A Man is Not a (Sound Financial) Plan

A man is not a (sound financial) 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.


    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.


    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:

    • Understanding how much you will receive in retirement from government programs, such as Social Security in the US or the Canadian Pension Plan in Canada.
    • Setting your retirement savings goal.
    • Estimating how much you need to save each year to meet your retirement savings goal.
    • Deciding what are the best types of accounts in which to put your retirement savings – taxable, Roth (TFSA in Canada) or Traditional (RRSP in Canada).
    • Determining in what assets (bonds, stocks, mutual funds or ETFs, for example) to invest your retirement savings in light of your risk tolerance and diversification needs and how those choices affect your investment returns.


    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.


    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.


    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 for a Sound Financial Plan

    The table below lists the types of obstacles you might be facing and the types of advisors that might be able to help you create a sound financial plan.

    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.

What You Need to Know About Stocks

What you need to know about stocks

Stocks are a common choice for many investors.  There are two types of stocks – preferred and common.  Because most investors buy common stocks, they will be the subject of this post.  I’ll talk about what you need to know about stocks before you buy them, including:

  • Stocks and how they work.
  • The price you will pay.
  • The risks of owning stocks.
  • Approaches people use for selecting stocks.
  • How stock are taxed.
  • When you might consider buying stocks.
  • How to buy a stock.

What are Stocks?

Stocks are ownership interests in companies.  They are sometimes called equities or shares.  When you buy a stock, you receive a certificate that indicates the number of shares you own.  If you buy your investments through a brokerage firm, it will hold your certificates for you.  If you buy them directly, you will usually receive the certificate (and will want to maintain it in an extremely safe place as it is your only proof that you own the stock).  Some companies track their stock’s owners electronically, so you may not always get a physical certificate.

How Do Stocks Work?

Companies sell stock as a way to raise money.  The company receives the amount paid for the shares of stock when they are issued, minus a fee paid to the investment banker that assists with the sale.  The process of issuing stock is called a public offering.  The first time a company offers its shares to the public, it is called an initial public offering (IPO).

Stockholder-Company Interactions

After the stock has been sold by the company, the stockholder has the following interactions with the company:

  • It receives any dividends paid by the company.
  • It gets to vote on matters brought before shareholders at least annually.  These issues include election of directors, advisory input on executive compensation, selection of auditors and other matters.
  • It has the option to sell the stock back to the company if the company decides to repurchase some of its stock.

In addition to these benefits of owning stock, you also can sell it at the then-current market price at any time.

Why Companies Care About Their Stock Prices

Interestingly, after the stock has been sold by the company, future sales of the stock do not impact the finances of the company other than its impact on executive compensation.  That is, if you buy stock in a company other than when it is issued, you pay for the stock and the proceeds go to the seller (who isn’t the company)!

You might wonder, then, why a company might care about its stock price.  That’s where executive compensation comes in!  Many directors and senior executives at publicly traded companies have a portion of their compensation either paid in stock or determined based on the price of the company’s stock.  When the leadership owns a lot of stock or is paid based on the stock price, it has a strong incentive to act in a way that will increase the price of the stock.  As such, with appropriate incentive compensation for directors and executives, their interests are more closely aligned with yours (i.e., you both want the price of the company’s stock to go up).

What Price Will I Pay?

The price you will pay for a stock is the amount that the person selling the stock is willing to take in payment.  Finance theory asserts that the price of a stock should be the present value of the cash flows you will receive as the owner of a stock.

In my post on bonds, I explain present values.  They apply fairly easily to the price of a bond, as the cash flows to the owner of a bond are fairly clear – the coupons or interest payments and the return of the principal on a known date.

By comparison, the cash flows to the owner of a stock are much more uncertain.  There are two types of cash flows to the owner of a stock – dividends and the money you receive when you sell the stock.


Dividends are amounts paid by the company to stockholders.  Many companies pay dividends every quarter or every year.  In most cases, the amount of these dividends stay fairly constant or increase a little bit every year.  The company, though, is under no obligation to pay dividends and can decide at any time to stop paying them.  As such, while many people assume that dividends will continue to be paid, there is more uncertainty in whether they will be paid than there is with bond interest.

Proceeds from the Sale of the Stock

The owner of the stock will receive an amount equal to the number of shares sold times the price per share at the time of sale.  This cash flow has two components of uncertainty to it.

  1. You don’t know when you will sell it. You therefore don’t know for how long you need to discount this cash flow to calculate the present value.
  2. It is impossible to predict the price of a stock in the future.

I find figuring out when to sell a stock one of the hardest aspects of investing.  I can get excited about investing in a company, but waffle on when to sell.  Brandon Smith, founder of Launchpad Finance, provides seven indicators that it is time to sell a stock in this post.

What are the Risks?

The biggest risk of buying a stock is that its value could decrease.   At the extreme, a company could go bankrupt.  In a bankruptcy, creditors (e.g., employees and vendors) are paid first.  If there is money left after creditors have been paid, then the remaining funds are used to re-pay a portion of any bond principal.  By definition, there isn’t enough money to pay all of the creditors and bondholders when there is a bankruptcy.  As such, the bondholders will not get all of their principal re-paid and there will be no money left after payment has been made to bondholders and creditors.  When there is no money left in the company, the stock becomes worthless.

Any of the following factors (and others) can cause the price of the stock to go down.

Economic Conditions Change

Changes in economic conditions can cause the interest rate used for discounting in the present value calculation to increase. When the interest rate increases, present values (estimates of the price) will go down.

Company Changes

Something changes at the company that causes other investors to believe that the company’s profits will be less than previously expected. One simple way that some investors estimate the price of a company’s stock is to multiply the company’s earnings by a factor, called the price-to-earnings ratio or P/E ratio.  Although P/E ratios aren’t constant over time, the price of a stock goes down when its earnings either decrease or are forecast to be lower than expected in the future. For more about P/E ratios and how a company calculates and reports on its earnings, check out this post

Increased Risk

Changes either in the economy or at the company can cause investors to think that the future profits of the company are more uncertain, i.e., riskier. When a cash flow is perceived to be riskier, a higher interest rate is used in the present value calculation.  This concept is illustrated in my post on bonds in the graph that shows how interest rates on bonds increase as the credit rating of the company goes down.  Recall that lower credit ratings correspond to higher risk.  The same concept applies to stock prices.  The prices of riskier stocks are less than the prices of less risky stocks if all other things are equal.

How Do People Decide What to Buy?

There are a number of approaches investors use to decide in which companies to buy stocks and when to buy and sell them.   I will discuss several of them in future posts.

Reasonable Price Investing

Reasonable price investors look at the financial fundaments and stock prices of companies to decide whether and when to buy and sell them.

Technical Analysis

Technical analysts, sometimes called momentum investors, look at patterns in the movement of the prices of companies’ stocks.  Day traders tend to be technical analysts whose time horizon for owning a stock can be hours or days.

High-Yield Investing

Some investors focus on companies who issue dividends.

Mutual Funds and Exchange-Traded Funds (ETFs)

Rather than invest in individual companies, some investors purchase either mutual or exchange-traded funds.  Under this approach, the investor relies on the fund managers to select the companies and determine when to buy and sell each position.

Investing Clubs

A great way to get started with investing or expand your research is to join an investing club.  They provide the opportunity to pool your money with other investors to buy positions in individual companies that the group has resourced.  In addition, you get to know other people with interests similar to yours.

Turnaround Plays

Turnaround plays (companies that have struggled but are about to become successful) can produce some of the highest returns in the market.  However, identifying companies that will actually be successful under their new strategies is difficult.  As such, investing in turnaround plays can also be quite risky. The Piotroski score is one tool that can be helpful in identifying companies that are more likely to produce above-market-average returns.

How are Stocks Taxed?

There are two ways in which stocks can impact your income taxes:

  • When you receive a dividend.
  • When you sell your ownership interest in the stock.

The total amount of the dividend is subject to tax.  The difference between the proceeds of selling the stock and the amount you paid for the stock is called a realized capital gain or loss.  It is gain if the sale proceeds is more than the purchase amount and a loss if the sale proceeds are less than the purchase amount.

In the US, realized capital gains and losses on stocks you have owned for more than a year are added to dividends.  For most people, the sum of these two amounts is taxed at 15%.  For stocks owned for less than a year, the realized capital gains are taxed at your ordinary tax rate (i.e., the rate you pay on your wages).

In Canada, dividends and half of your realized capital gains are added to your wages.  The total of those amounts is subject to your ordinary income tax rate.

When Should I Buy Stocks?

Understand Stocks

The most important consideration in determining when to buy stocks is that you understand how stocks work.  One of the messages I wished I had given our children is to invest only in things you understand.  If you don’t understand stocks, you don’t want to invest in them.

Understand the Companies or Funds

You also want to make sure you understand the particular company or fund you are purchasing.  One of the biggest investing mistakes I made was when I was quite young and didn’t understand the business of the company whose stock I owned.

My parents gave me some shares of a company called Wang Laboratories.  In the 1970s and early 1980s, Wang was one of the leaders in the market for dedicated word processors.  Picture a desktop computer with a monitor that’s only software was Microsoft Word, only much harder to use.  That was Wang’s biggest product.  At one time, the stock price was $42.  Not understanding that PCs were entering the market and would be able to do so much more than a dedicated word processor, I was oblivious.  As the stock started going down, I sold a few shares in the high $30s.  When the stock dropped to $18, I told myself I would sell the rest when it got back to $21.  It never did.  A year or so later, the stock was completely worthless. Fortunately, I was young enough that I had a lot of time to recover and learn from this mistake.

Be Willing and Able to Understand the Risks

You should also not buy stocks if you can’t afford to lose some or all of your principal.  Even though only a few companies go bankrupt, such as Wang, the price of individual stocks can be quite volatile.  As discussed in my post on diversification, you can reduce the chances that your portfolio will have a decline in value by either owning a large number of stocks or owning them for a long time.  Nonetheless, you might find that the value of your portfolio is less than the amount you invested especially over short periods of time when you invest in stocks.  If you want to invest in stocks, you need to be willing to tolerate those ups and downs in value both mentally and financially.

Market Timing

There is an old investing adage, “Buy low, sell high.”  In principle, it is a great strategy.  In practice, though, it is hard to identify the peaks and valleys in either the market as a whole or an individual stock.

People who invest over very short time frames – hours or days – often use technical analysis to try to identify very short-term highs and lows to create gains.  I anticipate that most of my followers, though, will be investing for the long term and not day trading.  While you will want to select stocks that are expected to produce a return commensurate with their riskiness, it is very difficult to time the market.

