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Make Your Personal Financial Life More Effective (Part 2 of 2)

Here are the final five axioms for personal finance. The first five appear here, and can be summarized as:

  • Spend less than you make
  • Planning precedes every activity
  • Systematically monitor your progress
  • Save early and as much as possible
  • Diversify, diversify, diversify

Reading or remembering them isn’t required to grasp the ones that follow.

Match your planning horizon to the duration of your investment

Just like you would not want to finance an automobile with a 30-year loan, you should not use a long-term investment for a short-term goal.
If you are investing for a period of less than 5-years, you should not invest in stocks because their value may be down just when you need the funds. Stocks are for the long run and over the long run pay higher returns.

If you are saving for the down payment for a home in three to five years, you need to consider short-term investments such as money market funds, certificates of deposit, or liquid short-term bond funds, which better preserve stable values and offer a reasonable return.

Costs do matter

The costs of investing vary greatly and most people have no idea what they are paying. The fees charged by mutual funds can differ by more than a full percentage point per year and significantly damage your portfolio’s value.

If you have an IRA with a $100,000 balance, an additional 1 percent can drain an extra $1,000 from your account each year regardless of whether the fund made or lost value for the period.

High investment costs are avoidable. First, find out exactly how much you are paying by asking your adviser, consulting your plan administrator, reading the investment prospectus, or by referring to an independent service such as MorningStar (available online or at your library).

Studies have concluded that when it comes to investing, on average there is no relationship with long-term performance and fees paid by investors. You don’t always get what you pay for when you are investing.

Simplicity is a worthwhile objective

Investing does not need to be complicated to be efficient. Sometimes it seems like the investment world attempts to confuse rather than convince. A basic rule to follow is that if you don’t understand, don’t invest.

Other ways to simplify include: don’t invest in a security that you cannot easily sell or redeem; limit your portfolio no more than 10 to 12 mutual funds and/or exchange-traded funds; use only investments whose values and returns are reported daily in the media; develop a plan and follow it with discipline; select investments based upon their objectives; and always consider the risk-adjusted performance ratings.

Timing the market can be hazardous to your wealth

There are countless studies that indicate investors who trade more (higher turnover) generate worse performance records. Other reports conclude that investors who “bob and weave” with the market generally record weaker performance than investors who buy-and-hold.
There are also databases that indicate that long-term returns suffer significantly when investors miss just a handful of days in the market. According to Charles Ellis author of “Winning the Loser’s Game”, investors sacrificed 29% of their average annual returns by missing just the 20 best days in the market from 1982 to 2000.

Staying the course is generally the best strategy. An investor that fled the stock market in early March of this year forfeited a recovery of more than 60 percent. Investing at regular time intervals, following a disciplined approach, with periodic rebalancing is optimal.

Manage debt prudently

As Benjamin Franklin said, “Credit is the key to wealth.” However, for too many people credit and overspending have been the road to destruction.

The old rules of thumb that have been abandoned over the last 15 years need to be resurrected. A useful credit guideline is that your monthly repayment burden should not exceed a maximum of 20 percent of your take-home pay, not including mortgage payments. For example, if your monthly take-home pay is $3,500, your maximum monthly consumer debt should not exceed $700 and the optimal range is $350 to $600.

Mortgage payments should not exceed 25 to 30 percent of the borrower’s gross income and the borrower’s total monthly installment loan payments (including mortgage payment) should not exceed 33 to 38 percent of monthly gross income. Buying a home is an admirable goal, but you must consider the lifestyle impact. The responsibility of home ownership may require an adjustment to your spending habits.

You also need to consider taxes involving debt. Some debt such as qualified residence mortgage interest is tax deductible, which means that the federal government is subsidizing its cost and thus lowering the borrower’s effective cost of borrowing. The effective cost of the home equity loan is better than a non-deductible automobile loan. Definitely forget about using credit cards to finance major expenditures. The 18 to 30 percent charged by credit card institutions is a killer and those zero interest rates for limited periods are a sucker’s deals. Always focus on the after-tax annual percentage rate.

As a bonus, here is one more axiom to consider:

Education and information are integral to success. Improving your financial literacy can pay big dividends.

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