rate of return

Investing Is Great, But Saving Is Even Better

Tim Lemke — Tue, 24 Jul 2018 08:00:09 +0000

When people talk about investing, they often emphasize getting the most return for their money. If they are getting a 7 percent return on their stock portfolio, they'll strive to get 8 percent. If they are already at 8 percent, they'll push for 9 percent or more.

Shooting for a high return is laudable, but what often gets lost in this discussion is the most powerful element of building wealth: saving as much money as you can in the first place.

It's important to remember that individual investors can't control stock market returns. They also can't entirely control the cost of commissions, fees, taxes, and the like. They can, however, control their own rate of savings. And there is ample evidence that it is the initial savings, not investment gains, that determines how much you end up with over time.

Let's examine this phenomenon further.

Saving more can offset lackluster returns

If you save as much as you can, you don't have to stress as much about getting the optimal return on your investments. In fact, a boost in savings can often be more powerful than a higher rate of return.

Here are two scenarios to illustrate this point.

In the first scenario, you save $5,000 per year for 30 years and get a healthy 10 percent annual return. This results in about $900,000.

In the second scenario, you save $8,000 per year for 30 years, but you only average an 8 percent annual return. You will end up with around $978,000 in this second scenario. In other words, just $3,000 additional dollars each year (or $250 per month) can more than offset a 2 percent difference in return. Bump the savings up to $10,000 per year, and you're looking at more than $1.2 million in the end. (See also: 6 Confidence-Inspiring Facts About the Stock Market)

Saving more can supercharge great returns

In an ideal world, you're able to save a lot and get a great return on your investments. When these things happen together, the results can be amazing.

Let's revisit the scenarios above. Imagine if you were able to boost your contributions from $5,000 to $8,000 annually while also getting that great 10 percent return. You'd be looking at $1.44 million 30 years later. In other words, that additional $3,000 each year results in $500,000 more over time.

Saving more can let you be more conservative

Not everyone is entirely comfortable with the notion of investing. There is always an element of risk when you put money in the markets, and everyone's tolerance for this is different. If you don't save a lot of money up front, you may find yourself trying aggressive and risky investing strategies to make up the difference. That cannot only take you out of your comfort zone, but lead to financial disaster.

If you save as much as you can, you can afford to be more cautious about what you invest in. This is especially true for older investors who are looking to preserve their savings as they near retirement. (See also: 4 Simple Ways to Conquer Your Fear of Investing)

More savings can mean more matching funds

If you have a 401(k) plan through your employer, you are likely eligible to receive matching contributions from the company. For example, the organization may choose to match all contributions up to 5 percent of your salary. Some match even more than that. It's free money, but you don't get that money unless you contribute yourself.

Fidelity reports that one in five 401(k) plan holders don't put in enough to get all potential matching funds. If you are unsure of how much to contribute to your 401(k), the best answer is as much as possible, but at least up to the maximum company match. (See also: 7 Things You Should Know About Your 401(k) Match)

Saving more can give you a bigger tax break

With traditional IRAs and 401(k) plans, any money you contribute is deducted from your taxable income. So let's say you earn $50,000 annually and contribute $5,000 into your 401(k). That means only $45,000 is taxed; under current tax law, that's $1,100 less you would pay in taxes compared to $50,000.

Investors can contribute up to $18,500 annually into a 401(k). With traditional IRAs, you can contribute as much as $5,500 each year. That is a big chunk of money that can grow into an even more massive sum over time and will lead to big tax savings.

You can withdraw Roth IRA contributions early, but not gains

If you have a Roth IRA, it's generally not a good idea to take out money before you retire. But, if you run into a financial crisis, you are permitted to take out your own contributions without paying any penalty or taxes. For this reason, there are some financial advisers who say it's OK to think of a Roth as an emergency fund if you have nowhere else to turn.

