Friday, April 20, 2007

Is a stock market crash coming?

I just finished the book, Rick Dad's Prophecy. I know, I know, it has been around for a few years, but what can I say? I'm behind on my reading.

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

Homeowners-Tax Minimization 101

Every year about this time, if you own your home, a couple of things happen that reiterate the fact that you are working a good part of the year supporting your government. First, you've completed and sent off your federal and state tax return, possibly with big checks, despite the fact that you hardly recognize your paycheck after the government has taken their share each week. Second, you receive your property tax appraisal. It, of course, indicates your home value has increased, meaning you'll owe even more property tax next year. This, despite the fact that your property value may have gone down in the past year after the housing bubble burst.

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

Don't Fool Yourself with Online Calculators

The proliferation of online calculators has been amazing. It is easy to find numerous calculators on line to help you with almost any question. They are useful in that they generate simple answers to complex questions, and yet that same characteristic means you should use them very carefully.

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

Gardening/Landscaping can build wealth

Lots of personal finance gurus spend their time hunkered down over their computer, studying investments and tools. I have to admit to some of that myself. But there is room for another life. In fact, some times the best way to accomplish your goals is to do what you love.

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.

Ignore most of what you read...Buying Stocks to Beat the Market is tough

As do most personal finance bloggers, I enjoy reading the financial news and stock recommendations. There is something exciting about believing you might read something that will add to your personal wealth. But, ultimately, the key to success in investing is to ignore most of what you see on financial news networks, newsletters, magazines, etc. Ironically, beating the averages is easy using some basic tools I'll give you.

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, 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

Managing Your Cash Flow during Retirement

Personal finance articles about good (and some not so good) ways of building your retirement portfolio are ubiquitous. A number of good strategies are well documented and, taken together, they create a nearly a foolproof roadmap to building that retirement next egg. For examples, see some of my previous articles. Unfortunately, I’ve found few good articles on managing your funds to provide the cash flow you need in retirement. Even worse, some of the best tools that work for you in building your nest egg can begin to work against you in retirement if you are not careful.

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.