Tuesday, July 31, 2007
Bripblap wrote a post saying that automatic / opt-out 401K enrollment is not a good idea. I vigorously disagree, but the article is very well written. My company recently adopted automatic enrollment. Many people that do not enroll in their company's plan, simply neglect to do so out of laziness or lack of understanding. For those, destitution in their old age is too big of a punishment for those "crimes".
Brian, over at Financial Dominance, has a post about ROI criteria in selecting an MBA program. Spoken like a true MBA. Personally, I got my MBA from a top rated University of California school, and I have nothing but good things to say about the program. While part-time MBA programs may show a better ROI, as the article claims, students are missing out on several important aspects of the program, including the unique full time MBA experience, and some recruitment options. If you are going to get an MBA, I certainly recommend the full time program.
John at Queer Cents asks whether you would disrupt your life to take care of your elderly parents. My response to that question is: "HELL, YES!" Are you kidding me? These are the people that gave me life and disrupted their own life to raise me. What kind of person would I be if I let them down in their hour of need? I truly hope that I raise my kids well enough that they will one day decide to take care of me and my wife if, god forbid, we need their assistance.
Finally, Amy at Saving Advice says that lifestyle inflation can creep up on you. Well, some types of lifestyle inflation are negative, however, I have recently written a post about why lifestyle inflation is a good thing. May your lifestyle forever inflate, in a sustainable fashion...
Another carnival I am participating in this week is the Carnival of Money Stories over at The Dough Roller. Check it out. The format is a little clunky, but the content is good.
The new Festival of Frugality is up at Frugal Babe. Frugal Babe sends good wishes and health to our Kitty. Finally, the Carnival of Wealth Building Ideas is up at Business Management Life, with my article titled Stock Market Summer Sale. Enjoy.
Monday, July 30, 2007
Are you happy with your company's 401K plan?
Please cast your vote. The poll is located in the top left column of this blog.
Let's analyze the situation for a second. In securities fraud involving investors, such as options back-dating, insider trading and so forth, the primary victims of the crime are shareholders. Who else could it be? If you didn't own the stock at the time of the crime, and don't own it now, you really couldn't care less about any fraudulent transactions involving the stock. So, if we can all agree that shareholders are the true victims of such crimes, let's take this logic one step further.
The owners of a company are its shareholders. When the SEC imposes a fine on a company, the payment of this fine decreases the assets of the company, and therefore its value. If the value of the company declines, so does the value of its stock, which is owned by the shareholders. The result is that in retaliation for a crime the company committed against its shareholders, the SEC punishes those shareholders by decreasing the value of the stock they own. Hmmm... that does not sound like a very equitable form of justice to me. This is basically the equivalent of fining a robbery victim for the crime of getting robbed. If anybody can make a coherent argument against this line of reasoning, I'm listening.
So, what am I saying? Should the SEC let offending companies off the hook? Yes and no. In cases where the injured party are the shareholders, such as the cases I discussed above, I see absolutely no sense in punishing the victim. There are many other cases where the shareholders should rightfully pay for the crimes of the company. For example: patent infringement cases, environmental violations, price fixing etc. The common denominator to all of these is that the shareholders are the potential beneficiaries of such violations, which in fact may increase the value of their stock at the expense of others. In such cases, shareholders should suffer the wrath of the SEC since it is their responsibility to make sure that the management they hire to run their company does so in accordance with the law.
Still, your basic sense of justice may be telling you that somebody must take the blame and suffer the consequences for options back-dating, insider trading and the like. I absolutely agree. The ones that must pay for these sins are the people that actually perpetrated them. Let's face it, it is not the company that back-dated some options, it's an individual, probably an executive, who is responsible for this. That person should stand trial and pay the consequences for his actions. Making shareholders pay for crimes committed against them makes absolutely no sense.
Sunday, July 29, 2007
1. Our Kids - our oldest will be turning 5 this week. We will hold his birthday party at a local kids' gym. The party itself will cost a couple of hundreds of dollars and we are also buying him a Nintendo Wii as a present (if I can find one. Apparently, all the stores in our area are out). All in all we'll probably be spending about $500 on the party and the present.
2. Our Vacations - we don't go on many vacations, but when we do, I have no intention of counting pennies. It's not that we'll stay at the fanciest hotels, but we'll stay somewhere nice, eat at good restaurants and get a few souvenirs.
3. Our Home Entertainment - with three kids you don't get to go out much. With that in mind, we pay a pretty penny for our cable and Internet packages, we subscribe to Netflix and we own a high-end Plasma TV. Next month I hope to also improve our sound system.
I guess what I am trying to say is that personal finance is all about making the right trade-offs, and by right I mean right for you. In my case, I am content with driving a dinged up Geo Prizm 1997, if I can spend some money on my next ski weekend.
As long as we are saving enough for our major life goals, such as retirement and education for our kids, I don't feel bad spending some money on the things that really give us pleasure.
Friday, July 27, 2007
The curious thing is that most people view a stock market decline as a bad thing, regardless of their personal financial situation. I am not quite sure why this is the case. I mean, if Macy's or Target holds a sale, they advertise it and people stand in line to be the first in the store. If stocks go on sale, people head for the exits. Can you imagine NASDAQ advertising a summer sale? That would be a pretty lame commercial, but how are the two cases different? In both cases you get a discount today for something that would have cost you more yesterday. That's cause for enthusiasm. Well, it's cause for enthusiasm if you have a long investment horizon.
Nevertheless, I will admit that a few back-to-back days of "stock market sale" can be a little unnerving. Hey, I'm not made of stone.
