User's blog

Month: September 2022

  • Where do I invest and when do I start?

    In my previous post, I wrote about the various types of assets you can use for investment. To have a diversified portfolio, you should invest in a variety of assets.

    Diversification can mean two things:

    The first is diversifying within the same asset class.
    The second is having different asset classes in your investment portfolio.
    We all need a diversified portfolio

    So, for example, if you are investing in fixed-income securities, you need to invest in different types of those such as government bonds, corporate bonds, CDs etc.

    Similarly, if you are investing in stocks, you should invest in multiple companies from different industries and sectors. But when you invest in individual company stocks, you may only be able to invest in 5, 10, or maybe 15 companies.

    To achieve diversification using individual stocks, you will need to do a lot of research and invest a lot of money buying stocks from different companies in different industries.

    Thus, if stocks comprise a majority of your investment portfolio, then your investment is risky because it is based on the performance of those companies you bought shares of.

    So what’s the solution?

    For a beginner investor, who doesn’t want to put too much money in several individual stocks, the best way is to start with investing in an index fund or a passively managed mutual fund.

    What’s an index fund?

    Index fund is a fund whose portfolio are built to mimic the constituents of a stock market index. The most widely used indices in the US are S&P 500 index or Dow Jones Industrial Average, or the Nasdaq Composite index.

    Generally, Index funds should give you the same return as the index they follow. These funds buy all the stocks that are part of the index in the same proportion. So, it is like you have invested a little bit in each of those companies that comprise that market index. So yes, that would give you a very well diversified investment portfolio.

    Also, index funds are less volatile and therefore are a good investment compared to individual stocks, esp. for long-term investing. So, they are a great option for investment for your retirement.

    In my next post, I will argue why I like index funds more than actively managed mutual funds. I feel if you are sticking to read my post this far, you will be interested to know more.

    Don’t put all your eggs in one basket!

    The main point is to diversify so that if one sector or asset class doesn’t perform well, you don’t lose all your money.

    The second key thing for diversification is having different asset classes in your portfolio, such as stocks, bonds, real estate, commodities, etc.

    This brings us to the concept of asset allocation. Asset allocation simply means you decide what percentage of your money you want to put into each type of asset class.

    Asset allocation will vary from person to person, depending upon their savings, age, risk tolerance and financial circumstances.

    Finance theory suggests that generally, your investment in stocks should be 100 minus your age. So, if you are 25 years old, it should be 75% stock and 25% fixed income.

    So yes, it means you need to keep changing your asset allocation as you grow older. Later in life, your investment in stocks should be less, and high in other fixed-income assets.

    Now comes the million-dollar question.

    When should you start investing?

    The easy answer is now if you haven’t started already.

    You can start investing as early as when you first start earning. Even kids can start investing their allowance money and add to it periodically.

    Time plays a huge role in making your money grow, more than the dollar amount you invest. This is due to the power of investing!

    Your money grows overtime exponentially!

    If you are not convinced, you can take a look at my post here, where I explain this concept by using some simple examples.

    How much money do I need to invest?

    In the past, you would need a substantial amount of money to start investing. But things are much more simple now. With no minimum, no commission brokerage accounts, and fractional ownership of shares, you can start investing with as little as $10 a month.

    You can set aside $1-$5 a day and make monthly contributions of $30-$150 a monthly.

    These are some of the top brokerage firms in the U.S. – Charles Schwab, Fidelity, TD Ameritrade, and Vanguard. Stay tuned for my post on how to open a brokerage account!

    I hope you found this information useful, I will cover Real estate and commodity investment in another post! But this is useful info to start investing now.

    Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice on an individual basis. 

    Credits:

    Images- https://www.freepik.com

  • Investment basics, you should know: part 1

    After we have established 6 months’ worth of saving in a bank for our emergency fund, what do we do with our remaining savings? Finance experts will tell us that if we want our money to grow, leaving the extra money in a bank will not take us anywhere. So, the best strategy is to invest your extra money.

    Now the question arises, without proper financial literacy, how do we know where can we invest our money? In this post, I will tell you some of the asset types where you can invest your money.

    Also, you will learn why diversification is very important for investing. By diversification, we mean, having a variety of assets so that if one asset doesn’t do well, you don’t lose all your money. This will also allow you to minimize risks from fluctuations in return from each asset class.

    Let’s begin by understanding an asset class!

    Asset class means a group of assets that display similar features. These assets will have similar risks and give you similar returns. They are also usually subject to similar tax laws.

