Each Monday, Money360 opens up the reader mailbags and answers ten to twenty simple questions offered up by the readers on personal finance topics and many other things. Got a question? Ask it in the comments. You might also enjoy the archive of earlier reader mailbags.
As usual, let’s open things up by linking to a few of my older articles that directly address some of the questions I’ve been asked recently.
The only two cookbooks most beginners in home food preparation will ever need
How to get started with a slow cooker and five of my favorite crock pot recipes
My thoughts on Ayn Rand and Atlas Shrugged
How to deal with all of those old 1980s baseball cards in your closet (this actually got carried in Beckett Baseball Card Monthly a few months back)
Also, I asked my wife to write a guest post, but she’s not a speedy writer so it may be a little while. Be patient – she’s working on it.
And now, for some questions.
I have a question that has been nagging at me for a little while. I understand how compounding interest works, but I don’t understand how compounding in 401k’s work. I have around $45,000 in my 401K in stocks, but how does that compound? If the value of the stocks goes up, the value of my 401K goes up, but I don’t see how it compounds? Or doesn’t a 100% allocation to stocks compound? Thanks.
OK, let’s say for example that your retirement plan is 100% invested in the Vanguard 500 – I’m using that fund as an example, and the basic principle works for any fund. Let’s say you put in $10,000 at the end of 1997 and haven’t invested since.
If you take a peek at Vanguard’s information abot the fund, it shows that over the last ten years, it’s had an average annual return of 12.69%. That means that each year for the last ten, your $10,000 investment in VFINX has gone up 12.69%. Obviously, that’s not the actual return each year, but we can use it as an approximation.
At the end of 1998, your $10,000 investment has become $11,269 and has earned you $1,269.
At the end of 1999, your initial $10,000 investment has become $12,699.04 and has earned a total of $2,699.04. Notice that the first year of growth was $1,269, while the second year earned $1,430.04. That’s the power of compounding – the annual percentage return during year two has a bigger starting balance to work on than the first year.
Let’s extend this out to 2007. At the end of 2007, that $10,000 investment is now worth $33,025.83. During that final year, the investment earned $3,719.03 – truly showing the power of compounding.
The compounding of stocks works like thus: if stocks go up an average of 8% every year, then over a long period, your investment will grow at 8% compounded annually. In the real world, the market might go up 15% one year and down 6% the next, but over a long period of time, a rate around 7%-8% annual compounded growth will come out, and you can use that info in calculations like the above to see it grow.
This is why it’s important to invest early. If your retirement plan earns an 8% average annual return, putting in $20,000 when you are 25 years old is the exact same as putting in $43,178.50 when you’re 35 years old. The earlier you put your money in, the less you have to put in overall to get the same results in the end.
What is your favorite Wii game?
In terms of total time played, easily Guitar Hero III. It’s a social game that pretty much anyone can pick up and goof around with on Easy, it fits in well with almost any age group, and my wife really enjoys playing it, too. In my rare spare moments, honestly? I downloaded Harvest Moon and am playing through it again – I played it a lot in high school and playing it again is a big nostalgic rush.
how do you get things done with constant interruption from kids / babies? My 4mo baby does not allow me to free up my time for more than 15-30 minutes, and for me it is difficult to work efficiently since I have to warm up my work every time there is interruption, and I have to interrupt my work once i become really hot at work.
My wife and I both take turns being the sole person with the children while the other one engages in things that need to be done. When I’m home alone with the children, I don’t even attempt to work unless they’re firmly sleeping. My advice? Start pushing your four month old baby gently towards one to two naps a day. Keep the baby awake by actively playing for a long period (the entire morning, say), then cap it off with a healthy meal in a quiet and dark room. Lay the baby down and you’ve got a good one to two hours of naptime in which you can get work done.
In a nutshell, I don’t recommend doing serious work if you’re in a situation where you can’t get into some semblance of flow.
I would like to see advice geared toward people just starting out of college/grad school… My husband and I want to work a lot at first and then cut back. What’s the best way to make that happen?
The first day you go into work, start socking away 50% of your paycheck into a high-interest savings account. I’m dead serious – I’m not kidding in the least. Learn how to live on the other 50% and don’t even think about altering the first 50%.
Then, every year you work, you have at least a year of freedom in your bank account. Work like a mad dog for five years and you have five years of freedom, more than enough time to have a child and care for that child until the baby’s in school. Work like a mad dog for ten years and save your money correctly and you may not ever have to work again if you complement it with some small freelancing work here and there.
You advise to pay down mortgage before investing in Index-funds. However, elsewhere, the consensus seems to be to maintain some mortgage for it’s tax benefits. Have you done research to arrive at a break-even point when paying down mortgage is equal to investing in Index funds? Eg. I just got my tax refund; my mortgage is the only debt I have; should I put it towards mortgage (currently paying 6% interest on it) or should I buy Index funds (historically 10% return over the long term)?
