Please, no Auto Bailout

The Democrats made a clean sweep in elections and control the House, Senate, and Presidency. Now there are no checks and balances on what legislation they can pass. Already, there is talk of giving a way another stimulus package, bailing out the American auto manufacturers, and confiscating 401k accounts for a Government run pension-like program.

Now my worst fears of a socialist country are coming true. Clearly Obama won the election mostly due to the hate of the Bush administration, rather than his plans for the future. We know the Democrat elites have a love for Europe, but let's not turn this country into another France, where the Government protects everyone's jobs and ends up stifling innovation and economic growth. Nancy Pelosi and Harry Reid are calling for a loan package be issued to GM, Ford, and Chrysler to keep them in business. We can't start bailing out every industry. We need to allow them to sink or swim on their own. We have to allow the car companies to fix there own problems, by consolidating, reducing costs, and focusing their products to what the market wants.

Notice how the foreign car makers (who employ thousands of Americans) are having an off year, but are still making a profit. This is because they make a product that people want and can manufacture it at a low enough cost to be competitive. And they don't do this by having low paid workers in Japan or China. Toyata, Nissan, and Honda, have plants in Texas, Mississippi, and Alabama where they make cars for the US market. However, they don't have a history of bad deals and promises with the United Autoworkers (UAW).

The US companies have too many product lines, many that are unprofitable, and too many longterm pension and healthcare costs that are killing their bottomline. I heard Larry Kudlow say today that basically the US auto industry is a healthcare company that makes cars on the side. It may require that Ford, GM, and Chrysler file for bankruptcy, scale down operations, and emerge as a leaner, smaller, but profitable company. Likewise, the UAW may have to negotiate contracts that don't kill their own industry. If the Government bails them out, it will only be a temporary patch, that will re-occur over and over again.

Some may argue that if the banks were bailed out then why not a large industry like the auto industry. First, a strong banking and credit system is needed for any and all businesses to function and has world wide implications. No other industry has this far reaching effects. Second, there are alternatives and profitable car manufacturers, so if some were to disappear, it would not create all to fail, but rather strengthen the other businesses.

The airline industries have been going through a similar problem for years, it has caused consolidation, some to file bankruptcy, and new profitable competition to step up. Loaning money to a company like GM is not going to help them, as their problems are not a temporary shortfall of cash, but rather a fundamental business operations problem that won't go away without major changes to the business.

The College Fund

I recently had a little baby boy and started a college fund for him. My plan of attack is to put as much as possible in there for the next two years, at which time it should be close to being enough for in-state tuition for four years. Then I'll let it sit for the next 10 years invested in index funds. I'll re-evaluate around year 12 if it still is enough for in-state tuition and start making adjustments from there. So my priority of investing at this point is: 1) emergency fund, 2) retirement, 3) college.

Traditionally in the past, people have contributed to their son’s, grandchild’s, or nephew’s future education through Savings Bonds or with cash. We have instead established a 529 Plan account for the purposes of saving for college because it has many distinct advantages over traditional investments.

College Costs
College tuition has always been expensive and continues to rise at a higher rate than general inflation. On average, tuitions in 2007 increased over 6.6% at public institutions, 6.3% at private, and 4.2% at 2-year schools. A survey of the costs of local New Jersey schools, in the table below, shows the current formidable challenge of paying for college. It is unlikely that college tuition inflation rate will decrease in the future years, as there is no incentive for colleges to do so, as more and more people attend universities each year.

Investing for College
To combat the college inflation rate, a more aggressive approach is needed than simply socking away money for 18 years in a savings account or using low-yielding EE bonds. To at least keep up with inflation, a college fund needs to average a greater that 6% return. That can only be done by having exposures to equities, which although more volatile than savings bonds, have a history of providing an average annual return of over 9% over the last 15 years. Luckily, college for Jack is 18 years away and the long time horizon allows for a more aggressive approach, as time can be used to smooth out the ups and downs of the stock market.

Savings Bonds vs. 529 Plan
People have felt safe buying savings bonds because they are guaranteed to never lose money and have a face value double of the invested principle. However, the current savings bonds are also guaranteed to not keep up with inflation. EE bonds purchased today have an interest rate of 1.4% and a maturity date of 2028. In addition, the interest is not exempt from Federal income tax. On the other hand, the 529 plan allows one to invest in a number of diversified mutual funds, tax free (not tax deferred like 401(k) or IRAs), that can provide a much greater, although more volatile, return. They benefit from the tax free growth, as well as, tax free use when used for college expenses. In addition, the fund holdings can be very conservative in Government bond funds or more aggressive in all equities, such as a small cap fund, and shifted over time from aggressive to conservative funds very simply online. These are the primary reasons we chose to open a 529 Plan, which are offered separately by every state.

Our 529 Plan
New Jersey’s 529 Plan does not provide any significant incentives for residents, so we chose our plan based on finding the one with the lowest fees and best fund options. We opened with the state of the Nevada, which is administered by Vanguard, who is known for having low cost index funds in a large number of areas. They offer a total of 22 funds in many areas in the Nevada plan. The stock market has been very volatile the past few years, with small gains seen last year and significant losses this year. This coincidentally provides a good time to start our college fund, and since it has an eighteen year horizon, we can utilize the equity funds to provide a higher return. Jack’s College fund was established with an asset allocation as follows:

• Vanguard Total Stock Market Index Fund – This mirrors the complete US stock market including the large, small, and mid caps and provides the core holdings for the college fund. The US total stock market has seen about a 11% drop this year (as measured by the Wilshire 5000), but we expect the broad stock market to recover and provide respectable results over the next eighteen years around its historical average of 6-8%
• Vanguard Total International Stock Index Fund – This is a fund of funds that includes three international funds, the European Stock Index Fund, Pacific Stock Index Fund, and Emerging Markets Stock Index Fund and provides a very diversified international weighting. Much of the growth is expected to come in the emerging and Asian markets over the next few years and provides a good uncorrelated return to the US stock market.
• Vanguard Small Cap Index Fund - This index fund follows the small cap market and provides a heavier weighting of the faster growing small cap segment of the US stock market. This boosts the small cap representation already present in the Total Stock Market Index Fund.
• Vanguard Value Index Fund – This index fund follows value stocks in the US stock market, which includes those stocks whose are considered undervalued and have great potential for growth. Including this fund provides a small additional weighting to value stock.

Our asset allocation for 2008 is shown in the table below:

No bond funds were used in the allocation for two reasons. First, with eighteen years until funds will likely start to be drawn, there is no need to be conservative now, especially as college cost are increasing at over 6% and Treasury rates are low at 3%. Second, interest rates are expected to rise over the next few years in response to the low rates we have now, and expected increase in inflation. If interest rates do go up, it would follow that bond funds will see a drop in net asset value as their yields increase. If and when that happens it may be appropriate to buy into those funds to capture some of the increase yield.

Back online

I have been away for a few months, having had a baby boy at the end of June. I will start back up again now. I have started a new college fund and my first post will concentrate on that. In addition, I will update my investment progress. All in the next few posts.

Yes, CDs are still safe

Over and over again the ultra-conservative investor seems to ask the question on financial shows like MoneyTalk, "Are my CDs safe?". Especially when relating to banks or institutions that have been in the news such as Countrywide. Of course these troubled institutions are the ones with the best rates on deposits, since they are the most desperate for money. You know there is a real panick, when people start to question the riskiness of CDs.

The simple answer is make sure you are insured by the FDIC at the bank and sit back and relax. FDIC insurance covers deposit amounts up to$100,000 per person per bank. You can verify the bank has FDIC insurance by visiting http://www.fdic.gov/. If your bank does fail, its assets will either be taken over by another bank or you will be paid principal and interest by the FDIC in usually one day.

Stimulus Package Rebate Checks

The checks are on their way for those eligible for the Government's economic stimulus package. Here are the rules for how much you should be getting:

• If $0 to $300 in tax liabilities, but still earned at least $3000, you will get $300
• $301 to $600 tax liabilities, and greater than $3000 in earnings, you will get back an equal amount
• >$600 tax liabilities and earned <$75,000 you will get $600
• 5% decrease in benefits for any amount over $75,000 (or $150,000 for couples)

So, for every $1000 over the limit you lose $50, which means no rebate for those making $87,000+ (or $174,000+ for couples).

