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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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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Do you need a financial advisor?

You may think that just because don’t have a lot of money yet, you don’t. And even if you want a financial advisor, you may think it’s impossible to get a qualified advisor to work with you if you don’t have six figures in the bank.

Many of the people I’ve been meeting with lately have echoed these sentiments, but I can tell you that just the opposite is true. Even if you don’t have large assets to manage, you may find that by working with the right advisor, you can reach your financial goals faster. In fact, it’s my opinion that, in many cases, young people need advisors more than older clients!

The question remains, how to choose the right advisor? The best way to answer this question is to be very clear on what your financial needs are.

Most of my younger clients need help in the following areas:

• Starting Investing
• Finding Small Business Funding
• Budgeting
• Buying Life Insurance
• Setting Up Wills and Trusts

The first thing you have to understand that financial advisor is a generic term. An advisor can be anybody who helps you with financial matters including: an attorney, an accountant, a banker, financial planner, or wealth manager. It’s no wonder that when trying to choose a financial advisor, most people don’t know where to begin!

But if you are sure about which of the five areas listed about you want help with, the job of finding the right advisor is actually pretty simple.

Starting Investing

If you’re looking for the best investments to make, a money manager will be the advisor for you. Try as hard as possible to avoid working with anyone who works on commissions like stock brokers and insurance agents. They may be as honest as the day is long. But if a person makes more money by selling you one investment or another, that is what they’re going to try to sell you.

Now, it may be difficult or expensive to get a money manager to work with you if your resources are limited. But here’s a tip that may work. Speak to a successful friend or family member and get them to recommend a good advisor. Ask your well connected friend to make a call and introduce you to her advisor. Ask your friend to convince her advisor to meet with you as a personal favor. Advisors don ‘t like to turn their well-to-do clients down. As a result, you’ll have a good shot at working with a top advisor even if your resources are very limited.

An alternative, if you can afford it, is to look for a good fee-only financial advisor who charges by the hour and hire him or her for a few hours to review your investments and make a plan.

If $500 or so is too much for you at this point, you can start investing on your own with an online broker and guidance you glean from books and blogs like ours. Don’t go all crazy day trading. Find a few low-cost mutual funds and regularly invest in them. But when you’ve amassed $20,000 or more, spend a few hundred bucks to make a plan with an advisor.

Finding Business Funding

Let’s say you have some great business ideas but you need some help getting your enterprise off the ground. People come to me all the time with scenarios like these. But in this case, what you really need is a business lawyer and a good CPA. These professionals are much more important to the success of your business than a financial planner. Save your time and money by visiting with them first.

At the same time, you may consider alternative funding resources like a start up business loan from Lending Club. They may be able to help you raise the money you need quickly and inexpensively. You won’t need a financial planner for this either.

Budgeting

If you are convinced that you need help with budgeting, you may be able to find a fee-only planner or money coach who specializes in this kind of planning.

Before you spend your money that way, however, explore free or affordable self-service options like a budget tracking software package like You Need A Budget or Mint. Of course, once you master your software, you have to really use it. I’m a big fan of recruiting an accountability partner to make sure you stay on course— a friend who wants to get his or her budget in line too.

Life Insurance

If you need life insurance, you can determine how much life insurance you need by yourself and then shop for the coverage you need without an advisor. In fact, I’ll make it even easier for you. If you’re asking yourself whether to buy term life insurance or whole life, always opt for term life insurance when your main objective is to protect your family. Many agents love to sell you whole life or universal life but my experience tells me it’s a waste of money.

Wills and Trusts

If you’ve started a family and/or inherited money, it may be time to start thinking about your will and, if you do have significant assets, creating trusts for your children. Obviously this may come later in life, but it may apply to a few of you! In this case, you’ll want to talk to an estate attorney who specializes in this field. You can search for attorneys in your area using the ABA’s Lawyer Referral Service.

