smartwomansecurities Personal Finance Saving and Investing September 15
smartwomansecurities Personal Finance, Saving, and Investing September 15, 2016 Susan Middleton Chief Investment Officer Counsel Fiduciary, LLC www. counselfiduciary. com susan. middleton@counselfiduciary. com 814. 450. 6246 1
Why save and invest now? The Bad News: • Social Security outflows exceed inflows starting 2018. Trust funds projected to be exhausted 2030. (Congressional Budget Office) • From 1980 through 2008, the proportion of private wage and salary workers participating in traditional defined benefit pension plans fell from 38 percent to 20 percent. (Social Security Administration) • College costs rose at an annual rate of 5. 94% from 19582005. Compare this to general inflation rate of 2. 99%. (Finaid. org) 2
Why save and invest now? The Good News Time Value of Money, or The Miracle of Compound Interest: • Scenario 1: Right now, at age 20, you start investing $4, 000 per year for 10 years by using your savings from summer jobs and eventually your full-time job. You never save another dime. • Scenario 2: You decide that you don’t have enough money to save right now because you are paying down college loans, so you wait. At age 30, you start investing $4, 000 per year for 10 years. • Scenario 3: You don’t start saving because you are paying not only college loans, but also a car and then a house, and before you know it, you are 40. You start investing $4, 000 per year for 10 years. 3
Scenario 1: Invest starting at 20 Age 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 Year Investment Interest Assets 1 $ 4, 000 $ 400 $ 4, 400 2 $ 4, 000 $ 840 $ 9, 240 3 $ 4, 000 $ 1, 324 $ 14, 564 4 $ 4, 000 $ 1, 856 $ 20, 420 5 $ 4, 000 $ 2, 442 $ 26, 862 6 $ 4, 000 $ 3, 086 $ 33, 949 7 $ 4, 000 $ 3, 795 $ 41, 744 8 $ 4, 000 $ 4, 574 $ 50, 318 9 $ 4, 000 $ 5, 432 $ 59, 750 10 $ 4, 000 $ 6, 375 $ 70, 125 11 $ - $ 7, 012 $ 77, 137 12 $ - $ 7, 714 $ 84, 851 13 $ - $ 8, 485 $ 93, 336 14 $ - $ 9, 334 $ 102, 670 15 $ - $ 10, 267 $ 112, 936 16 $ - $ 11, 294 $ 124, 230 17 $ - $ 12, 423 $ 136, 653 18 $ - $ 13, 665 $ 150, 318 19 $ - $ 15, 032 $ 165, 350 20 $ - $ 16, 535 $ 181, 885 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 TOTAL 21 $ - $ 18, 189 $ 200, 074 22 $ - $ 20, 007 $ 220, 081 23 $ - $ 22, 008 $ 242, 089 24 $ - $ 24, 209 $ 266, 298 25 $ - $ 26, 630 $ 292, 928 26 $ - $ 29, 293 $ 322, 221 27 $ - $ 32, 222 $ 354, 443 28 $ - $ 35, 444 $ 389, 887 29 $ - $ 38, 989 $ 428, 876 30 $ - $ 42, 888 $ 471, 764 31 $ - $ 47, 176 $ 518, 940 32 $ - $ 51, 894 $ 570, 834 33 $ - $ 57, 083 $ 627, 917 34 $ - $ 62, 792 $ 690, 709 35 $ - $ 69, 071 $ 759, 780 36 $ - $ 75, 978 $ 835, 758 37 $ - $ 83, 576 $ 919, 334 38 $ - $ 91, 933 $ 1, 011, 267 39 $ - $ 101, 127 $ 1, 112, 394 40 $ - $ 111, 239 $ 1, 223, 634 41 $ - $ 122, 363 $ 1, 345, 997 42 $ - $ 134, 600 $ 1, 480, 597 43 $ - $ 148, 060 $ 1, 628, 656 44 $ - $ 162, 866 $ 1, 791, 522 45 $ - $ 179, 152 $ 1, 970, 674 $ 40, 000 $ 1, 930, 674 $ 1, 970, 674 You retire with nearly $2 Million at age 65. 4
Scenario 2: Invest starting at 30 Age 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 Year Investment Interest Assets 1 $ - 2 $ - 3 $ - 4 $ - 5 $ - 6 $ - 7 $ - 8 $ - 9 $ - 10 $ - 11 $ 4, 000 $ 400 $ 4, 400 12 $ 4, 000 $ 840 $ 9, 240 13 $ 4, 000 $ 1, 324 $ 14, 564 14 $ 4, 000 $ 1, 856 $ 20, 420 15 $ 4, 000 $ 2, 442 $ 26, 862 16 $ 4, 000 $ 3, 086 $ 33, 949 17 $ 4, 000 $ 3, 795 $ 41, 744 18 $ 4, 000 $ 4, 574 $ 50, 318 19 $ 4, 000 $ 5, 432 $ 59, 750 20 $ 4, 000 $ 6, 375 $ 70, 125 TOTAL 21 $ - $ 7, 012 $ 77, 137 22 $ - $ 7, 714 $ 84, 851 23 $ - $ 8, 485 $ 93, 336 24 $ - $ 9, 334 $ 102, 670 25 $ - $ 10, 267 $ 112, 936 26 $ - $ 11, 294 $ 124, 230 27 $ - $ 12, 423 $ 136, 653 28 $ - $ 13, 665 $ 150, 318 29 $ - $ 15, 032 $ 165, 350 30 $ - $ 16, 535 $ 181, 885 31 $ - $ 18, 189 $ 200, 074 32 $ - $ 20, 007 $ 220, 081 33 $ - $ 22, 008 $ 242, 089 34 $ - $ 24, 209 $ 266, 298 35 $ - $ 26, 630 $ 292, 928 36 $ - $ 29, 293 $ 322, 221 37 $ - $ 32, 222 $ 354, 443 38 $ - $ 35, 444 $ 389, 887 39 $ - $ 38, 989 $ 428, 876 40 $ - $ 42, 888 $ 471, 764 41 $ - $ 47, 176 $ 518, 940 42 $ - $ 51, 894 $ 570, 834 43 $ - $ 57, 083 $ 627, 917 44 $ - $ 62, 792 $ 690, 709 45 $ - $ 69, 071 $ 759, 780 $ 40, 000 $ 719, 780 $ 759, 780 You retire at 65 with over $750, 000 5
