Selecting Stocks with a Score

My husband really likes selecting stocks with a score, the Piotroski score in particular.  Briefly, Professor Piotroski created a set of nine financial ratios that contribute to the score. If a company meets a certain criterion and has favorable results on 8 or 9 of the ratios, his analysis indicates that the company’s stock is likely to do well. My husband is primarily a value investor. The appeal of the Piotroski score to my husband is that it focuses on value stocks and, while it relies heavily on statistical analysis, it isn’t a black box.

In this post, I’ll identify the group of stocks to which the Piotroski score applies. I’ll then briefly explain the financial ratios that determine the score. I’ll close with a specific example of a stock I bought solely using the Piotroski score and provide some general guidance on applying the results of the score.

Book-to-Market Ratio

What is It?

The book-to-market (BM) ratio is a financial ratio. The numerator is the book value of the company. This value is shown on the balance sheet in the company’s financial statements and is usually reported as “Shareholders’ Equity.”

The denominator of the ratio is the total market value of the company on the evaluation date as the financial statements. The total market value is the stock price multiplied by the number of shares outstanding and is also called the market capitalization.

In mathematical terms,

Piotroski waits for the financial statements to be published for a particular year end to get the book value. He then looks up the market capitalization on the evaluation date of the financial statements for use in the ratio.

Piotroski’s Criterion

In his paper, Piotroski identifies value stocks as companies that have BM Ratios in the highest quintile (highest 20%) of traded stocks. These stocks have high book values relative to their market capitalization. Looked at from the other perspective, these stocks have low market capitalizations (and therefore low stock prices) relative to their book value.

Recall that the book value is the company’s assets minus its liabilities. In theory, if the company were liquidated on the evaluation date of the financials, shareholders would get their portion of the Shareholders’ Equity, based on the proportion of shares owned. Therefore, a BM ratio of 1.00 means that the market capitalization of the stock is equal to the Shareholders’ Equity.

By comparison, the cut-off for the highest quintile of BM ratios[1] across all stocks reported in the ValueLine Analyzer Plus on May 29, 2020 is 1.47. The book values per share of these companies are almost 50% higher than their stock prices!   You can see why Piotroski might consider these stocks to be potentially good values at their current prices.

Why Might It Be High?

There are at least two reasons that the BM ratio might be high.

First, the market may perceive that either assets are overvalued or liabilities are undervalued. Both of these situations would cause the reported book value to be higher than its true amount.

For example, some companies have not fully funded their pension plans. That means that the estimated present value of the future pension benefits is more than the liability on the balance sheet. Companies disclose these differences in the Notes to Financial Statements. If the liability for pension benefits is understated, it will cause the company’s book value to be overstated.

Second, financial theory tells us that the market value of a company’s stock is equal to its book value plus the present value of future profits. If the market perceives that the company is unlikely to make money in the future, the market capitalization will be less than the book value.

The Piotroski score focuses on companies in the second category. That is, it attempts to identify companies that will be profitable in the future from among all of the companies that the market thinks will have negative future profits.

Piotroski Score

The Piotroski score is calculated as the sum of a set of 9 values of 1 or 0. There are 9 criteria in the calculation, in addition to the BM ratio being in the highest quintile. The process assigns a 1 if a company’s financial statement values meet each criterion and a 0 if it does not. As such, companies that meet 8 or 9 of the criteria are considered more likely to have above market average performance.

The 9 criteria are listed below:

  1. Return on assets (ROA) = Net income / Total assets at beginning of year > 0
  2. ROA this year > ROA last year
  3. Cash flow from operations > 0
  4. Cash flow from operations > net income
  5. Long-term debt / Total assets this year < Long-term debt / Total assets last year
  6. Current ratio this year > current ratio last year
  7. Shares outstanding this year <= shares outstanding last year
  8. Gross margin this year > gross margin last year
  9. Total sales / Total assets this year > Total sales / Total assets last year

Piotroski performed his analysis using data from companies’ financial statements from 1976 to 1996. The average of the one-year returns for the companies with scores of 8 or 9 was 7.5 percentage points higher than the average for all companies with high BM ratios and 13.5 percentage points higher than the average for the market as a whole.

How to Calculate It

If you are familiar with reading financial statements, you can calculate the Piotroski score yourself using the formulas above. Or, you could extract the key ratios from a source, such as ValueLine, Tiingo or Bloomberg, all three of which require subscriptions. I use the latter approach as I have a subscription to ValueLine that I use for a variety of purposes.

An easier option is to use a Piotroski calculator or screener.   I’ve never used any of these tools, but I used Google to find a couple free options you might try.

  • Old School Value – This Excel spreadsheet will calculate and show you how a company does on each of the 9 tests and the total score.
  • ChartMill – This screener lets you identify stocks based on their Piotroski score. As such, it helps you find stocks with scores of 8 or 9, but does not show you the details of the underlying calculation.

I suggest being careful to check the documentation of any of these tools to make sure that the descriptions of the 9 tests are the same as I’ve included above (which I took directly from Piotroski’s paper). In poking around on-line, I found more than one site that did not correctly specify the nine tests.

My Experience Selecting Stocks with a Score

Although I’ve looked at stocks using the Piotroski score several times, I’ve made only one purchase using it as my primary buying criterion. I purchased FUJIFILMS (FUJIY) in March 2012. At the time, FUJIY had a BM Ratio of about 1.40, as compared to a market average BM ratio of about 0.5. It had a Piotroski score of 8, having failed the test for an increase in gross margin.

For many, many years, FUJIY’s biggest product was film for cameras. With the advent of the digital camera, its market shrank rapidly. In the year before I purchased the stock, its price decreased by 32%. As I was looking at the company, it was transitioning its business from camera film to other types of related products, including medical imaging and, more recently, office products with its purchase of Xerox. With a good story and a high Piotroski score, I decided to buy the stock.

It turns out I was a little early in buying the stock. In the 12 months after I bought the stock, it decreased by 19% while the S&P 500 increased by 13%. However, if I had bought it a year later, my total return would have been much better over both the short and long term, as shown in the table below.

Total Return starting in March 2013
1 Year2 YearsUntil June 2020
FUJIFILMS+51%+84%+171%
S&P 500+22%+36%+110%

 

So, even though my returns were lower than the market average because I bought the stock too early in the company’s turnaround, I correctly decided to keep it after its first year of poor performance. That is, if I had sold the stock one year after I purchased it and bought an S&P 500 index fund, I would have been worse off.

Caution

As with any investing strategy, it is important that you understand the assumptions underlying the Piotroski score. I also recommend that you understand the story behind the company you are considering for investment, as described in my post on buying stocks based on their financial fundamentals. There are companies that may have a Piotroski score of 8 or 9 that don’t have a good turn-around story, such as the one I described for FUJIY. In those cases, you may not want to rely solely on the Piotroski score.

 

[1] Calculated in this case as Book Value Per Share at most recent fiscal year end divided by Price on May 29, 2020, so not exactly equal to the ratio as calculated by Piotroski.

Picking Stocks Using Pictures

Picking Stocks using Pictures

Technical analysts select companies for their portfolio based on patterns in stock prices.  That is, it allows them to enhance their process of picking stocks by using pictures. This approach is very different from some of the others I’ve discussed, as buy and sell decisions are based in large part on these patterns and less on the financial fundamentals of the company. Every technical analyst has a favorite set of graphs he or she likes to review and their own thresholds that determine when to buy or sell a particular stock.

I’ve done just a little trading based on technical analysis, so asked Rick Lage, a family friend who has much more experience with this approach, to help me out. In this post, I will provide some background on Rick and provide explanations of the graphs he uses. I’ll also provide some insights on who I think is best suited for this type of trading.

Rick’s Story

Rick’s Background

“I was first introduced to the stock market in a Junior High School math class. I made my first trade with a stockbroker about 6 years after graduating from High School.

My interest in the stock market never faded. I was always focused on this platform to make money. Unfortunately losing money was a regular occurrence for many years in the beginning, with not many gains to be proud of.

My interest peaked in 1999 when I attended my first stock trading event in Las Vegas, known as the TradersExpo[1]. TradersExpo provides a wealth of information available for the beginner to the pro, including hardware, trading software, classroom instruction and more.

I personally have never been a day trader. Swing trading is more my definition. I do touch base with my stock watch list daily. It’s always managed and checking my technical indicators is a must.”

Rick’s Goals

“I stock trade for the challenge; not so much for the fun or success. If there is success the fun will follow. There will be losses. No doubt. But you learn how to manage those losses. You have no choice. Technical trading is my science.”

Rick’s Advice to New Traders

Rick says, “I have tried hard to never complicate the trade. There are many technical indicators, so don’t get overwhelmed. I pick stocks that have the momentum. Pick your favorite few indicators and go with those.”

Rick’s Tools

Rick’s favorite indicators are

  • Simple Moving Averages using 9 and 180 days (SMA 9 and SMA 180)
  • Price and Volume Charts
  • Relative Strength Index (RSI)
  • Moving Average Convergence Divergence (MACD)
  • Heikin-Ashi bar chart

I will provide brief introductions to each of these indicators, illustrating each with two stocks – Apple and Shopify. A graph of Apple’s stock prices from January 1, 2018 through mid-May 2020 is shown below. It had some ups and downs in price in 2018 and 2019, followed by a significant decrease and recovery so far in 2020.

Shopify had a steadier increase in 2018 and 2019, but much more volatility so far in 2020, as illustrated in the graph below.

Simple Moving Averages (SMA 180 and 9)

In this context, a simple moving average (SMA) is the average of the closing prices for the past n days, where n is specified by the person making the chart. In Rick’s case, he looks at the 180-day simple moving average and the 9-day simple moving average. For the former, he takes the average of the closing prices for the previous 180 days; for the latter, the average of the closing prices for the previous 9 days.

SMA Charts

Technical analysts add their favorite SMA lines to the chart of the stock’s price. For illustration, I’ve added the SMA 180 and SMA 9 lines to the Shopify and Apple stock price charts below.

SMA Indicators

Technical analysts then look at the crossing points on the chart to provide buy and sell indications. For example, a technical analyst might look at when the closing price line (black in these charts) goes up through the SMA 180 line (blue in these charts) and call it a buy signal or an indication of a time to buy a stock. You can see an example of a buy signal, using this method, for Shopify around May 1, 2019, as indicated by the green circle.  The buy signals for Apple are much more frequent using this criterion, two of which are indicated with green circles.

Similarly, a technical analyst might look at when the SMA 9 line (yellow/orange in these charts) goes down through the SMA 180 line and call it a sell signal. Using this criterion, there was a clear sell signal for Apple in early November 2018, as indicated by the red circle.

Every technical analyst has his or her favorite time periods for SMA lines. In addition, each technical analyst selects his or her own criteria for buy and sell signals based on those SMA lines. The shorter the time period associated with the SMA, the more often buy and sell transactions will be indicated. When I use SMA graphs to inform my buy and sell decisions, I use fairly long time periods as I am a long-term investor. By comparison, some people trade in and out of stocks several times a day, so use very short time periods, such as minutes or hours.

Price and Volume

A price and volume chart shows plots of both the price of a stock and its volume on a daily basis, color-coded to indicate whether the stock price went up or down each day. The graph below is a price and volume chart for Shopify.

The upper chart has rectangles (called boxes), sometimes with lines sticking out of them (called whiskers). The combination of the boxes and whiskers is often called a candle. There is one candle for each trading day.

Price & Volume Indicators

A red box indicates that the price was lower at the end of the day than at the end of the previous day; a green box, higher. Green boxes can be interpreted as follows:

  • The bottom of the box is the opening price.
  • The top of the box is the closing price.
  • The bottom of any whisker sticking down from the box is the lowest price on that day. If there is no downward whisker, the lowest daily price and the opening price were the same.
  • The top of any whisker sticking up from the box is the highest price on that day. If there is no upward whisker, the highest daily price and the closing price were the same.

Red boxes can be similarly interpreted, but the opening price is the top of the box and the closing price is the bottom of the box.

The lower section of the chart shows the number of shares traded each day. If the bar is green, the stock price went up that day, while red corresponds to down.

Technical analysts use these charts to identify trends. A really tall green bar in the lower section green is an indication that a lot of people think the stock will go up so are buying. Many technical analysts consider this a buy signal. Similarly, a really tall red bar is considered by some to be a sell signal. My sense is that you need to be very quick to respond using this type of strategy, as you don’t want to sell a stock after everyone has already sold it and the price has dropped or buy it after the price has increased.

Relative Strength Index (RSI)

The Relative Strength Index (RSI) is intended to measure whether a company’s stock is in an over-bought or over-sold position. If it is over-sold, it is a buy signal; if over-bought, a sell signal. The RSI is one of a broad class of measures called oscillators, all of which are intended to evaluate whether the market is over-bought or over-sold.

The RSI is determined based on a moving average of recent gains and the moving average of recent losses. The value of the RSI is scaled so it always falls between 0 and 100.

The RSI was developed by J. Welles Wilder. He considers the market over-bought when RSI is greater than 70 and oversold when it is below 30. There are many other ways in which the RSI chart can be used to identify trends and inform trading decisions that are outside the scope of this post.

The chart below shows the RSI for Apple (blue) and Shopify (orange).

The red horizontal line corresponds to RSI equal 70, Wilder’s over-bought signal. The green line is Wilder’s over-sold signal at RSI equals 30.

In this chart, there are several times when both stocks were over-bought. That is, the RSI for both stocks goes above the red line. Apple was considered slightly over-sold a few times, when the blue line crossed below the green line. By comparison, Shopify’s RSI came close to indicating that it was over-sold a few times, but never went below the green line.

Moving Average Convergence Divergence

The Moving Average Convergence Divergence indicator (MACD) is similar to the Simple Moving Average indicator discussed above. However, it uses an exponentially weighted moving average (EMA) instead of a simple moving average. A simple moving average gives the same weight to each observation. An exponentially weighted moving average gives more weight to more recent observations. MACD can use any period – minutes, hours, days, etc. For this illustration, I will set the period equal to a day. If you are trading more often, you’ll want to replace “day” in the explanation below with “hour” or “minute.”

The MACD was defined by its designer as the 12-day moving average (EMA 12) minus the 26-day moving average (EMA 26). MACD is compared to its own 9-day moving average to determine buy and sell signals. As with the simple moving average, the MACD crossing its 9-day moving average in the upward direction is a buy signal. When MACD falls below its 9-day moving average, it is a sell signal.

MACD Charts

The graph below shows Shopify’s daily closing prices along with the EMA 12 and EMA 26 lines in orange and green, respectively, starting on February 1, 2020.