Thursday, July 26, 2007
Well, I've got new for you. The real estate bear market is going to be with us for a while. Here are a few recent comments on the topic:
- Country Wide CEO was quoted as saying that the housing market is not likely to recover before 2009.
- Economists from the prestigious Anderson Forecast are saying that "recovery in the housing market will resemble an “L” as opposed to a “V,” with the imploded sub-prime mortgage market representing a second leg down in housing activity.” Meaning: prices are not going to recover anytime soon.
- In his recent podcast, Bill Gross of PIMCO is warning that the "sub prime crisis" is not isolated, and that he expects the wider U.S. economy to take a hit.
- A couple of days ago while driving I heard a news story on NPR where they spoke of how badly the California real estate market is doing. California apparently has 6 of the 10 metro areas with the highest rate of foreclosures nationwide. Now get this, on the Peninsula (the area between San Francisco and San Jose) where I live, prices are not even coming down yet.
There is a lot worse still in store for the real estate market. I think many people, home owners and builders alike, are still in denial about the situation. The real estate market is not going to magically shake off its hangover. This is going to take years to wear off. If people are now talking about 2009 as the target date for recovery to begin, I think prices will not really pick up until late in 2009 at the earliest.
Here is a related example from just a few years ago. At the height of the dotcom bubble, office space in the Bay Area was virtually impossible to obtain. I once visited the offices of a 50 person company which was located, in its entirety, in a warehouse. When the bubble burst, office space quickly became abundant. For years, huge numbers of office buildings stood empty. My favorite empty building was the old headquarters of now defunct Excite@Home. This huge and empty campus stands just off the 101 freeway linking San Francisco with the South Bay. Every evening, while driving down the freeway, I could see the sun setting through the windows of these empty buildings. Those buildings stood empty for years. They are only now being occupied.
My point is this: after a crazy bubble comes an extended period of bust. The bust tends to be longer and harder than people think. I am guessing that this will be true for the residential real estate market as well. We'll be lucky if this real estate down market does not drag the economy into recession as well.
Wednesday, July 25, 2007
Shortly after I joined my company (about two and a half years ago) I realized that our 401K plan was not adequate. The first thing I did to address the problem was... nothing. There is nothing worse than joining a new company and immediately creating a name for yourself as a complainer and a trouble maker. Instead, I quietly waited several months for the right opportunity to present itself. In my company, as in many other companies, the group that was responsible for managing the 401K plan was HR. Yes, that makes very little sense. Welcome to corporate America. After a few months of patiently gritting my teeth, I was put in a position to do a favor to our HR director. I took that opportunity to also raise the issue of our 401K plan, and suggest that a few improvements could be made.
To my surprise, our HR Director was enthusiastic that an employee would want to contribute to the running of the plan, and shortly thereafter I found myself on the 401K plan's management team, where I was able to influence the decision making process. As luck would have it, a few months ago my company underwent a restructuring. As part of this restructuring our HR Director left the company and I was asked by our VP of Finance to take a more central role in the management of the plan. That's when I made my move and decided to push for our plan to be completely overhauled. We are now in the process of restructuring our plan401K and are switching plan providers from ING to ADP. This has been a long and laborious process, and it is still going on. In fact, I think that the full process will take another several months to complete.
The point of my story is that if you want your company to make changes to its 401K plan and you have some concrete and constructive advice for making those changes, speak up. I am guessing that much like our own HR group, many human resources folks would be delighted or at least willing to listen to your input.
Regardless, you should also be aware that plan managers are always concerned about being sued by employees unhappy about the company's management of the retirement plan. If for no other reason, plan managers may be willing to listen and act on your advice just to remove you as one potential source of trouble. In short, my advice is to speak up. Do it professionally, do it courteously, but be direct about it, and if necessary, repeat your requests and do so in writing. Eventually, you will probably be heard.
Tuesday, July 24, 2007
A relative of mine joined Boston Consulting Group after finishing his MBA. When I asked him what the company match to his 401K was, he said that there was none. The company simply contributed the maximum amount permissible to each employee's 401K account. No contribution from the employee was needed. That is the second best 401K plan I have heard of. Of course, the downside to this contribution structure is that the employee doesn't get a chance to contribute even more towards his own retirement plan. Actually, I am not sure whether employees were prevented from adding to the amount contributed by the company. Regardless, we are still talking about a lot of free money.
This is where I open up the floor for discussion and comments. I am asking my readers to tell me about the best 401K plans out there. Let's see if we can create a list of the best retirement plans offered by ordinary employers. Call it the "Best Companies for Future Retirees" list. All viable suggestions will be added to this post with a link to the appropriate blog.
Monday, July 23, 2007
1. Surprisingly Few Options - I was fully expecting to find dozens of funds investing in international real estate markets. Instead I found a surprisingly small number of funds investing in this asset class, and many of these funds are either brand new, or just a few years old.
2. High Costs - The few options that I was able to locate seem to be on the expensive side, and most are actively managed. Costs and active management seem to go hand in hand.
Out of all the investment options I found I researched the following funds in detail: EGLRX (expense ratio: 1.17%); RWX (expense ratio: 0.6%); FIREX (expense ratio: 1.12%); IIRAX (expense ratio: 2.01%). Of these, only RWX is an ETF seeking to track an index. The rest are actively managed mutual funds. Alpine International Real Estate (EGLRX) is the only one of these that has been open for longer than a couple of years. RWX for example, has only been in business since December 2006.
