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Personal Finance: Investing Strategies, Financial Planning, Retirement Education and More

The world of investing and personal finance can occasionally be perplexing. Often when a specific personal finance question comes to mind, no obvious source for an answer is apparent.

Here is a list of practical answers to frequently asked investing and personal finance questions. This quick reference guide is designed to be a "go to source" for answers to your investing and personal finance needs.

AAII's Personal Finance area is your key to successful investing.

Creating a Financial Plan


Where can I find a good financial planner?


How do I go about creating an estate plan?


How can I get my debt under control?


I want to get my older teenagers involved in handling their finances. Where do I start?


I'm a retiree living off of my savings. What's a safe withdrawal rate?


Life Insurance


What kinds of life insurance are available?


What do I need to consider when purchasing life insurance?




What are annuities?


How do variable annuities compare to mutual funds?


What are the pros and cons of annuities?


Managing Your Investment Portfolio


What is diversification and why is it important?


What is the benefit of time diversification?


What's the danger of using a market timing strategy?


How do I calculate my return?

Creating a Financial Plan

Personal Finance: Where can I find a good financial planner?

Financial planners are generalists who help individuals delineate personal financial plans with specific objectives, and help coordinate various financial concerns. Here are some general tips when conducting a search for a financial planner:

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  • You will probably want to find a personal finance planner that is located close to you, since you will need to spend some time going over your financial concerns.
  • Check on the planner's formal educational background, his professional training and continuing education.
  • Make sure you understand the methods of compensation—whether fee-only, or if the planner receives part or all of his compensation through commissions on investment products he sells.
  • Most financial planners will offer free one-hour consultations. Use this opportunity to ask questions and find out if you will get along well with the planner.
  • Ask about the make-up of the planner's clientele. You should look for a planner who is familiar with the kinds of problems you face, and therefore his clientele should have personal financial situations similar to your own.
  • Ask for client references.
  • Ask the financial planner for a copy of his brochure and/or ADV form; the ADV form is filed with the Securities and Exchange Commission and is required if the planner is registered with the SEC. It will disclose an extensive amount of information on the financial planner and his practice, including his philosophies, practice structure, fees and potential conflicts of interest. If possible, request both Parts I and II. Part II must be provided to clients; Part I is optional, but contains useful information concerning possible past regulatory problems.

Contact these professional organizations for a select list of personal financial planners in your area:

  • American Institute of Certified Public Accountants, Personal Financial Planning Division: 220 Leigh Farm Rd., Durham, N.C. 27707; (888) 777-7077; The AICPA Web site features a searchable database of CPAs who have earned the Personal Financial Specialist designation.
  • Certified Financial Planner Board of Standards: 1425 K St., N.W., Suite 500, Washington, D.C. 20005; (800) 487-1497; Visit the Web site or call to find out whether a financial planner has earned the Certified Financial Planner (CFP) certifi cation, which is given by the CFP Board.
  • Financial Planning Association: 4100 E. Mississippi Ave., Suite 400, Denver, Colo. 80246-3053; (800) 322-4237; Upon request, the institute will send information on financial planners in a specified location who have the Certified Financial Planner designation.
  • The National Association of Personal Financial Advisors: 3250 N. Arlington Heights Rd., Suite 109, Arlington Heights, Ill., 60004; (800) 366-2732; Upon request, the association will send a list of members (by location); members are fee-only financial planners.

Personal Finance: How do I go about creating an estate plan?

In general, your "estate" includes all of your assets, less all debt, plus death benefits from all life insurance policies not held in an irrevocable trust. The biggest reason to have an estate plan is to make sure that your personal values about both medical and personal finance financial matters are honored in the event that death or incapacity prevents you from acting for yourself. In addition, tax minimization is a further and very important goal of estate planning for persons with taxable estates. To create an estate plan for yourself or update an existing plan, you will most likely need the services of an estate planning attorney.

