1. How to manage your spending without a traditional budget.
2. How to create a bank account buffer to eliminate the risk of overdrafts.
3. How to put your bills and savings on autopilot.

What I’ve written is incomplete, however, without one piece of the puzzle: an automatic investment plan.

Arguably, putting your investments on autopilot is the most important thing you can do for your finances.

If you don’t want to automate the rest of your finances—if you prefer to set aside a few hours a month to pay bills, transfer money to savings, and balance your checkbook, that’s fine. Some people will sacrifice time for that kind of control. But you should still consider setting up automated investments.

Investor and financial author Robert G. Allen sums up the biggest reason:

How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.

Many of us delay investing (or fail to start at all) because we’re either intimidated by choosing investments or we’re afraid of the risk. An automatic investment plan can help. One of the techniques I outline here requires zero investing knowledge to get started—it’s as easy as opening a bank account. And, when you put your investments on autopilot, you take your emotions out of investing, which can temper your fear—or at least limit fear’s ability to cost you money. Let’s look at how an automatic investment plan does this.

Dollar Cost Averaging

The technique of buying a fixed amount of an investment at regular intervals is known as dollar cost averaging (as opposed to investing a big chunk of money at irregular times).

If you were to buy $1,000 of a mutual fund when it’s per-share price is $100, you would own 10 shares.

If, however, you invest $100 a month for ten months and the fund’s price varies from $80 to $120, you may end up slightly more or less than 10 shares depending on the stocks prices. As the market climbs, the notion is you will end up buying more shares at a lower price than if you invested in a lump sum. Advocates of dollar cost averaging say this reduces risk, but critics disagree. The market goes up in the long run, so you want to get money in as soon as possible.

If you have a lump sum sitting around that you want to invest, then do it. Get it into the market and don’t worry about spreading it around and definitely don’t try to time the market or wait for the right time.

For the rest of us, an automatic investment plan makes sense for two reasons:

1. It lets you invest on a regular schedule.
2. It prevents self-sabotage.

INVEST AS YOU’RE PAID

Ask people who are successful at saving and building wealth and you’ll find that many of them have two things in common:

1. They invest, rather than leaving all of their cash in a bank account.
2. They pay themselves first.

I’ve recommend paying yourself first as a strategy for building cash savings for emergencies, and you can do the same thing with your investments.

Your employer may make this easy by offering a 401(k) or similar retirement plan to which you can contribute through automatic payroll deductions.

Otherwise, you can start a Roth IRA and begin making regular contributions on paydays in addition to cash you transfer to a savings account.

Are you already saving enough for emergencies and retirement? Then it’s time to open a nonretirement investing account and put money away for “life”. Use this flowchart to help you decide how to allocate your investing dollars:

PREVENT SELF-SABOTAGE

You can’t rely on willpower to reach your financial goals.

You may be able to hunker down and fight the urge to splurge at the mall or bet on a hot stock tip…for a while. But eventually your emotions will get the best of you. You’ll calm your nerves after a tough week with a spending spree. Or give into fear and postpone an investment during a volatile month in the market.

Carl Richards, author of The Behavior Gap, knows this, and in a recent New York Times blog post offers the same advice I’m giving now: Use automation prevent your emotions from influencing your financial decisions.

HOW TO SET UP AUTOMATIC INVESTMENTS

Nearly every mutual fund company and online stock brokerage makes it easy to set up automatic investing in mutual funds, whether it’s in an IRA or nonretirement account. Most will waive minimum investment requirements when you enroll in an automatic investment plan.

This is how it works:

1. You set up an automatic transfer from your bank account to your investment account (for example, on pay day).
2. You specify which mutual fund(s) to invest in and your money is automatically invested at the current price.

The key to keeping automatic investing affordable is to invest directly with a mutual fund company (for example, buy Vanugard funds through Vanguard or Fidelity funds through Fidelity) to avoid paying a trade commission each month. Alternatively, some online brokers (TD Ameritrade*, for one) offer hundreds of no-transaction-fee mutual funds in which you can automatically invest with no extra fees.

WHAT ABOUT INDIVIDUAL STOCKS?

Mutual funds make automated investing easy because you can invest any amount in a mutual fund regardless of the current price. (You can buy fractions of a share.)

In most cases, however, with individual stocks and exchange-traded-funds, you must purchase whole shares. So if you want to automatically invest $100 in ABC stock with a current price of $11, you can only buy nine shares and will have a $1 left over.

One way around this is with ShareBuilder, an alternative broker owned ING Direct. ShareBuilder’s entire model is built around automatic investing plans, and for $4 a month you can invest a fixed amount in individual stocks as well as mutual funds (you can hold fractional shares).

A final alternative to both direct mutual fund investing and ShareBuilder is Betterment, the new radically simple investing account that lets you make autopilot investments in entire stock and bond markets. Investing with Betterment is about as simple as opening a bank account, and I think it’s a perfectly acceptable strategy for hands-off investors.

What about you? Do you have an automatic investment plan? How do you structure it? Where do you invest? Let me know in a comment.

Note: MoneyUnder30 has financial relationships with the following companies mentioned in this post: TDAmeritrade, ShareBuilder, and Betterment. We may earn a referral commission if you visit one of these companies and ultimately open an account. If you choose to support our free content in this way, thanks!

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Today, we take a look at three leading tax software programs—TurboTax, H&R Block at Home, and TaxAct—to help you better decide how to file.

TurboTax, H&R Block at Home and TaxCut Compared

Explaining the Differences

Over the years, I’ve used each of these programs to file my taxes. (This year I hired a CPA to help with the increasing complexity of running a business.) But in years past these tax software programs handled made preparing my tax returns relatively easy if not entirely painless; after all they’re still taxes.

In comparing the best tax software programs, all three guarantee the accuracy of their calculations. The big differences among tax software programs lie in their:

• Intuitiveness/usability
• Pricing
• Support options

INTUITIVENESS

For the most part, all three programs are easy to use and provide intuitive navigation. I think TurboTax stands out in a bit when it comes to entering W-2s and walking you through questions for complicated credits and deductions. TaxAct, by contrast, does a fine job for simple returns but begins to get cumbersome when tackling advanced topics.

PRICING

Tax software prices can be misleading. TurboTax and TaxAct advertise that you can file your simple, federal tax return for free. And in many cases this is true. But with TurboTax, if you want to access certain features (detailed questions to guide you through deductions, for example), you’ll have to upgrade. And in every case, you will have to pay to file your state tax return with the software or if you tax situation ends up being more complex than you imagined. That’s why it’s a good idea to figure out exactly what you’ll need and how much you’ll pay before starting your return.

In most situations, TurboTax ends up being the priciest of the three packages. But after combing over 250+ online user reviews, most think that the quality of the software and the online help (user forums etc.) make the price worth it, especially for more involved returns. TaxAct, by contrast, is much less expensive: you can file a basic federal return and a state return for only $14.95…the least expensive way to file everything. But if you want phone support, it’s an extra $7.95 (phone support is included with TaxAct Federal Deluxe, so you can file federal, state, and get phone support for $17.95).

