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.
Monday, March 5, 2007
Wednesday, February 21, 2007
Good debt, Bad debt?
Is debt bad or good? I'm not sure that debt is either bad or good, it is how we manage it that determines whether it has a positive or negative effect on our financial health.
For instance, I mentioned in a previous post that I routinely charge nearly everything I buy to a credit card. If I have rebate cards and pay off the balance on time each month, it has a positive effect on my finances. If I were to miss the payment dates or decide to carry a balance, the costs would quickly eat up the benefits.
The addictive type of spending/debt I mentioned in the previous post certainly is a mistake. It can make it nearly impossible to realize our financial goals, and it can put tremendous stress on us personally as making financial progress becomes more and more difficult.
On the other hand, in certain circumstances, debt can have a positive effect. Borrowing to finance an investment that makes money is one way to make debt work for you. For instance, if you borrow to buy a property which has a positive cash flow the result can be very handsome profits. Keep in mind, though, that this enhanced profit is a result of the leverage resulting from the debt and the leverage works both ways. The same leverage that produces handsome profits can result in devastating losses if your assumptions turn out to be wrong.
Let's take an example. Say you buy a rental house and put $5,ooo down and get a mortgage for $95,000. Assume the value of the house goes up 5% per year and the house rents for $1000/month and your mortgage, taxes, insurance and other expenses come to $800/month. You are making $5000/year in appreciation plus $2400/year in cashflow. That amounts to nearly 150% profit per year on your original investment. In this case, debt is very positive. With these assumptions you can't afford not to buy the house and incurr the debt, right?
But wait, what happens if some of your assumptions are wrong? Let's say the housing market takes a tumble of 10% per year for 2 years. You discover the foundation needs $10,000 in repairs and a hail storm does $5000 damage to your roof. Your deductible is $1000, so you dodge a bullet on the storm, right? But now your insurance goes up $100/month. The tenants move out and it takes 3 months to rent it again at $800/month. The realty company charges a month's rent. After 2 years you realize this house is not the profit machine you had envisioned, so you sell, incurring 10% selling cost. Let's see, that's $21,000 in depreciation, $2,400 in negative month-to-month cash flow, $2,400 lost revenue during the vacancy and over $18,000 in additional expenses. Your $5000 investment has generated about $40,000 in losses over 2 years, or NEGATIVE 400% annual return.
Sounds like an extreme example, right? It is, yet each assumed event can happen. Believe me, they have all happened to me! Again, my point is that debt creates leverage which can work both for or against you and therefore creates additional risk. The two cases above would still generate positive and negative returns respectively without the borrowing, but the debt multiplies the effect. If you had bought the above property with cash, your investment would have yielded about a 9% annual return in the first case and a negative 10% return in the second case. The debt just leveraged both the profit and the risk.
When evaluating an investment, it is always worthwhile to evaluate the investment both with and without the debt. Evaluate with both the best and the worst assumptions. Then you are able to see both the benefits and the risk of the debt.
But, what about other kinds of debt? My rule of thumb is that debt is positive if the after tax interest rate is less than what I could obtain on a similar investment. If you have no investments, it probably means you cannot afford the debt. The result of these two rules is that debt should rarely be used. And then only after careful consideration of both the benefits and the risks using very conservative assumptions.
As an aside, one of the most frequently asked questions is whether it is better to keep your mortgage or pay it off. Since mortgages have one of the lowest after tax interest rates, it may be possible to beat the rate with other investments, depending on your risk profile. When you are young, you can afford more risk in your investments, so a mortgage probably is a good thing. For older folks, a lower risk profile may be in order, meaning it makes sense to pay it off. Either way, make sure you can afford it under conservative assumptions before you take it on.
For instance, I mentioned in a previous post that I routinely charge nearly everything I buy to a credit card. If I have rebate cards and pay off the balance on time each month, it has a positive effect on my finances. If I were to miss the payment dates or decide to carry a balance, the costs would quickly eat up the benefits.
The addictive type of spending/debt I mentioned in the previous post certainly is a mistake. It can make it nearly impossible to realize our financial goals, and it can put tremendous stress on us personally as making financial progress becomes more and more difficult.
On the other hand, in certain circumstances, debt can have a positive effect. Borrowing to finance an investment that makes money is one way to make debt work for you. For instance, if you borrow to buy a property which has a positive cash flow the result can be very handsome profits. Keep in mind, though, that this enhanced profit is a result of the leverage resulting from the debt and the leverage works both ways. The same leverage that produces handsome profits can result in devastating losses if your assumptions turn out to be wrong.
