Tag Archives: financial advice

Maybe We Should Take Socialism Seriously

My Comments: To me, it’s both pathetic and amusing to hear political candidates rail against the idea of ‘socialism’ and declare it’s mankind’s greatest threat.

Like so many of the ‘…isms” applied to economic models of all stripes, socialism is no more a threat to the health and welfare of any society than is capitalism or communism. Well, maybe communism, but certainly not capitalism.

Unfettered capitalism, as some would have it today, is not far from the feudalism of long ago in that the masses would be under the thumb of a wealthy elite whose only motivation is the preservation of their power. Does any of that sound familiar to you?

by Noah Smith \ October 26, 2018

When President Donald Trump’s Council of Economic Advisers released a 55-page report called “The Opportunity Costs of Socialism,” many economists scoffed. But the report is important, because it shows that big, systemic economic issues are again being considered. And it provides an interesting jumping-off point for those important discussions.

Two decades ago, it seemed as if capitalism had decisively won the battle of ideas. The collapse of the Soviet Union and the grinding poverty of Mao’s China and communist Vietnam and North Korea clearly demonstrated that the most extreme versions of socialism were disastrous. But even in non-communist countries, attempts at regulation, nationalization and redistribution suffered big setbacks. The License Raj, a system of heavy-handed business regulations in India, was repealed, and the country’s growth leapt ahead. Privatizations and other market-oriented reforms in the U.K. helped the British economy make up ground it had lost. Sweden made its fiscal system much less progressive, and North European countries deeply reformed their labor market regulations.

But as inequality of income and wealth steadily rise in countries like the U.S., and as populism and political discontent roil nations across the globe, some are beginning to question the consensus that emerged at the end of the Cold War. Polls show an increasing number of young Americans responding favorably to the word “socialism”:
Openly socialist candidates are starting to win a few elections in the U.S., and calls to end capitalism are starting to appear in the mainstream news media with increasing frequency.

The CEA’s new report should be seen in this light. It’s an indication that both socialism’s proponents and its opponents have begun to take the idea seriously again. With the world troubled not just by inequality but also by productivity stagnation and the threat of climate change, it’s time to ask whether there are big systemic improvements that could be made.

The CEA report shows just how long it has been since such a discussion was held. A key explanation of socialism is taken from “Free to Choose,” a 1980 book by Milton and Rose Friedman. The economics profession has shifted decidedly to the left since those days, but most economists now concern themselves with highly specific topics rather than the grand sweep of political-economic systems. The people spending their time thinking about socialism, capitalism and other really big ideas are now more likely to be the writers of Teen Vogue or activists on Twitter. Let’s hope the CEA report will prod more economists, who tend to have more empirical knowledge and theoretical depth, to think bigger.

But although it’s an important conversation starter, the report doesn’t do a good job of comprehensively debunking socialism in all its forms. Some of the examples it invokes are particularly inapplicable to the modern day, and it overlooks much of the evidence in favor of an expanded role for government.

For instance, the report highlights collectivized agriculture as a prominent example of a socialist failure. Collectivized farming is indeed a disastrous policy, failing essentially everywhere it has been tried, and leading to widespread famine and death. But modern-day socialists in Western countries are — wisely — not calling for this. Instead, the industries they want to nationalize are health care and (possibly) finance.

Socialized health insurance exists in many countries — for example, France, Canada, and Japan. The costs and benefits of government health insurance systems don’t have to be assumed — they can be observed. The U.S., with its unique hybrid of public and private insurance, pays much more than other rich countries for the exact same medical services — and achieves similar health outcomes. Meanwhile, the U.S. biggest government health insurance system, Medicare, holds down prices much more effectively than its private counterparts:


The Forgotten Architect of the American Social Security System

My Comments: I’ve never understood the fear that surfaces among some people when the term ‘socialism’ appears. What threat do they feel from this poorly understood word? Yes, I remember the McCarthy hearings and the red menace of Communism. It manifested itself in Russia and China, and was perceived as a global threat to capitalism. We are still bothered by the notion that Cuba has never officially renounced Communism as its mantra.

But socialism describes any civil action that communalizes behavior, such as the education of children, caring for the sick, or the elderly. It appears among chimpanzees and other advanced animals, humans being one of them. But suggest someone favors social behaviors in our society and they are immediately branded a heretic.

