Investments Include More than Just Stocks
Keeping a Mix of Asset Classes is the Key to Diversification
Although you may have a diversified portfolio of stocks, this first step of Level Four advocates that you diversify across many different asset classes, not simply stocks. So, what is an asset class? There are varying definitions in the investment world, but we define an asset class as a group of investments that have similar characteristics and behave similarly in the marketplace. Some of the common asset classes include:
- U.S. Stocks
- Non-U.S. Stocks
- Treasury Bonds
- Precious Metals
- Real Estate
- Corporate Bonds
- And many others…
The goal in Level Four is to stay diversified across many different asset classes. You cannot consider yourself diversified if you own Microsoft stock, Apple stock, Chevron stock, and a few bonds. These are all paper assets. You want to have hard assets as well, like physical precious metals, real estate, or others. Even owning your own business is a great way to get diversified.
Recall from Level One that you began a systematic savings plan. By now, you are undoubtedly saving at least 15% of your gross income every single month. Prior to embarking on Level Four, you were directing this 15% into your savings, building a total reserve of six months of your income. Now that you have your savings built up, you will not stop your systematic savings plan. However, you will re-direct this money into your investments now. At any point in time you may need to use part of your six months savings (for a flat tire, a new roof on the house, or even a great investing opportunity), you will immediately stop funneling your 15% to investments, and build your savings back to the six month level.
This is also a good time to examine your retirement savings plan (if you haven’t already). If you have a 401(k) plan at work, you may want to begin or continue to put a portion of your income into the 401(k) plan, especially since it allows immediate tax savings and tax-deferred growth on your investment within the account. Many financial advisors recommend maxing out your 401(k), but we have a different opinion.
A 401(k) itself is not an investment; it is essentially just an account that is regulated by the 401(k) section of the IRS tax code. If you have a 401(k) at work, you are able to contribute pre-tax dollars up to a certain limit ($17,500 for the year 2014). Furthermore, employers are allowed to match some or all of the contributions you make. For example, your employer may have a matching program in which they match your contributions dollar-for-dollar up to 3% of your gross income. Here’s an example of what that would look like if you earned $4,000 per month.
401(k) Contribution Example
- Your monthly gross income = $4,000
- You contribute $200 per month, or 5% of your income, to the 401(k)
- Your employer matches and contributes the max of 3% of your income, or $120
- Total employee and employer contributions for the month = $320
- Instant return on your money due to the match = 60% (a.k.a. ‘Free Money’)
Earlier we mentioned that most financial advisors recommend maxing out your 401(k). We suggest contributing enough to get the full employer match, but seriously consider other financial products for the rest of your retirement savings. Here’s why.
Remember that when you contribute to a 401(k), you do not have to pay income taxes on your contributions. The taxes are deferred until you reach retirement and begin taking distributions from the 401(k). This is great when it comes to tax savings, but not so great when it comes to control over your money. You see, a 401(k) is completely government-controlled. Try to collateralize your 401(k), and you will get laughed out of the bank. You may have $150,000 in your 401(k) now, but since you have not paid the taxes on this amount yet, you can not use it as collateral (unlike most other assets you own). And since the U.S. federal government is on a collision course with bankruptcy our country, it may be wise to think twice about placing most or all of your retirement savings into a government-controlled asset like a 401(k).
Before proceeding to the next step, be sure that you:
|– Continue your systematic savings plan, ideally saving 15% each month.||– Place your investment dollars into various asset classes, not just stocks and bonds.||– Think twice about contributing in excess of the employer match on your 401(k).|
When you have examined this step, you are now ready to advance to the next step of Level Four which is to Remember P.A.C.E. for Inflation Protection.