Education Saving Plans

Plan ahead with a 529 or Education Savings Account to jumpstart your child’s career.

ELI5

Paying for higher education can be a substantial cost for a family – and many times it’s the most significant cost after purchasing a house. A majority of families will utilize student loans to help pay for their child’s college and/or university costs. To help reduce the size of the student loan burden on you or your child, it’s best to prepare and stay ahead of the curve by investing money well before they step onto a college campus.

The two major ways to effectively save for education are – a 529 plan or a Coverdell Education Savings Account (ESA). Which one should you use to prepare for your child’s secondary and higher education costs?

Detailed Definition

529 Plan

A 529 plan is a tax-free, education savings plan that is sponsored by most states. There are two main types of 529 accounts – prepaid tuition and college savings plans.

Prepaid tuition plans allow individuals to purchase units or credits at colleges and universities at the current time (locking in lower prices). Prepaid tuition plans specifically only cover tuition and not room & boarding fees. Since you are purchasing credits at today’s dollar value, you are protecting yourself against inflation. Due to this feature, these plans actually don’t let you invest the money. Here’s a list of prepaid tuition plans.

Prepaid tuition plans aren’t as prevalent as the most popular type of 529 plan – the college savings plan. Let’s look at the pros and cons.

College savings plan advantages:

  • Very high contribution limits unlike 401(k) [$19k] & IRA’s [$6k]. You can deposit as up to $380,000/year (will vary state by state) to help the account beneficiary (typically your child or another family member).
  • Contributions are not deductible, but the money can grow and be withdrawn tax-free. Important to realize that only qualified educational expenses are allowed, otherwise you will be penalized.
  • State-sponsored 529 plans can have additional tax breaks.
  • As of 2018, you can also use up to $10,000 towards private or public elementary and secondary schooling.

College savings plan disadvantages:

  • High account fees depending on which 529 plan you choose.
  • Limited investment options unlike IRA. The 529 plan you proceed with has a limited set of investment selections which can deter some financially savvy plan owners.

Here’s a list of college savings plans.

Coverdell Education Savings Account (aka ESA)

ESA’s are the main alternative to a 529 plan, and they come with their own set of pros and cons. One thing to note is, similar to an IRA & 401(k), you have the option to use both and can be strategic about allocating your money between a 529 plan and ESA.

Funds in an ESA can be withdrawn for more than solely tuition expenses and can go towards a broader category of schooling costs including course materials and on-campus activity fees. In addition, ESAs can be spent towards almost all forms of schooling including public or private primary, middle, secondary, and higher education.

ESA advantages are:

  • Funds in the account can be used towards a more general list of qualified expenses.
  • Contributions are not deductible, but the money can grow and be withdrawn tax-free. Important to realize that only qualified educational expenses are allowed, otherwise you will be penalized.
  • Flexible investment options, similar to a Roth IRA. Better suited for the financially savvy investor.

ESA disadvantages are:

  • Unlike the 529 plan, there is a contribution limit of $2k/per beneficiary. The contributor will be penalized with a 6% excise tax if this amount is exceeded.
  • Income eligibility requirements based on MAGI (modified adjusted gross income). For a single filer with a MAGI between $95K-$110K or a married couple with a MAGI between $190K-$220K – the $2k limit decreases.

Being ‘Rich’ vs. ‘Wealthy’

We often hear the terms rich and wealthy thrown around interchangeably, but they have different connotations. Someone who is rich tends to have plenty cash (this is subjective and depends on your background) at the current moment. On the other hand, a wealthy person tends to possess assets that generate money passively.

It is possible to be rich, but not wealthy. These are individuals who make above average incomes, but tend to immediately spend their money. There’s nothing wrong with this, but it generally makes life a little more challenging down the road. Spending your money immediately vs. being disciplined by saving and investing it guides people towards challenging financial situations. Having the patience to allocate a portion of your capital towards savings and investments helps generate wealth and increases your net worth. Building wealth is inextricably tied with building your nest egg (definition #2, not #1).

A relevant analog would the be the great Stanford Marshmallow experiment. This simple study examined the effects of delayed gratification. A population of young children had two choices – either receive one marshmallow (or whatever your favorite vice is) now, or wait a short period of time and receive two of them. Being patient and decisive with your money nets larger benefits in the future, particularly thanks to compounding.

Why choose wealth over being rich?

Let’s put this in perspective and look at this simple example with 2 people. We’ll look at their financial nest eggs during their careers and retirement.