The following words talk about the architect of what we now call Social Security. Today, there are over 62M US citizens receiving benefits from the Social Security system. Put that in your pipe when you think about Congress talking about reducing benefits instead of finding ways to keep the system viable. And then all the effort to nullify the benefits of the Affordable Care Act that saw almost 12M people insured in 2018. Why do universal health insurance and Social Security come to be such a threat to so many people?

BTW, Medicare Open Enrollment started yesterday, October 29, 2018

by Stephanie Buck, June 8, 2017

In the early 1930s, homeless Americans were picking food scraps off the street and cooking over oil drums in shantytowns. At one point, the unemployment rate reached an all-time high of 25 percent. The country needed new leadership, a plan for healing. It elected President Franklin Delano Roosevelt, whose New Deal ushered in many successful programs, not the least being Social Security. That’s where Barbara Armstrong stepped in.

Her theories on economic security formed the backbone of one of America’s most successful social benefit programs. Social insurance, she felt, should be a universal right enjoyed by all — without an expiration date. Today, it’s one of the reasons Baby Boomers are off kiteboarding in Florida.

Before she became the first female law professor in the country and a drafter of the Social Security Act of 1935, Barbara Armstrong (nee Nachtrieb) was born in San Francisco in 1890. She grew up the third of four children. By 1913, she had earned her BA from the University of California at Berkeley, and her law degree two years later from the university’s Boalt Hall — one of two female graduates that year.

For two years, she split time taking on occasional cases and working as executive secretary for the California Social Insurance Commission. There, she studied worker’s compensation and other government-sponsored poverty solutions, which inspired her return to school for a Ph.D. in economics. In 1921, she earned her doctorate while at the same time working as the first tenure-track female faculty member at a law school approved by the American Bar Association.

Armstrong was beloved by students and faculty alike. She worked diligently as a lecturer and later as an assistant professor in both the law and economics departments at Berkeley. She was an ardent feminist whose early interests in social insurance preceded popular theory by years. Many of these ideas she had studied during academic travels to Europe between 1926 and 1927. When she returned home, Armstrong synthesized the social insurance applications of 34 different industrial countries into Insuring the Essentials: Minimum Wage Plus Social Insurance — A Living Wage Program in 1932. Not exactly a rollicking read, but an important work. In it, she concluded, “Except in the field of industrial accident provision, the United States is in the position of being the most backward of all the nations of commercial importance in insuring the essentials to its workers.” The book astounded Washington with its theories on unemployment, disability, health care, and retirement.

In 1928, Boalt Hall hired Armstrong as an associate professor full time. She was promoted to professor after seven years, longer than most of her male colleagues. She was also paid less. Her dean — who presumably wasn’t in charge of compensation — reportedly said no professor should earn so little.

In the throes of the Great Depression, Armstrong put forth progressive hypotheses about the obligations of industrialized nations to the economic well-being of their citizens. This drew the attention of FDR, who in 1934 invited Armstrong to work as Chief of Staff for Social Security Planning, on the Committee on Economic Security (CES). Suddenly, she moved from advocating radical reform to writing actual legislation.

Prior to Roosevelt, U.S. presidents were expected to steer clear of Wall Street interests. President Herbert Hoover had formed a conservative belief in small government that would define his approach to Depression Era economics, which offered no immediate or major federal intervention. Instead, he called upon states to regulate minimum wage and private charities to help solve the nation’s poverty.

Meanwhile, conditions around the country worsened. By 1931, the unemployment rate hit 15.8%. Homeless families scavenged in makeshift shantytowns (sardonically known as Hoovervilles). Still, Hoover refused to involve the government by fixing prices or controlling currency, which he feared would lead to socialism. Instead, he emphasized aid through private volunteerism and charitable works. He asked employers not to cut wages. He suggested neighbors help each other. He believed the economy relied chiefly on morale, and that it would self-correct.

When it didn’t, the country elected FDR, who believed an aggressive federal intervention was needed. He surrounded himself with people like Armstrong, who had studied social insurance for years.

