The ABCs of Personal Finance

Monday, September 8, 2014

The A, B, C’s of Personal Finance

This past week scores of our children and grandchildren returned to school.  After the disappointment that summer is over, excitement surfaces when pondering the possibility of learning new things.  High schools and universities do a fine job in helping kids complete their academic requirements, but what about the basic principles of starting off life on a firm financial footing? Let’s examine seven lessons which we can teach students in our lives, and even those early in their professional careers, to help them get started on solid financial ground.

1) Start Early

It’s never too early to start saving for the future.  In July I wrote about the concept of teaching kids at a young age to put ten percent of pay from babysitting jobs, summer employment, or chores into a savings or investment account.  Compounding interest is an amazing thing. Albert Einstein called compound interest  the greatest mathematical discovery of all time. We think this is true partly because, unlike the trigonometry or calculus you studied back in high school, compounding can be applied to everyday life.

The wonder of compounding (sometimes called compound interest) transforms your working money into a state-of-the-art, highly powerful income-generating tool. Compounding is the process of generating earnings on an assets reinvested earnings. To work, it requires two things: the re-investment of earnings and time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment, which takes the pressure off of you.

To demonstrate, lets look at an example:

If you invest $10,000 today at 6%, you will have $10,600 in one year ($10,000 x 1.06). Now lets say that rather than withdraw the $600 gained from interest. you keep it in there for another year. If you continue to earn the same rate of 6%, your investment will grow to $11,236.00 ($10,600 x 1.06) by the end of the second year.

Because you reinvested that $600, it works together with the original investment, earning you $636, which is $36 more than the previous year. This little bit extra may seem like peanuts now, but lets not forget that you didnt have to lift a finger to earn that $36. More importantly, this $36 also has the capacity to earn interest. After the next year, your investment will be worth $11,910.16 ($11,236 x 1.06). This time you earned $674.16, which is $74.16 more interest than the first year. This increase in the amount made each year is compounding in action: interest earning interest on interest and so on. This will continue as long as you keep reinvesting and earning interest.

When you invest, always keep in mind that compounding amplifies the growth of your working money. Just like investing maximizes your earning potential, compounding maximizes the earning potential of your investments but remember, because time and reinvesting make compounding work, you must keep your hands off the principal  and  earned interest .

If a young person starts saving $100 per month over 40 years, they can accumulate over a million dollars at reasonable rates of return.  If this money is saved in a Roth IRA, there is no tax on the earning or withdrawals.

2) Take advantage of employer plans

Young professionals starting their first jobs after completing school should take full advantage of an employer retirement plan.  Besides the benefit of saving their money on a before tax basis, many employer plans offer a match of the employee contribution, or a straight contribution of their own.  Employees are always 100% vested in their own contributions, but it may take a few years to fully vest in the employer match.  Regardless of the return earned in the portfolio, a match on funds you put in is free money.  Kids should be encouraged to participate at least to an employer match.

3) Be confident in the stock market as part of a long term investment strategy

Many teens and twenty somethings have vivid memories of the financial crisis of 2008 and the tech demise of 2000.  These events have caused some young people to adopt a more cautious investment posture.  While risk tolerance is a personal consideration, an investor with more than a 30 year time frame to use their funds has derived the greatest returns from stock market participation.  Going back to the great depression, the data shows that over twenty year periods of time, stocks out perform all other asset classes.  Help the young people around you understand the long term wealth creation benefits of the stock market.

The most complete historical database for stocks, bonds and mutual funds can be found at the Center for Research in Security Prices (CRSP) at the University of Chicago’s Booth School of Business. Figure 9-1 shows the annualized rates of return for 24 different indexes. This table provides an interesting review of various indexes over several different time periods. Note the pattern of higher annualized returns of small cap and value stocks over large cap and growth stocks over time.

4) Manage your debt

Asset management is an important part of building an investment portfolio.  Liability management is also vitally important in helping young people start a solid financial plan, but also seek to avoid a serious financial mistake.  As a rule of thumb, we should encourage kids early in their investing lifestyle to keep their debt service to less than 30% of their take home pay.  While a conservative measure, this will allow them the flexibility to spend, save, and invest.

5) Manage your risks

A young professional starting out in the workforce should at best understand the basics of insurance.  Even a simple renters policy for a college student renting an off campus apartment can be a valuable resource in the event of a fire or theft.  While one can make an argument to put off buying life insurance until they are married or financially responsible for someone else, I find many young people do not understand the benefits of long term disability insurance.  Your ability to earn income is an asset worth protecting.  A personally owned, own occupation specific long term disability policy is a key element of a sound financial plan.  Once approved, you are protected against an inability to work as long as you pay the premiums.

6) Maintain a cash buffer

Some forward thinking college students and young professionals are eager to start an investment portfolio.  While a laudable goal and one my team would support, it is crucial to start with an ample cash reserve.  Having a cash buffer equal to at least three to six months of living expenses on hand provide a child with a cushion in the event they lose a job or a significant expense surfaces unexpectedly.  While investments such as stocks, bonds, and mutual funds outside of a retirement account are liquid, they are also subject to volatility.  Having a cash cushion allows you to not disturb them in a market downturn.

7) Make philanthropy part of your budget

For most people, the ability to earn more money is the driving force behind going to college. According to a national report by the State Higher Education Executive Officers Association (sheeo.org), high school graduates earn an average of almost $30,000 per year. Bachelor’s graduates earn an average of just over $50,000 a year. A young person starting a professional career earning fifty thousand dollars will be earning more than 73% of the other Americans.   If you earn $50,000 USD or greater annually you are in the top 1% of the world financially.

The ability to save and invest is both a blessing and a responsibility.  We need to encourage kids around us upon whom we have influence, the importance of helping others.  When this habit is instilled early, a lifelong benefit occurs as they have the ability to help those with less.

Thank you for taking the time to read this piece.  I welcome any thoughts or feedback.

-Greg Sarian

Gregory Sarian, Francis Masse, and Norman Deitrich are registered with HighTower Securities, LLC, member FINRA, MSRB and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors.

All data and information reference herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary, it does not constitute investment advice. Jordan Waxman and HighTower shall not in any way be liable for claims, and make no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice.

This document was created for informational purposes only; the opinions expressed are solely those of Gregory Sarian, Francis Masse, and/or Norman Dietrich and do not represent those of HighTower Advisors, LLC, or any of its affiliates.