For some, the actual checks have been less than expected. I know of people who make well under $75,000 (more like around $19,000) who only received a $530 check (direct deposited). This is probably due to the first two bullets above. Since this is a rebate on taxes, it is limited to the amount of taxes actually paid, so if you paid less than the $600 last year, you will only get the amount back. The exception is that you can't get less than $300 if you have at least $3000 in income. This was put in to take care of seniors. Comment below if it seems like you are getting cheated out of the rebate. Call the IRS at 800-829-1040 if you run into problems and have your IRS letter that explains how they calculated the refund handy.

Bob Brinker Calls Bottom, Bullish

Bob Brinker, famous Marketimer newsletter author and radio host, is going on the record with calling the market bottom on March 10, 2008. He is bullish that, while we may be in a small recession and have had a nice little correction, we will seen new highs in early 2009. There is likely to continue to be high volatility in 2008, but a general postive trend. I find this interesting that he would be so bold to call this. I cannot pretend to be able to agree or disagree with his prediction, but I do agree that staying invested in a diversified portfolio that includes equities (100% of long term money in my case), and continuing to dollar cost average into index funds is a sound strategy for now. Trying to time the market is difficult, if not impossible. It may have been easy to get out on the way down (although I am sure very few got the top correct), but deciding when to get back in with all this volatility is near impossible. There has been great buying opportunities in 2008 and, if taken advantage of, will pay off nicely has the trend begins to climb back up.

Death to Income Tax?

To take from one, because it is thought his own industry and that of his father has acquired too much, in order to spare to others who (or whose fathers) have not exercised equal industry and skill, is to violate arbitrarily the first principle of association, "to guarantee to everyone a free exercise of his industry and the fruits acquired by it. -Thomas Jefferson

Those are the words of Thomas Jefferson on the issue of income taxes. Something to think about now that most of us have filed our taxes for 2007. Our founding fathers and, in fact, our Constitution did not allow for the collection of income taxes. The Government was funded by excise taxes, tariffs on imports, and donations from the states. The states collected primarily property, flat taxes, or import taxes. The federal Government started using income taxes on and off through 1895 to fund wars. In 1895, the Supreme Court declared the income tax unconstitutional. It took an amendment in 1913 (the 16th) to the Constitution to firmly establish the income tax as a permanent fixture in the tax code.

The income tax rate has fluctuated throughout the years, reaching as high as 91% for the top bracket in 1964. After the recent Bush tax cuts, rates are currently more moderate than those times, but still higher than the Reagan years. Now, the rate looks to be in danger of again increasing, if a Democrat wins the Presidential election.

Many have called for elimination of the income tax as they are fed up with increases in spending and increases in other tax rates. The Social Security tax cap continues to go up every year (and will be eliminated if Obama has any say about it), state taxes are increasing, and basic necessities like food and fuel are seeing high inflation. Ron Paul has been the Internet cheer leader for calling for the elimination of income tax, and although has a strong cult following, could not mount any significant momentum in the Republican primaries. Still many call the income tax system unconstitutional (which it really isn't). Flat tax and "fair tax" supporters also have been vocal, but both plans result in lower taxes for the upper income brackets, and do not lower the already low middle class rates.

Therefore, the populists tactics of the candidates prevail with battle cries to help the middle class and tax the rich. As do promises of more Government programs to support and help the country, whether it be for universal health care or money for college. There will be no relief or reduction of taxes without large cuts in programs, adjustments to social security, and reduction in Government. But when was the last time a candidate won any office by promising to do less than his/her predecessor?

Moving on up!: Great time for a new house

Despite the subprime problems and real estate recession, or actually because of it, this is a great time to be looking at real estate - whether you want to upgrade or downgrade your house or invest in REITs. I've been dollar cost averaging into real estate mutual funds for a while now and, while it certainly lost money last year, this is a great time to buy at a dip. It may continue to be very volatile and even lose more money this year, but since stocks are forward looking, REITs may be poised to start recovering. However, it is even a better time to make a move with your personal residence.

This is something that I assumed I would be saving for a couple more years. But I recently came to the realization that I might as well look at purchasing now. I do have considerable equity in my current townhouse and I do have a decent amount saved for a downpayment. Moreover, it's a great time to buy or upgrade because it's a buyer's market and interest rates are low for those with really good credit. Usually low interest rates do not coincide with low house pirces and instead push prices higher. I could continue to save a few thousand each month and then in a couple of years I would have an even bigger downpayment, as my equity would also have grown. However, the other alternative is to buy cheap now and instead of saving that $1000 each month, put that directly into the house in the form of a higher mortgage payment. To put it in perspective, I am looking to go from approximately $350k to $450 - $550k house. At the same time I am looking at some slightly cheaper neighborhoods that get me more for my money. Since there is such a good choice of homes on the market, I am excited about what bargains can be found. You can really afford to make many low ball bids and get a good value in this market.

On the flips side, most homeowners are just looking at how much less their home is now worth. That doesn't bother me, as I have been in my current home almost 7 years and still have made considerable gains. I would much rather be trying to sell now at a discount and pickup a new house at an even better discount. It bothered me more when we had outrageous home prices the last couple of years.

So this may be a great time to upgrade if you

• live in a desirable area
• are willing to price your house at a discount that reflects current market conditions
• have great credit to qualify for a low rate
• have 20% of the purchase price for a downpayment

Having found some great properties in my area that would double my living space, I am very motivated to list my house. All I have to do is some minor repairs and touchups to get started. I'll keep you updated.

We're all paid what we're worth

I don't see, on average, how anyone is underpaid or overpaid in a free market, with the exception of those making minimum wage (who could be overpaid). In a free market professions are paid what they are worth to the employer and what the employee is willing to work for. Basic supply and demand. If it is really hard to find qualified people for a particular job, then the employer has to raise the wage until it becomes attractive for the employee. On an individual basis, it is true someone could be a bad value and normally things would self-correct and they are either fired or receive smaller raises. Unfortunately, if you throw in unions and tenure, that breaks the normal free market, and prevents individuals from being correctly compensated (whether more or less) according to their worth. However, professions on the whole are still governed by supply and demand.

That is why you see athletes and actors with large salaries. They a) make a lot of money for their employer and b) good ones are in very low supply. However, something like education is not a money making profession, but its value is set by what the tax payers are willing to pay for the service. Since there is no shortage of teachers who can do the job (compared to athletes who can throw 95 MPH fastballs) that wage can be held much lower. So whatever the current compensation for a profession, it has been set by the free market. Thus I find it hard to accept frequent comments about how certain profession are under or overpaid.

Bob Brinker MoneyTalk Commentary 3/22/08-3/23/08

Bill Flanagan took over this week. It was amazing to see the types of calls coming in these days and shows a lot about investor confidence. An inordinate amount of people are worried about CDs and brokerages. Even those with insured CDs are getting skittish. At the same time, the fixed income crowd is getting worried about their return dropping, due to the lowering of interest rates, and wondering how to get a better return "safely". Obviously there is no real way to remain at the same level of risk and get a better return, unless you were in some really bad investments.

I think the rest of the show was about his dislike of annuities, which I can't disagree with, but he never really gives the callers a chance to explain the specific terms and quickly shoots it down. I think it would be more effective to spend more time and go through the specifics to show why these are not as good as they seem. The subject probably deserves a series of posts, but the short of why annuities are no good:

• high expenses
• low returns
• fixed returns, rarely stay fixed
• high surrender charges
• main purpose is to provide tax advantages, which is of no use if bought within a 401k or IRA
• surrender charges on early withdrawals
• usually combines life insurance with investing, which is not synergistic
• pushed very hard by sales to the uninformed looking for safe investments because of the high commissions

One interesting call was for someone looking to transfer his 8,000 shares up AT&T into a more diversified mutual fund that had similar dividend payouts. Presumably this was because it made up a very large protion of his portfolio. This touches on a common misconception that you need income producing stocks to use the proceeds for expenses or to live off of in retirement. Bob Brinker tries to correct this point quite often, but Bill didn't mention it at all during this call. There really is no reason to limit yourself to dividend funds. You can just as easily sell positions periodically to generate the same income. So you can invest in growth stocks or index funds, both of which have low distributions (which makes them tax efficient), and still get the income you need by selling that 4% per year or withdrawing monthly. I think it must be more of a psychological issue to sell the stocks because it feels like you are losing something forever, but actually it doesn't matter how you pull the money out of your account, whether it is from dividends or capital gains.