Armstrong was attuned to politics. According to Nancy Altman, author and president of Social Security Works, she was an “infighter” whose outspokenness convinced the CES to propose a federal program that addressed old age insurance. With the help of Labor Secretary Frances Perkins, the first woman appointed to the U.S. Cabinet, the Social Security Act of 1935 passed. “There were a lot of very strong women who surrounded Roosevelt at the time,” says Altman.

Granted, the act had its flaws, one being that participants wouldn’t see the first monthly benefits until 1942. Republicans argued that building up reserves amounted to IOUs and warned people would have to start paying taxes. Many of the act’s original proposals, such as the inclusion of agricultural and domestic workers, were “temporarily” thrown out due to implementation difficulties. Armstrong supported excluding the groups for these reasons, though Altman insists critiques around gender and racial bias are unfounded. A series of reforms in 1939 expanded Social Security benefits to include family dependents, wives, and widows — but no benefits for dependent men, who were presumed to be in the workforce.

“The 1939 legislation changed the basic nature of the program from that of a retirement program for an individual worker, to a family-based social insurance system (based on the then-current model of the family, in which the man was the breadwinner with a nonworking wife who cared for the minor children),” according to the Social Security Administration today.

The first person to become a Social Security beneficiary was Ida May Fuller, who, upon retiring as a legal secretary in November of 1939 at age 65, received her first benefit on January 31, 1940 — a monthly check for $22.54 (an amount equal to $389 today).

In 1950, the Social Security Advisory Council demanded further expansion. Congress brought 10 million additional workers under coverage, mainly self-employed, domestic, and agricultural workers; disabled workers were added in 1957. The goal was universal old-age and disability security (and actually, was initially designed with universal health care in mind). Today, about 93 percent of working Americans pay taxes into the Social Security program. By June of 2016, one in six Americans was collecting, at an average of $1,350 per month.

Barbara Armstrong returned to Berkeley after the initial Social Security Act of 1935 passed, long before Social Security’s many additional reforms. She had clashed with a few cabinet members — she reportedly called CES executive director Ed Witte “half-Witte” behind his back. Alas, she had a professorship, a daughter, and new issues to tackle back home. She taught courses on family and labor law, and in 1940, she and others attempted to introduce universal health insurance in California, but failed. On campus, Armstrong was a respected, passionate, opinionated, and witty presence. She supported other female staff through the Women’s Faculty Club at a time when “most of the faculty thought of women as frankly inferior beings,” said Lucy Sprague Mitchell, the first dean of women at Berkeley.

In 1970, at age 79, Armstrong was still actively teaching at Boalt Hall. That year, she was attacked by three unknown men while walking in Berkeley. She spent the rest of her years in a wheelchair, and contributed studies in cooperative measures against crime. She died in her Oakland home on January 18, 1976.

Source article: https://timeline.com/barbara-armstrong-social-security-842a4d9308ac


The Next Bear Market is Coming, but it Should Be Less Fierce than the Last Downturn

My Comments: I’ve been cautious for a long time. Some would say too long since it means I’ve missed some great advances in the markets. But I’ve reached an age where I simply don’t want to be stressed and watch huge chunks of our money disappear. That being said, I can only urge you to be careful going forward.

by Tai Hui \ South China Morning Post

This month marks the 10th anniversary of the collapse of Lehman Brothers, the event that turned turmoil in the United States housing market into the global financial crisis. A decade on, people are naturally wondering how long it will be before the next equity bear market.

Investors are growing increasingly mindful of just when the US economic growth cycle will end. While the relationship between bear markets and recessions is not perfect, eight of the last 10 bear markets in the US were associated with recessions.

Given that the Hong Kong market is highly correlated with the US market, it would be difficult for the region to decouple from the US when the downturn comes. Since 1990, 73 per cent of the monthly returns for the S&P 500 and the Hang Seng Index have moved in the same direction, whether up or down. On a more positive note, market downturns are usually shorter than upturns.

Precisely predicting market downturns and recessions is notoriously difficult. Since the current US economic growth cycle is already the second longest on record, some investors think the end must be near. However, comparing the length of the cycle with the averages tells you little about the durability of the current cycle.

