It's amazing to me that the simplest principles in the world of finance are often the most overlooked. Granted, I don't expect CNBC and other financial news outlets to offer lessons on the basic concepts of finance but I can dream!
Vanguard, the massive mutual fund management firm that pioneered the index fund for individual investors, has a great article on the power of compounding on its website. Basically, compounding is the effect that you get when your earnings grow on top of prior earnings. These earnings can be in the form of interest, dividends, capital gains distributions or the like.
For example, if you have 1,000 shares of an index fund with a NAV of $10 which pays out a quarterly dividend of 0.25 in the 1st quarter, you will have $250 in dividend income. If you decide to reinvest that, come the next quarter, you will have 1,025 shares (holding the price of the fund constant). As the fund pays out its dividend of 0.25 in the 2nd quarter, you will subsequently receive $256.25 in dividend income. Imagine the results if you keep adding to this by investing systematically. All of this highlights a key principle that is proved true due to compounding: its easier to make money when you already have it.
That adage shouldn't discourage you - in fact, it should inspire you. After all, by starting at a age young like I hope members of Generation WISE are, you will begin to realize the full benefits of compounding investment returns. As your investments and savings grow from a young age, compounding will work its magic. Vanguard says that for compounding to work, you need to "start now, invest regularly and be patient." I couldn't have said it better myself.
Thursday, February 17, 2011
Thursday, February 10, 2011
"There's Plenty of Time To Save"
Perhaps you're like me, 22 years old and excited about graduating from college and starting in the proverbial "real world". The prospect can be exciting and frightening at the same time, but also full of misconceptions. A recent article on FOXBusiness.com highlights "8 Misconceptions College Students Have About Money". These misconceptions run the gamut from fear over credit, seeing no need to budget and other general financial pitfalls. Yet, the worst misconception to me is the idea that there's "plenty of time to save."
While retirement may seem far away - 40+ years is likely for a worker just getting into the workforce - the day where you will begin to seriously consider it will come faster than you think. As a result, the planning and saving that we do today will affect both when we retire and how we retire. By that, I mean that how much money we have saved and invested will dictate the terms of our retirement - will we retire at 62, collect Social Security (if it's still around) and live comfortably off a lifetime of savings - or will we "retire" at 70, collect Social Security yet be forced to take a part-time job to cover rising living expenses? The former should be our goal, yet the latter is an unfortunate reality for many people.
By saving and investing more money early on, you will have less of a return differential to make up for as you get closer to retirement age. Ideally, your portfolio will grow and compound enough with the additional contributions that you make during your working years to negate the need for any makeup return as you get closer to retirement. The FOX article quotes a 2009 Vanguard report which states, "only 31% of employees under age 25 save for retirement, compared to 61% for those between 25 and 34.”
Those are harrowing statistics because it means that we are forgoing the best years of our life to save - when we have limited obligations such as a house payment or raising a family - and wasting precious time. Sure, a dollar today is worth more than a dollar in the future. However, a dollar today is not worth more than a dollar invested today for 40 years earning a 7% average annual return.
While retirement may seem far away - 40+ years is likely for a worker just getting into the workforce - the day where you will begin to seriously consider it will come faster than you think. As a result, the planning and saving that we do today will affect both when we retire and how we retire. By that, I mean that how much money we have saved and invested will dictate the terms of our retirement - will we retire at 62, collect Social Security (if it's still around) and live comfortably off a lifetime of savings - or will we "retire" at 70, collect Social Security yet be forced to take a part-time job to cover rising living expenses? The former should be our goal, yet the latter is an unfortunate reality for many people.
By saving and investing more money early on, you will have less of a return differential to make up for as you get closer to retirement age. Ideally, your portfolio will grow and compound enough with the additional contributions that you make during your working years to negate the need for any makeup return as you get closer to retirement. The FOX article quotes a 2009 Vanguard report which states, "only 31% of employees under age 25 save for retirement, compared to 61% for those between 25 and 34.”
Those are harrowing statistics because it means that we are forgoing the best years of our life to save - when we have limited obligations such as a house payment or raising a family - and wasting precious time. Sure, a dollar today is worth more than a dollar in the future. However, a dollar today is not worth more than a dollar invested today for 40 years earning a 7% average annual return.
