Financial Freedom: Prioritizing Personal Investments

Financial Freedom: Prioritizing Personal Investments

After I opted for financial freedom, created a budget to reflect that new paradigm, and committed resolutely to stick to that budget I was left with a larger portion of my income ready for investment (Total Investable Funds).  So where did I put that money?  In order of priority:

1)      Emergency Savings Account

2)      Roth IRA 

3)      Tax Deferred Retirement Options (401ks, other pre-tax employer sponsored retirement plans or Traditional IRAs)

4)      Taxable Account

(I already owned a home.  I would not have allocated any of my Total Investable Funds to any retirement accounts if this was not true.  Had I not owned a home, I would have likely kept all of my Total Investable Funds in a savings account until I was able to make a sizable downpayment on a home purchase.  I don’t see the logic in saving for a retirement 40 or 50 years in the distance when I need a place to live now.)

Emergency Savings Account

Before committing any of my Total Investable Funds to retirement plans, I first set up an emergency savings account.  Now, this was the least palatable option for investing my excess capital because savings accounts, almost universally, have anemic returns on investment.  Their primary purpose of course is to be a vehicle for capital preservation and not capital appreciation.  Understanding that going in doesn’t make that 2% return any more appealing as an investment choice. 

Having said that, it is absolutely necessary, in my opinion, for most people to first create an emergency savings account.  Why?  Because we need money that is readily available for withdrawal in the event of tragedy or unanticipated financial difficulty.  What we put into our retirement accounts are not to be touched until we retire.  If we insist on withdrawing from our retirement accounts on a regular or semi-regular basis we should call it something else. 

The emergency savings account serves as a flotation device in the event of calamity.  Trials and tribulations are often as unanticipated as they are unwelcomed, but unfortunately they happen and being unprepared for them is unwise.  Emergency savings accounts are meant to serve as a safety net – a raft that keeps us afloat should a storm hit.  Without adequate savings storms can become infinitely more tragic.  Job loss, health issues, death are tragic enough, but without a buffer to shield us from the full brunt of the financial loss associated with these difficulties we inadvertently add poverty and crippling debt to an already heartbreaking burden. 

The general convention is to establish an emergency savings account with sufficient funds to cover anywhere from 3-6 months’ worth of expenses.  The timeframe will often fluctuate according to a variety of factors – the health of the job market and the economy, the strength and stability of one’s safety net outside of an emergency savings account (i.e. family, friends, social safety nets etc.), one’s income needs and one’s occupation and work experience.  The idea being to have enough in store to cover the expenses while looking for employment in the event of job loss.  If the job market and the economy are struggling it may take 6 months or longer to find another job with comparable income.  Previous occupational history and how specialized the field of work will also factor into the calculus.  The availability of safety nets will also determine how much should be invested in an emergency fund.  If a person has wealthy family members or friends who are financially stable and they know to a certainty that they will come through for them financially when the water gets choppy then that person may not need a large emergency savings account. 

These emergency savings accounts and how much is saved is entirely a matter of personal preference and the determination should be made with a great deal of sobriety.  It is not an uplifting topic of conversation, but it is of greatest import and the decision should be made in consideration of a variety of factors both personal and external. 

I was fortunate enough to be in a position where I had a variety of wells to draw from in the event that my primary source of income dried up.  Moreover, I had spent such a great deal of time and energy in cutting expenses that I had a very small percentage of my net worth tied up in my emergency savings account.  This of course is ideal because nobody wants to create a situation where a large percentage of their net worth is stuck earning 2-3% annually when those funds could be utilized to earn three or four times that.  Ideally, it is best to make this account as small a percentage of one’s net worth as their financial condition and personal comfort and security will allow. 

And when choosing an institution to invest one’s emergency savings it is important to choose a financial institution that: (1) provides good liquidity, (2) gives a relatively decent rate of return and (3) is FDIC insured.  

Roth IRA v. Tax Deferred Retirement Options

Before I discuss the next step, it is important to give a brief primer on the basic difference between Roth IRAs and tax deferred shelters such as 401ks (and other employer sponsored pre-tax retirement plans) and Traditional IRAs.  IRA stands for Individual Retirement Account (or more technically the IRS term is individual retirement arrangement).

