WORK IN PROGRESS – Financial Literacy
An introduction to personal finance, exploring how wealth is generated and the financial instruments used to accumulate, grow, and preserve it
Introduction
Many people enter adulthood without a solid foundation in personal finance. Most people learn about personal finance from their own experience, peers, books, financial experts or their parents.
My parents were financially conservative. The financial instruments I knew about were generally limited to:
Their financially conservative nature also applied to their spending. They didn’t make major purchases until they had the money to pay for them.
Their financial discipline worked for them, and it left an impression on me. This was the only approach to spending and saving that I knew while growing up. I was equally conservative as well in my spending and investing for the first few years of my career.
A few years into my career, I partnered with a financial planner, and my financial education began. My financial planner introduced me to a much broader range of financial instruments and investment opportunities than I knew growing up. I learned that there were different ways to approach saving and investing, depending on my circumstances and financial goals.
The financial discipline I learned from my parents provided a solid foundation. Working with my financial planner expanded my understanding of personal finance and the options available to me. Together, these experiences shaped the approach to personal finance that has served me throughout my life.
Over the years, I’ve learned quite a bit about personal finance. I’d like to share some of what I’ve learned, beginning with a look at the basic concepts and instruments that make up a financial toolkit.
DISCLAIMER: I’m not a financial advisor. The information presented here reflects my personal opinions and experiences and is intended for educational purposes only. It should not be considered financial, investment, or tax advice. Readers should conduct their own research and consult qualified professionals before making financial decisions.
Financial Toolkit
Income and wealth are related, but not the same. Sometimes we hear stories of high-paid athletes struggling with their personal finances and eventually filing for bankruptcy. In contrast, we sometimes hear stories of those who never earned stellar salaries, yet accumulated millions in wealth.
Income and wealth aren’t entirely independent. Income is a potential source of wealth, but wealth can also generate income. Income is how much you earn. Wealth is what you accumulate and retain.
If your only source of income is your labor, you’ll always have to work for your money. As you accumulate wealth, you can become less dependent on employment income. Your accumulated assets can generate income, appreciate in value, or both.
Instead of working for every dollar, you have something that produces money for you. The more productive assets you accumulate, the more your money can work on your behalf. It’s like owning a legal money-printing machine. Who wouldn’t want a legal money-printing machine in their basement or garage?
Of course, there is no such thing as a legal money-printing machine. But productive assets can serve a similar purpose.
Think of the financial concepts and instruments you use to generate and manage wealth as your financial toolkit.
Your financial toolkit consists of two basic components:
- Asset Generation
- Asset Instruments
Asset Generation
Wealth doesn’t appear on its own. You need a way to acquire it and make it grow.
Parents
Our parents are financially responsible for us while we’re children.
Some parents extend financial support to their adult children as well by paying for their college education, contributing toward a first home and beyond.
Some children will inherit substantial wealth from their parents. Trillions of US dollars will be transferred from the older generations to younger generations through the Great Wealth Transfer. However, inheritance is not evenly distributed from one generation to the next, and you cannot determine when you receive it.
Your best bet for parental support and a significant inheritance is to choose your parents wisely.
Regardless of parental support, the next two asset generators are available to most people.
You
For most people, income earned over a lifetime is the primary source of wealth generation.
You generate income, but you also need food, shelter, clothing, transportation, insurance, etc. You earn a lot, but you spend a lot, too. You may be a great asset, but you are also a high-maintenance expense.
How much of your income have you put toward building wealth? How much of your income have you spent?
To build wealth from your income, your income must exceed your expenses. Even those with high incomes may fail to generate wealth if their expenses are too large.
Time
The earlier you start saving and investing, the easier it will be to reach your financial goals. This isn’t just because you have more time to put more money away. It’s because the money you invest has more time to grow through compound interest.
Compounding creates a snowball effect. When you’re rolling a snowball to make a snowman, the snowball will reach a sufficient size so that it will start to pick up snow from the ground just by rolling it.
With investments, earnings start to produce their own earnings, which produce their own earnings, etc. Albert Einstein is often credited with calling compound interest the eighth wonder of the world, although there’s little evidence he actually said it.
