Basic Concepts in Personal Finance

Financing your Life as a Student - Credit Card Management - Short Term Investing - Long Term Investing - Selecting an Investment Vehicle - Mutual Fund Indexing - Retirement Accounts

* Financing your Life as a Student

There are many scholarships for students in financial need. Call the Office of Student Services. Invest some time in the library researching scholarships. Then, do three things: Apply, apply, and apply.

If you cannot get a scholarship, you should consider student loans. Moreover, you should use student loans as much as possible. The Federal government has different plans to help you. Student loans have low interest rates. Call the Office of Financial Services.

Make a serious effort to avoid credit card debt. It is very expensive.

* Credit Card Management

You should use other alternatives if available: family loans, friend loans and bank loans. (They tend to be cheaper in the given order.)

You should consider transfering balances to other credit cards if they offer a lower interest rate.

You should analyze the cost and benefits of long-term credit card debts:
Cost: High interest rate payments (14 to 21 %).
Benefits: Immediate use of the purchase, gratification. (Ask yourself: do I need it right now?)

* Personal Investments I: Short and Medium Term Investment of your Excess (extra) Cash

Before even thinking about investing, make sure to pay your credit card debts. There are very, very few sound investments (actually, I cannot think of one) that have a higher expected rate of return than the high interest rates credit card companies charge you.

Ok, now, you don't have any debts. You have excess cash and you are ready to invest it. The first thing you should know is that investing involves risk. Very few investments vehicles have no risk. The lower the risk, the lower the expected payoff of your investment. That is, there is a positive relationship between risk and expected return. This is the financial version of the old gym rule "No pain, no gain."

In finance, risk means that the value of the funds you invest may decrease. That is, there is a chance that the total amount you receive when you cash out your investment is lower than than the amount you invested. Thus, if you will need your excess cash to pay for a heart transplant, in 18 months, you should look for a "safe" (very low risk) investment.

Very Short-term excess cash
Go to a local bank and open a Savings Account. For all practical purposes, a Savings Account has zero risk. The Federal Government guarantees your funds, up to $100,000. A Savings Account should be your first step in building a solid financial future. A Savings Account pays higher interest than regular Checking Accounts.

If you have more than $2,500 to invest short-term, you should think of a Money Market Account. A Money Market Account allows you to earn a higher interest rate than a regular Savings Account, plus it allows you to draw funds using checks. A Money Market Account pays you a higher interest rate because your funds are invested in short-term (usually, very safe) bonds. Money Market Accounts are offered by banks, stock brokerage houses and mutual fund Companies. Usually, Savings Accounts and Money Market Accounts give you a return anywhere between 1% to 5% a year. Better than nothing!

Short-term excess cash
If you are not going to use your excess cash for a period of at least three months, open a Certificate of Deposit (CD). A CD is a time deposit you make at a bank. Usually, you cannot withdraw the money for the duration of the life of the CD. At maturity, you'll receive the amount you deposited plus the accumulated interest. These days, CDs can pay between 4.5% to 6%. Look in the Sunday newspaper for the highest yielding CD's. By the way, like Saving Accounts, CDs offered by banks are insured by the U.S. government.

Medium-term excess cash
If you are not going to use your excess cash for a long period of time (say, over a year), you might consider a mutual fund if you are willing to take risks. A mutual fund allows you to invest with other investors in a fund that is professionally managed. The manager of the mutual fund decides where to invest your money. Mutual funds offer financial alternatives with higher yields than CDs, but they are riskier. Again, risk means that the value of the funds you originally invested in the mutual fund may decrease.

* Personal Investments II: Investing your Excess Cash for the Long-term

Let us consider again the relationship between risk and expected returns. You might have noticed that we talked about expected returns, not actual returns. When you invest in an investment vehicle that bears risk, you do not know what the rate of return of your investment is going to be -that's the nature of risk: uncertainty! You only have an expectation about the investment vehicle's rate of return. In general, this expectation will be based on the return the investment vehicle has produced over the past several years. Keep in mind this simple rule: the longer the past you use to calculate historical returns, the more accurate your measure of expected returns.

