Finance 101: April 2023

In April the financial advisors at Ruedi Wealth Management wrote 5 more “Finance 101” columns for The News-Gazette’s Business Extra section. Make sure to look for them every Sunday, but in case you missed the columns from April all five are below.

Seeking Yield at Online Banks

Paul R. Ruedi, CFP®

I have received a handful of questions about higher-yielding savings accounts from online banks lately, I suppose because they are offering interest rates as high as 5% to get people’s attention. With inflation taking a bigger bite out of cash savings each year, savers should shop around and look for the best interest rate they can get on their savings within reason. However, they should not be so tempted by the prospect of higher yields that they forget to do their basic due diligence, or take too much of a risk on a specific bank.

If you have been attracted by a rate an online bank is offering on savings, it is important to take a closer look at that company. How long has it been around? Does it have a successful track record? Though these are no guarantees of a good experience, I would personally feel more comfortable with an institution that has some degree of a successful, crisis-free history. You should at the very least make sure they are FDIC insured.

When looking at online banks, customer reviews on Google can be very helpful. I recently looked into an online bank that offered a yield slightly above 5% and found that many of the reviews mentioned difficulty depositing and withdrawing funds - a rather important feature for a savings account. The high yield they were offering wasn’t worth taking the risk on a company with several red flags in the reviews. The risk it would be difficult to access the money when it was needed was just too high.

Oddly enough, when you looked at financial websites that reviewed this same bank, it was given 4.5 stars. These financial websites get paid for promoting the services these banks offer every time a person clicks on a link and opens up an account. Obviously these sites have an incentive to sell you on these particular banks which makes their reviews entirely conflicted. So when it comes to reviews, trust your peers, not the financial websites who are trying to sell you something.

Savers all want higher yields, but they must balance that against the quality of the bank and the service level provided. You will find that banks who offer poorer service must offer higher yields to attract deposits. Banks with better service don’t offer as high of yields because they can attract people with good service. It is possible to find a gem that has the right balance of both for you. But always remember, if it sounds too good to be true, it probably is.

Market Capitalization

Paul Ruedi

Though investors can readily look at stock price, or the value of a small portion of a company, the total value of the company or “market capitalization” is often less understood. Market capitalization, or “market cap” for short, is defined as the total number of shares of a company outstanding multiplied by the value of those shares. For example, if company X had a share price of $100 per share and 1 million shares outstanding, it would have a market capitalization of $100 million.

Companies with a market value of over $200 billion are called “mega-cap.” Large capitalization or “large-cap” companies are larger than $10 billion but smaller than $200 billion. Companies worth less than $10 billion but more than $2 billion are considered “mid-cap.” Companies with values below $2 billion but above $250 million are considered “small-cap.” Any company with a market value of less than $250 million is considered “micro-cap.”

You will often see terms like “Large-Cap,” “Small-Cap,” etc. in the titles of different investment funds. If that is the case it is fairly clear what size companies the fund invests in. Other times it is less clear based on the title. The S&P 500, for example, is made up of large and mega cap companies. The Russell 2000 is made up of small companies. Though many investment funds focus on a particular company size, diversified investment funds often will invest in companies of all sizes.

Market capitalization is important because it is one of the features of a portfolio that determines your expected return. Though you can’t predict the performance of any individual company, academic research has shown that, as a group, smaller companies tend to provide higher returns than larger companies. This makes intuitive sense, as investors feel large companies are a safer investment, and therefore don’t demand as high of a return for investing in them. The excess return small and micro-cap stocks produce over their larger counterparts over time does not show up every year, and should only be expected over long time horizons.

When building the stock portion of your portfolio, it is important to hold all different sizes of companies to be adequately diversified. Investors who only own the S&P 500 may feel diversified, but they are leaving out thousands of other companies in the mid, small, and micro-cap space. If you aren’t sure how to build a diversified stock portfolio that considers the impact of market cap yourself, you may want to talk to a financial advisor.

What Does a Financial Planner Do?

David Ruedi, CFP®

We often talk about financial planning and the importance of having a financial plan. Still, many people wonder, what does a financial planner actually do?

A good planner will first get to know you as a person, learn about what is important to you, and understand your attitude about investing. They need to understand your unique situation to determine the right approach to help you achieve your goals in life.

Once a financial planner understands what you want to accomplish, they have to get a clear picture of your current financial situation. To do this, he or she will gather information about your assets and liabilities, sources of income, and how much you’re currently spending versus saving. A good planner will also want to know about other financial considerations such as health issues or dependent family members. By looking at these items, they can get a clear understanding of your finances and your means to achieve your financial goals.

Understanding where you are now and what your ideal future looks like, your financial planner will develop a plan to bridge that gap. A financial plan will answer key questions like: How much do I need to save while I’m working? When can I retire? How much can I spend in retirement? What types of insurance do I need? How should I invest my money? When should I claim Social Security?

