Saturday, August 30, 2008

Why one million dollars just isn't worth what it used to be

Forty years ago, if you had one million dollars, you had it made.  While one millions dollars is still a huge some of money, being a millionaire just isn't what it used to be.  Either you are old enough to remember when bread, candy bars, and soda cost a nickel or have have heard your elders lament how expensive everything is these days.

The slow (or sometimes quick) rise of prices over time is caused by inflation.  Most researches agree that over the past 93 years in the United States the price of goods and services has risen by an average of approximately 3.5% every year.  According to this great inflation calculator on coinnews.net, an item that cost $20 in 1968 would cost $126 today!

Inflation is easy to measure for some goods, such as ground beef.  One pound of ground beef purchased today is going to be just about the same thing as a pound of ground beef purchased 50 years ago and will probably be the same in another fifty years.  Because of this, it is easy to measure price inflation for ground beef.  But how do you measure the inflation rate of computers?  A laptop computer today might cost, on average, $1500.  Ten years ago, you could also get a laptop for about the same price.  However, the one you buy today is a much different, much faster, much better product.  Because of factors like this, overall inflation is very difficult to measure and many researchers disagree about the rate of inflation that the U.S. has experienced over time.  If they don't agree on the historical rate, you'd better believe that there is no consensus on prediction for the future rate of inflation.

What does this mean for you?  It means that when you are planning for the future, you better make sure that you take inflation into account - you don't want to plan $20 for an expense that will actually cost you $126.  Even though you don't know what the rate of inflation will be, you can be certain that you will experience the effects of inflation to some degree.

Because people are living longer and retiring earlier, inflation is becoming an increasingly significant factor in retirement.   If you retire at age fifty and live to age 90, your retirement will cover a span of 40 years.

Investments with a fixed rate of return - savings accounts, CDs, and most bonds - can be great investments, but offer you no real protection from inflation.  In fact, many bank savings accounts pay such low interest rates that, depending on the rate of inflation, your account might actually be losing value even as you collect interest.

However, investments such as stocks, mutual funds that invest in stocks, and TIPS (Treasury Inflation Protected Securities - a savings bond that pays a base rate plus the current rate of inflation) all tend to grow faster than inflation.  If you are planning for a long term financial goal, you need to include investments like these in your portfolio.

One million dollars isn't what it used to be.  In fact, to have the same buying power as a 1968 millionaire, today you would need more than 6.3 million dollars.

Friday, August 29, 2008

Financial Values post included in Finance Fiesta

For the first time, a Financial Values blog post has been included in a carnival.  A carnival, for those not yet in the know, is a collection of recent blog posts on similar topics.  Please be sure to head over to Master Your Card for the latest edition of the Finance Fiesta.

Thursday, August 28, 2008

New Links!

I frequently search the web and the blogosphere for the best personal finance sites out there.  There are two great sites that I have just posted links for:

Smart Spending - This site has great saving and spending advice.  It is a collection of blog posts from different authors and typically has several new posts everyday.  I particularly enjoyed Donna Freedmen's post on Doing without in your 20s - by choice.

Frugal Dad - A great blog on living a frugal life.  10 Truths about Frugal Living was a great post and is worth a read.

Be sure to check out these sites and the others that I have provided links to in the right hand column of this page.

Are there any other great sites out there that you think I should know about?  If so, please send me an email or leave a comment!

Tuesday, August 26, 2008

Your values and your money

Warning: This post gets a bit philosophical.  My next few posts will get back to the nuts and bolts of how to manage your money and prepare for the future.

In order to determine how to manage your money, you need to think about much more than just your money.  You need to think about what you want your life to be like.

Yesterday I told you that I was happy with where my money goes and how I spend my money.  The reason that I am happy about it is that the decisions that we make about spending our money help us to live the life that we want to live.

It is very easy to become seduced by advertising and consumerism and spend money without regard for whether or not it is in your best interest.  If you do not consciously make decisions about how much of your money to spend and how much to save you will almost certainly make poor decisions about your money.  Furthermore, if the decisions that you make about your money are not rooted in your values, you will find that your plan is difficult to stick to and your goals will be difficult to achieve.

Establishing your goals is a matter of setting priorities.  How do you best use a limited resource to meet unlimited wants and needs?

Our list of goals includes making sure that we have financial reserves to ride out a financial emergency, saving for our children's educational expenses, taking regular vacations, supporting charities, and achieving financial independence at a relatively early age.

The reason that we make sure that we are financially able to cover emergencies is because I want my family to be well provided for regardless of our short term circumstances.

The reason that we invest in a 529 plan for my daughter is because we value her future success and want to give her every opportunity to succeed that we can.

The reason that we save for vacations is because we value time with our family and seeing new parts of the globe.

The reason that we support several charities because we believe that it is important to make the world a better place and because we believe that this is what God wants us to do.

And the reason that we are planning to be become financially independent relatively early is because we value our time together and we value the freedom to decide how to spend our time.

We also spend time and money to enjoy our lives right now.  But we make sure that what we spend to enjoy ourselves today does not prevent us from meeting our goals for the future.  Because these goals are linked to our values, when we consider how additional expenses would hamper our efforts to achieve our goals, it becomes much easier to stay on track. 

Does this work for everyone?  I don't know, but it's a big help for us.

