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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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Portfolio Diversification 101: Investing in a Unicorn vs a Herd of Cattle

Let’s face it. None of us can predict the future. We don’t know when the next stock market crash will happen, when the market will hit new highs, or which companies will be the next Unicorn. This is why individual stock picking is so hard. Yes, sometimes you get lucky and buy a stock like Apple when the company is in its infancy, and years later you become a rich bitch. But picking the unicorn of companies to invest in is like playing the lottery. Pure luck.

To increase your odds of winning the investing lottery, you can diversify your portfolio.

Portfolio Diversification Basics

Let’s start with some investing basics. Buying Apple’s stock is an investment. When that stock is grouped together with all of your other investments, this conglomerate of investments makes up your portfolio. Your investment portfolio includes all of your stocks, bonds, real estate, crypto currencies, etc. Your goal should be to receive the highest possible return on a portfolio with a level of risk that you are comfortable with. (To get a more comprehensive understanding of the risk/reward trade off, see this post.)

Stock picking, like playing the lottery, has a high level of risk because the odds of you winning are very low. If you manage to beat the odds and win, you will receive a high return, but most people lose money playing the lottery. The same concept can be applied to picking a unicorn company (this is a real term by the way). Venture capitalists use this strategy. They invest millions of dollars in lots of risky startups, and sometimes they get lucky and find a unicorn company and make shit loads of money. But most of the time, they’re losing money on their risky investment choices. This is like buying a bunch of horses with a disease that turns 1% of them into unicorns the other 99% die. The odds aren’t great and you’ll probably end up with a bunch of dead horses. So if you’re a venture capitalist, you can stop reading now. For the rest of you, let’s keep going.

Decreasing Your Risk with Portfolio Diversification

To decrease your level of risk you want your portfolio to be well diversified. This means that your portfolio contains various investment types, in several market sectors, and in diverse geographical regions. This type of investing is more like buying a herd of cattle than a unicorn. You have lots of cows (investments), and if one gets sick, you still have the rest of your healthy herd (portfolio) to keep making you money. It isn’t as shiny or fun as investing in a unicorn, but it is a much less risky investing strategy. So how do you choose well-diversified investments for your portfolio? You have several options.

Target-Date Funds

My favorite diversification option is to invest in a target-date fund. A target-date fund is a diversified fund that decreases your risk level as you get closer to your target date. This is popular with retirement accounts like 401Ks or IRAs where the target date is your retirement date. The premise behind this is that a higher percentage of your investments should be in riskier assets when you are younger because if you experiences losses, you have plenty of time to recover from those losses before retirement. The closer you get to retirement, the more impactful losses will be because you will have less time to recover from them. Therefore, you should reduce the risk level of your portfolio and lower the percentage of your investments in riskier assets as you age. Target-date funds do this for you. Each year they will reallocate your investments based on your target date and automatically reduce your risk over time. This saves a lot of time on your end, and an added bonus is that many of these funds have low or zero trading fees, and minimal maintenance fees.

Index Funds & ETFs

If you don’t want to use a target-date fund, you can research your own strategy for diversifying, and then pick investments that fit it. See the chart below for an example of different asset allocations in a portfolio.

Chart from an article by Fidelity Investments.

If you decide to build your own portfolio, two great options for diversifying are index funds and Exchange Traded Funds (ETFs). Indexes track a group of companies. You are probably familiar with these even though you may not know it. The S&P 500 index compiles 500 companies and tracks all of them together as 1 investment. The Nasdaq and Dow Jones do something similar. There are also lots of foreign indexes to choose from.

Index funds can be quite expensive, so ETFs allow you to buy a portion of 1 share of the index fund. This way, you can still reap the diversification benefits of the index, but at a fraction of the price. Both of these investments track the overall market in a region as opposed to a singular company. This can be beneficial when certain sectors of the market burst or perform poorly. A great example of this was when the dot-com bubble burst in the 1990s. If you were heavily invested in tech stocks and were therefore not well diversified, you would have lost a lot of money compared to someone who had investments in many market sectors. Again, when one cow is sick, you still have the rest of the herd.

The downside to structuring your own portfolio is that it is much more time consuming because you need to reallocate your investments at regular intervals (ie: annually) to compensate for any percentage changes that have occurred. For example, if you had a really great year and made a lot of money on your US stocks, you may now have too high of a percentage of your portfolio invested in US stocks and need to reallocate the extra funds to the rest of your portfolio. On top of that, you will also need to review your overall investment and diversification strategy as time goes on to make sure you are reducing your risk over time. Unless you are extremely interested in investing, I don’t suggest this approach.

