Finance 101: March 2023
In March the financial advisors at Ruedi Wealth Management wrote five more finance 101 columns for The News-Gazette’s Business Extra section. Make sure to look for them in the paper every Sunday, but just in case you missed any of the columns from March you can find them below.
Certificates of Deposit
Paul R. Ruedi, CFP®
A Certificate of Deposit or “CD” for short is an agreement to keep a deposit at a savings institution for a specified term that can be as short as a few months or as long as a decade. In exchange for doing so, savers receive interest on their deposits that build up until their maturity date when the funds can be withdrawn or rolled into a new CD. Though CDs can be withdrawn before they mature, there is a penalty for doing so. This is a key distinction between a CD and a savings account, since money in savings accounts can be withdrawn at any time.
Most CDs pay a fixed interest rate that is locked for the entire term and will not be impacted by movements in the prevailing interest rates. Other CDs may offer a rate that can rise or fall with interest rate movements, or may be fixed for a time with the option to bump up the rate later. Though interest is often paid monthly or quarterly, you often cannot withdraw the interest payments without penalty until the CD matures. But savers should be aware that any interest the CD paid is considered taxable interest income even if you cannot withdraw those interest payments without penalty.
The rate investors receive on CDs is very low because they are considered extremely safe. Certificates of Deposit are insured up to $250,000 by the FDIC for banks, and NCUA for credit unions, so savers are covered even if the financial institution that issued their CD goes under. Because they have to compensate savers for locking their money up for a certain period of time, they pay an interest rate above that of a typical savings account.
A CD can be a good option for someone who wants to set aside funds they will not need for a certain period of time in a very safe way. But because they are so safe the interest rates they offer usually do not keep up with inflation. For this reason they are not a great option for those looking to grow their wealth and fund long-term goals.
There are many brick and mortar and online options for those looking to purchase CDs. The terms, interest rates, and early withdrawal penalties are all set by the financial institutions that offer CDs so it is very important to shop around. If you are unsure how to decide between different CDs, or are wondering if CDs fit in to your financial plans, you may want to talk to a financial advisor.
Paul R. Ruedi, CFP®
Many people have heard the saying “don’t put all your eggs in one basket” with respect to investing. Though that saying contains a ton of practical investment wisdom, what it doesn’t cover is how many eggs is too many for one basket. When an investor has a large amount of money in a single type of investment, they run the risk that if something goes wrong with that one investment it can take their whole financial health down with it. This is often called “concentration risk” and should be avoided to the best extent possible.
Concentration risk comes in many forms. There are some fairly obvious concentration risks, like having all of your money invested in a single company. We know even the best blue-chip companies can go out of business or produce terrible returns for investors. Any investors who have a large amount of money in a single stock are bearing a serious risk that things could go poorly with that company and destroy their finances.
But even a portfolio of multiple stocks, or hundreds of stocks could still involve some concentration risk. For example if a person owned dozens or hundreds of stocks all in the same industry, they may feel diversified by investing in so many different companies but are still facing a concentration risk. If something happens to go poorly for that industry, it will take down the entire portfolio.
This can even apply if investors diversify across a number of industries, but invest entirely in one country. Individual countries go through streaks of good and bad performance. Concentrating all your money in a single country, even a large one like the United States, runs the risk you catch that country during a bad performance streak.
The question is, how much of a person’s portfolio can one investment represent before it creates a serious risk to that person’s finances? This is one of those situations where you have to simply look at the potential downside and see what risks your finances can handle. If a person has 10% of their portfolio invested in a single company and having that much of their portfolio go to zero would make them unable to fund their goals, then they have a concentration risk they should try to remove.
If a person is planning for serious financial goals like funding a retirement, it is best to have as few of these risks present as possible. If you cannot spot and remove the concentration risks in your portfolio yourself, you may want to seek the help of a financial advisor.
What is FDIC Insurance?
Paul R. Ruedi, CFP®
With news headlines about bank failures, FDIC insurance has come to the forefront. Though many people know the basics, that it is a financial safety net for depositors in case the bank holding their money goes under, I think the details about how much is covered and what this insurance actually applies to are much less understood.
The Federal Deposit Insurance Corporation, or FDIC for short, was founded in 1933 in the wake of a huge number of bank failures that occurred during the Great Depression. The idea was to give consumers some sort of guarantee that their money would be returned to them, even if something happened to the financial institution where the deposit was being held. The FDIC is an independent government agency that is funded by fees paid by banks and savings institutions called members.
FDIC deposit insurance applies up to $250,000 per account, per legal ownership name. A husband and wife could have accounts in their individual names covered up to $250,000 each, or a joint account covered up to $500,000. A person who owned multiple businesses could have an account for each business and those accounts would all be insured up to $250,000. Consumers also have the choice to put their deposits at different banks, and have up to $250,000 in coverage at each institution. Given the ability to spread money around and the relatively high limits for each account, the vast majority of people should be able to have all their deposits covered by FDIC insurance.
