Think Your Way to Wealth

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A reader, Slinky, recently commented on my article “10 Great Ways for College Graduates to Start Off on the Right Track With Their Finances” that many recent graduates know information about budgeting, and know not to go “wild” with their new found income, such as by buying a brand new car, etc, but were less knowledgeable about SAVING and INVESTING their new found income. One thing she specifically asked about was in regards to emergency funds, where one should keep an emergency fund and the pros and cons of different options. I recently wrote an article on why you need an emergency fund, and how it can be a powerful tool for keeping from getting into debt or going deeper into debt, but did not go into details on where the best place to keep one is. You want some liquidity and little risk, so index funds and the stock market are not a great place for your “base” emergency fund. You don’t want to HAVE to sell index funds at a time when the market may be down. Three of the most common places to keep an emergency fund are 1.) online savings accounts, 2.) money market accounts, or 3.) a local branch or “bricks and mortar” bank savings account.

Online Savings Accounts- Online savings accounts such as INGDirect , HSBC Direct, and Emigrant Direct generally pay a much higher interest rate than local bank branch savings accounts. Online savings accounts generally do not provide you with an ATM card, so to get your money you must transfer it to a linked checking account. Currently, I have a small amount of money in my local bank account savings account as a cushion, and I believe it pays 0.2 % interest, as opposed to ING Direct which pays 3.0% interest. That is a difference of 15 X ! For getting to your money, time-wise, with ING it takes about 4 to 5 days to transfer money in from a linked checking account, and about 2-3 days to transfer money back out of ING into your checking account. So if you think you may need the money faster than a few days, this might not be the best option for you.

Money Market Accounts- Money market accounts are similar to online savings accounts, but they usually have check writing privileges and may have an ATM card as well. They also usually pay a higher interest than a local branch savings account, many with rates similar to online savings accounts. I currently use a Capital One Direct Banking High Yield Money Market Account as an irregular expenses account and have an ATM card and checks, both of which were free. It has a current APY of 3.0%, the same as ING Direct. Capital One seems to take an extra day or two to transfer money into your account, or about 5 days. There are usually monthly transaction limits on check writing and withdrawals, for the Capital One account it is 6 withdrawals, of which only 3 can be by check, but that is plenty for my purposes and should be for an emergency fund as well.

Local Bank Branch- A local bank branch savings account is the old standard for many people’s savings, including emergency funds. You can drop off deposits in person or transfer money from your checking account, and it will be available to you by the next business day. Most savings accounts, similar to online and MM accounts, do have limits on withdrawals per month as well though. Local bank savings accounts will provide the easiest access to your money, but generally offer very little interest. Nowadays, if you are earning the typical rate savings accounts pay, you are losing money due to the effects of inflation.

So how do you determine which account is the right place for your emergency fund? -Ask yourself the following questions:

Are you likely to need cash really fast ? (Like 1 day or less)

How soon will you need access to it? Is 2 to 3 days OK?

Do you want it to be a little harder to access?

How concerned are you with rate of return?

By thinking about and answering the above questions, you can determine which account provides the benefits most important to you. If I were just beginning an emergency fund, I would probably think about using a money market account, as I like the ability to access your money with an ATM card or write a check in a true emergency if need be. I do like ING very much, I have had an account for almost 6 years, and used to really like the fact that you can’t access it immediately, although since I am more disciplined now this isn’t quite as important to me. Since a MMA provides basically instant access to your money as well, I personally find the bank branch savings account the least attractive, although I do keep a small amount of money as a back up to my checking account.

Where do you think is the best place to keep an emergency fund?

Image by purpleslog

Filed under: Building Wealth, Investing by RC - 10 Comments →

The new rates for I Bonds came out last week, and I think many people, including myself were quite surprised that the fixed rate portion went from 1.20% to 0.0%. The inflation rate went up to 2.42%, for a composite rate of 4.84%. I think most people were expecting it to drop fairly significantly and the inflation indexed portion to go up, but I don’t think too many people thought the fixed rate component would go to zero. As I have explained previously about I bonds, the total rate is the fixed rate plus 2x the semiannual inflation component plus the semiannual inflation rate x the fixed rate.

Here’s how the composite rate for I bonds issued May 2008 - Oct. 2008 was set:

Fixed rate = 0.00%
Semiannual inflation rate = 2.42%

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
Composite rate = [0.000 + (2 x 0.0242) + (0.0000 x 0.0242)]
Composite rate = [0.000 + 0.0484 + 0.0000000]
Composite rate = [0.0484]
Composite rate = 0.0484
Composite rate = 4.84%

 So what does this means for I bonds purchased now or in the next 6 months?

