Your Money: The Missing Manual

by J.D. Roth

On the other hand, the advantages of renting include: Flexibility. With a rental, you don’t have a long-term commitment. You can move on short notice, whether to get away from bad neighbors or to take advantage of lower rents elsewhere. There’s also a wider range of rental options than homes for sale. It’s difficult to buy a tiny house, for example, but you can easily find one- or two-room rentals. Lower costs. In the June 2007 issue of Kiplinger’s Personal Finance (http://tinyurl.com/kip0607), editor Knight Kiplinger wrote, “It often costs less to rent. The annual cost of owning a property, be it a house or a condo, is usually greater than the cost of renting, after taxes.” True, you don’t build equity when you rent, but you’re not burdened with taxes, insurance, and maintenance costs either. You can use the money you save to travel or buy stocks. Lack of responsibility. When you rent, somebody else does the yard work and repairs the leaky showerhead. (Of course, this can be a disadvantage if your landlord is slow to respond to problems.) All you do is stick to the terms of your lease or rental agreement and someone else takes care of the rest.

why they’re right and the other side is wrong. The bottom line is that the decision isn’t just a financial one, so it’s hard to generalize.

How do you feel about homeownership? For some, owning a home is a piece of the American Dream. For others, the chores and maintenance are a nightmare. Your feelings about homeownership are just as important as the financial stuff.

Note Here’s an excellent article from the New York Times (http://tinyurl.com/NYT-buying) that explains why the author — a long-time renter — decided to buy a home. It does a good job of laying out the pros and cons of each choice.

If you decide to buy, do it for the right reasons: because it fits your goals and will make you happy. Don’t do it because you think it’s a good investment. A mortgage is not a retirement plan — it won’t make you rich. Instead, think of it as an investment in a certain lifestyle. If h...

Tip To find out how walkable an address is, check out WalkScore.com, which calculates how close it is to things like restaurants, libraries, and grocery stores.

In The Automatic Millionaire Homeowner (Broadway, 2008), David Bach writes: You should generally assume that the amount the bank or mortgage company is willing to loan you is more than you should borrow. […] Don’t fool around with this. Do the math. Be realistic about your situation. Don’t pretend you’re in better shape than you are.

According to the U.S. Census Bureau, the average new home was 2,349 square feet in 2004, up from 1,695 square feet in 1974. During those 30 years, kitchen sizes doubled, ceilings rose more than a foot, and bedrooms grew by more than 50 square feet. But home sizes are ballooning even while our families are getting smaller: The average family had 3.1 people in 1974; it had shrunk to 2.6 people in 2004. (For the stats geeks out there, that means we’ve gone from having 547 square feet of home space per person to 903 square feet per person.)

Note Be wary of mortgage products like adjustable-rate and interest-only loans. These may seem attractive, but there are a lot of pitfalls involved. These types of loans are for “sophisticated” borrowers. (If you’re not sure whether you’re a sophisticated borrower, you’re not.)

Most of the time, using insurance to spread risk is a good thing. That’s why most states require car insurance, and why smart folks keep homeowners insurance even after their mortgage is paid off. But insurance can be expensive, especially if you have too much or the wrong kinds.

All insurance works pretty much the same way: You pay a premium (a set amount of money) to the insurance company, usually on some sort of schedule (monthly or yearly, for instance). In return, they issue you a policy, which is a contract that gives you certain coverage, or financial protection. When you suffer an insured loss, you file a claim and the company pays you a benefit.

Insurance is meant to protect against catastrophes, not day-to-day annoyances. You use insurance to protect yourself from things that aren’t likely, but which would cause financial hardship if they did happen.

In most states, you at least need to have liability insurance, which covers the cost of any damage you do to other people or things with your car. (But note that liability insurance doesn’t cover injuries to you or other people on your policy; for that, you need PIP insurance, which we’ll cover in a moment.)

Insurance companies quote liability coverage as a series of three numbers, like 50/200/25. The first number is how much, in thousands of dollars, the policy will pay for each person (besides you) injured in an accident ($50,000 in this example). The second number is the total that the policy covers for each accident ($200,000 here). And the last number tells how much property damage will be reimbursed ($25,000 in this case).

Many experts recommend carrying liability coverage equal to your net worth — the total value of everything you own. This can be expensive to do on individual policies. Instead, it may be more cost effective to buy an umbrella policy, which gives you extra liability coverage above what your home and auto policies provide.

Collision insurance, as you can probably guess, covers damage to your car when it hits (or gets hit by) another vehicle or object. But because collisions aren’t the only way your car can get banged up, comprehensive insurance covers damage from events other than collisions: floods, fire, theft, and so on. Collision and comprehensive coverage make more sense for newer vehicles, and are generally required if you’re still making payments on your car. They’re less necessary — and may actually be a waste of money — on older cars.

