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Mutual Funds Growing Savings
The basic concept behind the rule of 72 is finding when, given a set interest rate or return, your investment will double. If you receive a 6% return, your money will double in 12 years. The formula: Divide 72 by the interest rate (6) and the time table is set. It works in reverse for determining when a loan will be paid off. Now that you know, forget about it.
True investors although understand that the future is a less predictable place than the present. They understand that they can not seek safety when they are shooting for growth or returns larger than 6%.
The new investor, the one who is redirecting their new found money hiding in their tax refund or in pre-tax income should approach the idea of growing money differently. They need to do things differently.
Money put in active market places like the stock market (even when using mutual funds) requires two things: a time horizon and a risk tolerance. The time horizon is the easy part. Determining your risk tolerance is impossible.
You may think you know what type of person you are in the everyday world, but when it comes to investing, people change in incomprehensible and unpredictable ways. Daniel Kahneman, a psychology professor at Princeton won a Nobel Price in economics for "having integrated insights from psychological research into economic science". His award was the result of his observation of the human condition during periods of uncertainty. He was able to discern pain and pleasure and apply it to two distinct groups based on their reaction to money.
A wealthy individual and a considerably poorer person, he found experienced the same pleasure upon finding $10. But the pain experienced at the loss of $10, was much different for the subjects. Even though both could have told you what kind of person they were, what they believed in, and even ventured to tell you how they would react, those emotions change when it comes to money.
So don't waste your time trying to figure out if you have the financial fortitude to become an investor. You will never be able to reveal your investor self until you actually participate. That is a key first step in getting involved. The person you are today may not be the person you will be in ten years. Your investment style will change also. But recent legislation has made finding your investor self and determining where to put your money much easier.
Once you have found the money to become an investor or you have decided to commit yourself to become a serious saver/investor, the choice of how to allocate those funds became much clearer thanks to some tax changes courtesy of President Bush.
No longer should stocks and equity mutual funds be part of a tax deferred savings plan. It no longer makes sense. With the current capital gains tax at 15% and possibly headed lower, savings in these kinds of growth oriented offerings should be kept outside of a tax deferred account. Because of those changes in the tax code, equity based investments might find a more favorable tax environment than if those taxes were deferred and paid later as income many years down the road. Without knowing what the tax code will look like in ten or twenty years and without knowing what your income will be as a result of longer careers, it is doubly difficult to determine tax brackets for the growth that might result in allocationg your retirement plan to the stock market.
One thing for sure, that 15% capital gains tax is here and likely to stay. Equity mutual funds, the stalwart of the 401(k) and IRAs alike should be kept outside of these plans, allowed to grow with dividends reinvested. Any gains these funds make in a year over year basis are better taxed now and not later. This means that you need to structure your tax deferred accounts to reflect a predictable and less taxable gain. And that means bonds.
Bonds and bond funds should become the new darlings of these types of tax deferred accounts. In many cases, the returns are more predictable, often they are inflation protected and ultimately, it is a more conservatively investment. No need to determine your risk tolerance in these staid investments.
With your retirement savings safely tied up in the most tax favorable, inflation friendly environment, you free other savings - assuming this will be the beginnng of a new you geared toward savings - to really run in equity funds. And for those, you need to: Start early, stay consistent, watch those fees, reinvest dividends, diversify, and of course, invest with some sort of dollar cost averaging.
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