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Picking Stocks

Many investors create their own portfolios by picking stocks in individual companies. As discussed in my post on the basics of stocks, picking stocks in individual companies is one of several strategies for creating an investment portfolio. Alternatives to picking stocks in individual companies include buying mutual funds and exchange-traded funds. I’ll talk about those strategies in another post.

When I first started investing in the early 1980s, mutual funds were quite common but index funds and exchange-traded funds, while they existed, were not well known. I started my investment story by picking stocks in individual companies. One of the best books I’ve ever read on investing is One Up on Wall Street by Peter Lynch, originally published in 1989.

Confirmation of Independence: I have no affiliation with the author or publisher of the book I am reviewing. I do not receive any compensation for recommending it or if you purchase it.     I truly think it is a great source of investing information.

Lynch was the manager of a very successful mutual fund, the Fidelity Magellan fund, from 1977 to 1990. During that time, the fund had a 29.3% annual average return or more than twice the average return on the S&P 500 over the same time period. If you are considering picking stocks in individual companies, I recommend his book even though it is quite dated. It references companies and trends with which you may not be familiar, but the fundamental concepts are still relevant and it is a quick, easy read.

In this post, I’ll essentially provide an overview of some of the key points I learned from One Up on Wall Street and illustrate them with some personal examples when I can.

Picking Stocks in Companies You Know

One of the first concepts that Lynch introduces is that you are your own local expert. You are familiar with the business in which you work and shop. You are a consumer and you can observe trends in the area in which you live. By watching the world around you, you can identify possible investment opportunities, possibly even before the “market” or “experts” discover them. In many cases, if you identify a trend very early and invest in a company that will benefit from it, you can earn a much-higher-than-market-average return on your investment. In fact, Lynch points to this opportunity as giving individual investors a better chance of beating the market than professional investors who have to invest larger amounts so tend to purchase more mature companies.

Our Kids’ Choices

To illustrate what I mean by “invest in what you know,” I will use an experience we had with our children as an example. When they were in their early teens (probably around 2004 or 2005), we gave them each a very small amount of money to invest. Our son, who was very interested in trains and large equipment, chose the following companies:

  • Microsoft
  • John Deere
  • Canadian Pacific Railway
  • Canadian National Railway
  • ASV – a company that makes skid-steer loaders.

Our daughter, who was much more aware of what was happening in the retail space, chose the following companies:

  • Apple
  • Nordstrom
  • JC Penney
  • Target
  • One other company that I don’t recall.

How it Turned Out

I don’t remember exactly when we started this exercise, so have looked at the two- and five-year average annual returns starting on January 1, 2006. By using two-year returns, I have excluded the impact of the market decline in 2008 and early 2009. The five-year returns go through December 31, 2010, so include the market decline and part of the recovery.

The S&P 500 averaged a 4.5% increase per year during the two-year period and was essentially flat for the five-year period. By comparison, my daughter’s stocks increased at an annual average rate of 9% over the two-year period and 8% over the five-year period. My son did even better, with annual average returns of 15% over the two-year period and 9% over the five-year period.

What is even more impressive about my son’s returns is that his returns were dragged down significantly by a single company – ASV. When my son bought it, the company had its own patented suspension system for its tracks. As I recall, not too much later, it had a change in management. The new management decided to license the patent to Caterpillar. Unfortunately for ASV, Caterpillar’s much larger market share caused a large reduction in ASV’s sales that couldn’t be made up by the licensing fees. Over a several year period, ASV’s stock price went down by about one-third. This experience illustrates another lesson when looking a company’s fundamentals for investment decisions – carefully follow the decisions of any new management teams.

Without ASV, our son’s returns were much more impressive – 19% over the two-year period and 13% over the five-year period.

Don’t Invest in What You Don’t Understand

A related concept, but somewhat different one, is to avoid picking stocks in companies and sectors you don’t understand. Lynch has all sorts of great examples of why people buy stock in companies whose business they don’t understand – hot tips from a “rich uncle,” aggressive buy recommendations from a broker and so on and so forth.

Not understanding a company’s business can be everything from it having a very technical focus to not being familiar with its marketplace (i.e., to whom and how it sells its products) to being so diverse that it is hard to figure out what drives profits.   Essentially, his advice is that, if you can’t explain to someone what the company does in a few sentences, you shouldn’t buy its stock.

One Example of My Choices

I fell into that trap. We had a little extra money many years ago and decided to take some risk by making a very small investment in a private placement. When a company sells its stocks to a small group of investors and not the general public, it is called a private placement.

The two choices we were offered were a company that was marketing telemedicine to the Veterans Administration and a barbeque restaurant that was just opening its first locations. Our assessment was that the restaurant space was grossly overcrowded and that telemedicine would catch on quickly with the aging population and increases in technology. Not understanding that the telemedicine company didn’t actually have any customers or the challenges of getting a contract with the Veterans Administration, we made a very small investment in it.

Were we wrong! Many years later, we wrote off the entire value of the investment in the telemedicine company as it had become worthless. The restaurant was Famous Dave’s.

Ten Baggers

One of Lynch’s goals is picking stocks that are ten-baggers. These are companies whose stocks appreciate to at least 10 times what you paid for them in relatively short periods of time. By identifying trends in your local area, you are more likely to be able to earn the high returns associated with companies that start small and grow rapidly. As an example, consider the increases in Apple’s stock price.

The picture above shows the annual appreciation of Apple stock from 1981 through 2018. If you had owned the stock during any of the years circled in green, you would have more than tripled your money in two years. Not quite 10 times, but 3 to 5 times in 2 years is still a return anyone would envy. If you look at the returns in more recent circled in orange, you’ll see much more modest appreciation. The returns were still very attractive, but much lower than the earlier period.

Lynch points out the benefit of having just one ten-bagger in a portfolio with otherwise mundane performers. For example, if you invest the same amount in 9 stocks each having a total return of 5% per year, your total return in 5 years will be 27.6%. If you add a ten bagger to the mix, your total return increases to 115% or 16.5% per year.

Although our daughter didn’t have any ten baggers, her portfolio benefited from a similar effect. From 2006-2010, her three retail stocks had an annual average return of -1.6%. Apple, on the other hand, was almost a 4.5-bagger (its price at the end of 2010 was 4.4 times its price at the end of 2005). The addition of that one company to her portfolio increased her return from -1.6% to +8.2%!

