Finance 1: Money Management Skills (v1.1)
A key reference is Professor Michael Finke of Texas Tech University. It is not to be considered professional financial advice from me. Please consult a financial planner for advice that suits you.
The two most basic things every household should do are plan
for emergencies, and follow a budget and take control of the spending. Robert
Wunderlich well and simply explains these two subjects below along with the power of compound interest.
Becoming
Financially Resilient - by Robert Wunderlich (substack.com)
Simplify
your money life - by Robert Wunderlich (substack.com)
The Power of Compound Interest - by Robert Wunderlich (substack.com)
The rest of this blog is oriented more towards people who
want to understand concepts, than people who are looking for a flow chart for
financial decisions. Money management requires knowledge of financial products,
investment and risk theory, and applicable tax rules. Financial planning
requires us to not only know what to do but how to put together a plan that
will actually work. It also requires us to understand how we as fallible humans
make mistakes - temptation and emotions come in the way of good financial
decisions. This blog will not touch much on that aspect.
Life Cycle Theory is an important framework to help make
rational financial decisions. Life cycle Theory says financial decisions are
all about decisions about spending and saving over different time periods and
transferring funds across time (forward or back). It is based on a number of
assumptions. First is Decreasing marginal utility of money. Utility here means
satisfaction. It means we get a little less satisfaction with each additional
dollar we spend. With this lens borrowing and saving is transferring money
across time to yourself – to a point where utility is higher. Spending the same
amount of money every year of your life maximizes utility. The instruments
typically used to transfer are bank accounts, mortgages, mutual funds, student
loans, etc. Second is our income tends to follow a predictable pattern over our
lifetime. More education means a steeper income growth path — an average
college graduate makes roughly $1–2 million more over a lifetime. So, a
student loan to get educated makes good sense. You should save a larger
fraction as your income rises. Investment is anything we do to reduce our
spending now to increase it in the future. Getting an education is an
investment. A mortgage finances an investment (the home), but the mortgage
itself is a liability. Buying durable goods is not technically an
investment in finance because they depreciate, but you can continue to
enjoy them much later. Risk is all about a wider range of spending
possibilities in the future. Insurance is the key vehicle to manage certain
types of risks. Insurance is a way to transfer money to yourself in the future
that has experienced a disaster.
Choosing the right kinds of instruments to invest in is what
smart investing is all about. This section gives you a framework on how to
think of investments. The purpose of investments is to make available funds in
the future to spend. So, it should match your spending goals. Your spending
goal should drive how you invest. The key factors to consider are liquidity,
risk, and diversification. Sometimes tax may make asset sale less attractive.
You may want to lock up some assets while keeping others for sale in
emergencies.
Liquidity: Liquid assets can be turned quickly into
cash. But liquid assets have an exceptionally low or nonexistent rate of return
but are safe. Safe assets have a lower rate of return than risky assets.
Investments that are easier to exchange for cash will have a lower return.
Liquid assets also create temptation.
Risk: Risk is degree of uncertainty of the value of
the funds in the future. Risk tolerance for an investor is the degree of
comfort with risk. Bonds tend to be less risky than stocks. The difference is
called the risk premium. Historically stocks have outperformed bonds
consistently. You may want to take more risk for long term goals. Risky
investments tend to be more volatile. A good approach is to accept an
occasional loss when taking risk makes sense.
Diversification: Modern Portfolio Theory (MPT) points
to some of the benefits of diversification. By mixing asset types in your
portfolio, you reduce volatility. MPT recognizes that you cannot fully get rid
of systematic risk as the economy goes through its cycles. MPT also recognizes
the risk associated with a single stock as opposed to a bucket of different
stocks. This is an unsystematic risk (also called firm-specific risk). MPT says
that the risk in your portfolio is directly related to the amount of systematic
risk. Greater systematic risk should get higher expected return. They get no
extra return for bearing unsystematic risk. A broad diversified portfolio is
called a market portfolio.
So, what are the key financial instruments?
Cash is the most liquid asset. The main purpose of
cash is direct transactions between individuals.
The most useful liquid assets are checking accounts, money
market and savings accounts and money market mutual funds in increasing order
of returns. FDIC protects most checking, money market and savings accounts in
the US for up to $250K/account. Money Market mutual funds however are not
insured by FDIC. Most of these liquid funds are fully taxable, though
municipal money market funds can be tax‑exempt.
Mutual Funds buy stocks or bonds in the market and
sell shares representing a proportional interest of the fund to investors. The
most common fund is an index fund for the S&P500. A global fund instead
spreads across the US and other foreign markets. An international fund will not
include the US. Mutual funds charge an expense ratio for the service. There are
actively managed funds and passively managed funds. Interestingly actively
managed funds underperform after fees and trading costs.
ETFs are similar to mutual funds but trade on the
market instead of issuing a redeeming share to retail investors.
Growth stocks are from companies with a good
potential to grow and tend to be younger companies. Value stocks tend to
be older dividend-paying companies. Stocks held for a longer period qualify for
capital gains tax rate. I will dwell deeper into how the stock market works in
another blog.
Bonds are paid an agreed-to return periodically and
when the bond matures you get your money back. The current market value of a
bond holding will fall if the interest rate rises and will rise if the interest
rate falls. The amount of rise or fall depends on bond duration. Long term
bonds are more affected than short term bonds. So bonds do have some market
risk which disappears if you hold it to term. Also, the organization issuing
the bond may default. Higher quality bonds give less return than lower quality
bonds. Bank certificates of deposit (CDs) behave similarly to bonds but are
not bonds; they are bank deposit products with FDIC insurance. Bonds
generally give a higher return than liquid assets. Bond payments are taxed at
the ordinary income tax rate. U.S. Treasury bonds are exempt from state and
local taxes; municipal bonds may be federally tax‑exempt.
Derivatives and hedge funds are complex advanced
approaches and beyond the scope of this blog.
Loans are a financial instrument to get money now to
spend to repay later over time. This blog does not dwell into loans. A mortgage
is a loan as is a reverse mortgage. A credit card is a revolving credit line,
which could become longer term if you carry a balance month on month.
Real estate and commodities/precious metals/jewelry
like gold, art and gems are another instrument but beyond the scope of this
blog. REITs are instruments that invest in real estate.
A business that you own that grows is another
instrument to accumulate wealth. Don't really consider that a financial
instrument though.
The number one goal of saving/transfer funds across time is
often retirement. The key vehicles are annuities, savings, traditional IRA,
ROTH IRA, 401K, TSA, and pensions. There is also Social Security that provides
funds for retirement and Medicare that provides health insurance. Retirement
planning is beyond the scope of this blog. Other major goals for
saving/transfer funds across time are buying your home and your education, but
these are beyond the scope of this blog. Using insurance to mitigate risk is
also beyond the scope of this blog. Lastly factoring in inflation into your
financial decisions is also beyond the scope of this blog. After you pass what
happens? Estate planning, wills, living trusts and life insurance are beyond
the scope of this blog.
Want to Read on?
NEXT: How the stock market works
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