Of these four I was most intrigued by EGLRX - it has been in business for about 18 years, it is well diversified across countries, the fund manager has been with the fund since its inception, and over the past 5 years the fund has shown very impressive average returns of 29.93%. But herein lies the problem. I have a distinct feeling that this impressive run cannot continue and that it is fueled by the cheap and abundant supply of global credit. Buying at this point feels a little bit too much like buying at the top of a very steep roller-coaster. To top this off, I examined EGLRX's historical returns. Take a look at this crazy chart. It seems like the fund was basically flat for years and years before blasting off in 2003. My spidey sense is tingling.
RWX is an ETF trying to track the DJ Wilshire International Real Estate Index - an index comprising of 158 stocks, weighted by market cap. It seems that a wide range of countries are represented in this index, but I was not able to ascertain their relative weights. As mentioned earlier, this fund is also very new, having launched in December of last year. I think that this ETF has some potential and I will continue to research it.
As a bottom line, I have decided to stay on the fence for now. I will continue to track this sector, specifically RWX and EGLRX, and will probably make a decision in the next few months. I will keep you posted.
For those of you who think that my strategy feels a lot like market timing (which I often speak against) - you are correct. There is an element of market timing here. While I don't trade to try to take advantage of market fluctuations, when putting new money into the market I sometimes hesitate if I feel that the market may be over-valued. If I was planning to invest a large amount in this segment, I would probably content myself with moving into the market incrementally through a series of trades. In this case, since I only intend to commit a small portion of our portfolio, there is no sense in making multiple purchases. I will wait a few months to make sure I am comfortable with my next step. Since I am a buy and hold, minimize your expenses and diversify like crazy kind of investor, my most important priority is to achieve a high degree of comfort with all my investment decisions. After all, I am in it for the long haul.
Any ideas, comments or suggestions are welcome.
Sunday, July 22, 2007
The insulin shots are expected to cost about $100 per month, and the special food an extra $70. That's a sizable expense. We'll be looking into lower cost sources for the food and medicine, but I am not terribly optimistic.
The funny thing is that we may actually have lucked out. A couple of weeks ago we noticed that our cat was constantly asking for water. This was unusual and I immediately suspected diabetes, given the age of our cat (almost 12) and the fact that excessive drinking is a clear symptom of the disease. My wife took her to the vet, and the diagnosis was confirmed (to the tune of $300). In fact, when we brought her in the vet said that she was borderline - and had her condition been just slightly worse, he would have recommended hospitalizing her. Think $1,000 a day. Can you even imagine? $1,000 a day? What kind of medical system do we have in the U.S. where hospitalizing a cat costs that much? If that's the cost for a cat, what is the cost of hospitalizing a human?
Anyway, we are still not out of the woods. The cat is refusing to eat and drink properly, and until she does, we cannot start the insulin treatment. So, for all I know, next week could cost us several grand in cat emergency care. Such is the price of pets.
Friday, July 20, 2007
1. Cash Back - if pay for your business expenses using a cash back credit card, any cash back your card gives you is yours to keep. For example, if you a purchase a flight for $500 and get 1% cash back, that's a profit of $5. On the $3,500 in expenses I filed earlier this week, I will probably earn about $30 in cash back. That's not even a night at the movies, but it's something.
2. Loyalty Programs - most companies let employees keep any frequent flyer miles they earn and any hotel loyalty points they accrue when traveling. When it's time to go on that next family vacation all those frequent flyer miles and hotel points could turn into serious cash. Most companies, however, will not let you pick a more expensive flight or hotel just to fit with your frequent flyer preferences. For that reason, it is a good idea to sign up for multiple loyalty programs, and to make business trip arrangements as far in advance as possible so that you can hopefully get your preference in hotel stays and airlines.
3. Per Diems - some companies, mine included, pay their employees a flat per diem instead of reimbursing them for actual dining expenses. My company pays employees a flat $50 per day for meals, regardless of actual spending. Assuming you were able to eat out three times per day on less than that amount, the extra is yours to keep. Personally, I find it difficult to accomplish this in a strange city without resorting to fast food.
On balance, between the amounts I lose to unreimbursed business expenses and the amounts I gain from frequent flyer miles and cash back programs, I am guessing I am just about breaking even, but with a lot of hassle to show for my troubles.
Thursday, July 19, 2007
I am guessing that on average it takes me about two to three weeks to fill out each expense report. You know how it is. You really plan to do it, but all of a sudden the week is over and all those receipts are still languishing in your wallet. When I finally do fill out the reports, it takes my employer another two weeks to reimburse me. All in all, from the time I spend the money until the time I get it back, about four or five weeks pass. The value of this free credit is approximately $4.1 per month for each $1,000 in expenses - assuming that the funds would have been deposited in a high yield money market account during that time. If you are paying credit card financing charges to finance your unreimbursed expenses, the calculation may be much less attractive for you. That's not a huge amount, but still.
There is another way that I lose money through the expense reimbursement process. Sometimes I misplace a receipt; forget a certain activity that I paid for; or make a mistake in adding up the numbers in the report. I am guessing that I don't always recover 100% of the amounts I spend, even though I make an effort to account for everything. The more time passes between the time I spend the money and the time I fill out the expense report, the more errors I make and the more money I leave on the table.
Given all the free money I am supposedly giving my employer, you would think that my company would be delighted and encourage people to delay filling out their expense reports. Not so. My company is really pushing people hard to file their expenses within 2 weeks of spending the money. It's not that they are altruistic, they simply want to have complete control and visibility as to how they are spending money.
I am making an effort to improve my evil ways, but if I were you I wouldn't bet on success in this category. It is one of those things that I can always find an excuse to postpone to the next day. At least for this trip I remembered to file my expenses within 24 hours of my return. Here's to small victories.
Anyway, in tomorrow's post I will cover the bright side of business expenses. Sometimes they actually make you money...