A Comparison Example
NOTE: This example assumes a constant 10% annual return, which is unrealistic. It’s illustrating the power of compounding rather than representing actual investment performance. The example excludes taxes, fees, and withdrawals.
Twins Anna and Billy start their careers when they graduate from college at age 21.
Anna decides to invest $1,000 annually at the beginning of each year toward retirement in her company’s retirement plan. It’s tight at first, but it gets a little easier with several raises. Then Anna gets married and starts a family and decides to become a stay-at-home mom at age 28. Anna does not make additional contributions to her retirement account after she stops working.
Her brother, Billy, takes a different approach. He waits to start investing. He has always intended to start saving for retirement, but he never got around to filling out the paperwork with Human Resources. When he sees his sister start a family, he decides to get serious about his future as well, and he visits his Human Resources representative to start. He invests $1,000 annually at the beginning of each year also starting at age 29 and continuing until he retires at age 65.
Both twins earn an average of 10% on their investments annually.
At age 65, Billy has invested a grand total of $37,000; however, his account contains around $363,000. He has around 10 dollars for every dollar he has invested during his career!
At age 65, Anna has only invested $8,000 during her short career – less than a quarter of what her brother has invested. However, Anna’s account contains $427,800! She has over 50 dollars for every dollar she has invested. Those eight early years made all the difference, thanks to compound interest.
When Anna stops investing, her eight $1,000 contributions have already grown to almost $12,600 due to compound interest. Billy must supply $1,000 of new money from his income. Anna’s growth continues from her head start. Her retirement fund continues to grow, even as Billy contributes another $1,000 each year. Eventually, the earnings on Anna’s larger balance exceed Billy’s annual contribution. The gap between their balances will widen. Anna’s early start gives her an advantage that Billy can overcome only by dedicating more of his income toward retirement.
This spreadsheet shows the accumulation for each year for Anna and Billy. Here is an abbreviated version listing their progress:
| Age | Anna | Billy |
|---|---|---|
| 21 | $1,100 | $0 |
| 25 | $6,716 | $0 |
| 30 | $15,221 | $2,310 |
| 35 | $24,514 | $10,436 |
| 40 | $39,480 | $23,523 |
| 45 | $63,583 | $44,599 |
| 50 | $102,400 | $78,543 |
| 55 | $164,917 | $133,210 |
| 60 | $265,600 | $221,252 |
| 65 | $427,752 | $363,043 |
By age 28, Anna’s $8,000 in contributions has grown to almost $12,600. That balance becomes her virtual legal money-printing machine. Even after she stops contributing, her money continues working for her, generating earnings that can produce additional earnings.
The lesson is simple: START EARLY! You don’t need to invest large amounts when you’re young. Even relatively small contributions can grow substantially when given enough time. Don’t wait until you can afford to invest more. Start with what you can.
Asset Instruments
Assets can take several forms.
Cash and Cash Equivalents
Cash is king. Cash provides liquidity, convenience, and certainty about its nominal value. It’s useful for paying expenses and handling emergencies. But it generally isn’t a great long-term wealth-building instrument because inflation erodes its purchasing power. Cash includes physical currency and readily accessible balances held in financial accounts. Income is often in cash. Expenses are paid with cash.
When discussing personal finances, we often use the term cash to describe money that is readily available for spending. This includes physical currency as well as electronic balances in financial accounts.
Some financial products aren’t strictly cash, but they are so similar in their liquidity and stability that they’re considered cash equivalents.
Strictly speaking, however, a checking or savings account isn’t cash. It’s a financial product that holds your money and provides convenient access to it. Because those funds are readily available, these accounts are often treated as cash equivalents.
In the United States, the Federal Deposit Insurance Corporation (FDIC) insures eligible deposits at insured banks up to $250,000 per depositor, per insured bank, per ownership category. There are additional rules and restrictions, but the basic coverage is sufficient for most depositors. This insurance protects most deposits should an insured bank fail.
Checking accounts, savings accounts, money market deposit accounts, and eligible CDs at FDIC-insured banks generally qualify for coverage, subject to the applicable limits.
Money market mutual funds and Treasury bills are not bank deposits and are not covered by FDIC insurance.
