getting started with investing: the Roth IRA

Some friends of mine recently asked me about how to get started with investing. One is in graduate school and the other is in the work world. Both have some money saved up in a savings account and realize that the rate of return is pretty piddly in a bank savings account and want to get a better return elsewhere.

Before Investing
Before we jump into investing, I'd like to say two things. First, one should always have enough money in plain old savings as an emergency fund. Most financial advisors suggest having three months of living expenses always readily available just in case the job goes south or some unexpected emergency comes up. Good old common sense advice here. Second, my perspective on investing is based on A Random Walk Down Wall Street, by Burton Malkiel. We believe that investing is very different from speculating and that investing requires a balanced approach. I know everyone's got plenty to do already, but if you are interested, I suggest giving the book a read.

I think the best way to get started with investing with money that you've already saved in a savings or checking account is by opening a Roth Individual Retirement Account (IRA). The Roth IRA is a special account you can set up through an investment company that has some excellent benefits and a couple of limitations.

Benefits and Limitations
Benefit 1: The Roth IRA offers tax-free growth. That's right, you don't pay any taxes on anything you earn in your Roth IRA account! This is huge -- we pay taxes on everything we earn in the U.S. so having a special account where you don't pay taxes on your earnings is a really big benefit.

Benefit 2: Although the term IRA is associated with retirement, you can use your Roth IRA earnings, tax-free and penalty-free, to (a) pay educational expenses for yourself, your spouse, and your children, (b) pay for certain medical expenses, or (c) pay for your first home under certain conditions (ask me about the details). If you are in a real bind, you can borrow from your own IRA as long as you pay it all back within 60 days.

Limitation 1: You are only allowed to contribute a maximum of $3,000 a year to a Roth IRA account. In 2005, the limit has been raised to a $4,000 maximum contribution, effective until 2007 when the limit will be raised again. Since it is still before 15 April 2005 (tax day), you are still allowed to contribute the $3,000 for 2004, and then you are free to contribute $4,000 in the remainder of 2005.

Limitation 2: If you take your Roth IRA earnings out before you retire (anytime after age 59.5) for anything that wasn't mentioned above, you will pay a 10% penalty on what you take out. Again, if you are in a bind, you can take out your contributions anytime you want to five years after opening your account, but if you're serious about investing, and you actually want it to work, you should really think of all of this money, both contributions and earnings, as untouchable until age 59.5, or you need it for one of those special cases I listed in benefit 2.

The Real Motivation
Unlike those TV commercials that tell you to invest for riches, the real motivation to invest should be to beat inflation. If you earn extra beyond beating inflation, which you most likely will, then all the better. Inflation slowly eats away at your savings unless you do something to combat it. In my favorite example, the McDonalds index, I look at the price of a McDonalds (double) Hamburger from 1962 to 2002, forty years, which is about how long it will be before we retire. In 1962, the double hamburger was 28 cents. In 2002, the same double hamburger is $3.18. If you look at the prices for cars, gasoline, candy, food, rent, houses, whatever, the trend is the same. So consider that money in your savings account. It's not going up like the prices are, which means forty years from now, that money in your savings account can't buy squat. In other words, you really can't afford not to invest.

Now Is the Time
Everyone talks about the power of compounding. I find an example says it all because you can't argue with the mathematics of it. Let's say we have two friends, Robin and Jay. Both are the same age but Robin starts investing ten years earlier than Jay. Robin contributes to her Roth IRA at age 25 and invests $3,000 a year for ten years. Jay begins saving in his Roth IRA at age 35 and invests $3,000 a year for 30 years. Note that although Jay started ten years later, he contributes 20 more years than Robin does. Now let's say they both earn the same rate of return, 8% per year (slightly below stock market average).

Plugging all the numbers into an Excel spreadsheet (or solving the corresponding differential equation), we check up on Robin and Jay at age 65. Robin has $510,090 in her Roth IRA, while Jay has $396,401 in his Roth IRA. By starting ten years before Jay, Robin ended up $113,689 more than Jay, even though Robin only contributed $30,000 total to her Roth IRA compared to Jay's $90,000 total contribution. This makes sense if you look at the equation because time is an exponential, while contribution (principal) is just a multiplier. (I'll see if I can find a good image of the equation to add in here later.) So it's critical to start early.

The Plan
Ok, hopefully by now you are sort of convinced on investing and you want to open a Roth IRA for yourself. You can go to a number of investment companies to open your account, but in my research I found that Vanguard was one of the best (and my money is where my mouth is on this one). They have some of the lowest fees in the industry. Fees eat into your earnings, so low fees are good. They've been around since 1975 and they've built a good reputation for themselves. If you look at the scandals surrounding mutual fund companies in the past several years, you will find Vanguard has not been involved in any of the shadyness.

Assuming it's still before 15 April 2005 when you are reading this, go to Vanguard.com, click on Personal Investors, and make your way through the website. It will take a little time to get setup and everything, but the process is pretty straightforward. When it comes time to choose your funds, I suggest two funds: the Vanguard Total Stock Market Index Fund and the Vanguard Developed Markets Index Fund. For your 2004 contribution, I'd place $2,000 into the Total Stock Market Index Fund and the remaining $1,000 into the Developed Markets Index Fund.

For the 2005 contribution of $4,000, I'd suggest setting up an Automatic Investment Plan through Vanguard.com after you setup your 2004 contribution. You can set the amount you want to contribute ($50 minimum and schedule it weekly, monthly, quarterly, or whenever. Contributing in small increments over time is actually a good strategy for investing too. I personally try to invest monthly, but you know how much you can personally contribute over time, of course the more the better. I'd try to keep the same proportions as your original contribution -- twice as much in the Total Stock Market Index than the Developed Markets Index.

I like index fund investing for many reasons, but the main one is that it's low maintenance with low fees and you don't really have to watch it all that much. The Total Stock Market Index Fund tracks an index called the Wilshire 5000 index, a measure of how every stock in the U.S. stock markets perform. So if the entire U.S. stock market is doing well, your fund will do well. This also minimizes your risk to the extent possible in investing. Instead of speculating on one or two companies or one or two industries, your earnings are based on how everyone performs in total, not just one specific company or industry. The other fund, the Developed Markets Index, tracks an index called the Morgan Stanley EAFE -- that's Europe, Australia/New Zealand, and the Far East. Like the Wilshire 5000, the EAFE index tracks a very broad selection of international stocks in stable countries overseas. Keeping in mind that we are in a global economy, it makes sense to have some money invested in developed countries overseas as well as our economy here in the U.S. The takeaway point is this: investing in the Total Stock Market Index is roughly equivalent to investing in all U.S. stocks and investing in the Developed Markets index is roughly equivalent to investing in all of the stocks in Europe, Australia/NZ, and the Far East (Japan and others).

I invite you to be proactive with your own money and savings, so you should definitely check out the Vanguard website and read for yourself. If you want to look at other investment companies too, you can try T. Rowe Price, Fidelity Investments, and E-Trade. I personally think Vanguard gives me the most bang for my buck, given the strategy I want to pursue. My friends who speculate more than I do (but they call it investing too) use E-Trade to trade stocks and it works for them.

Parting Note
Good luck getting started with investing. I hope taking some first steps now brings you some great rewards later. Remember, now is the time, and you can't afford not to start. I'll be around if you have questions or you want to find out some more details. If you want to see the Excel spreadsheet or if you want to learn how to calculate a rough estimate of returns, let me know and I'd be glad to show you the math on paper or in Excel (although I can do Excel better than I can do the differential equation -- it's too far gone in my head).