Finance 101: April 2022

In April the financial advisors at Ruedi Wealth Management wrote 4 more “Finance 101” columns for The New-Gazette’s Business Extra section. Make sure to look for them every Sunday, but in case you missed the columns from April all four are below.

Inverted Yield Curve

David Ruedi, CFP®

This week you may have heard rumblings from the financial media about an “inverted yield curve.” An inverted yield curve is often cited as an indicator of an oncoming recession, which can be concerning to investors. But what is an inverted yield curve? Is it really a reliable indicator of tough times ahead? Should investors do something in response?

To understand what an inverted yield curve is, it is important to understand what a “normal” yield curve is. This requires a trip back to grade school math class as it involves plotting points on an “X” and “Y” axis to form a line. A yield curve is a graphical depiction of the relationship between bond terms (number of years before a bond returns your principal) on the X-axis, and the yields of those bonds, which is on the Y-axis.

Under normal circumstances, people prefer to have their money back sooner rather than later. Naturally, the longer a bond’s term, the higher the return investors demand to loan out their money. Therefore, the farther you go out on the X-axis (years) the higher the interest rate, resulting in an upward sloping yield curve.

But occasionally, bonds at the shorter-term end of the curve will actually have higher interest rates than the longer-term end of the curve – the opposite of what is usually the case, which is why it is called a yield curve “inversion.” For whatever reason, people are demanding a higher return on short-term bonds than long-term bonds. But why?

Though it is hard to distill the movements of capital markets into a single explanation, if people are demanding a higher return on short-term bonds than long-term bonds, they are likely worried about the short-term prospects of the economy. This doesn’t necessarily mean a recession is looming, but often the concerns that caused a yield curve inversion do materialize and a recession follows.

It is a fairly reliable indicator of recessions, as the yield curve inverted before each of the last 7 recessions. But it is tough to predict when that recession will follow, if at all. For example, the yield curve inverted in 1998 and was not followed by a recession. When recessions did follow a yield curve inversion, it was only after a significant lag time. Because of this, using yield curve inversions as a market timing strategy runs the risk of doing more harm than good. The better approach for typical investors is to follow a disciplined, buy-and-hold approach to investing, regardless of what the yield curve happens to be doing at the time.

Bummed About Your Bonds?

Paul A. Ruedi

People generally purchase bonds to be the stabilizing asset in their portfolio. Unfortunately, this year bond investors have seen the value of their bonds or bond funds drop due to rising interest rates. This leaves many people wondering why they are invested in bonds in the first place. But if investors had a good reason to own bonds to begin with, that reason probably still applies.

A quick glance at some of the most widely-used bond funds shows they have taken a dip in response to interest rates, with diversified bond funds like the Vanguard Total Bond ETF down around 7% just this year. Not only that, there is a fear bond prices could fall even further in response to future interest rate rises. Is the “safe asset no longer safe?

Though they are used as the stabilizing asset in many investment portfolios, it is important to remember that bonds will fluctuate in value in response to market forces. However, these fluctuations in value are relatively small compared to what could happen to the stock portion of a portfolio. If the purpose of bonds in a mixed portfolio is to make sure you do not have to sell from your stock portfolio while it is down 30% or more, they still achieve that purpose.

Yes, bonds are down, but nowhere near as far down as a stock portfolio’s potential decline during a bear market. If retired investors keep several years’ worth of spending in bonds to draw from in the event of a bear market, even if those bonds are down slightly it doesn’t make a big difference from a planning perspective. They are still able to rely on their bonds to ride out the storm and give the stock portion of their portfolio time to recover.

If there is somewhat of a silver lining in falling bond prices, it is that as your bonds mature, your money can be reinvested in bonds at higher rates. Of course, I had to mention it is only “somewhat” of silver lining because most of this return is stripped away by inflation and taxes. But it has always been this way. Bonds have always produced practically 0 return net of inflation and taxes. You don’t own bonds for the return; you own them so you have something to draw from when the stock market tanks. If that is your reason for owning bonds, it still makes sense to own them.