This next chart shows the corresponding values of MACD (black) and its 9-day moving average (green).

If you compare the two graphs, you can see that MACD goes below the 0 line on the second chart on April 1, 2020. This transition is consistent with the orange line crossing above the green line on the first chart on the same date.

MACD Indicators

When Shopify’s MACD is bullish, its MACD is greater than its 9-day moving average or the black line is above the green line in the second chart above. This situation has been seen several times in the past few months – for short periods starting on February 11, March 23 and May 4 and a longer period starting on April 9.

The Apple MACD chart, shown below, has gone back and forth between bullish and bearish (black line below the green line) much more often in the past few months. It sometimes changes from bearish to bullish and back again on almost a daily basis.

The “convergence” and “divergence” part of MACD’s name refers to how the MACD behaves relative to the price. The relationship is somewhat complicated, so I suggest you refer to one of the sources I mention below if you are interested in this feature of MACD charts.

Heikin-Ashi bar chart

Also known as a Heikin-Ashi candlestick chart, the Heikin-Ashi bar chart is similar to the price part of the Price-Volume chart described above.   However, instead of using the actual high, low, open and close prices, all four of the points on the candle are calculated in a different manner. The purpose of the adjustments is to make a chart that makes identifying trends easier. I refer you to one of the resources below to learn the details of how these values are adjusted.

Heikin-Ashi Charts

The charts below show the Heikin-Ashi charts for Shopify and Apple for the past six months.

As mentioned, they look a lot like Price charts, except the boxes corresponding to the adjusted open and close and the whiskers corresponding to the adjusted high and low. The boxes are colored green when the adjusted close is higher than the previous adjusted close and red otherwise.

Heikin-Ashi Indicators

Here are some of the indicators people review when using Heikin-Ashi charts:

  • Longer boxes are indicative of trends. In the charts above, you can see that the Apple chart tends to have longer boxes than the Shopify chart.
  • When there is no whisker on one end of the box, the trend is even stronger. For example, neither the Apple nor Shopify charts have upward whiskers on the red boxes from mid-February to mid-March 2020. This time period corresponds to the time period highlighted by the red arrow on the chart below when both stocks’ prices were going down.

Similarly, almost none of the green bars in the last month of the Heishen Ashi chart have downward whiskers, corresponding to the time period in the price chart indicated by the green arrow.

Time periods when the boxes are short, have both whiskers and change color often are indicators of changes. For example, the Apple Heikin-Ashi chart from mid-January to mid-February shows several bars of alternating colors. Apple’s price changed from an upward trend to a downward trend in this period, as shown in the purple circle in the chart below. Identifying turning points is very important in deciding when to buy and sell stocks.

Who Can Use Technical Analysis

Technical analysis isn’t for everyone. It requires people who (a) have the ability to focus on markets fairly closely every day in the case of swing traders or all day in the case of day traders, (b) are happy with growing their portfolio with a large number of small “wins,” and (c) have a solid understanding of the charts being used.

Time Commitment

Unlike many other investment strategies, many day traders and swing traders do not consider a company’s financial fundamentals in their buy decisions. Instead, they monitor the patterns in their charts. Without the comfort of believing that the companies they own have sound fundamentals, it is important that they follow their charts consistently so they can quickly sell any positions that are not meeting expectations.

Lots of Small Wins

In my post on financial fundamentals, I talk about Peter Lynch’s concept of a 10-bagger – a stock whose value is at least 10 times what you paid for it. In that paradigm, the goal is to attain better-than-market-average returns by getting average returns on most of the positions in your portfolio and big gains on one or two positions.

By comparison, the goal of day traders and swing traders is to make a very small amount of money on every trade, but to make lots and lots of those trades. If you earn 0.1% on average on every trading day, it compounds to just over 20% a year!

For many of us, buying and selling with gains of less than 0.1% per security seems really small and might not seem worthwhile. As such, you need to be willing to be happy with lots of little wins rather than a 10-bagger if you want to be a day trader or swing trader.

Understand the Charts

One of the requirements of using technical analysis is to make sure you understand how to interpret the charts correctly. For example, Southwest Airlines (ticker: LUV) has done very poorly recently from the impact of COVID-19. The plot below shows its closing stock price from February 15, 2020 through May 20, 2020.

As can be seen, the last stock price on the graph (about $29) is almost exactly half of the stock price in mid-February (peaked at $58.54). As such, while it has had a few days on which the price increased, the overall trend has been down.

The RSI chart is shown below. Remember that an RSI value of less than 30 is an indication that it might be time to buy the stock.

In this example, there was a buy signal when the RSI crossed below the green line (30) on February 25. The closing stock price on that day was $49.66. If you had bought the stock on that date, you would have lost 41% in the subsequent three months as the stock was at $29 on May 20, 2020.

As you can see, interpreting charts takes time and expertise. If you are willing to invest the time to learn all of the nuances of each type of chart and monitor your positions, technical analysis might be the right investing strategy for you.

There’s a lot more to know about each of these indicators than I’ve provided in this post. Here are a few links to other sources of information to learn more.

  • Stock Charts
  • Technical Analysis for the Trading Professional by Constance Brown, McGraw-Hill Education, 2nd Edition, 2012.
  • Investopedia

How I Use Technical Analysis

I primarily rely on analysis of the underlying fundamentals of a company when I purchase individual stocks. Once I make the decision to buy a stock, I look at the charts to evaluate whether the timing is good for a purchase. If the consensus of the charts I review indicates that the position is over-bought (i.e., price is too high), I will wait to see if the price decreases before buying.

In addition, I use technical analysis in my Roth IRA, where there are no capital gains taxes on trades so more frequent trading isn’t adversely impacted. I follow a large handful of industry ETFs using technical analysis and buy and sell them as each one appears to be doing well. Because I am trading in industry exchange-traded funds (ETFs) and not individual stocks, I feel comfortable looking at my positions once a week. My thought is that industries aren’t likely to experience sudden weaknesses not seen throughout the market in shorter time frames.

When I pay sufficient attention to the positions in my Roth IRA, I tend to get about or slightly above market-average performance. However, when I don’t look at my positions and re-balance regularly, I find that my performance suffers which just confirms my first point in the previous section that using technical analysis requires time and diligence.

[1] There are now TradersExpo events held regularly in many cities (subject to change by the coronavirus).

How to Buy Life Insurance

How to buy life insurance

Choosing the right type of life insurance policy and its death benefit can be confusing. Not too long ago, I published a guest post from Baruch Silverman of The Smart Investor on the different types of life insurance. In this post, you’ll learn how to buy life insurance.  Specifically, I’ll help you evaluate which, if any, of those types of policies fit your situation and how to select your death benefit.

Why are You Buying It?

The first thing you want to consider is why you are buying life insurance. Three common purposes are:

  • the death benefit.
  • the investment returns.
  • sheltering gifts to your heirs from income taxes.

Death Benefit

If your primary purpose for purchasing life insurance is the death benefit, you’ll want to focus on term and whole life insurance.

Investment Portfolio

Some people use life insurance similar to other financial securities (such as stocks and bonds). Variable life and universal life have investment components to them. In simplified terms, the total amount you pay as premium for these types of life insurance is split between the amount to cover the cost of a whole life policy and the excess which can be invested. As such, the life insurer doesn’t invest the portion of premium related to the death benefit.  Further, the life insurer reduces the excess to cover its expenses, a risk charge and its profit margin before investing it.

Variable and universal life policies include the cost of whole life insurance.  Thus, only people who want the coverage provided by whole life insurance might consider using life insurance as part of their investment portfolio. Even then, the returns may not be as high as other investment vehicles with similar risk because of the additional costs charged by the life insurer.

Tax Shelter

Sheltering gifts to your heirs from income taxes only applies to the very wealthy (those who have more than $11 million in assets). I’m assuming that the vast majority of my readers aren’t in this situation, so won’t address it here.

Other Considerations

All types of life insurance can have an indirect impact on your investment portfolio. If you purchase life insurance in an amount that will cover your dependents’ basic living expenses, it allows you the option to invest your portfolio in riskier assets in anticipation of getting higher returns. That is, the death benefit itself could be considered a low-risk investment.  It reduces your overall portfolio risk when added to the other assets you own.

Do I Need Life Insurance?

Some people don’t need the death benefit from life insurance. In that case, it doesn’t make sense to buy life insurance as an investment security either. In the last section of this post, I provide the details of estimating your target death benefit. People whose target death benefit is zero are those who don’t need life insurance.   Briefly, characteristics of people who have a target death benefit of zero are:

  • Their available assets are more than their debts. Available assets exclude any illiquid assets (such as any real estate or personal property they own), savings for their dependents’ retirement (but not their retirement as they don’t need retirement savings after you die), emergency savings and any savings designated for large purchases.
  • They have enough money to cover their dependents’ education expenses.
  • Their dependents can support themselves on their existing income plus your available assets, including being able to make debt payments as they are due or after using available assets to pay off any debts.
  • They have enough money to pay any end-of-life expenses related to their death.

If you aren’t sure if you meet these criteria, keep reading!

Term vs. Whole

If  you’ve decided that you are buying life insurance for the death benefit, you need to decide whether term life or whole life insurance will better meet your needs. The primary differences between the two options are the length of time you need the insurance and the cost.

Term Life

If you think you will need life insurance for a limited period of time, term life insurance is likely better for you. For example, you might have dependents who aren’t currently able to cover their living expenses and the cost of any debt.  In that case, you might want to buy life insurance that will pay off your debts and support your dependents until they are independent.  If your needs change, many insurers will let you convert a term life insurance policy to a whole life policy without having to provide medical information or have a physical, one or both of which are often pre-requisites for purchasing whole life insurance.

Term life premiums are constant over the term of any policy you purchase. However, if you buy a policy when you are older, the premium will be higher than if you buy the same policy when you are younger.

Whole Life

If you think you will need life insurance for your entire life, whole life insurance is likely better for you. For example, if you have a spouse or disabled children who will never be able to support themselves, whole life insurance could supplement your savings to help make sure they are able to live more comfortably, regardless of when you die.

In addition to the death benefit, whole life insurance gives you the option to borrow money. As you pay premium, life insurers designate a portion of your premium as the cash value. The cash value is always owned by the insurance company, but you are able to borrow an amount up to the cash value at any time without prior approval, any collateral or impact on your credit score. The interest rates on cash-value loans are less than many other sources, particularly credit cards. If you die before the loan is re-paid, the amount of the loan will be deducted from your death benefit.

Cost Comparison

Whole life insurance is much more expensive than term life when you are young, but eventually becomes less expensive.

Probability of Dying

The graph below provides some initial insights into the difference in cost between whole life and term life, as it shows the probability that you will die at each age. I calculated the values based on 2016 data from the Social Security web site.

Not surprisingly, the probability you will die increases at each age. If you buy whole life insurance, it will cover the entire portion of the graph from your current age until you die. As such, there is a 100% probability that the life insurer will pay your death benefit (assuming you continue to pay your premiums). It is just a question of when.

If you buy a 20-year term policy and you are 30 years old, only the deaths that occur in the portion of the graph below highlighted in green would be covered. That is, you will receive the death benefit if you die between ages 30 and 50 and will get nothing if you die after age 50.

The probability you will die is much smaller in this narrow window than the 100% probability you will die at some point.

Present Value of the Death Benefit

There are many factors that determine the premium for term life and whole life insurance policies, but the most important component relates to the death benefit. Actuaries (who help price life insurance) usually base the portion of premium related to the death benefit as the present value of the death benefit expected to be paid, on average, in each year.

One-Year Term Policy

The chart below shows the present value for $1 of death benefit for several sample policies. For illustration only, I have calculated the present values using a 3% interest rate and the probabilities of dying from the charts above.

The easiest way to see the impact of the increasing probability of dying is to look at the present value of the death benefit for a 1-Year Term Life policy. You can see it increases from almost zero (actually $0.0015 per dollar of death benefit) at age 25 to $0.042 per dollar of death benefit at age 70 which corresponds exactly to the increase in the probability of dying at each age.

Policies with Longer Terms

There are also increases in the present value of the death benefit for the Whole Life and 20-Year Term Life policies as the age you first start buying the policy increases.

You can also see that the present value of the death benefit at age 25 for the Whole Life policy is much, much larger than the present value for either of the two term life policies. This relationship corresponds to the graphs above which compared the probability of dying in a 20-year period as compared to the 100% probability that you will die at some point.

The difference between the Whole Life and 20-Year Term Life policies is fairly small at age 70, because there is a high probability that you will die between age 70 and 90 – the period covered by the 20-Year Term Life policy. In fact, almost 80% of people age 70 will die during the 20-Year Term Life policy period.  As such, the present value of the death benefit for a 20-Year Term Life policy at age 70 is very roughly 80% of the present value of the death benefit for a Whole Life policy.

Annual Premium

The insurance company collects premium over the full life of the insurance policy to cover the present value of the death benefit. That is, you don’t pay all of your premium to the insurance company in one lump sum, but rather on an annual or monthly basis.

Unless you die during the policy term of the Term Life policy, you will pay premium for more years under a Whole Life policy than under a Term Life policy. Therefore, the differences you see above are larger than the differences in premium payments.

Illustration

The chart below shows the annualized amount of the loss costs. That is, I divided the present values of the death benefits by the average number of years an insured is expected to pay their premium. For example, for the 20-Year Term Life policy, the denominator was calculated as the sum of the probabilities that the insured would be alive in each of the 20 years and therefore able to pay his or her premium.

Post 49 Estimated Premium

Although these relationships are not precise, they are roughly representative of the differences in annual premium you might pay for the different types of policies at different ages. At age 25, the annual cost of a Whole Life policy in this illustration is roughly three times the cost of either of the Term Life policies. By age 70, the annual cost of a Whole Life policy is less than the cost of 20-Year Term Life policy because, while the present value of the death benefit isn’t all that different between the two policies, people who buy Whole Life policies make more premium payments, on average.

Reality vs. Illustration

It is important to understand that I prepared these examples as illustrations to help you understand the differences between Whole Life and Term Life insurance premiums. In practice, life insurers use different tables showing the probability of dying and different interest rates than I used for illustration, as well as using more sophisticated methods for calculating the present value of the death benefit and including provisions for expenses, risk and profit.

In practice, I’ve seen estimates that Whole Life annual premiums are anywhere from three to fifteen times more than Term Life premium at young ages. As you are looking at your options, you’ll want to get several premium quotes, as they vary widely depending on your age, location, gender, health and many other factors.

