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Some Things Are More Important Than Investing In Stocks

by Bill Jones

Bill Jones Before you make substantial investments in stocks or stock mutual funds, you need to do two important things:

Eliminate debt that carries a high interest rate.
Establish an adequate emergency cash reserve.

Start a money market account to hold most of your cash reserve at a large, reputable mutual fund family that offers a substantial number of no-sales-load investment options.

Ditch high interest debt

It is generally a good idea to pay off any debt with an interest rate of 10 percent or more before you invest in stocks or bonds. Why should you do this when stocks are doing so well? In the average year, stocks return

9 percent to 12 percent, which is only 6 percent to 10 percent after allowing for taxes on dividends and capital gains. So, you’re likely to beat the stock market just by paying off those high-interest debts.

Example: If you pay off $1,000 in credit-card charges at a 19 percent interest rate, you will have an extra $190 in your pocket one year later. In a taxable account, stocks would have to return something like 21 percent to 27 percent over a year in order to match that. This is because taxes reduce those high returns to about that same $190. That kind of stock market gain does not happen very often; in fact, the stock market might even lose money in the coming year. So the credit-card payoff is usually a far better choice.

A reasonable exception to this is to have payroll withholding into a 401k plan to the extent that you receive an employer's match of at least 25%. Even then, you may lose if such withholding keeps you from paying off all credit card debt within three years.

Example: If your 401k investment earns 10 percent and your credit card debt costs you 19percent, you are losing 9 percent each year that this continues. If you have a 25 percent match from your employer, you will reach the break-even point in about 2.8 years. So you will tend to come out a little behind if you are still paying 19 percent interest three years later.

A mortgage loan is a different matter from other debts. It is tax deductible to at least some extent for most people. And the interest rate is rarely much higher than the rate you can earn by investing in bonds. So, it makes excellent sense to add money to a tax shelter (a 401k or similar workplace plan, or a deductible or Roth IRA) rather than make additional payments on a mortgage or home equity loan.

However, if you invest through a regular taxable account rather than a tax-sheltered one, it is debatable whether it would be better than making extra payments on a mortgage.

Prepare for stormy weather

Make sure you have some immediately available cash for emergency needs. Financial advisors almost universally recommend at least three months worth of paychecks, but it depends heavily on your particular situation. It might be six month’s or even a year’s worth if you are a free-lance consultant or writer whose income varies from year to year. Less than that may be fine if you have a very secure job and a substantial home-equity line of credit that you could draw on if you lost your job.

Tip: It’s possible to take a small step toward stock investing even before you fully establish your emergency reserves. You can invest as little as $100 a month through an automatic investment plan, available through most mutual fund families. When you establish such a plan, money is taken from your bank account once each month, and invested in one or more funds you choose. This allows you to get your investment feet wet, and gives you a feel for how stock prices can move drastically up and down.

Consider putting part of your emergency reserves in a Roth IRA if it is unlikely that you will need the money (emergencies do not come up very often), and you would otherwise miss out on the chance to create a Roth IRA for the current calendar year.

You are allowed to contribute up to $2,000 in any one calendar year, and you cannot "make it up" later if you miss the chance. With a Roth IRA, you can remove the initial contribution (but not the earnings) whenever you like without paying a penalty or taxes. So the initial contribution remains available for emergencies.

Investing your cash stash

Some good possibilities for your emergency cash reserve are a money market fund, a bank account, 1-year U.S. treasuries, or a mutual bond fund whose portfolio contains securities with an average maturity of one year or less. A money market fund generally gives the best balance of availability and high interest earnings. You can also use the money market fund to save up money you put aside monthly or biweekly for annual insurance payments, property taxes, and the like.

Money market funds typically pay interest of 3 percent to 4 percent more than a normal checking account. So if your balance averages around $5,000, you can make an extra $150 per year with a money market account rather than a checking account. Typically, money market accounts are free of charge and come with free checks. However, you may be restricted to checks of at least $250, and deposits of at least $100.

It is convenient to keep your first $20,000 or so that you have invested with one family of funds. When you accumulate more, you will probably want to branch out to other fund families. The following are the five largest fund families that have a substantial number of no-sales-load fund choices, including money markets:

1. Vanguard, 1-800-892-3335, $3,000 minimum, $1,000 for an IRA.

2. Fidelity, 1-800-544-8888, $2500 minimum, $500 for an IRA.

3. T. Rowe Price , 1-800-541-8803, $2500 minimum, $1000 for an IRA.

4. American Century, 1-800-345-2021, $2500 minimum, $1000 for an IRA.

5. Scudder, 1-800-225-2470, $2500 minimum, $1000 for an IRA.

These fund families represent large, financially sound companies. They are also no-load funds, which means you avoiding paying a sales load (sales commission) when you buy them. Although you do not get advice from a full-service broker or other professional, you also save the three to percent to six percent sales charge that comes with such advice. You handle your business with these companies by phone and mail. Each has an Automatic Investment Plan for $100 per month or more taken from your bank account, and the minimum amount to start the plan is usually only $1,000 or less.

The list above shows the minimum investment required to start a non-IRA account ($2,500 to $3,000) and the minimum to start an IRA ($500 or $1,000). Most of these fund families allow the balance to drop as low as $1,000 from time to time, once you have established the account with the minimum investment. So all but $1,000 is available for emergency needs. However, each family charges a fee of $10 or $12 per year for each fund that has a low balance; the cutoff for this low-balance fee is anywhere from $1,000 to $10,000, depending on the fund family.

William C. Jones, Jr. was born in Chicago in 1944. He obtained the Ph. D. in Mathematics from Purdue University in 1969. He has taught full-time in the Departments of Mathematics and Computer Science at Central Connecticut State University since then, except for a year teaching at the Bundeswehr University in Hamburg, Germany in 1981-82. He earned a Master's degree in Computer Science in 1989 and has had three textbooks in Computer Science published, by Harper & Row and by John Wiley.

Dr. Jones has been investing all of his retirement assets in equity and bond mutual funds since 1974. He is married to Virginia, who also teaches Mathematics and Computer Science at CCSU, and they have a daughter working on her Ph. D. in Mathematics. Dr. Jones is also a frequent contributor to the MFI newsgroups.

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