Thoughts on Personal Finance
Personal finance is a tricky subject for young workers, as it is often a scary and unfamiliar path. Whether or not you took personal finance classes in college, it will definitely be something you need to prepare to deal with, as your actions (or inactions) will have drastic consequences. With current interest rates, putting money in a traditional savings account is akin to stuffing money under a mattress. Here I seek to highlight alternative methods of saving that will preserve and grow the value of your money.
Why does preservation of capital matter? For simplicity sake assume you graduated in 2013 and have been working for the last 3 years taking home an average of $100K a year. According to U.S. Inflation Calculator, you effectively lost $6.6K over that time just due to inflation (2.2%). Another way of putting it, the average prices for goods and services have increased 2.2%, thus eroding your purchase power.
So what exactly are these better uses to grow your savings? The following suggestions are things you can do yourself – I am discounting estate managers, and other money managers that you have to pay exorbitant fees to use.
Better uses:
Part 1) Traditional Brokerage Accounts and IRAs
At the most basic level, brokerage accounts (ex. TD Ameritrade, Schwab, Fidelity) are used to invest in stocks. They are as simple to open as a regular bank account and you can do this online. To most people, the term stock market incites fear and risk and while these descriptions are true depending on how you invest, the stock market is also one of the best ways to protect your capital against ongoing events like inflation. I won’t discuss trading individual stocks as the purpose of this post is to speak to those who are risk adverse yet understand the need to protect and grow capital at a reasonable rate.
As a risk adverse individual, what you can do is to simply invest in the market (ex. S&P 500 – an index based on the market capitalizations of the largest 500 U.S. companies). It does not matter what price you buy into the market at, the time to invest is NOW. This strategy is buy and hold regardless of what happens. We all know market is unpredictable – it will to go up and down and sideways. But what you may not have noticed is that over time, stocks along with all major asset classes, rise (and rise faster than the value of cash). Look at this chart of the S&P 500, which dates as far back as 1977:
Imagine this chart going forward until the day you retire. There will be ups and downs, and there may be a span of 5 years where the last 10 years gains are wiped out, but by the time you retire, the probability of the market being more valuable than when you began investing is near certain. There could be a financial crisis tomorrow where stocks nose dive double digits, but for this strategy to work, you need to remain invested. You’re essentially making the bet that regardless of the number of crises that you experience in your lifetime (and there will be a few), things in general will simply be worth more by the time you retire. Again, this strategy is for the market as a whole, not for any specific stocks.
Consider what would happen if you failed to do anything with your direct deposits in your savings account. From the same time period of 1977 to 2016, your account value would be worth 1/3 what it was because goods now cost 3x as much (293% inflation). Conversely, if you invested 100 dollars back then, it would be worth $2000 today, for a 1900% return in 39 years, crushing inflation. Ironically 39 years is the length of an average American career before retiring under current law and assuming age 21 college graduation. The message is clear: something should be done to offset the decay of your money, and joining the market for the long haul is a smart investment. You are betting that over time society will progress and innovate, and that is a safe bet.
These words are echoed time and time again in Buffet's 2016 Annual Letter.
You may have heard about Roth IRAs as well, and functionally, they do the same thing as a brokerage account. The difference is in the tax rules. You pay taxes on the money going into your account and withdrawals are tax free. This means you can let that investment grow and take it out later with your gains without getting taxed. In a regular brokerage account, the tax you pay is on any profits you make from a trade, and you get a tax break if you made a loss.