How Much to Buy

As with any financial decision, there are two conflicting factors that will influence the amount of the death benefit you buy on a life insurance policy – your budget and your financial needs. In the section, I will talk about how to estimate the best (i.e., target) death benefit for your situation. Once you’ve selected an amount, you can get quotes from several insurers to see whether the premium for that death benefit will fit in your budget or whether you will need to find the best balance between premium affordability and death benefit for you.

Rules of Thumb

Not surprisingly, there are some rules of thumb for guiding your selection of a death benefit. Some of the ones I’ve heard are:

  • Three to five times your salary
  • Ten times your total earned income (i.e., salary, value of benefits and bonus)
  • Ten times your total earned income plus $100,000 per child for college

Rules of thumb like these can provide some insights, but they, by definition, can’t take into account your personal circumstances.

Tailored Approach

A better approach for selecting a death benefit is to analyze your own finances and goals for buying life insurance.   I suggest calculating your target death benefit as the total of the amounts needed to meet your goals, considering the following components.

Debt

If you have debt, you’ll want to consider whether your dependents will be able to continue to make the payments on the debt out of their own income. For example, if your spouse’s earned income is high enough to continue to make your mortgage payments, along with all of the other expenses he or she will need to cover if you die, then you might not need to include the remaining principal on your mortgage as a component of your target death benefit. On the other hand, if you are concerned about your dependents’ ability to continue payments on any debt, you’ll want to include the outstanding principal on those debts as a component of your target death benefit. I’ll define this amount as “Debt Principal to be Pre-Paid.”

Final Expenses

When you die, your dependents will incur some one-time expenses. These expenses can include your funeral or memorial costs and professional expenses to settle your estate. I’ll call the amount of these expenses, “Final Expenses.”

Net Future Living Expenses

The next component of your target death benefit calculation is the amount you need to cover your dependents’ future living expenses.

Current Expenses

Start with your household’s total expenses from your budget. This amount will include monthly expenses for everyone in your household, the amounts you are setting aside each month for your designated savings and any amounts you are setting aside for your spouse’s retirement. To be clear, it will exclude any amounts you are saving for your own retirement.

You can eliminate any monthly expenses or amounts for designated savings for things that are only for your benefit. For example, if you spend enough money on clothes for your job to include it in your budget, you can eliminate those expenses. Similarly, you can also eliminate any expenses related to a vehicle that only you drive or designated savings to replace it.

Earned Income

You then need to calculate your dependents’ monthly earned income. This amount may be calculated in two parts – current monthly earned income and future monthly earned income. For example, your spouse may currently work part time as you are relying primarily on your income for support. If you die, your spouse may be able to work full time to increase his or her earned income. Alternately, your spouse may need some education (discussed below) to get the qualifications needed for his or her desired profession.

Extra Expenses

Next, you’ll need to calculate the amount of any expenses that your household will have because of any changes in your spouse’s availability to provide household services. For example, your spouse may work part-time while your children are in school and provide childcare after school. If your spouse starts working full time after your death, you will need to add after-school care expenses to your budget.

Time Periods

The last factor that goes into this calculation is the length of time until you think your dependents will become self-sufficient. For children, you might assume that they will become independent after they turn 18 or graduate from college. The ability of your spouse to become self-sufficient will be a function of his or her skills, education and/or need for more education and household responsibilities (e.g., childcare or elder care).

I suggest splitting the calculation of this component of your death benefit into three time periods – short-term, medium-term and long-term. For each time period, you’ll calculate your net living expenses as expenses minus income. For any periods for which income is more than expenses, set the difference to zero.

  1. Short term – During this time period, you’ll use your current monthly expenses, excluding your personal expenses, and your dependents’ current monthly earned income.
  2. Medium term – During this time period, you’ll use your current monthly expenses with adjustments for extra expenses for services currently provided by your spouse and your dependents’ future monthly earned income.
  3. Long term – During this time period, you’ll assume that your children (other than those who will always be dependent on you for care) are self-sufficient, so can eliminate all expenses related to children and their care from your expenses. You’ll use your spouse’s future monthly earned income. In many households, income in this period will exceed expenses so there may not be a need for death benefits to cover expenses in this period.

You also need to estimate how many months each of these three time periods will last.

Net Future Living Expenses

Your Net Future Living Expense amount for each time period is calculated as the number of months it will last multiplied by monthly net living expense amount. You can then calculate your total Net Future Living Expenses as the sum of the three amounts you calculated for the three time periods.

For those of you who like to see formulas instead of words, you will calculate:

  1. Short-term Net Expenses = Greater of 0 and Current Expenses – Current Income
  2. Medium-term Net Expenses = Greater of 0 and Current Expenses + Extra Expenses – Future Income
  3. Long-term Net Expenses = Greater of 0 and Future Expenses – Future Income
  4. Net Future Living Expenses = (number of months in short-term period x Short-term Net Expenses) + (number of months in medium-term period x Medium-term Net Expenses) + (number of months in long-term period x Long-term Net Expenses)

You could refine this amount by considering inflation and investment returns. Depending on your investment strategy and the time until the funds are used, your investment returns, on average, can be more than inflation. As a conservative first approximation, I suggest using the total without adjustment for inflation and investment returns.

Education

There are two types of education expenses that you might want to include in your target death benefit calculation:

  1. The portion of the cost of education for your children that you want to provide. Some people suggest $100,000 per child for college. This amount may or may not be the right amount depending on how much you expect your children to contribute to their educations, how many years of college education you want to support and what type of school they attend. Prestigious colleges can cost as much as $75,000 to $80,000 a year currently (2020), while in-state tuition (assuming your children live at home while attending college) can cost as little as $15,000 a year in some states. Other children may not go to college or may attend a trade school.
  2. The cost of any education your spouse needs or wants to allow him or her to work in a profession he or she enjoys and allows him or her to earn enough money to increase his or her independence.

Target Death Benefit Calculation

You can now calculate your target death benefit as follows:

Debt Principal to be Pre-Paid

Plus        Final Expenses

Plus        Net Future Living Expenses

Minus   Savings in excess of your real estate and personal property assets, emergency fund, designated savings and spouse’s retirement savings

Plus        Education Expenses

Minus   Amounts in existing college funds

Minus   Any amounts included in your Net Future Living Expenses designated for college

If you are single with no debt, this amount could be zero indicating that you might not need to buy life insurance. If you are married with no children, don’t have a lot of debt and have a spouse who can increase income or decrease expenses to be self-sufficient fairly quickly, you may need only a small death benefit. At the other extreme, if you have several children and a spouse who won’t be able to be financially independent for many years or ever, your target death benefit could exceed $1 million.   As you can see, the specifics of your financial situation are very important to setting a target death benefit and a rule of thumb may not work for you.

Do I Need a Financial Planner?

Do I Need a Financial Planner?

Creating your own financial plan can be a daunting task. If you aren’t sure where to get started or have a plan but want to improve it, a financial planner might be able to help. I’ve never used a financial planner, so I interviewed two friends who use a planner and Graeme Hughes[1], The Money Geek, to get their insights and perspectives.

In this post, I’ll first distinguish financial planners from other types of financial advisors. The rest of the post provides responses to questions asked by a few of my readers to help you with the following:

  • Figure out whether and how a financial planner can help you.
  • Prepare for your first meeting with a financial planner.
  • Understand the process for developing a financial plan and the deliverables.
  • Select a financial planner who meets your needs.

Financial Planners vs Other Financial Advisors

There are many types of advisors who can help you with your finances. In this post, I’ll focus on professionals who provide financial planning services. These professionals can be independent advisors, work for firms that perform solely financial planning services or can be employed by mutual fund companies, stock brokerage firms (e.g., Schwab or Morgan Stanley), other financial institutions (e.g., Ameriprise) or other types of firms (e.g., accounting firms). Most of these financial planners provide a brand range of services intended to assist you in creating a sound financial plan and attaining your financial goals.

Types of Other Financial Advisors

There are many other types of financial advisors, some of whom may be called financial planners, who specialize in segments of your financial plan. Examples of these advisors include:

  • Insurance agents who can assist you in finding the best insurance policies to meet your needs. Some insurance agents specialize in just property & casualty lines (such as residences, cars or umbrella policies) or health or life insurance or annuities, while others can assist with several or all types of personal insurance.
  • Stock brokers who provide advice about specific companies or financial instruments in which you might want to invest.
  • Money managers who make decisions about what to buy and sell in your portfolio and execute the transactions.
  • Debt consultants or consolidators who can help you find the best strategy for paying off your debts.
  • Tax accountants and tax lawyers who can provide advice about your tax situation and how it might impact your financial decisions. Tax accountants can also prepare your tax returns.

What’s Best for You

You’ll want to choose an advisor who has the right expertise to address your questions. If you want help with your overall financial plan, a financial planner is best. If you go to an advisor with a narrower focus in that situation, you might not get the best information for your overall financial health. For example, an insurance agent who specializes in life insurance and annuities would be less likely to focus on non-insurance savings mechanisms, such as 401k’s or exchange-traded funds, than a financial planner with a broader area of expertise.

To be clear, all of these types of advisors can be very valuable in refining your financial plan, but you’ll want to make sure you have the right expectations about their expertise. In fact, your financial planner may refer you to one or more of these consultants on a specific aspect of your financial plan.

What Services do Financial Planners Provide?

The primary service provided by a financial planner is the development of a sound financial plan. This process can include assistance with setting financial goals, budgeting, estate planning, retirement planning, selection of insurance coverages and investment strategies.

The specific services provided will be tailored to your needs. If you are just getting started, the financial planner may focus on identifying goals and creating a budget. If you already have a financial plan and want increased comfort that you will meet your goals, these services could be as sophisticated as statistical (Monte Carlo) modeling of your future financial situations under a wide range of assumptions regarding future investment returns.

As part of or before your first meeting, a good financial planner will ask about the current status of your finances and what your goals are for deliverables to make sure the planner helps you in a way that makes sense for you.

Do I Need a Financial Planner?

Using a financial planner is a matter of personal preference. I’ve never used one, but my background as an actuary and working with the finance and risk management departments of insurance companies has given me the confidence to go it alone. However, most people can benefit from good advice. As Graeme says, though, “You only need to be careful not to pay for more than you need.” His thoughts about the services you might want to use by age are:

  • A young person starting out might get counseling on budgeting, savings strategies, how much to save, and which tax-advantaged accounts to use.
  • Middle-aged individuals with more substantial savings ($100K+) might want to get an assessment of where they stand for retirement and how much to save to meet their retirement income goals, considering all of the resources at their disposal.
  • Pre-retirees (5-10 years out) will want to have a comprehensive plan to ensure they have adequately covered all likely scenarios, so they can be confident in their retirement plans before pulling the plug on work.

If you have enough assets for it to matter and aren’t highly confident you are on track to meet your goals or you suspect there are gaps in your knowledge, a professional financial planner can help.

For a different perspective on using a financial planner, check out this article from Schwab that I happened to read as I was writing this post.

What Will I Get?

Primary Deliverable

The most important deliverable from a financial planner is a financial plan. Depending on where you are in the process of managing your finances, it will include some or all of the following items:

  • Your financial goals
  • A statement of your current financial position (assets and debt)
  • A budget
  • Your savings strategies and actions, including
    • Short-term savings
    • Designated savings
    • Retirement savings, sometimes including investment advice
  • A plan for re-paying your current debt
  • Guidance about the types and amounts of insurance to buy, along with descriptions of your current policies
  • A brief description of your income tax situation
  • Guidance on what needs to be done to ensure that the legal documents are in place in case you become incapacitated or die

Other Deliverables

In addition, financial planners can provide longer term projections that show estimates of the growth in your income, assets (from investment returns and additions to savings) and expenses. These types of projections can provide insights about your ability to retire when and in the style you want.

Another benefit of working with a financial planner is that you can get referrals to other advisors and can become aware of other financial resources to help with different aspects of your financial life. For example, most financial planners do not draft legal documents, such as wills, trust agreements or powers of attorney. Many financial planners, though, have worked with lawyers who have this expertise and can provide you with a referral.

How Should I Prepare?

All financial planners have their own unique processes. As such, you’ll want to ask your planner the format of the information he or she would like to see. Many planners will provide you with a questionnaire and/or an information request to guide you through the process of compiling your information. Nonetheless, there are a number of fundamental pieces of information that every financial planner will request. They are your:

  • Assets, including retirement accounts
  • Liabilities
  • Income
  • Monthly expenses
  • Current or future defined benefit pension benefits
  • Financial goals
  • Values

Graeme was quite clear that the numerical values above should be firm, accurate numbers, not guesses. It will take some time to compile all of this information, but will ensure that you get the best service from your financial planner. He also added that you should “run away” from any planner who makes recommendations before obtaining this information.

What is the Process?

You are likely to meet with your financial planner once or twice to create or refine your financial plan initially. Some planners prefer to learn about your finances by reviewing documents and answers you provide to their questionnaires. Other planners prefer to have an introductory meeting to learn about you and your finances. In either case, the financial planner wants to learn your objectives and concerns, along with your family structure.

The financial planner will then assess your situation and goals, identify gaps and challenges, and determine the most appropriate strategy for ensuring your goals will be met. The planner will prepare a financial plan and an investment plan, including an asset allocation assessment for investments, and provide them to you in writing.

Your financial planner will then meet with you in person to present the plan and make recommendations. You and your planner will then identify the action items that come out of the plan and assign them to either you or the planner, depending on their nature and your planner’s areas of expertise.

How Often Should I Check Back In?

Financial planning is not a “one and done” exercise. You’ll want to track your progress against your plan and adjust it as necessary. Adjustments might be needed as there are changes in the economy and investing markets or changes in your personal life, such as marriage, a death in the family, children, or a change in your goals.

If both your life and the economy are fairly stable, once a year may be often enough to meet with your financial planner. More typically, you’ll want to check in with your financial planner twice a year. Of course, if you have any life changes, it will also be a good time to check in with your financial planner to see if any tweaks or more significant changes to your financial plan are indicated.

How are Financial Planners Paid?

There are a number of different ways in which financial planners are paid. Here are some of the more common options.

No Charge

If you use a financial planner at a brokerage firm or mutual fund company, you can often get some financial planning services at no charge. The more money you hold at the brokerage firm, the more services you can get at no charge.

Fixed Fees Per Service

Many independent financial planners will provide services on a fixed-fee basis. That is, they will charge you a fixed cost for each of the different aspects of your financial plan with which they provide assistance. Financial planners at brokerage firms also can charge fixed fees for services that are beyond those that are provided at no cost.