That is, my suggestion for new investors with long-term investment horizons (e.g., for retirement or your young children’s college expenses) is to buy stocks or mutual funds you understand and think are likely to appreciate whenever you have the time and money available to do so.  If you happen to buy a fundamentally sound stock or index fund just before its price drops, it will be difficult to hang on but it is likely to increase in the price by the time you need to sell it.

As Chris @MoneyStir learned when he reviewed the post I wrote about whether he should pre-pay his mortgage, a fall in the stock market right after he started using his extra cash to buy stocks on a monthly basis was actually good for him!  While he lost money at first on his first few month’s investments, the ones he made over the next several months were at a lower stock price and produced a higher-than-average return over his investment horizon.  The process of buying stocks periodically, such as every month, is called dollar-cost averaging.

How and Where Do I Buy Stocks?

You can buy stocks, mutual funds and ETFs at any brokerage firm.  This article by Invested Wallet provides details on how to open an account at a brokerage firm.

Once you have an account, you need to know the name of the company or its symbol (usually 2-5 letters that can be found using Google or Yahoo Finance, for example), how many shares you want to buy and whether you want to set the price at which you purchase the stocks, use dollar-cost averaging to purchase them over a period of time or buy them at the market price.

Limit Orders

If you determine you want to buy a stock at a particular price, it is called a limit order.  The advantage of a limit order is you know exactly how much you will pay.  The disadvantages of a limit order are:

  • You might pay more than you have to if the stock price is lower at the time you place your order.
  • You might not buy the stock if no one is interested in selling the stock at a price that is a low as your desired purchase price.

Market Orders

If you place a market order, you will buy the stock at whatever price sellers are willing to take for their stock at the moment you place your order.  In some cases, you may end up paying more than you want for a stock if the price jumps up right at the time you place your order.  The advantages of a market order are (1) you know you will own the stock and (2) you know you are getting the best price available at the time you buy the stock.

Transaction Fees

Many of the major brokerage firms have recently announced that they will no longer charge you each time you purchase or sell a stock.  Some firms charge you small transaction fees, such as $4.95, each time you place a buy or sell order.  Other firms have higher charges.  You’ll want to consider the fees when you select a brokerage firm.

Savings Accounts for Kids

Savings Accounts for Kids

Many parents want to create savings accounts for their kids – for one or both of funding their education or giving them a head start on life.  In this post, I’ll focus on the different types of accounts you can use for the latter purpose – giving them a little (or maybe more than a little) money to get started.  Savings accounts for kids can also be used if your children receive an inheritance, such as from a grandparent or other relative.  I’ll talk about saving for education in a separate post, as it is a lengthy topic all by itself.

Ways to Save for your Kids

There are several ways to save for your kids.  They range from easy – for example, just open an account in your name with the intention of giving the money to the kids – to quite complicated and possibly expensive – for example, setting up trusts.  Besides the ease of the process and the expense, your choice will also depend on when you want your children to be able to access the money and your and your kids’ tax situations.

Starting from simplest to most complex, I will explain the following options here:

  • Open an account in your name.
  • Open a joint account.
  • Create an account under the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA).
  • Create a trust.

A Caution about Gifts and Taxes

Before making gifts to your children, you need know that there are tax rules in the US about gifts themselves as well as any investment returns your children earn.

Gift and Inheritance Taxes

Information from the Internal Revenue Service (IRS) about gifts can be found at this link.  Each individual can give another individual a gift of up to the gift tax limit ($15,000 in 2019) each year without any tax consequences.  For example, each of a father and mother could give their daughter a gift of $15,000 for a total of $30,000 in a year and there would be no additional tax reporting or taxes.

If you make a larger gift, the portion in above the gift limit is called an excess gift and needs to be reported to the IRS.  According to Schwab’s web site, you do not have to pay gift tax to the IRS as long as the combination of your gifts in excess of the limit and the amount you give to people as part of your estate when you die doesn’t exceed a stated threshold ($11.18 million for 2019 through 2025).  I believe that the excess gift and estate tax limit in some states is much, much lower.  If you are fortunate enough to be able to make large gifts, I suggest you contact your tax advisor to ensure you understand the tax ramifications.

Taxes on Children’s Income

A child’s unearned income (e.g., interest, dividends and capital gains) exceeds $2,100 may be subject to tax, according to the IRS web site.  As outlined at that link, in some cases, parents can report the child’s income on their own tax return.  In other cases, the child must file its own tax return.

The 2019 Federal tax rates on child’s taxable income go up very quickly, as shown in the table below.  Taxable income includes all earned and unearned income.

Taxable IncomeTaxes
Up to $2,55010% of taxable income
$2,550 – $9,150$255 + 24% of taxable income in excess of $2,550
$9,150 – $12,500$1,839 + 35% of taxable income in excess of $9,150
More than $12,500$3,011.50 + 37% of taxable income in excess of $12,500

If you choose to gift large amounts of money to your children, you will want to consider whether you can include your child’s income on your return, the complexity of filing a separate return for your child and the difference in the taxes on your income as compared to your child’s income.

Separate Bank or Brokerage Account (in Your Name)

The easiest way to open a savings account for your kids is to open a bank or brokerage account in your name and know “in your mind” that you intend to give the money to you kids.  The advantage of this type approach is that you have complete access to the money and can change your mind about giving it to your children.  Of course, that defeats the purpose of setting aside money for your kids!

You will report any interest, dividends or capital gains from the account on your tax return, as you own the account.  If you use this approach, you’ll want to be careful of the gift tax rules when you transfer it to your child.  The value of the account may exceed the gift tax limit when you give the money to your child if you have been contributing to it for many years and/or it has grown through investment returns.

Joint Bank or Brokerage Account

Another form of savings accounts for kids is a joint account at a bank or brokerage account. That is, both your and your child’s name will be on the account.  We took this approach for our children to teach them about saving.

Some of these accounts allow your child to deposit or withdraw money at any age, while others allow only you to make transactions on the account.  If you choose a truly joint account (which means your child can make withdrawals), you need to be certain you can stand watching them withdraw the money and spend it on their own.  I will admit I was surprised at my emotional reactions to watching my children spend money.  They were much stronger than I would have guessed.

According to Pocket Sense, if your child doesn’t file a tax return, you will report the income, gains and losses on the account on your tax return – the same as if you open the account on your own.  If your child files a tax return, you’ll report all of the income as yours, but you then deduct your child’s share from your return and report it on his or her return.  In addition, the amount you deposit into the account is considered a gift to your child in the year it which it is withdrawn.

UTMA/UGMA Accounts

There are two types of savings accounts for kids that give you a bit more control over the money than a joint account.  These accounts are Uniform Transfer to Minors Act (UTMA) and Uniform Gift to Minors Act accounts.

UTMA and UGMA accounts are easy to set up at a bank or brokerage firm. Someone, often the parent or person who opens the account, is identified as the custodian on behalf of the minor (the beneficiary).  The money in these accounts can be used by the custodian for the benefit of the minor, though there are fewer restrictions on how money in an UTMA account can be spent than an UGMA account.  Broadly, expenses that parents usually pay for their children, such as food, housing and clothes, are considered to be “for the benefit of the minor.”  At ages established by each state individually for each type of account, often 18 for UGMA accounts and 21 for UTMA accounts, the beneficiary becomes solely responsible for the account.

These accounts have the benefit that your child can’t access the money until they are at least 18.  They have the drawback, relative to a joint account, that you can use the money only for the benefit of your child.

The money you put in an UTMA or UGMA account is considered a gift when you deposit it.  Any interest, dividends or capital gains will be reported as the child’s income, so you might have to file a tax return for your child if he or she has enough income.


Another legal structure you can use when you open a savings account for kids is a trust.  A trust is a legal entity that requires a trust agreement and gets its own tax ID number.  The trustee is the person who oversees the trust until the child receives the money.

We created a trust for each of our children, as they each received an inheritance that stipulated that the money be put in trusts, and had a lawyer draft the trust agreement.  I suspect there are books and websites that will help you do it yourself as well, but you’ll want to consider the cost of establishing a trust as you decide it this option is best for you.

Once you have created the trust, you can then open a bank or brokerage account on its behalf.  The trust agreement will specify who can withdraw money and for what purposes. One of the advantages of a trust over an UTMA or UGMA account is that you determine the age at which your children receive the money.  In some cases, people even release portions of the money to their children at two or three different ages.  If you are concerned about your child’s ability to handle money responsibly, a trust will allow you to delay distribution of the money to them until they are more mature.

Trusts always needs to file a tax return separate from you and your child.  The 2018 tax rates for trusts are the same as those shown above for children shown earlier in this post.  Any deposits into a trust are considered as gifts by the IRS.


This table shows a quick comparison of the four different options I’ve described here.

Account in your nameJoint AccountUTMA/UGMATrust
Who owns the accountYouBothChild, with custodian oversightChild, with trustee oversight
When can child spend moneyOnly when you transfer itAnytimeAt age established by stateAt age established by trust agreement
Purposes for which you can withdraw moneyAnythingAnythingFor benefit of childAs specified by trust agreement
When considered a giftWhen you transfer moneyWhen spent by childWhen depositedWhen deposited
Who pays taxesYou50% by you/50% by childChildTrust


For other tips on how to help your kids become financial literate adults, check out my guest post for Grokking Money in honor of Financial Literacy Month and my post on financial advice we gave our kids.

Should Chris Pay off his Mortgage?

Should Chris Pay Off his Mortgage?

Chris @Money$tir asked other financial literacy and financial independence (FI) bloggers, in a post on March 9, 2019, whether he should pre-pay his mortgage or invest the money. He provided his thought process and calculations. In this post, I will review his calculations and then show that his decision will be easier if he narrows his question and analysis. I will also provide my findings and analysis to help inform his decision.


Chris’s post provides all of the background. You might want to read his post quickly to understand his calculations and other considerations before you read the rest of this post.

Briefly, he will have just under $310,000 left on his mortgage on July 1, 2019. His payments are $1,525 and he will have an additional $4,000 a month available to either pre-pay his mortgage or invest.

I followed up with Chris and learned that he expects to take the standard deduction on his tax return, so he will have no tax benefit from his mortgage interest. His marginal tax rate on ordinary income is 22%; on capital gains and dividends, 15%. I also confirmed that Chris does not have any pre-payment penalties associated with his mortgage.

Three Re-Payment Options

Chris suggested three options in his article, two of which involve making pre-payments. The three options are:

1. Make $1,525 a month in mortgage payments until his mortgage is fully re-paid in July 2045, while investing the remaining $4,000 at 8% per year.