  • Person #1 aka Bob:
    • Post-tax income of $100k
    • Annual expenses of $90k
  • Person #2 aka Juan:
    • Post-tax income of $100k
    • Annual expenses of $80k
  • For both:
    • 20 year careers
    • Post-tax income stays constant for simplification
    • 7% return on their nest eggs (average historical, real stock market returns)

Working Years

Years workingBobJuan
1$10,000$20,000
2$20,700$41,400
19$373,790$747,579
20$409,955$819,910

Note that this is a simplified example, but it conveys the point. Bob and Juan have identical career paths and income (it’s quite amazing really…). The main difference is that Bob spends $10k/year more for the 20 years of their careers.

Bob and Juan are both considered rich in most parts of the US, but after 20 years Juan is wealthier as his nest egg is about 2x. These two don’t plan on working forever, and after they hit the 20 year mark in their careers, they want to look forward to greener pastures. Let’s examine what happens in the next phase of their lives.

Retirement Years

  • Person #1 aka Bob:
    • 3.5% return on nest egg ($409,955)
    • Annual expenses of $45k
  • Person #2 aka Juan:
    • 3.5% return on nest egg ($819,910)
    • Annual expenses of $40k
Years in RetirementBobJuan
1$409,955$819,910
2$379,303$808,607
12$7,132$671,364
13-$37,618 (out of money)$654,862
36$66,283
37$28,603
38-$10,396 (out of money)

During retirement, let’s say they each spend about half of their current annual expenses during this period – so $45k for Bob, $40k for Juan. Let’s assume they earn 3-4% on their nest egg during retirement and shift towards a risk averse portfolio consisting of fixed-income assets.

Here are the main takeaways:

  1. The 3.5% rate of return implies Bob gets a retirement income of ~$14k while Juan has an income of ~$28k during their first year of retirement. This number decreases as money is withdrawn from the nest egg, but Juan clearly benefits from his higher savings rate during his working years.
  2. Bob runs out of money in 13 years! Assuming both he and Juan retire at 65, Bob will be out of money by 78. Juan on the other hand will run dry after 38 years of retirement, or when he hits 103. Juan with his higher savings rate yields about 25 extra years of retirement without financial worry.

Even with the simplifications in this analysis, there’s no doubt that the effects of being able to grow your nest egg, and wealth, are hard to argue against. Being able to forego luxuries in the near time will improve the odds of you living a financially secure future. The other important realization is that even with a lower income, if you can maintain a healthy savings rate, you can become wealthy.

Remember – two marshmallows are always better than one.

Guide: Money Management Basics

Overview

We’ve created a simple flowchart of what to do with a paycheck. This won’t be perfect for everyone, but provides a good starting point for being smart with your income. Following these steps will help get you on the right track (if you already aren’t) or accelerate your saving & investing goals.

Recession

NBER (National Bureau of Economic Research)

Recession [noun] — a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

ELI5

The NBER definition explains that a recession is a drop in economic activity apparent through GDP (gross domestic product) decreasing for more than a few months. GDP is simply the financial value of all goods and services (cars, planes, candy, IT consulting, etc.) created within a nation’s borders. Intuitively, this makes sense as when the economy struggling, you expect to see a decrease in overall productivity. Typically the GDP growth rate (how much it increases from one month/quarter/year to the next) is negative.

More importantly — what exactly happens during a recession? Here’s a short list of typical scenes.

    • Unemployment – This will tend to increase during a recession. Companies start to struggle as demand for goods and services will decrease thus reducing the number of employees necessary to make goods and services.
    • Home prices – Home prices tend to drop as well. People might struggle to pay their mortgages due to financial hardship, and foreclosures become commonplace. An oversupply of homes and dwindling demand leads to a decline in housing market prices.
    • Interest rates – The Federal Reserve will decrease interest rates during a recession to help incentivize people to borrow money and spend. Lower interest rates makes it ‘cheaper’ to acquire a loan. This is a move made to help stimulate the economy during a downturn.
    • Consumer & business spending – Just as unemployment increases and consumers have less cash to spend, businesses also tend to become more cautious just as consumers during a recession. They tend to refocus on cash generating aspects of the company cutting on departments such as R&D and taking steps to reduce risk.
  • Government debt – As business spending decreases, the government tends to ratchet up spending to help with unemployment benefits and other social welfare programs to assist those in need.

Recessions are a natural part of the economic cycle we live in, but most people are probably just wondering — how do I protect my family’s fiscal health during one? Here’s a short list of actions to take before and during one.