Do Your Research

Once you’ve identified a company with an appealing product or service, it isn’t time to buy yet! Lynch suggests looking at the company’s financial statements and several financial metrics. I’ll talk about a few of them here.

Percent of Sales

The first thing to check is whether the new “thing” is big enough to have an impact on the profitability of the company. To illustrate, let’s look at two companies that make widgets. Company A makes primarily widgets, so 90% of its sales is from widgets. Company B makes a lot of things. Only 5% of Company B’s sales is from widgets. A new thingamabob has been designed that will double the sales of widgets with no impact on the profit margin (percent of sales cost that turns into profit). Company A’s profit will increase by 90%, whereas Company B’s profit will increase by only 5%. Because stock prices are driven in large part by estimates of future profitability, you would expect that Company A’s stock price would increase much more if it added thingamabobs to its widgets than Company B’s stock price.

Future Earnings

For many reasons identified by Lynch, stock prices don’t always move in line with earnings. Nonetheless, the more that earnings increase, the more that the stock price is likely to go up. Lynch suggests that you make sure you understand how a company plans to grow its earnings.

Ways to Increase Earnings

He identifies the following five ways for increasing earnings:

  • Reduce costs
  • Raise prices
  • Expand into new markets
  • Sell more product to existing markets
  • Revitalize, close or otherwise dispose of losing operations

If you plan to hold the company’s stock for a fairly short time, any of these ways of increasing earnings could provide nice returns. I tend to buy and hold my stocks for a long time (over 25 years in several cases), so I prefer companies whose growth strategies include expanding into new markets or selling more product to existing markets. The other three approaches tend to produce one-time increases to earnings that can’t be replicated over and over again.

Expanding into New Markets

One of the most common ways existing companies expand into new markets is through acquiring other companies. There are many companies that have grown very successfully through acquisition.

Berkshire Hathaway

One such company is Berkshire Hathaway, whose chairman is Warren Buffett. Over the past 40 years, Berkshire Hathaway has purchased such companies as Burlington Northern, Dairy Queen, and Fruit of the Loom, among others. The graph below shows the value of $1 invested in Berkshire Hathaway (stock symbol: BRK-A) since 1980 as compared to a $1 investment in the S&P 500.[1]

Clearly, Berkshire Hathaway has been highly successful in its acquisition strategy.

General Electric

Other companies have been less successful with their expansion and acquisition strategies. One such example is General Electric (GE). When I was young, I thought of GE as primarily manufacturing appliances and light bulbs. The graph below shows how the value of $1 invested in GE increased between 1962 and 2000 as compared to the same investment in the S&P 500.

Clearly, over that time frame, GE was very successful. In fact, my in-laws bought a few shares of GE for each of my kids when they were young (in the 1990s) because it was considered such a great, stable company.

Over the past 20 years, it has expanded its operations into loans, insurance and medical products and related services.   In hindsight, it appears that GE wasn’t sufficiently familiar with all of the business it entered or acquired.  It also used a lot of debt to finance its acquisitions and expansions.  As a result, its stock price suffered. The graph below shows how much a $1 investment in GE’s stock has changed over the past 20 years as compared to the S&P 500.[2]

Comparison

From 2000 to late 2019, Berkshire Hathaway’s stock price went up by a factor of almost 5 while GE’s stock price decreased by more than 50%. Interestingly, GE’s new CEO (hired in 2018) announced a transformation plan that includes selling several of its businesses, allowing it to focus primarily on “safely delivering people where they need to go; powering homes, schools, hospitals, and businesses; and offering more precise diagnostics and care when patients need it most.”[3]

You’ll want to make sure you understand which new markets a company plans to enter, think about whether management has sufficient experience or expertise to expand successfully and understand how much debt the company is using to finance these expansions.

P/E Ratio

The ratio of the price of a company’s stock to its annual earnings is known as the P/E ratio. A P/E ratio is one way to measure whether a company’s stock price is expensive. A rule of thumb mentioned by Lynch is that a stock is reasonably priced when its P/E is about the same as its future earnings growth rate. He acknowledges the important point that the future earnings growth rate isn’t ever known and that lots of experts spend a lot of time incorrectly estimating the earnings growth rate.

Nonetheless, you can at least look to see if a company’s P/E ratio is the right order of magnitude. For example, if you are looking at a company that slowly expands its sales in its current market, its earnings growth rate might be 5% to 7%. If that company’s P/E were 25, you’d know it was expensive. If the P/E ratio were 2, it might be an attractive buy. So, it isn’t necessarily important to know whether the company’s earnings growth rate is going to 5% or 7%, but rather whether it is likely to be 5% or 25%.

Schwab has an entire post on using the P/E ratio as part of stock analyses.

Debt/Equity Ratio

Companies can get cash from three sources to finance their operations – equity (selling shares of stock), borrowing and profits. Long-term debt is the amount of money that a company has borrowed, other than to meet short-term cash needs (such as through a line of credit). Long-term debt frequently is in the form of bank loans or bonds issued by the company.

The ratio of the amount of long-term debt to equity (the difference between assets and liabilities which is an estimate of the value of the company to the stockholders) is known as the debt-to-equity ratio. There are both advantages and disadvantages to a high debt-to-equity ratio. Let’s look at an example.

Company A has $100 of profit before interest (and ignoring taxes) and $60 of interest payments, for net income of $40 ($100 – $60). Company B is the same as Company A but it has no long-term debt, so its net income is $100. If profit before interest went down by 40%, Company B’s net income would also decrease by 40% to $60. Company A’s net income, though would go from $40 to $0 or a 100% decrease. The primary disadvantage of debt is that it magnifies the impact of bad news. The 40% decrease in profit before interest turned into a 100% decrease in net income for Company A with all its debt. This magnification is called leverage or debt leverage.

On the plus side, increases in profits are also magnified. If Company A’s profit before interest increased by 50% to $150, its net income would increase by $50 to $90. The percentage increase in net income in this case is +125% as compared to the +50% increase in Company B’s net income.