IF YOU DON’T KNOW WHAT YOU NEED

Now, some of us don’t always know what we need—and if that describes you—hire a good financial planner who will work with you on an hourly “fee-only” basis.

You may be tempted to work with a stock broker or insurance agent because they’ll offer to meet with you for free, but don’t fall for it. While they’d love to get in front of you for a few hours without charging you, they’ll do whatever they can to sell you a high-commission product that you likely don’t need. You may feel like you’re saving money by getting a “free” evaluation or plan, but if you blindly buy the investment products this kind of advisor recommends, you may be spending far more than you would for a few hours of a financial planner’s time.

Meet with a fee-only advisor. Pay for an hour or two of his or her time and map out a financial plan. It’s worth it!

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My response is always another question: “What’s the money for?”

Where you should save or invest your money depends entirely on when you need that money back. Fortunately, this can be simplified a bit:

Let’s break this down.

MONEY YOU (MIGHT) NEED NOW

Your emergency savings (a rainy day fund for unexpected expenses, illnesses or job loss) belong in a regular old savings account. Online accounts pay slightly better than regular bank accounts, but this money isn’t for earning returns, it’s for:

1. Security (in case you lose your job or get sick).
2. Paying for stuff in the next year.

Warren Buffett has been known to keep a rainy day fund of around $20 billion. He’s hardly making anything on that cash in today’s economy, but in his own words, he sleeps well at night. Do this, and so will you.

MONEY YOU WILL NEED SOON

You’ve mastered personal finance 101 (a rainy day fund and the makings of a nest egg). Now, you want to save for the good stuff: a car, a house, a wedding, maybe a couple of kids, a bigger house, etc. But the more you save, the more it bothers you that your bank only pays you about 1% interest. Having not slept through all of Econ 101, you recall that inflation historically averages about 3%. What that means, of course, is that if you let your money sit in a savings account for several years, it will start evaporating right before your eyes. 

So when saving for purchases a year or more in the future,you want to move cash out of the bank and into an investment where your cash can grow. The downside, of course, is risk. If you don’t know what you’re doing (and even if you do), you could lose money.

Because of this risk, combined with the intimidation factor, most people do nothing. If they have money for mid-term goals, they let it rot in a savings account. If they haven’t yet saved the money, they spend it instead. What you will do (because you’re smarter than everybody else), is open up a brokerage account and pick one, two—or a few at most—low cost mutual funds that are widely diversified and include a healthy amount of bonds. Examples include Vanguard’s LifeStrategy Funds, broadly diversified mutual funds that are managed for risk depending on the time frame you select.

If even this seems like it involves too many decisions, consider Betterment. It’s a site that lets you invest in stocks and bonds in two steps: 1) Deposit money and 2) select the percentage of stocks and bonds you want. (Hint: For short-term periods, choose 50% bonds or more.)

MONEY YOU WILL NEED LATER (RETIREMENT)

If the money is for retirement, it belongs in an employer sponsored plan à la a 401(k) or 403(b) and a Roth IRA that’s invested in a mix of low-cost mutual funds or ETFs that index the overall markets. Investing for the really long term is easy. The basics are:

• Choose funds that include stocks and bonds (when you’re young, mostly stocks).
• Make contributions to your account every month or pay period to take advantage of dollar cost averaging.
• Sell investments only as part of periodic re-balancing (when you look at your portfolio and make adjustments to ensure the right mix of stocks and bonds for your age).
• Don’t withdraw money before you retire.

That’s really all there is to it.

A FINAL NOTE ABOUT THE STOCK MARKET

I was having lunch with a coworker recently when he turned to me and—without so much as a trace of humor—said: ”I’m going to cash out my 401(k) and put the money under my mattress or buy gold or something, I have absolutely no faith in the stock market.”

My friends’ extreme views are less about money than politics, so my arguments weren’t going to change his mind, but they underscore common sentiments that  the stock market is too volatile for Main Street investors. It’s easy, of course, to say “look at how crazy stocks have been recently”. But when you want the higher returns that come with investing in stock, that craziness is what you sign up for.

