Many of you have heard of the term Hedge Fund and probably wondered, “What does that mean!? What exactly is it, why is it only associated with big institutions or rich people?” Well let me give you a quick summary and I welcome any questions below about them. We invest in many hedge funds at the College and visit with them all the time to discuss what is going on so we get a good view of this aspect of the investment industry. A hedge fund simply put is a unconstrained mutual fund. In a normal mutual fund (or ETFs but thats a subject for another post) that many people have heard about or are invested in they have a very specific goal, like a tech focus, or a large company or small company focus, or maybe international, or growth oriented. Mutual funds only buy and hold stocks and maybe a little bit of cash they don’t do anything more than that. Hedge Funds on the other hand can go anywhere or do anything investment wise, they can short stocks (bet against them), they can buy gold, they can buy or sell options on stocks, they can own bonds, or even private companies. In practice when you invest in a hedge fund they usually have a specialty, like bonds, or distressed companies, or events like mergers, etc. They are experts in that area, and work long hours to dig up different angles on different potential investments. The origin of the term Hedge Fund has to do with early hedge fund’s desire to “Hedge” which is an investment term for protect against risk. These early funds used options and stock shorting to protect their investors while still producing good returns. Now a days there are all sorts of hedge funds that specialize in all sorts of things. One of the main negative features of hedge funds is how long your money is locked up and the fees. Hedge Funds will usually have a time restriction on when you can actually take out your money like once a year or sometimes even as long as once every three years. And for the privilege of investing with them you pay usually 1.5 – 2% of the amount of money you put in along with 15 – 20% of any profit they make you. For some of the good ones, that’s a great deal! But if they don’t do well it can eat into any small amount of return you may have gotten. All that said, these investments are generally restricted to “Accredited Investors”, Accredited Investors are basically large institutions or relatively rich individuals that the government has deemed sophisticated enough to risk their money in this way. In the past few years some hedge funds have begun to create mutual fund products that allow everyday individuals to invest. But I would warn that any institution who is marketing to the public is likely to be of lower quality, and that is for several reasons which I won’t go into because it will make this post even longer!
A question that comes up sometimes is how do you even get a credit score if no one will give you a loan unless you have a credit history!! It does seem like a catch 22. Well there are two easy ways to start your credit history. One of them happens almost automatically if you go to college… student loans. If you get a student loan while in college, those prove your identity and as soon as you start paying on them you begin establishing an on-time credit history. Another quick way to establish your credit is to get a secured credit card. This is a credit card that has a small limit, and has some savings account or other account that guarantees your balances. So for example you can get a secure credit card that has a $500 limit, for buying gas and what not, you’ll need to have $500 in an account as back up for the bank. This means the bank has no risk about you not paying, so they don’t care that you have no credit history. As long as you use the card and pay it off monthly you start to establish your credit history.
Below is a link to a description of how a credit score is calculated with much more detail…
How its Calculated – Credit Balances – Another important aspect of what goes into your credit score is your credit available and credit balances. So for example if you have 3 credit cards all with $5,000 limits, you have credit available to you of $15,000. Now if you have $4900 on each of those cards your net available is $300. For a credit score that is a bad situation, and if you think about it it makes sense. On average a person who had nearly all of their credit lines utilized means they are close to a financial breaking down, if some emergency comes along and they don’t have any credit available (and if they have that much credit card debt they most likely don’t have their emergency savings in place) then they are in serious trouble. So the credit score takes that into account, that’s why if possible you don’t want to carry balances on your cards, never mind the interest charges. Now if that same person has zero on their cards, it looks way better, that person must be doing fairly well, and if they are looking for a loan they are probably a safer bet. Yes it is ironic that those who need the money get punished and those who don’t are rewarded, but when you think about it from a risk perspective it makes sense. This is also why some say you shouldn’t close down credit cards, in general that’s true but if you have 10 credit cards your not using it might be better just from an administrative point of view to close a few of them and just ask for larger credit lines on the remaining accounts, that would get you to the same place. Next post will be on building your credit score especially if your young or have no credit history.
How its Calculated – Payment History – So how is a credit score calculated, well its complicated and if I said I knew exactly how they were calculated I’d be lying. But I do know some principles about them that I can share. First paying things on time, matters. That portion of the score is trying to measure how responsible you are, do you think ahead and plan when and how to pay your bills? If not you are probably going to run into trouble later and so your score will be lower. For this I would suggest automatic payments! First off they save you time, and second you don’t have to worry about being late. Of course you need to make sure you have your budget in place (the base of financial planning) other wise you may end up running out of money which would of course be a bad thing and defeat the purpose of doing automatic payments to begin with. Another thing to think about when setting up an automatic payment is where the money is coming from. If you charge it to a credit card, remember that as soon as that card expires you are going to need to make a bunch of changes, and that might be worth it to you if you are getting points or other rewards from your credit card and feel like your responsible enough to keep track of that. I do most of my bills through a credit card, and I have to admit something always falls through the cracks in that transition. If you auto pay out of your checking account that isn’t an issue, though you have the possibility of running out of money if your running on a thin budget. Also on an annual basis it would be a good idea to pull your credit report (for free) and just check out what is being reported and make sure there aren’t any mistakes. They’ll have a list of all of your accounts and which payments have been made on time or late, you can then dispute anything that doesn’t seem correct. Next post will be on credit balances and how they effect scores.
