These fundamental concepts will provide a foundation for understanding investments, markets, and investment strategies. Supply and Demand The value of an item depends not on what you paid for it, but on what someone else would be willing to pay for it today. What someone is willing to pay is related to supply and demand. For example, if there is a fixed supply of something, and the demand for it increases, then the price will increase. If demand for something remains constant, and there is an increase in supply, the price will decrease. Yield, Total Return, and Compounding For any asset, yield is the income earned (interest or dividends) divided by the price of the asset, such as a bond or a share of stock. Price and yield move in opposite directions. If a $100 bond earns 5 percent interest, it earns $5 on a $100 asset, or $5 divided…
Understanding Taxes and Tax Efficiency
For tax-deferred accounts, such as 401(k)s and 403(b)s, you contribute money from your paycheck before it is taxed, or with “pre-tax dollars.” In other words, you do not pay taxes on the portion of your salary that goes directly into your 401(k) or 403(b). Moreover, each year, you do not pay taxes on the income or capital gains earned. You pay taxes when you withdraw money from the account in retirement at the ordinary income rate. Ordinary income is the tax rate that you pay on your salary, interest, and other sources of income. Roth IRAs are tax-advantaged accounts. You fund Roth IRAs with after-tax dollars, so you do not get a tax break upfront. After you fund a Roth IRA, however, the income, appreciation, and withdrawals are all tax-free. The long-term tax advantages of Roth IRAs are powerful. For taxable accounts, you can access the money whenever you like. You have complete flexibility. At the…
Saving for a Rainy Day
When it comes to our financial lives, we should remember to “save for a rainy day.” Financial planners suggest that we have an emergency reserve equal to three-to-six months of our essential living expenses. It should be in a safe, stable vehicle such as a savings account or a money market fund. If you don’t have a sufficient reserve, make it a top priority. The easiest way to address the shortfall is to transfer a portion of your paycheck every pay period directly into a savings account. If you dip into your emergency fund, replenish it as soon as possible. In addition to an emergency reserve, you need to think about your overall liquidity. Liquidity is a term from economics that indicates how easily an asset can be converted to cash. Some asset classes are more liquid than others. Cash and money market funds are the most liquid assets. Stocks…
The Power of Compounding
I have heard people refer to it as “The magic of compounding.” Personally, I don’t like the term “magic.” Magic implies something mystical, beyond our comprehension. Rather than “magic,” compounding is just math – incredibly powerful math – but it is just math. Compounding means that there is growth on the growth. For example, an investment of $100 that appreciates 7 percent will be worth $107 at the end of the first year. If the investment grows 7% percent again in the second year, the return would be 7 percent on $107 or $7.49. 7% growth on $100.00 = $107.00 7% growth on $107.00 = $114.49 In year two, the dollar amount increase exceeds that in year one. You have a 7% return on the original $100 and a 7% return on the $7 you earned in year one. Each year, you earn a return on the original amount ($100) and…
Understanding Financial Credentials
Financial professionals may possess a variety of certifications and designations. These credentials instill a sense of competency. In recent years, however, the number of financial credentials has expanded significantly. If you choose to work with a financial professional, you should understand what these credentials mean. The prestige of certifications and designations and their usefulness to clients varies considerably. The Financial Industry Regulatory Authority, or FINRA, has a designation lookup feature on its website, https://www.finra.org/investors/professional-designations. The tool is beneficial, especially because you can compare different designations. FINRA does not endorse or recommend any of these designations. The list of designations on the FINRA website is extensive. Currently, there are more than 200 listed. How do you determine which are the most meaningful? Look up what is required to achieve and maintain the various designations. If you need help with retirement planning, what are the prerequisites for becoming a Certified Retirement Financial…
Investing and Taxes
As an investor, you need to understand the impact of taxes. The taxes owed on investments depend on the type of investment account. For tax-deferred accounts, such as 401(k)s and 403(b)s, you contribute money from your paycheck before it is taxed, known as “pre-tax dollars.” In other words, you do not pay taxes on the portion of your salary that goes directly into your 401(k) or 403(b). Moreover, you do not pay taxes on the income or capital gains generated each year. Instead, you pay taxes when you withdraw money from the account. Roth IRAs and college savings plans, such as 529s, are examples of tax-advantaged accounts. You fund these kinds of accounts with after-tax dollars, and you do not get a tax break upfront. After you fund a Roth IRA or 529, the income, appreciation, and withdrawals are tax-free. For taxable accounts, income and capital gains are not tax-exempt or tax-deferred, so…
Yield, Return, and Total Return
As you evaluate various investment choices, yield, return, and total return are essential considerations. Although the concepts are fairly straightforward, there can be some confusion. Here is a quick overview. For any asset, yield is the income earned (interest or dividends) divided by the price of the asset, such as a bond or a share of stock. Price and yield move in opposite directions. If a $100 bond earns 5 percent interest, it earns $5 on a $100 asset, or $5 divided by $100, which is a 5 percent yield. If the price of the bond increases to $105, the yield declines to $5 on a $105 asset, or 4.8 percent. $5 ÷ $100 = 5.0% and $5 ÷ $105 = 4.8% If a share of stock is worth $50 and pays a $1 dividend per share, the yield is $1 divided by $50, or 2 percent. If a company…
Diversification and Risk
When markets are turbulent, people increasingly focus on risk. It is vital to understand the difference between risk you can control and risk you cannot. The saying “Don’t put all your eggs in one basket” applies to investments because concentration increases risk. Whether you invest your money yourself or work with a professional, never put all your assets in the same basket—the same kind of stock, bond, mutual fund, or other investment. In addition to avoiding concentration, diversification is key to improving investment results. Various asset classes, or types of investments, tend to perform differently under certain market conditions. Some perform better, and some perform worse, depending on what is going on with the economy and financial markets. The best investment strategy is to have a diverse portfolio that includes a mixture of stocks, bonds, and international investments. Diversification across asset classes helps reduce risk; correlation illustrates this benefit. Correlation measures…
Financial Credentials Matter: Which Are Most Important
In recent years, the number of financial credentials has risen dramatically. It is important to note that the quality and usefulness vary. If you are choosing to work with a financial professional, you should understand what these credentials mean. The prestige of certifications and designations and their usefulness to clients varies considerably. The Financial Industry Regulatory Authority, or FINRA, has a designation lookup feature on its website, https://www.finra.org/investors/professional-designations. The tool is very helpful, especially because you can compare different designations side by side. FINRA does not endorse or recommend any of these designations. The list of designations on the FINRA website is extensive. Currently, there are more than 200 listed. How do you determine which are the most meaningful? Look up what is required to achieve and maintain the various designations. If you need help with retirement planning, what are the prerequisites for becoming a Certified Retirement Financial Advisor (CRFA),…
Time is Your Friend – The Power of Compounding
Especially when you are just starting out, time is your friend. It is important to save and invest every year and leave your money to grow. Consistency and discipline are key to your long-term financial well-being. Market returns and the power of compounding allow you to build your nest egg nicely over time. I have heard people refer to it as “The magic of compounding.” Personally, I don’t like the term “magic.” Magic implies something mystical beyond our comprehension. Rather than “magic,” compounding is just math – incredibly powerful math – but it is just math. Compounding means that there is growth on the growth. For example, an investment of $100 that appreciates 7 percent will be worth $107 at the end of the first year. If the investment grows 7% percent again in the second year, the return would be 7 percent on $107 or $7.49. 7% growth on…