Tuesday, December 18, 2007
But, as I thought about it, the slipup seemed almost fortuitous. In fact, the 1929 depression is far from the worst that could happen. Consider a complete financial breakdown...All utilities shutdown. All goods distribution shuts down. All retail outlets shut down. All money and traditional investments become worthless.
I'm not a doomsday theorist. I don't see the above scenario being likely in the near future. But, I don't think anyone can guarantee it won't happen tomorrow, next week or next year. I won't go into what might trigger it. You've seen the movies, and your imagination works as well as mine. Suffice to say, it is always a possibility. As a result, it makes sense to do some thinking and planning for such an event. Work through your own situation, but my thinking goes something like this.
Many own some rural property for just such a situation. I'm one, since that gives you additional resources. But, I believe even the typical single family homeowner has access to the resources required to gain self sufficiency.
Assuming there is plenty of air to breathe, your most urgent need is water. You are good for only a few days without it. Fortunately, you probably have 50-100 gallons in your house plumbing system, stored in the water heater, toilets and pipe. Don't use any of it for washing or flushing...this is your drinking water for 2-3 months. If you live within walking distance from a stream, pond or other natural water supply, you are set. Otherwise, consider setting up a system to collect rainwater and even dew from your roof, driveway or plants. Depending on your location, you probably can be self sufficient in water terms for the long term by collecting the rain and dew.
Your next most pressing need is food. You can live for a month or two without it. But, again, you probably have a significant supply around the house. Your refrigerator will be dead, so use the perishable food from there first. A loaf of bread, box of crackers and peanut butter are food for several weeks. A 5 pound bag of potatoes and a 2 pound bag of beans is good for considerably more, but save some back for seed. Even the leftover bacon grease and cooking oil will supply the energy you'll need for the first few months. The list is endless and varied, but you likely could survive with the food in your house for most of a year.
Next, check your yard and neighborhood. Dandelion is edible...roots, leaves and blossoms. The same applies to wild onions and garlics which commonly thrive in your yard. If you have an oak, pecan or other nut tree, you could have adequate food for a large part of each year. Even seeds from wild grasses such as oats, rye or almost any grass are edible and nutritous. In many neighborhoods dove, pigeons or other birds are harvestable by traps, or even slingshot or rock throwing, at least initially. If there is a stream or pond, you likely have fish, frogs, snakes and turtles.
All the above will likely become rather scarce fairly quickly, but they help provide the time for a transition. Ultimately, you'll need to live from what you grow. Start by putting newspapers, grass clippings, leaves or other debris on your grass to create a garden. Plant whatever beans, potatoes or other seeds you can find. The typical yard has room for more garden than you'll need to supply all your food. Remember you are not using water for flushing, so you've been going in a bucket and composting it for fertilizer and recycling the moisture for the garden. You'll need to know your neighbors and barter, trading both materials and knowledge. Maybe a bag of acorns for an ear of corn which, when planted will supply both a few months of food and replacement seed. Or knowledge about gardening for information about solar collectors.
Notice no mention until now of energy. Despite the fact that it seems critical to our modern lives, it falls fairly far down the priority list in a real financial breakdown. You can do without lights, heat, air conditioning and long distance travel. Perhaps you'll use wood or solar for cooking, dehyrating or sterilizing, but your energy needs are not great.
There you have a potential start. At this point you have a fairly sustainable life. Your plan will be different reflecting your local and resources, but give it some thought. This is the ultimate in personal finance.
Friday, November 30, 2007
Meanwhile, my son gave me a copy of "The Intelligent Investor", the definitive book on value investing by Benjamin Graham. In the preface, Warren Buffet says Graham was had more influence on him than anyone other than his father. I'd heard of Graham before, of course, but had never read any of his work. I'm only part way through, but I'm already absolutely amazed to see the similarities between Graham's philosophy and what I've been writing here in this space.
And right there on page 2, written over 50 years ago, he quotes an example that sheds more light on the recession question than anything I've seen from the illustrious names above. It is set in 1929, the year of the penultimate recession/depression. The DJIA was at 300. The crash came, followed eventually by a recovery. But, by 1949, the Dow had recovered to only 177. Ouch, that is a serious depression!
Here's the kicker...If you had invested equal amounts each month during this same time frame, by 1949, when the Dow was still down 41% from your starting point, you would have gained over 8% annually on your money, more than doubling it. How is that possible, you ask? It is the result of dollar cost averaging.
Those who have been dollar cost averaging over the past several years have already seen even better results. So, if you are just starting out, quit worrying about a recession and jump in. The results from 1929-1949 demonstrate majic that is rare in financial circles.
Unfortunately for those of us who have accumulated substantial nest eggs, things are not quite so simple. We still have to worry about the potential 41% reduction in our starting balance. Besides, today we have the option of investing in several different markets. And those are the reasons I developed the "Dollar Cost Averaging on Steroids" system. I'm still hoping to find something similar in the later parts of the book, but I can see already he would approve of the concept.
It takes maximum advantage of the diversification available today to extend the majic, even in the face of significant correlation, especially for those with significant portfolios. If you are interested you can read about it in my prior article (March 12, 2007). I suspect Graham had something similar in mind when he talks about going to a cocktail party and enjoying the opportunity to participate in the market discussion with "I don't know, and I don't care. If it goes up I'll make money and if it goes down I'll buy at better prices." Yes, whether he invented it or not, he would have been a fan! I think I've used some similar words in decribing my process.
It may not be quite as simple, but it is not far from it. And it extends the basic dollar cost averaging principal to meet the needs of those who already have a substantial portfolio.
Wednesday, October 24, 2007
Some of my earliest memories were of our family worrying about where money for groceries or the mortgage would come from. I remember vividly when I was about 5 years old when they got out a jar of pennies to pay a bill collector at the door. Out of that came a determination to attain a degree of financial independence that would largely insulate me from these worries. But how do you get from there to independence? The answer for me was to work hard and save as much as possible, paying attention to the details...a philosophy that has stuck with me to this day. My first job was moving trash for 10 cents per hour. And, I still pick up a penny when I see it on the ground. The penny may be a small amount of money, but the time involved in picking up a penny is approximately 1 second, so the work pays about $36/hour, tax free. Not bad for unskilled labor. And, besides being good exercise, the mentality of paying attention to details at this level is the start of financial independence. Interestingly, I've noticed an inverse correlation between the wealth of the neighborhood and the amount of change you are likely to find. In a low rent apartment complex, pennies are everywhere. In a neighborhood of multimillion dollar homes you'll rarely see one. I suspect this is because the rich got that way by paying attention to the details.
From there, you are on your way. Is the dinner out worth a couple thousand pennies? Is the Beemer worth 50 million pennies? Better to camp for the night than spend the 5 thousand pennies for a cheap hotel? At least until you are well on your way to financial independence, consider taking the cheap way and investing the resulting change.
Each penny not spent will be with you for the rest of your life, multiplying through compound interest to give you space between worries about running out of money. I'm not saying you shouldn't spend the money. Just pay attention to the details and make a conscious decision, and if you make the frugal decision, one day you'll realize you are well on your way to financial independence.
I like to think I'm frugal, but others have had less complimentary descriptions. Penny pincher is one I can't dispute, and it got me started on the way to independence from most money worries.
Sunday, August 5, 2007
Since that post, markets are down about 7-8%, and have been very volatile in the process. That has provided my "Dollar Cost Averaging on Steroids" system with an opportunity to shine, selling at the highs and now buying back the indexes while they (at least relative to a few weeks ago) are on sale. As usual, the system is forcing me to do things that feel uncomfortable, like selling on the euphoria of market highs and buying into down markets. Of course, only time will tell whether the market will continue downward from here or recover. But it is certain that this volatility has provided an opportunity to outperform the markets.
You see, outperforming the markets is relatively easy, with some simple systems and tools, as long as you have uncorrelated and volatile markets. When I talk about outperforming the markets, I'm referring to the weighted averages of whatever markets you are in. For me, that includes a wide range of US and International Stocks and Bonds, but the principals apply to any market.
I don't want to be repetitive with previous posts explaining the system, but the key is as simple as dollar cost averaging and aggressive rebalancing.