Commissions

Financial planners who also sell products, such as insurance or mutual funds, are often paid based on the products you purchase through them. For example, sellers of insurance are often paid 5% to 15% of the premium on the policies you purchase.

Percentage of Assets

Although it is more common with people who manage your money than with advisors who help you with your financial plan, some financial planners are paid as a percentage of the market value of your assets that they manage. This type of compensation is also common for financial planners who work for mutual fund companies.

What’s Best for You

When you get advice from a financial planner, you’ll want to understand the possible biases introduced by the form of their compensation. The vast majority of financial planners are ethical and are focused on your best interests. Nonetheless, you’ll want to be aware of the possibility that the solution proposed by a financial planner is potentially influenced by their compensation. As such, I suggest seeking financial planning advice from people who provide their services either at no charge to you or for a fixed fee.

How Do I Find the Financial Planner that is Best for Me?

One of the best ways to identify possible financial planners is to get recommendations from other financial professionals with whom you already have a relationship, such as an accountant or attorney. If you have friends who are particularly financially savvy, you might ask them for a recommendation. However, you are probably at least as skilled at selecting a financial planner as any friends who are in the same boat as you. And, you are a better judge of a good fit for you than anyone else. Also, I strongly recommend against using a family member as a financial planner. There are almost always too many emotions tied up in family relationships for a family member to be able to advise you on a subject that often requires difficult conversations, such as your finances.

Check their Qualifications

Once you have identified one or more possible financial planners, you’ll want to check their qualifications and whether they have been disciplined. In the US, the most common designation attained by professional financial planners is a Certified Financial Planner, though there are many other designations that indicate expertise, such as a Certified Financial Analyst or a Certified Public Accountant (CPA).

Once you’ve identified the candidates’ professional designations, you’ll want to check to see if there has been any disciplinary action against them. Disciplinary actions are all available on-line. Graeme’s words of wisdom are, “I don’t care how minor the infraction. I wouldn’t go near anyone who has been disciplined. It’s not hard to be an honest advisor, and I wouldn’t trust anyone who has failed at that.”

Interview a Few Financial Planners

You then want to interview the remaining candidates. Again, I’ll provide Graeme’s advice, as I think it is right on target.

  • Are they generous with their time?
  • Do they listen to you?
  • Do they listen to your spouse?
  • Are they genuinely curious about your situation and your plans and goals?
  • Do they ask questions?
  • Or, are they too quick to sell you something?

Your Final Selection

Look for a combination of training and experience. A financial planning designation should be a minimum, along with several years in the industry. They should also be able to refer you to current clients who can recommend their services.”

I suggest that you also think about whether you feel you can develop a good, long-term relationship with the potential advisor.  Also, consider whether they garnered your respect during the interview. Starting the process of financial planning on a shaky foundation will be unproductive at best.

[1] Graeme Hughes is an accredited Financial Planner with 23 years of experience in the financial services industry. During the course of his career he completed hundreds of financial plans and recommended and sold hundreds of millions of dollars of investment products.

A Man is Not a (Sound Financial) Plan

A man is not a plan

“A Man is Not a Plan!” It sounds like a very dated statement, but a guide on a recent trip I took told me about a conversation he had with one of his nieces about her finances.  They were talking about how she could improve her financial situation by building a sound financial plan. As they were talking, one of them came up with the slogan, “A Man is Not a Plan.” He suggested I use it as the title for one of my posts. So, here it is!

In this post, I will talk about the key components of a sound financial plan. A financial plan provides the structure to help you organize your financial information and decisions. I’ll provide brief explanations of the things to consider about each component, what you need to do and, for most of them, links to posts I’ve written that provide much more detail. I’ll also provide insights on how to know when you need help and who to contact.

Sound Financial Plan

A sound financial plan includes the following sections:

    • A list of your financial goals – In this section, you’ll want to identify your three to five most important financial goals.
    • A list of your current assets and liabilities (debts)
    • Your budget
    • Your savings and investment strategies to help you attain your goals, including
      • Short-term savings
      • Designated savings
      • Retirement savings
    • Desired use of debt, including re-payment of current debt
    • Your giving goals
    • Risk management strategy, i.e., types and amounts of insurance to buy
    • Understanding of your income tax situation
    • What you want to have happen to you and your assets when you become incapacitated or die and related documents

     

  • You will likely be most successful if you create a formal document with all of these components of a sound financial plan. You’ll want to review and update your financial plan at least every few years, but certainly any time you have a significant change in your finances (e.g., a significant change in wages) or are considering a significant financial decision (e.g., buying a house, getting married or having children). Of course, a less formal format is much better than no plan at all, so you should tailor your efforts to what will best help you attain your financial goals.

    Budget

    A budget itemizes all of your sources of income and all of your expenses, including money you set aside for different types of savings. It provides the framework for all of your financial decisions. Do you need to change the balance between income and expenses to meet your goals? Can you make a big expenditure? How and what types of insurance can you afford? How much debt can you afford to re-pay?

    I think that a budget is the most important component of a sound financial plan and should be the first step you take. Everyone should have a good understanding of the amounts of their income and expenses to inform the rest of their financial decisions.  While some people will benefit from going through the full process of creating a budget and monitoring it, others can be a bit less detailed.

    In the text section of your financial plan, you’ll want to include a list of your financial goals as they relate to your budget and how you plan to implement them. You can include your actual budget in your financial plan itself or as a separate attachment.

    Savings

    I generally think of savings in three categories (four if you include setting aside money for your kids): emergency savings, designated savings and retirement savings. You will want to address each of these types of savings in your financial plan. The information you’ll want to include for each type of savings is:

    • How much you currently have saved.
    • The target amounts you’d like to have saved.
    • Your plan for meeting your targets.
    • For what you’ll use it.
    • How fast you’ll replenish it if you use it.
    • How much you need to include in your budget to meet your targets.
    • Your investing strategy.
    • A list of all financial accounts with location of securely stored access information.

    Emergency Savings

    Emergency savings is money you set aside for unexpected events. These events can include increased expenses such as the need to travel to visit an ailing relative or attend a funeral or a major repair to your residence. They also include unexpected decreases in income, such as the reduced hours, leaves of absence or lay-offs related to the coronavirus.

    The general rule of thumb is that a target amount for emergency savings is three to six months of expenses. I suggest keeping one month of expenses readily available in a checking or savings account that you can access immediately and the rest is an account you can access in a day or two, such as a money market account.

    Designated Savings

    Designated savings is money you set aside for planned large expenses or bills you don’t pay every month. Examples might include your car insurance if you pay it annually or semi-annually or money you save for a replacement for your car you are going to buy in a few years.

    To estimate how much you need to set aside for your designated savings each month, you’ll want to look at all costs that you don’t pay every month and figure out how often you pay them. You’ll want to set aside enough money each month to cover those bills when they come due. For example, if your car insurance bill is $1,200 every six months, you’ll want to put $200 in your designated savings in each month in which your insurance bill isn’t paid. You’ll then take $1,000 our of your designated savings and add $200 in each month it is due to pay the bill.

    Retirement Savings

    Saving for retirement is one of the largest expenses you’ll have during your working lifetime. There are many aspects of saving for retirement:

    Debt

    Debt can be used for any number of purchases, ranging from smaller items bought on credit cards to large items purchased with a loan, such as a home. Whether you have debt outstanding today, use credit cards regularly and/or are thinking of making a large purchase using debt, you’ll want to define your goals with respect to the use of debt.

    For example, do you want to never have any debt outstanding (i.e., never buy anything for which you can’t pay cash and pay your credit card bills in full every month)? Are you willing to take out a mortgage as long as you understand the terms and can afford the payments? Do you have a combination of a high enough income and small enough savings that you are willing to use debt to make large purchases other than your home? Do you have debts you want to pay off in a certain period of time?

    As you think about these questions, you’ll want to consider what debt is good for you and what debt might be problematic.  A sound financial plan includes a list of your debts, how much you owe for each one, your target for repaying them, and your strategy for using debt in the future.

    Credit Cards

    Credit cards are the most common form of debt. Your financial plan might include the number of credit cards you want to have and your goals for paying your credit card bills. As part of these goals, you might need to add a goal about spending, such as not buying anything you can’t afford to pay off in a certain period of time.

    Student Loans

    Many people have student loans with outstanding balances. In your financial plan, you’ll want to include your goal for paying off any student loans you have. Do you want to pay them off according to the original schedule? Are you behind on payments and have a goal for getting caught up? Do you want to pay off your student loans early?

    Car Loans

    In a perfect world, your car would last long enough that you could buy its replacement out of your designated savings. However, the world isn’t perfect and you may need to consider whether to take out a loan or lease a car. Your financial plan will include your strategy for ensuring that you always have a vehicle to drive. How often do you want to replace your car? What is your goal with respect to saving for the car, loans or leases? How much will it cost to maintain and repair your car?   Your budget will include the amounts needed to cover the up-front portion of the cost of a replacement car, any loan or lease payments and amounts to put in designated savings for maintenance and repairs.

    Mortgages

    Most homeowners borrow money to help pay for it As part of creating your financial plan, you might include your goal for home ownership. Are you happy as a renter for the foreseeable future or would you like to buy a house?

    If you want to buy a house either for the first time or a replacement for one you own, you then need to figure out how to pay for the house. How much can you save for a down payment? Can you set aside enough in designated savings each month to reach that goal? What is the price of a house that you can afford, after considering property taxes, insurance, repairs and maintenance?

    Once you have a mortgage, you’ll want to select a goal for paying it off. When a mortgage has a low enough interest rate, you might make the payments according to the loan agreement and no more. If it has a higher interest rate or you foresee that your ability to make mortgage payments might change before it is fully re-paid, you might want to make extra payments if you have money in your budget.

    Paying Off Debt

    If you have debt, you’ll want to include your goals and your strategy for paying it off in your financial plan. You’ll first want to figure out how much you can afford each month to use for paying off your debts. You can then compare that amount with the amount needed to meet your goals. If the former is less than the latter, you’ll need to either generate more income, reduce other expenses, put less money in savings or be willing to live with less aggressive goals. These decisions are challenging ones and are a combination of cost/benefit analyses and personal preference.

Giving Goals

Many people want to give to their community either by volunteering their time or donating money.  If you plan to give money or assets, you’ll first want to make sure that you can afford the donations by checking your budget and other financial goals.  It is also important to make sure that your donations are getting used in the way you intended, as not all charities are the same.  A Dime Saved provides many more insights about giving in her Guide to Giving to Charity.

  • Insurance

    Protecting your assets through insurance is an important part of a sound financial plan. The most common types of insurance for individuals cover your vehicles, residence, personal liability, health and life. There are other types of insurance, such as disability, dental, vision, and accidental death & dismemberment, that are most often purchased through your employer but can also be purchased individually.

    As I told my kids, my recommendation is that you buy the highest limits on your insurance that you can afford and don’t buy insurance for things you can afford to lose. For example, if you can afford to pay up to $5,000 every time your home is damaged, you might select a $5,000 deductible on your homeowners policy. Alternately, if you can afford to replace your car if it is destroyed in an accident, you might not buy collision coverage at all. Otherwise, you might set lower deductibles as your goal.

    For each asset in your financial plan, including your life and health which can be considered future sources of income or services, you’ll want to select a strategy for managing the risks of damage to those assets or of liability as a result of having those assets.

    A financial plan includes a list of the types of policies you purchase, the specifics of the coverage provided and insurer, changes you’d like to make to your coverage and your strategy for insurance in the future. You’ll also want to attach copies of either just the declaration pages or your entire policies to your financial plan.

    Car Insurance

    Car insurance can provide coverage for damage to your car, to other vehicles involved in an accident you cause and injuries to anyone involved in an accident. The types of coverages available depend on the jurisdiction in which you live, as some jurisdictions rely on no-fault for determining who has to pay while others rely solely on tort liability.

    Homeowners Insurance

    Homeowners insurance (including renters or condo-owners insurance) provides coverage for damage to your residence (if you own it), damage to your belongings and many injuries to people visiting your residence.

    Umbrella Insurance

    One way to increase the limits of liability on your car and homeowners insurance is an umbrella insurance policy. An umbrella also provides protection against several other sources of personal liability. If you have money in your budget for additional insurance, you might consider purchasing an umbrella policy.

    Health Insurance

    Health insurance is likely to be one of your most expensive purchases, unless your employer pays a significant portion of the cost. Whether you are buying in the open market or through your employer, you are likely to have choices of health insurance plan. Selecting the health insurance plan that best meets your budget and goals can be challenging.

    Life Insurance

    There are many types of life insurance, including term and whole life. Some variations of whole life insurance provide you with options for investing in addition to the death benefit. Once you have compiled the other components of your financial plan, you’ll be better able to assess your need for life insurance. If you have no dependents and no debt, you might not need any. At the other extreme, if you have a lot of debt and one or more dependents, you might want to buy as much coverage as you can afford to ease their financial burden if you die. To learn more specifics about buying life insurance, you might review this post.

    Income Taxes

    Some of your financial decisions will depend on your income tax situation.

    • Do you want your investments to produce a lot of cash income which can increase your current income taxes or focus on appreciation which will usually defer your taxes until a later date?
    • Is a Roth (TFSA) or Traditional (RRSP) plan a better choice for your retirement savings?
    • Are you having too little or too much income taxes withheld from your paycheck?
    • Do you need to pay estimated income taxes?
    • How will buying a house, getting married or having children affect your income taxes?
    • Will moving to another state increase or reduce your income taxes?

     

  • As you consider these and other questions, you’ll want to outline at least a basic understanding of how Federal and local income taxes impact your different sources of income as part of creating a sound financial plan.

    Legal Documents

    Although it is hard to imagine when you are young, at some point in your life you may become incapacitated and will eventually die. There are a number of documents that you can use to ensure that your medical care and assets are managed according to your wishes. You can either include these documents as part of your financial plan or create a list of the documents, the date of the most recent version of each one and where they are located.

    Powers of Attorney

    There are two important types of powers of attorney – medical and financial.

  • A medical power of attorney appoints someone to be responsible for making your medical decisions if you are physically or mentally incapable of doing so. You can supplement a medical power of attorney with a medical directive that is presented to medical personnel before major surgery or by the person appointed to make medical decisions that dictates specifically what is to happen in certain situations.A financial power of attorney appoints someone to be responsible for your finances if you are physically or mentally incapacitated. The financial power of attorney can allow that person to do only a limited number of things, such as pay your bills, or can allow that person to do anything related to your finances.