Cash
Cash is a useful tool, especially for recurring expenses, but cash is a limited tool. Cash doesn’t generally generate much of a return. Even when it earns interest, inflation can erode its purchasing power over time.
Cash does have its uses. It is useful for its liquidity and also for its stability when the stock market takes a downturn. For those who have a tendency to slip back into debt, cash may be a primary tool for managing household finances to prevent sinking further into debt.
Checking Account
Checking accounts are used to manage day-to-day financial transactions, such as paying bills and making purchases.
Savings Account
Savings accounts are places to hold money while earning modest interest.
Money can often be easily transferred between checking and savings accounts.
High-Yield Savings Account
A high-yield savings account is like a traditional savings account, but it generally pays a higher interest rate.
These accounts are often offered by online banks, which may have lower operating costs than traditional banks.
Like traditional savings accounts, eligible deposits at FDIC-insured banks are protected by FDIC insurance, subject to applicable limits.
Money Market Account
A banking money market account is like a savings/checking account on steroids. Money market accounts combine some of the features of checking and savings accounts. They are often used to hold larger balances and often pay more interest than traditional savings accounts. They may also impose restrictions on withdrawals, transfers, or minimum balances.
Money Market Mutual Fund
A money market mutual fund is an investment fund that provides a convenient place to hold cash while earning a return.
Money market mutual funds pool money from many investors and use it to purchase short-term, relatively low-risk investments, such as Treasury bills, certificates of deposit, and commercial paper.
They are often used to hold larger amounts of cash and generally provide convenient access to your money. They generally offer competitive interest rates and provide convenient access to your money.
Unlike a bank money market account, a money market mutual fund is an investment, not a bank deposit. It is not insured by the FDIC, and its value and returns are not guaranteed. Although these funds are designed to maintain a stable share price, they can lose value.
Certificate of Deposit
A Certificate of Deposit (CD) is a bank deposit that earns interest over a specified period of time. The interest rate is usually fixed, and the money is generally expected to remain on deposit until the maturity date.
CDs are generally very safe, but their rates of return tend to be modest. There are usually penalties for early withdrawal as well.
Treasury Bills
U.S. Treasury bills (T-bills) are short-term loans to the federal government, generally maturing in four to 52 weeks. T-bills are generally purchased for less than their face value. At maturity, the government pays the face value, and the difference represents your return. They are exempt from state and local income taxes on their interest.
They’re considered very safe because they’re backed by the U.S. government. They can also be sold before maturity, although the price received may differ from the purchase price.
They’re a useful example of an instrument that isn’t technically cash but can serve a cash-like role.
Loans
A loan is an arrangement in which one party lends an asset, usually money, to another party with the expectation that it will be repaid, usually with interest.
Principal is the amount borrowed. Interest is the cost of borrowing money, generally expressed as a percentage of the outstanding principal.
A bond is a formal debt security that specifies the terms of a loan. In buying a bond, you’re lending money to a person or institution that promises to repay the principal according to specified terms, often with interest.
Unlike a typical personal loan or mortgage, a bond can generally be bought and sold by investors in financial markets. This allows the original lender to sell the debt to someone else rather than waiting for the borrower to repay it. The maturity date is when the issuer is due to repay the bond’s face value (principal). You may be able to sell a bond before maturity, but its market value may be higher or lower than what you paid. The money you lend may be at risk, depending upon the type of bond.
Common types of bonds are government bonds and corporate bonds. Governments and corporations issue bonds to borrow money for projects, operations, or other financial obligations. A government may borrow money by issuing a bond to build a new bridge. A business may borrow money to purchase another company.
Government and corporate borrowing is not much different than taking out student loans to pay for college or taking on a mortgage to purchase a home. Borrowing money finances a purchase that might not be possible by any other means.
Loans can be secured or unsecured:
- Secured loans are backed by collateral, such as a home or automobile. If the borrower defaults, the lender may have the right to repossess the collateral or foreclose on the property.
- Unsecured loans aren’t backed by specific collateral. Credit cards and many personal loans are examples.
The borrower intends to repay the loan, but there is no guarantee. Sometimes borrowers default, meaning they fail to meet their repayment obligations. The lender may be able to recover some of the money through collateral or legal proceedings, but could lose some or all of the investment.
