I was reading another personal finance book this weekend, The Coffeehouse Investor, and it was a pretty good find. The Coffeehouse Investor has been a popular book for a few years. Schultheis shared his expertise as a stock broker and wrote a guide to help people invest wisely. Now Mr. Schultheis has updated his book and added four new chapters to his guide.

Check out the The New Coffeehouse Investor.

If you are looking at investing and want a book to get your started and give you advice with a winning track record, then you should add this to your list. I’m going to review just some of the chapters to give you an idea on the book’s content and style. It’s not a thick book and the author mixes life stories along with data to keep it interesting.

Introduction

In the preface, Schultheis start off  with sharing his 3 fundamental principles of investing:

1. Don’t put all your eggs in one basket.
2. There is no such thing as a free lunch.
3. Save for a rainy day.

As you go through the book, you’ll see the numbers and data behind his principles.

The Coffeehouse Investor

Schultheis presents examples of how the transaction obsessed many brokers are Wall street are and how people can hurt themselves by following it.

An interesting fact I found was less than 10% of millionaires think of themselves as active traders, and a whopping 42% of millionaires in America makes less than 1 transaction per year for their portfolios.

This Thing Called Risk

Making a case for investing in the stock market, Schultheis provides data on returns from 1926-2008. Looking at one-year, five-year, and ten-year returns, the author shows how long term investing is not as risky as some imagine. The problem becomes when people think in more short term time frames.

Approximating the Stock Market Average

Schultheis lays some hard numbers out on how investing in individual stocks and actively managed mutual doesn’t lead to wealth as advertised. Did you know that only 36% of all managed funds beat the stock market’s average within the last 3 year period? Ramit Sethi also remarked how ineffective many mutual fund managers have been with their returns.

My Thoughts

If you’re just getting started with investing or need a guide to point you in the right direction, this a solid book. You’re going to find some useful information like:

• Finding an asset allocation for your retirement portfolio
• Indexing the Stock Market
• Figuring out how much to set aside for saving

The New Coffeehouse Investor Contest

I have an extra copy of  The New Coffeehouse Investor to give away to a reader. Just leave one comment on this blog post about why you’d like to win this book. I’ll pick the winner this Thursday evening around 6pm EST.

Rules

• You can only enter once.
• You must be a resident of the U.S. or Canada

How Powerful Is Compound Interest?

Albert Einstein is rumored to have said “the most powerful force in the universe is compound interest”. That is an incredible statement for anyone to make, especially the Nobel Prize winning physicist who developed the theory of relativity! Obviously, compound interest is very important to understand, and even more so because it directly affects you nearly every day.

How Does It Work?

Compound interest is relatively easy to understand. The concept starts with the principle that you have money ($1,000) which is earning interest (10%) each year. So the first year, you earn $100 in interest. However, the next year, you do not earn another $100—you earn $110.

This is because your 10% interest is applied to both your initial principle and the interest you received. Thus, as time continues, your interest each year grows larger and larger because it is compounding on top of itself.

Returning to our earlier example, after a little more than 7 years, you will have earned $1,000 in interest—doubling your original investment without having to do anything. If you wait another 7 years, your balance will be over $3,750—a 250% return on your initial investment.

Compound interest is best explained visually. This chart continues our example of an initial deposit of $1,000 growing at 10% a year. As you can see, after 50 years the money has grown to just over $117,000—an unbelievable 11,639% total return on your $1,000, or roughly 233% average annual return.

Make Compound Interest Work For You

The two most important factors for obtaining the benefit of compound interest are the interest rate and the length of time your money earns interest. The latter is the most important; your investment will grow slowly at first, but over the long term you will see dramatic improvements.

Since time is the most important factor of compound interest, you must not put off planning your investments or retirement—this is especially true for young people who are decades away from retirement. While 40 years is a long time, the best time to start saving and investing is now in order to let compound interest work for you. Over time, you can make compound interest work for you.

Silicon Valley Blogger points out how you can keep compounding interest working in your favor:

• You make consistent contributions to your investments, thus continually growing your nest egg.
• You live below your means.
• You don’t get tempted into spending money as fast as it grows.
• You don’t live in an area with an absurd cost of living.

Compound Interest’s Effect on Debt

It is important to remember that while compound interest is very powerful over the long term and can help you retire in style, it can also work against you. Interest works against you every time you take out a loan or have some sort of debt. The higher the interest rate, the faster the debt grows. Luckily, the effect isn’t quite as powerful if you are able to make payments on the loans, because the balance is decreasing.

Paying Down Your Mortgage Faster Can Be a Smart Move

While the negative effect may not be as powerful, interest expenses on debt can often add up to more than the value of the loan. For example, let’s assume you take out a typical 30-year mortgage for $150,000 at a 6% annual interest rate. By the end of the loan, you will have paid a total of $323,758.80—some quick math shows us that the interest paid on the loan was $173,758.80—more than the entire amount of the loan! It cannot be overstated how important it is to find the best interest rate on your loan in order to keep your interest expenses low.

Paying off your mortgage earlier may be a smart move. You’d be making what’s called  principal pre-payment. If you have a 30 year mortgage, you can save thousands by making extra payments. One of the best ways to keep yourself on the plan is automating your extra mortgage payment with your bank.

What Should You Do?

Be sure that you allow compound interest to work in your favor by saving now and investing for the long-term. If you keep focused on your goal of long-term financial security you can ensure a great financial future.

Guest Post Author: Jonathan is blogger who wants to help others get out of debt. He currently writes at Debt Loans.