If you take out capital gains, however, you must pay tax on that money and a 10 percent early withdrawal penalty. Thus, if you don't put in a lot of money into your Roth to begin with, you may not really have that much available to withdraw. (See also: 7 Penalty-Free Ways to Withdraw Money From Your Retirement Account)

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This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

How Just $5 a Day Can Improve Your Financial Future

Dr Penny Pincher — Fri, 19 Jan 2018 10:00:05 +0000

As a penny pincher, I sometimes get into debates with people about whether cutting back on small expenses really makes much difference in the grand scheme of things. For example, if you are trying to put away $1 million, is it worth the effort to save only a few dollars every day?

Let’s look at what investing $5 per day could do for your financial future. The easiest way to come up with an extra few bucks per day is to simply spend less — and that can be easy, since there are plenty of mindless ways you're probably wasting money. If your spending is already throttled back as far as you want to take it, you could find a side hustle for fast cash.

Stuffing $5 per day under your mattress

Now that you have identified a way to find $5 per day that you can save, let’s look at how your fund would grow if you put your cash under your mattress with no interest or growth:

After 10 years: $18,263.
After 20 years: $36,525.
After 30 years: $54,788.
After 40 years: $73,050.
After 50 years: $91,313.
After 60 years: $109,575.

As you can see, saving $5 per day does add up to real money over time if you do it long enough. But to really get the benefit of putting money away for the future, you need to put it to work so it can grow.

Due to inflation, your stash of cash will eventually lose value if you keep it under your mattress or in a low-interest savings account. Since prices tend to rise over time, your money will have less buying power in the future than it has now. If you invest your money instead, it will grow faster than inflation and your funds will have more buying power as time passes by.

Invest $5 per day

Here’s what would happen if you invested your $5 per day. Let's assume a return of 8 percent (instead of the 0 percent you would get by simply stuffing it under your mattress):

After 10 years: $27,843.
After 20 years: $89,643.
After 30 years: $226,818.
After 40 years: $531,296.
After 50 years: $1,207,130.
After 60 years: $2,707,236.

Investing $5 per day with a return of 8 percent can turn into $1 million after about 48 years. Clearly, this has a huge advantage over simply hoarding the cash. But how can you invest your money so that it grows at around 8 percent? No one knows how future investments will perform, but historical average returns from stock market and real estate investments have been around 8 percent.

How to invest small amounts of money

Can you really invest a small amount of money such as $5 at a time? I faced this situation when I wanted to start contributing $50 per month ($1.67 per day) to a Roth IRA. I found a great mid-cap growth fund with a low expense ratio, but a minimum initial investment of $2,500 was required to open an account. I corresponded with the fund manager, and he agreed to set up the account with automatic deposits of $50 per month from my checking account. The balance of this investment fund from my contributions of $1.67 per day has grown to over $4,000 so far. (See also: 5 Retirement Accounts You Don't Need a Ton of Money to Open)

A good way to manage investing small amounts is to accumulate your daily savings in your bank account and set up an automatic monthly contribution to an investment account.

If you have any high-interest credit card debt, making extra payments on that debt can have a bigger financial impact than investing the money. Set up an automatic payment to your highest interest credit card from your $5 per day funds. After your credit cards are paid off, you can switch to paying down other debts or start contributing to an investment account. (See also: 5 Ways to Pay Off High Interest Credit Card Debt)

Benefits of investing $5 per day

The small step of setting aside an extra $5 per day to invest can boost your fund balance down the road, but taking this action has other benefits. Establishing the habit of identifying extra money and investing it is the key to financial success. You don’t need to wait until someday when you have more money — you can start saving and investing today with whatever small amount you can scrape together. Even the process of finding “extra” money to invest can have benefits. You might find that cutting back spending on things you don’t really need makes life less stressful. (See also: 18 Times in Life When Less Is More)

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This article is from Dr Penny Pincher of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Don't Be Fooled by an Investment's Rate of Return

Tim Lemke — Fri, 08 Dec 2017 10:00:07 +0000

When you invest, you are looking for return. You want your money to grow over time, preferably at a rate that will allow you to achieve your financial goals.

An investment's rate of return can be a deceptive thing, however. The amount of money that an investment has made in the past isn't a guarantee of future returns. Moreover, these returns by themselves don't tell you a whole lot about what you are investing in.

Learning how to analyze an investment's returns — and understanding its limitations — will help you on the path to financial freedom. Just remember these key facts about an investment's return when examining it.