Not all borrowers are equally creditworthy. The interest rate depends partly on how likely the lender thinks the borrower is to repay the loan. Lenders generally demand higher interest rates from borrowers they consider more likely to default, compensating them for taking on greater risk.
Organizations such as S&P Global Ratings, Moody’s Ratings, and Fitch Ratings assign credit ratings to governments, corporations, and their debt obligations. These ratings are opinions about creditworthiness, not guarantees that a borrower will repay its debt. Credit ratings help investors evaluate the likelihood that a borrower will meet its debt obligations. These ratings use letter grades, often with additional distinctions within each grade, to indicate the issuer’s creditworthiness.
Ownership
One way to generate wealth is to own things that have value.
Those things may appreciate over time, generate income, or both. You can own an individual company, a collection of investments, or other assets.
Stock
Stock is ownership. When you buy a stock, you own a piece of that company.
Issuing stock is a way for a company to raise money by selling ownership. Issuing bonds is a way to borrow money. Nascent companies often obtain their initial equity funding from founders and early investors. This seed money helps the company get started by purchasing raw materials and services, renting space, hiring employees, and covering other startup expenses. Those who provided the initial and subsequent equity funding own a portion of the company.
As a company becomes established, it hopes to generate more revenue from selling its products or services than it spends operating the business. It becomes profitable. It may become self-sustaining. It may no longer need external funding to support its ongoing operations, although it may seek additional funding for expansion.
The value of the company may grow, increasing the wealth of its founders and early investors. However, that wealth exists primarily as ownership in the company. They can’t easily spend it.
A company can divide its ownership into shares of stock, with each share representing a portion of the company. Those shares can be offered to the public through a stock exchange. This also creates a market where existing shareholders can sell their shares to other investors.
A company may also issue additional shares to raise money for expansion or other business purposes when other sources of funding are insufficient.
When a company first offers its shares to the public, it conducts an Initial Public Offering (IPO).
When a company goes public, it becomes subject to regulatory reporting requirements, including regular disclosures about its finances. Becoming a public company is not a requirement. Many successful companies have remained private, and that includes keeping their finances private as well.
If a company performs well and investors expect it to continue doing so, demand for its stock may increase, causing its price to rise. The company may also distribute some of its profits to shareholders as dividends. A dividend is somewhat like interest, but the two are different. Interest is generally a contractual obligation associated with a loan. Dividends are distributions of money to shareholders, when authorized by the company’s board of directors. A company earns a profit when its revenue exceeds its expenses.
Suppose a company sells a widget for $15, and the total costs associated with producing and distributing it are $10. That leaves $5 in profit before taxes and other expenses not included in the example. A profitable company has several options for using its profits. Distributing part of it to its shareholders as a dividend is one option. Other options include investing it back into the company to grow it or buying back shares on the open market.
If a company performs poorly, its stock price may fall. Stocks generally carry greater risk than high-quality bonds issued by the same company, but the risk depends on the particular investment.
Investors often distinguish between growth stocks and value stocks.
Growth stocks are shares of companies investors expect to grow their revenue or earnings rapidly. Investors may be willing to pay higher prices in anticipation of future growth.
Value stocks are shares that appear relatively inexpensive compared with measures of the company’s financial performance or assets. Some pay substantial dividends. They are often shares of more established companies.
Growth and value are investment styles, not mutually exclusive categories. A company can exhibit characteristics of both.
Stocks can be issued by small-cap, mid-cap and large-cap companies. This refers to their market capitalization, which is the total market value of a company’s outstanding shares. It is calculated by multiplying the number of outstanding shares by the current price per share. Stocks can be issued by domestic companies or foreign companies.
Common stock often includes voting rights, typically with one vote per share. However, some companies issue different classes of shares with different voting rights. Shareholders commonly vote on the election of the board of directors and may vote on other matters, depending on the company.
Shareholders can also attend shareholder meetings to vote or make their voices heard. Many years ago at an AT&T shareholders meeting, a retired shareholder addressed the CEO, Bob Allen, and said, “I’m a millionaire due to your leadership.” Allen smiled, and then the gentleman added, “I used to be a multi-millionaire.”