For many people I would surmise they have become less attractive, because if you purchase I bonds when they have a higher fixed rate (or any fixed rate, as it is now 0%), you are guaranteed a certain minimum fixed return in addition to whatever the semiannual inflation rate. However, the inflationary rate went up to 2.42%,  so the composite or total rate of return is currently 4.84%, which is not too bad, considering that most high-yield savings accounts currently return around 3.0% or less.  But that rate is only guaranteed for 6 months and then the rates will change again. If the inflation rate portion begins to trend down, and your fixed rate is 0%, your returns could end up dropping significantly. So, now may not seem like a great time. Remember, you are required to hold them a minimum of 1 year (really 11 months if you purchase them at the end of the month), and you lose 3 months interest if you cash them in before 5 years. So, if you were to cash them in after 1 year, your effective rate would be 0.75 x 4.84% (although your real rate will depend on the change in November 2008 as well) = 3.63%, which is still not too bad and still better than most liquid investments such as high yield savings accounts. Even though you will have to pay tax on the earned interest, it is deferred until you cash it in, which is also better than most liquid investments where you will pay tax on the earned interest every year.

What’s my take?

I still think I bonds can be a good high yield alternative to savings accounts, even after you look at the puzzling change in the fixed rate. One explanation to the change could be that the U.S. Government is trying to peg the I bond rate entirely to inflation, which may not make them as attractive in the future, although when inflation may start coming down is anyone’s guess. I bonds have averaged a 4.5% return over the last 10 years, and even with the change in the fixed rate to 0%, this is still the case. They are appropriate for a medium range investment, something you will not need for at least a year, and preferably 5 years so you don’t lose any earned interest. They are also tax-free if used for education, which is another positive. I recently started buying I bonds on a monthly basis, in small amounts, and am going to continue to do so. As the rates change over the future semiannual (6 month) periods, I will evaluate my strategy.

Filed under: Building Wealth, Investing by RC - No Comments →

Even though I am only 34 years old (I know, that is ancient to some but young to others), I feel like I’ve made more than my share of money “mistakes” over the last 10 to 15 years.  For whatever reason, I have done many of the things that you always read that you should not do. Here are a few of the highlights (read: low-lights!)

Taking a 401k Loan- About 7 or 8 years ago, I took a 401k loan . Well, 3 months later, I changed jobs, and of course did not have the money to pay the loan back, so I ended up paying a 10% penalty and taxes on the loan proceeds.

Cashing in a 401k- A couple of years ago, after my wife stopped working to become a SAHM, we decided to go ahead and cash her 401k in, as it was not a lot of money. We really didn’t need it at the time, but we did it anyway, and once again paid the 10% penalty as well as taxes on the proceeds.

Taking out a loan for our wedding-  My wife and I, who will hit our 5 year anniversary in a couple of weeks, were both previously married.  We did not really expect her or my parents to pay for much of the wedding, so we decided to take out a bank loan to pay off some debts and pay for the wedding.  Although it joyous occasion, and wasn’t extravagant, we paid for the wedding for the next 30 months.

Financing both of our cars for 60 months-  Even though I though I was being thrifty by purchasing our current cars used, one 2 years old and one 3 years old, I financed both of them for 60 months each.  While one will be paid off in a few months and the other next year, it was a terrible idea. I do plan on keeping the cars for as long as possible, but I am currently paying 2 car notes, and have so for the last 4 years.  The day I no longer have a car note will be a happy one indeed.

Paying the minimum on my credit cards- Up until about 3 or 4 months ago, I did this regularly for the previous 5 or so years.  Obviously, I never made any real progress on paying down my debt because of this.  It has only been in the past few months that I have begun to make real progress on paying them down.

Not investing in a 401k at my first job- Even though it was a part-time job while I was in school, my company offered a 401k plan. I could have easily invested a small amount on a regular basis, but, being financially unsavvy, I did not even think about it until I graduated college and started my first full-time job.

Filed under: Investing, Saving Money by RC - 3 Comments →

Although this is the first time in 13 years that Bill Gates in not No. 1, no, I don’t have any real secrets on how to become the next Warren Buffet (No. 1-$62 Billion), Carlos Slim Helu (No. 2 -$60 Billion), or Bill Gates (No. 3 -$58 Billion).  But the numbers themselves and the fact that they have changed over the last year do indicate something significant, yet simple in nature. While Bill Gates’ net worth only increased a modest 3.5% over the last year, that amount was $2 billion dollars!

