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.

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 whose stock pays high dividends relative to the price of the stock.

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.

Recovery from Financial Disaster

Ever wonder how you’d handle a complete reversal of your finances? I have a friend who had a lifestyle most people would envy and lost everything, including her marriage. I didn’t meet her until after her recovery from her financial disaster. She is one of the most resilient, generous people I know and was kind enough to let me interview her about the changes in her life, the financial lessons she learned and her advice to you on how to avoid finding yourself in a similar situation.

The High Life

“My life was very plentiful with many material objects.

  • 6,000+ square foot custom designed home – 6 bedrooms, 5 bathrooms and two full kitchens
  • Photography and recording studios
  • In ground swimming pool
  • Custom designed furniture
  • Six cars
  • Trips
  • Private education for both kids
  • Entertainment

I never priced groceries, just grab and dash.  We belonged to a private country club as well.  We also had an investment property that we rented to a family member.”

Tell Me about Your Finances

“I did not think of my financial future.  I was in my mid to late 40s and I thought the gravy train would never stop.  We had many investments, 401(k) and IRA retirement accounts for us as well as the children.  My husband was a very successful stock broker, financial planner and money management specialist. We had a dual income, and mine paid for the cream on the top.”

What Happened?

“The stock market along with the real estate market became very soft in 2007.  When I began to notice that these change were imminent, I suggested that we liquidate assets into a strong cash position.  My husband dismissed my thoughts on this topic because I had never been persistent in being a co-manager of our funds.  The economy was showing its ugly powerful head and so was our 40-year marriage.

Things went from bad to worse.  We lost our home. Instead of getting money from the buyer when we sold our house, we had to come to closing with a six-figure check to pay off the mortgage balance (because we owed more than we got for the house). Otherwise, we would have had to negotiate a short sale with the holders of the loan on the house to try to get them to accept only the amount for which we sold it, but chose to close in a traditional manner due to a prideful attitude that made no sense at all.

We divorced.  The money, the investments and the lifestyle were gone.  I was 59 years old. Our children were grown and gone.  Thank God they had their educations!”

What Did You Do?

“I moved into a house with five other people to secure a reasonable rent of $600 a month.  I rolled up my sleeves and decided to re-invent myself as a strong salesperson with a steady stream of income.  As part of creating a fiscally responsible lifestyle, I consolidated my debt and made a conscious effort to understand my taxes and my expenses.  These changes allowed me to pay off the tax liability for which I was half responsible after the divorce.”

What is Your Life like Now?

“My lifestyle now is very simple.

  • I use one credit card.
  • If I can’t afford something, I don’t buy it.
  • I shop at thrift stores, make curtains, paint, have learned some electrical skills and can do just about anything.

Having made the financial changes, I now have the opportunity to travel. I have investments and simple monthly debt. My credit score is very high and I am able to contribute to my savings account and an IRA on a regular basis.”

What Advice Do You Have?

“I learned these financial lessons that might help your readers:

  • Always know your cash position whether or not you are wealthy.
  • Have a good grasp on your finances.  Knowledge is power.
  • Cash is king.
  • Know your financial position at all times.
  • Stay away from credit cards and their incredible interest rates.
  • Save and keep adding to your retirement.”

Closing Thoughts from Susie Q

You’ll notice that my friend’s financial lessons learned are similar to themes you’ve seen in posts I’ve written, especially in the post on advice we gave our kids.

Her story, though, provides real-life insights into why these actions are so important.

You’d never know if you met my friend now that she had to make such a long recovery from financial disaster. She is always upbeat, willing to lend a hand and a great motivator. In fact, she contributed to the initial costs of this blog because she was so thrilled that I am willing to share my knowledge with others to help them be financially literate. I hope I am as resilient as she is if I ever face an equally daunting challenge.

