Seven Personal Finance Principles to Teach your Children


img_0131Like it or not, you are the primary people who teach your children how to handle their money.  They are watching the choices you make and will likely replicate them, even if they act like you’re absolutely clueless on everything.  If you buy new cars on payments every two years, they will as well.  Buy a house you can’t afford and be home poor, and they’ll follow suit.  Some children may take the initiative and pick up a book on personal finance or two, meet someone else who is doing well with money and use them as a mentor, or maybe even follow The Small Investor and learn some good habits, but the majority will just follow Dad and Mom, both in how to handle money and even with who is the spender and who is the saver/budgettor.

To get your offspring out on the right path so that (maybe) they don’t come back in a few years, and hopefully they’ll be financially stable enough to take you in during your old age if needed, here are seven principles to teach them now:

1.  An emergency fund is key.  Having an emergency fund is what keeps you from going into debt when bad things happen.  Everyone should have about $5,000-6,000 in cash plus maybe another $3,000-$5,000 in an accessible bank CD to take care of emergencies that pop up and things like a job loss.   Otherwise, emergencies all goes onto the credit card or personal loan, and then the debt starts to build up.

2.  Pay cash for cars.  Buying new cars on credit will cost you a lot more over your lifetime than buying used cars for cash.  Not only do you pay interest, but you also lose lots of money to depreciation.  During the first four years you’ll lose twice as much per year for a new car as you will during the next four years.  Get your kids to save up and buy whatever they can for cash, moving up in car every four to eight years, and they’ll have enough to do things like save for their children’s college and save for retirement.

3.  Learn to cook.  The other big budget killer is eating out.  Learn to cook simple meals at home and you’ll save about $100 per day for a family of four.  Even a single will save $20-$30 per day by eating in.  For example, a single person could make seven meals out of a $6 chicken.

4.  Budget.  Some people think that a budget will be a constraint, but really it is just a way to make sure your money is going where you want it to.  In fact, many people who start a budget feel wealthier since the money they were spending without thought is now available to buy things they really want.   An important part of any budget is putting some of your money away into savings and investments.  Doing so increases your income later in life.

5.  Start an IRA or 401k.  While it’s hard to believe at 21, almost everyone will need to have money to retire some day.  If you start out putting money away right when you start your first job, it is a lot easier to amass as much as you need than it is if you wait until “you have the cash to save.”  Not only will it help you keep your lifestyle in check, but it will also allow your money to make money by investing in different businesses.  Even if it is only $25 per paycheck, teach your children to start putting money away right from the start.

6.  Work your way up in house.

Children may think that their parents just moved right into the McMansion they live in now.  Help your children to understand that most people start out in a small apartment, maybe with a couple of roommates, and probably go through one or two other apartments and small houses before they finally get to their dream home.  Renting a small place to start allows children to start to learn to live on their own and save up for a down payment. Buying a smaller home to start will reduce the percentage of their income that goes towards the mortgage, which will reduce their risk substantially and allow them to do other things like save for retirement.  Many people will also tell you that the days before they had the big house and all of the upkeep that goes with it were some of the happiest of their lives.

7.  Save short term, Invest long term.

If you really need the money to be there next year, it needs to be in cash assets like bank CDs and money market funds.  The price of stocks and bonds one year from now is totally unpredictable.  Hold assets in cash assets for a long period of time, however, and you’ll lose money to inflation, plus miss out on the opportunity to actually grow your money.  Money you will not need for ten or twenty years belongs invested in stocks, bonds, or real estate.

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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.

Should I Add Bonds to my 401k?


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Jeffery Bogle, founder of Vanguard mutual funds, is credited with what has been come to be known as the “Bogle rule,” which says that you should invest your age in bonds.   In other words, if you’re 25, you should have 25% of your investments in bonds and the other 75% in stocks.  If you’re fifty, you should be 50%-50%.  The idea is that as you get older and closer to needing the money, you should add bonds since they have a more predictable rate-of-return than stocks and will hold up better in down markets since the interest payments they provide will both offset any loss in price, plus will tend to keep the price from going down as much.

In addition, if you hold a bond until it matures, no matter where the price has gone during its lifetime, the company or government that issued it will pay you the face value, usually $1,000 per bond for corporate bonds.  Because of this, the closer to maturity the bond is, the closer it will stay to the redemption value.  If you buy short-term bonds (or a short-term bond fund), the potential return you’ll receive will be less than you’ll find with long-term bond funds, but the volatility of their price will also be less since the bonds will be near redemption.

The issue with holding all bonds is that your return will be less than it will be with stocks over long periods of time (about 5-8% versus 10-15% annualized per year).  With a middle-class salary, if you contributed 15% of your salary to your 401k but only bought bonds  your whole career, you’d end up with millions of dollars less than someone who put all of their money into stocks for the first thirty years.  Holding 100% bonds can also make your portfolio more volatile during periods where interest rates are rising rapidly or inflation takes off because bond prices are very sensitive to changes in interest rates and inflation.  It is therefore safer to have a portfolio consisting of 80% bonds and 20% stocks than a 100% bond portfolio.

So with bonds, you tend to want to add them to your portfolio as you get closer to needing the money, which is usually your retirement date.  The Bogle rule assumes that you always want a few bonds, just to reduce volatility, but that you’ll want to have the majority of your assets in stocks until you’re entering retirement.   Having some stocks even in retirement is needed because it helps fight inflation, keeping your spending power from declining late in retirement, so even at age 70 you would still have at least 30% of your portoflio in stocks.  As you got older, you’d sell some of those stocks and buy more bonds to increase the amount of cash you’d receive each year to make up for the reduction in spending power you’d have if you kept receiving the same amount of cash each year due to inflation.    Because life expectancies are longer than they used to be, such that people are living twenty to thirty years into retirement, the Bogle rule has also been adjusted to “buy your age minus 10% in bonds” so that you’ll have a bit more in stocks when you enter retirement.