H&R Block at Home’s pricing falls in between. They don’t offer free filing of your basic federal return. If you purchase their Deluxe, Premium, or Business package, one state return is included (meaning you can prepare it, print it, and file by mail) but they’ll charge you $19.95 to e-file the state return.

Note: With the links in this article, you can save 15% off the listed prices of H&R Block at Home. *H&R Block, TurboTax, and TaxAct are affiliates, meaning if you decide to use them we get a little bit in our online tip jar. If you choose to support us in this way, thanks!

SUPPORT

I’m a figure-it-out-myself kind of guy, so I turn to online FAQs and forums before calling an 800 number; I can say both TurboTax’s and H&R Block’s knowledge bases are very good. From the 250+ online user reviews I read, most agree that their phone support is good, too. Reviews note that TaxAct’s phone support falls short with limited phone hours and less-helpful-than-desired responses. Again, TaxAct is a good choice for straightforward returns, but spending a bit more might be warranted for anything more complex.

H&R Block has the advantage of local offices around the country and offers a “best of both” program. For $79.95 you can begin your return online and have a professional sign your return as a professional preparer.

Both TurboTax and H&R Block include audit support in the event your return they prepared is audited. This support includes a professional to communicate with the IRS for you and explain the audit process, but may fall short of everything you might need to handle the audit (such as legal advice in some situations).

Recap

Due to the way different companies bundle and price their software, the best value for my return may not be the best for yours. TurboTax and H&R Block at Home both offer complete solutions, usable software, and full-featured support, but come at a cost. TaxAct provides an affordable option for simple returns.

What about you? Had good/bad experiences with these or other tax software programs? Let us know in a comment.

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The key is to put your money on autopilot.

Why does something so simple matter so much?

THE BEHAVIOR GAP

Because we’re human, and we do stupid things. In his blog and new book by the same name, doodling financial planner Carl Richards coins this “The Behavior Gap“.

Looking at the long-term returns of investments like the S&P 500 compared to the returns of individual investors, Richards found that the investors consistently did worse than the investments. He explains the difference, The Behavior Gap, as humans’ tendency to let emotions influence decisions (for example, to sell off stocks during scary economic times or buy a particular stock based on a tip in the financial media).

Emotions can lead us to make a lot of terrible financial decisions like:

• Making a big purchase you can’t yet afford—perhaps an engagement ring or a wedding dress—on a 19% APR credit card.
• Taking on too big a mortgage because it’s “your dream house”.
• Cashing out your 401(k) because you’ll “feel more secure” with cash in hand.

Putting your money on autopilot can’t stop us from all of the stupid things we do, but it goes a long way in protecting ourselves from two of the most common:

• Ceding to temptation.
• Being lazy.

TEMPTATION

Emotional decision-making is part of the problem; pure temptation is another. If you have ever tried to resist a temptation—to turn down an extra drink, to surf YouTube instead of working, to buy something you shouldn’t—and failed, you know what I mean.

Psychologists have shows that although it is possible to stretch and strengthen our willpower like a muscle, our ability to self-regulate is a consumable resource that depletes. What this means is:

• The more we exercise self-control, the better we become at it in the long-run.
• BUT, the more we use self-control in the short-run, the harder it becomes in the short-run (Muraven and Baumeister, 2000).

So if you focus on not procrastinating every day for a month, you may find it easier to diet next month. But if you’ve had a particularly exhausting, stressful day at the office and you’ve been fighting off distractions to get stuff done, resisting the candy bars in the checkout aisle (or going out to dinner even though you don’t have the money) may be all but impossible.

Although we can work to improve our self-control in the long run, as humans we’ll always be susceptible to moments of weakness when our self-control is depleted. To prepare for this inevitability, we can alter our environments to remove or reduce temptations.

An obvious example is that cliché advice that debtors should cut up their credit cards or put them in a block of ice. The next time your willpower is depleted and you want to charge the Forever Lazy you saw on a late-night infomercial, you may have second thoughts by the time your Visa defrosts.

LAZINESS

Sometime we do stupid stuff because we are emotional or tempted. And sometimes we’re just lazy.

If you currently pay for a monthly subscription that you don’t use—a gym, a magazine, $12 a month for DVR service on cable—and don’t do anything about it, whose fault is it? The recurring-subscription business model that gyms, cable companies, and Netflix use is one of the most stable and profitable in existence. And guess what? It is built on the simple fact that people are lazy. When we stop using something, most people will pay $20 or more each month for many months before making a 10 minute phone call to cancel.

Laziness hurts our wallets in all sorts of ways.

Overspending on credit cards or paying for unused subscriptions are just a couple of ways our behavior sabotages our finances. Other examples include:

• Forgetting to pay bills, incurring late fees and credit penalties
• Depleting savings by comingling them with everyday spending money
• Failing to invest enough for retirement
• Failing to invest in regular intervals

There may be different reasons for making these mistakes, but don’t discount laziness. If you’ve ever thought of cancelling something you don’t use or opening a Roth IRA or increasing your 401(k) contributions and said “I should look into that” but haven’t done it yet, your laziness has already cost you money.

WHY AUTOMATION IS THE ANSWER

Think about your daily habits.

Most likely, you brush your teeth every day and don’t even think about. It doesn’t take willpower to brush your teeth. It’s automatic.

Now think about something you’d like to do but are struggling with; perhaps it is to quit smoking, lose weight, or spend less.

These things are difficult to do. They take conscious effort—active self-regulation—to achieve. Meanwhile, the corresponding bad habits (smoking, overeating, spending money) have become automatic.

But talk to somebody who has successfully changed a habit—for example, a daily exerciser—and you’ll hear that  it’s the good habit that is now automatic. Getting out of bed to jog becomes as routine as brushing your teeth.

Your brain has an autopilot!

When your can teach your brain to include a habit on autopilot, maintaining it takes much less effort, if any at all. Better yet, seemingly tiny habits can have big ripple effects.

In the book Willpower: Rediscovering the Greatest Human Strength, the authors explain how even small automatic behaviors can trigger better decisions. For example, have you have ever felt like when you’re well dressed, you work harder? There’s something to that.

Studies show that little habits like shaving, dressing neatly, and keeping an organized home correlate to more self-control in other areas of life. People who exhibit these behaviors are more likely to exercise, eat less, moderate alcohol, even use condoms more often.

So the more good habits you can put on autopilot, the more success you may have regulating other areas of your life.

And when it comes to putting your money on autopilot, your brain has an ally in technology. Twenty years ago, automated personal finances were impossible. Having your paycheck directly deposited was still cutting edge, and paying bills meant cutting a check every single month. Today, it’s not only possible to have an entirely electronic checking account, it’s becoming the norm to do away with paper checks altogether. And these new financial technologies make it possible to put your money entirely on autopilot.

