This past month the advisors at Paul R. Ruedi, CFP® covered four more “Finance 101” topics that appeared in The News-Gazette’s Business Extra Section. Make sure to look for them every Sunday, but just in case you missed them in March, the columns are below.
Puts and Calls
Paul R. Ruedi, CFP®
Options contracts provide a buyer with a right, but not obligation, to buy or sell a certain amount of a stock (usually 100 shares) at a specified price. The option only exists for a certain amount of time, and can only be “exercised” before the expiration date. The two types of options contracts are called “put options” and “call options.”
A put option provides a buyer with a right to sell a certain amount of stock at a certain price. In other words, they are able to “put” those shares on someone else at a specified price. One reason a person would buy a put option would be to hedge (reduce risk) of a stock they own a lot of shares of dropping in price. A person may buy a put option if they wanted to speculate on the price of a stock dropping even if they do not own the stock.
A call option gives a buyer the right to purchase a certain amount of stock at a certain price. That is, they can “call” the stock away from someone else at a specified price. A person would buy a call option if they wanted to speculate on the price of a stock increasing.
These contracts are purchased from a seller, who is obligated to take the other side of the transaction. Since the seller is taking a risk by guaranteeing to either buy or sell a security at a certain price, they sell options contracts for a price that compensates them for that risk. If the buyer never exercises the option before it expires, they lose what they paid for the option, and the seller is able to pocket that amount.
If the price of a stock moves below the strike price for a put or above the strike price for a call, the option is “in the money.” A buyer would then exercise that option, and the seller must buy or sell shares accordingly. This makes selling options incredibly risky, as any movements past the strike price start to make it very expensive for the seller to be on the other end of the transaction. The downside of selling a call, for example, is practically unlimited, and all you can gain is the amount you sold the call for.
The risk of buying options is limited compared to selling them, but both should be approached with caution. If you are not absolutely sure you know what you are doing with options contracts, it is probably a good idea to avoid them altogether.
What is Wealth Management?
Paul R. Ruedi, CFP®
When I tell someone I work for a company called Ruedi Wealth Management the response is often a polite: “that’s nice; but I have no idea what “wealth management means.” You may assume the obvious - that it means “somebody managing your wealth,” but of course there is always more to it than that. Wealth management is the process of using the resources you have to live the very best life possible. That really requires three distinct components.
The first component, a financial plan, will help you clearly identify your goals for your money. Decisions about how much to spend each year and if it is possible to achieve any lump-sum spending goals can be made at this point. With your goals on paper, a financial advisor can build a plan for how to use your assets to achieve those goals. Central to achieving your most important financial goals will be the investment portfolio you use to fund those goals.
The second component, an investment portfolio, serves as the engine that powers your financial plan. Decisions about how much to hold in stocks vs. bonds can only be made with respect to certain financial goals, and should not be made arbitrarily based on what a person thinks they want or would simply prefer to invest in. The portfolio must be managed to make sure it is adequately diversified and continues to be aligned with the goals of an investor. And of course, an investor must stick to that portfolio through good times and bad, something that often requires the help of an advisor.
A trusted advisor, the third component, will be a voice of reason during times of both investor euphoria and outright panic. They are often the only thing that stand in the way of emotional actions taking your investment portfolio and financial plan with it.
Like three legs of a stool, these three components really depend on each other. Decisions about how to invest a portfolio can only be made with respect to a financial plan; a financial plan cannot be funded without some sort of investment portfolio. A trusted advisor is often needed to keep you from making mistakes regarding your investment portfolio and can help provide you with the expertise and confidence to make difficult financial planning decisions.
When a financial plan, investment portfolio, and trusted advisor all work together, the end result can be nothing short of amazing. If you aren’t sure you can take responsibility for all three components of wealth management, you may want to talk to someone who can.
Financial White Belt Moves
Paul R. Ruedi, CFP®
Last year I started practicing martial arts for the first time in over a decade, starting pretty much at square one – white belt. At this stage I am in awe of the higher-level belts, especially those all-knowing black belts and their complicated moves and strategies.
Though what black belts do is interesting, black belt moves aren’t very helpful to a white belt who doesn’t have the same level of expertise or experience. Everyone has to start with the basics, master them, then focus on mastering increasingly more complicated moves as they pass through the belt ranks.
Personal finance is not so different – it requires a foundation of basics, and once you have mastered one set of skills you can move on to the next to build upon that success. We would all love to skip straight to financial black belt, but everyone has to start at white belt and work their way up. So today I want to cover some of the financial white belt moves people should master before anything else.
The very first step on the path towards your financial black belt is gaining an awareness of your current spending habits. Take an honest look, perhaps by simply tracking what you spend. Apps or websites like mint.com make this very easy.
The next step is to create a budget. However you want to divide your spending on different things is up to you, but I think the most important thing about a budget is that your total spending is less than your net paycheck (the amount that gets deposited in your bank account, not your salary) so there is some money left over each month to start working towards financial goals.
Get in the habit of using the leftover money you have each month to chip away at any high interest rate debt (credit cards) that have been stressing you out for too long. You don’t need to knock the debt completely out at white belt, just get in the habit of making progress by paying down a little extra each month. Additionally, start putting away some leftover money each month in cash to build a buffer that can help you pay for sudden expenses or loss of income without going into debt. This emergency fund will serve as a foundation that makes you secure to move towards other financial goals.
Financial white belt moves aren’t very fun or exciting, but they are essential. Next week we will move on to slightly more advanced “blue belt” moves.
Financial Blue Belt Moves
Paul R. Ruedi, CFP®
Last week we set out on a path to a “financial black belt” with a handful of white belt moves like tracking spending, creating a budget, and starting to pay down debt. Today we will move on to slightly more advanced “blue belt” moves.
The first of which is to completely pay off high interest rate debt. Though we started chipping away at debt at white belt, in this stage you want to pay off any bad, high-interest rate debt completely. You should be paying off any credit card debt entirely by the end of each month.
At white belt I suggested people start putting aside some cash savings as an emergency fund. By “blue belt” you should have a full 3-6 months of fixed expenses in cash as your emergency fund. How much you need depends on your personal situation. A single person with low expenses and an income that is easily replaced may only need 3 months of spending saved, while a person who is married with kids, is the sole income source for their household, and works in a highly specialized field may want to have more than 6 months of fixed spending set aside.
The next move is to start saving a fixed percentage of your paycheck up-front. Start building the habit of saving a little bit up-front each month, as long as it doesn’t cause you to run out of money at the end of the month and require using debt for expenses while you wait for your next paycheck. Company-sponsored retirement programs like 401(k) plans make this easy – some even automatically enroll you and contribute on your behalf.
After you have tackled any bad debt, and have established a cash buffer to smooth out any financial punches life may throw at you, you can start investing for the future. A company 401(k) is a great place to start. You can assemble a diversified stock and bond portfolio to start building your wealth, and fund your long-term goals. Your automatic 401(k) contributions will make removing a percentage of your paycheck and investing it very easy. Many companies will even match a percentage of your contributions to your account, which is something you want to take advantage of to the fullest extent possible.
If your employer does not offer a 401(k) plan, you may want to start contributing to other types of retirement accounts such as Traditional IRAs and Roth IRAs, or a “taxable” brokerage account. Only after you have trained yourself to save regularly for retirement, can you move on to obtaining your financial black belt.
Paul R. Ruedi is a Certified Financial Planner™ professional with Ruedi Wealth Management in Champaign, Illinois.