Why Liquid Net Worth Matters

Why Liquid Net Worth Matters

“Liquidity is a good proxy for relative net worth. You can’t lie about cash, stocks, and bond values.

Mark Cuban

Understanding your net worth and how to calculate it is hugely important for measuring your financial health at a particular point in time. It is simply the difference between assets and liabilities. However, it doesn’t consider the liquid nature of your assets.

For example, stocks and bonds tend to be more liquid than other assets as they can be quickly and easily converted into cash. Other assets like your house or car take time and negotiation to sell if you need money. Net worth remains a helpful benchmark but depending on the type of assets you have it may be a less accurate picture.

Liquid Net Worth Is A Realistic Snapshot Of Your Financial Condition

Liquid net worth is what really matters. It is a far more realistic reflection of your financial condition should you face an immediate need for money such as a medical crisis or a business opportunity. While liabilities remain the same for both calculations, your liquid assets have more significance when unforeseen events occur.

Those assets for readily available as cash with little or no loss of value to be counted in liquid net worth. Having liquid money provides a sense of financial security for disasters and opportunities alike.

Asset Rich Cash Poor Can Be Uncomfortable

To a great degree, when you need to take money out to pay for an unforeseen event, would it be easier to take $15,000 out of your savings account or sell your land? Depends if you have $15,000 in the bank. The expression “asset rich cash poor” comes to mind. Often, people have economic assets like land or other economic interests but are not able to easily liquidate them for money.

Land and antiques are assets we have owned and enjoyed. However, you can’t count on those assets to pay for a costly emergency in your life. When I think about mistakes I have made, those purchases stand as major regrets. You sleep easier with access to liquid assets.

What Is Net Worth?

Your net worth is your personal balance sheet that provides a snapshot of your financial position at that time. Net worth is all that you own less than all that you owe. For an expanded explanation, see 10 Reasons Why You Need To Know Net Worth.

The  Formula: Net Worth =  Total Assets less Total Liabilities

Using an excel spreadsheet with different assets/liabilities is an excellent tool for you to put all of your categories in one place that can be periodically updated. You should do it on at least a quarterly basis. However, if you are true to your monthly budgeting, reviewing your monthly net worth is better.

Try putting it on a spreadsheet first. You can use Personal Capital’s net worth app for tracking your investments. Frankly, any way you can keep on top of your net worth with an eye towards building the amount will work.

Knowing Your Net Worth:

  • is a crucial benchmark and report card at a particular time.
  • will allow you to set near-term and long-term goals.
  • track its changes for better money management.
  • highlight your liquid asset balances.
  • helps you to get a loan for a house, car, college tuition, or new business.
  • pay down high-cost debt.
  • refinance your mortgage loans.
  • encourage you to save and invest more.
  • buy your own home, rather than pay high rent.
  • is a great road map to building your wealth.

 

What Is Liquid Net Worth?

Although net worth provides a view of your current financial condition, it doesn’t differentiate the assets that can provide you with liquidity quickly and easily. When facing a medical crisis or an opportunity to buy a business, getting access to your money matters. Sure, you can sell your car quickly but likely for less than the estimated value. Understanding what assets are more liquid means they can be readily converted into cash with little or no loss in value.

The Formula = Liquid Assets Less Total Liabilities

You can either remove non-liquid assets from your total assets or discount their values from their appraisals. Additionally, you need to recognize that tapping certain assets too early such as retirement accounts could result in paying penalties and taxes. More than that, you lose momentum when you withdraw assets that were benefiting from compounding growth.

 

Your Liquid Net Worth:

  1. Understand the differences between your net worth and liquid net worth. Liquid net worth is what you need to count on for immediate funds.
  2. Liquidity varies among our assets which have different growth rates. Money market accounts are liquid but typically have lower returns than stock investments long term.
  3. Consider costs involved in the transactions such as penalties, taxes, fees, and such

 

How To Calculate Your Liquid Net Worth?

Liquid Assets:

  • Cash
  • Cash-Equivalent Securities
  • Brokerage/Investment Accounts

The most liquid assets are cash, cash-equivalent (or money market) securities, and investment or brokerage accounts. These are either already in cash or are those financial or monetary assets that can easily turn into cash with little or no loss in value.

Cash is the best form of liquidity but of course, doesn’t grow unless it is invested.  This category broadly consists of cash on hand, prepaid cards, savings accounts, checking accounts, money market accounts, certificates of deposit (CD), savings bonds, and emergency funds. If your CDs are in a fixed term like 6 months or a year, you may need to pay a small prepayment penalty but this is fairly accessible money. Separately, you need to have an emergency fund earmarked for unforeseen expenses.

Brokerage/Investment Accounts

All types of financial securities can be bought or sold in your brokerage account. Typically, they are stocks, bonds, REITs, mutual funds, and ETFs that are in these taxable investment accounts. While these accounts are liquid in a matter of three business days, you do pay taxes on price appreciation based on the time you held the security. Holding the securities for over one year is taxed at a lower 15% capital gains rate. Otherwise, you pay taxes at the same rate as ordinary income.

Less Liquid Assets

The cash value of your life insurance policy is fairly liquid but you may have to absorb small fees. Depending on the company, it can take more time (eg. 10-20 days) than access to financial securities. On the other hand, access to pensions and investments in real estate such as multifamily homes are less liquid.

Retirement Accounts

When withdrawing money from your retirement accounts before you turn  59.5 years,  you will likely be hit with a 10% penalty and immediate payment of taxes, losing the deferred benefit on that amount. Generally, if you withdraw early from a 401K plan or IRA account you will pay taxes at your marginal tax rate. The marginal tax rate is the tax rate paid on the dollar of earnings (eg 22%-24%).  On the other hand, Roth IRAs are treated differently. For those accounts, so long as you have had this account five years or more, you may withdraw contributions you made to your Roth IRA anytime tax-free and without penalty.

While you may have access to your retirement savings, these are not considered to be liquid. You should not dip into your retirement accounts unless needed as a last resort. By withdrawing these funds, you lose the compound benefit on this money for your future when you are less likely to earn money at your job.

A Temporary Exception

The federal government had waived the 10% penalty if you made a withdrawal between January 1 and December 31, 2020, for those impacted by COVID. Qualified individuals that put back this withdrawn money within a three-year time frame will be excused from paying taxes on the money.

If you are including retirement accounts in your liquid net worth, you should discount your retirement balances by 25% to be conservative.

529 College Savings Accounts

Like retirement accounts, withdrawal of money saved in a 529 college savings plan may be subject to a 10% penalty and you will have to pay taxes. The exception to this rule for 529 savings is withdrawals made for qualified education expenses such as tuition, fees, books, computer, and related costs.

If you are including 529 accounts into the liquid net worth, I would use a similar discount of 25% off the account balance.

Other  Assets

The cash value of your life insurance policy is fairly liquid but you may have to absorb small fees. Depending on the company, it can take more time (eg. 10-20 days) than access to financial securities. On the other hand, access to pensions and investments in real estate such as multifamily homes is less liquid.

Tangible assets

These assets are real and personal property that reflects your lifestyle and is harder to liquidate for funds.

Your Primary Home

If you own the primary home you live in, this may be your largest asset. While the home is an investment, it is not a liquid asset like financial securities you invest in. You cannot count on liquidating real property for quick conversion to cash. You need to figure out how the real estate market is faring in your area using Zillow Zestimate and other sources.

Selling your home is a complex process that can take several months or more to accomplish. An appraisal value is not necessarily your sales price which is often lower. Also, to complete your sale, you are responsible for fees and costs including broker fees of 5%-6% on the sales price, closing costs of 1%-2%, and attorney costs.

Most likely you are carrying a mortgage that is picked up in total liabilities. Upon the sale of your home, you will pay off your mortgage in full from the proceeds of the sale of your home, reducing your liabilities.

Your primary home as an asset should be discounted about 25%-30% off its estimated value for purposes of liquid net worth.

Other Real Estate

Besides your primary home, you may own other types of real estate, including vacation or second home, timeshares, land, and rental property. Having just sold a plot of land, I can tell you that we took a 30%-35% hit from our cost basis in an ugly market after putting it on the market over a year ago.

Use current conservative market values for real estate. Appraised values may not reflect actual sales or liquidated values. You should not be inflating your liquid or net worth unrealistically.

You would need to approximate the value of your home, cooperative, condominium, cars, boats, and any other large items. To approximate real estate values, you can look at Zillow Zestimate, Redfin, Chase Home Estimator, or real estate websites for your zip code.

Your Business(es)

If you own businesses outside of your primary income, it is tricky to calculate a value let alone consider it to be a liquid asset. While you may want to include in your net worth statement a discounted multiple of annual revenues, it doesn’t make sense to include for purposes of liquid net worth unless you had the business appraised and a ready buyer.

Personal Property Is Tricky To Value

Unless you have a meaningful fleet of cars and boats, you should not add these to your assets for your net worth or liquid net worth.  These assets depreciate too fast and sell too slowly to add fairly to your liquid net worth. If you do have that fleet, for cars, you can look at Kelly Blue Book, Edmunds, or AutoTrader. Similarly, for boats, you can consult Boat Trader.

What Else Goes Into Total Assets?

Art, rare books, rugs, and antiques may be a large part of the net worth of wealthy households handed down to the next generation. Unless they are highly desirable or rare, these assets tend to be wildly low liquidated values to count on if you needed money in a pinch. Musical instruments have their value, but again, they are very difficult to peg and their sales are less predictable to raise capital.

This category has a lot of sentimentalities but its value may be very difficult to ascertain. In my opinion, these assets should not be counted on unless you work with an estate professional steeped in knowledge and who has a terrific network to help you sell the items.

My Own Personal Experience Provides A Valuable Lesson

When I worked on Wall Street, I was restricted from making investments in financial securities. If on that rare occasion I was able to buy certain securities, I was often not allowed to sell that security when I wanted to. So, on either side of the trade, I was burned and finally abandoned investing until I left my career as an equity analyst.

So what did I invest in?

A large part of our assets was in art, rugs, rare books, and antiques. What was I thinking?

These assets are on our walls (art), in our bookcases (rare books such as the first edition of the Federalist Papers), on the floors (ancient rugs), and antique furniture (signed in the mid-1760s by the cabinetmaker).

Ever try to sell an 18th-century Tiger Maplewood card table? We have! And we are still waiting for that sale.

Beautiful stuff, but they can’t pay the bills! So I don’t include these personal assets. The few pieces we have sold were at prices 70% below what we paid for them.

I digress but a worthwhile lesson for those who are collectors.

List all your Liabilities By Current Balances

 

Mortgages

  • Your mortgage loan balance is probably your largest liability.
  • The home equity loan balance.
  • Separate mortgage loan balances for the other real estate property (listed above in assets)

Other Loans

  • Student loans at the current balance.
  • Loans associated with the business(es) even though you aren’t including the value of the businesses.
  • Personal loans
  • Credit card account balances (you should break these out individually).