Tuesday, July 17, 2007
My mother does not make the connection between risk and return. She understands the concept of risk, and understands the concept of return, she simply does not understand that the two are intimately connected. My mother's appetite for returns is high. She is always looking for ways to increase the returns on her investment. Unfortunately, and paradoxically, she is also extremely risk averse. For one thing, she checks the performance of her investments on a daily basis. So far, this is not an issue. I do the same thing myself. The problem is that if an investment fails to generate a high enough return for her taste, she sells and moves on to the next hot-ticket within days. Until she does, she complains and is unhappy about her investments.
If you are a day-trader, good for you. I don't believe in day-trading, but if you think you can make money that way, more power to you. You perform a valuable service for the capital markets by adding liquidity and increasing the market's efficiency. However, if you are Shadox's mother and your training and understanding of investment vehicles is limited to their return over the past 30 days, you are probably doing yourself a very big disservice by trading frequently.
I think that the number one thing any new investor must do is to develop a complete understanding of his appetite for risk. Everyone thinks that they can take more risk when the market is going up, but will you feel the same way if your investments lose 20% in a month? My mom's ability to stomach risk is far lower than her appetite for returns. This both makes her nervous and causes her to make bad financial decisions such as selling her investments just when they are about to hit bottom.
If I were asked to offer just one piece of financial advice it would be this: only invest in a way that will allow you to sleep at night. Not following this advice can only lead to unhappiness and bad financial decisions.
Monday, July 16, 2007
This line of reasoning leads to an intriguing conclusion. If you see an asset class that is expected to generate a high return, your warning bells should immediately go off. Even if the promise of a higher return is real, it no doubt carries more risk than an investment option that promises a lower return. This is clearly true of individual stocks, bonds and other investment vehicles, but is it true of entire markets?
My father met with a financial advisor last week. One of the many "excellent" pieces of advice my father received was to invest in the South-Korean stock market based on the dramatic returns that market has achieved in recent years. In fact, the South-Korean market tripled since January 2003. Never mind the fact that what the "financial advisor" proposed is simply performance chasing in its simplest and most dangerous form. If the logic I proposed above with respect to individual investment options holds true for entire markets, then the very fact that the Korean market has achieved such gravity defying returns is an indication of a very high level of risk that is attached to that investment option.
I am happy to report that my father declined the advice he was given. He did so not because of any argument that I made, but rather because he is a very risk averse investor. He understands his appetite for risk and invests his money in a way that allows him to sleep well at night. While he is far too conservative for my taste, he is a careful planner and knows exactly what he is doing. Kudos to him for that.
Today's post was meant to cover my mom's approach to investing, but I will postpone that discussion until tomorrow. My mom and dad have polarized investment strategies. It is amazing that they are able to share the same portfolio, but more about that tomorrow.
Sunday, July 15, 2007
Investment Costs - reviewing my parents' investment portfolio this weekend, I was shocked to find that they are paying about 3% in fees to invest in an international stock fund. This is a fund that was recommended to them by a financial advisor.
Academics typically estimate the equity premium at about 6% per year. The equity premium is the extra return that investors receive for investing in stocks rather than in a risk free asset such as t-bills. This means that if t-bills yield 5%, an average stock investment is expected to yield about 11% per year. This increased return is your payment for accepting risk. My parents are paying about half of their equity premium to the mutual fund company. Why on earth would anyone want to do this?
Diversification - it recently struck me that the real-estate portion of our portfolio is not sufficiently diversified. Our real-estate position, which totals approximately 8% of our portfolio, is invested exclusively in Vanguard's REIT Index fund (NASDAQ: VGSIX). This gives us a diversified exposure to the U.S. real estate market, but does not give us any exposure to international real-estate markets.
In recent decades, equity markets around the world have become much more tightly correlated. This means that the diversification benefit gained by investing abroad has declined (it is still well worth it, though). Global real estate markets on the other are far less correlated, which means that they can probably add substantial diversification benefits to our portfolio.
Since my long term objective is to invest 10% of our portfolio in real-estate, I am thinking about increasing our current real-estate exposure by investing only in global real estate markets. If you have any ideas about highly diversified global real-estate funds, please let me know. In my initial research I did not find any global real-estate index funds, so going active may be my only alternative.
Success with My Brother - a few months ago I wrote a post about the fact that my brother was investing his money without a plan and without really understanding what he was doing. In the last few months my brother has gone through an amazing transformation. For one thing, he read a "A Random Walk Down Wall Street" which I had recommended to him, and was fully converted by the experience. Last semester he also took a class in modern portfolio theory, and I am guessing that this was another major factor in this welcome change. Rejoice ye index faithful! We have another convert to fill our ranks!
Now the challenge is to convert my parents. The main problem is the fact that my mother's tolerance for risk is much lower than her appetite for returns. This typically causes her to cash out of the market at exactly the wrong time.
I think I may cover that topic in more detail in tomorrow's post.
Thursday, July 12, 2007
Many financial institutions are now moving towards two factor identification of users. Previously, all you needed to log into your account was your trusty user name and password. These days many institutions require another element to ensure that you are who you say you are. Some financial outfits are able to provide this extra layer of security elegantly and gracefully, while others seem on a mission to make life as difficult as possible for their customers.
One institution that does a phenomenal job of increasing security without creating a hassle, is Bank of America. Bank of America uses what it calls a SiteKey to help you verify that the website you are visiting is indeed their corporate website. The idea is as simple as it is elegant. When you sign up for BoA's online account access, you are asked to select a personalized picture from a long list. When you get to the BoA log-in page you are asked to enter your user name. On the next page, there is a copy of the personalized picture you selected, as well as a place to enter your password. Since only BoA knows which picture you originally selected, if that picture is not displayed, you know that something fishy (or physhy... ) is going on. In addition, if you log into your bank account from your regular computer, you are only asked for your password. If you are using a computer that you did not previously designate as authorized, you are also asked a simple security question, to verify your identity.