Monday, August 25, 2008

Where my money goes

This weekend I analyzed all of my spending for the previous thirty days.  There were no really big surprises for me, but it was a good snapshot of where our money goes.  This is it:

42% - Real Estate - this includes the house that we live in, an investment property that we own, and homeowners insurance

18% - Savings and Investment

10% - Food - both groceries and eating out

10% - Baby - anything purchased for our six-month-old daughter

5% - Utilities - electricity, gas, phone, internet

5% - Household - things for the house, drug store items, and postage

5% - Clothing

4% - Transportation - gas, bus fare, and parking (remember we have only one car, it's paid off, and I bike to work)

1% - Entertainment

1% - Life Insurance

1% - Gifts

(These don't add up to 100% because I rounded them off)

The bad news is that the above outflows of money account for 110% of our income during those 30 days.  However, overall we do live within our means.  Overspending this month made our checking account balance shrink, but did not require any debt.  Furthermore, there are a few special considerations that explain why we spent so much this month.

1.  We have started to cloth diaper our daughter.  We believe that it is better for her.  In the long run this will save money.  However, the start-up costs, which we paid during the past 30 days, are high.

2.  We live outside the United States, but visited the U.S. during this past month.  Because there is a greater availability of products and they are cheaper in the U.S. than where we live, shopping across several categories - baby, household, clothing - was unusually high.  We also paid for long-term parking at the airport during our trip, so transportation costs were much higher, as well.

3.  Some of our utility bills are paid every two months.  So our utility payments are artificially high.

However, we also do give roughly 10% of our income to charities.  We just didn't happen to make any gifts during the past thirty days.

This experience has reassured me that we are on target.  We are saving and investing a good amount of our income and generally spending less then we earn (which we did even this month because 18% of our money was put into different savings and investment accounts).  There are some places we could and probably should cut back - mostly in food.  As a start, I took my lunch to work today.

Saturday, August 23, 2008

Thoughts about managing money well

Investing well is not all that hard to do or to measure.  All you need to do is earn a relatively high rate of return.  A good investment for you, is almost certainly a good investment for anyone else.

However, managing your money well is much more difficult goal to achieve and to measure.  Money is a tool that can help you achieve your goals, realize your values, and live the life that you want to live.  A good decision on what to do with your money might be a lousy decision for someone with different goals.  Therefore, in order to manage your money well, you need to know what your goals and dreams are, so that you can use your money to live the life that you want to live.

As you look over how you spend (and save) your money think about whether your spending patterns are helping you live the life that you want to live.  Are your choices with your money moving you closer to achieving your goals?  If not, why not?

One exercise that can help you figure out your values and goals is to think of your past accomplishments.

A few of the things that I am most proud of about my own life:

1. I have a strong marriage to a wonderful woman.
2. I am raising an absolutely incredible little girl.
3. I learned how to speak Chinese.
4. I ran the Great Wall Marathon.
5. I am successful in a difficult and competitive career.
6. I have traveled extensively and seen many parts of the world.

Think about what you have done in your life that make you the most proud.  Did your spending habits, either directly or indirectly, have any affect on your accomplishments?  Did they help you, hinder you, or neither as you accomplished these things?  What are the best decisions that you have made with your money?  Why is it that you think of these decisions as being so right for you?  I will talk more about how to manage your money according to your values and goals in a post in the next few days, but for now think over these questions.

Friday, August 22, 2008

Congratulations

If you have been with this blog from the beginning, you know that I have been tracking my expenses for the past 30 days.  If you have been doing so too, and I hope that you have - congratulations - the 30 days are up and there is no need to keep tracking purchases if you don't want to.

Over the weekend take a few minutes to look over your spending and calculate how much you spent and what you spent it on.  Divide it up into categories and figure out how much of your money was spent in each category.

We will talk more about how you can use this information.  For now, just figure it out and, if you want to, think it over.  Does it surprise you how much or how little you spent overall?  Within different categories?  Did you have a good feel for how much you were spending and where it was going?

Thursday, August 21, 2008

Budgeting system #3 - let the bank manage your envelopes

I used to think that I had the great financial mind in my family.  Now I know that it's not me --my brother is clearly a financial genius.

My brother and his wife recently explained to me the budgeting system that they invented for themselves.  It's incredible.  If there was a Nobel Prize for budgeting systems, this one would be a pretty solid candidate.

It works very much like the envelope system described two days ago, but with a technological twist that means you don't need to make all of your purchases with cash.  You will need an internet friendly bank and a cell phone or another device capable of accessing the internet.

As with any budget, first you create your categories and determine how much money to allocate for each one.  Then instead of envelopes, you open a checking or savings account for each category.  In addition, you should have a "main" checking account.  You could easily have more then 10 checking accounts - but don't worry there is a simple way to manage these accounts and you will only actually write checks and pay bills out of your main account.  You can think of the other accounts as electronic envelopes.  They are only there to help you budget - not to use like a traditional bank account.

Set up all of your accounts so that whenever you get your paycheck (which will go into your main checking account), the proper amount is automatically transferred into each of your separate accounts.

When you go shopping, you can use your cell phone or Blackberry or whatever to check the balance of each of your budgeted accounts.  When you purchase something,  you can put it on a credit card.  Then, while you are still standing at the cash register, use your phone to transfer the appropriate amount of money from whatever category the purchase falls under into your main checking account.  At the end of the month, you will then have enough money in your main account to pay your bill.

Using this system enables you to know how much you have to spend in every category, prevents you from overspending, and allows you to use whatever payment method you prefer.

Sheer genius for the tech savvy budgeter.

Wednesday, August 20, 2008

Budgeting system #2 - tracking your purchases

If you don't like the idea of the cash-based envelope system, or you want know exactly where every penny that you earn winds up, then you might want to budget the old fashioned way -- track every purchase.

Just like with the envelope system you will need to divide all of your spending into different categories and assign a weekly or monthly budget to each category.  Then either using a pen and paper or a computer, you keep track of ever dollar that comes in and every dollar that goes out.

If you use a computer program such as Quicken or Microsoft Money you can link your bank accounts, investment accounts, credit cards, mortgages, and more.  The program can then automatically download all of your transactions.  It is also often smart enough to categorize them for you.  A program like this takes a great deal (but not all) of the work out tracking your spending.

