Personal Finance Guru

Retirement Economics

2009-06-23T14:40:00.005-04:00

I recently received this question from a friend who is nearing retirement... How do you decide how much you are able to spend each year? A set percentage of your assets or a fixed amount? Retiement economics are very different than when you are working. Much more difficult.

After a few years in retirement in the recent environment, this question/comment rings more true than I realized at the time I left the work force, and is particularly timely with the bulk of baby boomers approaching retirement. So, I thought I might share my response.

You are right that retirement economics are considerably more complicated than when you are working.

When you are working you have a good handle on your income. You can just decide how much you want to save/invest and budget to spend the rest. When the market is up, your net worth seems to almost effortlessly skyrocket. If the market is down you still feel good, because you are buying at lower prices. And, worse come to worse, you always have your steady income coming in.

At the outset, retirement didn't seem so much different. I just budgeted 4% of my net worth. That is in line with most experts advice for long term maintenance of your portfolio and keeping up with inflation. Fortunately, my wants are modest and I generally came in well under my budget. Meanwhile, the markets were rising and my net worth was still growing significantly. I also determined to keep at least 3-5 years of spending money in liquid, low risk investments so I wouldn't have to sell assets in down markets. Things were good. So good, that I began to think of early 2008 as a down market. So, I didn't sell assets when I bought a new car, went on a luxury cruise and made gifts to the kids. Besides, returns on things like CDs were relatively low, so I didn't want to keep too many assets there. Meanwhile. I was able to live on less than capital distributions and dividends from my after tax account and stock options looked like money in the bank. I began to wonder if I'd ever even need to tap my retirement accounts.

Then things got a bit more complicated. The market was down more, I invested the surplus cash in my system (read about the system I use, call Dollar Cost Averaging on Steroids in previous posts) and my liquid assets had shrunk to less than 3 years spending. While I was still spending well under 4% of my assets per year, the capital gains distributions disappeared and the options became worthless. So, my disposable income went to near zero. I could always sell assets, but who wants to do that with the market at these levels. Besides, the return on liquid assets, which previously seemed marginal fell to 1-2%, and in some accounts where I'd prefer to keep the money, less than 1%.

I decided to invest a bit more in high dividend stocks, like BP, GE and Dow. Unfortunately, these stocks dropped by 50-75% before Dow and GE slashed their dividends. So far, BP is the best of the lot, and it is down 50% from a year ago. That makes the dividends look puny, and they don't feel much like the safe investments I envisioned. Fortunately, I held on and GE and Dow are up 100-200% from their lows, but they still are well below where I bought them.

And, even though my original assumptions still looked workable at current market levels, I began to worry that the markets might continue the freefall and I might have to replenish my cash by selling at asset levels I'd never dreamed of. Fortunately, I held on and ended up nearly 100% invested at the market lows, so the bounce has improved my outlook considerably and I've raised some cash. Still, the ridiculously low returns on liquid investments irks me, but the experience has driven me to conclude that I need to be just a bit more conservative. So, the problem now is where to put that cash. So far the answer has been oil and gas protected by covered options (see the link to my Energy Guru blog at right for details). I do worry that that is not as safe as it seems, despite the fact that it has worked great so far. I have considered selling options on the Dow and GE, and perhaps even the S&P 500 to make my investments more conservative, but so far I've not done it.

I did make some opportunistic investments in CDs of failing banks last fall which have a 5% return, but they expire in a few months and the best I can do to replace them with truly safe money is the 1.5% at Orange savings. Even my I savings bonds have a zero return now because of the negative inflation last year. And all this in the face of what I expect to be rising inflation in the next few years.

Bonds have been the traditional conservative investment, but I have little confidence it that route for now. For one thing, I think the current artificially low interest rates will really hurt bonds when it is unwound over the next few years. Bonds would also be badly hurt by high inflation that seems likely just over the horizon. Put all that on top of the fact that bond funds are the widely available and accepted substitute for bonds these days, and I see a disaster in the making for bond fund holders. This alternative is nothing like the old days of buying a bond and holding it to maturity in a stable market that made the reputation of bonds as a good route to conservative investment. I might add some inflation adjusted bonds when that becomes available in the 401-k in August, but otherwise I can't see adding to my 15% allocation to bond funds.

Some suggest gold as an alternative, but I'm not much of a fan of gold. To the extent I feel hard assets are justified I prefer something utilitarian rather that symbolic. So, oil, gas and land have filled that bill for me. That has worked pretty well, acting as a source of more reliable income and uncorrelated diversification. And you can always use them to match/generate your most basic needs like energy, shelter, food and water. Even so, these, like gold and other commodities, are subject to the same uncertainty as other market based products, meaning they are far from safe.

