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You’re Losing Money by Saving

Since March when the pandemic began in the U.S. I’ve learned a couple of things.

1. The government was definitely not prepared to handle this situation.

2. Most of us weren’t either.

When the effects of the pandemic first started being noticed in early 2020, we focused all of our attention on the mistakes the government made that got us into this situation. We constantly heard about the inadequate supply of PPE for doctors or the inability for the Department of Labor to process the number of unemployment claims being made. What was left out of the conversation was the fact that while the government was improperly prepared for a global recession, few of us had prepared by saving an emergency fund that would help us through this either. While it is almost unanimously agreed upon that we should all have an emergency savings that covers 6 months of expenses, only 23% of Americans do. That means that when the staggering job losses started in March, ¾ of those people had little to no savings they could rely on to pay their bills until they found a new job. AKA, we weren’t prepared.

The pandemic has exposed the incredible importance of having an emergency savings, but an unfortunate fact about your savings is that you’re losing money with it every year. Don’t go running off to check your account balance; it’s staying the same. The loss you’re experiencing is due to a decrease in purchasing power caused by inflation.

Purchasing power is what you can actually buy with your money. If you have $100 today, and you want to buy a pair of shoes that costs $100, you can buy that pair of shoes. Next year if you want to buy the same pair of shoes they will cost around $102. The $2 increase in price for the same pair of shoes is due to inflation. The inflation rate of around 2% each year is what erodes your purchasing power, so unless you earn another $2 by next year you won’t be able to purchase the shoes.

The erosion of purchasing power caused by inflation is also why you’re losing money by saving. Every year prices are getting higher while your balance remains the same, so every year you can buy less and less with the money you have saved.

If you’re thinking that somebody must have found a way around this by now, you’d be right. Introducing the high-interest savings account! This type of savings account pays you a much higher return for keeping your money in it than a traditional savings account. Right now, high-interest accounts are paying around 1% as opposed to a traditional savings account that pays around .01%. That means if you’re saving in a high-interest account you’re only losing 1% purchasing power due to inflation instead of the total amount of inflation at 2%.

“But that means I’m still losing money!”

True, but once interest rates go up again the rate of return you’re receiving on your account will also increase. The return on high-interest savings is so low right now because the Federal Open Markets Committee (FOMC) dropped its target federal funds rate to 0% earlier this year at the start of the pandemic. The federal funds rate is the rate at which banks can borrow money from each other to meet their reserve requirements each night. A bank’s reserve requirement is the amount of cash they need to have in their vault at the nearest Federal Reserve Bank. If they are below their requirement near the end of the day, they’ll ask another bank to lend them the money overnight. The rate at which they borrow this money is the federal funds rate.

If one bank can’t find another bank to lend them the money they need to meet their reserve requirement, they can borrow the money directly from the Fed at a different rate. This is called the discount window. The Fed sets the rate for the discount window slightly higher than its target federal funds rate. That incentivizes banks to set the federal funds rate below the discount window rate. That’s because a bank wants to make whatever money it can by lending to other banks. To make borrowing from their bank more attractive than borrowing from the Fed, they offer a slightly lower interest rate than is offered at the discount window.

Banks use this same methodology to determine the interest rates they charge to consumers. When the federal funds rate is lowered, a bank will lower the interest rate it’s charging to the public to become a more attractive lender to consumers. These rate drops mean that it costs you less to take out a loan. This is why you’re probably hearing that you should buy a house right now since mortgage rates are so low. (Don’t do that unless you’ve saved 20% for a down payment and have prepared to buy a house.) While you should only take out a mortgage if you’re adequately prepared, this increase in borrowing is what the Fed wants to happen. Stimulating borrowing also stimulates spending and keeps money flowing through the economy, which is the Fed’s goal when the economy is struggling.

In times of hardship, people tend to stop spending and start saving a lot more money. This is good if you don’t have an adequate emergency fund, but a large decrease in spending will exacerbate the poor economic situation. When you stop spending, businesses’ revenues decline, which means they need to reduce their expenses, which often leads to layoffs. The people who are laid off now have less money to spend because they no longer have an income (or a far smaller one), so they reduce spending, which reduces companies’ revenues, which leads to more layoffs, and the cycle continues.

To avoid this downward spiral, the Fed lowers rates to incentivize spending. While this is good for borrowers, it also means that the rate you’re receiving on your high-interest savings account goes down. Since the bank you have your savings with is now earning less money from lending, they aren’t able to pay you as much to save with them.

Unfortunately with COVID, the interest rate drop did little to increase spending. That was because the lockdown caused entire sectors of the economy, like restaurants and airlines, to be completely shut down. Even if you had the money to travel or go out to dinner, you weren’t able to. Since it was impossible to spend in these sectors, they suffered huge losses of revenue even though interest rates were as low as possible.

As these sectors begin to open back up, spending will increase gradually and more people will go back to work. Then the people who go back to work will start spending more again, and the cycle will continue. As more people increase their spending, demand for goods will increase which means companies will in turn increase their prices. An overall increase in prices is what causes inflation.

Once the actual inflation rate is exceeding the Fed’s target inflation rate, they will start to raise interest rates. This will cause a decrease in borrowing because borrowing will become more expensive. A decrease in borrowing causes a decrease in spending which then stabilizes prices. While borrowing becomes more expensive when interest rates increase, the rate of return you’ll receive from your high-interest savings account will also increase. In the future when interest rates rise and the return you’re receiving exceeds the inflation rate, you’ll be able to preserve all of your purchasing power and earn money on your savings.

Future Interest Rate Expectations

Next week on September 15-16 the FOMC will meet to discuss whether it should raise interest rates. Unfortunately for your savings, it’s expected to leave the target federal funds rate at 0% until it sees significant economic improvement. That level of improvement is likely several quarters or years away, so for now, you can expect to continue to lose money through your savings.

Raising and lowering interest rates is one of the best tools the Fed has to stimulate economic recovery. With the federal funds rate at 0%, the Fed can’t cut rates any further to stimulate spending. To find another means to do that, they recently revised which of their goals they will be focusing on. The Fed’s goals are to maximize employment while controlling inflation. To help speed up economic recovery, they have decided to focus heavily on maximizing employment and allow inflation to increase slightly in order to do that.

With these new goals in mind, they will now be targeting an inflation rate slightly above 2% since inflation has been running slightly below 2% recently. This will create an “average” rate of inflation around 2%. To bump up inflation, the Fed has decided to increase the money supply. The stimulus check you may have received is one way they are doing this. Increasing the amount of money in circulation is called quantitative easing, and is a strategy that is used to stimulate spending and economic activity the same way that lowering interest rates does. The Fed is hoping that an increase in economic activity will then lead to an increase in employment, which will allow them to achieve their goal of maximizing employment.

While an increase in inflation may be good for employment rates and the overall health of the economy, it will only further erode the purchasing power of your savings. If you’ve been lucky enough to keep your job in 2020, have an adequate emergency fund, and still have extra money to spend, you can help out the entire economy by continuing to spend your money. Once our economy is back in full swing, the Fed will increase interest rates and you can start earning some money by saving, but until then your savings is going to cost you.

Citations

September 2020 Fed Meeting — New Policy Updates Over the Horizon?

How Does Your Emergency Fund Compare? New Stats Reveal Americans’ Rainy Day Savings Habits – Money Under 30

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The 3 Biggest Money Mistakes I Made in My 20s

In 2014 I was a newly minted MBA who was ready to take on the world. I thought those three letters after my name meant the money would just come rolling in and I would be wealthy in no time! Boy was I wrong.

