Last month the financial advisors at Ruedi Wealth Management wrote five more “Finance 101” columns for The News-Gazette’s Business Extra Section. Make sure to look for the columns every Sunday, but in case you missed any of them this past month the columns from July are below.
Every Dog Has Its Day: Small Cap Value Stock Performance
Paul R. Ruedi, CFP®
We recently received an email from a very well-informed reader of our columns asking us to show the historical returns of small cap value companies vs. large cap growth companies. His thought was that the perspective could be useful for investors who may have been drawn in by the recent performance of large cap growth companies, and I couldn’t agree more.
In a past column, I explained how small company stocks have historically produced higher returns over long periods of time than large company stocks. Similarly, lower-priced “value” companies have historically produced higher returns than less attractively priced “growth” companies. Considering small cap value stocks are a combination of the higher-returning groups, and large growth stocks are made of both lower-returning groups, you would expect small cap value stocks to produce higher returns than large cap growth stocks over long periods of time.
In order to compare the two groups I consulted Dimensional Returns Web and compared two “research” indexes that were created to study these two groups of stocks. For small cap value companies, I used the Dimensional US Small Cap Value Index; for large cap growth companies I used Fama/French US Large Cap Growth Index. Though you can’t go back to 1927 and invest in a product that matched these indexes, they do tell us how stocks with those characteristics performed as a group.
If you look at the entire period from June of 1927 through the end of May this year, Small Cap Value stocks produced returns just shy of 13.5% annualized. Large cap growth stocks produced returns just under 10% annualized over that time period.
But of course, there is some risk behind the extra return of small value companies. Small value companies don’t outperform large growth companies over every block of time. Over the past 10 years large cap growth companies grew at a rate of just above 17% annualized while small value stocks experienced growth of just under 12%. This type of performance causes investors to pile in to the winner, and often just when the performance difference is about to go the other way.
Though small cap value stocks are catching up from over a decade of underperformance, they are off to a screaming start this year, while their large cap growth counterparts have experienced relatively muted growth in comparison. Though nobody knows if this streak will continue, perhaps it is about time the small value dogs have their day.
What is Financial Independence?
Paul R. Ruedi, CFP®
As I was celebrating Independence Day last weekend, I couldn’t help but think of one of the newer pieces of financial jargon you may hear in the retirement and financial planning industry: financial independence. As the name implies, a person reaches “financial independence” when they have saved up enough that they no longer need to work their full-time job to support their lifestyle.
The big question, of course, is how much do they need in savings and investments to be able to do that, and the answer is different for everyone. The first step to understanding how much you will need is by gaining an understanding of what it takes to fund your lifestyle now. If after all your taxes and savings you are spending $70,000 per year, you will need to figure out a way to replace that spending in some way when you are no longer working.
That can be done many ways, but almost all involve some form of saving and investing. A person could invest in rental properties with a goal of buying enough properties over time to produce the same income they make working. Others may invest in a diversified stock and bond portfolio and take withdrawals from that once their account balance is high enough that it can support their spending indefinitely. If a person used the 4% rule as a guideline for how much they can withdraw from their portfolio, it would mean they must save 25 times their annual spending to achieve financial independence. Many people pursuing early financial independence will target saving 30 times their annual spending just to be extra safe.
It is very helpful to save as much as possible as early as possible if you aim to achieve financial independence as soon as possible. I think it is also important to emphasize how big of an impact lower spending has on the math of financial independence. Lower annual spending requirements considerably lowers the bar for how much needs to be saved to achieve financial independence, which generally means it can be achieved much sooner. The tradeoffs between spending more and working longer to be able do so are important to consider when diving into the math of financial independence.
There is no single best route to financial independence, but I think it is important that whatever route you choose you make a plan and stick to it. If you are not sure if you are on the path to achieve financial independence at some point, I’d highly recommend you seek the help of a financial planner.
Keys to Retiring Early
Daniel Ruedi, CFP®
After reading my brother’s column about financial independence, I’m sure many of you were left wondering how you can achieve financial independence as early as possible. This type of thinking has become increasingly popular in recent years as the “FIRE” movement (short for Financial Independence/ Retire Early).
This wasn’t a political movement or anything like that, just a group of motivated super-savers who prioritized achieving financial independence early and were willing to do whatever it takes to make it happen. Many of these people successfully retired early and shared their stories to motivate others. There were a few key recurring themes in their stories I’d like to highlight.
The first was that most of them didn’t actually “retire” in a traditional sense. Most people who claimed to retire early actually transitioned to another job they liked more or worked to produce income in a lower-stress, lower-hours way. The reason for this is that even replacing a small portion of spending through a lower-paying job allows you to withdraw less from your savings. This ultimately means you need less in savings to “retire early” into a lower-paying job or side hustle than you do to retire completely.
