Today I thought I'd take some time responding to some of the questions that have been sent to my personal mailbox about Rule Maker Step 2 (Mastering Finances) and Rule Maker Step 3 (Allocating Savings), which I authored.
One Fool asked: "How can I determine the security of transacting through one of these 'deep-discount' brokerages that advertise on the Internet at rates of $7 or $10 per transaction? I currently use Schwab due to my concern about possible fly-by-night brokerage operations over the Internet."
The first thing to do is make sure that the broker is registered with one or more of the known regulatory bodies: the National Association of Securities Dealers (NASD), the Discount Brokers Association (DBA), or the Securities and Exchange Commission (SEC). You also want to make sure that securities held for you by the broker are insured. For example, a discount broker that I use is registered with all three of the agencies that I named. My account is also protected for up to $500,000 (limited to $100,000 for cash claims) by the Securities Investor Protection Corporation (SIPC), and an independent firm provides additional protection of $10,000,000 (limited to securities protection).
For more information on this topic, you should definitely check out the Discount Brokers discussion board, where thousands of Fools have shared their thoughts and experiences. The Fool's Discount Brokerage Center is also a great source for general broker information. Using a deep-discount broker can significantly reduce commission costs, enabling many investors to keep fees within our portfolio's target range of 0-2% of the total investment. But each of these brokers varies in their manner of customer service, their costs for additional services, and their trading infrastructure. Check out our Discount Brokerage Center -- we think you'll learn much from it.
The same Fool felt compelled to ask a second question! He wrote: "If my investment horizon is short -- say, two years -- is it ever advisable to use long-term call and put options to hedge against short-term volatility in the stock market?" (Need a refresher on what an option is? Visit the Fool FAQ.)
My take (and it's certainly open for discussion on the Rule Maker Strategy discussion board) is that no, you shouldn't. I can't say never, but the general rule that we like to follow is that money should only be invested in the market when your time horizon is five years or more. For Rule Makers, we've extended the holding period to 10 years, not because we consider it a risky approach, but because we believe that, through the blessings of compounded growth, the greatest investment rewards come farther and farther down the road.
Personally, I only like committing long-term money to the market because it substantially decreases the chance that I'll be forced to sell a stock to meet short-term cash needs. As for options, due primarily to the high level of volatility and risk, these are generally not investment vehicles used by long-term investors. We don't like to introduce time as a major factor in our investment approach, and that's exactly what options have you focused on. In the end, we'd rather invest $1,200 for the next 20 years than $5,000 for the next two months.
Our third question today came from a different Fool, who asked about paying off credit card debt. As discussed throughout Fooldom, getting your personal finances in order before investing in stocks is critical. You really do want a rock-solid foundation before you start. Ah, but this question is much more complex. This particular Fool has already purchased some stocks and was wondering whether they should be sold to eliminate existing credit card debt.
This isn't a simple question to answer. It depends at least partially on the transaction fees related to selling the stock. If the sales don't result in significant capital gains or commissions, then it would probably be best to cash out, pay off the credit cards, resolve not to incur any new balances, and start saving for your next stock purchase.
At interest rates of 14-18%, credit cards cost more than the market typically rewards investors (with the pre-tax historical growth rate of 11% per year from U.S. common stocks). The banks in America simply cannot stop laughing loudly enough at how much debt their customers are willing to carry over from one month to the next at double-digit interest rates. Don't give them cause to laugh at you, too, Fool.
Now, if your transaction and tax costs are too significant, we can see holding onto your investments and using your new savings to pay off your debts. In this context, "significant" means that the transaction costs will be greater than the expected interest costs that would be incurred by paying the debts off over time. Hey, you're going to have to do a little math yourself.
The last question to be discussed today relates to what exactly we mean when we say in Step 2 of the 11 Steps to Rule Maker Investing: "Set aside and save a portion of each of your paychecks. For most Fools, this should be around 10% of your annual income." The questions about this line ranged from whether we refer here to pre-tax income (gross income) or after-tax income (net income) and whether all types of savings (401(k), college, etc.) should be included in the 10%.
For us, the 10% refers to gross income, but the real key is to set up some type of regular savings plan and to gradually increase in percentage terms the amount that you set aside. If you can't handle 10% when you start your regular savings plan, that's OK. Just determine how much you can manage to put away and save that. If you can comfortably save more, by all means do.
As for the second part of the question, I'd consider college savings to be separate from the rest of your savings. The 401(k) could be included but, personally, I exclude it from how much I'm putting away. Why exclude 401(k) savings? Because it represents money that I don't plan to use until I retire. The other savings I put away, I may very well use before retirement. I love building that portion of my savings account; it's money I can expect to use before I'm old and gray and sitting by the fire.
So let's restate our Q's and A's:
- Deep discount brokers? Drop by the Fool's Discount Brokerage Center.
- Options for hedging short-term investments? Not our style.
- Sell stocks to pay down credit bills? Probably, but run the numbers.
- Ten percent savings beyond retirement funds? Yes, we think so.
We'll see you all tomorrow with more talk of our companies. Until then, don't forget that doctors recommend 8 1/4 hours of sleep a night. If you're like most Americans, you're working too hard. Get some rest!
Phil Weiss and his family reside in northwestern New Jersey. With two young boys and two dogs, things there can be crazy at times. You can see Phil's stock holdings in his profile. The Motley Fool is investors writing for investors.