Accumulation phase has two meanings for investors and those saving for retirement. It refers to the period when an individual is working and planning and ultimately building up the value of their investment through savings. The accumulation phase is then followed by the distribution phase, in which retirees begin accessing and using their funds.
Key Takeaways
Accumulation phase refers to the period in a person’s life in which they are saving for retirement.
The accumulation happens ahead of the distribution phase when they are retired and spending the money.
Accumulation phase also refers to a period when an annuity investor is beginning to build up the cash value of the annuity. (The annuitization phase, when payments are dispersed, follows the accumulation period.)
The length of the accumulation phase will vary based on when an individual begins saving and when the person plans to retire.
How the Accumulation Phase Works
The accumulation phase is also a specific period when an annuity investor is in the early stages of building up the cash value of the annuity. This building phase is followed by the annuitization phase, where payments are paid out to the annuitant.
The accumulation phase essentially begins when a person starts saving money for retirement and ends when they begin taking distributions. For many people, this starts when they begin their working life and ends when they retire from the work world. It is possible to start saving for retirement even before beginning the work phase of one’s life, such as when someone is a student, but it is not common. Typically, joining the workforce coincides with the start of the accumulation phase.
Importance of the Accumulation Phase
Experts state that the sooner an individual begins the accumulation phase, the better, with the long-term financial difference between beginning to save in one’s 20s vs. in the 30s substantial. Postponing consumption by saving during an accumulation period will most often increase the amount of consumption one will be able to have later. The earlier the accumulation period is in your life, the more advantages you will have, such as compounding interest and protection from business cycles.
In terms of annuities, when a person invests money in an annuity to provide income for retirement, they are at the accumulation period of the annuity’s life span. The more invested during the accumulation phase, the more will be received during the annuitization phase.
Real-World Examples
There are many income streams that an individual can build up during the accumulation phase, starting from when they first enter the workforce, or in some cases, sooner. Here are a few of the more popular options.
Social Security: This is a contribution automatically deducted from every paycheck you receive.
401(k): This is an optional tax-deferred investment that can be made paycheck-to-paycheck, monthly, or yearly provided your employer offers such an option. The amount you can set aside has yearly limits and also depends on your income, age, and marital status.
IRAs: An Individual Retirement Account can be either pretax or after-tax, depending on which option you choose. The amount you can invest varies year-to-year, as set out by the Internal Revenue Service (IRS), and depends on your income, age, and marital status.
Investment portfolio: This refers to an investor’s holdings, which can include assets such as stocks, government, and corporate bonds, Treasury bills, real estate investment trusts (REITs), exchange-traded funds (ETFs), mutual funds, and certificates of deposits. Options, derivatives and physical commodities like real estate, land and timber can also be included in the list.
Deferred payment annuities: These annuities offer tax-deferred growth at a fixed or variable rate of return. They allow individuals to make monthly or lump-sum payments to an insurance company in exchange for guaranteed income down the line, typically 10 years or more.
Life insurance policies: Some policies can be useful for retirement, such as if an individual pays an after-tax, fixed amount annually that grows based on a particular market index. The policy would need to be the kind that allows the individual to withdraw in retirement the principal and any appreciation from the policy essentially tax-free.
Anchoring is a heuristic in behavioral finance that describes the subconscious use of irrelevant information, such as the purchase price of a security, as a fixed reference point (or anchor) for making subsequent decisions about that security. Thus, people are more likely to estimate the value of the same item higher if the suggested sticker price is $100 than if it is $50.
In sales, price, and wage negotiations, anchoring can be a powerful tool. Studies have shown that setting an anchor at the outset of a negotiation can have more effect on the final outcome than the intervening negotiation process. Setting a starting point that is deliberately too high can affect the range of all subsequent counteroffers.
Key Takeaways
Anchoring is a behavioral finance term to describe an irrational bias towards an arbitrary benchmark figure.
This benchmark then skews decision-making regarding a security by market participants, such as when to sell the investment.
Anchoring can be used to advantage in sales and price negotiations where setting an initial anchor can influence subsequent negotiations in your favor.