Roth IRAs, 401ks, other employer sponsored pre-tax retirement plans and Traditional IRAs are merely vehicles or conduits through which investments are made.  They are tax-sheltered accounts.  401ks and other employer sponsored pre-tax retirement plans and traditional IRAs are not the same thing, but they operate in relatively the same fashion insofar as they generally fall in the universe of tax-deferred shelters for retirement funds.  So for the sake of ease I’ve lumped them together.  There are a lot of differences and rules distinguishing Roth IRAs, 401ks, other employer sponsored pre-tax retirement plans and Traditional IRAs, much of which is beyond the scope of this post.  I would simply advise anyone interested to do some research to educate themselves on the intricacies of the rules governing each.  For the sake of this discussion and in the name of general mental health and well-being I will focus on what I believe to be the most important distinction: pre-tax v. after-tax. 

There is a lot of confusion as to what exactly an IRA or a 401k is.  There are those who believe these are actual investment products i.e. mutual funds or individual stocks and bonds.  Again, retirement accounts are not investment products in and of themselves rather they are the baskets in which these investment products can be stored while sheltering those funds from tax liability. 

I like to imagine IRAs and 401ks as shopping carts.  You pick your shopping cart and then take it to the store.  If your shopping cart is pre-tax (Traditional IRAs, 401k, etc.), meaning you are funding the account with money that has not yet been taxed, you get to go right on in and shop around.  But, when you’re getting ready to leave you have to go through the checkout counter (IRS).  If your shopping cart is after-tax (Roth IRA), meaning you are funding the account with money that has already been taxed, you have to go through the checkout counter (IRS) first before you shop.  But, when you’re done you leave the store with all the goods bypassing the checkout counter (assuming of course you meet certain requirements). 

Additionally, for 401ks or other pre-tax employer sponsored plans, generally you can only shop at certain boutique stores which have a limited selection of products.  For Roth IRAs and Traditional IRAs you can take your shopping cart to places where the selection is significantly more expansive.  In the stores are the investment products you can choose to put into your cart.  In most cases, the more selection and variety in the store the better. 

Roth IRA

After establishing my emergency savings account and funding it, I had excess capital left over every month.  I chose to first invest that capital through my shopping cart of choice: the Roth IRA.  Why?

First, I had a long time horizon to invest with.  I did not anticipate retiring for another 40 years at least.  I wanted what I earned through my investments to be completely tax-free upon withdrawal (again, assuming I meet certain requirements) and the Roth IRA offered me that.  Taxes and fees are anathema to investment growth.  I did not care to get the present benefits of a tax deferral, I wanted to harness the full potential of the power of compounding interest.  I wanted to take my shopping cart into the store and straight loot the place and leave it without having to account for the gain.  There is something sexy about giving the government their token upfront, packing my cart full of as much stuff as possible and then leaving the store while the tax-deferred shoppers wait in line for the government to take their cut.  There is a reason why Roth IRAs and all-you-can-eat buffets are so popular. 

Second, my employer did not provide a contribution match to incentivize my participation in their pre-tax employer sponsored retirement plan.  The only way a pre-tax employer sponsored retirement plan would have trumped a Roth IRA, in my opinion, is if my employer gave me free money to participate.  Some employers offer their employees a monetary incentive to opt for their retirement plan.  Some will match the employee’s contribution to their 401k or other employer sponsored retirement plan by a certain predetermined percentage.  This is free money.  Nothing trumps free money.  Unfortunately, my employer did not provide this option.

