Archive for March, 2012

29
Mar
12

Risk & Reward

We all know the age old rule that the more risk we take, the higher the potential reward.  And we tend to think this relationship looks something like this:

We tend to think the relationship between risk and reward is linear.   In other words, for an additional amount of risk we take, we are compensated a proportional amount of reward, with no limit on the amount of reward we can reap.  This is common thinking when describing the Risk/Reward balance.

If we were whipping up charts to model our ideal Risk/Reward relationship, this is what we would want.

This way, we are compensated exponentially over the long term for taking more risk.  And, just as with the linear chart, there is no limit to the amount of reward one can reap.  Sadly, neither of these are the case when it comes to the stock market.

We are more likely to see diminishing returns for incremental risk that we take on.  Something like this:

Eventually we run into an asymptotic behavior, when we go out to infinity with our risk, the reward will seize rewarding for that additional risk.

So, when people say, “more risk = more reward,” stop a moment and think how you are being rewarded.  Is it in proportion to the amount of risk you are willing to take?  Will you be exponentially rewarded for your risks?  Will you take additional risk that barely return you more reward?

Food for thought.  What’s your risk/reward relationship?

26
Mar
12

Peer-to-Peer lending is a bad idea for investing

Maybe we’re just old curmudgeons who fear change and new things?  We’re the same people who won’t click anything on our computer screen if we don’t know what it is for fear of our computer combusting.  And, we don’t like peer-to-peer lending.  Or “P2P” if you are a young hipster who wildly clicks everything on their computer (sans combustion).

Why you ask?

  • We can’t help but ask, why don’t these people go to a bank and take out a loan?  Why won’t the people who are professionals offer them a loan?  Is there not enough exposure through investing in a bank?
  • How quick we are to forget the credit crisis of a few years ago.  When shit hits the fan, self preservation becomes the number one priority for people.  People will go so far as to use you as a shield so they don’t get the durdy stuff on them.
  • People will say anything or do anything to make you believe they are up for sainthood…and so you give them money.
  • We also find some irony to personal finance blügs pushing P2P lending.  These loans are typically for the very thing personal finance blügs preach against.  Yet they “invest” in it?  Not to mention, blügs are often paid for you signing up with a click through their affiliate links.
  • Some of the reasons given to loan people are uncorrelated to their ability to pay the loan back.  This mainly revolves around business loans.  Their credit rating has nothing to do with their ability to run a business.  And if the business tanks, good luck collecting.
  • It is time consuming.
  • It is risky.

General consensus is for a person to use a small portion of their portfolio for P2P lending.  And that is ok in our mind if that portion is part of their equity allocation.  P2P lending should be viewed as a risky “investment.”  And since we know reaching for yield is a bad idea, P2P lending shouldn’t be part of fixed income allocation or emergency funds.  That, in our mind, is OK.

So, why don’t we use a small portion of our portfolio for P2P lending?  Two reasons: 1) it takes time and research.  In fact, it would take us a significant amount of time to understand websites like Lendstats.com.  and then we have to read through loan after loan to understand where to put our money.  Limiting exposure by investing the minimum $25 in multiple loans?  All the more reading and research.  2) if we are going to risk a small portion of our portfolio and invest time, why not invest in a hobby or something we get non-monetary gain from?  Or go on a vacation which provides us excellent utility, especially while working.

Overall, we don’t think this is a right or wrong decision as long as people are assigning the risk of P2P lending to the correct risk bucket and limiting their exposure (<5% of their portfolio).  But, it is a time consuming endeavor, which can, for some people provide them utility.  And that is a good thing, as some people may enjoy helping someone consolidate their debt and get out of their hole.  But, it shouldn’t be viewed as a serious investment, but more of a hobby.  In fact, we’ve spent less time checking our portfolio and re-allocating our investments than we did researching P2P lending.

 

22
Mar
12

Reaching For Yield

We once upon a time knew a young women who was getting married in the Spring of 2009.  She and her parents had saved a good chunk of change for the wedding through equity investments, and they made the mistake of budgeting the wedding based on the valuation of the funds at some peak around 2008.  Well, since they continued to think they could reap the same returns, which quite frankly they were lucky to have in the first place for such short-term needs of the funds, they left their money in stocks.  Everyone knows the rest of the story, the girl’s wedding was ruined, she had to buy out of contracts she was already in, change venues and cut back the list of guests.

Their mistake?  They were greedy and wanted more return for their money in the short term for risks they didn’t want to shoulder.  Sometimes people get away with this and they squawk about it at parties.  When they get burned, you are unlikely to hear a peep about their finances.  And while cutting back a guest list isn’t the same as paying a mortgage or putting food on the table, the mistake was a classic, often repeated and common one.

Reaching for yield is what we are talking about, and it is a viral theme often preached as being acceptable in today’s 20 something and 30 something blüg-o-sphere.