Other Metrics

Lynch discusses several other things to check on a company’s financial statements before making an investment.   I talk about one of them, the dividend payout ratio, in my post on investing for dividends. I’ll let you read One Up on Wall Street to learn more about the other metrics and to get Lynch’s views and examples on the ones I’ve discussed here.

Create Your Story

For every company in which you invest, Lynch recommends that you create a story. There are two parts to the story.

Two-Minute Story

First, you should be able to describe the company’s business in what I would call an “elevator speech.” That is, it is important to be able to explain to someone else what the company does and why you think it will grow all in two minutes. If your explanation takes longer, it is likely an indication that the company’s business is too complex to benefit from a trend you observe or you don’t fully understand its business.

Additional Details

Second, you’ll want to have a story for yourself that includes a bit more detail about what you think will cause earnings (and hopefully therefore the stock price) to increase. Is it one of the one-time actions, such as cutting expenses or increases prices, or a longer-term plan to increase sales?

If the former, you’ll want to monitor the progress of those actions. Are they being implemented? Have they been effective? Has their full impact been reflected in earnings and/or the stock price? If the company’s plans don’t come to fruition or they were successful and reflected in earnings, you’ll want to evaluate whether you want to continue to own the company’s stock or whether it is time to sell it.

If the latter, you’ll want to understand what steps the company plans to take to increase sales. You can then monitor the company’s progress towards those plans. If it doesn’t appear to be on track, it might be time to considering selling the stock and investing in another company.

Final Thoughts

As I re-read Lynch’s book in preparation for writing this post, I was reminded how many useful tidbits he provides in it. Interspersed among the anecdotes are lots of lists, checklists and guidance on everything from identifying a company in which to possibly invest to determining the company’s growth pattern to reading financials to designing your portfolio. If you plan to start picking stocks in individual companies, I highly recommend One Up on Wall Street by Peter Lynch as a good first book on the topic. If you are looking for a shorter source for similar information, I suggest this post from Schwab.

 

 

[1] Taken from Yahoo Finance, November 8, 2019.

[2] Taken from Yahoo Finance on November 8, 2019

[3] General Electric 2008 Annual Report, https://www.ge.com/investor-relations/sites/default/files/GE_AR18.pdf, p3.

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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

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.

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.

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 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.

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Credit Cards: What You Need to Know

Credit-Cards

Credit cards are a terrific convenience but also can be very costly.  Effective use of a credit card can make life easier and improve your credit score.  On the other hand, credit cards are an example of bad debt. It is easy to buy more than you can afford using a credit card, leading to high interest charges and a lower credit score.  The latter process can lead to a downward spiral as the purchases you couldn’t afford lead to ever increasing finance and interest charges on your credit card.  At the same time, your credit score goes down which increases the interest rate on other loans, if you can get them at all as discussed in this post. For a real-world example of how credit cards and lead to a financial disaster, check out this post about a friend of mine.

In this post, I’ll explain how credit cards work, including how finance and interest charges normally apply.  Every credit card is different, so you’ll want to look closely at the terms of any credit cards you currently carry or for which you plan to apply.

How They Work

When a financial institution issues you a credit card, it is offering you a loan in an amount that you can choose based on the amount of your purchases up to your credit limit.

Credit Cards from Your Perspective

From your perspective, you:

  • Pay the annual fee, if there is one.
  • Make purchases or get a cash advance. When you get a cash advance, you are borrowing cash from your credit card company instead of borrowing money to buy something.  You can get a cash advance at an ATM, among other places.
  • Pay your bill – hopefully the full amount every month, but at least the minimum payment if at all possible. If you don’t pay your bill in full, issuers will add interest charges to your next bill, as discussed below.  If you don’t pay as much as your minimum payment, they will also add finance charges.
  • Get rewards. Many credit cards provide rewards in the form of cash back or “points” that can be used for travel or other purchases.

In addition, you have the option to transfer your balance from one credit card to another.  Many people make this type of transfer when they have at least one credit card with a very high interest rate and one with a low interest rate.  By transferring the balance from the high-rate card to the low-rate card, you can reduce the amount of interest you will pay.  Most issuers charge a fee of roughly 3% of the amount transferred when you make a transfer.  If your interest rate decreases by more than 3 percentage points and you are paying off your credit card debt fairly slowly, though, your interest savings will be more in one year or a little longer than the transfer fee. As discussed below, though, the transfer could impact the interest charged on other purchases, so you’ll want to look at the whole picture before making a transfer.

Credit Cards from the Issuer’s Perspective

Income

The credit card issuer generates revenue from several sources:

  • Your annual fees.
  • Interest and financial charges you pay.
  • Fees it receives from vendors who accept their credit cards. Most issuers require vendors to pay them 2% to 4% of the amount of your purchases.  Recently, some vendors have started passing these fees on to customers.  That is, they charge customers who use credit cards more than customers who use a check or pay cash.  I ran into that when paying for many of the costs of our daughter’s wedding.  To keep the cost down, I made sure I paid any vendors who charged these fees using an electronic transfer.
  • Finance charges. If you don’t make a payment toward your credit card bill at all or the amount you pay is less than the minimum payment, issuers charge you a fee in addition to the interest charges.
  • Cash advance fees.  Many issuers charge $10 to $25 or 5% of the amount every time you get a cash advance.  I never use my credit card for a cash advance as 5% of the cash is a steep charge to access cash.  There are emergencies, though, when having cash at any price is imperative.
  • Foreign transaction fees. Many issuers charge fees when you buy something outside your home country.  I carry two Visa cards one of which charges me 3% on my purchases every time I leave the US.  For years, I carried only one credit card but I was leaving the US for a month to travel and decided I wanted a back-up card.  I went to the bank where I keep my checking account and clearly didn’t read the fine print! In hindsight, it was silly to get a back-up credit card for travel with such a high foreign transaction fee.

Issuers’ Expenses

Credit card issuers have four primary expenses – their overhead costs (salaries, rent, etc.), the cost of the rewards they give customers, the cost of borrowing the money that they “loan” you between the time you make a charge and pay your bill, and the amount of money they have to write off because customers don’t pay their bills.

When Do You Pay Interest

If you pay your credit card bill in full every month, you don’t transfer a balance from another card and you don’t get a cash advance from your credit card, you won’t pay any interest.   When you do any of those things, you’ll get interest charges.