A SIMPLE APPROACH TO PUTTING YOUR MONEY ON AUTOPILOT

As you get older, your finances will get more complicated whether you want them to or not. So the simpler you can keep your financial system, the better. Two primary accounts—one checking and one savings—should suffice unless you own a business or are married with separate finances.

The Three Steps to Automatic Finances

1. Put your savings on autopilot
2. Put your bills on autopilot
3. Put your investments on autopilot

Here’s what somebody’s basic financial autopilot looks like.

Today we’ll cover setting up your savings and bills, next time we’ll talk about investments.

Put your savings on autopilot.

The first step in putting your money on autopilot is to pay yourself first. This means directing a portion of the money you earn into a savings account as soon as you earn it.

• If you’re still working on your emergency fund, put this money towards that.
• If you’re in high-interest consumer debt, put this money in an account that automatically makes extra payments on your debt each month.
• If you’ve funded your emergency fund, then put this money towards your next life savings goal (e.g., a house, a car, a wedding, or a vacation).
• If you’re set on cash, skip this step and focus on investments instead.

There are two ways to pay yourself first:

1. Split your direct deposit between your checking account and savings account (ask your HR manager for the form).
2. Set up an automatic transfer between your checking account and savings account on the day after you are paid. Any online savings account will make this easy.

Put your bills on autopilot.

In part one of this series, I talked about your “nut”, the fixed monthly expenses like rent, insurance, and student loan payments, that you pay every month in the same amount. Once you have a comfortable bank account buffer in place, the next step in putting your money on autopilot is to setup automatic bill payments to each of these bills. There are different ways to do this, and I rank them in order of my preference.

1. Pay with a rewards credit card.
2. Pay with your banks online billpay.
3. Pay through an automatic bank draft (ACH).

Let’s talk about the options:

Credit Cards. Some billers like insurance, cable, and cell phones let you pay with a credit card. As long as they don’t charge a convenience fee to do so, this is your best bet. For one, you can earn your one or two percent of the bill back in rewards and two, you have a third party in between you and the biller. (Remember one of the best things about paying with a credit card—not cash check or debit card—is your right to dispute the payment with the credit card company and not pay a dime until that dispute is resolved).

Online Billpay. The next best option is setting up a recurring payment through your bank’s online billpay service. I like this option because you have control over multiple bills in one place (your bank’s online login). You can stop or change payments to more than one bill instantly in one place.

Autodraft/ACH. Traditionally, if you wanted to pay a recurring bill automatically, you have to sign up with the biller, give them your checking account and routing number, and let them automatically withdraw the bill amount from your checking account each month. This is fine, but there are some concerns:

• Redundant Maintenance. You must maintain your autopay with each biller individually. If you change banks, for example, you have to remember to change the accounts at each biller.
• Less Control. Let’s say you accidentally rack up $3,000 of data roaming charges on your phone while travelling abroad. Since you’re travelling, you forget to check your bill before the autodraft goes through. Your cell provider withdraws the $3k from your checking account and overdraws the account. Not only are you out that money and responsible for overdraft fees, you may lose your ability to negotiate the charges down (after all, the cell company already has your money).
• Returned Payments. If you have your checking account to reject overdrafts, your auto payment will be returned if you don’t have enough money in the bank at the time it’s processed. This may trigger a returned payment fee in addition to late fees from the biller. (Also, be sure to enter your checking account numbers correctly when you enroll at the biller’s Website. You payment will be returned if you make a typo, too.)

Put your investments on autopilot.

Once you have your savings and bills on autopilot, the last (but I would argue most important) step is to set up automatic investing. We will cover this in detail in part four of this series.

RECAP

We humans are emotional, easily tempted, and lazy. We do stupid stuff with money. Therefore, it’s my opinion that the single most important thing you can do for your finances is to put your money on autopilot. Start by transferring a percentage of your income to a savings account as soon as you get paid. Then, setup all of your bills to be paid automatically by their due date either by credit card, bank bill pay, or ACH autodraft. Next time, we’ll talk about the final piece of the puzzle: establishing an automatic investment plan.

ACTION ITEMS

1. Pay yourself first. If you haven’t already, open a separate high-yield savings account and set up an automatic transfer or split direct deposit to correspond with every payday. Do this even if you can only afford to save $20 a paycheck. You can increase the amount later. Having the system in place is what matters.
2. Ensure you have a bank account buffer. Do not proceed to action item three until you have this in place.
3. Put your bills on autopilot. With a bank account buffer in place, put all of your monthly bills on autopay. Set aside an hour to set this up tonight and you’ll easily save an hour a month for the rest of your life.

Join The Discussion: How do you put your money on autopilot? What’s your system? Let us know in a comment.

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Last week, we talked about how budgets are a pain in the ass to maintain and how they can actually hold you back from getting your money in order. I offered a way to minimize budgeting, doing just enough to know your expenses while eliminating the need to worry about how much is left in the coffee budget this month.

Today, we’ll cover an important prerequesite to putting your finances on autopilot:

The bank account buffer.

A bank account buffer is my name for what other people may call a cash cushion, mini emergency fund, or back-up savings. And it’s simply this: some extra cash in your checking account.

When you have a bank account buffer in place, you don’t have to worry that a mistimed latte on your debit card will overdraw your account and trigger a $35 overdraft fee. More importantly, you’re free to start putting bills and investments on autopilot. And as we’ll discuss in the upcoming posts, when things are on autopilot you will worry less, spend less time managing your money, and keep yourself from meddling with your savings and investments.

WHY BUFFERS MATTER: AN ANALOGY

Modern aircraft can basically fly themselves. Although your pilots will likely land the plane by hand, they will definitely punch on the autopilot for much of a long flight across the Atlantic.

Two factors make autopilot safe to use during cruise flight:

• A predictable set of circumstances. The pilots can, for example, set the plane to fly a certain altitude and heading for several hundreds of miles while air traffic controllers help ensure they won’t run into other planes.
• Altitude. At 35,000 feet above the Earth, there is a plenty of time to react if things go wrong.

Planes fly at certain altitudes for many reasons—in part, fuel efficiency—but the higher they go, the more time pilots have to recover and land should things go wrong.

You can think of your money the same way. 

When you’re living paycheck to paycheck, you’re flying close to the ground. One bad bump and you can crash: wracking up overdraft fees or going into debt.

You wouldn’t dare put your money on autopilot in this situation. How can you set your rent to pay automatically on the first of the month if you’re not sure there will be enough in the account each month to cover it?

But imagine if you had an extra $1,000 in your checking account that serves as a buffer between you and an overdraft fee. You don’t spend it, but it’s there to protect you in case your bank debits your rent payment a couple days before you get paid. It’s like an aircraft having an extra 20,000 feet of altitude.

So a bank account buffer is a good thing. But how is different from an emergency fund? And how much do you need?

BANK ACCOUNT BUFFERS VS. EMERGENCY FUNDS

An emergency fund—that separate savings account stuffed with six months expenses or more—is a vital part of financial stability. But it comes later.

