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This program last aired Oct. 30, 2014.
NEW YORK (TheStreet) -- Sometimes we need to "take a step back and talk about the big picture," Jim Cramer told his Mad Money viewers as he dedicated tonight's show to helping them improve their financial life as well as managing their money.
"Sometimes that means we need to take a deep breath, step back from the day-to-day nitty gritty of the market, and focus on the educational side of things, what I call Investing 101," Cramer said.
It’s pretty hard to invest if you don’t save any money to start with, Cramer said. Without savings, we’re hostage to Social Security, and nobody wants that. But by investing part of your savings in the stock market, investors can increase their wealth dramatically.
Eventually, by saving and investing your money, you’ll find the path to “real financial independence,” he said.
So where exactly should investors put their money? Cramer says investors should save 10% to 15% of their income and put half to two-thirds of those funds in a tax-sheltered retirement account. The rest of the funds should be put into a low-cost online brokerage account.
Investors should use their retirement accounts for lower-risk investments and use their standard brokerage account for taking larger risks. Younger people under the age of 30 can afford to take more risk, he added.
“You should have a retirement portfolio to make sure you’ve got enough money once you stop working,” Cramer said, “and you should also have a discretionary portfolio, where you can take more risks and use your gains to have some fun before you turn 65.”
Where to Begin?
Now that we’ve decided to take the plunge into the investment world, where should we begin? Cramer said investors should avoid individual stocks until they have at least $10,000. Until then, investors should put their money to work in a cheap index fund that tracks the
, such as the
Vanguard Five Hundred Index Fund
If investors aren’t willing to do the homework of owning individual stocks -- which includes reading the company’s SEC filings, reading the earnings reports and listening to the conference calls -- then they should stay invested in mutual funds.
But if they are willing to do the homework and invest in individual stocks, investors need to remember to stay diversified, he said.
“I believe that a diversified portfolio of five to 10 individual stocks is the best way to go,” Cramer advised. No position or sector should take up more than 20% of an investor’s portfolio.
On the flip side, investors should try to limit their holdings to no more than 10 stocks. Beyond that, it’s unlikely that investors will be able to do the necessary homework to stay on top of each company’s operations, Cramer reasoned.
“You also have to research the company’s sector,” he stressed, “then compare the stock to its competitors to see if its valuation make sense.”
Again, for those who can’t commit to investing in individual stocks, “keeping your money in an index fund that mirrors the S&P 500 is a perfectly reasonable way to go,” Cramer reminded his viewers.
Assuming investors are willing to take on the challenge of investing in individual stocks, they’ll have to consider the company’s valuation, Cramer said.
“Never judge a stock by its dollar price,” he advised. “Judge stocks by their price-to-earnings multiple.”
The price-to-earnings ratio, or P/E, is simply the price of the stock divided by the company earnings. But Cramer reminded investors to use the earnings estimates for the next year, not the past year’s worth of earnings.
“Valuing stocks is all about the future, not the past,” he reasoned. “That’s what the major institutions are looking at.”
Investors can use the P/E ratio to compare different stocks to each other. Unfortunately, this metric does not give investors enough information to assess a stock’s value, Cramer said. That’s why investors also need to study the company’s growth rate.
“The growth rate is definitely the most important factor,” he said, advising investors to use to the PEG ratio. As a rule of thumb, investors shouldn’t pay more than two times a company’s growth rate. In other words, avoid stocks with a PEG larger than 2. A cheap stock is one that has a PEG reading below 1.
Many times these stocks may be value traps. But sometimes “you see a high quality company selling for less than one times its growth rate,” he said. “Then you might just have a terrific long-term opportunity.”
Remember the Cash
and deciding how much to invest, don’t forget about cash.
According to Cramer, cash is something every investor should have in their portfolio. At times it can be the most important component in an investor’s portfolio, although he wouldn’t go as far as to call cash “king.”
“Being fully invested is something you should almost never do,” he stressed, and investors should never, ever be using margin. “Using margin is the height of arrogance and it’s bound to get you in trouble, so don’t do it.”
Cramer said he always keeps at least 5% of the Action Alerts PLUS portfolio holdings in cash. Investors should even considering keeping 10% or more of their holdings in cash, if a rally feels particularly over-extended.
Although it may seem counterintuitive, the higher the stock market goes, the more cash investors should keep on the sideline.
“You need to have cash in your portfolio if you’re going to take advantage of pullback in the market,” Cramer reasoned, “and there will always be pullbacks.”
The one exception when investors can justify using most, if not all of their cash reserves, is when the S&P 500 declines by 10%. Remember to buy low and sell high, he reminded his viewers.
The Tax Man Cometh
So while investors are concerned about doing their homework, measuring stock valuations and eyeing economic conditions, one thing they shouldn’t be overly concerned about is the tax bill.
Long-term capital gains are paid on stocks that are held for more than one year and are taxed at a 15% rate for most people. Short-term capital gains are paid on stocks that are held for less than one year and are taxed as ordinary income — which can be at a rate as high as 39.6%.
And although an investor’s tax bill can be cut in half, and sometimes more, depending on how long they hold a stock, they shouldn’t put too much thought into timing their stock sales in regards to the tax implications, Cramer said.
“It’s okay to pay the taxes,” he reasoned. “You should never keep holding a stock that could have an iffy future just so you can avoid paying the higher, short-term capital gains rate.”
After all, it’s better to have a big tax bill on a big short-term capital gain than it is to have a small tax bill on a small long-term capital gain — or worse yet, a loss.
Holding a stock for over a year to get that lower tax bill is simply “bad investing,” he explained.
It’s hard enough to do everything else in investing, so we don’t need to add another step to the whole process, Cramer stressed. “It’s okay to pay the tax man. It’s a sin to give up your gains.”
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At the time of publication, Cramer's Action Alerts PLUS had no position in stocks mentioned.