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.
Tuesday, July 3, 2007
Thursday, June 28, 2007
Dealing with the Complexities of Non Quallified Options
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.
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.
Saturday, June 16, 2007
Great Investment in Home Conservation
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.
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.
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