Top Ten Posts in Our First Year

Financial IQ by Susie Q celebrated its first birthday last week. In the first year, we published 52 posts on our site, two of which were guest posts from other authors, and published two posts on other blogs. In case you haven’t had time to keep up with reading the posts as they are published, we provide you with a list of our ten posts with the highest page views. (We note that there were two periods during which our site wasn’t “talking” to Google Analytics, so there might be a few posts that should have made the top ten, but didn’t.)

#1 Advice We Gave our Kids

This post had almost 1,000 page views in large part because it is the only post we’ve had featured on Money Mix. It provides a list of 7 themes about money that my kids heard frequently as they were growing up or as they were starting to make their own financial decisions. In addition, I added two other pieces of advice I wished I had given them.

#2 Should Chris Pre-Pay His Mortgage

This post was one of my favorite ones to write! Chris @MoneyStir published a post given a lot of detail about his financial situation. He asked others whether their opinion on whether he should pre-pay his mortgage. In my response, I showed Chris that, given his particular circumstances, he would be substantially better off after he fully re-paid his mortgage a large percentage of the time if he invested his extra cash instead of using it to pre-pay his mortgage. One of the broader takeaways from this post is the importance of isolating a single decision and not confusing your thinking by combining separate decisions into one process.

#3 Introduction to Budgeting

Introduction to Budgeting was our very first post. I’m not sure how high on the list it would have been had we published it later, as many of our friends viewed the post just to see what we were doing. I still think budgeting, whether done in great detail or at a high level, is a critical component of financial literacy, so hope that it is valuable to our regular followers and not just our curious friends.

#4 What to Do Once You have Savings

This post is the first in a series of three posts intended to provide a framework and guidance once you have some savings. The series talks about how much to put in emergency savings, how to save for big-ticket items, savings for retirement and deciding whether to pre-pay your student loans. For each type of savings, it provides suggestions for appropriate asset choices.

#5 Getting Started with Budgeting

This post is the first in a series of nine posts on how to create a detailed budget. The process starts with tracking your expenses to see how you are spending your money.  Subsequent posts talk about setting financial goals and figuring out how you want to spend your money.  The series finishes with monitoring your expenses to see how you are doing relative to your budget. This post includes a spreadsheet that allows you to track your expenses.

#6 New vs Used Cars

This post totals up all of the costs of owning a car to help you understand how much better off you might be by buying a used car rather than a new car.  For some cars, it is much less expensive to buy used, whereas for other cars it doesn’t cost much more to buy new especially if you plan to own it for a long time.

#7 Traditional vs Roth Retirement Plans

This post provides lots of information about Traditional and Roth IRAs and 401(k)s. It also explains in what situations a Roth is better than a Traditional plan and vice versa, including some examples. The biggest determinant of that decision is your expectations about your marginal tax rate at the time you save relative to your marginal tax rate at the time you make withdrawals. The post provides lots of information on taxes, too, to help you make that decision.

#8 New Cars: Cash, Lease or Borrow?

This post explains the costs related to buying a new car with cash, leasing a new car and borrowing to pay for a new car. It provides a detailed illustration for three different models.  The best choice among those three options depends on your ability to pay cash, how many miles you plan to drive, and the terms of each individual offer. For some cars and situations, leasing is less expensive than borrowing whereas, for others, borrowing is better. It also provides a spreadsheet that allows you to compare your offers.

#9 Car Insurance

I was surprised that this post made the top 10.  I spent my entire career in the insurance business so probably have forgotten how complicated car insurance is! This post describes all of the important terms and coverages you’ll find in a car insurance policy. It also provides some insights on how to decide what coverages, deductibles and limits to select.

#10 Health Insurance

On the other hand, it didn’t surprise me at all that this post made the top 10. In fact, I would have expected it to rate higher than it did. As with #9, this post explains all of the terms included in health insurance policies. Its companion post explains how to select the health insurance plan that best meets your needs and your budget.  That post includes a spreadsheet that follows along with the calculations. I recently had to select an individual health insurance plan as my COBRA benefits expired.  I used exactly the process described in this post to make my decision!

