Sunday, September 30, 2007

The Rule of 72. How long will it take to double my money?

There is a simple mathematical rule that I learned as a kid that I have never forgotten -- the "Rule of 72." This is a very simple way to find out how long it will take to double your money at a certain interest rate.

Here's how the rule works.

Suppose you want to know how long it will take to double your money at 10% interest. 72 divided by 10 is 7.2. Therefore it will take 7.2 years to double your money if you are earning 10%. If you are earning 7%, it will take a little over 10 years. (Because 72 divided by 7 is roughly 10.) There is no need to figure the exact calculation, because this rule is only for estimating -- but what a powerful little rule it is.

Thanks to several readers who pointed out that this rule is mathematically derived from the "natural log" of 2 which is 0.69. So, it could technically be the "Rule of 69," although 70 or 72 seems easier for quick estimating.

Friday, September 14, 2007

Previous Performance is not an indicator of Future Results

Have you ever noticed in small print at the end of every mutual fund commercial or magazine layout they say "Previous performance is not an indicator of future results."? Ever wonder why? While they may be legally bound to do so, there is also quite a bit of mathematical truth to that statement. Let's take one of my favorite examples, offered in Larry Swedroe's "Rational Investing in Irrational Times" book. (A great read, by the way.)

Imagine giving a room full of 1000 kids (or adults for that matter) a coin and telling them to flip it and try to get heads. Half of them would get it right. Taking the remaining 500, 250 could repeat their performance -- getting heads twice in a row. Continuing down this path, half of the kids would flip heads each time taking our winners down to 125, 62, 31, 16, 8, 4, 2 and eventually the final winner on the 10th flip. So did the kid who flipped heads 10 times in a row demonstrate skill at flipping heads? No, his odds of flipping heads on his next flip are still 50/50, just like everyone else. He just illustrated a statistical fact. That random acts produce a bell shaped curve. A very small percentage of kids flipped almost all tails, and a very small percentage flipped almost all heads, but the vast majority were somewhere in the middle. The problem is that at the beginning of the game, there would have been no way to identify the "genius" with the head-flipping "talent."

So while I agree that some investors have more skill and prowess than others, scores of academic studies have shown that chasing the "hot hand" on Wall Street is an unwinnable game for multiple reasons, but here are the two biggest:

1. Previous performance was enhanced by chance, and not purely a result of skill.

2. As more money flows in due to success, the manager must find more and more opportunities. The more money the fund manages, the less likely they will be to beat their benchmark.

All of that to say that you really should pay attention to the mutual funds when they say "Previous performance is not an indicator of future results." It's quite true.

Thursday, September 13, 2007

5 Questions to Consider When Choosing a Mutual Fund

1. What are the goals of the fund?
Before you select a mutual fund, you first ought to know what your goals are and make sure you select a fund with similar goals. Obviously, every fund's goal is to make a profit for the investors, but how much risk you are willing to take and what industries you want to invest in are up to you. There are many fund families that now offer "target retirement" or "life strategy" funds which change with you as you get older. This is a great way to simplify your diversification if you don't feel comfortable doing that yourself.

2. How much are the fees?
Every mutual fund is required by law to disclose their fees to you in the prospectus (that booklet you are supposed to read before you invest). Typically funds come in two flavors, "loaded," and "no-load". A "loaded" fund will typically charge a fee either when you buy ("front-end loaded") or sell ("back-end loaded") the fund. This comes out of the money you invest. Typically these fees are about 5%.
The second type of fee is the yearly fee the fund charges to be a member of the fund. These fees can range from 0.05% up to 3%. There have been several academic studies to show that the only accurate predictor of which funds will produce better returns for their investors, are the ones with the lowest fees. Makes sense, right? If all managers basically perform the same over time, you, as an investor, will do better with the one that charges you less fees.
The third, and often overlooked source of fees comes in the form of transaction fees. While in a sense these are transparent to the investor, the effects are felt nonetheless. As the fund managers buy and sell the stocks in the portfolio, they create expenses both in the form of trading costs as well as taxes. So funds with a higher turnover percentage (for example, 50% would mean they turn over half of their portfolio every year, holding an average stock 2 years) would generate more of those fees, and create more drag on your total return as an investor than a fund with a 10% turnover.

3. Is previous performance an indicator of future results?
The short answer is, no, they are not an indicator of future results. And even though every fund is required by law to remind you of that, people pour billions of dollars every year into the latest "hot" fund. Again, the only proven indicator of better future results in the future is lower fees. Interestingly enough, the one rule that does seem to hold true is that poor performance over several years does seem to be an indicator of poor performance in the future.