Scenario 3: Invest starting at 40 Age 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 Year Investment Interest Assets 1 $ - 2 $ - 3 $ - 4 $ - 5 $ - 6 $ - 7 $ - 8 $ - 9 $ - 10 $ - 11 $ - 12 $ - 13 $ - 14 $ - 15 $ - 16 $ - 17 $ - 18 $ - 19 $ - 20 $ - TOTAL 21 $ 4, 000 $ 4, 400 22 $ 4, 000 $ 840 $ 9, 240 23 $ 4, 000 $ 1, 324 $ 14, 564 24 $ 4, 000 $ 1, 856 $ 20, 420 25 $ 4, 000 $ 2, 442 $ 26, 862 26 $ 4, 000 $ 3, 086 $ 33, 949 27 $ 4, 000 $ 3, 795 $ 41, 744 28 $ 4, 000 $ 4, 574 $ 50, 318 29 $ 4, 000 $ 5, 432 $ 59, 750 30 $ 4, 000 $ 6, 375 $ 70, 125 31 $ - $ 7, 012 $ 77, 137 32 $ - $ 7, 714 $ 84, 851 33 $ - $ 8, 485 $ 93, 336 34 $ - $ 9, 334 $ 102, 670 35 $ - $ 10, 267 $ 112, 936 36 $ - $ 11, 294 $ 124, 230 37 $ - $ 12, 423 $ 136, 653 38 $ - $ 13, 665 $ 150, 318 39 $ - $ 15, 032 $ 165, 350 40 $ - $ 16, 535 $ 181, 885 41 $ - $ 18, 189 $ 200, 074 42 $ - $ 20, 007 $ 220, 081 43 $ - $ 22, 008 $ 242, 089 44 $ - $ 24, 209 $ 266, 298 45 $ - $ 26, 630 $ 292, 928 $ 40, 000 $ 252, 928 $ 292, 928 You retire at 65 with less than $300, 000 6
Time Value of Money • Those examples all used 10% interest rate • Impact of taxes, transaction or other fees was not included • Example also did not account for inflation • Most importantly, example did not account for variation in returns • BUT… the numbers don’t lie. Returns are exponential in nature, not linear. 7
Personal Financial Planning • Set your financial goals • Educate yourself about investment options, risk and return, asset allocation and investment strategies, and costs • Set an initial plan • Use a PDCA cycle going forward 8
Setting Financial Goals • Record your goals, and save them for future reference. • Include goals over time – pay down any debts, car, house, college for kids, retirement, vacations, toys, etc. • Make a budget. There are online tools to help. • Plan for random, large expenses. You will have a fender bender. You will use the medical system. These are not (necessarily) emergencies, and they are not unexpected. They are just large expenses that occur at random times. You can and should plan for them. 9
Assets vs. Investment Assets • An asset is something you can buy with cash and then sell or receive cash for later – Either it has LIQUIDITY, meaning it can be bought and sold, or – It acts like a loan or bond, and it has a payoff. • An investment must be likely to rise in overall value – Value increases because it has income. The investment then invests its own income, and/or it gives you income directly (a company, real estate rental properties) – It has a fixed value but generates income (bond, your education) – It appreciates in value because it is rare (undeveloped real estate, art). Be careful with this last type – they often cost money to maintain and may not appreciate as anticipated. • If it is not expected to appreciate in value and/or generate income, then it is not an investment. – – – Your car Your jewelry(usually) Your hobby (restoring old cars, etc. ) A loan to a friend A lottery ticket 10
Investment Options • • Individual stocks Index funds Active funds Bond funds Cash Alternatives – Real Assets (real estate, commodities, art) – Funds for qualified investors only (hedge funds, venture capital, private equity, MLPs, CTAs) – Other (Public futures, options, other derivatives, Forex) 11
Individual Stocks, or Equities • Individual Stocks – Purchase of a share of stock is buying a piece of a company. Shares are identified by ticker. Must be purchased in whole shares. – Apple (AAPL) ~$107 per share – Ford Motor Company (F) ~$12 per share – Berkshire Hathaway (BRK-A) ~$223, 000 per share • The value of the stock varies. This is the price return. • Many companies issue dividends. This is cash given out to stockholders. • The price return plus dividend is your return on investment. 12
Equity Funds • Index Funds – Purchase of a share of a fund is buying a small piece of many tickers. The makeup of the fund is intended to match a published index, so you know exactly what you are buying. These may be mutual funds or ETFs. • Active Funds – Purchase of a share of an active fund is also buying a small piece of many companies. However, fund management is only required to announce their holdings quarterly. You do not know exactly what you own. These are mutual funds only (for now). • Returns on funds are the combined return of all the shares the fund owns, along with dividends received on those shares. • Funds charge fees, so your return is reduced by the amount of the fee. 13
