Financial New Years Resolutions

It is that time of year again where one year is ending and another about to begin. We reflect on the past year and make resolutions for the New Year. With the economy in recession and reports that it may get worse in 2009 this is a good time to think about how you are going to get your financial house in order. Hear are some good financial resolutions you can consider.

Pay down debt
If you have debt on credit cards with high interest rates pay them off first. Consider transferring credit card debt to a home equity loan for a better rate. You will also get a fixed payment for a fixed period of time. This makes people fell better because they know when they will be out of debt.

Pay cash for purchases
If you clear your credit card balances by putting it on a home equity loan don’t charge it back up. Many people feel so good about clearing off the credit card that they go out and use it. Even if you do not transfer the balance, get in the habit of only paying cash for purchases. This will force you to save for what you want. If you don’t have the money, don’t buy it. That leads us to our next resolution.

Live within your means
When credit was so easily available you could increase your living standard buy going into debt. Now with credit tightening we are being force to live within our means. People need to consider what certain purchases do to their long term financial situation. Buying a more expensive car by spreading the payments over 7 years so you can afford it is an example of not living within your means.

Make savings automatic
Take advantage of payroll deduction in your employer’s retirement plan. Every investment company now should offer an automatic debit from you checking or saving account into their investments. Studies show those who make their savings plan automatic save more because they stick to the plan.

Buy income producing assets
One major point in Robert T. Kiyosaki’s book, "Rich Dad Poor Dad" is that we consider cars and boats as assets but they do not really increase our net worth over time. You want to buy asset that will increase your net worth and wealth. They are assets like stocks and real estate.

I could keep going, but I think this is where most individuals need to start. If you have already done the things above good for you and I will continue to write about how to get your financial house in order in future blogs.

Happy New Years!!

Keep saving in your 401K

Many of the individuals that I have meet over the last month stopped saving into their employer sponsored plan.  The reason that they all gave, is that when they look at their account balance they have been losing their contributions.  That is not exactly the case but certainly looks that way.  What they are actually losing is past principal and earning.  If you have $10,000 in your account and make a $100 contribution and the losses in your stock funds are $350 for the contribution period, it looks like you lost your last contribution. What really is happening is you are now buying more shares for the same contribution.  If a $100 contribution bought you 10 shares of a stock fund, it now buys you about 20 shares. So when your stock fund goes back up $1, you make $20 on your last contribution.  This helps your account value come back much faster, but that is not the only reason why stopping contributions is a bad idea.

Let’s say you have two individuals, Sally Saver and Fred Freeloader (I was going to use Joe the Plumber).  Both 35 years old and saving $250 a month for retirement.  They both plan on retiring at the age of 65.  For simplicity sake we will assume they are both just starting to save. Because of the market they want safe investments earning 3.5% (not advisable but I want to make a point).  If Fred Freeloader waits 5 years to start making contributions he will have at age 65 $119,053 and Sally Saver would have $157,789, a difference of $38,736 more for Sally.   That is still not the whole story.  Sally would be paying less in federal income tax for five years all things being equal. This may be about another $3,500 in tax savings. The above example does not even take into account an employer match, which could have Sally's account balance much higher. 

Stopping contributions to your retirement plan is one of the worst things you can do.  If the losses in the stock market have you that upset, then ask the company that manages your plan if they have a guaranteed investment.  Be sure to ask if there are any strings attached with the guaranteed investment as there usually is.  This is the time to save more to make up for the losses, not give up on your retirement goals.  

The Difference Between Saving, Investing, and Gambling

Let’s take a look at the definition of each of the above words from dictionary.com.

Saving-
A Reduction or lessening of expenditure or outlay: a saving of 10 percent

Investing-
To commit (money or capital) in order to gain a financial return: investing their savings in stocks and bonds.

Gambling-
To stake or risk money, or anything of value, on the outcome of something involving chance: to gamble on a toss of the dice.

The above definitions shed some light on the differences of each word, but let me elaborate on them a little further.

In finance, saving would refer to setting aside money for the future. Forgoing consumption today to have more in the future. It does not mean buying shoes on sale. The major difference between saving and investing in my opinion, is that saving involves little or no chance of loss to the principle. Things like Money Markets, bank CDs and U.S. saving bonds. 

Investing on the other hand has both the potential for gain or loss. Because of the potential for gain or loss many people think of investing as gambling. They say things like, I lost money in the stock market before, and I rather take my chances at the casino. This is simply not true and I will explain why.

There are major differences between the two. Gambling involves either total gain or total loss. Also you can put up a small sum for a large payout, like the state lottery. Investing is more of a process in which you put up relatively a large sum of money compared with gambling, and it can take a long time for your investment to grow. Your money is placed into something, whether it is companies, real estate or a promissory note. You rarely lose all of your money when investing. With gambling one party wins and one party loses. With investing and saving many parties benefit from the transaction. For example, I put money into a saving account at the bank, the bank pays me interest and I make money. The bank loans the money to you for a new car, you get a car. The bank and the dealership make money. If the dealership deposits that money back into the banking system the process starts all over again.