Interest on Unpaid Balances

You pay interest on unpaid balances from the day they are due until the day the issuer receives your payment for those charges.  Once you haven’t paid your previous bill in full by its due date, though, the issuer starts charging interest on the day you make each future purchase rather than starting on the day the bill is due until all charges have been paid in full.  I’ll provide an example of this difference below.

Interest on Cash Advances

You pay interest on cash advances from the day you withdraw the money until the day the credit card company receives your payment.  I looked at one of my credit cards and it has a higher interest rate on cash advances in addition to having interest charges from the date of the withdrawal.  The same is true with other credit cards I’ve seen on line or discussed with my friends.

Interest on Balance Transfers

Some issuers allow you to transfer the balance from one credit card to another. You might want to do this type of transfer if the interest rate on one card with a balance is significantly higher than another card you hold.  When you make this type of transfer, the issuer starts charging you interest on the day of the transfer and continues to do so until you pay the balance in full.

In addition, even if you had previously paid off the balance on the card to which you transferred your balance, you will pay interest on all new purchases starting on the date of purchase.  That is, until you have fully paid off your credit card balance including the amount transferred, you do not get a grace period between the date of purchase and the due date of your bill.  The additional interest could offset some or all of the savings you attain by reducing your interest rate when you transfer a balance.  This article from creditcards.com provides more details about some of the risks and benefits of transferring a balance.

How Is Interest Calculated

Still confused about how and when interest is calculated?  Hopefully these examples will help.  Before going into the examples, I need to explain what the interest rate or APR (annual percentage rate) really means.

A 24% APR, for example, doesn’t mean you pay 24% interest if you carry your balance for a full year.  The 24% is divided by 365 (number of days in a year) to get a daily rate.  The daily rate is multiplied by your balance on each day and added to the balance for the next day.  As such, if you didn’t pay or charge anything on your balance for a year, the interest rate on the beginning balance would not be 24%, but rather 27.1%!  I calculated 27.1% as (1+.24/365)365 – 1.  By raising the term inside the parentheses to the 365 power, I’m compounding the daily interest charge for a full year (365 days).

Example 1 – Paid Bill in Full Last Month

In the first example, I’ll show how interest is calculated if you paid your bill in full at the end of the previous billing cycle.  Here are the assumptions for this example:

  • Interest rate on charges = 18%
  • Cash advance interest rate = 24%
  • The cash advance fee is the greater of $10 or 5% of the amount of the cash advance
  • You make a $500 purchase on Day 5
  • You take a $100 cash advance on Day 8
  • Your issuers receives your payment on Day 10 of the next billing cycle (i.e., 33 days after you took the cash advance)

In this example, you don’t pay any interest on the $500 purchase during this billing cycle.

The cash advance is different.  First, you are charged the cash advance fee.  5% of your cash advance is $5 which is less than the $10 minimum, so you will be charged $10 as a cash advance fee.  In addition, you will pay interest at a 24% APR.  The interest charge is $2.19 which is calculated as:

As such, you will re-pay the issuer $112.19 for the $100 cash advance you received. This example illustrates why it is often better to tap sources of cash other than your credit card, if at all possible.

Example 2 – Didn’t Pay Bill in Full Last Month

In this example, I’ll show how interest is calculated if you didn’t pay your bill in full at the end of the previous billing cycle.  Here are the assumptions for this example:

  • Interest rate on charges = 18%
  • Unpaid balance from last month = $750
  • You make a $500 purchase on Day 5
  • Your issuer receives your payment in full on Day 10 of the next billing cycle

I haven’t included a cash advance in this example because it will cost you the same amount regardless of whether you paid your bill in full in the previous month.

In this example, you will pay interest on your unpaid balance for the 30 days in the month plus the 10 days into the next billing cycle, for a total of 40 days. The interest on this balance totals $14.93 and is calculated as:

In addition, you pay interest on the $500 purchase for 25 days in this billing cycle plus the 10 days in the next billing cycle, for a total of 35 days.  The interest charge on this purchase is $8.70 for a total interest charge of $23.63. If you have gotten behind on your credit card balances, check on this post for strategies that will help you get caught up.

The Best Credit Card for You

As with every financial decision, picking the best credit card for you requires balancing the costs and benefits.  In large part, the best credit card for you depends on how you will use it.  The bottom line is that you want the credit card that will have the greatest net benefit or lowest net cost for you.  Here’s how you can calculate that benefit/cost.

Plusses

The plus in the equation that determines your net benefit is the value of any rewards you earn.  Some credit cards provide no rewards, so the total plusses equal 0.  Other credit cards provide rewards, such as  1% of all purchases or 5% of gas purchases plus 3% of food purchases plus 1% of everything else.

To calculate the value of the benefits, you’ll need to estimate how much you expect to charge on your credit for each category of expense.  You can then multiply those benefits by the corresponding reward percentage.  As an illustration, I’ll use the 5% for gas, 3% for food and 1% of everything else example I mentioned above.  The table below shows three different combinations of monthly expenses in those categories and the rewards you would earn.

Category Scenario 1 Scenario 2 Scenario 3
Gas 100 200 500
Food 300 500 300
Other 600 300 200
Monthly Rewards 17 23 33
Annual Rewards 204 276 396

By comparison, you would receive $10 a month or $120 a year with a credit card that provides 1% back on every purchase under all 3 scenarios.  I note that most credit cards do not give rewards for cash advances, so I have not included them in the table above.

Some rewards are harder than others to access or might be in a form that isn’t useful for you.  If that is the case with one of the credit cards you are considering, you might reduce the annual benefit by some amount, such as 50%, for the chance that you don’t use it.

Minuses

Offsetting the rewards are all of the fees and charges I mentioned above – the annual fee, cash advance fees, finance fees, foreign exchange fees and interest charges.

The table below shows the fees I’ve used for illustration for the two cards above.

Rewards 5%/3%/1% 1%
Annual fee $75 $0
Cash advance fee $10 $10
Cash advance APR 24% 18%
Purchase APR 18% 12%

To keep the examples simpler, I’ve assumed you make at least the minimum payment every month so there are no finance charges and you have no foreign transactions.