Bonds • A bond is a loan, with a standardized contract. • Bonds have a set payoff at end date, and may have interest payments at set dates. • Types of bonds (taxable fixed income) – – Bank CDs => safety and insurance U. S. Treasuries => safety Corporate bonds => high/medium quality High yield bonds => lower quality/high volatility (junk bonds) • Tax-exempt – Municipal bonds-federal, state, local 14
Bond Funds • Bond funds are similar to equity funds. You buy a piece of the fund and own a small part of many bonds, and pay a fee. • Bond funds can be index funds or active funds, like equity funds. • Bond indexes (or indices) are more complex than equity funds. – Stocks stay the same over time. Even if more shares are issued, the existing stock and new shares are all equivalent. – Entities can issue new bonds at any time, and every issue is different. – The price of a bond changes as it gets closer to being paid off, so the value of a bond is constantly in flux compared to the universe of bonds. – Bonds are eventually paid off, and some can be called (paid off early). – The market for bonds is much less liquid, so pricing is less certain. • Active vs. passive decision is not equivalent for stocks and bonds. 15
Cash • Lowest returns, but immediate access and very low or zero risk of loss of value • Bank accounts • Money market funds • Short term (< 1 year) bonds (Treasury bills) 16
Alternatives – Real Assets • Commodities: Agricultural (corn, sugar, coffee), Energy (coal, oil), Mineral (industrial metals, precious metals) • Real Estate: Individual properties, REITs • Collectibles: Art 17
Alternatives – Qualified Investors SEC defines qualified investors Complex, illiquid, or high risk investments Funding for startups Hedge funds – essentially actively managed funds that can invest in anything • MLPs – Most often infrastructure • CTAs – Funds that use specific strategies to trade options • Fees are often significant. (2 + 20) • • 18
Alternatives - Other • Mutual funds or ETFs that attempt to replicate hedge fund or CTA strategies • Mutual funds or ETFs that own REITs or MLPs • You can trade options and futures on your own • Foreign currencies • You can also bet on football games, but that’s not investing. 19
Risk and Return • What is risk? Risk is the chance that investor cannot get initial investment back at the end of their time horizon. • How is risk measured? We use standard deviation. • In general, as risk increases, expected return increases. You are compensated for taking on additional risk. • As risk increases, return also becomes less even. Drawdowns are more common and more severe. 20
Risk & Return, Lowest to Highest: • • Cash Government Bonds, shorter term Government Bonds, longer term Corporate and other Bonds, by rating Large Cap US Stocks Smaller Stocks Foreign Stocks Emerging Market Stocks 21
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Asset Allocation • Asset Allocation is the amount of the different types of assets in your portfolio. • Remember to account for human capital. – This is the amount of your future earnings. – It’s not a known amount, but you need to think about its path and what economic events are expected to impact it. • Also account for your behavioral tendencies and preferences. – Risk profile (not set in stone; can be modified through education) – Personal discipline 23
• Diversification 24
Diversification • Across Asset Classes: Stocks, bonds, cash, other assets (real estate, human capital, stock options) • Within Asset Classes (Stocks and bonds): Company size, country of origin, industrial sector, other measurable attributes • Diversification guarantees a return somewhere between the extremes of the assets – you will never do as well as your best performing asset, but you will never do as poorly as the worst. • If it is done carefully, diversification can reduce the overall risk of the portfolio without sacrificing a lot of return. 25
Costs in Investing • Taxes – – Some types of accounts have favorable special tax treatment Municipal Bonds are tax free, even in taxable accounts Short term and long term capital gains taxes Regular income tax on dividends • Trading costs – Be sure you understand the cost associated with the purchase or sale of an investment – Sales costs (front end load or back end load) – Commissions (broker fee for making trades) • Advisory Fees – These are sometimes tax deductions – May be based on hours worked, percentage of assets managed, or flat fee 26
