Eddie Murphy and Dan Akroyd would tell you to corner the market in FCOJ (Frozen Concentrated Orange Juice) just like they did in the classic comedy: Trading Places.For the average investor there is somewhat defined, but often argued, "waterfall" of how one should invest their precious greenbacks. It's called a waterfall because as the cash fills up one category it then "falls" down to the next category, and so on...
The "Investment Waterfall" that I follow is shown below:
1. 6 - 9 Months worth of all family living expenses/bills in a high yield savings account such as E*Trade, ING Direct, etc. (No more then $100k per account to ensure you money is federally insured by the FDIC!)
WHY: No matter how strong you think your company is, or how secure you think your job is, you simply cannot predict the future! (See: "And Igby (Lehman) Goes Down!" article). You may need this cash while you look for a new job, and it may take this long (or more) to find one.
2. 401k: Contribute as much as your employer will match!
WHY: You simply cannot turn away free money, and it will grow tax free in the account.
3. Pay down credit card debt with interest rates exceeding 5%.
WHY: Over time the stock market averages 10% to 12% annual nominal growth. Subtract 3% inflation from this growth rate and you are averaging 7% to 9% net annual growth.
If you earn 7% to 9% growth, it will also be taxed, so you'll end up with say 5% to 7% in earnings.
Therefore, you should be indifferent between paying down debt costing you 7% versus earning a nominal 10% to 12% in stocks - either way you are achieving about the same return.
That said, I personally have a disposition toward paying off all non-investment related debt very rapidly (Investment Debt includes debt for a home loan or college loan which are an investment in real estate or an investment in an education that should result in stronger earning power. The key here is that these are appreciating assets, so a car loan does not count!!!)
4. Roth IRA: Max it out for the year.
WHY:
a. These are after tax contributions, so the investments will grow tax free!
b. You may withdrawal your contributions (not the earnings) for certain qualifying purchases / uses (e.g. - home purchase)
c. Tax rates (believe it or not) are at historical lows and chances are good that taxes will be higher in the future when you withdraw the cash.
5. 401k: Max out your 401k after your Roth IRA.
WHY:
a. This will reduce your annual tax liability.
b. The earnings on your contributions will grow tax free!
6. Traditional Brokerage Account Investments or Real Estate.
WHY: A traditional brokerage investment account is good to keep your investments liquid (can easily be converted to cash). Real estate is another good investment (despite the bad news in the market) if purchased in the right location, at the right price. The interest expense on the loan is tax deductible among other perks.
7. Start your own business!
WHY: More millionaires make their fortunes by taking calculated risks and starting their own businesses then any other job category - even more then doctors, lawyers, and Ph.D's!
So those are the basics of the investment waterfall. I haven't advised what to invest in within these accounts, just the types of accounts to consider.
Also: If you can't sleep at night because you are going to be worried about outstanding debt, then pay it down! Even though "the math" doesn't make complete sense, this is about securing your future - both financially and mentally!
Let me know if you disagree or have any questions!
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