A bank account buffer is a starting point. A bank account buffer:

• Protects against minor cash flow fluctuations, like paying rent a few days before your paycheck deposits.
• Is equal to 25% – 50% of one month’s expenses.
• Stays in your checking account.

An emergency fund:

• Protects against big expenses and loss of income.
• Is equal to at least six months of expenses.
• Should be kept in a separate, interest-bearing savings account.

HOW BIG A BUFFER DO YOU NEED?

In the past, I’ve recommended $500-$800 for a bank account buffer. For most people, this is enough. But your bank buffer should be whatever makes you comfortable.

If you have predictable income and expenses and track your spending to the penny, you don’t need much of a buffer. If, however, your expenses or income vary from month to month or you simply don’t want to worry about your bank balance very often, a larger buffer is in order.

Once you know your average monthly expenses, you can build a buffer of between 25% and 50% of your monthly expenses. So if you typically spend $2,500 a month, start with a buffer of $625. If you want more than that, gradually work up to a $1,250.

There is a sweet spot. You don’t want to build your cash cushion too big because that money could be at work for you in some other way. Although interest rates are dreary now, one percent in a high yield savings account is better that zero percent in a checking account. (As an alternative, you can look into interest-bearing checking accounts.)

And yes, you should have a bank buffer even if you’re in credit card debt. But keep the buffer no bigger than necessary. Then, funnel all extra money to paying down your credit card balances.

RECAP

Keeping $500-$1,000 of extra cash in your checking account (a “bank account buffer”) helps protect against overdraft fees and serves as a mini emergency fund when small, unexpected expenses pop up. Building this buffer will enable you to begin putting your money on autopilot, reducing stress and making it easier to reach financial goals.

YOUR ACTION ITEM

If you don’t already have one, build your bank account buffer in the next 30 days.

Putting an end to the paycheck-to-paycheck lifestyle is the best thing you can do for your finances. And it will feel frigging phenomenal.

With some hard work, you can get there 30 days or less. Sell some stuff you don’t use. Cut back on luxuries, if only for a month. If you’re paying extra toward debt or making investment contributions, skip a month; the buffer comes first.

Your Thoughts

If you already have a bank account buffer, how do you structure it? How much of a cash cushion do you keep?

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It’s not because I don’t like pie charts and spreadsheets. (I do.) I don’t like budgets because I hate telling you to write them when I know myself how boring, pointless, and difficult it is.

It’s like the doctor finishing up a physical saying: “You’re healthy. Just lose 20 pounds”. (Happened to me yesterday.) I already knew that, thanks, but dropping a few pounds is easier said then done. Do you know how many freaking books there are on losing weight?

And do you know how many people try to lose weight (AGAIN) every January 1st?

Millions.

Having the right information is useless if you’re not going to do anything with it. And it is doing something that is so hard.

Budgeting is the same.

WHY BUDGETS FAIL

Old-school personal finance books tell you that if you just create a budget and stick to it, then—POOF!—all your money problems will be solved.

But anybody who has ever tried budgeting knows that it’s complete crap.

You know you should budget, but you also know you’re not really going to do it. Learning how to budget isn’t the problem. You can visit any one of hundreds of personal finance blogs to read about budgeting techniques. You can download free spreadsheets here and on countless other sites. You can pick up one of dozens of books. You can use any one of dozens of budgeting apps— many free.

But even if you write down every dollar you spend for 30 days (which, done manually, is a complete pain in the ass), you are still human.

As a human, you are intelligent enough to know that on Jan 1st, you can afford to spend $200 on food and drinks out this month. Unfortunately, as a human, you are quite susceptible to temptation. This means that on Friday, January 20th, after having already spent $190 on going out in the preceding weeks, your willpower will be tested. While you are out with friends, three quarters of a vodka tonic sloshing in your gut, will you:

• A. Say: “I have to go home, this drink puts me overbudget?”
• B. Order one—maybe two more drinks—and then do dinner? After all, it’s Friday, you’ve worked hard, you deserve it, budget be damned.
• C. Completely forget you had set a $200 budget in the first place, and have no idea you’ve already spent $190 on going out.

Over the past five plus years, I’ve experimented a lot with budgets. I’ve set monthly budgets, annual budgets, and weekly budgets. I’ve tracked my spending using paper and pencil, spreadsheets, and apps like Mint.com. And I’ve learned two things:

Tracking spending manually is pointless. I never keep up. And I’m a financial blogger…a total nerd about this stuff. If I can’t do it, I don’t expect you to.

Monthly budgets are fairly useless because we underestimate our monthly expenses. Think about it. Although there are some things you pay for every month: housing, transportation, utilities, food, and debt payments, there are lots of things you pay for less than every month: car repairs, home improvements, trips and vacations, holiday presents, and insurance payments, to name a few.

For some people, these less predictable expenses may only be 10% or so of your total spending, but for me, especially after becoming a homeowner, they’ve crept up to more like 30% (home repairs aren’t cheap).

What this means, of course, is that if I take my annual take-home pay, divide it by 12, and proceed to spend that amount every month, I’m going to be in trouble when that unexpected car repair comes up, or it’s December and I have to do my holiday shopping.

We need to fix the following problems:

• Our human tendency to cave in the face of temptation.
• The futility of tracking every dollar ourselves.
• The difficulty of getting an accurate sum of monthly expenses.

How do we do it? And how do we make it simple?

For one, we stop budgeting.

THE ANTI-BUDGET

I’ve been outlining this post for a week or so. Then, yesterday, a funny thing happened. I was in the doctor’s office waiting for my physical and I picked up the Nov. 2011 issue of Money Magazine and randomly turned to a page that actually recommended the same thing: stop budgeting!

As a way to reduce financial stress, the piece recommended to ease off budgeting, saying:

“Money (or its lack) is the nation’s most common source of stress, reports the American Psychological Association. Making a detailed budget — a widely advised fix — only makes things worse, says Cleveland financial planner Kenneth Robinson, based on a decade of work with clients; the problem is that people hate to think about where they’ll need to cut back.”

In other words, when money is tight, focusing on that shitty fact day in and day out doesn’t do us much good.

Money’s fix for the problem is the same as mine:

• Put your money on autopilot.
• After the big things are take care of, you’ll only need to track “what’s left to spend”…on whatever you want.

This idea isn’t new.

THE IMPORTANCE OF AUTOMATION

I first read about automatic finances over 10 years ago in The Automatic Millionaire by David Bach. The entire book is devoted to setting up automated systems to manage and invest your money. This does two glorious things:

• It eliminates worry. You stop wasting time thinking about stupid things like “did I pay the electric bill this month?”
• It protects you from yourself. Automated finances make it harder for you to sabotage your money. No more late credit card payments and the associated fees and damage to your credit score. No more skipped IRA contributions. And on and on.