When you consult with an estate planning attorney, the attorney considers how you want assets distributed to heirs, what taxes might your estate be liable for and whether there are tax-minimization strategies that would be appropriate and appealing; what your preferences and values are with respect to the management of medical and financial affairs in the event of incapacity; and any complicating family issues. To deal with these issues, your attorney will need full and accurate information about you, including:

  • Demographic Information: spouses, children, date of residency in the state, date of marriage(s), country of citizenship, whether you have previously made taxable gifts and if you are a beneficiary or a trustee of an existing trust.
  • Financial Information: a detailed list of what you own and owe, life insurance policies on your life, business interests, and how each asset is currently titled.
  • Personal Finance Circumstances: special issues for the attorney to consider—e.g., potential inheritances, creditor problems, a strong desire to give gifts, potential family disputes, medical concerns, or any uncertainty that you may have about your current estate plan.
  • Personal Finance Preferences: your wishes for end of life medical care, for how your wealth will be distributed to heirs, and for how much planning you are interested in doing to minimize taxes.

When an estate plan is formulated, be sure you understand what the attorney is saying. Estate planning ideas can be elusive, but strive for a layman's working knowledge of the material presented for your consideration. It is also appropriate and expected for you to ask about the attorney's fee for any legal service you are considering.

Personal Finance: How can I get my debt under control?

Reduce Use of Credit Cards: Compounding monthly a $2,500 unpaid balance on a credit card that charges an 18% annual percentage rate means you're paying an effective interest rate of 19.56%, or nearly $500 in annual interest charges. If you paid off the $2,500 balance, you would earn, in effect, a 19.56% "return" on your money.

Reduce Current Debt: If you currently are heavily burdened with debt, there are several steps to consider. First, of course, is to start paying off your debt, and two approaches are possible: You can pay off the highest-interest debt first, which would save you the most money; or you could pay off the lowest balance first. You may want to consider consolidating your loans, but don't spend the savings, or you won't come out ahead.

Develop a Personal Finance Debt Plan: Unless you develop a plan for paying your debts, frustration and bad credit can easily result. By developing a worksheet listing the name of creditors, dates last paid, when balances are due, interest rates being charged, monthly payments and totals due, you can address your credit obligations. Be sure to list all consumer debts, noting the maturity dates for non-revolving charges.

When you write down the interest rate of each loan, check to see if it exceeds the aftertax return on your invested savings. If it does, you have negative interest spread, and it would be wise to pay off that loan from a savings account. After you have totaled monthly debt obligations, calculate the percentage of take-home pay they represent. If the percentage is higher than 15% to 20%, you are in danger of overloading your short-term credit. Ask yourself, could you pay off all your debts within an 18- to 24-month period? If not, you are probably exceeding your credit limit.

Remember that credit can be an important lifeline in the event of a crisis, such as temporary or permanent loss of employment or other financial crunch. If you have used all your credit, you have removed a valuable cushion of security.

Personal Finance: I want to get my older teenagers involved in handling their finances. Where do I start?

The challenge is to develop a series of cumulative steps that will make the world of personal finance visible, credible, and appealing to young adults. What follows is a collection of various steps to consider for creating financial coming-of-age traditions tailored to your family's values and circumstances. They are offered as a way to jumpstart brainstorming. Specific traditions will obviously vary for each family according to family values and family wealth.

Once a child turns 16, consider getting a credit card in the child's name, with the parent as the guarantor. At age 18, consider a low-limit card for which the child is responsible, in addition to a card in the parents' name to use in case of emergency and/or for purchases that in your family are paid for by the parent. Help your older college student to order a credit report from one of the national reporting agencies (,, or the college years, and especially early on, keep the communication about credit card use ongoing.

In families where inheritances in the form of trust funds are part of the picture, consider working with your attorney to develop a series of steps designed to draw your child gradually into trust management while educating them about the world of personal finance. For example, trust documents can specify that young adult heirs become co-trustees with limited responsibility and authority before assuming full responsibility at a later age.

At age 18 a child can open his or her own checking and savings account. Consider making a parent/child visit to the bank to open these accounts an honored coming-of-age ritual in your family. During the visit with the bank officer, review how to track deposits and withdrawals, arrange for an ATM debit card and a first PIN number. Review safe ATM machine habits. Help your child think through what percentage of earned income, and of gifted monies, will go to checking versus to savings. Use this opportunity to promote the notion that "in our family"—or at least in smart circles—people save 10% to 20% of every dollar they earn, starting with the first dollar.

Once a child has earned income—income reported on a W2 form at year-end—consider opening a Roth IRA account. When the child turns 18, she can directly open an IRA account herself. Explain that Roth IRAs are one of the most powerful personal financial savings vehicles available, and a potentially important source of long-term wealth. Contributions are made with aftertax dollars, but then grow tax-sheltered and (with reasonable planning and under current law) also escape taxation at withdrawal.

