If you’re a small business entrepreneur or solopreneur and wondering what to do with the amount of money left over from your income after you’ve covered personal and tax expenses, this is a great time to consider strategies to manage your savings and investments. As Australian personal finance guru, Noel Whittaker, says: “Those who put an investment program in place will have a lot more money when they come to retire, than those who never get around to it.”
Here are several options for entrepreneurs to save and invest money from their business.
Active vs. Passive Investment
For your savings and investments, you have the option of managing them actively or passively.
- Active: An active investment is anything that will require more hands-on work by you or someone else to manage the investment. Examples include investing in real estate to lease to tenants, making your own stock picks through intensive research procedures, etc.
- Passive: A passive investment is something that does not require more hands-on work, and usually allows the money to work for you. Examples include investing in index funds or investing in a variety of individual fixed income vehicles, such as P2P portfolios, CDs, annuities, etc.
Do You Really Need a Financial Advisor?
While traditional advice would have you consulting a financial advisor to manage your investments, many people today are managing their own investments without the use of a financial advisor due to the vast amount of information available as well as more cost effective/efficient do it yourself investment options.
“The reason so many financial advisors are called brokers is because they are often broker than you are,” says “Rich Dad, Poor Dad” author Robert Kiyosaki.
You can easily create your own diversified investment portfolio through minimal effort. Here’s an example of a portfolio consisting of a stock mutual fund, bond mutual fund, individual fixed income ladder, and emergency cash:
- You can put a portion of your monies into a Vanguard S&P Index Mutual Fund (Index funds, as opposed to actively managed funds, are a good option for beginning investors and those saving for retirement because they usually have lower expense ratios.)
- You can put a portion of your monies into a Vanguard Total Bond Market Index Fund
- You can put a portion of your monies into a CD Laddered Portfolio or P2P Laddered Portfolio
- Then you can store a portion of your monies in a savings account that will be used to cover emergencies. This storage should be designed to cover around six to 24 months of emergencies.
The amount you allocate to each investment depends on your comprehension of investment risks, your individual risk tolerance, and sometimes even your age. Vanguard offers a great tool to lookup and compare different funds, their past performance, and well as the risk potential of the fund.
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Understanding the Main Investment Risks
All investments carry risks, and there’s no such thing as a risk-free investment. So it’s up to you as an individual investor to determine which risks you are willing to tolerate. Here are some of the major risks to consider:
- Inflation Risk – This is risk related to the loss of purchasing power through inflation. Every month the Bureau of Labor Statistics will release the latest inflation rates based on the current Consumer Price Index. “Inflation is taxation without legislation,” as the late economist Milton Friedman said.
- Systematic Risk – This is risk related to stock market volatility where a stock’s price can decrease over both short and long periods of time.
- Unsystematic Risk – This is risk related to an individual issuer of a stock or fixed income investment going bankrupt. This can be mitigated through spreading out your investment dollars among many individual investments—known as diversification—as well as putting a portion of your funds into investments that come with built-in insurance protection against losses, such as FDIC-Insured CDs and annuities, which are backed by Insurance Guaranty Associations.
- Interest Rate Risk – This is risk related to Central Bankers changing interest rates, which could cause the value of some types of fixed income investments, such as a bonds, to decline. Now if you buy individual bonds and hold to maturity, value losses have no real effect on your holdings, but there’s a chance of a loss of purchasing power if the average inflation rate over the term of the individual bonds is higher than the coupon rate (interest rate being paid). Bond mutual funds, however,rise or fall in value due to changes in interest rate policies that are set by Central Bankers like The Federal Reserve.
- Credit Risk – This is risk measured by bond rating agencies such as Standard & Poor (S&P), that provide the likelihood that an issuer of a bond will be able to make the expected principal and interest payments of the bond term. Ratings that are BBB and above are considered to be the lowest risk (“investment grade”).
Know Your Risk Tolerance
Although traditional wisdom will tell you to put your “age” in fixed income investments such as bonds and then put the rest in stocks, my recommendation is to base your investment allocation on your own individual risk tolerance. For example, some people cannot stomach systematic risk (stock market volatility) and end up selling their holdings during bear cycles when they should in fact be focused on buy/hold strategies. This could cause massive investment losses and it would be much better for an individual who can’t handle stock market volatility to invest more of their funds in fixed income investments.
Efficient Saving and Investing
Using a hypothetical person known as Bill, who is a 28-year-old single male, with no debt and no children, here’s how his savings and investment plan could work out from age 28 until retirement.
Income, Expenses, and Taxes
- You can’t efficiently save and invest if you don’t make enough money and, manage your expenses responsibly so you have a good amount of the money leftover for savings and investments.
- In our example, Bill makes $60,000 a year and manages his personal expenses efficiently to where he lives below his means in a low cost of living area. Bill’s personal expenses are about $30,000 a year and he manages his taxes efficiently to where his effective tax rate is 12%. After paying personal and tax expenses, Bill has just over $22,000 remaining to put in savings/investments.
Savings and Investments
- For year one, Bill decides to build up his emergency savings with $15,000 to cover six months of expenses, then he opens his Vanguard S&P Index Fund with $4,000 and opens his Vanguard Total Bond Index Fund with $3,000.
- For year two until Bill turns 65, assuming income and personal/tax expenses leave him with the same $22,000 available for savings and investments, Bill puts the entire $22,000 into investments as his emergency savings “should be” already built up efficiently.
- So he adds $15,000 to his S&P Index Fund and $7,000 to his Total Bond Market Index Fund every year for 36 years until he turns age 65.
- At this savings rate, by age 65, with a compound annual growth rate of 5% on the index fund investments, Bill’s investments will be worth $2.4 million. Bill could then move the entire $2.4 million into multiple FDIC-Insured CD accounts at various banks, paying 2.3% per year in interest, which is $55,200 a year. On top of this, Bill will receive Social Security retirement benefits that might average around $17,000 per year. In total, this gives Bill $72,200 per year before taxes, which makes for an excellent retirement!
While Bill’s income and personal/tax expenses are likely to change over the 37-year period—due to temporary unemployment, inflation, tax hikes, emergencies, health issues, if he starts a family, or if he gets married and goes through a financially challenging divorce—this example allows one to see the power of having a savings and investment program. As a small business owner, it’s imperative that you set up an efficient savings and investment plan to help your retirement become more secure.