Building a Safety Net for your Children


img_0131Today the news is full of stories of children returning home to stay after college.  The recession certainly made it difficult for some to find jobs, but the recession has been over for a number of years, yet adult children are still sticking around.  In some cases perhaps parents may be making their homes a little too comfortable. With few rules, no expenses and no responsibility, who wouldn’t want to stay?  At some point it becomes enabling, which is a curse, not a blessing for the child.

But if you think about it, stepping out into the world with just the clothes on your back is pretty scary and very risky.  You have no room for error, since you have no safety net there to catch you if you lose a job or just have an unexpected expense.    Many families also don’t talk about money, which leaves young adults needing to figure things out for themselves with no training.  Unfortunately, many kids today seem to think they can step into their parent’s lifestyle immediately, not realizing all of the work and time it took for their parents to be where they are.  By starting children out early learning about saving and investing, and by giving them a little nest egg with which to start, you can dramatically reduce the chances that they will be knocking on your door, duffel bag in hand after college.  Without another safety net, Mom and Dad become the safety net by default.

Starting an investment fund can be very quick and easy, especially if you use index mutual funds.  If you start a fund about the time the kids are born, add to it as they get those checks from relatives early on, and then match their contributions once they start to earn their own money, you can build up a substantial fund by the time they leave the house.  This is money they can then use when they have the unexpected expenses that always occur instead of running up credit card debt.  It can also provide rent payments for a couple of months after a job loss.

The first step in building this safety net is to find a fund family with a low enough minimum to allow you to open the account using the free cash flow that you have.  I personally like Vanguard because their funds have very low expenses and the minimums for many of them are only a few  thousand dollars.

In selecting which fund to buy, you are looking for a fund that invests in a large number of stocks over a broad range of the market.  Good choices would be a largecap fund such as an S&P500 fund or a midcap or smallcap fund.  Selecting specific sector funds or ETFs is probably not a good idea since you want something you can hold for years rather than needing to move in and out of it, incurring capital gains taxes.

Once you have selected a fund, simply create a custodial account in the child’s name and send in a check.  As time passes, add extra money to the fund.  You should avoid the temptation to make many if any changes or move money from fund-to-fund or into and out of a fund.  You want to minimize expenses and taxes, plus you might be in cash right when the market makes a big move up if you try to time the markets.  Just let it grow with the economy.  If you need to do something, wait for dips and buy more shares.

Once the fund has grown large enough, you should consider selling part and using the proceeds to buy another fund in a different sector of the market.  For example, if you’ve amassed $15,000 in a large cap fund, you may want to sell half and buy a small cap fund with the proceeds.  This diversification will reduce the risk of losses and smooth out the fluctuations that occur.  In general, different sectors of the market do well at different times.

Note that capital gains and dividends will be tax-free below a threshold amount, but be sure to check with your accountant on what those minimums are in any given year.  They are generally less for investment income than earned income.  You may also need to file tax returns in some years if the income is large enough even when they haven’t made enough to pay taxes.  Payment of quarterly estimates may also be required.  Minimization of trading, and thereby the realization of gains, will delay the time at which you will need to start preparing tax returns for their accounts.

Once the child reaches 18, the money will be theirs (you have no say over this).  You therefore should be teaching them the importance of managing the money so that it grows by leaving the principle alone and just spending a portion of the interest/dividends.  You can perhaps let them spend a small portion of the profits, but allow the rest to be reinvested and grow the account, so that they can see that their income will increase each year this way.    Explain that if they start spending the principal, the income they can receive will decline and eventually the money will be all gone.  Also teach them along the way that the money is there to help them in emergencies, such as when the car breaks down, and not just for day-to-day expenses.  Talk about what would happen if they had an emergency but had no money available, versus what would happen if they keep money aside.  Explain that going into debt means that they will be working extra hours just to pay interest rather than getting money from investments without needing to work for it.

Even given the best advice. they may make mistakes while they are young and foolish.  Think about holding a bit of money back and giving it to them when they are a bit older.  In this way you can give them a second chance should they fail the first time.

By giving your children a nest egg with which to start their lives, you can help keep them out of debt, help them have a down payment for a house when they are ready, and be able to stay out on their own between jobs and other issues. You will also give them an extra source of income that they can use throughout their lives.

Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How is Your Stock Picking Working? How to Measure Your Returns.


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Most people who’ve been trading stocks for a while think that they are excellent stock pickers.  They will have all sorts of stories of stocks that they bought and then turned around and made a quick profit.  Or maybe they have a stock or two that they’ve held for ten or twenty years where they have a 500% or even 1000% profit.  They forget about the losers they’ve had.  The stocks that went nowhere.

Really, if you honestly compare your returns to “the market,” many people will find that they would have been better off just investing in a set of mutual funds and following “the market” than they were investing on their own in individual stocks.  But how do you tell?

Well, one common way to judge your performance is to compare your returns against those of an appropriate index.  For example, if you were buying individual stocks, you might compare your progress against the returns of the S&P500 or S&P100 index.  If you were buying small stocks, you might compare your returns against the Russell 2000 index.  You could also compare your performance against the return of index funds, such as the Vanguard Total Stock Market Index fund or the Vanguard S&P500 Fund.

Of course, comparing year against year does not always give the clearest picture.  For example, here are the returns for the S&P 500 for the last five years, along with the returns for one of my accounts:

S&P 500:

Year Return
2016 8.02%
2015 -0.73%
2014 11.54%
2013 29.60%
2012 13.29%
2011 0.00%

 

My Account:

Date Return
2016 6.28%
2015 0.15%
2014 20.73%
2013 27.16%
2012 7.40%
2011 4.84%

Note, to calculate these returns, I just subtract the value at the start of the year from that at the end of the year, then divide the result by the value at the start of the year.