Compound Interest + Tax Deferral Yellow Bar: Taxable Account. Bank accounts, standard brokerage accounts. Red Bar: Tax free account. Growth and withdrawals are not taxed. For Roth IRA and 529, taxable money is contributed. HSA accounts are completely tax free. Blue Bar: Tax deferred account. Money is not taxed when it is contributed, but it is taxed on withdrawal. IRA and 401 k are tax deferred. 27
Investment Strategy: Tax Advantaged Accounts • • • All of these accounts grow tax free. That is, no tax on income or capital gains. IRA: Anyone with earned income. $5, 500 max contribution. Pre-tax income goes in, you pay tax on withdrawals. Penalty on withdrawals before retirement age. Roth IRA: Anyone with earned income. $5, 500 max contribution. Post-tax income goes in, no tax on withdrawals. Penalty on withdrawals before retirement age. 401 k: Must be set up by an employer. Similar to IRA, and you can roll over 401 k accounts to an IRA if you leave employer. You make contributions, some employers match part of your contribution (free money!). $18, 000 max contribution ($53, 000 including employer contribution). HSA: Health savings account. $3, 350 max contribution. Either your employer must have an HSA plan or you have to select an HSA plan when you purchase individual insurance on the exchange. Pre-tax income AND no tax on withdrawals. Must be used for medical expenses. Accumulates over time, and can be invested. 529 accounts: Savings for education. Taxable money goes in, growth and withdrawals tax free. 28
Investment Strategy in Tax Advantaged Accounts • 401 k accounts typically only offer a limited number of mutual funds. • 529 s, IRAs and Roth IRAs are limited only by the rules of the custodian. • HSAs are similar to 401 k accounts. The custodian is often pre-determined, and the investments are limited. • Because these accounts grow tax free, you should concentrate taxable income to these accounts. Consider both cash income (bond interest payments, dividends) and capital gains events. 29
Investment Strategy • Buy and Hold: Select an asset allocation, buy it, and rebalance periodically • Stock Picking – – – Top Down Analysis Bottom Up Analysis: sws approach Technical Analysis Momentum Strategies Mean Reverting Strategies Quality, Value, Dividend, Volatility, and other quantitative screening strategies • Market Timing 30
• Notes on Strategy On published research, especially regarding investment strategies: http: //www. advisorperspectives. com/articles/2015/02/10/curiosity-free-research A few questions to ask about research: • • • Is this new? If so, why hasn’t it been found before? Is it really just a new way to look at an existing strategy, or a new name for an old idea? Does it make sense? Can it be explained in words and make sense? What time periods and markets were tested? Look for out of sample confirmation, using different time periods and/or different countries to confirm the hypothesis. Were taxes, trade commissions, liquidity, or other costs considered? Will it continue? Why or why not? If you see a strategy you like, look for an ETF or mutual fund that employs that strategy to see how it may perform. Compare the performance of various strategies to a benchmark. If you see a strategy that shows results from backtesting, be sure to understand the assumptions behind the backtest. Are costs included? All the data that you use to evaluate strategies changes over time. This means that the best strategy using data over varying time periods will not be the same. The best strategy for 2016 is likely not the same as 2015. Be sure to evaluate strategies over time periods similar to your plan. 31
Regarding Individual Stocks • Only 25% of active (stock picking) mutual funds beat their benchmark in 2015 (source: S&P Dow Jones Indices). – Does it make more sense to buy an active fund or an index fund? How will you evaluate active funds? – What can you do better than the 86% of professional fund managers, so that your stock picks beat your benchmark? • Extreme positions vs. Diversification (from Farnam Street Blog): “The most profitable strategies are “extreme” strategies that commit companies to positions of either product differentiation or cost leadership. These extreme positions expose firms to a greater likelihood of bankruptcy by increasing the strategic risk they face. Consequently, the strategies likeliest to succeed are also likeliest to fail. That is the strategy paradox. “ This means that if you are trying to win a stock picking contest, don’t diversify too much, and don’t hedge. However, if you are trying to save for retirement, you may prefer a diversified portfolio, trying to achieve a lower potential return but with lower likelihood of failure. The “all your eggs in one basket” philosophy is also explained by Charlie Munger, the partner of Warren Buffet, in a speech from earlier this year, also at Farnam Street Blog. 32