Friday, July 13, 2007
So, should you be worried or euphoric? I've traded thoughts with a few friends recently and the insights might be worth sharing.
First of all, keep in mind that the new highs are over those of about 6 years ago, when euphoria was high but earnings were much lower. Thus, while the market is certainly not cheap today, it does not seem wildly overpriced either. Assuming some of the worries dissipate, it would seem the market has room to run.
On the other hand the bull run is over 4 years old, so the market is a bit nervous. Any sign of new worries or worsening of those now being mentioned are causing traders to keep a finger on the sell button.
As I've said to my friends, I'm neither optimistic nor pessimistic on the market. It does seem a bit bubbly now, but it could well go higher over time. The most likely result is increased volatility. That is great news for me, since my system depends on volatility to outperform the markets (see previous articles for an explanation if you are not a regular reader).
In accord with all this, my system had me buying a few weeks ago but is flashing a sell right now. Of course, this is the short term response to the volatility. In the longer term picture, my system has me holding a significant cash position, meaning I'll be ready to capitalize on any volatility, whether it be short term or a significant bear market. That's the beauty of the system...you don't need to know what the market will do to ourperform the market. Check it out in posts on "Taking Advantage of Volatility" or "Dollar Cost Averaging on Steroids".
Friday, July 6, 2007
Let's start with the fact that there are a huge number of potential types and sources of insurance available, each with a salesman trumpeting its benefits. Obviously, if you are not careful, you could insure yourself into the poorhouse.
So, how should you identify those you must have, versus those it would be nice to have? Start with the premise that you must insure yourself against a financial catastrophe, but not against events that might be painful, but not catastrophic. That is the basis for buying medical insurance and for buying liability insurance. A reasonably likely event such as a major illness or accident could be catastrophic to all but the most financially secure without these insurances. The same applies to flood, fire and casualty insurance on your home. And, for those with minimal financial reserves who have families including young children, term life and disability insurance is mandatory. Death or disability could financially handicap the family for many years.
Beyond these basics, the case for insurance becomes more murky. It would, of course, be painful if you wrecked your car and had to replace it yourself, but would it be catastrophic? Would failure of your washing machine be catastrophic enough to pay for the insurance of an extended warranty? I know it would be nice if these things were insured, but keep in mind there is an offsetting cost. Remember that, under the best of circumstances, the insurance company must base their rates on the likelihood and cost of the insured event, as well as a profit for themselves, commissions for the salesman plus allowances for the less careful and for possible fraud, all on top of their administrative costs. Would the insured event be catastrophic enough to justify these costs? Would your death be financially catastrophic if you are single are newly married? What about if you are near retirement? Note the emphasis on financial-of course it would be catastrophic emotionally, but insurance will do little to help with that. I'd suggest that life insurance should be reduced as the family gains more financial independence and nears retirement.
What about deductibles? Generally, high deductibles considerably reduce insurance cost. Why? Because most events are small and the administrative cost for small claims is high, while the difficulty of preventing fraud or unjustified claims also climbs. At the same time, deductibles which are higher than the usual may fall well below a level that would be catastrophic for you. Because of this, my strategy is to buy deductibles which are just below the catastrophic level for insurances I must have. The cost of the insurance covering the difference between low and high deductibles may be some of the most expensive insurance you can buy. For example, in looking at my medical insurance, I discovered that the cost of medical insurance with a $200/year deductible is about $4000/year. The cost of a similar policy with a deductible of $4000/yr is less than $1000/yr. So, in effect, it cost me $3000/year to insure against the possibility of spending an additional $800/year out of pocket, should I have over $4000 medical cost in a given year.
Let's talk about when and where you should buy your insurance. Buy insurance only after you have created a strategic plan for all your insurances, thinking logically about what events would be catastrohic for you. Then, talk to several companies, comparing rates, coverages and the stability/reliability of the company. Avoid buying coverage adhoc or on the spur of the moment, especially if packaged with another product. These make if difficult to assess the risk or identify what are often outrageous rates or large fees.
As an example, whole life combines insurance with investments. Unfortunately the investment is often subject to large fees and commissions or low returns hidden in the policy. In another personal example, I had an auto salesman try to insert (without even mentioning it) life insurance that would pay off the balance of my auto loan in case of my death. Once I discovered it, he launched into an emotional plea in favor of my wife and kids, who he thought might have trouble paying off the loan if something happened to me. I advised I already had adequate life insurance and, on checking found that the cost of the insurance from my normal insurer would have been less than half what the dealer would charge, and would have been for the full balance of the loan, rather than the declining balance covered by the dealer. Extended warranty insurance is fraught with the same issues, and is even more difficult to evaluate.
I could go on and on, but you can take it from here. Just remember the basics:
- Develop an insurance strategy in a calm time and logical manner. This allows you to quickly dismiss offers which do not fit your strategy.
- Insure against only those events that would be catastrophic for yourself or your family. The administative cost, fees and profits involved are too high to justify insuring other events.
- Get competitive quotes for the insurance you need.
- Do not combine insurance with other products.
With these simple steps, you can save yourself thousands of dollars in unnecessary cost, and at the same time be comfortable that you have the insurance you need.
Tuesday, July 3, 2007
Saving or investing was no better. Your broker called and recommended an investment. You had to research it and make a decision, then try to call him back and execute the order. Then, just to get the money to the brokerage or bank meant a trip or a search for addresses and stamps, and paperwork to fill out.
Spending, same story. Trips to the bank for cash. Gathering the bills and finding addresses, envelopes and stamps. Probably a trip to the post office. I used to spend a few hours a couple of times a month just to make sure the bills got paid, meanwhile enriching the post office and taking my money out of investments early to make sure the money was available.
Thank goodness the good old days are gone. These days, payments are automatically deposited, on time, no hassles, no paperwork. Buying a stock or mutual fund is just a few clicks away on line, any time of day at my convenience. Got a little extra cash? Compare on-line banks for the highest rate and move money to the best place effortlessly. And most the investing is even easier...deducted from my pay and automatically invested or reinvested in accordance with my allocation. No research, no decisions, no real need for any effort once it has been set up.
Spending? Even easier. I haven't been to the bank or post office in months. I put everything on my credit card, from the electric bill to the quick lunch, from the airline flight to the magazine subscription. Then, once a month I download the bill, take a glance and pay all the charges with a few clicks of the mouse, perhaps from my hotel room on my way to the mountains. On the rare occasion that I have to pay cash or send/deliver a check I first get agitated, then take the opportunity to remember how much improved things are today.
For such service, you'd expect to pay a fortune, right? Not so. Payers and collectors alike are glad to avoid the postal expense and paperwork. You can keep your money invested for a month or more, and they'll pay you between 1-5% of your expenses for the privilege, plus often a bonus when you sign up. Unsafe, you say? If you have incorrect charges (which hasn't happened to me in several years), you just dispute the charges and don't need to pay unless the charges turn out to be justified.
I'm led to believe there are still dinosaurs out there who make regular trips to the bank and post office. Who generally pay by cash or check, in person or by mail. You probably refuse to use the cruise control on your car too, right? If that is you, I invite you, step on in to the 21st century, where the living is easy. Put your finances on cruise control. It's cheaper, it's easier, it's more profitable. If you don't believe that last one, check out my post on dollar cost averaging on steroids.
Thursday, June 28, 2007
When options are issued, they seem innocuous enough. There is no immediate effect on your taxes and the value is zero. If the stock price does not increase, they remain valueless. However, if, as in my case, the stock price appreciates, it leads to a number of nice-to-have, but none-the-less perplexing issues concerning when to exercise them. These issues, and their effect on your decisions are outlined below:
1. The value of options is extremely volatile. Options are more volatile than the stock by a factor of the current stock price divided by the difference between the current and the strike price. In my case, that means the options are 3-4 times as volatile as the stock price, which of course is likely already considerably more volatile than, say, a stock index fund. If the value of the options is low and you are still working, this may be a small issue. But, once you've retired and the value grows to a significant percentage of your portfolio, this begins to create a significant risk, despite the fact that the volatility has a huge upside if the price appreciates significantly. Incidently, running a standard set of assumed appreciation will always mean you are far ahead to keep the options until the last minute due to the leverage, so you have to consider whether the risk makes this worthwhile.