  • Before
    • As mentioned in the budgeting section, ensuring you have an emergency fund with at least 6 months of money will help you get through this downturn. It’s worth increasing your savings rate during a recession to handle any unforeseen mishaps.
    • Tackle as much debt as you can before the recession. Job loss is one of the toughest parts of a recession so making sure you are in a position to handle loan payments successfully is critical.
  • During
    • If you don’t have enough money to last through the recession, it’s crucial to cut down on discretionary spending. Look at the budgeting article to get an idea of what to drop. Some low hanging fruit would be eating out and entertainment costs.
    • Be a stellar employee – keep your head down, ignore what might be happening to your portfolio, and get your work done. Battling through a recession is as much mental as it is material. If you can put yourself in the right mindset and brace yourself for impact, you’ll be better off for it.
    • Do not panic sell your investments. Stock market drops significantly before and during a recession. Put some money into fixed-income investments that will provide cash flow through dividend and yield income.
      • In fact, periodically investing your money into the market can have significant upside during a recession. The S&P 500 has gone up ~275% since it’s low point in 2009 (that’s a 2.75x return)! Don’t try to predict the ‘lowest point’ of the stock market in a recession, it’s like catching a falling dagger, just be disciplined and invest with a schedule.

Detailed Definition

What causes a recession?

In the US economy, there is typically only a small fraction of cash circulating. Most goods and services aren’t purchased with cash — they are acquired with credit. This enables individuals and businesses to accelerate their growth by having access to money that they don’t have right now.

The creation of credit is balanced by the creation of debt. Of course, the individual or business will have to repay their loan with interest. With the distribution of more credit, the economy becomes more and more leveraged. Businesses will grow as inflation and interest rates tend to rise while the market ‘heats up.’ With prices for goods and services rising quickly, demand for them might start to wane if income doesn’t increase concurrently.

There are situations where industries or markets (i.e. subprime mortgages) pass a tipping point and become over-leveraged when folks aren’t able to make their payments on time. This leads to an increase in the default rate with banks not acquiring their expected payments during a loan period.

As a result of banks having a liquidity shortage, and they end up reducing their level of lending which makes makes borrowing more challenging for businesses to start, grow, or sustain themselves. Since businesses aren’t as productive as they once were, this typically contributes to a decreasing GDP since fewer goods and services are being produced – marking a recessionary period if this occurs for at least a few months.

When individuals and businesses overextend themselves and become too aggressive with their spending plans, it creates a credit crunch that serves as a catalyst for an economic recession.

Consumer confidence predicts how likely consumers are to spend their money. When consumers sense a recession coming about, this metric declines as people choose to save their money rather than invest. Individuals begin to sell assets and store cash while divesting from the market. More people see stocks tumbling and consumer confidence dropping it creates a positive feedback cycle.

How does country overcome a recession?

Now how do you combat a recession now that it’s in full swing? The government and Federal Reserve are the primary fighters in this battle. That’s right the Federal Reserve is actually a completely independent entity from the government! They end up serving both public and private markets and act as an in-between of sorts.

There is a blend of fiscal policy and monetary policy. Fiscal policy involves the government cutting taxes and increasing spending while monetary policy is the Federal Reserve decreasing interest rates and increasing the money supply to steer the economy in the right direction (the cases I listed are generally true, but not always). For a much better detailed explanation of the two policies, check out this link. which details the the various levers of the government and Federal Reserve during a recession.

Other than the subprime mortgage crisis, two other debt markets susceptible to defaulting are ballooning credit card & student loan debt. Credit card debt levels surpasses $1 trillion while student loan debt bumped passed $1.5 trillion in 2018!

IRA

Oxford Dictionary

IRA [noun] — Irish Republican Army or Individual Retirement Account (your pick).

ELI5

There are many ways to prepare for retirement and a common way to do so is to create an IRA, or individual retirement account. There are a number of different types of IRA’s, but typically individuals will open up either a Traditional IRA or a Roth IRA. The benefit of putting money into an IRA is that an individual has earmarked this money for the future, and it is not meant to be touched until they leave the workforce (of course there are a few, convenient, exceptions).

The terminology can be confusing, but really it comes down to a handful of concepts – taxes and contribution limits. Primarily — when the money is deposited into the account, whether the money is entered pre- or post-taxation.

For a traditional IRA, income before taxes is deposited to the account, and the individual can declare a tax deduction on that amount of income. When the money is withdrawn from the account, it is taxed as regular income.

For a Roth IRA, income post-taxes is deposited into the account. The benefit of this is that the no taxes are paid when the individual decides to withdraw the money giving some extra financial flexibility during retirement.

 

Detailed Definition

As mentioned above, some key concepts that need to be understood are contribution limits, age restrictions, withdrawal penalties, and also a couple less common IRA account types for the average person. We’ll structure the rest of this in an interview form.