Of course, my system, Dollar Cost Averaging on Steriods, does provide quite a bit of protection. It reduces volatility and increases returns over even the tradional dollar cost averaging and diverse allocation methods. In addition to my 3-5 years basic reserve, it has me in an additional 10% cash now. The problem is that in the most severe down markets I tend to run out of cash to utilize too soon, losing its conservative effect in the most severe downturns. So, I've promised myself to be more conservative and disciplined in reinvesting that cash. I've lowered my target return to 3-4% over the past year, which keeps more cash in the account. I had planned to do that all along when I retired, but had not done it since I was not drawing cash from retirement accounts.

Yes, more difficult indeed. Partial solutions, perhaps, but, the hunt for conservative alternatives goes on. So, I'm open to suggestions for more conservative investments which offer at least a decent return that matches inflation and taxes. But, whatever you do, realize than some rethinking of your financial approach is worthwhile as you enter retirement.

System Outperforms the Market

2009-01-01T20:23:00.004-05:00

Well, the New Year's party is over. Time to plug some numbers into the spreadsheet and see how my 401-k performed this year. I admit to some trepidation...the market has been so wild this year, the carnage so widespread, is it possible my system failed me this time?

I guess it was inevitable... I'm down big time this year. But, with the help of the year end rally, the news is not as bad as it felt. For those who are not familiar with this blog, I use a system I call "Dollar Cost Averaging on Steroids" to manage my 401-k. (You can read about in in earlier posts if interested). The claim I've been making is that it virtually guarantees "beating the market."

The bottom line...I beat the weighted average of the markets I invested in for the 9th straight year. For 2008, I'm down 25.1%, while the weighted average of the markets was down 28.3%, consistent with the results from previous years, when I've beat the market by 2-4% per year.

Okay, so a loss of more than 25% is not exactly what you hope for each year. But, the 2-4% per year outperformance over the long term is huge, more than doubling your nest egg over your career, and redoubling it during a typical retirement. That's enough to make difference between happy early retirement and slogging away for extra years and worrying about running out of money.

Hank, Here's an Idea

2008-12-18T17:54:00.004-05:00

Dear Hank and Ben,

Since you are determined to pump liquidity into the economy, why not do it in a way that would guarantee a nice profit for the taxpayer? Is there some rule that says the taxpayer always must get hosed? If not, I'd like to propose the following outstanding investment that I believe will meet all your goals, while enriching the taxpayer.

You may have been too busy to notice, and if so, you may want to call the Secretary of Energy and ask him to do some checking. But, the energy market is so chaotic these days that it has created a unique opportunity for the federal government (as well as a small group of investors).
I know this seems too good to be true, but give me just a few seconds.

The crude price today closed below $38 per barrel. Meanwhile, the February Futures contract for the same oil is about $46 per barrel. That means if you buy oil today you can store it and sell Feb futures and guarantee a 20% return in 2 months, less expenses. That is an annualized return on your money of over 100%.

You may be wondering-if this is such a good deal why isn't everyone doing it? Good question, and according to a recent article in the Wall Street Journal, some are. The article mentions that BP and other oil companies are storing crude in tankers to take advantage of this golden opportunity. But, here's the kicker...the Federal Government is in a unique position to work this deal, as a result of available capacity in the strategic reserve. This storage option is uniquely large and low cost, and the government has the people and infrastructure in place to activate the plan. Invest a billion dollars and get $1.2 billion back in two months. I know the government can just print money, but this is almost as good, and it is a real money maker in contrast to the printing presses with their risk of unintended consequences. Just to review, here is what you can accomplish with a pen stroke:

Inject liquidity in the market
Guarantee a great return for the taxpayer
Stabilize the commodity markets, which I believe are a big part of the overall instability in the economy.

For my readers, I'm sorry it would be difficult for you too capitalize directly on this idea. But, if it makes sense to you, you may want to forward it to someone in Washington.

Regards,

Energy Guru/Personal Finance Guru

Hoping for a Bottom

2008-11-23T18:41:00.003-05:00

I got my wish. The market has now dropped so far that I’ve had the opportunity to get all the cash from my retirement plan into the market. As you may know, I was lamenting last fall that my “Dollar Cost Averaging on Steroids” system had me sitting on a huge pile of cash after a long bull run with few interruptions. So, I was wishing for some market volatility that would allow me to invest the cash at lower levels. As of last week, it was all in the market.

I should have recognized that time as one of those “Be careful what you wish for” moments. I have to admit I underestimated how painful that might be. Now, I’m wishing for a bottom. Emotionally, that feels pretty awful, but from a logical standpoint the chances seem pretty good to me. Most major bear markets have ended with long term average P/E ratios of around 10. Currently, I believe we are about 10-11. Not that this was a factor in my decisions, of course…my system works on autopilot. But, now it can’t operate effectively until we at least get some significant bounces.

While I would like to have some more cash to invest at these levels, most of what I see on financial shows is about where you can “hide” from the market. So, while I pray for a bottom, I think that discussion is worth some ether ink.