2. Dividends are not rec'd. If dividends are a significant part of the long term total return of the stock, as in my case, the fact that option holders do not receive the dividends becomes a drag on the investment as compared to owning the stock. If the price appreciates substantially, the leverage mentioned above more than overcomes this problem, but if not, the options suffer relative to other investment options.
3. Taxes. The proceeds for the exercise of options are taxed as regular income, including social security and medicare. If you are still working and the deadline for exercising is far away, it may be wise to hold in hopes of being in a lower tax bracket by the time you need to exercise and it is hard to justify triggering these high taxes any earlier than necessary. But, if you are retired and approaching the deadline, holding them exposes any future increase to regular tax rates and SS and Medicare, as opposed to alternative deployment of the capital. Other alternatives, such as index funds, expose any future increase only to much lower capital gains or dividend rates and allows you to time even this taxation to your best advantage over many years. And, it avoids the SS and Medicare taxes altogether on future gains. But, that must be balanced against the tax hit today.
So, where does all this leave you? With a jigsaw puzzle!! Generally, if you can see yourself with a lower tax rate prior to exercise deadlines and the value/volatility is not too high, it probably makes sense to delay exercise. If, however, the additional risk is an issue, and your tax rates are more or less steady through the period before your deadline, you may want to exercise early to minimize taxes on future gains. Even if your rates are otherwise steady, you'll need to evaluate the amount to exercise each year to avoid pushing yourself into a higher bracket by virtue of the exercise. My answer to this is to use a copy of TaxCut software to run a plethora of cases. This exercise may surprise you, as it did me, prompting me to sell more early on than previously planned. With all the complexities it is almost impossible to arrive at the best option without using tax software, although the ultimate answer almost always depends on your conviction about the prospects for the stock. If you're sure the price of the stock will move firmly upward, you can laugh all the way to the bank while holding the options as long as possible. Just keep in mind that this is a two-edged sword. You could be crying all the way to the poorhouse if the stock drops.
Saturday, June 16, 2007
Last week, I was visiting my parents and my brother. The topic of insulation came up and we realized that both homes have minimum insulation in several areas. I volunteered to do an analysis of the cost/savings potential in adding some insulation.
For example, both homes are built in pier and beam style and have no insulation under the floor. Granted, ambient temperatures are moderated by the shade and air contact with the ground. But even after adjusting for this, the investment potential for adding insulation is outstanding.
One exposed area is approximately 1500 sq ft. I estimate this can be insulated with 6" of fiberglass at a cost of about $900. Meanwhile, I calculated the energy savings at over $500 per year. This is an annualized return of over 50% per year, essentially risk free. Compare that to the 5% they are getting on CDs these days! In fact, I challenge anyone to come up with an investment with this return and so little risk.
But wait, I can hear the protests...I don't have that kind of money laying around!! In that case the deal is even better. If you finance the $900 for 10 years at 10%, your monthly payment would be about $12/month. Since your average savings on utilities is about $43/month, you would end up with $31 in your pocket every month with no outlay. In less than 4 years you can pay off the note, have $900 in your account and still have the insulation, where it will save you $43/month for as long as you live in the house! You just can't beat that for an investment.
Friday, June 1, 2007
Personal finance is not brain surgery. And, you can be virtually certain of beating the market with as little as a couple of hours of preparation and setup and 15 minutes per month for maintenance. If you don't know how, spend half of your preparation time reading some of my previous articles on dollar cost averaging, diversification and rebalancing.
Admittedly, you'll beat the market averages by only 1-4%, while you could dream of wildly outperforming the market. But a small margin of outperformance will work miracles over the long term when combined with the power of compounding. If you can consistently outperform the markets by 2.5% over 40 years, your nest egg will be over 60% larger than it would have been just matching the markets.
And, using a financial advisor does not guarantee outsized returns. In fact, if he tries to justify his fees by trying to chase trends, or by using more sophisticated investments and frequent trading, I believe the likelihood of outperforming the markets is decreased. But, if you can outperform the markets, why couldn't the advisor do the same? He could, if he used the same methods! But, then his fees would eat up half the outperformance. And, why exactly would you pay him to do what you could easily do yourself with minimal effort?
Of course, there is the chance the advisor could be brilliant and dramatically outperform, but the chances of this are small. It amounts to whether you want to go to Vegas to seek your fortune or would prefer the near certain path to financial security. To me, the latter sounds more appealing. Perhaps this example sounds extreme, but I have heard numerous horror stories from colleagues about the results they obtained with their financial advisor. Remarkably, some of them still used the same advisor, or switched to a different one for similar service!! I can only conclude that gambling is indeed an addiction!
Of course, there are times when expert advice is needed, such as estate planning or second opinions on your strategies, and I've used advisors in these cases. But, I'd rather pay a few hundred dollars for the specific advice I rarely need than to pay a substantial percentage or fixed fee on a regular basis.
Thursday, May 17, 2007
I thought this an interesting question, and I've spent some time thinking about it since. Generally, I believe trying to time the market is a big reason why most investors underperform the market averages, a prospect that seems counter intuitive. As a result, I usually think of market timing as a bad idea.
And yet, I enjoy reading the news and trying to anticipate what it may mean for the markets, the economy and society as a whole. And that often results in a desire to act on these thoughts to tweak my portfolio.
If you don't enjoy the kind of rumination described above, don't worry. I sincerely believe that the systems I've outlined in my previous posts on managing your portfolio through allocation, rebalancing and dollar-cost-averaging-on-steroids will help you outperform the markets while spending no more than a few minutes per month, or even a few minutes per year, thinking about your financial assets. In that case, there is no need to read further. The systems I have outlined are a kind of autopilot for market timing, when you think about it.
But, if you like to study the news and anticipate what it may mean in the future, it is possible to improve the performance of your portfolio without substantially increasing your risk (or perhaps even decreasing your risk). Before you consider doing so, however, I'd recommend you consider setting some ground rules.
Following are my ground rules:
- Stay true to the spirit of your allocation. Allocation is your main tool for managing risk in your portfolio, so you should avoid the temptation to stray substantially from it, thereby increasing your risk. My decision to have a reduced exposure to bonds could lead to substantial risks if it meant I invested more in stock, but I believe cash, in the form of money market funds or short term CDs, are a reasonable proxy.
- Tweak in ways that are contrarian, rather than following the crowd. I have less bonds because the market seems to have priced in significant decreases in interest rates. Many of the experts seem to be saying the same thing. I disagree, therefore I see reducing my bond holding in favor of CDs being a contrarian move that fits better with my expectations. I've had above average exposure to energy for the same reason over the past few years...the oil and gas companies seem to be priced based on $30-40 oil, and most people seem to think prices are unreasonably high, but I believe prices will remain reasonably close to where they are. (See my Energy Guru blog at www.energy-guru.blogspot.com for more on my logic in this area.) Let me just reemphasize my warning here-Do not listen to the news and decide to tweak your portfolio in a direction recommended by all the experts. If everyone seems to agree on a direction it is probably dangerous to move in that direction...the end is likely near for that run. The tendency to follow this path is the main reason market timing often leads to underperformance.
- Tweak for personal reasons. If you notice everyone you know is suddenly using a new product by a company you never heard of, it might be worth checking into. I'm familiar with the oil and chemical industries, so maybe I understand the business a little better than most. In the past few years, I've been moving toward dividend paying blue chips. The decreased risk and low-tax income meets my personal needs. At the time, this was also contrarian, since blue chips seemed to be out of favor. Interesting that blue chips seem to be popular these days, with the Dow hitting new highs almost every day. And the Yahoo Financial poll results today indicate that 65% think the Dow will be higher at the end of the year vs 24% who expect it to be lower. Hmm, I'll have to think about that!
- Tweak only at the margins. A few percent here, a few percent there can give you the satisfaction of acting on (and perhaps benefiting from) your beliefs without betting the farm or putting your financial independence at risk.
- Act only on a strong conviction that goes against the conventional wisdom. Perhaps you see this in the examples I've mentioned. Don't act based on a few articles, or the conviction of an expert.
So, there you have the Personal Finance Guru rules for market timing. Maintain your allocation, think contrarian, think personal, work at the margins, act on strong convictions. Using these rules, I believe you can do a bit of market timing or use your judgement to personalize your portfolio without much risk, and possibly to improve your returns.
