Explaining personal finance can be pretty dull, but it’s a subject we all need to continually learn about. I’m trying to fix the problem by using a quirky (funny?) story to explain personal finance. In this story, two friends discuss risk tolerance, asset mix and the concept of beta.
The stories are written in chapter order, so that there is a logical flow for the reader. Enjoy!
Is that house going to take up the entire lot- will there be any lawn at all?
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Greg turned toward his driveway and headed back inside with his dog, Colette. Greg’s St. Louis neighborhood prided itself on lots of trees and older homes, but a local builder was buying up property and putting huge homes and smaller lots.
After he wiped off Colette’s paws, he opened his backpack and took out his company 401(k) investment information. Over the past few months, he had created a personal budget- and, surprisingly- stuck with it. He and his wife Layla had funded a savings account and decided to invest in his firm’s retirement plan. Now, he was considering his risk tolerance.
He sat at the kitchen table and called his friend Tony. “Have you seen this house across the street from us? It makes the house next door look like a storage shed.”
Tony laughed. “Yeah- the irony is that the builder lives in a renovated old home- not one of his new home projects. That’s pretty curious… Anyway, I have that 401(k) info in front of me. So, based on our last conversation, you were going to consider your risk tolerance, and use that decision to decide on your investment choices.”
Greg flipped through the marketing information. “Ok- I’m comfortable with the year-to-year price fluctuations that we talked about in the Standard and Poor’s 500 index– that group of large stocks. Given my age and years to retirement, I think a mix of 50% bonds and 50% stocks is the right balance for me.”
A truck started up across the street. Greg glanced up to see some packaging blow out of the big dumpster in front of the house and into his yard. “Tony- I gotta run outside. Some stuff blew out of the dumpster again. Anyway- what do you think?”
“Maybe you can buy a big lid for that dumpster.” Tony thought for a minute. “OK- your decision about risk and the asset mix sounds great. When you looked at the stock fund selections, did you see a fund that had a portfolio similar to the S&P 500 index?”
Greg shut the door as he came back in. “I grabbed a plank off of the front porch and tossed it on top of the dumpster trash- maybe a short term fix.” He ran his finger down the listing of stock funds. “Yeah, I did find one. Growth Fund of America has a 10-year return of 6.3%, which compares with 6.95% for the Standard and Poor’s Composite Index. That one looks really close in comparison to the index.”
“Yeah- that’s a fund that’s been around for years. The portfolio is very similar to the index. But here’s a way to know for sure.” Tony said. “Do you see a number listed as the beta for the fund?”
“Hummm…..OK. The beta is listed as .98.” Greg looked at the other funds in his investment literature. “The other funds have betas that are as low as .50 and as high as 1.3. They seem to be all over the place.”
“Beta is great. It measures how closely the price changes in your fund track with an index- in this case, it’s the S&P 500. So, a beta of 1 means that the fund moves exactly the same in price. If the S&P 500 is up 8%, so is your fund- and the same is true on the downside.” Tony took a sip of tea. “So, a beta of .98 is very close- it sounds like a fund that will perform closely with the index.” He turned off his MacBook. “Next, look at some other stock funds and a few bond funds to fill out your portfolio.”
As always, this information is for educational purposes only. Consult a CPA or a financial advisor for more information.
Action Steps To Consider
Check the beta for any mutual fund that you own.
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
(website and blog) http://www.accountingaccidentally.com/
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Image: Ed Kohler, Dumpster (CC By 2.0)