Looking at the returns together, you see that I beat the S&P500 in 2011, 2014, and 2015, but the S&P500 won out in 2012, 2013, and so far in 2016.  Should I have just invested in index funds, or is my stock picking actually doing something useful?  Well, let’s look at thing s a different way.  Let’s say that I invested $1.00 in the S&P500, and also invested $1.00 in my portfolio.  Here are the results:



S&P 500:

Year Return Value of $1 Invested
2016 8.02% $1.76
2015 -0.73% $1.63
2014 11.54% $1.64
2013 29.60% $1.47
2012 13.29% $1.13
2011 0.00% $1.00
Start of 2011 $1.00

My Account:

Date Return Value of $1 Invested
2016 6.28% $1.84
2015 0.15% $1.73
2014 20.73% $1.73
2013 27.16% $1.43
2012 7.40% $1.13
2011 4.84% $1.05
Start of 2011 $1.00

To calculate these results, I multiplied the value at the end of the previous year by one plus the return for the present year,  For example, the 2012 value is just:

($1.05)*(1+0.740) = $1.13.

Now it is clear that I’m beating the S&P500 over the period.  If you had invested $1.00 in the S&P500 at the start of 2011, you would have $1.76 now, where by investing in my portfolio over the same period,  you would have $1.84.  This isn’t much of a difference, but it does show that my efforts at least do mean something.  A lot of mutual fund managers do not beat the S&P500.  My values also include my brokerage costs and account fees, where the indexes include no fees.  It might be more fair to include representative fees in the indexes as well when doing your own comparison.

Another thing to consider is the time period over which you’re comparing.  My investing style, which I consider to be the only style worth doing if you’re picking stocks, is long-term investing.  I could not tell you which stocks will do better over a year or two, but I can do pretty well at picking stocks that will do well over five or ten years.  The fact that I beat the S&P500 in 2011 therefore meant little.  It was just good luck.  It also didn’t matter that the S&P500 did better than me in 2012.  Now that we have five years under our belts, however, we can start to make some real comparisons.  Comparisons at ten years would make even more difference, since that will allow my stock picks to really flourish, hopefully, and outpace the market in general.

But, wait a minute, you may say.  If you need to wait five or ten years to decide if what you’re doing is working, isn’t that a lot of time lost?  After all, you don’t want to go for 20 years, only to discover that you’re a bad stock picker and would have been better off in an S&P500 fund.  The answer is that you don’t need to choose one or the other.  Instead, put your 401k funds and a good portion of your taxable portfolio into index funds.  At the  same time, pick a few individual stocks that you think will shine over long periods of time, buy substantial quantities (acquiring 500 to 1000 shares over a period of time).  You will then be playing both sides.  If you’re a bad stock picker, your index funds will bail you out.  If you’re a good stock picker, your individual picks will add to the returns from your index funds, perhaps substantially if you catch something like the next Home Depot or Microsoft.  It doesn’t have to be an either-or proposition.

Questions?  Comments?  Let me know what’s on your mind by using the comment form below!

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

 

With Bond Investing, It’s About Income, Not Price


FireAlarmEveryone hates to lose money.  It’s not fun to look at your portfolio value and see that it has gone down.  Yet if you are investing in bonds for income, portfolio value really isn’t all that important.  What is important is income.

Before going further, let’s talk about what a bond is.  When a company (or government) needs money, they can get a loan from investors.  Unlike a consumer loan, where you are lent some amount of money and then pay it off over a number of years, companies issue bonds.  With a bond, the investor will be paid a fixed amount of money for a period of several years.  At the end of the period, the company then pays back the loan.

Normally corporate bonds are issued in $1,000 increments and have a period of ten to twenty years before maturation – when the loan is repaid.  The first investors pay $1,000 per bond, but then they are able to sell these bonds to other people for more or less than $1,000.  The price they are able to get depends on interest rates and how safe people think the bonds are.  If interest rates go up after the bond it issued, the price will decrease, and vice-versa.  In really low interest rate environments like today, bonds may actually sell for more than the maturation price ($1,000) because people are willing to lose money when the bond matures because the interest they will receive in the mean time is worth the loss at the end.  They might buy a bond for $11,000 that they know will be repaid at $1,000 in a few years.

If the company has great finances and is almost sure to repay the loan at the end, the price fo the bond will tend to also stay around $1,000.  If things get dicey, where the company may default on the bond, the price will decline.  People want to make sure the interest rate they receive is worth the risk of a default.  Because bonds pay a fixed amount of money each year, the effective interest rate you get for your investment goes up if the price you pay goes down.

So right now, interest rates ae very low and the Federal reserve is indicating that they may raise interest rates soon.  If that happens, the price of bonds is sure to go down, so the value of your bond portfolio may decline.  If you are speculating, planning to sell your portfolio in a year or two, you should be concerned.  If you are planning to hold on for a long time, such that the bonds in that portfolio will have time to mature, price fluctuations between now and maturity date won’t really matter – you’ll get $1,000 per bond when the bonds mature regardless of what happens to the price between now and then.

So if you’re investing in bonds, don’t worry about what happens to the value of the portfolio.  It will go up and down with interest rates.  In fact, if the value declines and you have some cash sitting around, you can buy more bonds at a discount.  You’ll then get a better interest rate plus a little gain at the end when the bonds mature.  Instead, just focus ont he income you are receiving.  So long as the income stream remains in place, the rest is just noise.

To ask a question, email vtsioriginal@yahoo.com or leave the question in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

 

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