Monday, May 7, 2007
First, the summary.:
- Boomers have had a significant effect on markets of all types and it is reasonable to expect that to continue as the bulge makes its way through retirement. This may well include underperformance by the stock market and other investments, but it seems likely to tighten the US labor market and present greater opportunities for those in it.
- Markets rise and fall, and it is reasonable to expect that to continue. Included in this assessment are markets of all kinds, from stocks and bonds to real estate and commodities. Booms and crashes alike are regularly fueled by imbalances. The only questions are severity, duration, timing, rotation and what we should do about them.
- Leverage can increase returns, but it also increases risk. In boom times it can create outstanding performance. In crashes it can be disastrous.
I know most of the above is pretty obvious, but it is amazing how often these facts and their results are ignored or obscured by those selling various schemes. For more details than shown in the summary above, please check out my previous post and comments. More important than understanding the above facts is understanding what you should and should not do about them. That is where I really want to take the discussion.
It is very tempting to conclude, based on the above, that the way to invest is to ride each boom to its crest and them jump to the next booming market, repeating this process as markets rotate. And, in fact, if you could do this consistently it would be the route to quick riches. Unfortunately, this process looks simple in hindsight, but is virtually impossible to maintain in real time. There are a number of reasons for this, but I think the key reason is that it is very difficult emotionally to jump ship as a market is hitting new highs, or to climb on as a market is near a bottom. It is human nature to believe that recent history will be repeated. If a market is up dramatically this year, it is almost impossible to believe it will reverse tomorrow. If a market is down dramatically it is almost impossible to find the courage to buy. Worse, most of the experts will reinforce this natural inclination. When markets are cresting, most of the media coverage will be euphoric, when markets are down the media will be negative.
I mention above that getting into booming markets early is easy in hindsight, and most sales pitches take advantage of this phenomenan. They look back in history, see what is obvious from this vantage point and paint a picture of what was possible based on this "obvious" insight. Then, they convince you they have the insight to repeat the process. After many years of observation, it has become obvious to me that they rarely, if ever, do. Trying to find the gold in this haystack is like going to the casino...you might get lucky now and then, but over time you will almost certainly lose.
So, what can you do to take advantage of the obvious facts? There are some proven tactics, which, while they won't make you rich quickly, will help you perform better than most, and will help you become financially independent over your life time. Here's what you need to know to get there.
- Smile and take with a grain of salt what you see in the media and from get-rich-quick artists about the best investment today.
- Use leverage only rarely and cautiously...it puts you into the casino realm. You want to be in the long term financial success realm.
- Invest broadly in an asset allocation that reflects your timing and risk tolerance. In light of the baby boom phenomenan, I believe more than ever, this includes significant international exposure
- Add to your investments and rebalance regularly. In so doing, you will, in affect jump from the crests to the bottoms. But, again, in a way that keeps you out of the casino realm and on the track to long term success. This method allows you to take advantage of the above facts, while reducing risk. And, it satisfies the emotional need to do something in the time of booms or busts, while taking the emotion and the need for brilliant decisions out of the jumping process.
Based on my experience, the simple steps above are what is necessary to profit from the booms and busts that are surely coming. If you need help with the details of how you go about executing these steps, you'll find it in my previous posts, or you can post a comment or question. The expertise is out there reading and ready. I'm also open to alternative approaches. Let the discussion begin!
Friday, April 20, 2007
It has an intriguing premise. Like any intriguing premise, it starts with some well known facts and builds on these facts with a reasonable theory. For those who may not have read the book, the basics are:
- Due to changes in law and economic forces, there has been a shift from Defined Benefit retirement funding toward Defined Contribution funding.
- Most employees are ill equipped to manage their investments as required for the Defined Contribution system.
- Baby Boomers will be moving en mass into retirement in the next few years.
- The resulting drawdown of Defined Contribution accounts, largely in the form of selling mutual funds, will cause a major market crash within the next 10 years.
- Only financial education and building your own financial ark based on this education can save you from catastrophe.
If true, the financial basics I've previously laid out in this blog would lead to your personal financial disaster. Specifically, saving, investing in mutual funds, and diversification are painted as unsophisticated financially, and are branded as routes to that financial disaster. Although the author carefully avoids making specific recommendations other than "financial education", his solutions appear to revolve primarily around entrenuership and real estate which result in positive cash flow.
With so much at stake, it makes sense to give some serious thought to these issues. Based on that, let me throw some rambling thoughts at it and seek your imput and ideas on the matter.
At first glance, it makes sense. Boomers have had a big influence on megatrends from the beginning of the boom. Doesn't it make sense they will do the same for retirement? Doesn't it make sense that the impending boomer retirement will cause a sea change in investment cash flows? Certainly, on some level it does.
The question though, is how significant the change will be and what are the alternatives for minimizing the risk or benefiting from the change?
For my money, I'm betting that the sea change will be small compared to the noise in the markets resulting from other events, and here are some of the reasons:
- Boomers will not all suddenly decide to retire. The process will span over 20 years, and perhaps more if a market decline does occur within the next 10 years.
- Retiring boomers will not suddenly cash in their chips at retirement. Since most can expect to live 20-40 years after retirement, they must plan for 40 years with fairly conservation assumptions. That means that, in all likelihood, they will continue adding to their investments for many years beyond retirement, taking only a part of the return for living expenses.
- Due to the necessity of conservative assumptions, most boomers will end up leaving a significant amount of their retirement funding to their kids, who will add to it for their own retirement, 20-40 years away.
- Globalization will mitigate the effect of the boomers, since world population continues to increase at a dramatic rate and most companies and markets are now global entities.
Don't get me wrong. Ups and downs as well as rotation in the markets are inevitable, but these are based on a multitude of different factors and create noise much larger than any overall boomer effect. Even though the boomer effect may be significant in some segments, such as health care (up) or real estate (down), I believe the overall effect on world markets will be marginal, rather than catastrophic.
But maybe there is a better way. What about the author's suggestions? He seems to imply that real estate will always go up. Certainly not true in the short term, but perhaps it is a reasonable assumption for the longer term. He implies this is not true for the stock market, but aren't the same assumptions reasonable there? Stock market ups and downs are more visible, because of more efficient markets, but doesn't the same logic apply to each? And if the stock market crashes, is it reasonable to assume the real estate market or small companies will be immune to the effect? I don't think so.
The author makes the reasonable assertion that positive cash flow is the key to wealth. But he seems to imply that stocks have no cash flow. What about dividends? He seems to imply that for real estate and entreprueners, the positive cash flow is a given, and is locked in at purchase. Who does he believe will be paying the rents or buying the entrepruener's products when the boomers are devastated in the crash? He seems to imply that leverage makes real estate a good investment. This is quite true as long as the market goes up, but it dramatically increases the risk when the market goes down or the renters can't afford the rent any more.
I don't mean to degrade entreprenuership or real estate. They can be good investments in the right conditions. But I don't see them being immune to risks, or to any boomer effect.
My conclusion is that market ups and downs will happen in all markets. The key is to ride through while minimizing risk and positioning yourself to gain from the volatility. I do agree that financial education is advantageous. If you can effectively evaluate investments, that is a huge advantage. But financial wisdom starts with saving, diversification, and maximizing return while limiting risk. I believe the systems I've outlined in previous posts is the best way to get there.
Tuesday, April 17, 2007
Since governments have assumed/established their power to tax you however they see fit, it is tempting to take a fatalistic attitude and just accept what seems to be the inevitable. Before you throw in the towel, there may be a few things you can do, and this may be the time to think about them and put some new strategies in place.
Let's take the property appraisal first. Since, in most cases, property tax rates are based on a percentage of the appraised value, or some related figure, the property value directly affects your taxes. Amazingly, the taxing authority probably provides you the tools to challenge the appraisal, and reduce your taxes. Your appraisal form will probably help you identify where you can go to do just that, but these days the starting point is usually a web site maintained by the taxing authority. There you can compare how your appraisal (and taxes) matches up with your neighbors. You also can likely see the prices of recent home sales in your area. Compare prices per square foot, age, amenities and condition of the homes. There is a good chance that you can make a case that your appraisal is too high. Sources I have seen indicate that as many as 80% of homeowners who challenge their appraisals win some relief. You can do this in one of 3 ways.
