Savings rates start to drop

Last week, the Federal Reserve cut the Federal funds rate from 4.75% to 4.5%. The relationship between the federal funds rate and the rest of the economy is complex and long term. You won't see mortgage rates drop by 0.25% straight away, for example, because they depend more on long term interest rates.

But we are already seeing rates coming down on high-interest savings account. ING Direct has dropped their rate from 4.30% to 4.20%. Countrywide Bank are down from 5.50% to 5.35%. We will see if Emigrant Direct (currently 4.75%) and HSBC Direct (4.50%) follow suit.

How to get started investing

Let’s say you’ve decided to start investing. How do you get started? This article describes the basics of investing, and gives some hints on how to get started.

Before you start investing, however, make sure you have the following covered. If you can’t put check marks against all of the following, then you aren’t ready to start investing yet.

• You have no high-interest debt (such as credit card debt). If you do have high-interest debt, pay it off first.
• You have an emergency fund covering expenses for a few months. If you don’t have an emergency fund, put your investment money into an emergency fund first. This will cover your living expenses if the worst happens – such as you lose your job, or your car gets totaled in an accident.
• You are contributing to a retirement plan (such as a 401(k) plan). Yes, this is a form of investing, but investing for retirement takes precedence over investing for the shorter term. You will want to balance your investments.

What investing is (and isn’t)

What is investing? There are really two ways that you can put your money to work for you. The first is “savings”. This covers things like putting money into a savings account or certificate of deposits. The thing about saving is that the money you put in (called the “principal”) cannot lose value. If you put in $1000, you will definitely get back at least $1000 (unless you, for example, withdraw from a CD before the term is up).

With investing, your principal (which, remember, if your money) can lose value. You could put in $1000 and get back only $500. This sounds like a bad deal, but people invest because they have the potential to get higher returns than savings.

For example, a typical savings account (such as ING Direct or HSBC Direct) currently pays between 4% and 5%. But on average, stocks have returned about 10%. But the risk with stocks is that 10% is a long term average. They might go up or down over the next week, month, year or decade. So investing should really only be done with money that you can (a) afford to lose completely and (b) won’t need for a long time (several to many years).

Investing Options

What can you invest it? There are three main options: individual stocks, bonds and mutual funds.

When you invest in a stock you are buying part of a company. Most of us will only ever by a tiny fraction of the total company, so we have no say on how the company is run. But if you did have enough money and went out and bought most of the stock of a company, you would become the owner of that company. That is how company takeovers (and buy-outs) often work. When you buy a stock, you hope to make money in two ways: first, you hope that the price of the stock will go up so when you sell it you’ll have made the difference between what you paid and what you sold it for, and second, you might get payments from the company – called dividends - a few times a year.

Bonds are almost the opposite of stocks. Whereas buying a stock is buying a part of the company, when you buy a bond you are loaning money to the company. In exchange for the loan, the company will (normally) pay your interest. As well as companies, the federal, state and local governments also issue bonds. People often thinks of bonds as less risky than stocks, and as a way of diversifying (that is, decreasing risk). This can be true, but not necessarily. In the same way that you could be a very risk stock, you can buy very risky bonds. But there are also very low risk bonds (the lowest risk probably being US Treasury bonds, which are more like savings accounts).

The third type of investment is mutual funds. Buying a mutual fund is like buying stock in many companies at once, without the hassle and cost of actually buying the stocks individually. Mutual funds come in two flavors: those that try to beat the market by actively buying and selling stocks, and those that try to track exactly how the market performs. The later are called index funds. As well as index funds that track the overall market (such as the S&P index), there are index funds that track specific industries (say, the retail industry) or other more specialized groups of stocks. You can also buy mutual funds that invest in bonds.

Getting Started

Buying a stock or fund is an easy process, but the difficult part is deciding which stock or fund to buy. Researching and understanding companies is complex enough, plus then you need to figure out if you think the stock will go up in the future. If you do want to research individual stocks, try a finance site such as money.msn.com, finance.google.com or finance.yahoo.com. Each of those sites has plenty of tools for finding stocks and understanding the company. Each stock has a stock symbol which you’ll see all over financial sites. For example, General Motor’s stock symbol is GM. Enter GM into the appropriate search box on a finance site and you’ll get all sort of information about the company.

Investing in individual stocks takes a lot of research. Unless you have time to learn how to research companies, it is best to start by investing in a broad market index fund, such as one that tracks the value of the S&P 500 index. Today, many index funds trade just like stocks. For example, the Vanguard Total Stock Market Index Fund is also available as a stock: Vanguard Total Stock Market Index (stock symbol: VTI). Funds that trade as stocks are called Exchange Traded Funds, and you can research them at the ETF area of financial sites.

To buy a stock, you’ll need an account at a “brokerage”. Some common low-cost brokerages are TD Ameritade, E-Trade and Fidelity. These companies typically charge about $8 to $16 per trade (a trade is a buy or sell). You can sign-up online, transfer money electronically from your bank account, and start buying.

