ACADEMICS TALK about the risk-free rate—the return we can earn while taking virtually no risk. In the academic literature, the yield on Treasury bonds is typically deemed to be the risk-free rate. But for many families, the risk-free rate will be the interest rate on the highest-cost debt they have. After all, by paying down that debt, we effectively earn a rate of return equal to the interest rate that we’re getting charged—and we can do so without taking any risk.
IS A HOME A GOOD investment? We’re talking here about purchasing a place for your own use, rather than as a rental property, though many of the same issues arise.
There are two key factors to consider. First, there’s a question of time horizon. Because of the hefty costs involved in purchasing and especially selling a house, few people would advise buying if you have less than a five-year time horizon—and even that’s arguably too short.
WHEN WE BUY BONDS, we lend money to the government or corporations and, in return, we receive regular interest payments. When we borrow money, the roles are reversed: Instead of receiving interest, we’re paying it to others. On the family balance sheet, any money we borrow is effectively a negative bond.
This is a useful concept for two reasons. First, by viewing our mortgage, student loans, car loans and credit card balances as negative bonds,
IMAGINE YOU’RE a teenager, your older sister is heading off to college and she wants to take the car you share. She offers to buy you out, and says she’ll pay you $5,000 five years from now, after she graduates. But you’d rather be paid today.
What’s a reasonable sum to ask for? The right number might be around $4,500. If you got $4,500 today and invested it, you’d have $5,000 after five years,
SUPPOSE YOU BOUGHT a stock mutual fund five years ago and you still own it today. What return did you earn? If you go to the fund company’s website, it’s easy enough to find out the five-year total return. There’s a chance, however, that your personal performance was quite different from the fund’s published result.
The total return number will be a so-called time-weighted return, meaning it’s the return you would have earned if you bought the fund at the beginning of the period,
ESTATE PLANNING might sound like a daunting undertaking—and it can be for some families, such as those with great wealth or who have children with special needs. But for most folks, it isn’t all that complicated.
What’s involved? First, make sure you have the right beneficiaries listed on your retirement accounts and life insurance. For everyday Americans, their retirement accounts are often their most valuable asset, so it’s crucial that they have the correct beneficiaries named.
ANSWERING THIS question is surprisingly easy. Start by figuring out how much pretax income you want each year in retirement. Next, subtract what you expect to receive from Social Security and any employer pension plan. Whatever amount that leaves—let’s say it’s $40,000 a year—will need to come from your savings. You multiply that $40,000 by 25 and you have your answer: $1 million.
Sound like a huge sum? Keep a few things in mind.
WE PURCHASE insurance either to protect the property we own or to protect ourselves and our family. Reflecting this, insurance companies are divvied up into two broad categories. Property-casualty insurers offer auto, homeowner’s, renter’s and umbrella liability coverage. Meanwhile, life companies offer disability, health, life and long-term-care insurance.
Add up these various policies and we’re talking about eight different types of coverage. Which of the eight do you need? Here’s a quick rundown:
MANY OF US gradually buy into the financial markets over the course of our career. Arguably, that’s ideal, both from an investment and an emotional perspective: We purchase stocks and bonds at all kinds of prices—some high, some low—and the fact that we have future dollars to invest means any market decline has a huge silver lining.
But every so often, we’ll have a larger sum that we want to invest in the stock market.
OUR PORTFOLIO’S asset allocation—its basic split between stocks and more conservative investments—is the most important investment decision we make. Too often, folks make this fundamental choice based on some hunch about the stock market’s short-term direction. Alternatively, they back into the decision, buying a hodgepodge of investments and never formally settling on an asset allocation.
Want to do it right? We should think about how much risk we can reasonably take and how much risk we can stomach.
THERE ARE TWO reasons to hold cash investments: to cover upcoming spending and in case we’re hit with a financial emergency.
Suppose you plan to make a house down payment in the next five years or you’re five years from making your teenager’s first college tuition payment. You don’t want to see this money devoured by a stock or bond market decline, so you probably shouldn’t own anything more adventurous than a high-quality short-term bond fund.
VENTURING INTO the financial markets for the first time can be daunting, in part because there’s so much choice. Add up the number of individual stocks and mutual funds available in the U.S., and the options are in the tens of thousands. What if we also include all the individual bond issues? Now we’re looking at more than a million different securities.
To make that choice more manageable, try three strategies. First, look to fund your employer’s 401(k) or similar plan.
CONVENTIONAL WISDOM says those in the workforce should save 10% of their pretax income. But this is a number that each of us will likely want to adjust up or down—for four reasons.
First, this 10% savings rate is the amount often suggested for retirement savers. What if we have other goals, such as buying a home or putting the kids through college? These other goals would require additional savings, and we might find our total savings rate should be more like 15% or 20% of income.
AS WE TRY TO FIGURE out how to invest our savings, we need to tackle two separate—but closely connected—questions. First, why are we investing? We might be aiming to save for retirement, build up an emergency fund, pay down debt, fund a child’s college education or amass enough for a house down payment.
Second, what are our most attractive investment opportunities? We know what interest rate we can avoid by paying down debt. We can also be reasonably confident that,
GOT QUESTIONS? We’ve got answers. This chapter’s goal is to tackle basic financial questions that often crop up, especially among those new to the world of investing and personal finance.
When we’re starting out, there’s so much we don’t know—and so much uncertainty—that it can be paralyzing. Want to get your finances headed in the right direction? You might focus on the nine questions below. The good news: All nine can be answered fairly easily.