- Call up the tax appraisal office and discuss. I've had considerable success in agreeing on a lower appraisal using this method. The tax appraisal office seems like a huge, faceless, bureacracy, but once you are talking to an individual you may find they are very understanding, and even willing to help.
- File a formal protest and set up a meeting to protest or challenge the evaluation. There is usually a deadline for protests, so now is the time to act. Prepare for the meeting and go ready to make your case.
- Call in a professional. If you don't feel comfortable making the case, or if you just don't have the time, you can get a professional to do it for you. There is a cottage industry of professionals who do this full time. They will know the people, understand the system and have both an understanding of the strategies and experience in negotiation. And, best of all, they usually work on a contingency basis. That means that if they are unsuccessful, it costs you nothing. If they reduce your taxes, you pay them a percentage of the reduction. This alone tells you that a high percentage of protests are successful.
Whichever way you go about it, there is likely to be both a short term and a longer term benefit. If you get a reduction in the evaluation, that is money in the bank at the end of the year. And, since appraisals are often handled as percentage increases from previous appraisals, your taxes for years to come are likely to be lowered.
With that savings under your belt, take a good look at your Form 1040. Were your itemized deductions higher than the standard deduction by the full amount of your mortgage interest and property taxes? Probably not, and, if not, you have some room for tax savings. Your deductions are being offset by the standard deduction, meaning your interest and property taxes are not effectively fully benefiting you. You many not ever be able to make them fully work for you, but you can likely increase the benefit (therefore reducing your taxes) by a couple of different strategies.
- First, consider paying your house payment the last day of the year rather than the first day of next year. By doing this, you squeeze 13 months of interest into the year. This will speed up the deduction to this year, and if you take the standard deduction or are very close, it may not effect your taxes next year. Just alternate each year paying on the last day one year and the first day the next. You'll get the benefit of your deduction every other year, maximizing your standard deduction in the alternate years.
- Second, consider when you pay your property taxes. Assuming you pay them directly, you can apply the same bunching into alternative years as above. If you don't pay your taxes directly, try to set them up that way. By collecting for these taxes on a monthly basis in an escrow account, your mortgage company is getting a free loan from you, since they collect the taxes each month and don't pay them out until the following year. In fact, they probably have significant carryover from year to year, all interest free. They'll be reluctant to eliminate this profit center for obvious reasons-they make money on it, and they reduce the risk that you won't pay the taxes and lead to foreclosure. But, if you've paid regularly, demonstated fiscal discipline and have a significant equity in the house, they probably will allow you to pay taxes directly. In some states, laws require them to allow you to pay the taxes directly under certain circumstances. When you are buying, insist on this arrangement. I haven't allowed my mortgage company to collect the taxes in an escrow account on any of the houses I've owned over the past 20 years. Just make sure you put the money aside each month in some solid investment, so the money is available to pay the taxes at the end of the year.
So there you are. With a few simple strategies, you can cut back on your cost of feeding the government machine. Yes, death and taxes are inevitable, but in the case of taxes, at least, you can negotiate a reduction.
Wednesday, April 11, 2007
In general, calculators are like the proverbial black box. You answer a few simple questions, the calculator performs a few calculations not understood by you and spits out an answer. Unfortunately there are a few problems with this approach.
First, is the garbage in/garbage out phenomenan. The answers to the simple questions have a big impact on the outcome. If they are garbage, or even sometimes slightly wrong, the answer is garbage. Often, default answers are provided. Unfortunately, these answers may or may not be applicable to your situation. Even if you provide your own answers, they may well reflect only your best guess rather than the actual facts.
Second, the black box may well have all sorts of assumptions hidden inside, which may, or may not, reflect reality. And these assumptions can have a significant, but not understood, impact on the answer.
Let me take a few examples I have experienced.
Recently, I was considering whether to execute some incentive stock options and happened upon a calculator designed to help decide whether to execute or keep these options. I dutifully answered questions about what I would expect to earn on proceeds from the options and how much appreciation I expected on the underlying stock. Since anything I put would be a guess, I entered the same figure for each. Magically, out pops tables and charts showing clearly that I would be better off to not execute the options. It all looked very ironclad. But ultimately, I realized that with this was very questionable, and given this set of assumptions the answer was obvious, despite all kinds of assumptions about tax rates, etc. Since options are leveraged, any positive appreciation equal to normal investment expectations would favor the leveraged investment. However, after looking at several different sets of assumptions, I realized that the options were much more risky that the other potential investments. And, since I was within one year of option expiration, I didn't have time to ride out any short term setbacks. I decided to execute the options.
In another case, I was within a year of early retirement when I saw a calculator to determine what I needed to do to retire. I entered assumptions about how much I planned to spend annually in retirement, what rate of return I expected, my planned retirement date. The calculator returned with notice that I needed to save $100,000 annually to be able to retire on that date, which of course was not in the cards. My dream was shattered... but wait, if I lowered my spending expectations by 1%, magically I could retire immediately. Or, if I increased my assumed return by 0.1%, I could retire. The answer was right according to my assumptions, but minor changes made a huge difference in the outcome.
So, what should you do? If you want to take advantage of the calculator, make sure you take a number of steps to understand better the outccome you receive. First, take the output of online calculators with a grain of salt. Second, try to understand what assumptions may be built into the model, and whether they are appropriate. Then, run a number of different assumptions that cover the entire range of possibility so you have an idea of the sensitivity of the model to the assumptions you make. Be even more careful if the calculator is designed by someone trying to sell you something. It almost certainly has hidden assumptions that tilt the answer toward their product.
My personal preference is to do my own calculations. Generally, the calculations in the calculator are easy to model in a spreadsheet and can be set up within a few minutes. I set up the assumptions in a table and write formulas with use the cells in those tables. By doing this, you will have a good understanding of the assumptions that are the basis for the answer you are getting and can easily change the numbers in your assumption table to run sensitivities. This approach may take a few minutes longer than plugging guesses into a calculator, but you'll have a more better understanding of the complexities in arriving at an appropriate answer to your questions, and much better chance of arriving at the correct answer.
Friday, April 6, 2007
One of the things I love is gardening. There is just something about watching your food grow, cutting out all the fuel and environmental costs associated with transport and bringing things down to a personal level and providing groceries with taste that cannot be bought at a grocery store. Growing shade, to increase your comfort and keep down your utility costs(see article on my Energy Guru blog) . Adding beauty, to increase your enjoyment of life and increase the value of your property. Gardening/Landscaping can be a substantial source of wealth, both in money terms and in terms of priceless luxuries.
As I've mentioned, gardening can be a good way of cutting your cost of groceries, trees and shrubs can be a good way of cutting your utility bills. But, gardening and landscaping can be expensive. To help offset this possibility, consider using native plants that will do well in your area without a lot of chemicals, fertilizers and watering. Using these will substantially reduce your cost and frustration.
Also, take note of plants free for the taking along roadsides, empty fields, etc. I've taken the opportunity in the past to use cuttings or saplings growing wild in the vacant lot next door or along the roadside. My son-in-law (Ryan) is creating a great landscape in his yard using bay, myrtle, oak and magnolia from a vacant lot and roadsides nearby, as well as cast offs from friends.
So, try this wealth building home run. Less cost for groceries, less cost for utilities, more value for your house, beauty and taste that are priceless. It is not often you get to touch all 4 bases with a single swing in your own backyard.
The key to understanding why this it the case is to understand how the market works. Stock recommendations generally take one of two forms; Either
1. The growth philosophy. This stock has huge growth potential, earnings are predicted to go up dramatically, it has a large moat, etc...
2. The value philosophy. This stock is cheap, it has been beaten down, it has prospects for a turnaround, etc...
The problem with both philosophies is that the details are already known. The information was already public record. The talking head has told everyone that is listening of this info. It is priced into the price of the stock. The story sounds good, it probably even is right, but all that and much more is already reflected in the price of the stock.
Colleagues regularly come to me indicating they have bought, or are thinking of buying, a stock. When I ask why, they quote details that everyone knows...earnings are growing 20% per year, it is leading its field, they just read a positive story about its prospects, etc. I tell them that, while the stock may be a good investment, to beat the market you have to understand or perceive something that others do not. If you are buying something based on well known public information, the best you can hope for is to match the market because that information is priced in to the point of making it an average investment. While it is possible to do better or worse than average on any particular stock, the chances of regularly being right in perceiving something others do not, are pretty low.
So, at best, buying based on well known public information is a recipe for average performance. Unfortunately, there is a likely worse case...If the stock price is being forced up because many are buying the stock based on the talking heads recommendation, the likely returns are being forced down. In this case, to get ahead you have to be going against the crowd, a process known as contrarian investing...ie, buying based on a perception about the stock that others do not have. After years of trying, I gave up trying to beat the market on this basis. After long observation I also gave up on trying to anticipate in advance which advisor might be able to do it. And, though many haven't yet realized it, this is the reason that 80% of investors underperform the averages, a prospect that seems contradictory. Hopefully the above helps you understand how something so contradictory can be true.
But, here is the good news. By taking advantage of this understanding and taking the emotion out of the equation by using some mechanical tools, you can easily beat the market averages. The tools? Index funds, dollar cost averaging, rebalancing and my own version of this process, "Dollar Cost Averaging on Steroids". For more details, see previous posts on this blog.
Sunday, April 1, 2007
So, let’s take a look at some of the problems specific to managing your portfolio and cash flow in retirement and then talk about some of the strategies for safe, tax efficient ways of managing the issues.
First, dollar cost averaging. If you’ve read my previous posts, you know that dollar cost averaging is a very powerful tool when you are accumulating your nest egg over the long term. But in retirement, when you are withdrawing, rather than accumulating, dollar cost averaging is reversed and it can work against you. If you are selling assets to raise a specific amount of cash flow each month or each year, you are effectively selling more when the market is low and less when it is high. So, in retirement, you have to either avoid dollar cost averaging or put in place different strategies to avoid the problems with it.
Second, cash. While you are working you need a relatively small amount of cash. A few months living expenses will be enough to get you through most emergencies without too much damage, and other than that, you want to keep most of your money working harder in more profitable assets, such as stocks and bonds. In retirement, your need for cash from your assets is ongoing, so you will need a larger volume of cash. Generally, I think it makes sense to keep 3-5 years worth of living expenses in cash or short term investments. This larger cash fund helps you avoid the negative effects of dollar cost averaging, allowing you to avoid selling securities when the market is down.
Third, taxes. Generally, when you withdraw money from your 401-k or traditional IRA, the withdrawals are taxed at your normal rate. When you sell assets from your after tax accounts, in most cases taxes will be at reduced capital gains rates. The funds you withdraw from cash accounts will be nearly tax free. Generally, from Roth accounts withdrawals are tax free. Prior to retirement, you aren’t bothered with any of these problems because you are rarely making withdrawals. Hopefully you’ve done some tax planning related to this issue, but in retirement, a strategy for tax efficient withdrawal must be optimized based on your situation and may need to be updated regularly.
Fourth, making it last. This is one area where there is some reliable advice out there. It is pretty clear and well documented that retirement rates of 4-5% are the maximum unless you retire later than most. If you go much above that, you are substantially increasing your chance of outliving your money. I, in fact, like to be even more conservative and keep my withdrawals below 4%.
Other than the withdrawal rate, I am astonished to find little good advice for addressing these problems in personal finance articles, hence this post. Let’s take a look at some strategies for addressing these issues.
To avoid problems with dollar cost averaging, the key is to avoid selling when the market is low. There are a couple of good strategies for doing this, both involving keeping increased cash. One often recommended strategy is to build a “CD Ladder”. This involves setting up CDs so you have a long term (up to 5 years) CD maturing each year. This allows you to have the cash you need available each year, but still get the higher rates which are normal for longer maturities. I believe this is a reasonable strategy, although right now long term CDs have little rate advantage, and short term accounts have reasonable yields of around 2-3% above inflation. For this reason I’m keeping most of my cash in shorter term accounts right now.
One of the problems, though, with the CD ladder is that you still need to have approximately the same cash (plus inflation) each year to replenish the ladder. And if you need to sell assets to replenish when the market is down, you still can have dollar cost averaging working against you.
Another strategy, if you have substantial dividends and interest to fund your spending and feel confident these will continue consistently, you can increase your dependence on this asset.
Another strategy is to sell when the market is high, and buy when it is low, keeping a percentage of the cash to fund your cash flow. Not so easy to do, you may say, and this is true. However, if you use the “Dollar cost averaging on steroids” strategy I wrote about in a previous post, you can put this process on auto pilot. I won’t go into the details of that strategy again, but it can effectively supply cash flow from your tax deferred account if you reduce your expected return by your expected withdrawal rate, thereby raising cash over time while still profiting from the market's volatility with a dollar cost averaging process.
And, that brings us to taxes. This can be a complex subject, and I’ll warn that I am not a tax expert. Yet, I have to develop a strategy for tax efficiency to effectively manage my retirement portfolio and have managed little help from the pros in this area. They can give advice about the tax effects of each asset, but apparently most are not trained to optimize the overall tax efficiency.
So, let me talk about the strategies I use, and open it up for discussion. First of all, I do keep a significant amount (3-5 years cash flow) of cash. This gives me the flexibility to ride out long down markets and to operate my “Dollar cost averaging on steroids” strategy. It also allows me to optimize my tax situation by using the cash to avoid high tax events.
Second, I fund my cash flow, as much as possible from sources on which I have a tax burden regardless of whether I use the funds or reinvest. That means I exercise incentive options (and use the proceeds for my cash flow needs) spread over the time period when they must be exercised (and taxed). It means I take my dividends, interest and capital gains distributions to fund my cash flow, since they are taxable, whether I use them or reinvest. For now, I’m not tapping my tax deferred accounts, since I have adequate funding without it and I don’t want to start the high tax withdrawals. Later, when the options have all expired, or when the other sources run low I will begin making withdrawals from the tax deferred accounts. At some point prior to reaching 72 years old, I will probably begin making withdrawals from the tax deferred accounts when I am in a relatively low tax bracket rather than being forced to take larger minimum withdrawals later. Also, in years when I’m in a relatively low tax bracket I’ll look for opportunities to roll some tax deferred accounts into Roth accounts in small increments that do not pump up my tax rate. This will allow me (and possibly my heirs) to avoid tax on the income completely and to withdraw it as needed to optimize my tax situation.
Finally, I have both company stock and after tax funds in my 401-k. When I need income that will not be taxed, and consequently raise my tax rate, I will withdraw the after tax funds. Also, at some point when I may be within a year or so of needing funds, and before I roll over into an IRA, I will take the stock out of the account and keep it for one year, converting appreciation on the gains to a long term capital gains rate.
So, there’s my strategy. I believe this will do a reasonable job of maintaining tax efficiency in my withdrawals. I know I’ve left out a lot of detail, but hopefully this will get you to a position to more effectively develop your options in the absence of much other concerted advice. Get tax advice to make sure you are not making any serious mistakes, but I think it makes sense for you to develop your strategy and get it reviewed before you plunge in.
As I mentioned, I’m open to other ideas. If you have different strategies that have worked for you, please let me know. With all the boomers getting ready to retire, I think it is time for a more robust body of knowledge in this area, and I’m hoping I can help provide/provoke it.
Monday, March 26, 2007
Let's take that most popular of deductions, the mortgage interest deduction. Personal finance columns routinely recommend not paying off your mortgage, because the interest is tax deductible. But, unless you have a very large mortgage, large charitable deductions or astronomical medical or miscelaneous deductions, your mortgage interest is probably not really deductible. It disappears because the standard deduction is larger than your itemized deductions. Even if you itemize, it is likely that most of the interest is not reducing your taxes, since you are only slightly over the standard.
I'd guess the mortgage deduction applies to only a small percentage of filers, and only marginally to many of them. But, this is just the tip of the iceberg. Medical expenses are deductible, right? Only to the extent they exceed 7.5% of your income(read very rarely). Miscellaneous deductions, such as professional fees, are deductible only to the extent they exceed 2% of your income. IRA contributions are deductible, right? Only to the extent your income is below certain limits. The same goes for tuition payments. The list goes on and on, with deductions being ruled out by income limits or minimums. I haven't been able to take any of these deductions for 25+ years, and yet they remain out there, tantalizing promises unfulfilled.
Then, of course, there is the Alternative Minimum Tax (AMT). Enacted to keep the rich from escaping taxes by using tax deductions, it was not indexed. It also was not included in the Bush tax cuts. As a result, it is beginning to significantly affect the middle class by eliminating their deductions. Your contributions are deductible, right? Maybe not, with AMT. You itemize, so your mortgage interest is deductible, right? Maybe not, with AMT. Your outrageous state taxes are deductible, right? Maybe not, with AMT. Even non taxable income, such as municipal bond interest, can become taxable with AMT.
I won't go more into AMT, since there are many articles out there that address the issues in detail. Just be aware that what appears on the surface to be positive because of the tax implications, may not be, these days. It pays to take a look below the surface of your tax return and analyze them, to see how it could effect your financial decisions this year. You may be surprised that the smart tax move turns out to be an illusion, leading to less than optimal decisions.
Friday, March 23, 2007
- Those who are well on their way to financial independence and are looking for one more lever, and
- Those who are struggling to get to the starting line.
This post is for those in the second category. If you just can't seem to get ahead enough to scrape together a few dollars to make a start toward financial independence, you need to look at the little habits that keep your spending above your income.
For this post, let's talk about saving money on your utilities. Many of you know that I also publish the Energy Guru blog (see link at right). There you'll find energy advice and investments which can easily earn triple digit returns from perfectly safe outlays funded by your pocket change. But, even more compelling are returns which require no investment beyond minor changes to the way you do things around the house. Here is a good starting list.
- Put an extra blanket (or two) on the bed in winter, and cut them to a minimum in the summer. Few actions save money on your utilities like turning down your thermostat in winter and up in summer. And I've found each extra blanket means I sleep very cozily at a thermostat setting approximately 3 degrees lower.
- In winter, get used to wearing a sweater, sweatshirt or vest around the house, with warm socks and houseshoes. In summer, it's shorts, t-shirt and no shoes or socks. Again, these habits will automatically move your thermostat in the right direction.
- When you leave the house, turn off the a/c or heat. For today's families that are out of the house most of the time, this significantly lowers the average utiity bill and most systems are designed to recover quickly, so when you return they will quickly return the house to your comfort range in all but the most extreme weather. And, when you return, don't set the thermostat above the comfort range. This will not get the system to return to the comfort range sooner, but it will eat up your savings from turning the system off while you were gone.
- While we are talking about thermostats, make sure the thermostat on your water heater is at the lowest setting that provides an adequate supply of hot water. Doing so not only decreases your utility cost, it is safer. Having a higher setting is doing nothing but forcing many of your hard earned dollars through the insulation of your hot water heater and plumbing.
- Pay attention to your window coverings. Assuming your house is reasonably designed and efficient, most of your utility dollar is escaping through your windows. But, make a habit of closing them when the sun is shining in during the summer and opening them when it is shining in during the winter. And, make a habit of closing them at night. With attention to these small habits you can change your windows, potentially a big dollar waster, into an asset.
- Make sure your electronics (TV, VCR, DVD, Stereo, Computer, Printer, Battery chargers, Cable boxes, etc.) are really off when you are not using them. These devices are using an increasing share or your utilities and most of them use power even when they are turned off. Studies have shown that 15-30 of energy usage of these devices is when the units are turned off. Make a habit of unplugging them when not in use, or plug them into power strips with a switch you can shut off.
- When cooking and you notice something is almost done, go ahead and turn the oven/stove off. This will have little effect on the cooking, but will save energy. This also helps assure you will not forget and leave them on for hours after the meal is done.
- Get in the habit of regularly cleaning your filters and coils on your heating and A/C system and refrigerator/freezers. The build up of gunk on the filters and coils, both inside and outside, can substantially reduce the efficiency of this equipment.
I could go on and on, and you probably could as well, but these are the biggies. The exact savings are hard to quantify and depend on each situation, but I think I am safe in saying these habits will save the average household hundreds of dollars per year. This is the seed money you need to get on the starting line to financial independence.
Tuesday, March 20, 2007
Practicing my methods in a taxable account, particularly if done on a relatively short term basis (say, once per month), would mean several sales for each fund which would have to be accounted for at tax time. Assuming you have several different funds, this could well mean 50 or more transactions for which you would have to calculate a basis vs sales price and apply capital gains rates. And, if you are not careful, some of this could be short term gains, with relatively high tax rates. You could also run afoul of wash sale rules. Having said that, however, if you are willing to carefully plan and execute your trades and keep detailed records and do the math at tax time, working this system in a taxable account could actually be advantageous over a tax deferred account.
The reason for this is that the gains in your tax deferred account will eventually be taxed at your relatively high regular tax rate, when withdrawn. This is true, even if the gains were long term gains which would have been subject to much lower rates if they were in a taxable account. But, in a taxable account, if you are willing to plan, execute, record and calculate carefully, you can probably limit yourself mostly, if not entirely, to long term capital gains rates, which are probably about half your normal tax rates.
This is where it gets complicated. In order to accomplish the above goal, you would have to:
- Keep precise records of every purchase and sale, including dividend reinvestments.
- Order execution of all sales by specifying sale of specific shares purchased at specific dates at specific prices, rather than a general sale for which you would have to use the average purchase price of all shares as the basis. By doing this, you could make sure all gains were long term, and greatly limit any gains in a specific year by selling shares bought at the highest price first.
As you mentioned, you would want to avoid sales which would push you into a higher tax bracket, but long term capital gains rate scales are fairly broad, so it would be unusual to be at the precise point where you would be pushed into a higher bracket.
So, I believe, if you were willing to do the work it is possible you could work the system very effectively in a taxable account. This would be particularly true for someone who is near retirement and will be in a high tax bracket in retirement. For each particular case you would have to run the case of the years of time value of money vs any differences in tax rates today vs those you expect in retirement. I don't do it, because I don't enjoy accounting that much and because most of my assets are in retirement accounts anyway. Plus, I don't have a great deal of confidence in my ability to predict what my tax rates will be in 20 or 30 years. For me, it is better to minimize my taxes today, save all that work and hope that things work out down the road.
Friday, March 16, 2007
Way back in high school, one of my teachers gave the class some savy advice... it is always better to get money sooner and pay it out later. He went on to describe the time value of money and the power of compounding. I don't know how many other students remember that advice, but I've taken it to heart and it has helped me get to financial independence. Over the years, I've discovered that this is free money, done right. I know, FREE MONEY is advertised so frequently today it is almost a flag that says they are trying to rip you off. And yet, there is a way to create free money... Pay as late as possible, without incurring fees and interest, of course.
That gets us back to your tax refund, and several other areas where you may be giving away free money. In getting a tax refund, you are getting back money you paid almost a year sooner than you needed to. You gave your rich uncle a free loan. Resolve to turn the tables on Uncle Sam this year by demanding that he give you a free loan. All you need to do is analyze your tax situation and adjust your W-4 so that next April 15th you'll owe something close to 10% of your annual taxes. Take that extra money every paycheck and put it into your emergency fund, which is presumably earning 5-6% interest. That interest on the difference between your refund and what you would owe is free money.
Amazingly, there are many ways to accomplish similar feats. I've mentioned that I charge essentially everything to my credit cards so I can pay it later and keep my money working as long as possible. I even try to arrange to make big charges the day after the statement closes so I can extend the period before I have to pay it for another 30 days. Need new tires on the car? Wait until the day after the credit card statement closes and you've created free money.
I arrange to delay payment on bills until just before they are due. I use the internet for most payments and transactions and this makes it very easy. When you get the bill, just schedule your payment for a few days before it's due and keep your money in an internet bank or money market account, rather than paying the bill as soon as you get it or whenever it rises to the top of the pile.
I know some who transfer balances to new credit cards with teaser, no interest on transfers. This is another way to create free money. Just make sure you read the fine print. There are numerous articles out there on the fine print, what they mean and how to stay out of trouble with these deals, so I'll leave it that.
Whatever you do, with all these strategies, make sure you are not incurring interest or fees. These will quickly eat up your free money if you are not careful. And, put the money away, don't spend it just because you have it. This is your first step to financial freedom, don't spend it on an upgrade for your daily latte.
Wednesday, March 14, 2007
Let's take a simple example. Say you have $2000 and want to allocate it 50% to bonds and 50% to stocks. Using index funds, you buy 100 shares of each at $10/share. Now, apply a long term average return. I use 0.7% per month, or about 8.5% per year. That means, on average, you would expect after one month each fund would appreciate 0.7% to $10.07share. But because of volatility ( and assuming they are completely correlated) in the market the price goes to $9/share after one month. You would purchase the difference for each fund, buying 11.19 shares at $9/share. You now own 111.19 shares(100+11.19) of each fund. Now, assume after another month the share prices return to $10/share. Each fund would now be worth $1111.90 (111.19 x 10), but you would have invested only $1100.7 in each, and the market is exactly where it was when you started. Voila, you make about 1% in a flat market by taking advantage of the volatility. Since you make this in 2 months, your annualized return in this flat market is over 6%. And, it works the same way for upside volatility.
Let's take an example for the upside. Assume the same starting point, but then assume after the first month the market is up 10% . You would sell the difference between your assumed value($1007) and the actual value($1100), ie 8.45 shares at $11/share. You now have 91.55 shares. Again, assume the price goes back to $10/share after the second month. You now have $915.5 and have invested only $907 . Again, a return of almost 1% in a flat market. And , this is with perfectly correlated investments, which would eliminate the advantage for normal rebalancing. To the extent markets are not correlated, the returns would improve, as with the usual rebalancing methods.
This will always improve your returns if the market is up less than your money market rate, as well as when the market is up more than the money market, assuming there is significant volatility. The only conditions in which your returns will be less than the market are when the market goes up steeply with little volatility. I have been using this method for over ten years and tracking the results. Only 2 of those years have I underperformed the average of the markets I'm in, and on average I've beat the market averages by 1-2% per year.
Now about the spreadsheet. My spreadsheet is fairly complex, as I've added features over the years to allow me to track the performance of each fund, the average of all funds and my actual results, both numerically and graphically. All the above seems a little complicated, but with a spreadsheet it is easy. All you need to do is start with your allocations across the top row and write a formula on the row below which multiplies the balance above by (1 + your long term assumed return) for the period. For the example above, that would be 1.007. Now, on the next sheet, enter your actual values each period. On a third sheet, write a formula which calculates the difference between the two. This is the amount you would buy and sell each period. Then, all you have to do each period is enter the actual values of each fund and buy or sell the amounts automatically calculated on the third sheet.
I should mention that I do this in my 401K, so there are no tax implications. And, I use no load index funds, so there are no transaction costs.
Monday, March 12, 2007
Most investors do not like volatility, since, by traditional measures, it increases risks. And, if you get whipsawed by trying to react to each up and down, or worse, begin listening to the experts about which way the market may be headed next, it will hurt your financial performance.
Handled properly, though, volatility can be your friend. In fact, my system for managing my investments depends on it to outperform the averages. If you've read my previous posts, you'll know that I advocate a fixed allocation, broad diversification and dollar cost averaging. If you follow the advice in those posts, you'll have gone some distance toward taking advantage of volatility.
However, this system depends to a large extent on the idea that various stocks, various industries, various markets are uncorrelated. While there is some truth to this, the fact is that there is a significant amount of correlation between all these areas, particularly in the short term. After studying the amount of volatility which is typical and observing the correlation that is also typical, I concluded that a twist on my philosophy could enhance my returns, which I believe has contributed to my outperforming the markets.
Here is the way it works. After I set up my allocation, I assume that each asset will perform in line with the historical average for investments. Then, when I make my regular adjustments, instead of the classic rebalancing, I buy or sell each asset up to the assumed value. To make this possible, I start with a significant amount of cash (above my emergency fund) in a money market account. With this approach, I keep my target allocation (except for the cash, which becomes the reservoir for this process), but can take advantage of volatility even when there is a significant amount of correlation between the assets. Of course, I use a spreadsheet to make these adjustments and because of this, the whole adjustment process takes about 15 minutes per month. Essentially, this process puts dollar cost averaging on steroids. Of course, the cash can be a drag on performance in times of low volatility, but in times of higher volatility it more than makes up for it in increased dollar cost averaging benefits. Either way it decreases the volatility of your overall portfolio.
As I mentioned, this has worked for me, but I'd certainly be interested in any comments on this approach.
Wednesday, March 7, 2007
Unfortunately, there are several problems with having large amounts of cash.
- Readily available cash can burn a hole in your pocket. If readily available cash tempts you to spend, put it somewhere it is a bit less available. This is one of the reasons to keep a minimum amount in your checking account.
- Risk averse, short term investments generally have low returns. This is particularly true of the checking account, another reason to minimize the balance in your checking account. I generally keep a small balance in my checking account, charge nearly everything to my credit cards and transfer the needed funds to pay the credit card each month just in time to pay the bill. This allows me to keep maximum balances in higher yielding accounts. There are a couple of caveats to this method: 1. If the use of credit cards increases your spending, don't use this method. 2. Do not maintain balances so low that you incurr overdraft and other expenses. These expenses can easily eat up the increased returns. On the other hand, getting maximum return from every dollar is a key to making forward financial progress.
Fortunately, improved competition and availability make it easier than ever to improve returns on your short term investments. Here are some vehicles I have used recently for this purpose:
- Internet banks such as Ing Direct and Countrywide have made it possible to easily access the best possible rates. These accounts can be easily set up in a few minutes on the internet and make it easy with a few keystrokes to move money to a better return or to your checking account when needed. These banks offer FDIC, so they are some of the safest investments around.
- Money market accounts through a brokerage, mutual fund company or Paypal are also easily available via the internet. Although not FDIC insured, these are generally safe investments. The return changes on a daily basis, but right now they have some of the best rates for immediately available cash. This is particularly true of Paypal, where I have much of my cash right now, although you'll want to check regularly to see what rates are available. The best rates seem to rotate between various companies. If you are considering either opening an account at either an internet bank or a money market account ask your friends whether they have an account. They often have bonuses for referring new customers that can improve overall returns for moving your money.
- Because of the increased competition, local banks are also forced to increase their returns to attract deposits. Frequently, I see high teaser rates from local banks. Just keep in mind that they offer the teaser rates to bring in customers, hoping to lower the rate later, so if you go this route make sure you keep on top of the rates and terms being offered. These banks are also less convenient for me, but if you are willing to spend the time to shop and patronize the local banks you may be able to improve your return.
- If you can get by with less availability for some of your funds and are worried about inflation you may want to consider the US Government, in the form of I Savings Bonds. These offer a combined rate made up of inflation plus an incremental rate, meaning you'll always earn a return above inflation, which is not always possible in other short term investments. They require a minimum term and you will lose 3 months interest if redeemed within 5 years, but again, they are easily accessible via the internet. These are obligations of the US government and are therefore about as safe as you can get. Taxation of interest is deferred until withdrawal as well, which makes them ideal for those in high tax brackets nearing retirement.
The list could go on and on, but you get the idea. To ease the pain of keeping a significant amount of cash available, use all your resources and keep watch. Remember, each dollar your investments earn is a dollar you don't have to earn somewhere else and then it begins to compound.
Your example uses just two stocks vs one, so imagine how significant the decrease in risk if you consider thousands of stocks from different industries with different market caps and from different international economies. And, this extreme diversity is easy and cheap with todays index funds. This is why I indicated I'm comfortable with a higher percentage stocks in my portfolio than conventional wisdom allows.
I'm struggling with one point you make, which is that your average return is only slightly decreased. From what I know, I think there is no decline in average return unless you can predict which stocks will have higher average returns in the future. With the efficiency of markets today, I'm not sure that is possible to do consistently.
I'll point out another thing to worry about, though. Your example talks about two negatively correlated stocks, and the case is clear for that example. Unfortunately, I have found that most stocks worldwide have a significant degree of correlation, which is the basis for my trading in international stocks. I've discussed this with many readers, although I have yet to post a blog on this topic. And, the real trick to understanding the decrease in risk is predicting the amount of correlation of your assets. The big worry is underestimating the risk by underestimating the correlation.