Finance 101: November 2022
In November 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 any of the columns from November all five are below.
The Retirement Voyage
Paul Ruedi
In a past column, I spoke about the uncertainty of investment returns and the importance of adapting to whatever hand you are dealt. But trying to explain how that process actually works in practice is often difficult without being too technical.
For this reason, I think it is helpful to use the analogy of a voyage on a sailboat. Though you know generally where you are heading, due to the variability of winds or currents you don’t know the exact path you will take or how long the journey will last. For the sake of example let’s say this voyage will take anywhere from two to four months.
Now suppose you had a certain amount of resources (food, water, etc.) to get you through that journey. How would you plan to use up those resources along the way? Consume too much and you end up running out before you get there, which could be rather catastrophic. On the other hand, you don’t want to consume so little you end up malnourished with plenty of resources to spare upon your arrival.
Likely, you would start out conservatively – using up your resources at a pace to last the entire four months or even longer if necessary. If you were one month into the journey and found you were more than halfway there, but only a quarter of the way through your resources, you’d likely start consuming more to celebrate being ahead of schedule. If you used three months of resources and realized you were only halfway there, you’d likely cut your consumption to avoid running out of resources.
Though retirement plans set off in a certain direction and know roughly how they will get clients through multiple decades of spending, they will have to adapt to whatever hand they are dealt as far as investment returns. These adjustments should be expected and are extremely crucial to the process if you want to balance living life to the fullest with minimizing the risk of running out of money.
When planning for retirement, we usually start off on the conservative side. But we aren’t hoping to get to a destination, we are hoping for a fantastic voyage. So we will want to make upward adjustments whenever we find we are ahead of schedule to avoid ending up the richest person in the graveyard. If you aren’t sure how to build a retirement plan and make those adjustments yourself, you may want to talk to a retirement planner.
Paul Ruedi is the CEO of Ruedi Wealth Management in Champaign, Illinois.
The Tao of Passive Management
Paul R. Ruedi, CFP®
Though I read and write about financial topics at work, some of my favorite subjects to read about in my personal time are the various religions and spiritual philosophies from around the world and across time. Though I don’t like to pick favorites, I certainly seem to relate to the Taoist view of the world more readily than a lot of other spiritual philosophies. For me, Taoist philosophies find a lot of easy application in almost all aspects of life, even when it comes to managing investment portfolios.
Taoism is an Eastern philosophy that traces its roots back to the Chinese hermit Lao Tzu. My entirely over-simplified understanding of Taoism is that it essentially describes or understands reality as the natural arising and unfolding of things. I used the word natural because I think the Tao is most easily observed in nature, for example as trees grow toward light and water flows downhill.
The key to a successful existence would be to align yourself with this process. If you happen to be swimming in a stream, it is obvious you will be able to maneuver more easily by swimming downstream, with the current, than trying to fight it. In this way, a person is able to use all the energy of nature not by overcoming it but by embracing and becoming it.
I can’t help but see how this philosophy applies to how investment portfolios are to be managed to achieve their desired goal of generating a return. Lao Tzu’s Tao Te Ching mentions that the best way to manage or rule is to simply act natural and manage by “not managing.” Sound familiar? This is the entire philosophy of passive index investing that Paul Sr. has been discussing on the radio for decades.
Traditional active managers put forth great effort to “create” returns, by researching and deciding which stocks to pick and when to own them. This is wasted effort at best, detrimental at its worst. Compare this to the passive managers who don’t waste effort deciding which bets to make and simply harness what happens naturally – the upward march of the entire market over the long term. While the active managers spend their effort rowing ferociously to get to their destination, the passive manager puts up a sail and gets there effortlessly. The question is, which boat would you rather be in?
Paul R. Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.
Can Rising Interest Rates Benefit Retirees?
Paul Ruedi
With the Fed on a mission to bring down inflation with aggressive interest rate hikes, the prices of bonds have experienced a massive decline this year. Though this cure is worse than the disease of inflation, This may leave investors feeling burned by their bonds or bond funds. But higher interest rates can actually be a good thing for retirees with a long enough time horizon.
Though rising interest rates and falling bond prices are painful in the short-run, they usually provide a better opportunity set to invest in going forward. For example, at the beginning of this year the 10-year treasury was yielding around 1.5%. It is now yielding in the ballpark of 4%. Yes, the path we took to arrive at this situation was rather painful. But as a retiree wouldn’t you rather own bonds that produce 4% over the next 10 years instead of 1.5%?
Most retirees invest in bonds through bond funds, which themselves own a diversified portfolio of bonds with different maturity dates. When those funds receive coupon payments or the bonds they own mature, they are then free to reinvest the proceeds at higher yields. Eventually investors get to trade up their entire bond portfolio into one with higher yields, which ultimately results in higher nominal returns (not adjust for inflation) going forward.