Third, the Roth IRA gave me the option of taking my shopping cart to whatever store I wanted to shop in thereby giving me a great deal of selection and flexibility to choose which investment products to put in my shopping cart.  Employer sponsored retirement plans often have very limited selection and more often than not the selection stinks.  The employer sponsored retirement plans will often have a handful of mutual funds to choose from and most, if not, all of them are terrible and ill fitted towards my particular needs.  It would be like taking my shopping cart to a dollar store and having to shop for groceries there.  How healthy do you suppose my household would be if it had to live off of Cheetos and Coca-Cola for the next 40 years?  With a Roth IRA the investment world is mine for the choosing and there is a wealth of selections to choose from.  A Roth IRA can be established with Vanguard, Fidelity, Dodge and Cox, or some other quality mutual fund company and the selection at these institutions in terms of mutual funds are of a higher quality than those I would typically find in my employer sponsored retirement plan.  A Roth IRA can also be established with an individual brokerage service like Charles Schwab or Merrill Lynch which allows for investments in individual stocks, bonds, ETFs, or the mutual funds they have on their shelves. 

Employer Sponsored Pre-Tax Retirement Plan

The Roth IRA has contribution limits – meaning I could only contribute a certain amount of after-tax money every year to the Roth IRA depending upon my gross income.  And so, after I created my emergency savings account and after I maxed out my contributions to my Roth IRA, I invested my excess capital through my next best tax-sheltered option: my employer sponsored retirement plan.

There is not a whole lot I can say about my investment choices through my employer sponsored retirement plan that would be of any practical use to anybody else as selection and contribution limits are so varied.  My choices will likely mean very little to anyone reading this because my employer sponsored retirement plan will likely not have the same selection. 

What I can say is that I declined the active portfolio management option offered by the company that created the employer sponsored retirement plan for my employer.  The agent for the company made a sales pitch and advised that I opt for their actively managed portfolio service.  Essentially, they tried to sell me on having a portfolio manager take my contributions and invest them in mutual funds of their choosing.  They choose the mutual funds and the percentage allocations to each and then charge me 1-2% annually to do it.  Then what the portfolio manager will likely do is invest my contributions into their company’s actively managed mutual funds regardless of the quality of those funds.  The agent gets a commission, the portfolio manager gets his fee, and the company gets their fee for the mutual funds they actively manage. 

Let’s say my company is working with Financial Institution A.  An agent from that company will try and sell me on their actively managed portfolio service.  They will tout their annual returns and charge me 1-2% to invest my funds for me.  Assuming I agree to this arrangement, the agent gets a commission so he’s happy.  They then take my money and give it to a portfolio manager from Financial Institution A who will most likely turn around and invest my money into Financial Institution A actively managed mutual funds.  The portfolio manager gets his 1-2% fee so he’s happy.  Financial Institution A gets its fees for actively managing the mutual funds and so it’s happy. 

So what’s the big deal?  It’s only 1-2% and you don’t want the headache of actually trying to figure out how to invest the money do you?  Here’s why I felt this was such a damaging course for me to take.  Imagine I have $50,000 in my employer sponsored retirement plan.  Financial Institution A, for their actively managed portfolio service, will take $500-$1000 every year right off the top for actively managing my portfolio.  Then they will invest whatever is left of my money into their Financial Institution A actively managed mutual funds which will likely also take 1-2% in fees or another $500-$1000 approximately every year.  It is highly unlikely that the Financial Institution A actively managed mutual funds will ever beat the S&P 500 on an annualized basis in the short term and it is a mortal lock that they never will in the long term, because two-thirds of all actively managed mutual funds fail to beat their relative benchmark.  So Financial Institution A is charging me right around $1000-$2000 every single year for absolutely nothing.  And the more money I contribute into my retirement account the higher the corresponding fees.  The only benefits they convey – (1) the belief that they are professionals who actually know what they are doing and have my best interest at heart and (2) the corresponding peace of mind that the first part is true so it saves me the trouble of actually thinking. 

I opted to do my own research and study the various investment options presented to me and I opted to invest in a stock market index fund.  I saved myself around $1000-$2000 every year and my passively managed portfolio trounced the actively managed portfolio option.

Bottom line: Nobody cares more about my financial well-being than I do, because others care more about their financial well-being than my financial well-being.  The time spent studying and researching my options allowed me to control my own financial destiny.

Taxable Accounts

After I created my emergency savings account, after I maxed out my Roth IRA, and after I maxed out my employer sponsored retirement plan, I invested the funds left over in a taxable account.  I opted to place that money into an online stock brokerage and I invested in individual stocks.  How I went about choosing individual stocks is a discussion for a later post.