Financial Literacy
The Financial Toolkit to build your Wealth Engine
Introduction
Many people enter adulthood without a solid foundation in personal finance, relying instead on trial and error, peers, books, or their parents to figure things out.
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 in my spending and investing when I first entered the workforce.
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 money-printing machine. Who wouldn’t want a 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 several basic components:
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. Inflation and lifestyle creep can erode what once felt like a monumental salary.
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, which is 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 investment. Her retirement fund continues to grow, even as Billy contributes another $1,000 each year. 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 wealth building 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.
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 coverage depends on the depositor’s account ownership and the amount deposited. 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, as in paper currency, is a useful tool, especially for recurring expenses, but cash is a limited tool. Inflation can erode its purchasing power over time.
Cash does have its uses. It is useful for its liquidity and for its stability when the stock market takes a downturn. For those who tend 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 money market deposit 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.
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
Certificate of Deposit (CD) are generally safe when held at an FDIC-insured bank and within applicable insurance limits. Their interest rates are usually fixed, but the money is generally expected to remain on deposit until maturity. There may be penalties for early withdrawal.
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 generally considered 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 are 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 represent opinions on creditworthiness rather than guarantees, helping 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 creditworthiness of the issuer or specific debt obligation.
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.
While issuing bonds is a way for an institution to borrow money, issuing stock is a way to raise money by selling equity. Nascent companies often obtain initial funding from founders and early investors. This seed money helps cover early operations, such as hiring employees, renting space, and building products.
As a company matures, it aims to become profitable by generating more revenue than it spends. Early investors accumulate wealth as the company’s value grows, but that wealth remains tied up in private ownership. To unlock liquidity, raise capital for expansion, or allow early owners to sell shares, a company may go public through an Initial Public Offering (IPO), listing its shares on a public stock exchange. Becoming public isn’t mandatory; many successful businesses remain private to keep their financial disclosures confidential.
When a company is profitable, its board of directors has choices on how to deploy those profits. For example, if a company sells a widget for $15 and incurs $10 in total costs, it nets $5 in profit before taxes. It can reinvest those earnings into research and development, buy back shares on the open market, or distribute a portion directly to shareholders as dividends. Unlike interest on a bond, which is a strict contractual obligation, dividends are discretionary distributions authorized by the board.
Investors evaluate stocks across several dimensions:
- Growth vs. Value: Growth stocks belong to companies expected to expand revenues quickly, while value stocks appear bargain-priced relative to current fundamentals and may pay dividends. (These are investment styles rather than strict categories; companies can exhibit traits of both.)
- Market Capitalization: Stocks are categorized by total market value (share price multiplied by total outstanding shares) into small-cap, mid-cap, and large-cap, across domestic and international markets.
Owning common stock often grants voting rights, typically one vote per share, for electing the board of directors or voting on major corporate decisions. Shareholders can also attend annual meetings.
Many years ago at an AT&T shareholder meeting, a retired investor addressed CEO Bob Allen: “I’m a millionaire due to your leadership.” Allen smiled, until the gentleman added, “I used to be a multi-millionaire.”
Stock ownership offers two avenues for returns: capital appreciation and dividends. However, neither is guaranteed, and individual stock prices can fluctuate significantly based on company performance and market conditions.
Liquidity and the Secondary Market
A bond has a maturity date years in the future, and a stock may appreciate significantly, but neither is legal tender. You can’t walk into a store and use shares of stock or a corporate bond to buy a new household appliance.
Accumulating assets builds your net worth, but a portfolio can easily leave you asset-rich and cash-poor if your wealth is tied up in non-cash holdings. What happens when you need liquidity to make a major purchase?
Fortunately, secondary markets exist so you can sell assets to other willing buyers. Publicly traded stocks can be bought and sold in minutes on exchanges like the New York Stock Exchange (NYSE) or the NASDAQ. Other assets have their own markets, including bonds, commodities, and real estate. Each market operates on a different timeline. Selling a publicly traded stock may take minutes, while selling real estate may require weeks or months.
You can generally sell publicly traded stocks and many bonds at any time, but the price you receive depends on what a buyer is willing to pay at that moment.
Mutual Funds
A mutual fund is an investment vehicle that pools money from many investors to purchase a collection of assets. Think of a mutual fund as a bucket that holds stocks, bonds, or real estate. Rather than buying a single company’s stock or bond, you buy shares of the fund itself, giving you proportional ownership of every asset in the portfolio.