My deposit- $20,000

Bank lends you my-$20,000

You give dealer $20,000 for a car

Dealer deposits same-$20,000

the bank lends the same $20,000 again and the process goes on and on. So my $20,000 deposit has provided $40,000 in loans or money into the financial system so far. This is an over simplified example of the multiplier effect to make a point. The bank has reserve requirements for safety and to meet withdrawals. A different process happens with stocks and bonds but has somewhat of the same effect. When investing, you are a contributor to the capital markets. Gambling may be fun but it is not the same as investing. As far as I can tell in the long run investors come out way ahead.

So which are you a saver, investor, or gambler, two of the three or all three?

Bernard L. Madoff and his Ponzi scheme

Bernard Madoff market maker and hedge fund manager was charged with securities fraud last week taking investors for as much as 50 billion dollars according to reports.  Investors in his fund use to state they do not know how he does it but his fund consistently returned 9-10% a year.  We now know how he did it, with a giant ponzi scheme. 

Ponzi schemes work by creating the illusion of profits by taking the funds of new investors and putting them into the accounts of current investors. Eventually new money stops coming in and original investors start asking for their money back and the whole things collapses.  People will want to assign blame for this whole thing. Clearly Madoff himself is to blame. He has been around Wall Street for 50 years and with his connections and reputation he did not need to defraud investors to make a living.  He got greedy and I hope he spends the rest of his days on this planet in a jail cell. 

I do not think we should over look the investors in Madoff’s fund. His list of investors is a who’s who of the world's rich. These were not your average 401K type of investors.  They were people with millions and billions to invest and should have known better.    The fund seemed to defy logic and Madoff gave very little explanation of how he made his returns.  Investors also got greedy and took an attitude of as long as I keep making money whatever he is doing is ok with me.  Investors long for the ideology that a money manager can continue to make money in equities no matter what the market is doing.  The investors in Madoff’s fund broke a fundamental rule; if it sounds too good to be true it probably is. 

The regulators are to blame also, but remember hedge funds have fought regulation and won time and time again.  They have basically operated outside the regulator environment.  So I will not blame the regulator as much as those in congress who fought against the regulation of hedge funds. 

No matter who we blame it will not get back the 50 billion dollars of losses for investors.  I just hope some investors will learn from this. There are certain principals of investing that no fund manager can get around.  One of those principals is that there will be periods of loss and if your fund never losses money be suspicious and get your money out while you can. 

Social Security; When to Collect

A major decision facing individuals turning age 62 is; should they take Social Security benefits early or delay until full retirement age or even later. You will get different answers among financial professionals depending on who you talk to. If a financial service person goes right into; take Social Security and invest the money into XYZ, you should be suspicious. They are more than likely thinking of a sale, than what is really best for you. Because your decision to take Social Security early depends on your life expectancy and future returns of investments, an absolute answer to the question is not possible. What is possible is to inform you what to consider when making the decision.

According to an example on SSA.gov a 62 year old would receive $1018 a month. At age 67, which would be full retirement age, the monthly benefit is 1476, and at age 70 the benefit is $1840 monthly.

Let’s say you collect your benefit at age 62 and invest 100% of the after tax amount into an investment that earns 6% per year for 5 years. Let us assume you are married, file a joint tax return, and have a combined income of $42,000. About $76 of each check will go toward income taxes. That leaves $942 to invest each month. Invested for five years at 6% you would have $65,744. If you invest in an immediate annuity for you and your spouse, you would get about $390 (Joint life annuity) a month according to immediateannuity.com. This is short of the increase in monthly benefits of $458 from Social Security for delaying payments until age 67. The increase in your SS benefit comes with a cost of living adjustment (COLA) and more favorable tax treatment. A single life annuity would produce about $465 monthly. This may be more than the increase in your SS benefit, but with  one or two COLA adjustments you should have a greater benefit from SS in a few years.

The other way to look at it is; how long it takes to accumulate $65,744 (cost of delaying benefit) if you invested the $458 a month (the increase in benefit). You would break even in 9 years and 1 month using a 6% rate of return. Which means if you live past the age of 76, it was worth the delay in benefits. Most articles now state the probability of a 67 year old living to age 76, this misses the point. You need to make your decision at age 62. The probability of a 62 year old male living to age 76 is 75%, and a female 80% according to The Vanguard Group’s life expectancy calculator.

Some other things to consider are:

If you still plan on working before your normal retirement age, $1 in benefits will be deducted for each $2 you earn above the annual limit. In 2008 the limit is $13,560.

Your health, you may want to take SS benefits as soon as you can, for obvious reasons. If you take the early benefits, remember it may impact your spouses’ benefits.