Related Post: Pros And Cons of Credit Cards

Total Liabilities

As mentioned earlier, the formula is fairly easy:

Total  Liquid Assets minus Total Liabilities = Your Liquid Net Worth

Depending on the composition of your assets, it is possible that your liquid net worth may be negative, especially when you are conservatively discounting large assets like your home but including the full mortgage balance. It is important for you to consider whether you need to adjust your investment strategies, spend less, save more, and make sure you have money for emergency purposes.

 

How Can You Build Up Your Liquid Net Worth: Make Good Trade-Offs

Track changes in your liquid net worth statement as early as possible to make sure you are making progress towards your goals.

Track your spending, review for areas you can reduce and produce savings

Have an ample emergency fund of 6-12 months for unexpected events like a lost job. Invest this fund in a liquid account like money markets.

Put more of your money into investment assets like stocks that can expand wealth rather than in personal possessions.

Add to your retirement accounts to the contribution limit. Avoid withdrawing money from these accounts which trigger penalties and taxes. The same goes for 529 plans.

Making more money at your job or a side gig to boost income.

Consider buying recently used cars than luxury fast-depreciating vehicles.

Choose to invest based on your appetite for risk and where you are in your life cycle.

Related Post: How To Make Better Trade-Offs

Where Should I Invest My Money To Maximize My Liquid Net Worth

Stocks are riskier but generate higher returns than keeping your savings in bank accounts at low returns.

According to Bankrate, the best annual percentage yield (APY) which is your effective annual return as of August 28, 2020 ranges from  0.60%- 0.91% for the top ten banks. Those paltry rates which do not provide much in the way of income. Typically, banks may require a minimum balance from $1 to $25,000 and have monthly fees up to $15.

The younger you are, the more able you are to ride out the greater risk found in stock investing, with the benefits of compounding effects.

Homeownership remains a worthwhile investment with currently low mortgage rates. But your home is less liquid than financial securities.

Decreasing your loans or debt liabilities will increase your liquid net worth.

Your Mortgage Loan Deserves Your Careful Attention

Look into refinancing your mortgage if you carrying a mortgage with more than 5% loan rates. You may realize savings.

Target carefully what you borrow, for how long, and at what rate. Look at taking out a 15-year mortgage loan versus a 30-year mortgage loan. While your monthly payments will be higher for the 15-year loan, total borrowing costs will be lower.

Taking on a mortgage loan is a big cost but home prices have generally kept pace with inflation until 2008-2009 when subprime mortgages played a huge factor in declining home values.

Lower Your Debt Where Possible

Pay off your credit card debt in full. It’s likely your highest cost debt so use extra savings, bonus, or tax refund to lower this amount. Otherwise, slow your spending.

Pay off your student debt as soon as you are able.

Final Thoughts

While net worth is a more common benchmark, refining your assets for liquidation purposes gives you a more realistic picture. Tracking liquid net worth helps you to understand your ability to deal with a crisis or an unexpected opportunity. When facing an immediate need for cash, you don’t want to withdraw funds that are earmarked for retirement.

Thank you for reading! If you found this of value, consider reading other articles on our blog, and join us by subscribing to The Cents of Money. Please let us know your thoughts!

How To Make Better Money Tradeoffs

How To Make Better Money Tradeoffs

“There are no solutions; there are only trade-offs.”

Thomas Sowell

There are tradeoffs in most aspects of our lives. We have a plethora of choices and cannot do everything we want to do. For every choice we make, opportunity costs requiring us to forego benefits for the option not selected. Opportunity costs are the loss of potential gains from other alternatives when making a choice.

Tradeoffs between time and money differ significantly based on age and lifestyle based on our unique set of values. With less time like Boomers as an older generation, you might place more importance on time while young people may favor money. That is not always the case.  Based on this global survey, those in the 20s and 30s tend to lean more time than money, valuing experiences over possessions than boomers, as seen in this infographic.

Each of us has to decide based on our characteristics and circumstances. Typical examples of trade-offs between time and money as we ponder our individual decisions, we:

  • Opt for a job requiring a long commute for a pay hike.
  • Have one income with mom or dad staying at home with the kids.
  • Go to a movie instead of working on an assignment due the next day.
  • Job security with the government or seeking a wealth opportunity with long hours and traveling.
  • Attend a community college initially, then transfer to a four-year college.
  • Work at home to spend more time with family.

Sure, we can try multitasking or combine activities when we face conflicting demands on us. However, there is often a price to pay when poor execution results.

Make Diligent Choices

Instead, we may inform ourselves by making diligent choices. How conscious are we when we make these decisions? For some decisions, make complex financial calculations as needed. On the other hand, there are times when we may not even be aware of having made a choice. Time, money, productivity, and health may act as alternative constraints, reflected in your priorities.

Time is a precious finite resource we often waste. Even if we have unlimited capital available, we just don’t have the time to spend it fruitfully. We want to enjoy our lives to the fullest, with health on our side. Without taking care of ourselves, time is short, and no amount of money may cure our illness. Since we have longer life expectancies, we need to support ourselves by fulfilling well thought out financial plans.

Typical Tradeoffs We Face:

 

Your Home: Buy or Rent

Owning versus renting your home is among the most common tradeoffs involving personal preferences, age factors, and your financial situation. Our family has rented and owned our home. After many years of ownership, we are renting a home in a lovely town, taking advantage of a great public school system.

If you seek to own a home, do you prefer stability, building equity, control over the home, and its responsibilities and tax benefits? Will you enjoy a sense of pride in ownership? These benefits come at a high cost based on a 20% down payment and mortgage loans for 80% of the home’s principal price, with interest rates strongly determined by your credit scores. The opportunity cost of owning your home may prevent you from saving for retirement and making other investments. Your home will not likely appreciate more than inflation.

The term of your loan can vary based on 15 years versus 30-year mortgages–another trade-off. The longer the loan, the lower your monthly payments. However, the 30-year mortgage raises your total costs compared to the 15-year loan.

Financial Implications For 30 Year versus 15 Year Mortgage

When comparing the different loan maturities on a $300,000 loan:

  • The APR will be higher for the 30-year mortgage than a 15 year one, all else being the same.
  • The monthly mortgage payments will be significantly higher for the 15-year mortgage, given the shorter period. If you can afford to pay the higher monthly amount, you are better off with the 15-year mortgage because you pay less in total interest.
  •  Assuming you have a 720 credit score, the total home price, including total interest paid and down payment, will be lower with a 15-year mortgage loan.
  • The 30-year mortgage is much higher because you are paying interest on your loan longer, so the total home price or principal is $375,000 plus $189,622, equalling $564,620.
  • If you opt for a 15 year mortgage, your total home price or principal  is $375,000 ($300,000 loan + $75,000 down payment of 20%) + $76,012 in total interest equals $451,012 for principal and interest.

On the other hand, renting provides flexibility and freedom. Your rent is usually more affordable than home costs, not having to deal with the home’s repair and maintenance, freeing you to use savings to make investments, and not have to worry about potential declining home values. The downside of renting your home has restrictions to do what you want to make your place more livable. Your landlord could decide to sell the property and require you to move. There is always the risk of having a bad landlord whose actions force you to pick up and leave.

My Take

The necessity of the tradeoffs of owning your home versus renting considers the tug between time and money differences.  When buying your home, you are making a long term commitment to the neighborhood, greater responsibilities in maintaining the property, insurance, and keeping up with monthly payments for some length of time. Alternatively, renting is usually a shorter-term commitment that may require future moves but with less responsibility and costs.

For families who want to control their home, buying is the way to go, especially if you can handle the shorter mortgage terms so you can pay off your debt sooner. Understand your long term goals for your family and financial priorities for your money. Don’t take on too big a house that you can’t afford. Renting is a great choice, especially if you don’t want the headaches of your own home. We compare advantages and disadvantages in our guide to owning and renting your home here.

A Car: Buy, Lease or Borrow

If owning your home is seen as the American dream, our culture has long embraced car ownership as a faithful supplement to our lifestyle. When seeking a car, you have a few alternatives. Do you want a new or used car, preferably certified pre-owned? Are you buying or leasing this car? If you are getting this car for personal rather than business use, the tradeoffs between buying the car with a loan or a lease are relatively straight forward. Assume you are getting a new car in a low-interest-rate environment and similar credit scores whether you are buying or leasing. About 30% of those getting a new car is leasing.

The Advantages And Disadvantages Of Leasing A Car:

There are lower upfront costs requiring a security deposit and usually the first month’s payment. Payments for registration and taxes are needed for leasing and buying the car. When leasing, you will make lower monthly payments for the lease term. Your credit score influences the amount, favoring those with very good to excellent scores.

The manufacturer’s warranty covers most if the leased car’s repairs.

Depending on your term, you are getting the latest technology available in safety, entertainment, and comfort. Those who lease can get a new car every 2-3 years.

There are mileage limits on the car though you may be able to negotiate a bit.

You don’t own the car at the end of your lease. Gap insurance is an optional add-on car insurance covering the difference between the amount owed on a vehicle and its actual cash value in the unforeseen event it is totaled or stolen. When returning the leased car, you may have to pay for excessive maintenance, wear and tear costs.

End of lease costs can be a bit shocking when returning the car. When we finished our lease recently, we were quite surprised at some of the hidden fees discussed when we initiated the lease. We incurred costs close to $1,000 to the lessor to reimburse them for taxes to the local municipality. These fees were relatively new to us, causing dismay. This lease was likely our final one.

Advantages and Disadvantages Of Buying A Car:

Higher upfront costs, including down payment and trade-in, if you have another car. Of course, the more the upfronts costs, the lower your monthly expenses.

Owning presents higher monthly costs than leasing, depending on term length. According to ValuePenguin, the national average of US auto loans is 4.37% in 60 months, though in recent years, buyers have increasingly extended their loan terms to 72 months, with 84 months gaining popularity. The longer the loan, the higher the total interest you are adding to the car’s cost. Experian has reported that new car buyers with the highest credit scores have average loans of 63 months versus those with the lowest scores taking out loans of 72 months.

As you own the car, there are no restrictions on mileage or what tires you want. While you can resell your vehicle, keep in mind that it is a depreciable asset that loses value in the early years and is impacted by mileage long term.

My Take:

The tradeoff on buying or leasing a car is similar to owning or renting your home. A third option to buying or leasing a new car is buying a certified used car. Depending on its age and mileage, it may have remaining time left on the manufacturer’s warranty. After purchasing and leasing cars for years, we recently chose this third option. We paid cash for a 4-year-old certified Subaru as a second car, given its strong reputation for longevity. We are tremendously happy with it.

Spending vs. Saving

This tradeoff’s concern is that it ignores the need to temper spending in favor of saving money. If you spend more than you earn, you either will be withdrawing from your savings and investment accounts or, worse, borrowing to pay for your purchases. On the other hand, if you spend less than you earn, you can better afford your living costs and enjoy life. Having money left over to build an emergency fund, save for retirement, and make investments provides you with more options over the long term.

Adopt an attitude that allows you to enjoy life but not be so costly that you can’t afford your bills. Avoid lifestyle inflation, which comes about when your earnings rise, and you increase your spending. The more you can delay spending and reduce impulse buying, the better your financial health. Many experiences are free, healthy, and worthwhile pursuits. Make room in your budget for a solid emergency fund, pay off your debts to manageable levels, and save for retirement.