Thursday, February 3, 2011
Brokerage Advice Can Be Hazardous to Your Wealth
I have a confession to make. As a young investor in the late 1990s, I was naive and quite taken by the Internet euphoria. At the time, I owned a single stock - PepsiCo (PEP) - which I still own to this day. However, I couldn't help but watch stock prices explode without feeling like I should be a part of the game. Granted, I didn't have much spare cash to work with, but when I did, I was advised by my broker to buy Munder NetNet - one of the pioneering Internet-focused funds that grew to a whopping $8.5 billion in asset size in April of 2000. I should have been smarter, but as an 11 year old investor, I believed in the transformative power of technology and the "new paradigm". Didn't you?
When all was said and done, my small investment in Munder was wiped out to the tune of 90% or so. And while our broker was confident that it would rebound all the way down, it was only then that I realized investing works best when you:
1). Keep it simple and index
2). Buy what you know
Contrary to what Wall Street tells you, it's OK to be conservative as a young investor. And by conservative, I mean that it's OK to invest in index funds. Interestingly, former bond trader and famous author Michael Lewis of Liar's Poker, Money Ball and The Blind Side fame, notes in a recent interview that he took advice from a broker and in 2008 purchased Lehman Bros. preferred stock and auction-rate securities - both investments were wiped out by the financial crisis and Lehman's bankruptcy. So, after this gut-check experience, what does Lewis advocate for individual investors? Surprise, surprise! He says, "be conservative, don’t listen to brokerage advice, and index."
I couldn't agree more. Ultimately, Wall Street is all about sales and brokers are at the forefront of making sure products - investments in this case - get sold. Unfortunately, the first place they often look to unload their worst products are to unwitting individual investors. It's best to keep it simple by indexing and to avoid listening to brokerage advice!
When all was said and done, my small investment in Munder was wiped out to the tune of 90% or so. And while our broker was confident that it would rebound all the way down, it was only then that I realized investing works best when you:
1). Keep it simple and index
2). Buy what you know
Contrary to what Wall Street tells you, it's OK to be conservative as a young investor. And by conservative, I mean that it's OK to invest in index funds. Interestingly, former bond trader and famous author Michael Lewis of Liar's Poker, Money Ball and The Blind Side fame, notes in a recent interview that he took advice from a broker and in 2008 purchased Lehman Bros. preferred stock and auction-rate securities - both investments were wiped out by the financial crisis and Lehman's bankruptcy. So, after this gut-check experience, what does Lewis advocate for individual investors? Surprise, surprise! He says, "be conservative, don’t listen to brokerage advice, and index."
I couldn't agree more. Ultimately, Wall Street is all about sales and brokers are at the forefront of making sure products - investments in this case - get sold. Unfortunately, the first place they often look to unload their worst products are to unwitting individual investors. It's best to keep it simple by indexing and to avoid listening to brokerage advice!
Thursday, January 27, 2011
Dow 12,000? So what!
The financial media has been growing increasingly giddy over the prospect of the Dow Jones Industrial Average (DJIA) eclipsing 12,000. Now you're probably thinking "haven't I heard this already?". Indeed, you have. On Monday, Tuesday, Wednesday and now today, the Dow hit an intraday high of just over 12,000 - a level considered to be a key level of "resistance" for the overall market. The Wall Street Journal's homepage has a headline boldly proclaiming: "Dow Regains 12,000".
Not to be outdone, similar headlines can be found all throughout the financial press, detailing the minute-by-minute moves in the Dow as it approaches, reaches, and surpasses 12,000. In the case of the last 3 days, this type of reporting held little relevance because the Dow didn't close above 12,000. The last time that the Dow closed above 12,000 was during the height of the financial crisis - on June 19, 2008 - when the index closed at 12,063. Thus, given all that's happened in the financial markets the past few years and the way that stocks have rallied since their bottoming out in the beginning of 2009, 12,000 may seem like a significant level for the Dow.
Alas, it's not. The constant reminder that the Dow is "regaining" 12,000 serves more as a testament to the resilience of U.S. markets than anything else. It holds little educational or predictive value. After all, the Dow only includes 30 companies and the true driver of stock prices - expected future earnings - have not changed all that much in the past few days.
From a psychological perspective, Dow 12,000 is a good sign because it means that investors have renewed optimism in stocks and are pushing prices higher. On the other hand, what do investors gain by reading news headlines detailing tick by tick moves in the Dow as it approaches a level that holds little relative importance? Not too much, especially since the fundamentals of Dow 12,000 are pretty much the same as Dow 11,999.