Example 1

In the first example, you have $1,000 a month in charges plus a $200 cash advance 30 days before your issuer receives your payment.  You pay your bill in full every month.

In this example, your annual costs are $243 using the higher reward card and $150 using the lower reward card.  The table below shows the net cost of using your credit card under each of the 3 scenarios above for both cards, remembering that the lower-reward card has the same rewards under all three scenarios.  A negative net cost means that you pay more in fees than you get in rewards, whereas a positive net cost means you get more in rewards than you pay in fees.

Card 5%/3%/1% 5%/3%/1% 5%/3%/1% 1%
Scenario 1 2 3 All
Rewards +240 +276 +396 +120
Costs -243 -243 -243 -150
Net Cost -3 +93 +189 -30

 

In this example, you don’t incur many fees, so the lower fees in the lower-reward credit card don’t help you.  As such, you are better off with the higher-reward credit card under all three spending scenarios.

Example 2

In the second example, you have $1,000 a month in charges plus a $200 cash advance 30 days before your issuer receives your payment.  Unfortunately, you got behind on your credit card payments so you average 60 days between the time you make each purchase and take out your cash advance and pay your bill.

Your annual costs are $652 using the higher reward card and $379 using the lower reward card.  The table below shows the net cost of using your credit card under each of the 3 scenarios above for both cards.

Card 5%/3%/1% 5%/3%/1% 5%/3%/1% 1%
Scenario 1 2 3 All
Rewards +240 +276 +396 +120
Costs -652 -652 -652 -379
Net Cost -412 -316 -220 -259

 

In this example, the lower-rewards credit card has a lower net cost than the higher-rewards card, unless you buy a lot of gas in which case you are somewhat better off using the higher-rewards card.

Summary

This comparison illustrates that high-rewards credit cards are not always the best.  To select the best credit card, you’ll want to balance the fees you are likely to pay based on your spending and payment patterns with the available rewards and their usefulness to you.

 

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How to Budget Step 9 – Monitoring your Budget

You may have thought you were done when you created and balanced your budget.  However, there is one very important step left in the budgeting process – making sure you are living within the guidelines set by your budget, i.e., monitoring your budget.  That is, are you earning as much income as you planned? Are you limiting your expenses to the amounts in your budget?  Did you put aside the savings you included in your budget, whether for expenses you pay infrequently, for retirement or something in between?

In this post, I’ll tell you how to use a new, budget-monitoring worksheet to compare your budget with your actual income and expenses.

Entering Your Budget

Since the purpose of the spreadsheet is to compare your actual expenses with your budget, the first thing to do is to enter your budget.  Most people find it easiest to monitor their budget on a monthly basis, even if they created an annual budget.  If you created an annual budget, you’ll want to divide all of the values in your budget by 12.

Once you have your monthly budget, you’ll enter it on the Budget Monitoring tab of the budget-monitoring spreadsheet at the link below.  Note that this spreadsheet is different from the one you used to track your expenses and create your budget, though many aspects of it will work the same as the budget creation spreadsheet (named Budget Template).

Enter Your Category Names

To enter your budget, enter the names of the categories from your budget in Column A starting in Row 8. Here are three different ways you can input your category names:

  1. Type the names directly into Column A.
  2. Use Excel’s copy and paste features to copy them from your Budget Template spreadsheet.
    1. On the Budget tab in your Budget Template spreadsheet, highlight all of your category names by putting your cursor on cell A11, holding down the shift key and moving the down arrow until all of them are highlighted. Let go of the shift key.
    2. Hold down the Ctrl key while you hit C or hit the copy button if you have one.
    3. Go to the Budget Comparison tab of the monitoring spreadsheet.
    4. Put your cursor in A8.
    5. Hold down the Alt key while you hit E, S and V or hit the paste-values button if you have one. If you just use a regular paste button, you will get errors because the cells from which you are copying have formulas in them.
  3. Link your monitoring spreadsheet to your Budget Template spreadsheet.
    1. Put your cursor in A8 of the Budget Comparison tab of your Budget Monitoring spreadsheet.
    2. Hit the equal sign on your keyboard.
    3. Go to the Budget Template spreadsheet.
    4. Go to the Budget tab.
    5. Put your cursor in A11.
    6. Hit Enter.
    7. Excel should return you to cell A8 of your Budget Monitoring spreadsheet.
    8. Hit the F2 (edit) key.
    9. Hit the F4 key 3 times. Hit Enter. There should now be no $ in the cell reference.
    10. Copy the formula in A8 and paste it in as many cells in Column A as needed until all of your category names appear.

When you enter the category names, make sure that the row with the total amount of income is called “Total Income,” the row with the expense total is called “Total Expenses,” and the difference between those two values is called “Grand Total.”

Enter Your Budget Amounts

Next, enter the monthly budget amounts in Column B next to each of the category names in Column A. You can use any of the three approaches described above for the category names. If you have an annual budget, you’ll need to divided the values by 12 before copying them if you use the second approach or add “/12” (without the quotes) in step (i) before you hit enter if you use the third approach.

Entering Your Actual Income and Expenses

You can enter your actual income and expenses using the same instructions as were used for entering them in the Budget Template spreadsheet.  See my posts on tracking expenses and paychecks and income for more details or review the instructions at the top of each tab.  Be sure to use the same category names as you used in your budget so all of your income and expenses will be included in the Actual column on the Budget Comparison tab.

For monitoring your actual income and expenses, you don’t need to enter the number of times per year you receive each type of income or pay each bill since your goal is compare what you actually received and paid with your budget.

Options for Expenses You Don’t Pay Monthly

Here are three different ways to monitor expenses that you don’t pay monthly:

  1. Enter them in the Monitoring Spreadsheet as you pay them and keep them in mind as known variances from your budget each month. This approach is the easiest to implement but also the least helpful for comparing your actual expenses to your budget.
  2. Adjust the budget amounts to reflect the amount of those expenses you expect to pay in each month. For example, if you pay your car insurance bill four times a year in March, June, September and December, you would
    • take your budget amount
    • adjust it to a full year if you budgeted on a monthly basis by multiplying by 12
    • divide the annual amount by 4
    • include the result in your budget for March, June, September and December
    • put 0 in your budget column in all other months

This approach is a little more complicated to implement, but will make comparing actual expenses with your budget much easier.