I have to admit it sounds comforting at one level, but I have a hard time believing the best thing to do is hide from a market that is on sale at it’s best valuation in 30 years. The last time valuations were this low was in the 1970’s. Of course, most profess to be ready to get back in once the bottom is comfirmed. When it will come, I’ll admit don’t know, but I heard a commentator on PBS a couple of days ago expressing things pretty much as I see them. His comment was something along the lines of “We’ll only know we have a bottom about 6-8 weeks after the fact when prices are up 30-40%.”

Be that as it may, the vehicle many are choosing as their hiding spot, US Treasuries, seems a questionable choice to me. Granted, according to conventional wisdom, these are the safest bet you can make. But, 3 month treasury bills are yielding well under 1%, and 5 year bonds are yielding only about 3%. This is because of the huge buying related to the flight to safety, but, to me, this only makes sense if you expect massive deflation accompanied by much lower interest rates. While I expect some deflation as a result of the big decrease in energy and other commodity prices, I expect this will be relatively short term. Over the longer term, I worry the massive borrowing governments are doing will lead to inflation. In fact, aside from the immediate borrowing binge, I believe the only way government can get out of the massive federal debt is to inflate their way out. And those in treasuries would be murdered by inflation. No, treasuries don’t sound so safe to me.

An alternative might be US I Savings Bonds. They yield only about 1% over inflation, but at least you are protected from inflation and don’t have to worry about rising interest rates. Unfortunately, the rules prohibit you from parking large sums there. Inflation adjusted treasuries are unlimited, and might seem a good substitute, but these would still be hurt badly by increasing interest rates.

Federally insured short term (up to 1 year) CDs seem like a better choice. They are yielding several times as much as treasuries of similar duration, and for my money are just as safe. You would do well during any deflation and you can be pretty sure you will get your money back with interest. And you can always roll them over at higher rates if interest rates go up over the longer term.

Of course, most who are hiding their money want to be able to jump back into the market at a moments notice once they have confirmed the bottom (Note that, according to the theory stated above, that might be 30-40% above the bottom!). For this purpose, money market funds would appear to be hard to beat. Yields are not as good as CDs but generally are better than short term treasuries, and they will go up rather than down in case of inflation. In the case of deflation they probably would not do as well as CDs or treasuries, but I don’t think they would do too badly. Now, with the extending of FDIC insurance to many of these accounts, they again appear to be very safe.

As for the ultimate in hiding your money, I guess you could consider your mattress… or gold. But neither of those seem too comfortable to me. If you are that worried, buy land. You can't eat cash or gold, but you can always raise your food if you have some land. Though I still don’t expect to really need it, I’ll admit I have my farm, bought and paid for several years ago.

Crossroads of Depression and Free Enterprise

2008-09-25T19:06:00.002-04:00

I'd like to hear, dear readers, your opinion of the current markets and the apparently imminent bailout. I'll admit I'm on the horns of a dilemma.

Philosophically, I'll almost always come out on the side of free markets and reduced control and spending by the government. Besides, I can't escape the feeling that things are not as bad as they are painted. I believe that prices have been driven down to an extreme, such that once the fear recedes, issues would be priced considerably higher and a good, free market bounce could occur. After all, mortgages are going for $.20 on the dollar, and I can’t believe that many mortgages will foreclose, not to mention that the residual value of properties that do foreclose should be at least 70-80 % of the mortgage value.

On the other hand, I'm not really familiar first hand with the conditions in the money market. Those who are and have the economics background to interpret what they see, for the most part, say the markets are grinding to a halt. And, at a certain point, fear begets fear, driving irrational markets to even more irrational pricing and spilling over into seemingly unrelated areas. I'm reminded of my Dad's summary of the Great Depression..."Most people had no money, and those that did were afraid to spend or invest for fear things could get worse. So, everything just ground to a halt." That sounds eerily familiar these days, although obviously that attitude is mostly on Wall Street so far, and the general economy is nowhere near those conditions. But, following the fear begets fear rationale and the tendency to spill over, it is possible to see that shaping up. And, that fear spiral is difficult for any company or individual to reverse. Perhaps that is a role of government.

Meanwhile, I can't escape the conclusion that government regulation has contributed to the situation with the "mark to market" regulations, and government encouragement of questionable borrowing. And if I’m right that the market has been driven far below rational pricing, could it be that government could not only reverse the market psychology but make a substantial profit in the deal? Ok, given usual government performance, that seems too good to be true! Even so, I’m convinced that anything that can reverse the market psychology could return us to a positive future path rather quickly and possibly avert a rather dismal period.

So, this is your chance...What say ye?

Recent Market Chaos was Predictable

2008-09-22T12:50:00.003-04:00

The past few weeks got me thinking about some previous posts concerning the implications of debt and leverage. In particular, the following excerpt from a post in Feb 2007 has been screaming in the back of my mind:

"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."