Even after spending four years in undergrad studying money and another year studying business in grad school, I had no idea how much discipline it actually takes to get rich. My two degrees allowed me to find a good job with benefits and a decent salary, but I quickly learned that a decent salary on its own doesn’t build wealth.

Once I had this realization, I decided that I needed to figure out how wealthy people get wealthy. What do they do differently than most to become financially stable, and eventually rich? What I learned is actually quite simple. They spend far less than they make, and they use the money they have to make more money. Since learning this I’ve made a lot of changes to set myself up to build wealth, but I’ve also made several expensive mistakes. To help you avoid making the same mistakes on your personal finance journey as I did, here are the 3 biggest money mistakes I made in my 20s.

1. Not investing in my 401K as soon as I could

After I became eligible for my 401K at my first job, I spent about a year and a half dragging my feet on setting it up. Even though I had studied finance and knew how amazing employer matches and compound interest were, I was enjoying traveling and didn’t want to stop shopping. I was living the good life.

Eventually, the nagging thought in the back of my mind about needing to set up my 401K became overwhelming, so I decided to research my options and set everything up. The first thing I learned was how much money you actually need to have saved to retire. If you envision a carefree retirement for yourself, you’re going to need several MILLION dollars invested to make that happen. That seemed like an impossible number to reach to me, so my next step was to figure out how on earth I could get there.

This led me to learn that you should contribute a much higher percentage to your retirement accounts than you think you should, especially in the beginning. This is because of compound interest. Compound interest means that you make money on any interest you earn, as well as what you contribute. If you contribute $1,000 to your 401K this year and see a return of 10%, you’ll have $1,100 at the end of the year. Next year if you earn 10% again, you’ll have $1,210. The extra $10 you made in year 2 was from the 10% interest you earned on the $100 you made in interest in year 1.

At first, the additional earnings you receive will be small, but as these gains accumulate you will see a snowball effect on how much you earn. If you invest $100 each month at 20 and continue until you’re 60, you’ll have $632,500 at 60 if you received a 10% annual return. Only 8% or $48k of that will have been from your contributions. $584,405 will have been made from the snowball effect of compound interest. If everything in that scenario stayed the same except that you started investing at 30, by 60 you will only have $226,048. That’s a difference of $406,452 because you didn’t benefit from compound interest for 10 more years. On top of that, 16%, or $36k of your earnings will be from your contributions, instead of only 8%. Compound interest is your BFF when it comes to building wealth, but to see huge benefits from it you need to start investing as early as possible.

While one and a half years of dragging my feet may not seem like a lot of lost time, that’s 15% of my 20s, and I was already 24 when I was first offered my 401K. That means I had less time to accumulate the gains from compound interest to start with and was still putting off contributing to my 401K. To catch up, I would need to make much larger contributions to be able to accumulate the several million dollars I needed to have by retirement. In the earlier example, you can see that contributing $100 every month for 40 years will only get you to around $600k for retirement, which isn’t going to be enough. If you really want to live out your vision for retirement, you’re probably going to need to contribute a lot more of each paycheck to your 401K than you want to.

No matter how old you are, if you haven’t started contributing to a retirement account, you’re missing out on a ton of future money. Don’t make the same mistake I did and keep dragging your feet. These links give you all of the info necessary to understand how much money you will need to have to comfortably retire, and how to set up your retirement account and start investing today.

2. Increasing my expenses when my income increased

My starting salary out of grad school wasn’t the greatest, but I quickly received promotions and salary increases and doubled my salary in just a few years. With each salary bump came more spending on luxury items. By luxury, I don’t mean high-end; I mean things I didn’t need. I would do things with my extra money like shop, or plan another vacation, or move into a more expensive house. I spent everything I made and didn’t save or invest any of it. To outsiders my spending made it seem like I was becoming more financially stable, but my financial stability was actually remaining the same.

Like 24 year old me, most people think that being financially stable means earning enough money that you can easily pay your bills every month and also afford to purchase some luxuries. This common line of thinking couldn’t be further from the truth. No matter how high your salary is, if you spend all of your money every month, you’re living paycheck to paycheck. A person who makes $250k/year and saves or invests none of it is no different than a person who makes $30k/year and does the same thing. They may be spending on different items, but they’re both financially unstable. If either of them loses their job, they won’t be able to afford their house or cars, no matter how nice they look on the outside.

Remember at the beginning of this post when I said one of the things I learned about rich people is that they spend far less than they make? That habit is what allows them to build a savings and become financially stable. Having financial stability means that you can maintain your lifestyle for at least several months if you have a large drop in your income. To create this stability, you should strive to have at least 3-6 months of expenses saved. Start automatically sending a portion of each paycheck to a high-interest savings account. Once you’ve reached your savings goal, you can then start investing to grow your wealth and begin generating passive income. Having passive income and a savings will allow you to comfortably spend on luxuries when the money is rolling in, but also smoothly chug along through the rough patches.

3. Buying an expensive car

While I love my husband dearly, buying his expensive car straight out of school is one of my biggest money regrets. (He wouldn’t agree with this, but this isn’t his blog now is it!) He had always wanted a Subaru WRX STI, so as soon as he graduated college he treated himself to his dream car. In total, the car cost more than $30k, and years later we’re still making insanely high payments on it. His sky-high car payment comes on top of the student loans were also paying off. While we have a healthy debt to income ratio, so much of our money that we could be using for other things goes to pay off debt each month.

While paying off our student loans sucks, taking out these loans isn’t something I regret. That’s because I consider our college degrees to be appreciating assets. Appreciating assets go up in value over time. Since we expect our income to increase far more over the long term than we will end up spending on interest on our student loans, I consider them money well spent.

My husband’s car on the other hand… not so much. While cars are technically considered assets, they are depreciating assets. That means that they decrease in value over time. In short, we bought a car we can technically afford (even though I get nauseous at the thought of the payments), that we will end up paying more for after factoring in the interest charges, and we will never be able to recoup our money when we sell it. It honestly couldn’t get worse than that.

While I’m glad that my husband loves his car, financially it was a huge mistake to buy it. We will end up losing a lot of money to interest and are tying up funds that we could be using to invest and build our wealth. Remember how important it is to invest as much as possible as early as possible? Buying an expensive car right out of college ties up money that you could be using to invest and make tons of money on in the future.

Since cars are necessities for many people, if you need to take out a loan to get a car, that’s ok. If you don’t absolutely NEED a new car right now, but you want to buy one soon, you should look at the trade-in value for your current car vs the price of the car you want to buy and start saving for the difference. If you pay for the car in cash, you’ll save thousands of dollars on interest that you can then use to buy appreciating assets and build your wealth.

We all have regrets about what we haven’t done or should have done with our money. These regrets often keep us from taking the steps we know we should because we’re scared of making more mistakes. Some people started investing in high school and will make a lot more money from compound interest than I ever will, but that didn’t stop me from starting. If you’re in your 30s and haven’t started your retirement account because you’ve already missed out on a lot of potential earnings, think about how you’ll feel in your 40s after skipping 10 more years of earnings. If you can go shopping or out to dinner each month, you shouldn’t be living paycheck to paycheck and should start contributing to a savings. Buying things you want but can’t afford only will make it harder for you to get the things you want in the future. I made all of these mistakes, but turned the guilt I felt about them into action. Feeling guilt about prior financial mistakes means that you have acknowledged that the mistake was made, and you won’t make it again in the future. Stop letting it hold you back from doing what you know needs to be done. Never starting to save or invest will hold you back far more than any of the minor mistakes you will make, and then learn from, in the future. Take it from me.