  1. Add an expense transaction every month equal to 1/12thof your annual expense on the Bank Transactions, Cash Transactions or Credit Card Transactions tab. In the months in which you actually make the payment, you’ll enter 1/12th of your actual annual expense.  If the total of the amounts you set aside in previous months differs from the amount you actually pay, you’ll need to include this difference in the actual payment amount in the month you make the payment. This approach is equivalent to moving money from your checking account to your savings account in every month you don’t have this expense and moving it back to your checking account in the month in which you pay the expense.

You can also use any one of the above approaches for income you don’t receive monthly.  If you use the third approach, you’ll put 1/12th of your actual annual income on the Income tab.

Monitoring Your Budget – What Happens When Your Actual Isn’t as Good as Your Budget

There are many reasons why your actual income and expenses might look worse than your budget.  You may have been planning to work overtime or get a second job to increase your income.  Those lifestyle changes can be challenging, so you might not have done them.

More likely, you spent more than you budgeted, either due to an emergency, an impulse purchase or difficulty in breaking long-standing habits.  Emergencies happen to everyone.  If possible, you’ll want to include building or re-building your emergency savings (see this post for more on that topic) in your budget. While overspending your budget can be problematic, especially if you do it continuously, don’t be too hard on yourself. Changing your spending habits is really hard.

A Few More Words about Budget

Congratulations!  You made it through the entire budgeting process. As I said in my first post on budgeting, staying on a budget is like being on a diet.  Just as every calorie counts, so does every dollar spent.  Sticking to your budget will increase the likelihood you will meet your financial goals, so do your best!

Download Budgeting Monitoring Spreadsheet Here

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How to Budget Step 8 – Refining your Budget

Very few people have a balanced budget on the first try.  This week, I’ll talk about how to refine your preliminary budget if it isn’t in balance.  I have been very fortunate in that it has been a long time since I found it challenging to meet my financial goals.  Also, I don’t know the specifics of any of your budgets, life-styles or financial goals. So, in this post, I will identify the changes you can make to refine your budget at a high level and provide links to articles by other financial literacy bloggers that provide a whole host of ideas on the specifics.  I hope that one or more of those articles will provide you with the ideas you need to successfully balance your budget.

The Bottom Line

The number on which you’ll want to focus is the Grand Total on the Budget tab.  If it is close to zero (i.e., within a percent or two of your total income) and you have incorporated all of your financial goals, you are done.  Otherwise, you’ll want to look at the section below that reflects your situation, i.e., whether the Grand Total is positive or negative, to learn how to refine your budget.

Your Budget Shows a Large Positive Balance

Congratulations!  If the value in the Grand Total line of the Budget tab shows a large positive number, you have more income than you are spending and saving.  You are among the fortunate few.

Before spending your excess income, you might want to review your financial goals.   Questions you could ask yourself include:

  • Do I have emergency savings of three to six months of expenses?
  • Are there other large purchases I’d like to make in the future?
  • Do I have enough savings to take maternity/paternity leave?
  • If you have children, am I saving for their education?
  • Have I studied the full costs of retirement and am I saving enough?
  • Have I contributed the maximum amounts to all of my tax-advantaged retirement savings accounts (IRAs and 401(k)s in the US, RRSPs and TFSAs in Canada)?
  • Do I want to retire sooner (which would require more savings now)?

If you still have a positive balance after your review, you can consider increasing your discretionary expenses (possibly a newer car or a nice vacation or the addition of a regular treat).  Of course, there is never any harm in increasing your savings.

Your Budget Shows a Large Negative Balance

A large negative balance is much more common than a large positive balance.  I wish I could give you a magic answer to resolve this situation, but there are really only three options.

  • Increase your income.
  • Decrease your expenses.
  • Borrow money either from a third party or by drawing down your savings.

Unless absolutely necessary, I suggest avoiding the third option.  If your expenses exceed your income and you make up the difference by borrowing either from your savings or a third party, you are likely to have a worse problem next year.  Unless either your income or expenses change, it can lead to a downward spiral.

Increase Your Income

Increasing your income can be a more effective way to balance your budget.  However, it has its own challenges and often requires a significant investment of your time and/or money.   Examples of ways to increase your income include:

  • Get a part time job, but make sure it won’t jeopardize your primary job.
  • Work overtime if you are eligible.
  • Make sure you are earning a competitive wage by looking at relevant salary surveys. If you aren’t, ask your boss for a raise, such as described in this post, or look for another job in your field that pays more or offers more benefits.
  • Consider getting more education that will provide you with the opportunity to make more money in the future. Some employers will pay for some or all of your tuition if the additional education is related to your job.  This choice is likely to cause more pain in the short term, but can produce large benefits.  As an example, check out this post.
  • Sell things that you don’t need. Here is a  post on this topic.
  • Start your own business. This option is one that I suggest you pursue only very cautiously if you already have a tight budget.  Starting a business can be very expensive, which of course will put further pressure on your budget.  Also, a large percentage of new businesses fail which means the owners lose money. According to Investopedia, 30% of business fail within two years of opening and 50% fail within five years.  Of those that survive, one source indicates that many business don’t make money until the third year.  If you want to start a side business, turning a hobby into a business is one of the most fun ways to do so.  Here is an article with some suggestions on how to do so.
  • There are hundreds of articles about “side hustles.” I’ve provided a few examples. There are lots of pitfalls with side hustles, including many that might end up costing you money rather than making it. So, as with starting your own business, I suggest exercising caution if you decide to proceed with one or more of them.