In this way, security is improved dramatically without sacrificing ease of use. I don't say this often, but Bank of America deserves serious kudos for this approach.
On the flip side, there are those financial institutions that appear intent on annoying their customers. For example, I pulled the vast majority of our money from ING, because of their annoying security features. Log-in required me to provide my account number - a long list of digits - instead of an easy to memorize user name. In addition to my password, they also required me to enter a security code using an on-screen virtual key board. As if that was not enough, they kept shifting the location of letters on this keyboard, seemingly for the sole purpose of confusing me further. Why was all that necessary?
Ironically, I shifted our money from ING into HSBC, which adopted very similar and annoying security measures only a few months after I opened an account with them.
Interestingly most of our financial institutions have not changed their security and log-in procedures. Our credit card companies, online broker, 401k providers etc. all require a simple user name and password for log-in. Quite frankly, this simpler approach is perfectly fine with me. I feel just as secure with those basic measures as I do with those more elaborate and cumbersome ones.
Do you have similar examples? What's you opinion of the trend towards tighter and more cumbersome security measures?
Wednesday, July 11, 2007
I find this theory very interesting, and I think it is worthwhile discussing in a little more detail. If you think about it, it is not not a trivial statement. Prices in a free market are supposed to be governed by the laws of supply and demand. If demand for apples falls off a cliff, it is only reasonable to assume that the price for apples would decline as well. Why would housing not follow the same logic?
According to the professor, from the prestigious UCLA Anderson Forecast, the problem with real estate pricing is that buyer and seller are not using the same time line to evaluate the deal. In a declining real estate market, the seller uses previous deals as a benchmark for the price he is demanding for his property: "The house down the street sold for $x last month, why should I settle for less?", while the buyer is thinking about future deals: "the market is going down. I should offer less than what the previous buyers paid, or else wait a few months and get the property for an even lower price." With buyer and seller using different benchmarks for valuing the property, an agreement is difficult to reach and fewer properties are sold. So this explains why fewer deals get made, but why does price not fall?
If you think about, the same logic can also be applied to the stock market. I mean theoretically you can replace the word "house" with the word "stock" and use the same argument. So why are stock prices subject to steep declines while real estate is more stable? Quite frankly, I am not sure. However, I would guess that the answer has something to do with liquidity and the rate at which price signals are transmitted across the stock market, as opposed to the real estate market. Since most stocks are re-priced many times per minute, both buyers and sellers know and trust that the price of the last trade is the market price. Real estate on the other hand is priced much less frequently, and no two pieces of real estate are identical. This allows both buyers and sellers to more or less ignore market prices and fixate on their own perceived value of the property - the seller looks back in time, the buyer looks forward, and no deal gets made.
I think it's an interesting idea to consider.
Tuesday, July 10, 2007
As a simple example, assume you have $100 in your portfolio. You decide that you would like to split the portfolio between two asset classes: stocks at 50% and bonds at 50%. At the beginning of the year you have $50 in each asset class. Now, let's say that during the year stocks appreciate by 20% while your bond investment remains flat. At the end of the year, you will have $60 in stocks, and still only $50 in bonds. Your bonds now represent only 45% of your portfolio, while stocks now account for 55%. This allocation is different from your intended allocation of 50% - 50%. To re-balance, you need to sell $5 worth of stocks and buy $5 of bonds, such that you have $55 in each asset class.
Why does re-balancing make sense? Re-balancing is a method that is supposed to help you automatically buy low and sell high. You buy those discounted assets that have declined or that have failed to appreciate as much, while taking some profits out of those segments that have seen a run-up in value. When re-balancing you should watch out for the following:
Timing the market is counter-productive - the whole idea of re-balancing is to remove judgement and emotion from the asset allocation process. You are not supposed to try to out-guess the market or try to determine when would be the right time to buy or sell. It is better to pick a date in advance, say December 1st of each year, and decide that no matter what the market does, you will re-balance your portfolio on that day. Trying to time the market is akin to stock-picking: it is not likely to work out very well.
Tax liability - re-balancing, by definition, involves selling winning asset classes, in which you are likely to have capital gains. For this reason, the act of re-balancing is likely to create a tax liability for you. One way to address this issue is to re-balance your portfolio by only using assets within tax advantaged accounts such as IRAs and 401k's. In my opinion, re-balancing that creates a tax liability may defeat the whole purpose of the exercise, which is maximize your returns in the long run. I have another solution to this tax liability issue: I re-balance by adding assets, without selling. I know what my target asset allocation is, and as my portfolio shifts away from this asset mix, I invest any new money I saved in the asset classes which are now under-represented in my portfolio.
Cost - don't re-balance every day, every week or every month. Even once a quarter could be considered excessive. Trading is expensive. One of the best ways to destroy your returns is to increase your costs by excessive buying and selling. If you want to re-balance, once or twice a year is sufficient.
Hassle - wouldn't it be easier to just forget the whole thing? I mean is it really worth the hassle to sell a few stocks or buy a few bonds? Is there really enough value in this exercise? Frankly, I am not sure. However, one of my previous employers offered an excellent solution to this problem: in its 401K plan it offered an automatic quarterly re-balancing option. This addressed both the hassle and market timing issues I mentioned above.