Umbrella Insurance Reduces Your Risk

Umbrella insurance provides broader coverage and more limits than your auto and homeowners policy for liability claims made against you. In this post, I’ll provide:

  • An explanation of what liability is.
  • A description of what is covered under an umbrella policy.
  • An illustration of how the limits work.
  • Some examples that compare the cost of an umbrella policy to the cost of buying higher limits of liability on your auto and homeowners policies.
  • A few suggestions for deciding whether an umbrella policy might be a good purchase for you.

What is Liability

According to the Cambridge English Dictionary, liability is “the responsibility of a person, business, or organization to pay or give up something of value.” In the context of insurance, it is something for which you are responsible to repair, replace or pay related to a third party (i.e., not you or your immediate family). That is, if you injure someone or damage their property, you are liable for their medical costs and lost wages and the repair or replacement cost of their property.

The most commonly considered forms of personal liability relate to your car and your residence. One component of your automobile policy is liability coverage. That coverage defends you and pays the cost (up to your limit of liability) of any injuries to other people or damage to other people’s property from accidents you cause. Similarly, your homeowners (or renters or condo-owners) policy defends you and pays the cost of any injuries to other people or damage to their property related to owning your home.   For example, if someone trips over an uneven spot in your front walk and gets injured or is injured or killed in fire in your home, the costs will be covered by your Homeowners policy.

What is Covered by an Umbrella

There are two ways in which an umbrella policy provides coverage for you:

  • It provides additional liability limits above those on your Homeowners and Auto policies.
  • It provides protection from other sources of personal liability.

Home and Auto

One of the choices you have when purchasing home and auto policies is the liability limit. Most insurers offer limits as high as $500,000 and some have limits has high as $1 million. There are many types of injuries, such a brain trauma, burns and quadriplegia, which can cost well in excess of $500,000 or even $1 million. One source estimates that the average lifetime medical cost for a 25-year-old paraplegic is $2.5 million; for a quadriplegic, $3.6 million to $5 million depending on the location of the injury. In addition, the person causing the injury could be liable for lost wages.

If you injure someone in a car accident or they are injured in your home, you are liable for the total cost of their injuries. If that total is more than the limit of liability on your policy, you are responsible for the excess. That doesn’t mean everyone will make a claim against you for the excess, but they generally have the legal right to make a claim on and, if successful, take your assets.

To reduce the likelihood that your insurance won’t be enough to cover the costs in these situations, you can purchase an umbrella policy that, in essence, increases the limits on your home and auto policies by the limit on the umbrella policy. For example, if you have a $500,000 liability limit on your auto insurance policy and purchase an umbrella policy with a $2 million limit, your insurer will pay $2.5 million to people you injure in auto accidents you cause. It is much less likely that their costs will exceed $2.5 million than $500,000 or $1 million.

Other Sources of Personal Liability

There are many sources of personal liability other than your home and cars. These include injuries or damages from:

  • pets
  • boats
  • ATVs or other “toys”
  • libel
  • slander
  • volunteer activities
  • participation in sports in which you might injure someone else
  • vacant land you own, especially if you lease it out for activities such as hunting

Generally, these sources of personal liability are covered under an umbrella policy though there are exclusions that you’ll want to check.

For example, there are exclusions that limit the coverage for motorized boats and toys and large boats, such as requiring them to be listed on the declaration page and paying a higher premium, buying an underlying policy to provide insurance for liability related to them or limiting the locations at which they are insured. If you have any of these “toys,” you’ll want to make sure that the umbrella policy you purchase is going to provide the coverage you seek.

Limits of Liability

Personal umbrella policies are generally offered with limits ranging from $1 million to $10 million. I’ve read that most people who purchase umbrella policies select a $1 million limit. Our umbrella policy has a $2 million limit, though I don’t have an analytical reason why we chose $2 million.

How Limits Work

The limits on an umbrella policy apply differently for the two types of coverage, as illustrated in the graphic below for an umbrella policy with a $2 million limit and the required liability limits of $300,000 on homeowners and $500,000 on auto.