2. Take a middle-of-the road option and make mortgage payments of $3,525 each month and invest the remaining $2,000. Under this option, his mortgage will be re-paid in 2027.

3. Pay $5,525 each month – $1,525 in scheduled payments and $4,000 in pre-payments – until his mortgage is fully re-paid in 2024.

Chris calculated his pre-tax savings using an 8% return through July 2045. The values he calculated are:

• Option 1 – $4,145,000
• Option 2 – $3,772,000
• Option 3 – $3,594,000

In his post, Chris indicated he is leaning towards Option 3 – pre-pay his mortgage as quickly as possible.

Chris’s Math

One of Chris’s questions is whether his calculations are correct. I re-created Chris’s calculations. While I did not get his ending balances exactly, my results were within a couple of percentage points, so I suspect we made slightly different assumptions regarding either the timing of the interest charges (beginning or end of month) and/or his exact mortgage balance. I’m quite comfortable that the calculations he performed are what he intended.

I also confirmed that increasing his payments by $2,000 or $4,000 a month shortens the time until his mortgage is fully re-paid as he indicated in his post.

Re-framing the Question

Many of Chris’s considerations relate to additional flexibility he will have after his mortgage is fully re-paid. I believe that Chris has not correctly separated the mortgage re-payment question from his other decisions – renting out his house and buying a new one, not having a mortgage if he decides to downsize, freeing up money for other purchases and so on. That is, as discussed below, he can use his first five years of savings in Options 1 and 2 to make the rest of his mortgage payments. By understanding that, he can independently decide to do with the $5,525 a month after five years doesn’t depend on his choice of payment option.

If Chris changes his calculations consistent with the re-framed question (i.e., looking at only the $5,525 a month for the first five years), he can eliminate all of the noise of these other questions as they will become independent of his mortgage decision. In his calculations, Chris has set aside $5,525 every month until his mortgage would be fully re-paid in 2045 if he made the minimum payments. Instead, I propose that he set aside $5,525 a month only until 2024 (and not after) – that is, only until his mortgage would be fully paid under Option 3. Except in certain situations discussed below, Chris will make his mortgage payments starting in August 2024 from the savings that accumulates from the money he saved up until then and not from his future income or other savings. That stream of payments, if invested in a hypothetical risk-free, tax-free financial instrument at 3.625% would exactly pay off his mortgage regardless of which of his three re-payment options he chooses.

By focusing on this shorter stream of payments until 2024, he can do whatever he wants with the $5,525 a month after his mortgage is paid off under all three re-payment options. As a result, his decision-making process can focus solely on the risks and rewards of his three re-payment options without any consideration of other, unrelated financial decisions.

My re-framed question does not eliminate one of his considerations – his peace-of-mind from not having a mortgage. Chris will need to include this subjective consideration in his decision-making process, along with the considerations regarding risk and rewards presented below.

My Math

There are four changes I made to Chris’s calculations:

1. I assumed that Chris set aside $5,525 a month from July 2019 through August 2024, rather than until 2045. In addition, except as noted below, after July 2024, he will make his remaining mortgage payments from the savings he has accumulated and not from his income. Therefore, starting in August 2024, he can use the $5,525 a month however he wants as I excluded it from my analysis.

2. I introduced the impact of income taxes. Chris will pay taxes on his investment returns which will make the first two options look less attractive than is shown in his analysis.

3. I quantified the risk Chris will assume by investing in the first two re-payment options.

4. I focused on Chris’s financial position not only in 26 years (when his mortgage would be paid off making the minimum payments), but also in 10 years (when he might want to down-size).

Three Investment Strategies

Chris’s first and second options assume he will invest in an S&P 500-like ETF returning 8%. His calculations do not quantify the riskiness of the S&P 500, though he does mention the risk in his subjective considerations. I will provide explicit insights on the risk. In addition, because Chris is concerned with the riskiness of the S&P 500, I also looked at two other options, for a total of three investment strategies:

1. Invest in 100% in stocks, such as an S&P 500 ETF.

2. Invest in 100% bonds, such as a bond fund. I used the Fidelity Investment Grade Bond Index (FBNDX), as a proxy.

3. Invest 50% in each of stocks (an S&P 500 ETF) and bonds (the Fidelity bond index).

Under all three strategies, I assumed the Chris would re-invest all interest, dividends and capital gains, after tax, and would not withdraw it except to make his mortgage payments.

In my analysis, I calculated Chris’s financial position as if stocks and bonds had the monthly returns observed historically for the 10-year periods starting on the first of each month from January, 1980 through October, 2008 (10 years before my time series ended). There are 345 overlapping 10-year periods. For the 26-year time frame, there are only 153 overlapping periods covered by the Fidelity bond index data. I therefore looked at only the S&P 500 investment option when doing the calculations of Chris’s financial position in 2045.


The infographic below clarifies the key dates under all three options and provides a teaser of the results.

Chris's Mortgage Timeline Infographic

Option 1

Under Option 1, Chris will make payments of $1,525 a month to his lender from July 2019 to August 2024 from his income. He will also save $4,000 a month over the same time period. This time period is represented in green. From August 2024 until July 2045, he will withdraw $1,525 from the savings he accumulated in the first five years to pay his mortgage. This period of time is shown in orange. This use of debt to finance investments is discussed in more detail in my post on good and bad debt.

Option 2

Under Option 2, Chris will make payments of $3,525 a month to his lender from July 2019 to August 2024 (the green segment) from his income. He will also save $2,000 a month over the same time period. From August 2024 until December 2027 (the orange segment), he will withdraw $3,525 a month from his accumulated savings to pay his mortgage. He will have fully re-paid his mortgage by December 2027, so any leftover savings will remain invested until July 2045. This time period is represented in yellow.

Option 3

Under Option 3, Chris will make payments of $5,525 a month to his lender from July 2019 to August 2024 (the green segment) at which point his mortgage will be fully re-paid. Because he hasn’t put any money in savings, he will have no savings so nothing will happen related to the money from the green time period during the yellow time period.

Check-In Dates

The infographic also calls out July 2029 and July 2045. These are the two dates that Chris mentions in his post as being possible decision dates. In ten years (July 2029), he might want to sell his house and downsize. In July 2045, his mortgage will be fully paid if he makes his minimum payments and it offers another point at which to consider selling the house.

The infographic shows the balance of his mortgage and the average amount of his after-tax savings if he invests 100% in stocks. As will be discussed below, there is a lot of risk around this average and it is calculated using historical returns, so there is also uncertainty around it.

Summary of Findings

Here are the key findings of my analysis. They will be discussed in detail below.

● Chris’s time horizon is important in making his decision.

o If he plans to keep his house until 2045, the historical data indicate he is better off in three-quarters of the scenarios making his minimum payments and investing in stocks. The average values of his after-tax savings are shown in the infographic above and show that he will have more savings on average with lower monthly mortgage payments.

o If he plans to sell his house or use the money he has saved to fully re-pay his mortgage 10 years from now, the decision is not as clear cut and will need to consider his risk tolerance. Because Chris plans to continue to work for many years, he may be able to tolerate more risk than someone who plans to retire before their mortgage is fully re-paid.

● Chris’s investment mix is important in making his decision.

o If he plans to keep his house until 2045, the historical data indicate that he is better off investing 100% in stocks.

o If he plans to sell his house or use the money he has saved to fully re-pay his mortgage 10 years from now, the mix of investments will depend on his risk tolerance.

● The historical data indicate Chris’s downside risk is not significantly changed by the stock market possibly being near its peak.


I will start by providing insights on Chris’s financial position on average across all of the time series of historical investment returns – first for the 10-year period and then for the full 26-year period. I will then discuss the riskiness of the options. The last part of this discussion will focus on how I evaluated his results if the stock market were at a peak.

Average Results – 10 Years

The table below summarizes Chris’s average financial position, based on the historical investment returns, in 10 years on July 1, 2029, the time frame he referenced as possibly wanting to downsize. The invested asset row shows the balance of his investments if he sells all of his positions on that date and pays the related taxes. The “net worth” row shows the average amount Chris will have left if he pays off the balance of his mortgage with his after-tax investments.

Payment Option3222111
Mortgage Payment$5,525$3,525$3,525$3,525$1,525$1,525$1,525
Investment OptionAll100% Bonds50% Bonds/ 50% Stocks100% Stocks100% Bonds50% Bonds/ 50% Stocks100% Stocks
Invested Assets$0$10,620$25,515$34,396$248,941$285,615$324,269
Mortgage Balance0000221,928221,928221,928
“Net Worth”010,62025,51534,39627,03364,687102,341

I use “net worth” in quotes because it includes only the assets emanating from the $5,525 per month for the next five years and only his mortgage balance as a liability. In addition, Chris will have his house, all of his other taxable savings, his retirement accounts, and so on and so forth. Because all of these other assets are the same regardless of which option he chooses for his mortgage re-payment, I have excluded them from the comparison.

The positive “net worth” numbers mean Chris will get to keep the entire proceeds of his house if he sells it in 10 years plus the positive “net worth.” If there were negative “net worth” numbers (which there are in the graphs below), Chris would need to use that portion of the proceeds from his house to contribute to the settlement of his remaining mortgage balance.

The farthest left column – paying off his mortgage as quickly as possible – is the option Chris indicated is his initial preference. Under this strategy, he will have saved no invested assets from the $5,525 a month for five years and have no mortgage balance, so would get exactly the proceeds of his house if he were to sell it then. The remaining columns show that, on average using the historical returns, Chris will have more savings than his mortgage balance if he makes his lower mortgage payments and invests the rest of his $5,525 per month than if he pre-pays his mortgage as quickly as possible.

The smaller his mortgage payment, the higher his “net worth” or the more he will have available in excess of his mortgage balance in 10 years. For example, Chris will have a “net worth” of $34,396 at the end of 10 years, on average using historical returns, if he pays $3,525 a month towards his mortgage and invests the rest in 100% stocks as compared to $102,341 if he pays $1,525 a month towards his mortgage and invests the rest in 100% stocks. Because the average historical after-tax returns on his investments are higher than Chris’s pre-tax mortgage interest rate, he will accumulate savings above the balance of his mortgage.

In addition, at the average, Chris is better off if he invests more heavily in stocks. For example, if Chris makes his minimum mortgage payments and sells his house in 10 years, he will have $27,033 in after-tax savings if he invests 100% in bonds as compared to $102,341 in after-tax savings if he invests 100% in stocks.

I also calculated the averages for the 100% stocks investment strategy using the longer time period (back to 1950). While the results are slightly less favorable, they show generally the same results as are shown in the 100% stocks columns in the table above.