Hire A Financial Advisor

The last option is to pay someone else to manage your portfolio for you. Unless you have hundreds of thousands of dollars or more to invest, I think this is a terrible option. Your portfolio manager will charge you tons on fees that will eat into any gains you make and lower your overall return. They also usually don’t perform better than the market, so why pay them to do what you can for free!

So there you have it! Don’t invest in the shiny unicorn. Invest in the herd of boring ass cattle! Slowly but surely and with minimal stress, they will make you a rich bitch!

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BUY BUY BUY!

Should you snooze on timing the market?

In last week’s post, we discussed how market volatility can be beneficial to your investment portfolio if you capitalize on the dips in the market by buying stocks “on sale”. (If you haven’t read that, you can find it here.) In that post, I gave the example of a pair of Nikes going on sale for 20% off, and we concluded that you would obviously want to buy the Nikes on sale as opposed to at full price. When the market declines and stock prices go down, the same principle applies, and you want to invest at the lower “sale” price.

To get the highest possible return on your investments, you need to invest at the lowest price, and sell at the highest price. Trying to predict future prices to perfectly time your buy or sale is called timing the market. Sounds simple enough, right? WRONG!

A few months ago, the panic surrounding the novel coronavirus caused investors to liquidate their investments, and stock prices plummeted. A large scale sell-off, like the one caused by the coronavirus, decreases stock prices because the selling of shares signals that investors think stock prices are about to decline, and they are trying to sell their stocks at the highest possible price in order to receive the largest possible return. When other investors see this, they also want to sell at the highest possible price, so they then sell their shares, which further devalues the stock, and the trend continues. The algorithms that are now used to buy and sell stocks further complicate this, but that is a topic for a whole different post.

With stocks plummeting, it now becomes a buyers market. But how will you know when the sell-off stops and the stock is at its lowest price? Bad news, you won’t. In these scenarios, unless you are lucky enough to be the first seller before the price drops, or the first buyer before the price starts to increase, you didn’t time the market properly.  While sales on goods usually have a defined start and end date, as wells as a defined discount, the stock market is not as transparent. Timing the market to wait for stocks to be at their lowest price to buy, or highest price to sell, is nearly impossible. On top of that, the amount of anxiety you will feel trying to make these decisions will be paralyzing.

To avoid the anxiety around picking the perfect time to invest, and usually failing, I recommend using a long term investing strategy with a phased in investing approach. So how do you do this? Let’s say you have $1,000 you want to invest. Instead of trying to pick the perfect time to invest all $1,000, you could invest $200 over the next 5 weeks, or $100 over the next 10 weeks, or $200 over the next 5 months. You get it.

This approach helps mitigate any losses you may experience from a down period that occurs after you make your investment. Since market volatility is just that, volatile, you may think the stock is beginning to rebound only to see it drop significantly again. If you phase your investments in and invest the $200 over 5 months, you will only experience a loss on the portion of your $1,000 that you’ve already invested, and you will be able to capitalize on investing the rest of the $1,000 at the now lowered price.

Take a look at the table below.

Approach 1Approach 2
MonthMarket ChangeInvestedBalanceInvestedBalance
1-2% $1,000 $980 $200 $196
2-3% $-   $951 $200 $384
3-2% $-   $932 $200 $572
4-4% $-   $894 $200 $742
53% $-   $921 $200 $970

Approach one uses a lump sum investment, and approach 2 uses phased in investing. You can see that if the market continues to decline and you use a phased investing approach, you will be able to capitalize on the decline in prices, and have higher returns at the end of the down cycle.

The downside to this approach is that it also works in the opposite direction. So, if you phased your investments in during an increase in the market, this would have the opposite affect on your investments, and the lump sum would give you the higher overall return. Let me be clear that using a phased in approach and making some investments at a higher price does not make these investments losses! Basically, this means you bought one pair of Nikes on sale, and the next pair at full price. In both cases, the Nikes are still well worth the money, you just got a better deal on the first pair.

Since it is so hard to time the market, and nearly impossible to predict what will heavily impact it (did you see the coronavirus coming?), minimizing your stress about investing, while making smart decisions to create a generous return for yourself is ideal compared to trying to perfectly time the market, failing, and not investing at all or losing money by paying a financial advisor to do it for you. (News flash, financial advisors also didn’t see the coronavirus coming.)