An alternative to having bonds in retirement is raising cash by selling stocks and putting the money into a money market fund or bank CDs.  Because it is very rare for the stock market to be down for more than 5 years, and because the level of declines that do extend beyond five years tend to be very minor, having five-years worth of cash in your portfolio can help you avoid needing to sell right after a market crash because you need to raise cash.  This kind of strategy, where you have a larger cash position and forego bonds, can make sense at times like right now where interest rates are very low, such that bonds really aren’t paying enough to generate enough income for living expenses, and rates are expected to rise.  You can also mix in alternative income investments to bonds, such as high dividend paying stocks like utilities, real estate through REITs or by buying rental properties directly, and investments like limited partnerships which pay out a large percentage of the money they make through pipelines and the like.  (Be cautious with this last one, as you could end up filing taxes in multiple states with limited partnerships.)

Good times to buy bonds are the following:

  1.  You’re nearing retirement (age 45+) and interest rates are in the range such that quality bonds are paying at least 5-6% with junk bonds paying in the 8-10% range.  Savings accounts would be paying 2-3% interest.  In this case you might be able to generate enough income from interest payments to avoid needing to sell stocks or bonds to raise cash for living expenses.
  2. Interest rates are very high, such that even quality bonds are paying in the 10% plus range and rivaling the potential returns from stocks.
  3. Interest rates are relatively high, the economy is slowing, and interest rates are therefore likely to begin heading down.

If at least one of these conditions were not met, I would probably forego buying any bonds until I was within about five to ten years of retirement since the returns I would get from the stock market would be so much better.   I instead would accept the larger volatility in exchange for the better returns.  Then again, I have an iron stomach when it comes to stock market fluctuations, knowing that as long as I have several years until I need the money that the market will likely come back from any drop.  If seeing your portfolio decline in value really affects you, however, such that it would make it hard to sleep at night, mixing in a few bonds even early in life with the understanding that you’re reducing your future returns in exchange for less volatility may be worth the sacrifice.

Finally, if you buy a target date retirement fund, they do the bond/stock ratio adjustments for you.  Just pick a portfolio with a date near when you will retire and let it go.  If you want to be a bit more aggressive, pick a date ten years after you’ll retire.  If you want to be more conservative and reduce volatility, pick one ten years before you retire.

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.

 

How Do I Determine My Rate-of-Return?


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Let’s say that you’re invested in a mutual fund and you think you’re doing pretty well, but you’re just not sure.  One of the best way to see how you are doing is to calculate your annualized rate of return (let’s call this ARR for short) and then compare your results to other investments.    You ARR is the interest rate at which you would need to invest your money at in a bank account to end up with the same amount of money at the end as you did in your mutual fund.  This allows you to compare how you’re doing versus just putting the money in a bank CD, for example.  It also allows you to compare different mutual funds.

At this point I could give the formula for calculating ARR, but instead, let’s just use some of the tools already available to us from the net.  On the right sidebar in the blogroll is a link to an Investment Calculator.  Use that link or just click here.  You should end up with a screen that looks like this, from the Dave Ramsey website:

invcalcblank

Now let’s say that you started out ten years ago with $1,000 in a mutual fund and have been contributing $200 per month ever since.   Let’s say that you now have about $41,000 in the account.   Do the following:

  1.  Put $1,000 in the starting balance box, 5% in the annual return box (this is the ARR), $200 in the monthly contribution box, and 10 years in the remaining two boxes.
  2. Press “show results.”  This will then show the amount your investment would be worth after 10 years.
  3. Adjust the annual rate of return up if the total number is too low.  Adjust it down if it is too high.  In our example, we’re too low, so let’s adjust it up a bit.
  4. The final result for our example is shown below.  I found that with an ARR of about 8.5%, I ended up with $40,892, which is close enough to $41,000 for our purposes.

invcalc8pers

So now that we know we made about 8.5% ARR for the period, which is quite a bit better than we would have done in a bank CD.  For comparison, where would we have ended up if we had put the money in a bank CD making 1% interest?  Change the ARR on the investment calculator to 1% and see the results.  I now see that I’ll end up with only about $26,000, so the higher rate of return definitely helped me out (to the tune of about $15,000).

A word of caution here.  While it is valid to determine a ARR for a portfolio of stocks or a mutual fund over a long period of time, like five to ten years, a mutual fund does not behave like a bank CD and pay steady returns.  Instead, it may go up 30% one year, then down 15% the next.  You cannot plug in 8.5% into the calculator now and try to predict where your fund will be three years from now or even five years.  If you want to predict, you can do things like project out ten or twenty years and assume ARR limits of maybe 8% to 12% and get a rough idea of the range of portfolio values you might see for the mutual fund.  You can use this as a guide to see if you need to be saving more to reach your goals or get an idea of when you might become a millionaire, but realize that your actual returns might be a little above or below that range.  Stocks are unpredictable.

Finally, I now know that I’ve made an 8.5% ARR for the period of Jan 2007 to Jan 2017, but how did my fund do versus “the market?”  Well, a good benchmark to use is the S&P500, which is an index of the 500 largest companies in the US markets and gives you a sense of where most of the money invested in the market did for the period.  You can get the returns for the S&P500 index over any period of time through this calculator here.  If I plug-in the start and end dates of Jan 2007 to Jan 2017 with this calculator, I find that the S&P500 had an ARR of about 4.8% over the period without reinvesting dividends, and 6.9% if dividends were reinvested.  Since my fund made 8.5%, it did pretty well for the period.

Got a question or comment about personal finance or investing?  Please leave a comment.

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