Consider this…Investing 101
As a Certified Public Accountant (CPA) for over 35 years, I have had thousands of opportunities to participate in business and personal investment strategies and decisions. The decisions were diverse, sometimes quite complex, and all required computations based on tax, interest, and inflation rate expectations, and ultimately a comparison to normal money growth rates over the investment period being considered.
Here are three questions I was asked most often: 1) When is it appropriate to make additional payments towards the principal portion of your debt or more specifically your home mortgage? 2) Should I buy tax-exempt securities? And 3) How long will it take to double my investment?
The debt pay down question has a lot to do with the current use of your cash and your future liquidity needs. For example, if you have idle cash sitting in a bank account, or a money market earning 5% or less, and you have a 7% mortgage, it would seem to make sense to pay the mortgage down. But remember, there might be tax savings related to the deductible mortgage interest. Consequently, there may be no real benefit to giving up your cash and liquidity on the extra mortgage payment. But if the debt is a high interest credit card, giving up the 5% earnings to clear an 18% interest-bearing obligation makes good economic sense. Many lending companies use the latter argument to encourage homeowners to use their home equity to borrow funds for this purpose when they don't have the idle cash to liquidate the higher rate debt.
I don't get the tax-exempt earnings question as much anymore. I think the brokers are informing and explaining this investment much more carefully these days and I am sure investors are now savvier. The fundamentals work like this: if you can earn 6% on your investment free of Federal and State taxes, divide the earnings rate by 1 minus the combined tax rates. For illustration purposes, if you have a combined tax rate of 37.5%, then divide the earnings rate of 6% by 62.5%. This formula gives you the fully taxable equivalent rate of 9%. This should be all you need to make a decision between the tax-exempt security earning of 6% or the taxable rate of 9%. For you the rates are now comparable and you can decide which investment makes sense for you.
The third question can be answered quite easily by understanding the “Rule of 72.”
The “Rule of 72” will allow you to estimate when your investment will double in value by making one simple calculation. Divide 72 by the expected annual investment interest rate. For example if your investment interest rate is 5% your investment will double in 14.4 years (72 ÷ 5 = 14.4) or at 9% your investment will double in 8 years (72 ÷ 9 = 8). This computation an easily be adapted to evaluate your portfolio performance as well. For example, if you started with an investment fund worth $90,000, and 8 years later it is worth $180,000, you have experienced an 8% growth rate. Refer to the table in this article to help you put the whole stock market phenomenon in perspective. Check out the period of time that it took the NYSE market to go from 5,000 to 13,000 points. It is fascinating and empowering to speculate on the market growth on your own.
Remember: active personal involvement, quality property, quality securities, good investment advice and time are all essentials of smart investing, but it starts with you.
Don't worry. You don't need to do it yourself. Talk to your friends, your lawyer or your accountant to help you find the one broker out of the hundreds in this area that will guide and educate you with the investment process and products. I have been fortunate over the years to have John Yarrison of Smith Barney by my side and as the investment counselor and educator for many of my clients. I know there is a broker out there for you—may he or she help you get to a 21,000-point market!