Average Results – 26 Years

The table below summarizes Chris’s average financial position on July 1, 2045, based on the historical investment returns. As discussed above, I don’t believe there is enough historical data regarding bond returns to include those investment strategies in this analysis. This table therefore shows results only based on the 100% stocks investment strategy and is based on stock returns going back to 1950.

Mortgage Payment Option321
Mortgage Payment$5,525$3,525$1,525
Investment Option100% Stocks100% Stocks100% Stocks
Invested Assets$0$84,534$373,269
Mortgage Balance000
“Net Worth”084,534373,269

This table shows that the smaller mortgage payments Chris makes, the higher his savings will be 26 years from now on average using the historical returns.

Risky Results – 10 Years

So far, I have focused on Chris’s average returns. I mentioned in my introduction that one of the aspects of his decision that Chris does not quantify is risk. By looking at his “net worth” under 345 different historical scenarios (i.e., the number of complete 10-year time periods in my historical data) regarding bond and stock returns, we can get a sense for the riskiness of Chris’s choices.

Box & Whiskers – 10 Years

The graph below is called a box and whisker plot. My post on risk provides additional information about these graphs. The boxes represent the 25th to 75th percentiles of Chris’s “net worth” at 10 years. That is, I put the 345 “net worth” results in order from smallest to largest. The 25th percentile is the 86 th one on the list; the 75th percentile, the 259th. The whiskers (lines sticking out from the ends of the boxes) represent the 5th percentile to the 95th percentile and correspond to the 17th and 328th in order from smallest to largest.

Taller boxes and wider spreads between the top and bottom of the whiskers represent more risk. The placement of the boxes up and down on the graph show the overall level of the results. That is, boxes that are higher on the graph have higher returns than boxes that are lower.

This graph shows Chris’s “net worth” after 10 years under each of the investment and re-payment strategies.

"Net Worth" after 10 Years

Chris’s Re-payment Option 3 – pay off his mortgage as fast as possible – is shown on the far left. Because he makes no investments under this option, there is no risk and he always has no savings at the end of 10 years. As either the percentage of investments in stock increases or the amount of savings increases (moving to the right on the graph), both the risk and level increase. That is, with more savings, the boxes are higher on the graph and taller (e.g., compare the $1,525/0% Stocks box with the $3,525/0% Stocks box). The same comparison can be seen as the percentage of stock increases, by looking at the $1,525/0% Stocks relative to the $1,525/50% Stocks and $1,525/100% Stocks.

The tops of the boxes, tops of the whiskers and average values (shown in the table above) are all clearly higher with lower mortgage payments and a higher investment in stocks. The bottoms of the boxes and bottoms of the whiskers are all lower, though, so those options have more risk.

Efficient Frontier – 10 Years

Making a decision from the box & whisker plot can be challenging. If Chris is willing to view his risk-reward trade-off as being between his average “net worth” and his worst “net worth,” he can narrow down his choices. The drawback of this approach is it considers only one point in the range of possible results for measuring risk.

The graph below is a scatter plot showing the different options. My post on financial decision-making provides more insights on this type of graph. The x-axis (the horizontal one) shows Chris’s average “net worth” in 10 years. The y-axis (the vertical one) shows the worst “net worth” result observed based on the historical returns. Points on this chart that are up (worst results aren’t as bad) and to the right (higher average result) are better than points that are lower or to the left.

Efficient Frontier after 10 Years

I have drawn a dashed line, called the efficient frontier, that connects those strategies (dots) that are optimal in that there are no other dots that have a higher average with the same worst result or have a higher worst result with the same average. Using the worst result as the sole measure of risk would allow Chris to narrow his choices down to the four on the efficient frontier, depending on how much risk he is willing to take.

You’ll see that there are two orange dots on this graph. They represent the points using the S&P 500 returns going back to 1950, whereas the blue points all use data starting in 1980. What I found most interesting is that the worst results are the same for both time series, though the average results are somewhat lower using the longer time series. The worst results occurred using the time series starting in February 1999.

Risky Results – 26 Years

The graph below shows the box & whisker plot of Chris’s “net worth” in July 2045, using the historical returns.

Balance after 26 Years

The 25th percentile of Chris’s “net worth” under all three options is about $0. As such, in 75% of the historical scenarios, Chris will be somewhat to significantly better off making smaller mortgage payments than making larger payments.

The much clearer results shown in this chart as compared to the one at 10 years results from the benefits of diversification over time. That is, the longer time period over which Chris is invested, the less risk there is in his financial results. Diversification is one way a portfolio can be diversified. Investing in both stocks and bonds is another. My post on how diversification reduces investment risk discusses these concepts in more detail.

The scatter plot below shows that in the worst scenario, Chris ends up losing about $120,000 over 26 years if he is 100% invested in stocks. The trade-off is that in 75% of the historical scenarios, he will have at least some savings and more than $370,000 in savings on average.

Efficient Frontier after 26 Years

Current Market Cycle

Another concern that Chris and others on Twitter expressed is that the stock market has been going up for many years and is at risk of going down significantly in the near future.

Selection of Prior Peaks

To address that concern, I have reviewed the historical stock market returns to find points that would correspond to the market being at a peak. The two graphs below show the cumulative returns on the S&P 500 since 1950. (I had to create two charts so that the ups and downs from older periods could be seen. Even then the first peak on the second chart is a little tough to see even though it includes the largest single monthly decline in the entire time period.)

Accumulated Returns 1950-1980

Accumulated Returns Since 1980

The eight green circles correspond to important peaks in the market, similar to Chris’s concern about today’s market.

“Net Worth” After Prior Peaks

I looked at Chris’s “net worth” ten years after each of those peaks, as shown in the table below. Recall that the bond index data are available starting only in 1980, so we can’t look at any strategies that include bonds for the earlier peaks.

Mortgage Payment$5,525$3,525$3,525$3,525$1,525$1,525$1,525
Investment OptionAll100% Bonds50% Bonds/ 50% Stocks100% Stocks100% Bonds50% Bonds/ 50% Stocks100% Stocks
Average – Last 4017,25432,18945,72033,64679,733125,819
Average – All 8018,02148,916
All Scenarios010,62025,51534,39627,03364,687102,341

In some of the time periods, particularly the ones starting on November 1, 1965 and November 1, 1968, Chris would have been better off pre-paying his mortgage as quickly as possible rather than investing. In others though, he would have been much better off making his minimum mortgage payments.

The average result for the most recent 4 “bad” time periods (third-to-bottom row) is slightly better than the average result across all possible time periods (bottom row). If all eight periods are included, Chris is better off making minimum payments, but not by as much as was observed in all scenarios.

Dollar Cost Averaging

In several of the “bad” periods (e.g., the ones starting on 12/1/1980, 8/1/1987 and 6/1/2007), Chris ends up with a very high “net worth” if he invests 100% in stocks. Although Chris buys some stocks at the peak of the market, he will also buy stocks as the prices go down (generally taking a year or two). The graphs above show that the market often re-bounds fairly rapidly after it has fallen. In these situations, Chris will achieve a high return on the stocks bought at or near the bottom of the market, thereby boosting his overall return.

Dollar cost averaging is the process of making regular investments regardless of the market cycle. It is a common investing approach and, although it may not be intentional, it is exactly what you do when you contribute to a 401(k) through payroll deductions. Dollar cost averaging lets you buy stocks at all levels, without timing the market, which can produce better total returns than trying to time the market and make your investment on a single day or just a few days a year. If Chris invests monthly, he is implementing a dollar cost average strategy.


The findings presented here depend on a large number of assumptions.

Investment Returns

I used historical monthly returns on the S&P 500 and the Fidelity Investment Grade Bond Index (FBNCX) downloaded from Yahoo Finance. I assumed that any dividends and distributions, reduced by any related income taxes, were immediately reinvested.

Yahoo Finance provides a Closing Price and an Adjusted Closing Price. I used the percentage changes in the Adjusted Closing Price to calculate the total return for each financial instrument. For the S&P 500, the Closing Prices and Adjusted Closing Prices were identical. For the Bond Index, they were not. I assumed that the difference in the percentage changes between the Adjusted Closing Price and the Closing Price were interest payments.

I assumed that Chris would fund any shortfalls from current income or other after-tax savings and that there would be no borrowing costs or additional taxes.

Income Taxes

I made several key assumptions about income taxes:

● All investments will be held in taxable accounts. Chris is already contributing the maximum amounts to his tax-sheltered retirement plans. In addition, he might encounter penalties if the withdrawals needed to make his mortgage payments did not meet the guidelines of the specific tax-sheltered account to which he made contributions. See my post on retirement plans for more details on such withdrawals.

● The interest payments from the Bond Index will be taxed at Chris’s marginal rate on ordinary income of 22%.

● Chris will pay tax at his marginal capital tax rate of 15% capital gains and losses when he sells his investments, either to make mortgage payments or withdraws the money at the end of 10 years or 26 years.

● Chris’s marginal tax rates won’t change over the time horizon of the analysis.

● There were no tax implications of borrowing.

Fine Print

Having been a consultant for over 20 years, I feel it necessary to touch on the many limitations on the findings of the analysis.


Most importantly, actual results will vary from those presented herein. I have used historical data as a proxy for what might happen in the future. However, it is unlikely that future results will exactly replicate any results previously seen. If any of the assumptions discussed above or otherwise made do not turn out to be appropriate to Chris’s situation, the findings may similarly be relevant to his decision-making process.

Economic Environment Differences

An important component of these differences is the interest rate environment. As shown in the chart below, interest rates (as measured by the 10-year Treasury in this chart) declined or were flat during almost the entire period from 1980 to the present – the time period for which data were available for the Bond Index.

Interest Rate on 10-Year Treasury

It is more likely than not that interest rates will increase during the time horizon of this analysis. When interest rates increase, bond prices tend to decrease. If that were to happen, the findings based on historical bond returns likely overstate the results that might be observed in the future.

Data Used in My Analysis

I downloaded S&P 500 and the Fidelity bond index monthly returns from Yahoo Finance. Data were available for the S&P 500 going back to 1950, but only to 1980 for the Fidelity bond index. To the extent that these data are incorrect, the findings herein might also be incorrect (i.e., garbage in, garbage out).

Intended Use

The purpose of this analysis was to provide insights to help Chris make a more informed decision. It should not be interpreted as making a recommendation for any financial decision. The only information I have about Chris’s financial situation is what is outlined above and in his post. As such, there may be other aspects of his financial situation that cause this analysis to not apply correctly to his specific situation.