Part 2) Peer Lending - a newer investment option
There are alternative investment options that can generate capital protecting returns as well. One relatively new investment option is peer to peer lending. Lending Club, currently the largest company in this space, begins with borrowers looking for small loans ($1K - $35K), generally to consolidate debt or to pay off credit card interest. Lending club screens each application allowing only the highest quality of requests through:
We as investors buy notes which represent a portion of the total amount the borrower is looking for. Each note is a minimum $25 investment. As borrowers repay the loans (notes), investors get a stream of cash every month in a similar way a mortgage or bond works. Investors diversify their p2p portfolio by buying notes associated with different people (minimum of 100 notes is recommended). The interest rate return you get can be as small as 5% (A-Grade low return & low risk) or as high as 30% (G-Grade high return & high risk) depending on the person want to loan to. But even if you stick with safe grades A-C, you can still make a considerable return, anywhere from 5%-9% yearly! This chart explains:
In fact, portfolios with more than 100 notes (aka $2.5K worth of investment), 99.9% of investors see positive returns.
Just as with any investment, there is risk. There is the possibility that the person you loaned to doesn’t pay it back. The punishment for not paying back is damage to their credit, which can be very serious and affect their ability to get loans later on. Defaults on loans will occur no matter what, which is why a well-diversified portfolio of over 100 notes will better protect you while still earning you a solid +5% return year over year.
Part 3) 401K - maximize your contribution at least to the point of employer match
Most employers offer traditional 401K retirement accounts (and often matching a small % of your contributions) where you contribute pre-tax income into the account. Your money gets taxed at the tax bracket you’re at when you withdraw the funds.
Also, it is common for people to have both a Roth IRA and traditional 401K to help balance the tax savings and hits when they retire.
The next step is to invest in something. You will likely invest in a mutual fund which is essentially as a fund that is invested in range of things like stocks, bonds, real estate, etc. Think of a mutual fund as a pizza that has different toppings on each slice representing different investments, and the entire pie represents one fund. This chart is a simplified example of what a pie can look like:
You would likely be recommended a target mutual fund: T. Rowe Price 2045, T. Rowe Price 2050, T. Rowe Price 2055, etc. In this example T. Rowe Price is the name of the fund and the target refers to the date, and people usually just invest in the fund with the date that they are closest to retiring on. The difference in the dates represent the difference in the levels of risk each fund is taking on. Look at the chart example above at TODAY, as a young worker you are more likely to accept risk so your 2050 fund will presently have more stocks than bonds since bonds provide less return, but are safer than stocks. Over time, your 2050 fund will adjust to take on less risk to adjust to the appetite of an older person which means more bonds and less stocks. This adjustment doesn’t happen for free – the pie is actively managed by fund managers who buy and sell the slices that make up the pie and charge management fees.
With the exception of a retirement mutual fund, you should stay away from buying regular mutual funds yourself. There are many nuances associated with the fee structures and restrictions that you should read if you are considering buying. Instead, you can achieve the same levels of diversification by investing in Exchange Traded Funds (ETF) which are broad level exposures like real estate, foreign stocks, commodities, etc. Buying ETF’s is like buying by the slice where every slice is different. You only buy what you want - what kind of broad exposure you want. Buying a mutual fund means buying every slice of the pie including things you decided you don’t want, along with high expense ratios and fees. The only fees you incur from buying an ETF with a regular brokerage account is whatever the broker's trading fee is, so it’s much more predictable.
The lesson is, buy pizza by the slice, not by the pie – unless it’s a retirement pie.
Part 4) High Yield Savings Account – at least you’re doing something
Let’s assume you are the most cynical person ever - you hate the word stock and markets and want nothing to do with them. You rather make negative money with a 100% likelihood than make any money at all because the risk is inherently >0%.
This is what you would do: put your current savings account into a high yield savings account like Ally Bank. Ally bank will give you 1.00% interest annually vs. the ~0% you get from a traditional savings account. Wouldn’t it be nice to see a 10K deposit be worth $100 more in a year than the $0.10 from Chase or Bank of America? This sounds too good to be true, but high yield savings accounts like Ally exist because they don’t have operating expenses from maintaining actual bank branches. They exist entirely online, and so they can pass on the savings in the form of higher interest rates.
Now 1.00% is great for a savings account, but keep in mind the average inflation year over year since 2010 has been 1.68%, so even with this super safe strategy where you literally have no market exposure, you will still be losing 0.68% of your wealth every year.