The best part of using a program like this is that you can, if you are so inclined, really analyze where your money goes.  It can show you, at the touch of a button, how much money you spend every year at McDonalds, or on yarn, or getting your haircut, or whatever else you want to know.

Tuesday, August 19, 2008

Budgeting system #1 - the envelope system

If you are spending more than you want to be, then you need a budget.  If your debt and spending are out of control and you need to take drastic action, the envelope system might be the right system for you.

The envelope system works wonders to bring spending under control.  Better yet, it does so without requiring tedious recording of all of your purchases.  You don't need any special software, books or anything else.  All you need are a few envelopes.

The first step is to figure out how much money you have coming in every week.  Then, take some time to list out the different categories that you regularly spend money on.  You will probably need categories for: transportation, groceries, utilities, entertainment, dining out, saving, rent or mortgage, debt reduction, clothing, and gifts.  Include a category for anything else that you spend money on.

Next, figure out how much money you have every week to allocate between these categories.  Then determine how much to put in each category.  Write the name of each category, and the weekly amount, on the front of an otherwise blank empty envelope.

At the beginning of each week, pull out enough cash from your bank account to fill each envelope with the alloted amount.  Then, spend nothing but what you have put into the envelopes.  In order to make this work, you need to do all of your spending in cash.  Bills, of course, can not be paid in cash, but everything else comes out of those envelopes.  If you have extra left over from one week, that's great - let it keep building.  If you run out too soon, you need to make changes in your spending to make sure that it does not happen again.  If you keep consistently coming in under budget in one category and run out of money before the end of the week in another, then you might want to adjust the amounts set aside for those categories.

The great thing about this system is that it is simple to implement and absolutely guarantees that you will not spend more than you want to.

Monday, August 18, 2008

I don't budget - I spend the leftovers

Budgeting is a great tool that helps you get more out of your money.  If you are struggling with debt, can't ever seem to save any money, or wonder where all your money goes, you need to budget.  I confess that I don't budget, but I do generally keep track of income and expenses and have a good feel for where my money goes.  My wife and I have no debt other than mortgage debt and we aggressively save for the future.  That being said, I am certain that we would be better off if we did budget.  However, we spend most of our time living abroad and deal with expenses in different currencies.  I have not found an easy and convenient way to keep track of everything.  If you know of one, please tell me about it.

Over the next few days, I will share a few different methods for how to track your expenses.  Today, I would like to share with you how my wife and I are able to met our financial goals without budgeting and tracking our money.

A large part of managing your money properly comes down to establishing your values and  priorities and using your money in a way that reflects those values and priorities.  We have set a high priority on a comfortable retirement.  Therefore, we have set up automatic funding for all of our retirement accounts.  We value education.  Therefore we have set up a college fund for our daughter that is automatically funded every month from our checking account.  Time together as a family is a priority for us.  Therefore, we make certain to set aside enough money to take vacations together.  We believe that it is important to give generously to causes that we care about.  Therefore, we plan out our giving for the the year ahead of time.

All of our high priority goals are automatically funded.  As soon as that money comes into our checking account, it is automatically whisked away.  We know generally how much our bills will be every month.  So, what ever is leftover is what we spend.  Doing this almost invariably means that we spend less then others in our same income bracket.  However, because we know that we are using our money for the things that matter most to us, it makes it much easier (most of the time) to cut back in some areas where our friends and colleagues indulge.

One of the reasons that it works is because we have always been good at not spending beyond what we earn.  If you have a problem with debt, this might not be the best method for you.  This plan isn't perfect, but it works for us. 

Saturday, August 16, 2008

What debt does to your lifestyle

Many people get into financial trouble because they live for the moment and fail to plan for the future.  One of the easiest ways to sabotage your own finances is accumulate too much debt.

While the use of debt to purchase a house, start a business, or in some cases make a major purchase such as a car can be smart, debt is always dangerous.  Debt used to finance a lifestyle - dining out, vacations, remodeling, or shopping - is especially dangerous.

Lets take a look at two young couples to see how debt can effect your lifestyle and financial well-being.

Both couples make a combined income of $70,000/ year.  However, they both handle that money very differently.

Couple A is not presently concerned about saving for retirement.  They eat our frequently, take great vacations, drive nice cars, and thoroughly enjoy life.  However, their salary does not quite cover all of their expenses.  They manage to rack up $5,000 of credit card debt every year.

Couple B likes nice things too, but also wants to plan for the future.  They save 10% of their income for retirement and give $3,000 to charities every year.  Couple B also makes sure that not to spend more than they have and does not accumulate credit card debt.

So for right now, couple A has $75,000 to support their lifestyle, where as couple B is choosing to make do with only $60,000.  However, lets see what things look like if both couples continue down this path.

After five years have gone by, Couple A is still spending and accumulating debt.  However, one of them gets a $5,000 raise, bringing their annual income up to $75,000.  They decide that it is finally time to start planning for retirement.  Taking stock of their situation they realize that they have nothing saved and have accumulated $25,000 in debt.  If they are paying 18% interest on their debt, that means that they need to pay $4,500 in interest payments every year.  They will need to pay even more to pay down the balance on their cards.  So, they decide to set aside $6,000 every year to pay down their debt and to begin saving 10% of their salary for retirement.  When you add all of this up, couple A has nothing saved and now despite a nice raise, has only $61,500 each year to spend.

Believe it or not, one of the members of Couple B gets a $5,000 raise after five years too!  They continue to give $3,000 to charities and to save 10% of their income for retirement.  This means that couple A now has $64,500 left to spend and assuming an 8% return on their investment, already has $44,000 put away for retirement.  If this $44,000 is given another 25 years to grow it will be worth $442,000 even if Couple A never adds another dime.