Diversify: Stay away from individual stocks

Yes, the market overall is not doing great now, but it could be a lot worse if you had a lot of your money invested in some individual stocks like Countrywide or Bear Stearns. Try losing 90% or more on these stocks, instead of 9% on the market. That is why the general rule of thumb is to never have more than 4% of your money invested in a single company. Most investors understand the value of diversity, but still don't follow this rule for a number of reasons:

• they see stocks like Google, Microsoft, or Apple beating the market regularly and think these stocks are sure bets
• they think they know a lot about specific companies or industries and feel comfortable taking a gamble
• they see certain retail products everywhere and think the company must be doing well
• they work for the company and get discounts on stock purchases, pressured into buying, or free shares as bonuses

Despite any of these reasons, you should try to maintain diversity in your portfolio. This is even more critical if you own a lot of your company's stock, as your employment, retirement, and savings may all be tied to a single company. The moment things turn bad at the company, you could lose all three. For that reason, I would suggest holding even less than 4% of your company's stock. Sometimes it cannot be avoided, such as when you are awarded stock options or shares as compensation. However, if that is the case you should try to maintain diversity by doing the following:

• immediately exercise options when vested and sell the proceeds to maintain the 4% ratio
• do not invest your 401(k) in company stock based mutual funds
• resist enrolling in employee stock purchase plans (even if there is a discount) unless you can immediately liquidate. Avoid costly transaction fees by selling the shares only once or twice a year, reinvesting in diversified funds
• Balance your portfolio by purchasing enough other funds or stocks to keep that 4% ratio
• Elect to receive cash bonuses vs. stock or options, whenever possible

This applies equally, whether you are at a public or private company. I have had this situation come up many times at my job, which is privately owned, but does have shareholders. The problem with private companies is that there is no liquid market to sell shares and often there are strict rules as to when and how you can sell them back. I have been awarded bonuses in the form of shares for many years and have no choice in the matter. So I have avoided investing my own money in shares whenever possible. I haven't participated in stock offerings and I have elected to receive cash the one time the choice was offered. I know there can be a lot of pressure to buy company shares to show your committment, but I value my personal financial freedom and philosophy higher than making a good impression and I have had to explain that on more than one occasion.

The stock market has shown to go up over the long term, but individual stocks have not. Stock prices depend on companies constantly growing. It is not enough for a company to continue to make a steady profit every year, it has to continue to increase that profit. So rather than guess which company will continue to grow, keep a broad, diverse portfolio.

Bear Stearns bail out becomes buy out

It was only Friday that JP Morgan was helping to bail out Bear Stearns with the US Government's backing. Now it apparently has decided that it would be better to acquire the company for far less, just $236 million. Its only assets at this point are probably its office buildings and furniture, as its debts far outway any value of the company. The purchase price equivalent to $2 a share represents a discount of 93% from Friday's close, which itself was already down 47% from Thursday.

Bear Stearns got into liquidity problems when two hedge funds failed last summer and their bread and butter mortgage backed securities suffered huge losses. Banks can take a quick tumble when investors and the financial communites lose faith and begin to pull their money out or stop offering lines of credit, as the only real assets a bank holds are the loans it gives out and the only source of liquidity are investments people make in it. When those both turn sour, things can go bad real quick. Bear Stearns' share price dropped greater than 97% since last Monday's open.

Bear Stearns was less diversified than some of the other financial institutions, but there is no doubt the whole financial sector will feel the pain on Monday. Expect huge losses that drag down the whole market on Monday. This all but guarantees a rate cut of the Fed funds rate of 100 points this Tuesday, with rumors it could go as high as 200 points. It already cut the discount rate 25 points this weekend.

Bear Stearns is feeling the same pain as the investor who was too leveraged in real estate and didn't diversify their portfolio. Only the private citizen won't even be offered the $0.67 on the dollar Bear is getting.

Bob Brinker MoneyTalk Commentary 3/9-1/10

Bob called for a guaranteed 75 basis point rate cut on March 18, with a slight probability of higher. I wonder how that changes with the latest Fed actions. It looks like we still may get a 50 point cut, but we'll see.

Bob also gave 50% chance of being in a full blown recession, but thinks if it happens, it will only be for the first two quarters of 2008. His guest, Dan Ariely, author of Predictably Irrational, was quite interesting and talked about the psychology of things such as stealing, lying , cheating, and investing.

On Sunday, Bob's guest, Teresa Ghilardu, was an odd choice as she seemed to preach pension and annuity ideas contrary to his often repeated opinion. She was pro pension and annuity (when provided buy the company). In particular, she generalized to always take the annuity rather than the lump sum, when offered. I was waiting to see how long it would take for Bob to jump all over her. He actually tried to give her an out, by saying it was a case by case basis, but she wouldn't bite. She didn't really like giving the investment choices to the person, but wants them to trust in the pension.

Gut Check Time: Do you have what it takes?

So far 2008 has been a real test to see

• Who really believes in investing for the long term
• What your risk tolerance really is
• If you are diversified and trust your asset allocation

Listening to the weekend talk shows and talk around the office, all I hear are people questioning whether they should sell their stocks. However, selling now would be the opposite of what should be done. The time to sell was when you were at record highs, not now that they've pulled back 15%. If you still believe you are investing for the long term and you have a good diversified allocation, then this is the time to buy those beaten down stocks. We may still see some losses ahead, but since it is just as hard to predict a bottom as it is a top, this is a good time to start loading up again.

The only question in my mind is on the commodities front. Gold and oil are at all time highs. Corn is also close to 52 week highs. I have no doubt that oil will continue to do well, but I am not sure how much higher gold and corn will go. So if you have already made gains in these areas, it is time to rebalance your portfolio, if you haven't already.

Corrections like we are currently seeing cleanse the market of inflated prices and nervous investors. This generally keeps the markets healthy over the long term. Kind of like a controlled fire clearing the dead wood from a forest and being beneficial in the long run.

So I will continue to invest twice a month and maintain the faith in my asset allocation.

My Equity Asset Allocation

I've already described in previous posts how I save/invest for short term goals using Vanguad's Prime Money Market and currently put half of my money there each month. The other half I invest in mutual funds and ETFs for longer term goals (5+ years). If you haven't already, read these posts first: Are you ready to begin investing?, Investing for the Short and Long Term, and Equity Asset Allocation.

I practice the simple philosophy of buy and hold for the long term using inexpensive funds. I encourage you to look at some popular allocations over at Marketwatch.com. I use the U.S. stcok market as my backbone, as I believe it will continue to rise over the long term, but supplement it with some other areas to be even better diversified. I'll go through my target allocation for this year:

• VTSMX - 50% - This Total Stock Market Index fund is the backbone of my allocation and represents an investment in all U.S. domestic stocks. This includes large CAPs, small CAPs, mid CAPs, etc.
• VGTSX - 10% - Total International Stock Market Index holds the larger European and Pacific funds, as well as emerging markets.
• VEIEX -10% - Emerging Market Index increases the exposure to emerging markets, which has had great return recently, although traditionally it is a volatile sector.
• VGSIX - 20% - REIT Index fund provides a very diversified investment in the real estate market.
• DBC -10% - Commodity Index ETF that tracks 6 areas: Crude Oil, heating oil, corn, wheat, aluminum, and gold. Provides some inflation protection.

The recent return (as of March 7, 2008) is shown above for this allocation. Obviously, the year to date numbers won't look too good with the recent stock market performance. Also note that DBC has only been in existance for 2 years, so I don't have any five year numbers for it.

My goal for this portfolio was to continue investing in the U.S. stock market which has historically provided solid performance. In addition, diversify into real estate without having to actually buy property and become a landlord. The emerging and international markets also provide weaker corrolated returns, as does the commodities markets, for times when the stock market slows or weakens. I expect oil demand to only increase over the next few years, as will food prices. However, I am not sure how long gold can keep up its pace, but as the dollar continues to weaken it could continue to grow. I'll re-examine the target allocation at years end.

Comment below with your current target allocations.