Understanding Anchoring
Anchoring is a cognitive bias in which the use of an arbitrary benchmark such as a purchase price or sticker price carries a disproportionately high weight in one’s decision-making process. The concept is part of the field of behavioral finance, which studies how emotions and other extraneous factors influence economic choices.
In the context of investing, one consequence of anchoring is that market participants with an anchoring bias tend to hold investments that have lost value because they have anchored their fair value estimate to the original price rather than to fundamentals. As a result, market participants assume greater risk by holding the investment in the hope the security will return to its purchase price.
Market participants are often aware that their anchor is imperfect and attempt to make adjustments to reflect subsequent information and analysis. However, these adjustments often produce outcomes that reflect the bias of the original anchors.
Anchoring is often paired with a heuristic known as adjusting, whereby the reference level or anchor is adjusted as conditions change and prices are re-evaluated.
Anchoring Bias
An anchoring bias can cause a financial market participant, such as a financial analyst or investor, to make an incorrect financial decision, such as buying an overvalued investment or selling an undervalued investment. Anchoring bias can be present anywhere in the financial decision-making process, from key forecast inputs, such as sales volumes and commodity prices, to final output like cash flow and security prices.
Historical values, such as acquisition prices or high-water marks, are common anchors. This holds for values necessary to accomplish a certain objective, such as achieving a target return or generating a particular amount of net proceeds. These values are unrelated to market pricing and cause market participants to reject rational decisions.
Anchoring can be present with relative metrics, such as valuation multiples. Market participants using a rule-of-thumb valuation multiple to evaluate securities prices demonstrate anchoring when they ignore evidence that one security has a greater potential for earnings growth.
Some anchors, such as absolute historical values and values necessary to accomplish an objective, can be harmful to investment objectives, and many analysts encourage investors to reject these types of anchors. Other anchors can be helpful as market participants deal with the complexity and uncertainty inherent in an environment of information overload. Market participants can counter anchoring bias by identifying the factors behind the anchor and replacing suppositions with quantifiable data.
Comprehensive research and assessment of factors affecting markets or a security’s price are necessary to eliminate anchoring bias from decision-making in the investment process.
Examples of Anchoring Bias
It is easy to find examples of anchoring bias in everyday life. Customers for a product or service are typically anchored to a sales price based on the price marked by a shop or suggested by a salesperson. Any further negotiation for the product is in relation to that figure, regardless of its actual cost.
Within the investing world, anchoring bias can take on several forms. For instance, traders are typically anchored to the price at which they bought a security. If a trader bought stock ABC for $100, then they will be psychologically fixated on that price for judging when to sell or make additional purchases of the same stock — regardless of ABC’s actual value based on an assessment of relevant factors or fundamentals affecting it.
In another case, analysts may become anchored to the value of a given index at a certain level instead of considering historical figures. For example, if the S&P 500 is on a bull run and has a value of 3,000, then analysts’ propensity will be to predict values closer to that figure rather than considering the standard deviation of values, which have a fairly wide range for that index.
Anchoring also appears frequently in sales negotiations. A salesman can offer a very high price to start negotiations that is objectively well above fair value. Yet, because the high price is an anchor, the final selling price will also tend to be higher than if the salesman had offered a fair or low price to start. A similar technique may be applied in hiring negotiations when a hiring manager or prospective hire proposes an initial salary. Either party may then push the discussion to that starting point, hoping to reach an agreeable amount that was derived from the anchor.
How Do You Avoid Anchoring Bias?
Studies have shown that some factors can mitigate anchoring, but it is difficult to avoid altogether, even when people are made aware of the bias and deliberately try to avoid it. In experimental studies, telling people about anchoring and advising them to “consider the opposite” can reduce, but not eliminate, the effect of anchoring.
How Can I Use Anchoring to My Advantage?
If you are selling something or negotiating a salary, you can start with a higher price than you expect to get as it will set an anchor that will tend to pull the final price up. If you are buying something or a hiring manager, you would instead start with a lowball level to induce the anchoring effect lower.
What Is Anchoring and Adjustment?
The anchoring and adjustment heuristic describes cases in which an anchor is subsequently adjusted based on new information until an acceptable value is reached over time. Often, those adjustments, however, prove inadequate and remain too close to the original anchor, which is a problem when the anchor is very different from the true or fair value.
