pretty good:
http://www.fool.com/personal-finance/index.aspx?source=ifltnvpnv0000001
http://money.cnn.com/magazines/moneymag/money101/index.html
They cover a much wider variety of topics in personal finance.

Full Disclaimer: I work for a Financial Research Software company, I'm not a financial advisor of any sort professionally... but honestly they don't add much more value then what I told you here.. if they tell you anything else, it is probably a bad idea.