Your homeowners and auto policies will pay the first $300,000 and $500,000, respectively, of any covered claim. The $2 million of umbrella limit applies on top of these limits, for a total of $2.3 million of liability coverage for homeowners claims and $2.5 million for auto claims. For all other types of personal liability claims, the umbrella policy starts paying immediately (after any deductible on the umbrella policy) and provides $2 million of total coverage for these claims.

I note that many umbrella policies have a small deductible. For example, ours has a $250 deductible. In the graphic above, there should be a very small layer just below the orange box that represents the deductible. In our case, we will pay the first $250 of every claim before our umbrella policy starts paying.

A Clarification about Insurance

As indicated above, if you cause an injury to someone and don’t have enough liability limit on your insurance policies, they can make a claim against your assets. An important point to understand is that insurance policies don’t “protect” or shelter any of your assets. That is, if you buy an umbrella policy with a $1 million limit, it doesn’t mean that claimants won’t be able to take some or all of that $1 million in assets. Rather, it means that claimants can only take your assets if their claims are larger than the total coverage provided by your insurance (e.g., $1 million for personal liability claims and $1 million plus the liability limit on your auto and homeowners policies for those types of claims).

Cost Comparison

I asked my insurance agent, Billy Wagner, Personal Insurance Sales Executive at PayneWest Insurance in Helena, MT, for some examples of the pricing of umbrella policies. He created three different insurance buyers to use as illustrations.

Buyer 1 Single male 1 car Renter No kids No toys or high-risk activities (e.g., dogs that might attack, bungee jumping, local politics)
Buyer 2 Family 3 cars A primary home, rental property and lake cabin 4 teenage drivers Trampoline, pit bull, fast boat, snowmobiles, etc.
Buyer 3 Empty nesters with solid credit 4 cars 1 house No kids at home Two canoes, volunteer work, medium risk overall

Just Auto and Home

The table below shows rough estimates of what each buyer will pay for the liability portion of their auto coverage and the total cost of their homeowners coverage all with $1 million limits.

Buyer Auto Liability Primary Home Total at $1 million limits
1 $800 $1,450 $2,250
2 4,000 2,500 6,500
3 1,500 3,250 4,750

Add Umbrella

If, instead, each buyer purchased the minimum limits required by the umbrella policy ($500,000 for auto liability and $300,000 for homeowners) and bought an umbrella policy with a $1 million limit, the rough costs would be those shown in the table below.

Buyer Auto Liability ($500,000) Home ($300,000) Umbrella ($1 million) Total
1 $650 $1,300 $325 $2,275
2 3,800 2,250 1,250 7,300
3 1,250 3,000 625 4,875

How Much More for the Umbrella?

The total costs of the two options are shown in the table below.

Buyer

$1 million/ No umbrella

Umbrella Additional Cost
1 $2,250 $2,275 $25
2 6,500 7,300 800
3 4,750 4,875 125

If you are already buying $1 million limits on your auto and home policies and aren’t considered high risk, the additional cost of purchasing umbrella coverage is very small ($25 for Buyer 1 and $125 for Buyer 3). Not surprisingly, if you have high-risk drivers, lots of risky toys and participate in risky activities, the additional cost increases, as is the case for Buyer 2.

If you are buying somewhat lower limits, such as $500,000 on your auto and $300,000 on your home, your total insurance bill will increase by the cost of the umbrella coverage – in these examples ranging from about $325 for the single, low-risk insured to $1,250 for the riskier family for $1 million of coverage.   And, if you are buying low limits (such as $100,000 or less), your premium would increase by the cost of raising the limits on your underlying policies to $500,000 and $300,000 for auto and home, respectively, in addition to the cost of the umbrella itself.

How to Decide Whether to Buy

Umbrella policies aren’t for everyone. Generally, people who are the best candidates for purchasing umbrella policies are those who both:

  • Participate in activities that can lead to personal liability claims (such as those listed above), are high-risk drivers or have high-risk characteristics at their residences
  • Have assets that they want to protect

If there isn’t much risk in your life, either in your cars, residence or activities, you might decide to not buy an umbrella policy because you don’t think you will ever have any claims that would be covered by the policy.  Similarly, if you don’t have any assets someone you injure could take, it might not be worth purchasing an umbrella. However, as shown in the tables above, it might not cost much more to purchase an umbrella policy so it is something to consider as it may not have a large impact on your budget.