Monday, July 09, 2007
First, for my international readers and for the benefit of my American readers who have never watched late night cable channels, a brief explanation of the concept of payday loans. Payday loans are basically a short term loan given by private lenders, which you are expected to pay back out of your next pay check. The interest rates on these loans are incredibly high, and can reach several hundred percent per year or more. For example, one payday loan company I found online (by clicking on their ad) charges its customers $18.62 for $100 borrowed for a period of 7 to 14 days... 968% per year... by the way, that company bills its services as "Quick and affordable cash advances". Affordable, no less.
My opinion on this industry is twofold. My gut reaction is that this industry is an abomination and should be eliminated. This is loan sharking at its worst. I mean, this industry preys upon the financially weak and on the uneducated, driving them deeper and deeper into debt and poverty. As someone who has his financial house (mostly) in order, I view the existence of this industry as an abomination.
However, as readers of this blog know, I am a free market capitalist at heart. I believe that any business transaction between responsible adults, in which no market failure can be clearly demonstrated to exist, is no business of the government. The market should rule. If there was no need for this industry, if it did not provide a valuable service to its customers, it would not survive. The industry's very existence is proof enough that it should be allowed to exist. It is very easy to be sitting in my comfy chair in my office writing this post about the evil payday loan companies, but would I be feeling the same way if this industry was my only source for getting urgently needed cash? Probably not. As much as I hate it, payday loans are probably some people's only financial option.
My ambivalence leads me to the following conclusions:
1. Regulation - the payday loan industry should be tightly regulated. While I would not support setting maximum interest rate levels, I would certainly support such things as big, bright red letters informing people of their loan's APR; requiring a 24 hour mandatory waiting period before loans are funded, to prevent people from using this very expensive capital for such frivolous pursuits as gambling; and other measures to ensure that people are aware of exactly what it is that they are getting into. Very much like the tobacco industry, I would also favor bans on advertising of payday loans.
2. Education - people must be made aware not only of the tremendous costs payday loans carry, but also of the other options available to them. It is important that people view payday loans only as an absolute last financial resort, not as a first step to take at the first sign of financial difficulty. Practically any other source of cash is preferable to a payday loan: an advance from your employer would be ideal, a loan from a family member or a friend, renegotiating the terms of payment with your creditors. For other ways to avoid payday loans, check out this link from the FTC.
3. Preparation - there are some people that are no doubt forced into a situation where they must take a payday loan through no fault of their own. However, for the most part, the best way to avoid the need for a payday loan is to prepare for emergencies. Build an emergency cash fund; live below your means; insure against your biggest risks. For the most part such preparation will eliminate the need for a grotesquely expensive payday loan.
As a bottom line, yes I think that payday loans are bad. Yes, I think that they provide a service that is essential to some people at certain points in time. The payday loan industry must be tightly regulated and controlled, but there is no escaping the fact that there are some people for whom payday loans are the only option out of a bad situation.
In case you are wondering, I turned down the payday loan company's request to advertise on my blog. Here are portions of my e-mail response to their request:
"...As you may have guessed, my opinion of payday loans is quite negative. However, being strongly on the side of free markets, I am willing to concede that your industry fills a necessary economic niche, and provides a service that a certain portion of the population requires and greatly appreciates.
Despite this, I have decided to not accept your offer to advertise on my blog. I consider myself to be financially secure, and I am grateful that I have never needed the services that your industry offers. I feel that by accepting your offer of payment I would be taking advantage of those who are less fortunate economically, and who come to my blog in search of advice and information on how to improve their lot..."
Do you think that I have made the right decision? Do you agree with my take on the industry?
Friday, July 06, 2007
The 401K system creates bad outcomes, discrimination and strange tax consequences. Simply put, the system should be scrapped and rebuilt from the ground up. Here are some of the main problems I see with the 401K system, and how I propose to solve them:
Lack of Expertise – here is the biggest problem with the 401K system: in most companies, and certainly in all the small and mid-sized companies that I have ever worked for, or that my wife has ever worked for, 401K plans are managed by the HR team. With all due respect, the vast majority of HR professionals do not have the first clue about retirement planning, investment options or even basic financial concepts. They view 401K plans as something to be administered while keeping company costs to a minimum.
Concepts such as diversification, return and investment cost reductions are completely foreign to many HR professionals. Many of them are actually afraid of these topics and are paralyzed by their fear. I know very few people who wake up in the morning thinking: “I have some money I would like to invest for retirement. I should talk to a human resources specialist…”, but ironically this is exactly the group that controls a large portion of American’s retirement plans.
Lack of Choice – if your company does not offer a self directed 401K plan, you can invest your retirement assets in only a limited number of often poorly selected and expensive funds. Your company is deciding for you how you may invest your retirement savings. Why is this a good idea? Even if your company offers a self directed 401K 30% of your funds must still go into the company selected funds. The 70% you can invest yourself are, in all likelihood, subject to trading and investment fees that you would probably consider excessive in an online brokerage account.
High Cost – 401K’s are an expensive investment vehicle. The new 401K we are adopting will have an expense ratio of 1.14%. My personal portfolio, built around multiple Vanguard index funds, carries an average expense ratio of around 0.3%. The high cost of 401K plans is one of the reasons we invited a Vanguard representative to bid for our 401K business. However, while Vanguard offered us a fund line-up with an average expense ratio of 0.22%, they also required a plethora of fees that when factored in would increase the cost of the proposed plan to approximately 0.6% - 0.7% of assets per year, and the level of service which they offered us was not adequate for our corporate needs. It seems that even Vanguard, the champion of low cost investing, finds it difficult to offer truly low cost 401K plans.