    There are several types of asset classes, such as

    • stocks or equities,
    • fixed income assets (bonds and CDs),
    • mutual funds, ETFs
    • Cash and cash equivalents like money market funds
    • commodities like gold and silver, oil, etc
    • real estate (property)

    Asset class and allocation are very important concepts in investing. They help you diversify your investment, so you can have a well-balanced portfolio. I will cover more on asset allocation in another post.

    In this post, I will cover the first two types of assets

    Stocks

    Stocks are the shares in a company. People who buy a company’s stock actually get a share of ownership in that company. Companies typically issue their stock in the Initial public offering (IPO) to raise money (capital) for its growth.

    Stocks or shares mean the same and I am using them interchangeably throughout this post. Similarly, you can either say stockholders or shareholders, they are the same.

    When we buy stocks, we get payments in the form of dividends. When the company is doing well and earning profits, it pays its stockholders a share in the profit called dividends.

    Another way we get earnings from stocks is when the share price of that company increases, also called capital appreciation. This could be due to the company’s good earnings or any positive news in the company. The company’s share price reacts to the news as the market values its worth more now.

    Is there a safer way to invest in stocks?

    The answer is yes if you follow certain rules.

    The first thing to understand is that finance theory and the supporting research show that no one can beat the market. Even seasoned investors, like, Warren Buffet don’t recommend cherry-picking a few stocks, esp. for someone who is not a very risk-taking person.

    A company’s shares can fluctuate a lot due to various reasons. People who think they can predict a company’s performance and hence its share price doesn’t know finance theory that well.

    Most of the time, people don’t have enough time to research individual companies. Also, investing in a variety of companies to make a truly diversified portfolio may require a lot of money.

    A good strategy for a new investor is to invest in an index fund that mimics the market such as an S&P 500 in the US. An index fund is a type of mutual fund that buys all the stocks that make up the market index in the same proportion. So, the money that you earn from investing in an index fund will be very similar to the return on the index it mimics.

    Another key feature of Index funds is that they generally follow a passive, rather than active, style of investing. This means they maximize returns over the long period by not buying and selling securities very often. 

    Because index funds are diversified, you don’t lose money when some stocks don’t do well. Index funds mimic the market and are less volatile and over the long term (like 10 years or more), they give good returns. Don’t put all your eggs in one basket rule should be the most important thing to follow when investing.

    The second way to minimize risks is to use a strategy called dollar cost averaging, where you invest a fixed $ amount every period, monthly, weekly, etc.

    I didn’t want to make this post super long that you loose interest, so if you want to learn about dollar cost averaging, you can read my post here.

    Let’s quickly turn to our fixed-income assets. The first one is bonds.

    Bonds

    Unlike stocks, if you buy a bond of a company, it doesn’t give you ownership in that company. Bonds are actually a loan a company takes to raise capital.

    Both individual companies and the government need to raise money and thus, issue bonds. Thus, when we buy bonds, we get interest payments on the money we loan to a company or the government. Along with interest payments, at the end of our loan period called “term”, we also get our Principal amount back. 

    Bonds are part of fixed-income investments. As the name suggests, they give a fixed amount of income with regular interest payments until maturity.

    Other fixed income assets include Certificates of deposits (CDs), municipal bonds, t-bills and t-bonds.

    Just like stocks, we can invest in fixed-income securities directly, or through Electronically traded funds called ETFs and mutual funds or index funds.

    As a bond owner, you bear less risk and you will get the interest amount, irrespective of how the company performs.

    Thus, a good part of owning a bond is that, if a company does bad and goes bankrupt, the bondholders still will get their money back. The company can pay them by selling their assets such as their buildings, factories, etc.

    However, this is not the case with shareholders. During bankruptcy, the stock price of the company crashes to a very low mark, and shareholders could lose all of their investments.

    Treasury bonds are considered very safe investment options. It is like lending money to the US government.

    Stocks usually pay more than a bond, but owning a stock is riskier than owning a bond. So, your decision to invest in stocks or bonds should depend on how quickly you want to grow your money and how much risk you are willing to take.

    So which one should we invest in?

    The answer is in everything. We all should have a diversified portfolio, consisting of stocks, bonds, and other assets, like commodities, real estate as well. Although this post covered investment in stocks and bonds, we can have a portfolio with more types of assets.

    Your age and risk tolerance will determine the percentage of each asset you should keep in your portfolio. For younger people, investments in bonds shouldn’t be the main part of the portfolio, simply because they don’t pay as much as stocks do.

    However, as we approach retirement age, our ability to bear risks falls. So, more investments in fixed-income assets like bonds, should be done later in life.

    I hope you found this post useful. Stay tuned for my next post on asset allocation and diversification.

    Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice. I recommend you consult a qualified financial advisor to make investment decisions.

  • How does people’s expectation about inflation affect the actual inflation?

    What people like you and me think about inflation directly impacts the actual inflation rate. So, if we think inflation will be high in the coming months, it will most likely be. In this post, I will explain how this phenomenon works.

    If we expect that overall prices are going to rise in the coming months, we may buy more things now, rather than in the future. If a lot of people do that, this increases the demand for goods and services.

    High inflation is directly linked to a higher demand that is not immediately matched by an increase in supply. As a result, firms increase the prices of goods and services when there is more demand. This enables them to make more profit. As a result, we see increased prices passed on to the consumers causing higher inflation.

    On the other hand, if people expect prices to fall in the future, they may delay spending now to get a better deal. This will result in a decrease in demand for goods and services and businesses will end up lowering prices to clear up their stock.

    So, now we understand how inflation expectations affect actual inflation. If you want to know more about inflation and how it is calculated, you can refer to my post here.

    What is the current inflation expectation in the U.S.?

    After suffering from really high inflation close to 8%-9% for over half a year, we foresee some good news. A survey conducted by the Fed reserve bank of New York shows a decrease in these expectations.

    People in the U.S. feel that one and three-year-ahead inflation are now going to be 5.7 % and 2.8 % respectively.

    These are clearly lower than 6.2 % and 3.2 % in June for one and three years ahead inflation rates respectively. In the figure from the Federal Reserve of New York website, you can see how there is a decline in the curve of the expected inflation rate towards the end. This is the survey done in the month of August 2022 about what people think inflation may look like for 1 year and 3 years.

    It shows that people’s expectations are consistent with what the Fed is trying to achieve. By raising interest rates, the Fed is trying to slow down the demand in the U.S. When borrowing becomes expensive, people generally tend to borrow less for things like cars, mortgages, etc.

    In their September 20 meeting, the Fed is most likely going to raise the key federal funds rate by another 75 basis points. The Fed has been raising interest rates to fight the high inflation in the U.S for the last 6 months. Central banks in a lot of other countries fighting inflation have been doing the same.

    To learn more about the role of the central bank, stay tuned for my next post.

  • What is a 529 plan in the U.S.?

    In my earlier post, I wrote about ways to fund your child’s college education. One of them was opening a 529 account. In this post, I will talk about what these plans are.

    529 plan is a tax advantage account, where people invest money to fund the college education of their kids. You can open an account for your education as well.

    529 plans are state government-sponsored plans and each state has its plans.

    Advantages of 529 plans

    The first advantage is that you invest your post-tax money and it grows tax-free. This is similar to a Roth IRA or 401 K. The other advantage is that there is no maximum contribution limit.

    Additionally, if the original beneficiary can’t use his account for any reason, there is an option to change the beneficiary anytime.

    Who can open the account?

    Mostly parents or grandparents open this account to fund money for their child or grandchild’s higher education.

    Anyone with a Social Security Number (SSN) or Individual Taxpayer Identification Number (ITIN) can open this account. Though non-U.S. citizens living outside the U.S. can’t open the account, they can still contribute to a child’s 529 plan.

    Also, anyone can contribute to a 529 plan, a grandparent, a friend, or a relative.

    Only U.S. citizens or resident aliens with a Social Security Number or Individual Taxpayer Identification Number can be the beneficiary.

    Also, you don’t have to be a resident of that state to apply for that plan. Most states offer it to both residents and nonresidents. However, there are six 529 plans that are only available to in-state residents:

    Two types of 529 plan

    • Savings plans: This is where you are building up money, which you can use toward almost any college tuition and related expenses in the US. This can also be used for K-12 education as well.
    • Prepaid tuition plans: This lets parents lock in today’s tuition rates for a child’s future education (but may limit where a child can go to school). The money can’t be used for room and boarding.

    Choosing the right 529 plan

    Savings plans tend to be more popular than prepaid tuition ones, as they are less restricting. Not all states offer prepaid tuition plans.

    Many families choose their state’s plan because their state can offer more tax benefits to them. However, you are free to choose any state’s plan. One tip is to compare different plans and choose the one with a low expense ratio.

    Disadvantages of 529 plan

    Since the money invested should only be used for education purposes, if you use it for anything else, you pay a 10% penalty and will owe taxes on the capital gains.

    Also, you can’t control which assets these plans invest in.

    Should you invest in 529 plan?

    Despite these limitations, it is still a great plan for funding college education if you think your child will go to college.

    Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice.