Higher Deductibles vs. High Limits

One way to offset the additional cost of increasing your liability limits and/or buying an umbrella is to increase your deductibles. I don’t have any specifics on the premium reduction from increasing your deductibles, but one source cited a difference between a $100 deductible and a $1,000 deductible ofvery roughly $200 per year per car. If you have one car and are low-to-medium risk, you could cover a significant portion of the cost of an umbrella policy if you carry the required auto and home limits or the full cost of the changing from a $1 million policy limit to an umbrella policy.

The Risk-Reward Trade-off

The choice of a higher deductible versus more coverage and a high limit is one of risk and reward. If you increase your deductible, you are increasing the maximum amount you will pay on each claim by a fixed amount – say the $900 difference between a $100 deductible and a $1,000 deductible. Using the $200 premium savings estimate above, the additional $200 saves you up to $900 in repair costs each time you have an accident. Even if you have 5 accidents of more than $1,000 each, the total repair cost savings would be less than $5,000. Using the $5,000 as the repair cost savings, the ratio of the premium savings to the repair cost savings is 4% (=$200/$5,000).

On the other hand, spending $325 on an umbrella policy provides you with an additional $1 million of protection if someone is seriously injured either physically or economically by something you own or your actions. If someone is awarded damages that includes the full $1 million coverage under your umbrella policy, the ratio of premium savings to liability savings is 0.03% ($325/$1 million). Of course, it is much less likely that you will cause a loss that goes through the full $1 million coverage of your umbrella and, if you didn’t have the coverage, the amount of damages for which you are sued might be lower.

The trade-off between the much smaller additional cost of repairs with the higher deductible and the potentially much higher cost of a large liability claim is something to consider, especially if you can afford to pay for the repairs to your car from accidents you cause from your budget or emergency savings.

Retirement Savings: How Much Do You Need

Retirement Savings

Retiring is one of the riskiest financial decisions you will make. On the day you retire, you can calculate your net worth. You won’t know, however, how much retirement savings you need because you don’t know:

  • how much you will actually spend on day-to-day expenses
  • how much those expenses will be impacted by inflation
  • whether you’ll have significant medical or other expenses
  • how long you will live or
  • what returns you will earn on your investments.

I retired a little over a year ago and realized that, even though I have a lot of money saved, it wasn’t enough to give me confidence we wouldn’t run out.  I took on a large consulting project to help cover our expenses for the next year or two. Researching this post, though, added even more confidence as we have more than enough to meet some of the simple rules of thumb.   We will see what happens.

In this post, I’ll provide some insights about how to think about a target you might want to set for your retirement savings.  As a follow up, I’ll talk about how much you need to save to meet your retirement savings goal in this post.

4% Rule and Multiply by 25 Rule

As I checked to see what others were saying on this topic, I found a very common theme for determining how much you need to save for retirement.  In some places, it was called the 4% Rule and, in others, the Multiply by 25 Rule.  Being the math geek that I am, my first thought was that 4% = 1/25 so they are the same thing!  It turns out that, in the nitty gritty details, the Multiply by 25 Rule is intended to tell you how much you need to have available on the day you retire while the 4% Rule guides you in how much you can spend in your first year of retirement.  Nonetheless, as explained below, they both result in the same amount needed in savings on your retirement date.

4% Rule for Retirement Spending

The 4% rule is intended to tell you how much you can spend from your retirement savings each year.  Let’s say you have $1,000,000 in invested assets when you retire.  It says you can spend 4% of that amount or $40,000 (including all of your expenses and taxes) in your first year of retirement.  In each subsequent year of your retirement, you can spend $40,000 increased for the cumulative impact of inflation since you retired.   The 4% Rule assumes that you are invested 50% in stocks and 50% in bonds.