It’s true: The stock market is risky! But taking risks is what create rewards. That’s investing. That’s business. That’s life. The key in managing those risks is to not invest like an individual, not a multi-billion dollar hedge fund. Don’t take wild bets. Don’t make short term trades. Buy a mix of widely diversified stocks and bonds and get back to living life.

If this still makes you uncomfortable, there are alternatives to the stock market:

• You can purchase investment properties.
• Start your own business.
• Or even lend money to other people.

But all involve risk, and most take more know how, time and/or effort than picking a few mutual funds.

What about you? How do you invest money for the short- mid-, and long-terms differently?

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For example, unless you’re sitting on a seven-figure trust fund, the best financial advisors probably won’t return your calls. (And you should be wary of those who do, especially if they’re hawking life insurance policies to you when you’re 24, single, and childless). And if you do find a trusted financial advisor, you may not be able to afford regular planning sessions.

But just because you don’t have millions in the bank (at least not yet) doesn’t mean you don’t deserve investment advice you can trust.

Enter Bo Lu and his company FutureAdvisor.

Bo and his team realize that not every investor is best served by exclusive—and expensive—financial advisors. That’s why they’ve launched FutureAdvisor, a new Web application that provides automated portfolio analysis and diversification recommendations. Essentially, it’s a virtual investment advisor.

Today, I bring you the FutureAdvisor story for two reasons. For one, I think FutureAdvisor is a promising product—especially if you agree with my simple, low-cost investing philosophy. But this post is as much about entrepreneurship as it is investing, and a good start-up story should inspire anybody, whether you’re trying to make it on your own, too, or just earn a few extra bucks to get on top of your finances.

*To clarify something that came up in the comments, I am NOT part of FutureAdvisor’s affiliate program nor do I have any sort of financial relationship with them…Bo approached me through a fellow blogger and I liked his ideas and company, hence the post.

Here’s Bo:

Seeing The Need

Long before FutureAdvisor, my cofounder Jon and I were rookie software engineers at Microsoft. Like many of our peers, we were geeks in our early 20s who never before had much money (nor cared much for it), and suddenly started earning almost six figures.

As you might expect, some predictable things happened: friends bought BMWs, posh waterfront apartments downtown, and all the plasma TVs and video games you could imagine.

But something else happened, too: some of us started asking each other: “I want to start saving some of this cash to maybe buy a house, and even retire early someday…but how? Where do we start?” And eventually, some of my friends started complaining to me that it wasn’t easy to figure out how to start or manage 401(k)s.

Becoming Reluctant Advisors To Our Friends

Some of our friends went to find financial advisors, but found two problems.

One, many advisors have asset-minimums, meaning that you needed usually $250,000 or more in assets before they would take you as a client. We in our early twenties didn’t have anywhere near that much.

Second, the few advisors who would consider working with us wanted to charge 1% of our total portfolio value, which was a ton of money, and would quickly become thousands of dollars a year as we got older.

Meanwhile, I had been investing since I opened an IRA with money from my first summer job at the age of 16. I had read up on the research behind index investing, and why low-fee, broadly diversified mutual funds and ETFs are the absolute best way to invest.

My friend Simon, who is a CFA and had worked for Putnam Investments and the Bank of England, ran his investments the same way. We helped our friends over numerous dinners, teaching the underlying tenants of passive investing and proper asset allocation. Slowly, one-by-one, we helped our friends clean up their 401(k)s and create broader portfolios.

It took forever, but along the way we quickly realized that while everyone’s financial situation was different, much of the underlying tenants of our investing advice were broadly applicable.

The Idea

We realized that the underlying math to pick the best funds for a particular purpose (such as finding the lowest-cost way to broadly index domestic blue-chip stocks), and the algorithms to tailor a portfolio to an individual’s financial situation (such as a 27-year old who wants to retire early at 55), was something that computers were well-poised to handle.