Lastly, the analysis may not be applicable to anyone else’s specific situation.

When Is It Good to Pay Off Student Loans

You Have Some Savings. What's Next? Paying off Student Loans

 This week, I’ll conclude the case study about Mary and her savings.  Her last question focused on whether to pay off her student loans.  The considerations include:

  • The interest rate on her loans.
  • How many more payments she has.
  • What she can earn if she doesn’t pay off her loans.
  • Her risk tolerance and other cost-benefit trade-offs.  

To help set the stage, I created a fictitious person, Mary, whose finances I use for illustration.

  • Mary is single with no dependents.
  • She lives alone in an apartment she rents.
  • She makes $62,000 per year.
  • Mary has $25,000 in a savings account at her bank and $10,000 in her Roth 401(k).
  • Her annual budget shows:
    • Basic living expenses of $40,000
    • $5,000 for fun and discretionary items
    • $10,000 for social security, Federal and state income taxes
    • $4,000 for 401(k) contributions
    • $3,000 for non-retirement savings
  • Mary has $15,000 in student loans which have a 5% interest rate.
  • She owns her seven-year-old car outright. She plans to replace her car with a used vehicle in three years and would like to have $10,000 in cash to pay for it.
  • She has no plans to buy a house in the near future.

Mary's Savings Infographic

I’ll explain how she decides what to do and then will conclude with a summary of the benefits of all of her decisions. As a reminder, Mary has $10,000 of student loans outstanding at a 5% interest rate.  She has 5 years of payments remaining, so her monthly payment is $189.  She has $25,000 in total savings and has already decided to set aside $13,000 for emergency savings and $5,500 for her car.  These decisions leave her with $6,500 for long-term savings and paying off her loan. There are several different approaches Mary could take to pre-pay her student loans. In her case, she could pre-pay up to $6,500 with her savings. Alternatively, she could pre-pay her students loans more slowly using one of the methods in this post.

Should I Pay Off the Principal on my Loans?

Simple Answer

Instead of investing her long-term savings, Mary could use some of her savings to pre-pay her loans.   When you pre-pay a loan, it is the equivalent to earning a return equal to the interest rate on the loan.  I’m sure that analogy sounds weird.  To help make more sense of that statement, consider the following thought process:

  • You don’t pre-pay your student loan.
  • You loan the money you have available to make pre-payments to someone else at the interest rate on your student loan. The loan to the other person also returns your principal at the same rate you are paying principal on your student loan.  The return on the loan that you made to the other person is the same as the interest rate on your student loan because that is what you are charging the other person.
  • When you combine your student loan payments and the payments you get from the loan you made to the other person they offset and you have no net cash flows.
  • If you pre-pay your student loan, you also have no net cash flows.

As you can see, pre-paying your student loan puts in you the same situation as if you didn’t pre-pay your student loan and you loaned that money to someone else at the same interest rate.  Therefore, the return on the money you use to pre-pay your student loans is equal to the interest rate on the loans. In Mary’s case, she has student loans on which she pays 5% per year on the outstanding balance.  The simple approach to answering Mary’s question is that it makes sense for her to pre-pay her loans if the after-tax interest cost on the loans is higher than the after-tax return she could earn on the money if she invests the money in financial instruments with the same level of risk.

What is Risk?

Risk is the volatility in the returns on a particular financial instrument, as discussed in more detail in this post.  If you buy a Treasury bond[1]and hold it to maturity, you are pretty much guaranteed that you will earn the yield to maturity[2]at the time you buy it.  If you buy an S&P 500 index fund (a form of exchange traded fund or ETF), the long-term average return is around 9%, but the returns can vary widely from one year to the next.  In fact, the S&P 500 return was outside the range of 0% to 18% in half of the years from 1951 to 2017.[3]

Risk of Pre-paying a Loan

There is no volatility in the return Mary gets from paying off her loan.  In all scenarios, it will be the interest rate on the loan.   As such, the simple approach will tell Mary she should pre-pay her loan if her interest rate is higher than she can earn on a Treasury bond with the same time to maturity as her loan, after adjusting for the difference in the tax rates.

Complex Answer

There are several benefits to Mary if she pays off the loan, including:

  • The sense of relief that she no longer has to make the payments.
  • Extra cash in the future she can either save or spend.
  • Improvement in her credit score.

On the other hand, Mary is so eager to start investing in something other than risk-free instruments which she can do if she doesn’t use all of her available savings to pre-pay her loan.  That is, Mary has the choice between taking the risk that she will lose money (if she doesn’t pre-pay her loans) and not having the opportunity to start investing (if she does pre-pay her loans).  Her view on this choice is called her risk toleranceRisk tolerance is an individual decision. To make this comparison, Mary needs to know or decide:

  • At what return can she invest the money if she doesn’t pre-pay her loans?
  • What is the tax rate applicable to the investment returns she would earn?
  • Is the interest on her loans tax-deductible?
  • If she can deduct the interest on her loans, what is her marginal tax rate?

After-tax Return by Paying Off Loan

In the US, you can deduct up to $2,500 of student loan interest as long as your income (measured using a value calculated on your tax return called modified adjusted gross income which, for Mary, is essentially her wages) is less than $65,000 for an individual.[4]  Mary’s state uses the same rules as the Internal Revenue Service.   Her total interest is below $2,500 and her income is below $65,000, so the entire 5% interest is tax-deductible.  Mary’s marginal tax rate (the percentage she will pay on the next dollar of income) is 25% including state income taxes.  We can calculate the after-tax cost of the loan as the interest rate times the portion she keeps after she pays taxes (= 100% – the tax rate of 25%): 5% times (100% – 25%) = 3.75%

After-tax Return of Treasuries

Mary’s combined Federal and state tax rate on a Treasury bond is the same as her marginal Federal tax rate (20%) as Treasury bond interest is exempt from state tax.  As I write this post, the yields on US Treasuries of between one and five years are all right around 2.7%.[5]  She can calculate the after-tax return on a Treasury bond as: 2.7% times (100% – 20%) = 2.2% Because the after-tax interest rate on her loans of 3.75% is higher than the after-tax return on a risk-free US Treasury bond (2.2%), the simple approach would tell use she should pay off her loan.

Expected After-tax Return of S&P 500 Index Fund

Mary will consider an S&P 500 index fund (a form of exchanged-traded fund that is intended to track S&P 500 returns fairly closely) as a risky asset in which to invest any money she doesn’t use to pre-pay her loan.  Mary’s combined Federal and state tax rate on the S&P 500 index fund is 20%.[6]  She can calculate her expected[7]after-tax return on the S&P 500 index fund as: 8.9% times (100% – 20%) = 7.1%

Cash Flow Comparison

Mary isn’t quite sure she knows what the differences in the returns mean to her.  She therefore calculated the total amount of interest she will pay in the future if she pays off her loan immediately ($0) and if she pays it off as scheduled ($1,323).[8]  She then calculates the total expected return she would get if she invests in her savings account, Treasuries and the S&P 500 index fund between today and the time each loan payment is due.  She also adjusts those returns for the tax payments she will make and the reduction in her taxes she will get if she makes the interest payments on her loan.  She summarizes her findings in the table below.   As a reminder, these values are the total amounts she would pay or earn between now and the time she has made all of her loan payments.


Future Interest Payments

Average Future Investment Returns

Average Future Taxes

Average Cash from $10,000 in 5 Years

No Pre-Payments, Leave in Savings





No Pre-Payments, Invest in Treasuries





No Pre-Payments, Invest in S&P 500





Pre-Pay 100%





As you can see, on average, she will earn $2,383 if she invests in the S&P 500, leaving her with $914 at the end of five years once all her loan payments have been made and after consideration of interest payments on the loan and taxes.[9] If she pays off her loan immediately, she has no future interest payments or investment returns, so she has no cash from investments in five years.  If she puts the $10,000 in savings or Treasuries, she is worse off than pre-paying her loan because the average cash she will have in five years (the fourth column) is less under these two options than if she pre-pays the loan.  These findings are consistent with the calculations presented earlier about the expected yields – she is better off if she doesn’t pre-pay her loans and earns the expected return on the S&P 500 and worse off using the returns on a savings account or Treasuries.

How to Think About Risk

Looking at the table above in isolation, Mary might conclude that she should not pre-pay her loan and, instead, invest in the S&P 500.  However, as noted above, the S&P 500 returns are volatile or risky. That is, she will not earn the average return in every single year.  To try to get a view on how much risk she will take if she takes this approach, Mary asked me for some help.[10]  Because modeling future stock returns is very difficult, I chose to use historical returns to provide Mary some insights.  I downloaded the monthly prices of the S&P 500 from January 1951 to August 2018 from Yahoo finance.  I then created all of the possible five-year time series of S&P 500 prices to use as returns over the time Mary will make loan payments.  I explained to Mary that there are many flaws in this approach, but that it can help inform her decision nonetheless. The first risk metric I calculated is how much money would she lose if the stock market had the worst returns of any five-year period in the historical data.  I calculated that she could lose $3,592. The second and third metrics I calculated were the percentages of the time would she be better off investing in the index fund than if she (a) didn’t pre-pay her loan and invested the $10,000 in Treasuries or (b) pre-paid her loan today.  That is, out of all of the possible five-year periods, would the cash she had after she paid off her loan be greater than (a) $-451 or (b) 0[11]?  Using the historical returns on the S&P 500, she was better off investing in the S&P 500 than Treasuries 73% of the time and better of than pre-paying her loan 65% of the time.

Other Options

Mary decided that $3,592 was too much to lose in the worst-case scenario.  She then considered pre-paying only a portion of her loan and investing the rest in the S&P 500 index fund.  To help her understand how much she might want to pre-pay, I repeated my analysis assuming she pre-paid of each of 25%, 50% and 75% of her balance. To put these results in perspective, I created a graph that showed the average amount of money that she would have (the x or horizonal axis) as compared to the least amount of money she would have, using the historical returns on the S&P 500 (the y or vertical axis).  Here’s my graph.

Cost-Beneift of Paying Off Loan

There is a lot of information in this graph, as follows.