Contribution Limits

Roth: Your contribution limits are also dependent on salary. Most importantly, for a Roth IRA, single tax-filers can’t contribute if their AGI earn more than $135K, and married tax-filers can’t contribute if their AGI is more than $190K. These numbers will vary year to year, and are also calculated in a specific way. AGI is adjusted gross income which is total gross income minus some deduction.

Traditional: There are no salary-based restrictions for traditional IRA’s.

As of 2018, an individual’s contribution to traditional and Roth IRA cannot be more than $5,500. This limit increases to $6,500 if the individual is 50 years or older. There are no salary-based restrictions for traditional IRA’s.

Age Limits

Roth: An individual can deposit money, up to the contribution limit, regardless of age any given year.

Traditional: An individual can deposit money, up to the contribution limit, up till they reach 70.5 years of age. This coincides with the age that traditional IRA’s force RMD’s or required minimum distribution (RMD). Refer here to see how it is calculated. Why does this exist? The government doesn’t want you to accumulate money and have it sit pretty in account, it would rather that money go towards the economy.

Penalties

Roth: In most cases, if an individual withdraws prior to the age of 59.5, the withdrawal will be categorized as gross income and an extra 10% tax penalty will be added.

Traditional: Same as Roth.

Exceptions

The exceptions tend to apply to both Roth and Traditional IRAs. Hardship distributions an immediate, financial need is seen. Typical cases include medical costs, disability, tuition, costs related to employee’s residence, funeral costs. These are covered as part of the “Safe Harbor” regulations, please check this for further information. It is also critical that no more than the amount needed to deal with the financial hardship is withdrawn from the account – or penalty fees will accrue. Individuals will be taxed on their hardship distribution as income tax.

There are also another handful of helpful exceptions to IRA early withdrawals. These benefits are specific to IRAs.

  • Healthcare insurance premiums when unemployed pending certain conditions.
  • First-time homebuyers can withdraw up to $10,000 without being penalized pending certain conditions.

Restricted Stock Units (RSU)

ELI5

Many companies these days, particularly in tech, provide additional ways to compensate employees including options and restricted stock. We’ll touch on options in an another discussion, and will focus on a specific type of stock grants – restricted stock units or RSUs (note these are different from restricted stock awards).

RSUs are a promise made by an employer to grant an employee shares of the company at a future time. Note the word, promise. When the RSUs are granted you don’t actually own any shares until they are vested per a schedule. The terms of vesting schedule are decided by a contract agreed upon by you and your employer. One main difference between an RSU and restricted stock award is that RSU owners have no voting rights during the vesting period since they don’t actually own any shares.

Employers tend to grant RSUs as a performance incentive for employees especially during their initial compensation package. If you can hit certain performance targets, you are granted RSUs as a reward for your hard work. From the company’s perspective, these are beneficial because they are promising shares for the future, not now letting them be more financially flexible. They can choose to invest this money back into the company accelerating its growth which might lead to a higher share price in the future. 

 

Detailed Definition

It’s important to have a solid understanding of RSUs as they can be a great source of wealth generation. In addition to receiving RSUs as part of an initial compensation package, employers also distribute them as performance bonuses or promotion awards. Over time, RSUs can quickly accumulate and can potentially produce as much money as your salary (if not more). It’s typical to see executive-level employees accept RSU packages that would constitute many multiples of their base salary.

Vesting Schedule

The shares from RSUs are actually transferred to an employee as it vests. Vesting schedules tend to be time-based where shares will vest at periodic intervals. There are two typical types of vesting – cliff-based and graded.

Cliff-based is when all the granted shares vest after a set period of time. Typically tech companies have a one year cliff for a percentage of total shares granted, around 25%.

So let’s say you get 1000 shares of a company total. A one-year cliff means 250 of these shares will vest after you hit one year. This incentivizes employees to stay at the company for at least a year before considering jumping to another company, a common case in the Silicon Valley.

Graded-vesting is a form of vesting where an employee receives a percentage of shares at a fixed time intervals – monthly, quarterly, etc. Going back to the tech example above, companies typically offer graded-vesting after the one year cliff is achieved.

In our example, the other 75% of RSUs, or 750 shares, will be vested based on this graded-vesting schedule (most commonly in 12 chunks, quarterly over 3 years). Doing the math, that corresponds to 1/16 of all granted shares being vested every quarter for 3 years.

Taxes

In terms of taxation, RSUs are taxed at their market value when they vest, not when they are granted. RSUs, as they vest, are included in your W2 form. It’s important to be wary of double paying for vested RSUs! In certain cases, an employer might elect to withhold or ‘tender’ shares which are equivalent to the taxable amount.

