My dad taught me how to rig a mainsail, my college buddies taught me how to hold my Jim Beam, and my teachers taught me how to parse Chaucer. But somehow no one got around to helping me calculate compound interest or build a diversified portfolio. Arcane skills? Perhaps, but learning them is the best way to avoid spending your retirement years nibbling on Alpo.
Of course, people teach only what they know, and previous generations had less cause to study the finer points of finance, says Charles Farrell, a Denver-based investment advisor. Most men died within a few years of retirement; the rest squeaked by on pensions and Social Security. Today, employer pension plans are largely history and Social Security is endangered, leaving us to rely on our own savings during our waning years. And with life expectancies rising, we'd better be prepared to grow those savings and make them last. "This generation has to figure out how to afford to live off its investments for 20 to 30 years," Farrell says. "It's never been tried before."
Ensuring your financial survival will require learning to be your own CFO. Herewith, seven skills to help begin your education. (The rules of investing, debt, and saving have completely changed. Have you kept up? Ric Edelman, founder of one of America's largest financial management firms, spills his insider secrets in his newly updated book, The Truth About Money.)
Figuring Out Your Net Worth
Would you start a diet without knowing your weight? Of course not. So begin your financial planning by determining your net worth. It's assets minus liabilities, or what you own minus what you owe. Simple enough, but fewer than half of Americans can even approximate their net worth, says the Consumer Federation of America (CFA).
And if you've never stepped on a financial scale, it's way too easy to binge on debt. "Too many people think they can afford a loan if they can make the minimum monthly payments," says CFA executive director Stephen Brobeck. They might even feel fiscally fit because their bank accounts are growing each month. Meanwhile, every new debt dollar takes them further away from buying a home, funding a child's education, or retiring with seven figures. Fortunately, software like Quicken and MSN Money and Web sites like Yodlee MoneyCenter can help you manage both sides of the balance sheet by tracking your net worth in real time. The calculator at americasaves.org can even help you project it into the future.
One warning about net worth: The equity in your home is an asset, but its value is subjective, and it's not as useful in a pinch as cash or nonretirement investments. In general, you don't want home equity making up more than half of your net worth.
Running Your Ratios
Smart stock investors use handy ratios (price divided by earnings, for example) to gauge the health of a company. Do the same for yourself. Farrell has devised three simple personal-finance ratios that can tell you quickly whether you're on track for a secure retirement.
The ratios are built around Farrell's belief that you should be investing or saving 12 percent of your pretax income each year. Then at retirement you'll have saved enough to withdraw 60 percent of your preretirement income annually. What Social Security and pensions add on top of that is gravy.
Gauging Interest
It's an old saw in financial planning that some debt is good and some is bad. A loan to buy a home or attend school is good debt, because owning property or being educated tends to grow your wealth—and the interest is tax deductible. Credit-card and auto-loan debt is "bad" because you're buying stuff that loses value.
Don't fall for this line. Today, millions of families could lose their homes because sleazy brokers convinced them to take out "good" loans on ludicrous terms. As for student loans, the interest is tax deductible only if you earn less than $70,000 a year. Plus, a growing share come from private lenders demanding double-digit interest rates. And school administrators don't care whether that degree in culinary arts or sociology will translate into a job that pays you enough to fend off the debt collectors.
"It's not as simple as good or bad debt," Farrell says. "Your debt has to be kept in proportion to your income."
While we're blowing up conventional wisdom, here's another bomb: It's not always cheaper to pay off bad debt before good debt.
Good debt
30-year mortgage, $250,000
Interest rate, 6.5%
Monthly payment, $1,580
Bad debt
5-year car loan, $25,000
Interest rate, 8%
Monthly payment, $507
Let's say at the end of the first month you have an extra $1,000 to pay down the principal of one of the loans. Use it for the car loan and you'll save $470 in interest over the life of the loan. Put it toward the mortgage, and because it's a much bigger loan amount, you'll save $5,890 over the life of the loan. One caveat: You see that savings only if you stay in the home long enough to pay off the loan. If you sell in 10 years, for example, you'll save only $900 in interest.
