Part I: Bank Accounts
by Mark Lawrence
Mark's Market Blog
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Portfolios & Risk
What is money?
Interest and Growth
Money Utility and Risk
Trade Deficits and Inflation
Distribution of Income
Distribution of Wealth
Zero Coupon Bonds
Reading Bond Pages
Risk & Volatility
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There's an amazing amount of misleading information available on how to invest money. This is a short primer on the topic. I became interested in managing my own retirement account, and learned that it's surprisingly easy to pay people a lot of money to do almost nothing, and equally easy to do almost the same things yourself very inexpensively. This is a primer that covers many of the available ways to invest money.
Different people will have different financial situations and therefore different needs. You'll have to decide for yourself about this.
Popular investments include bank accounts, real estate, gold and natural resources, bonds, and stocks. There are many ways to invest in each of these.
In this article we're going to compare the various types of available investments: bank accounts, real estate, gold and natural resources, bonds, stock, mutual funds, index funds, and ETFs. We'll see that each of these investments has strengths and weaknesses. However, historically some of these investments have hugely out performed others, and a close look shows us why.
Currently inflation in the US is running at about 2% per year. This means you have to make 2% on your money just to break even. Actually, it's worse than that: most people pay about a third of their income in taxes, so actually it takes more like 3% per year to break even after taxes. Technically, your tax rate for investments perhaps should be calculated at the margin: how much do your taxes go up if you earn one additional dollar income. For most people the marginal tax rate is more like 45%, so you need to make almost 4% on your money to break even in this calculation.
Why do we have inflation? Historically, it has happened from time to time that an economy has had falling prices instead of stable or rising prices. Most of the world had falling prices during the Great Depression. Japan had falling prices for much of the '90s. When prices are falling, it is called deflation. Deflation is considered to be crippling to an economy and very difficult to manage for various technical reasons, which include something called a liquidity trap that means government banking and bond policies have almost no effect on the economy. Because of this, currently most economists favor a small amount of inflation to price stability. It's considered very important to keep a step or two away from the Deflation cliff.
When you're earning interest, your money increases in time. A quick rough calculation can be made with the rule of 72. This rule says that the (interest rate) * (number of years for your money to double) = 72. So if you're earning 4%, your money will double (before taxes) every 72/4 = 18 years. If you're earning 10%, your money will double every 72/10 = 7 years and 10 weeks. This is not exact, but it's very close and good for making quick estimates of your retirement nest egg. Einstein is credited with discovering the rule of 72. He watched his retirement fund too.1
An important consideration in investments is liquidity. Liquidity means how fast you can convert an asset into cash, and how much it costs to do so. Bank accounts are very liquid - you can write a check on most accounts these days, and most people will accept your check as cash. Individual stocks are quite liquid, you can sell them on about 250 days out of the year and the cost of selling is quite low. We'll see that mutual funds are a bit less liquid than stocks, as it takes an extra day to sell them and there is an additional hidden cost of selling. Bank CDs and long term bonds are less liquid, as it takes some time to redeem them and there are early withdrawal fees and market discounts. Real estate is far less liquid, as it typically takes a few months to sell a property and in extreme cases can take years, and the cost of selling approaches 10% when you include sales commission, buyer required repairs, and escrow fees. It's important before you invest that you carefully consider your liquidity requirements. It's possible that your liquidity requirements will have an impact on your investment strategy, forcing you to choose to invest some of your money in more liquid investments than perhaps you would otherwise choose.
If you have some money to save, your first and most obvious choice is to put it in a bank. In a bank you can have a checking account which will typically pay no interest. Your value will slowly decline due to inflation. You can put your money in a savings account, typically paying about 1% interest. Your money will decline, and you'll have to pay taxes while it's declining. Money market accounts pay perhaps 2.5 - 3%. CDs pay perhaps 3 to 3.5%, but are slightly less liquid than savings or money market accounts. After taxes, these investments mean you're just treading water, or perhaps sinking a bit. We need to find something just a bit better than this.
Banks need working capitol. They can get this from a number of sources - they can borrow from other banks, they can borrow from the Federal Reserve board, they can borrow from investors by selling bonds, and they can borrow from ordinary people by offering money market accounts. The best money market accounts typically require a balance of $10,000 to as much as $1,000,000, but the interest paid is considerably more than at your neighborhood bank. Of course, you would want to feel pretty confident about any bank that you were going to loan $1,000,000.
If you're willing to open an account over the Internet, better money market and CD rates can be found than at your local bank. You can get a nationwide daily survey at Money-Rates.com. Money market rates change at most banks on a monthly, or even weekly basis, so if you choose to have a lot of money in a money market account, I'd advise you to keep track of the current rates.
If your yearly interest rate is x%, then the number of years n it takes your money to double is found from:
(1+(x/100))n = 2
n ln( 1 + x/100 ) = n x/100 = ln 2
n x = 100 ln 2 = 69.3
Finally, we note that this formula is off by a little bit. It's not precisely true that ln(1+a) = a, this is just an approximation. The error is about 2.5% when the interest rate is 5%, and it's about 5% when the interest rate is 10%. We compromise and fix the formula to be correct at an interest rate of 8%, which increases the 69.2 to about 72. 72 has the added benefit of being divisible by 12. That's it, that's what Einstein figured out.
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Revised Tuesday, 27-Jul-2010 06:21:36 PDT