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Why Women Should Think More Like Men When it Comes to Our Finances

I know. Not the most feminist sounding title for an article that’s coming from a women’s personal finance blog, but hear me out.

Last year, I realized I could help other women by spreading my financial knowledge, so I decided to start a finance blog and some social media accounts to go along with it. My goal was, and still is, to provide women with the tools needed to make informed financial decisions, grow their wealth, and bridge the gender income gap. The first thing I did after setting up my blog and social accounts, was to try to find other likeminded women to follow. My financial education started with getting my BS in finance and an MBA and continued by listening to podcasts and reading books. I hadn’t used social media as a tool for financial teaching, so I wasn’t sure what to expect in my search for these likeminded women. I found no shortage of personal finance accounts, but most of them were hyper-focused on budgeting and becoming debt-free, which wasn’t what I planned to focus on. My focus was going to be on how to use debt properly, and how to grow your wealth through investing.

After following many finance accounts by women, I shifted my search to finding other accounts to follow that provided good financial information, no matter who ran them. These included accounts run by men and businesses like Yahoo! Finance.

After several months of following accounts run by women, men, and businesses, I’ve noticed a trend. Most of the information from #womeninfinance comes from a scarcity mentality. That means that the actions they promote stem from the idea that there is a limited amount of money and you need to hang on to anything you’ve got. Men’s finance accounts are much different. The information they provide comes from an abundance mentality. That means they focus on how abundant money is and what techniques you can use to bring more of it to your bank account.

While it’s important to make sure you aren’t spending outside of your means, extreme budgeting from a scarcity mentality won’t get you very far on your journey to becoming a rich bitch. If you’re paying all of your bills without running up credit card debt, it’s time to make the shift to an abundance mentality and find ways to grow your money. Below are the two most popular money “tips” I’ve seen on women’s finance accounts, why you should avoid them, and what you should do with your money instead.

No Spend Days

This is one of the most popular budgeting “tricks” I’ve been seeing. What people do is aim to only spend money on necessities, and when they buy something that doesn’t fit into that category, they mark their calendars with an X to show that it was a “bad” day.

Understanding your spending is eye-opening for many people. There’s usually at least one thing that you realize you’re spending way more money on than you thought you were. But as long as you’re spending less money than you make, you do not need to start shaming yourself into penny-pinching. Going from spending money on whatever you want to demonizing spending altogether, is like going from never working out to going to the gym every day. You’re never going to stick to it, you’re going to feel guilty when you don’t, and you’re not going to make any progress. So figuring out how you’re spending your money is great, but you don’t need to stop spending money on anything that isn’t a means to your survival.

Another “tip” that comes along with no spend days is to take the money you didn’t spend and to pay down debt. This tool is deemed a wealth-building tool but actually builds no wealth for you. Wealth building is the process of generating long-term income through investments and income-generating assets. Paying your debt off sooner will save you some money on interest, but it will not make you wealthy.

Since we’re talking about making money, let’s take a look at some real numbers. Let’s say you start saving $100/month with No Spend Days. After 30 years, you’ll have saved $36K. Below, you’ll see how much you’ll save in interest by paying off debt with the money you’ve saved vs what you could earn from investing it.

Paying an extra $100/month toward debt

  • If you take out a mortgage for $250K with a 3% interest rate, you will end up paying $129,443 in interest over 30 years. If you use the $100 you save from your no spend days and apply that to your mortgage every month, you will save $18,946 in interest.  

Investing $100/month

  • If you invest $100 into the stock market every month and receive the average annual return on the market of 10%, you could earn $226K in 30 years.

The choice is clear. You’re going to invest the $36k because you’ll earn $190k from it. Investing the money you save is what builds wealth, not paying off debt. 

Now you’re probably thinking, “but I still have to track no spend days to get the $100 I’m going to invest every month.” Don’t worry. I have a better way. Instead of tracking each day you don’t spend money and making yourself feel guilty every time you do, set up automatic payments into an investment account as part of your monthly spending. Just like your rent and student loan payments, it will come out of your account every month as a budgeted item. Now that your investments are factored into your spending, any money you have leftover that month can be spent on whatever you want. No guilt required!

If You Aren’t Trying to be Debt Free, You’re Doing it Wrong

There are certain things that you shouldn’t use debt for, but lumping all debt together in one basket and calling it bad is wrong. When debt is used to pay for appreciating assets like a college degree or an investment property, it can be instrumental in building wealth. If you use debt to make discretionary purchases, like shopping with your credit card or paying for your wedding with a personal loan, that’s definitely a bad idea.   

Trying to pay down all of your debt as fast as possible only needs to be your priority if you have high-interest rate debt like credit card debt, or you have too much debt and a high debt to income ratio. If you have a healthy debt to income ratio and no expensive debt, you do not need to make paying off debt ASAP your top priority. In fact, I would advise against it.

The opportunity cost of deciding to put all of your extra money toward paying off debt is the lost earnings you could have received from investing it. Opportunity cost is just what it sounds like, the loss of a potential gain from another opportunity when a different opportunity is chosen. If you choose to put your extra money toward paying off your debt faster, you miss out on the opportunity of the earnings you could have received by investing it. If you decide to invest the money, you miss out on the opportunity of saving money on interest by paying off your debt sooner.

As we saw in the earlier example, there is much more money to be made from investing than there is from becoming debt-free as early as possible. Since the opportunity cost of not investing is higher, I would recommend shifting from wanting to be debt-free ASAP to wanting to be a rich bitch ASAP. Make sure you have a healthy debt to income ratio, no expensive debt, and you’re making all of your minimum debt payments on time, and then invest the rest!

While men are out there trying to take more pieces of the pie, women are trying to keep our piece from getting moldy. You can save some money by penny-pinching and guilting yourself into never buying the things you want, but by focusing on these small wins you’re missing out on larger opportunities. To start really building our wealth, we need to shift our thinking from the scarcity mentality to the abundance mentality. Money is power and if we want #girlpower to be the norm, we’ve got to go out there and eat bigger slices of the pie.

Check out our step-by-step guide to taking control of your finances and growing your wealth!

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A Fail-proof Guide to Taking Control of Your Finances

There’s a lot of talk about how much money you should have saved, how debt is the enemy and that you need pay it off ASAP, and that you should start investing as early as possible. This is all great information to have, but the fact is that when you’re young and you only have a small amount of money to allocate to these things, your fear of missing out on good money making opportunities quickly turns to information overload and then paralysis. How can you possibly save 6 months of expenses, max out your 401K contributions, and overpay each month on your student loans when you’re only making an entry level salary? If you still want to pay your rent and eat, you probably can’t. So most people do nothing because they become overwhelmed and don’t know where to start. If you’re one of the people who wants to make good financial decisions but easily becomes overwhelmed with all of the things you “should be” doing with the little money you have, you’re not alone. To help calm your anxieties and give you the confidence to start taking control of your finances, we’re giving you a roadmap for when and how much you should allocate to your savings, pay toward your debt, or invest.