Emergency Fund Vs. Debt Payoffs

You should be put savings aside for an emergency fund to cover at least six months of essential living costs. This habit will eliminate the stress of the unknown and reduce your need to abuse your credit card. Many people lack $1,000 in savings to pay for unforeseen costs like a job loss, an emergency surgery for a favored pet, or a damaged car. Having to pay for these costs often leads to higher debt, especially credit card debt with higher interest costs. Set small savings amounts aside earmarked specifically for an ample emergency fund and invest this money in a readily accessible liquid account.

Paralleling these savings, you need to pay your monthly student loans and your credit card bills. If you can’t pay your credit card balances in full, reduce your spending. It is easier said than done. However, committing to keeping debt at a manageable level is critical.

Saving For College Or Retirement: A Tough Choice

When faced with helping your children with their college funding or tapping your retirement money, it becomes a tough choice you don’t have to make. If you are in your 50s or more, you should not touch your retirement account. True, you want to avoid burdening your kids with student loans early in their lives. The average student loan is $31,172, a significant amount of debt to carry. However, they have the benefit of a longer-term horizon than you.

As a young couple, your earnings are rising through your 20s, 30s, and beyond. To avoid having to make a difficult choice, later on, save, and invest now. These are the years you should make your money work for your future. It may mean spending less now, so you have more money to address critical areas of your lives later consciously. These involve essential trade-offs.

Don’t ignore what you can do now to provide plenty of benefits to you and your family long term. Handling money allocation into key baskets for college funding, retirement, and investments early will improve your financial outlook.

Save For College Early Using A 529 Savings Plan

When you expect a child, put aside some money into a 529 Savings Plan or other plans you can read about here. You get tax benefits using pretax money invested in several options based on your preferences. The more money you can put into these funds, the greater likelihood of lower borrowing in your children’s college years. Most states have their plans and have a lot of investment choices. Prioritize saving early in your child’s life so that you don’t have to borrow from your retirement funds.

Retirement Savings In Your 20s

You should begin to save for retirement as soon as you enter the workforce, if not before. Most employers offer 401K retirement plans that make it easy to fund your account through your paychecks. Automating these payments is simple though it may require an opt-in process. Setting this up at work is among the first things you should do when you start your first job.

Many employers will contribute to your retirement account based on a pre-determined match formula. For example, if you save a targeted percentage of 6% of your paycheck to your company-sponsored retirement plan, they may add 50% of that amount or an additional 3% of the money to your account. Separately, you should also set up an IRA or a Roth IRA and focus on contributing up to the maximum amount allowed.

Saving for retirement in your 20s allows you to have a sizable nest egg with compounding returns when you are ready to move to the next stage of life. On the other hand, catching up to saving for retirement in your 50s, while possible, is very difficult. It may mean working longer or tapering down your lifestyle in your later years. The risk you have of waiting too long to accumulate retirement money is that of losing your job in your 50s or if, for health reasons, you no longer can work.

Facing these tradeoffs head-on and early in life create a lot of flexibility and freedom in your later years. Make your money and time work for you as productively as possible. It is easier to sacrifice some choices for the more significant wallet needed later on. Long term comfort in retirement is a worthwhile aim.

Final Thoughts

Making tradeoffs that consider time and money may be intuitive or involve financial calculations balanced with your financial priorities. Addressing many major decisions early in life may provide you with financial flexibility and the freedom to choose an array of lifestyle options. The more you delay thinking about your choices, the harder the trade-offs you have to make. Your 20s and 30s are golden times to tackle savings as your earnings rise. Avoid finding more things to spend on that don’t positively add to your comforts.

Thank you for reading! Please visit us at The Cents of Money to see other such posts and subscribe to our weekly newsletter.

What kind of tradeoffs have you been facing? Did your choices involve your lifestyle or career? We would love to hear from you!

 

 

 

 

 

 

7 Steps To Buying A Home Thru Closing Day

7 Steps To Buying A Home Thru Closing Day

You and your family have decided to buy a house. Now what?

Buying a home takes about six months from your search to the closing day at a minimum. There is a lot to consider when likely making the biggest purchase of your life. So you will need to make some effort to get things in order.

Pay special attention to the steps we outlined below. You will be working with key professionals—real estate agent, banker, title insurer, attorney, inspector—that will be part of this process. Mortgage rates happen to be at record lows.

However, Don’t Hurry!  Ok, ready?

Step 1: Get your finances in order.

You will likely need a loan unless you have loads of cash to pay for your house. Hopefully, you have been budgeting and saving for a house purchase.

Review Your Credit Report

Review your credit file to make sure it is in good shape. You will need to check with the credit bureaus, Equifax, Experian, and TransUnion credit reports. Make sure your credit report is accurate. If not, make corrections to clean up your credit file. At the same time, look up your credit scores and see if there are ways you can raise your score.

You need a working estimate of what your ongoing monthly costs for your new home will be. The budget for your home will include the mortgage principal and interest cost, real estate property taxes, homeowner’s insurance, and mortgage insurance.

These costs could be at least 50% higher than what your current home costs are. You should look at current mortgage interest rate levels at www.bankrate.com. There are calculator apps to help you estimate your monthly payments. Look for a conventional fixed loan and consider a shorter term of 15 years versus 30 years. Your interest costs, and therefore your total home costs, will be lower. See our post on Making Better Money Tradeoffs, such as shorter-term loans.

Also, you are likely moving to a larger space. If so, you will need to calculate incremental utility costs (heating,  A/C, electric, and water).  These costs are different than the one-time costs associated with buying a house, which I will discuss below.

 Step 2: Prequalify For A Mortgage – Takes About One Month.

Before you actively go house-hunting, it is a good idea to get preapproved for a mortgage. It will help to narrow your search. By doing so, it will save you some angst from the disappointment of finding a dream home out of your price range. The pre-approval letter may expire between 90 days and 120 days, giving you an idea about how long you should time your house search.

Many online mortgage providers, such as LendingTree, Lending Club, or Rocket Mortgage by Quicken Loans, streamline the process. Find three lenders in addition to your banker in your local area to speak to at this point.

Pre-Approved Letters Reflect Motivation

Keep in mind, getting prequalified does not guarantee a loan. However, it does help to have a preapproved letter for a mortgage. Lenders want to see motivated buyers who have made an offer with a pre-approval letter from a lender or mortgage broker in hand. The sellers expect this and even demand it, so this step is a must.

Go to a lender, either in person or online, complete a form, provide your financial information to the most minute detail. They are looking for a good income and good credit history to pre-qualify you. When you decide that you are ready to purchase a house, what do you do? Location.

You’ve narrowed down the locale, the state, and the city or town. Now what?

Step 3: Search for your home online and in-person*. This process can take two months or longer.

Early in this process, you may what to explore desirable areas. Driving around can be a fun part of the process or emotional as you move to the next stage of your life. You will need to consider your budget. Brace yourself from making an impulsive buy of a too big or too perfect a home that will be difficult to afford.

Check on Zillow.com  to get an idea of what you get for your budget in terms of floor plans, features, square footage. You may want to go to a couple of Open Houses.

*During the pandemic, it is likely you will see homes virtually.

Should I Get A Real Estate Agent?

You may have started thinking that you will do your search without a real estate agent and deal directly with the listing real estate agent. As you probably know, the seller usually pays the real estate agent. Still, engaging a real estate agent is very important.

The search can be overwhelming. Ultimately, you may decide to grab an excellent real estate agent after all.  There are many pluses to this as a real estate agent likely knows the neighborhoods you are exploring. I recommend you interview a few real estate agents, so there is good chemistry. There is a lot at stake here for the buyers and agents.

Respect Your Agent

Once you have a real estate agent, make sure to understand the ground rules for working with your agent. You want your relationship to go smoothly. We hear some stories where the buyers are late to appointments or call the listing agent without their agent. Being late is a no-no. Respect your agent.

Unlike a rental arrangement, the seller pays both buyer’s and seller’s real estate agents. The agents split the commission per a written agreement. You should sign a representation letter so that you can be sure that the broker is representing your interests as the buyer, not his or her pocketbook.

Now you are ready to search for that new dream home. After seeing a “zillion” houses, you finally found the one for you and your family. The search can take two months or longer depending on the buyers, frankly.

Step 4: Always Negotiate  With The Seller

This step is complicated with some parallel tracks.

Now The Negotiations Begin

You can negotiate the price, the timing of the closing, the outdoor furniture, and other details.

Everything Is Up For  Negotiation,

Sometimes there are contingency clauses designed to protect the buyer in individual events. These clauses could be a down payment, usually between 3% and 10% of the house price. The down payment may be returned to the buyer if:

  • the buyer cannot get satisfactory financing;
  • the appraisal value done by the buyer’s lender comes in below the agreed-upon price, or
  • the home fails inspection.

Make a written offer for the purchase of the home.

Before accepting an offer, there usually is a counteroffer. The agent will submit a written offer once you are comfortable with a price. That offer should be subject to a formal contract review and approval by your attorney (more to come on that).  Your bid is also subject to home inspections by a qualified professional.

Home Inspection Is Needed

Once your offer is accepted, you will want to have a home inspection before signing a contract. 

Your broker should have a list of competent licensed home inspectors. They are usually civil engineers, retired building inspectors or experienced contractors. 

You should expect a DETAILED report of the inspector’s inspection of the house, from the roof to the basement. The information should highlight the defects and deficiencies that the inspector discovers throughout the house. Ask the inspector for repair estimates and how they would rank the repairs based on their urgency. This report should be written and delivered to you in a few days.

The home inspection could be a means to negotiate the price downward

The findings can help you negotiate preclosing repairs the seller will pay for or get a price reduction. It also gives you an idea of the work that you will need to address in the future. The inspector should also conduct a termite inspection and provide you with a wood-boring insect certificate. Your lender will require this certificate.

Depending on where you live, you will want a radon gas test. Radon is a dangerous, odorless gas that tends to get trapped in basements and crawl spaces. It quickly breaks up, but you first have to discover it. An older house, pre-1978, may have lead paint residue. After 1978 lead paint was no longer in use in the US.

Ask your inspector to check for lead paint. Buyers can move forward with a satisfactory inspection and an agreed price for the house. The next stage is the transaction deal memorandum or “The Deal Sheet”.

While this is all happening, the agents are generating a transaction deal memorandum for the parties.

Step 5: Hire An Attorney And Formally Apply For A Mortgage Loan

Once you make an offer for the house, you will want to hire an attorney. Their role is to write a contract of sale through the home’s closing. 

Typically the seller’s attorney will draft and present a printed form of a contract of sale, a seller’s rider, and a lead paint disclosure. Your attorney will then provide a purchaser’s rider in response. Riders are common additions for most purchase agreements containing provisions such as a buyer’s obligations and special conditions relevant to the deal.

The purchaser provides the down payment, which is a show of earnest money or good faith deposit. Attorneys review many of the documents in an exchange between the buyers and sellers.

Among those key documents that will need to be reviewed by your attorney are:

  • mortgage loan estimate
  • title documents
  • closing disclosure
  • title or uniform settlement statement
  • closing costs.