Another writer who has taken the idea of automated finances to the next level is behavioral finance guru Ramit Sethi. He lays out simple plans for automating your personal finances on both his blog, I Will Teach You To Be Rich, and in his book by the same name. He’s a vocal advocate of what so many other financial “experts” for some reason refuse to acknowledge: Our generation does not want people our parents’ age telling us to just “set up a budget” and “cut back on lattes”…the latter a direct jab at Bach, who trademarked the term “Latte Factor” to describe how daily coffee habit can eat into long-term wealth.

A few years ago when I wrote about automated finances, Ramit made a kerfuffle because he felt the post was too similar to his own material. To be collegial, I took that post down—obviously, I never want to hear the faintest whisper that I’m trying to rip off another blogger’s material; I’m not. I’m a student of Sethi’s methods myself; he’s a brilliant psychologist, blogger, and marketer. In this case, one of his favorite concepts—automated finances—is too important not to address on a blog that aims to provide a complete resource for your finances.

So check out Bach’s book, Sethi’s blog and book, or what I’m going to cover in the next few days. But when you finish reading, my only hope is that you’ll actually do what it takes to put your finances on autopilot.

Your wallet will be better off.

AUTOPILOT SPEND TRACKING

Forget about manually tracking every beer and burger. The goal is to set up a system that keeps track of all of your spending electronically without any additional work from you so that you can access it if an when you need to.

The Single Card Method

One of the best ways technology can help our wallets, I think, is by eliminating the need to use cash, and therefore, eliminating the need to keep track of our cash expenses.

Now this is counterintuitive to what a lot of old-school financial gurus say:

• “Cash is king!”
• “You spend less with cash!”
• “You can’t overspend with cash! When it’s gone it’s gone.”

That’s all true, but the fact is cash also can get lost and stolen. And, more importantly, cash is on the way out. Electronic payments are here, like it or not, and the times you need cash (for anything) over a debit or credit card are fewer and fewer.

But the best thing, in my opinion, about using a credit or debit card, is that you automatically have a record of all of your spending. You don’t have to do a damned thing.

Credit vs. debit

Credit cards are slightly better than debit cards because most give you ways to sort and even tag your transactions, although some banks are starting to offer this for debit cards, too. With most cards, you can also export your transactions to spreadsheet…which, for the nerds like me, is where the fun begins.

Using Personal Finance Managers

As an alternative to the Single Card Method, there’s Mint.com* or similar personal finance management (PFM) tools. These applications link to your credit and debit cards, aggregate your transactions, and can even categorize them automatically. You set spending limits, and they can send an email or text when you hit them. *Full disclosure, Mint is an affiliate of Money Under 30.

These apps are powerful and effective…if, of course, you remember to login occasionally and make sure the categories are right and view your tallies. But even if you don’t, that’s OK. The important thing is that data is there if you need it (for example, you want to know if you can afford to move to a bigger apartment and need to analyze your past spending).

YOUR MONTHLY NUT

Setting up Mint or downloading all of your credit card transactions is great for historical analysis of where all of your money goes. Looking forward, however, this data is less important. What you need to know are your fixed monthly expenses. Things like:

• Your rent or mortgage
• Utilities and insurance
• Loan payments (student, auto, etc.)
• Minimum credit card payments
• Desired savings, investments, or additional debt payments*

That last one is important. It’s vital that you calculate how much you want to save, invest, or use to pay down debt first. (What we usually do is look at how much we want to spend, and then take whatever’s left and save it. Problem is, there’s not usually much left.) To find what’s left:

• Total your fixed monthly expenses (your Nut).
• Figure out your net (take-home) pay, per month.
• Subtract your Nut from your take-home pay.

This is what’s left to spend. On whatever. Food, gas, beer, travel. Of course, if something big happens, you may need to spend money on that and have less for fun stuff. That sucks, but it’s also why you should have a buffer, which we’ll talk about in another post very soon.

Download my simple “Anti-Budget” Worksheet here.

If There’s Nothing Left…

“But wait!”, you say. “After my nut, I don’t have anything left!”

OK. Deep breath.

If money is tight, it’s likely there won’t be much (or any) left to spend after you’ve laid out your necessary monthly expenses and what you hope to save.

In the short-term, you can reduce–but not eliminate–your savings goals while at the same time trimming spending. Do what you must to get these in check so you’re not going into debt.

At the same time, this is time to look at making the kinds of big changes that can impact your overall financial picture. Forget about trying to trim your food budget by $25. Look at big places you can save. Can you get a roommate? Can you refinance your mortgage? Or, can you earn more money?

Cutting little things gets a little bit of money. Making big changes gets you a lot of money.

YOUR SPENDING ALLOWANCE

The amount of money that you have left after your Nut (fixed monthly expenses and savings) is what I call your Spending Allowance. It’s how much you can spend this month without worrying. On whatever you want.

Using whatever method you’ve setup for Autopilot Spend Tracking, you can keep a simple eye on how much your Spending Allowance you’ve used month-do-date. For example, by setting up a goal in Mint or by using the Single Card Method for all of your day-to-day spending. (This is what I do. If my family’s Spending Allowance is $2,500 in a month, I can eye our credit card balance throughout the month. If it reaches $2,000 too far before the end of the month, for example, I know it’s time to ramp down the spending a bit.)

You can use the Anti-Budget Worksheet to figure your Spending Allowance. Get it here. 

RECAP

This is a lot to digest. But here’s what’s important:

• Budgets are overrated. They create stress and we don’t stick with them.
• All you need is a Spending Allowance. Instead of tracking dozens of categories of spending, know how much you can spend per month—your Spending Allowance—after you’ve covered big expenses and savings.
• Forget manual spend tracking. Keep an eye on how much of your Spending Allowance you’ve spent with Mint or by simply using one credit card for everything you buy. Cash is dead.

YOUR ACTION ITEMS

Read all you want, but this information won’t help you unless you put it to work in your life. This week:

• Determine your Nut and Spending Allowance using this worksheet.
• Decide how you will track your spending going forward, with a service like Mint or using the Single Card Method.
• Leave a comment letting me know:

1. What you hate about budgeting. Be specific.
2. Your biggest worry or stress about managing your money day to day.

I’ll try to answer your questions in the upcoming series. In a couple days we’ll talk in detail about building your Bank Account Buffer. This is tiny emergency fund of $500-$1,000 that can cushion you from unexpected expenses like car repairs so when they happen they don’t eat up your entire Spending Allowance for the month. Then we’ll move on to discuss ways to put your bills and savings on autopilot.

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We buy insurance. We work for a paycheck. We put our money in an FDIC-insured savings account even though it pays less than 1.0% interest.

These things aren’t necessarily bad; a little bit of caution is a good thing.

But when you become conditioned to reject nearly any risk in your life, think of how this influences your behaviors and, more critically, how it impacts your life.

• you don’t talk to that beautiful guy/girl at a party because you’re afraid of rejection; you stay single
• you don’t take credit for an outstanding job at work because you’re afraid others will think you’re bragging; somebody else gets promoted
• you don’t follow your passion because you’re afraid others will call you crazy; you have major regrets in 30-40 years

Risk is good.