Decrease Your Expenses

To be blunt, it is hard to decrease your expenses.  Here are some tips on things to consider:

  • Separate your discretionary expenses from your required expenses. Required expenses include the cost of basic housing, a basic car, gas, groceries, medical care, insurance and the like.  Discretionary expenses are things you could live without, even if you don’t want to.  Here are several posts I’ve seen that provide ideas on how to cut back on discretionary expenses.
  • Review the amount you pay for your necessities to see if you can reduce any of these costs. Here are several posts that provide some ideas.
    • 40 Smart Ways to Reduce Your Monthly Bills
    • 5 Ways To Save $532.30 On A Tight Budget
    • This post focuses specifically on your cell phone bill.
    • This post discusses your energy costs.
    • I really like this post as it covers one of my biggest areas of savings – cooking at home instead of in restaurants. Here is another variation on the same theme.
    • Figure out how much you are spending to pay off your debts, particularly if you have a lot of credit card debt. Research ways to re-finance your debt to reduce interest rate or, if necessary, lengthen time to payment.  For example, if you have something you can use as collateral, a collateralized loan will have a much lower interest rate than your credit cards. See my post on loans to understand the factors that affect the interest rate on a loan and the sensitivity of your monthly payments to changes in interest rates and term.  This post has a lot of great information on re-paying student loans. I also like this post which talks about refinancing student loans – are you ready for it and some options.
    • There are dozens (hunderds?) of blogs on FIRE (Financial Independence, Retire Early). These bloggers tend to post their personal stories about how they are living very frugally so they can retire very early.  Although many of their approaches seem almost draconian, reading one of more of their posts might give you some ideas how you can cut back on your expenses.

There are a few other expenses you can adjust to balance your budget, but I suggest you do them only after you have fine-tuned your budget and looked into re-financing your debt.

  • Reduce the amount you set aside for savings. Clearly, covering the basics, such as food and shelter, take priority over meeting your longer-term financial goals.   Once you have covered those expenses, you’ll need to balance your short-term wants with your long-term goals.  For example, you’ll need to decide whether you want to spend more today on entertainment or put more into your savings so you can have the retirement you desire. The idea of foregoing things today to the benefit of something you will get in the future is called delay of gratification.  It is a difficult concept to implement in practice but is often a key to long-term financial success.
  • Avoid taking on too much more risk. For example, one way to save money on insurance (cars, homeowners/renters or health) is to increase your deductible, lower your limit of liability or, in the case of car insurance, not purchase physical damage coverage.  As I discussed in my post on making financial decisions, these choices reduce your upfront cost, but can have serious consequences in an adverse situation.  If your budget is tight, you may not be able to afford to pay your full share of costs in the case of a serious accident, damage to your home or serious illness.

Closing Thoughts

Working to refine your budget to bring it in balance can be a real challenge. If you can’t do it on the second or third try, be patient with yourself. Learning to be financially responsible is often a long, challenging process.

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How to Budget Step 7 – Create your Budget

You made it!  This week your only task will be to create a first draft of your budget.  

Budgeting can be challenging as you try to balance your long-term goals with your short-term needs and wants.  As such, I suggest creating it in two steps. This week I’ll provide guidance on creating the first draft of your budget.  Next week’s post will talk about how to refine it.

Practical Steps

To create your budget, you will enter values in Column D of the Budget tab of your spreadsheet.  As long as you don’t enter values in Column D of any of the “Total” rows, the formulas will automatically calculate those values.

While the spreadsheet was built to be fairly flexible, one of its weaknesses is that it is not easy to add or delete income or expense categories once you have started entering your budget amounts.  So, before you get started, I suggest making a final review of the line items on the Budget tab. If you need to make changes, you can look back at last week’s post for the instructions.

If you find you need to add or delete a line after you have entered budget amounts, here’s what you’ll need to do:

  1. Make a note of the budgeted amounts of all of the line items you’ve entered.  
  2. Add or delete the line item name according the instructions in the last week’s post.
  3. Copy the formula from cell D110 to all of the cells into which you previously typed values.  You can copy a formula by:
    1. Going to cell D110.
    2. Holding down the Ctrl key and hitting C.
    3. Moving your cursor to cell D11.
    4. Holding down the shift key and then hitting the down arrow until all of the cells into which you entered values are highlighted.
    5. Holding down the Ctrl key and hitting V.
  4. Re-enter the budget amounts that you noted.

If you don’t take this approach, some or all of your category names in Column A will change rows, but your budgeted amounts in Column D will stay in the same rows.  You’ll end up with a mismatch between category names and budget amounts.

Budget Amounts

For each line item in your budget, you’ll need to select a budget amount.  These selections will require your informed judgment. Things to consider in making your selection include:

  • How much you’ve recorded in each category over the past several weeks, as shown in Column B.
  • Any changes in your income or expenses you anticipate in the next several months.  
    • Some of these changes might result from life changes – a new job, moving, getting a roommate, getting married, having children or the like.
    • Other changes might result from intentional changes in your habits – fewer meals in restaurants, hiring a cleaning service, newly carpooling, among others.
    • You’ll also have changes from prior expenses if you change your spending or income to better align with your financial goals.
  • If you’ve used the tax approximation, the amounts in Column C for Federal and State/Provincial income taxes.
  • The goals you set as described in my post on setting financial goals.  You might want to increase one or more of your emergency savings, savings for a designated purchase (vacation, house, new car) or long-term or retirement savings.

Final Steps for This Week

Once you have completed your first draft, take a look at the value in Column D of the Grand Total row.  If that value is positive, it means you have more income than expenses and additions to savings. If it is negative, your expenses and savings goals are higher than your income.  In this href=”https://financialiqbysusieq.com/how-to-budget-step-8/”>post, I’ll talk about things you can do so the value is close to zero.

 

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Review the Expenses for your Budget

You’re almost there!  Only one more week until I describe how to create your budget.  Before you can do that, you’ll want to make sure that the income and expenses you’ve entered don’t have too many mistakes.  In this post, I’ll talk hot to review the expenses and income you’ve entered in the spreadsheet to make sure you have an accurate starting point for your budget.

Before getting to that topic, here are your budgeting tasks for this week:

  1. Continue using and refining your expense tracking system.
  2. Continue to enter your income and expenses into the spreadsheet.
  3. Make sure to update the number of months you have been entering information on the Basic Inputs tab.
  4. Review the first two columns of the Budget tab, as described in the rest of this post.

Make Sure Categories are Right

Over the past several weeks, you’ve been entering the category name with each income and expense line item.  Mistakes I’ve made include using more than one variation on some of my category names, such as household expense and household supplies.  I also sometimes misspell one or more of category names.