Equity Asset Allocation

Before proceeding with determining your equity asset allocation, be sure you have read my previous posts: Are you ready to begin investing? and Investing for the Short and Long Term, where you can determine what type of investing you are ready for and where you should place your money for the short and long term.

Determining your asset allocation is the most important step in investing. This is a long term approach to investing and has been proven to be more important in your success than trying to time the market. A great book on the subject is Asset Allocation: Balancing Financial Risk by Roger C. Gibson. In this post I am just going to concentrate on the equity portion of your investment, but much of this applies to your entire portfolio. I will give a few guidelines for now and next post discuss my current asset allocation.

First there a few assumptions you must agree to before beginning.

• This is a long term strategy
• The sectors your are investing in will go up in the long term

Now to the guidelines:

1. Use a diversified approach. Anyone who has been following the markets the last 3 years can see the value of diversification. We have seen multiple sectors lead the market and then pull back, whether it's been housing, large caps, gold, oil, emerging markets, etc. Your goal is to have exposure in all these areas. Focusing on just one would work if you could always predict which will be the winner this year, but that is nearly impossible. You can certainly overweight your allocation to favor one, but should have exposure in all. To stay truly diversified you need to invest in sectors that are uncorrolated, so that they don't all go up and, more importantly, down at the same time. Everything has some corrolation to one another, but there are different degrees, for instance oil is negatively correlated to large CAP stocks, gold is positively correlated to inflation, small CAP stocks are strongly correlated to larg CAP.
2. Stay comfortable. You need to be comfortable with the risk level and volatility of your allocation. Just as you have already allocated between equities and bonds to meet your comfort levels with risk and volatility. More volatile areas of the market such as commodities or emerging markets, may not be something you can stomach, even if they are promising higher returns. And this is important because of...
3. Stick to your allocation. You need to choose an allocation and stick with it. Otherwise you are starting to play the market timing game. Tweaking your target allocation every year after analyzing where things are going makes sense, but do not try to tweak every month.
4. Don't chase past performance. You need to be forward looking in your allocation. Often areas that have been the biggest losers last year, might be good choices for this year. Likewise, winners at all time highs maybe ready to fall (think real estate, tech bubble)
5. Low expenses. Choose your allocation first and then find funds with the lowest expense ratios. I believe in sticking with index based funds or ETFs, especially in taxable accounts. This is because they have shown to outperform actively managed funds in the long term, have low expense ratios, and very low distributions since they have a low turnover.
6. Re-balance your portfolio yearly. After you choose an asset allocation you believe in and are comfortable with, rebalance it at least yearly, or whenever the allocation deviates by 3 or more percent. This ensures that you capture any gains made and transfer them to your lagging sectors. This is a good idea for 401ks and IRAs, however this will trigger capital gains tax in taxable accounts, so an alternative is to rebalance by adding new investments such that you rebalance it.

This brings me to the investing discussion. You can buy shares via lump sum or regular installments throughout the year. A few methods exist:

1. Dollar Cost Averaging. Where the same amount is invested each time period for each fund according to your allocation. This keeps your investment amount constant, but your purchase amount changes, as you buy more shares when they are cheaper and less when they are expensive.
2. Value Cost Averaging. You change your investment amount depending on the current value of your investments. You set a target value of growth for each fund each period and only invest enough to bring it up to that target.
3. My method. My method is a combination of both, I try to constantly maintain my target allocation. So I am in effect rebalancing each period by adding new money.

In my next post I will discuss what my current asset allocation is and invite others to post comments as to what they are using.

Prosper Lending

I have been involved with peer to peer lending site Prosper for almost a year and a half. I decided to try it out as further diversification of my portfolio and because I thought the idea was interesting. For those who don't know, Prosper allows peer to peer loans to be made. Basically borrowers apply for a loan, and many lenders bid on the interest rate with a small piece of the loan. For the lenders, the rates are higher than you could get with a CD or money market, but for the borrowers lower than most credit card rates, usually in the range of 7-25%. However, with the higher interest rates come the risk of default. Typically, a lender would own many loans in the range of $25-$50 spread across a diverse set of credit ratings.

Not surprisingly, this interest rate mostly attracts borrowers who couldn't get a home equity or lower interest loan, so you know immediately these are rather risky loans. Doing a quick look at the lendingstats.com you can find a lot of statistics on current lenders. The average return on investment (ROI) for lenders with loans of >6 months is shown in the graph below:

I started with a pretty diversified investment of $3,187. Over the last year and half, I 've seen two loans default, two get paid off early, and the rest are current.

One problem with Prosper is I can’t really trust the ratings and there is a very high default rate. Virtually everyone has experienced at least one default who has loaned any sizable amount of money. The current Prosper history of all loans is shown below.

Note that 10.2% of all loans are currently 3+ months late or defaulted. Typically 3+ month late loans don't become current. Then the loans that are in really good shape, end up paying off their loan early. So you don’t make much interest off of the good loans, and you are stuck with a number of risky loans that may default. Just one or two defaults can seriously eat into your profits for the year. Last year I had about $2900 invested and ended up with net profits of $19, while my current ROI is estimated to be 7.18% for the life of the loan. Plenty of A rated loans default as well. See from my loan breakdown below that I had a diversified collection. An A and C rated loan defaulted, while a AA and D loan were paid early.

Finally, perhaps the biggest problem is there is no liquidity. There currently is no secondary market, so your money is tied up until the loan is paid off in a maximum of three years. I would consider investing on a continuous basis if I was able to pull it out when I needed. Here are a few things I've learned and suggest:

1. Don't setup any automated investing through Prosper, you can use filters, but in the end you need to do a little investigating before pulling the trigger,
2. Don't invest in any businesses: Most businesses go bankrupt and there is very little damage to the individual's credit (or motivation to pay off the loan) if they had it setup as an LLC.,
3. Fund only smaller loans, <$3,000, as there is less chance of them falling behind.
4. Research online using LendingStats and the message boards at Prospers.org.
   
   

ETFs vs. Mutual Funds

Quick list in the difference between Exchange Traded Funds (ETFs) and Mutual Funds. If you listen to talk radio financial advice, you may have come across Ric Edelman, financial planner extraordinaire, who loves to bash mutual funds (since his last book came out). He, besides endlessly promoting himself, pushes ETFs instead. However, he is making an apples to oranges comparison. His main problem with mutual funds are with actively managed funds, while ETFs are index based funds, so it is more proper to compare ETFs to index mutual funds. So if you believe in the philosophy of investing for the long term by indexing, I think both options are equally good. Main differences:

• ETFs are traded throughout the day on the stock market, Mutual Funds are only bought at the close of the market. For the long term, this is not a major issue, as you can more precisely buy and sell and ETF using limit or stop orders, however with mutual funds you need to check the index performance and decide to buy or sell just prior to market close. If you are dollar cost averaging and investing for the long term, daily market swings are unlikely to cause a major difference in performance. Slight advantage to ETFs.
• ETF transactions incur a broker commission. Index mutual funds have no transaction costs. Ultra low cost brokers do exist, so this can be somewhat mitigated, but for dollar cost averaging, ETFs will cost a little more. Slight advantage to mutual funds.
• Expense ratios for each are very low. ETFs are typically slightly lower. For example, at the moment VTI (the total stock market ETF) vs. VTSMX (the total stock market mutual fund) is .07% vs .19%. Both are very low compared to actively managed funds that can be 2% or more. To see what this means for performance, I compared the total performance of each over the last 5 years. Currently they are almost identical, VTI is up 69.5%, versus 69.7% for VTSMX. So the mutual fund actually did better. This comparison will vary based on what indexes you are using and which mutual fund product.
• Tax advantage is really none. Both should have minimal distributions, since there is low turnover, and both will generate income from dividends. Capital gains are handled the same.
• Minimum investments for ETFs are one share. Often mutual funds require a few thousand dollars to open the account and then some small amount per transaction ($50 or $100). This is an advantage for ETFs for the very small investor just starting out.
• ETFs can be shorted and Options are available, so calls and puts can be used. Mutual Funds cannot do this. So for the very active trader, ETFs are a much more sophisticated product.