    Trusts

    There are several forms of trusts that can be used to hold some or all of your assets to make the transition to your beneficiaries easier when you die. Trusts can also be used to hold money for your children either before or after you die. While I am familiar with some types of trusts, I don’t know enough to provide any guidance about them. If you are interested in them, I suggest you research them on line and/or contact a lawyer with expertise in trusts.

    Your Will

    If you die without a will, your state or provincial government will decide how your assets will be divided. In many jurisdictions, your spouse, if you have one, will get some or all of your assets. Your children or parents may also get some of your assets. Most people want more control over the disposition of their assets than is provided by the government.

  • A will is the legal document that allows you to make those specifications. Your will can also identify who will become legally responsible for your minor children or any adult children who are unable to take care of themselves. That responsibility can be split between responsibility for raising your children and responsibility for overseeing any money you leave either to their guardian(s) or for them.

    How to Know When You Need Help

    As you can see, there are a lot of components to a sound financial plan and many of them are interrelated. There are many resources available to help you develop and refine your plan. Many of those resources are free, such as the links to the articles I’ve published on relevant topics. There are also many other sources of information, including personal stories, on line.

    You can also get more personalized assistance. There are many types of financial advisors, a topic I’ll cover in a post soon. Many financial advisors provide a broad array of services, while others specialize in one or two aspects of your financial plan.

    Sources of Advice

    The table below lists the types of obstacles you might be facing and the types of advisors that might be able to help.

    ObstaclePossible Advisors
    I can’t figure out how to make a budget or how to set aside money for emergency or designated savings.Bookkeeper, accountant, financial planner
    I can’t make my budget balance.Bookkeeper, accountant, financial planner
    I have more debt that I can re-pay.Financial planner, debt counselor, debt consolidator
    I don’t know what insurance I should buy.Financial planner, insurance agent or, for employer-sponsored health insurance, your employer’s human resource department
    I’m not sure I’m saving enough for retirement.Financial planner
    I have questions about how to invest my savings, including whether I am diversified or need to re-balance my portfolio.Financial planner or stock broker
    I don’t understand how income taxes work.Accountant
    I need help with a Trust, Power of Attorney or Will.Wills & estates lawyer

    Clearly, a financial planner can help with many of these questions, but sometimes you’ll need an advisor with more in depth expertise on one aspect of your financial plan.

At What Price Should I Buy a Stock?

Deciding at what price to buy a stock or other security is almost as hard as deciding whether to buy the security at all.  There are many different approaches for deciding at what price to buy a stock.  One of the ones I’ve seen discussed most often is dollar-cost averaging.  Other strategies include (1) buying the position on whatever day you decide to buy it and (2) setting a target price that is below the current trading price, among many others.  In this post, I’ll explain and compare these three strategies.

Dollar-Cost Averaging

Dollar cost-averaging is a strategy for buying stocks that is intended to reduce the risk that you will “buy high.”

How it Works

Here are the key steps for implementing this strategy:

  • Identify the security you want to buy.
  • Determine how much money you have to invest in that security.
  • Divide that amount into equal increments. In the examples below, I have split the amount into four increments.
  • Decide over what time period you want to make your purchases. In the examples below, I have illustrated a purchasing time period of four weeks.
  • Invest one increment at points in time evenly spaced over your selected time period. For example, let’s say you want to invest over four weeks.  You might buy the selected security every Wednesday in four equal pieces.  If you have $1,000 to invest, you would buy $250 of the selected security each Wednesday for four weeks.

The underlying premise of this approach is that you buy more shares of the selected security than if you happened to have bought the security on a day that the price is high.  Specifically, because you are buying the security in equal dollar amounts, you will buy more shares when the price is low and fewer shares when the price is high.  As such, your average purchase price will be low.

Simple Example

Here’s a simple example in which you invest a total of $4,800 in increments of $1,200 a week for four weeks.

WeekStock PriceShares Purchased
1$10.00120
28.00150
312.00100
49.25130

In this example, you buy a total of 500 shares.  If you had bought all of your shares on at $10 (the first week price), you would have 480 shares ($4,800 / $10).  In this scenario, you will have 4% more shares ([500 – 480]/480 – 1) if you use dollar-cost averaging than if you bought all of your shares at the first week’s price.  4% more shares corresponds to 4% more money when you sell the security.  Although 4% may not sound like a large difference, it can add up over time as you buy and sell stocks.

To be clear, though, dollar-cost averaging isn’t always better.  If you had bought all of your shares at the Week 3 price of $8, you would have 600 shares or 20% more than if you used dollar-cost averaging.

Investing Strategies

Here are the three strategies for determining when to buy a security that I’ll use for illustration.

Strategy 1 – Invest Immediately

Invest all of your available money on the day you decide to make the purchase.

Strategy 2 – Dollar-Cost Averaging

Use dollar-cost averaging by buying ¼ of your money available on Wednesday of four consecutive weeks[1]. This strategy is similar to what happens when you buy securities in your employer-sponsored retirement account if you are paid weekly.  Every week, you employer takes some of your wages and invests it in the security you have selected.

Strategy 3 – Wait for Price Drop

Invest all of your available money after the stock price has dropped by 5%. Hold your money in cash while waiting for the price to decrease.

More Examples

I’ve created a few more simple examples to compare the strategies for deciding when to buy a security.  These examples are intentionally simple and therefore unrealistic.  Nonetheless, they are helpful in understanding the different strategies because of their simplicity.  In all of the examples, you have $1,000 to invest.

Smooth Increase

In the first scenario, the stock’s price goes up smoothly by 10% every year.  A graph of its price over two years would look like this.

The chart below focuses on the first month of the above chart and includes the purchases for Strategies 1 and 2 as dots.

Under Strategy 1 (big red dot), you buy all of your stock on the first day at $10 a share, so you are able to purchase 100 shares.

Under Strategy 2 (smaller green dots), you would buy $250 of stock on each of the first, eighth, fifteenth and twenty-second days.  The table below shows the prices on those days and the number of shares you buy.

DayPriceShares Bought
1$10.0025.00
810.0224.95
1510.0424.90
2210.0524.88

The total number of shares you buy is 99.73.

Under Strategy 3, you never buy the stock because the price never decreases by 5%.

The table below compares the numbers of share bought under each strategy

StrategyNameNumber Shares BoughtValue in Two Years
1Invest Immediately100.00$1,210
2Dollar-Cost Averaging99.731,203
3Wait for Price DropN/A1,000

In this scenario, there is very little difference between the first two strategies, though you will buy more shares if you invest immediately. Any time you delay your purchases in this scenario, you are certain to pay a higher price which reduces the number of shares you can buy.  Under Strategy 3, because the price never decreases, you never buy the stock, so end up with the same amount of money with which you started.

Smooth Check Mark

The second illustration is stock whose price goes down smoothly for six months and then increases for the next 18 months.  A graph of its price would look like this.

The chart below focuses on the first six months of the above chart and includes the purchases for all three strategies as dots.

Under Strategy 1 (big red dot), you buy all of your stock on the first day at $10 a share, so you are able to purchase 100 shares.

Under Strategy 2 (smaller green dots), you buy $250 of stock on each of the first, eighth, fifteenth and twenty-second days.  The table below shows the prices on those days and the number of shares you buy.

DayPriceShares Bought
1$10.0025.00
89.9825.05
159.9625.10
229.9425.15

The total number of shares you buy is 100.30.

Under Strategy 3, you buy 105.2 shares at $9.50 (5% below the initial price of $10) on day 177.

The table below compares the numbers of share bought under each strategy and the amount of money you will have at the end of two years.

StrategyNameNumber Shares BoughtValue in Two Years
1Invest Immediately100.0$1,097
2Dollar-Cost Averaging100.31,100
3Wait for Price Drop105.21,154

In this scenario, the best strategy is to wait until the price drops by 5% which happens to be the minimum price over the two-year period.  The results of the other two strategies are very similar, though investing all of your money on the first day is the worst choice, as you buy stock during the period in which the price has fallen under the other two strategies.

Bumpy Increase 1

Next, we will look at two illustrations of what a stock price might actually look like.  Here is a graph of the first illustration.

The chart below focuses on the first month of the above chart and includes the purchases for Strategies 1 and 2 as dots.

Under Strategy 1 (big red dot), you buy all of your stock on the first day at $10 a share, so you are able to purchase 100 shares.

Under Strategy 2 (smaller green dots), you would buy $250 of stock on each of the first, eighth, fifteenth and twenty-second days.  The table below shows the prices on those days and the number of shares you buy.

DayPriceShares Bought
1$10.0025.00
89.8325.43
159.8825.30
229.8025.51

The total number of shares you buy is 101.24.

Under Strategy 3, you don’t buy any shares because the price never falls by 5%.

The table below compares the numbers of share bought under each strategy

StrategyNameNumber Shares BoughtValue in Two Years
1Invest Immediately100.00$1,144
2Dollar-Cost Averaging101.241,158
3Wait for Price Drop0.001,000

In this scenario, the best strategy is to buy your stock using Dollar-Cost Averaging (Strategy 2), but only by a small amount compared to using the Invest Immediately strategy.  You will have 1% more money than if in you invest it all on the first day and 13% more money than if you wait for the price to drop.

Bumpy Increase 2

The second realistic illustration is exactly the same as the first one with the exception that, in the first month, the price bounces around a bit above the initial $10 price rather than just below it.  The chart below focuses on the first month for this illustration and includes the purchases for Strategies 1 and 2 as dots.

Under Strategy 1 (big red dot), you buy all of your stock on the first day at $10 a share, so you are able to purchase 100 shares.

Under Strategy 2 (smaller green dots), you would buy $250 of stock on each of the first, eighth, fifteenth and twenty-second days.  The table below shows the prices on those days and the number of shares you buy.

DayPriceShares Bought
1$10.0025.00
810.2124.49
159.8825.30
2210.3124.25

The total number of shares you buy is 99.04.

Under Strategy 3, you don’t buy any shares because the price never falls by 5%.

The table below compares the numbers of share bought under each strategy

StrategyNameNumber Shares BoughtValue in Two Years
1Invest Immediately100.01,144
2Dollar-Cost Averaging99.041,133
3Wait for Price Drop01,000

In this scenario, the best strategy is to use the Invest Immediately strategy (Strategy 1), but only by a small amount compared to Dollar-Cost Averaging.  You will have 1% more money than if in you use Dollar-Cost Averaging and 14% more money than if you wait for the price to drop.

More Realistic Examples

Now that you have a better understanding of the three different strategies, I’ll turn to even more realistic scenarios.

  • The first of these scenarios will use the actual returns on the S&P 500 from 1928 through early 2020. This scenario is likely to be relevant when you are considering an investment in an index fund.
  • The second scenario is intended to be similar to an investment in an individual stock. To create the example, I took the S&P 500 times series and doubled the volatility.[2]

The daily stock prices are illustrated in the graph below.

Investment Horizons

To illustrate the impact of the different strategies, I looked at three different time periods over which you might hold the stocks – one year, five years and ten years.  If you are young and hold a stock until you retire, such as I have with some of the stocks I own, you might own the stock for 30 or 40 years.  I didn’t feel there was enough data available in the above time series to look at the impact on owning securities for more than ten years.  So, if you think you will be a very long-term investor, you will want to focus on the ten-year results.  Also, these analyses are not helpful to people who plan to own stocks over very short periods of time, such as some traders who might buy and sell a security in the same day.

Comparison of Realistic Results

The table below compares how much money you would have, on average across all possible starting dates for which data were available, at the end of each of the three time periods if you used each of the three strategies to buy $1,000 of an S&P 500 index fund.

StrategyOne YearFive YearsTen Years
Invest Immediately1,0741,3721,873
Dollar-Cost Averaging1,0741,3731,877
Wait for Price Drop1,0221,1811,485

 

The table below compares how much money you would have, on average, at the end of each of the three time periods if you used each of the three strategies to buy $1,000 of the illustrative stock.

StrategyOne YearFive YearsTen Years
Invest Immediately1,0871,3761,875
Dollar-Cost Averaging1,0871,3791,880
Wait for Price Drop1,0771,3301,772

 

Dollar-Cost Averaging vs. Invest Immediately

For both the S&P 500 and the illustrative stock, there are only very small differences (less than 0.3% for the one-year investment horizon and less than 1.3% for the longer investment horizons) in the average amount of money at the end of each of one, five and ten year between the Dollar-Cost Averaging and Invest Immediately strategies.

Wait for Price Drop

On the other hand, there is a larger difference between the average amount of money at the end of the three time periods if you use the Wait for Price Drop strategy and the average amount using either of the other two strategies.  For the S&P 500, you will have between 5% and 20% less money, on average, if you use the Wait for Price Drop strategy than if you use the Invest Immediately strategy, depending on your investment horizon.

For the more volatile illustrative stock, you will have between 1% and 5% less money, on average, if you use the Wait for Price strategy than if you use the Invest Immediately strategy.  With the higher volatility of the illustrative stock, it is more likely to have a 5% price drop.  There are therefore fewer scenarios in which you don’t get any investment return than there are using the S&P 500 prices.  As such, there is a smaller difference between the results of the Wait for Price Drop strategy and the other strategies for a more volatile security than for a more stable one.

Key Takeaways

As can be seen, the best strategy depends on the pattern and volatility of the security’s price.  Briefly:

  • For securities that have fairly smooth trends, there isn’t a lot of difference between the Invest Immediately and Dollar-Cost Averaging strategies.
  • For securities with more volatile prices, such as the two Bumpy Increase scenarios, the choice between the Dollar-Cost Averaging and Invest Immediately strategies can be a bit larger. However, there isn’t one that is better in all situations – Dollar-Cost Averaging was better in Bumpy Increase 1 while Invest Immediately was better in Bumpy Increase 2.  Because you can’t know whether your security’s price will follow a pattern closer to Bumpy Increase 1 or Bumpy Increase 2, neither strategy is preferred.
  • If you think that the price of the stock might trend down somewhat significantly or has a lot of volatility allowing the price to be significantly lower than the current price, waiting for a 5% (or other value you select) price decrease (Strategy 3) could be the best strategy. The drawback of this strategy is that there are a lot of scenarios in which you will never buy the security and then will get no return.

What Do I Do?

With all this information, you might wonder what I do.  I first need to provide a little background about my current investing situation, as it is likely to be different from yours.

I am retired, so am starting to spend my investments.  As such, I have a shorter investment horizon than I did when I was younger and in the saving mode.  I have a number of stocks and a few mutual funds that I have owned for many, many years and do very little trading of those positions.

Another portion of my money is in sector funds (index funds that focus on one segment of the economy, such as industrial companies, healthcare or technology) and a few large companies.  I tend to hold those securities for six months to two years.  The securities I am trading are closer in nature to the S&P 500 time series than even the hypothetical company with twice the volatility as the S&P 500.  As such, the Wait for Price Drop strategy doesn’t work for me.