A primary advantage of mutual funds is diversification. Spreading capital across dozens or hundreds of holdings reduces the impact of any single company failing, though it does not eliminate broader market risk.
A mutual fund’s per-share value is called its Net Asset Value (NAV). NAV is calculated at the close of each trading day by subtracting the fund’s liabilities from the total market value of its holdings and dividing by total outstanding shares.
Funds generate returns through price appreciation and distributions (dividends, interest, and realized capital gains). Distributions can be taken as cash or automatically reinvested into additional shares. Importantly, reinvested distributions may still trigger tax obligations in taxable accounts.
Management Styles and Fees
Offered by financial firms like Vanguard and Fidelity, mutual funds generally fall into several management styles:
- Actively Managed Funds: Portfolio managers select specific assets attempting to beat market benchmarks. Because they require research teams and active trading, they charge higher operational costs, known as an expense ratio. Some funds also charge sales commissions, or loads.
- Passively Managed Index Funds: These funds seek to track published benchmarks like the S&P 500 or Dow Jones Industrial Average. While index funds may seem dull, their relatively low expense ratios and broad exposure have allowed many index funds to outperform a majority of actively managed funds over the long term.
- Target-Date Funds: These are retirement funds targeted to a specific retirement date. For example, someone born in 2000 might invest in a 2060 or 2065 target retirement fund designed for retirement when the investor is 60 or 65 in each of those years respectively.
Funds tailor their strategies to specific investment objectives, such as focusing on growth stocks, value stocks, specific industry sectors, or bond markets.
Some focus on socially responsible or ESG (environmental, social, and governance) criteria, selecting assets based on sustainability, labor standards, or corporate ethics. Some ESG funds avoid industries like defense or tobacco.
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 like 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 attempting 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 investments priced once per day, rather than fluctuating intraday.
- 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.
Homeownership
Homeownership is often considered a central pillar of the American Dream, but it raises a fundamental financial question: Is a house an asset or a liability?
Strictly speaking, the physical property is an asset, while the mortgage used to buy it is a liability. Owning a home comes with significant ongoing operational expenses, such as maintenance, utilities, home insurance, and property taxes, which can be substantial. Renters have fewer ongoing operational expenses.
Mortgages are also expensive long-term financial commitments. Depending on the interest rate, total principal and interest payments over a 30-year mortgage can exceed twice the amount borrowed. (In the U.S., mortgage interest may be tax-deductible if you itemize deductions, subject to IRS limits.)
Despite these costs, homeownership can be an effective vehicle for wealth accumulation. Real estate often appreciates over time, forced savings occur as you pay down mortgage principal, and once the debt is paid off, a major recurring expense disappears from your budget. Under the right financial conditions, a home can serve as a foundation for intergenerational wealth.
Retirement Plans
In the United States, specialized tax-advantaged accounts, such as 401(k) plans and Individual Retirement Accounts (IRAs), are designed to encourage long-term saving.
It’s helpful to think of these plans not as investments themselves, but as tax-sheltered wrappers or containers that hold investments like stocks, bonds, mutual funds, and ETFs.
Because these account rules and tax incentives are specific to the United States, they deserve dedicated attention and will be the primary focus in a subsequent entry (TBD) in this series.
Asset Management
Managing your wealth isn’t just about picking individual assets. It’s about how you assemble, monitor, and adjust them over time.
Asset Classes
There is no perfect asset. The ideal asset would:
- Never lose value and possibly rise in value
- Have a great rate of return
- Pay interest or a dividend
- Be effortlessly convertible into cash
It does not exist.
The assets discussed above fall into several broad categories: cash and cash equivalents, bonds, and stocks. I’ll refer to these categories as asset classes. An asset class is a group of investments that share common characteristics.
I’m going to refer to these as asset classes. That is, it’s a group of different specific assets that have shared traits. For example, while stocks have similar traits, there are thousands of companies that issue stock. There can be significant distinctions within broad asset classes. For example, equities span high-growth tech startups and dividend-paying utilities, while bonds range from ultra-safe U.S. Treasury bills to high-yield corporate debt. A tech stock will have different traits than a restaurant stock.
Each of these asset classes has traits associated with an ideal asset, but none of them have the entire package. Each asset class has its own advantages and disadvantages. Each asset class has its niche in helping to reach a financial goal.
Cash and cash equivalents are generally safe, but their returns may not keep pace with inflation, causing their purchasing power to erode over time.
Bonds tend to be relatively safe, depending on the issuer. They generally provide interest income, but their returns may not keep pace with inflation. They also offer less potential for growth than stocks.
Stocks tend to have the greatest reward along with the greatest risk and volatility. They produce your greatest gains and losses, and fortunes can swing between the two quickly.
Asset Allocation
A well-funded retirement is a financial goal. While this blog series has focused upon retirement, retirement is generally not the only financial goal for a person or household. Other common financial goals include:
- Purchase of a car
- Down payment for a house
- College fund for children
- Paying off student loans
Goals require different amounts of money and have different time horizons. Some goals are near term, such as a car purchase and paying off student loans. Some goals are further away, such as a college fund for a child or retirement, but even far away goals creep up upon us.
Contributing toward all goals at the same time may not be an option either. A household with a $1,000 per month financial margin has a better chance of funding its goals than a household with a $100 per month financial margin. Goal funding and/or financial margins may require adjustment.
Different goals have different risk/reward sensitivity based upon their time horizon. Asset class risk/reward should be aligned to the risk/reward sensitivity of the goals they are funding within the risk tolerance of the investor. Investors have their own risk tolerance. Some investors are comfortable accepting greater risk and can sleep well at night, even when the market is falling. Others with lower risk tolerances constantly worry about their investments regardless of market conditions. In general, investors may be able to accept more short-term volatility for goals that are further away, since there’s more time to recover from market declines.
Choosing an appropriate mix of asset classes for each financial goal, based on its time horizon and your tolerance for risk, is called asset allocation.
Let’s consider a family with 35-year-old parents with a ten-year-old child with the following goals:
- Car fund to replace one of the current cars in two years. This fund should be in CDs and Treasury bills, since a new car purchase is right around the corner.
- College fund for their child. This fund should be a mixture of stocks and bonds. The child won’t start college for another eight years. The stocks will provide some growth for the interim, and the bonds will provide some stability should the stock market run into a recession in the interim.
- Retirement fund for the parents. This fund should be mostly in stocks, since retirement is still 30 years away. However, they will want to consider adding bonds in the next five to ten years.
Asset allocation changes as time advances. The 35-year-old couple can absorb the volatility of stocks 30 years from retirement, but when they reach retirement at age 65 a portion of their retirement fund should have cash and bonds. And it should still retain some stock too. The 65-year-old couple could easily have a 30-year retirement. They would still need some stocks for growth to guard against inflation along with their cash and bonds as a hedge against volatility.
Target-date funds often contain different asset classes, as described above. Different asset classes respond differently to different market conditions. In some years stocks may outperform bonds and in other years bonds may outperform stocks. Therefore, rebalancing between asset classes may be warranted.
For example, let’s assume that our 65-year-old couple wants their retirement asset allocation to be 50% stocks and 50% bonds. One year the stock market does great, but the bond market does not. Their allocation changes to 60% stocks and 40% bonds, not because of anything they did, but because of market conditions. Therefore, they may rebalance their portfolio by purchasing more bonds with future contributions to bring their asset allocation closer to a 50/50 balance. They may even sell some stock and purchase bonds to bring the ratio closer to 50/50.
Asset Diversification
In addition to the appropriate asset allocation, the assets should have some diversity. That is, don’t put all your eggs in one basket.
While the 30-year-old couple’s retirement fund should mostly be invested in stocks, it should not be invested in one stock. Everyone dreams of buying Amazon, Google, Nvidia or Apple before they became big. But for every company that would have made you a fortune, there was an equally compelling company that would have cost you a fortune, such as Enron.
Mutual Funds and ETFs can provide an easy way to achieve diversification, depending on what they hold. Diversification is often built into their very nature.
Some financial companies offer target-date mutual funds as mentioned above. They are mutual funds with a specific target date in mind. Target-date funds generally change their asset allocation over time, becoming more conservative as the target date approaches. This is often called a glide path. Rebalancing maintains the fund’s intended proportions at a given point in its glide path. Changing the allocation over time moves the fund along that glide path.
Target-date funds can be good for retirement. Age-based funds, which are similar to target-date funds, can be good for a child’s college fund. These goals have a time horizon that’s often decades long when first opened. Their asset allocation profile will change as time advances to the start date. Rebalancing and reallocation generally happen automatically.
Summary
Building long-term financial security begins with mastering the fundamentals: understanding how wealth is generated, appreciating the power of compounding time, and selecting the right instruments from your financial toolkit.
With these foundational tools in place, the next blog entry will put them to work by exploring how to design a concrete Retirement Plan using the assets, tactics, and strategies in your financial toolkit.