While ETFs and index mutual funds are quite similar, there are some advantages to each. For the long term passive investor, either will serve you well. If you are currently invested in quality index mutual funds, there is no advantage to transferring that to ETFs. If you want ultimate control and have a very low cost broker, ETFs are probably better, but don't be scared away from mutual funds. No matter which you choose, what is ultimately important is your asset allocation, and low expenses. Research has shown those factors to far outweigh market timing techniques over the long term.

Myths about the Government Stimulus Package

I couldn't help but write a quick note to correct misinformation about the Government Stimulus Package. There has been a lot of discussions in both the media and discussion forums.

• This is not merely an advance on your 2008 tax returns. This is an actual rebate of $600 that is in addition to what you would have gotten. Yes you are getting it early, but it is additional money. Which is why it will cost an additional $170 billion to implement.
• The purpose of the stimulus package is to help the economy, not to help the individual. There is a lot of discussion about what is fair, where the cutoff should be, and who is wealthy. This is not meant to help the poor, unemployed, or middle class; it is meant to help the econonmy. Consumer spending drives the US economy, the main purpose is to pump money into retail and raise GDP. Unfortunately the Government can't do that itself, so it needs a proxy to do that, and that proxy is the consumer.
• Opinion: There is no better way to get the money in the hands of consumers than a check. Debit cards, gift cards, etc. cost more, are less secure, less liquid, and provide no real benefits. Changing tax rates such as payroll taxes favor the wealthier and is a logistical nightmare. Plus you need a lump sum amount, not a small amount over many weeks.
• Opinion: This stimulus package is good for votes, but will do little to stimulate the economy. Look for actual spending to increase slightly over the next few months, but it will not be sustained.

Investment Goals

In the spirit of my last post about investing for the short and long term, I decided to keep track of my current goals publicly on my blog. These only include goals outside of retirement. I listed my short and long term goals in the table and show how close I am to achieving them in the bar chart. I'll keep updating them throughout the year. I included the end target date in the name.

• The yearly investment goal includes all investements for the year
• The emergency fund is currently fully funded in a money market
• The new house fund is in a taxable Vanguard account
• The car fund is also being funded in the money market
• The college fund will be in a Vanguard 529 plan
• The new bathroom fund will be in held in a money market

I am currently contributing half of my investment money into a money market, which is building up my car fund, and half into index funds, which is building up my new house fund. My plan is to continue that way until the car fund is done, hopefully in 3 months or less. Then I will start funding the bathroom fund with the money market half. However, in July I will start investing in the College Fund with 100% of my available money, using a 529 Plan, until I reach my goal of $70,000 in 2 years or less. At that point, I will continue with the half long term investing, half short term investing allocation.

Investing for the Short and Long Term

Please be sure to first read my previous post "Are you ready to begin investing?". If you have determined that you are ready to invest, then keep reading. When putting together an investment plan you need to initially consider two things: (1) when do you need to use the money, (2) and how much money will you need. This determines your risk tolerance and volatility tolerance, as well as how much you should be contributing.

If you are planning to have a major purchase soon, using your investment money in the next 1-4 years, then your tolerance for volatility is low. Long term investment goals for 5 years or greater have a higher tolerance for volatility. I recommend splitting your investments between the two different goals.

For short term purchases and emergency funds, establish a high yield money market fund. Using something like ING Direct, Vanguard Prime Money Market Fund, or something similar. "High Yield" for a money market as of February 2008 is considered to be around 4.1%. Look for low expense ratios in the fund, less then 0.5%. I personally use Vanguard's Prime Money Market Fund. This is where you can keep your money liquid and safe, while still earning some return. If you don't need to keep the money liquid you may also consider a CD for a higher yield, however right now CDs are yielding less than money markets as interest rates are expected to continue to fall.

Long term investments for things like retirement and college should be allocated in a diverse portfolio with higher volatility. I do not consider retirement to ever be a short term investment, therefore it should always have a volatile component. Even if you are 64 and plan to retire at age 65, retirement is not a single "purchase" and needs to continue for another 20 or more years. Therefore, it is a long term investment.

Risk vs. Volatility

Often, people are interested in low-risk, high returns, and guarantees. Unfortunately it is impossible to accomplish all simulaneously. I prefer to look at risk and volatility separately. I define here volatility as the change in returns from year to year. While risk is the chance of not meeting your goal. Having low volatility is not necessarily good, as it still may be risky. Most important is the expected return over the long term, as a longer time horizon will smooth out the volatility and lower your risk. Generally, equities are considered to be more volatile, with bonds and CDs much less. However, there may be a greater risk that you cannot meet your goals using bonds and CDs, than with equities.

Determine Your Goal

Whether investing for a car, retiremement, or college, you need to know your end goal for funds. Sometimes, the cost will drive your purchase date, and sometimes the purchase date will drive your monthly contribution. Either way, determine how much you will need and plan how to get there. There are numerous online tools to calculate this such as savingforcollege.com and retirement calculators. They also can help with things such as asset allocation to meet your goals.

For long term investments, a combination of bonds and equities will likely be necessary to meet your target goal, to provide you with adequate return. As equities, have historically provided the greatest return and volatility, these should be used increasingly as your time horizon is long. As you approach your goal amount, shifting your allocation to all bonds or other fixed incomes is advisable.

My Allocation

I have employed for a few years now a simple formula for splitting these investments. First, as mentioned in another posting, I fully fund all retirement accounts. I then take was is left at the end of each pay period and evenly divide it between a money market fund (where I already have a $15k emergency fund) and my equity mutual funds. I use the money market fund for my short term goals, which have included a new kitchen, bathroom, and car. There is always some major purchase I am saving for, but if there wasn't, then I would increase the amount I put in my equity funds. I am currently saving for a new (used) car that I know I will need in the July timeframe. In my retirement account I invest almost 100% in equities, as retirement is at least 32 years away for me. I plan to shift to about 75/25 when 10 years away, 65/35 when 5 years away, and 50/50 when in retirement. The goal is continue to earn an annual income of 6-7% while in retirement to support a 4% distribution and 3% annual inflation. You can see my investment goals here.

My asset allocation in equities is done almost entirely with index funds and I passively manage them, only rebalancing yearly. I'll get into more detail about my asset allocation in another post, but I'll summarize by saying I like a small number of highly diversified funds. We've seen many sectors, such as emerging markets, real estate, large caps, and international funds take turns as the market leaders and I believe in owning them all.

My Super Tuesday Vote

I live in New Jersey and we will be voting February 5 as part of Super Tuesday. I have been waiting to let the dust clear before making a decision, but now that the field has been narrowed, it is time to choose. I will be voting in the Republican Primary, which has become a two horse race. For me, it comes down to a few issues that I base my decision on: taxes, energy, spending, the war, and illegal immigration. On most of these topics, I feel the Republicans pretty much agree, although their implementation may differ somewhat.

I'll give you the bottom line upfront and say that I will be voting for Mitt Romney. Although I may have been voting for Guilliani if he was still running. Now let's look at each of the issues:

• Taxes. They all agree to keep income taxes low, eliminate or fix the AMT, and make the current "Bush" tax cuts pernament. McCain and Romey propose to do this by keeping the current rates. Mike Huckabee and Ron Paul want to do this by completely changing the tax system. Huckabee with the completely unfair FairTax, and Paul by eliminating all taxes. Neither solution would ever be supported by Congress, and thus are not realistic. Romney also would like to reduce corporate taxes. I believe these changes are necessary to keep the American economy strong and make America companies competitive, where we currently have one of the highest corporate tax rates.
• Energy. Everyone agrees we need to lower our dependence on imported oil. The best solution is massively and rapidly increasing our production of nuclear energy for electricity. Aggressively drilling for oil where it currently exists in North America (e.g., ANWR). At the same time, increasing our reasearch and use of alternative energies in our cars. However, this has to be balanced with our food supplies. Tapping into our food supply to be used as fuel causes inflation in all our food prices and may not be the best solution. All the candidates favor a strong, bold energy plan. However, Mitt Romney and Mike Huckabee seem to align best with my views. Ron Paul believes in free market forces to guide energy, but because of the enormous initial expense of building new plants and bringing new solutions from research to the mass market, I believe you need Government incentives. Allowing the best and cheapest solution to merely win out, means the dirtiest coal solutions may be in our future.
• Spending. The theme is low. From the extreme low preached by Ron Paul that is supported by his no income tax plan, to the more moderate levels of the other candidates. John McCain has long been working to end earmarks and proposes the line item veto. However, simply eliminating earmarks will not do it alone. In addition, no new programs should be formed and existing programs need to be scaled back. This is the root cause of where Democrats and Republicans really differ, Democrats want to help America by increasing services and spending, Republicans want to lower costs by minimizing services.
• The War. All candidates except Ron Paul want to finish the fight and come home victorious. Whether you were originally in favor of the war or not, the fact is that we are in it and need to now complete the mission. Paul may like to argue the premise of the war, but we need a President who is going to complete the job decisively and as quickly as possible. This is where John McCain has the advantage in my mind, with his experience and service. The other candidates are talking the right strategy, but are still unproven.
• Illegal Immigration. This is John McCain's weakness, having supported amnesty for illegal immigrants. The other candidates all support strong physical borders, strong screening, and an increase in agents. We need to stop providing support for illegal aliens and instead provide a more controlled immigration process and increasing the speed of the process will encourage immigrants to come in the proper way.