After you sign the purchase contract, you will formally apply for a mortgage loan.

Mortgage Loan

Getting a mortgage loan can take time, even though you have preapproval from a lender. That preapproval letter speeds up the process for getting a formal loan but could expire before you found your desired home.  It is a good idea to consider more than one lender. You will likely want a lock-in agreement for your mortgage, especially if the interest rate is changing. These agreements are usually for 30-60 days.    

Step 6: Prepare For The Closing

Once you have made an offer, you will need to engage an attorney to represent you in the title’s negotiations and the closing. With that in mind, we will explore the contract process through the eyes of a  New York residential deal.  In many states, attorneys are minimally involved, if at all. A contract is a fill-in-the-blank form prepared by the brokers and a title company. This step takes place within one month of the closing.  

Step 7: The Closing

Who attends?

There is some nervous excitement when you reach this step. Several key people attend the closing. They are the buyers and sellers, their respective attorneys, the buyer’s and seller’s real estate agent, the lender’s representative (either a paralegal or an attorney), and the title company’s representative, usually called a closer.

At the closing, the buyer signs the mortgage documents, the seller signs the deed, transferring the title to the buyer. The buyer writes big checks in exchange for the keys to the buyers’ new home.

You did it! Time to celebrate!

Final Thoughts 

 

Thank you for reading! If you found this of value, consider subscribing to The Cents of Money and receive some freebies and our weekly newsletter.

If you own your own home, how was your home buying experience? Please share your thoughts with us. We want to hear from you!

 

Common Credit Mistakes And How To Avoid Them

Common Credit Mistakes And How To Avoid Them

“No man’s credit is as good as his money.”

E.W. Howe, novelist

What is credit? Credit is defined as the ability to borrow money or something of value now with the understanding you will repay the lender later with interest. Managing credit well is one of the essential disciplines in your financial life. Developing good credit habits can enhance your financial health.

Unfortunately, there are many ways to make common mistakes that can be costly by lowering your credit score. A reduced credit score can make it difficult for you to borrow at a more affordable interest rate, fall behind in paying debt, or turn off landlords from renting to you.

You are not born with good credit, but you can earn it by handling your debt reasonably well. Understanding your FICO credit score may help you to raise it a few points to a better level. By doing so, you may get lower interest rates when you take out loans, shaving your interest costs meaningfully.

Determining What’s Important To Your Credit Score

Calculating the FICO Scores formula involves five different criteria:

Payment History: 35%

Payment history carries the most significant weight in your score. Payment history picks up on patterns of making consistent payments on time for the length of your credit. Having a more extended credit history is a better gauge than someone who has just received their first loan. Having a good track record of not missing payments and being on time works in your favor.

For example, making a late credit card payment, that is, a payment past the due date will hurt your score.

Those who are new to getting credit have to build up a practice of paying what they owe on time. Any occurrences of past-due accounts or delinquencies, especially for current amounts, are red flags. This component looks at different account types such as credit cards, retail or store accounts, installment loans, mortgages, and finance company accounts.

Credit Utilization: 30%

As a significant influence on your credit score, credit utilization is the ratio of your total outstanding revolving credit balances divided by full available credit. Revolving credit refers to your credit cards and credit lines you may have but does not include your car loan (unless on your credit card) or your mortgage.

The utilization ratio is also known as the balance of debt to available credit or debt-to-credit ratio. It measures how much credit you have used for the total amount available to you. You don’t want to “max out” your cards. You should not be above a 30% ratio as it will impact your score. Stay in the mid-20s range to be assured of not hitting the 30% level. Think twice before closing a credit card as it will have a negative impact on this factor.

Credit History: 15%

Lenders look at your credit history and your experience with credit matters. The length of time of your oldest credit account and the average age of all of your accounts determine your credit history. The longer you have an account, the better your credit score. If you are new to obtaining credit, it will take time to benefit from showing up in your score. Don’t close your old credit cards because they count positively in your credit history. 

Credit Mix: 10%

Lenders favor some variety of borrowing in your mix of credit. A borrower handling different kinds of debt products may reflect less risk to lenders. A person without a credit card tends to be seen as a higher risk. That said, don’t go out and get different kinds of loans for the sake of improving your mix.

New Credit: 10%

Your inquiry will be reflected on your credit report for up to two years when you apply for credit. That is called a hard inquiry. As such, it can negatively impact your credit score, particularly if you are making multiple inquiries. However, don’t let it stop you from doing comparison shopping for the same type of loan.

A soft inquiry occurs when you are checking your credit score or report. Someone other than yourself may make a soft inquiry by accessing your credit background for something different than a loan such as an employer. Soft inquiries do not generate negative hits.

11 Common Credit Mistakes To Avoid

Avoid making common credit mistakes. Becoming informed and determined to avoid these mistakes may yield great returns for you and your family. I will refer to the score criteria when relevant to a specific mistake you may be making.

 

1. Not Paying Your Credit Card On Time

You are required to pay the minimum amount by the due date on your bill as a credit cardholder. If your household is like ours, you probably lead busy lives. You probably are responsible for many monthly bills, not just your credit card bills. If you are late paying a card bill, you will likely incur $25 the first time you are late, but the amount will rise the next time.

Depending on the terms of your credit card agreement, you may face a hike in your APR on any balance you carry along with future charges. Lateness is pretty consequential to your credit score as payment history at 35% of the FICO score calculation is the largest component.

To avoid being late in paying the required minimum, you should automate payments of all your bills, including your credit cards, through your bank account. When it comes to paying your card bills, automate and don’t procrastinate. The penalty charges are punitive for a reason.

2. Carrying A Large Balance On Your Credit Card

Paying the minimum on your credit card bill on time is an easy fix and makes the card issuers happy. They stand to make a tidy sum on interest income at the high APR rate they charge their average customer. Roughly 58% of cardholders carry an average balance of $6,354 per person at the current average APR of 16.03%.

Of course, card issuers are happy because it is highly profitable. The problem for cardholders is those carrying balances result in paying extra costs on their purchases. Instead, pay your credit card balances in full. Otherwise, it takes years to pay off your current payments while piling on more debt as you continue to use your cards.

An Example

Let’s say you have a current balance of $4,000, and your APR is 16%. Typically, your minimum payment as a percentage of your balance, around 2.5%, or $96 that you owe. If you pay the minimum rate going forward, it will take you 18 years and four months, costing you $4,148.86 in extra interest charges to pay that balance. And, that assumes you never make additional purchases with that card in the future.

Carrying high balances is dangerous for your pocket, and it also has implications for your credit score. After payment history, amounts owed (accounting for 30% of your FICO score) is your credit utilization rate. If you are using too much of your available credit on your card, it may signal to the banks that you are overextended or a potential risk.

Stay Well Below The 30% Credit Utilization Rate

Using more than 30% of your credit utilization can negatively impact your credit score and future borrowing ability. Stay well below that 30% threshold. It is essential to tackle your high balances by making a plan to pay off your card debt, usually the most expensive debt you hold at the double-digit APR. Become disciplined about your spending wisely. Credit cards are convenient, too convenient if you tend to overspend. Cut your spending drastically if you want to have a chance to reduce a large balance.

How To Raise Your Score By Lowering Your Utilization Rate

Most of us don’t pay a lot of attention to our credit card bill, but we should. Your due date is when the payment is due on your statement and reflects the previous billing cycle charges. The last day of the billing cycle is your statement’s closing date. The due date is the grace period, typically 21-25 days, and falls between the closing date and payment. The credit card companies are required to give you this period, not because they are friendly folks.

You are required to pay by the due date to avoid penalties. However, you can benefit by paying your bill on or before the statement closing date, the last day of the billing cycle. By doing so, you can improve your credit utilization rate and, therefore, your credit score. For example, if you have a $3,000 credit limit, spend $2,500 but pay off $1,900 before the closing date, it will appear as if you spent only $600, or 20% of your credit available on that card.

Related Post: 6 Ways To Raise Your Credit Scores

3. Don’t Close Any Credit Cards

Even if you don’t use certain credit cards, don’t close these accounts. Often we have several credit cards that were once appealing because of certain features or through a favorite store. However, over time, you have lost interest and decide to close the account to worry about theft or temptation to use it.

Don’t do this—the length of your credit history matters for 15% of your credit score. The longer you hold open cards, the better, even if you aren’t actively using them.

My Mistake

I made this mistake with a Saks Fifth Avenue card I applied for and got 10% off a large purchase I happened to make for a special occasion. While I liked to browse their stores, I realized I didn’t want to have their card. So, I closed the card. Perusing my credit report months later, I got a ding on my report, which translated into a lower score. To avoid this mistake, simply throw unused cards in a drawer and say goodbye.

4. Not Reviewing Your Credit Report Periodically

According to an FTC study, one out of five people has found errors on their credit report. The sooner you find the mistakes, the easier it is to fix them.

Current and future creditors use your credit report and review its potential impact on your credit score. Others that may want or need access to your credit report are landlords, utility companies, insurance companies, prospective employers. Also, legitimate access to your credit report may be required by collection agencies and if you are a party of court orders.

Fixing Errors On A Credit Report

Fixing errors on a credit report is not difficult, but you don’t want to delay doing so. Delaying a review of your credit report may result in you having to pay a higher interest rate than you should when you apply for credit. Don’t wait for those needs to arise. The best way to fix errors, disputes, or possible fraud is to follow these instructions.

Besides looking for errors, you may be dismayed at some notations on your credit report. Your report may shine a light on poor judgment or reflection of your impulse spending habits. Additionally, it may help you to pinpoint potential fraud when someone has made unauthorized inquiries or purchases.

Fear of fraud may motivate you to make essential changes to get the information in good shape before shopping for a home or a car. We once found a tax lien for a small amount that was burdensome in applying for a car loan. Be timely when you encounter these issues. It is easy to forget when something is a small amount but remains a nuisance to do.

5. Not Reading The Fine Print On Your Credit Agreements

Fewer than 1 in 1,000 people take the time to read the fine print online, spelling out the terms and conditions in financial contracts like credit cards, insurance policies, car, or mortgage loans.  Not doing so may have long-term financial implications for you and your family.

Credit card agreements have incredibly complex terms and conditions. You should understand the particulars of the APR, penalty structure, the benefits from cashback, rewards, discounts, and other perks they are providing.

Terms of Your Mortgage

When you are buying a home, it is typically, for most people, your largest asset. True, your attorney plays a significant role in helping you through the home-buying process. However, you should understand the key elements of the mortgage loan and its interest rate, fixed or variable, prepayment penalties, and length of the term. How owed mortgage interest compounds (semi-annually or monthly) can make a difference in the total cost of your home.

To avoid problems later, become familiar with the typical terms and conditions for the respective agreements you are shopping for. Certain laws have been passed in recent years to protect consumers from providers. These laws, like the Credit CARD Act of 2009, recognize the imbalance that often exists between parties. However, you are responsible for understanding what you are signing. Yes, these documents can be boring and hard to understand, so ask questions.

6. Paying A Loan Off Early Can Hurt Your Credit

If you suddenly received an incredible amount like a bonus or an inheritance, you may want to pay off your loan. Be aware that there may be negative consequences. Some loans, if paid ahead of time, incur pre-payment penalties. These are usually relatively small and worth getting rid of the debt burden. While there may be a temporary hit to your credit score, it is probably beneficial in the long term.