Here are the important points that I see in this illustration:
  • Taking on debt means spending future income today.  Doing so only sets you up for future disappointment.  While couple A probably had a lot of fun in those first five years, it will be a long time before they will be able to spend at that level again.  Even though they got a raise, they had to cut their spending by almost 20%.  Couple B meanwhile, will likely generally be able to steadily increase their spending as time goes by and their income level rises. 
  • Couple A had five years of better living than couple B did.  However, after only five years, Couple B has no debt, a substantial amount of money saved for the future, and a higher level of spending then couple A.  All this while still donating a significant amount of money to causes that matter to them.
  • Over those first five years, couple A did have more to spend and probably had a lot of fun.  However, couple A will never catch up to couple B.  There is now a $71,000 difference between the net worths of each couple.  Even once couple A pays off their debt, they will still have significantly less money saved for retirement.
  • The longer one lives above their means, the more damaging it is to their long term financial situation.
  • Even while saving for your future, it is often possible to give generously to causes that you care about. 

Friday, August 15, 2008

A guaranteed instant 100% return - really!

Generally, when you see advertisements for investments that will double your money you should probably stay away.  Get rich quick schemes just don't work.

However, most Americans do have an opportunity to earn a 50-100% return on retirement savings.  If your employer offers a 401(k) plan, a 403(b) plan, or a Thrift Savings Plan and offers to match your contributions, you should at the very least invest enough to obtain the full match.  Period.  Doing anything else is very literally turning down free money.

Even if your employers plan has high-cost investment options or investments that you don't particularly like, if you can get free money by participating, it is almost impossible to do better with another investment.

Let's say that you make $50,000/year and your employer will match your contribution - dollar for dollar, up to 5% of your salary.  That means that you need to contribute $2,500 per year in order to receive the maximum $2,500 contribution from your employer.  If your investment grows at an average of 8%/year, and you contribute every year for 40 years, when you retire your investment will be worth almost $1.4 million!  Without your employer's matching contributions, you would need to earn an annual return of nearly 10.5% in order to achieve the same amount of money after 40 years.

If you are eligible for an employer sponsored retirement plan with employer-match contributions and you are not yet contributing enough to get the full match, do yourself a favor and fix that immediately.

Thursday, August 14, 2008

Life insurance for babies?

Yesterday, I received a letter from a life insurance company offering me a whole life insurance policy on my six-month-old daughter.  I can hardly think of a product that I need less.

Life insurance is a fantastic product that is used to help alleviate the financial burden created by the death of a family member.  While any death in the family is emotionally devastating, the death of your spouse can also be financially devastating.  Most six-month-old children (my daughter included) don't bring home a salary or offer much help around the house.  While the death of a baby would be absolutely heartbreaking, there is nothing that about the loss of a baby that a few thousand dollars can replace.  While life insurance money will not replace a spouse, it will help fill financial needs created by the loss.

Furthermore, life insurance for a baby is incredibly expensive.  The rate that this company is offering is $3.18/month for $5,000 of coverage.  By way of comparison, my term life policy costs me 23 cents/month for $5,000 of coverage.  I know, this isn't a fair comparison - whole life insurance builds up cash value.  Lets take a look at how that cash value builds up:

The letter I received claims that after 25 years the policy can be cashed in for the amount of premiums that you have paid in.  This cash value is one of the main benefits of the policy.  The company suggests that once your child is 25 you can give them this money as a nest egg.  Assuming that you purchased this policy the month that your child was born, you would have paid in $954 in monthly payments over those 25 years.  So you will end up with 25 years of insurance coverage (which you didn't need) and $954 which grew at a rate of 0%.

Lets take a look at what would happen if instead of purchasing the insurance policy, you invested the money in a low cost mutual fund for your child.  If you took the same amount of money - $38/year - and invested it at an 8% annual return, when your child is 25 your investment will be worth $3,000.  Which one do you think your child would prefer?

My advice: skip the life insurance policy and start saving for college.

Wednesday, August 13, 2008

Annuities: investments generally worth avoiding

An annuity is something of a cross between an insurance policy and an investment.  They are complicated, expensive, and generally probably not something that most people need.

An annuity is an investment vehicle.  You purchase an annuity bit by bit over time or in one lump sum.  The money inside the annuity will be invested for you until you "annuitize" your policy.  Once annuitized, you no longer own the money inside the account.  Instead you hand the money over to the insurance company who runs your policy.  In exchange, they agree to make a regular, fixed payment to you for the rest of your life.  It is almost like life insurance in reverse.

When I was a financial advisor I sold exactly zero annuities.  While having a fixed stream of income from an annuity can be very attractive, in practice I found that my clients were always better off investing on their own without an annuity.

The fee structure for these vehicles is enormously complex.  Even after attending seminars for financial advisors about specific annuity products, I recall not entirely understanding all of the different fees that an investor in that annuity needed to pay.  The one thing that was incredibly clear to me was that advisors who sold annuities made a great deal of money.

Because of the high fees and complexity of annuities, I quickly realized that they were not right for my clients.  This does not mean that annuities are always a bad choice or that anyone who tries to sell you one is a crook.  However it does mean that you should very carefully consider an annuity purchase.  Once you have purchased an annuity, it is usually very difficult - and very expensive - to move your money out of it.  Most annuities have "surrender fees" that you have to pay if you wish to transfer your money within the first 7 - 10 years that you own the annuity.  There might also be some very serious tax implications if you transfer money out of an annuity.