In addition, I like what Mitt Romney accomplished in Massachusetts on health care. To me, the religious views of the candidates are unimportant, unless those views would negatively influence the issues listed above. Remember, there still are the Congress and Courts to keep the President in check. The criticisms of "flip-flopping" have been used on both Romney and McCain so I look at that as a wash. McCain will probably win the majority of votes on Super Tuesday, however it will be interesting to see if Romney can keep it close.

Government Stimulus Package: The Senate Strikes Back

The battle has probably just begun, but as I predicted in my previous post on the Government Stimulus Package, the Senate is trying to shove additional spending packages and "help" for the unemployed. This will probably continue for two weeks (Feb. 15), so I will update this post as it becomes clearer but they have already mentioned:

• Cutting the rebate to $500
• Giving the rebate to all earners, wealthy, Social Security recipients
• Extending unemployment benefits

What the Senators are forgetting is that this is not an aid package to workers and unemployed, which are at historical lows. This is supposed to stimulate the economy and I still disagree giving people money to spend will have lasting effects. It will show a bump but no long term effects. Stimulating businesses, expansion, and entrepreneurs have a much larger impact on the economy, although it may take a little longer to see its effect. It is becoming a money grab and we can't leave anyone else, lest we offend.

Bob Brinker MoneyTalk Commentary 1/26-1/27

Some of the more basic questions came up today on the show. These questions almost come up every week:

Pension: Annuity vs. Lump Sum

It almost always makes more sense to take the lump sum and invest it yourself. However, people always like the sound of "guaranteed" money for life. The call on Saturday had the following scenario: lump sum of $1,000,000 or $60,000 per year for life, indexed 3% for inflation. People often think the only risk is how long they will live, but while that is important, the return is equally important. This example shows a 6% return plus 3% indexing, so really about 7.8% return, however this return includes eroding your principle (since you never get that back). Time is a really important and interesting factor here. The longer you live, the more payout you get, but also the easier it is to beat the 7.8% return by investing a portion of that lump sum in stocks. The expected returns of equities over the long term is greater than 7.8% per year. In addition, you still have your original principle. In the annuity, all you get is the return, the principle is owned by the annuity company. More details:

• You need to live at least 14 years to be paid back the $1M
• There may be a tax concequence of receiving the lump vs. yearly, it all depends on your other income, but for sure the lump would be taxed at 35%
• Even if you assumed a very conservative return of 5% on your lump sum, you would have to live 25 years before the annuity returned more. And over that long term I hope you would use a more aggressive approach with your lump sum.

High Inflation

Every week someone calls in to argue that they are seeing high inflation, no matter what the CPI is saying. And every week Bob gives them an ear full. Here is the problem: most people ignore the big and less frequent things and only concentrate on what they do often, buy food and gas. Of course these are seeing high inflation, energy is up 18.1% for the year, and food 5%. However, less frequently purchased items such as housing, apparel, recreation, and education are down or very low inflation. See the whole report here. The point is that despite the higher energy costs, the price of things like apparel are not increasing, in fact they are down -0.4%. This is because the higher costs for food and energy leave less money to buy extras, and thus less of a demand, this keeps the prices in check. If we had true inflation, all of these categories would be higher.

Government Stimulus Package

There were many ideas again on how to best stimulate the economy. Bob still prefers they lower the pay roll deduction on Social Security. He is right that it would be similar in that it does not help people of above a certain high income level, it would only delay slightly how long it takes them to max out the contribution. However, I think the Government thinks sending out a physical check is more tangible. Getting a little bit more money in every check doesn't necessarily make you go out and spend it, like a fat check in the mail would. He also fails to realize that doing what he suggests would give the middle class more than the poor. I might have to call in and explain this to him. For example:

• If you earn $35,000 per year and they lowered the witholding from 6.2% to 3.2% you would save $35,000 x 3% = $1050
• If you earn $50,000 x 3% = $1500

Yes, the person making $50,000 still contributes more to Social Security, but this is not the same as having everyone pay 6.2% and send a flat check of $600.

And for the dumb question of the day...
One caller asked about using options to buy stock from his employer at a price above market value. He was trying to justify exercising an option to buy at $47, when the current values was $43. I don't think he understood that those option are currently considered "out of the money" and worthless. There is absolutely no advantage or reason to use those options now. They do give him a ceiling on the maximum he'll ever have to pay for the stock and if the stock goes above $47 then he should exercise, when and only when he wants to sell the position or when the options are about to expire. If they are about to expire and they are equal to or below $47 then let them expire. Likewise, if you want to buy and hold the stock, don't do it until they will expire (unless you really want that dividend income). Bob understood this but seemed to toy with the guy a little and never gave him the straight answer.

Housing Crisis, Solution: Time

There are three basic categories of people feeling the effects of the housing recession.

1. 1. The seller who can no longer sell his house for the price they think they deserve. Anybody can sell any house quickly if they lower the price enough, however people have been spoiled from skyrocketing prices and can't bare to face reality of what there property is really worth now.
2. 2. The mortgage holder who can no longer afford their property. This is because they either took the gamble that they could refinance their house before an ARM kicked in, they thought they would have significantly larger incomes, they thought they would quickly be able to resell their house (speculators), or were too ignorant of finances to understand what they were doing (perhaps helped by fast talking/moving mortgage brokers).
3. 3. Realtors, mortgage brokers, loan officers, and real estate investors who are no longer enjoying the income from large volumes of sales and new loans.

The good news for (1) above is that if you are selling and buying in the same area (or maybe in another area) you will enjoy lower purchase prices as well, so in many cases you will get a similar discount on the purchase, and it cancels one another out. In case (2) I really can't feel too sorry for those who took out loans that were larger than they can afford. They took a gamble and it is not paying off. Some people like to play on emotions and say people should be protected from getting kicked out of their homes, but in actuality these places should have never been their homes in the first place, otherwise they could afford their payments. Politicians, such as Hillary Clinton, want to help these people and have been proposing ridiculous solutions:

I have a plan - a moratorium on foreclosures for 90 days [and] freezing interest rates for five years, which I think we should do immediately,

And Edwards, not to be topped, has proposed a longer freeze of seven years. These plans at best are useless, at worst illegal. How can the government step in and re-write legally-binding contracts? A moratorium on foreclosures will merely postpone the inevitable. However, illegally forcing freezes on interest rates makes no sense. First, these are risky loans, and investors have purchased these notes (as you've probably noticed mortgages are sold and re-sold often) knowing the risks and expecting appropriate returns in return for the default rate. Second, this will only cause subsequent loans made by the banks to be abnormally high as they will need to recoup these costs, which will further drive down housing prices. The main reason housing prices appreciated so rapidly was the availability of cheap money. I defy you to find a time where prices rose and interest rates were high.

The only way to resolve the housing issues is time. The current interest rates are very low and still falling. Most likely there will be 15 year mortgages under 5% by the end of January for credit worthy investors. This is of course due to the Fed cutting rates to 3.5% and will probably drop soon to 3.25% or 3.0%. The last time rates were this low is May of 2005. This will help lower the reset rates on subprime loans and maybe prevent some of the foreclosures. But only time will help set the new equilibrium of housing prices, where the spread between bid and ask prices are $0.

