September was a busy month for Paul Jr., who wrote all four investing 101 columns for the month! Check them out below:
Living Within Your Means
Paul R. Ruedi, CFP®
So far in our 101 columns, we have discussed mostly investment topics. But for this column, I want to take a step back and discuss what must take place before any money is invested, or even saved: it must not be spent.
The importance of living within your means is something people have understood for a long time. Charles Dickens summed it up perfectly in David Copperfield: “Annual income twenty pounds, annual expenditure nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”
Living within your means is the first step on the path to financial prosperity, but it can be difficult in a society obsessed with materials that easily enables you to spend more than you should by using credit cards. Keeping up with the Jones’s always seems to justify spending a little extra and figuring out how to pay for it later. Making matters worse, people don’t get immediate feedback when they are living outside their means and often get away with it for years or even decades. Though you may get away with it for a while, eventually it will catch up with you.
To avoid the misery of over-spending, you must first be aware of your spending but also make choices to control it. The first is actually fairly easy in a modern world where most spending is done via credit and debit cards and can be easily tracked. Online tools like mint.com make it very easy to automatically track and categorize spending to get a better perspective on where your money is going. But then of course, you must do the more difficult thing: control your own behavior.
With a certain amount of income to go around for spending each month, you will need to make calculated decisions about how your money is spent. Ben Franklin took a somewhat extreme stance on this when he said, “rather to go to bed without dinner than to rise in debt.” Though I think that may be a bit harsh, the seriousness of the comment shows how strong he felt about people doing everything possible to live within their means.
I agree with Dickens but am less harsh than Franklin. I don’t think living within your means requires cutting everything non-essential out of your life, and certainly not essentials like food. But you will need to make conscious choices to make your money go as far as possible, to create a life that makes you happy without having to live outside your means to do it. If you don’t, the result won’t be pretty.
Paying Off Debt vs. Investing
Paul R. Ruedi, CFP®
Savers often get stuck choosing between investing their money or paying off debt. There are many things that must be considered when making this decision, both the objective mathematical considerations but also the human emotional side as well.
If you use $100 to pay down debt that is accruing at 5%, thus saving you 5 dollars of interest, you are $5 better off. If you were to instead use that same $100 to invest and receive a 5% return, you are $5 dollars better off. Though one involves saving $5 in interest and the other involves earning that $5 as an investment return, it is functionally the same thing. It is mathematically optimal to put more of your dollars wherever you get the highest rate, whether it be saving on interest or receiving a return as an investor.
When the gap is large the decision is obvious – for example an investment that returns 10% vs. paying down a mortgage at 3.5% interest. If you have credit cards accruing interest at upwards of 20%, it is probably better to pay those off than invest at 10%. But people often get stuck when the rates they are choosing between are similar. In those cases, it may actually be better to simply choose whichever option makes them feel better.
Though on paper paying down debt vs. investing could be a purely mathematical decision, in real life there are practical elements that can take priority over the numbers. Debt often feels like a monkey on people’s backs – the constant feeling of being “in the hole” can be oppressive. It hangs over their personal finances like a dark cloud, which makes it difficult to celebrate any other financial successes that occur in life because they feel like moving pebbles relative to the boulder that is their debt. Regardless of what the numbers say, it may be better for someone who is very stressed about their debt to pay down their debts before investing and get the mental reward of doing so, which will eventually turn to lasting peace of mind once the debt is paid off.
My job as a financial planner is more often to prevent people from acting on their emotions and pursuing a course of action just because it makes them feel better. But given the choice between empowerment or frustration as people start taking responsibility for their own financial well-being, the first option certainly is more likely to reinforce good habits and set someone on a path to financial success, even if it is a little mathematically sub-optimal.
Target Date Funds
Paul R. Ruedi, CFP®
One of the most common investment options in 401(k) plans is an age-based investment solution called a “target date fund.” Target date funds, as the name implies, invest funds as if a saver is “targeting” a specific retirement date. For this reason, the retirement date the fund is targeting is included in the second half of the name, usually preceded by the company that manages that target date fund. If you have seen investment options with names along the lines of Vanguard Target Retirement 2050, Fidelity Freedom 2030, or something similar in your 401(k) menu, those are target date funds.
Target date funds put so much emphasis on investing for a specific retirement date because investors with different time horizons should invest differently. Young investors with a long time horizon should have more of their investments in stocks, as they have the time and capacity to take on more risk in exchange for participating in the higher returns stocks provide over long periods. By contrast, investors on the brink of retirement after a lifetime of saving should hold a higher percentage of bonds, as a bad stock market drop on the front-end of retirement could derail their retirement completely.
Target date funds shift the mix of stocks and bonds automatically for savers over time. A target date fund with a date far away, 2060 for example, will hold almost all stocks, around 90%. This allocation will shift over time, lowering the amount of stocks and increasing the amount of bonds. When the targeted retirement date rolls around, the fund will likely hold around 50% stocks, 50% bonds.
Target date funds are more or less a good investment solution for retirement savers. They are almost always globally diversified, and often low-cost. Compared to not saving at all, or randomly selecting from other 401(k) investment options, they are a very good starting point for investors with little or no financial background.
However, any “one-size-fits-all” investing approach is bound to have its shortcomings. I personally tend to recommend young savers invest in 100% stocks, and even the longest-term target date funds usually have around 10% in bonds, which provide a drag on long-term returns. On the back end, though 50% stocks/50% bonds is an entirely reasonable retirement portfolio, it may not be the right allocation to fund everyone’s unique individual goals.
Though they aren’t perfect, target date funds are a step in the right direction compared to what many people would do if left to make uninformed investment choices themselves. Better to be approximately right than precisely wrong.
Different Stocks, Different Returns
Paul R. Ruedi, CFP®
Although we often refer to “stocks” as a single group, not all stocks are exactly the same. Different groups of stocks have different underlying characteristics and some of those characteristics create differences in the returns investors can expect to receive.
One of the characteristics that research has shown to make a difference in returns is the size of companies. Small companies, those with market capitalizations under two billion dollars are very different than giant companies with market capitalizations over ten billion dollars. Investing in small companies is higher risk than investing in large companies, and as a group small companies have historically provided higher returns than large companies to compensate for this risk.
Another characteristic that impacts returns is the relative price you pay for stocks. Relative price can be defined in many ways, the price-to-earnings, price-to-sales, or price-to-book value of a company, but they all measure the same thing: how relatively expensive or inexpensive a stock is to buy. Stocks with a low relative price are called “value” stocks, those with a high relative price are called “growth stocks.” Over long periods of time, value stocks have historically provided higher returns than growth stocks.
Small company stocks and value stocks provide an opportunity to further diversify an investor’s portfolio beyond the stocks they would find in a typical S&P 500 index fund, which is made up entirely of large growth companies. They behave differently, and can perform well when large growth companies are doing poorly. Of course the opposite can also happen, and has been the case lately with the performance of the S&P 500 being so strong.
Though small cap stocks and value stocks can provide higher returns over long periods of time, there will be periods of time they do worse than other groups of stocks. These return differences are cyclical and impossible to predict. That is why investors must approach investing in these higher-risk, higher-return groups of stocks with a long time horizon, and an expectation that they will need to remain disciplined through some rough periods. As small cap and value stocks tend to bounce around a lot more than large growth stocks, they are best suited for people with a relatively high risk tolerance who can stomach those large swings in their investment account balance.
If you aren’t sure if your investment portfolio has exposure to these higher-risk, higher-return groups of stocks, or are wondering whether or not they would be a good idea for you, you may want to talk to a financial professional.