If an advisor recommends that you purchase an annuity, make sure that you know what you are getting into.  Ask him why he is recommending the annuity.  Ask him to explain all of the fees involved and ask him to show you the projected results of purchasing the annuity vs. investing the same amount of money in mutual fund.  You should also ask how many of his clients own annuities.  They are very specialized products, and in my opinion, they are generally not the best investments for most people.  If an advisor tells you that he recommends annuities to all or most of his clients, unless he has a very specialized market, I would be concerned.

Tuesday, August 12, 2008

What if you got money smart?

There are plenty of things that we should all do - eat our broccoli, floss our teeth, rotate our tires regularly, and manage our money well.  However, even though we know that we should do these things we often just don't do them.

Liz Pulliam Weston has a great article about what would happen to the U.S. and world economy if suddenly all U.S. consumers got "money smart"and paid off all debt, did not overspend on houses and cars, saved for retirement, and had adequate savings on hand for emergencies.  It is an interesting piece and I encourage you to read it (but not yet - finish reading this first!).

Take some time today to think about what your life would be like if you started doing all of the things that you know you should be doing with your money.  What would your life be like if you:
  • Had a plan to save for retirement and children's college expenses
  • Followed that savings plan
  • Paid off all of your debt
  • Never spent more then you earned
  • Had adequate life insurance
  • Made sure that you had several months of living expenses in your savings account
  • Regularly supported charities that you believe in
How would your life change?  Would you have less stress, less worry?  Probably.  Would you need to cut back on spending?  If you are saving, do you know how to tell if you are saving enough?  Too much?

Take a moment to think about what your life would be like if you knew that you were doing all of the things listed above.  If you are already on this road, congratulations.  If not, once you finally start down the path of making good decisions about your money you will probably find that the costs are not so great as you expected and the rewards are far greater.  If you need some incentive to get started now, take a look at this earlier post.

Monday, August 11, 2008

Portfolio rebalancing - buying low and selling high automatically

You probably know the old adage that you should buy low and sell high.  However, did you know that there is an way to make your portfolio automatically do that - even if you are not investing new money?

Suppose you decide that investing 70% of your money into a stock fund and 30% of it into a bond fund is the appropriate asset allocation for your retirement account.  Because these investments will rise and fall at different rates your ratio of 70% stock to 30% bond will not hold.  Properly managed, this is a good thing.  However, if you do not rebalance your account, because your riskier investments tend to grow fastest, your portfolio will slowly expose you to greater risk.

In order to maintain your proper asset allocation, you need to periodically rebalance your portfolio.  In this case, that would involve periodically transferring money from the fund that recently performed the best into the fund that did not perform as well.

In addition to keeping your investment risk at the appropriate level it will force you to buy low and sell high.  If the stock market has a great year you will need to sell some of your stock investment, at this relatively high price, to even things out.  If stocks have a lousy year, you will sell some of your bonds to put more money into the relatively lower priced stock market.
 
I recommend that you consider establishing a schedule to rebalance your portfolio every 6 - 12 months.  Many investors find it difficult to sell their best performing investment and transfer money into their worst performing investment.  However, doing so is often a very rewarding financial move.  If you have a regular schedule for doing this you can make what could be a difficult, emotional decision into a simple administrative action.

You should also rebalance your portfolio off schedule if the markets have made a dramatic move and you notice that your chosen asset allocation is off by more than a few percentage points.

Friday, August 8, 2008

A few things I do or have done to save money

I would like to share with you a few things that my wife and I do or have done to save money. You will notice, that this list is not called "things that you can do to save money." Because I don't know about your particular situation, I don't know if any of these will work for you. If they do, great. If not, I hope that they will at least be able to spark some ideas for things that you can do that will save you some cash.

  1. We did not own a car for four years. During these four years we lived in a highrise downtown in a major city. While there were times that we missed having a car, we never really needed one. We walked or biked to work, occasionally went on shopping trips or other driving excursions with friends, and took a lot of taxis.
  2. Currently, we only have one car. Now that we have a child and are no longer living downtown, we found that we needed a car. However, we only wanted one car, so we carefully chose a neighborhood that is on a major bus route and has a grocery store, butcher, and baker all within walking distance. I bike to work in the summer and take the bus in the winter.
  3. We canceled our cable. Because of hulu.com, other sites that allow you to legally watch TV online, iTunes, and Netflix we just don't watch TV very much. We have been without cable for several months now, are saving almost $50/month, and don't miss it one bit.
  4. We rarely drink soda. Given that you can easily pay $3-4 for a soda at a restaurant, we usually stick to water. If we want a Coke (or beer, or glass of wine) we order it. But only if we actually want it.
  5. We consult each other before making any large purchases. My wife and I have a standing agreement that we will consult each other before purchasing an item with a value of $100 or more. This not only ensures that we are on the same page for major spending, it often helps to curb impulse buys. It still surprises me how often one of us will suggest purchasing something, the other will agree, only for the first person decide that they don't really want to spend the money after all.
  6. We don't have cell phones. Nor do we want them.
What is important about these decisions for us is that we have found ways to save money that don't make us feel that we are giving anything up. Is there anything in your life that you could cut back on or eliminate? You might be surprised at how little you miss it once it is gone.

Have you already found things that you can save money on? Leave a comment and share your experience.

Giving

I just read an article on WalletPop about Keith Taylor and his impressive website, Modest Needs.

Taylor's website allows people to lend a helping hand to the working poor in America.  He accepts applications from people who need one time financial help (medical bills, car repairs, and the like), posts their needs online, and allows people like you and me to fund these needs.  His goal is to stop the cycle of poverty for low-income workers before it starts.  Taylor screens the applications carefully - only 20% make it through - and employs rigorous anti-fraud measures.  I have not used this site, but I encourage you to check it out if you are interested.