While it feeds the pationate emotions of the desperate, the bleeding hearts, and voters to force a solution to save all the unfortunate people losing their homes, and it might make you a hero come election time, it doesn't allow the natural forces to correct inequities. People used to complain that house prices were so high and unaffordable, that was fueled by easy money, and now will be corrected at the expense of those who took the easy money, but never had the means to repay it.

Government Stimulus Package

By now, everyone has seen the headlines: $600 tax rebate for every working person, $1200 per family, plus maybe $300 per child. This includes rebates to those who did not pay taxes, but at least earned $3000 (only a $300 rebate for them). They now are including an income limit of $75,000 per single person and $150,000 per couple, where the rebate will decrease, but no details on how or where it goes to $0. They say this is aimed at the "working" and middle class. So good news, if you make more the $150,000 combined income you are no longer middle class, but I guess considered rich! Of course, where I live $150,000 is not wealthy, not when a three bedroom house still costs a minimum $400,000.

Don't get too excited yet, as this agreement still has to be written up and passed by Congress. And already the Democrats want to tag on additional spending and Government programs, such as building roads. They are talking about trying to extend unemployment benefits and food stamps. From Charles Rangel, D-N.Y.,

I do not understand, and cannot accept, the resistance of President Bush and republican leaders to including an extension of unemployment benefits for those who are without work through no fault of their own,

Maybe because unemployment is not the problem. We are at historically low levels of unemployment. There are always going to be people unemployed. The stimulus needs to be focused on the problem areas in the economy. In truth, the most important part of the stimulus package may be tax breaks to companies and small businesses, which allows tax write-offs for 50 percent of the purchase price of plants and other capital equipment and permit small businesses to write off additional purchases of equipment. Giving people money to spend is a band aid. Giving businesses incentives to invest, be more productive and create jobs is a real stimulant to the economy. Although it is not clear this goes far enough to really help businesses, thus is the problem with compromise.

The Dems really want to hand out free money to the middle class and working class (like the rest of us don't work). Why? Because they make up the largest voting base for one. They are against helping out businesses. While the Republicans would like to use business to stimulate the economy, which is longer lasting. So we get a little of each, but probably not enough to amount to anything. It will be interesting to see how this changes when Congress gets a hold of it. Likely it will drag on for a while and be diluted and expanded before going to the President, who probably won't be able to veto it in an election year.

Bob Brinker MoneyTalk Commentary 1/19-1/20

Interesting discussions this week about energy issues, especially nuclear energy. Regular listeners to MoneyTalk would not be surprised to hear that Bob is a big supporter of nuclear energy. I've favored nuclear energy except for the waste problem. However according to Bob's guest, Dr. Bill Wattenberg, all the nuclear waste generated for a family of four over 20 years can fit in a shoe box. In addition, they now can recycle the waste and what would be left fits in a shot glass.

I did a little research on the subject, but I find it hard to get the truth. It seems that no source can agree on the facts. Greenpeace and the Sierra Club call nuclear energy too dangerous for the environment and unsafe. There is no doubt that both sides are overplaying fears or the technology. Our current energy production using coal, oil, and natural gas polute the environment way more than nuclear energy would. What is generated by nuclear energy is confined, unlike coal and oil that pollute the air. The "risk" of pollution from nuclear energy is very small (though not 0%), however, the risk from fossil fuels is 100%.

I tried to dig up some facts:

• France gets 90% of it electricity from nuclear power plants
• No CO2 emmisions from the nuclear power plants (however I have seen arguments that mining the uranium, creating rods, and transportation makes up for it)
• The cost of nuclear energy is more or less than other sources, depending on who you listen to. Below is a table from the Nuclear Energy Institute:

Bob and his guest also argue that ethanol is a scam. Environmentalist and farmers love the idea of growing your own energy in the ground, however, opponents claim it costs too much money and energy to convert corn to ethanol. The amount of CO2 and other energy spent in the conversion process makes it a no better solution than oil. If it takes oil to make ethanol, then what is ethanol really buying us? The same argument is made against nuclear, but if you believe the table above, it just isn't true. Who to believe in all this?

Government Bail Out Part Deux

First it was the housing market. Now the broader economy. The Government is looking to bail out the slowing economy. President Bush is looking to eliminate the 10% tax bracket, which would save everyone that already owes taxes $800 a person. What the Government is saying with this:

• They fear the economy won't recover on its own
• The consumer's propensity to spend can save the economy
• People are not expected to pay off debts or invest, but spend, spend, spend
• Tax rates must be too high as they are willing to lower them
• Lower taxes equals a stronger economy

And both the Democrats and Republicans seem to be behind this. Could this be because it is a election year? Interesting how the Democrats mostly want to raise taxes if elected, see my entry, but here agree they need to cut taxes temporarily to stimulate the economy. I don't particularly like the Government mailing out checks to help the economy, unless they are backing it with less spending to cover it. Unsurprisingly, the Democrats want to additionally increase spending plans such as repairs to highways and bridge to stimulate growth. Although, there is no doubt we need infrastructure repairs, it can't be paid for by temporary tax cuts. This is an attempt to pile on more spending, under the guise of helping the economy. I probably won't mind seeing my check in the mail, however fiscally irresponsible it may be.

Maximize 401(k) Employer Matching

Be sure to maximize your matching funds from your employer. Money from your employer is basically tax free money that you lose if you don’t properly configure your contribution amount for each paycheck. Typically, a company will match your contributions at some rate up to a percentage. For example, the company may match 50% of your contributions up to 12% of your pay. Or 100% of your contributions up to 6%. Both effectively paid a maximum of $7,750 for 2007 (and 2008). However, to collect that amount, you need to be sure of two things. As a minimum, you must at least contribute up to the matching amount, or 12% in the first example and 6% in the second. Second, you should only contribute over that minimum if you will not max out your yearly limit early. If you do over-contribute, it will reduce the amount you receive from your company matching. For example:

For someone who makes $150,000 and receive 50% match up to 12%:

(a) They should be contributing at 12% per month, but not any more. Since each month they would contribute $1500 and there company would match at $750. After 10.3 months they would be at $15,500 and have a company match of $7750. Maximum contributions for both.

(b) If instead they contributed more at 15%. Each month they would contribute $1875 and be matched $750 (since capped at matching upto 12%). After 8.27 months they would hit the maximum contributions of $15,500, but the match would only be $6200.

Bob Brinker MoneyTalk Commentary 1/12-1/13

The MoneyTalk On Demand sound output has been really low recently which means I can only listen in quiet places. Anyone else have this problem? Once again Bill Flanagan was hosting. Does Bob work anymore?

Again they were talking about return on rental properties. The caller was contemplating the value of only getting a 5% return on rent. He wasn't considering the appreciation. Rent is analogous to stock dividends, and appreciation, capital gains. You need to consider both portions. Bill Flanagan didn't really give the best advice saying "Real estate doesn't always go up, may you'd be better off investing in the stock market". He was really pushing him out of the rental property. However, the stock market doesn't always go up either, as we are frequently reminded. To compare both equally, you need to look at the expected return and volatility of both and see what makes sense for you.

Every week there are so many calls on Roth vs. Tradition IRA or Roth 401(k) vs. regular 401(k). As, Bill said, it is the choice of pay now or pay later. There is no real perfect answer to this question. If you are in a low tax bracket now, like 15%, it probably makes sense to invest in the Roth. But that still assumes that one, the rules won't change in the future, and two the tax brackets don't significantly change. It is entirely possible that in the distant future, taxes rules will change. Highly unlikely, but say we moved away from income taxes and created a national sales tax. Or say the tax brackets shifted lower. Then the Roth IRA was not the best choice. Financial planners are now advising that because of the uncertainty, you invest half of your retirement savings in Roth and half in the traditional IRA or 401(k). I still prefer to put everything in the regular 401(k). For one, I am not in the lowest bracket, and I would rather save now on taxes. Those savings translate into me having more to invest outside of the 401(k).

There was a caller who said he had $200,000 he could not lose. He wanted no risk. Bill correctly said he only had a few options, GNMA, Treasuries, and CDs. However, Bill missed an opportunity to really probe why he wanted "no risk" and what the money was need for. The caller went on to reveal he needs this when he retired in 15 years. With a 15 year time horizon, he really is missing out on a opportunity for much greater returns with relatively low risk of loss of principle. There are also risks of under investing, mainly that you will not keep up with inflation.