Personal injury protection (PIP) insurance is sometimes called "no-fault” insurance, and is required in certain states. It covers medical costs (and possibly lost wages) if you’re injured in an accident. It may also cover passengers and pedestrians. Uninsured motorist insurance covers you and your passengers if you’re in an accident caused by a driver who doesn’t have insurance. It also covers hit-and-run accidents.

For more on the different types of auto insurance coverage, check out this handy page of definitions: http://tinyurl.com/cins-def.

Ditch towing coverage. Towing — or “emergency roadside service,” as it’s sometimes called — is an easy cost to self-insure (see General Insurance Tips). You likely pay $10–$30 a year for towing insurance, and one tow costs $100. (If you’re in an accident, towing is usually covered under collision, but check with your insurance company to be sure.) Sometimes your car will break down, but if it’s well maintained, that won’t happen often. Tip If the value of your car has dropped so low that a major repair would cost the same as replacing it, consider dropping your comprehensive and collision coverage. Then use your savings on premiums to boost your self-insurance fund (see General Insurance Tips).

Dwelling coverage insures your home in case it’s damaged or destroyed. You want a guaranteed replacement cost policy, which requires the insurance company to fully rebuild your home. (Other policy types may not offer enough coverage.) But you don’t need a policy that covers the full resale value of your property, since that includes your land, which doesn’t need to be insured.

Personal property coverage insures the Stuff inside your house, like clothes and furniture, and usually also insures the personal property you have with you while you’re away from home. Your insurance can be for either actual cash value (how much your things are currently worth) or replacement cost (how much it would cost to buy them new). The latter is your best bet: You should carry insurance that would pay you to replace your belongings, not pay you based on what the insurance company thinks they’re worth.

Liability coverage protects you if somebody is hurt on your property and sues you. Most policies cover you off your property, as well. You should have at least as much coverage as your net worth, and some experts say you should have twice your net worth. If someone trips on your doorstep and breaks his collarbone, say, he just might follow through on his threat to sue you for everything you own.

it’ll just push me into the next tax bracket” aren’t true. As long as there’s no 100% tax bracket, there’s always a benefit to earning more money.

In his book Stocks for the Long Run (McGraw-Hill, 2008), Jeremy Siegel analyzes the historical performance of several types of investments (economists call them asset classes). He tries to answer the question “How much does the stock market actually return?” After crunching lots of numbers, Siegel found that since 1926: Stocks have returned an average of about 10% per year. Over the past 80 years, stocks have produced a real return (meaning an inflation-adjusted return) of 6.8%, which also happens to be their average rate of return for the past 200 years. Bonds have returned about 5%. Adjusted for inflation, their real return has been about 2.4%.

Costs Low.) Tip To find how much your mutual fund is costing you, pull out the fund’s prospectus. (If you can’t find your copy, go to your fund company’s website and download it.) For help deciphering the prospectus, check out http://tinyurl.com/GRS-prospectus.

The Little Book of Common Sense Investing (Wiley, 2007), John Bogle writes that the average actively managed fund has a total of about 2% in annual costs, whereas a typical passive index fund’s costs are only about 0.25%.

Exchange-traded funds (or ETFs) are basically index funds that you can buy and sell like stocks (instead of going through a mutual fund company). To learn more about the subtle differences between index funds and ETFs, head to http://tinyurl.com/YH-etfs.

(This long article offers a good summary of the arguments for using index funds: http://tinyurl.com/dowie-index.)

The key to successful investing — whether you own index funds or not — is overcoming bad behavior.

If you’re a math whiz and want to see all the calculations and proofs behind why index funds do better than actively managed funds, pick up a copy of Bogle’s book or take a look at this short (but dense) paper from Stanford professor William Sharpe: http://tinyurl.com/sharpe-rocks.

Investing is a game of years and decades, not months. What your investments did this year is far less important than what they’ll do over the next decade (or two, or three). Don’t let one year panic you, and don’t chase after the latest hot investments.

Here’s a dirty little secret: Wall Street makes money on activity; you make money on inactivity.

In his 1997 letter to Berkshire Hathaway shareholders (http://tinyurl.com/BH-1997), Buffett — the company’s chairman and CEO — made a brilliant analogy: “If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef?” You want lower prices, of course: If you’re going to eat lots of burgers over the next 30 years, you want to buy them cheap.

The No-Brainer Portfolio by William Bernstein William Bernstein is a retired neurologist who has turned his attention to financial matters. He wrote The Four Pillars of Investing (McGraw-Hill, 2002), which is one of the best books on investing published in the past decade. In his book, he suggests several different portfolios, including this “no-brainer” collection of index funds that keeps things simple: 25% Vanguard 500 Index (VFINX) 25% Vanguard Small-Cap Index (NAESX) 25% Vanguard Total International Stock Index (VGTSX) 25% Vanguard Total Bond Market Index (VBMFX) You can read more about this portfolio at http://tinyurl.com/LP-nobrain.