To fund a Roth IRA for a young adult, it is necessary for that young adult to have earned income. However, there is no IRS prohibition preventing parents or grandparents from funding all or a part of the contribution, if they choose to do so. Some families offer a parental (or grandparental) matching contribution, some families fund the entire contribution, while other families make up the difference between an agreed upon child's contribution and the IRS maximum allowed contribution—or between an agreed upon child's contribution and the minimum amount required by the IRA company to open an IRA.

Children grow up with an intuitive notion of their family's standard of living—but no dollar amount to associate with that standard of living unless parents share that information with them. At some point it becomes appropriate and helpful for parents to share information about their income and wealth with their children, a process that is perhaps the most profound financial coming-of-age ritual of all. There are few higher honors for a child than when a parent trusts the child with family's personal financial information. For this reason, coming to know one's own family net worth and income level, as well as the financial history and philosophy of one's parents, can be a fruitfully maturing experience in itself.

Personal Finance: I'm a retiree living off of my savings. What's a safe withdrawal rate?

For retirees, the perfect portfolio withdrawal rate is a magic number that provides the extra funds they need to supplement their pension and Social Security each year, but also maintains their portfolio's viability for as long as they live.

Several studies in the bull market of the 1990s suggested that 5% was a safe withdrawal rate, and 6% to 7% could work if you had a high percentage invested in stocks. However, most credible studies found that lower rates, of 4% to 4.5%, were sustainable if you could accept a 10% to 20% chance of plan failure. Yet most retirees would prefer as close to 100% odds of success as possible. In virtually all of the sustainability studies, if you take on more risk (i.e., investing in stocks), you can count on a higher withdrawal rate as part of your personal financial plan.

The problem facing retirees with portfolios invested in stocks is that the sustainability of the portfolio when you are withdrawing from it depends on the timing of stock market returns.

In your personal financial plan, the best approach to portfolio withdrawals is to create a gradual increase or decrease in spending based on portfolio volatility and asset size compared to expenses. If you couple this with good portfolio discipline, you've got a great chance of accomplishing your long-term spending goals in retirement.

If you can accomplish your goals at a 3% withdrawal rate, great. If 4% is needed, stay more disciplined on buy/sell targets and rebalancing, and look for special opportunities to occasionally boost returns. If 5% or more is needed, you should consider more radical strategies to enhance returns, but you must be willing to temporarily tighten your belt if your investment strategy does not go as planned.

Life Insurance

Personal Finance: What kinds of life insurance are available?

There are two basic types of life insurance: term insurance and cash value life insurance. Term insurance is straightforward and easy-to-understand—it provides a death benefit with no cash value. The term premium increases either every year or at specified intervals, usually five or 10 years.

Cash value life insurance is variously known as whole life, universal life, interest-sensitive whole life and variable life. Cash value premiums are generally three to eight times the amount of the initial term premium and, unlike term insurance premiums, remain level. The cash value policy's premium can be designed to be paid for a limited number of years. How many years can't be exactly known because it depends largely on future investment yields.

Cash value life insurance policies combine investment with insurance protection, and should be evaluated relative to alternative investment opportunities. A cash value policy is essentially term insurance plus an investment account. The investment accrues on a tax-deferred basis. The most common examples are whole life, universal life, and variable. Whole life is reducing term insurance plus a savings account. Universal life is a variation on whole life. Premiums (net of commissions and expenses) are paid into a savings account; mortality charges for a term policy are withdrawn.

As part of your personal finance plan, when cash value life insurance is considered, keep in mind the following points:

  • Whole life, universal life and interest-sensitive whole life are very similar;
  • Universal life is more flexible;
  • Whole life, in order to keep up with competitive pressures, has become more like universal life in its premium flexibility and potential for underfunding;
  • Interest-sensitive whole life is usually structured to give policyowners an early warning when actual policy results diverge from anticipated results; and
  • Some variable life policies have much higher policy expenses compared to universal. This is something you will have to discover through closer examination of the policies. Variable life policies with much higher expenses should be avoided.

Personal Finance: What do I need to consider when purchasing life insurance?

