Soldier of Finance (16 page)

Table 13-1
CD Ladder

 

Why use a CD ladder? Think of someone who is afraid of heights. It doesn't matter how much you pay him; he still will be afraid to climb to the top of a ladder. He might be okay climbing to the first or second rung, but any more than that and his heart starts to race and he is ready to jump off.

A CD ladder allows investors who are afraid of locking in their money for too long (the highest rung) to always have their feet on the first rung, maintaining a level of security, knowing that a CD will be maturing within the year. For example, assume that you are interested in opening a five-year CD to get the best rates, but you want to have access to some of the money yearly. A shorter-term CD does not provide a good APY (Annual Percentage Yield). Laddering allows you to benefit from the higher interest-earning potential and still have access to cash at regular intervals.

Open your five-year term CD with part of your funds, even if it is only the minimum required. That locks in the higher rate you wanted. Next, take the remaining amount of your investment money and open additional CD accounts with varying terms in increments of twelve months (one, two, three, and four years). The interest rate on those will be less than the five-year term. As each one-year CD comes due and you are sure you don't need the money, you can then lock up that CD at a five-year term knowing that you have another one coming due in a year.

A new form of lending has appeared in recent years. If people need money to pay off a debt or start a business, and they can't get a traditional loan from a bank, they now have the option to use a peer-to-peer lending site. One of the biggest right now is called Lending Club (
www.lendingclub.com
).

You apply as you normally would for a loan and the organization completes a background check and a credit check, just as a bank would. Then it raises capital for the loan.

Raising the capital for the loan involves searching for investors willing to put up their money. For example, I might have $1,000 that I want to invest. I decide how much risk I want to take, and the Lending Club then selects the consumer note for me based on my tolerance level.

Typically, the risk is spread among numerous investors. If I have $1,000 invested, for example, only $25 will go to any one borrower, which further minimizes my risk. Instead of investing in corporate bonds, I'm investing directly in consumer loans. I've done this myself for several years now, and on average, I've made about 9% on my investments. With recent difficulties in the stock market, peer-to-peer lending has certainly gained traction.

Go / No Go

• The type of investment vehicle you choose is determined by your goals. There are short-term investments as well as middle-distance and long-term vehicles.
  
• Short-term investments should be as liquid as possible so that you have rapid access to them.
  
• In the short term, a basic savings account allows you ready access to your funds and provides a safe, steady increase.
  
• If you are comfortable with online banking, there are savings accounts that you can open that way.
  
• Investment accounts provide better interest than do savings accounts. Commonly called money market accounts or CDs, they require a longer investment cycle.
  
• Investment accounts are for goals that you want to accomplish in three to five years.
  
• CD ladders give you more flexibility if you don't want to commit to a full five years.
  
• Peer-to-peer lending provides an opportunity to lend money to private individuals through an organization that handles the loan details for you. The risk is spread among a number of private lenders.
  

As you learned in
Chapter 13
, when traveling on long convoys we relied on five-ton trucks to carry as many personnel as possible; my buddies in Afghanistan got to ride in MRAPs (Mine Resistant Ambush Protected vehicles). Both vehicles were built to transport big loads over long distances.

When it comes to investing for your retirement, you'll want to put your money in a vehicle designed to transport you into your golden years. You need to utilize retirement accounts engineered specifically for this purpose.

If you've joined the working force, the main vehicles you'll focus on will probably be Roth IRAs, traditional IRAs, and 401(k) plans. In essence, these vehicles enable you to invest in mutual funds, stocks, and bonds. As your investment portfolio grows, you might decide to buy specific stocks on your own. Long-term investments carry varying degrees of risk and varying yields. To effectively invest, you do not have to be an expert, but you do need to have enough understanding of how various vehicles work to choose the best for your situation and your temperament.

The first investment we will explore is the Roth IRA. If you have read other investment books, you already know that this advice is different from what is often recommended. Conventional wisdom says that if you can open a 401(k) with a good employer-matching plan, you should get your free money first and then look at other investment vehicles.

I don't agree with that advice. The reason is simple. As a Soldier of Finance, you must be actively involved in your investments, and you need to know what they are. Most people who sign up for a 401(k) get a form from their employer. They fill in some personal information, check a box or two regarding the types of investments they prefer, and hand it back. That's usually the last time they look at the account until they retire. They leave the 401(k) on autopilot and don't have a clue whether they're accessing the best investments or not.