The column went on to give a real estate example that illustrated the issue and some advice on how to avoid problems. At the time, the advice seemed almost archaic. Today it seems a bit more prescient, although I'll admit I was thinking on a personal scale rather than the macro scale so obviously applicable today. Even so, for those who are struggling to understand the markets today or a related pressure cooker, a review of those Feb 2007 posts might be worthwhile.

If you are considering debt, give the following some consideration:

What is the worst that can happen?
Can I afford the debt if the worst case develops?
Are the benefits worth the risk?

If the risks are seriously evaluated and considered, most debt will not be undertaken.

If you are already in the pressure cooker:

Accept the reality of your situation. Denial is generally the biggest barrier to recovery.
Sell off assets to reduce debt.
Reduce living costs to that required to clear debt in a reasonable time frame.
For details and support, I'd recommend some time spent listening to Dave Ramsey on TV or radio.

Amazingly, the above advice seems eerily applicable to the CEOs of many financial companies making the news these days. If you are watching the stocks of those companies, be aware the damage has been done. It is too late to unload them. The good news is that, as with individuals, if they can work through the issues, life can be good on the other side.

Blood in the Streets-Time to Buy?

2008-09-16T14:52:00.002-04:00

Apparently, I may have been watching too much CNBC. Yesterday, when my "Dollar Cost Averaging on Steroids" (see previous posts) system flashed a buy sign, I considered passing on the opportunity. After all, the talking heads were throwing out scary statements like "collapse of our financial system", "worse than the great depression" and "worldwide economic collapse". Within the past couple of weeks, the feds were forced to bail out Fannie and Freddie, and Lehman and Merrill Lynch ceased to exist as viable, independent companies. AIG seems on the brink of being the next giant to go under, with a string of others in the line behind them. Projected losses are turning from billions of dollars to trillions (with a T).

Yet, times like these are the type that financial gurus are referring to when they talk about buying when the "blood is in the streets". The adage is true precisely because it is so difficult to find buyers in times like these. Even those who use a system designed to enforce discipline may be scared off. These are among the most difficult times to stick to the system, despite the fact that this is where the money is made (Almost as difficult are times like last fall, when my system had me selling while holding a substantial amount of cash in the face of euphoria in the markets!).

So, putting faith in the system, I maintained discipline and bought yesterday. Just like I bought near the lows in July and sold near the highs in August. Of course, it doesn't always work out so nicely. I can't guarantee we are near a bottom. If the market is up next month, I'll smile smugly. If it is down, I'll grit my teeth and buy more. After all, the reason my system all but guarantees beating the market is the discipline it imposes at times like these. If you can't pull the trigger at times like these, you are doomed to underperforming the markets, as the vast majority of investors do.

200 Month Moving Average-an opportunity to test the system

2008-08-20T16:06:00.004-04:00

A friend recently sent me an article which highlighted the significance of the 200 month moving average (mma). The article asserted that if the S&P 500 were to drop another 20% it would hit the 200 mma, an event which has happened only a few times in the past century. Each time, it marked a massive bear market.

My friend went on to remark that this was a scary thought, being only 20% away from such a marker. Ok, that seemed like a reasonable, if dour, sentiment. At the same time, the market didn’t seem that bad to me.

He then went on to say that this would mean that if you bought the market using dollar cost averaging over the past 16.6 years (200 months), it would mean you would have received zero return over this period. Not quite… perhaps he meant to say that if you had bought the S&P 500 at the average price for the 16.6 years you would have no return. The two statements may sound pretty similar, but there is a world of difference. Dollar cost averaging implies that you buy more when the market is down and less when it is up. The result is decreased risk, as well as profit from taking advantage of volatility.

To get a quick check on the logic, I checked my 401-k, where I use an advanced form of dollar cost averaging. I reduced the balance by 20% and checked the return over the last 16.6 years. The result surprised even me, resulting in about a 9% annual return over the period. I expected a positive result, but that seemed too good to be true.

That had me doing a bit more checking. I downloaded the monthly closing prices of the S&P 500 for the past 16.6 years, adjusted for dividends and splits. Sure enough, it seemed to confirm the assertion of the article…the 200 mma for the S&P 500, according to my calculations, was about 24% below the current average. But it also revealed a few other things. The 200 mma was about 140% above the level of 16.6 years ago. In other words the 200 mma was so high because the market rose significantly in the ‘90s and has been relatively flat to downward since. It also meant that any balance in the S&P 500 16.6 years ago would have increased about 5.4% per year if it had just been left alone to grow.

Time to check what ordinary dollar cost averaging would have done to an equal investment each month in the period. When I ran those numbers, it turned out that dollar cost averaging would have also resulted in an annual return of about 5.4% on the dollars invested in the period.

All pretty positive when compared to the thinking that hitting the 200 mma meant effectively a no return market for 16.6 years, but still significantly lower than my returns. So, it was back to the drawing board to explain the outperformance of my portfolio.