Another tax concern is that once you own the shares and you decide to sell, you will be subjected to capital gains tax. If you sell within a year, you’ll be paying short-term capital gains tax.

If you are confident that the company is going to do well, you can choose to elect for Section 83(b). In this case, you can declare your taxable income at the time the shares are granted rather than when they vest.

For example, let’s say you are granted 20 shares at $100 in with a 1 year cliff-based vest. If you elect for 83(b), you declare 20 x $100 = $2,000 as taxable income. In 1 year, the share price moves up to $500 so you end up with a total of $10,000 worth of shares and you only had to pay taxes for $2,000 worth. If you didn’t elect for 83(b), you’d end up paying taxes on the $10,000 amount!

Be wary of the risks with the 83(b) as you have already paid taxes on shares that you might not end up receiving either due to leaving the company or the company going under.

Time Value of Money (TVM)

This one’s going to be all ELI5. Tried to keep out the gory math details for this. Goal is to provide intuition on this topic and help provide a basis for future discussions.

There are a couple of fundamental concepts with regards to money that are useful to understand. One of the most important is the time value of money. This sounds a lot more intimidating that it actually is. The definition is that a sum of money now is worth more than the same amount in the future. Let’s make it concrete and look at a couple scenarios.

Example #1

You have the following two options in this case —

  • Option #1: You take $100 now with a (almost) risk-free 2.5% interest rate investment.
  • Option #2: You take $100 one year from now.

If you can place your money in an investment like a 1-year US Treasury bond for an interest rate of 2.5%, you take Option #1. You’d invest your money in this bond, and at the end of the year receive $102.5 ($100 + 2.5% * $100). If you took Option #2, at this same time you’d only get $100. You end up making $2.50 more with Option #1.

We’re capitalizing on the earning potential of money. Money that rests as cash, isn’t living up to its full earning potential, so generally we invest that money to make use of its potential.

The two follow up ideas are present value (PV) and future value (FV). The present value of money is the current value of a future sum of money based on a discount rate. In contrast, the future value of money is the future value of a current sum of money based on a growth rate.

In the example above where we were looking at time value of money, we were actually calculating the future value of money. In Option #1, the present value of $100 has a future value of $102.50 at the end of a year based on an interest, or growth rate, of 2.5%.

Example #2

Now, let’s take our example above and spice it up. Here’s case #2 —

  • Option #1: You take $100 now with a 2.5% interest rate investment.
  • Option #2: You take $105 one year from now.

Now the question really is – how do we compare the two options? Which one’s better? There are a couple ways to do it.

Method #1

Compare the future value of Option #1 with Option #2. From the earlier case we know the FV of Option #1 is $102.5. This is less than Option #2, so we’d rather go with Option #2.

Method #2

Instead of comparing the future values, we can also compare the present values. PV for Option #1 is $100. What’s the PV for Option #2? In other words, how do you determine what the value of $105 in a year is right now?

Similar to the interest rate which projects forward in time, we also have the discount rate which projects backwards in time.The discount rate helps us translate some future value of money to the present value. We can determine the PV with some very straightforward math. We can start by using the formula from Option #1 actually.

P = Principal (initial investment amount) 
i = Interest Rate
V = Value after one year

Simple interest formula for one year investment. 

V = P + P * i 
V = P (1 + i) 
P = V / (1+i)

In our example, V is $105 and I is 2.5% for the 1-year Treasury bond.
Let’s swap out V and i with these values.

P = $105 / (1 + 2.5/100)
P = $105 / (1.025)
P = $102.44

That’s it! Not too much math. The present value of $105 at the end of one year is equal to $102.44 at present. Now, we can ask ourselves is it better to have $100 or $102.44 now? Hopefully you answered the latter. Even with this method, we arrive at Option #2 being the best case. It’s important to note that this factors in present value for one year. Things get a little more interesting when looking at multiple discount rates, varying cash flows and discount rates. Let’s table that for later.

A couple important concepts to extract from this. In the equation, the bolded value of 1.025 is the discount factor. It’s a factor that lets us figure out the PV from the FV. The discount rate is the % value of 2.5%.

It’s important to realize the present value calculation depends heavily the discount rate. This number is an estimate – there’s no way to be completely certain what this will be in a year and even less so ten years from now. However, this method is useful in providing a way to compare and evaluate investments.

Hopefully you gained some intuition from the example, but you might be asking what’s the use of this? If you know of potential cash flows in the future, like the $105 you’d receive in a year, you can effectively compare them with your current investment options. If the present value of these future cash flows is higher than the initial amount you have, then it’s a good option.

Bonds

Oxford Dictionary

Bond — [noun] A certificate issued by a government or a public company promising to repay borrowed money at a fixed rate of interest at a specified time.