Either way, instead of letting your money decay in your bank account, put it to better use and start investing!
Why does preservation of capital matter? For simplicity sake assume you graduated in 2013 and have been working for the last 3 years taking home an average of $100K a year. According to U.S. Inflation Calculator, you effectively lost $6.6K over that time just due to inflation (2.2%). Another way of putting it, the average prices for goods and services have increased 2.2%, thus eroding your purchase power.
So what exactly are these better uses to grow your savings? The following suggestions are things you can do yourself – I am discounting estate managers, and other money managers that you have to pay exorbitant fees to use.
Better uses:
- Brokerage Account and IRAs
- Peer Lending
- 401K
- High Yield Savings
Part 1) Traditional Brokerage Accounts and IRAs
At the most basic level, brokerage accounts (ex. TD Ameritrade, Schwab, Fidelity) are used to invest in stocks. They are as simple to open as a regular bank account and you can do this online. To most people, the term stock market incites fear and risk and while these descriptions are true depending on how you invest, the stock market is also one of the best ways to protect your capital against ongoing events like inflation. I won’t discuss trading individual stocks as the purpose of this post is to speak to those who are risk adverse yet understand the need to protect and grow capital at a reasonable rate.
As a risk adverse individual, what you can do is to simply invest in the market (ex. S&P 500 – an index based on the market capitalizations of the largest 500 U.S. companies). It does not matter what price you buy into the market at, the time to invest is NOW. This strategy is buy and hold regardless of what happens. We all know market is unpredictable – it will to go up and down and sideways. But what you may not have noticed is that over time, stocks along with all major asset classes, rise (and rise faster than the value of cash). Look at this chart of the S&P 500, which dates as far back as 1977:
Imagine this chart going forward until the day you retire. There will be ups and downs, and there may be a span of 5 years where the last 10 years gains are wiped out, but by the time you retire, the probability of the market being more valuable than when you began investing is near certain. There could be a financial crisis tomorrow where stocks nose dive double digits, but for this strategy to work, you need to remain invested. You’re essentially making the bet that regardless of the number of crises that you experience in your lifetime (and there will be a few), things in general will simply be worth more by the time you retire. Again, this strategy is for the market as a whole, not for any specific stocks.
Consider what would happen if you failed to do anything with your direct deposits in your savings account. From the same time period of 1977 to 2016, your account value would be worth 1/3 what it was because goods now cost 3x as much (293% inflation). Conversely, if you invested 100 dollars back then, it would be worth $2000 today, for a 1900% return in 39 years, crushing inflation. Ironically 39 years is the length of an average American career before retiring under current law and assuming age 21 college graduation. The message is clear: something should be done to offset the decay of your money, and joining the market for the long haul is a smart investment. You are betting that over time society will progress and innovate, and that is a safe bet.
These words are echoed time and time again in Buffet's 2016 Annual Letter.
You may have heard about Roth IRAs as well, and functionally, they do the same thing as a brokerage account. The difference is in the tax rules. You pay taxes on the money going into your account and withdrawals are tax free. This means you can let that investment grow and take it out later with your gains without getting taxed. In a regular brokerage account, the tax you pay is on any profits you make from a trade, and you get a tax break if you made a loss.
Part 2) Peer Lending - a newer investment option
There are alternative investment options that can generate capital protecting returns as well. One relatively new investment option is peer to peer lending. Lending Club, currently the largest company in this space, begins with borrowers looking for small loans ($1K - $35K), generally to consolidate debt or to pay off credit card interest. Lending club screens each application allowing only the highest quality of requests through:
We as investors buy notes which represent a portion of the total amount the borrower is looking for. Each note is a minimum $25 investment. As borrowers repay the loans (notes), investors get a stream of cash every month in a similar way a mortgage or bond works. Investors diversify their p2p portfolio by buying notes associated with different people (minimum of 100 notes is recommended). The interest rate return you get can be as small as 5% (A-Grade low return & low risk) or as high as 30% (G-Grade high return & high risk) depending on the person want to loan to. But even if you stick with safe grades A-C, you can still make a considerable return, anywhere from 5%-9% yearly! This chart explains:
In fact, portfolios with more than 100 notes (aka $2.5K worth of investment), 99.9% of investors see positive returns.