Short time frames don't tell you much

"Hey, this mutual fund went up 29 percent last year! Woo hoo!" That's great, but what did it do the year before? And the year before that? How has it performed over the last decade? Looking at the rate of return for a single year is not particularly useful, as any investment can have a hot 12 months. To get a sense of how an investment may perform in the future, it helps to have a long record of performance to examine. Fortunately, most brokerages and financial websites have comprehensive information on historical returns, so you're not simply looking at the performance of the last year.

It offers no information on the type of investment

It's great if an investment has a solid rate of return, but that should not be the only consideration when looking to buy shares. If you are buying a stock, you need to ask yourself key questions aside from just looking at performance. What industry does the company operate in? How big is the company? Does it operate internationally? If you're talking about a mutual fund, what is the investment mix? Answering these questions will help you understand whether you already own similar investments, and whether it makes sense to add them to your portfolio.

It's almost useless without context

Let's say you come across a mutual fund that earned a 9 percent return last year. You might think that is pretty good, right? Well, it doesn't look so good when you consider the S&P 500 returned 11.96 percent. Information on returns is only meaningful when it is paired with information about the broader stock market, comparable investments, and specific indexes. A small cap ETF, for example, should be examined alongside the Russell 2000 index. A mutual fund focused on technology should be compared to prominent technology indexes. Fortunately, most brokerage firms and financial websites do provide this, so it's important to analyze market returns using that context.

It does not always factor in all costs

If you purchase a mutual fund or ETF, a certain portion of your investment is taken in expenses and fees. While mutual fund returns are usually reported net of expenses, not every cost is included in this calculation. Many funds have sales charges and commissions (also known as loads) that you pay when buying and selling. Your brokerage firm may also charge a commission to execute the trade. This can reduce your overall return. The good news is that there are many good no-load mutual funds out there, and many can be traded without a commission, depending on the broker.

One more caveat regarding costs. Capital gains taxes will also reduce your balance when you sell. Be sure to factor in these costs when examining an investment's rate of return.

It does not offer detail on volatility

Let's say you have a stock that rose in value from $50 to $90 in five years. The annualized return on that stock is 16 percent. But that does not tell you whether the stock's performance has been consistent or wildly up and down.

For example, during that five-year period, that stock may have risen 20 percent, then dropped 25 percent, then risen 44 percent, dropped 10 percent, and finally rose 53 percent. That's pretty volatile, and may be outside the comfort zone of many investors even though the overall return is good. To get a better picture of the investment's performance, you need to look at the returns from each individual year, but even that offers no insight into price swings within any given year.

It can't answer the question "Why?"

An investment's rate of return may be the crucial piece of information you need to know before investing, but there's a lot that it doesn't tell you. Perhaps most importantly, it does not offer any insight into why an investment's price moved up or doing during a certain period.

Investment values go up and down for a variety of reasons, not all of them related to company performance. Perhaps a retailer saw its shares fall sharply during one quarter due to a series of natural disasters. Perhaps another company saw shares rise dramatically because of hype over its Super Bowl commercial. Returns on investment are crucial to know, but if you are an investor, it's important to do your own homework to understand why a price went up or down. Doing so will help you better understand how an investment may perform in the future.

It gives you no information on fundamentals

An investment's historical rate of return can give you insight into how it might perform in the future. But the company's actual financial performance may be even more important. It's not enough to just examine an investment's return. You should also look at company balance sheets, analyze earnings reports, and look at things like cash flow, debt, and price-to-earnings ratio. This will help you understand whether an investment's price is justified. Examples abound of companies that saw share prices skyrocket based on speculation although earnings weren't there to support it.

It tells you nothing about taxes

Let's say you invested $1,000 in a company stock and it earned an annual return of 9 percent a year over five years. That means you'll end up with $1,450 when you sell, right? Well, not exactly. Remember that unless you are investing in a tax-advantaged account such as a Roth IRA, the government takes its share when you sell. Assuming that you'll be taxed at the long-term capital gains rate of 15 percent, suddenly, that 9 percent annual return became something closer to 7 percent. Keep this in mind when trying to calculate how much money you'll actually walk away with.