Determine Your Portfolio • Select an investment strategy. You may use different strategies for different accounts • Determine how much of your portfolio will go into which accounts (taxable vs. tax advantaged) • Determine asset allocation overall, and by account • Determine the specific investments that will make up your portfolio • Your portfolio will need to change over time – Your risk profile changes over time – Your goals are likely to change over time • Understand the difference between saving, investing, and speculating • Consider all the risks in your plan – Risks presented by random but expected events (interest rate changes, inflation, economic cycle) – The investment risk of the specific positions chosen, and the overall investment portfolio 33
How to Open your Account • You can set up your own Roth IRA, HSA, 529, and taxable investment accounts. – – Do it yourself online broker/dealers, like E*Trade, Fidelity, Schwab Varying account minimums and fees. Be sure you understand all the fees. Varying levels of customer service and financial advice. Read any agreements you sign. This is not like other online TLDR user agreements – this is your money. • You can get professional help. – Robo Advisors, like Betterment or Future. Advisor. They will recommend and implement an investment portfolio for you. – RIAs. These advisors have fiduciary duty to you, meaning they are legally required to put your interests first. Often full service, helping with complete financial plans, not just investment advice. – Other investment professionals. Broker/dealers (Edward Jones, Waddell & Reed), Banks (PNC Wealth Management, BOA Merrill Lynch), Insurance companies. Keep in mind that these are not fiduciaries. – Be sure you understand exactly what services you will receive and ALL the fees 34
Requirements for Successful Investing • Time. Researching investment strategies, and once you have selected that, the specific investments to implement the strategy. Then implementation and monitoring. • Math. If you don’t enjoy the math, you may find investing tiresome. • Discipline. Both to do the work, and to follow the plan. • Temperment. You may select a strategy, but have problems with implementation. This is related to your risk tolerance, and ability to emotionally detach from the investing or trading process. 35
Source: Barrons. com 36
Questions to ask an Advisor • Are you acting as my fiduciary? • Is your firm registered as RIA? Are you also a broker/dealer? • How do I know when you are acting as my fiduciary and when you are selling a product as an agent of the broker/dealer? • What fees are being charged? Directly and indirectly (fees to the funds)? • Exactly what services do you provide? – Planning, which includes what? Will you help me select a mortgage? Will you recommend insurance levels? Do I get a documented plan? What about plan updates as things change? – Investment advice? – Portfolio management? Will you help me manage investments not in your custody, like my 401 k? – How will you help me stick with my plan? • What conflicts of interest exist in our relationship? Any product related conflicts or other conflicts related to recommendations? • http: //www. sec. gov/investor/brokers. htm 37
PDCA Cycle • PLAN – – • DO Determine your goals Determine your budget: How much $ into which accounts Determine your investment strategy and specific investments Your plan should include expectations of return and volatility (standard deviation) – Set up accounts – Implement investment strategy – Follow up with the strategy (rebalancing, periodic monitoring, trading per plan) • CHECK – Review results compared to plan. – Are you sticking to budget and saving per plan? – Are returns within expected range? • ACT – If strategy is not working as planned, learn from it. Record any changes to your strategy along with rationale. – Research and learning is continuous. – Start over at PLAN step. Review entire plan, including all assumptions. 38
Financial Plan Contest • Sponsored by CFA Society of Pittsburgh • Cash prizes • Contact Mike Ulicny at CMU, 412. 268. 8186 | mulicny@andrew. cmu. edu 39
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