Financial conditions in the US remain accommodative. Real interest rates remain low by historical standards, and the real yield on the US 10-year Treasury, at 0.5 per cent, is well below the long-term average of 2 per cent. In six of the last eight US recessions, the real yield on the 10-year Treasury breached 2 per cent in the lead-up to an economic decline. The current interest rates are still favourable for debt servicing and should stay this way for the next 12-18 months.

Beyond the US, the global economy is showing decent momentum. The global manufacturing Purchasing Managers’ Index is still above 50, reflecting firm growth. Despite the political noise, the unemployment rate continues to fall in the European economy, consumption is solid and business investment is picking up.

China’s economy has softened on the back of Beijing’s effort to deleverage, but the authorities are prioritising selective stimulus measures to maintain growth around the official target in the face of trade worries. Global trade has weakened in the first half of 2018, with uncertainties from the US-China trade war yet to fully manifest themselves, but this should be partially mitigated by strong demand globally.

On the issue of recession, it needs to be said that, despite the past crisis, the US economy has actually been getting more stable over time. Better inventory management and more stable housing and services sectors in the US have all contributed to this trend. Banks are also better capitalised. This suggests the next recession is more likely to resemble the relatively mild recessions of 1990 and 2001 than the monster of 2008.

Likewise, the next bear market should not be as ferocious as the last two. In the last two bear markets, the US stock market fell by an average of 50 per cent. However, in the previous nine recessions, the average stock market decline was just 24 per cent. This makes intuitive sense – the last stock market tumble came against a backdrop of the single biggest recession since the Great Depression, while the stock market entered the previous bear market with valuations that were a full 50 per cent higher than the average forward price-to-earnings ratio over the last 25 years.

If the next bear market is indeed serious but not catastrophic, then investors need prepare to weather the downturn prudently, instead of adopting an Armageddon strategy.
For investors in Hong Kong, the extra complication is the performance of the Chinese markets, which has been challenging this year due to the trade tensions, and the slowing growth momentum due to deleveraging.

Sentiment in China is also pessimistic. This may be undue, especially given the chance of the central government bringing in further stimulus measures. Nonetheless, it makes sense for local investors to reduce their exposure to Hong Kong equities.

Tai Hui is chief market strategist, Asia-Pacific, at J.P. Morgan Asset Management

The Biggest Risk Retirees Face Right Now

My Comments: On TV and in murder mysteries, there’s often a reference to ‘being in the wrong place at the wrong time’. Well, it can happen to any of us planning to retire, but instead it reads this way: ‘being born at the wrong time…”.

These words from Michael Aloi from earlier this year show what this means. And it has special meaning for any of you planning to retire in the next twelve months or so. We’re close to the end of an historic bull market and for some of us, it will be painful. Look at the two respective totals in the chart below.

Michael Aloi, CFP | March 23, 2018

Those planning to retire face many risks. There is the risk their money will not earn enough to keep up with inflation, and there is the risk of outliving one’s money, for example. But perhaps, the biggest risk retirees face now is more immediate: Retiring in a bear market.

To put this in perspective, First Trust, an asset manager, analyzed the history of bull and bear markets from 1926-2017 and found bull markets — which are up or positive markets — lasted on average nine years. If that is the case, this bull market should be ending right about now, as it just turned 9 on March 9, 2018. Consider also the study found that the typical bear market lasts 1.4 years, with an average cumulative loss of 41%.

Not to be all doom and gloom, but the chart below illustrates why the biggest risk retirees face right now is a bear market. It shows what happens to two identical $1 million portfolios, depending on the timing of bad stock market years.* Adjusted for 3% inflation

Mr. Smith and Mrs. Jones start off with the same $1 million portfolio and make the same annual $60,000 annual withdrawal (adjusted for 3% inflation after the first year). Both experience the same hypothetical returns, but in a different sequence. The difference is the timing. Mrs. Jones enjoys the tailwind of a good market, whereas Mr. Smith’s returns are negative for the first two years.

The impact of increasing withdrawals coupled with poor returns is devasting to Mr. Smith’s long-term performance. In the end, Mrs. Jones has a healthy balance left over ($1,099,831), whereas Mr. Smith runs out of money after age 87 ($26,960).