Whose record will your spouse collect under? If your spouse will be collecting SS under your record, then an increase in benefits to you will mean an increase in benefits to your spouse if he/she outlives you.

Can you afford not to take it? Sometimes retirement is not by choice, and people need to figure out how to make ends meet. Collecting SS early may be a necessity.

Individuals considering taking early SS benefits should think about other sources of income to sustain themselves for as long as possible. Social Security is the one benefit backed by the taxing power of the federal government; which makes it one of the most secure lifetime benefits in the world today. As noted above it also has a COLA and favorable tax treatment. There is not another product available today by financial service companies that can match the value of your SS benefits.

Is actively managed funds dead?

In today’s Wall Street Journal there is an article on Bill Miller legendary stock picker for Legg Mason’s Value Trust Fund (Article:Stock Picker's Defeat). According to the article the fund outperformed the Standard & Poor’s 500 Index from 1991 to 2005. Now due to recent losses and big bets on financial stocks the fund has underperformed the S&P 500 for nearly all time periods. So does this mean investors should abandon stock pickers and just invest in index funds?

There are plenty of people who would say yes, but I say not so fast. Index funds are great and should be part of your overall stock portfolio, but that does not mean you should not even consider actively managed funds. It is true that over long periods of time index fund outperform most actively managed funds. I attribute part of that to the fact that there are so many bad actively managed funds. Let me explain what I mean by bad without naming any funds. A bad actively managed fund would be one with high expense ratios and 12b one fees. The higher the fees the less likely the fund manager will be able to outperform the market. You also need to consider were the fund is spending its fees. If it is going to wholesalers and brokers to push the fund, then investors are getting no return on investment for the fee. If the fees are going to pay for research and analyst than that should provide value for fund investors in the form of higher returns. Another thing you want to be careful of is so called actively managed funds that are really index funds. This is where a fund claims to be actively managed and charges a higher fee than an index fund but invests like an index fund.

Proponents of index funds would say why bother with all that and just relax and invest in a low cost index fund. I say if you are willing to do a little research and find some low cost actively managed fund with a fund manager that has a solid track record; it can pay off big time. Just a 1% higher return can be thousands of dollars over a 10 to 15 period. Of course I realize that it works the other way to.

The bottom line is you should not just dismiss a fund because it is actively managed.

What do you think? Are you an index only investor, actively managed or both?

Mortgage Relief Programs

New data came out this week from the Office of the Comptroller of the Currency and the Office of Thrift Supervision showing that borrowers who have taken advantage of the mortgage relief programs are still defaulting by about half. It seems that many of the borrowers simple can not afford the new terms.

The question I have is; how far are we willing to go to keep individuals who made irresponsible decisions in their home? At what point are we simply giving them the home? Not questions I have an answer to.

I do believe we need relief for individual homeowners and not only big corporations to get the economy moving again. That does not mean all borrows should get relief. I like Sheila Bair’s plan. Her plan will lower the interest rate to3-4.5% and your loan payment will be no more than 38% of your income. Borrowers will have to pay interest on deferred principal. The part I do not like is if the borrow ultimately defaults the government (taxpayer, you and I) are on the hook for 50% of the losses. Although I do not like I think it needs to be there to get lenders moving on the plan.

The Bair plan has angered many individuals because it is not fair to those of us who took out responsible mortgages and have been making are payments. At some point we need to get past that and have a plan in place that will benefit everyone in the long run. Sometimes life just isn’t fair and this is certainly a prime example.

Have you been making your mortgage payments on time and do you agree with bailout of borrowers?

It's Officail

The National Bureau of Economic Research stated this week that the U.S. is officially in a recession. You can read the full report at http://wwwdev.nber.org/cycles/dec2008.html

The good news is that we have been in a recession since December of 2007; the bad news is this may be a very long and deep one. So what is an individual to do?

As much as the government would like consumers to spend money to help get us out of recession, it is the last thing you should be doing. This is the time to take at look at your over all finances to make sure you are able to weather the storm. If you do not have an emergency fund saved up start one right away. You can use a money market mutual fund, the ING saving account or a safe account at your local bank or credit union. Try to get the highest rate possible, but it is more about safety and availability (easy access) than anything else.

The job market is a tough one in most sectors and employers can afford to be choosey when hiring. Make sure your resume is up to date and think about projects and other things you may have done that will really set you apart. Join or update any networking sites you are a part of. If you do get laid off you want to hit the ground running.

Pay down debt. Paying a little more toward the credit card bill or auto loans goes a long way in the amount of interest you pay in the long run. With interest rates so low, if you already have an emergency fund established put any extra money into paying down existing debt.

Help out others. One report I heard stated food banks are seeing 40 new families a month. So if you can afford to buy some can goods, give to you local food bank.

What are you doing to get through the down turn in the economy? We would love to hear your ideas, so please post them. Thanks.