Correction—July 21, 2022: This article was updated to make clear a risk of anchoring resulting in buying overvalued assets or selling undervalued ones, not buying undervalued assets and selling overvalued ones.
The annual percentage yield (APY) is the real rate of return earned on an investment, taking into account the effect of compounding interest. Unlike simple interest, compounding interest is calculated periodically and the amount is immediately added to the balance. With each period going forward, the account balance gets a little bigger, so the interest paid on the balance gets bigger as well.
Key Takeaways
APY is the actual rate of return that will be earned in one year if the interest is compounded.
Compound interest is added periodically to the total invested, increasing the balance. That means each interest payment will be larger, based on the higher balance.
The more often interest is compounded, the higher the APY will be.
APY has a similar concept as annual percentage rate (APR), but APR is used for loans.
The APY on checking, savings, or certificate of deposit holdings will vary across product and may have a variable or fixed rate.
APR vs. APY: What’s the Difference?
Formula and Calculation of APY
APY standardizes the rate of return. It does this by stating the real percentage of growth that will be earned in compound interest assuming that the money is deposited for one year. The formula for calculating APY is:
Where:
r = period rate
n = number of compounding periods
What Annual APY Can Tell You
Any investment is ultimately judged by its rate of return, whether it’s a certificate of deposit (CD), a share of stock, or a government bond. The rate of return is simply the percentage of growth in an investment over a specific period of time, usually one year. But rates of return can be difficult to compare across different investments if they have different compounding periods. One may compound daily, while another compounds quarterly or biannually.
Comparing rates of return by simply stating the percentage value of each over one year gives an inaccurate result, as it ignores the effects of compounding interest. It is critical to know how often that compounding occurs, since the more often a deposit compounds, the faster the investment grows. This is due to the fact that every time it compounds the interest earned over that period is added to the principal balance and future interest payments are calculated on that larger principal amount.
Comparing the APY on 2 Investments
Suppose you are considering whether to invest in a one-year zero-coupon bond that pays 6% upon maturity or a high-yield money market account that pays 0.5% per month with monthly compounding.
At first glance, the yields appear equal because 12 months multiplied by 0.5% equals 6%. However, when the effects of compounding are included by calculating the APY, the money market investment actually yields (1 + .005)^12 – 1 = 0.06168 = 6.17%.
Comparing two investments by their simple interest rates doesn’t work as it ignores the effects of compounding interest and how often that compounding occurs.
APY vs. APR
APY is similar to the annual percentage rate (APR) used for loans. The APR reflects the effective percentage that the borrower will pay over a year in interest and fees for the loan. APY and APR are both standardized measures of interest rates expressed as an annualized percentage rate.
However, APY takes into account compound interest while APR does not. Furthermore, the equation for APY does not incorporate account fees, only compounding periods. That’s an important consideration for an investor, who must consider any fees that will be subtracted from an investment’s overall return.
Example of APY
If you deposited $100 for one year at 5% interest and your deposit was compounded quarterly, at the end of the year you would have $105.09. If you had been paid simple interest, you would have had $105.
The APY would be (1 + .05/4) * 4 – 1 = .05095 = 5.095%.
It pays 5% a year interest compounded quarterly, and that adds up to 5.095%. That’s not too dramatic. However, if you left that $100 for four years and it was being compounded quarterly then the amount your initial deposit would have grown to $121.99. Without compounding it would have been $120.
X = D(1 + r/n)n*y
= $100(1 + .05/4)4*4
= $100(1.21989)
= $121.99
where:
X = Final amount
D = Initial Deposit
r = period rate
n = number of compounding periods per year
y = number of years
Special Considerations
Compound Interest
The premise of APY is rooted in the concept of compounding or compound interest. Compound interest is the financial mechanism that allows investment returns to earn returns of their own.
Imagine investing $1,000 at 6% compounded monthly. At the start of your investment, you have $1,000.
After one month, your investment will have earned one month worth of interest at 6%. Your investment will now be worth $1,005 ($1,000 * (1 + .06/12)). At this point, we have not yet seen compounding interest.