Just as with any investment, there is risk. There is the possibility that the person you loaned to doesn’t pay it back. The punishment for not paying back is damage to their credit, which can be very serious and affect their ability to get loans later on. Defaults on loans will occur no matter what, which is why a well-diversified portfolio of over 100 notes will better protect you while still earning you a solid +5% return year over year.
Part 3) 401K - maximize your contribution at least to the point of employer match
Most employers offer traditional 401K retirement accounts (and often matching a small % of your contributions) where you contribute pre-tax income into the account. Your money gets taxed at the tax bracket you’re at when you withdraw the funds.
Also, it is common for people to have both a Roth IRA and traditional 401K to help balance the tax savings and hits when they retire.
The next step is to invest in something. You will likely invest in a mutual fund which is essentially as a fund that is invested in range of things like stocks, bonds, real estate, etc. Think of a mutual fund as a pizza that has different toppings on each slice representing different investments, and the entire pie represents one fund. This chart is a simplified example of what a pie can look like:
You would likely be recommended a target mutual fund: T. Rowe Price 2045, T. Rowe Price 2050, T. Rowe Price 2055, etc. In this example T. Rowe Price is the name of the fund and the target refers to the date, and people usually just invest in the fund with the date that they are closest to retiring on. The difference in the dates represent the difference in the levels of risk each fund is taking on. Look at the chart example above at TODAY, as a young worker you are more likely to accept risk so your 2050 fund will presently have more stocks than bonds since bonds provide less return, but are safer than stocks. Over time, your 2050 fund will adjust to take on less risk to adjust to the appetite of an older person which means more bonds and less stocks. This adjustment doesn’t happen for free – the pie is actively managed by fund managers who buy and sell the slices that make up the pie and charge management fees.
With the exception of a retirement mutual fund, you should stay away from buying regular mutual funds yourself. There are many nuances associated with the fee structures and restrictions that you should read if you are considering buying. Instead, you can achieve the same levels of diversification by investing in Exchange Traded Funds (ETF) which are broad level exposures like real estate, foreign stocks, commodities, etc. Buying ETF’s is like buying by the slice where every slice is different. You only buy what you want - what kind of broad exposure you want. Buying a mutual fund means buying every slice of the pie including things you decided you don’t want, along with high expense ratios and fees. The only fees you incur from buying an ETF with a regular brokerage account is whatever the broker's trading fee is, so it’s much more predictable.
The lesson is, buy pizza by the slice, not by the pie – unless it’s a retirement pie.
Part 4) High Yield Savings Account – at least you’re doing something
Let’s assume you are the most cynical person ever - you hate the word stock and markets and want nothing to do with them. You rather make negative money with a 100% likelihood than make any money at all because the risk is inherently >0%.
This is what you would do: put your current savings account into a high yield savings account like Ally Bank. Ally bank will give you 1.00% interest annually vs. the ~0% you get from a traditional savings account. Wouldn’t it be nice to see a 10K deposit be worth $100 more in a year than the $0.10 from Chase or Bank of America? This sounds too good to be true, but high yield savings accounts like Ally exist because they don’t have operating expenses from maintaining actual bank branches. They exist entirely online, and so they can pass on the savings in the form of higher interest rates.
Now 1.00% is great for a savings account, but keep in mind the average inflation year over year since 2010 has been 1.68%, so even with this super safe strategy where you literally have no market exposure, you will still be losing 0.68% of your wealth every year.
Either way, instead of letting your money decay in your bank account, put it to better use and start investing!
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