Step 1 – You’re Making All of Your Minimum Debt Payments On Time

Your first step is to make sure you’re paying all of your minimum debt payments on time. Debt is a financial obligation. That means, that you must make your minimum debt payment every month, no matter what. Making sure to hit every minimum payment is critical to building good credit and avoiding defaulting on your loan, which will wreck your credit score. To do this, you should take your debt inventory. Make a list of all of the outstanding debt you have, what the minimum monthly payment is for each, and when each payment is due. If you’re comfortable with setting up auto payments, I would highly recommend it. If you have multiple loans with varying due dates, you can call your lenders and ask them to move your due dates so all of your payments are due at the same time. This way, you can pay everything at once, and you don’t have to remember multiple dates throughout the month to make your payments.

Step 2 – Start Building an Emergency Fund

Once you’ve set yourself up to meet all of your minimum debt payments, the next step is to start building an emergency fund. The best type of account to use for this is a high-interest savings account because they offer much higher rates of return than traditional savings accounts. A good rule of thumb for how much you need to have saved in your emergency fund is 6 months of expenses. Having closer to a year of expenses saved is better, but starting with a goal of 6 months of savings is great. Having an emergency savings is your foundation for financial stability. It is CRITICAL to your financial health that you build a savings account in case you ever lose your job or have large unforeseen expenses, like medical expenses. Remember in the previous paragraph where we discussed that your debt payments are financial obligations? If you lose your job, you still have to make those payments, and that’s where your emergency fund comes in. (For more info on emergency funds and high-interest savings accounts, see this post.)

Step 3 – Start Investing

Now that you’ve set up your emergency fund and are meeting your minimum debt payments, should you start investing any leftover money? As a rule, you should allocate as much as possible to your savings until you’ve reached your savings goal of six months of expenses saved. There is one exception though. If you’re offered a 401K with a company match, you should invest. A company match means that if you contribute to your 401K, your employer will also contribute a percentage of your contributions. If you have a company match, you should contribute up to the percentage of the match. For example, if your company matches 50% up to 5%, that means that you should contribute 5% of your income to your 401K, and your company will contribute an additional 50% of the 5% contribution you are making. 401K contributions are pre-tax, which means they come out of your earnings before any other deductions are made. So if you make $50k/year, and contribute 5% to your 401K, you contribute $2,500/year. If your company matches 50% of that, they will also contribute $1,250/year. That makes your total annual 401K contributions $3,750. If you’re offered a company match and you aren’t investing in your 401K, you’re leaving money on the table. Once you’ve set up your 401K contributions to meet your employer match, you should follow the savings rule above and allocate any extra money to your emergency savings until you reach 6 months of expenses saved. If your employer doesn’t offer a 401K or company match, you should contribute as much as you can to your savings until you reach 6 months of expenses saved before you begin investing.

Step 4 – Increase Your Debt Payments and Investment Contributions

Once you have 6 months of expenses saved, I would still recommend contributing to your savings until you’ve reached 1 year of expenses saved, but you can start allocating some money elsewhere. You have two options. Make larger payments on your debt, or start investing more. The best way to decide where your money should go is to look at your interest rates. If you are young and starting to invest, you will most likely be heavily investing in stocks, so you can expect to receive the average return on the stock market of 10% annually. Now compare the return of 10% that you can expect from investing to the interest rates on your debt. If your debt interest rates are well below 10%, which they probably are, you should keep making your minimum debt payments and start investing any extra money you have. If you have expensive debt, like credit card debt, I would first look at refinancing with a personal loan (more on that here), and if you aren’t going to do that, allocate everything to paying off any high-interest debt before investing.

Another reason to pay down debt before investing is because your debt to income ratio is high. Having a manageable DTI is a key component of financial stability. Again, debt is a financial obligation. If you have a lot of debt obligations, the likelihood of you being able to pay them if you experience financial difficulties decreases. Having a high DTI means that you’re more at risk for not being able to make your payments. If you want to buy a house or take out a loan for another reason, the bank will evaluate your DTI ratio to decide whether or not they should lend to you. You can learn how to calculate your DTI in this post. If you find out that your DTI is high, you should increase your debt payments to reduce your debt to a more manageable level before investing.

If you have a healthy DTI and no expensive debt, you can start investing! Making the transition to investing as soon as you can is extremely important because of compound interest. Compound interest will grow your money exponentially over time, literally. The earlier you start investing, the longer you have to take advantage of compound interest, which means more money in the future. 

 When it comes to investment options, the possibilities are endless, which is exciting and also daunting. Retirement accounts are one of the easiest tools to use starting out. If you’re contributing to your 401K, you can increase your contributions, or you can open an IRA. If you’re at this step and you’re not sure where to invest, you can learn about the pros and cons of each type of retirement account in this post. You can also invest in ETFs and index funds outside of retirement accounts. In either case, managing risk and building a diversified portfolio are essential when setting up your long-term investing strategy. It is fun to think about investing big in your favorite companies, but long-term investing is all about diversification, which means you’ll usually end up investing in a lot of boring things. Our post on how to build a diversified portfolio and manage risk will help you understand why this is important to the success of your portfolio and help you set up your investments.

If you’ve gotten through all this and still think these steps are confusing, don’t worry. Below is a decision tree that will help you through each step of this process. Each decision point in the process is marked with a diamond shape and contains a question. Start at the top and answer the question and follow the corresponding arrow to see what you need to do next. You may come to another decision point, or a circle. When you reach a circle, complete that step, and go back to the previous decision point and answer the question again. Continue following the decision tree until you reach the star.

Following this process will take the guesswork and anxiety out of managing your finances. It will set you up with a good foundation for financial stability, and get you moving toward investing and building wealth. You no longer need to feel paralyzed by the choices you’re making, or not making, about your finances, and by using this guide you can confidently take control of your money and become a rich bitch!

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Financial Self-care: How to Build an Emergency Fund

With our economy crumbling faster than a drunk girl going down the stairs, many of us have recently realized how critical it is to have an emergency fund. Maybe you lost your job and are now faced with a new reality. Maybe you’ve seen many of your friends and family members lose their jobs, and are worried the same could happen to you. No matter what brought you to the realization that you need to start an emergency fund, be glad that you’re here, because you may one day find yourself asking, “how the F**K am I going to pay for all of this stuff?!”

The fact is that most of us prepared for this pandemic the same way the government did. We didn’t. Few of us have an emergency savings. Only some of us were investing in the 401K at our company. We were using a big chunk of our salaries to pay off our student loan debt, but still bought a too-expensive house because we just couldn’t pass it up. In times of prosperity, we tend to ignore the possibility of economic hardship. But the fact is that it will come. It always does. The good news is that you can begin a financial self-care routine to better prepare for the next time the economy takes a nosedive. The first step is to build an emergency fund. And this is how to do it.

Step 1: Understanding Your Spending

The first thing you need to do is calculate your monthly spending. This includes only necessary spending like rent or a mortgage, student loans, food, insurance, electricity, etc. The bills you must pay and the necessities you must have to survive. This should also include things like internet and Netflix, but not what you spend at weekly happy hour, eating at restaurants, or shopping. List out all of your monthly expenditures, and add them up. The total is your base amount of monthly expenses assuming no unexpected expenses arise. But we know nothing ever goes to plan. That is why you’re doing this in the first place! To account for unforeseen expenditures like replacing a tire, a medical procedure, or your annual Amazon Prime membership fee, multiply your base amount by 1.25. This will give you an additional 25% for the unforeseen expenses you know you’ll have.