I use dollar cost averaging on steroids… investing in several markets and using long term projected returns to buy when the market is below the projection and sell when it is above. Many of the markets I trade would be difficult to trace back 16.6 years, but I downloaded the S&P Midcap and Smallcap history. Sure enough, these indexes had significantly outperformed the S&P 500 ( I had to use the midcap as a proxy for smallcap for a few months, since that index doesn’t go all the way back that far). I calculated that they had returned 6.6 and 5.8% respectively in the past 16.6 years. Although significantly better returns than for the S&P 500, it still didn’t come close to explaining my returns of about 9%. So, I set up a simulation of my “dollar cost averaging on steroids” system, in which I started with 210 units about 16.6 years ago, with about 60 invested in each index and 30 in cash. Then, I simulated investing 1 unit each month for the period, using my system(buying when each market was below trend and selling when above). This resulted in a current balance of 1270, for an annualized return on investment of 8.4%, reasonably close to my actual results, considering I invest in several other indexes as well as those simulated, mainly using the same system.

Despite the fact that I’ve been preaching the merits of this system to all who would listen for several years, I’m impressed with the results. This kind of returns, in what by some measures, might be considered a poor market, is pretty amazing. Of course, investing in indexes which are doing better than the S&P 500 is part of the explanation, but that is part of the system…spreading the risk with broad diversification. The fact that this result is obtained using an easy, mechanical process and basic index investing with minimal effort makes it even more remarkable. When you consider that you get decreased risk and volatility in the bargain, it is pretty hard to beat. And, it justifies my claims that it is easy, in fact almost automatic, to beat the market using this system.

Of course, if you could guess the right market to be in and effectively jump onto the best market trends, you'd do even better. But few can do that consistently. This system helps you do something close, with ease. And it allows you to sleep at night.

Sun Emerges from Gloom and Doom

2008-04-01T23:08:00.003-04:00

A recent article in the Wall Street Journal made much of the fact that the S&P 500 Index is only slightly higher than 10 years ago. I didn't see the article, but I've seen comments about it in several places, and I even had a comment from a friend in Indonesia. The general tone of most articles and comments I've seen are despair that the "US Markets" have had such a meager return.

All the noise put me in the mood to develop my own perspective and to look at my own returns during this "disturbing" period in the market. After all, I depend heavily on use of index funds, of which the S&P 500 is the biggest. The results brought the sun out of gloom and doom for me and confirmed the power of the investing system I use.

First, it is interesting that this one index and single period is highlighted, with a reference to the fact that the Nasdaq did even worse. A 5 or 15 year period would have painted an entirely different picture, as would a look for the 10 year period for, say, the MidCap Index.

I use a system of dollar cost averaging, agressive rebalancing and broad diversification across several indexes (You can see the details in my article of March, 2007) in my 401-K. And, so, my results beg comparison to the performance of the S&P 500 Index. After a quick look back at my performance, I came back with a smile... and a return of about 11% per year over the past 10 years! How is this possible in such a flat market, particularly by a passive system that focuses on index funds, rather than brilliant stock picking? The results are a testament to the power of a disciplined, mechanical system that uses simple, basic, money management techniques like diversification, dollar cost averaging and rebalancing to beat the markets, while reducing risk.

Spring is here, and the sun is out. The gloom and doom is pushed back, for at least another day.

Cash Comforts, but the Fed has set off a scramble to find profitable yields.

2008-02-05T16:19:00.000-05:00

I'm certainly not advocating a run for cash. If that is your thinking, read my previous couple of articles. But, I do advocate everyone having an emergency fund, and for us retirees, the fund needs to be considerably bigger to avoid the necessity of selling low to raise living expenses. And, while the recent market action has made the cash feel a lot more comfortable than before, the Fed's response has made it much more difficult to find a decent profit on the cash part of our portfolio.

On the off chance that others are struggling with this issue, I'm documenting what I'm doing and looking for suggestions from those who may have found a better solution.

Over the past couple of years, I've been relatively happy with CDs and money market funds that paid 5-6%, or 2-3% over inflation. Suddenly though, I'm faced with money market funds, and renewing CDs at a 2% lower rate.

Three to four years ago, when interest rates were also very low, I bought I-Savings Bonds. These generally guarantee 1-2% over inflation, and driven largely by energy inflation the 5-6% yield looked relatively attractive. The inflation guarantee and the tax deferral feature also suited my needs. I still hold those bonds, although over the past several months the 4.5-5% yield made me question the decision. Now, that looks relatively attractive again. These are easy to set up and fund on-line with Treasury Direct, but be aware they do have some holding limits and penalties for premature withdrawal. Annual purchases are also limited.

Outside of that, the best thing I've found is the Washington Mutual Savings for Success program. It guarantees 6.5% for accounts which are funded by regular withdrawals from your checking account and held for a year. It is essentially an inclining balance, 1 year CD. Unfortunately the structure of the program makes it difficult to invest significant sums and I'm sure they'll try to hang on to the deposits at a lower rate after the one year guarantee. Even so, it seems worthwhile for those who keep close tabs on how hard their money is working and are looking to place even modest amounts.