Bill Schultheis, the author of The New Coffeehouse Investor (Portfolio, 2009), believes that the secret to financial success is mastering the basics: saving, asset allocation, and matching the market. He says you can match the market with this lazy portfolio: 40% Vanguard Total Bond Index (VBMFX) 10% Vanguard 500 Index Fund (VFINX) 10% Vanguard Value Index (VIVAX) 10% Vanguard Total International Stock Index (VGSTX) 10% Vanguard REIT Index (VGSIX) 10% Vanguard Small-Cap Value Index (VISVX) 10% Vanguard Small-Cap Index (NAESX) To read more about The Coffeehouse Portfolio, head to http://tinyurl.com/LP-coffee

In fact, there’s a subculture of investors who love lazy portfolios. You can read more about them at the following sites: Bogleheads. http://tinyurl.com/BH-lazy MarketWatch. http://tinyurl.com/MW-lazy The Kirk Report. http://tinyurl.com/TKR-lazy

With systematic investing (also called dollar-cost averaging), you regularly contribute to your mutual funds by, say, putting $100, $250, or $500 into your investment account every month. When prices are high, your money buys fewer shares (since each one costs more); but when prices are low, your money buys more. Your constant contributions and the long-term growth of the market help you build wealth over the long run.

If you plan to invest on your own — whether instead of or in addition to investing through your company’s plan — contact the mutual fund companies directly instead of going through a broker. Three of the larger no-load (Keep It Simple) mutual fund companies are: Fidelity Investments. http://tinyurl.com/FID-ind, 800-FIDELITY T. Rowe Price. http://tinyurl.com/TRP-ind, 800-638-5660 The Vanguard Group. http://tinyurl.com/TVG-ind, 800-319-4254

When you’re just beginning to invest, your contributions are far more important than your asset allocation (Know Your Goals). So don’t sweat it if you can’t get your target asset allocation perfect right off the bat.

Though many investment professionals swear by rebalancing, some research shows that it’s not as important as people once thought. In The Little Book of Common Sense Investing, John Bogle writes, “Rebalancing is a personal choice, not a choice that statistics can validate. There’s nothing the matter with doing it…but also no reason to slavishly worry about small changes…” In other words, rebalance if your asset allocation is way out of line but don’t worry about small changes — especially if you’d end up paying a lot of fees by rebalancing.

Ultimately, the most important thing isn’t how you invest, but that you do invest. When you’re just starting out, your contributions have a bigger impact on your success than any other factor.

You can spend a lot of time looking for the best options — or you can just get to work, reminding yourself that the sooner you start saving, the better. Besides, “best” is a moving target; what’s best today may not be best tomorrow.

Expenses often drop in retirement because your kids are out of the house; your mortgage is gone — or nearly so (one of the surest steps toward retirement security is to pay off your mortgage); you have no commuting costs or other work-related expenses; and, ironically enough, you no longer have to save for retirement. Sure, you’ll have other expenses — especially health care — but if you’ve been smart and planned ahead, you should be in good shape.

Tip At some point, you may want to shift money from one retirement account to another, like moving the money in a 401(k) from your old job to a Roth IRA. (The technical way to say this is that you want to roll over your 401(k).) Be warned: These moves can be tricky. The IRS has a handy chart that shows which accounts can roll over into other accounts: http://tinyurl.com/IRS-ropdf. For more info, read the Get Rich Slowly article at http://tinyurl.com/GRS-401kmove and contact a financial planner (see How to open a Roth IRA account).

To learn more about early retirement, check out the Early Retirement Forum (www.early-retirement.org) or track down a copy of How to Retire Early and Live Well by Gillette Edmunds. Edmunds’ book pays special attention to the financial challenges faced by early retirees — including the psychological impact of a market crash.

Because early retirement presents so many financial hurdles, some people choose semi-retirement instead. Semi-retirement is like early retirement except that you continue to draw income from some sort of work. In Work Less, Live More, Bob Clyatt explains the advantages of this option: With a modest income from part-time work, early semi-retirees may not have to face the dramatic downshifting in spending and lifestyle that so often confronts those who live only on savings or pensions. And semi-retirees learn that a reasonable amount of work, even unpaid work, keeps them energized, contributing, and sharp.

But it is possible to spend time with friends without going broke. The key is to recognize that peer pressure is mostly internal; it comes from a desire to fit in. When you realize that you don’t have to spend to impress your friends, most of the pressure goes away.

Kids do best with clear, consistent expectations, so think carefully about your family’s money rules before setting them.

Wealth and happiness aren’t mutually exclusive, of course. In his final column for the Wall Street Journal (http://tinyurl.com/wsj-final), Jonathan Clements wrote that financial stability improves well-being in three ways: If you have money, you don’t have to worry about it. By living below your means, you get a degree of financial control — even if you aren’t rich. Avoiding debt gives you options. Money can give you the freedom to pursue your passions. What do you want out of life? What gives you a sense of purpose? These are the sorts of things you’ll want to pursue in retirement. Better yet, structure your career so you can do the things you love now. Money can buy you time with family and friends. In fact, Clements says, true wealth comes from relationships, not from dollars and cents. In other words, social capital is worth more than financial capital.