The faster and earlier in your life you invest your money and have it work for you the sooner even an average or below average return on your investment (3.5%- about what ING Direct is paying right now) represents a significant amount of money, or, as in the case of Bill Gates, $2 billion dollars. Now, it is unlikely that you or I will ever amass enough wealth to generate that kind of money from a 3.5% return, but the more money you can sock away, as quickly as you can, the faster you will build wealth. And if you happen to have a pretty good year, like Warren Buffet, gaining $10 billion dollars or 19% over the last year, keep in mind that the total amount you will make on that investment in any given year is based on the amount you have invested. If your debt keeps you from investing for your retirement and future, you need to eliminate it as soon as possible and begin building wealth.

Filed under: Investing, Saving Money by RC - 1 Comment →

What’s the value of a dollar these days? Less than it was a couple of years ago, I imagine.  But what I am talking about here is the value of a dollar not due to inflationary effects, but rather on where that dollar is being utilized– and how much it really costs you. 

Let’s first look at paying off debt. For example, say you have $1.00 in credit card debt at 20% interest.  In order to pay off that debt you have to earn money, pay taxes on your earnings, and then pay off the debt. For the sake of simplicity, let’s say you are taxed at a 20% rate. You will have to earn $1.25 to pay off that $1.00. ($1.25 x 0.8 =$1.00). So to pay off that one dollar now, you have to earn $1.25.  Now suppose you put off paying that $1.00 for one year.  At 20% interest you owe, one year later, $1.20.  But to pay off that $1.20, you will have to earn $1.50 ($1.50 x .8= $1.20) one year from now to pay it off.

Now let’s look at building wealth.  Suppose you put $1.00 into your 401k account.  Since you won’t pay taxes on your contribution, that $1.00 only costs you $0.83 ($0.83  x 1.2 =$1.00) from your take home pay. So if you are building wealth with pre-tax dollars instead of pay off debt with post-tax dollars,  it costs you 66% less to invest $1.00 than to pay $1.00 in debt ($0.83/$1.25 =66%). If you want $1.00 a year from now, it costs you even less, depending on what interest rate you receive over the course of the year. Let’s assume 7%. You only need to decrease your spending by $0.77 now to have $1.00 in one year ($0.77 x 1.2 x 1.07 = $1.00). So creating $1.00 one year in the future only costs you $0.77 now.  If you delay paying off debt in the above example one year, it will cost you $1.50, or almost double what it takes to create $1.00.  If you were to throw in an employer match to your 401k contribution, you are talking about an even larger difference. 

(Now, I know I have not considered taxes when the 401k money comes out sometime in the future, but this example is to illustrate the difference in the price of debt (high) vs. investing, particularly over time. Even if you were to invest in a Roth IRA , to get $1.00 in a year at 7% would cost you $0.93 now, and be tax free, vs. the $1.50 for the $1.00 in debt if you wait a year to pay it off.)

These numbers show how much more it costs you to carry high interest debt and how it can actually cost less (to your take home pay) to invest, and should motivate everyone to pay off debt as quickly as possible, particularly non-deductible, high-interest debt, and begin investing. A great place to start is with pre-tax savings, to minimize the effect on your take home pay, certainly up to the employer match in a 401k if your employer offers one.

Filed under: Debt Reduction, Frugality, Investing by RC - 2 Comments →

Is now a good time to invest in I Bonds?  With the recent cut in interest rates by the Federal Reserve bank in the last month or so, many online banks, such as ING Direct , have lowered their interest rates, most under 3.5%.  While this is better than 0.2% in a regular local bank savings account, people looking for the most out of their money are always on the lookout for better returns.  Well, the I bond currently pays 4.28%.  I Bonds, a type of savings bond issued by the U.S. Treasury, pay a composite or total rate, which is a combination of an inflation component and a fixed component. Below is a table of I Bond rates for the past 2+ years. With I bond, the fixed rate remains the same for the life of the bond, while the inflation rate “resets” every six months, for a new composite or total rate. Underneath the table is an explanation of how the composite rate is calculated.