Another option I've been moving toward, although certainly not cash accounts, is high dividend blue chips. It is relatively easy these days to get 4-5% dividends on solid stocks like Dow or GE that also have some growth potential.

Once you get beyond these relatively modest proposals, ideas get pretty uninspiring. Stick with the money market and hope rates head upward soon? Invest in CDs, with the anticipation that even today's low rates may look good tomorrow? Maybe the best chance to do better is to look for short term, local, promotional deals, but read the fine print carefully.

Ok, here's the best part...where you, the reader, get to enlighten us with your research and ideas. Come on guys, here's your chance to publish. Just hit "comments" and let us know what you have.

Run for the Exits? Follow the herd at your peril!!!

2008-02-01T23:44:00.000-05:00

I normally am reluctant to comment on the happenings on Wall Street and the Beltway. After all, the philosophy I preach doesn't require either following the daily market news and politics, or forecasting what is over the financial horizon. Besides, most people have access to far more financial information and prognostication than is good for their financial health. Even while I was in Artarctica for the past few weeks, CNN kept up the steady drumbeat...The market is crashing! The economy is slowing! Democrats and Republicans agree emergency stimulation is necessary! The Fed responds to the crisis! Financial companies make emergency deals to maintain liquidity!

Back in civilization, I picked up a newspaper in Buenos Aires, and though I don't really speak much spanish, I noticed the word "crisis" was used 14 times on the front page alone. Though I'll admit I can't predict the future, I can say with confidence that good companies were selling for 15% less than they were a few months earlier. So, by using some of the cash I accumulated during the fall upmarket, I was able to buy at a lower cost.

But, I admit I've had some surprises. I didn't expect either the Congress, the President or the Fed to capitulate as they have. I suspect they've been watching too much TV as well, but it has me trying to evaluate what it all means, so let's sort through what we know.

Obviously, we've been borrowing and spending too much and that has led to a dependency on cheap credit. The worst offenders are in some hot water.
The economy is slowing. How much and how long, nobody knows.
We've had a couple of bubbles inflate and burst...think dotcom and housing.
Oil and other commodities have been on a roll for the past few years, putting a damper on growth.
The U.S. has been driving the world economies.
It is an election year.

That's about it. There's nothing very surprising here. Everything on the list has been known for months. And if we want to understand what is likely to happen, these are the foundation. Even so, what we might reasonably assume may be more illuminative:

Eventually, we must be weaned from the addiction to credit. Based on this, one might theorize that the recent moves by Congress and the Fed are the reverse of what is needed. They seem designed to increase availability of credit and overspending, feeding the addiction. However, an aversion to discipline and pain, coupled with politics, are promoting giving drugs to the addict to minimize the worst effects of withdrawal. The big question is whether the process will result in a slow, less dramatic withdrawal or a feeding of the addiction leading to a Paul Volcker style, cold turkey approach. Until the last year, the former approach seemed to be in place and working, with slowingly increasing interest rates, but now I'm not so sure. Meanwhile, I'm hoping for the former, preparing for the latter, and trusting my investment system to manage the process.
The economy is slowing, but will that turn into a crash? And how will the outcome effect investments? This is a subject for a book, rather than an article, but let me take an abbreviated attempt. I anticipate more slowing and perhaps some reasonable contraction, but no crash. Housing will continue to fall, since prices are still 20-30% above the long term trend line, but I suspect the process will take several years and it will be very uneven geographically. This will limit the annual drag to less than the long term upward trend. Oil and commodity prices may continue upward for a while, but will eventually return lower to their long term trend lines. This will relieve some of the inflationary and budget pressures resulting from the credit and housing crunch. And, amazingly, traditional energy stocks are already priced for this scenario, so they shouldn't fall too far. Gold seems likely to follow the commodity trend, although the long term gold trend is not so clear. Bonds seem poised for poor performance, since interest rates will eventually return to their long term trend, significantly higher than today. Cash seems a poor bet, with the current low interest rates ( Particulary short term rates, which are more subject to government control. Interestingly, pun intended, artificially lowering short term rates may exert upward pressure on long term rates by raising the risk of inflation.). Meanwhile, stocks in general seem reasonably priced, perhaps even underpriced for today's low interest rates, and stock prices are near long term trends. I expect a relatively slow upward longer term trend in the markets, interrupted by significant volitility as the long term trends are exposed or impeded by daily events and stories.
In the long run, international markets will begin to take more leadership from the USA. Free trade is taking hold. Governments, on the whole, are becoming more democratic. These trends will allow billions of people to begin catching up, to the benefit of both themselves and the world economy. Progress will be uneven, but I believe the long term trend is unquestionable and positive for those not afraid to invest on a worldwide basis.
Politics will rule in the short term, but fade in the long term. This is not only true in the ebb and flow internationally, it applies perhaps even more to the USA. Election years yield increased uncertainty, and at the same time produce more quick fixes, such as tax rebates and mortgage modifications, resulting in increased volatility. Ultimately, though, these fixes succumb to the long term realities, ie, that the USA is tending to regulation and government interference rather than freedom.