I talked this over with my good friend Jon, an experienced investor himself and a graduate of MIT’s Computer Science program, and we decided to build ourselves a prototype to see if our hunch proved out. We applied to the start-up incubator Y Combinator, a California boot camp for new companies run by experienced entrepreneurs.

We consider ourselves exceptionally fortunate to have spent the summer working with some of the best start-up advisors and fellow founders in the world. Soon afterwards, we built a team of engineers and finance professionals and began our journey in the historic Pioneer Square district of Seattle.

FutureAdvisor’s Mission and Methodology

FutureAdvisor is a registered investment advisor now serving thousands of clients with unbiased, personalized investment advice delivered via the web application FutureAdvisor.com.

We implement well-known best practices of personal investing and apply it via algorithms to address the unique financial situations of each of our clients. We believe that you shouldn’t pay mutual fund managers thousands of dollars in fees to pick stocks for you, because research shows that stock picking doesn’t work for the long-term. We believe in asset allocations that match your time horizon and risk tolerance, implemented in low-cost, passively-managed mutual funds and ETFs.

(Here’s a screen shot:)

Throughout the application, whenever we give advice, that advice is backed by research and clearly-written explanations.

We believe FutureAdvisor is especially needed now, as companies completely move from pensions (defined benefit plans) that guaranteed employees a certain amount per month in retirement, to 401(k) and similar plans (defined contribution plans) under which your financial future is in your own hands.

We also think that professional quality investment advice should be personalized, research-driven, and available to clients anytime…even in your pajamas. Most importantly, we believe that advisory services should be accessible regardless of how much money you have now or will have invested someday.

This is our story; we hope join us on our mission to democratize unbiased and high-quality financial advice and make it affordable to all.

Learn More: Give FutureAdvisor a free test drive for 14 days.

*Note on the free trial. The FutureAdvisor site currently requires a credit card to enroll in the free trial, but Bo has offered to waive that requirement for Money Under 30 readers if you email him at bo@futureadvisor.com.

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Of course, I certainly can see why many people would like to work with one. Making sense of money is no easy task (it’s what keeps blogs like mine in business), and it would be nice to have somebody in your corner who seems to know what she’s doing.

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For some people, money is confusing, daunting, even terrifying.

Others may be more comfortable with money, but might still benefit from a professional opinion.

Enter the financial advisor.

Financial advisors help clients reach financial goals by recommending how to allocate and invest the client’s money. For many, those goals include a comfortable retirement and perhaps education funds for children, but goals might also be pursuing a second career, buying a vacation home, or starting a business.

Although every financial advisor performs similar work, there are big differences among the services provided by different types of advisors…and how these services are priced.

For a bit of background, I’ve worked as a financial advisor for the past six years, specializing in investment management. I’ve learned a lot about the industry. I also know a number of financial advisors and can tell you that the quality of services they provide ranges from outstanding to virtually worthless.

As with any profession, there are some great financial advisors who do everything that they can to help their clients and that really care about their clients needs. Unfortunately, there are also some who are just in it for the money and only exist to sell the products that put the biggest commission in their pockets.

Before you even consider hiring a financial advisor, you must educate yourself about the difference between the two.

Types Of Financial Advisors

Financial advisors come with different titles. Sometimes they are financial advisers with an “E”, financial planners, or investment advisors, or wealth managers. They may (or may not do the same thing). In general, financial planners may be able/interested in helping you with your entire financial picture, including budgeting and debt, whereas investment advisors/wealth managers will be solely focused on helping you choose investments.

Despite the different titles, the most important difference among advisors is not what they call themselves, but how they get paid.

FEE-ONLY FINANCIAL ADVISORS

Fee-only financial advisors provide financial help to investors for a fee. The fee may be an hourly rate or per-planning session fee, or it may be charged as an annual percentage of assets under management (common among investment advisors).