I recommend a Roth IRA because it requires you to take action to open the account. You have to meet with a financial advisor or go online and physically do something; from the beginning you will be more engaged and more in control. Additionally, I'm a much bigger fan of tax-free money than free money, and when you eventually withdraw money from a Roth IRA it's tax-free.

Another factor is that 401(k) accounts usually have a limited number of options for investment. Even if you are paying attention to how your account is invested, you will probably only have a list of fifteen to twenty options at the most. A Roth IRA gives you many more choices.

Roth IRAs are limited in two ways. You must qualify, meaning that your modified adjusted gross income (MAGI) must be below a certain amount. If you are married and filing jointly, the limit is between $178,000 and $188,000. If you are single, the limit is between $112,000 and $127,000.

Note that if you make too much money to qualify for a Roth IRA, you can still open a traditional IRA. They operate much the same, except for how the money is taxed. The money in a Roth IRA is taxed before it goes into the account. A traditional IRA is taxed when you take the money out. Obviously, that makes the Roth IRA preferable, because all interest accrued is tax-free.

The second limitation is the total amount that you are allowed to deposit into the account. Basically, you can invest a maximum of $5,500, or $6,500 if you are over 50 years of age. For a married couple, the maximum is $11,000, or $13,000 if they are both over 50. Please note that the limits apply both to Roth and traditional IRAs. You are allowed to have both but you can only contribute the max between the two of them. These numbers are for 2013 and change every year, so check with the IRS to make sure you have the current limits.

One benefit of a Roth IRA is the ability to invest in a wide variety of options. The account itself is not a stock. Many people ask me, “How much does your IRA pay?” as though it generates interest on its own. In fact, it is an investment account into which you put money that is then invested in other vehicles. You don't buy an IRA, you open one. Then you buy investments with the account. How much interest you earn depends on what you buy.

You have a great deal of control over where you invest; you can choose from mutual funds or stocks or an ETF (exchange-traded fund) or CDs, among other options. The investment potential is much greater than it is with a 401(k).

Starting a Roth IRA account is no more complicated than filling out an application for a credit card or a bank account. You will need some basic information, including your Social Security number and bank account details. It can take as little as fifteen minutes and likely won't require more than an hour.

Deciding where to open your Roth IRA will take more effort than actually doing it. Your final decision depends on your comfort level. There are many options online, if you are comfortable with that. Fidelity Investments, Vanguard, and T. Rowe Price are three large companies to consider. Most banks and credit unions offer IRAs, though there could be limitations in what investments you can choose. You also can directly contact brokerage firms (I have worked with Scottrade). Other firms provide services as well; simply call their toll-free call center and speak with a rep. If you've never done this before, I recommend you meet with a financial advisor and discuss your options.

Before you make a decision, ask the following questions:

• Does the provider require a minimum initial investment?
  
• What fees are involved? Many funds have custodial fees, or fees that kick in if you don't hit a minimum amount of investment.
  
• What investment options are available?
  
• Is the provider reputable?
  

These questions are important. Banks might allow you to invest only in CDs. Scottrade has a huge mutual fund database, with thousands of possibilities to choose from, and does not require a minimum initial amount to open an account (although some of the funds in its database have minimum requirements). Some companies require minimum amounts to start; Fidelity requires $2,500 to open an account, though they will waive that if you commit to a $200 a month automatic contribution. You don't need much to get started, but if you don't have much, you will be more limited in your choices.

While I prefer a Roth IRA to a 401(k), you should not ignore the 401(k) as a possible investment vehicle. There
are
advantages. You can invest much greater amounts than are allowed for Roth IRAs. The maximum annual amount allowed is currently $17,500, substantially more than the $5,500 for a Roth IRA. This number is also subject to change, so check with the IRS to be sure you are up-to-date.

Another advantage most 401(k) plans provide is an employer match program. Your employer might agree to match a portion of the money you put into the account, which is basically free money. If you have a 50 percent match, for example, your employer contributes 50 cents for every dollar you invest.

I advise my clients to start with a Roth IRA and max it out. Once they have reached the limit, they can consider starting a 401(k).

My apprehension about 401(k) accounts is that people rarely understand them or utilize them to their greatest benefit. Mechanically signing a form that their employer plugs into a default investment option, many people have no active participation in the process until they are ready to retire. The most important investment of their life, the money they will live on in retirement, is left in the hands of someone else. That's not the attitude of a Soldier of Finance. You should be in control of your financial decisions. Take responsibility.