We know the fundamental investing principal of “Risk = Reward.” The greater the risk we are willing to take, we are potentially rewarded more.  Reaching for yield is when you veer from your investment plan and take on a greater amount of risk than you are willing to accept for a bucket of funds hoping for greater returns because you think the yields are unacceptable.

What makes a yield unacceptable?  We’ve heard a variety of reasons: the value of cash is being eroded by inflation to a friend getting lucky with junk bonds to thinking one can get ahead without getting burned.  Whatever the reason, reaching for yield, or going up the yield curve can put one’s plan in danger.

More money has been lost reaching for yield than at the point of a gun

-William Bernstein

Just as our bride friend above, a person reaching for yield can find the money they need to be gone when they need it.  Emergency funds are something where we should accept whatever the FDIC savings rates offer.  Whatever you decide on the amount of money you need for an emergency, you never know when you’ll need it.  An emergency, by definition, is an event you don’t plan on happening.

Reaching for yield with emergency funds isn’t the only example of reaching for yield.  Funds being saved for a home down payment, holding too many equities & not enough bonds, using peer-to-peer lending to replace fixed income allocations, etc.

We know the rates on FDIC insured saving vehicles are relatively low compared to 6 years ago and there are fears of inflation eroding the spending power of money away.  We wish inflation was moderate and predictable, we wish savings accounts were yielding 5-6%.  But, it isn’t in cards today without accepting greater risk.  We just hope people will think of the needs for their money and not find their money consumed by the market when they need it.

19
Mar
12

Actively Managed Funds do worse than expected

We’ve read on other personal finance blügs that 50% of actively managed funds (ones where you pick people to “beat” an index or benchmark and in turn pay higher fees) do worse than their benchmark.  We were curious about this because everyone throws it out there like it is common knowledge but never citing any sources.

Well, we’ve rolled up our sleeves and found some data.  Standard & Poor’s keeps a scorecard which is called SPIVA (S&P index versus active).  One issue they account for is survivorship bias, as other entities who track this don’t count a fund who fails as doing worse than it’s benchmark which is one reason you see 50% of active funds underperforming rather than the much higher SPIVA numbers.  Seriously, the first page is a must read.  Some of our favorites:

  • There are no consistent or useful trends to be found in annual active versus index figures. The only consistent data point we have observed over a five-year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices.
  • There is a common perception that the large-cap market is efficient and should be indexed while the small-cap market is inefficient and should be active. This principle has stood the test of time; indexing continues to be much more deeply entrenched in the U.S. large-cap market than the U.S. small-cap market. However, over the last decade, SPIVA has consistently shown that indexing works as well for U.S. small-caps as it does for U.S. large-caps.
  • Bear markets should generally favor active managers. Instead of being 100% invested in a market that is turning south, active managers would have the opportunity to move to cash, or seek more defensive positions. Unfortunately, that opportunity does not often translate to reality. In the two true bear markets the SPIVA Scorecard has tracked over the last decade, most active equity managers failed to beat their benchmarks.

Without further adieu, here are some high level results from Report 1, page 7:

% of funds outperformed by their benchmark

With the bar set low at 50% of actively managed funds doing worse than their benchmark, this is certainly bad news for their advocates.  These are the 5 year numbers, because as S&P points out, year to year data will fluctuate.  But, if you think you can pick the winners, then the 1 year numbers are in the report as well.

It should also be noted that Large Cap value funds have less than 50% outperformed by their benchmark, or 36.71% were outperformed.  This is the only category to do so.  It is also the category with the lowest survivorship, at 91.8%.  Or, over 8% of the funds which were started have failed.

This nothing new to us and our dawghouse.  We are big believers in passive, indexed, mutual funds.  Not only because of the performance, but because the fees are lower.  It would be interesting to compare after fee returns of all funds.  We think over the long term an actively managed fund will do worse after fees than a low-cost index fund.

15
Mar
12

Roth IRA = Traditional IRA, a case for thoughtful Roth consideration

One of the most frustrating things to read in the blüg-o-sphere is how much better the Roth IRA is than a traditional IRA.  Heck, there is even a website fully dedicated to Roth IRA’s.  People seem to get caught up in paying fewer taxes and tax free growth.  These are all things which a Roth IRA offers, but is the Roth always better?  No, more times than not, it is not better.

It depends on what your definition of “better” is.  If your main goal in life is to stick it to Uncle Sam and pay the absolute minimum in tax, then yes, a Roth IRA is always better.  But, we propose this is not what the average working stiff who has retirement in mind wants.  We think everyone should look at after-tax dollars, not the amount of taxes paid, to weigh their options.

By definition, a Roth IRA has taxed contributions and earnings (growth and dividends) which are never again taxed (people with a year supply of ammunition in their fallout shelter may refute this).  Regardless of your conspiracy theories, the equation for computing after-tax return on an investment in a Roth IRA is:

By definition, a traditional IRA has pre-tax money used for the contribution and earnings which aren’t taxed until distribution, at which time they are taxed as ordinary income (but not FICA).  The equation to compute your after tax dollars of a traditional IRA is:

You see where we are going with this?  If you start out with the same principal investment (“P“), have the same return (“r“, they are the same because you would invest them the same) and you have the same taxes in retirement as you do now (“t“), then these equations leave you with the exact same after-tax dollars.