Fee-only advisors may offer financial planning, retirement planning, wealth management, budgeting, debt help, etc. All of the fees are disclosed up front to clients so that they have an idea of the exact services that they are getting for their money. Fee-only financial advisors can charge by the hour or by the project.

One of the biggest advantages of fee-only financial advisors is that they are able to offer clients unbiased advice since they are not compensated by companies to sell products. They receive no commission or sales fees from companies, so they are not motivated to put clients in any particular product. Clients do not have worry about conflicts of interest with fee only advisors. For these reasons, fee-only financial advice has become increasingly popular in the industry.

COMMISSION-BASED FINANCIAL ADVISORS

Unless an advisor or planner explicitly advertises he’s working on a fee-only basis, chances are he’s being compensated in some way by an investment company.

Commission-based financial advisors may offer the same services as fee-only advisors but are compensated differently. They receive a commission by fund companies or brokerages for the sale of financial products. They often receive a percentage of the total amount clients invest in particular funds or products.

As you can imagine, the chances to earn big commissions on certain products—even if they’re not the best investment for the client—can create an ethical dilemma for these advisors.

Although many, many of these advisors may be reputable and try to act in their cleints’ best interest, as long as they are paid by selling certain investments, there’s at least the perception that you—the client—may not always come first.

For example, let’s say you are in the market for a few funds for your retirement portfolio and you decide to get a financial advisor. You hire a commission-based advisor that works for Acme Investments, a mutual fund company. Your financial advisor can sell you mutual funds from a number of different fund companies, including Acme. However, she will likely be more motivated to sell you Acme’s own mutual funds because she will get a higher commission. For example, if you invest $200,000 in Acme funds, she may earn $1,000, but if you put the same amount of money in other mutual funds, she’ll only earn $250.

If you decide to work with an financial advisor or planner that does not promote themselves as “fee-only”, ask them to detail for you how they are compensated…including what commissions they earn on any products they’re selling you. If they won’t give you a straight answer, find a new advsior.

Common Questions To Ask When Hiring An Advisor

Now that you know a little bit about the background of financial advisors, let’s take a look at some of the more common questions that you might have when it comes to selecting a financial advisor.

When should you hire a financial advisor?

Here’s the cop-out answer: it’s personal. If you have questions about investing, saving money, retirement planning, taxes, or just need some help getting your finances in order, a financial advisor may be able to help.

On the other hand, you may be just fine managing your own money and investments for a long time. If, however, you have $500k or more in investments (and certainly more than $1 million), it’s probably time to get an advisor. Even if you know a ton about investing. Heck, even if you’re an investment professional yourself, half of hiring an advisor is to get an outside, unemotional opinion about your financial choices.

How much do you need in assets to hire a financial advisor?

Although you may find some advisors willing to take you on with any amount of assets, you may find many advisors will only advise high net worth clients and impose investment minimums of $100,000 on the low end ranging up to $1 or $2 million.

How much does a financial advisor cost?

Fee-based financial advisors average $150 to $300 per hour. Commission-based advisers will receive a percentage of the total number of transactions that you make. Financial advisers that offer managed portfolio services may charge anywhere from 0.5% to 2% of the assets under management.

What determines whether or not you have a good financial advisor?

Finding the right financial advisor depends on a number of factors. You want to fund someone that is trustworthy, knowledgeable, ethical, and has experience. But most importantly, your financial advisor should listen to your goals and be willing to help you craft a plan to meet them. Do your homework, and talk to several advisors before hiring. Ask for references. And don’t be afraid to switch advisors if you don’t get a good feeling.

Some financial advisors and planners hold specific designations such as Certified Financial Planner (CFP) or Chartered Financial Analyst (CFA)…both designations that require certain combinations of education, experience, and exams. Others may be accountants, attorneys, or other professionals who also offer financial planning services. No single degree or title guarantees a cracker-jack advisor, goods ones may be out there that don’t hold these titles, but it’s a place to start.