DATE            INFLATION                 FIXED             COMPOSITE
                       RATES*                  RATE               (TOTAL)RATE
1-Nov-07        1.53%     1-Nov-07       1.20%              4.27836%
1-May-07       1.21%      1-May-07      1.30%              3.73573%
1-Nov-06       1.55%      1-Nov-06       1.40%             4.52170%
1-May-06      0.50%      1-May-06      1.40%             2.40700%
1-Nov-05       2.85%      1-Nov-05       1.00%            6.72850%
1-May-05      1.79%       1-May-05      1.20%            4.80148%

Here’s how the composite rate for I bonds issued Nov. 2007 - Apr. 2008 was set:

Fixed rate = 1.20%
Semiannual inflation rate = 1.53%

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
Composite rate = [0.0120 + (2 x 0.0153) + (0.0120 x 0.0153)]
Composite rate = [0.0120 + 0.0306 + 0.0001836]
Composite rate = [0.0427836]
Composite rate = 0.0428
Composite rate = 4.28%

Historical Averages: 2 Year average 4.41%, 10 Year average 4.65%

I bond Pros and Cons:

Pros:

• I bonds are currently returning 4.28%, a pretty good rate considering ING, for example, is returning 3.40%
• The interest on I bonds can be taxed deferred, meaning they do not have to be reported on a yearly basis (as savings account interest would be)
• The interest from I bonds are tax free if used for education.

Cons:

• I bonds cannot be cashed in for 1 year. So if you have any idea that you may need the money in that time frame, this is not an option for you.
• If you cash I bonds in before 5 years, there is a penalty of 3 months interest. (i.e., you lose 3 months worth of interest.)
• I bond rates change twice a year, the next rate change will take place May 1st (The rates are usually released a few weeks earlier) So that 4.28% could (and may) go down, leaving you locked in at a lower rate for at least six months. Although the historical averarage over the last 10 years is over 4.5%.

If you have money you will not need for at least a year, I bonds may be an option to look in to. If you cash them in before 5 years you will lose 3 months interest. If you will not need the money for 5 plus years, they could end up being pretty good. Using them as part of education savings make them quite attractive-especially with the low risk.
Since you can purchase any amount starting with $25.00, adding them to your investment portfolio in small increments may be something to consider. By starting with small increments, and adding them on a monthy basis, you can create a “ladder” of I bonds, and after 60 months, each one will become “cashable” with full interest.

Filed under: Investing, Saving Money, Taxes by RC - 4 Comments →

Whenever I get worried about my retirement investments or  stock market
volatility, I try to remind myself how successful investors view the market
 and investing. Since I like to read, I frequently read books written by or
about the “giants” of investing.  Warren Buffet and Peter Lynch are two that
 come to mind, both extremely well known in the financial as well as the
non-financial world. Several years ago, I became aware of  Benjamin Graham,
the author of “The Intelligent Investor” and “Security Analysis”
(co-authored with David Dodd, a former student and colleague), the latter
book known as the “bible” of investing on Wall Street.  Graham is known as
the “Father of Value Investing”, having laid the framework for modern day
stock analysis; Warren Buffet was a student of his, and reportedly the only
student ever to receive an A+ in his class.

The following is an excerpt from an interview with Benjamin Graham,
conducted in 1976 (shortly before his death). The full text of the
interview can be found here:
A Conversation With Benjamin Graham.

(My comments are interspersed with blockquotes)

What is your view of the financial community as a
whole?

Most of the stockbrokers, financial analysts, investment
advisers, etc., are above average in intelligence, business honesty and sincerity. But they lack adequate experience with all types of security markets and an overall understanding of common stocks–of what I call “the nature of the beast.” They tend to take the market and themselves too seriously. They spend a large part of their time trying, valiantly and ineffectively, to do things they can’t do well.

What sort of things, for example?

“To forecast short- and long-term changes in the economy, and in the price level of common stocks, to select the most promising industry groups and individual issues–generally for the near-term future.”

Can the average manager of institutional funds obtain better
 results than the Dow Jones Industrial Average or the Standard & Poor’s Index over the years?

No. In effect, that would mean that the stock market experts
as a whole could beat themselves–a logical contradiction.

Do you think, therefore, that the average institutional
client should be content with the DJIA results or the equivalent?

Yes. Not only that, but I think they should require approximately such results over, say, a moving five-year average period as a condition for paying standard management fees to advisors and the like.

What about the objection made against so-called index
funds that different investors have different requirements?

At bottom that is only a convenient cliche or alibi to justify
the mediocre record of the past. All investors want good results from their investments, and are entitled to them to the extent that they are actually obtainable. I see no reason why they should be content with results inferior to those of an indexed fund or pay standard fees for such inferior results.