Risk creates progress.

(In this video, Peter Diamandis explains why he’s comfortable asking people to risk their lives in pursuit of the X PRIZE, which he created.)

But you don’t have to risk your life to rocket into space. You don’t have to quit your job to become an entrepreneur (unless you want to, in which case, you probably should). But this year, after your resolutions to hit the gym and stop buying lattes have failed (and most of them will), resolve to take a risk or two.

Talk to a pretty stranger. Go skydiving. Start freelancing. Leave a job.

There is a line, of course. I’m not telling you to stake your life’s savings on red at the roulette wheel. There are big risks and small risks. Some risks have positive expectations, like the strong likelihood a boss will grant a hardworking employee’s request for a modest raise. Some risks have negative expectations—roulette, for instance.

Of course, not all risks will pay off.

But success is earned on the back of many such small risks, and the obdurate takers will be rewarded with far more than the costs of their failures.

I know this isn’t specific financial advice you might be expecting, but it is—most importantly—actionable. You can resolve to take risks this year. And you can start today.

MY LATEST RISK

I’m taking risks all the time. And recently, I took a big one:

Last month, I left my day job to work full-time on Money Under 30.

Now, if you’ve been around awhile, you’ll know that for a few months in 2009, Money Under 30 was my primary focus while I juggled some other part-time projects after moving from Boston to Portland, Maine to be with my wife. I then began work as a marketing manager for a software company until I left that job last month.

What changed?

In 2009, Money Under 30 was ready to be worked on full-time, only I wasn’t ready to do it.

I had just moved to a new city. I was getting married. I had repaid most of my debt, but I needed to save a lot more before feeling comfortable being self-employed. And I’d soon be a dad.

I know that some people would’ve made the leap sooner. But, then again, some people wouldn’t make the leap at all.

I admit, I hesitated.

I liked having two incomes. (Indeed, I still believe in diversification, and will be consulting with my old employer and some other contacts to ensure my livelihood isn’t 100% dependent on this blog).

Ultimately, however, I’ve always known that I wouldn’t be truly happy unless I were working for myself. It’s a personality thing. Some people work well—or at least tolerate—working under supervision. I can’t. It makes me resentful, even angry. I would get the worst cases of road rage because of how much I dreaded marching into work for 8:00 on somebody else’s schedule. And I’ve had GREAT bosses. I’ve gotten along with all of them. They’ve been nice people and competent managers. But that doesn’t matter. I just need set my own hours, and most importantly, go at my own creative pace. If I want to be working on A but you tell me to do B, I can’t do it. I simply can’t. If I try to focus on B, I’m too busy thinking about A and won’t get anything done. Despite all this, I waited to take this risk because of the same reason people don’t ask strangers out, ask their boss for a raise, or make any big change in life…

…fear.

Not fear that that I wouldn’t succeed on my own. Of that, I’m quite confident. But the fear of what other people think. The fear that my parents would think I’m throwing away a “real career”. The fear that my friends would think, as a blogger, I must just be sitting on my ass eating bonbons all day.

This is the worst kind of fear, of course, because it’s totally irrelevant. If you’re skydiving and afraid your chute might not open, at least that fear serves a purpose; it might remind you to inspect the parachute.

The fears that prevents us from taking little risks in our daily lives, however, are mostly unnecessary. Unfortunately, that doesn’t make them any less paralyzing, and you need to overcome them.

Ultimately, in order to take the risk I needed to take, I had to face my fears. My friends and loved ones can think what they want. I don’t care. I’m doing what I love, and I’m far happier because when I get up every day, I get to work on creating my own material that will help you. And that’s awesome.

WHAT RISK(S) WILL YOU TAKE?

That’s my story, but I want to know: What risk(s) will you take this year? How do you expect it to change your life? Share with us in a comment. (And when you follow through, don’t forget to circle back and let me know how it worked out.)

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Although I’ve done it once or twice before, I try to avoid recommending individual stocks or funds. Such “picks” are a dime a dozen on other blogs, in major financial magazines or on Jim Cramer’s TV shows.

At best, investing in stocks and funds featured in the media won’t hurt you. The problem is, it could.

This is why I recommend beginning investors invest solely in one or two index funds that track the entire stock and bond markets. Often times, the entire market will beat most mutual funds anyway. But most importantly, when you invest this way, it’s a lot harder to make mistakes.

If you get to the point in your investing that you feel you need more specific investment recommendations, it’s time to hire a fee-only financial advisor who can evaluate your situation and provide some unbiased recommendations. In my opinion, you probably need at least $100k invested before you consider this, and you’d probably be OK waiting until you have $200k or so in play.

For the rest of us, simple index funds do the trick.

If you are investing in your employer’s 401(k) or similar plan, you will have to choose your investments from among a limited list of investments. That’s why these general guidelines on how to pick a mutual fund—choose an index fund with less than 1.0%—are more useful than individual picks.

If you must know, however, here are a couple of example mutual funds that meet these criteria.

STOCK MARKET MUTUAL FUNDS

Vanguard Total Stock Market Index Fund (VTSMX)
Expenses: 0.18%
Turnover: 5%
Min. Investment: $3,000*

If I were going to pick only two funds in which to invest, it would be a mix of this one and the Vanguard Total Bond Market Fund (below). Providing total exposure to the stock market and extremely low fees, this fund is the perfect incarnation of low-cost index investing.

TIAA-Cref Equity Index (TINRX)
Expenses: 0.29%
Turnover: 11%
Min. Investment: $2,500

Although Vanguard’s mutual funds are synonymous with simple, low-cost investing, this TIAA-Cref fund is proof that good, low-cost index mutual funds exist elsewhere. This fund holds a portfolio that closely tracks the U.S. equities market.

Vanguard Total International Stock Index Fund (VGTSX)
Expenses: 0.29%
Turnover: 11%
Min. Investment: $3,000*

This fund invests in both developed and emerging markets around the globe, excluding the United States. That makes it an ideal compliment to a US Stock index fund. Investing in foreign stocks is thought of as riskier in the short run but provides the possibility of bigger long-term returns, making it a good option for young investors with a long time to stay invested.

Dodge & Cox Stock Fund (DODGX)
Expenses: 0.52%
Turnover: 12%
Min. Investment: $2,500

Unlike the other funds listed here, DODGX is actively-managed; it’s not an index. But with low turnover and modest expenses, the Dodge & Cox Stock Fund is a solid bet for someone looking to keep things simple with one fund providing exposure to both domestic and international markets.

BOND MARKET MUTUAL FUNDS

Vanguard Total Bond Market Index (VBMFX)
Expenses: 0.26%
Turnover: 75%
Min. Investment: $3,000*

Every portfolio should have some bonds in it for diversification and stability. (Bonds are less volatile than stocks, but also don’t provide the growth potential that stocks offer). For many investors, you don’t have to look further than this Vanguard fund to grab some exposure to bonds.