Personal Finance Friday – Net Worth – What is “Net Worth”? Why should you care about it and how would you calculate it? Your net worth is a very simple concept and easy to calculate. It’s what you still have left after you pay all of your debts. All you need to do to calculate your net worth, is create a list of all your assets, your savings account, checking account, car, IRA, 401k, brokerage account, house, rare art, land holdings (be sure to include islands, and mineral rights), private companies, classic car collection, diamond vault… you know all the usual stuff :)… add that all up. Note the amounts you use should be what you could sell those things for today, net of any costs it would take to get rid of them, like the fees you’d pay a realtor to sell your house. That number is your total assets. Now create a list of all your debt, credit cards, personal credit lines, student loans, mortgages, your loan from Vinnie that carries a stiff penalty if you don’t pay, and anything else where you owe someone money at some future point, add that all up and that number is your total liability (which means you owe to someone). Take your asset number and subtract your liability/debt number, the resulting number (hopefully positive) is your net worth. This is the broadest measure of how you are doing financially. In general this number should be low to negative when you are young and then proceed upward throughout your life (that’s the hope and goal at least). And statistically speaking it should probably really start to grow in your late 30’s through your 50’s which is your prime earning period. So why should you care? Well if you want a simple number to gauge how things are going financially, this is a good candidate, below is a website where you can compare your age and your net worth number to see how are doing compared to the rest of the population. American’s are terrible savers, so if you have any savings or equity in your house you might be surprised by the results. Sometimes having a simple goal post to watch can be motivating, trying to increase that net worth number by paying down debt or saving additional money can be very satisfying.
Personal Finance Friday – Most people have a real hard time getting organized with their money, and feel like its kind of a mysterious subject. If you don’t know where to start or what to do next here would be a suggested step by step list to look at…
1 – Create a budget! This doesn’t have to be super detailed, you can use the cash envelop method, or use a site like Mint.com, anything that works for you and gives you the information you need. Having a budget helps you understand where you stand, and may uncover some very uncomfortable truths about what your spending your money on, or how much your making. You can go online and compare your spending to others to see where your problem areas might be but, I’m sure if your honest with yourself you probably already know. Can you live with out a budget, yes I know people how have lived their whole lives without one but I’d argue they’d be in a much better place financially if they had one.
2 – Emergency Savings – Its super important to have a little stash ($3000 to 6 months of expenses if your super conservative) in case you get hit with something unexpected. Sure there are stories of people getting hit with one thing after another and even though they’ve had savings they still were knocked down, but that is the exception not the rule. Having that stash helps you feel more at ease and keep you away from revolving expensive debt.
3 – Pay Down Consumer Debt – So you know how much your making and spending each month, you have a safety net. Now its time destroy that credit card debt, personal credit lines, student loans. You can think of this as your first real investment. Buy paying down debt your are in effect earning back what you were paying in interest. If your credit card has a 15% rate, and you pay that off, that was the same thing as making an investment that returns 15% which is a ridiculously good return. As you pay down that debt you will be freeing up more month to spend on things or save.
4 – Retirement Savings/Life Goals – now your ready to actually build your future. Starting an IRA account, or contributing to your work’s 401k plan. If you’ve got the other three steps down, your probably pretty safe dumping most of your excess income into this, unless you have other specific goals like a house or something along those lines.
5 – Retire Early or become wealthy – If you’ve got a good handle on steps 1 through 4 and you still have additional money per month, then you can enter the wild open world of investing. Investing is a broad and deep topic, there is no one way to do it, and you can make money doing all sorts of fun and weird things. I for one have enjoyed reading about people’s Lego portfolios, people buying cars at auctions and selling them, flipping house, renting apartments, starting businesses, stock trading, etc, etc, the world is your oyster and if something goes wrong, oh well steps 1 – 4 will keep you from disaster.
I think steps 1 – 3 are pretty solid and straight forward as you get to steps 4 and 5 its up to more interpretation and individual needs. That might be the time to talk with someone about coming up with a plan. I think with enough study and thought all of its possible on your own, but many times its good to have someone double check your thinking. Like I’ve said before I love this stuff and investments more broadly, I’d love to talk. I’m not selling anything, I’m your friend or family member and just want those around me to do well.
Beware the confident! It’s human nature to want to follow a person who knows what they are doing, who is confident, and says “Don’t worry I know exactly what to do!” In life as well as with investing and personal finance this is most often a huge mistake. “Sure things” don’t exist. If you’re talking to someone about an investment (or “opportunity”), and they can’t explain the downside or why it might not be appropriate for you, then walk away. I get to sit and listen to Hedge Fund and Private Equity managers, supposedly the best of the best, and they more often than not are humble about what the future might hold. The real professionals know what they don’t know and that is a lot. Only the ignorant are confident in their beliefs and recommendations. That isn’t to say there isn’t valuable knowledge and skill out there, only that many times it comes in a package wrapped in humility and nuance.
Personal Finance Friday – How do you decide if you do a Roth IRA or a Traditional IRA? I know its one of life’s deep questions. Well here’s what the math says, if you had the same tax rate through out your life then you would actually end up in the same place using either one. But we all or hopefully all go through a cycle of being at the bottom of the income pyramid and moving our way up over time and then maybe stepping down again later in life. So for the typical person you will be paying the lowest taxes when you are younger and higher when your in your late 30’s to your 50’s or 60’s. So if you are a typical person that would mean saving in a Roth IRA early in life and then switching to a traditional IRA when you start to get into the upper income brackets. Also with a Roth IRA you can pretty easily take the money out that you have put in (but not any earnings), meaning if you are young and saving and later you want to buy a house that money is there if you need it. My general thought is if you are at or under the 15% federal tax bracket (income of $37,650 for a single or $75,300 for a family or below) you should be putting any savings beyond your emergency fund into a Roth IRA, and 25% or above the traditional IRA is probably the safer bet.