Example

Bridgette’s monthly spending is as follows:

  • Rent: $1,000
  • Student Loan Payments: $250
  • Car Insurance and Gas: $300
  • Electricity/Water: $150
  • Groceries: $500
  • Internet/Netflix/Spotify: $100
  • Cell Phone Bill: $150
  • Gym Membership: $50

Total Predicted Monthly Spend: $2,500

Additional 25%: $625

Total Actual Monthly Spend: $3,125

Step 2: Open a High-Interest Savings Account

Now that you know what your monthly spending is, you can start building your emergency fund. A good rule of thumb is to have 6 months of expenses saved. Take the monthly spend you calculated in the previous step with the additional 25% included, and multiply it by 6. This is the goal amount you want to have in your emergency fund savings account.

Example

Bridgette’s monthly spend is $3,125.

$3,125 x 6 = $18,750

Now I know what you’re thinking. HOLY SHIT! I’ll never be able to save that much! But it is totally possible! It won’t happen tomorrow, but over the next several years, you’ll be surprised what savings you can accomplish with minimal effort, and I’m going to show you how.

The next step to reaching your savings goal is to open a high-interest savings account. Mine is through Citizens Access, a division of Citizens Bank. (Bonus, Citizens Bank is a black-owned business!) If you do a quick Google search of high-interest savings accounts, you can review your options and choose the one that fits your needs best. Once you’ve selected the best option for you, open your account.

Many of you will want to skip this step because you already have a savings account with the same bank you have your checking account with. You think it’ll be easier to just use the account you already have. DO NOT do this! Citizens Access currently offers a 1% return on your savings, while Chase Bank offers a .01% return. That means that for each $100 in your account, Chase will give you $.01 while Citizens Access will give you $1. If you had the option to take a penny from someone or a dollar from another person, that would be a no brainer! You would take the dollar. Choosing to open a high-interest savings account is the exact same decision. The 1% return is well worth the 10 minutes it will take you to set up the new account because the higher return will help you reach your savings goal faster.

Another reason why it is important to get a higher return with a high-interest savings account is because of inflation. Inflation causes your money to lose purchasing power (PP). (Check out this post on why combating inflation is one of the most important rules of finance.) Purchasing power is how much you can buy with your money. You know the stories your parents and grandparents always tell about how they remember when gas was $.50 a gallon, or when they could buy candy for a penny? These stories sound crazy to you because you could never buy gas for $.50 a gallon or candy for a penny today. This is because inflation has caused a decrease in the purchasing power of the dollar. AKA prices went up. In the future, you’ll also be telling your kids and grandkids stories like this. That means that the money you’re saving now will be able to buy less and less as time goes on because of inflation.

The annual rate of inflation is usually around 2%. So each year, your money can buy 2% less than what it could the year before. This is where the high-interest savings rate comes in handy. The 1% return Citizens Access gives you on your savings will help you combat the effect that inflation is having on the purchasing power of the money in your savings account. Inflation is an unseen expense on your money, so people tend to ignore it. But at the end of the day, you’re saving this money so that you can spend it one day when you need it. If that day is 10 years down the road and you’ve experienced 2% inflation each year, you’ll have nearly 20% less purchasing power than you have now.

Example

  • Bridgette has reached her savings goal and has $18,750 saved at the beginning of the year.
  • Inflation was 2% this year.

Bridgette’s purchasing power due to inflation is

$18,750 x .98 = $18,375

With Bridgette’s .01% return on her Chase savings account, her purchasing power is

$18,750 x 1.0001 x .98 = $18,377

PP increase from Chase return = $2

With Bridgette’s 1% return on her high interest savings, her purchasing power is

$18,750 x 1.01 x .98 = $18,559

PP increase from high-interest savings return = $184

By putting your money in a high-interest savings account, you can combat a significant portion of the effect inflation will have on your money. When interest rates increase, so will the return offered by your high-interest savings account. If your savings rate of return is equal to the inflation rate, you will maintain all of your purchasing power. If your savings rate of return is above the inflation rate, you will be increasing your purchasing power. So what I’m trying to say is, OPEN THE DAMN HIGH-INTEREST SAVINGS ACCOUNT!

Step 3: Move Your Current Savings and Set Up an Automatic Deposit

Now that you have opened your high-interest savings account, it’s time to put some money into it! If you have a current savings account alongside your checking account, move your savings balance to your new high-interest savings. Since the new high-interest account will only be used for life-changing emergencies, like a job loss, large medical expenses, etc., the money in the high-interest account should be considered off-limits for fluctuating expenditures. To give yourself some cushion, leave a small balance in your original savings, and move the rest to your high-interest savings.

Once you’ve rearranged your current savings balance, it’s time to increase your nest egg! Set up automatic deposits into your new savings. You can update your direct deposits with your employer, or set up regular transfers from your checking to your new savings. Either way, you should be realistic with what you’re able to contribute while still pushing yourself to save more than you really want to. You started this journey thinking you would never be able to save enough, so don’t self-sabotage by only saving $20 a month if you know you can contribute more.

Step 4: Increasing Your Contributions

Now that you’ve figured out your monthly contribution amount, you may be discouraged again. If the amount you need to save to reach 6 months of expenses is around $20,000, and you’re contributing $100 per month, some quick math will tell you that it will take you over 16 years to reach your savings goal. First, take the time to appreciate that you just started building an emergency fund for yourself, and are contributing 100% more than you were before! That is no small feat! Everyone starts somewhere. The point is to get better and make your life easier over time. If you only have 3 months of expenses saved by the next recession or major life change, that is 3 months of covered expenses that you wouldn’t have had before. You’ve already put yourself in a much better position than you would have been in had you never begun to save.

Now that you understand how amazing you are for taking the first 3 steps, I’m going to help you reach your savings goal faster. The key to doing this will be to increase your contributions.

Over the next several years, your financial situation will change. This can be due to things like getting a promotion and a raise, or paying your car or student loans off. When your salary increases or your expenses decrease, or amazingly both happen, your disposable income will also increase. Disposable income is the amount of money that you have leftover to spend on things like going out to a nice restaurant, going shopping, or taking a vacation. I’m going to call your disposable income your personal profits.

In business, profit = revenue – expenses. This concept is exactly the same in personal finance. Your revenue is your income. When that goes up and your expenses stay the same, your personal profits increase. When your expenses decrease, your personal profits increase. Usually, when your personal profits increase, your first thought will be to increase your expenses again. Maybe you move into a bigger, more expensive apartment. Maybe you start shopping at more expensive stores. Maybe you take more vacations. But whatever your indulgence, you will quickly put your extra personal profits into that by spending more. While this is super fun, it won’t help you reach your financial goals.

When you have an increase in personal profits, first treat yo’ self! You deserve to celebrate! Take your extra money and take a weekend getaway, or buy those shoes you’ve been eyeing. It is no fun accomplishing something if you don’t allow yourself to acknowledge the achievement. The key is to not make the celebration last forever. Pick a timeframe or item to splurge on, and then set yourself up to achieve your next goal. If you got a raise of $1,000/month, increase your savings contributions by $500 and take the rest for added fun. If you were contributing $100 each month before your raise, and increase your contributions by $500, you’ll now be contributing in two months what you used to contribute in a year. If you pay your car off, take the monthly amount you were paying and put that amount into your savings each month. You already know you can live at your current spending level, so reallocating your expenses will allow you to maintain your quality of life while setting you up to reach your financial goals.

