Finance 101: January 2023
In January the financial advisors at Ruedi Wealth started the year with five more columns for The News-Gazette’s Business Extra section. Make sure to look for them every Sunday, but in case you missed any in January all five are below.
The Roth Opportunity for Young Savers
Daniel Ruedi, CFP®, RICP®
When saving for retirement, people often get stuck on the Roth versus Traditional decision. As it is basically a choice between paying taxes now and paying them later, the option that makes a person better off depends on his or her tax rate now versus the future, which is often very hard to predict. But there are certain groups that can be pretty confident they will be better off with a certain option. One of which is young people who are making their first paychecks.
Young people who are just beginning to earn money will likely have a low income, and thus a low tax rate. With the standard deduction at $13,850 for a single tax filer in 2023, it is possible for someone earning below the standard deduction (who thus owes $0 in taxes) to have enough earned income to max out an IRA as the 2023 limit is only $6,500. Obviously, you can’t go lower than a tax rate of 0% so this really creates the perfect opportunity to choose the Roth option. Because a young person’s contribution will grow over decades, this will effectively shield a lot of gains from being taxed.
A simple example can show how useful this could be to a young saver. Suppose a person in their early 20’s working a summer job decides to save in a Roth IRA, giving the money almost four decades to grow before retirement hits. Though past performance is not an indication of future results, money invested in the stock market has historically doubled roughly every 7.2 years, which gives any amount that young saver contributes now, enough time to double five times. At that rate, $6,500 would potentially grow to over $208,000 around retirement time, and then be withdrawn tax-free, shielding $201,500 from taxes.
Of course, this all assumes a young person has the discipline to save a large portion of a limited income, which may be a stretch at best, impossible at worst. I used a Roth IRA in the example because babysitting, lawn mowing, and other summer jobs aren’t likely to provide 401k plans that make it easy to save. For this reason, a parent or other party who is interested in the success of a young person may want to open and contribute to a Roth IRA for them.
What can seem like an insignificant amount of income can provide savings that have a material impact on retirement. Young savers should take advantage of the opportunity they have to use a Roth IRA to the fullest extent possible.
Daniel Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.
The Three Steps to Wealth
Paul R. Ruedi, CFP®
What makes a person become wealthy? Is it a single stroke of luck or good decision? Not likely. More often wealth requires a lifetime of correct choices. But that lifetime of correct choices condenses into three main steps: wealth requires that you first make money, second that you don’t spend all of it, and third that you invest it wisely.
The first step, making money, is very ambiguous for a reason. The more you can make the seemingly easier it is to become wealthy, but I’ve seen major wealth built on modest incomes. Some may seek out education and work hard to increase their wages. Others may go slow and steady at a reliable job and let the second two steps on the path to wealth do more of the heavy lifting. Moral of the story, simply having regular income is the first step to wealth. The path you take to that income is totally up to you.
However even a high income isn’t going to guarantee wealth. I know plenty of high earners who are not on a path to wealth due to their spending. So the second key step on your path to wealth is that once you are making some income, you must then not spend it frivolously. This doesn’t mean you need to live a ridiculously frugal lifestyle; you do want to enjoy life to some degree. But you must set up your spending habits relative to your income in a way that provides you with an ongoing cash surplus that you can save and invest.
But even a high income and sensible lifestyle that results in a good savings rate aren’t guarantees of wealth. I know people who had both, but had a very unfortunate experience investing that ultimately undid a lot of their hard work. That is why the third step to wealth is to invest your money wisely. Make sure you do your due diligence to understand what you are investing in.
Though any one of these three parts taken to an extreme could produce wealth independently, it is much more likely that you will need to get all three parts correct in order to become wealthy. The problem is, not everyone has the right mix of motivation, discipline, and knowledge to make it through all three steps on their own. If you need help with any one of the steps mentioned above, you may want to seek the advice of a financial professional.
Paul R. Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.
Investors Quietly Quit Losing Investments
Paul Ruedi
When Bitcoin ran up to around 65,000 at its peak, a lot of people who had jumped on board were eager to tell you all about their investments in Bitcoin and other cryptocurrencies. Between the social media “experts” and the talking heads on traditional financial media, it was tough to avoid. It made investors feel terrible, like they had missed the boat on a life changing investment. Or worse, that they could still get on board.
Fast forward a little over year and Bitcoin is worth roughly a quarter of its old high. And I happened to notice those same people did not so loudly inform us of the fall of Bitcoin as they did its rise. This is not meant to put down Bitcoin investors. I am simply using them as an example of something that happens all the time: when people choose a winning investment, they are very likely to tell you all about it. When things don’t go well, you get crickets.