I don’t think investors should stand for sub-par performance,
 although we are sometimes limited in the choices we have, such as in a 401k.

Turning now to individual investors, do you think that
they are at a disadvantage compared with the institutions, because of the latter’s huge resources, superior facilities for obtaining information, etc.?

On the contrary, the typical investor has a great advantage
over the large institutions.

Why?

Chiefly because these institutions have a relatively small
field of common stocks to choose from–say 300 to 400 huge corporations–and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor’s Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list–say, 30 issues or more–that offer attractive buying opportunities.

This is a very strong argument against actively managed funds,
in my opinion.

What general rules would you offer the individual
investor for his investment policy over the years?

Let me suggest three such rules: (1) The individual investor should actconsistently as an investor and not as a speculator. This means, in sum, that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money’s worth for his purchase–in other words, that he has a margin of safety, in value terms, to protect his commitment. (2) The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques. Typically, he should set a reasonable profit objective on each purchase–say 50 to 100 per cent–and a maximum holding period for this objective to be realized–say, two to three years. Purchases not realizing the gain objective at the end of the holding period should be sold out at the market. (3) Finally, the investor should always have a minimum percentage of his total portfolio in common stocks and a minimum percentage in bond equivalents. I recommend at least 25 per cent of the total at all times in each category. A good case can be made for a consistent 50-50 division here, with adjustments for changes in the market level. This means the investor would switch some of his stocks into bonds on significant rises of the market level, and vice-versa when the market declines. I would suggest, in general, an average seven- or eight-year maturity for his bond holdings.

This is also an argument against a technique people frequently
use, (and I have myself)  “buying what you know”. Just because you like a company’s product or service, if you do not perform due diligence of the company’s cash flow,income, and assets, you may not be doing much more than “guessing”. You should justify an individual stock purchase as a “good buy”, as opposed to saying to yourself, “Well, Company X  seems like they really have their act together, I think I will buy a few shares”. The last sentence, however, is pure gold. After significant rises in the stock market, switch some of the stocks to bonds and vice-versa when the market declines. Why is it so hard to do this? And I don’t think he is implying  market timing here, either.

 

In selecting the common stock portfolio, do you advise careful
study of and selectivity among different issues?

In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.

The first time I read the last paragraph was the first time I had heard that Graham had changes his views somewhat on investing from those prescribed in “Security Analysis”, which was rather interesting to me.

In light of the recent market performance, it appears that Benjamin Graham’s advice still has merit. Here are a few tips I gleaned from reading it:

• Don’t settle for below market performance from your actively managed funds, if possible.

• Forecasting the overall trends of the market or the economy are extremely difficult,if not impossible. It is also extremely difficult to predict short term performance of individual stocks.

• If picking individual stocks, look for value and perform due diligence.

After a significant rise in the overall market, one should certainly examine a rebalancing of one’s total portfolio, as well as after a significant decline.

Look for value, including based on earnings or dividend yield.

Filed under: Investing by RC - 4 Comments →

Let me repeat. I CAN’T PREDICT THE FUTURE. 

No one can.  That’s why, in light of the stock market performance over the last few weeks, I’ve done nothing.  I haven’t sold a single share, mutual fund, or ETF.  Why? Because I can’t predict the future!  But, common sense tells me, the stock market will continue to rise. (As it has for the last 100+ years.)  Do I want to miss out on long term gains because I think the market is going to go down a little further in the next couple of months?  Since I have 25-30 years till retirement, No. 

If I had 5 to 10 years till retirement, I think the answer would still be No.

Common sense tells you to buy low and sell high.  What benefit is it to me if I catch the market on the way down, after having sustained losses(selling low), and then don’t catch it on the right time on the way up(end up buying high)? 

None.

•  If common sense tells me to buy low and sell high, do I want to sell low?
• Do I want to sell my stock investments at a loss, only to place that money into a savings account earning the rate of inflation (and less than it did a month ago due to the drop in the interest rate)?
• Do I really want to worry about when to get back in?

The answer is, none of the above. 

 The market has already come up from its low of a couple of weeks ago, approx. 6 % for the Dow Jones.  Is the market going to rise for the rest of the year?  I don’t know. No one does.  But I don’t want to be the person that got out of the market two weeks ago, and will  still be waiting on when to get back in next year.

When it comes to long term investing:

• Don’t ever think that you are smarter than everyone else.  
• Use common sense.
•  Don’t try to predict the future.

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