It is important to be aware of what exactly is covered under FDIC insurance and what is not. FDIC insurance applies to checking accounts, savings accounts, money market deposit accounts, Certificates of Deposit, cashiers checks, money orders, and a few other bank-issued items. Stocks, bonds, mutual funds, or really anything else held in a brokerage account, including money market funds and other cash equivalents, are not covered by the FDIC. It is also important to note that this insurance is only available to depositors regarding money held at a certain bank. It does not protect the bank’s stockholders, bondholders, or creditors.
If you are looking to deposit money in a bank, make sure it is at an FDIC member. It will likely be fairly obvious, as banks put “Member FDIC” all over their ads and official documents because it is such a big deal. If you aren’t sure, you can verify if the bank is a member on the FDIC’s website.
Stocks vs. Bonds and Retirement Spending
For retirees in globally diversified stock and bond portfolios, the ratio of stocks and bonds they choose to hold will determine the vast majority of their return as investors. Stock returns are less certain and thus provide higher returns over time. Bond returns are less variable and therefore offer a lower return. It makes sense that how much you put in one of these buckets versus the other would have a big impact on the return you receive as an investor. But what is less obvious is how it impacts a financial plan and how much people can plan to spend in retirement.
When we build financial plans we can’t just assume average returns. We have to account for the unpredictability of returns and the chance we could have bad luck. Stock returns are much more variable than bond returns, which means a much wider range of potential investment outcomes. Though over time you expect to be rewarded for this in the form of higher returns, it isn’t a lock. This can really anchor retirement spending plans, which must account for the possibility of bad portfolio returns.
When building financial plans, it is often the case that increasing the stock allocation of a portfolio from 50% to 60% or even 70% doesn’t increase planned ongoing spending as much as people would expect. You simply can’t bank on good or even average stock returns showing up until they do, at which point you can make an adjustment.
Though a higher stock allocation may not result in much higher planned spending on the front-end of retirement, there is a much higher likelihood that spending is able to be increased if the extremely bad returns we anticipate in our planning process don’t show up. Because of this greater potential for spending increases, a plan funded by a higher stock allocation will likely end up spending more if stock returns aren’t downright terrible; we just can’t plan on that in advance.
Though this is often the way the mix of stocks and bonds impacts retirement spending, this is by no means the case for all retirees. Depending on the specific plan and the timing of spending goals, the tradeoffs between owning more stocks and owning more bonds may be entirely different. If you don’t know the impact your specific mix of stocks and bonds will have on your financial plans, you may want to talk to a financial planner.
What if My Financial Firm Goes Under?
Paul R. Ruedi, CFP®
Modern investors often have their money held and managed by several different firms. They may work with a financial advisor, who manages their portfolio using investment funds that are held at a broker-dealer/custodian like Schwab or Fidelity. Those actual investment funds are managed by an entirely different company. I think this leaves a lot of people wondering: what happens to me if something happens to one of those firms?
If you work with a financial advisor who holds your assets at a large custodian like Charles Schwab, you will be minimally impacted if that financial advisor goes under. Your assets would still be held at Charles Schwab or whatever broker-dealer that advisor uses, and you would have access to them just like you had before. Though I’m sure it would be a somewhat alarming experience, and it may be a pain to lose your advisor and need to search for another, it really wouldn’t have a direct financial impact on investors.
The next question or concern is what happens if the custodian goes under. These are firms like Schwab, Fidelity, and E-Trade that buy, hold, and sell investments. In all likelihood if one of these firms went under it would be taken over by another firm and life would go on relatively unchanged. In the worst-case scenario, these firms are covered by the Securities Investor Protection Corporation, which provides similar insurance to what the FDIC provides for bank depositors.
In the event one of these firms goes under and your assets are missing, the SIPC will replace those assets. This coverage extends up to $500,000 for securities and up to $250,000 for cash, but only provides for total coverage of $500,000 per account. The rules of SIPC coverage are somewhat nuanced, and will be covered in a future column.
Last but not least, if the mutual fund company (Vanguard, iShares, etc.) that manages your investment funds goes under, the actual investment funds would likely just be taken over by another mutual fund company. You would still own the shares in that fund, and your portion of the stocks, bonds, or whatever the fund was investing in would remain yours.
People in the Midwest are very polite. But you shouldn’t be afraid to ask questions or voice the concerns that are keeping you up at night. Your advisor should be comfortable explaining to you what happens in these types of scenarios. The answers will likely bring you comfort. If they don’t, you may want to consider a new advisor.
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.