4% Rule Illustration

The graph below shows the amount you can spend each year (blue bars which use the left axis scale) and the amount you’ll have remaining at each age (red line which uses the right axis scale) if you retire at 65, inflation is 3% per year, bonds earn 2.5% and stocks earn 7% annually. These assumptions are similar to long-term average assumptions that are common these days.

As you can see, in this scenario, the amount you can spend increases from $40,000 when you are 65 to almost $100,000 a year when you are 95 solely due to inflation. In the first few years, your spending is less than your investment returns, so your savings increases.  After you turn 72, your savings exceeds your investment returns so your savings starts to decrease.

4% Rule Background

The 4% rule was developed by William Bengen and is presented in detail in a 1994 study published in the Journal of Financial Planning.  (If you like numbers and graphs, check out this paper. It is a surprisingly easy read.)

Using historical data from 1926 to 1991, Bengen found that there were no 50-year periods in which a retiree would run out of money if his or her initial withdrawal rate was 3.5% or lower.  With a 4% initial withdrawal rate, the shortest time period in which the savings ran out was 33 years.  In only 10% of the scenarios did the money last for less than 40 years.

If you turn this rule around and know how much you want to spend in your first year of retirement, say $60,000, you can calculate the amount you need to have saved by dividing that amount by 4% (=0.04).  In this example, you need $1,500,000 (=$60,000/0.04) in savings on the day you retire using this rule.

Multiply by 25 Rule for Retirement Savings

The Multiply by 25 Rule says that the amount you need in retirement savings is 25 times the amount you want to spend in the first year of retirement.  Using the example above in which you want to spend $60,000 in your first year of retirement, you would calculate that you need $1,500,000 (=25 x $60,000) in savings.  As I said, the math is the same for determining how much you need to save because multiplying by 25 is the same as dividing by 0.04.  It is just that the rules are stated from different perspectives (how much you can spend given the amount saved as opposed to how much you need to save giving how much you want to spend).

When do you need more or less?

As indicated, those rules make assumptions that might not be right for you. There are a number of personal factors that impact how much you need in retirement savings.

Your Risk Tolerance

The 4% Rule assumes that you invest half in bonds and half in stocks. Some people are willing to take more risk by investing more heavily in stocks. Other people can’t tolerate the ups and downs of the stock market, so invest more heavily in bonds. As shown in this chart below, taken from my post on diversification and investing, the higher percentage of stocks in your portfolio, the higher your average return (the blue lines) but the more likely you are to lose some of your principal (the portion of the whiskers that fall below 0).


If you plan to put more than 50% of your retirement assets in stocks, you can withdraw a bit more than 4% each year. Turning that around, it means you need a bit less than 25 times your estimated expenses in your first year of retirement. The table below was copied with permission from a March 19, 2019 article from Schwab found at this link.  It shows how your time horizon (see below) and investment risk impact the 4% Rule.

Life Expectancy and Retirement Age

The analysis underlying the 4% Rule focuses on a retirement period of 30 years.  If you retire in your mid-60s, it would imply that you would most likely have enough money to last through your mid-90s.  If you are in poor health or have a family history of dying early, you could consider spending a bit more than 4% (that is, multiply by less than 25 to determine how much you need to save).

On the other hand, if you plan to retire at 45 and want to have enough money to last until you are 95, you’ll need to save more.  The Schwab table above shows planning horizons up to 30 years.  Based on the numbers in the table, it looks like you could subtract about 0.1 percentage points from the numbers in the 30-year row for each year your planning horizon extends beyond 30 years to estimate how much you need to save.

For example, if you want to be highly confident (90% sure in this case) you will have enough money to last for 50 years, you would be looking at 20 years beyond the 30-year horizon.  Multiplying 20 years by 0.1 percentage point is 2.0%.  According to the table, you can spend 4.2% of your savings in the first year with a Moderately Conservative portfolio and 90% (highly) confident that you won’t run out of money in 30 years.  My approximation would subtract 2.0% from 4.2% to estimate that you could spend about 2.2% of your savings in the first year if you wanted to be 90% confident you won’t run out of money in 50 years.  You could then divide your estimated first year expenses by 2.2% or multiply by 45 to estimate how much you need to save.