You would want to weigh the value of saving interest over the time remaining on the loan. Usually, there is a relatively small ding to your credit score. Unless you seek a bigger loan and need the best rate possible, paying off a loan should not be a big deal.

How It May Hurt Your Score

When you do not have much payment history (35% of score) may not be a good idea to pay off a car loan. An installment loan is a type of contract involving a loan to be repaid through scheduled payments like for cars and homes. As long as they are paid on a responsible basis, these loans are reflected positively on credit score according to Experian. A good credit mix means there are different types of credit being used. Credit mix accounts for 10% of your credit score, so paying off a car loan may negatively impact your score.

7. Don’t Make Excessive Hard Inquiries For A Loan

Creditors get worried about people making too many “hard inquiries” that occur when applied to a lender of some sort. Lenders see this as a sign of risk that you may be overextending your debt. As we mentioned earlier, hard inquiries may hurt your credit score.

On the other hand, “soft inquiries” occur when someone is accessing your credit report for reasons having nothing to do with a loan. Instead, it is someone such as a landlord considering whether to rent their house to you. That inquiry is for reasons better to understand your creditworthiness as a reflection of your character.

Hard inquiries to your debt burden is often a big problem. These kinds of consequential inquiries come from those who apply for loans or have too many credit cards that they max out. If you have too much debt, applying for debt will worsen your situation. Instead, you should consider working with a financial debt counselor that can provide strategies to reduce what you owe.

8. Avoid Cards With Annual Fees Unless They Have Important Features You Will Use

Generally, there are so many credit cards to choose from without an annual fee that paying one seems like a waste of money. That, at least, is the conventional thinking. Some yearly payments of $550 or over are outrageous but appeal to those who enjoy the card less for the numerous benefits than the status symbol they provide.

If you have the time and desire, you likely can find credit cards with annual fees below $100. There is enough competition in the industry for you to find appealing rewards and money-saving perks that pay for the yearly fee. Just make sure that you will use these benefits. For most people, finding a competitive card with good perks and avoiding the annual fee is the better way to go.

9. Overspending For Rewards

Studies show that credit cardholders spend more when they use their card as compared to paying with cash. As such, this has been referred to as “the credit card premium.” Rewards offered by issuers are designed to encourage more spending in order to get more points or some other perk. Ever sit next to another table where the diners are actively comparing the points and rewards they have earned? I have, and often wish I could get a dollar for every time I did!

According to a recent survey from Coupon Chief, one in five consumers say the rewards are the best perk, ahead of 16% who responded that building credit was the most valuable benefit. More concerning, 52% of Americans don’t actively track their credit card points. Holders are attracted to getting something for free; however, they may be more costly to those shoppers who are tempted to impulse buys.

10. Fear Of Getting A Credit Card

You don’t have to get a credit card. A third of Americans don’t have one for a variety of reasons. They could be fearful of temptation to overspend, poor credit, or prefer an alternative to a credit card. I didn’t have a credit card for many years, and then I used it sparingly when I did. My parents never had a credit card and never accepted cards in their retail store.

Credit cards have many benefits, but ONLY if you use it responsibly as we discuss here. Don’t fear getting a credit card. Instead, learn how to pay balances in full and on time. Building credit is important as a means of borrowing money for buying a car or a house.

11. Don’t Get A Retail Store Card

The temptation of getting a store card often comes right at the point of purchase when the store clerk waves an application at you. “If you sign up today, you will get 10% off today’s purchase, Ma’am?” And, you say, “Sure, why not?”

Okay, let’s rewind that conversation so that you understand that retail store cards may be a mistake. A store card has limited use because you can only use it at that specific store or enterprise. That’s great for the specific merchant because they collect a lot of information to market daily offers to you.

Other merchants do not accept retail credit cards. On average, store cards charge higher APRs than credit cards, which are already high enough. The average APR for store-only credit cards was 24.06% in 2Q 2020 versus 16.03% for traditional credit cards, according to WalletHub.

They usually provide low credit limits, so you won’t get a big bang in credit availability to improve your utilization rate to hike your credit score. At the end of the day, retail credit cards have fewer benefits than traditional cards.

 

Final Thoughts

Creditworthiness is a valuable trait when you need to borrow money, or someone wants a good read of your character. Take steps to avoid common credit mistakes that will put you in good standing and help you raise your score. To be in good financial health, managing credit well is an important discipline. Develop and maintain good credit habits and keep your debt levels from overwhelming your life.

Thank you for reading! Please consider subscribing to The Cents of Money blog and receive our weekly free newsletter. Stay healthy!

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Finding Income In A Low Yield Environment As The Pandemic Persists

Finding Income In A Low Yield Environment As The Pandemic Persists

“Cash is king” is an old expression that implies that this most straightforward form of money has the most significant merit for investments. Liquid assets are desirable for their ability to be easily be converted into cash in times of financial stress.

When the stock market tanked in March 2020 due to the pandemic impact on our economy, those with cash on the sidelines were able to grab stocks at battered prices and benefit substantially. Participating in the market has been a challenging year unless you were holding a growth portfolio. Finding income from low-risk investments has been somewhat limited since the Great Recession and has become more so this year.

The Role of The Fed

The Fed, through its monetary policy, took swift action to deal with the economic downturn. They brought down the fed funds rate to nearly zero and expanded our money supply through aggressive quantitative easing measures. These necessary actions caused market interest rates, already low since the Great Recession, to their lowest levels historically.  We have commented on the Fed’s role in our economy and its impact on the markets here.

If you are an income investor, the low yield environment has been frustrating to earn returns. Retirees, and those who are risk-averse, often favor income investing. However, income investing is for anyone who wants to balance the risk in their portfolio.

Income generation will likely be a key priority for many people. According to experts, income investors are confronted with low-interest rates today, limiting their returns. So what are their choices? They can be patient or consider adding some risk to the portfolio, which will add better returns. I have faced a similar dilemma, concerned about having too much risk while reaching for yield.

What Is Income Investing?

There are several investment strategies, such as growth, value, and income investing or a combination to give you a more balanced portfolio. We wrote about growth vs. stock investing here. Income investing centers on building a portfolio of investments that are structured to generate income in predictable streams.

The income comes from interest payments earned from having cash in a high yield savings account, interest from bond yields, and stocks’ dividends. Income investors seek low risk, low volatility, stability in their investments that generate income to replace earnings after retirement. An income investing-oriented portfolio may be too conservative to build a retirement fund for someone in their 20s or 30s who have longer time horizons and better tolerate risk.

A more balanced portfolio can combine investments that provide more growth combined with less risky investments. Such a portfolio could be a mix of money markets, Treasury securities, municipal, and high-grade corporate bonds. To add more risk, stocks with good track records for paying good dividend rates can be part of this balanced approach.

 

Macro Background On Interest Rates And Inflation

Interest rates, the amount charged by a lender to a borrower, are keyed off the Fed’s fed funds target set as one of its primary policy tools. When the economy is weak, the Fed reduces the fed funds rate to stimulate the economy, influencing other borrowing rates. Consumers, if incented with a lower mortgage or car loan rate, spend and borrow money. Related post:

 11 Reasons Why Investors Need To Understand The Fed

As the economy recovers and strengths, it may cause inflation to rise. If inflation is too high, the Fed will raise the fed funds rate to cool off the economy. Inflation is when there is a general and steady increase in the prices of a basket of goods and services. Inflation reduces your future purchasing power compared to the money you have today. We have been experiencing low inflation, below the Fed’s target of 2%.

How Interest Rates And Inflation Impact The Markets

Interest rates and inflation rates can have a significant impact on stocks, bonds, and other investments.  When interest rates fall, the interest payments received from bank deposits decline. The low-interest rates will cause lower yields from income-generating investments like CDs, other money market securities, and bonds. Income investors rely on these investments for predictable income streams and to preserve their capital, but higher yields are hard to find unless you add risk. There are different strategies for an investor to add more income by balancing risk and diversification.

 The low-interest-rate environment should remain for the foreseeable future. What about inflation? Low-interest rates, if they do their job in stimulating the economy, can lead to higher inflation. If there has been a concern, it has been about zero inflation or deflation. Deflation is problematic because it means reduced pricing in goods and services.  Lower prices could lead to reduced wages, lower production hurting our economy.

Trade-Off Between Risks And Returns

All investors need to consider the risks and returns for their investment choices. Typically, risks and returns are positively correlated. Moving in the same direction means that making low-risk investments is usually commensurate with low returns while taking high risks should be compensated with high returns.

Wouldn’t we all seek low-risk investments to be rewarded by high returns? Madoff’s high return strategy turned out to be a spectacular Ponzi scheme.

Low-Risk High-Return Strategies

I can point to a few legal low-risk high return strategies if you look for income generation from money in savings. Here are a few possibilities  that may be beneficial for your pocket:

Refinancing your mortgage may produce savings, net of fees if you are currently paying a higher mortgage.

Paying off high-cost credit card debt will provide positive returns if you are being charged double-digit rates and carrying balances.

Reduce or eliminate other consumer loans if you can refinance loans at lower rates.

Improving your credit scores ahead of planned borrowing may produce some savings.

Lifelong learners can seek out learning new skills or training that can bump their salary.

Various Risks To Consider When Investing

Before anyone becomes an investor, you should understand that all investments carry risks. There are no free rides, but you can protect yourself from the downside of losing hard-earned money. While you may not be able to control all the risks, there are ways that you can protect yourself from them. The ability to take on risk varies by individuals based on age, income, net worth, lifestyle, time horizon, family responsibilities, and tolerance.

Here Are Some Of The Potential Risks:

Interest Rate Risk

Interest rate risk is a risk that occurs when interest rates rise, causing bond prices to fall. Bond prices and their yields have an inverse relationship, moving in opposite directions. When there is a high demand for bonds, bond prices rise, yield declines, and vice versa.

All money market securities and bonds have interest rate risk. As interest rates rise, the market value of existing debt securities tends to drop because newer bonds have higher yields.

Inflation Risk

Inflation risk, also called purchasing power risk, is the danger that your money will not keep pace with inflation. As such, your money will be worthless in the future than today.   When investing for the long term, be aware that inflation may diminish your returns. Deflation risk has the opposite effect. The value of an investment will decline in the face of lower overall prices.

Opportunity Risk

Putting financial resources into a bank savings account does not generate much income when interest rates are low. Putting money in a low yielding bank account is saving, not investing. As such, you incur opportunity risk from not pursuing higher growth options. 

Credit Risk

Credit or default risk is the uncertainty associated with not receiving promised periodic interest payments and the principal amount at the time of maturity from the bond issuer.

Liquidity Risk

You cannot easily convert some assets into cash without losing value, which is liquidity risk. An asset quickly convertible into cash with minimal loss is liquid. Treasury securities are notable for having strong liquidity characteristics. However, other investments such as real estate or collectibles have greater liquidity risk.