Finally, always remember this: Paying off a 10 percent loan is like finding an investment with a guaranteed 10 percent return—and good luck finding an honest investment advisor who can promise that.Taking a Financial Punch
For people who are a decade or more away from retirement, investing in the stock market has proved to be the best way to grow wealth. But most investors can't match the market's performance. Why? Because sell-offs freak them out. They tend to sell on the dips and then miss out on the climbs.
A 2005 University of Michigan study found that if you'd invested $1,000 in an index fund in the beginning of 1963 and sold at the end of 2004, your money would have grown to $74,000. If you'd missed the 10 best days for the market over those 42 years, you'd have only $44,000. And had you sat out the best 90 trading days—just 0.85 percent of the total—you'd have only $2,700.
Indeed, the market may feel like a yo-yo if you follow it day to day. But imagine that a boy is playing with that yo-yo as he climbs a steep hill. That metaphor best captures how the market has performed over the years, says Ric Edelman, the author of The Truth About Money. The gains have tended to be longer—and larger—than the dips.
Edelman's koan: "Focus on the hill, not the string." In other words, stiffen your spine and keep buying through those dips. That's the only way to make the most of the climb.
Hedging Your Bets
Yes, markets rise and fall. Yes, you should keep buying during the worst of times.
But you don't have to be a masoch*st. Always keep a portion of your portfolio in investments that tend to soar (or at least stay calm) when the economy tanks. "People who buy a couple of mutual funds and think they're diversified are kidding themselves," Edelman says.
Between 17 percent and 18 percent of the assets Edelman recommends to his clients are hedges: natural resources, real estate, cash, and emerging market stocks. Held for 10 years or longer, these portfolios should stay upright in any weather.
Hedging Your Life
We all face bigger financial risks than a market crash: a natural disaster, a disabling injury, an extended job loss. Your defense: insurance. You'll want health, auto, and homeowner's insurance, of course, and level term life insurance if you have kids.
Disability is the most commonly overlooked insurance, says Bill DeShurko, an Ohio-based certified financial planner. The U.S. Social Security Administration estimates that the average 20-year-old has a 3 in 10 chance of missing work because of a disability before reaching retirement age. Most workplace-sponsored plans, however, cover only 6 to 12 months. So you'll want your own long-term policy as well.
Disability insurance can be expensive—annual premiums, even for young men, can approach $2,000. Reduce your premium by buying a policy that will pay you only 60 to 70 percent of your salary. The disability income you receive won't be taxed, so you'll essentially still receive 100 percent of your take-home pay. Also, set up your insurance so that it kicks in after 3 to 6 months of being unable to work. Young people recover quickly, so this will lower your premium by 25 to 40 percent, estimates DeShurko.
As for life insurance, here's DeShurko's formula for figuring how much you need:
Annual income your family would need if you died/0.06 + The amount you'd need to pay off your debts, including mortgage.
Doing Your Own Taxes
In a 2006 experiment, government auditors posed as ordinary taxpayers at 19 tax-prep outlets. The preparers, they found, screwed up every return. "The IRS goes after the taxpayer if there are errors," says Cindy Hockenberry, a spokeswoman for the National Association of Tax Professionals.
Nearly two-thirds of Americans pay a professional to do their taxes, and the National Society of Accountants estimates the average cost at $205. But most could just as easily—and less expensively—do it as well themselves, says Bryan Camp, J.D., a professor of tax law at Texas Tech. Software like TurboTax and TaxCut makes tax preparation a cinch. You answer a few questions, hit "send" to file electronically, and wait for your refund. If you own a home or trade equities outside of a retirement fund, you'll have to drop $75 for a premium version of the software. If your financial life is still E-Z, you can use TurboTax to figure and file your federal taxes for free.
Another major benefit of doing your own taxes: You'll get real insight into your saving and spending habits, says Camp, especially if you itemize. Consider it an annual fiscal physical. Then make the necessary lifestyle changes to stay healthy, financially speaking, for years to come.
