Here are some articles that caught my eye this past weekend. Topics include: How to get 1.3% higher returns on your investments, making mistakes, lower expense ratios (again), and my reaction to Flash Boys.
Does knowing more about finance lead to better returns?
An interesting study here by the National Bureau of Economic Research determining a correlation between a person’s financial literacy and investment returns. The study found an annual 1.3% increase in returns from those who could correctly answer the following questions: (see answers below)
1) Interest rate: Suppose you had $100 in a savings account and the interest rate was 2 per cent per year. After 5 years, how much do you think you would have in the account if you left the money to grow?
- More than $110
- Exactly $110
- Less than $110
2) Inflation: Imagine that the interest rate on your savings account was 1 per cent per year and inflation was 2 per cent per year. After 1 year, how much would you be able to buy with the money in this account?
- More than today
- Exactly the same
- Less than today
3) True or false, buying a single company’s stock usually provides a safer return than a stock mutual fund.
4) Tax Offset: Assume you were in the 25 per cent tax bracket (you pay $0.25 in tax for each dollar earned) and you contributed $100 pretax to an employer’s 401(k) plan. Your take-home pay will then:
- Decline by $100
- Decline by $75
- Decline by $50
- Remain the same
5) Match: Assume that an employer matched employee contributions dollar for dollar. If the employee contributed $100 to the 401(k) plan, his account balance in the plan including his contribution would:
- Increase by $50
- Increase by $100
- Increase by $200
- Remain the same
The study determined that those investors who answered more questions had better historical returns on their investments. The higher returns were due primarily due to a higher asset allocation to stocks. The cause is not exactly clear. Do more educated investors better handle the risks in stocks? Do more financial literate investors understand the advantages of equity investments over fixed income or cash? The study does not clearly answer these questions, only notes the correlation.
How did you do? The average score was 3.7 correct. Here are the answers:
1) The correct answer is “More than $110”, because of compounding interest. In the first year, the savings account would earn $2 in interest, so many just assume that it will earn $2 per year for 5 years, but that is not correct. That answer does not account for the compounding interest of the savings account. Because the interest on your gains from the previous years ALSO earn interest, you end up with $110.41:
2) The correct answer is “Less than today”. Though, I thought that this question was worded poorly. What it should ask is “What is the purchasing power of this money after 1 year?” Think of inflation as a negative interest rate. If you are earning interest at a rate that is less than inflation, you are losing purchasing power of your savings. Here, since the rate of inflation was 2% compared to the 1% savings interest rate, you are effectively losing 1% of purchasing power in a year.
3) The correct answer is “False”. This is the basic concept of diversification. If this concept is new to you, I encourage you to sign up for our free e-book at the bottom of the post for on the right hand side of this page, where we have a section describing the concept of diversification in detail.
4) The correct answer is “Decline by $75”. If you did not contribute that $100 to your 401(k) plan, it would have been taxed at 25%, which would have given you $75 in “take home pay”. For more information on the tax rules and other benefits of 401(k)s and other investment accounts, see our post here: Comparison of Investment Account Types.
5) The correct answer is “Increase by $200”.Once again on the topic of 401(k)s this question highlights another important feature of most company retirement plans, the company match. Many investors forgo their employer’s investment plan and miss out on free money. If you are lucky enough to work for a company that offers any type of match, at the minimum contribute enough to get that full match. Otherwise you are just throwing away free money!
Worst money mistakes you can make at any age
“It’s good to learn from your mistakes. It’s better to learn from other people’s mistakes.” – Warren Buffett.
Here is a nice, quick look at some common financial mistakes that can set you up for failure later in life.
For those in their 20’s, the problem is simple. Not saving. It doesn’t matter how much, but a dollar saved today is worth so much more than a dollar saved a decade from now. For example, consider one of my favorite examples of the benefits of saving early, originally posted in part 1 of our “Getting Started Series”:
Person 1 contributes $1,000 a year to his retirement account starting at age 20 until he turns 34, for a total of $15,000 saved. Person 1 does not contribute another dollar to his account. The money grows in a tax-friendly retirement account such as a Roth IRA until he retires at age 65. His investment grows at a rate of 7%, the average return of the S&P 500 index over the last 55 years.
Compare that situation to Person 2, who waits until age 30 to start investing $1,000 a year. Person 2 puts away $1,000 a year into a retirement account for the next 35 years, until he reaches 65 years old. Person 2 has saved a total of $35,000 ($20,000 more than Person 1), and will see that investment grow at the same historical average rate of 7%.
How do these situations play out in the long run?
Person 1 has saved $15,000, and got started 10 years earlier.
While Person 2 saved $35,000, but got started 10 years later.
At age 65:
Person 1 will have $206,148.
Compared to Person 2, who will have only $149,660.
Even though Person 1 saved $20,000 less, they will end up with more than $56,000 more than person 2!
Person 1 will have $56,000 more to spend on traveling, a house, a car, etc., later in life because of the sacrifice early to save $1,000 a year (less than $100 a month!) early on in their life. 10 years makes all the difference!
I’m Just Now Realizing How Stupid We Are
Here is a short collection of thoughts by Morgan Housel, a long time contributor to Fool.com (in fact, this is his 3,000th post). He calls the post “A few of the lessons he has learned” in his years of writing and learning about investing.
“I’ve learned that finance is actually very simple, but it’s made to look complicated to justify fees.”
iShares Doubles ‘Core’ Lineup To 20 ETFs
ETF managers are in fierce competition to reduce the expense ratios on their funds. While this may be a tough market for fund managers, it is producing incredible cost savings for regular investors like you and I. (Want to see how much small reduction in expense ratios can save you? Use our Expense Ratio Calculator)
iShares slashed the expense ratios on several funds:
Brokers Fight Rule to Favor Best Interests of Customers
If you need any more evidence to not believe a word of any Wall Street salesman, here you go. It amazes me how the financial industry can so clearly fight this, but then argue how necessary and helpful they are in your retirement planning.
You don’t need to pay 1%+ of your assets every year to invest intelligently. With the advent of cheap ETFs, lifecycle funds and an infinite number of investment blogs like begin to invest, you can easily invest your own money (and probably outperform that would-be manager anyway!)
I just finished the book I mentioned last weekend reading article: Flash Boys: A Wall Street Revolt
In it, Brad Katsuyama is quoted:
“You want to create a system where behaving correctly would be rewarded, and the system has been doing the opposite. It’s rational for a broker to behave badly.”
The book discusses numerous times where brokers use of “dark pools” costs investors money and shows brokers clearly not doing what is best for their customers.
I still maintain a similar opinion before I started Flash Boys, I don’t think high frequency trading really hurts an individual investor who behaves responsibly. If you trade once a month, paying a penny a share more really doesn’t hurt. Is it wrong? Yes. Is it happening? Yes. But is it a reason for people to not invest in the market and worry about some “rigged” market? I don’t think so.
That’s all I have for the weekend. What are you reading this week?