Time Risk

Time or duration risk refers to assets like debt securities that mature at different times. Typically, the longer the term to maturity, all other things being equal, the greater the risk. For example, a two year Treasury note should provide a lower return than a 30 year Treasury bond.

Volatility Risk

Market volatility risk varies between securities and even within an asset class. Typically, high growth tech stocks are likely to be more volatile than a utility stock.

Reinvestment Risk

Reinvestment risk is the risk that the return on a future investment may not be the same as the return currently found on the same asset. If you rolled over a CD this year that you owned in 2019, chances are you would be doing it at lower returns.

Where To Find Yield In A Low-Environment

Seeking income in the current environment is a matter of considering your risk-reward profile when putting together an investment portfolio. Sitting down with a financial advisor can be hugely beneficial. They likely have years of experience and talk to many investors facing the same predicament as you.

To help your understanding of the possible investments available and the relative risk, from the low to high risk, here are choices:

High Yield Saving Account

Keeping your money in a traditional savings account will not provide you much interest based on an annual percentage yield (APY). However,  it is a better alternative to keeping your money in your checking account. That is just a recipe for spending more.

High yield savings accounts are preferred over traditional savings accounts as they are known for rewarding with higher yields. Bank accounts are FDIC-insured up to $250,000 per account, so there is no risk. Restrictions like monthly fees, minimum balance requirements, and withdrawals offset offers of higher yields. During the pandemic, banks may have relaxed limits. Shop around as there is plenty of competition where you can get 0.80-1.00% APY.

Certificate of Deposits or CDs

A CD is an interest-bearing saving instrument purchased for a fixed period from three months to eight years. Minimum deposits may range from small amounts up to $100,000. CDs are FDIC insured, like bank accounts. CDs have slightly higher yields than high yielding bank accounts. For the best rates, check Bankrate for their best and latest rates.

The longer the period, the higher the rate on the CD. You probably don’t want to subject yourself to a more extended period if you expect higher inflation in the future.

Banks often have minimums of $1,000 with fixed rates are fixed through expiration. If you withdraw your money, you will likely pay a penalty charge. There are variable CDs where rates fluctuate.

Money Market Securities

Money market securities are a mix of short-term debt securities and are also known as cash-equivalents. Like high yield bank accounts, they are liquid as they can be quickly convertible into cash with little or no loss of value. These instruments are issued at a discount to par value by various issuers, borrowing for their short term needs. These money markets generally mature in one year or less and trade in the secondary market.

Money market securities differ by the issuer. The US Treasury issues Treasury bills; corporations raise short term capital through commercial paper (CP), banks issue negotiable certificates of deposits or CDs). A banker’s acceptance security is created by a company’s transaction with another and guaranteed by a commercial bank should the firm fail to pay the amount.

MMDAs And Money Market Funds

Money market deposit accounts (MMDAs) are government-insured from a depository institution. They vary on the size of account balance, the number of transactions each month, minimum deposits to open and maintain. Alternatively, investment advisers offer money market mutual funds. Money market funds are uninsured like the MMDA, but they may be more flexible in their terms.

Keep in mind, the income from money market securities is historically low. For example, a six month T-bill currently yields just  0.12% today, tracking our very low-interest-rate environment. Indeed, it is virtually risk-free that short-term T-bills have been traditionally more attractive to hold in a higher interest environment. While it is better than keeping your money in zero-interest savings accounts, it is not much in our pandemic-world of 2020. Historically, T-bills return 3.5% per year. The other cash-equivalent securities tend to trade at slightly higher yields than T-bills in a relatively narrow range.

Besides low risk, money market securities are for those that prefer liquidity and easy accessibility to money, particularly great for your emergency fund.

In the early 1980s, these cash-equivalent securities were very attractive, providing double-digit high yields in the face of a tough economy with high inflation. Keeping at least a small amount of your savings in money market securities makes sense for low-risk low return investors, especially when interest rates rise.

Government Savings Bonds

Series EE and Series I government savings bonds are promissory notes issued and backed by the US Treasury. Income generated is exempt from state and local income taxes. These are low-risk investments with low rates. The Series is available online through Treasury Direct. They can be bought at denominations as little as $25 and often are as gifts. Series EE provides a market-based fixed interest rate, and Series I adjusts for inflation.

Savings bonds have a 30-year maturity and can be redeemed any time after 12 months (if issued after February 2003). However, holders will lose the last three months of interest. Investors can report the accumulated interest or defer until maturity.

Bonds of Varying Risk And Return

Like money market instruments, bonds are debt securities issued by the borrower at below par for a fixed face amount with a specific interest rate (called the coupon). The issuer pays the principal on maturity.

To calculate your annual income streams from the coupon, you would receive an annual interest income of $40 on a $1,000 corporate bond with a 4% interest rate, paid semiannually. 

Bonds provide predictable fixed income streams. Bonds vary in credit risk from the Treasury securities rated AAA to municipal and investment-grade corporate bonds rated BBB or better. There are also corporate bonds that provide higher yields than investment-grade corporate bonds. The high yield bonds are often called “junk bonds” because of their more risky nature.

When you invest in a bond, you are effectively lending money to the issuer instead of owning part of a company’s equity when you invest in a stock. In the event of a default, a bondholder has a priority claim as one of the company’s creditors.

Bond prices and their yields have an inverse relationship, moving in opposite directions. When there is a high demand for bonds, bond prices rise, yield declines, and vice versa.

All money market securities and bonds have interest rate risk. As interest rates rise, the market value of existing debt securities tends to drop because newer issue bonds are at higher yields.

Treasury Bonds Are Safe and High Quality

In addition to the short term T-bills, the US Treasury issues Treasury notes (intermediate-term) and treasury bonds (up to 30 years). With these bonds, the Treasury is borrowing for long term needs as well as retiring debt. Longer-term maturities carry more yield based on more risk than short term securities. Like money markets, Treasury yields are historically low given the Fed actions that brought down interest rates when the pandemic impacted our economy.

Treasuries are considered virtually risk-free versus the other debt securities because of their triple AAA rating. Treasury investors have confidence in the full faith and credit of the US Government,

Historically, T-bonds returned 5.5% per year, but today it yields about 1.67%. Treasuries represent quality, safety, excellent liquidity and are modestly tax-exempt (holders do not pay state or local taxes). The primary risk in Treasuries is that they are subject to interest rate and inflation risk. To counter inflation risk, TIPs or Treasury Inflation-Protected securities adjust rates with the inflation-indexed CPI. Variable bonds that adjust inflation rates are also available in most fixed securities, particularly munis and corporate bonds.

Treasuries are desirable for many investors, especially those seeking quality, safety, and capital preservation. Without inflation protection, a bondholder with a 4% interest rate is fine if inflation is 2% or below. However, at that same 4% rate, the investor will be losing ground on your returns if inflation increases to 5% or more.

Municipal Bonds Have A Unique Tax Benefit

 State and local governments or municipalities issue general obligation bonds or revenue bonds for general long term needs, debt paydown, or infrastructure projects based on shifting population growth and regional employment. Minimum denominations are $5,000, so they are attractive for individuals and households. Muni yields at 1.52% on a 30 year AAA bond is close to the 30 year T- Bonds. Municipal bonds have better tax benefits than Treasuries.

Tax Exemption A Big Plus

Owning a municipal bond has outstanding tax benefits. Muni holders have federal income tax-exemption, and sometimes even state and local taxes are exempt. As a result, your aftertax returns on these muni securities will be higher than treasuries and may exceed the returns of riskier corporate bonds.

These securities are attractive, especially if your marginal tax rate is above 25%.

While rare, there have been some notable defaults, such as in housing. The default risk is historically low, below 1%. Muni bonds are generally safe, second to Treasuries in safety. An excellent way to minimize risk is to buy a municipal bond mutual fund bundled with diverse muni securities.

Corporate Bonds: High Grade Or High Yield

Corporations issue debt instruments vary by their credit risk, growth prospects, and potential restructuring. The higher-quality corporate bonds are investment-grade bonds, rated triple BBB, or better. They generate low-to-moderate returns historically. Yield is impaired in these securities as well in 2020. Moody’s current yield for the highest quality (Aaa) corporate bond is 2.36% versus 3.02% a year ago.

Disappearing AAA Corporate Bonds

There are only two corporate bonds with the coveted AAA ratings left: Johnson & Johnson and Microsoft. In 1992, there were 98 companies with the highest credit rating. Companies started increasing debt levels associated with merger & acquisition deals, leveraged buyouts, restructuring, damaging lawsuits, and the Great Recession.

High Yield Corporate Bonds

For risk-oriented investors seeking higher returns, high yielding corporate bonds could provide attractive returns. These are corporate bonds below investment grade and vary significantly. However, you need to do your homework as you would when buying individual stocks. I would recommend buying a high yield bond mutual fund readily available through Vanguard or Fidelity. Being diversified is your best path to exposure to these risky instruments.

The riskier, higher-yield “junk” bonds have higher yields than high-grade corporate bonds. Historically, junk bond yields are 3%-7% higher yields than investment-grade corporate bonds. Default rates are higher for junk bonds, rising to the mid-teens rate during the Great Recession. Typically, debt-heavy companies that are restructuring issue junk bonds. Today, investors seeking higher yields may want to consider high yield bonds currently in the 3%-4% range, but; remember these bonds carry higher risk.

Holders of corporate bonds do not have any tax benefits like treasury and municipal bonds. These bonds tend to have pretax yields higher than their brethren. Historical corporate bond returns average about 6% per year, below the 9%-10% return of the common stock. As creditors, these bondholders have priority claims in the event of a default, which stockholders do not have.

Preferred Stock

Preferred stock is considered equity but shares characteristics with bonds and common stock. This security is a type of fixed income ownership security in a corporation. Like a bond, preferred stock may have call provisions and rarely provide voting privileges held by stockholders. Preferred stockholders receive fixed dividends per share and have priority claims after bondholders but before common stockholders receive dividends. The market price of preferred stock is sensitive to interest rates, like bonds.

The attraction to income investors is the regular dividend payments. Investors can rely on dividends. Sometimes companies skip payments, due to poor results, for example, but are eventually paid to the holders of cumulative preferred stock provisions. Preferred stockholders have priority claim over the common stockholders. The preferred stock carries a higher risk than traditional high-grade corporate bonds but less so high yield bonds or growth stocks. For income investors, preferred stock may be a good alternative.

Not every corporation issue preferred stock. Specific industries are known to issue preferred stock, such as financial institutions, telecom, energy, and utility companies. You can buy them individually though, for diversification purposes, buying ETFs like iShares US Preferred Stock ( 4.93% yield) or Invesco Preferred (5.49% yield) may be more desirable.

 Common Stocks With Strong Dividend Track Records

With the highest historical  S& P 500 annual returns of 9-10% relative to money markets and bonds, stocks (“equities”) are attractive instruments to own in your portfolio. However, they are too risky for most income investors.

Income Stocks

This group of stocks is classified as income stocks (instead of growth stocks) because they tend to grow less quickly but are relied on for above-average dividends consistently paid. These stocks tend to be less volatile because of the higher dividend yield, which provides an anchor.