You can start your search for a fee-0nly financial advsior at http://www.napfa.org/ (National Association of Fee-Only Financial Advisors).

Not ready for a financial advsior? Take control of your own investments with a simple investing strategy or Betterment, a service that keeps your investments diversified in a simple mix of stocks and bonds that track the entire market.

Have you used a financial advisor? How did you find him/her? What have you gotten out of the relationship? Share your story in a comment.

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“If you have trouble imaging a 20% loss in the stock market, you shouldn’t be in stocks.” -– Jack Bogle, founder of Vanguard.

If you invest 100% of your money in stocks, and the stock market has a bad year (or ten), you lose money. That’s why asset allocation is one of the most important investing concepts even though it’s so often ignored by everyday investors.

If you want to learn how to create an investment portfolio that grows year after year, you must master this essential art.

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Note from David before we get started: Every time we post about investing, I get mixed feedback. I hear from people who want to know more about individual funds and advanced topics, and I get very basic questions, like what’s the difference between an individual retirement account (IRA) and a regular brokerage account.

Answer: IRAs have tax perks to encourage you to save for retirement, but have limits to how much you can invest each year and restrictions on when you can withdraw your money. In a regular brokerage account, you can invest and withdraw money as you please, but you’ll pay taxes on your gains. Those differences aside, whether an account is an IRA or not, choosing investments is the same. An IRA or an investment account is simply a bucket that you fill with many different investments.

To intermediate and advanced investors, it may seem silly to explain this, but believe me, many many people are totally confused by this distinction.

Because I started this blog for people who are new to learning (or re-learning) personal finance and my goal is to keep explanations as simple as possible, I focus investing content on the fundamentals. If we ever repeat ourselves, it’s only because I want to drive home the big, important concepts that, when followed by ordinary people (especially from a young age), make ordinary people wealthy. If you want to get into stock picking, options trading, and forex markets, more power to you, but here, we’ll stick to basics.

Here’s Mark:

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If you’ve gotten your feet wet investing, you’re probably at least aware of the three major asset classes: stocks, bonds and cash. Moving beyond these common asset types, however, and you could invest in real estate, private equity, natural resources, foreign currencies, and more.

These are examples of asset classes, and the list is endless.

BUT WHAT IS ASSET ALLOCATION?

Asset allocation is about choosing how much to invest in each asset class.

It doesn’t matter if your investment account is an IRA, 401(k) or 403(b), or a regular brokerage account, asset allocation works for any portfolio.

The Grocery Basket Analogy

Here is an analogy that explains exactly how asset allocation works:

When you go to your local grocery store, you grab a shopping basket. The basket is where you place all the items you are going to purchase. You put cereal, milk, soup, steak, juice, pasta, ice cream, and anything else into your basket.

The quantity of items you put into your basket is based upon your wants and needs. Asset allocation works exactly the same way.

Your retirement account or investment portfolio is the grocery basket. The food items that you selected are different asset classes. You can select from amongst different stocks, bonds, mutual funds, exchange traded funds, Treasuries, and money market accounts. Your portfolio mixture is determined by your investment goals (based upon your wants and your needs).

The objective of asset allocation is to broadly diversify your investment portfolio, just like you probably diversify your diet. (Even if you love cheeseburgers, you don’t want to eat them all the time because you’ll miss out on nutrients in other foods.)

In investing, you never want to be overly invested in one asset class and you want to avoid investing in assets of poor quality. The goal of proper asset allocation is to provide the ideal mix of investments that gets you the greatest long term gains for a minimal amount of risk.

How You Should Allocate Your Portfolio

There are a number of factors to consider when determining proper asset allocation. For example, I advise clients to break investments up based on their age, risk tolerance, years to retirement, and goals.

The portfolios of two 26 year-old employees can be dramatically different due to risk tolerance. For example:

Aaron:

• Is a risk taker who wants maximum exposure to the stock market.
• Figures that whatever money he loses now, he’ll have the time to make back.
• As a result, invests his portfolio 75% or more stocks.

Meanwhile, Joe:

• Is much less of a risk taker.
• Focuses primarily on capital preservation.
• As a result, invests only 50% of his assets in stocks and place the rest in bonds or cash.

Of course, age is not the sole factor when making investing decisions. A 26 year-old millionaire may care a whole lot more about preserving capital than a 26 year-old starting out with a $10,000 401(k) that she wants to grow as quickly as possible.

Cases like these are normally the exception rather than the norm. On average, the younger you are, the more heavily you should invest in stocks. (This could be in individual stocks, stock mutual funds, or index funds.)

All of these methods give an investor access to the market. A person in her twenties may devote 80% of her portfolio to stocks, whereas a retiree may have less than 20% of his overall portfolio in stocks (primarily because, in retirement, he’s relying upon his nest egg for annual income and can’t afford losses).

Source: Smart Money

Put another way, the longer the time period that you have to invest, the larger the growth you should expect from your portfolio (and the more stocks need to be a part of it).

My Asset Allocation Strategy

I have personally found that a strategy of investing primarily in common stocks works well for me. I am an aggressive investor who enjoys taking on plenty of risk as long as the potential reward is worth it. I prefer to place the bulk of my money in my best investment ideas and less money in just the “good” ideas. This way I am heavily invested in the stocks that I believe in the most. In fact, one of my biggest regrets was not pouring enough money into several big name stocks that were trading at ridiculous valuations during the March lows of 2009.

I have a limited amount of fixed income investments because I prefer the long term capital appreciation that stocks offer. I figure that I have enough time to outlast any substantial dips in the market. For this reason, my portfolio is 90% concentrated in equities because this strategy has been, and continues to be, effective for me.

Although this configuration works well for me, it’s definitely not something that I would recommend to any of my investment clients. I take a more balanced approach with client’s funds because their investing goals and risk tolerances are substantially different than mine. I learned a long time ago that there is no such thing as a perfect portfolio. The closest thing to perfection is to pick an asset allocation strategy that you feel is tailor-made for you.

Why Asset Allocation Matters

The goal of asset allocation is to eliminate risk as much as possible.

There will, of course, always be market risk…the risk that an entire market will decline.

(We saw a good example of market risk from the fall of 2008 to the spring of 2009. Every asset class declined across the board. Stocks bonds, mutual funds, and real estate all took a nose dive. Money market funds—considered the safest of safe investments— even lost money.)

Market risk is the risk that comes with any investment. Even savings accounts and United States Treasuries carry the risk that the government could default on them. (Most banks accounts are FDIC insured to $250,000, but even then there is the risk the U.S. Government could become insolvent. The bottom line is that risk, however slight, is everywhere.)

The good news is that with smart investment, you can eliminate many other risks, specific the kind of risk known as unsystematic risk (the risk that lies within a specific investment.)

Investing in any individual stock or bond leaves investors vulnerable to the risk that the particular investment could go down in value. Fortunately, you can eliminate this type of risk by properly diversifying your portfolio. Diversification gives you the opportunity to make money with one asset class even while another declines.

WHAT YOU CAN DO NOW

If you already have an investment portfolio (and yes, an IRA or 401k counts), give your portfolio a checkup. With a free membership to Morningstar, you can “x-ray” your portfolio and save it to see how changes could affect your asset allocation. If you notice, for example, that your portfolio is too heavily weighted in one asset class, you should consider adding investments of another class. Check out recommended mutual funds and ETFs or—if you have an employer-sponsored 401(k) or 403(b), check with your plan administrator for your available investment choices.

SHARE YOUR ALLOCATION

How old are you and what are your investment goals? What’s your asset allocation look like (stocks/bonds/cash/other). Let us know in a comment!

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