With the plan completed, a financial planner will review the plan with you, gather your feedback, and potentially modify the initial plan based on your feedback. Many financial planners will include alternative scenarios to illustrate the impact of altering key planning assumptions such as savings rate, retirement age, retirement spending, or portfolio asset allocation. Viewing these alternative scenarios allows you to analyze the tradeoffs involved in financial planning so that you can select the plan that appeals to you the most.

Once you both agree on a plan and finalize the details, a planner will help you determine the steps to get everything set up and begin implementing your plan. This typically involves setting up investment accounts, transferring assets, and managing your investment portfolio to keep it aligned with your plan.

With a financial plan established and implemented, your financial advisor shouldn’t be a stranger. Life will inevitably present you with surprises and challenges that will require you to adapt your initial plans. A good planner will provide ongoing advice, monitor the status of your plan, adjust the plan when necessary, and remain your trusted advisor for decades.

How We Adjust Financial Plans

Ryan Repko, CFP®

When we build financial plans, we set out on a path of great uncertainty. Though we do our best to realistically account for what can happen, we simply don’t know what will happen until it does. At that point, we may need to make an adjustment to the financial plan depending on the hand we were dealt. Here’s how that works in practice.

When we initially build retirement plans, we line up decades of annual spending and other financial goals and compare them to what we can reasonably expect a client’s assets to provide. We don’t know what market returns will be in advance, so we have to run financial plans through thousands of potential investment returns and make sure any financial goals will be funded a reasonable percentage of the time. We actually don’t want them to be funded 100% of the time, as that likely means the plan is too conservative and needlessly sacrifices spending by being too pessimistic. We look for plans to be in a “comfort zone” where we are confident goals will be funded, but not unreasonably confident.

This process must account for the possibility of very bad returns, which ultimately anchor how much a person can plan to spend at the beginning of a long period like a multi-decade retirement. What usually happens is that those completely horrible returns do not show up, and the plan ends up over-funded. This means a client could spend more each year, take out a lump-sum for a dream vacation, reduce risk in their portfolio, or some combination of the three. If the client wanted to increase spending, for example, we would re-run the plan and test the impact of increased spending until we found an amount that landed the financial plan back in the comfort zone.

If the opposite happens, and you are given a market so bad you have to make adjustments, the process works just the same. Spending could be reduced until the plan was back in a reasonable comfort zone. Though reducing spending is not a fun adjustment to make, it is usually small and temporary, and has a huge impact on the long-term viability of the plan.

Though a financial plan has value in pointing you in the right direction initially, one of the key benefits of working with a financial planner is the ability to make these mid-course adjustments. If you aren’t sure how to make adjustments to your lifestyle in response to the financial hand you are dealt, you may want to consider working with a financial planner.

What is an IRA?

Daniel Ruedi, CFP®, RICP®

An IRA – short for Individual Retirement Account, is an investment account that allows people to set aside money for retirement. There are two different types of IRAs: trraditional IRAs and Roth IRAs. Though similar, they are in some ways opposites for tax purposes.

When you contribute to a traditional IRA, you can deduct the payment from your income now, lowering your current tax bill. Any money invested in an IRA grows tax-deferred, so you do not have to pay taxes on any investment gains until you withdraw them in retirement. When the funds are withdrawn, you owe taxes on the entire amount of the withdrawal (your contributions and any earnings) at your ordinary income tax rate.

Traditional IRA investors must wait until age 59½ to withdraw their money, or they will be hit with an extra 10% penalty on the entire amount withdrawn (with some limited exceptions.) They must also start taking out required minimum distributions once they turn 73.

Anyone with earned income can contribute to a traditional IRA and can receive a tax deduction for up to $6,500 worth of contributions ($7,500 if over age 50), though this amount may be reduced based on their income and whether their workplace has a retirement plan. There is no income limit to non-deductible contributions to traditional IRAs.

Roth IRAs are in many ways the opposite. Contributions to Roth IRAs are made with “after-tax” dollars – you do not get to deduct them and lower your taxes. Contributions grow tax-free and when it is time to withdraw from the account during retirement, the entire withdrawal (contributions and earnings) is tax free.

Roth IRA investors must wait until age 59 ½ and the account must be open for 5 tax-years before withdrawing any funds from a Roth IRA, or they will owe taxes and a 10% penalty on the earnings portion of the withdrawal. Since contributions to Roth IRAs are made with after-tax dollars, they can always be withdrawn tax-free, penalty free. People under certain income thresholds can contribute up to $6,500 per year to a Roth IRA, or $7,500 if they are over 50.

IRAs are easy to open up with major brokers like Charles Schwab, Vanguard, and Fidelity. IRAs are attractive to investors because of their tax benefits, but also because they provide more flexibility and investment options than a 401(k). In addition to the mutual funds and ETFs, IRAs can also hold individual stocks, CDs, and even real estate. If you aren’t sure how an IRA fits into your retirement plan, you may want to talk to a financial planner.

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.