With the very small differences between the Dollar-Cost Averaging and Invest Immediately strategies, I choose the Invest Immediately strategy because it is easier.  I have to place only one buy order instead of several orders.

Limit and Market Orders

As discussed in my post on stocks, there are different types of orders you can place when you want to buy a stock.  I always place limit orders.  A limit order allows me to buy a stock from the first person who wants to sell it to me at the price I have stated in the order.

The other type of order is a market order.  If you place a market order, you don’t get to set the price.  You buy the stock at whatever price it is trading at the moment you place the order.

There are risks to both types of orders.  If you place a market order and the price jumps up, you will buy the stock at the higher price.  If you place a limit order for a price below the current market price, you might never buy it similar to the Wait for Price Drop strategy.

A Compromise

To avoid the risk that I might buy a stock at a significantly higher price than I intend, I place a limit order with a limit that is about half way between the closing price and the low price from the previous day.  (I almost always place my orders over the weekend, so don’t have “up-to-the-minute” prices.)  This difference is often between 0.5% and 1% of the price.  By taking this strategy, I get a very small boost to my return by setting my limit below the market price but with very little risk that I won’t buy the stock because I have chosen the limit amount to be within a single day’s trading range.  The additional 0.5% to 1% doesn’t sound like a lot, but if I am able to increase my total return by that amount every year or two, it compounds quickly.

 

[1] There is nothing special about once a week for four weeks.  I did some testing of once a day for five days and found that there wasn’t a lot of difference in the number of shares bought, on average across a wide range of scenarios, from what the number using once a week for four weeks.  I also did some testing of what happens when you buy shares once a month for a year.  Across a wide range of realistic scenarios, you own fewer shares on average if you spread your purchases over a year as you purchase securities that you think will increase in price.  If the price of the security increases over the year, you will buy some of your shares at the higher price and own fewer shares.

 

 

[2] This note explains the nitty gritty details of how I adjusted the S&P 500 time series to create the second scenario.  I calculated the 200-day moving average of the daily closing prices of the S&P 500 from 1928 to early 2020.  The deviation is the actual closing price minus the moving average.  I doubled this deviation and added it back to the moving average to simulate prices for the hypothetical stock.

Your Bills: Pay Them or Defer Them?

Your-Bills-Pay-Them--or-Defer-Them

Many of you are facing difficult financial decisions as your hours are reduced, you have to take an unpaid leave of absence or you are laid off. At the same time, some creditors are offering to help you by waiving or deferring payments. In this post, I’ll provide my thoughts on how you might decide whether to pay or defer your bills.

Key Takeaways: Pay or Defer Your Bills

Here are the key takeaways about whether to pay or defer your bills.

  • If a creditor is willing to waive some or all of your debt, accept the offer.
  • When creditors are willing to defer payments without any extra charges, accepting that offer, rather than paying from your emergency savings, is likely to make sense for most people. The same holds true when the extra interest or late fees are small.
  • The only situations in which dipping into your emergency savings is preferable for most people are those in which the fees or extra interest are expensive.
  • If you are unable to make your payments on time, whether they are from your income or emergency savings, it is very important to contact your creditors. If you do, you are less likely to incur fees and it is less likely that there will be an adverse impact on your credit score.

What are Debtholders Offering?

Before deciding whether to pay or defer your bills, you’ll want to make sure you understand what is being offered. There are generally three types of offers made by creditors:

  • Eliminate some or all of your debt.
  • Defer payments without extra interest or fees.
  • Defer payments with extra interest or fees.

I explain and provide examples of each of these three options.

Waive Some Payments or Forgive Debt

Under this option, the creditor forgives some or all of your debt. Debt can be forgiven by waiving (eliminating) some of your payments or reducing each of your payments. If all of your debt is forgiven, you will not need to make any more payments.

Clearly, you will want to accept offers from any creditors that are willing to forgive some or all of your debt. If only a portion of the debt is forgiven, you’ll want to make sure that you understand how that portion will be reflected in your payments.

  • Will you have to continue making payments as in the past, but with fewer payments?
  • Are you able to stop making payments for a certain period of time?
  • Will you have to continue making payments as in the past, but with a smaller amount?

As an example, I have seen several proposals from US Senate Democrats ranging from wiping out all education debt to cancelling between $10,000 and $50,000 per borrower of Federal student loans (but not private student loans). One description of the latter indicates that the $10,000 of forgiveness would be accomplished by having the Department of Education make monthly payments on behalf of borrowers during the course of the “emergency.” Under this proposal, you would be able to stop making payment for a certain period of time and then would continue making payments in the future as if you had been making your payments instead of the Department of Education.

Defer Payments without Interest or Fees

Under this option, you take a break from making payments. At the same time, the creditor does not charge you any fees and no interest accrues on your outstanding balance. Once the break is over, you will make the same number and amounts of payments as you would have without the break, but they will extend further into the future. That is, your payment scheduled will be shifted by the length of the break.

On March 20, 2020, US President Trump announced that this approach would apply to Federal student loan payments. Federal student loan debtors will not have to make any payments for 60 days and no interest will accrue. If you have a US Federal student loan, you should research the details of this mandate, as debtors whose student loan payments are not currently in arrears will need to apply to get their payments suspended.

Income taxes for 2019 are another example of payments that can be deferred without interest or fees as the result of the coronavirus upheaval. In the US, the Federal government and many states have extended the deadlines for filing and paying 2019 income taxes until July 15, 2020.

Defer Payments with Interest or Fees

Under this approach, the creditor allows you to take a break from making payments, but will charge you one or both of interest during the break and additional fees. Once the break is over, you will not only make the number and amounts of payments you would have without the break, but you will have to pay the additional interest and/or fees.

If you select this option, you’ll need to understand when these additional amounts will be due.

  • Will they be due immediately at the end of the break?
  • Are the extra amounts added to each payment ?
  • Will you have to make more payments?

Utility Example

An example of this option is the Enmax Relief Program. Enmax is the power utility company in Alberta. It has indicated that it will allow customers to set up payment arrangements for overdue bills, but only if current monthly charges continue to be paid. It appears (though isn’t 100% clear) that customers who miss any payments, even customers with payment plans, will need to pay late charges.

Mortgages

According to an article in Forbes, many mortgage companies are also offering flexibility. Some Federal and state mortgage programs are halting foreclosures, but aren’t necessarily waiving or deferring payments. More importantly, some private mortgage companies are allowing payments to be deferred. Not all of these companies have been clear about how interest or late fees will be treated during this period. As such, if you need to defer some mortgage payments, it is important that you get the details specific to your lender and loan.

The Forbes article contains a bit more detail from Ally. It will allow mortgage payments to be deferred for 120 days with no late fees, but interest will accrue. As such, the total amount you will pay for your mortgage will increase by an amount slightly more than your annual interest rate divided by 12 times the number of months you defer your payments times your outstanding principal at the time you started deferring your payments. The “slightly more” in the previous sentence refers to the fact that the interest will compound over the deferral period, so you’ll have to pay interest not only on the outstanding principal but also on the interest that has accumulated since you made your most recent payment.

Deciding What to Do

Once you’ve understood the options available from your creditors, you’ll want to make informed decisions about whether to pay or defer your bills. In this section, I will illustrate the analysis you can do to help support your decision.

In this illustration, you have $20,000 of emergency savings. You have a debt with $50,000 of outstanding principal, 10 years remaining on the term and a 5% interest rate.   This combination of characteristics leads to a monthly payment of $530. Although the illustration looks at payment of a debt, it is equivalent to a monthly bill of the same amount. You are able to resume your regular payments at the end of three months.

When looking at the option to take the payment out of your emergency savings, I assume that you plan to replace that money within a year. I also assume that your emergency savings is in a checking, savings or money market account that is currently paying such a low interest rate that it can be ignored.

Waive Some Payments or Forgive Debt

No analysis is needed for the option under which a creditor offers to waive some of your payments or forgive your debt completely (without any additional costs on your part). You will always be better off if you accept the offer.

Deferring Payments without Interest

For this illustration, you defer three months of payments without interest. You re-stock your emergency savings within a year.

Take Out of Emergency Savings

The table below shows the cash flows and balances if you pay the three months of payments from your emergency savings.

Take Out of Emergency Savings/No InterestTodayIn 3 MonthsIn 12 MonthsWhen Debt is Paid in 5 Years
Amount Paid to Creditor from Savings$0$1,590$0$0
Amount Paid to Creditor from Income004,77057,240
Contributions to Savings from Income001,5900
Emergency Savings20,00018,41020,00020,000
Principal50,00049,03046,0460

In the first row, you see the three months of payments, totaling $1,590, that you pay the creditor from your emergency savings. The second row shows the payments you make from your income after the initial three-month period. The amounts you put in your emergency savings to bring it to the pre-crisis level are shown in the third row.

The last two rows show the ending balances for your emergency savings and the outstanding principal on your debt. At 3 months, you can see that your emergency savings has been reduced by $1,590. It returns to its original level after 12 months. Your principal declines to $0 in five years as anticipated under the original schedule, as you have made all payments as planned.

Defer Payments

The table below shows the cash flows and balances if you defer three months of payments.

Defer Payments/No InterestTodayIn 3 MonthsIn 12 MonthsWhen Debt is Paid in 5 Years, 3 Months
Amount Paid to Creditor from Savings$0$0$0$0
Amount Paid to Creditor from Income004,77058,830
Contributions to Savings from Income0000
Emergency Savings20,00020,00020,00020,000
Principal50,00050,00047,0530

In the first and third rows, you see that there are no payments to or from your emergency savings. The second row shows the payments you make from your income after the three-month deferral period. The total of these payments is the same as the total payments from your emergency savings and income (first and second rows) under the Take Out of Emergency Savings Strategy. The difference is that the $1,590 paid from your savings in the Take Out of Emergency Savings Strategy in the first three months is added to the amount paid from your income in the last column of the Defer Payments Strategy. In addition, the header on the last column shows that your payments are extended for three months to 5 years, 3 months instead of 5 years.

The last two rows show the ending balances for your emergency savings and principal. Your emergency savings stays constant at $20,000. Your principal doesn’t decrease in the first three months when you defer your payments. After that, your principal declines to $0 in five years and three months. It is higher at 12 months than under the Take Out of Emergency Savings Strategy because you deferred three months of payments.

How I’d Make the Decision to Pay or Defer Bills

When the creditor won’t charge you extra interest or fees, the choice between whether to pay or defer your bills is one of personal preference. It depends not only on your current and anticipated future financial situations, but also any increase in your level of comfort by having more money in your emergency savings. The creditor isn’t increasing the amount you owe. As such, the financial inputs to the decision relate to the timing with which you make the payments to the creditor.

I would probably defer the payments unless I were expecting difficulty in making the extra three months of payments at the end of the loan term (because I was planning to retire in exactly five years and don’t want to change that goal, for example). I’d rather have the extra money in my emergency savings in case something else happens.

Defer Payments with Interest

For this illustration, you defer three months of payments at the loan’s interest rate with no late fees. If you tap your emergency savings, you re-stock them within a year.

Take Out of Emergency Savings

The transactions are the same under the “Take Out of Emergency Savings” Strategy regardless of whether the creditor charges interest on the deferred payments. I’ve shown the table again so it will be easier to compare it to the “Defer Payments” Strategy under this scenario.

Take Out of Emergency Savings/Wit InterestTodayIn 3 MonthsIn 12 MonthsWhen Debt is Paid in 5 Years
Amount Paid to Creditor from Savings$0$1,590$0$0
Amount Paid to Creditor from Income004,77057,240
Contributions to Savings from Income001,5900
Emergency Savings20,00018,41020,00020,000
Principal50,00049,03046,0460

 

Defer Payments

The table below shows the cash flows and balances if you defer the three months of payments during your time of reduced or no income.

Defer Payments/With InterestTodayIn 3 MonthsIn 12 MonthsWhen Debt is Paid in 5 Years, 3 Months
Amount Paid to Creditor from Savings$0$0$0$0
Amount Paid to Creditor from Income004,83359,607
Contributions to Savings from Income0000
Emergency Savings20,00020,00020,00020,000
Principal50,00050,62847,6440

In the first and third rows, you see no payments to or from your emergency savings. The second row shows the payments you make from your income after the three-month deferral period. For this illustration, the extra interest is added to each payment, increasing it from $530 to $537 a month and your payments extend for an extra three months (see header in last column). As a result, the total of the amounts paid the to creditor are $840 higher than if no interest had been charged.

The last two rows show the ending balances for your emergency savings and principal. Your emergency savings stays constant at $20,000. Your principal increases in the first three months as the additional interest is added during the deferral period. After that, your principal declines to $0 in five years and three months. It is higher at 12 months than under the Take Out of Emergency Savings Strategy because (a) you deferred three months of payments and (b) additional interest accrued.

How I’d Decide

From a financial perspective, you will be better off in this scenario if you make your payments out of your emergency savings because you will avoid paying interest or late fees. You also will have paid off your debt sooner – in five years instead of five years and three months.

Low Interest Rates

If the interest rate on your loan isn’t very high, say less than 6% a year, the additional payments may be relatively small. For example, at a 6% interest rate, the extra accumulated interest on a $200,000 loan with 10 years of payments left (such as our mortgage) is about $3,000. That may sound like a large number, but it adds only $34 to each payment.

Credit Cards

Some people are suggesting that you should make only the minimum payments on your credit cards as a way to keep as much cash in your emergency savings as possible. To date, I haven’t seen any credit card companies that are deferring interest or fees if you don’t pay your credit card in full. Credit card interest rates are generally quite high, often in excess of 10% per year, and many credit card companies charge fees if you don’t pay your balance in full. While many debts have interest rates that are low enough to justify deferring payments, most credit cards do not fall in that category. As such, I would pay off as much of my high-interest credit card balances as I could afford, even it if meant dipping into my emergency savings.

Personal Decision

Here is where the decision to pay or defer your bills becomes more personal. There is an emotional benefit to leaving the money in your emergency savings in case something else happens or your reduction in income lasts longer than you expect. You’ll need to weight that increased comfort level with the additional cost of deferring the payments under this scenario. For many people, the $34 a month increase in their mortgage payment in my illustration is a small cost to pay for the additional comfort. For other people, particularly those whose budgets are already very tight or who have a fixed amount of time until they retire, the increased payments and lengthening of the term of the loan are too expensive. As such, you’ll need to decide for yourself whether to pay or defer your bills, but now you’ll be able to make an informed decision.