After the second month, your investment will have earned a second month of interest at 6%. However, this interest is earned on both your initial investment as well as your $5 interest earned last month. Therefore, your return this month will be greater than last month because your investment basis will be higher. Your investment will now be worth $1,010.03 ($1,005 * (1 + .06/12)). Notice that the interest earned this second month is $5.03, different from the $5.00 from last month.
After the third month, your investment will earn interest on the $1,000, the $5.00 earned from the first month, and the $5.03 earned from the second month. This demonstrates the concept of compound interest: the monthly amount earned will continually increase as long as the APY doesn’t decrease and the investment principal is not reduced.
Banks in the U.S. are required to include the APY when they advertise their interest-bearing accounts. That tells potential customers exactly how much money a deposit will earn if it is deposited for 12 months.
Variable APY vs. Fixed APY
Savings or checking accounts may have either a variable APY or fixed APY. A variable APY is one that fluctuates and changes with macroeconomic conditions, while a fixed APY does not change (or changes much less frequently). One type of APY isn’t necessarily better than the other. While locking into a fixed APY sounds appealing, consider periods when the Federal Reserve is raising rates and APYs increase each month.
Most checking, savings, and money market accounts have variable APYs, though some promotional bank accounts or bank account bonuses may have a higher fixed APY up to a specific level of deposits. For example. a bank may reward 5% APY on the first $500 deposited, then pay 1% APY on all other deposits.
APY and Risk
In general, investors are usually awarded higher yields when they take on greater risk or agree to make sacrifices. The same can be said regarding the APY of checking, saving, and certificate of deposits.
When a consumer holds money in a checking account, the consumer is asking to have their money on demand to pay for expenses. At a given notice, the consumer may need to pull out their debit card, buy groceries, and draw down their checking account. For this reason, checking accounts often have the lowest APY because there is no risk or sacrifice for the consumer.
When a consumer holds money in a savings account, the consumer may not have immediate need. The consumer may need to transfer funds to their checking account before it can be used. Alternatively, you cannot write checks from normal savings accounts. For this reason, savings accounts usually have higher APYs than checking accounts because consumers face greater limits with savings accounts.
Last, when consumers hold a certificate of deposit, the consumer is agreeing to sacrifice liquidity and access to funds in return for a higher APY. The consumer can’t use or spend the money in a CD (or they can after paying a penalty to break the CD). For this reason, the APY on a CD is highest of three as the consumer is being rewarded for sacrificing immediate access to their funds.
What Is APY and How Does It Work?
APY is the annual percent yield that reflects compounding on interest. It reflects the actual interest rate you earn on an investment because it considers the interest you make on your interest.
Consider the example above where the $100 investment yields 5% compounded quarterly. During the first quarter, you earn interest on the $100. However, during the second quarter, you earn interest on the $100 as well as the interest earned in the first quarter.
What Is a Good APY Rate?
APY rates fluctuate often, and a good rate at one time may no longer be a good rate due to shifts in macroeconomic conditions. In general, when the Federal Reserve raises interest rates, the APY on savings accounts tends to increase. Therefore, APY rates on savings accounts are usually better when monetary policy is tight or tightening. In addition, there are often low-cost, high-yield savings accounts that consistently deliver competitive APYs.
How Is APY Calculated?
APY standardizes the rate of return. It does this by stating the real percentage of growth that will be earned in compound interest assuming that the money is deposited for one year. The formula for calculating APY is: (1+r/n)n – 1, where r = period rate and n = number of compounding periods.
How Can APY Assist an Investor?
Any investment is ultimately judged by its rate of return, whether it’s a certificate of deposit, a share of stock, or a government bond. APY allows an investor to compare different returns for different investments on an apples-to-apples basis, allowing them to make a more informed decision.
What Is the Difference Between APY and APR?
APY calculates that rate earned in one year if the interest is compounded and is a more accurate representation of the actual rate of return. APR includes any fees or additional costs associated with the transaction, but it does not take into account the compounding of interest within a specific year. Rather, it is a simple interest rate.
The Bottom Line
APY in banking is the actual rate of return you will earn on your checking or savings account. As opposed to simple interest calculations, APY considers the compounding effect of prior interest earned generating future returns. For this reason, APY will often be higher than simple interest, especially if the account compounds often.