Remember that stocks are best held for a long period of time. Don’t worry if the stock declines after you buy it -- over the long term, stock market indexes have performed quite well. That is no guarantee that they will in the future, but if you wanted a guarantee you’d keep your money in savings account or treasury bonds.

A note on taxes

Unless you are investing in stocks and mutual funds inside your 401(k) or similar retirement plan, you’ll have to pay taxes. You’ll owe income tax on dividends paid by the companies (due each year), and you’ll owe “capital gains” tax on any growth in the value of your investment (due only when you sell the investment).

How to reduce spending and start saving

My philosophy is that how rich you are depends not on how much you make, but on how much you spend. If someone earns $80,000 a year but spends all of it, they are less well off than someone making $60,000 who spends only half of that and saves the rest.

You might ask how someone who spends less can be richer. It depends on your definition of financial richness. I think that richness can be expressed in two ways:

• Financial richness: you know that are on track to save enough for retirement, you have an emergency fund, and you have low rates of debt. Overall, you can feel confident that you won't end up running out of money in retirement. You can handle any emergency expense that might come up, like a car repair.
• Material richness: you spend money on products and services now. You might not be saving enough for retirement, and might have a bunch of high-interest debt to pay for your lifestyle.

Everyone has to make a decision about what type of richness they prefer, and how much they are prepared to compromise on the other type. In effect, you have to make a choice between enjoying the fruits of your labour now (by spending the money you make now) versus enjoying them later (by saving for retirement and spending it later). In practice, these two are not exclusive but you need to get the balance right.

I have a preference to work towards financial richness. This doesn’t mean stopping spending, or living like a hermit. However it does mean avoiding unnecessary expenses, and spending money wisely. This article is about how you can reduce your spending and increase your savings for the future.

If you want to reduce your spending now and start saving, how can you do that? You probably have three types of expenses, each of which requires a different strategy. The types of expenses are regular low value expenses, occasional big-ticket expenses, and other expenses.

Regular low-value expenses

These are things you buy every day or week or month, and don’t cost a lot. Think of your daily lunch at work, or a coffee on the way in, or newspaper you buy on Sunday. With these types of expenses it is natural to think that they don’t cost much so how much can saving money really help? Surely a coffee a day doesn’t impact your long term ability to retire early. But the fact is that regular low-level expenditure does add up over years and decades. Even more importantly though is the psychological impact. If you don’t think about each small expense, it is easy to get into the habit of not thinking about what you are spending. If one coffee a day ir okay, why not two? If lunch out everyday is okay, why not dinner out every day as well? It is a slipperly slope towards spending all your income on little things.

What can you do about regular low-value expenses? Think about whether you need to spend the money at all. Do you need a coffee every morning? If you enjoy drinking coffee, why not limit yourself to one morning a week rather than every day? Could you reduce the amount you spend? If you buy lunch every day at work, could you switch to a lower cost meal? Or make your own lunch and bring it in? Or if making entire lunch is too much, what about bringing in some fruit for a snack during the morning so you aren’t s hungry at lunch time?

There are plenty of ways you can reduce spending, but one factor that will reduce your ability to make a change is habit. Habits are of course something you are used to doing. Many times, your regular spending becomes more of a habit than a need. Breaking a habit can be difficult. I used to eat the most expensive dish for lunch. It was a habit, and it made my lunch decision easy – I didn’t have to think about it, I just went to the counter and ordered. But I wanted to save money, and there were plenty of other options at lower cost. To change required breaking a habit, and going from a comfortable, unthinking process to a new process and having to think about what I wanted to order each day. It took a while to break the habit and feel comfortable with the new approach, but it works if you stick at it.

Occasional big-ticket items

In contrast to small value habitual spending, big-ticket items tend to be occasional expenses. You aren’t trying to break a habit here, but instead spend less on these large purchases. There are three approaches I take to big ticket items

• Do I need it? Many times, a big-ticket item is not needed. I don’t need a new flat screen TV because my 24" regular TV works fine. That doesn’t stop we wanting a flat screen TV, since it would be newer, have more features, fit better into my house and so on. But I don’t need it. I should wait until my old TV breaks before I buy a new TV.
• Can I spend less on it? If I do decide I need a big-ticket item, my next objective is to figure out how to pay the least for it. For a TV, for example, do I need a 42" model when a 36" would be adequate? Where is the best value place to buy it – somewhere online rather than a local retailer? This approach is all about reducing the amount I spend.
• How do I get best value over the long term? This is all about making sure I buy a good purchase for the long term. For example, it is false economy to save money by being an unbranded item that breaks after a year, when I could spend some more for a better brand item that will last ten years or more. In some ways, this objective opposes the previous one which was about spending less: this one is about spending more for long-lasting quality.

Other expenses

Then there are other expenses, from occasional (gifts at Christmas) to regular (electric bill). Of these, I am concerned most about regular bills. It is easy to get into the habit of paying a bill and not notice how much it adds up to over the years. Some bills are necessities, such as electricity, and all you can do is try to reduce them. But others are luxuries. Do you really need a Netflix subscription, or premium TV channels? Perhaps you do get enough use out of these to justify the expense, but if not, these are easy to cancel and can add a lot of extra money to your savings.