*You can avoid the minimum investment by purchasing these funds as ETFs. Also, if you have $10,000 to invest, the Admiral’s Shares versions have even lower expenses.

Do you have other favorite low-cost index funds you would recommend to new investors? Share them in a comment.

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That is, if you have zero interest in immersing yourself in fund performance data and anlayst research, you will do best with a simple investing strategy: invest in an index fund that tracks the entire stock market.

Why? Because in the long run, actively-managed mutual funds rarely outperform the market.

CHOOSE INDEX FUNDS FOR SELF-GUIDED INVESTMENT

If you are investing on your own for more than 10 years (in an individual retirement account, for example), I recommend investing in a stock market index fund and a bond market index fund with low expense ratios. (Last week, I explained mutual funds costs and their importance to your investment returns here.)

If you plan to invest small amounts over time—monthly, for example—invest directly with the fund company using their automatic investment plan. Find examples from Vanguard, TIAA-CREF, or T. Rowe Price.

If you are investing a lump sum, you may consider an exchange traded fund (ETF) as an alternative.

Later this week I’ll provide some examples of each.

WHEN YOU MUST PICK A MUTUAL FUND…

Sometimes, you won’t be able to choose an index fund in which to invest. For example, your 401(k) or other retirement plan at work will likely ask you to choose from a number of mutual funds. If an index fund in not among them, how do you know which fund is best for you?

There are two areas to consider: 

• The fund’s suitability to your investing goals.
• The fund’s management style.

THE RIGHT FUND FOR YOUR GOALS

Long Term
If you’re under 35 and investing for retirement, you’ll want to seek out funds that have the following caracteristics:

• Invest mostly in stocks (domestic or foreign)
• Use terms like “aggressive”, “high risk/high return”, or “capital appreciation”

For investing periods of less than 30 years but more than 10 years, look for funds with more moderate risk/reward profiles. These funds will:

• Invest in a mix of bonds and (mostly domestic) stocks
• Use terms like “balanced” or “moderate risk”

Short Term
Investing for short-term goals requires a lower risk fund. Look for funds that:

• Invest mostly in bonds
• Use terms like “conservative” and “capital preservation”

A note about target-date funds

Target date funds are increasingly popular in 401(k) plans and other plans that provide you, the participant, with limited investment choices.

Target date funds are designed to provide the ideal risk level for a given withdrawal year (most commonly, the year in which you plan to retire). These funds are popular because they make choosing the fund easy and eliminate the need to move money into more conservative funds as you get holder.

To find the right target date fund for you, simply subtract your current age from 65 (or your desired retirement age). Add that number to the current year, and choose the nearest target date fund. Example: I’m 30. 65 – 30 = 35. 2011 + 35 = 2046. I’d pick a 2045 target date fund.

For most investors, target date funds are fine and allow you to “set it and forget it”. Some are better than others. So if you want simplicity, go with a target date fund. If you’re willing to do a bit more work to make sure you’re putting your money in the best place possible, compare facts about the target date fund to other available funds before picking your fund.

DECIPHERING A FUND’S MANAGEMENT STYLE

Found a fund candidate based on your investing objective? Next, review data on the fund on a site like Moringinstar or directly in the fund’s prospectus. Make sure it has:

• NO load, a sales charge that you should never pay
• A low expense ratio (under 1%)
• Low turnover (less than 50%)

To better understand a fund’s load and expense ratio, read last week’s post.

Turnover is the length of time a mutual fund holds stocks. The goal is to find mutual funds that hang onto stocks for a long time, resulting in a lower turnover. This results in lower trading expenses and capital gains taxes.

MUTUAL FUND RETURNS

Obviously, you’re not going to invest in a mutual fund without taking a peek at its historical returns. When you do, remember two things:

• Consistency is more important than a single blockbuster year.
• Past performance is no guarantee of future results.

Look for a fund that has done as well, better, or at least almost as well as the overall market year after year. If that fund meets your investing goals and has low expenses, you’ve found a winner.

Check back later this week for a few specific fund suggestions to get you started.

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Before you invest, do you know how much that mutual fund costs?

Last week, I wrote a beginner’s guide to mutual funds. As I said, mutual funds are ideal investments for new investors and anybody who wants to take advantage of the stock market’s upside but has no interest in trading stocks or worrying about the markets daily ups and downs. Mutual funds offer set it and forget it investing. That’s a good thing.

When you invest in a mutual fund, you want:

• the right mutual fund for your investing goals (we’ll cover this soon)
• a low-cost mutual fund

WHY MUTUAL FUNDS COST MONEY

When you buy stock in a single company, you must pay a stock broker a commission to execute the transaction. Then, you own the stock, and there are no more expenses to hold that stock until you sell it, at which time you pay another commission.

Mutual funds, however, have other fees.

Remember that mutual funds are collections of stocks, bonds, and other securities. Often times, they are actively managed, meaning a team of people are doing research and making trades daily to ensure the fund performs according to its investment objectives. Even in a fund that’s not actively managed, trades are executed to keep the fund’s portfolio balanced as money flows in and out of the fund.

These trades—and the management and research in an actively managed fund—cost money. And these costs are passed along to the mutual fund investor. That’s OK, but a key to smart mutual fund investing is to identify the funds with the lowest cost for your investing objective.

MUTUAL FUND COSTS

What you need to know about any mutual fund are its expense ratio and sales load.

Expense Ratios

A mutual fund’s expense ratio is the percentage of a fund’s assets that go purely to running the fund. It encompasses many things, including:

• investment advisory fee or management fee
• administrative costs
• 12b-1 distribution fee (advertising)

Basically, all the funds costs are rolled up into the expense ratio, which is expressed as a percentage like 0.20% (on the low end) or 1.60% (on the higher end).

Why do these fees matter?

Mutual fund fees are sneaky, because you never feel them come directly out of your wallet. When you invest $2,000 in a mutual fund, for example, you pay $2,000, not $2,000 plus $20 for expenses. But over time, the mutual fund company takes its expenses out of the fund’s total assets, and any investment returns you earned are reduced by the amount of the fund’s expenses.

For example, if you invested $10,000 in a mutual fund that gets an 8% average annual return for 30 years, here’s how mutual fund expenses can impact your return:

In a fund with a 1% expense ratio, you’ll have $76,122 in 30 years. Invest that same money in a fund with the same return but a 2% ratio, and you’ll only have $57,435 after 30 years. That’s a difference of $18,687 on just a $10,000 investment. The more you invest, the more fees eat away at returns. (And if you found a mutual fund with just a 0.20% expense ratio, you’d have $95,184 after 30 years. Take that to the bank!)

Sales Loads

Mutual fund expenses are a necessary evil—mutual funds cost money to administer. If you want the convenience of investing in these funds, you have to pay the expenses. But there’s another far more sinister fee that some funds charge known as a load.