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This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Here's How Rate of Return Can Help You Invest Smarter

Matt Bell — Wed, 19 Jul 2017 08:30:18 +0000

At first glance, judging an investment's past performance would seem to be a fairly simple exercise. For most stock market investments, such as individual stocks, mutual funds, and exchange-traded funds, a lot of performance information is readily available online.

However, the sheer quantity of information that's out there can make understanding it all somewhat overwhelming. And some of the terminology can be confusing.

So, let's make sure you understand a couple of key metrics and how to put them to use — whether you're evaluating the performance of an investment you already own, or you're thinking about making a new investment.

Annual return and average annual return

Two of the most fundamental ways of looking at an investment's results are how well it performed in a specific year and what its average annual return has been over multiple years.

Annual return

This is how an investment performed in one particular year. Let's use Vanguard's 2030 target-date mutual fund [VTHRX] as an example. If you go to Yahoo Finance, enter that ticker symbol in the search box, and then click on the fund's Performance tab, you can see how the fund performed each year going back to 2006. For example, in 2016, it generated a return of 7.85 percent.

Average annual return

To see an investment's average annual return over multiple years, look on the same Yahoo Finance page under Trailing Returns (%) vs. Benchmark" ("trailing" just means "looking back" — we'll get to the "benchmark" reference in a minute). You can see that VTHRX's average annual return for the past five years was 9.9 percent.

On their own, such metrics aren't very useful. However, when used together, they can provide helpful insight. For example, a 9.9 percent average annual return may seem attractive. But when you examine the past five years individually, you can see how unrealistic it is to expect that return each and every year. In 2015, the fund even suffered a loss.

When looking for meaning in performance numbers, context is king.

What's a "good" return?

To properly judge how well an investment has performed, you have to choose the right benchmark. Many investors make the mistake of comparing a specific investment or their entire portfolio to "the market."

It's fine to do that if you're investing in an S&P 500 index fund, which is designed to mirror the market. However, sticking with our previous example, VTHRX isn't designed to perform like the market.

It's designed for people who have less than 15 years until retirement. According to the basic rules of asset allocation, as you get older, the percentage of your portfolio that's invested in stocks should decrease and the portion invested in bonds should increase.

That's exactly how target-date funds, such as VTHRX, are designed. This particular fund holds a 72 percent/28 percent mix of stocks and bonds. Plus, it's diversified across U.S. and foreign stocks and bonds.

If you compared VTHRX's performance over the past five years to the S&P 500 (through the end of June), you might be disappointed. The S&P 500 has delivered an average annual return over that time period of 14.6 percent whereas VTHRX has averaged 9.9 percent.

But again, that's an apples-to-oranges comparison. A better comparison would be how VTHRX has performed against other 2030 target-date funds, and the same Yahoo Finance page referenced earlier tells you that as well.

The table showing the fund's average annual returns over various time periods also shows how its performance has compared with the "category" — in this case, the average 2030 target-date fund. As you can see, it has done a good job of outperforming its category.

Should past performance impact which investments you choose?

The prominent display of historical performance information can give the impression that it's what's most important in choosing investments. However, how an investment has performed in past years has virtually nothing to do with how it'll perform in future years.

What's more important is designing a portfolio around your optimal asset allocation — the mix of stocks and bonds that's appropriate for your investment time frame and risk tolerance. Then, if you're using a target-date fund, choose one with that asset allocation, keeping mind that funds with the same target date may be designed with very different asset allocations.

Even more importantly, use an online calculator to develop an investment plan — how much you need to have in your investment accounts by the time you retire, how much money you need to invest each month, and the average annual rate of return you need to achieve.

Such a plan would serve as the best possible benchmark because it's based on what you need to achieve in order to meet your long-term investing goal.

On its own, investment performance data isn't very helpful. But with the proper context — how an investment performed versus other similar investments, and most importantly, how your investments performed compared to the rate of return you're trying to achieve — can be very helpful indeed.

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This article is from Matt Bell of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Why Does the Stock Market Keep Going Up?