If you’ve made similar mistakes, you’ll want to correct these mistakes so you have exactly one line in your budget for each type of income and expense.  Here are the steps to find and correct these mistakes:

  1. Go to the Budget tab.
  2. Review the category names to see if there is more than one row in Column A that corresponds to the same category.
  3. If there is, figure out which category name you want to use.
  4. Make note of all of the incorrect names.
  5. Go to each of the Bank Transactions, Cash Transactions, Credit Card Transactions, Less-Than-Monthly Expenses, and Income tabs.
  6. Hold down the Alt Key and hit E.
  7. Hold down the Alt Key and hit F.
  8. Enter one of the incorrect names in the box next to “Find What.”
  9. Hit the Find Next button.
  10. Any time Excel finds the incorrect category name, replace it with the correct name.
  11. Repeat steps 9 and 10 on each of the tabs listed in Step 5 until the incorrect label no longer appears on the Budget tab.
  12. Then repeat steps 6 through 11 for any other incorrect names.

You’ll know you are done when each category name appears exactly once on the Budget tab.

Make Sure Amounts Look Reasonable

Once all of the category names appear only once and have the names you want, you’ll want to make sure that the values in Column B look reasonable.  These values are the totals of the values you entered on the various tabs, adjusted to either an annual or monthly basis depending on the choice you made in Cell B5 on the Basic Inputs tab.  Two reasons these amounts could look wrong are (1) you entered the wrong amount for a transaction or (2) you entered an incorrect value in the “How Many Times a Year” column.

If a number looks too high or too low, you can use the following steps to help find the problematic input:

  1. Identify the category name in Column A of any value in Column B that looks too high or too low.
  2. Go to each of the Bank Transactions, Cash Transactions, Credit Card Transactions, Less-Than-Monthly Expenses, and Income tabs.
  3. Hold down the Alt Key and hit E.
  4. Hold down the Alt Key and hit F.
  5. Enter a category name that has an unexpected value in the box next to “Find What.”
  6. Hit the Find Next button.
  7. Look in the Amount column of any row in which Excel finds your category name.
  8. Does the amount look right? Common entry errors are to transpose digits (i.e., enter them in the wrong order) and put the decimal point in the wrong place.
  9. Fix any errors in the amount.
  10. Look in the “How Many Times a Year” column.
  11. This column can be blank for any row that contains an expense you pay every month.
  12. For payments made less than once a month, the entries in this column should be the numbers of times per year you make payments of the amount shown. For example, if you pay your auto insurance bill twice a year, the semi-annual amount should be in the Amount column and 2 should be in the “How Many Times a Year” column.
  13. Repeat steps 7 through 12 on each of the tabs listed in Step 2 until the amount on the Budget tab for this category looks reasonable.

Next Steps

Next week, I will talk about how you can create your budget using the income and expense information you have tabulated so far and corrected.

Download Budgeting Spreadsheet Here

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How to Budget Step 5 – Paychecks and Income

Your budget includes your income in addition to money you spend.  In my previous posts on the budgeting process, I talked about setting your goals and tracking and recording your expenses.  This week, I’ll focus on your paycheck and other sources of income.

Before getting to that topic, here are your budgeting tasks for this week:

  1. Continue using and refining your expense tracking system.
  2. Continue to enter your expenses into the spreadsheet.
  3. Record the details from your pay stubs and any other sources of income.

Pay Checks

Your pay stubs include both your wages and some expenses and taxes that are deducted by your employer.  This information can be entered on the Income tab.  You’ll need your pay stub as it lists all of the items that flow into and out of your paycheck to get the net amount of your check or automatic deposit. Put information from each line on your pay stub in a different row on the Income tab of the spreadsheet.

The date of each paycheck goes in Column A.

Record the amount of each line item in Column B.  Your income, such as your wages, should be entered with positive numbers. Deductions, such as taxes, your share of employee benefit charges and retirement savings, should be entered using negative numbers.  Use one row in the spreadsheet for your wages and another for each of your deductions.

You can record the category for each line in Column C.  If you want to use the tax approximation included in the spreadsheet, you’ll need use the labels “Wages”, “Retirement Savings” “Federal Income Taxes” and “State Income Taxes” for each of those categories.  Otherwise, you can use whatever labels you want.

If you get paid less often than once a month, enter the number of paychecks you get each year in Column D of each row.  Otherwise, leave this column blank.

Other Sources of Income

If you have other sources of income you receive on a regular basis, such as returns on investments, disability income or support from your parents, you’ll want to include those in your budget.  Unless you are on a leave from work or retired, you might leave any investment returns in your savings and not use them for spending. It is important to be aware of all sources of income in your budget including increases in your savings, so I suggest including them in your budget explicitly.

Interest, dividends and appreciation are the three most common types of returns from investments. If you have any such returns, enter their amounts in Column A, their category in Column B and how often you receive the amount from Column A in Column C.  The three types of returns are taxed differently in the US.  If you live outside the US or don’t want to use the very rough tax approximation in the spreadsheet, you can enter a single line item for total investment returns and call it whatever you would like.  Otherwise, enter “Interest” in Column B for interest payments, “Dividends” for dividends received and “Appreciation” for changes in the market value of your investments.  Appreciation can be either positive (market value has gone up) or negative (market value has gone down).

For any other sources of income, enter the amount, category (with a name of your choosing) and how often you receive that amount in Columns A through C, respectively.  Sources of income other than investment returns and wages will be ignored in the income tax approximation.

Download Budgeting Spreadsheet Here

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When Is It Good to Pay 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 tolerance.  Risk 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.

Option

Future Interest Payments

Average Future Investment Returns

Average Future Taxes

Average Cash from $10,000 in 5 Years

No Pre-Payments, Leave in Savings

1,323

0

-331

-992

No Pre-Payments, Invest in Treasuries

1,323

676

-195

-451

No Pre-Payments, Invest in S&P 500

1,323

2,383

146

914

Pre-Pay 100%

0

0

0

0

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.

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.

Summary

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. 

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_publink1000178298.  Modified 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.

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Retirement Savings/Saving for Large Purchases

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.

Maturity CD[1] Treasury[2]
1-3 Months 2.32% 2.3%
4-6 Months 2.42% 2.5%
7-9 Months 2.56% N/A
10-18 Months 2.8% 2.7%
1.5–2.5 Years 3.4% 2.8%
3 Years N/A 2.85%
5 Years N/A 2.9%

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 bond, don’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.