Of course, the huge unknown is how those yields will be eroded by inflation. You could say that with inflation running above 8% bond investors who are investing at a 4% yield are worse off than those who invested at close to a 1.0% yield two years ago when inflation was running 1.4%. But that assumes inflation stays at this rate, which is uncertain. With a potential recession looming we could easily see inflation drop. Nobody can really predict future inflation. The higher payments of your bond portfolio, however, are fairly certain.
It is difficult for investors to stick with their investments during tough times, especially when what they thought was the stabilizing asset in their portfolio takes such a large hit. But investors often have a time horizon that enables those higher yields to make up for the current drop in the value of their bonds. This can actually make retirees better off, but they have to let it play out over time. If you don’t have the discipline to do that yourself, you may want to seek the help of a financial advisor.
Paul Ruedi is the CEO of Ruedi Wealth Management in Champaign, Illinois.
Source: Treasury Yield and inflation data from ycharts.com.
Bond Duration
Paul R. Ruedi, CFP®
Though the term (length of time) and the credit quality of a borrower determine your risk and return profile as a bond investor, perhaps the single most important number to understand about your bond portfolio is its duration. Mathematically, the duration of a bond or bond portfolio is the weighted average maturity of all its expected cash flows, expressed as a number of years. This number can then be used to tell you a couple of things about the behavior of your bond portfolio. The first is approximately how much it will fall in response to interest rate rises. The second, is roughly how long it will take to break even given a rise in interest rates.
For example, suppose a bond portfolio has a duration of 7. If interest rates rise 1%, that bond portfolio will drop 7%. It will also take this same portfolio 7 years to recover from this drop in principal and “break even,” as if the rise in interest rates never happened. Now imagine that same portfolio with a rise in interest rates of 3%, like we saw this year, and you can see how things got ugly for a lot of bond investors. After all, a bond duration of 7 isn’t ridiculously high– The Vanguard Total Bond Market Fund has a duration of 6.5 for example.
Duration allows bond investors to understand their risk in a very practical way. It is wise for investors to choose a bond duration that is shorter than any goal those bonds payments are intended to fund. For example, if a couple was setting aside money in bonds to buy a home in 5 years, they would want to make sure their bond duration was below 5 years.
In the context of using a balanced portfolio to fund retirement, the purpose of bonds is to provide stability and something to draw on when stocks experience a temporary decline. High-quality, low-duration bond portfolios don’t provide much of a return, but they provide much more stability in the face of interest rate rises. Many temporary declines are accompanied by interest rate drops, but this year has shown the opposite can be the case.
Investors should understand the duration of their bond portfolio and make sure it is aligned with their goals. Retired investors in a balanced portfolio may want to keep their duration very short in pursuit of stability. If you are not able to figure out how to do that yourself, you may want to talk to a financial advisor.
Paul R. Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.
When Investing Gets Hard, Remember Its Purpose
Paul Ruedi
Even in the best of times, setting aside a portion of your money to take the risk of investing and growing your wealth can be difficult. When you are saving and investing to fund future goals, you make a sacrifice now but get nothing in the short-term to reward you. Even though you get closer to your goals little by little, when goals are still off in a distant future, you don’t feel any closer to them.
In this way, saving and investing can feel thankless, like you are on a financial treadmill getting nowhere. It is quite easy for investors to lose motivation, even in the best of times when they are being rewarded with good returns. When markets decline and people feel they received nothing for that sacrifice, or even worse were punished for it, staying motivated to save and invest can become even more difficult. This can cause some investors to burn out completely.
This is when it is most important to remember the purpose of your saving and investing. People don’t just invest to grow their wealth arbitrarily – they always have a purpose for their money. Maybe that purpose is funding your dream retirement or a child’s education. Perhaps it is leaving behind money to family members or your favorite charitable cause or providing wonderful family vacations.
Whatever the purpose, when you are feeling burnt out of saving and investing, or wondering why the heck you are taking the risk of investing, focus on that purpose for investing. This is helpful in both good times and bad, but it seems to be especially useful in the bad times.
Though your progress may be small relative to how much more you need to achieve your goal, track and celebrate every bit of progress. If you’ve taken a step back because of the most recent market decline, don’t dwell on that. Though it is not a guarantee, when prices drop, expected future returns tend to be higher, which often can make up for lost progress towards your goals.
Always remember your purpose for investing, because if you have a plan to achieve that purpose and the discipline to stick to that plan, it is only a matter of time until you get there. If remembering your purpose for investing is not enough to keep you in your seat during tough times, you may want to seek the help of a financial advisor.
Paul Ruedi is the CEO of 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.