4. How does this fit with the rest of my portfolio?

This is a crucial decision. When I was a younger, less experienced investor, I thought I was diversifying my portfolio because I had 4 or 5 mutual funds. However, I had no idea how those funds fit together, and how it affected the overall picture known as my "portfolio." Each fund will list in their prospectus the percentage they invest in each type of stock and bond, and you should track the percentage of each in your overall portfolio. Furthermore, you should have targets for Domestic and Foreign equities, Small/Mid/Large caps, and Bonds. There are various guides for helping you decide your allocations, but mostly it is an individual decision based on your beliefs about the market and your financial picture (such as when you will need to begin withdrawing money).

5. Would I be better off in an ETF?
ETFs (Exchange Traded Funds) have come on the scene in the last few years and made quite an impression. Although they act much like a mutual fund (holding baskets of stocks), they trade on the stock exchange like a stock. The good news is that for most small and medium investors, their is very little difference between a mutual fund and an ETF. ETFs generally track a certain index, although as time has gone on, those indicies have gotten more and more non-traditional. Because they are generally not "managed" funds (following an index instead of active management), the fees are typically lower than a managed fund, and about the same as an indexed mutual fund. Be careful, however. Just because it is an ETF, doesn't mean it is well diversified -- some can be quite narrowly focused.

Tuesday, September 11, 2007

31 Ways to Save More Money

It’s been said that a penny saved is a penny earned. Thanks to income taxes, a penny saved is actually worth about 1.3 pennies earned.

Here are 31 ways to save a few pennies (and dollars):