  • First, let’s figure out the axes.
    • The horizontal axis is the average cash Mary will have after she pays off her loan. Higher numbers are better so anything to the right is better than anything to the left.
    • The vertical axis is the cash she will have after she pays off her loan in the worst-case scenario from the historical data.Again, higher numbers are better so, in this case, anything that is higher on the graph is better than anything lower on the graph.
    • These concepts are illustrated by the arrow pointing to the upper right and the words next to it.
  • Next, we’ll look at the dots. I plotted a dot for each of the options she is considering.  The first part of the label for each dot tells in what she will invest with the money she doesn’t use to pre-pay her loan.  The second part of each label shows what percentage of the loan she pre-pays.
  • I added lines connecting the dots in which she invests in the S&P 500.
    • All of the dots corresponding to investing in the S&P 500 have average cash after she pays off her loan that is positive (to the right of the y-axis). The less of her loan she pre-pays, the higher that average (further to the right on the graph).
    • These same dots all have negative values for the worst scenario (the one with the least cash after she pays off her loan).The more of her loan she pre-pays, the less she loses in the worst-case scenario (further up on the graph).
    • These lines form something called an efficient frontier. For each of the values of the average cash at the end of five years, the efficient frontier identifies the least bad result in the worst-case scenario.   That is, there are no points to the right of or above the efficient frontier in this chart.
    • When making a choice among the options, Mary will want to pick an option on the efficient frontier. If she picks one of the other options, the average cash will be higher for some other option with approximately the same worst-case scenario result.  For example, let’s look at putting her money in a savings account.  The average and worst-case results are both $-992.  If she pre-pays 75% of her loan and invests the rest in the S&P 500, the average result is $58 (to the right on the graph – the good direction) and the worst-case result is $-1,083.  So, she can have a slightly worse worst-case result and a somewhat higher average cash after she pre-pays 75% of her loan.
    • The choice of option along the efficient frontier is one of personal preference as defined by your risk tolerance. Mary needs to decide how much risk (in this case measured by the worst-case result) she is willing to take in order to get the higher return (in this case measured by the average result).

Mary’s Decision

The last consideration in Mary’s decision is how much cash she has available to pre-pay her loan.  While she has decided she really likes the characteristics of the option in which she pre-pays of 75% of her loan, she has only $6,500 in savings available and would very much like to start investing.  She decides to pre-pay 50% of her loan or $5,000. She will put the remaining $1,500 in a Roth IRA.[12] The historical data indicate that 64% of the time, she will be have most cash in five years than if she was able to fully pre-pay her loan today and an 84% chance of having more cash in five years than if she doesn’t pre-pay the loan at all and invests in Treasuries.  These two options are the risk-free options, the riskier option she has chosen has a high probability of putting her in a better position (based on historical S&P 500 returns) and she gets the benefit of starting to invest.


To recap, here are the answers Mary selected to her questions.

  • Should I start investing the $25,000 in my savings account? ANSWER:  Mary decided to move all of her money out of her savings account.  Mary set aside $13,000 for emergency savings.  She put half of her emergency savings in a high-yield checking account so she is sure to have instant access to it and half in a money market account.  This decision gives her an average return of 1.275%, as compared to the 0.06%[13]she was earning on her bank’s savings account.
  • Should I have a separate account to save the $10,000 for the car? ANSWER:  She allocated $1,500 a year from the money identified for savings in her budget over the next three years for her car.  To meet her $10,000 goal, she had to designate $5,500 of her current savings for the car.  Rather than create a separate account for the car savings, Mary bought a certificate of deposit earning 3.4% to distinguish those savings from her other savings.
  • Should I pre-pay some or all of the principal on my student loans? ANSWER:  Mary considered how much of her savings was available after allocating money for her emergency and designated savings and the risks and rewards of different options. She decided to pre-pay $5,000 of the principal on her student loans.  This decision saved her 5% interest on the portion she pre-paid.
  • What are good choices for my first investments for anything I don’t set aside for my car or use to pre-pay my loans? ANSWER: Mary chose to invest her long-term savings ($1,500) in an S&P 500 index fund.  She sees the benefits of this choice as (a) easily attained diversification and (b) less time needed for research relative to owning individual stocks. Over the long-term, the average return on the S&P 500 is about 8.9%.

The pie chart below illustrates how Mary will use her savings. 

Pie Chart of Mary's Savings

In summary, Mary has increased the long-term average pre-tax return (excluding her 401(k) investments) from the 0.06% return on her savings account to a weighted average return of 2.9%.

Key Points

The key takeaways from this portion of the case study are:

  • Pre-paying your student loans is equivalent to earning a pre-tax return on your money equal to the interest rate on your student loans.
  • If you live in the US, the full amount of your student loan interest reduces your taxable income unless you have a high income (more than $65,000 a year) or high interest payments (above $2,500 a year). The tax benefit will be the highest tax rate applicable to your income.
  • Other risk-free alternatives to pre-paying your loan include leaving the money in a savings account or investing in risk-free instruments, such as government (Treasury) bonds with the same maturity as the term of your loan.
  • If you are willing to take more risk, you could invest some of the money in a riskier instrument, such as an S&P 500 index fund. If you make that choice, your average or expected cash when you are finished paying off you loan will usually be higher, but there is a chance you could end up with less money.

Suggested Next Steps

This post talks about Mary’s situation.  Here are some questions you can be asking yourself and things you can do to apply these concepts to your situation.

  • Determine if you have any savings left after setting aside emergency and designated savings and, if so, how much.
  • Compare the interest rate on your student loans with the values that Mary calculated. If your interest rate is similar to the 5% Mary paid, you can review her analysis. If it is higher, pre-paying the loan will be more attractive than it was for Mary.  If it is lower, pre-paying the loan will be less attractive.
  • Consider your own risk tolerance. You can think in terms of making bets.  At the extremes, think about how much would you pay to have a 1% chance of winning $1,000. Then use numbers that are closer to the question you are evaluating.  What is the most amount of money you are willing to use to have a 70% chance of being better off than the risk-free alternative?  How much for a 90% chance of being in a better position?

[1]As a reminder, a Treasury bond is issued by the US government.  The term Treasury bond is used broadly to include bills (maturities less than one year), notes (maturities of one to ten year) and bonds (maturities of more than ten years).  The term Treasury bond can be confusing because it can mean two different things. You’ll need to figure out which is being used based on the context. [2]When you buy a bond, your brokerage firm will provide the yield to maturity.  It is different from the coupon rate on the bond if the bond price is different from $100 when you buy it.  More on yields to maturity and bond prices in a future post. [3]All statistics about the S&P 500 were calculated based on data downloaded from https://finance.yahoo.com/quote/%5EGSPC/history?p=%5EGSPC. [4]https://www.irs.gov/publications/p970#en_US_2017_publink1000178280, December 10, 2018.  For the definition of modified adjusted gross income, see Worksheet 4-1 in https://www.irs.gov/publications/p970#en_US_2017_publink1000178298Modified adjusted gross income includes your wages and any investment returns, reduced by contributions to your health savings account, some moving and education expenses, among other things, and adjusted for some items related to foreign income and income from Puerto Rico and American Samoa. [5]https://home.treasury.gov/, December 10, 2018. [6]This rate is lower than the marginal rate on her wages because dividends and capital gains are taxed at a lower rate than wages and interest by the Internal Revenue Service. [7]Expected is a statistical term referring to the expected value or average over all possible results. [8]To keep the math a little simpler, Mary does the calculations assuming she has $10,000 available to fully pre-pay her loan. She will take into consideration the fact that she has only $6,500 available to pre-pay her loan later when she is making her final decision. [9]The fourth column is calculated as the second column minus the first and third columns.  Negative numbers in the third column mean that the tax savings from the interest deduction from her loans is more than the taxes on her investment income. The positive number for the S&P 500 option indicates that the taxes on the dividends and capital gains is more than the tax savings from her interest deduction. [10]I’ll provide details of how to do this type of analysis for yourself in a future post.  For now, I suggest focusing on the logic of the analysis and not thinking about the nitty gritty details. [11]See the fourth column in the table above. [12]Because Mary chose to put her money in a Roth IRA, she won’t pay taxes on any investment returns and won’t get a tax benefit in years in which the S&P 500 index fund loses money.  She’ll want to consider this additional volatility in her decision-making process. [13]https://www.wellsfargo.com/savings-cds/rates, November 17, 2018.

Retirement Savings/Saving for Large Purchases

You Have Some Savings. What's Next? Saving for Large Purchases and Retirement
In my previous post, I presented the first part of a case study that introduced Mary and her questions about what to do with her savings. In this post, I will continue the case study focusing on retirement savings and saving for large purchases. 

Case Study

To help set the stage, I created a fictitious person, Mary, whose finances I use for illustration.

  • Mary is single with no dependents.
  • She lives alone in an apartment she rents.
  • She makes $62,000 per year.
  • Mary has $25,000 in a savings account at her bank and $10,000 in her Roth 401(k).
  • Her annual budget shows:
    • Basic living expenses of $40,000
    • $5,000 for fun and discretionary items
    • $10,000 for social security, Federal and state income taxes
    • $4,000 for 401(k) contributions
    • $3,000 for non-retirement savings
  • Mary has $15,000 in student loans which have a 5% interest rate.
  • She owns her seven-year-old car outright. She plans to replace her car with a used vehicle in three years and would like to have $10,000 in cash to pay for it.
  • She has no plans to buy a house in the near future.
Mary's Savings Infographic

Her questions are:

  • Should I start investing the $25,000 in my savings account?
  • Should I have a separate account to save the $10,000 for the car?  
  • What choices do I have for my first investments for any money I don’t set aside for my car?
  • Should I pay off some or all of the principal on my student loans?

I talked about a framework for thinking about her savings and setting aside money for expenses she doesn’t pay monthly and emergency savings here.  In this post, I’ll focus on the rest of her savings.  I answer her questions about student loans here

Designated Savings

Designated savings is the portion of your investable asset portfolio that you set aside for a specific purchase, such as a car or home. Mary would like to buy a car for $10,000 in three years.  She needs to designate a portion of her savings for her car.

As part of her savings framework, Mary

  • Will set aside $13,000 for emergency savings.
  • Has $12,000 in her savings account after setting aside the $13,000 for emergency savings.
  • Included $3,000 a year for non-retirement savings in her budget, some of which she can use for her car.

Mary has decided she will use $5,500 as the start of her designated savings to replace her car. After reading this post, she has decided to pay cash for a car, rather than borrow or lease,  She will add half of her $3,000 of non-retirement savings each year to bring the total available balance to $10,000 in three years.  If Mary’s car becomes unrepairable sooner, she can use some of the money in her emergency savings, but will want to replenish that account as soon as she can.

Considerations for Investment Choices

When I’m saving money for a large purchase, such as a car or a down payment on a house, I’m willing to invest in something less liquid than a savings account or a money market account. That is, I don’t have to be able to access the money on a moment’s notice.  

I do, however, want a similar level of security.  It is very important to me that the market value of my investment not go down as I don’t want to risk my principal.  Because I tend to have time frames that are less than one year for these types of purchases, I tend to put my designated savings in certificates of deposit. 