ELI5

Let’s not forget about the bond – which, out of the major investment types including bank products, stocks/mutual funds, are generally the least risky. For investors looking for higher returns than bank products, but a steady rate of return this investment type is likely a good fit.

A bond is a fixed-income investment which an individual lends money to a group – typically either a company or government. Normally, the institution issuing the bond needs cash at the moment to fund or support a project. An investor agrees to lend the entity money but expects repayment with periodic interest payments.

As mentioned, bonds are the safer investments since they offer you a fixed periodic payments over the time of ownership of the bond. However, the risk levels can vary depending on who is issuing the bond.

Consider a bond issued by a 2-person startup that has no revenue vs. a bond issued by the US government – which one sounds like a safer investment? Hopefully you answered the US government bond since they are less likely to default. As a result, the coupon rate will be lower for the US government bond vs. the startup’s bond. You’ll make more money via interest investing in the startup but are exposed to a higher likelihood of not receiving your initial investment back.

 

Detailed Definition

Bonds are simple in theory, but there are a handful more concepts that are important to understand before investing in them. Here are some of the terms you’ll encounter when purchasing a bond from a brokerage.

A bond investor purchases the bond from the issuer at face value, or par value. The initial principal invested will be paid back at the maturity date or length that the bond is held for. Bonds can be short-term typically less than 10-years (also called notes) and long-term which tends to be 10-30 year terms.

The coupon rate of a bond is the interest rate that will be paid over the lifetime of the bond, and this tends to be in semi-annual or annual payments. These fixed payments make bonds a fixed-income, steady investment that do not change as the bond matures.

Bonds are inherently tied to interest rate. This is best explained with an example. Let’s say you purchase the bond at a face value of $1,000 with a coupon rate of 5% annually with a 2-year maturity date. So every year you’ll receive $50 dollars worth of interest on the bond.

Now let’s say market interest rates go up to 10% and another investor wants to purchase the same bond. With prevailing interest rates being higher than the coupon rate, the bond becomes less attractive to buy, and the buyer is less inclined to pay the current face value of $1,000. Instead they will pay less than face value to acquire the bond – thus purchasing the bond at a discount. Without this discount, the buyer could purchase a newly issued bond that will pay the better coupon rate of 10%.

The other major term worth noting is bond yield. With a bond, there are two main methods of making money – one is through the periodic interest payments and the other is by purchasing the bond at discount. To capture the entire return on investment, investors commonly use the bond yield. This formula is for adjusted bond yield:

[Coupon Rate/Market Price] * 100 + [Premium/Discount Delta/YTM]

There are a variety of bonds, but they tend to be characterized based off of credit quality and duration. It is akin to the factors affecting an individual’s credit score. The main bond categories are government, investment-grade corporate, high-yield corporate, and mortgage-backed bonds.

Treasury bonds are the lowest yielding bonds, but they are one of the hardiest investments since they are backed by the US government (so almost zero credit-risk). One other benefit is that interest from treasury bonds are tax-exempt. There are also large federal agencies (or government sponsored-enterprises, GSE) like Fannie Mae, Freddie Mac that offer government bonds at higher yields, but they don’t offer the same tax benefits and have a small, but non-zero credit-risk.

Investment-grade bonds are issued by corporations that have a high credit rating by a third-party rating agency (Standard & Poor’s, Moody’s) typically greater than or equal to BBB. The rating system goes from AAA for highest quality, AA is a step down, A, BBB, etc. These companies are equivalent to an individual with a high credit rating – they have a strong balance sheet where there assets are greater than liabilities and are typically generating profits. As a result, they offer higher yields than most treasury bonds, but also contain substantially more risk. Investment-grade bonds are safer than stocks for a couple reasons including the scenario the company does go bankrupt, bondholders will receive their principal before shareholders receive their bit.

High-yield bonds, more affectionately known as junk bonds, are also corporate issued bonds with higher yields than investment-grade corporate since they are offered by companies with a below BBB rating. These companies run the highest risk of bankrupting, but the higher yields attract many investors. Many companies issuing these bonds are in a high-growth stage where it might make sense to purchase the company’s stock instead if possible.

Mortgage-backed bonds are another major type of bond and a little unorthodox to the ones discussed above. For an MBS, a bank will pool together similar mortgages into a bundle and then sell this bundle to a government sponsored-enterprise like Fannie Mae or Freddie Mac as collateral. These MBS’ from GSE are more vetted and less risky than some that are actually offered by private firms that might pool mortgages together from less creditworthy individuals. MBS also tend to pay monthly (as mortgages are) and the investor isn’t solely receiving interest — but also principal in each of the payments.