Not to be outdone, similar headlines can be found all throughout the financial press, detailing the minute-by-minute moves in the Dow as it approaches, reaches, and surpasses 12,000. In the case of the last 3 days, this type of reporting held little relevance because the Dow didn't close above 12,000. The last time that the Dow closed above 12,000 was during the height of the financial crisis - on June 19, 2008 - when the index closed at 12,063. Thus, given all that's happened in the financial markets the past few years and the way that stocks have rallied since their bottoming out in the beginning of 2009, 12,000 may seem like a significant level for the Dow.
Alas, it's not. The constant reminder that the Dow is "regaining" 12,000 serves more as a testament to the resilience of U.S. markets than anything else. It holds little educational or predictive value. After all, the Dow only includes 30 companies and the true driver of stock prices - expected future earnings - have not changed all that much in the past few days.
From a psychological perspective, Dow 12,000 is a good sign because it means that investors have renewed optimism in stocks and are pushing prices higher. On the other hand, what do investors gain by reading news headlines detailing tick by tick moves in the Dow as it approaches a level that holds little relative importance? Not too much, especially since the fundamentals of Dow 12,000 are pretty much the same as Dow 11,999.
Thursday, January 20, 2011
Gen Y Home Preferences & Investing
The Wall Street Journal noted interesting findings from a recent panel regarding Gen Y's housing preferences. Last week's National Association of Homebuilder's conference broke out a few panels that discussed how millennials differ from their Baby Boomer parents in what they look for in a house. The article noted that Gen Y's "want to walk everywhere" Further, "surveys show that 13% carpool to work, while 7% walk" and Gen Y still much prefers city living as opposed to settling down in the suburbs. In fact, 88% of the survey respondents reported the desire to live in a city.
This should not be surprising as Gen Y's are known to crave action and excitement, traits that are no doubt due in large part to our growing reliance on technology and socializing. The hustle and bustle that comes along with our rapid socialization also leads to our interest in city living as cities are key population centers where we can be exposed to as many people and as much activity as possible.
Interestingly, much of what we know from these surveys about Gen Y's housing preferences can tell us a lot about Gen Y's investing habits. Indeed, Gen Y's tend to be more interested in active trading and other strategies centered on high activity rates. Unfortunately, this is also a very costly endeavor that can quickly eat away at any investment returns that are actually generated (and odds are, they won't be).
The old axiom "don't just stand there, do something" applies to Gen Y investors as they stand now but it shouldn't. In fact, as John Bogle notes, all investors should heed the following instead - "don't just do something, stand there". In the end, passive investment pays off for all investors.
This should not be surprising as Gen Y's are known to crave action and excitement, traits that are no doubt due in large part to our growing reliance on technology and socializing. The hustle and bustle that comes along with our rapid socialization also leads to our interest in city living as cities are key population centers where we can be exposed to as many people and as much activity as possible.
Interestingly, much of what we know from these surveys about Gen Y's housing preferences can tell us a lot about Gen Y's investing habits. Indeed, Gen Y's tend to be more interested in active trading and other strategies centered on high activity rates. Unfortunately, this is also a very costly endeavor that can quickly eat away at any investment returns that are actually generated (and odds are, they won't be).
The old axiom "don't just stand there, do something" applies to Gen Y investors as they stand now but it shouldn't. In fact, as John Bogle notes, all investors should heed the following instead - "don't just do something, stand there". In the end, passive investment pays off for all investors.
Thursday, January 13, 2011
Erasing the Gen Y Debt Burden
Unfortunately, much of my recent posts have been regarding things that millennials are "doing wrong" when it comes to saving and investing. I've noticed that most Gen Y's who have poor saving and investing habits are in such a predicament because their parents may not be great savers. The old saying "the apple doesn't fall too far from the tree" is quite true when it comes to successful saving and investing habits. After all, young people are quite impressionable and even leading up into our college years when we crave independence, many of us still look to our parents for signs of successful money management.
With that said, if you have manageable credit card debt - and 38% of Gen Y does - start paying it off! The time to do it is now, while you're still young. The worst thing in the world you can do when it comes to paying off your debts is to wait.