Nearly all cash value life insurance is now priced-to-the market. This means that the actual value of a policy at any point in time will be different than the value that was projected in the policy illustration. Consequently, the overall premiums paid over the life of the policy may be much higher than was originally expected by the purchaser.

Life insurance policies can be very flexible in their design and life insurance planning concepts can be complicated with exotic features. These complications require you to be very diligent when planning and purchasing life insurance and monitoring your purchases. Following is a checklist to help you do just that.

  1. As part of your personal finance plan, review your family's financial circumstances to determine your objective life insurance needs. This will result in determining an approximate amount and overall design.
  2. Review any existing policies that you and other family members own.
  3. Analyze whether term or cash value life insurance is most appropriate. If life insurance is needed is for family protection, term may be most appropriate; if it is needed for estate planning need, term insurance is generally not useful. (If term insurance is selected, steps 4, 5, and 6 can be skipped).
  4. Identify purchase design options for cash value life insurance (for example, increasing or level death benefits, continuous or vanish premium pattern), and determine which are most desirable for your family's circumstances.
  5. Analyze the most appropriate form of cash value life insurance for your family's circumstances: universal life, whole life, or variable life.
  6. Identify a range of pricing assumptions for cash value policies. If a specific death benefit is to be funded, select pricing assumptions to initially set a premium amount.
  7. Identify all policy riders to select from.
  8. Review policy every two years, both in terms of policy performance and in terms of changing family needs and circumstances and your overall personal financial plan.


Personal Finance: What are annuities?

Annuities are contracts between a life insurance company and a buyer. These contracts allow the buyer to make a single investment, or a series of investments, throughout the "accumulation period" during which money grows, tax deferred. At the end of the accumulation period, the contract provides a lump-sum payment or a series of payments which may include some of the following variations:

Income for life with:

  • nothing remaining upon death
  • 10-20 years of guaranteed payments to a beneficiary
  • a lump-sum payment at death equal to the difference between the fund balance and payments received
  • payments continued at some level for the life of a survivor
  • a specified period or amount

Annuities are most often used as a long-term investment for retirement. There are three types of deferred annuities: fixed, variable, and market-value-adjusted (hybrid). The fixed and variable deferred annuities are further classified as single premium deferred (SPD) and flexible premium deferred (FPD) depending on the number of deposits allowed. In addition to deferred annuities, there are immediate annuities.

Deferred Annuities: A fixed annuity credits interest based on the earnings of the company's general account. Both investment and mortality risks are borne by the company. Contract rates of return have a guaranteed minimum rate which is reset periodically. The guarantee periods vary and may range from one to 10 years.

In contrast to fixed annuities, variable annuities offer greater investor flexibility in that they allow the annuitant to select from several investment options and their corresponding returns are credited to the annuitant. The variable annuity is best explained as a mutual fund family within an insurance contract. The insurance company offers a mix of stock, bond, and money market funds and places allocation and selection responsibility directly on the policyholder. Therefore, investment risk is borne by the purchaser. The value of the account fluctuates with the changing market values of the underlying securities held. The variable annuity, however, differs from the mutual fund investment in one way—taxation.

If a taxable mutual fund is owned, all earnings would be taxable in the year paid. This includes realized capital gains. This is not the case with a variable annuity.

During the accumulation period, the investor incurs no income tax liability for reinvested dividends, interest, or realized capital gains. The insurance company pays a corporate capital gains tax on realized capital gains; a proportionate amount of that tax may be deducted from the benefits credited to the annuitant's account.

Market-value-adjusted deferred annuities are a hybrid of fixed and variable annuities. They provide a guaranteed interest rate for a specific period of time—usually 10 years. If, however, the contract is surrendered before the end of the guarantee period, adjustments are made to the cash value of the contract. Hybrids were developed to connect the temporary cash values to changes in the market value of the underlying investments caused by fluctuating interest rates.

Immediate Annuities: Immediate annuities provide a series of payments as soon as the premium is paid to the company. With fixed immediate annuities, payments are fixed at issue. With variable immediate annuities, payments vary based on the performance of the funds selected.

Personal Finance: How do variable annuities compare to mutual funds?

Like mutual funds, variable annuities do not offer a guaranteed cash value. Instead, the size of the payments received by the contract holder are directly dependent on the performance of a professionally managed portfolio.