With stock market valuations higher and this bull market overdue, by historical averages, retirees today could be faced with low to poor returns much like Mr. Smith in the first few years of retirement. However, retirees like Mr. Smith still need stocks to help their portfolios grow over time and keep up with the rising costs of living. Unfortunately, no one knows for sure what the equity returns will be in the next year or the year after.

This is the dilemma many retirees face. The point is to be aware of the sequence of return risk, illustrated in the chart above, and take steps now if retirement is in the immediate future.

Here are two of the many planning possibilities retirees today can use to avoid the fate of Mr. Smith:

1. Use a “glide path” for your withdrawals

In a study in the Journal of Financial Planning, Professor Wade Pfau and Michael Kitces make a compelling argument to own more bonds in the first year of retirement, and then gradually increase the allocation to stocks over time. According to the authors’ work, “A portfolio that starts at 30% in equities and finishes at 60% performs better than a portfolio that starts and finishes at 60% equities. A steady or rising glide path provides superior results compared to starting at 60% equities and declining to 30% over time.”

The glidepath strategy flies in the face of conventional wisdom, which says people should stay balanced and gradually conservatize a portfolio later in retirement.

The glidepath strategy is a like a wait-and-see approach: If the stock market craters in the first year of retirement, be glad you were more in bonds. Personally, I would only recommend this strategy to conservative or anxious clients. My concern is what if markets go up as you are slowly increasing your stock exposure — an investor like this could be buying into higher stock prices, which could diminish future returns. An alternative would be to hold enough in cash so one does not need to sell stocks in a down year per se.

Though not for everyone, the glide path approach has its merits: Namely not owning too much in equities if there is a bear market early on in retirement, which coupled with annual withdraws, could wreak havoc on a portfolio like Mr. Smith’s.

2. All hands on deck

The second planning advice for Mr. Smith is to make sure to use all the retirement income tools that are available. For instance, if instead of taking money out of a portfolio that is down for the year, Mr. Smith can withdraw money from his whole life insurance policy in that year, so he doesn’t have to sell his stocks at a loss. This approach will leave his equities alone and give his stocks a chance to hopefully recover in the next rebound.

The key is proper planning ahead of time.

The bottom line

Retirees today face one of the biggest conundrums — how much to own in stocks? With the average retirement lasting 18 years, and health care costs expected to increase by 6%-7% this year, retirees for the most part can ill afford to give up on stocks and the potential growth they can provide. The problem is the current bull market is reaching its maturity by historical standards, and investors who plan on retiring and withdrawing money from their portfolio in the next year or two may be setting themselves up for disaster if this market craters. Just ask Mr. Smith.

There are many ways to combat a sequence of poor returns, including holding enough cash to weather the storm, investing more conservatively in the early years of retirement via a “glide-path” asset allocation, or using alternative income sources so one doesn’t have to sell stocks in a bad market.

The point is to be mindful of the risk and plan accordingly.

4 Signs You’re Thinking About Social Security Benefits the Wrong Way

My Comments: For millions of us, Social Security has become a critical source of income if we expect to continue our current standard of living into the future. For those of you not yet claiming benefits, these four items are critical to your future retirement success.

Christy Bieber \ Oct 7, 2018

Social Security benefits are a major source of income for retirees, but far too many seniors have no clear idea how these benefits work. Even worse, many seniors have major misconceptions about Social Security benefits that could affect their plans for retirement in adverse ways.

To make sure you’re not one of the millions confused about how Social Security will provide for you as a senior, consider these four signs you’re thinking about Social Security benefits the wrong way.

1. You’re expecting Social Security to provide all the retirement income you need
Social Security benefits are designed to replace about 40% of your pre-retirement income, while most financial advisors suggest you’ll need at least 70% of the money you were earning prior to retiring.

If you aren’t saving money to supplement Social Security, you’re putting yourself into a position where your Social Security benefits may be your only source of funds as a senior. This is a recipe for financial disaster, as living on Social Security alone will leave you close to the poverty level.

Don’t count on Social Security to provide you with all you need. Instead, invest in a 401(k) or an IRA so you’ll have supplementary savings. Ideally, try to invest at least 15% of your income. If you can’t start there, at least set up small automated contributions to make sure you’re saving something. You can increase contributions over time as you get used to living on slightly less or when your income increases.