However, the WalletPop article glosses over what I think is one of the most important lines of Taylor's story.  Back before he ran Modest Needs he personally gave his money - $350 a month - to people in need.  At that time, he was only earning $33,000.  This means that he was giving $4,200 per year, almost 13% of his relatively modest salary, to charity.  That impresses me.

I believe that any good financial plan should include charitable contributions.  Some of the reasons that I think you should include charitable giving in your personal financial plan:
  • Giving reminds you of what it really important in life.
  • There will always be people with more money than you.  Giving reminds you that the vast majority of people in this world have much, much less than you do.  According to the Financial Times a net worth of $2,200 puts you in the wealthiest half of the planet and a net worth of $61,000 makes you wealthier than 90% of the world.
  • Giving tends to create a greater sense of satisfaction in what you do have.
  • Giving helps others and makes the world a better place.
If you do give, my advice is to make certain that you are giving to a financially responsible organization and to be very deliberate in where you give.

Many solicitors for charity pass on far less money to the cause than you might think.  Some fundraisers keep 80-90% of the money you donate to cover their own costs, passing along only 10-20% of the money to whatever charity they claim to be raising money for.  Fund raisers and charities are required to let you know what percent of your donation is used for the cause and what is used to cover other costs.  Always ask.

Choose to support one or more organizations that you are passionate about.  Don't fritter away your donations in small amounts.  Like the rest of your finances, giving should be planned.  My wife and I discuss at the beginning of the year how we will give.  When we get phone calls and door to door solicitors (other than young children) asking for money, we explain that we plan our giving ahead of time and ask for information about their organization by mail. 

Thursday, August 7, 2008

Asset allocation - the basics

If you are investing, asset allocation - or how you spread your money between different investments - is the single largest factor that will determine how well your investment does.

Proper asset allocation not only reduces risk, but can actually increase your returns.  The math behind this gets very, very complicated.  (Check it out in this wikipedia entry if you are interested.)  What the math shows is that you can create a diversified portfolio that will have a higher return and the same level of risk as a single (non-diversified) stock.  You could also create a diversified portfolio that has the same expected level of return as the stock but a lower level of risk.  Either one of these portfolios is a better investment than the single stock.

The main building blocks of a large, well diversified investment portfolio are: (listed in order of lowest risk to highest risk)
  • Cash
  • Bonds
  • Large cap stock
  • Small cap stock
  • Foreign stock
This does not mean that everyone needs to invest in every category.  If you are just starting to invest and only have a few hundred or few thousand dollars to work with it is best to chose only one fund.  I would suggest that you start with either a large cap stock fund or a bond fund, depending on your risk tolerance and your time horizon.

If, however, you have larger pool of money it makes sense to spread it between several different asset classes.  

Determining the proper asset allocation for yourself is part math and part psychology.  In order to determine the proper asset allocation for your investments, you should consider your willingness to experience volatility (risk), the length of time you have to invest, and how firm your investment target date is.

If you are interested in looking into the proper asset allocation for your investments, these sites might help:

Tuesday, August 5, 2008

A place for professionals

Managing your money well does not require a professional.  You can manage your money without help from a financial advisor or planner.

However, there is a time and place for professionals.  If you are not interested in spending the time to learn the basics of financial planning or if you don't have the disciple to stick to your plan when your investments are losing money, a financial professional might be able to help you.

If you are going to hire someone to help you with your money it is vital that you take the time to make sure that you find the right person.  Because your situation is unique you will need to decide what factors are most important to you in choosing an advisor.  Here are a few things to consider when looking for a financial advisor:
  • Talk to your friends and colleagues - especially those whose attitude toward money you respect.  Ask them for recommendations.
  • Brokerages and financial advice firms give their advisors a great deal of freedom.  There can be great variations in quality of advice and investing style within the same firm.  Therefore, it is often more useful to look for an individual that you want to work with, not a firm.
  • Understand how your advisor gets paid.  Most will be paid on either fees, commissions, or a combination of both.  All of these forms of compensation are legitimate.  It should be absolutely clear to you exactly how your advisor is making their money.  That money is coming from you, after all.  Commissions-based planners have been beaten up in the press in recent years.  However, they can make sense to newer investors with relatively straightforward needs and small amounts to invest.  If you have a larger amount of money and more complicated needs, a fee based planner might be more appropriate.  Only you can decide.
  • Find someone who you trust and who supports your values.  One couple I know went over their budget with a financial planner on their initial meeting.  Their budget included giving away 10% of their money to their church.  The planner noticed that they spent a lot of money on "tithe" (pronouncing it incorrectly as "tith") and asked if they might be able to cut back some spending there.  Probably not the right advisor for them.
  • Don't be afraid of someone who is new to the industry and hungry for business.  If they have few clients they can devote more time to you.
That should be enough to get you on your way.  For more detailed info, read what The Mole has to say on choosing an advisor.

Monday, August 4, 2008

5 simple ways to simplify your finances

The simpler your finances are the easier it will be for you to stay on top of them and meet your goals.
  1. Pay all your bills on the same day.  Call up everyone who regularly sends you a bill - credit cards, utilities, mortgage, cable, internet, college loans, and anything else - and ask them all to change your bill's due date to the same day of the month (I use the 5th).  If your bills are all due at the same time, you are far less likely to forget one.
  2. If you use credit cards, only use one.  Only one bill to pay and one statement to check over.
  3. Pay your bills online.  Better yet, set up your bills to pay themselves out of your checking account automatically.
  4. Automate your savings and investing.  Are you contributing regularly to your savings account, retirement account, and college savings accounts?  If so, set it up so that every month money is automatically transferred from your checking account.  This eliminates the hassle and the chance that you will skip a month.
  5. Combine accounts.  Do you have more financial accounts than you need?  Combine some of them?  Do you have a 401(k) from an old job?  Roll it over into a rollover IRA at the same brokerage that manages your Roth IRA.  How many life insurance policies do you own?  Look into what it would cost to replace them all with one new policy.  This might not work out if your health has deteriorated, but life insurance rates have fallen in the past several years, so it is worth checking out.
Keep your finances simple and you will have more time for far more important things!  (Like reading interesting blogs or whatever else you like to do.)

