In July the financial advisors at Ruedi Wealth Management wrote 4 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 July all four are below.
Living Within Your Means
Paul R. Ruedi, CFP®
The importance of living within your means is something people have understood for a long time. Charles Dickens summed it up perfectly in David Copperfield: “Annual income twenty pounds, annual expenditure nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”
Living within your means is the first step on the path to financial prosperity, but it can be so difficult in a society obsessed with materials that enables you to spend more than you should by using credit cards. Keeping up with the Jones’s always seems to justify spending a little extra and figuring out how to pay for it later. Making matters worse, you generally don’t get immediate feedback that you are living outside your means – people often get away with it for years or even decades. But though you may get away with it for a while, eventually it will catch up with you.
To avoid the misery of over-spending, you must first be aware of your spending but also make choices to control it. The first is actually fairly easy in a modern world where most spending is done via credit and debit cards and can be easily tracked. Online tools like mint.com make it very easy to automatically track and categorize spending to get a better perspective on where your money is going. But then of course, you must do the more difficult thing: control your own behavior.
With a certain amount of income to go around for spending each month, you will need to make calculated decisions about how you money is spent. Ben Franklin took a somewhat extreme stance on this when he said “rather to go to bed without dinner than to rise in debt.” Though I think that may be a bit harsh, the seriousness of the comment shows how strong he felt about people doing everything possible to live within their means.
I agree with Dickens but am less harsh than Franklin. I don’t think living within your means requires cutting everything non-essential out of your life, and certainly not essentials like food. But you will need to make conscious choices to make your money go as far as possible to create a life that makes you happy without having to live outside your means to do it. If you don’t, the result won’t be pretty.
The Rule of 72
Paul R. Ruedi, CFP®
As an investor, perhaps the most important feature of an investment is the return it provides over time. But when comparing an investment with a 3% return to one with a 10% over long periods, the calculations beyond the first year get tedious. It can be challenging for investors to truly understand the magnitude of difference in the growth rates of different investments over long periods.
This issue is one that humans have been dealing with for centuries. Fortunately, investors can use a rule of thumb called the “rule of 72” to get an intuitive sense for how fast their investment grows. The rule of 72 first showed up in the historical record in the late 1400s in the work of a Franciscan monk named Luca Pacioli. The rule of 72 provides a back of the envelope calculation for investors to quickly get a sense of how fast their money doubles provided a specified yearly interest rate by simply dividing the number 72 by that rate.
Dealing with investments in terms of how long it takes them to double is more straightforward to grasp and more useful for a typical investor than performing multiple years of percentage calculations. It can help investors intuitively understand what to expect from their investments over a long period. Using the example in the first paragraph, if you invest in something that grows 10% per year, it will take 72/10 = 7.2 years to double. An investment at 3% would take roughly 72/3 = 24 years to double.
The math can also be applied to see how fast inflation strips away your purchasing power. At previous inflation levels around 2%, it would take 36 years for the prices of goods and services to double. At roughly 8% inflation, prices will double every 9 years.
The rule is not perfectly accurate and works best in the 5-12% range. Below that, a person could divide the interest rate into 70 to be slightly more accurate. Above that range, the rule starts to break down slowly by increasingly understating the amount of time it takes for an investment to double. Running to the most extreme example, an investment that grows at 72% will not double in a single year; that would require a rate of return of 100%. But for investors using the returns of typical investments like stocks and bonds, it can be a helpful tool.
The First Investing Lesson
Paul R. Ruedi, CFP®
My wife and I welcomed our first son in late June and not even a month later I am already thinking about how I will teach him about investing. Attitudes about investing are formed at a young age, and instead of investing being introduced as a chore that must be done later in life, I’d prefer it be introduced as something fun, early in my child’s life.
I think the earliest lesson you can teach kids about investing has to be the most basic: that you can give your money to someone else with the expectation that you will receive even more money back in the future. I distinctly remember when I learned this concept in second grade, when my parents and I took the small amount of money I had been given for my First Communion and opened a savings account at a local bank. The account paid an interest rate in the low single digits, but even that was enough to excite my younger self. I was fascinated that I would be maing money doing nothing!
I think this concept can be introduced even sooner than second grade. But waiting a year to receive single-digit interest on a small sum of money is something that is going to be tough for young kids to wrap their heads around, much less get excited about. Fortunately, a listener who called into our radio show a couple years ago gave me a great idea.
The listener mentioned he would offer to give his children something like a dollar, but give them the option to keep it with “the bank of mom and dad.” If they decided to leave their dollar at the bank of mom and dad, he would give them two dollars at the end of the week. Those may not have been the exact terms of his bank, but the key features were that the time horizon was short and interest rate was exaggerated to make the opportunity exciting and easy to understand for children. I feel like this provides very intuitive lessons about deferring consumption and the ability to make your money work for you that most people don’t learn until much later in life.
Teaching a child about the concept of investing in this way is a great start. But eventually, children will need to graduate to “real world” investing. In my next column, I will cover how I plan to introduce my son to real world stock market investing the same way it was introduced to me as a child.
Stock Investing for Kids
Paul R. Ruedi, CFP®
In my last column, I covered how I plan to introduce the concept of investing to my son at a very young age by offering an artificially high return at “the bank of mom and dad.” But eventually kids need to make the transition to learning about how to invest real money in actual investments. I think a great place to start is by teaching them about stock investing.
I learned about investing in stocks in grade school. Though you might expect that of a financial advisor’s son, my first experience with stock investing was actually thanks to my grandparents on my mom’s side. My grandparents generously decided to open up stock brokerage accounts for each of their grandchildren and gave all of us a small amount of money to invest. They gave us a few options for stocks to invest in and let us propose some of our own as well. We ultimately decided on household names like Walmart and McDonalds.
With a relatively small amount of money (it felt like a lot of money to a kid) my grandparents were able to provide us with a handful of very valuable investing lessons. First and foremost, was that when you buy a stock you are not just buying some abstract financial instrument, you are buying a portion of an actual company that produces the goods and services you see people consume every day. This was during the internet era, so I remember being able to track the price of the companies we invested in and watch them bounce around unpredictably, but go up over long periods of time. This helped me learn to ignore short-term price swings and focus on long-term growth.
Thanks to changes in the financial industry this will be easier to do for my son than it was for my grandparents to do for me. Opening up a brokerage account online is very quick and easy these days, as is trading and putting money into the account electronically. On top of that, there are now what are called “stock slices” or “fractional shares” that allow you to purchase small portions of shares of stock, often for as little as $5. All of this has lowered the bar significantly to get a kid started with stock investing.
Learning about investing in theory is one thing, but I think you learn more from actually doing something. I credit my lifetime comfort with investing to starting early, and plan to provide the same experience for my son when the time comes.
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.