Let's take an example. Say you buy a rental house and put $5,ooo down and get a mortgage for $95,000. Assume the value of the house goes up 5% per year and the house rents for $1000/month and your mortgage, taxes, insurance and other expenses come to $800/month. You are making $5000/year in appreciation plus $2400/year in cashflow. That amounts to nearly 150% profit per year on your original investment. In this case, debt is very positive. With these assumptions you can't afford not to buy the house and incurr the debt, right?
But wait, what happens if some of your assumptions are wrong? Let's say the housing market takes a tumble of 10% per year for 2 years. You discover the foundation needs $10,000 in repairs and a hail storm does $5000 damage to your roof. Your deductible is $1000, so you dodge a bullet on the storm, right? But now your insurance goes up $100/month. The tenants move out and it takes 3 months to rent it again at $800/month. The realty company charges a month's rent. After 2 years you realize this house is not the profit machine you had envisioned, so you sell, incurring 10% selling cost. Let's see, that's $21,000 in depreciation, $2,400 in negative month-to-month cash flow, $2,400 lost revenue during the vacancy and over $18,000 in additional expenses. Your $5000 investment has generated about $40,000 in losses over 2 years, or NEGATIVE 400% annual return.
Sounds like an extreme example, right? It is, yet each assumed event can happen. Believe me, they have all happened to me! Again, my point is that debt creates leverage which can work both for or against you and therefore creates additional risk. The two cases above would still generate positive and negative returns respectively without the borrowing, but the debt multiplies the effect. If you had bought the above property with cash, your investment would have yielded about a 9% annual return in the first case and a negative 10% return in the second case. The debt just leveraged both the profit and the risk.
When evaluating an investment, it is always worthwhile to evaluate the investment both with and without the debt. Evaluate with both the best and the worst assumptions. Then you are able to see both the benefits and the risk of the debt.
But, what about other kinds of debt? My rule of thumb is that debt is positive if the after tax interest rate is less than what I could obtain on a similar investment. If you have no investments, it probably means you cannot afford the debt. The result of these two rules is that debt should rarely be used. And then only after careful consideration of both the benefits and the risks using very conservative assumptions.
As an aside, one of the most frequently asked questions is whether it is better to keep your mortgage or pay it off. Since mortgages have one of the lowest after tax interest rates, it may be possible to beat the rate with other investments, depending on your risk profile. When you are young, you can afford more risk in your investments, so a mortgage probably is a good thing. For older folks, a lower risk profile may be in order, meaning it makes sense to pay it off. Either way, make sure you can afford it under conservative assumptions before you take it on.
Tuesday, February 20, 2007
What about debt?
The overwhelming response to my blogs about investment and retirement planning is “How can I even think about investing and planning for retirement when I am in debt up to my ears?” This highlights one of the major hurdles most people have on their way to financial security, so let’s explore the issue a bit further.
Debt can be both addicting and suffocating. At first, it seems harmless enough… I want something and by incurring a bit of debt I can have it sooner. But, if I didn’t have enough cash to buy what I want today, the cost of the debt means I’ll have even less chance of having what I want tomorrow, unless I increase my debt again. This can easily become a vicious cycle, similar to an addiction. And in the end, it suffocates you financially.
Don’t get me wrong. I love debt. I charge virtually everything to my credit cards. I get significant rebates from the issuers and I get to keep my money invested longer. I just make sure my spending is such that I can pay it when the bill comes at the end of the month. Voila, interest free money and rebates to boot.
But the issurers know that most people will charge more than they can afford and will then be forced to pay their astronomical interest rates, drawing them further into the web. Don’t allow it to happen. If you can’t keep your spending to what you can pay off each month, cut the credit cards up and pay them off pronto. I know that is tough, but like drug addiction, the best way is to quit cold turkey. Resolve to buy absolutely nothing but necessities until the debt is gone, and don’t fall off the wagon again. You can do it if you make that commitment. Otherwise you’ll be permanently in pain and will find it difficult to meet your financial goals.
As I mentioned, the cost of consumer and credit card debt is high. This begs the question…Should I stop contributing to my retirement accounts until I’ve paid off the consumer debt?
While I know there is room for argument, my answer is that you should continue to fund your retirement while you pay off the debt. You are likely in debt because of a lack of discipline and funding a retirement account on a regular basis is a good way to establish that discipline. Automatic contributions establish the discipline needed and the tax deferred or tax-free nature of the vehicle makes it profitable. If your employer matches your contributions, so much the better. You need to establish that you can live below your means after meeting your long term obligations. Take the challenge, you’ll be surprised at how little you can really live on, and you’ll gain some confidence that will serve you well.
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.
Subscribe to:
Posts (Atom)
