Investment concepts and applications

Investment Strategies

Investment Recommendations for the Nicholsons

Case Overview

Chris and Faith Nicholson are a young married couple, both with regular salaried jobs and a fair amount of job security as well as stability in their income and their expenses expected over the next several years. Expenses are fairly standard, including rent and utilities payments, child support payments Chris makes to his previous wife for his two children, auto and renters insurance, and miscellaneous expenses such as credit card debt, food and clothing, etc. Chris, a corrections officer, makes $26,000 and has an employer-sponsored 401(k) plan that the employer will annually match contributions of up to six percent of Chris' income; Faith makes $20,000 without additional benefits, and both Faith and Chris' salaries are expected to grow by five percent annually. Inflation of four percent annually will eat away at some of this salary increase, however many costs are expected to stay at the same dollar value -- rent, insurance, child support payments, etc. -- for at least the next five years. The fact that revenue will be increasing for the couple over the next five years without major increases in expenditure means that this is a very good time for the Nicholsons to start considering their investment options and their financial goals quite seriously, as they will have increasing amounts of income to devote to investment and towards other goals.

To that end, a set of general recommendations for the Nicholsons in terms of their financial and investment strategy is provided in the following pages, with a focus on the five-year period starting with the current year of the case (2008) though with long-term recommendations also made. The primary goals the Nicholsons list are purchasing a home and establishing a six-month emergency fund to cover all of their monthly expenses should their income suddenly be cut off or dramatically reduced for some reason (e.g. job loss, injury, etc.). Though the Nicholsons have a good amount of health insurance and Chris has disability insurance, this emergency fund is still desired and shows the Nicholsons to be focused on security more than gain; this is definitely taken into consideration in the recommendations made.

Spending and Saving Habits

It is impossible to discuss investment strategy without touching on spending habits, as it is the balance between income and spending that determines how much can be saved or invested each year, and this amount in turn helps to determine what strategy will be most effective in meeting specified goals. Since the Nicholsons seem to be especially security-minded, with the purchase of a modest ($100,000 current value) home and a six-month emergency fund their only current stated goals, addressing certain spending habits and suggesting ways that they could improve their investment amounts, reach their goals faster, and establish greater financial security should be a part of any comprehensive financial planning strategy. It is thus recommended that the Nicholsons not add at all to their current credit card debt, which at annual payments of $1,800 is certainly not crippling but is still money paid to interest that could go elsewhere. The same is true of the furniture that the Nicholsons purchased at 18% interest with a repayment period of three years; purchasing cheaper furniture or waiting until cash could be paid would create significant savings for the couple. Figures in the accompanying spreadsheet assume that credit card payments must be made at the same level for the next five years, and also assume that the furniture will not be paid off early, however any additional savings that the Nicholsons are willing to forego in the next two years in order to discharge these debts sooner will yield an increased ability to save and invest in later years and in absolute terms, and would definitely be recommended. At any rate, it is most definitely recommended that the Nicholsons not take on any more consumer (or other) debt, and even that they cut their food and clothing budgets if possible (the spreadsheet assumes a ten percent reduction in food and a twenty percent reduction in clothing costs, adjusted up annually for inflation, and it eliminates vacation costs to show the Nicholsons the potential savings/investment they can create).

General Strategy

In addition to recommended change sin spending habits, a part of the general strategy recommendation for the Nicholsons is for Chris to increase his 401(k) contributions to the maximum amount matched by the company, namely six percent of his annual compensation. Failing to contribute the maximum amount to this retirement plan is simply giving up on free money; by doubling his current contribution of three percent, Chris would actually be tripling the amount added to the 401(k) each year due to the employer's matching policy. This account is also earning an estimated eight percent annually, not far behind the 9.5% the stock market is expected to earn, and the money in the 401(k) remain far more liquid with the ability to borrow up to 50% of the value at any given time, and at a rate lower than a mortgage and significantly lower than a secure personal loan (though funds must be repaid within five years). This strategy will build both short- and long-term growth to a much higher level without impacting the ability to have an emergency fund or purchase a home.

As the Nicholsons have short-term goals that are focused on stability, including the emergency fund and the purchase of a home, an aggressive growth strategy through increased investment in the stock market, even in mutual funds, is not recommended. The spreadsheet is currently optimized for contributions to the 401(k) maxing out at six percent and with the rest devoted to savings; though more substantial contributions to the 401(k) would lead to faster growth due to the interest earnings of the account (Chris is allowed to contribute up to 20% of his earnings each year) this would not be as liquid as the savings account due to the required repayment of borrowed funds within five years; while it makes sense to consider the 401(k) as a part of the Nicholsons' emergency fund, it would not be wise to use this money as a substantial portion of the down payment on their home, and thus maximizing savings contributions are recommended.

As shown in the spreadsheet, this will allow the Nicholsons to put a 20% down payment on their home as early as the end of 2010, with the use of some 401(k) funds, or by the end of 2011 using just over half of their savings account without touching their 401(k) and leaving their emergency fund fully funded (house price and thus down payments are adjusted annually for inflation). If the Nicholsons purchase their home at the end of 2011 with the price estimates given and twenty-percent down, the monthly mortgage payments for a 30-year mortgage at eight percent interest will only be $660 -- $110 higher than their current rent payments, Property taxes will add an additional $100 to their monthly payments, however the tax deductions for mortgage interest payments made will all but certainly offset this. A 15-year mortgage at 7.5% interest will lead to monthly payments of $834 with less of a tax incentive, and would not be recommended at current (and expected future) income levels.