2008 Candidates: Taxes and Investing

I came across a pretty good summary from the Tax Policy Center of the presidential candidates' positions on taxes. The general summary, as would be expected, is that Republicans want to either maintain the current tax structure or cut taxes, while the Democrats want to raise taxes. This refelects that the Democrats want to increase spending and need a way to pay for it, although it is not clear that the tax increases they suggest will fully pay for the programs. Not all candidates have provided equal detail about their plans, which is probably a smart thing to do when you need to raise taxes. The Tax Policy Center provides a nifty excel spreadsheet of the candidates proposals. I summarize below and supplemented it with some additional information:

Hillary Clinton

• Repeal tax cuts for the upper two brackets
• No AMT plan
• No capital gains plan
• Keep Estate Tax at 2009 levels, $3.5M, and extend beyond 2011
• Match savings plan contributions up to $1000 ($500 for income over $60,000)

John Edwards

• Repeal tax cut to upper bracket (back to 39.6%)
• No AMT plan
• Raise the capital gains top rate to 28% (from 15%)
• Estate Tax Exemption set to $4M

Barack Obama

• Repeal tax cuts for the upper two brackets, no income tax for seniors making under $50,000
• No AMT plan
• Repeal tax cuts on capital gains and dividend (bring back 20% and 10% brackets)
• Estate Tax Exemption set to $7M
• Provides a number of new tax credits

Rudy Guiliani

• Keep current income tax brackets and create an alternative F.A.S.T system
• Index ATM to inflation
• Lower capital gains and dividends tax to maximum of 10%
• Eliminate all Estate Tax
• Make a Bush tax cuts permanent, expand tax free savings accounts

Mike Huckabee

• Eliminate all income tax and replace with a FairTax
• National sales tax of 23%

John McCain

• Keep the current income tax rates
• Eliminate the AMT
• Keep the current capital gains and dividend rate
• No details on Estate Tax for 2011 (when current law resets Estate Tax exemption to $1M)
• No tax on Internet and cell phones

Ron Paul

• No income tax
• Reduce capital gains and dividends
• Fund government wholly on excise taxes and reduce government

Mitt Romney

• Keep current income tax brackets
• No AMT plan
• Eliminate capital gains, dividends, and interest taxes for AGI below $200,000
• Eliminate Estate Tax
• Keep Bush tax cuts
  

So is this a case of the Republicans saying what people want to hear? Not really, it is just two different classic philosophies at work. The Dems want to provide more services such as universal health care and pay credits to the poor. While the Republicans look to stimulate growth through lower taxes and tax credits for health care. Research has shown that tax cuts don't necessarily drop tax revenues if the economy responds.

Personally, I wouldn't mind a slight increase in taxes if it was accompanied by sizable spending cuts. The Government has been stealing from the Social Security fund to pay for current and increased spending, using triple taxation (income, gains, and estate), and refusing to make obvious permanent fixes to AMT - like indexing to inflation. The AMT was intended to apply to the 155 wealthiest families that had been avoiding taxes. Now every year it threatens the middle class until temporary patches are applied. However, it is more likely that spending will increase, as it has the last 8 years regardless of the tax revenue, and outpace the tax revenue. Therefore, maybe a drastic change as advocated by Ron Paul or Mike Huckabee is necessary to change the behaviors of Congress. There is only one problem, Congress will never let it happen. They won't vote to change their own ways.

The only realistic changes are small baby steps and I have to say the most favorable realistic plan for the personal investor looks to be Mitt Romney's.

Are you ready to begin investing?

Many of my friends and colleagues at work, whether young or old, often ask for help investing, which normally means which fund to pick for the 401(k). Before you even get to the point of picking stocks and funds you need to make sure you are really ready. At least ask the following basic questions:

• What is my outstanding debt?
• What is the interest rate on my debt?
• Do I have an emergency savings fund that is sufficiently funded?
• Do I have any big purchases or expenses in the next 5 years?
• How much am I contributing to my 401k or IRA fund?

Mathematically speaking, if you have outstanding debt with an interest rate that, after taxes, is greater than the expected return on your investments, then you should not begin investing. The one exception to that rule is you should still try to fund your 401(k) to the maximum employer matching amount. This is free money that you can never make back. In general, most mortgage rates and car loans are low enough that it make sense to carry them and invest, however, most credit card rates are not. Remember most school loans and mortgages are tax deductible so the effective rate will be less than the actual interest rate (interest rate X (1 - tax rate) gives after tax rate).

An emergency fund equal to your living expenses for at least 6 months should be in a high yielding savings or money market account, like INGdirect or the many similar. This can be built up while paying off debt, but should be in place before you begin to put money at risk.

If you plan to make a large purchase such as a house or car, make sure you are saving down payment money in a high yielding money market at a sufficient rate to get you there by the purchase date.

If you have all that covered and have money left to invest, now is when you have to decide why you are investing. As that will guide you to which is the best vehicle to use, 401(k), IRA, 529 plan, taxable account, etc. My opinion is that first priority is to make sure you will have enough money in retirement. This can be covered in many ways such as pensions, Social Security, or inheritance, to name a few. If it is not already covered, then you should try to max out (or contribute enough to meet your retirement goals) your 401(k), 403(b), IRA, or similar plan before investing for a child's college or investing in a taxable account. The reasoning is that money compounding tax free for retirement is a powerful thing. If you put it off or don't fully fund it your are missing out on many years of growth. Also, you can always get a loan or use a number of methods to pay for college, but you can't get a loan for retirement (Ok, maybe you could do a reverse mortgage, but still not the best plan).

So if you are executing a realistic retirement strategy, next on the priority list would be to invest for your children's education, if applicable. There are a number of tools online to calculate how much you will need and this is a huge topic on its own. I prefer using 529 plans and recommend dumping as much as you can into it early on, up to your tax limits ($60,000 per person for the first 5 years). Again this gives it a chance to grow tax free. The online tools can also estimate how much you need to contribute monthly.

Finally, if you have all the above taken care of, then you would consider investing in taxable accounts. Asset allocation and a range of other topics will follow. I'll get into how I chose to invest in these accounts and hopefully discuss with you your ideas.

Steroids and HGH likely a bigger problem in Hollywood

This post goes under the etc. category, but I couldn't help but comment. I've been saying to my friends for a while now that probably everyone in Hollywood and every male model probably uses or has used HGH and/or steroids. Considering all the competition to look great, how could they not be using something that keeps them lean and fit and employed? It has been pretty obvious for a while now, where it seems like everywhere you look there is some new buff B-list celebrity or model. It's not like they are ever going to drug test entertainers. Eight months ago Sylvester Stallone was busted with HGH in Australia and maybe Japan. Now a report out that many musicians are linked to it. I don't really think the average musician has the time or discipline to be sculpting the perfect body, but yet there is a disproportionate number of them in music videos. Now it seems even some women musicians like Mary J. Blige are in on it. Eventually it is going to become a big scandal in the entertainment world, but one with far less impact and consequences than in sports.

Bob Brinker MoneyTalk Commentary 1/5/08-1/6/08

Bob spoke a lot about real estate this weekend. I think one interesting discussion point worth mentioning here is how to evaluate investing in rental properties vs. investing in mutual funds (or any other investment).

Bob said he likes to use cash on cash to calculate return. He didn't quite go into all the details and seemed to assume the property was payed off. Your total return is calculated by first estimating the starting value and final value of the equity in the property. Second, determine the yearly cash flow of the property, income - all expenses (mortgage, maintenance, insurance, taxes, etc.).

The return on equity for the year would simply be (final equity - starting equity)/(starting equity)=x
Note that the final equity would be a factor of appreciation and repayment of principle

The return on income would be (income - expenses)/(starting equity)=y

Total return = x + y

You can now compare the return to an investment in a mutual fund. This may seem pretty obvious, but the trap people often fall into when evaluating, is that they'll use their initial down payment on the property as a reference point. Since the purchase was highly leveraged, they'll look at the return on that down payment. In actuality, they should assume they would be swapping the cash value of the house (equity) for a mutual fund and comparing the return on that. Quite often one will find that the equity appreciation has outpaced the rental income and you can actually do much better cashing out and reinvesting in something else, especially if you factor in the management time involved with being a landlord.