This week let’s get back to defining common financial terms. As in prior weeks, we’re working our way up the list of terms YouGov polled Americans about. You may know about these terms already, but hopefully this post can add a little extra to your body of knowledge.
Fixed-Rate Mortgage – There are different schools of thought regarding mortgages, but I’ll come right out and state my bias toward the fixed-rate variety. To me, having a fixed interest rate, a fixed term, and a fixed monthly principal and interest payment is the best way to borrow.
Yes, you could leverage an adjustable rate if you thought rates would go down as this would lower your borrowing costs. Perhaps you’re planning to live in your home for only a few years. You could opt for a fixed rate for a that timeframe, say three or five years, and then the mortgage starts adjusting right about the time you’re planning to sell.
Adjustable-rate mortgages can also offer a cheaper entry point, but nothing is free. Again, when I think about a huge purchase such as a house, I want the sense of security that comes from a straightforward fixed-rate loan. I don’t want to gamble.
Another aspect of why I favor fixed-rate mortgages is that we’ve been in a period of declining interest rates for over 30 years. Back in 1981, for example, the average 30yr loan cost over 18%! Currently we’re at about 4.4%. And rates this low will seem oh-so-cheap if (or when?) we move back toward the longer-term average of about 8%. In other words, long-term money is still cheap to borrow so I don’t think there’s much benefit in getting overly creative.
Hopefully you’ve been finding these weekly posts about financial terms to be helpful and informative. We’ve typically been reviewing two terms per week, but let’s switch it up a bit this time and look at shorter definitions of four: dividends, garnishment, FICO score and IRAs.
Dividends – Dividends are what companies pay to investors who own shares of company stock. These payments typically occur quarterly and, over time, make a big difference in an investor’s total return. How much of a difference? Going back many decades, reinvesting dividends has contributed about 40% of the S&P 500’s (the typical stock benchmark) historical average annual return of almost 10%.
But not all companies pay dividends. Apple Inc, Berkshire Hathaway, Amazon and Google are some of the largest companies in the index and don’t pay a regular dividend. Partly due to this, the index currently averages about 2% versus a historical average of about 4%.
Most folks receive their dividends from the mutual funds they own. These funds hold the stocks, receive the dividends and then pass them through to fund shareholders, usually every quarter.
While dividends help boost your return, they are taxable in the year received unless, of course, they’re owned in a retirement account, but we’ll get to that later.
Before we start this week’s post, I’m pleased to announce that Brayden Cleland has accepted a full-time position at Ridgeview Financial Planning as my assistant. Brayden has earned a degree in finance and will be starting his Certified Financial Planner studies in the coming weeks. Welcome, Brayden!
Also, I took our new website live this week. The format is more mobile friendly, and I’ve updated some of the content. The links you might have used the in the past (logging into your portal, sending documents securely, etc) will now be found in the “Clients” dropdown list on the homepage.
This week let’s review two more finance terms from the YouGov poll: premium and mortgage insurance. Like last week, I’m wondering if folks know of the terms but don’t necessarily understand the details. For example, most people know what a premium is because they pay it. But do they understand how premiums differ from deductibles and the associated tradeoffs?
This post will address those sorts of details as succinctly as possible, even though whole chapters of a book could be devoted to them.
Premium – “Premium” has multiple uses within the realm of personal finance. For example, investors may pay a premium to buy a higher-quality stock or bond, and there are “term premiums” that investors want to receive when buying longer-term bonds. There are many examples in this vein, but this week let’s focus on “premium” as it pertains to insurance and the tradeoffs that come into play.
With all the information out there on the Internet if you look hard enough for an investment fad you’re sure to find one. Just search for “invest in gold” or “invest in bitcoin” and jump down the rabbit hole. You’re likely to be more confused than when you started, maybe even frightened (because many fads are fear-based), and probably a little sore from sitting for so long.
I like to think that the investment philosophy we follow together is pretty straightforward. Traditional asset allocation, diversification, and focusing on what we can control might seem a little stodgy compared with the latest and greatest fad or hot stock of the day, but it works well over time.
If one thing is true with investing it’s that if you don’t have a plan you can stick to, you’re likely to fall prey to fads and are bound to fail in the long run.
So, in a departure from my posts in recent weeks, here’s a good essay from Dimensional Funds about the importance of avoiding the variety of investment fads that come along. We’ll get back to defining more financial terms next week.
This week let’s review two more finance terms from the YouGov poll: diversification and bonds. Now we’re starting to get into terms that about 60% of people tend to be comfortable with.
Honestly, I’m a little surprised that people weren’t more comfortable with “diversification”. I understand some confusion about “bonds” because, well, bonds can be confusing. But diversification is a concept in wide use, right? We even have catchy sayings about not putting all our eggs in one basket.
My guess is that folks understand the concept but not how it applies to investing. Assuming that to be true, here is my real-world-financial-planner explanation of diversification. Oh, and for bonds too.
Diversification – Assume you had $1,000 to invest back in 2002. You wanted the money to grow and weren’t afraid of losing it. This was right around the time of the first iPod but still five years before the global phenomenon of iPhone. Maybe you loved your iPod and thought you’d invest in Apple. We know now that this would have been a great investment.
If you were able to ride out the low points (there were many) and not sell shares along the way, you would have made over $100,000 from your initial investment. Maybe you’d consider yourself an amazingly astute investor. Maybe you’re honest and would consider yourself simply lucky. Either way, you’re still in the money.
Or you could have invested in Webvan, the biggest flop of the dot-com era. You could have invested after the company’s Initial Public Offering in late-1999 at about $25 per share. It was exciting times. The grocery delivery service was riding high in the press and you might have been counting your millions… for about a month. Shares fell precipitously into the new decade and would eventually trade for pennies per share the following summer.
The fourth quarter (Q4) of 2018, and the year itself, was marked by volatility, rising anxiety for investors, and a shift in the market environment. It was a year that saw record highs for the stock market in January and the worst December since the Great Depression. Investors began the year feeling "bullish" but ended by expressing extremely low market sentiment.
The economy remained strong throughout the year, however, while a variety of headlines seemed to coalesce at times to rile the markets. Stocks have recovered from their lows somewhat, but anxiety remains high amid a myriad of risks.