How to make volatile markets your friend: dollar cost averaging

Warren Buffet, one of the greatest investors of our time, is alleged to have said that he would pay a significant amount of money for the stocks he owns to decline 50% or more.

To find out why Warren feels this way, lets consider the following example of a hypothetical mutual fund:

The graph shows the share price on a monthly basis.  For this example, lets suppose that in January you started investing $100 per month into this fund.  As you can see, the fund didn't have a great year.  It lost almost half its value in the first two months, bounced around for a while before ending the year at a price of $4 - a full 20% decline from its price in December.

So in December you sit down to calculate just how much of your $1200 investment you have lost.  First, you look over your records to see how many shares you own.  You records show that you made the following purchases:

January 20 shares purchased for $5 each
February 25 shares purchased for $4 each
March 33 shares purchased for $3 each
April 29 shares purchased for $3.5 each
May 31 shares purchased for $3.25 each
June 33 shares purchased for $3 each
July 25 shares purchased for $4 each
August 33 shares purchased for $3 each
September 22 shares purchased for $4.5 each
October 25 shares purchased for $4 each
November 20 shares purchased for $5 each
December 25 shares purchased for $4 each

This gives you a total of 322 shares.  With the current price at $4 your shares are worth $1288.  You check over the math again because you don't believe it.  Even though the fund price went down, you managed to return over a 7% profit!

How did this happen?  Dollar cost averaging.

Dollar cost averaging is the process of making regular, usually monthly, investments into a mutual fund or other security.  By making investments at regular intervals you take the emotion out of your purchasing.  When the share price is low, your money goes farther, and you are able to purchase more shares.  It does not guarantee a profit, but it is a great way to invest.

Look at the above graph again and try to imagine how you would have felt investing in this fund as time went on.  From February to June, when the share price was the lowest you probably felt the worst about your investment.  But, now that we know how the year ended we can see that those were the best times to make purchases.  In those months, you were able to get more shares at a lower price.  This drove down the average price you paid per share to only $3.73 and you made a profit for the whole year.

Generally when things that you regularly buy go on sale, I am sure that you are happy about it.  This is often not the case with investments - but it should be.  If you are investing in low cost index funds or other well managed funds and are investing for the long term, any chance to buy them for a relatively low price is a good thing.  You should consider it your job to buy as many shares as you can, and the mutual fund's job to go up in price.  If it temporarily goes down, that just makes your job of buying shares easier.

Warren Buffet knows that he makes good investments and that in the long run they will pay off.  Therefore, he looks forward to opportunities to purchase his investments on sale.  You should too.

Saturday, August 2, 2008

What "average" returns really look like

Yesterday we assumed a 10% return on our hypothetical investments.  The rate of return has a huge effect on the outcome of both these hypothetical scenarios and your real life investments.  So how predict the performance of your investments?

In short, you can't.  It is impossible to predict the return on investments in stocks, bonds, and mutual funds.  However, if you have a diversified portfolio we can use historical averages as our guide and estimate reasonably well.

According to the Motley Fool, from 1926 - 1998:
  • U.S. Treasury Bills returned an average of 3.7%
  • U.S. Corporate bonds returned an average of 5.7%
  • The S&P 500, which is a good measure of the stock market, returned an average of 11.2%
You can use these numbers to form a solid estimate of how your investments will perform.

Those averages certainly make stocks look very appealing - and they are.  However, remember that higher returns are always associated with higher risk, and in the financial world risk = volatility.  Those are the averages, to see what those numbers looked like year-by year look at the following graph.


In this graph you can see that even though the S&P 500 averaged around 11% over this time period, from year to year the index was anywhere from down 40% to up 50%.  Returning 11% in any given year was a very rarer occurrence.

What this graph says to me is the volatility in the stock markets is not new or unusual.  Volitility is a part of how the stock market works and in the long run will not prevent you from meeting your financial goals.

Tomorrow, I will share an investing strategy that helps use these peaks and valleys to your advantage.

The importance of investing early - a $555,000 difference

When you start saving for retirement will have a tremendous impact on whether you will successfully save enough money.  Let's look at four different hypothetical investors to illustrate this point.  Each one of them started working age 25 and plans to retire at age 65.  Should they choose to take advantage of it, this gives them forty years to save for retirement.  Now, lets see what happens to our hypothetical investors.

1. Investor number one is a regular reader of this blog and understands the importance of investing early.  She invests $100/month, every month, for the full forty years of her working life.

2.  Number two gets a bit of a late start and does not begin investing until he is 35 years old.  However, starting at age 35, he invests$133/month, every month, for thirty years.

3.  Although investor number three knew she should be investing, she didn't get around to it until she was half way through her career.  Starting at age 45, she invests $200/month for twenty years.

4.  Sadly, investor number four never thought much about retirement until he was already 55.  When he hits 55, he panics, and starts to save as much as he can.  For the next 10 years he puts away a full $400/month.

If you do the math, you will realize that each investor put the same amount of money into his or her account - $48,000 over the course of 40, 30, 20, or 10 years.  However, there are some very big differences in the total amount of money each has accumulated for retirement.  If you assume an 10% annual return each investor would have accumulated:

Investor number 4: $82,600

Investor number 3: $153,100

Investor number 2: $303,800

Investor number 1: $637,700

What does this mean for you?  Start investing as much as you can as soon as you can.  You will be very, very glad that you did.  Remember, each of these investors put in the same amount of money and achieved the same return on their investments, the only difference was when they started.