The same could be said of investors who were crushing the market investing in Tesla stock until it took a nosedive. Or the folks who piled into meme stocks. If you follow up on a lot of these game-changing investments people were excited to tell you all about, they often don’t turn out pretty. But only a financial advisor like myself or someone who is very interested in investing is going to keep score like this.
When investments don’t go well, people are likely to quietly quit them instead of telling you about their misfortune. But constantly hearing about other investors’ winners and not their losers could lead a typical investor to believe everyone who is tinkering with their investment portfolios is getting rich. This could tempt bad behavior.
It is tough to avoid the temptation to chase the performance of the winning investments seemingly everyone is talking about. But remember to follow up on those stories. They don’t all turn out well. Investors are better off investing in a portfolio that is low-cost, diversified, and aligned with their most important financial goals, instead of taking the risk on investments they may have to quietly quit later. If you do not have the discipline to build a sensible portfolio and stick with it yourself, you may want to talk to a financial advisor.
Paul Ruedi is the CEO of Ruedi Wealth Management in Champaign, Illinois.
Asking the Wrong Questions
Paul Ruedi
On one of our recent “On the Money” radio shows, Dr. Fred Giertz mentioned how our show has morphed over the years to become more about practical retirement planning and less about debating investment philosophy. I had to admit that in the early days I was quite the evangelist when it came to promoting the benefits of passive investing over active investing. But these days the total dollar amount invested in passively-managed index funds is larger than the amount of actively invested dollars, so I simply assumed that battle had already been fought and won.
But occasionally I look through Google trends to see what financial topics are on people’s minds, and I noticed something interesting. Searches for “best stocks to invest in 2023” was on the list of the past month’s top ten searches in various iterations three times. Clearly the desire to actively manage is alive and well, and some words of caution may be needed.
Every day investors buy and sell investments based on all the available information that anyone could possibly know. With millions of people buying and selling all the time, investment markets are remarkably efficient at incorporating all available information. The idea that you know something the markets do not, or that you are going to outsmart the collective wisdom of millions is a dubious premise from the start.
Trying to constantly pick winners and shift between investments tends to result in investment portfolios that are overly-concentrated, have higher transaction costs, and are less predictable for financial planning purposes. This would be forgivable if active management actually enhanced performance. But when you look at active management in practice, it usually fails to deliver what it promises.
Year after year studies show that the vast majority of professional money managers fail to beat their relevant benchmarks. I can’t imagine the odds of an amateur stock picker doing so are much better. For this reason, investors are much better off simply buying and holding the entire market using a portfolio of diversified, low-cost, passively-managed index funds.
It sounds simple, but it isn’t easy. The desire to tinker with your portfolio to reach for higher returns, or abandon your investments during a perfectly normal temporary decline, are very tough to resist. If you aren’t sure you can handle the temptations and emotions of investing yourself, you may want to seek the guidance of a financial advisor.
Paul Ruedi is the CEO of Ruedi Wealth Management in Champaign, Illinois.
Can You Make Your Child a Millionaire?
Paul R. Ruedi, CFP®
Paul Sr. is currently in the middle of a project that has put him in very close touch with the long-term historical returns of the stock market. So when he came to visit a couple weeks ago, we were having fun figuring out how much it would take to make my 7-month old son a millionaire by a normal retirement age in 60 years. The answer is likely a lot less than you would expect.
Rather than dig through historical data, I think it is more helpful to give a sense of how much compound growth takes place over long periods of time using the rule of 72. The rule of 72 suggests if you divide the number 72 by the growth rate of your investments, you get a rough idea of how long it takes your money to double. A long-term stock return of just over 10% implies money doubles every 7.2 years or so on average.
Given my son has a full 60 years or more before retirement, any money invested now could have time to double 8 different times. So let’s start with $1,000,0000 and work backwards by dividing it in half 8 times. The first time gets you to $500,000, the second to $250,000, the third to $125,000, the fourth to $62,500, the fifth to $31,250, the 6th to $15,625, the 7th to $7,812.50, and the 8th to $3,906.25. I know it seems like a lot to spell out that number sequence, but without really breaking down the numbers like this, telling someone that just under $4,000 could grow to a million can sound downright unbelievable.
Of course inflation will devalue that million dollars by the time a child retires. To account for this you can use the inflation-adjusted returns, which have historically been just above 7%. Using the rule of 72 with 7% implies money invested at this rate doubles roughly every 10 years; over 60 years money will double 6 times. This means you would have to invest $15,625 to have $1,000,000 in today’s dollars in 60 years.
Yes, this was a very simple example based on average returns. Of course, past performance is not an indication of future results and there is no guarantee returns will be as high in the future. But it is clearly possible to grow a small sum into a million dollars by the time a child retires. But even if you can, should you do it? I suppose that is the real million-dollar question only you can answer.
Paul R. Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.
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.