Tag: Finance Basics

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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.