Even better, pay off your debts in full, if you can. While that may seem unrealistic and come at the sacrifice of immediate savings and investing goals, remember that you have plenty of time to work towards your investing goals and you will be much better off having gotten the debt burden off of your back.
After all, interest costs will ultimately grow exponentially if credit card debts go unpaid or if you continue to just pay the minimum payment each month and then any future earnings you have will likely go towards paying off your creditors. This is a sad situation that many millennials face but it shouldn't dishearten you from an investing perspective. Once the debt burden is erased, begin to focus on investing your money and you will feel so much better knowing the specter of a credit card company is no longer in your rear-view mirror.
With that said, if you have manageable credit card debt - and 38% of Gen Y does - start paying it off! The time to do it is now, while you're still young. The worst thing in the world you can do when it comes to paying off your debts is to wait.
Even better, pay off your debts in full, if you can. While that may seem unrealistic and come at the sacrifice of immediate savings and investing goals, remember that you have plenty of time to work towards your investing goals and you will be much better off having gotten the debt burden off of your back.
After all, interest costs will ultimately grow exponentially if credit card debts go unpaid or if you continue to just pay the minimum payment each month and then any future earnings you have will likely go towards paying off your creditors. This is a sad situation that many millennials face but it shouldn't dishearten you from an investing perspective. Once the debt burden is erased, begin to focus on investing your money and you will feel so much better knowing the specter of a credit card company is no longer in your rear-view mirror.
Thursday, January 6, 2011
Gen Y's Risk Aversion
A recent Kiplinger's article points out that Gen Y investors are typically more risk averse than other generations were when they were the same age. This risk aversion means just what it says - Gen Y investors are less comfortable with risk - and in turn have put more than half of their savings in relatively safe investment vehicles like "bonds, money market accounts or cash" as the article points out.
The article also goes on to examine the reason for this risk aversion, pointing out the following:
"They've seen little or nothing of the upside of long-term investing in stocks. In the decade since the oldest Gen Yers entered the workforce, the stock market has languished. Worse, many saw their parents' savings evaporate in recent years. If that reluctance to invest in the stock market lasts, many will come up short in their golden years."
While I'm sure the roller coaster ride that the stock market has taken investors on in the wake of the financial crisis was unsettling for many investors, I believe Gen Y's risk aversion boils down more to their temperament and personality. After all, Gen Y tends to have a shorter attention span and a burning want for instant gratification. Maybe they simply don't understand the benefits of investing the stock market and don't have a desire to learn. As a result, they park their cash in relatively risk-free vehicles like CDs and money markets, earning a meager return that can be eroded by inflation.
If Gen Y investors aren't motivated to learn about the importance of taking on at least some risk for higher potential investment returns over the long-term, it will be very difficult to change that mindset since it's probably ingrained in their psyche already. It can be done, however, and I remind readers that while risk aversion can be important, it's simply not practical for Gen Y investors.
We have the most to gain when investing because we have time on our side. However, in order to utilize that time we need to take some risk so that we can be compensated for bearing that risk. A time-tested investment principle continues to hold true, all else being equal: greater risk equals greater potential reward.
The article also goes on to examine the reason for this risk aversion, pointing out the following:
"They've seen little or nothing of the upside of long-term investing in stocks. In the decade since the oldest Gen Yers entered the workforce, the stock market has languished. Worse, many saw their parents' savings evaporate in recent years. If that reluctance to invest in the stock market lasts, many will come up short in their golden years."
While I'm sure the roller coaster ride that the stock market has taken investors on in the wake of the financial crisis was unsettling for many investors, I believe Gen Y's risk aversion boils down more to their temperament and personality. After all, Gen Y tends to have a shorter attention span and a burning want for instant gratification. Maybe they simply don't understand the benefits of investing the stock market and don't have a desire to learn. As a result, they park their cash in relatively risk-free vehicles like CDs and money markets, earning a meager return that can be eroded by inflation.
If Gen Y investors aren't motivated to learn about the importance of taking on at least some risk for higher potential investment returns over the long-term, it will be very difficult to change that mindset since it's probably ingrained in their psyche already. It can be done, however, and I remind readers that while risk aversion can be important, it's simply not practical for Gen Y investors.
We have the most to gain when investing because we have time on our side. However, in order to utilize that time we need to take some risk so that we can be compensated for bearing that risk. A time-tested investment principle continues to hold true, all else being equal: greater risk equals greater potential reward.
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