Mutual Funds

Oxford Dictionary

Mutual Fund — [noun] An investment program funded by the Mutual Fund shareholders that trades in diversified holdings and is professionally managed. Mutual funds are regulated by the Investment Company Act of 1940 and are registered with the SEC (Securities and Exchange Commission).

ELI5

A mutual fund is an investment that pools money from several investors and invests the money in stocks, bonds, or combinations of them. The total list of securities in the mutual fund compose a portfolio that can be actively or passively (track a fixed Index of stocks) managed by a brokerage such as Schwab, Vanguard, Fidelity, etc. The portfolios can be diverse – they can consist of stocks or bonds from similar industries, similar sizes (market capitalization), or consist of the entire stock market (index funds).

Okay, neat so your money gets pooled into a bunch of stock, what’s useful about mutual funds over a typical stock? A handful of reasons, but here are some main ones:

1/  It’s a great simple way to minimize the amount of risk you are exposing yourself to compared to investing in an individual stock. This process is known as diversification.

2/ Remove the need to do a deep valuation of every investment, the responsibility is passed on to the fund managers. Mutual funds are a simpler way to participate in the equity market.

Here’s an example – during the dotcom boom you invest $10K in Company A’s stock that’s very promising, but know it’s a high risk investment. To reduce the amount of risk, a decent alternative would be to invest in a mutual fund that is pooling money together in similar companies including the one are thinking of investing in. In this hypothetical scenario, let’s say Company A makes some poor product decisions and ends up filing for bankruptcy — and being a common stockholder you don’t get anything back. In this case, your $10K is worth…nothing. Looking at the mutual fund alternative, that $10K is invested in Company A, and B, C, etc. Since only a portion of the investment is in Company A, you will be less exposed to the bankruptcy and retain more of your initial $10K investment.

 

Detailed Definition

There are some other important concepts associated with mutual funds include how they are priced, who designs and manages them, and various costs associated with them compared to investments in standard stock.

How are the prices of a mutual fund determined? We look closely at the net asset value (NAV) the calculation involves taking the total assets minus liabilities divided by the number of outstanding shares. The assets would be the active investments, cash, and accounts receivables while liabilities would include operational expenses. The fund’s share price won’t be exactly 1:1 with the NAV (due sales load and other expenses), but are fundamentally tied to it.

There are a variety of different funds – bond, equity, balanced, index, specialty funds, and ETFs. If interested in a more detailed breakdown of the various types of funds, let us know!

Some downsides to mutual funds are the costs that are associated with them. For a standard stock the only typical fee is commission on trading. However, a mutual fund expenses includes the following major fee categories: management fee, distribution fee, operational fees, and sales loads.

Management fees are the costs associated with keeping a team of researchers and a portfolio manager who makes the decisions on what stays and goes in the fund. These range from 0.5-2% of total assets on average. A higher management fee is not indicative of better fund performance as well! Active funds have higher Management Fees than Passive funds.That may not sound significant, but long term, depending on the amount invested can significantly bite away at investor’s profit margin.

Distribution costs (aka 12b-1 fee) are the expenses that occur when the fund manager buys and sells the underlying assets. Depending on the trading frequency of the fund, this can also be a cost to consider when purchasing a mutual fund. This category also includes marketing and promotional costs – which ultimately help the fund manager increase their asset pool with more investor’s money.

Operational fees include legal, accounting, and administrative fees – this is typically the most minor of the three, but will vary based on the fund’s operational expertise.

These three are the main components of the expense ratio which tends to be between 0.5-2.5% for most mutual funds. Based on what you seek from the fund you are considering investing in, this number can play a big part. In the case you are seeking long term income, it would be worthwhile to find a low expense ratio fund so you keep most of your gains. In the case you want to invest short-term and expose yourself to a higher risk fund, it might make sense to participate in a fund with a higher expense ratio.

The final fee associated with a mutual fund, not included in the expense ratio, are sales loads. They are part of the shareholder fees and normally used to compensate the broker during the buying and selling of the fund.

The front-end load is the amount charged when the fund is purchased while the back-end load is the amount charged when the fund is sold by an investor. Front-end loads are fairly straightforward – let’s say a fund has a 2% front-end load. When you invest $100, $2 will go towards the sales fees and $98 will turn into actual assets for the fund.

The back-end load is a little different and tends to vary as a function of the length of investment in the fund. Typically, if an investor tries to sell in a short term timeframe they’ll have to pay a higher back-end load while a longer term timeframe will have a lower back-end load. This is to incentivize the investor to keep their money in the fund, so the fund manager knows the underlying asset won’t be highly dynamic.

