Anya Kamenetz Generation Debt

How much do you really know about what to do with your money?

Recently, a reader named Dave left this comment on my blog:

"I have tried asking for advice through other sites like Forbes and Vanguard, but it is all so confusing to me. I have money to invest; I just don't know how to invest it. With all of the fees and gimmicks, it is very frustrating. I know I need to get into stocks to get the max return, but I just can't make the distinction between mutual funds and that sort of thing. Any advice would be great."

I decided to write this column on my own approach to investing as a primer for readers like Dave, and a refresher course for those who may have gotten started with their investment planning already.

Saving, retirement planning, and speculation are three very distinct categories that are often lumped together under the heading "investments," which can be extremely confusing.

First, it's important to understand that you can't bury your money under your mattress; if you do this, inflation will destroy its value over time.

That leaves paying down debt; spending on necessary or elective depreciating assets such as food, clothing, and entertainment; and the three options above: saving, retirement planning, and speculation.

For the sake of this column, let's say that you've managed to pay down your high-interest debt -- such as credit cards -- and you manage your expenses well enough to reserve 10 percent or 15 percent of your income each month. Now we can cover what you are going to do with that reserved money in order to live with financial security both now and in the future.

First, there's saving. Saving means putting your money in a very safe vehicle such as a savings account, a money-market account, or a CD (certificate of deposit). With the majority of these ultra-safe vehicles, the rate of return is barely above inflation -- currently an average of 3.08 percent for a six-month CD on Bankrate.com.

Everyone must save. If you're just starting to put away money, you should aim to build up an emergency fund totaling three to six months' expenses. On top of that, you should have a dream fund for planned expenses such as a house, car, vacation, wedding, or baby -- whatever is in your one-year and five-year plans.

Next, there's retirement planning. This is the investment activity I'm going to spend the most time on because it's what people tend to need the most help with.

Everyone needs to plan for his or her own retirement, and most people don't start soon enough or save enough. Here's where members of Generation Debt can be savvy. If you start in your 20s, you can get away with saving just 5 percent of your income and be fairly well set when it's time to retire. If you're starting in your 40s, you'll be shoveling in 30 to 40 percent of your income just to make it to the finish line in decent shape.

Retirement planning should start with the money set aside from your salary in a tax-deferred retirement account: a 401(k) or 403(b) if your employer provides them, or an IRA if they don't. With those contributions, you will mostly want to buy a balanced portfolio of stocks. A good retirement plan is defined by reasonable, targeted long-term returns in the 7 percent range, similar to the rate of growth of the stock market as a whole.

You should try to diversify the funds in that account as much as possible while keeping your costs as low as you can (partly by keeping transactions to a minimum). And you need to take a long-term view.

To keep down your expenses, look for no-load, low-cost mutual funds. When you look up a fund, a number called the "expense ratio" tells you how expensive it is in terms of fees and commissions compared to other funds. The average expense ratio is over 1 percent, while an index fund can be as low as 0.02 percent. This article tells you more about fund expenses.

Speculating is the riskiest type of investment, and it has no place in retirement planning. You are speculating, not planning for retirement, if you're taking advice from Jim Cramer's "Mad Money", trying to maximize your returns into the double digits by choosing particular stocks, and timing the market so that you can buy low and sell high. Another activity that falls under the category of speculation is buying a house in order to "flip" it.

Most individuals find it very difficult to beat the market by speculating. If you want to try it for fun, after you've maxed out your retirement contributions, that's fine. But if you are really that good at doing research on individual companies or predicting what the economy is going to do, do what Cramer did: Go into finance for a living.

Get Good Sources of Information

Two-thirds to three-fourths of the information you will find on Yahoo! Finance, on CNBC, and similar resources about "investing" is really about speculating. That's because it's exciting for financial journalists to cover "stocks everyone is talking about" or the daily ups and downs of the market. But this won't help your long-term retirement-planning strategy.

The big brokerage firms like Fidelity and Vanguard offer some great information on retirement planning, but remember that their income depends on fees and commissions, so you have to be vigilant in seeking out the lowest-cost investment options on their sites.

That leaves folks who specialize in personal finance, which is distinct from investing. We all have our own personal philosophies and agendas, so it's good to read as widely as possible and compare to find an approach that sounds good. As a rule of thumb, don't pay attention to anyone who promises to make you rich.

I like Henry Blodget's "Wall Street Self Defense Manual" (you can read about his approach here in Slate). He was once on the dark side, disgraced and banned from the securities biz for playing a part in pumping the biggest stock bubble in history, but in his new, reformed life, Blodget gives solid advice.

This recent "New York Times" article about top Yale investor David Swensen's book, "Unconventional Success: A Fundamental Approach to Personal Investment", contains some good information as well.

So, you have maxed out your contributions to a 401(k). Now what?

Buying and holding a low-cost index stock fund such as Fidelity's Spartan 500 is the easiest way to capture returns close to the overall market return of 7 percent to 10 percent. The 500 refers to the 500-stock average; owning this fund is like owning the whole stock market.

If you want to diversify beyond owning a U.S. stock index, two good places to look are foreign stock markets and real estate. Most of the value of the world's markets is outside the U.S., but most American investors keep the majority of their money inside the country. Right now I have about a third of my retirement money in foreign stock indexes.

You can also invest in real estate. Such investing could mean buying a home or other property, especially if you plan to live in it as well. But you can also invest in a REIT, or Real Estate Investment Trust. With a REIT, you are owning a piece of a bunch of properties, similar to a mutual fund of stocks. That way, you're not gambling on the rise or fall of one particular real estate market. Check out the Vanguard REIT Index Fund.

Every time you make a trade, you pay commissions and fees, and when you sell an investment, you pay capital gains taxes on any income from that sale. Over the long run, these costs can eat heavily into your returns. So save more money and add to your investment mix over time, but don't make rash decisions based on short-term changes in the market. Remember -- if you're a young investor, time is on your side.