Needless Complications – 401K plans are subject to a wide range of regulatory requirements and administrative costs. The person that deals with the administration of our 401K plan can be constantly seen running around the corridors with various forms that need to be signed, filed or returned. It’s a mess. That’s one of the reasons 401K plans are so expensive.
Strange Tax Outcomes - Do you find it strange that if your company offers a 401K you can contribute $15,500 this year towards your retirement, while if it doesn’t offer a plan you are basically stuck with the much lower $4,000 contribution level of an IRA? Do you find it amusing that if your household income is above $166,000 per year you cannot contribute to a ROTH IRA, but if your company offers a ROTH 401K you can contribute $15,500 to it, even if you make a cool million every year? What is the justification for such asinine outcomes?
With these and many other problems plaguing the vary concept of company managed, defined contribution retirement plans, I would like to suggest a much simpler, and less expensive option. Hell, this would be good for everyone: employees, companies and government: let’s completely eliminate 401K’s and instead allow everyone to invest the full amount of $15,500 in either a ROTH IRA or a traditional IRA as they choose. Companies could still match employee contributions in exactly the same way, only they would do so by means of direct deposit to the employee’s IRA rather than into a cumbersome and expensive 401K plan.
While we’re at it, let’s allow everyone to make such contributions, whether or not they are employed. Why does it make sense to prevent the unemployed or the under-employed from saving for retirement?
What do you think? Am I making too much sense? Given my “high degree of confidence” in Congress (and the IRS), I am not holding my breath for such common sense changes to occur.
Thursday, July 05, 2007
If you are lucky enough to be in a company that matches your 401K contributions, not taking advantage of this free money is practically a crime. Nevertheless, even if you are taking full advantage of the matching, there are a couple of things that you should watch out for:
1. What is being matched? My company matches 50% of the first 6% of pay contributed to our 401K plan. However, matching is only awarded for contributions out of base pay. Bonuses are not matched. Be aware which contributions entitle you to the company match, and make sure you contribute enough to get every free dollar you can.
2. How is matching calculated? My company matches employee contributions on a per-pay-period basis. You only receive matching funds for the first 6% of contribution out of each pay check. This means that if your 401k contribution rate changes throughout the year you may not get the full amount of the match.
For example, an employee who makes $100K per year and wants to max out his contribution at $15,500. If he contributes an even 15.5% of salary per pay period, by the end of the year he will receive company matching of $3,000 (50% match up to the first 6% of salary). However, if the employee wants to max out his contributions by June 30, he will only be getting a total match of $1,500 that year - because contributions in excess of 6% per pay period are not matched. If you are not aware of this and your contribution rate varies over time, you may be leaving money on the table.
This matters especially if you are a new employee joining the company in the middle of the year, or if you are about to quit your job. In fact, this is exactly why this policy is in place. The company wants to ensure that employees are not able to max out their contributions early, get the full match for the year and then quit.
3. Be Aware of Your Vesting Date - most companies that match employee contributions require that the employee work for the company for a certain period of time before the employer match is completely vested. My company has a four year vesting schedule, where 25% of the matched funds vest each year. My wife's vesting schedule is three months - her company matching funds vest at the end of each fiscal quarter.
It is important to know your company's vesting schedule for two reasons. First, if you are thinking about switching jobs, it may be a good idea to time your departure such that it happens after your closest vesting milestone. For example, I vest in 25% of my company match every May. If I wanted to quit my job and were to get a good offer with another company in April, I would try to postpone my departure date by a month to vest in more of my matching funds. Of course, there is no point in missing out on a great career opportunity for a couple of thousand dollars, so use common sense.
It is also worthwhile to check up on your vesting, even if you have no plans to go anywhere. One of my colleagues recently noted that his account did not show a vested match balance, even though he was with the company for two years. When he reported the error, it was corrected within days.
4. Matching in Company Stock - you would expect that after the Enron scandal people would realize that investing large amounts of money in your own company stock was a bad idea. You would also hope that companies would realize that it is not fair to match employee contributions using company stock. No such luck. My wife's company matches her contributions in company stock. On the plus side, since her match vests every quarter, we sell the stock and invest the proceeds in a more diversified investment option. For more about why I think it is a bad idea to invest in your own company stock, check out this post.
Wednesday, July 04, 2007
Much like ROTH IRAs, a ROTH 401K allows employees to contribute after-tax dollars, however, the money is tax free when withdrawn in retirement. So what are the benefits of a ROTH 401K and who is it good for?
Let's start with tax diversification. Believe it or not, we are living at a time in which taxes are at historically low levels. When you consider that the federal government is running a deep budget deficit, social security is projecting a massive shortfall and medicare costs are projected to skyrocket in the coming decades you have to ask yourself, who will pay for all these expenses? Well, dear citizen, look no further than the nearest mirror. Many believe that tax rates must increase in the long run to cover these costs and, if you believe that thesis, you may want to pay your taxes now and save yourself from a bigger tax bill in the future.
If you are just beginning your career and expect your retirement tax bracket to be higher than your tax bracket today, a ROTH 401K might be right for you. Your ROTH 401K contributions will be taxed at your current low rate, rather than at the higher tax rate you expect in retirement. This is typically true of young workers in low tax brackets who only get a meager tax break when contributing to a regular 401K.
A nice feature of ROTH 401K is that your eligibility to contribute is not limited by your household income. If your company offers a ROTH 401K, you are eligible. ROTH IRAs on the other hand have eligibility thresholds. For example, married couples can only contribute to a ROTH IRA if their household income is below $166,000 per year. Highly paid individuals that want to invest in a ROTH, can do so through the ROTH 401K.
