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.
Monday, March 5, 2007
Invariably, at times like this, my colleagues come by to visit, because they know I enjoy tinkering in the market. The conversation invariably goes something like this:
Them: How 'bout this market?
Me: Wow, a bit scary isn't it?
Them: Yeah, so what are you doing, selling?
Me: Oh, I'm just working my system of diversification, dollar cost averaging, and rebalancing, which at times like this mean I'm generally buying.
Them: So, you are optimistic? You're pretty sure that the market has bottomed?
Me: Well, I'm optimistic in the long term, but who knows if the market is near the bottom? I'm just trying to keep the emotion out of it and working my system.
Them: Well, I'm thinking of selling until I'm surer what the market is going to do.
Me: If you do that, I predict you'll start buying just when the market hits the next peak.
Them: Oh, no, I'll reinvest when I'm sure the market is on an upward trend.
Me: Right, I think that is what I just said.
It is amazing how consistently this conversation plays out with each market dip. And each time, I become more convinced that it requires a disciplined, mechanical system to me a successful invester. Trying to predict where the market is going over the short term is impossible and is a recipe for underperforming the market.
So, remember. Set up a diverse allocation that makes sense for you in the long term. Dollar cost average. Rebalance. Above all, don't try to change your system in times of stress. Particularly so, if all the "experts" are telling you it is clear where the market is headed tomorrow or next week. When all the experts are in agreement, they almost invariably are wrong.