To minimize your stress, set up an investment account and make small, regular investments over many years. This allows you to use the higher returns you will receive from investing during a downturn (sale pricing), to compensate for the higher prices you will invest at during the up swings (regular pricing), all while never having to worry about what the stock market is doing. Pick an amount of money that fits your budget, and auto invest it at regular intervals. This is an easy and worry-free long term investing approach that anyone can start today.

Now that you’ve set up your investment strategy, you will need to decide what you will invest in. And you guessed it, that’s next week’s topic!!

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Stocks On Sale!

You’ve probably heard that you should BUY! BUY! BUY! (*NSYNC voice) your stocks right now since the market is down. On the surface, this doesn’t seem to make any sense. Investors are losing money, so why should you put your money into something that is decimating others’ fortunes? I’m here to give you the DL.

I am a believer in the Efficient Markets Hypothesis. This hypothesis says that the market price of a stock reflects all of the available information about that stock. Basically, the market price is a correct reflection of all of the available information on the company, and unless you have insider information, you won’t be able to beat the market.

Warren Buffet is an example that this assumption is not always correct. You can find stocks that are undervalued and buy them at a low price. Later when the price goes up to reflect to true value of the company, you will make money and beat the market. So while it is possible to beat the market without insider info, it is only possible if you dedicate all of the time that Warren Buffet has to finding undervalued stocks. And even most of the financial advisors and fund managers who dedicate this amount of time, produce an average annual return on their hand selected funds that is equal to, or less than the average market return over the long term. If trained professionals rarely beat the market, and Warren Buffet is either the only billionaire investor you know by name or one of a few, my guess is that you will probably not be successful using this investing strategy.

So then the question becomes, how can you maximize your returns if you can’t beat the market? I have good news. The market, on average, goes up over the long term. There will be short-term peaks and valleys, and when stocks start to dip, investors’ instincts are to sell before they lose more money. But if you’re playing the long game, which I suggest you do, this makes little sense.

I’m 30, and I do a quarterly review of my financial situation. Each quarter since I’ve started doing this, my investments and net worth have gone up…until my April 2020 review. The coronavirus has caused me to lose money on my investments for the first time in my life.  But unlike many others, I didn’t sell off any of my investments and I’m not worried about them.

Unless you are near retirement, this dip in your investments is only a paper loss. A paper loss means that when you look at your account, the funds in your account are less than the amount you invested. If you withdraw the money, this becomes a real loss. Here is an example. Q1 2019 you invested $100. Q1 2020 you had $90 in your account. So after 1 year $10 is your paper loss amount. If you withdraw the $90 from your account, this loss will become a real loss of $10. Instead, you can leave the $90 in your account and wait for the market to improve over time, since as we learned earlier you should receive a positive return on the market over the long term.

On average, the market’s annual return before adjusting for inflation is about 10%. So in 5 years, your $90 should become about $145. This means you will have a paper gain of $45 above your initial investment of $100. While you will have to wait longer, if you withdraw your money after 5 years you will then have a real return of $45. If your retirement date is many years in the future, you have plenty of time to recover any losses you’re experiencing now. And this is why you should not sell off your investments or be worried.

Now that you have an understanding of why these dips aren’t as scary as they seem, we will discuss how you can actually benefit from them.

In Q4 2019, the market was up and had experienced its longest expansion to date. Everyone was making money and loving it. Let’s say for this example that the S&P 500 Index was trading at $100/share in Q4 2019. Then along came the coronavirus, which led to global shutdowns, the fear of supply chain disruptions, job losses, and stocks plummeting. So now with the coronavirus in full effect, let’s say the S&P 500 Index is trading at $80/share at the end of Q1 2020. The stock lost 20% of its value, but basically what this means is that the stock is on sale. (This assumption only applies to well-diversified portfolios, or index or ETF style funds. It can, but does not always apply to individual company stocks.)

Let’s take a look at a tangible example. If you want a pair of Nikes that retail for $100, and then buy them for 20% off during a sale, you would say you got a good deal on them. The same goes for stocks. Next week the Nikes will be priced back at $100, and next year the index fund’s price might be back up to $100, and in both scenarios it is best to buy at the sale price.

While the sale prices of goods are more transparent and well defined than stock prices, the principles behind buying at the lowest possible price remain constant. Timing the perfect buy is very challenging, but next week, we will discuss the process for investing during a downturn.

Read our next post in this series on timing the market.