Finally, if you contribute to a ROTH IRA consider this: while the IRA only allows you to contribute $4,000 per year, the ROTH 401K gives you many of the same advantages but allows you to contribute $15,500 this year. That's pretty impressive.
I haven't decided whether to contribute to a ROTH 401K or go for the traditional version, primarily because there is a good chance that my tax rate in retirement will be lower than it is currently. I will keep you posted when I make a decision.
Tomorrow's post will discuss some interesting aspects of 401K matching.
Tuesday, July 03, 2007
Without further delay, let's get to business. Here are some of the interesting features that we will be including in our new 401K plan:
1. Opt-Out 401K - I am happy to report that we have decided to go the opt-out route. From this point forward, every employee joining the company will be automatically enrolled in the company's 401K plan unless they explicitly opt-out. The default investment amount will be 6% of pay, which will give people full benefit of the company match. Regular readers of this blog probably remember that our 401K committee deliberated long and hard about this feature, but in the end we reached consensus and adopted this feature. Money contributed to the plan under the default option will go directly to the target date fund most appropriate for that employee's age.
2. ROTH 401K - this is another issue on which we reversed position. Previously we were thinking that this option will be utilized by only a small number of employees and will only add to employee confusion, however, last week we decided that the benefits out-weighed the risk of increased confusion. Tomorrow's post will cover this feature in more detail.
3. Self Directed 401K - employees that choose to do so will from now on be able to invest their retirement assets as they choose. Employees will be able to open a brokerage account within the plan, and transfer up to 70% of their assets to that account. Within that account they will be free to trade stocks, mutual funds, and options as they see fit. The downside is that the such accounts are subject to fairly high trading fees. Personally, I intend to utilize this option in order to invest in low cost Vanguard mutual funds. Even with the relatively high trading fees, the cost of investing in this manner is lower than the cost of investing in the actively managed 401K funds that predominate our plan (that is a story for another post, and a topic well worth a discussion in its own right).
4. Expanded Fund Selection - our plan offers a total of 20 funds, including 3 target retirement date funds, three index funds (international; S&P 500 and Russell 2000), a real estate fund and a commodities fund. These in addition to your everyday run of the mill funds that cover all standard asset classes. As mentioned above, most of our funds are actively managed and the average expense ratio is 1.14%. Even the index funds are fairly expensive, with the cheapest one clocking in at 0.63%. 401K plans are an expensive investment option - but more about that later this week.
Generally speaking I think that this new plan is far superior to our old ING plan. For one thing, we now have a clear understanding of the costs we will be charged. We listed them all on one form and have written confirmation from our provider that these are all the expenses that we will incur. Another big advantage is the fact that our funds are real, actual mutual funds, which have ticker symbols, MorningStar ratings and daily quotes. Now we will finally be able to understand what our money is doing... what a novel idea.
Monday, July 02, 2007
My company is a subsidiary of a publicly traded international company. It is also the end product of a number of acquisitions that have happened over a period of several years. Long, long ago, somewhere in the mists of time, someone in one of the companies we acquired made the decision to start a 401K program with ING. We inherited this plan. We don't know who that person was, nor do we know exactly why they made that decision, but we do know that this decision did not turn out very well for us.
Here are only some of the problems we have in our current plan:
1. No Ticker Symbols - because ING is an insurance company, they are not permitted to sell us normal mutual funds. Instead they sold us a financial vehicle called a variable annuity, which as our agent explained, is basically an insurance contract under which our 401k funds own shares in actual mutual funds. Convoluted? Hell, yeah! In addition, none of these funds have a ticker symbol, or a MorningStar rating. In essence, there is no way to keep track of these funds, or to truly understand how they invest and what their performance looks like. As far as I am concerned, the funds in our current plan are a black box. I don't like black boxes, especially if my money and my colleagues' money is in them.
2. No Way to Understand Costs - ING provides us with information for the expense ratio associated with each fund. But since we don't own "actual" mutual funds, there may or may not be other costs that we incur in addition to the expense ratio. When I asked our agent a direct question on the topic, I got several different stories, and finally an obfuscating answer. Good enough for me. If I can't even understand what our costs are, we are heading for the door.
3. Nasty Wrap Fees, and a Nastier Elimination of Those Fees - ING had the nerve to charge us a wrap fee, for the pleasure of doing business with them. This wrap fee, which was pointed out to me by a third party, was 0.7% of assets per year, and is paid on top of all the fund expenses and other plan charges. This fee was well hidden in the fine print, and it appeared that no one in my company knew about this.
I called ING and invited them over the re-bid for their business. I told them that costs are our main concern. The ING agent opened the meeting by saying that our account was reviewed two days earlier and that our wrap fee has been eliminated. Just like that. Our plan has about $8M in assets. 0.7% is $56K per year. All we had to do to get them to waive this charge was to mention it. If I hadn't called, ING would have been content to keep charging us 0.7% of assets every year. Even more annoying than the fee itself was the ease with which they waived it. It felt like we were being taken advantage of.
4. Limited Investment Options - ING's plan lacked many basic options, such as lifestyle funds and index funds. They offered us many of these missing options, but to do so we had to move our plan to their new platform. Essentially, this was like switching to a new provider. Thanks for making our decision so easy ING!
5. No Way to Understand Performance - I am a fairly educated person. I hold an MBA from a top 10 school, as well as a law degree. When I got my account statement from ING, I could not figure out how my investments performed, even after spending considerable amounts of time trying to puzzle this out. Last quarter, ING finally changed its statements to a more... readable format. Too little, much too late.
These are some of the problems with our current plan. Tomorrow I will cover some of the ways in which our new plan with ADP will correct them.