Certificates of Deposit and Treasury Bills

In Mary’s case, she has three years.  She might consider longer-term certificates of deposit (CDs) or short-term government bonds. (Click here to learn more about bonds.) A CD is a savings certificate, usually issued by a commercial bank, with a stated maturity and a fixed interest rate.  

A treasury note is a form of a bond issued by the US government with a fixed interest rate and a maturity of one to 10 years.  A treasury bill is the same as a treasury note, except the maturity is less than one year.  When the government issues notes, bills and bonds (which have maturities of more than 10 years), it is borrowing money from the person or entity that buys them.  The table below shows the current interest rates on CDs and treasury bills and notes with different maturities.

1-3 Months2.32%2.3%
4-6 Months2.42%2.5%
7-9 Months2.56%N/A
10-18 Months2.8%2.7%
1.5–2.5 Years3.4%2.8%
3 YearsN/A2.85%
5 YearsN/A2.9%

When thinking about whether to buy CDs or Treasury bonds, Mary will want to consider not only the differences in returns, but also the differences in risk.  

Risks of Owning a Bond

Bonds have two key inherent risks – default risk and market risk

  • Default risk is the chance that the issuer will default on its obligations (i.e., not pay you some or all of your interest or principal).  Treasury notes, bills and bond issued by the US are considered some of the safest bonds from a default perspective.  I’m not aware that the US government (or Canadian government for that matter) has ever not paid the interest or repaid the principal on any of its debt. 
  • Market risk emanates from changes in interest rates that cause changes in the market values of bonds.  As interest rates go up, the market values of bonds go down.  All bonds come with a maturity date that is almost always stated in the name of the bond.[3]   If you buy a bonddon’t sell it until it matures and the issuer doesn’t default, you will get the face amount (i.e., the principal) of the bond no matter how interest rates change.  Thus, if you hold a bond to maturity, you eliminate the market risk

In summary, using certificates of deposit or Treasuries held to maturity can increase your investment return relative to a savings account without significantly increasing the risk that you’ll lose the money you’ve saved.  

Mary’s Decision

Because she can buy them easily at her bank or brokerage firm and they are currently yielding more the Treasuries with the same maturity, Mary has decided to buy 2.5-year CDs, earning 3.4%, with the $5,500 she has set aside to buy her car.

Long-term Savings – What to Buy

Mary has $6,500 in her savings account that isn’t needed for her emergency savings or her replacement car. She wants to start investing it or use it to pay down some of her student loans.  I’ll talk about her student loans next week.

Mary doesn’t want to spend a lot of time doing research, so is not going to invest in individual securities.[4]  Instead, she is looking at mutual funds and exchange-traded funds (ETFs).  A benefit of these funds over individual securities is that they own positions in a lot of companies so it is easier for Mary to diversify[5]her portfolio than if she bought positions in individual companies.

Mutual Fund and ETF Considerations

Briefly, here are some of the features to consider in selecting a mutual fund or an ETF.  I note that you may not have answers to a lot of these questions, but they should help you get started in your thinking[6].

  • The types of positions it holds and whether they are consistent with your investment objectives. Is the fund concentrated in a few industries or is the fund intended to produce the same returns as the overall market (such as the S&P 500 or Dow Jones Industrial Average)?  Does it invest in larger or smaller companies?  Does the fund focus on growth or dividend-yielding positions?  Is it an index fund or actively-traded?
  • The expense load.  All mutual fund and ETF managers take a portion of the money in their funds to cover their expenses.  The managers make their money from these fees.  Funds are required to report their expenses, as these reduce your overall return on investment.  There are two types of expense load – front-end loads and annual expenses.  If you buy a fund with a front-end load, it will reduce your investment by the percentage corresponding to the front-end load when you buy it.  Almost all funds have annual expenses which reduce the value of your holdings every year.  Although funds with lower expense loads generally have better performance than those with higher loads, there may be some funds that outperform even after consideration of a higher expense load.
  • Historical performance.  Although historical performance is never a predictor of future performance, a fund that has a good track record might be preferred to one that has a poor track record or is new.  As you review returns, look not only at average returns but also volatility (such as the standard deviation).  A fund with higher volatility should have a higher return.

Mutual Funds and ETFs – How to Buy

You can buy mutual funds directly from the fund management company.  You can also buy mutual funds and ETFs through a brokerage company.  If you buy them through a brokerage company, you will pay a small transaction fee but it is often easier to buy and sell the funds, if needed.  Holding these assets in a brokerage account also lets you see more of your investments in one place.

Mary’s Decision

Mary decides to invest in an S&P 500 index fund (a form of exchanged-traded fund that is intended to track S&P 500 returns fairly closely).  Since 1950, the total return on the S&P 500 corresponds to 8.9% compounded annually.  It is important to understand that the returns are very volatile from month-to-month and even year-to-year, so she might not earn as much as 8.9% return over any specific time period.[7]

Retirement Savings – What Type of Account?

As Mary thinks about her long-term savings, she not only wants to decide how to invest it, but also in what type of account to put it – a tax-sheltered retirement savings account or a taxable account she can access at any time[8].  In addition, she needs to think about how much she needs in total to retire and how much she will need to set aside each year.

Retirement Account Contribution Limits

In the US for 2018, she is allowed to contribute $18,500 ($24,500 after age 50) to a 401(k) plus $5,500 ($6,500 after age 50) to an Individual Retirement Account.  

In Canada, the 2018 maximum contribution to group and individual Registered Retirement Savings Plans (RRSPs) combined is the lesser of 18% of earned income or $26,230.  The 2018 maximum contribution to group and individual Tax-Free Savings Accounts (TFSAs) is $5,500.  If you didn’t make contributions up to the limit last year, you can carry over the unused portion to increase your maximum contribution for this year.

In Canada, there are no penalties for early withdrawal from a RRSP or TFSA as long as the withdrawal is not made in the year you make the contribution, so it is easy to take advantage of the tax savings.  If you make the withdrawal from an RRSP, you need to pay taxes on the withdrawal.  In the US, there is a 10% penalty for withdrawing money from a 401(k) or IRA before the year in which you turn 59.5. As such, the choice of putting your money in a 401(k) or IRA needs to consider the likelihood that you’ll want to spend your long-term savings before then.

Returns: Taxable Account vs. Roth IRA/TFSA

Mary has decided she won’t need the money for a long time.  She will decide how much to put in her retirement account and taxable accounts after she looks at her student loans.  Mary’s savings is considered after-tax money.  As such, she can put it in a Roth IRA or TFSA.  She will not pay taxes on the money when she withdraws it.  If she didn’t put the money in a Roth IRA or TFSA, she would have to pay income taxes on the investment returns.[9]  If she puts it in a Traditional IRA or RRSP, the amount of her contribution will reduce her taxable income but she will pay taxes on the money when she withdraws it. This graph compares how Mary’s money will grow[10]over the next 30 years if she invests it in a Roth IRA or TFSA as compared to a taxable account.  

Savings comparison, Roth vs Taxable savings

As you can see, $4,000 grows to just over $30,000 over 30 years in a taxable account and just over $50,000 in a Roth account assuming a constant 8.9% return and a 20% tax rate.

Key Points

The key takeaways from this case study are:

  • You may need to save for large purchases over several years.  The amount you need to set aside today as designated savings for those purchases depends on how much they will cost, when you need to buy them and how much of your future budget you can add to those savings.
  • Certificates of deposit are very low-risk investment instruments that can be used for designated savings.  
  • Treasuries with maturity dates that line up with your target purchase date can also be used for designated savings.  By holding bonds to maturity, you eliminate the market risk.
  • Mutual funds and ETFs require less research and more diversification than owning individual companies (unless you own positions in a very large number of companies).  These instruments are an easy way to get started with investing.

Your Next Steps

This post talks about Mary’s situation.  Here are some questions you can be asking yourself and things you can do to apply these concepts to your situation.

  1. Identify the large purchases you want to make.  These purchases can include a car, an extravagant vacation or a house, among other things.  For each purchase, estimate when you will want to spend the money and how much they will cost. 
  2. Determine how much of your savings you can set aside for these large purchases.  Look at your budget to make sure you can set aside enough money to cover the rest of the cost.  If you can’t, you’ll need to either make changes to your aspirations or your budget.  In my budgeting series starting in a few weeks, I’ll dedicate an entire post to what to do when your expenses are more than your income.  
  3. Decide whether to start a relationship with a brokerage firm.  Last week, I provided a list of questions to help you get started if you do.
  4. Look into options for your designated savings.
    • What are the returns offered by your bank or, if you have one, brokerage firm, on certificates of deposit with terms corresponding to when you need your designated savings? 
    • How do Treasury returns compare to certificates of deposit?
  5. Decide how much of your long-term savings you want to put into retirement accounts and how much will be left for other savings.  I put as much as I could into retirement accounts, but always made sure I had enough other savings for large purchases that I hadn’t identified in enough detail to include in designated savings.  If you want to retire before the year you turn 59.5, you’ll also want to keep enough long-term savings out of your retirement accounts to cover all of your expenses until that year. 
  6. Decide whether you want to start investing your long-term savings in mutual or exchange traded funds or in individual stocks.  If mutual or exchange traded funds, take a look at the list of questions above.

[1]https://www.schwab.com/public/schwab/investing/accounts_products/investment/bonds/certificates_of_deposit, November 17, 2018.

[2]www.treasury.gov, November 17, 2018.

[3]Some bonds have features that allow the issuer to re-pay the principal before the maturity date.  For this discussion, we will focus on bonds that do not give the issuer that option.  These bonds are referred to as “non-callable.”  Bonds that can be re-paid before the maturity date are referred to as callable bonds.

[4]For those of you interested in investing in individual equities, a guest blogger, Riley of Young and The Invested (www.youngandtheinvested.com), will write about how to get started with looking at individual companies right after the first of the year.

[5]Portfolio diversification is an important concept in investing.  I’ll have a few posts on this topic in the coming months.

[6]If you are interested in more information on selecting mutual funds, I found a nice article at https://www.kiplinger.com/article/investing/T041-C007-S001-my-9-rules-for-picking-mutual-funds.html

[7]This volatility is often referred to as the risk of a financial instrument and is another important concept in investing. Look for insights into the trade-off between risk and reward coming soon.

[8]I’ll cover retirement savings more in a future post.

[9]Income taxes on investments are somewhat complicated.  For the illustrations here, I’ll assume that Mary’s combined Federal and state tax rate applicable to investment returns is 20% and that all returns are taxable in the year she earns them.  There are some types of assets for which that isn’t the case, but identifying them is beyond the scope of this post.