Whew, now I'm much further out on a limb than I intended to be. There will be disagreement, of course, and I'd love to hear it. Will I be right, or will I be wrong? Either way, what can you do to prosper financially?

I was just reading, in a science magazine, no less, about a psychiatrist who is trying to build a model which plays reverse psychology with market emotion to predict investment movements. In other words, they search the internet for increases in "negative" or "positive" words and then bet against that trend. They didn't mention it, but I suspect the word "crisis" is one of the negative words. Apparently they are having considerable success, and, even though I suspect the models still need a lot of work, it all makes a lot of sense. As I've mentioned many times, and implied in the lead-in to this article, my experience is that following the emotions driven by the media is a key reason for underperformance of most investors. The herd mentality almost always leads to the worst decisions. And, while I didn't actually see it in print, the news could well be summarized by red, three inch letters screaming "Run for the Exits!!!". Most investors would be well served to avoid joining such stampedes.

Obviously, I believe that markets almost always return to long term trends, and that is the basis of my system, "Dollar cost Averaging on Steriods"...track long term trends and invest anticipating a return to the trend line. Use a mechanical system to avoid running with the herd, all with only a few minutes effort per month. Beat the markets without having to always be right about the future. Best of all, do something to take advantage of the volatility. Man, I'm glad I don't have to depend on my prognostication prowess to secure my financial future. Until the psychiatrists perfect their model, I'm convinced my process will get the job done. If you don't regularly follow this blog, go back to March 2007 for an outline of how the system works.

Are you prepared for the ultimate financial collapse?

2007-12-18T19:50:00.000-05:00

In my previous article, I called the 1929 depression the penultimate recession/depression. At the time, I thought this really meant the "ultimate recession". Imagine my embarrasment when I discovered the term penultimate meant "nearly ultimate" or "next to last".

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.

The Intelligent Investor

2007-11-30T16:10:00.000-05:00

Everyone, from Robert Kiyosaki to Ben Bernanke, from Alan Greenspan to yours truly, has been speculating recently about whether we are heading for a recession. The answer is certainly yes, but the big questions are when, how severe and what to do about it.

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.

Pinching Pennies

2007-10-24T01:19:00.000-04:00

When I talk to folks about personal finance, I have the feeling than many people want to get ahead but don't know where to start. And, all the info about mutual funds, dollar cost averaging, etc seem meaningless if you don't have the money to get started. This got me to thinking about how I got my start.

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.

Finally, some volatility...the opportunity to outperform the markets

2007-08-05T16:57:00.000-04:00

In my last post, I noted that the market felt a bit bubbly and that my system was flashing sell. While I couldn't predict the market's direction, I did predict, and look forward to, increased volatility. And boy, have we had volatility!!

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.

Markets at All Time Highs - Should you be worried?

2007-07-13T14:45:00.000-04:00

The markets seem a little bubbly these days, hitting all-time highs in several indexes. Most of the experts suddently seem to have become bullish, despite their agreement that the market has been climbing the proverbial "Wall of Worry" recently.

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".

Help with Understanding Your Insurance Needs

2007-07-06T16:40:00.000-04:00

One thing I've noticed is that insurance decisions are often made on an emotional basis, or on the spur of the moment with minimal analysis, and the decisions sometimes defy logic. As a result, it may be useful to at least work through the basics outside of the pressure of a salesman and in a strategic, rather than adhoc, basis.

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.

Financial Cruise Control, a great leap forward

2007-07-03T17:05:00.000-04:00

Maybe I'm the only dinosaur left, but I remember when my paycheck was delivered to me in person. I then had to make sure to get it to the bank before it closed, all the while worrying about whether I would forget it, lose it, or get stuck in a meeting. Most other income came in the same form, with the same hassles.

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.

Dealing with the Complexities of Non Quallified Options

2007-06-28T17:11:00.000-04:00

I recently exercised some Non Qualified stock options, and am struck again by the complexities of the decisions surrounding options. These complexities seem to be little understood by most, and if my experience is typical, there is little in the way of documentation/explanation to guide the holder. So, let me relate what I've learned about the rules regarding options and my experience concerning how it affects the decisions you must make. As always, comments from the experience of others is welcomed.

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.

Great Investment in Home Conservation

2007-06-16T12:57:00.000-04:00

I am constantly amazed at the opportunities for investments around the house, which have outstanding returns and are seldom recognized.

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.

Financial Advisor? No Thanks!!

2007-06-01T14:51:00.000-04:00

Many of my friends insist that a dedicated financial advisor is a necessity. I get the "If you needed brain surgery, would you insist on doing it yourself?" questions occasionally. Others insist they just don't have the time to do their finances justice. But, when I ask myself whether a financial advisor makes sense for me, the answer is clear...No, thanks!!