Financial Spring Cleaning

Daniel Ruedi, CFP®, RICP®

Many people are familiar with the concept of “spring cleaning;” designating a certain time of year to really clean things up so you can approach the rest of the year fresh and organized. I think this concept could also be applied to personal finance, as over the years a person’s financial life can become messy and need a designated time to clean things up. If you are thinking about doing a “financial spring cleaning” this year, below are a few ideas to consider.

Look at your budget and see if money is going towards things that do not provide you with enough benefit. Subscription services you don’t use are great examples of financial junk. Some subscription services are worthwhile, or even save you money. But try to take out the trash that you don’t use. Don’t assume you are going to spontaneously start using that service if you haven’t in over a year.

You may also want to look at your spending and saving levels in general. When I ask most people what amount of their paycheck goes to their 401(k) every month, the vast majority do not know the exact number. Financial spring cleaning can be a great time to really get a good concept of your spending and saving levels and see if you want to make an adjustment.

Another way to clean up your financial life is by consolidating accounts. People often accumulate investment accounts, especially 401(k) accounts as they switch employers. Rolling an old 401(k), or multiple old 401(k)s, into a new 401(k) or IRA can help simplify your life tremendously, and make it less likely that money in a certain account will be completely forgotten. Having multiple taxable brokerage accounts is also fairly common and can be unnecessarily complicated, so consolidating those can be helpful as well.

This could also be a great time to check out your account beneficiaries to see if they need an update. The account beneficiary designation supersedes what is in a will or the probate process, so it is very important to make sure your beneficiary designations reflect your wishes at all times. All too often, a death or divorce in one’s immediate family does not get updated in one’s beneficiary designations, and causes unwanted estate issues.

My last recommendation is to hire help if you need it. Yes, this is like a barber telling you to get a haircut. But if cleaning up your finances is simply too overwhelming, you may want to call in a financial “cleaning crew” to help you get organized. You won’t regret it.

Using FOMO for Good

Paul R. Ruedi, CFP®

Lately I have been thinking about the best way to drive home the importance of investing every single dollar possible to people my age. I couldn’t help but run to an example designed to really shock a person into investing. This example relies on the fear of missing out, or FOMO for short, in hopes that it motivates good behavior.

I am in my early 30’s, so most of my peers are a good three decades away from retirement. The amount of growth that can happen in an investment portfolio in that amount of time is staggering. If people really knew the full extent, they would be very fearful of missing out on those returns.

Let’s use, for example, an investment in a diversified stock portfolio that over a long period of time returns 10%. This may sound like an outrageous number, but it is actually slightly lower than the historical average compound return of the S&P 500. Applying the rule of 72 to a 10% return suggests money invested this way will double every 7.2 years on average. Of course, stock returns are lumpy so this is not what will actually happen in real life. This is just a rule of thumb for very approximate calculations. And, of course, I should mention that past performance is not an indication of future results.

This means that someone like me, with three decades until retirement, will see their money double in value four different times before typical retirement age. So let’s say someone my age is wondering about the impact of investing an extra $5,000 for retirement. Investing an extra $5,000 doesn’t really seem like it would make a difference in your financial life. But if a person foregoes investing that $5,000 they will miss out on $5,000 of gains the first 7.2 years, $10,000 of gains over the second, $20,000 in gains over the third, and $40,000 over the fourth. That decision not to invest $5,000 ultimately could cost $75,000 in missed gains by retirement. If that doesn’t give a person FOMO, I don’t know what will.

Even if retirement seems too far away to motivate behavior, emphasizing the gains a person misses out on the first handful of years can still have a big impact. Though I don’t generally like to use fear to motivate good behavior, in this case it seems warranted. Investors should be fearful of missing out on stock returns, and should act on that by responsibly investing as much as they can as soon as they can.

Disclaimer: Past performance is no indication of future results. You should not make any investment decisions without first performing your own due diligence and consulting your financial advisor.