Most families never claim any mortgage interest deduction because the standard deduction provides them with more. If you’re in the (relatively rare) situation where you’re actually claiming the house interest and it makes a difference, then you should definitely calculate things for your specific situation.
Another factor to consider is that the mortgage prepayment is a very stable investment with a clear return. Investing in an index fund carries some significant risk. Look at it this way: if you have $5,000 and you can either invest it at a stable 6% or straight into stocks right now, which would you take? It’s not an automatic answer for anyone, and for most people the steady 6% works much better in terms of sheltering them for the vagaries of a normal adult life.
In terms of smartness in money matters, what would you think is one important difference between you and Warren Buffett?
Well, when I read his biography, I couldn’t help but be struck by the difference between how Buffett grew up and how I grew up. Buffett’s natural childhood lessons and role models led him pretty directly to the life he led, as did mine. I see some similarities in how we were raised (self-sufficiency is good) and some big differences, too (I never learned the value of investing money or even how to get started with it).
Do I really *need* to use coupons in order to [be] frugal?
Absolutely not. Coupons are one way to translate a time investment into a financial return. If you don’t feel that’s a worthwhile time investment for you, then don’t do it.
I personally feel a well-constructed grocery strategy balancing coupons and store flyers can easily save my family $100 a week for maybe two hours of extra effort that I can do any time. I just save coupons and match them up with store flyers, as well as plan my meals for the week in advance around what’s cheap in the flyer. For me, that’s an exchange I find worthwhile and very cost-efficient.
Others, particularly people living alone, won’t get that kind of value out of the time investment, so it’s not worth it.
Frugality is about finding maximum value in things, and if you don’t find maximum value in couponing, then don’t do it.
How do you keep coming with such great posts? Do you ever feel scared as to what will happen when there isn’t anything more to write about personal finance, especially given the slew of PF blogs out there?
I have more ideas right now than I can ever write about. The last worry on my mind is coming up with ideas – a much bigger concern is making sure that I’m choosing from among those ideas in a way that readers will enjoy, so I usually just listen to what I hear from my readers as a guide for what to write about next.
If you ever feel that I’m being repetitive on Money360, it’s for one reason and one reason alone: reiterating key points to new readers. That’s something really important, to make sure new readers do pick up on the fundamental points sometimes.
would you discourage your children from choosing fields of study that traditionally have been lower paying if that is what they loved? art, music, theater, writing(!), etc.
Never in a million years. All I want for my children is for them to find what they’re truly passionate about and follow it with all their heart and talent. The financial and social resources they need will eventually follow.
I made the mistake more than once of not following my passions and instead following things that “made money,” and it was something I eventually wound up seeing as folly.
Do you have an exercise regimen that you stick to? What does it consist of?
Off and on, I’ve used the fitness ladder with quite a bit of success, but I’ve not used it in a while. My firm goal is to start it again the first Monday after I’m done with my job, and also add in a bit of jogging along with it.
When I was younger, particularly in the period leading up to my wedding, I had a lot of success with the fitness ladder exactly as described there.
You have an amazing following on your blog. What are some things that you did early on to recieve this kind of traffic?
– Matt Sullivan
The number one biggest thing I did was write content that I thought others would want to read. I would think of ideas, then honestly ask myself whether anyone else would want to read this. If my gut told me no, I tossed that idea in the trash.
After that, I didn’t really do too much. I introduced myself to bloggers in my topic area. I linked to their blogs when I found interesting articles. I commented on a lot of blogs. And I kept writing stuff using the “would others read it” filter. I never spent a dime in any sort of promotion for Money360.
The big catch is that traffic builds slow. I didn’t wake up one morning and have 50,000 readers. Instead, it grew a little bit each week. It takes a lot of patience and some luck, too.
If you want to know more, read my Building a Better Blog series from a while back.
Normally, I only looked over my account statements. I have not balanced my checking account. How can I start doing this? I have looked on the internet for “how to balance a checkbook”, but nothing tells me how to start balancing after the account has been in use for a while.
You can basically start with any account statement you have. Balancing a checkbook basically means ensuring that your own personal records of what’s in the checking account match what the bank claims is in the account. This way, you’re not in for a nasty surprise.
Starting means simply finding a point where you’re sure that your own personal accounting of your checking account exactly matches what the bank says is in the account and working forward from there. This may be at the end of your last statement, or it may be right now if you look at your account transactions online.
From there, just keep your own tally of transactions both into and out of the account and occasionally reconcile them with what the bank is reporting to you. Often, you’ll find that the balances aren’t equal – that means you have to go through your personal transaction record and their transaction record and find the difference.
What this does is protect you (somewhat) from overdrafting due to checks or payments you forgot about and so on.
Personally, I do what amounts to a checkbook balancing weekly using online statements and my own ledger. I find that using online banking makes this process substantially easier than it used to be back when I was a kid and my mother would start going through her checkbook ledger each month, reconciling canceled checks and such.
Got any questions? Ask them in the comments and I’ll use them in future mailbags.