The highest form of self-care is self-discipline. You’ve just begun your financial self-care routine, and if you’re disciplined and stick to it, I guarantee you’ll reach your savings goal. It may take you the next 10 years, but if you’re not actively making decisions to become the person you want to be when you’re 30, 40, or 50, you’re not going to get there. Imagine how you’ll feel at 40 knowing that you haven’t created the life you wanted because you never tried to reach any of your goals. You’ll probably feel pretty shitty, and need a lot more self-care in the form of therapy. The road to reaching your financial goals will be long. There will be recessions and expansions. Raises and job losses. Having an emergency fund will allow you to succeed during the downturns and give you peace of mind. Everyone might talk shit when you don’t want to go out every Saturday because you’re saving for your emergency fund, but they’ll be jealous when you’re the one shopping during the next recession.

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The Tortoise and The Hare

Using Compound Interest to Win the Race and Become a Rich Bitch

You’ve probably heard the fable about the tortoise and the hare. To sum it up, the tortoise and the hare are in a race. The hare is fast and confident that he will win the race with ease, so he runs most of the race super fast, then he stops to take a nap, and ends up losing to the tortoise. The tortoise knows he isn’t fast but maintains a steady pace toward the finish line throughout the race, and gets the W. The moral of the story, slow and steady wins the race. But what on earth does this fable have to do with finance?

In an earlier post (that can be found here), you learned why trying to pick a unicorn company to invest in doesn’t usually work out. Instead, you should create a diversified portfolio and invest in a herd of cattle. Diversifying your portfolio helps reduce your risk, but what grows your money? The answer is compound interest, and that is what you’ll learn about today.

First let’s discuss what interest is. Interest is the charge you pay for the privilege of borrowing money. It is usually expressed as a percentage. For example, you borrow $100 for 5 years with an interest rate of 5%. When you pay back your loan, you’ll pay back the principal amount of $100 plus an interest payment of $5 for a total of $105. Pretty simple.

Compound interest follows the same premise, but the interest rate is set per period. Let’s continue using the example above, but say you borrowed the $100 at 5% interest, compounded annually for a period of 5 years. Each year you will be charged interest on the principal, as well as any interest you’ve accumulated. Paying interest on interest is how the interest compounds. Take a look at the table below.

YearBalanceInterest Accrued
1$100.00$5.00
2$105.00$5.25
3$110.25$5.51
4$115.76$5.79
5$121.55$6.08
Final Balance $127.63

You can see in the table that the interest you are charged goes up each year because not only are you paying the 5% interest on your principal of $100, but also on any interest you’ve already been charged.

Now that you have an understanding of compound interest, back to the tortoise and the hare. In our discussion on diversification, we used a unicorn and a herd of cattle as examples. Well in this example, the hare in the fable invested in the unicorn, and the tortoise invested in the herd of cattle. The tortoise’s approach to investing is all about using compound interest as a long-term growth strategy. With this strategy, you reinvest the interest you make each period, compounding it over time, which adds up to significant gains over the long term.

This is how retirement accounts (like we discussed here last week) work. The earlier you start, the more compound interest you can accumulate before retirement. Let’s continue our table from before and assume that you invested the $100 when you were 20, and you plan to retire at 65. Let’s also assume you make 5% interest annually for those 45 years. If you make no additional contributions, you will have $898.50 in your account just from compounding your interest. That might not sound that great, but imagine it in larger terms. If you had invested $100,000, you would have $898,500 after 45 years. That’s almost ONE MILLION DOLLARS! And you didn’t have to do anything. It’s all thanks to the compound interest from your tortoise investing approach.

Let’s look at a more realistic example. We will keep all of the same parameters defined above, but you will contribute $100/month for 45 years. Over these 45 years, you will have contributed a total of $54K, but you will end up with $192,538.69! That means you will make 3.5X the money you contributed! That’s a pretty good deal, if I do say so myself.

In the tortoise and the hare’s race, and the race to wealth, slow and steady will always triumph. While you won’t have a cool investment story, you will make a lot of money over the long term. If you’re skeptical, just ask Warren Buffet. He is a huge advocate of growing your wealth using compound interest. And he is a billionaire, so I’d say he knows a thing a two. Compound interest is why you should start investing today, slowly and steadily build your investments, and eventually win the race and become a rich bitch.

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How to Become and Old Rich Bitch

The 411 on Retirement Accounts

Retirement accounts are one of the most important investment tools to begin using while you are young to grow your wealth. There are several different types of retirement accounts that you can use, and each one has different advantages and disadvantages. Below we will discuss the pros and cons of the different types of retirement accounts, and the ways that you can utilize them to become an old rich bitch.

401K

The first retirement account we’ll discuss, and the one you’re probably most familiar with is a 401K. 401Ks are retirement accounts that are offered by employers to their employees. These accounts are defined contribution accounts, meaning that the employee contributes a percentage of their income to their 401K each time they are paid. If you make $50,000 a year and set your 401K contribution at 5%, you will contribute about $96 to your account every 2 weeks when you get paid.

Pros

Employer Match – The biggest pro of a 401K is that you can give yourself a raise just by contributing to it. Welcome to the beauty of the employer match! Many companies will offer to match your 401K contributions up to a certain amount. This is usually written something like this, 50% match up to 5% of your salary. They are saying that for every dollar you contribute to your 401K, up to 5% of your salary, they will contribute an additional $.50. Let’s take a closer look using our previous example. You are contributing 5% or $2,500 of your $50,000 salary each year. The company you work for is also going to contribute 50% of what you’ve contributed, or an additional $1,250! So, your total annual contributions just went from $2,500 to $3,750! Some companies get a little more complicated with this and offer a tiered match. These look something like this. We will match 100% up to 2% and 50% up to 5%. This means that for the first 2% of your contributions, they will give you $1 for each dollar you contribute. For your contributions above 2% up to 5%, they will give you $.50 for every dollar you contribute. Let’s look at some numbers. You contribute $2,500 annually, or 5% of your $50,000 salary. For the first 2% you contribute, or $1,000, your company will match you 100%, amounting to an additional contribution of $1,000. On the remaining 3% that you contribute, or $1,500, they will match 50%, amounting to an additional contribution of $750. In total, they will contribute $1,750 to your account. When added to your $2,500 contribution, you increase your total annual contributions to $4,250! You just gave yourself a raise for trying to help yourself get richer. Who doesn’t love that?!

Tax Advantage – The money you contribute to your 401K is pre-tax. This means that you do not pay any taxes on the money before it goes into your 401K account. This is an advantage because it reduces your taxable income. In the example above, if your salary is $50,000 and you contribute 5%, or $2,500, of your salary to your 401K, you will only pay income tax on $47,500 instead of $50,000. Not only are you saving money you would otherwise be paying in taxes, but you are also contributing more money to your 401K due to this tax advantage. This allows you to benefit more from compound interest. Here is an example. If you contribute 5% of your pretax salary of $50,000, you contribute $2,500. If the 5% you contributed to your 401K was after-tax money and you had a tax rate of 25%, you would only contribute $1,875 to your 401K. That is a difference of $625 each year that you wouldn’t get the benefit of compound interest on!

High Contribution Limit – The 2020 contribution limit for an employee is $19,500. This is the most you are allowed to contribute to your 401K in a single year. 401Ks have extremely high contribution limits when compared with other retirement accounts, as you’ll see later in this post.

Cons

Early Withdrawal Penalties – The money you contribute to your 401K can’t be taken out until you reach the age of 59½. 401Ks are tax-deferred accounts, which means that you don’t pay income tax before making your contributions, but instead pay the income taxes when you withdraw the money. If you decide to withdraw money from your 401K early, you will pay the income tax on your withdrawal as well as an additional penalty. The penalties are quite steep at around 10%, and will significantly eat into your earnings. Since these accounts are not very liquid (see this previous post on liquidity), you should always make sure to have other easily accessible money saved to help cover any hardships or unforeseen expenses.