On a risk-adjusted basis, variable annuities perform similarly to mutual funds. On average, variable annuities offer slightly lower returns than mutual funds as well as lower levels of risk.

Unlike mutual funds, variable annuities provide tax-deferred growth of dividends and capital gains. However, if these investment vehicles are held for a short time period—less than six years—the extra fees associated with mortality and risk expenses more than offset the tax-deferral advantages. Therefore, variable annuities are best viewed as relatively illiquid, long-term savings vehicles that are most useful for the funding or partial funding of retirement income.

Variable annuities are appropriate for individuals who require a monthly income, desire flexibility and understand alternative investments, who want a tax-deferred investment vehicle and can tie funds up for an extended time period, and who already own fixed-income securities.

Personal Finance: What are the pros and cons of annuities?

Like any investment vehicle, an annuity has both good and bad points. The two biggest features in favor of an annuity are tax-deferred accumulation and safety. Historically, annuities have been very safe vehicles in which to invest and, with rare exception, there have been few defaults in this area. In addition, the tax-deferred accumulation allows for a significant additional accumulation of funds over and above what could be earned in a taxable vehicle.

However, you should remember that an annuity is a long-term accumulation vehicle. If the contract is surrendered prior to age 59 1/2, there is a 10% excise tax penalty levied. The advantage of tax-deferred accumulation is that eventually the additional earnings through tax deferral can offset this excise tax penalty. As a rule of thumb, you should plan on holding a deferred annuity approximately 15 years before liquidation (this can change depending on your tax bracket), if you plan on having your liquidation occur prior to age 59 1/2. This break-even point is reached sooner if the liquidation will occur after age 59 1/2. The holding period defines the break-even point between an annuity with tax deferral versus a similar investment at the same rate of return without tax deferral.

Another advantage for some in using an annuity is the selection of an annuitization (payout) option and the ability to guarantee an income for life. As one gets older, the annuitization factors rise because of the risk of the payout being over a shorter period of time for the insurance company due to a decreased life expectancy. With the rise in factors comes a corresponding additional payment that relates to a higher equivalent rate of return when comparing the annuitization payment received versus interest received on an account using the same initial lump sum invested. For some individuals, this certainty of continued income and the peace of mind it affords are important factors.

Again, as with any investment vehicle, there are disadvantages to the annuity and annuitization. Since your money is placed with an insurance company in an annuity contract, you have little control over the rate of return on your investment. A good company will pay a return competitive with that credited on 52-week Treasury bills and it should typically be slightly higher than this rate. However, the decision as to the crediting rate is entirely the insurance company's and you should be aware of this when making an investment decision.

In addition, although there is certainty in your continued monthly income payment when choosing an annuitization option, you definitely have purchasing power risks associated with this decision. Although you have eliminated the possibility of market risk on your investment because you have locked into a fixed rate of return, you have created the risk of loss of purchasing power. Your income will be a fixed income that will not have the flexibility of readjustment in case of higher inflation rates. In addition, annuities provide less flexibility for leaving an estate to your heirs if that is your wish. There is some flexibility in that an annuitization option can be chosen that allows the potential for remaining funds to pass to heirs. However, remember that any option such as this will reduce the amount of payout to you during your lifetime, since it corresponds to a lower annuitization factor and thus a lower monthly payment.

Managing Your Investment Portfolio

Personal Finance: What is diversification and why is it important?

If you invest in a single security, your return will depend solely on that security; if that security flops, your entire return will be severely affected. Clearly, held by itself, the single security is highly risky.

If you add nine other unrelated securities to that single security portfolio, the possible outcome changes—if that security flops, your entire return won't be as badly hurt. By diversifying the investments in your personal financial plan, you have substantially reduced the risk of the single security. However, that security's return will be the same whether held in isolation or in a portfolio.

Diversification substantially reduces your risk with little impact on potential returns. The key involves investing in categories or securities that are dissimilar: Their returns are affected by different factors and they face different kinds of risks.

Diversification should occur at all levels of investing. Diversification among the major asset categories—stocks, fixed-income and money market investments—can help reduce market risk, inflation risk and liquidity risk, since these categories are affected by different market and economic factors.

Diversification within the major asset categories—for instance, among the various kinds of stocks (international or domestic, for instance) or fixed-income products—can help further reduce market and inflation risk. Diversification among individual securities helps reduce business risk.