A load is simply a fancy name for a sales charge or commission.

Fortunately, mutual funds are grouped into load funds and no-load funds, so it’s often easy to search only funds that don’t have this added cost. Note, however, that if a broker or financial advisor is recommending funds for you to invest in, these may be load funds. That person will likely get the load as a commission for helping you pick a fund. (That’s why I recommend using a fee-only financial advisor to avoid this.)

You can read more from the SEC here or from The Motley Fool about fund costs here and mutual fund loads here.

HOW TO IDENTIFY WHAT A MUTUAL FUND COSTS

Mutual fund costs must be clearly disclosed in the mutual fund’s prospectus, which you can download directly from the fund company’s Website or from a mutual fund research Website like Morningstar.

Morningstar and other sites make it easy to research fund sand identify their fees. As an example, the following screenshot of a Morningstar free fund information page clearly shows both the fund’s load and expense ratio, which I’ve highlighted.

TAKEAWAYS

What a mutual fund costs is one of the most important factors in deciding on a fund to buy.

• A mutual fund’s expense ratio eats away at your returns. Avoid funds with expense ratios of more than 1.0%.
• If you’re comfortable learning about and choosing a mutual fund yourself, you should never buy a fund with a load.
• You can find a mutual fund’s costs listed in its prospectus or on Websites like Morningstar.

Stay tuned for more articles in this series including how to pick a mutual fund and some fund recommendations for new investors.

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Why? Because the word “mutual fund” is in the headline. I mean, really, even if you’re into investing, talking about mutual funds is about as exciting as watching a turtle cross the road.

But in recent reader polls, lots of people tell me they want more coverage on investing topics like understanding the basics and transitioning from just saving money to actually investing it. And in my opinion, mutual funds are one of the best ways to start investing even if you don’t know a lot about investing. Unfortunately, however, you do need to know a little bit about mutual funds to avoid putting your money into the wrong mutual fund. Does that make sense?

I’m kicking off a four-part series on mutual funds. Today I’ll provide a very basic overview on mutual funds for true beginners and how you can use them to start investing. Then we’ll sink our teeth into some stuff intermediate investors can use as well.

Here are the topics:

• Beginner’s Guide to Mutual Funds
• Understanding What Mutual Funds Cost
• How to Pick Winning Mutual Funds
• Five Mutual Funds to Get Your Started

Sound good? Let’s go.

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WHAT IS A MUTUAL FUND?

A mutual fund is a type of professionally-managed investment that pools your money with other investors. The fund’s managers then use the pooled money to buy securities for the group. A mutual fund’s primary advantage is that it provides automatic diversification and should be less volatile. (For example, if a mutual fund holds 100 stocks and one of those stocks becomes worthless, you only lose 1% of your money. If, by contrast, you only owned that single stock, you would’ve lost all of your money.)

For most individual investors, mutual funds provide the easiest way of maintaining the right mix of investments. To achieve the same thing on your own you need 1) a lot of money to invest and 2) lost of time to manage your investments.

On the downside, mutual funds have costs that can eat into your investment returns. Sophisticated investors may also find that mutual funds offer less control over the timing of gains and distribution of income. 

TYPES OF MUTUAL FUNDS

Mutual funds provide an easy way to invest for any type of goal (short or long term) with almost any amount of money. (You can find mutual funds to invest in with as little as $50 if you make automatic monthly investments or $500 in a one-time investment). The bad news is that choosing a mutual fund can be overwhelming. Morningstar, the leading source of mutual-fund research, tracks over 15,000 funds. How do you pick? First, you narrow the field.

There are many types of mutual funds:

• Open-end and closed-end funds.
• Actively-managed and index funds.
• Stock funds, bond funds, REIT funds, commodity funds, and more.
• Target date funds.
• Small-cap, mid-cap, and large-cap funds.
• Growth funds and value funds.

Head spinning yet? Take a deep breath. Here’s what you need to know.

Open- vs. closed-end funds
Most funds you’ll be interested in are open-end mutual funds, meaning they will continue to issue shares as long as investors want to buy them.

Active vs. passive funds
Most mutual funds are actively managed, meaning a manager or a team of people monitor the fund performance and routinely adjust the fund’s mix of investments based on their research and experience in an attempt to beat the return of the overall market. By contrast, index mutual funds or passive funds simply hold a fixed ratio of investments to track the entire market or a portion of the market. The advantage to these funds is they have significantly lower fees.

Target-date mutual funds
These mutual funds are designed to make investing for retirement (or other goals) super simple. You select the fund based on the year closest to when you want to retire. For example, if you’re 25 in 2011 and want to retire at 65, you would invest in a 2050 target date fund. The fund’s managers then automatically rebalance the fund’s investments based on that date, growing more conservative as you get older.

HOW TO INVEST IN A MUTUAL FUND

Buying shares of a mutual fund is easy; there are a few ways to go:

At Work
If you have a 401(k) or other retirement plan at work, chances are you already own a mutual fund or two. The easiest way to invest in mutual funds is to select one within your 401(k) or other employer-sponsored retirement account.

Brokerages
You can buy and sell mutual funds through any online stock broker.

Online brokerages provide the easiest way to trade any kind of investment—mutual funds, exchange-traded funds, stocks, bonds etc. They also offer lots of free research tools. The downside is that they charge commissions every time you buy or sell shares of an investment. This can get expensive, especially for new investors.

Direct investing
You can open a mutual fund account or IRA directly with a mutual fund company. (These include Vanguard, Fidelity, TIAA-CREF, T. Rowe Price, and many others.)

The good thing about investing this way is that you won’t have to pay a trade commission to buy or sell shares of your mutual fund, and most fund companies have automatic investing plans allowing you to start investing as little as $50 a month.

The downside to investing directly with a mutual fund company is that you’re limited to that company’s mutual funds. So if you someday want to invest in other company’s funds or buy individual stocks, you will have to open a second account somewhere else. (There are some exceptions. Fidelity and Vanguard, for example, have brokerages.)

If you’re new to investing, I recommend making regular monthly contributions directly to a mutual fund. If you’re saving for retirement, set up a Roth IRA account. If you’re saving for a shorter-term goal, set up a regular, taxable mutual fund account.

This approach (called dollar cost averaging for investing nerds) has two benefits:

• When you enroll in automatic investing directly with a fund company, you avoid per-transaction trade commissions.
• By purchasing the fund in small monthly increments (rather than as a lump sum), you take advantage of ups and downs in the market. This eliminates the risk that you’ll buy a lot of shares at a high price. Using dollar cost averaging you’ll purchase more shares at lower prices and this will give you a better return over time.

Next week, we’ll take a look at choosing mutual funds. First we’ll talk about the cost of mutual funds—a critical factor that even seasoned investors sometimes overlook. Then we’ll cover all the factors you should consider when choosing a mutual fund. In the meantime, if you have any general questions about mutual funds, drop me a note in the comments and I’ll do my best to answer them either here or in a future post.

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