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.

Rules for Tweaking Your Portfolio and Market Timing

2007-05-17T13:04:00.000-04:00

Recently in an email exchange with a friend, I mentioned that my bond allocation is somewhat lower than the normally recommended amount because I did not believe it was a good time to invest in bonds. Immediately, there came a reply asking whether this meant I am a "closet market timer"?

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.

The Crash(s) are coming! What should you do about it?

2007-05-07T11:40:00.000-04:00

Thanks to all those who participated in the comments and discussion on my last post. After reviewing the article and comments, as well as email and discussions with friends, I think is is worthwhile to summarize the conclusions and take a look at what you can do today to take advantage of what the future holds.

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!

Is a stock market crash coming?

2007-04-20T15:02:00.000-04:00

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.

Homeowners-Tax Minimization 101

2007-04-17T11:01:00.000-04:00

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.

Don't Fool Yourself with Online Calculators

2007-04-11T13:11:00.000-04:00

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.

Gardening/Landscaping can build wealth

2007-04-06T14:18:00.000-04:00

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

2007-04-06T12:30:00.000-04:00

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 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.

Managing Your Cash Flow during Retirement

2007-04-01T18:35:00.000-04:00

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.

Beware the illusion of a tax deduction

2007-03-26T13:34:00.000-04:00

When you are finishing up your taxes this year, take a hard look at your deductions, and look below the surface. It used to be simple, you either had a deduction or you didn't. Today, Uncle Sam regularly gives with one hand and takes away with the other, and you may not even realize it. Worse, you may be making financial decisions based on some faulty assumptions.

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.

Get your start by changing your habits

2007-03-23T11:02:00.000-04:00

The world of personal finance seems to be divided into two almost equal groups:

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.

Taxes may complicate, but you can overcome!

2007-03-20T15:03:00.000-04:00

Jon, I practice "dollar cost averaging on steroids" in tax deferred accounts because taxes complicate things, and I prefer to keep it simple. And, I planned to avoid the issue in my blog for the same reason. But, since you asked (see comments), and with the understanding that I'm no tax expert, let me take a stab at putting some broad outlines and ideas out there.

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.

Free money, anyone?

2007-03-16T11:35:00.000-04:00

This time of year, everyone is doing their taxes and hoping for a big refund. I can associate with this feeling- it is almost like getting free money. And, if by some miracle, you are getting a big refund, sock away the money in a good investment and resolve to never let it happen again!!

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.

Examples of "Dollar Cost Averaging on Steroids"

2007-03-14T16:05:00.000-04:00

From comments it sounds like a couple of examples might serve to further explain my previous post about taking advantage of volatility.

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.

Taking advantage of volatility

2007-03-12T11:45:00.000-04:00

If you are in the market, or watch the markets, you'll know that the past few weeks have been more volatile than we've come to expect over the last few years. This leads many to believe that the volatility is unusual. In fact, the opposite is true...the tranquility over the last few years, historically, is more unusual than the recent volatility.

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.

Meanwhile, back on Earth...What to do with cash.

2007-03-07T14:15:00.000-05:00

I enjoyed writing the previous post, and I think it is great to get folks thinking about risk and long term investing, but I suspect many of my readers have a shorter term focus. I indicated that nearly everyone should have a minimum of 3-6 months expenses in cash or short term investments. For retirees without other sources of income, the amount should be considerably larger, perhaps on the order of 3-5 years. This is critical because failure to be prepared for inevitable setbacks leads to the type of debilitating debt we've discussed in previous posts. And for retirees, the larger stack of cash helps prevent having to sell stocks or other assets in a down market.

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.

Effect of diversity on risk

2007-03-07T13:34:00.000-05:00

Jon, thanks for your comments (see comments on previous post). I certainly understand and agree with your premise that diversification greatly reduces risk, but I could not have made the case in as concise and detailed an argument. It may be time for you to write a guest article. If interested, just send it in an email and I'll post it.

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.

Good news for long term investors! The market is down!?

2007-03-05T10:27:00.000-05:00

For a retiree like myself, with no income but my investments, a market like the one over the last couple of weeks can easily cause a bit of panic. If you extrapolate this trend, I could be working at Mickey D's within a few years. Consequently there arises in your gut the desire to sell. It is this instinct, and an inverse one in the booming market, that causes most investors to underperform the market averages.

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.

Good debt, Bad debt?

2007-02-21T10:23:00.000-05:00

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.

What about debt?

2007-02-20T18:00:00.001-05:00

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.

Picking Investments and Understanding your risk profile

2007-02-14T16:06:00.000-05:00

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:

International
Small Cap Domestic
Mid Cap Domestic
Large Cap Domestic
Long Term Bonds
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.

Getting to retirement

2007-02-07T15:35:00.000-05:00

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!