Limited Investment Options – Since your employer selects your 401K plan, you are limited to the investment options from their chosen plan. Your employer dictates which financial services company you use, as well as what funds you can choose from.

IRAs

Individual Retirement Accounts (IRAs) are retirement accounts that are opened by individuals, not employers. There are two types of IRA accounts, Traditional IRAs and Roth IRAs. For ease, we will refer to Traditional IRAs as IRAs and Roth IRAs as Roth IRAs. Let’s take a look at the pros and cons of each.

Traditional IRA

Traditional IRAs are more similar to 401Ks than Roth IRAs, so let’s start with them.

Pros

Tax Advantage – Like 401Ks, the contributions you make to your IRA are tax-deductible.

More Investment Options – Unlike 401Ks, you will get to choose which financial services company you open your IRA with. Each company charges different fees and offers different services, so you can find the firm that fits your investment needs best. You will also have much broader investment options when compared to the options your company selects for your 401K. This allows you to further diversify from the 401K investment options selected by your employer. (See this post on the benefits of diversifying.)

Cons

No Employer Match – The biggest con when comparing IRAs to 401Ks is that there are no employer contributions. If you are offered a 401K match from your company, you should ALWAYS choose to contribute up to their match percentage before you consider opening an IRA. If you don’t, you are leaving money on the table.

Early Withdrawal Penalties – Like 401Ks, there are penalties for early withdrawals from your IRA. Since the money contributed to your IRA is tax-deductible, the penalty is the same as with a 401K, taxes plus about a 10% penalty.

Low Contribution Limit – The contribution limit for IRAs is less than half of 401Ks at $6,000 annually if you’re under 50, and $7,000 annually if you’re over 50.

Roth IRA

Pros

Tax-Exempt Withdrawals – The biggest advantage of Roth IRAs is, by far, that all of the earnings you make on them are tax-exempt. The main difference between Roth IRAs and other retirement accounts is that the money you contribute is after tax. This means that you have already paid income taxes on it. This is the money in your bank account that you can use to buy anything you want. When you invest your money in a Roth IRA, any earnings from your investments are tax-exempt. So, if you contribute $5,000 and make 10% or $500 on your investments, you will NEVER pay taxes on that $500 you earned. Not even when you withdraw it. Legally earning income without paying taxes is nearly impossible. That is why Roth IRAs’ tax-exempt withdrawals are so incredible.

Penalty-Free Withdrawals – Another huge advantage to Roth IRAs is that you can withdraw any contributions you’ve made penalty-free. If you contribute $5,000, you can withdraw that $5,000 any time you want. No age limit, no taxes since you’ve already paid them, and no penalties. This makes Roth IRAs the most liquid retirement account option. (Again, more on liquidity here.) Any earnings you make on your Roth IRA investments are subject to a 10% penalty if withdrawn before age 59½. This penalty would apply to the $500 you earned on your Roth IRA investments in the previous example. There are some other exemptions to these penalties, but we won’t get into those here.

More Investment Options – Roth IRAs offer all of the same freedoms as IRAs such as choosing who to open your Roth IRA with and the breadth of investment options available.

Cons

Low Contribution Limit – Roth IRAs have the same contribution limits as Traditional IRAs, and also have salary caps. If you are single, you can’t contribute to a Roth IRA if you make more than $139K, and if you’re married you can’t contribute if you have a combined salary of over $206K. You can only partially contribute if you are single and make between $124K-139K, and married and making between $196K-206K combined. Roth IRAs should be started as early as possible, so you can contribute as much as you can before you reach the salary cap. Once you reach it, you will have the highest possible amount invested, and be able to take advantage of tax-free compound interest until you reach retirement.

No Employer Match – Same as with Traditional IRAs, you won’t get any free contributions from your employer.

Key Take-Aways

1. Always contribute up to your full employer match to your 401K before contributing to any other retirement account.

2. Roth IRAs are the most liquid retirement account. Once you’re contributing up to your full employer match to your 401K, consider opening a Roth IRA.

3. If you’re self-employed or your employer doesn’t offer a 401K, consider opening a Traditional IRA to take advantage of the tax benefits.

After opening any of these retirement accounts you will need to decide how you want to invest your money and build your portfolio. (Info on building your portfolio can be found here.) Building a diversified portfolio and allowing compound interest to work its magic over time is the key to becoming an old rich bitch with your retirement accounts. Since you already know how to build a diversified portfolio, next week we will discuss the magic that is compound interest.

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Drink Up!

The Recipe for Liquidity

When you hear the word liquidity, your thoughts probably go to water, or wine, or something similar. And up until the late 1800s, that is exactly what this word was associated with, the quality of being liquid. In 1897 however, the term began being used in finance and not because people were using liquid money. After an extensive search into why this word started being used in finance, I have come up empty handed. If you have any insights into this, please enlighten me in the comments below.

Anyway, now that you know that we won’t be discussing mixology or any other liquids, you’re probably asking, “WTF does liquidity mean?” Liquidity is how quickly you can turn an asset into cash at its current market value aka full price. Anything that is bought and sold has a level of liquidity. Cash is the most liquid asset because, well, it’s already cash! Other assets, including investments and physical assets, have varying degrees of liquidity. Below we will discuss some of the different asset types and why their liquidity levels differ.

Investment Assets

Last week we discussed the varying risk levels associated with different investment types, and how to structure your portfolio to reduce risk. (see that post here.) While investments vary in riskiness, they also vary in liquidity. Some investments such as certificates of deposit (CDs) have fixed investment periods. These are basically loans you’re giving to the issuing entity. They work like this. You buy a 10-year CD for $1,000. The issuer pays you a defined amount of interest for 10 years, and at the end of the 10 years they pay you back your $1,000 principal payment. Since the investment period is defined and you won’t receive your principal back for 10 years, this asset is considered illiquid. If you must sell early, you will incur a penalty, which means that you will sell the CD at below market value. Since the definition of liquidity is how quickly you can turn an asset into cash at its current market value, this loss in market value for selling early is another example of why CDs are considered illiquid.

Like CDs, stocks and bonds are two other investment types, but they offer much more liquidity. Stock and bond markets are always open for trading. This means that you can easily buy and sell them at their current market value whenever you want. However, always having the ability to sell does not mean that you will always sell at a profit. If you bought a stock for $10 and in 3 years you needed money and decided to sell your stock, you would be able to sell it (pro), but if the stock price had declined to $8, you would sell at a loss (con). Being able to easily convert an asset to cash doesn’t mean that you will always make money on that asset, but it does mean that if you are in a bind and you need money now, you can get it by selling your asset at full price.

How about investment accounts like 401Ks and IRAs? 401Ks are not liquid. Once the money is in your 401K, you will not be able to take the money out without incurring a penalty until your sixties. Again, part of liquidity is receiving the full market value for your asset, and the penalty you incur from an early withdrawal means that you are not receiving the full market value.

Roth IRAs are a much more liquid retirement account. The money you contribute to your Roth is after tax, meaning that you already paid income tax on it, so you are able to withdraw any contributions you’ve made to your Roth at any time. This does not apply to any earnings you’ve made. You’ll still have to wait for those. But it does give you a penalty free withdrawal option on your contributions. This means that if you contribute $1,000 to your Roth, earn $50 on your investments in your Roth, and then need to withdraw money, you can withdraw up to $1,000 without any penalties. Not bad! And why Roth IRAs are a great liquid investment option.