Some years you will see a negative return (making you fell like an investment idiot). Some other years you will see an amazingly large positive return (making you feel like an investment genius). Again, you should not expect year in, year out a positive return on your risky investment. Over time, however, you will observe an average return. The longer you stick with your investment vehicle, the closer the average return will be to to the expected (historical) return. That is, in the long run, risk is going to be rewarded. It is important to stress this point. Bad years, for your investments, are expected. Bad years will happen. You should not panic after one or two bad years. Be patient. In the long run, bad years will be more than compensated with good years. Patience, in investments, pays!

Long-term Investing: The Miracle of Compounding
When saving for the long-term, remember that compounding makes miracles. If you save and invest $250 every year when you retire -say, in 40 years-, you will see the power of compounding.

For example, if you invest those $250 in a mutual fund that gives you an annual return of 12.52% -the average annual return in the U.S. stock market from 1926-1995-, you'll get $221,631 (almost a quarter million dollars!). As Huey Lewis (in Back To The Future) would say: "That's the power, the power of compounding."

Similarly, that lotto ticket that you buy every week can help you in your retirement. Don't spend $1 in a lotto ticket. Instead, save it and invest it. (Remember that your chances of winning the lotto are very, very small.) If you invest those $52 every year in the same mutual fund as above, after 40 year, you'll receive $46,100. Not bad!

Selecting an Investment Vehicle
Now, you understand the power of compounding. You see that saving and investing $1 a day, over the long haul, makes a difference. You are ready to invest for the long term. But, now, you ask yourself: "How do I select an appropriate investment vehicle?" Well, financial experts will say "You should invest in an investment vehicle that you are comfortable with." Comfortable means that you should be able to live with the risk of the investment vehicle you select. Remember that different investment vehicles have different expected returns but also different levels of risk. You should pay attention not only to the expected return, but also to the risk of an investment. Keep in mind that financial "No pain, no gain" rule: The higher the risk, the higher the expected return. After all, you take on higher risks because you expect a bigger payoff!.

Now, let us illustrate what comfortable really means. Suppose you choose to invest in mutual fund ZZ because you expect an annual return of 30% (that's what the ad in the newspaper says mutual fund ZZ has averaged in the past three years). Now, if every time the mutual fund ZZ goes down in value you suffer a heart attack, you are not comfortable with the level of risk you are taking with mutual fund ZZ. Therefore, you should invest in the vehicle that offers you a risk-return profile that you like.

We have already mentioned three investment alternatives: Savings Accounts, CDs, and mutual funds. You have heard of bonds and stocks. These vehicles have different risk-return profiles. (Click here to see the risk-return profile of several investment vehicles.)

If you don't like to take risks -that is, you want the value of your investment to never decrease- a Savings Account, a CD or a U.S. government bond are your best alternatives.

Now, you are willing to go beyond these no-risk alternatives. Then, you should consider bonds and stocks. You can buy individual bonds and stocks or just a portfolio of bonds and stocks offered by mutual fund companies, like Fidelity, T. Rowe Price, Vanguard, etc. For investors that do not have a lot of time to do research and analyze the quality and the value of a company's stock or bond, mutual funds are the best alternative.

If you are willing to take some risks, bonds or mutual funds that invest in bonds are good investment strategies. From 1926 to 1995, Corporate Bonds have had an average annual return of 6.02%, while Government Bonds (which are safer) have had an average annual return of 5.54%.

If you are willing to take on more risks, then stocks or mutual funds that invest in stocks are your thing. There are different mutual funds, depending on the kind of risk you want to take. In one side of the mutual fund spectrum, you have conservative mutual funds, which only invest in well-established (lower risk) companies, like AT&T or IBM. On the other extreme, you have aggressive mutual funds, which invest in companies with great appreciation potential (and higher risk), like High-Tech and Internet stocks.