Personal Finance: What is the benefit of time diversification?

Time diversification, remaining invested over different market cycles, is extremely important yet often overlooked.

Time diversification helps reduce the risk that you may enter or leave a particular investment or category at a bad time in the economic cycle. It has much more of an impact on investments that have a high degree of volatility, such as stocks, where prices can fluctuate over the short term. Longer time periods smooth those fluctuations. Conversely, if you cannot remain invested in a volatile investment over relatively long time periods, those investments should be avoided. Time diversification is less important for relatively stable investments, such as certificates of deposit, money market funds and short-term bonds.

Time diversification also comes into play when investing or withdrawing large sums of money. In general, it is better to do so gradually over time, rather than all at once, to reduce risk.

Personal Finance: What's the danger of using a market timing strategy?

The goal of a market timer is to enter the market when it is rising, and exit when it is falling. While the strategy sounds appealing, it is difficult to execute, since no one has been able to devise a system that can tell in advance if the market will rise or fall. Market timers therefore tend to follow the trends, bailing out after the market has started to fall, and jumping in after it has started to rise.

However, the stock market movements are jerky, not smooth, and allow little time for even the most prescient market timer to act. Thus, one of the major risks of this kind of strategy is that it may have an investor out of the market when the bulls stampede.

Probably the biggest risk of a market timing strategy is that a few missed bull markets can negate the long-term return advantage stocks have historically provided. And market timing strategies sometimes miss the boat. In recognition of this all too familiar trait, investors should refrain from full-bore timing strategies that require the portfolio to be either 100% in stocks or 100% in short-term debt. In the world of personal finance, diversifying a portfolio across asset types provides protection that is too certain to be discarded for the uncertain promises of market timing. Timing strategies that call for either an all-stock or an all-debt portfolio, or almost-all-stock or almost-all-debt, contain excessive and unnecessary levels of risk.

If you are interested in market timing strategies, you should at least limit the portion of your total portfolio that is subject to the risks of market timing.

Personal Finance: How do I calculate my return?

Calculating the performance of your total portfolio isn't that difficult if you don't want precision accuracy; the formula is presented below.

If the return isn't within the target range you expected based on your investment mix, you may need to make some adjustments in your future projections—for instance, you may have to increase your savings rate, you may have to take on more risk to achieve the target that you set, or you may simply have to adjust your target value downward, settling for less in the future.

Monitor the performance of the components of your portfolio—mutual funds, investment advisers and self-managed investments—either quarterly or semiannually and judge the results against relevant benchmarks.

The purpose of this monitoring is to see how well the professional expertise you have hired (or are performing yourself) is doing.

You do not need to make your own calculations to measure the performance of your mutual fund holdings; there are many resources that provide information on mutual fund performance, and that also provide appropriate benchmarks for comparison.

If you are investing in stocks or bonds on your own, measure your individual stock or bond portfolio performance against an appropriate index or similarly managed mutual fund as a test of your own investment decision-making ability. To determine the performance of your own stock portfolio, use the approximation formula, and make sure that the benchmarks you are comparing performance against cover the same time periods.

If you have an investment adviser selecting individual stocks for you, measure him against an index and mutual fund averages composed of stocks similar to those he is managing. The adviser should be able to provide you with the return on your portfolio; make sure it covers a standard time period, so it can be measured against an index or average that covers the same time period.

What do you do with this performance information? For mutual funds and advisers, if the performance figures are good relative to the benchmarks—no problem. If the figures are unsatisfactory, you have to decide if you want to sell the fund (or drop the adviser) and look elsewhere.

Calculating Your Return: An Approximation
Return =
End Value + Unreinv Inc - 0.50 (Net Additions) -1
Beginning Value + 0.50 (Net Additions)
END VALUE Value at end of investment period.
BEGINNING VALUE: Value at beginning of investment period.
UNREINV INC: Unreinvested income (for instance, dividends or interest received and not reinvested). Note that reinvested income is automatically accounted for because it is part of the ending value.
NET ADDITIONS: Total cash additions put into the portfolio during the time period less withdrawals. Use net withdrawals, a negative number, if total withdrawals are greater than total additions.
RETURN: Your answer will be in decimal form. Multiply by 100 to determine percentage return.

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