Other Sources of Income

Some people’s employers provide defined benefit retirement plans.  These plans generally pay a flat amount every month starting at normal retirement age (as defined by the employer) until death.  In the US, people who have worked or whose spouses have worked are eligible for Social Security benefits, as discussed in this post.  Many other countries have similar programs.

When you are estimating how much you need to save for retirement, you can consider these sources of income.  If all of your other sources of income increase with inflation, it is a fairly straightforward adjustment.  You just need to subtract the income from these other sources from your first-year-of-retirement expenses before applying the 4% Rule (as adjusted for other considerations).

For example, if you plan to spend $100,000 a year in retirement and have $40,000 of Social Security and defined benefit plan benefits,  you would subtract $40,000 from $100,000 to get $60,000.  Using the Multiply by 25 Rule, you would multiply $60,000 by 25 to get $$1.5 million instead of multiplying the full $100,000 by 25 which would indicate you need $2.5 million in savings.  In this example, you need $1 million less in savings because you have other sources of income.

Unfortunately, most defined benefit plan benefits do not increase with inflation.  The math for adjusting the Multiply by 25 Rule is fairly complicated.  I’ve developed a simple approximation that you can use that will get you close to the correct percentage.  To approximate the adjustment to the amount you Multiply by 25, divide your defined benefit plan income by 2 before subtracting it from your first-year expenses.

You Want to Leave Your Assets to your Beneficiaries

I remember being a teenager and having my father explain to me how much I needed to save for retirement.  The approach he proposed was that you could spend 2% of your assets which is equivalent to a Multiply by 50 Rule.  (No wonder I was nervous about my finances when I retired!)  His logic was as follows:

  • Invest in the stock market and get a 10% return.  (He did this analysis a long time ago, when stock market average returns, inflation and taxes were all considered to be a bit higher than they are today, but not by so much as to make the logic faulty.)
  • You will pay taxes of 40% of your returns, which makes your after-tax return 6%.
  • Inflation will be 4% per year.  Because he wanted his investment income in every year to cover his expenses without dipping into the principal, he had to re-invest 4 percentage points of his investment return so he would have 4% more investment income in each subsequent year.
  • Subtracting the 4% reinvestment from the 6% after-tax return leaves an amount equal to 2% of his investments that he could spend each year (excluding taxes because he separately considered them).

So, if you are like my father, you will want to save closer to 50 times your first-year retirement expenses, rather than 25 times.  It is important to remember that my father’s Multiply by 50 rule applies to your expenses excluding income taxes and the Multiply by 25 Rule applies to your expenses including income taxes, so they aren’t quite directly comparable.

Liquidity of your Assets

As indicated above, the 4% Rule assumes your assets are invested 50% in stocks and 50% in bonds. You may have other assets that contribute to your net worth, such as equity in your home, your personal property, a family farm and rental property, among others. These other assets are all consider illiquid – that is, you can’t convert them to cash easily. Further, some of them are assets that you never want to have to convert to cash to cover expenses, such as your home and personal property.

As you project how much you will have in retirement savings, you’ll want to exclude any equity in your house as it isn’t available to invest.  A portion of it may be available at some point if you plan to downsize, but you’ll want to be cautious about including it in your savings plan.  Other of these assets, such as rental property, could be liquidated to cover retirement expenses.  In your planning, though, you’ll need to make sure you consider the selling costs (e.g., real estate agent’s commission) and taxes you need to pay on capital gains and that they may not generate a return as high as underlies the 4% Rule.

Irregular Large Expenses

The analysis that supports the 4% Rule assumes that you have the same expenses every year and that they change due only to inflation. That’s not how life works! You may want to be like me and want to take an expensive vacation every three or four years in retirement, you’ll likely have to replace your car at least once in retirement or you could have major home repairs if you own your home.  In addition, end-of-life medical bills can be very expensive.