Mutual Fund Indexing
So, you are thinking: "Ok, ok, I understand. I'm young. I'm willing to face the risks of the stock market. Mutual funds sound like a good strategy for me. But there are so many..." Well, the huge number of mutual funds in the U.S. presents a big problem for investors. In 1998, there were more than 3,422 U.S. mutual funds that invested in the U.S. stock market. Nobody has time to research all these mutual funds to learn about their management styles, past returns, risks, fees and commissions, etc. Another problem is that, in general, the mutual funds that show you great returns, and advertise on the newspapers and on TV, are the ones that have done well lately. As the small print in the ads usually says, past performance is not an indicator of future performance. And you should be really aware of this fact. So, what can you do?

Many practitioners and academic researchers have shown that it is very difficult for an average U.S. mutual fund to beat the "Market." By the "Market," we mean a well-diversified portfolio of stocks represented by an Index. You have probably heard of the Dow Jones Index. The Dow Jones Index represents a portfolio of 30 of the largest companies in the U.S. (IBM, Disney, General Motors are part of the Dow Jones Index). Another popular stock market Index is the Standard and Poor's 500, which represents a portfolio of 500 of the major U.S. companies. From 1983 to 1997, only 28 funds (11%) of all the (surviving) U.S. mutual funds have had better returns than the Standard and Poor's 500 (S&P 500) Index. The annual return of an average mutual fund during the 1983-1997 period was 14.2%, while the annual return of the S&P 500, over the same period, was 17%. (That's 3% more a year, or $3900 if you had invested $250 a year on the S&P 500, instead of investing on the average mutual fund!).

Given this outstanding result, some mutual funds have become Index funds. That is, the manager of the fund buys the components of a well known market Index. This is the main job of the manager of an Index Fund. Pretty simple, huh? This approach to investing is called Indexing. Besides offering higher returns than the average mutual fund, Indexing is very inexpensive (after all, the manager of an Index fund does not do much). For investors that are looking to invest in the stock market, Indexing is probably the best alternative.

* More Long-term Investing: Retirement Accounts

In general, retirement accounts are governed by simple principles:
  • Money invested cannot be used until retirement.
  • If you use the money before retirement, you pay a penalty.
  • They offer tax-breaks. (This is the main appeal of these accounts.)
  • Big tax advantage: The money you deposit directly into an Investment Retirement Account (IRA) account is taken from your paycheck before taxes are taken out.

    Investment Retirement Account (IRA)
  • Anybody under age 70 1/2 with earned income can open an IRA.
  • You may deposit the lesser of your earned income or $2,000.
  • Interest made on IRAs id not subject to Federal tax. Thus, over the years, you'll make a substantial difference over just leaving your money in a standard regular account. (Thanks, compounding!)
  • You can invest the money in any financial instrument you like -for example, a CD, a particular stock, or an Index mutual fund.
  • There is a penalty if you withdraw IRA funds before retirement.
  • Roth IRAs differ from the traditional IRA because it provides no tax advantage up front on contributions. But it offers total exemption from federal taxes when you retire or for other qualified distributions, such as education expenses and paying for a first house.

    Employer's Retirement Accounts
  • Your contributions to these plans are tax-deferred income, that is, they will be taxed later, when you retire. (Your income is sheltered from government taxes for a while.)
  • Ask your employer about the following retirement plans:
    i. SIMPLE (Savings Incentive Match Plan Employees) IRA.
    ii. 401(k): Employers can match your contributions.
    iii. 403(b): It's a 401(k) but for nonprofit organizations.
    iv. 457: 401(k) plan for local and state governments.
    v. Keogh: An IRA that doubles as a pension plan for a self-employed person. The self-employed can put in the Keogh up to $30,000 a year.
    vi. Simplified Employees Pension (SEP): A Keogh for the small business. Both employer and employees can contribute to a SEP.

    Variable Annuity
  • It is an insurance contract with three advantages:
    i. Your contributions are tax-deferred income.
    ii. At retirement, you have different options to cash the insurance benefits. One of them is guaranteed fixed payment for the rest of your life.
    iii. Death benefits. (Hopefully, you won't use them!)

    For more information about mutual funds and IRAs, you can visit:

    The Vanguard Group's Home Page (Vanguard offers very inexpensive Index Mutual Funds).
    T. Rowe Price's Home Page .
    Index Funds Center .

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