Yay! By this point in the Financial Peace University program, we are learning about Baby Step #4, INVESTING! Dave advocates investing 15% of your household income in mutual funds. By this baby step, you have paid off all consumer debt (except the mortgage), and have a 3-6 month emergency fund saved. Now it is time to start building some wealth. Dave Ramsey teaches that mutual funds are a great way to invest. Of course, in an hour long lesson, we will not know all of the in's and out's of investing, but he points us in the right direction.
His first rule of investing is to never buy something you don’t understand. Only invest in companies and products that you can explain to a seventh grader. Stick to things that are easy to understand, or in other words, use the "KISS" principle: KEEP IT SIMPLE STUPID! Often times, financial planners or investment counselors use such complex terms that we don't know what we are getting into. Keep it simple, and understand everything you buy. Investing is methodical, week by week, month by month.
Dave begins by covering the basics of risk versus return. In other words, the safer and more liquid (accessible) that you want your money to be (low risk), the lower the potential return will be. Safe investments are typically CD’s and money market mutual funds. However, they tend to often time not even come close to the rate of inflation. Riskier investments (with generally higher rates of return) include single stocks (Dave says DON'T DO THAT), bonds, mutual funds, and real estate. Real estate is one of Dave's favorites, but only when he can pay cash for it. Real estate takes a lot of money to get into, and also to maintain. It should not be used for short term investments, but has a great return for the long term.
He spent quite a bit of time talking about diversification, or not "putting all of your eggs in one basket". This protects your investment more than about anything. Diversification is investing your money in many different products, companies, and levels of aggressiveness. You don’t want to have all of your money in one company’s stock (even if it’s the company you work for), or one mutual fund. If for some reason that company crashes, you will lose all of your money. Investing in multiple funds, stocks, and industries makes sure that even if one company or product tanks, your others will take up the slack. This makes it much less risky. Dave’s standard mutual fund diversification is as follows:
25% in Growth (mid cap): These are mid-sized companies that still have a lot of room for growth.
25% in Growth and Income (large cap): These are big, well established companies that grow a little but mostly stay stable.
25% in International: These are overseas and foreign companies.
25% in Aggressive Growth (small cap): These are small companies and emerging markets that have a lot of potential to grow, but alo have a lot of potential to crash.
Dave then tells us that your money will need to earn at least a 6% return in order to compensate for inflation and taxes. With that you simply break even. Dave shoots for an average of 12% return with his mutual funds. With the down markets we have had over the last several years, that would be hard to come by. He also recommends funds that have a strong track record for the past 10 years.
All in all, this class was an eye opener for me (and the class). When we looked at how debt has robbed us from earning real wealth, it was sickening.
Click here for a visual representation of what saving 15% of your income can look like. This is from Doughroller.net, and it puts it all in perspective.
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