In May the financial advisors at Ruedi Wealth Management wrote their second round of short “Investing 101” columns that appear every Sunday in the News-Gazette’s business extra section.
Make sure to look for them every Sunday, but in case you missed them this past month, below are the Investing 101 columns from May.
The Rule of 72
Paul R. Ruedi, CFP®
As an investor, the most important feature of an investment is the return it provides over time.
But comparing an investment with a 2% return to one with a 10% return over long periods, the calculations beyond the first year get tedious. It can be challenging for investors to truly understand the magnitude of difference in the growth rates of different investments over long periods.
This issue is one that humans have been dealing with for centuries. Fortunately, investors can use a rule of thumb called the “rule of 72” to get an intuitive sense for how fast their investment grows.
The rule of 72 first showed up in the historical record in the late 1400s in the work of a Franciscan monk named Luca Pacioli. The rule of 72 provides a back of the envelope calculation for investors to quickly get a sense of how fast their money doubles provided a specified yearly interest rate.
Using the example in the first paragraph, if you invest in something that grows 10% per year, it will take 72/10 = 7.2 years to double. An investment at 2% would take roughly 72/2 = 36 years to double.
Dealing with investments in terms of how long it takes them to double is more straightforward to grasp and more useful for a typical investor than performing multiple years of percentage calculations. It can help investors intuitively understand what to expect from their investments over a long period.
For example, if a person were to invest in something that grows at 10% each year for 15 years – they know it will double two times since the investment takes just over seven years to double. That means their original investment will be four times its initial value. An investment with a return of 2% won’t even be halfway to doubling its initial value in 15 years.
The rule is not perfectly accurate and works best in the 5-12% range. Below that, a person could divide the interest rate into 70 to be slightly more accurate. Above that range, the rule starts to break down slowly by increasingly understating the amount of time it takes for an investment to double. Running to the most extreme example, an investment that grows at 72% will not double in a single year; that would require a rate of return of 100%. But for investors using the returns of typical investments like stocks and bonds, it can be a helpful tool.
What is a Mutual Fund?
Ryan Repko, CFP®
As investors, it is very important to be diversified. But with the prices of some stocks in the hundreds or thousands of dollars, and bonds having par values in the thousands, it would be very difficult for most investors to spread their money around to enough investments to be truly diversified.
A mutual fund is an investment vehicle that solves this problem by enabling many smaller investors to pool their money. A single mutual fund may own thousands of individual stocks or bonds. Mutual funds are professionally managed by fund managers, who invest the money in the fund according to fund’s objectives. They can invest in a broad range of investments; there are stock mutual funds, bond mutual funds, and even mutual funds that invest in a specific country or sector. Like stocks, they have ticker symbols and can be purchased online through brokers like Charles Schwab, E-Trade, etc. Mutual funds are generally what you invest in within your 401(k) or 403(b).
Mutual funds are priced at net asset value (NAV), based on the value of their underlying investments. Similar to the price of a stock, it allows investors to track changes in the value of that particular fund. Investors purchase “shares” of the fund, but unlike stocks they do not need to purchase whole shares. Since fractional shares of mutual funds can be purchased, it allows for everyday investors to acquire more diversified shares with smaller investment amounts.
A mutual fund will include a prospectus that spells out the characteristics of the fund, relevant details about the type of investments the fund owns, and the expenses of the fund.
There are several important features of mutual funds investors should be aware of. The first is that mutual funds charge a fee for operating the fund, which is called the expense ratio. The second is how much the manager is buying and selling the individual holdings within the fund, which is called turnover.
Some mutual funds may charge sales fees, often referred to as sales loads. But there are also many mutual funds, called no-load funds that do not charge sales fees. Mutual funds may have different share classes, all of which invest in the same underlying investments, but with their expenses structured differently.
Investors should pay attention to the number of holdings in a mutual fund to make sure it is adequately diversified and look at the types of holdings in the fund to make sure the mutual fund is sticking to its stated objective.
Like any investment, make sure you fully understand what you are investing in, or talk to a financial professional who does.
What is an Index Fund?
David Ruedi, CFP®, RICP®
Decades ago, investors thought the job of mutual fund managers was to pick the right investments or pick the right time to get in and out of the market.
To assess the skill of these mutual fund managers, the investment industry began benchmarking the performance of their mutual funds against the performance of market indexes. A market index is a hypothetical investment portfolio that represents a segment of the stock market.
For example, a fund that invests in large companies in the United States would compare itself to the S&P 500 – a list of 500 of the largest companies in America, to see if it had performed well.
The purpose of developing these benchmarks was to show how much value managers were creating through their buying and selling. In an ironic turn of events, they ended up showing the opposite. Study after study has shown that the vast majority of fund managers underperform their benchmarks.
That begged a philosophical question; wouldn’t it be a better idea to skip all the extra management of a fund and just match a specific index? After all, that would make investors better off the majority of the time.