The most common investment option allocated is the target-date mutual fund or a life-cycle fund. They are very similar. The idea is that the default fund your 401(k) investments are put into is determined by your age now compared with the date you expect to retire. Investments are designed to be more aggressive when you are young and become more conservative as you get closer to retirement. This sounds good in theory, but what often happens is that conglomerates of fifteen to twenty funds are thrown together. Breaking them down, I usually find at least one-quarter of them are bad choices.

On top of that, because funds are rebalanced periodically to fit your target date, you will have internal fees and end up paying up to twice as much as you would if you built your own portfolio. With target-date mutual funds, you normally end up with higher costs and lower return. Because most people leave the investment up to someone else, they never know how much they could be earning.

I once had four separate clients come in at the same time to review their 401(k) plans; all of them had used the default plan and all of them had target-date funds. My junior advisor and I went through them one at a time. The lowest interest rate was 2.5%, and the highest was just under 4%. Investigating alternate options, it became clear that leaving the funds as they were would result in losing out on tens of thousands of dollars in interest over a ten- to thirty-year period.

You do have a choice. Select a handful of good funds and refuse to use the others, lowering your expenses and eliminating funds that drag down your return. The options available for a 401(k) are limited, but look through them and choose the investments you want. Do not leave your fate in the hands of a default program that knows nothing about your personality or your goals.

A useful investment tool if you use it right, a 401(k) is not a savings account. You need to know how much you have in it and what it is invested into. At the same time, you need to let it work for you the way it is designed to work best. Many borrow against it and thereby defeat the purpose of building a retirement account. If you do that and lose your job, that money will have to be paid back or it will become taxed as a disbursement.

A 401(k) is not for day trading, either. You are likely to incur fees every time you make a change. Examine the available options, make decisions, and let the investment grow.

If you're in the military or you have any other type of federal job, you will be offered a TSP (Thrift Savings Plan) rather than a 401(k). The TSP has the same flavor as a 401(k), but offers different investment options. Throughout my military career, I had the option of enrolling into a TSP, but decided against it. I felt the TSP's generic investment options did not allow me much control over the way my money would be invested.

Stocks are the single riskiest investment you can consider. If you have plenty of money that you won't miss if it all disappears, then stocks are for you. For most people, however, the risk isn't worth the gain.

If you do decide to develop a stock portfolio, remember that long-term stability is more important than making a quick buck. The stock market is usually something that people move into after they have built a substantial portfolio and have more money to work with. Stocks can make a lot of money very quickly, but they can also lose a lot just as fast.

I recommend staying away from stocks until you have enough extra money that you can invest without touching your core retirement investments. When you have extra money, and you don't mind the roller-coaster changes in the market, stocks can provide some dynamic investment opportunities.

The trick is in knowing which stocks to buy and when. There is no foolproof method for doing this. It's not enough to simply buy low and sell high. When you buy a stock, you are basically taking on a part ownership in that company. Good stock traders take the time to get to know the companies whose shares they buy.

The research involved is a subject far too complex to cover in detail. Because the stability of a company makes a great deal of difference in the outcome of your investment, it is wise to have some sort of familiarity with the company you're considering. For example, before I deployed to Iraq, I was aware of Under Armour sports clothing. My opinion was that it was overpriced, and I didn't pay much attention to it. But in Iraq, when it hit 140 degrees in the desert, I discovered why Under Armour used the slogan, “reflects the heat of the sun so you feel cooler and sweat less.” It
was
more comfortable and it really did help to take moisture away from my body. I wore Under Armour underwear, Under Armour socks, and an Under Armour skullcap under my helmet. I could have been an Under Armour spokesperson. Sixty percent of our platoon wore the same brand. After that, I had no problem buying Under Armour stock. I completely believed in the company.

Price is not the only consideration. For long-term investments, consider the yield, that is, the dividend that the stock pays. Many stocks, such as AT&T, have been around for a long time and pay regular dividends. If you invest with the idea of building a regular flow of income from dividend profits, it won't matter how much the stock price fluctuates. As long as the company is stable, you'll have money coming in. It's kind of boring, but in the long term, it can provide significant passive income. If you are a conservative investor, leave the gambling to the day traders.