Impact on Credit Rating

Another consideration in deciding whether to pay or defer your bills is your credit score. If you miss payments, there could be an adverse impact on your credit score, as timely payment is one of the important factors that drive your score. To be clear, if you make your payments from your emergency savings, there will be no adverse impact on your credit score. If you are not able to make your payments, even from your emergency savings, it is important that you communicate with your creditors and agree to a plan.

What Experian Says

I contacted Experian by e-mail and received the following quote from Rob Griffin, senior director of consumer education and awareness.

If you think you may have trouble making any of your monthly payments, contact your lender or creditor as soon as possible – try not to wait until you’ve missed your payment due date. Lenders may have several options for helping you cope with a variety of COVID-19-related financial hardships including placing your accounts in forbearance or deferment for a period of time. This means effectively suspending your payments until the crisis has passed and can help minimize the impact to the credit score if the account is in good standing and hasn’t had previous delinquencies reported.

While reported in forbearance or deferment, your accounts will have no negative affect on the most common credit scores from FICO and VantageScore. Keep in mind, lenders do not want you to fall behind on your payments any more than you do. Contacting your lenders early can help you protect your financial health in the long run.[1]

Other Credit Bureaus

I found similar statements on the web sites of the other two major credit bureaus, Equifax and Transunion.

How it Impacts You

These statements indicate that you may be able to avoid a deterioration in your credit score if you are proactive with your lenders about skipping or deferring payments.

 

[1] E-mail from Amanda Garofalo, PR Specialist, Experian, March 19, 2020.

Don’t Panic! Just Plan It.

Don't Panic. Just Plan it.

Financial markets have been more turbulent in the past few weeks than has been seen in many years, probably more volatile than has happened since many of you started being financially aware. You may be wondering what actions you should take. With the sense of panic and urgency surrounding recent news, it often feels as if drastic action is necessary. If you have created financial plan, inaction may be the best strategy for you!

As indicated elsewhere on this blog, I do not have any professional designations that qualify me to provide professional advice. In addition, my comments are provided as generalities and may not apply to your specific situation. Please read the rest of this post with these thoughts in mind.

Biggest Financial Risk from Recent News

I suspect that losing your job or losing business if you are self-employed is the biggest financial risk many of you face. Understanding your position within your company and how your company will be impacted by coronavirus, oil prices and other events will inform you as to the extent to which you face the risk of a lay-off or reduction in hours/salary.

If you think you might have a risk of a decrease in earned income, you’ll want to look into what options for income replacement are available to you, including state or federal unemployment programs, severance from your employers, among others. Another important step is to review your expenses so you know how you can reduce them to match your lowered income.  In addition, you’ll want to evaluate how long you can live before exhausting your emergency savings, with or without drastic reductions in your expenses. You may even want to start cutting expenses before your income is lowered and put the extra amount in your emergency savings.

Your Financial Plan & Recent News

In the rest of this post, I’ll look at the various components of a financial plan and provide my thoughts on how they might be impacted by the recent news and resulting volatility in financial markets. For more tips on how to handle financial turmoil, check out these mistakes to avoid.

Paid Time-Off Benefits/Disability Insurance

If you are unfortunate enough to get COVID-19 or are required to self-quarantine and can’t work from home, you may face a reduction in compensation. Your first line of defense is any sick time or paid time-off (PTO) provided by your employer. In most cases, your employer will cover 100% of your wages for up to the number of days, assuming you haven’t used them yet.

Once you have used all of your sick time/PTO, you may have coverage under short- or long-term disability insurance if provided by your employer or if you purchase it through your employer or on your own. Disability insurance generally pays between 2/3 and 100% of your wages while you are unable to work for certain causes, almost always including illness. It might be a good time to review your available sick time/PTO and disability insurance to understand what coverage you have.

Emergency Savings

Emergency savings is one of the most important components of a financial plan.  There are two aspects to your emergency savings that you’ll want to consider. The first is whether you have enough in your emergency savings.  The second is the risk that the value of the savings will go down due to financial market issues.

Do I Have Enough?

If you are laid off, have reduced hours or use up all, exhaust your sick time/PTO or get less than 100% of your wages replaced by disability insurance, you may have to tap into your emergency savings. The need to spend your emergency savings increases if you tend to spend most of your paycheck rather than divert a portion of it to savings.

I generally suggest one to six months of expenses as a target for the amount of emergency savings. In light of recent events and the increased risks lay-off and illness, I would focus on the higher end of that range or even longer. As you evaluate the likelihood you’ll be laid off, the chances you’ll be exposed to coronavirus and your propensity to get it, you’ll also want to consider whether you have enough in emergency savings to cover your expenses while your income is reduced or eliminated.

In certain situations, such as in response to the coronavirus, creditors will allow you to defer your payments.  You will then have the option as to whether to defer them or make those payments from your emergency savings./a>

Will it Lose Its Value?

I’ve suggested that you keep at least one month of expenses in emergency savings in a checking or savings account at a bank or similar financial institution. The monetary value of your emergency savings is pretty much risk-free, at least in the US. The only way you would lose any of these savings is if the financial institution were to go bankrupt. In the US, deposits in financial institutions are insured, generally up to $250,000 per person per financial institution, by the Federal Deposit Insurance Corporation (FDIC). For more specifics, see the FDIC web site. Similar protections may be available in other countries.

I’ve also suggested that you keep another two to five months of expenses in emergency savings in something only slightly less accessible, such as a money market account. There is slightly more risk that the value of a money market account will go down than a checking or savings account, but it is generally considered to be very small. Money market accounts are also insured by the FDIC. For more specifics, see this article on Investopedia.

As such, the recent volatility in financial markets are unlikely to require you to take action related to your existing emergency savings and could act as an opportunity to re-evaluate whether you have enough set aside for emergencies.

Short-Term Savings

Another component of a financial plan is short-term savings.  Short-term savings is money you set aside for a specific purpose. One purpose for short-term savings is expenses that don’t get paid every month, such as property taxes, homeowners insurance or car maintenance and repairs.   Another purpose for short-term savings is to cover the cost of larger purchases for which you might need to save for several years, such as a car or a down payment on a house.

Short-term savings are commonly held in money-market accounts, certificates of deposits (CDs) or very high quality, shorter term bonds, such as those issued by the US government. CDs and US government bonds held to maturity are generally considered to have very little risk. Their market values are unlikely to change much and the likelihood that the issuers will not re-pay the principal when due is small.

Thus, the recent volatility in financial markets is also unlikely to require you to take action related to your short-term savings.

Long-Term Savings

Savings for retirement and other long-term goals are key components of a financial plan.  If they are invested at all in any equity markets, your long-term savings have likely taken quite a beating. Rather than try to provide generic guidance on how to deal with the losses in your long-term savings, I’ll tell you how I’m thinking and what I’m doing about mine. By providing a concrete example, albeit one very different from most of your situations, my goal is to provide you with some valuable insights about the thought process.

Think about the Time Frame for My Long-Term Savings

As you may know, I’m retired and have just a little income from consulting. As such, my financial plan anticipates that I will live primarily off my investments and their returns. I have enough cash and bonds to cover my expenses for several years. As such, I’m not in a position that I absolutely have to liquidate any of my equity positions in less than three-to-four years.

For many of you, your most significant goal for long-term savings is likely retirement. As such, your time horizon for your long-term savings is longer than mine and you can withstand even more volatility. That is, you have a longer time for stock prices to recover to the recent highs and even higher.     In the final section of this post, I’ll talk about how long it has taken equity markets to recover from past “crashes” to help you get more perspective on this issue.

Know Your Investments

My view is that, if I wait long enough, the overall stock market will recover. It always has in the past. If it doesn’t, I suspect something cataclysmic will have happened and I will be focused on more important issues such as food, water and heat, than my long-term savings. For now, though, my view is that my investments in broad-based index funds are going to recover from the recent price drops though it may take a while and be a tough period until then. As such, I am not taking any action with respect to those securities. Once the stock market seems to settle down a bit (and possibly not until it starts going up for a while), I might invest a bit more of my cash to take advantage of the lower prices.

I have a handful of investments in stocks and bonds of individual companies. These positions have required a bit more thought on my part.   I already know the primary products and services of these companies and the key factors that drive profitability, as I identified these features before I purchased the stocks or bonds as part of my financial plan. I can now look at the forces driving the economic changes to evaluate how each of the companies might be impacted.

Example 1

I own some bonds that mature in two to three years in a large company that provides cellular phone service. As discussed in my post on bonds, as long as you hold bonds to maturity, the only risk you face is that the issuer will default (not make interest payments or re-pay the principal). With the reduction in travel and group meetings, I see an increased demand for technological communication solutions, such as cell phones. While the stock price of this company has gone down, I don’t see that its chance of going bankrupt has been affected adversely, so don’t plan to sell the bonds.

Example 2

One company whose stock I’ve owned for a very long time focuses on products used to test food safety. While the company’s stock price has dropped along with the broader market, I anticipate that people will have heightened awareness of all forms of ways of transmitting illness, including through food-borne bacteria and other pathogens. As such, I am not planning to sell this stock as the result of recent events.

Example 3

I own stock in an airline that operates primarily within North America. This one is a bit trickier. It looks like travel of all types is going to be down for a while. I’m sure that US domestic airline travel will be significantly impacted, but suspect it will not be affected as much as international or cruise ship travel. The reduction in revenue might be slightly offset by the lower cost of fuel, but that is probably not a huge benefit in the long term.

I’ve owned this company for so long that I still have a large capital gain and would have to pay tax on it if I sold the stock. At this point, I don’t think there is a high probability that this airline will go bankrupt (though I’m not an expert and could be wrong). I expect the price to drop more than the overall market average in the coming months, but also expect that it will recover. As such, I don’t plan to sell this stock solely because of recent events.   However, if this company had most of its revenue from operating cruise ships, was smaller, or had more foreign exposure, I would study its financials and business model in more detail to see if I thought it would be able to withstand the possibility of much lower demand for an extended period of time.

Summary

I have gone through similar thought processes for each of the companies in my portfolio to create my action plan. I will re-evaluate them as time passes and more information becomes available.

What We Can Learn from Past Crashes

Although every market cycle is different, I thought it might be insightful to provide information about previous market crashes. For this discussion, I am defining a market crash as a decrease in the price of the S&P 500 by more than 20% from its then most recent peak. I have identified 11 crashes using this definition, including the current one, over the time period from 1927 to March 14, 2020.

As you’ll see in the graphs below, the market crash starting at the peak in August 1929 is much different from most of the others. It took until 1956 before the S&P 500 reached its pre-crash level! Over the almost three years until the S&P 500 reached its low and then again during the recovery period (from the low until it reached its previous high), there were several crashes. I have counted this long cycle as a single crash, though it could be separated into several.

Magnitude of Previous Crashes

The table below shows the dates of the highest price of the S&P 500 before each of the 11 crashes since 1927.  It also shows the percentage decrease from the high to the low and the number of years from the high to the low.

Date of Market Peak

Price ChangeYears from High to Low

9/17/29

-86%2.7

8/3/56

-21%

1.2

12/13/61-28%

0.5

2/10/66-22%

0.7

12/2/68

-36%

1.5

1/12/73

-48%1.7

12/1/80

-27%1.7

8/26/87

-34%

0.3

3/27/00-49%

2.5

10/10/07-57%

1.4

2/20/20-27%

0.1

While they don’t happen all that often, this table confirms that the S&P 500 has suffered significant decreases in the past. What seems a bit different about the current crash is the speed at which prices have dropped from the market high reached just a few weeks ago. In the past, the average time from the market peak to the market bottom has been 1.4 years, but the range has been from 0.3 years to 2.7 years. While the 27% decrease in the S&P 500 from its peak on February 20, 2020 until March 14, 2020 is large and troubling, the average price change of 10 preceding crashes is -41% (-36% if the 1929 crash is excluded). As such, it isn’t unprecedented.

What Happened Next?

This table shows how long it took after each of the first 10 crashes for the S&P 500 to return to its previous peak. It also shows the average annualized return from the lowest price until it returned to its previous peak.

Date of Market Peak

Years from Low Back to PeakAnnualized Average Return During Recovery

9/17/29

22.29.3%

8/3/56

0.929.8%
12/13/611.2

31.7%

2/10/660.6

55.3%

12/2/681.8

28.3%

1/12/73

5.812.0%

12/1/80

0.2293.4%

8/26/87

1.6

28.1%

3/27/004.6

15.7%

10/10/074.1

22.9%

For example, it took 1.6 years after the market low price on December 4, 1987 (the low point of the cycle starting on August 26, 1987) for the S&P 500 to reach the same price it had on August 26, 1987. Over that 1.6-year period, the average annual return on an investment in the S&P 500 would have been 28%!

Because the values from the 1929 and 1980 cycles can distort the averages, I’ll look at the median values of these metrics. At the median, it took 1.7 years for the S&P 500 to reach its previous high with a median annualized average return of 28%.   There are obviously wide ranges about these metrics, but, excluding the 1929 crash, the S&P 500 never took more than 6 years to recover from its low. This time frame is important as you are thinking about the length of time until you might need to use your long-term savings.

After hitting bottom, the S&P 500 always had an average annual return of 12% or more over the recovery period, a fair amount higher than the overall annual average return on the S&P 500. Anyone who sold a position in the S&P 500 at any of the low points missed the opportunity to earn these higher-than-average returns – a reminder to not panic.

From Crash to Recovery

The graph below shows the ratios of the price of the S&P 500 to the price at the peak (day 0) over the 30 years after each of the first 10 market peaks in the tables above.

The light blue line that stays at the bottom is the 1929 crash. As you can see, by 30 years later, the S&P 500 was only twice as high as it was at its pre-crash peak. For all of the other crashes, the S&P 500 was at least four times higher than at each pre-crash peak, even though in many cases there were subsequent crashes in the 30-year period.

To get a sense for how the current crash compares, the graph below shows the same information for only the first 100 days after each peak. The current crash is represented by the heavy red line.

As indicated above, one of the unique characteristics about the current crash is that it occurred so quickly after the peak. The graph shows that the bright red line is much lower than any of the other lines on day 17. However, if you look at the light blue line (after the peak on September 17, 1929) and the brown line (after the peak on August 26, 1987), you can see that there were similarly rapid price decreases as occurred in the current crash, but they started a bit longer after their respective peaks.