  • How to fund higher education in the US?

    Before I answer this question, I want you to look at the income of people with a college education vs people who don’t. Publicly available data and our observation show that people with a bachelor’s degree or a master’s degree get higher-paying jobs.

    Below chart, I copied from the U.S. BUREAU OF LABOR STATISTICS. It shows the median earnings by education level in the United States from the 2021 population survey.

    People with bachelor’s degrees earned 48% more than people who don’t complete their degrees. Clearly, completing the degree has a huge positive impact on median earnings. Also, people with professional degrees such as doctors, engineers, and lawyers earn even higher amounts.

    Ways of funding college education

    How to fund their child’s higher education is an important decision all parents will have to make at some point. Planning early for a college education is better than planning later and it is esp. true when you have more than one child.

    In the US, there are several ways you can do that:

    529 plan

    You can create a college fund using a 529 plan. A 529 plan is a tax-advantaged college savings account offered by either your state government or college.

    The tax advantage is the main benefit of it. Tax advantage means you invest your post-tax money, but it grows tax-free. Also, when you withdraw your money for college, you don’t have to pay taxes on it, as long as it is used for education purposes.

    If you are aware of 401k plans, 529 plans are similar to those. However, this money you withdraw can only be used for education. There is a penalty of 10% for non-educational use and you will have to pay income tax on it.

    To know more about this option, you can look at this website for all the details.

    Loans

    If you can’t afford to pay for your child’s college education from your own savings or investment, you can borrow.

    I am going to get a little sidetracked here, but from what I learned from various finance books and legit websites is worth sharing. I feel borrowing for good investments pays off in long run.

    Loans taken for higher education, starting or growing a well thought business, or real estate are all good investments. As there is a very high chance of you earning more from these investments. It is like you are investing for your future. So even if you have to pay interest on your loan, your earnings increase much more in comparison, to compensate for it.

    However, borrowing to pay for things that will ultimately depreciate, such as cars, furniture, and vacation isn’t worth it.

    Coming back to the topic, alternatively, you can also borrow for higher education if your savings or investment can’t cover the cost.

    Take loans from either the Federal government or from private banks

    These student loans can be used for tuition, accommodation, books, and other miscellaneous costs related to college. The interest rates on Federal loans are usually lower compared to private banks.

    As of today, interest rate on federal unsubsidized loan is 4.99% for bachelor’s degree and 6.54% for professional and graduates degrees. The repayment period defaults to 10 years but can be extended up to 30 years. For more info, you can refer to the Federal student loan website.

    On Aug. 24, 2022, the U.S. Department of Education (ED) extended COVID-19 emergency relief for student loans through Dec. 31, 2022. Please see here for more details.

    https://studentaid.gov/help-center/answers/article/what-is-current-interest-rate-for-direct-unsubsidized-loans

    How much can I borrow for a student loan?

    For the undergraduate level, you can borrow each academic year between $5,500 and $12,500 depending on your year in school and dependency status. For graduate or professional level, you can borrow up to $20,500 per year.

    Types of Federal loans

    The main difference between Direct Subsidized Loans and Direct unsubsidized loans is the financial need element. Direct subsidized loan are available to undergraduate students with financial need, so the US government pays interest on your behalf.

    Direct unsubsidized loans are not based on financial need and hence you pay the interest on the loan. On these loans, interest accrues (adds up) every day.

    Borrow from private banks

    The other option is to borrow from private banks. Usually, the rates are higher than Federal student loans.

    With private loans, the payments get due while you are still in college. In the case of a Federal direct unsubsidized loan, payments are not due until after you graduate.

    My two cents

    Get higher education even if it requires borrowing. Also, you have to understand how much money you should borrow. The main aim is that it should cover your tuition and basic living expenses, if you are staying away from home.

    It may be tempting for you to go to a great location, a beautiful campus, and choose a college with the best athletics. But, you should decide if taking a bigger loan for these extra amenities is even worth it, esp. when you have to pay interest on your loan.

    Another option is to check with a nearby college. From my experience, degree from UCLA or USC counts equally well as a degree from UC Berkeley, if you are applying for jobs in and around LA. If your nearby college has a decent rating, living at home and attending local universities will save a lot money on accommodation.

    Some kids also join two years of community college and then attend two years at their local public university This is a much cheaper option and can save you thousands of dollars.

    Also, make sure to submit your student loan FAFSA (form) as early as possible for the best grant and loan opportunities. You can also check for grants or scholarships from your local civic organizations, your local community colleges and universities, and even your parents’ employers.

    I hope you found this information useful. Adios, until next time!

    Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice.