Finance 1: Money Management Skills (v1.0)
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 2.1
million dollars more over the 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 is an investment. Buying durable
goods is an investment because you can continue to enjoy it 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. All these liquid funds are fully taxable.
- 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 (because they have to pay a fund manager)!
- ETFs are similar to mutual funds but trade on the market instead of issuing a redeeming share.
- 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 capitals 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 certificate of deposits are bonds. Bonds generally give a higher return than liquid assets. Bond payments are taxed at the ordinary income tax rate. Government bonds have tax advantages.
- 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 short-term loan, 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.
Comments