Companies or stock groups with above-average dividend yields are  ATT, Verizon, Kraft Heinz, energy stocks, utility stocks, and REITs. Dividends from REITs, or Real Estate Investment Trusts, are substantial because they are required to distribute at least 90% of their taxable income to their shareholders annually. The average dividend yield for equity yields is above 4%, making REITs an attractive investment.

They are presumed to be safer, defensive, and slower-growing companies. One concern is whether that high yield is vulnerable to a cut in its dividend. Look for high-quality companies that have a history of paying above-average dividends.

Blue-chip stocks that pay dividends may be an excellent place to go for companies that have been around a long time and have track records. Not all blue-chip stocks pay dividends.

Dividend Aristocrats

Income investors may want to look at Dividend Aristocrat stocks. These stocks are an elite group of companies in the S&P 500 that paid and raised its dividend every year for at least 25 consecutive years. There are more than 60 companies on this list in 2020.

This subsector of above-average dividend-paying stocks is attractive for income investors. Coca Cola, Johnson & Johnson, Dover, Chevron 3M are in this elite group for more than 50 years.

Final Thoughts

Income investing is known for its predictable income streams and preservation of capital. Finding income in a low yield environment may be difficult these days. Adding some risk to a basket of government and corporate securities and income-oriented may be a good strategy. Remember to remain diversified in your assets.

Thank you for reading! Please consider subscribing to The Cents of Money blog and receive our weekly free newsletter. Stay healthy!

 

10 Tips To Diversify Your Investment Portfolio

10 Tips To Diversify Your Investment Portfolio

“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”  Robert G. Allen

When you have some savings, it is good to invest and allocate your money to work.

Keeping too much of your money in your checking account is too tempting to spend and counterproductive.

The best time to begin investing is now—the earlier in your life, the better your wealth accumulation.

As you grow your savings, you want to consider your investment goals, risk tolerance, time horizon, and where to invest.

Investment Goals

How to invest and allocate may differ on a range of factors. You may adopt different strategies based on age, income, family responsibilities, lifestyle, financial resources, risk tolerance, and desires. 

 You are diversifying your portfolio by considering various asset classes: stocks, bonds, money markets, and real estate. We have some guidance for new and experienced investors: Investing Rules For Success-It’s Not Rocket Science!

At different points in your life, your priorities may be to realize one or more of the following objectives:

  • Buy your own home, finance your children’s education, take vacations, buy a car, or start a business.
  • Gain wealth and financial freedom.
  • Increase your current income or add some financial flexibility.
  • Meet your retirement needs.
  • Preserve your capital.
  • Set risk tolerance

There are degrees of risks for all types of investments. The exception is when you keep all your money in savings accounts in the bank where they are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per person and per bank account. However, you will earn little to no money.

Risk and reward, sometimes referred to as your return, are positively correlated. The risk/return relationship means that higher returns come with greater risk, while low-return investments come with low risk.

Investment Horizon

If your time frame is short given your age or needs, you may want to opt for low-risk securities versus someone who can invest for a 20-30 year horizon. They can better absorb risk and volatility.

 10 Tips For Diversifying Your Investment Portfolio:

#1 Asset Allocation

You should distribute your money among different assets based on your age and lifestyle. You can afford more risk in your portfolio at a younger age and be aggressive with more growth, such as stocks, than someone closer to retirement age. A good rule of thumb for allocation is to subtract your age from 100, and that would be the percentage of stocks in your portfolio.

For example, a 30-year-old could keep 70% in stocks (100-30) in the portfolio with 30% in bonds. On the other hand, a 60-year-old should reduce risk exposure and have 40% in stocks and 60% in bonds.

#2 Diversification Is A Must

Don’t put all of your eggs in one basket. Instead, you should be distributing your money among various classes of securities using an appropriate allocation. You should diversify within each security class. Investing in 10 energy stocks is not diverse. Branch out into multiple industries with different characteristics (e.g., high growth and strong dividend history).

# 3 Growth Stocks

Stocks provide more growth, appreciating faster than other financial instruments over the longer term. However, the stock market can be volatile, as witnessed by the 57% decline during the Great Recession. It is a good idea to buy mutual funds or ETFs when you are first investing to achieve a diverse stock portfolio.

#4 Money Market Securities for Cash

Investors can easily convert money market securities into cash without loss of value. They are low risk/ low return instruments with liquidity, stability and provide access to money. The Treasury bills rated AAA are the closest to risk-free securities. They can be bought individually or as part of a MM mutual fund, including other short-term securities.

While these securities are known for safety, they do not provide much income. The Fed has battled the COVID-impacted recession in 2020.  They reduced the fed funds rate to virtually zero and used aggressive measures. As a result, its needed actions have extended the low yield environment, challenging investors to find income from low-risk securities.

#5 Bonds With Different Characteristics

Investing in bonds is desirable for more predictable income streams. It is desirable to invest in various bonds: treasury bonds, municipal bonds, and corporate bonds. These all differ in terms of credit risk, liquidity, and tax benefits.

#6 Buy-Hold Strategy and Don’t Be Greedy

It is a prudent idea when building an investment portfolio to use a buy-hold strategy rather than trading securities. That said, don’t be afraid to pare down a holding that has appreciated too fast or begins to occupy a more significant proportion than you prefer. An old Wall Street saying is: “Bulls make money, bears make money, pigs get slaughtered.” I mean, don’t be greedy.

# 7 Understand factors that impact the financial markets

You should know the role of interest rates, their connection to inflation, and how the Federal Reserve’s monetary policy can significantly impact the financial markets. To calm the markets, the Fed stepped in with substantial liquidity to combat the economic downturn caused by the pandemic in 2020. The Fed reduced already low-interest rates, making it hard to find income for savers and risk-averse investors.

#8 Have Some Exposure to Global Markets

Investors seek potentially higher returns and exposure to faster-growing global markets, especially when the US markets are experiencing weakness. The best way to do that is to find an ETF or mutual fund representing the exposure you want.

# 9 Start Early To Benefit From Compound Interest

The earlier you begin to save and invest for retirement and investment accounts, the longer the time to take advantage of the power of compound interest.  Start in your 20s. Find a compound interest calculator, plug in some numbers, using what you can set aside monthly for investing.

Use a reasonable return (don’t use 12%, which I have seen and find it challenging to achieve. Instead, try 7%) and provide the number of years you have until your retirement.

# 10 Rebalance Your Portfolio Periodically

It is essential to periodically review your investment portfolio and consider rebalancing the various assets. Review it annually and make changes based on significant life milestones. Meeting with your financial advisor or accountant is an excellent way to review where your investments stand relative to you and your lifestyle.

Different Asset Classes

Common Stocks

With the highest historical  S& P 500 annual returns of 10% relative to money markets and bonds, stocks (“equities”) are attractive instruments to own in your portfolio. Investing in stocks is among the best ways to build wealth.

Common stocks represent equity ownership in a publicly-traded company or business enterprise. Your holdings reflect the number of shares you have. As common stockholders, you have voting rights on major company issues determined by your fractional share amount.

These equity shares are different than money market and bond securities, commonly referred to as debt securities. Owners of these instruments have creditor rights and do not vote like equity owners.

The Wealthy Get Wealthier, But You Can Get Rich Too

A recent study by the Federal Reserve in 2016 found  51.9% of families owned stocks either directly or as part of a mutual fund for investment and retirement accounts. However, the distribution of stock ownership by wealth percentile shows that the top 10% hold 84%, the next 10% have 9.3%, and the bottom 80% save 6.7%, according to a 2017 paper published by NYU Professor Edward N. Wolff.

Asset Allocation And Diversification

Recognize the challenges of investing. I have been an investor, an equity analyst, and I teach finance courses in college. As part of their requirements, students develop diverse stock portfolios using the stock market game. To a great extent, I share my experiences and mistakes during the bull and bear markets. Nothing prepares you for the next great crash as we had in March 2020. The unexpected pandemic of 2020 caused substantial market volatility.

Many factors impact the stock market. Investors should have a basic understanding of the economy, differences between industries, and company fundamentals. You need to understand the basics when investing on your own instead of having a financial advisor or buying mutual funds.

Learn about the differences between stocks, bonds, money market securities, and other asset classes. Be aware of what you own, whether it is individual stocks, or through mutual funds in your portfolio, setting up a  529 Savings Plan, or as part of your retirement accounts. Stocks tend to generate high returns but naturally carry higher risks and volatility than money markets and most bonds.

How To Determine Your Allocation

You need to manage the risk with a balanced portfolio with assets distributed among stocks, cash-equivalent securities, bonds, and real estate.

Generally, a stock allotment guideline in your total portfolio considers your age deducted from 100. So if you are 30 years old, you should invest 70% of your portfolio in stocks with the rest in a mix of money markets and bonds. The 70% percentage is conservative and can go higher to 80% allocated to stocks.

However, a typical 60 years old’s portfolio should divide their ownership more conservatively: 40% in stocks with 60% in bonds and money markets.

Diversification is essential and your best means for reducing risk.

Holding a broad stock portfolio, along with a variety of bonds and money market securities, smooths out the bumps you encounter. Investing at an early age helps to weather the ups and downs in the financial markets and benefit from the compounding of returns long term.

Once the shares are publicly issued, they typically trade on the New York Stock Exchange or the NASDAQ. The stakes are accessible for all investors to buy and sell. If they are privately issued, they are closely-held, usually by a small group of individuals who may be founders or families owning a substantial part of the business.

Stocks tend to be the most common investment vehicle for households, either through tax-advantaged retirement accounts or taxable investment accounts.

Active Versus  Passive Investors

Individuals and households can be active investors by buying the shares outright through brokerage accounts or Robo-advisors, thus becoming direct owners. Alternatively, as passive investors, they can buy mutual funds and exchange-traded funds (ETFs) representing indirect ownership of publicly traded shares.

If you are just beginning to invest and have limited resources and research time, consider buying a mutual fund or ETF.  Exposure to only one or two individual stocks is too risky.  I have different types of funds you can search for just below. Funds or ETFs will provide you with a more diversified basket of securities from the get-go. Later on, if you want to become more active, you can do your stock picking.

Those with more assets often have access to private money managers and hedge funds. Their fees are often higher than low index mutual funds and ETFs without necessarily providing higher returns.

Dividend income, dividend growth, and stock price appreciation determine stock returns. Related Post: How To Start Investing: A Guide For Investors

Choose from the different types of funds (or ETFs) that might fit your needs:

#1 Company market capitalization.

From large-cap company stocks with a capitalization of $10 billion to midcap stocks from $2 billion up to $10 billion range; and small caps of less $ 2 billion.

#2 Industry Sector.

You may be seeking one or more industries with different characteristics to counterbalance your portfolio. Adding tech, consumer discretionary, industrial, and finance companies would diversify risk.

# 3 Value stocks

Value stocks are stocks trading below their intrinsic value compared to their fundamentals. Benjamin Graham is the founder of this type of investing. Warren Buffett and Charlie Munger favor these strategies for their Berkshire Hathaway portfolio. Examples of value stocks are General Motors, GE, and Philip Morris.