Physical Assets

Some other personal assets you may own are a car and a house. These are physical assets. Unlike stocks and bonds, physical assets tend to be less liquid. You may have heard of people “pricing their house to sell”. Obviously everyone prices their house to sell, but this phrase means that they listed it at below market value because they want to sell it quickly. To reiterate again, selling at below market value to get money fast means that the asset is not liquid. Why, my friends?! Say it with me now! Because for an asset to be liquid, you must be able to easily convert the asset to cash at the FULL MARKET VALUE. You all are liquidity pros! Go reward yourself with some actual liquidity, a drink!

JK we’re not done yet. It is hard to find a buyer for your house because it is unique due to the area it’s located in, the number of bedrooms and bathrooms it has, its style, how well maintained it is, etc. When you narrow down everyone looking to buy a house to those looking to buy a house with your house’s specific criteria, the number of potential buyers gets pretty small. If someone wants to buy stock in Apple, all of the shares being bought and sold on the market are the same, so buyers and sellers can easily trade whenever they want. This sameness is what makes stocks liquid. The uniqueness of physical assets is what makes them less liquid.

So far, we’ve discussed liquidity in terms of personal finance, but liquidity also applies to companies. The liquidity of a company is determined by the amount of cash they have on hand and the amount of liquid assets they have. Just like its important for you to have a savings account in case you lose your job or experience a hardship, the same is true for companies. You want a company to also be able to pay its bills in the event of a hardship. Let’s take a look at the varying degrees of liquidity for a company’s physical assets.

A company will have many physical assets. This will include their building if they own it, all of their machinery, inventory, cubicles, computers, artwork, literally anything they own that you can physically touch. General office items such as cubicles, computers, desks, copiers, etc. will be easier to sell, or liquidate, than more industry specific equipment. The more specialized a piece of equipment is, the smaller the market is for people looking to buy it. Therefore, the more specialized a piece of equipment is, the less liquid it is. Sound familiar?

The same is true of a company’s inventory. The more specialized their product, the less liquid their inventory is. If a company makes luxury yachts, they won’t be able to sell their inventory quickly because the market for luxury yachts is small. On the other hand, a company that makes little black dresses has a liquid inventory because everyone needs at least one LBD!

When determining the financial well being of your personal finances, or a company’s finances, liquidity is a key component. Making sure you have enough money in your savings, along with other available funds to pull from, like your Roth IRA, is important to make sure you have enough liquidity to stay afloat during any unforeseen challenges. It is also a key factor you should use when evaluating your investment strategy, alongside risk. Keep your stress low by managing your risk level, and your health in tiptop shape by managing your liquidity. And, of course, indulging in your liquidity of choice. I’m off to indulge in mine. Wine!

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The Golden Rules of Finance

During my first finance class in college, my professor drilled two principles into my head.

1. The greater the risk the greater the expected return.

2. A dollar today is worth more than a dollar tomorrow.

These two principles can be used when making all of your personal finance decisions, and here’s how.

The first principle, the greater the risk the greater the expected return, will apply to your investing strategy, and also demonstrates why your credit score is so important. But what makes one investment riskier than another?

There are several key factors to consider when looking at an investment’s risk level. One is the length of the investment. For example, if you invest in something like a Treasury Note that will repay you in a year or so, you can reasonably assume a couple of things. One, that the economic conditions should not change dramatically over that time period. And two, that interest rates will remain close to what they currently are. Based on these assumptions, you can conclude that you will receive your original investment plus your return on investment in a year. Since the investment time period is short, the future is better known, meaning there is less potential risk that the market will fluctuate and change the amount of your return or result in a loss. On the contrary, let’s say you invest in a 30 year Treasury Bond. There is no telling what the market will be like in 30 years, so there is a higher risk associated with investing your money in the 30 year treasury bond. Therefore, you will require a premium to be added to your rate of return above what the rate of return is for a Treasury Note.

A second factor in an investment’s risk level is the likelihood of default, or how likely the institution you invest in will be able to pay you back. Rihanna understands this principle well. Bitch better have my money! In general, US Treasury Bonds are low risk. This is because the likelihood of the US government falling apart and the US dollar being worthless are pretty slim. It doesn’t always seem like it in today’s political climate, but its true. In contrast, government bonds from a country experiencing a lot of turmoil, like Venezuela, would be high risk. There is a higher likelihood that their government could fall apart and their currency could diminish in value. So, a person investing in Venezuelan bonds would require a greater return than a person investing in US bonds.

Stocks are another investment type, and are considered riskier than bonds. This is because companies are subject to all sorts of market factors that the government isn’t. Let’s use Lexmark, a printer making company, as an example. In the 1990s when Lexmark became a publicly traded company, it probably looked like a solid company to invest in. People printed everything. Many people didn’t have home computers yet, so they didn’t have personal emails where they could receive documents, smartphones didn’t exist, and computer memory was waaaayyy smaller than it is now. But with the memory storage increases, the development of the cloud, the spread of personal computers and smartphones, printing has been declining rapidly. You even see companies now working to become completely paperless. Still think Lexmark would be a good investment in today’s world? Probably not. This is what makes stocks riskier than bonds. The likelihood that there will be unexpected changes in business is inevitable, and you’re betting on a company’s ability to ride out those bumps. Since stocks are riskier, the return you should expect to get on them is higher than bonds.

And here is how your credit score works into this. The lower your credit score, the riskier YOU are to a bank! A lower credit score tells a bank that if you take out a loan with them, you may not be able to pay them back. And banks are in the business of making money, so they charge you a higher interest rate because you are riskier to loan to. See my post on how lower interest rates can save you lots of money.

Ok, principle two! A dollar today is worth more than a dollar tomorrow. Essentially, the definition of inflation. This is a really important concept when you look at your savings. It is EXTREMELY important to have a savings built up, but most people will lose money in their savings account over time. I don’t mean lose money in the sense that the balance will go down. If you have $1,000 in your savings account now, you will still have $1,000 in your savings account in 10 years. But here is the kicker. You will be able to buy less with the $1,000 you have in 10 years than you can today because of inflation. (Disclaimer: I am not advocating that you spend the $1,000 now!)

Here is how it works. Year 1 is the year when you open your savings account and deposit $1,000. Let’s assume that over the next 10 years the inflation rate will be 2% every year.

YearSavings BalancePurchasing Power
1$1,000$1,000
2$1,000$980
3$1,000$960.40
5$1,000$922.37
10$1,000$833.74

As you can see in the chart above, in year 10 the money in your bank account is still $1,000, but it has less purchasing power than when you put it in. So what happened? Each year the inflation rate was 2%, so prices rose by 2%. If you tried to buy something that cost $1,000 in year 1 you could have done it, but in year 2 you would have needed 2% more money, or $1,020 to buy the exact same item. So your $1,000 had less value, or purchasing power in year 2.

Fear not! There is a way to combat at least some of the effects of inflation on your savings. A great option is to open a high interest savings account. These offer much higher rates of return than your typical savings accounts. The average annual inflation rate is projected to be 1.9%, and these accounts currently offer rates that are slightly under that. By utilizing a high interest savings account, most of your risk of inflation is mitigated.

And there you have it! The two golden rules of finance!

1. The greater the risk the greater the expected return.

2. A dollar today is worth more than a dollar tomorrow.