Dr Penny Pincher — Wed, 07 Jun 2017 09:01:06 +0000

Many people were taken by surprise when the stock market reached new highs after the 2016 election, with the Dow Jones industrial average (DJIA) breaking 20,000. But the recent record highs are only the latest in a long trend of stock market growth extending back well over 100 years.

The average rate of return for the DJIA since 1896 is about 7 percent when adjusted for inflation. Looking at a broader representation of the overall stock market, the average rate of return for the Standard & Poor's (S&P) 500 index since it's inception in 1928 is about 10 percent per year.

Of course, if you pay attention to the stock market, you know that stocks do not move steadily up all the time. Sometimes there are sudden market declines, such as the crash of 1929 that led to the Great Depression, or the 2008 collapse that led to the Great Recession. Sometimes there are long periods of market stagnation when stock prices do not go up much at all, such as during the 1970s. But over time, the long-term trend has been that stock values keep on pushing up, even after setbacks, and routinely go on to break record highs.

What makes stock values keep going higher and higher?

Investors think stocks will go up

Investors who decide to put money into the stock market select individual stocks and stock funds based on the financial performance of the businesses in the portfolio. Ultimately, investors weigh the potential for a stock to go up versus the risk that it will go down during their investment window.

Sometimes "irrational exuberance" seems to play a big role in driving stock prices. In a hot housing market, investors will pay essentially any price to buy a property if they are confident the price will go up, even if the price is not rational. Investors sometimes buy stock for the same reason — simply because they think someone else will pay more for it when they want to sell and they don't want to miss an opportunity to make a big gain. In some extreme cases, such as hot initial public offerings (IPOs), stock valuation seems to be driven by speculation without much solid financial basis.

Businesses have figured out how to make products for less

One way that businesses have become more valuable, and therefore garnered higher stock valuation, is by increasing productivity and efficiency. If a business can produce its goods and services at a lower cost, higher profits can be achieved.

Businesses boost their efficiency by using automation, optimizing product designs and reuse, and merging or partnering with other companies with complementary resources and capabilities. The continuous effort by businesses to reduce their costs and run their business more efficiently keeps driving stock prices up over time.

Fancy new products (with higher profit margins)

Innovation and technological advances result in new products with higher profit margins than established products. Consumers will pay a premium to get the latest technology and newest capabilities. When a new type of product is launched, there is a window of time when little or no competition is available in the market. This is why the introduction of new products keeps driving stock values up.

Growing consumerism

In the old days, it was common for people to grow their own food, make their own clothes, and craft other household items such as soap and even furniture. When people were more self-sufficient and made most things for themselves, opportunities for businesses to sell products to customers at a profit was limited.

Fast forward to today. The population has increased significantly, and most people buy products instead of making things themselves. As the number of consumers grows, and the demand by consumers for more and more products increases, so does profit for businesses that make and sell products.

Why did stocks unexpectedly go up after Trump was elected?

After an initial tumble in stock futures following the 2016 election, the stock market rallied during the following months and hit a record high, with the DJIA reaching 20,000 for the first time ever on January 25, 2017. Why did the stock market go up after the election of an unpredictable new leader?

Markets typically react negatively to uncertainty, and that is what happened when the S&P 500 and DJIA market futures fell around 4 percent on the night of the election. But soon, stock prices started rising again. Investors apparently feel that the new president will follow traditional Republican strategies of lowering taxes on businesses and reducing environmental, safety, and consumer protection regulations, resulting in higher potential profits. Also, the possibility of increased military spending and spending on huge infrastructure projects raises expectations for short-term economic growth among investors.

Will the stock market keep going up?

Stepping back and looking at the potential for stock market growth over the coming decades, the elements for continued stock market growth seem to be forthcoming.

New levels of automation promise to drive productivity and reduce the cost to produce and deliver products to consumers. Technical innovations such as renewable energy, virtual reality, augmented reality, and medical breakthroughs appear poised to result in highly profitable new products. New consumers are likely to enter the marketplace as developing economies grow, increasing overall demand for manufactured products and driving business profits higher.

This article is from Dr Penny Pincher of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: