Wednesday, February 21, 2007

Good debt, Bad debt?

Is debt bad or good? I'm not sure that debt is either bad or good, it is how we manage it that determines whether it has a positive or negative effect on our financial health.

For instance, I mentioned in a previous post that I routinely charge nearly everything I buy to a credit card. If I have rebate cards and pay off the balance on time each month, it has a positive effect on my finances. If I were to miss the payment dates or decide to carry a balance, the costs would quickly eat up the benefits.

The addictive type of spending/debt I mentioned in the previous post certainly is a mistake. It can make it nearly impossible to realize our financial goals, and it can put tremendous stress on us personally as making financial progress becomes more and more difficult.

On the other hand, in certain circumstances, debt can have a positive effect. Borrowing to finance an investment that makes money is one way to make debt work for you. For instance, if you borrow to buy a property which has a positive cash flow the result can be very handsome profits. Keep in mind, though, that this enhanced profit is a result of the leverage resulting from the debt and the leverage works both ways. The same leverage that produces handsome profits can result in devastating losses if your assumptions turn out to be wrong.

Let's take an example. Say you buy a rental house and put $5,ooo down and get a mortgage for $95,000. Assume the value of the house goes up 5% per year and the house rents for $1000/month and your mortgage, taxes, insurance and other expenses come to $800/month. You are making $5000/year in appreciation plus $2400/year in cashflow. That amounts to nearly 150% profit per year on your original investment. In this case, debt is very positive. With these assumptions you can't afford not to buy the house and incurr the debt, right?

But wait, what happens if some of your assumptions are wrong? Let's say the housing market takes a tumble of 10% per year for 2 years. You discover the foundation needs $10,000 in repairs and a hail storm does $5000 damage to your roof. Your deductible is $1000, so you dodge a bullet on the storm, right? But now your insurance goes up $100/month. The tenants move out and it takes 3 months to rent it again at $800/month. The realty company charges a month's rent. After 2 years you realize this house is not the profit machine you had envisioned, so you sell, incurring 10% selling cost. Let's see, that's $21,000 in depreciation, $2,400 in negative month-to-month cash flow, $2,400 lost revenue during the vacancy and over $18,000 in additional expenses. Your $5000 investment has generated about $40,000 in losses over 2 years, or NEGATIVE 400% annual return.

Sounds like an extreme example, right? It is, yet each assumed event can happen. Believe me, they have all happened to me! Again, my point is that debt creates leverage which can work both for or against you and therefore creates additional risk. The two cases above would still generate positive and negative returns respectively without the borrowing, but the debt multiplies the effect. If you had bought the above property with cash, your investment would have yielded about a 9% annual return in the first case and a negative 10% return in the second case. The debt just leveraged both the profit and the risk.

When evaluating an investment, it is always worthwhile to evaluate the investment both with and without the debt. Evaluate with both the best and the worst assumptions. Then you are able to see both the benefits and the risk of the debt.

But, what about other kinds of debt? My rule of thumb is that debt is positive if the after tax interest rate is less than what I could obtain on a similar investment. If you have no investments, it probably means you cannot afford the debt. The result of these two rules is that debt should rarely be used. And then only after careful consideration of both the benefits and the risks using very conservative assumptions.

As an aside, one of the most frequently asked questions is whether it is better to keep your mortgage or pay it off. Since mortgages have one of the lowest after tax interest rates, it may be possible to beat the rate with other investments, depending on your risk profile. When you are young, you can afford more risk in your investments, so a mortgage probably is a good thing. For older folks, a lower risk profile may be in order, meaning it makes sense to pay it off. Either way, make sure you can afford it under conservative assumptions before you take it on.

Tuesday, February 20, 2007

What about debt?

The overwhelming response to my blogs about investment and retirement planning is “How can I even think about investing and planning for retirement when I am in debt up to my ears?” This highlights one of the major hurdles most people have on their way to financial security, so let’s explore the issue a bit further.

Debt can be both addicting and suffocating. At first, it seems harmless enough… I want something and by incurring a bit of debt I can have it sooner. But, if I didn’t have enough cash to buy what I want today, the cost of the debt means I’ll have even less chance of having what I want tomorrow, unless I increase my debt again. This can easily become a vicious cycle, similar to an addiction. And in the end, it suffocates you financially.

Don’t get me wrong. I love debt. I charge virtually everything to my credit cards. I get significant rebates from the issuers and I get to keep my money invested longer. I just make sure my spending is such that I can pay it when the bill comes at the end of the month. Voila, interest free money and rebates to boot.

But the issurers know that most people will charge more than they can afford and will then be forced to pay their astronomical interest rates, drawing them further into the web. Don’t allow it to happen. If you can’t keep your spending to what you can pay off each month, cut the credit cards up and pay them off pronto. I know that is tough, but like drug addiction, the best way is to quit cold turkey. Resolve to buy absolutely nothing but necessities until the debt is gone, and don’t fall off the wagon again. You can do it if you make that commitment. Otherwise you’ll be permanently in pain and will find it difficult to meet your financial goals.

As I mentioned, the cost of consumer and credit card debt is high. This begs the question…Should I stop contributing to my retirement accounts until I’ve paid off the consumer debt?

While I know there is room for argument, my answer is that you should continue to fund your retirement while you pay off the debt. You are likely in debt because of a lack of discipline and funding a retirement account on a regular basis is a good way to establish that discipline. Automatic contributions establish the discipline needed and the tax deferred or tax-free nature of the vehicle makes it profitable. If your employer matches your contributions, so much the better. You need to establish that you can live below your means after meeting your long term obligations. Take the challenge, you’ll be surprised at how little you can really live on, and you’ll gain some confidence that will serve you well.

Wednesday, February 14, 2007

Picking Investments and Understanding your risk profile

So, how should you pick investments and how much risk should you take? The question came in an email from my son, who is in his senior year enroute to an economics degree. Seems a bit presumptious for a plugger like myself to answer a question from someone studying economics, but perhaps experience counts for something. The question refers specifically to picking stocks and bonds.

First, let me say I practically never pick stocks and bonds. I used to do that 30 years ago, and I enjoyed the challenge. I loved the thrill of occasionally beating the averages, but I also got experience with underperfoming the market, and over several years I noticed that, on average, I underperformed the market by about 2 percent. I listened to others talk about their big winners, but when I dug a little deeper I found losers that largely offset the gains. I read the bold advertising of professionals who had beat the average over this and that period, but I noted the research that says 80% of both professional managers and individuals underperform the averages in the long term. Of course, costs were higher back then, with only a choice of full service brokerages, but the statistics still paint much the same picture. I soon realized that picking stocks, even with a professional manager/advisor was a bit like going to Vegas. You might hit big, but over the long run you almost certainly will lose a percentage of what you play, at least on a relative basis versus the averages.

Fortunately, the market is not like Vegas in its average returns. It almost always wins over the long term. So, if you can match or slightly beat the averages over the long term you can accomplish your goals, rather than gamble with them. And there is an almost surefire way to do that with index funds. And, the really good news is that with index funds you can largely negate one of the cardinal rules of investing...that a probability of high returns can only be accomplished with higher risk. I'll talk more about that later.

So, let's talk about index funds. These are funds designed to replicate the performance of their target index. Costs are one of the few things you can control in investing, and no-load index funds have extremely low costs, particularly those from Fidelity and Vanguard.

How do you pick the index funds? First, make sure you are picking from no-load, low cost index funds. The best cost nothing to buy and have an expense ratio on the order of 0.1% per year. Then decide on your allocation. This will depend on your risk tolerance, which I will discuss later, but I believe everyone should have all of the following types of funds:
  1. International
  2. Small Cap Domestic
  3. Mid Cap Domestic
  4. Large Cap Domestic
  5. Long Term Bonds
  6. Short Term Bonds, money market or cash

These can be sliced and diced more finely with value vs growth, sectors, etc., but generally I've found the above will give sufficient diversification. Then simply pick the index funds representing each class from your fund family and invest the proper percent in each. The percentage allocated to each class is known as your allocation.

What should your allocation be? This is where risk enters the picture. I have listed the above classes with the generally accepted highest risk investments at the top and the lowest at the bottom. Just allocate according to your risk tolerance.

So, how do you determine your risk tolerance? To some extent this is a personal decision. It is easy to think you have a high risk tolerance when you are not under pressure, but how will you react if things start going bad. Often, folks see their risk tolerance quite differently when they are under pressure and begin making changes in the time of stress. This approach will yield disastrous results. Make sure you are comfortable with your level of risk and stick with the allocation based on that.

Even so, there are some guidelines. Generally the risk you take should be proportional to your time horizon. If you'll need the money in a year or two, you should keep it in low risk investments. If you won't need it for 30 years or more you should take more risk. Almost everyone should have 3-6 months living expenses in short term investments, since the emergency could well arrive tomorrow. And a typical rule is that the percent invested in stocks for retirement purposes should be equal to 100 less your age, although with the system discussed in my previous post, I feel comfortable with a larger proportion in stocks.

The discussion could go on and on, but with these guidelines, you should be able to set an allocation with which you are comfortable and find the funds to satisfy that allocation, but before you do, let me discuss the relationship of diversification, dollar cost averaging and rebalancing on risk and return.

With a well diversified portfolio, risks are greatly reduced because the up and down cycles of each individual class move largely independently of each other. That means that the risk of the portfolio is much less that the risk of each individual class. Dollar cost averaging and frequent rebalancing also reduce the risk. And the beauty of it is that these measures do not reduce the return as might normally be expected by the risk/return relationship. In fact, my experience indicates that the dollar cost averaging and rebalancing increase returns over the average performance of the funds allocated by as much as 1-2% per year. This may not sound like much, but over 30-40 years this can result in a nest egg 50-100% larger than average, due to the power of compounding.

So there you have it. Assess your risk tolerance. Determine your allocation. Buy index funds regularly in accordance with your allocation to dollar cost average. Rebalance regularly. Enjoy superior returns with less risk. Throw in a little real estate (your home) for additional diversification and you are on your way to financial independence.

If you really enjoy the thrill of investing directly in stocks, set aside a small amount for that purpose, but invest for your future with the discipline outlined above and below in the previous post.

Wednesday, February 7, 2007

Getting to retirement

Having made it to a happy retirement, I think I may have some insight which will help others get there. Even during my working days, colleagues frequently asked me about investments and other personal finance issues and I enjoyed the discussions. So, I embark on a blog to help those who are interested in planning for retirement, but don't feel comfortable that they have a clear roadmap

So, how do you get to retirement? By maxing out your retirement accounts and managing them well, of course. Ok, ok, I know that seems a bit simplistic, but in reality it is not much more complex than that. Here's the roadmap.

Step 1: Start early. I know when you are young, finances are tight and it seems that the contributions you can make are so small they are insignificant when compared to the retirement goal and the goal seems so far away. Even so, it is important that you begin as early as possible. The dollars you contribute at that stage are much bigger than those you'll contribute later, due to the power of compounding. In addition, it is important that you establish the behavior of regularly contributing before other spending starts to shrink your disposable income. It is true that spending tends to expand to match your income, so paying yourself first, early and often works to your advantage on both the saving and spending side.

Step 2: Keep your hands off the retirement accounts. It is easy to see the retirement accounts as money you can use for other purposes, but tapping them establishes them as a crutch that keeps you from living within your means and therefore cripples your retirement efforts down the road. I know there are circumstances dire enough that you have no choice, but tapping the retirement accounts should be an absolute last resort.

Step 3: Minimize your debt. Debt is another crutch that can contribute to crippling your retirement plan. Debt can easily become addicting and both eliminate your ability to contribute toward your retirement and increase your cash requirements in retirement. If you don't have the cash to buy something after your retirement contributions and other operating expenses, put off the purchase until you do have the cash.

Step 4: Manage your accounts. Here are the critical points in this process.
  • Keep costs low. For me, that means investing in index funds. I know, some will insist that costs are not significant if the investment performs better than average. True, but numerous studies have shown the odds of picking the high performers ahead of time is low. Don't be fooled by those who think they can and attempt to prove it by pointing to investments in the past. It is easy looking backward, but very few can do it consistently looking forward over a long period of time. You can't afford to take that chance. Take the safe road of low cost.
  • Diversify. Various types of investments perform quite differently over time, and it is tempting to try to jump with precise timing into the next high performing group. Don't try it. Again, the ability to make these timed moves such that you improve your returns is extremely rare. Allocate your investments so you are always invested in a diverse portfolio. As a minimum, spread them over domestic stocks (both growth and value), international stocks and bonds.
  • Dollar cost average and regularly rebalance. By regularly contributing to your account and setting them up to invest in diversified investments you put the power of dollar cost averaging to work for you. Ie, each time you contribute you buy more shares of investments at lower than average cost and less of those that are higher than average. Then regularly rebalance to your allocation plan. Voila, you are automatically buying low and selling high, on average. The classic buy low, sell high mantra is correct, but do it mechanically with dollar cost averaging and rebalancing. Trying to do it from the gut, or even with other valuation tools leaves too much room for error and emotion. Because of that, most people that try to buy low and sell high on these basis ending up hurting the performance of their portfolio. It is too easy to get wrapped up in the frenzy and end up doing what everyone else is doing, with disastrous results.

Step 5. Relax. If you follow the steps above throughout your working life, you'll almost certainly retire a millionaire. It is really pretty simple and satisfying.

So, there you have it. Start early. Keep your hands off your retirement accounts. Minimize debt. Manage your accounts by keeping costs low, diversifying, dollar cost averaging and regularly rebalancing. Relax. How could it be simpler!