Since I spoke a bit about my Roth IRA, I want to share my asset allocation to give you an idea of how the money is distributed.

What is asset allocation?

Asset allocation is your plan for your investment contributions. Are you going to put it in stocks, mutual funds, bonds, ETFs, etc?

Whatever choice you make, there is a risk involved. Stocks tend to preform well in the long run, but there is the risk of volatility. Bonds offer less risk in volatility but you also tend to get a smaller return.

Why is asset allocation important?

According to Financial Analysts Journal, asset allocation is huge factor in a fund’s variability. A benefit of having the proper asset allocation is to fit your goal of aggressive growth in the long term, stability of your money in the short term (for people retiring soon), or somewhere in between.

If you’re retiring in a few years, don’t keep most of your investments in stock. You should be focused on stability as you’re planning on withdrawing the money and living off of it for a couple of decades.

My Roth IRA’s Asset Allocation

I started setting aside money for retirement when I was 21. Unfortunately when I switched jobs, instead of rolling it over, I foolishly cashed it out. I started again and opened up an IRA.

After learning about the advantages of Roth IRAs, I moved my money into one. Right now, here’s what the asset allocation is:

I currently have my IRA at Sharebuilder. If you’re looking for a place to open up an IRA, here are some places to consider:

• E-Trade (Annual fee and minimum are waived when you sign up for electronic statements)
• Vanguard (Some funds require $3,000 minimum)
• T. Rowe Price
• Charles Schwab ($1,000 minimum is waived if you direct deposit $100/month)
• Zecco( No minimum to open; $30 annual fee)

I’m trying to adjust it to following a bit more of the David Swensen’s investment portfolio model. I use a mix of index funds and some ETFs in my Roth IRA.

My general guideline for my Roth IRA.

Chart: NPR

I’m going to direct future contributions to base it around the Swensen model, even though I may keep less bonds than what he suggests.

Just remember, the sooner you start saving for retirement, the better compound interest will treat you.

Ask Reader’s Thoughts

What’s your allocation for your investment account? How did you decide on them? Any tips or suggestions?

My Retirement Account Update 

It’s been a while since I shared how my Roth IRA was doing. I checked my retirement account in October 2008 and shared how it went down over 20%. That certainly stung, but I didn’t withdraw money in reaction to the market. 

Since I’m investing for the long term, I realize that sometimes you have to accept the losses.

I’m happy to say things can climbing back up slowly. Here’s a screenshot from Mint of my Roth IRA’s returns for the last 6 months:

It looks good, but I’m anticipating more ups and downs with this market as I invest for retirement. 

Talking a bit more about the fluctuating returns of the stock market, here’s some information from Behaviorial Gap on the average returns from the stock market:

Having an individual retirement account (IRA) can help you get started with retirement. Retirement planning is usually one of the furthest things on the minds of college students and new graduates. However, it’s a lot easier than many people think.

Individual retirement accounts allow you to easily set aside money for your retirement with some tax benefits.

What is the difference between a Roth IRA and a Traditional IRA?

Wikipedia defines Traditional and Roth individual retirement accounts:

• Roth IRA – contributions are made with after-tax assets, all transactions within the IRA have no tax impact, and withdrawals are usually tax-free. Named for Senator William Roth.
• Traditional IRA – contributions are often tax-deductible (often simplified as “money is deposited before tax” or “contributions are made with pre-tax assets”), all transactions and earnings within the IRA have no tax impact, and withdrawals at retirement are taxed as income.

As you can see, Roth IRA withdrawals are tax free while traditional IRA withdrawals are taxed.

How much can you contribute your Roth IRA?

The IRS has specific income limits with contributing to Roth IRAs. Right now you can contribute $5,000/year to a Roth IRA if your modified AGI is :

• $169,000 for married filing jointly or qualifying widow(er),
• $116,000 for single, head of household, or married filing separately and you did not live with your spouse at any time during the year, and
• $10,000 for married filing separately and you lived with your spouse at any time during the year.

How much can you contribute your traditional IRA?

Traditional IRAs have a different income limits with contributions. Right now you can contribute $5,000/year to a traditional IRA if your modified AGI is :

• More than $85,000 but less than $105,000 for a married couple filing a joint return or a qualifyingwidow(er),
• More than $53,000 but less than $63,000 for a single individual or head of household,
• Less than $10,000 for a married individual filing a separate return.

Where can you open an IRA?

The good news is many banks, brokerages, and credit unions offer both traditional and Roth IRAs. Some charge a flat fee for the year, some take a fee for each transaction made, others can take a percentage, and some do all of this.

The idea is to keep your fees as low as possible and get the best performance.

Some online options for opening an IRA:

• E-Trade (Annual fee and minimum are waived when you sign up for electronic statements)
• Vanguard (Some funds require $3,000 minimum)
• T. Rowe Price
• Charles Schwab ($1,000 minimum is waived if you direct deposit $100/month)
• Sharebuilder (No minimum to open; no admin annual fee)
• Zecco( No minimum to open; $30 annual fee)

The sooner you start the better. It’s generally accepted that the sooner you start the better compound interest will treat you.

More Information on Individual Retirement Accounts

• Which IRA is the Best Deal? (Get Rich Slowly)
• The world’s easiest guide to understanding retirement accounts (I Will Teach You to Be Rich)
• Save Now, Retire Rich (Free Money Finance)
• How Much Money Do You Need For Retirement? (The Simple Dollar)
• Determine your Retirement Needs in 3 Easy Steps (Moolanomy)