2. You’re counting on taking Social Security at age 65 or later
As many as 70% of workers think they’ll take Social Security benefits at age 65 or later according to Employee Benefit Research Institute. Almost 20% plan to wait until age 70, which is the last age at which you can earn delayed retirement credits to increase monthly Social Security income.

The reality, however, is that 62 is the most common age to claim Social Security, while age 63 is the median age at which retirees claim benefits. If you anticipate waiting to claim so you can increase your monthly income from Social Security, you could find yourself short of cash if illness or unemployment forces you to leave the workforce early.

To make certain you don’t end up with a shortfall, assume you’ll receive the monthly benefit amount you’d get at 62, and plan accordingly when deciding how much additional income you need from savings. If you’re lucky enough to be able to work longer and put off claiming benefits, you’ll simply have extra income — which is far better than having too little.

3. You aren’t considering your spouse when you make your plan for Social Security benefits
If you’re planning on simply claiming Social Security benefits under your own work record, you could potentially be missing out on a higher payment if you’re eligible for widow or spousal benefits. If your spouse earned more, you should carefully consider whether claiming under his or her work record could provide you with more funds than claiming on your own work history.

You can claim spousal benefits even after divorce as long as you were married for at least 10 years, so don’t assume claiming under your own work record is your only option, even if you’re currently single.

If you’re the higher earner, you also need to think about your spouse when making a decision on claiming benefits. When one spouse dies, the surviving spouse could opt to earn either widow’s benefits or their own benefits– whichever is higher. If you’ve claimed your benefits early instead of waiting to earn delayed retirement credits, you’ve reduce the widow’s benefits your surviving spouse would otherwise have received. This could leave your spouse with insufficient funds once you’re gone.

4. You think taking Social Security at 62 won’t impact your benefits over the long-term
Many people who retire at 62 have a major misconception about what claiming benefits before full retirement age does. In fact, 39% of pre-retirees think if they claim reduced benefits early their benefits will increase to a standard benefit at full retirement age.

This isn’t the case, and the reduction in benefits that occurs when you claim before full retirement age affects your annual Social Security income throughout your retirement. Your future cost of living adjustments are based on your lower starting benefit amount, and your monthly income will never be as high as it would’ve been had you waited.

Make sure you aren’t thinking about Social Security the wrong way

Since Social Security benefits are such an important source of retirement income, it’s worth doing your research to ensure you don’t make big mistakes when it comes to your benefits. Check out this guide to Social Security benefits, and ensure you know the answers to five key questions about Social Security before you claim your Social Security benefits as a senior.

Source: https://www.fool.com/retirement/2018/10/07/4-signs-youre-thinking-about-social-security-benef.aspx

This Data Visualization Shows What’s Really Responsible For Our Current Bull Market

My Comments: Apart from my concern that many of us will wake up one day soon and discover much of our money has disappeared, it is helpful to understand where all the gains have come from since the last significant crash in 2008.

By Nicolas Rapp and Clifton Leaf September 25, 2018

Who’s responsible for the bull market: Trump, Obama, Bernanke, Yellen? Answer: Tech companies. Here’s a look at what’s really driving growth.

As Wall Street’s raging bull continues its historic charge, there has been plenty of chatter about who deserves the credit: Mr. Trump? Mr. Obama? Former Fed chairs Ben Bernanke or Janet Yellen, perhaps? But the answer seems not to be a “who” but rather a “what”: tech companies. From the market bottom in 2009 to now, the capitalization of companies listed in the S&P 500 index grew by more than $18 trillion. But three of every 10 dollars in gain came from the 73 tech companies in the index. And the true bull market of the past decade was even narrower than that. Nearly 16% of the market cap growth derived from just four stocks: Apple, Alphabet, Microsoft, and Facebook. Their combined valuations soared from just over $300 billion to more than $3 trillion.


Most Americans Fail at Financial Literacy. Here Are 3 Concepts You Absolutely Need to Know

My Comments: A dilemma for many people is they find the language used by those of us in the world of finance and economics very hard to understand. It goes in one ear and comes out the other.

I’m about to launch an internet course that will help solve this problem. I call it Successful Retirement Secrets. Look for a blog post in the coming days and an opportunity for everyone to see a free preview.

In the meantime, here are three concepts to get you started.