Index funds which invest in well known stock indices like the S&P 500 or the Total Market have the lowest fees of about .10% or less and have no-load.

Mutual funds without loads are referred to as No-load funds and are generally preferred over funds with a load.

Stock

Oxford Dictionary

Stock — [mass noun] The capital raised by a company or corporation through the issue and subscription of shares.

ELI5

A share represents a unit stake of ownership in a company held by an individual or a group. The capital issued through sale of shares by a corporation is also known as equity capital. The shareholders, or owners of the stock, end up owning some small (or large) percentage of the company, based on the number of shares they own. Compared to banking instruments they are significantly riskier since the financial success and growth of company is never certain. At the same time, purchasing shares of Apple or Google early on (when undervalued) yield much higher returns (or losses) than a money market or savings account.

Companies issue stock to help raise money — this is typically what happens during an IPO, or initial public offering. A company places shares on an exchange (Dow Jones, NASDAQ, etc.) that people can purchase or sell through a broker (Schwab, Fidelity, E-trade, etc.) plus the additional commission.

There are a handful of different types of stock, but there are two that are worth understanding.

Detailed Definition

When the average person talks about investing in the stock market, they are normally buying and selling shares on a public exchange. More specifically, they own common stock, which is a class of stock with a handful of rights.

Common stockholders are entitled to voting rights – typically in a 1:1 ratio (one vote for one share) – for certain corporate matters. For example, if you own 10 shares of X company, you will get 10 votes. However, there are 349 million shares outstanding which unfortunately means your votes are limited in power compared to larger shareholders such as big banks and retail investors. The other perk of being a shareholder is receiving priority on buying stock to retain their level of ownership.

This is all great and dandy, but there are some significant downsides to being a common stockholder. In reality, not every company will have the same outcome as the big tech companies or a safe blue-chip, or a less volatile, profitable company like Disney or Intel. The reason the FDIC doesn’t insure stock is because there’s a very real chance you can lose money on your initial investment, maybe all of it depending on the company! When a company does go bankrupt, the common shareholders will be the last to get paid, typically the money will go to lenders (debt holder), employees, and preferred shareholders first.

Preferred stock offer some different advantages over common stock. In most cases they provide stockholders with a dividend — mimicking advantages of a debt instrument. Common stock for larger corporation also do the same, but in most cases preferred stockholders for most companies receive this benefit with some added bonuses. Typically, they receive a dividend earlier, more frequently, and at a rate that’s higher than that of their common stock peers. Companies that offer common stock dividend tend to be larger, well established companies such as Chevron, Johnson & Johnson, etc. As these companies aren’t in a high-growth stage where the stock price will be volatile (but are profitable), the wealth from owning these stocks comes through these periodic payments based on the timeframes set by the board of directors.

Preferred stock tends to be less volatile as a lot of the benefit comes from higher interest payments. There are situations where common stock can be more lucrative. It’s important to evaluate any investment based on the risk level you are willing to incur.

What about taxes?

Tax implications of stock or equity fund dividends — Dividends of US companies are treated mostly as qualified dividends and are subject to a maximum federal tax rate of 15% and as regular income for state taxes.

Tax implications for stock or equity fund sale Gains from the sale of shares held for more than a year are subject to taxation at the long term capital gains rate which is between 15-20% for 2018 depending on the income level. Gains from sales of shares less than a year is treated as regular income and taxed as such. Capital gains can be offset by capital losses, recognized on the sale of shares. A maximum of $3000 of capital losses can be used to reduce taxable income each year and the remaining loss is carried over into the next year.

What goes into share price?

The share price of a company reflects the present value of the future cash flows of the company profits and the prospects for maintaining or growing these profits, based on the product portfolio, cost structure, debt levels, competition and the economic environment.

A profitable company usually invests some or all of its profits back into the business and pays out the rest as dividends, or adds it as cash on its balance sheets. The interest rate used to determine the future values of a firm’s cash flows reflects the riskiness of the cash flows and is usually 2-3 percentage points higher than the risk free 10 year Treasury rate.

One of the key ratios used to determine if the share price is expensive is determined by a company’s Price-to-earnings (P/E) ratio. Companies that display strong earnings and growth prospects are rewarded with higher P/E ratios compared to mature companies with slower growth prospects.

A normal stock market P/E is about 14. A P/E of 7 is cheap and a P/E of 40 would be considered excessive (i.e a capitalization weighted P/E across all stocks). You want to buy when the P/E is low, but you need to understand if the P/E is low because future earnings are in doubt and reflected in a low stock price or if the price is low due to unexplained selling of the stock by other investors.