As you are determining your first-year retirement expenses, you’ll want to include amounts for any such expenses in your budget at their average annual cost.  For example, let’s say I want to take a vacation (in addition to my already budgeted travel expenses) every five years that has a total cost of $10,000.  I need to add $2,000 (= $10,000 per vacation divided by one vacation every 5 years) to my regular annual expenses for these big vacations.  Similarly, if I plan to buy a $25,000 car every 15 years, I need to add $1,667 (= $25,000/15) to my annual expenses.  In both cases, you would add these amounts to your budgeted expenses before you divided by 4%.

How to Set Your Personal Target

So, what can you do to estimate your personal retirement savings target? Follow the following steps.

Make a Budget for Today if You Don’t Already Have One

It is hard to estimate your expenses in retirement, but it is very helpful to understand what you are spending today.  If you don’t have a budget or haven’t tracked your expenses to see where your money is going, I suggest starting there.  Here is a link to a post I wrote with a spreadsheet to help you monitor your expenses.

Estimate Your Expenses in Your First Year of Retirement

Next, look at your current budget and/or spending and estimate how it would change if you were retired today.  On what types of things might you want to spend money in the future that you don’t spend now?  Might you want to buy special gifts for your grandchildren that are more extravagant than what you spend for your children’s gifts now?  Also think about expenses you have now that you won’t have in the future, such as commute expenses and possibly a separate wardrobe for work.

Be sure to think about Social Security (or equivalent) and income taxes. In addition to Federal income taxes, you may pay state or provincial and possibly local income taxes.  If you plan to live somewhere else in retirement, it might have a higher or lower tax rate.  In the US, Social Security taxes are 6.2% (12.4% I you are self-employed) of your wages up to the limit ($128,400 in 2019).  As you adjust your budget, you can eliminate Social Security taxes and will want to think about whether your state or provincial and local tax rate will be substantially different from their current rates.

Some people say that your expenses will decrease by 20% when you retire.  In my very short retirement, I find I’m spending more than I expected as I have more time to do things and many of them cost money.  This post from Financial Samurai provide some insights as to how retirement might impact your expenses.

Increase Your Retirement Expenses for Special Purchases

Do you want to travel? How often do you think you’ll need to buy replacement cars and how much do you think you’d spend if you bought one today? What other expenses might you have that aren’t in your budget? For each of these expenses, divide the amount by the time between them to estimate an average annual cost, as I illustrated earlier in this post.

Adjust Your Budget for Inflation

All of the amounts you’ve estimated so far are in today’s dollars.  That is, they reflect the current prices of every item.  You’ll want to increase these amounts for inflation between now and the time you retire.  Over long periods of time, annual inflation has averaged 3% to 3.5% though it has been a bit lower recently.  To adjust your budget for inflation, you’ll want to multiply it by 1.03n, where n is the number of years until you retire.  Don’t like exponents?  The table below provides approximate multipliers by number of years until you plan to retire.

Years 5 10 15 20 25 30 35 40 45
Factor 1.15 1.35 1.55 1.80 2.10 2.45 2.80 3.25 3.80

Subtract Other Sources of Income

If you think you’ll have a defined pension plan benefit or will receive social insurance (Social Security) benefit, you can subtract those amounts from your inflation-adjusted budget.  My post on Social Security provides insights on how to estimate your benefits for my US readers.

Figure Out your Risk Tolerance and Length of Retirement

If you want to be almost 100% confident you will have enough money to last for your full retirement, regardless of how long it is, and leave most or all of your principal to your heirs, multiply the difference between your inflated budget (excluding income taxes) and other sources of income by 50 to derive your retirement savings target.

If you plan to be retired for only 10 years, you can multiply by a number as low as 10, according to the chart from Schwab. Where between those two numbers you choose is up to you. The longer you expect to be retired, the more conservative your investments and the more confident you want to be that you won’t run out of money, the higher your multiplier.