Index funds were created to achieve the goal of matching the performance of a market index as closely as possible. Instead of picking and choosing what to invest in, index funds simply hold all the investments contained in a market index in the same proportions. An S&P 500 Index Fund, for example, would invest in the same 500, large-company stocks listed in the S&P 500 Index.
There are many benefits to this structure. Since index funds passively hold everything on a particular list, they do not have to spend any time or energy researching investments or buying and selling the investments themselves. Eliminating this work drives down the costs of operating the fund. Those cost savings are passed on to the investors in those funds and result in higher investor returns.
There are more specific index funds that cover a specific country or industry if an investor is looking to invest in something specific. Much more commonly used are broad stock and bond market index funds that invest in thousands of companies in the United States or all around the globe.
Index funds are an excellent option for investors seeking a simple, low-cost, and diversified approach to investing. Index funds can have radically different risk and return characteristics depending on what they invest in, so make sure you fully understand any index fund you plan to purchase or talk to a financial professional who does.
What is an ETF?
Daniel Ruedi, CFP®, RICP®
An ETF, short for Exchange Traded Fund, is an investment fund that can be bought and sold throughout the day, similar to a stock.
An ETF is not an investment type itself – it is a wrapper that holds many different types of investments, and thus takes on the characteristics of whatever it invests in.
There are many types of ETFs. Some are simple diversified stock and bond ETFs, while others may cover specific commodities, industries, or currencies. Though the rise of ETF investing coincided with the increased interest in index investing, not all ETFs passively follow an index.
ETFs can provide investors with the ability to invest in diversified groups of stocks and bonds around the globe at a low cost. Today it is possible to build a diversified global stock portfolio using a single ETF such as Vanguard’s Total World Index ETF. Though ETFs can be bought and sold frequently, they can serve as great buy-and-hold investments for long-term investors.
Since ETFs can be bought and sold throughout the day, they can be used for short-term speculation, and many are even designed for it.
Some ETFs, called leveraged ETFs, attempt to double or triple the performance of the stock market. For example, if the market goes up 1%, leveraged ETFs would go up 2% or 3%. Another type of ETF called an inverse ETF, attempts to do the opposite of the stock market; if the market goes down 1%, it goes up 1%. These types of ETFs are only designed for short-term speculation and would not make suitable long-term investments.
ETF shares have a price based on the value of their underlying investments. Similar to the price of a stock, it allows investors to track changes in the value of that particular fund. Unlike a mutual fund, investors must purchase whole shares.
An ETF will include a prospectus that spells out the characteristics of the fund, relevant details about the type of investments the fund owns, and the expenses of the fund.
There are several essential features of ETFs investors should be aware of. The first is that ETFs charge a fee for operating the fund, which is called an expense ratio. The second is how much the manager is buying and selling the individual holdings within the fund, which is called turnover. Investors should also pay attention to the number of holdings in an ETF to make sure it is adequately diversified.
Asset Allocation
Ryan Repko, CFP®
Though investing often seems very difficult, sometimes it can be very simple. Asset allocation, a term that sounds complicated and somewhat ambiguous, is simply a fancy name for how investors spread their money between the three primary asset classes: stocks, bonds, and cash. Asset allocation is extremely important because it determines the vast majority of the return investors will receive.
Stocks experience large short-term swings in value, but provide investors with returns above inflation as compensation for taking on that uncertainty. Bonds are just the opposite; they are relatively stable investments, and because of this, they provide a lower expected return. Cash is even more stable and provides practically zero return. A portfolio with more stocks will have a higher expected return and fluctuate a lot; a portfolio with more bonds and cash will provide a lower return but won’t experience such large swings in value.
Very few people choose to invest entirely in a single asset class, and try to balance their desire for a higher return with their desire for a portfolio that doesn’t experience large swings in value. The appropriate asset allocation for an investor will vary from person to person and investors should consider several factors when making this decision.
The first is the return they need to fund their investment goals. People are generally investing to fund specific financial goals, and should choose a mixture of stocks, bonds, and cash that will enable them to fund those goals.
The second is their time horizon. Though stocks provide investors with higher returns than bonds or cash over long periods of time, they can drop dramatically in value over short periods of time. Investors who have longer periods to invest (decades, not years) have a greater opportunity to reap the rewards of stock investing.
The third is their ability to handle the emotions of their investments rising and falling. Investors should not invest in an asset allocation they cannot stick with if a perfectly normal 30% temporary decline in the stock market were to occur.
Though asset allocation is a simple concept, choosing a mix of stocks, bonds, and cash is an important decision that has an enormous impact on the returns investors receive and their ability to fund their goals. For this reason, asset allocation decisions should be made with great care. If you cannot fully understand the impact your asset allocation will have on your finances, and your ability to fund your goals, you should talk to a financial professional who does.