All of these numbers were calculated with the very cool Kiplinger Personal Finance 401(k) calculator.  

Friday, August 1, 2008

How to pick mutual funds

Important disclaimer - before you get started, I want to warn you that this post is a bit longer and a bit more complex then my previous posts.  It covers a tremendous amount of important information and I urge you to read through it.  I think that you will be glad you did.

Now that you understand the benefits of investing in mutual funds, you are faced with the challenge of determining how to sort through the thousands and thousands of funds out there to find the best ones for you.  When you are looking for a fund, there are three factors that you need to consider to make an informed decision: what the fund invests in, how it is managed, and how much it will cost you.  You can find the answers to all of these questions in the fund's prospectus (a legal document that lists the details of the fund) or on websites that sell the funds.

Different kinds of funds

Discovering what the fund invests in is pretty easy - this is generally prominently displayed in any prospectus or other literature about the fund.  While there are almost unlimited possibilities for what funds can invest in, there are a few major categories:

U.S. stock funds - these funds invest in stocks of U.S. companies.  Some of these funds will invest only in large companies (large cap), medium size (mid cap), or small companies (small cap).  Others will invest according to a certain investment style such as growth (investing in stocks of companies that are growing quickly) or value (investing in stocks of companies that are out of favor and might be underpriced).

Foreign stock funds - these funds invest in stocks of foreign companies.  Some will invest only in certain countries or certain regions and like U.S. stock funds can often be further categorized as growth or value funds and as small, mid, or large cap.

Bond funds - these funds invest in U.S. bonds.  These funds might invest in federal government bonds, high quality (relatively safe with relatively low yields) corporate bonds, high yield or junk (relatively higher risk but relatively higher yield) bonds, municipal bonds, or foreign bonds.

Asset Allocation - These funds invest in both bonds and stocks.

Sector funds - these funds invest in stocks, but only in a certain sector.  For example, they might invest only in technology companies, energy companies, or healthcare companies.

Target date funds - these funds are designed for retirement investing.  They invest in stocks and bonds.  As time goes by and you approach retirement, these funds becomes more conservative by shifting money from stocks into bonds.

Active management vs. passive management

There are two primary methods to manage a mutual fund - actively and passively.  An active fund manager and his team of analysts actively choose the investments that they think are best for the fund.  They will monitor the economy and the market and will buy and sell investments as they feel appropriate.

A passively managed fund, or index fund, simply sets up its fund to mirror a specific portfolio of investments.  This type of fund follows a model portfolio (or index).  The most popular index to follow is the Standard and Poor's 500 (S&P 500).  This is an index of 500 of the largest publicly traded companies in the United States.  It includes companies such as General Electric, Microsoft, General Motors, Amazon.com, and Boeing.

Actively managed funds certainly sound like a great idea.  Who wouldn't want a team of professionals carefully selecting the best investments for them.  However, over the past ten years, the cheapest S&P 500 index funds beat over sixty percent of actively managed funds investing in similar stocks.

Costs

All mutual funds charge annual recurring fees.  Some funds also have a one time sales charge called a load.

Typically a load ranges from 1% - 8% of the amount of money you are investing.  For example, if you invest $1000 in a fund with a 5% load, $950 dollars would be invested in your account and $50 would be kept by the company or salesperson.  Funds without a load are called... wait for it... no load funds. 

Be wary of paying these fees.  When I was a financial advisor I sold load funds.  When my clients purchased these funds the load paid me for my advice and I believe that their money was well spent.  If you chose to invest in funds with a load make sure that you are getting something for your money.

All mutual funds have annual expenses (that come in several different categories).  These expenses pay for the management of the funds, the trading costs, the marketing, and other expenses.  The charges are absolutely invisible.  You never see them taken from your account and you never receive a bill for them.  They only way that you know about them is by reading up.  Both Etrade and Morningstar will tell you the net expense ratio of just about any fund.

These expense range from about .15% on the low end to upwards of 2% on the high end.  Index funds tend to have lower fees than actively managed funds.  This is one of the reasons that so many actively managed funds can not keep up with the cheaper index funds.  While these numbers sound small, they really add up.  Lets pretend that you start investing right out of college at age 22.   For the next 43 years you invest $1,000 a year into each of two different funds.  Both funds earn 10% per year before expenses and one has an expense ratio of 1% and the other has an expense ratio of 1.5%.  By the time you are 65, your investment in the fund with the lower expense ration will be worth $480,000 while the investment in the fund with only .5% higher fees will only be worth $413,000.  So that .5% cost you almost $70,000 over the course of your working life.

Picking the best funds for you

Congratulations, you now know the basics of how funds work and know enough to start picking some funds for yourself.  Here is my final guidance to get you started:

1.  Remember, simpler is generally better.  Don't invest in 18 different funds just because you can't decide which funds are best.  Generally, owing only a few funds is better than owning many funds.

2.  Stick to the basics if you are just getting started.  Invest in a fund that invests in U.S. large cap stocks (such as an S&P 500 index fund) and a U.S. bond fund.  A good rule of thumb is to "invest your age" (as a percentage) in a bond fund, and the rest in a stock fund.  This means that if you are 30 years old, you should put 30% of your investment into the bond fund and 70% into the stock fund.  We will talk about asset allocation (how to divide your money into different types of investments) in more detail in a future post.

3.  Low fees are better then high fees.  Personally, I like both Vanguard and Etrade brand mutual funds.  They are both among the cheapest options out there.

4.  If you are paying a load, make sure that you are getting some value out of it.

That's all for today.  We covered a ton of important info.  If you were not previously, you are now in a position to be a very well-informed investor.  Congratulations on making it this far.