  1. Decorate your home with pictures you have taken. Why pay big money for framed “stock” pictures. Sort through your personal collection and hang them around your house. If you’re not a photographer, there are plenty of professional looking photos on online picture sites that are high-resolution for printing and royalty free for personal use.
  2. Get a library card…and use it. Why spend money on books? Some libraries now have online interfaces that make it a cinch to request a book. They will sometimes even request a book from another library in their network if they don’t have it.
  3. Get a “lite” internet package. I’m too internet dependent to advocate getting rid of your home internet connection all together, but most people don’t use the bandwidth they are paying for. Call your provider and ask for their “lite” plan. Often they will have a lower-bandwidth option that is unadvertised.
  4. Get a deep freezer. This is one of my personal favorites. Inevitably, my local grocery stores will have a fantastic deal on one or two items each week. With a deep freezer in my garage, I’m free to buy 10 pounds of meat, or a cart full of frozen veggies. Not only do I get at least ½ off retail, but I have them when I need them.
  5. Don’t be an early adopter. Being an early adopter of technology is expensive. Its no secret that a new gadget is more expensive when it first hits the market, but some folks just HAVE to have it. You’ve gone this long without it. Save yourself some serious dough, and wait a few more months.
  6. Join a credit union. Credit Unions, unlike regular banks, are not trying to make a profit. Their goal is to make money for their shareholders, which conveniently enough are the members. That means they are almost always a better deal than a normal bank. If you are eligible for a credit union, it’s a good idea to join. They often offer the same features as a bank, but with better rates and fewer fees.
  7. Purchase the loss leaders. Most grocery stores put out a weekly flyer with their specials. Usually on the first page, they list what are known as loss leaders. These are items the stores sell for less than they paid for them. It sounds crazy, but realize that they are willing to take a few dollar loss to get you inside the store where you will buy a cart full of groceries. Maximize your buying power by buying the loss leaders and stopping there. When used in conjunction with the deep freezer, you can stock up on meats and frozen items on the cheap.
  8. Opt for generic prescriptions and over-the-counter medications. Prescriptions and medications are one area where the “store-brand” is absolutely as good as the branded product. Both products contain exactly the same medicinal ingredients, but one is a fraction of the cost.
  9. Never pay retail. When shopping online, it is easy to find exactly the same products sold for different prices at different stores. Spending a few minutes searching almost always pays for itself. And with Google, online e-coupons are just a click away.
  10. Grow your own herbs. A pack of 99 cent seeds will provide enough basil, rosemary, sage, and others to keep your food seasoned all year long. Put extras in a freezer bag for use during the winter.
  11. Get a high-yield savings account. If you have money sitting in a savings account, there is no reason why you shouldn’t be earning as much interest as possible. Several online banks (and perhaps credit unions) pay over 5% (at the time of this writing) on savings accounts, and your money is insured by the government, just like if it were at the bank down the street.
  12. Get rid of cable or satellite. You can likely get most of the networks in pure HD over the air.
  13. Lower your credit card interest rate. If you are carrying credit card balances at a high (more than 6%) interest rate, consolidate them to a lower interest card. There are plenty of 0% cards for consolidating balances. If you can’t pay it off by the time the promotional period ends, roll the balance to another 0% card.
  14. Make coffee at home. Why spend $3 for coffee when you can make it at home for 5 cents. Even if you buy the good coffee, it is still no more than 20 cents a cup.
  15. Cook at home. Restaurants can be fun and a great place to socialize with friends, but the bills add up. A home made meal usually only costs $1-$3. Try finding that deal at a restaurant. When you do go out, use restaurant coupons and take ½ of your entree home for lunch the next day.
  16. Pack your lunch. Going out for lunch, even at $5-$7 a pop, adds up over the month or year. Packing a lunch and bringing it to work usually costs only a dollar or two.
  17. Never buy a brand new car. Most cars depreciate 30% of their value in the first 2 years. Buying a good pre-owned car with a few miles will save you thousands over buying a brand new one.
  18. Use index funds. With all of the money you are saving, it is a good idea to begin investing. But too often, new investors get sucked in by “advisers” who put them in funds with outrageous fees. Sometimes as high as 5% of the amount invested. On the contrary, index funds and ETFs usually charge only a fraction of 1% and over the long-haul have beaten most managed funds.
  19. Install energy saving CF bulbs. Now that the price of compact fluorescent bulbs have come down to about $2-$3 per bulb (if you buy a 5 pack at a chain hardware store) it is definitely worth your money to install them. They last for several years and typically use 1/3 of the energy of a normal bulb. In a house with 40 bulbs, that’s about $300 in savings per year. (40 75-watt bulbs replaced with 23-watt bulbs, average use 5 hrs per day at $0.09 /kWh.)
  20. Install a programmable thermostat. Programmable thermostats only cost about $30 at a hardware store and can save you hundreds of dollars per year. During the summer, program the thermostat to allow the temp to rise a few degrees while you are at work, and begin cooling before you return. In the winter, do the opposite. Most of these thermostats even have weekday and weekend settings.
  21. Make purchases with a credit card with cash rewards. (Steer away from ambiguous “points” systems.) Many credit cards offer rewards, but most these days have moved to ambiguous points systems where it is nearly impossible to ever cash in on your rewards. However, there are cards out there that pay cash rewards every month. Getting 1% back on all your purchases should be your minimum goal. (Of course, always pay off your purchases at the end of the month.)
  22. Don’t purchase alcohol at a restaurant or a bar. I love a good beer as much as the next guy, but paying $6 for a beer that I can buy at the grocery store for $6 for a 6-pack just doesn’t make sense.
  23. Sell some unneeded clutter on ebay. Everyone has books, CDs, clothing, and whatnot that are just taking up space. Cash in on those things by selling them on ebay. You’ll likely get more than you think (and the buyer pays shipping).
  24. Clip coupons and use them wisely. Coupons can save a ton of money on groceries and other items (and many grocery stores double or triple face values). But don’t purchase something just because you have a coupon, and make sure that the final price after coupon is worth paying. Sometimes its not a good deal even with a discount.
  25. Try store-branded items. Many store-brands are just as good as their branded counterparts. The only difference is advertising. Companies have to pay for the advertising overhead by charging more for their product. At least try the store brand. If you don’t like it, don’t buy it again.
  26. Resist the urge to spend on impulse, no matter how small the cost. Get out of the habit of purchasing on impulse. A newspaper here, a pack of gum there, a magazine – they add up to big numbers by the end of the month. If you don’t believe me, keep a log of all of your purchases for a few weeks. Another way to avoid buying on impulse is to always go to the store with a shopping list, and only get those items.
  27. Use the lowest octane gasoline recommended for your car. There is usually absolutely no benefit to buying the “premium” gasoline for your car. If you don’t believe me, read your owners manual.
  28. Get a space heater. If you are a single person or couple living in a house, don’t waste money heating the entire house all night. Place a safe, thermostat-controlled space heater in your bedroom to keep you warm and save on energy bills. Also, buy an extra blanket or two.
  29. Don’t burn the pilot light in a gas fireplace during warm months. If you read the small print on your gas log fireplace, it will tell you how many therms of energy it uses while it is not being used. It can add up to $5-$10 per month depending on gas prices.
  30. Reduce your text messaging. Most text messaging is unneeded, and at $0.15 a message, text message conversations can add up to many dollars at the end of the month.
  31. Drink tap or filtered water instead of sodas. Most bottled water is no better than tap water, and sometimes even worse because of the lack of fluoride. Get used to drinking water instead of sodas. It’s better for you and will save a bundle. If you are uncomfortable with tap, get a filtered pitcher.
For more ideas, check out a similar posting I ran across on the fivecentnickel.