It has been quite some time since I’ve written a blog post on personal finance. Indeed the last one came on November 18, 2013. Well now that I am out of school and working 40 hours a week for the next 40ish years of my life, it is indeed time to get serious about investment, retirement, and saving some money. I’ll be using my tax return from Uncle Sam to kick start my portfolio. By the way, the average tax return is about $3000 currently. If we assume that grows at 1% per year, and you were to put that tax return away in an investment account that yields 6% a year by the time you retire (say your working career is 40 years) you will have over $500,000. A lot of people like to spend that “free money” on disposable goods, but hopefully those numbers make you reconsider what you do with that check from the government. Anyway… back to the original topic of this post. What I’m doing with my money. This blog is part 1 of 2. Part 1 is mostly background finance information that should hopefully be useful and interesting to those without a finance education. Part 2 will be about my chosen equities (asset allocation) and why I chose them.
I highlighted my dismal stock portfolio a few years ago and since I’ve taken a few finance courses (in fact, I even minored in finance!). It’s safe to say that this time around I will not be purchasing just a few stocks. In fact, to achieve maximum diversification, I would need a pool of about 30 stocks. But I don’t have the time to research individual stocks nor do I have the money to purchase 30 stocks without parts of my portfolio being seriously overweight. So what’s a young man gotta do to get a good pool of equities? Exchange Traded Funds.
Exchange Traded Funds (ETF) have been around since the 1990’s. They are a group of equities (stocks, bonds, or both) sold as one share. But unlike a normal stock, you’re not buying into a share of one company, you’re buying into a group of companies. The advantage of this is it allows investors to achieve greater diversification than selecting individual stocks. Common ETF’s track entire stock market indexes. For example, if you purchase an ETF that tracks the S&P 500 you are essentially purchasing a little bit of every company that is listed in the S&P 500. You could also purchase an ETF that contains just technology companies, healthcare companies, foreign companies, etc. ETF’s are bought and sold on the open market just like any other stock – therefore you and I can purchase a group of ETF’s and achieve a well diversified portfolio with little help from a finance friend. So is there a compelling reason as to why you should or shouldn’t purchase a group of ETF’s yourself and never hire someone to manage a portfolio account for you? Absolutely. Financial managers aren’t really that much better than you or I when it comes to selecting individual stocks. In fact, only about 25% of them beat major indexes every year. So if you were to purchase an index tracking ETF such as SPDR S&P 500 index you would beat 75% of financial professionals every year. The expense ratio on the SPDR fund is .09, meaning purchasing the index cost you $9 for every $1000 invested. Not a bad deal.
While purchasing ETFs is great, it doesnt tell the whole store. We need to know more about understanding our assets as part of a larger portfolio. Here are two terms I’ll talk about a lot in part two and briefly go over here: Asset allocation and rebalancing. The name asset allocation pretty much is its own definition; it is deciding how much cash, bonds, stocks, etc. make up your entire portfolio. Going hand in hand with asset allocation is rebalancing your portfolio. Unfortunately nobody yet has a time machine so we can’t know exactly when to sell stocks (at their highest price) or when to buy stocks (at their lowest price), but rebalancing your portfolio on a regular basis is the next best thing. Allow a quick example: Say on January 1st you have $100 to invest. You put $30 in small US companies, $50 in large US companies, and $20 in international companies. Your asset allocation is 30% small companies, 50% large, 20% international. On June 1st, your small and large US companies have done really well, growing to $40 and $85, but your international companies have lagged behind and stayed at $15. Your asset allocation is now 29%, 61%, and 10%. The idea is to always keep your asset allocation the same, so therefore in order to get back to the original allocation of 30, 50, 20, you will need to sell some of your large US companies and reinvest those profits into the small and international companies. Overtime rebalancing your portfolio has a huge effect. The Wall Street Journal published a short article on this in July, and there are many academic examples studying this.
Okay – so that’s some background information on what I’ll be talking about in my next blog. I promise it won’t be a year and a half before I get to it.