Investors can benefit from owning stock through dividends and capital appreciation, but neither is guaranteed.
Liquidity and the Secondary Market
A bond has a maturity date, which could be years in the future. It’s not legal tinder.
A stock may appreciate in value. It’s not legal tinder either.
You can’t use them to buy a new appliance.
Accumulating assets increases your wealth, but we don’t want to be asset rich and cash poor.
What if you need to make a purchase, but your wealth is tied up in non-cash assets?
Someone else might want to own an asset you own. You can sell it on the open market such as the New York Stock Exchange (NYSE) or the NASDAQ. Different assets are traded in different markets. Stocks are traded on stock exchanges, while bonds and commodities have their own markets. These markets can be domestic or international.
Buying and selling publicly traded stocks can happen in minutes. Buying and selling real estate may require weeks or months.
You don’t need to hold a stock indefinitely. You can sell your shares to another investor through the market. Similarly, you can sell a bond to someone else before it matures.
The price you receive depends on what a buyer is willing to pay. It may be higher or lower than the price you originally paid.
Mutual Funds
A mutual fund is an investment vehicle that pools money from many investors to purchase assets. Rather than investing in a single bond, company stock or property, you purchase a share of a mutual fund. Mutual funds have a fund manager who manages the fund’s assets on behalf of the pool of investors. A share represents a proportional interest in the fund’s overall portfolio. By owning mutual fund shares, it’s as if you indirectly own slices of the assets managed in the fund.
Mutual funds are essentially buckets that hold assets. They can invest in stocks, bonds, real estate and other investments.
A mutual fund’s per-share value is called its Net Asset Value (NAV). It’s generally calculated once each business day by subtracting the fund’s liabilities from the market value of its assets and dividing by the number of outstanding shares.
Mutual funds may distribute income earned from dividends and interest, as well as realized capital gains from selling investments. These distributions are generally passed along to shareholders. They can be paid in cash or reinvested in additional fund shares. These distributions may have tax implications, even when reinvested in additional fund shares.
One advantage of mutual funds is diversification. Rather than investing in a single company or bond, your investment is spread across multiple assets. This can reduce the risk associated with any single investment, but it doesn’t necessarily eliminate market risk.
Some funds charge sales commissions, commonly called loads. These can be charged when purchasing or selling shares. Many funds have no-load share classes.
Mutual funds are typically offered by financial institutions, such as Fidelity and Vanguard.
Some funds are actively managed, with managers selecting investments in an effort to outperform the market. Others are index funds, which passively track published indexes, such as the S&P 500 or Dow Jones Industrial Average. Some track narrow sectors or particular investment categories.
Actively managed funds generally have higher expenses. These expenses are expressed as an expense ratio, which is the annual cost of operating the fund as a percentage of its average net assets. Index funds typically have much lower expense ratios because they require less active management.
Index funds are a bit dull and boring since they simply follow their index. However, their lower expense ratios and broad market exposure have helped many index funds outperform actively managed funds over the long term.
A mutual fund usually has an investment objective that guides its investment decisions. For example, mutual funds may focus on growth stocks, value stocks or a blend of both. They may also focus on a particular sector, such as pharmaceutical stocks or telecommunications stocks.
Some mutual funds are socially responsible funds. Other common terms include environmental, social, and governance (ESG) and sustainable investing, although ESG is broader than socially responsible investing. ESG criteria can be used to assess investment risks and opportunities, not just to select companies based on ethical preferences. Each fund has its own criteria for determining what qualifies as socially responsible or sustainable. A socially responsible fund may avoid investing in tobacco or alcohol companies, defense contractors, or companies with poor labor relations. Other funds may actively seek investments in environmentally friendly (“green”) companies.
ETFs
Exchange Traded Funds (ETFs) are investment vehicles that pool money from many investors to purchase a collection of assets. Like mutual funds, they allow you to invest in a portfolio of stocks, bonds, or other investments by purchasing shares of the fund.
ETFs are similar to mutual funds in many ways. They provide access to a collection of investments, can offer diversification, and generally have a fund manager responsible for managing the fund’s assets.
However, there is an important difference in how you buy and sell them.