Current Crash

We can’t know the path that the stock market will take going forward in the current cycle. It could halt its downward trend in a few days to a week and return to set new highs later this year. On the other hand, if other events occur in the future (such as the weather conditions that led to the dust bowl in the 1930s and World War II in the 1940s that exacerbated the banking issues that triggered the 1929 crash), it is possible stock prices could decline for many years and take a long time to recovery. Based on the patterns observed, this trend is less likely, but it is still a possibility.

As such, it is important as you consider your situation that you look at your investment horizon, your ability to live with further decreases in stock prices and your willingness to forego the opportunity to earn higher-than-average returns when the stock market returns to its pre-crash levels if you sell now, among other things.

Closing Thoughts

My goal in writing this post was to provide you with insights on how to view the disruptions in the economy and financial markets in recent weeks and plan your responses to them. My primary messages are:

  1. Don’t panic. While significant action may be the best course for your situation, do your best to make well-reasoned and not emotional decisions. Although you might want to sell your investments right away to avoid additional decreases in value, it isn’t the best strategy for everyone.
  2. Stick with (or make) a financial plan. Having a financial plan provides you with the ability to look at the impact of the uncertainties in financial markets and the overall economy on each aspect of your financial future separately, making the decision-making process a little easier.

 

Mutual Funds and ETFs

Mutual-Funds-and-ETFs

Mutual fund and ETFs (exchange-traded funds) allow you to invest in securities without having to select individual positions. Instead, the fund manager makes the decisions as to when to buy and sell each security. As such, a fund is an easy way for new or busy investors to participate in financial markets. This post will help you learn about the different types of funds, their pros and cons and other considerations of owning mutual funds and ETFs.

What is a Mutual Fund?

A mutual fund is pool of money collected from the investors in the fund. The investors own shares in the mutual fund itself, but not in the individual securities owned by the fund. However, other than closed-end funds discussed below, an investor’s return is his or her share of the returns of the aggregation of the returns of the individual securities owned by the mutual fund. That is, if, on average, the securities in the mutual fund issue dividends of 3% and appreciate by 2%, fund owners will receive a dividend distribution equal to 3% of the value of their share of the pool plus the value of their ownership share will increase by 2%.

Most mutual funds also issue capital gain distributions once or twice a year. If the mutual fund had a gain on the aggregate amount of securities sold in the year, it will often distribute the amount of the gain to investors as a capital gain distribution in proportion to their ownership shares in the pool.

Mutual funds can be purchased directly from the fund manager or through a broker. Most mutual funds are not traded on exchanges. Purchases and sales of mutual funds occur once a day, with all buyers and sellers receiving the same price which is equal to the net asset value of the underlying assets. (See below for more information and exceptions.)

What is an ETF?

Exchange-traded funds or ETFs have several characteristics in common with mutual funds:

  • They are pools of money collected from their investors.
  • Investors share in the returns of the aggregation of the individual securities.
  • ETFs can hold a wide range of securities, including stocks, bonds and commodities.

These are a few of the ways in which ETFs differ from mutual funds:

  • They are exchange-traded securities (as implied by their name), so they can be bought and sold any time the exchange is open. As such, the price you pay or receive when you buy or sell an ETF can vary over the course of a day.
  • While many mutual funds have a minimum investment requirement, most ETFs do not.

Types of Mutual Funds and ETFs

There are many features of mutual funds and ETFs that are important in determining the best funds for your portfolio. Almost all of these features apply to both mutual funds and ETFs.

Active vs. Passive Management

An actively managed fund has a fund manager who is responsible for selecting the securities that will be owned by the fund. The manager decides when to buy and sell each security.  By comparison, the securities owned by a passively managed fund are determined so that the performance of the fund tracks a certain basket of assets.

Index funds are a common type of passively managed funds.   An index fund is a mutual fund or ETF that has a goal of matching the performance of an index, such as the S&P 500, the Dow Jones Industrial Average or the Fidelity US Bond Index.

There are other passively managed funds whose trades are determined so as to produce returns similar to a certain segment of a market, such as a particular industry or region of the world, that may or may not have an index that measures those returns.

Securities Owned

Funds can own a wide variety of securities – everything from stocks and bonds to commodities, among others. As you are looking for a fund, you’ll want to decide what type of security you are seeking.

Geography

Most funds focus on a specific geography. Many mutual funds focus on US investments, while others purchase securities from within a region of the US, the whole world or segments thereof, such as the developed world excluding the US. While I hold most of my North American equity positions in individual companies, I use mutual funds to diversify my portfolio globally.

Market Segment

Just as funds focus on a specific geography, they sometimes invest in one or more market segments.   Some funds focus on a specific industry, such as natural resources or technology or financial companies. If you think a particular industry is going to benefit from trends in the economy, such as healthcare as the population ages, you might want to buy a fund that focuses on the healthcare industry. On the other hand, you might want to avoid healthcare stocks if you think that the healthcare industry might be at risk of significant disruption from changes in the government’s role in healthcare.

Other funds focus on the size of companies.  For example, an S&P 500 Index fund only buys positions in companies in the S&P 500 which, by definition, are large.  Other funds focus on middle-sized companies (middle-sized capitalization of mid-cap) or smaller companies (small-cap).

Another “industry” on which many funds focus is municipal bonds. These funds invest in bonds issued by municipalities. In many cases, interest from municipal bonds and municipal bond funds is not taxed by the Federal government or in the state in which the municipality is located. For example, if you buy a bond issued by the City of Baltimore, it is likely that it will not be taxed at all if you are a Maryland resident.

Appreciation vs. Dividends

Some funds focus on high-dividend investments, while others focus on appreciation in the value of the securities they own. You can learn the focus of a fund by looking at its details either in a summary or its prospectus. Funds that focus on high-dividend yields often have “high-dividend” in their name, but not always. The type of return targeted by funds you purchase will impact the specific securities owned by the fund. In addition, the type of return impacts the taxes you will pay (discussed below).

Growth vs. Value

Companies are often categorized between growth and value, reflecting the two primary reasons that stock prices increase. The stock price of a growth company is expected to increase because the company will increase its profits. By comparison, the stock price of value company is expected to grow because its valuation, often measured by the price-to-earnings or P/E ratio, is considered low and likely to return to normal.

Closed-end vs. Open-end Funds

Most funds are open-end funds. The price you pay for these funds is equal to the market value of the securities owned by the fund divided by the number of shares outstanding.   This price is known as the Net Asset Value. You can buy shares from and sell shares back to the fund owner at any time at the net asset value.

A closed-end fund differs in that the number of shares available is fixed when the fund is first created. When you buy and sell shares in a closed-end fund, the other party to the transaction is another investor, not the fund owner.  In fact, closed-end fund shares trade in the same manner as if the fund were a company. As such, the price is not the net asset value, but rather has a market value that reflects not only the net asset value but also investors views of the future performance of the fund.

I found Investopedia to have some great information about open-end funds and closed-end funds.

Advantages and Disadvantages of Mutual Funds and ETFs

The biggest advantage of mutual funds and ETFs is the ease with which you can diversify your portfolio, especially in asset classes or market segments with which you are unfamiliar. I think index-based ETFs are a terrific way for new investors to participate in markets. As I mentioned above, I use mutual funds for international stocks, as I don’t know enough about economies and market conditions outside the US, much less about individual companies, to make informed buying decisions.

A drawback to actively-managed funds is that they tend to underperform the market. That is, there are not many money managers who can consistently produce returns that exceed their target benchmarks. This difference is even greater when returns are reduced for fees paid by investors (discussed later in this post).

There are many sources for statistics about mutual fund returns. CNBC states that, in every one of the nine years from 2010 through 2018, more than half of actively managed large-cap funds produced returns less than the S&P 500. The same article also indicates that 85% of those funds underperformed the S&P 500 over a ten-year period and 92% underperformed over a 15-year period. As such, care should be taken when investing in actively managed funds. If you are looking for funds that will produce returns similar to broad market indices, such as the S&P 500, an index fund might be a better choice.

Income Taxes

There are four types of returns that are taxed when you own mutual funds or ETFs that hold stocks or bonds held in taxable accounts. Funds held in tax-deferred or tax-free accounts will have different tax treatment. The taxable returns on other types of funds will depend on the types of returns generated by the underlying assets.

Capital Gains

When you sell your ownership position in a fund, the difference between the amount you paid when you bought it and the amount you received when you sell it is a capital gain.   The taxation of short-term capital gains (related to securities owned for less than one year) is somewhat complicated in the US. Long-term capital gains are taxed in the same manner as dividends in the US, at 15% for most people. In Canada, capital gains are taxed at 50% of the rate that applies to your wages.

Interest

When you own a bond fund, interest paid by the issuers of the bonds owned by the fund is taxable in the year the interest payment was made. In the US and Canada, interest held in taxable accounts is taxed at the same rate as wages, except for certain municipal and government bonds which may be exempt from state or Federal taxes.

Dividends

Dividends paid by companies owned by a fund are taxable in the year the dividends payments are made. For most people in the US, there is a 15% Federal tax on dividends from investments held in a taxable account plus any state taxes. In Canada, dividends are taxed at the same rate as wages.

Capital Gain Distributions

Over the course of a year, a mutual fund may sell some of its assets. The capital gains earned from those assets are distributed to owners as capital gain distributions. Capital gain distributions are taxed in the same manner as capital gains.

Fees

There are generally three types of fees that can affect your returns on ETFs and mutual funds: front-end loads, operating expenses and commissions. Schwab identifies two other hidden costs that are a bit more obscure, so I’ll refer you to its post on this topic if you want more information.

Front-End Loads

Some mutual funds require you to pay a fee when you make a purchase. The fee is usually a percentage of your investment. For example, you would pay $10 for every $1,000 you invest in a fund with a 1% front-end load. If you purchased this fund, its total return on the underlying investments would need to be 1% higher over the entire period over which you owned it than the same fund with no front-end load for you to make an equivalent profit.

Funds that don’t have a front-end load are called no-load funds.

Operating Expenses

Mutual funds and ETFs, even those that are passively managed, have operating expenses. The operating expenses are taken out of the pool of money provided by investors. Every fund publishes its annual operating expense load, so you can compare them across funds. Funds with higher expense loads need to have higher returns on the underlying investments than fund with lower expense loads every year for you to make an equivalent return.

ETFs tend to have much lower operating expense loads than mutual funds. Similarly, passive funds tend to have lower operating expense loads than actively managed funds.

Commissions

If you purchase a mutual fund or ETF through a broker, you may pay a commission both when you buy the fund and when you sell it. A commission is a fee paid to the broker for the service it provides allowing you to buy and sell securities. Many brokers have recently reduced or eliminated commissions on many ETFs. If you purchase the mutual fund or ETF directly from the fund manager, you will not pay a commission.

Dividend Reinvestment

Many funds allow you to automatically reinvest distributions (i.e., interest, dividends and capital gain distributions). Although it includes all types of distributions, it is often called dividend reinvesting or reinvestment. It is a great way to ensure that all of your returns stay invested, as you don’t have to keep track of the payment dates on any distributions so you can reinvest them.

I have a few cautions about dividend reinvestment.

First, you want to reevaluate your choice of fund periodically. If you blindly reinvest all of your dividends and something changes that makes the fund a poor fit for your portfolio, automatic dividend reinvestment will cause you to have more money invested in something that you don’t want.

Second, you’ll want to be aware of the tax implications of dividend reinvestment – one of which is helpful and one of which requires some care – if you hold the fund in a taxable account.

Increased Cost Basis

As indicated above, when you sell a fund, you pay capital gains tax on the difference between your proceeds on sale and what you paid for the fund. The distributions that you reinvest are considered part of what you paid for the fund. You’ll need to take care to keep track of the amounts you’ve reinvested, as they increase your cost basis (the amount you paid) and decrease your capital gains tax.

Taxes on Distributions

Even if you reinvest your distributions, you need to pay taxes on them in the year in which they were paid. As such, if 100% of your distributions are automatically reinvested, you’ll need to have cash available from another source to pay the income taxes on the distributions.

Selecting Mutual Funds and ETFs

There are thousands of mutual funds and ETFs from which to choose. Here are my thoughts on how you can get started.

Set your Goals

  1. Determine what type of fund you are seeking. Are you trying to focus on a small niche or the broader market?
  2. Narrow down the type of fund that will meet your needs. Do you want an actively managed fund or a passive one? Are you interested in an open end or closed end fund?  Do you want the fund to look for growth companies or those with low valuations?

Identify Some Funds

  1. Once you’ve narrowed down the type of fund you’d like, you can use a screener to help you further narrow down your choices. Most large brokerage firms, as well as many independent entities, have mutual fund and ETF screeners. For example, Morningstar, a global investment-research and investment-services firm, has a free screener (after you sign up at no charge) at this link.
  2. Look at the ratings of the funds that are identified. The entity assigning the ratings usually expects higher rated funds to perform better than lower rated funds.
  3. Look at the historical returns. While past performance is never a guarantee of future performance, funds that have done well in the past and have consistent management and strategy may do well in the future.
  4. Read the details of the fund either on the fund manager’s web site or in the prospectus. Look to see if the objectives of the fund are consistent with your objectives. Make sure the types of securities the manager can purchase are in line with what you would like to buy. The names of some funds can be much narrower than the full range of securities the manager is allowed to buy. Find out if the fund management and objectives have been stable over time. Some funds can change their objectives on fairly short notice, potentially exposing you to risks you may not want to take or lower expected returns that you desire. To learn more about reading a prospectus, check out the article on Page 9 of this on-line magazine.
  5. Compare the fees among the funds on your list. If the underlying assets are similar and are expected to produce the same returns, funds with lower fees are more likely to provide you with higher returns (after expenses) than funds with higher fees. Don’t forget to look at both front-end loads and annual operating expense ratios.
  6. Select a strategy for buying your mutual funds or ETFs, such as dollar-cost averaging, waiting for a price drop or buying at the market price.

Make a Decision

  1. Buy a position in the fund(s) that best fit your requirements. As indicated above, you can buy most funds either through a broker (which can sometimes add a commission to your expenses) or directly from the fund manager.
  2. Last, but not least, be sure to monitor your positions to make sure that the fund objectives, holdings, management and fees remain consistent with your objectives.

How to Raise Financially Smart Kids

I recently wrote a guest post for Grokking Money about how to raise financially smart kids.  Here is the start of it, to read the entire post, click here.

Instilling your children with good financial habits will increase their likelihood of success, just as is the case with many other types of habits.  In this post, I’ll provide you with eight things you can do to help your kids become financially smart.  All but one of these ideas are based on my experiences growing up or those I provided for my children.

1. Open a Bank Account

We opened savings accounts for our children with the money they received when they were born.  As they got older (probably around 5), we made them aware of . . . Read More