Maurie Backman Mar 31, 2018

While Americans might have no problem spending money, managing it is a different story. In fact, nearly two-thirds of U.S. adults can’t pass a basic financial literacy test, according to the FINRA Foundation. Specifically, Americans have a hard time calculating interest payments, answering questions about financial risk, and understanding the relationship between bond prices and interest rates (the former falls when the latter rises, and vice versa). With that in mind, here are a few basic financial concepts everyone should know.

1. Compounding
If you’re not familiar with compounding, you’re not alone — but you’ll also need a quick lesson, because this is a concept that can work both for you and against you. First, the positive. Compounding is the concept of earning interest on interest. Imagine you put $2,000 in a savings account paying 1% interest per year. Let’s also assume that interest compounds once a year. At the end of the first year, your account balance will be $2,020. But if you leave that money where it is and your interest rate stays the same, then during the second year, you’ll be earning 1% interest on $2,020, as opposed to just the $2,000 you initially put in.

Now here’s where compounding really gets interesting. Imagine you’re saving for retirement by socking away $300 a month in an IRA or 401(k). Over a 40-year period, that’s $144,000 in out-of-pocket contributions. But if your investments deliver a 7% average yearly return, then you’ll actually wind up with roughly $719,000 after 40 years, because your earnings will have compounded over time.

Sounds pretty great, right? Don’t get too excited, though, because compounding can also work against you. Any time you fail to pay off your credit card, for example, the balance you owe will accrue interest. But over time, you’ll be charged interest on top of that interest, and you’ll end up paying well more than the initial outstanding amount.

Imagine you rack up $2,000 of debt on a credit card charging 20% interest. If it takes you three years to pay off that sum, it’ll cost you a total of $2,675. But if you manage to pay it off in just six months, you’ll only spend $2,118. Why? Because you’ll be giving that interest less time to compound against you.

2. Inflation
In 1940, a loaf of bread cost just $0.10 on average. In 2013, it averaged $1.98. Why is this significant? Because it illustrates the point that a dollar today will have less buying power in the future. It’s a concept known as inflation, and it basically refers to the tendency of expenses to rise over time. This affects everything from housing to consumer goods to healthcare.

Why do you need to worry about inflation? It’s simple: If you’re eager to live comfortably in retirement (which you probably are), you’ll need to start setting money aside today. But the money you contribute to your IRA or 401(k) today won’t have the same buying power in 40 years as it does now. That’s why it’s crucial to grow your savings through smart investments — to take advantage of compounding and keep up with or outpace inflation.

In the above example, we saw that investing $3,600 a year at an average annual 7% return would result in $719,000. If you were to take those same $300 monthly contributions and house them in a savings account paying just 1% interest, then in 40 years, you’d have $176,000 — more than the $144,000 you originally put away, but still hardly any growth to keep up with inflation. As a result, that ending balance likely wouldn’t be enough to pay for your living expenses when you’re older, whereas $719,000 will more likely enable you to retain the buying power you had when you first set that money aside.

3. Diversification
We just saw how a 7% average annual return could turn a series of smaller contributions into a much larger sum. But why 7% and not another number? The truth is, it’s hard to say exactly what average return your investments might generate, but that 7% is a reasonable assumption for a stock-heavy portfolio based on the market’s historical performance. In fact, it’s for this reason that younger investors are typically advised to load up on stocks.

That said, you don’t want to put all of your money in stocks. Rather, it’s wise to spread your assets out over a variety of options, from stocks to bonds to cash to real estate. This way, if the stock market has a major downturn, you’ll have other assets to tap that won’t necessarily lose value the same way. It’s a concept known as diversification, and it basically means putting your eggs in different baskets to protect yourself from severe market conditions.

There’s even the potential to diversify within an asset type. For example, among your stock investments, you shouldn’t have 90% in, say, biotech. Rather, you should invest in different industries so that if a particular sector goes down, you’re not totally out of luck. Index funds are another great way to get some instant diversification in your stock portfolio, especially if you’re new to investing and don’t quite know how to choose individual stocks.

While you don’t need to be a financial wizard to successfully manage your money, it’s critical that you grasp these basic concepts and learn how to work them into your investment strategy. A little extra reading today could set the stage for a wealthier future.