Liquidity & Compound Interest

This week let's review two more finance terms: liquidity and compound interest. Both terms are entering the comfort zone of Americans polled by YouGov, a research firm, with a little over half of respondents reporting being comfortable with the terms.

As a reminder, the poll was trying to gauge awareness of 35 finance terms and phrases. Americans claimed to know about three quarters of the list, but how well do they (or you) really know them? I think we'd all agree that awareness doesn't necessarily equal understanding. There's the textbook definition and then there's the real-world, "how does this apply to me" definition. With these posts I'm aiming at the latter.

Hopefully this helps increase your understanding and allows you to take more control over your financial future.

Liquidity – This is probably one of the most important finance terms for companies and is definitely important when it comes to personal finance. When you think about liquidity, think short-term cash availability compared with your short-term needs. How much do you need, where is it, and how quickly can you get your hands on it? This could be cash in your bank, brokerage, or money market accounts. It's not invested in anything and it's probably not earning you very much interest.

This lack of interest is okay in the grand scheme of things because you don't want your short-term liquidity invested in anything with market risk. No bonds, annuities, and certainly no stocks or alternative currencies like bitcoin. The reason is the money needs to be "gettable" in an emergency without concern for whether the market is up or down. The recent storm knocked down your fence or blew some shingles off your roof? Get it fixed by accessing your cash, not by selling investments in a pinch or, gasp, by putting it on your credit card.

In all seriousness, personal liquidity is so important that you can consider it the foundation of a successful financial life. The time to think about it is now. Here are a few benchmarks to consider when thinking about your personal liquidity:

Look out a year or so and set aside cash you might need to spend on home improvement projects, vacations, etc, and don't invest it. If you want to maximize this money's earning potential, consider nothing more than a CD that matures by the time you think you'll need the money.

Still working? If "yes" for both spouses, it's prudent to have at least three months of your spending needs in cash. If only one spouse is working, make it six months.

Retired? Six months of spending in cash seems to be about right, but more is often better. The "right" amount depends on your circumstances.

Are you running leaner than this? If so, tweak your investments to allow for short-term emergency spending. This might mean investing more conservatively in general or cordoning off a short-term portion within your more aggressive portfolio.

Compound Interest – Albert Einstein reportedly declared compound interest to be the eighth wonder of the world, and that, "he who understands it, earns it, and he who doesn't, pays it". I couldn't put it any better myself, so let's thank the famed theoretical physicist for putting it so succinctly, even if he never actually said it

But how does compound interest work? The easy way to think about this is interest earning interest. Interest can be paid in a "simple" way, meaning it's a flat amount each year based on your original deposit, or it can "compound" over time, with reinvested interest earning its own interest. Here's an example:

Say you deposit $10,000 in an account earning 3% a year, guaranteed for three years. At the end of the first year you'd have $10,300, year two you'd have $10,609, and year three you'd have $10,927.

If you signed up for simple interest, your total ending balance would have been $10,900. The extra $27 came from compounding. Spread this out over more time, say ten years, and the compounding effect earns you almost $440. 20 years? Over $2,000. How about 30 years? Your $10,000 is now worth over $24,000 and includes almost $5,300 of excess return from compounding. In short, reinvest your dividends as often as possible to enjoy one of the few free lunches in finance.

But guess what? This also works in reverse. If you live your life on credit cards and don't pay them off monthly, you're not earning compound interest, you're paying it. Unpaid interest accumulates, compounds and well, you get the picture. Avoid this at all costs for a simpler financial existence.

Here's a link to a summary of the YouGov poll:
https://today.yougov.com/topics/finance/articles-reports/2018/02/27/americans-confident-financial-terms-mean

Have questions? Ask me. I can help.