The second is that they were very frugal. By living a lower-cost lifestyle, they didn’t need to replace as much spending and therefore didn’t need as many years of saving to be able to achieve financial independence. They did this in many ways, but in my personal experience the best way to keep spending low is by keeping your largest fixed costs in check. For many people the two largest fixed expenses are housing and car payments.
The third is that they saved a high portion of their incomes very early in their careers. A lot of people who were able to retire early prioritized saving not just a portion, but the vast majority of their income in pursuit of an early retirement. That was in many cases made possible by the frugal lifestyle I mentioned earlier. Investing early also enabled the money they saved to grow over time, allowing the effect of compounding to magnify what they saved in the early years.
These are just a few of the key paths to early financial independence, and often people will use a combination of all three to retire early. If you want to retire early but aren’t sure if you are on track to do so, you may want to talk to a financial planner.
Investing vs. Speculating
Paul R. Ruedi, CFP®
There is a thin line that separates investing from speculation. Two people may buy the same stock and while one is investing, the other may be speculating. Though I’m not exactly sure where the line is drawn, there are usually two things that set them apart. Time horizon is one, but even more important is justification for buy and sell decisions.
Investors take a long-term approach. Instead of buying a stock, they view themselves as taking partial ownership of the actual business. They tend to be more focused on long-term buy-and-hold investing strategies with the idea that they are committing to a company or investment for the long haul, and will reap whatever dividends or returns the company produces over that time period.
Speculators, on the other hand, generally are looking to make money on large, short-term price swings. A speculator buys a stock not necessarily intending to commit to ownership of the company, but with the intention of riding a price swing and eventually selling it to someone who will be willing to pay more for it later. This is the most common justification that allows speculators to abandon all sense, “I’ll just sell it to someone at a higher price later.” This is often called the “greater fool theory.” Other times they will often view themselves as knowing the “correct” price of a stock, and will sell it once the market gets smart and rises to the right price. Assuming the market is dumb now but will be smart later is a troublesome assumption at best.
There are many problems with speculation, not the least of which is that many people completely blow themselves up taking senseless risks with the intention to dump those investments on a greater fool later. Sometimes that bigger fool never shows up, and the fool is you. But investment performance aside, speculation as an “investment policy” is impossible to build a financial plan around. When a portfolio is committed to buying and holding thousands of stocks for a long period of time, you can use what we understand about the nature of stock returns to build a financial plan around that portfolio. This is completely impossible for a speculator; you simply can’t build a plan around random investment picks and unpredictable buying and selling.
You can tell by the tone of the article I think long-term investing is a better idea for investors. If you find yourself making investment decisions that depend on finding a greater fool to bail you out later, you may want to think again.
How Much House Can I Afford?
Paul R. Ruedi, CFP®
Housing costs have received a ton of attention lately, as rising home values have stacked the numbers against consumers with respect to affordability. I think this has left a lot of potential homeowners wondering just how much house they can actually afford.
In general, banks want your housing costs to be less than 28% of your gross (before-tax) income. This includes the total of principal, interest, taxes, insurance, and housing association fees, and is commonly called the “front-end ratio.”
But housing expenses don’t exist in a vacuum, and banks also want to know you can make the mortgage payments in addition to all your other recurring debt payments and expenses. This is called the “back-end ratio.” This ratio specifies that your total recurring costs – all housing payments, credit card payments, car payments, and even alimony and child support, should be under 36% of your gross income.
Most people look at those numbers, see they are just a fraction of their income, assume banks are smart, and take them as the benchmark for how much they can afford. But just because a bank will loan you enough to stretch for a house doesn’t mean you should do it.
People often underestimate the other costs of owning a home, particularly maintenance. I’ve heard a rule of thumb for homeowners is to budget 1% of the value of their home for unexpected repairs. Most people hear this number and don’t see how these expenses could show up, but trust me they do. Homeowners should be prepared to write a check for 1% of their home value in any given year, and occasionally be prepared to spend as much as 3%.
The initial cost of housing can also be deceiving as it is likely to go up over time. If your house appreciates, you can expect your property tax bill to increase as well. It may even increase even if your home doesn’t appreciate. Homeowners really don’t have any control over this, and it can cause housing costs to rise above a level you are comfortable with. In extreme cases taxes can rise so much people can no longer afford their homes.
With interest rates near historic lows, it is more tempting now than it ever has been to justify stretching for a more expensive home. But having a bit of a buffer financially after all costs are paid now, and even some room for costs to go up in the future, can ensure your home ownership experience is a dream instead of a nightmare.
Disclaimer: past performance is no indication of future results. You should not make any investment decisions without first performing your own due diligence and consulting your financial advisor.