[10]For illustration, this graph shows a constant 8.9% return.  Over long periods of time, the S&P 500 has returned very roughly 8.9% per year on average.  The returns vary widely from year-to-year, but for making long-term comparisons a constant annual return is informative even though it isn’t accurate. 

Savings Framework and Emergency Savings

You Have Some Savings. What's Next? Creating a Savings Framework

You may be thinking you’d like to get started with investing.  Before doing that, you’ll want to look at how much savings you have and how much you can invest.  In this three-part post, I’ll illustrate a framework to guide savings and investing decisions, key components of a financial plan.   This post will focus on a very high-level structure for your investable asset portfolio and, specifically, emergency savings.  My next post presenst a case study addressing saving for large purchases and retirement.  The third post will continue with the case study, focusing on when to accelerate your debt payments.

Case Study

To help set the stage, I’ll create a fictitious person, Mary, whose finances I’ll use for illustration.

Mary’s Situation

  • Mary is single with no dependents.
  • She lives alone in an apartment she rents.
  • She makes $62,000 per year.
  • Mary has $25,000 in a savings account at her bank and $10,000 in her Roth 401(k).
  • Her annual budget shows:
    • Basic living expenses of $40,000
    • $5,000 for fun and discretionary items
    • $10,000 for social security, Federal and state income taxes
    • $4,000 for 401(k) contributions
    • $3,000 for non-retirement savings
  • Mary has $15,000 in student loans which have a 5% interest rate.
  • She owns her seven-year-old car outright. She plans to replace her car with a used vehicle in three years and would like to have $10,000 in cash to pay for it.
  • She has no plans to buy a house in the near future.

Mary's Savings Infographic

Mary’s Questions

Mary’s questions are:

  • Should I start investing the $25,000 in my savings account?
  • Should I have a separate account to save the $10,000 for the car?
  • What choices do I have for my first investments for any money I don’t set aside for my car?
  • Should I pay off some or all of the principal on my student loans?

Investable Asset Portfolio

Investable asset portfolio? Isn’t that something for companies and for the rich?  Actually, no. I think about any savings and other invested assets as a portfolio.  My husband and I own many other assets, such as our home, our cars and our household goods.  Because those are not assets that we can invest, we include them when we are evaluating our net worth but don’t consider them part of our investable asset portfolio.   Mary’s investable asset portfolio consists of her savings account and her Roth 401(k).

Within my portfolio, I strive to keep a target amount in very liquid (i.e., easily converted to cash), low risk assets for emergency savings.  If I have a large purchase that I want to make soon, such as when we sold our house but knew we were going to buy a new one, I invest that money in slightly less liquid, slightly more risky assets with slightly higher returns.  I’ll call these designated savings and talk about the investment I chose in the next post in this series.  I then look at the rest of my portfolio in terms of how long until I will need the money, how much return do I want and how much risk I can tolerate, as well as how much time I’m willing to spend researching and monitoring it.

Expenses Paid Less than Monthly

There are some expenses that you pay less often than once a month.  Examples include presents (most of us have a relatively large expenditure in December, but also don’t forget birthdays), property taxes if you own a house and insurance.  In the months that you don’t have these expenses, you’ll want to set aside enough money so you make these payments when they are due.

Mary has made a list of these expenses from her budget.  Specifically, she has budgeted $400 for presents, $1,000 for a vacation and $1,000 for car and renters insurance which she pays once a year.   She puts $200 a month into her bank savings account to cover these expenses. When she pays for her insurance or vacation, she transfers the money back to checking.

Emergency Savings

How Much?

Three to six months of basic expenses is considered a good target for emergency savings.  To help me estimate how much I need in emergency savings, I imagine what would happen if I couldn’t work for that time period. There are many expenses that will be eliminated, such as income taxes, commute expenses and some others. However, there are also additional expenses, possibly including the full cost of health insurance.[1]

In addition to not being able to work, other uses of emergency savings include unexpected medical expenses, serious illness or death in your close family that requires travel and major repairs to your car or house.  It is important to recognize what is an emergency and what is not.  For example, a funeral is an emergency, while a wedding is a luxury.  Your furnace needing replacement is an emergency.  Routine maintenance and even medium-sized repairs to your car or house are not emergencies as they are budget items.  An important component of using emergency savings is to modify your budget immediately to start re-building it.

Mary has decided to start with a target of four months of expenses for her emergency savings and plans to build it up using $1,500 a year from her non-retirement savings budget until it reaches six months of expenses.  As a first approximation of how much emergency savings Mary needs, she could take a third (four months divided by twelve months in a year) of her salary or just over $20,000.  Because Mary has a budget, she can identify those expenses that absolutely necessary. Her budget shows $40,000 of basic living expenses so a third of that would be $13,333.  She will use $13,000 as her target for her emergency savings, leaving her with $12,000 for designated and long-term savings.

Where to Invest?

Mary considers only a few choices for her emergency savings – including her bank savings accounts, a high-yield checking or savings account at a brokerage firm and a money market account.

A Bit about Money Market Accounts

Money market accounts tend to return a slightly higher yield than savings accounts.  They are like other securities in that you have to buy and sell them, but you can often have access to your money in 24 hours (as compared to instantly for a savings account).

Money market accounts also have slightly more risk than savings accounts. Many money market funds buy very safe securities, such as certificates of deposit and US government bonds so have very little risk.  Others take more risk by investing in commercial paper which is essentially a short-term loan for a company.  In 2008, the value of a few money market funds backed by commercial paper fell below $1.00.  When the value of a money market fund falls below $1.00, it is called “breaking the dollar,” For emergency savings, you’ll want to focus on funds backed by US government debt securities.

Money market accounts from a bank are insured by the Federal Deposit Insurance Corporation, while those at brokerage firms are not.  Money market funds at brokerage houses are insured by the US Treasury if the brokerage firm fails but not if the fund breaks the dollar.  If the value of the investments purchased by the money market fund fall in value, the value of your principal might decrease.  I am not aware of any money market funds that have lost value.  There are some money market funds that invest in higher risk instruments.  For emergency savings, Mary will consider only money market funds that buy low-risk instruments.

You might be thinking I’m kidding.  Keep some money in a savings account!  You might be excited to participate in the seemingly glamourous world of trading stocks and other financial instruments.  Unfortunately, those financial instruments are risky.  That is, you might lose some of the money you invest in those instruments if their value goes down.  (I have a lot to say about risk and reward in this post.)

Back to Mary’s Emergency Savings

Because emergency savings are meant to be available on a moment’s notice at their full value, Mary will keep hers in those two very boring places – a savings account and a money market account.

At one brokerage firm, high-yield checking and savings accounts are earning 0.35% to 0.45% as I write this post.  US government-backed money market accounts are earning as much as 1.9%[2]or about 1.5 percentage points higher than the checking and savings accounts.  (The money market rate at one bank is 1.87%[3]or essentially the same as the brokerage firm.) Mary decides to put half of her emergency savings in a high-yield checking account so she is sure to have instant access to it and half in a money market account.  This decision gives her an average return of 1.275%, as compared to the 0.06%[4]she was earning on her bank’s savings account. So, while the savings account and a money market account are not as exciting as buying stocks, she can improve her return as compared to her bank’s savings account.

In the next post in this series, I’ll talk about how Mary plans to invest her designated savings and long-term savings.  I promise – the choices get a bit less boring.

Key Points

The key takeaways from this case study are:

  • There are different purposes for savings – expenses you don’t pay every month, emergencies, large future purchases and long-term.
  • Expenses paid less than monthly can be budgeted and set aside in a very safe, easily accessed place, such as a savings account, until needed.
  • Emergency savings of three to six months of basic living expenses is a good target.If you have lots of back-up options – financially supportive parents or relatives, another place nearby you could live for a few months in an emergency or the like, your target can be at the low end of the range.   On the other hand, if you are like one friend of mine whose family lives in Europe while he lives in the US so an emergency trip home would be very expensive or you don’t have many back-up options, you might want to set the high end of the range as your ultimate target.
  • It is important to replace emergency savings as quickly as possible after using them.
  • A portion of emergency savings (the greater of one month’s expenses or travel expenses to immediate family) should be available at any time; while a portion can be invested in something that takes a day or two to access.

Your Next Steps

This post talks about Mary’s situation.  Here are some questions you can be asking yourself and things you can do to apply these concepts to your situation.

  • Make a budget. A budget will help you understand your financial situations. For help with budgeting, check out my series of posts with a step-by-step plan for building a budget, starting with this one<//li>.
  • Identify the expenses in your budget that you pay less than once a month. Determine how much you need to set aside each month to cover them.  In each month, you will increase this component of your savings by 1/12thof the total amount of less-than-monthly expense.  You will also reduce it by any of these expenses that need to be paid in the month.
  • Do you want to start a relationship with a brokerage firm? If so, here are some questions to consider:
    • What types of accounts does it offer?
    • What are the fees and limitations associated with those accounts?
    • What are the returns it is offering on those accounts?
    • Can you access those accounts using an ATM card, electronic banking or checks? What are the fees associated with them?  My brokerage firm waives all ATM card fees which is great in an emergency because I can get cash anywhere in the world.
    • Do you want to be able to meet with someone in person? This question was critical for me.  While I probably use e-mail more than I should, I need to be able to go into the office for big transactions and, to a lesser extent, advice.  If you are like me in that regard, particularly if you are looking for advice, you’ll want a brokerage firm with a conveniently-located office and a team you can trust.
  • Set an emergency savings target.
  • Look into options for your emergency savings.
    • Does your bank or, if you have one, brokerage firm, offer high-yield checking or savings accounts? What are the fees and limitations on those accounts? An account with a large minimum balance isn’t attractive for emergency savings because you might need to empty it on short notice.
    • Do you want to consider a money market account for some of your emergency savings? If so, what options are offered by your bank and brokerage firm? What returns are being offered? How long will it take to access your money? How easy is it to access the money, such as by transferring it to your checking account? In an emergency, you probably won’t want to feel overwhelmed by the process of accessing your emergency funds.

  • [1]For a longer discussion of emergency savings, check out http://brokewallet.com/emergency-fund/.

    [2]https://www.schwab.com/public/schwab/investing/accounts_products/investment/money_markets_funds/purchased_money_funds#government_treasury, December 2, 2018.

    [3]https://www.wellsfargo.com/investing/cash-sweep/rates-and-yields/, November 29, 2018.

    [4]https://www.wellsfargo.com/savings-cds/rates, November 17, 2018.