# 4 Growth-oriented

Above-average growth comes with higher risk. These stocks appreciate at higher rates above the average for the market but don’t always pay dividends. Growth companies tend to plow their cash flow back into their business rather than pay dividends. A few examples of growth stocks are Amazon, Tesla, cloud companies like Salesforce, biotech stocks.

#5 Blended funds

A combination of value and growth stocks can offset some of the risks in # 4. 

#6  Dividend Growth Stocks

This group contains companies that have above-average dividend yields like ATT, British Petroleum, REITs. They are presumed to be safer, defensive, and slower-growing companies. Look for high-quality companies that have a history of paying above-average dividends. These names provide less risk but provide exposure to stocks.

# 7 Dividend Aristocrats

An elite subsector of above-average dividend-paying stocks not only provides above yields but are known for 25+ years of dividend increases. Chevron and PPG Industries are in this select group.

#8 Balanced

An investment portfolio should have a mix of different asset classes with fixed income and equity to help you achieve asset allocation.

#9 Index To A Specific Market Benchmark

It is difficult for the best portfolio managers with the expertise to “beat the market.” These funds track market indexes’ performances like that of the S& P 500 or the Russell 2000 for smaller cap stocks. These are prevalent ways to participate in the stock market.

# 10 Target Date Funds

These mutual funds adjust the asset mix based on your age and retirement plans. Vanguard has many funds labeled by decade eg. “2040.” They are appropriate for 529 Savings Plans and 401K retirement plans and a taxable investment portfolio.

# 11 Domestic or Global Markets

Suppose you may want to add international exposure to a mostly domestic-only portfolio for higher growth, especially if the USS is experiencing weak or recessionary growth. Several funds provide equity or mixed (including bonds) basket of companies in many countries, regionally oriented like Asia, or specific markets like China or India.

#12 Specialty funds

Gaining in popularity are specialty funds that contain stocks that represent companies with strong social responsibility or sustainability. ESG funds are portfolios of equities or bonds which address environmental, social, and governance factors into the investment process.

Money Market Securities

Money market securities are debt securities and are also known as cash-equivalents because investors can quickly convert them into cash with little or no loss. These instruments are issued at a discount to par value by various issuers, borrowing for their short term needs. These generally mature in one year or less and trade in the secondary market.

The US Treasury issues Treasury bills; corporations raise short term capital through commercial paper (CP), banks issue negotiable certificates of deposits or CDs). A banker’s acceptance security is created by a company’s transaction with another and guaranteed by a commercial bank should the firm fail to pay the amount.

T Bills or Money Markets Account

Individuals and households would largely buy the more popular T-bills with minimum denominations of $1,000. Individuals can buy a pool of money markets as an FDIC-insured money market denominated account (MMDA) or money market mutual funds. The investor would be holding a bundle of different money market securities, including Euro CDs issued in US dollars by European banks at higher yields is often in the funds.

On their own, the other money markets have higher denominations ($100,000) and are out of reach for the average household. Institutional investors often own or trade these securities.

For example, a six month T-bill currently yields just  0.12% today, tracking our very low-interest-rate environment. Indeed, it is virtually risk-free security but has been more attractive to hold in a higher interest environment. While it is better than keeping your money in zero-interest savings accounts, it is not much in our pandemic-world of 2020. Historically, T-bills return 3.5% per year. The other cash-equivalent securities tend to trade at slightly higher yields than T-bills in a relatively narrow range and low yields.

Besides low risk, money market securities are for those that prefer liquidity and easy accessibility to money, particularly for your emergency fund. Today’s yields are significantly lower than historically based on the Fed’s actions to combat the pandemic’s effects on our economy. 

In the early 1980s, these cash-equivalent securities were very attractive, providing double-digit high yields in the face of a tough economy with high inflation. Keeping at least a small amount of your savings in money market securities makes sense for low-risk low return investors, significantly when interest rates rise.

Older investors should be reducing their exposure to risky stocks and placing more of their portfolio in these securities and bonds

A Variety of Bonds

Like money market instruments, bonds are debt securities issued by the borrower at below par for a fixed face amount with a specific interest rate (called the coupon) and a specific maturity date when the issuer pays the principal.

To calculate your annual income streams from the coupon, you would receive an annual interest income of $40 on a $1,000 corporate bond with a 4% interest rate. The payment is paid semiannually or $20 every six months.

Bonds provide these predictable fixed income streams. Bonds vary in credit risk from the Treasury Bonds rated AAA to munis and corporate bonds with varying debt levels. There are also corporate bonds with high yields, so-called “junk bonds” because of their risky nature.

When you invest in a bond, you are effectively lending money to the issuer instead of owning part of the equity of a company when you invest in a stock. In the event of a default, a bondholder has a priority claim as one of the company’s creditors over stock ownership.

Relationship between bond prices, interest rates, and inflation

Bond prices and their yields have an inverse relationship, moving in opposite directions. When there is a high demand for bonds, bond prices rise, yield declines, and vice versa.

All money market securities and bonds have interest rate risk. As interest rates rise, the market value of existing debt securities tends to drop because newer issued bonds hav higher yields.

Warning: A Mini Macroeconomic Lesson For You

These securities also have inflation risk. There is a close connection between interest rates and inflation. Inflation refers to the rate at which prices for goods and services increase, reducing our purchasing power.

As inflation increases, so do interest rates. Interest rates, of course, are the amount charged by a lender to a borrower. The federal funds (“fed funds”) rate set by the Federal Reserve influences interest rates.

The fed funds are the interest rate at which depository institutions borrow and lend each other from their reserve balances overnight. That rate influences different interest rates, such as the prime rate, mortgages, and auto loan rates.

When inflation rises above the targeted 2% rate, the Fed, through its monetary policy, will raise the fed funds rate to stem inflation from going higher.

Related post: 11 Reasons Why Investors Need To Understand The Fed

As a bond investor, you don’t want your bonds to erode in value because of other bonds’ availability sporting higher yields. Issuers of Treasuries, municipal and corporate bonds know this so that they will offer inflation-indexed or protected securities. The yields on these bonds will adjust according to a formula linked to an inflation indicator like the Consumer Price Index (CPI).

Without that protection, a bondholder with a 4% interest rate is doing fine if inflation is 2% or below. However, at that same 4% rate, the investor will be losing ground on your returns if inflation increases to 5% or more.

Minimum denominations range from $1,000 for Treasuries, $5,000 for municipal bonds, and $1,000 or $5,000 for corporate bonds.

There are several different types of bonds with notable risk differences.

Treasury Bonds Are Safe and High Quality

In addition to the short term T-bills, the US Treasury issues Treasury notes (intermediate-term) and treasury bonds (up to 30 years). With these bonds, the Treasury is borrowing for long term needs as well as retiring debt. Longer-term maturities carry more yield based on more risk than short term securities.  Like money markets,  Treasury yields are historically low given the Fed actions that brought down interest rates when the pandemic impacted our economy.

Treasuries are considered virtually risk-free versus the other debt securities because of their triple AAA rating. Treasury investors have confidence in the full faith and credit of the US Government,

Historically, T-bonds returned 5.5% per year though they too are lower these days. Treasuries represent quality, safety, excellent liquidity and are modestly tax-exempt (holders do not pay state or local taxes). The primary risk in Treasuries is subject to interest rate and inflation risk. TIPs or Treasury Inflation-Protected securities are in demand as they adjust rates with the inflation-indexed CPI.

Treasuries are desirable for many investors, especially those seeking quality, safety, and capital preservation.

A True Story

I recall a story early in my Wall Street career when a friend of mine, a trader, had received an eight-figure bonus at the end of the year.

Curious, I asked what he was going to invest in with his bonus? With little hesitation, he practically yelled out, “Treasuries, of course!”

I was a stock analyst, and being surprised at his choice, I asked him why and he said, “Treasuries are safe, I have young children, I have all that I need, and I spend modestly, save abundantly, I donate generously, and I am risk-averse.”  That made more than a modest impression on me.

Municipal Bonds Have A Unique Tax Benefit

State and local governments or municipalities issue general obligation bonds or revenue bonds for general long term needs, debt paydown, or infrastructure projects based on shifting population growth and regional employment. Minimum denominations are $5,000, so they are attractive for individuals and households.

Tax Exemption A Big Plus

One of the outstanding benefits of owning a municipal bond is favorable tax treatment. Muni bondholders have federal income tax-exemption, and sometimes even state and local taxes are exempt. As a result, your aftertax returns on these muni securities will be higher than treasuries and may exceed the riskier corporate bonds.

These securities are attractive, especially if your marginal tax rate is above 25%.

While rare, there have been some notable defaults, such as in housing. The default risk is historically low, below 1%. Muni bonds are generally safe, second to Treasuries in safety. An excellent way to minimize risk is to buy a municipal bond mutual fund bundled with various muni securities.

Corporate Bonds: High Grade Or High Yield

These debt instruments issued by corporations vary by their credit risk, growth prospects, and potential restructuring. The higher-quality corporate bonds are investment-grade bonds, rated triple BBB, or better. They generate low-to-moderate returns historically. Yield is impaired in these securities as well in 2020. Moody’s current yield for the highest quality (Aaa) corporate bond is 2.32% versus 3.02% a year ago.

Disappearing AAA Corporate Bonds

There are only two corporate bonds with the coveted AAA ratings left: Johnson & Johnson and Microsoft. In 1992, there were 98 companies with the highest credit rating. Companies started increasing debt levels associated with mergers & acquisition deals, leveraged buyouts, restructuring, damaging lawsuits, and the great recession.

High Yield AKA Junk Bonds

For risk-oriented investors seeking higher returns, high yielding corporate bonds could provide attractive returns. These are corporate bonds below investment grade and vary significantly. However, you need to do your homework as you would when buying individual stocks. I would recommend buying a high yield bond mutual fund readily available through Vanguard or Fidelity. Diversity is your best path to exposure to these risky instruments.

The riskier, higher-yield bonds may be called “junk” bonds. Historically, junk bond yields are 3%-7% higher yields than high-grade corporate bonds. Default rates are higher for junk bonds, rising to the mid-teens rate during the Great Recession. Debt-heavy companies or those restructuring often issue junk bonds. Today, investors seeking higher yields may want to consider high yield bonds in the 3%-4% range but carry higher risk.

Drexel Burnham And Michael Milken

The earliest part of my career began at Drexel Burnham, known for developing high yield bonds by Michael Milken and his role in that market. That high yield market ultimately forced the company into bankruptcy. Mixed thoughts aside, many companies I covered as analyst survived and prospered due to those high yield bonds.

Holders of corporate bonds do not have any tax benefits like treasury and municipal bonds. These bonds tend to have pretax yields higher than their brethren. Historical corporate bond returns average about 6% per year, below the 9%-10% return of the common stock.  Bondholders are creditors who have priority claims in the event of a default, which stockholders do not have.

Rebalance Your Portfolio Periodically

It is essential to review your portfolio periodically and make sure it is balanced for your life. When you are young, you should take some risk given your longer investment horizon. As you grow older, you want to reduce risk by shifting more into predictable income streams.

Thank you for reading!

Have you reviewed your portfolio? Is it diversified enough? It is a good idea to work with a financial advisor or professional when considering changes. What strategies have worked for you? Please share your comments as we love to hear from you!

 

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