Unlike mutual funds, which generally transact once each business day at their Net Asset Value (NAV), ETFs trade on stock exchanges throughout the trading day, just like individual stocks. You can buy or sell ETF shares whenever the market is open, and their prices fluctuate throughout the day based on supply and demand.
An ETF’s market price is generally close to its NAV, but it can trade at a slight premium or discount to the value of its underlying assets.
ETFs can be actively managed or passively managed. Many ETFs are index funds that track published indexes, such as the S&P 500 or NASDAQ-100. Others focus on particular sectors, investment categories, or objectives. Actively managed ETFs have managers who select investments in an effort to outperform the market.
Some well-known ETFs include SPDR S&P 500 ETF Trust, commonly known by its ticker symbol SPY, and Invesco QQQ ETF, commonly known as QQQ. SPY tracks the S&P 500, while QQQ tracks the NASDAQ-100.
Like mutual funds, ETFs have expense ratios that represent the annual cost of operating the fund as a percentage of its average net assets. Index ETFs typically have relatively low expense ratios, although costs vary by fund.
ETFs may also distribute income earned from dividends and interest, as well as realized capital gains. These distributions can be paid in cash or reinvested in additional shares, and may have tax implications.
ETFs can have some tax advantages over comparable mutual funds. Their structure allows many ETFs to minimize capital gains distributions by transferring securities rather than selling them when investors redeem shares. However, this doesn’t mean ETF investors are exempt from taxes. Distributions and gains from selling ETF shares may still be taxable.
ETFs are often a convenient and relatively inexpensive way to invest in a diversified portfolio. However, not every ETF is broadly diversified. Some concentrate on particular industries, market segments, or investment strategies. As with mutual funds, it’s important to understand what a fund owns and what it is designed to accomplish.
Mutual Funds vs. ETFs
Mutual funds and ETFs offer many of the same investment opportunities. Both allow investors to pool their money to purchase a diversified collection of assets. Both can be actively managed or passively track an index.
So why choose one over the other?
Reasons to choose a mutual fund:
- You prefer to make investments at the end of the trading day, without worrying about intraday price fluctuations.
- You want to invest a specific dollar amount, including fractional shares.
- You want to automate regular investments, such as monthly contributions.
- Your employer-sponsored retirement plan offers mutual funds as its investment options.
Reasons to choose an ETF:
- You want to buy and sell shares throughout the trading day.
- You prefer to see market prices and control the price at which you place an order.
- You want access to potentially lower-cost investment options.
- You want the potential tax advantages that ETFs may offer over comparable mutual funds.
Neither investment vehicle is inherently better. The right choice depends on your investment objectives, costs, account type, and personal preferences.
Home Ownership
Homeownership is often considered part of the American dream.
Is a house an asset or a liability?
A house is an asset, but owning one comes with liabilities and expenses. Most people finance the purchase with a mortgage. The monthly mortgage payment may be greater than the cost of renting a comparable home.
Over time, a home’s value may appreciate, allowing the owner to sell it for more than the original purchase price. Once the mortgage is paid off, a major expense disappears from the household budget.
However, homeownership comes with ongoing costs. Utilities and maintenance are the owner’s responsibility. There may also be property taxes, which can be substantial, as well as insurance and other expenses.
The mortgage itself can be expensive. Over the life of a long-term mortgage, the total principal and interest payments can amount to two or more times the amount borrowed, depending on the interest rate. In the United States, mortgage interest may be deductible if you itemize deductions, subject to applicable limits.
You need a place to live, and as long as you can afford it, a home under the right conditions can be a wise option.
Owning a home can be an important part of asset accumulation. A house is often the foundation of family and intergenerational wealth.
Retirement Plans
The United States provides for several types of retirement savings plans, such as 401(k) plans and Individual Retirement Accounts (IRAs).
These plans provide tax advantages to encourage people to save and invest for retirement. The accounts can hold various types of investments, such as stocks, bonds, and mutual funds.
I’ll acknowledge these plans here without going into greater detail. They are specific to the United States and will be addressed in a subsequent blog entry (TBD).
Summary
This blog introduced retirement as something one works toward along with a brief review of financial literacy organized as your financial toolkit. The next blog entry will present retirement planning using the tools in your financial toolkit.