The average person has some disposable income. Disposable income is money left over after paying for basic necessities such as housing, food, clothing, transportation and entertainment. Notice how our needs have evolved from prehistoric needs to include entertainment. Well, I'm being realistic. If you had the money to spend, you would not miss The Dark Knight nor would you deprive yourself of a grande Cafe Mocha.
In order to secure our retirement, there must be a limit as to how much extra cash we can spend. If you live from paycheck to paycheck, you are bound to work for the rest of your life assuming you could still work when you are 89. That's a bet I'm not willing to make. I might be bedridden by 58. And no, the social security check will not be sufficient to cover your expenses in 2081 because it will only cover 42% of the average worker's wage. If you dream of living in a Malibu mansion and driving a 7-series, you better forget about social security. In fact, social security is nothing more than insurance for old age.
Of course, most of you are financial savvy and took advantage of employer sponsored retirement plans such as your 401ks and IRAs. Some even go as far as setting up a brokerage account to invest the balance after maxing out the retirement accounts. These are all good. But do you know how your mutual funds are performing? Do you know how much front load fees and administrative fees you are paying? Do you own Apple because you also happened to own an iPhone? Do you own Google because your co-worker was raving about how Google jumped 15% a few months ago? Do not get me wrong. Apple and Google are probably good stocks to own, but if you bought them for the wrong reasons they are not good investments, merely speculations.
Many people make the mistake of not trying to understand their investments. Admittedly, I was one of them. I used to work at a company that offered its employees an IRA plan with employer matching and stock options. The stock options were granted at $ 16 / share. I did not exercise any because I had no clue what a stock option was back then. I did put what little money I had left after all expenses in my IRA plan to take advantage of the employer matching. When my internship ended, I was not employed so I wisely cashed out my IRA at a 10% penalty. Good thing my tax bracket was small and with the employer matching I still ended up ahead. What bugged me was I had no idea where my money went once they were in my IRA. I was also fortunate to have avoided exercising the stock options because two years later the company was trading at $ 0.56 / share. This was an eye-opening experience. I realized if I want to keep the money I worked so hard for, I have to learn how to invest. It's crazy to leave the only guarantee to your retirement in the hands of people you do not even know.
A $ 50,000 / year wage earner will have approximately $ 5,000 / year in disposable income assuming a 30% effective tax rate and 60% expenses. If she continues to work and save for 50 years, she will end up with about $ 603k assuming a 3% interest on her savings. However, the erosion of buying power due to inflation combined with taxes will wipe out all her interest earnings and take a haircut off her savings. Of course, many of us already know this, our investments in mutual funds and stocks. Unfortunately, our initiative to invest ends right here. We know the hole to the left is deep, so we jump into the hole to the right which might well be an abyss. The vast majority do not even know their nest eggs are dwindling by the day because they pay more fees than they earn returns.
Investing is to the modern man what hunting is to the caveman. The key to a comfortable retirement is smart investment. You do not have to be a Warren Buffett to do well in retirement. But you do need to learn the basics to understand what is the best choice of investment there is for you. Paying an extra 2% of administrative fees on a $ 10,000 investment may seem like chump change. But that 2% fee on a $ 10,000 investment over a period of 50 years could buy you and your better half a Bentley Azure each. Apathy is a price one can not afford to pay. What's worse is many of us do not even attempt to understand who runs the mutual funds we are invested in. I bet you do not even know the name of the portfolio manager of your mutual fund, let alone his track record. Would you let a stranger fresh out of finance school invest your life savings?
Then there are some who are more adventurous, myself included, who think they are somehow born with a talent to pick winning stocks. This group of investors are perhaps the ones who pose the greatest threat to themselves. There are a myriad of investing methodologies spanning from technical analysis to value investing. The worst of these is what I would call rumor investing. You see, we are all born with a great virtue – generosity. As a matter of fact, this value is so powerful that it drives us to share everything from friends at Facebook, photos at Flickr to even our poop. Sharing our hottest stock tips is no exception. At any given social function, you can be sure to hear tips about some of the hottest stocks at the time. Last summer, I was tipped off about Google. Last Christmas, it was Apple. Incidentally, the prices of these stocks were near their peaks when they were recommended to me. Had I bought them when they were recommended, I would have lost some money. Not a bundle. But bad advice overtheless. Bear in mind this is no fault of my friends who just wanted to share their best investment ideas. They were just trying to help. If I bought the rumor and invested, I'd have no one to blame but myself.
The most important lesson in investing is to understand what you are buying. This is perhaps the one lesson that many are unwilling to learn. If you do not understand what you are buying, you are not investing. You are speculating. You are gambling. You are betting that whatever it is that you bought will increase in value. Imagine you are presented with a sealed box. You and a group of gentlemen are invited to bid on the content of this box. You are welcome to examine the box however you wish but you can not open the box. Once the bid ends, the auctioneer will buy the content of the box from the winner at fair price. One gentleman, after a glance at the box, starts the bidding at $ 100. The next, without even so much as a glance at the box and not willing to concede the right to own the box, bids $ 120. Will you bid higher? If you were scientifically inclined, you might begin to examine the workmanship and age of the box in hope that it might yield a slight indication to the value of the content in the box. You might pick up the box to feel the weight. You may rattle the box to hear the sound it makes and feel the weight of the content shifting around in the box. Once you are satisfied, you place a bid or, if the price is too high, you walk away. This is the kind of skill you need to learn to master to invest. You do not have all the answers. But you need to make an educated guess about what a company is worth. Do you own any sealed boxes you have not examined in your portfolio? If you do, sell them now.
Stop putting off educating yourself about investing. Investing is a survival skill. Go to the bookstore. Buy a book and start reading up on investing. Make sure you know who is managing your money if you have your money in mutual funds. If you are bolder and pick your own stocks, make sure you understand the companies you are buying. Finally, if you can not stand numbers, just put all your money in a low cost index fund like Vanguard and go back to enjoy what you love to do best.