Of course, if you pay the taxes before compounding, it will be less than paying the taxes after compounding.  So, you do pay fewer taxes with a Roth than a traditional investment vehicle, but the after tax value is the same if the tax rates are the same at contribution time vs in retirement.  It should also be pointed out, that it may be appropriate to apply one’s effective tax rate at distribution time if they are completely in pre-tax dollars.

AH HA!  You wouldn’t take the taxes out of the Roth investment, P*t, instead you would invest the entire amount, P?  Well, that could very well be the case, but, you still have P*t to invest somewhere if you go the traditional route.  So, where do you put it?  Top off your 401(k), or maybe you top off a traditional IRA?  If you do this, you use the exact same equations above and end up in the exact same place as above.

What if you are able to max a 401(k) and an IRA and choose the traditional route?  You have no other tax advantaged accounts to invest in.  The difference would have to go into a taxable account.  If the tax rates are the same, the after tax dollars will favor a Roth investment vehicle.  But, it should be noted that there are other qualitative benefits to having money in a taxable account oppose to a tax advantaged account – liquidity of the money being probably the biggest benefit.

All this can be summed up in the following table which is an output of our nifty spreadsheet found at the bottom of this article.

The table above shows investments made in Roth investment vehicles, Traditional tax advantaged investment vehicles and taxable accounts.  The big surprise is the difference between Roth accounts and some of the traditional accounts is nothing!  It is no surprise that the Roth yields more than a traditional account with taxable accounts.  Even less surprising should be growth in a taxable account is more tax efficient than dividends (wink, wink young dividend investors).  But, don’t forget the qualitative characteristics of having taxable money.

Remember to compare apples to apples and oranges to oranges.  It isn’t fair to compare a Roth where the taxes haven’t been taken out of the principal to a straight traditional IRA where taxes are taken out at distribution and not invest the taxes to be paid for a Roth.

And for curiosity sake, what does the output look like if taxes are less in retirement than working?

Just as if taxes went up in retirement the Roth would be heavily favored, the traditional comes out ahead if taxes decrease.  What is interesting (wink, wink young dividend investors) is if you invest totally in dividends, you are better off in a Roth!

The choice to invest in a Roth should be based on the following:

  1. Income and source of income in retirement
  2. What tax rates will be in retirement
  3. “Intangibles” (e.g. using a Roth for estate planning, having a taxable account for liquidity)

Generally speaking, most people’s income in retirement will be less than what they were bringing home pre-retirement.  Very few people will be able to bring in more than their working income.

We think the Roth investment vehicles are very powerful, especially for those in lower marginal tax rates.  It is not, however, automatic or a “slam dunk” to always invest in a Roth.  We would by no means suggest anyone over the current 25% marginal tax bracket be a shoe in for investing after-tax money in a Roth account.  Yes, you pay fewer taxes now, but you are more than likely to be in a lower tax bracket in retirement, thus your after tax returns will be less.   Roth conversions or maxing out Roth 401(k) & Roth IRA’s are usually best utilized by younger workers (who hopefully have many years of income growth ahead of them), but regardless of age, one should always beware of what their income will be in retirement compared to their income today, their outlook on future tax structure and other “intangibles” such as estate planning or liquidity of other types of accounts.

What we didn’t look at

We aim to provide information applicable to the general readership.  We did not apply any state income or LTCG/Dividend tax.  Also, we assumed in some scenarios that all earnings are from dividends, and this is more times than not completely true.  Therefore, the scenarios in which we did this carry a bit of “penalty,” as some earnings will be growth and taxed at the time of distribution.  Also, tax loss harvesting is not accounted for in taxable accounts (people say that like tax loss harvesting is a good thing).

We’ve attached our spreadsheet for your pleasure (really, so someone doesn’t say, what about this or what about that).  As always, this was created by us, and is therefore our property.  We appreciate a little linky love if used to generate any published material (or if you just think it is cool).

 

12
Mar
12

Taxes going up! Taxes staying the same! Taxes going down!

Welcome! from our blüg’s tax research dawghouse based in a sunny spot here in the Milky Way.  Last week, we posted that taxes are more than likely to decrease in retirement.  And, a Grumpy, wisely gave us some push back.  Each and every one of us can toss about conjecture when it comes to future tax rates.  Personally, we like to look at our tea leaves every day to get a reading on future tax rates.

Regardless of who’s kool-aid you’re drinking, prudent retirement planning will require some sort of tax rate assumption.  So, what assumption do we use?  Well, let’s take a look at what you would have paid from 1913 all the way up to 2011 to have some sort of historical foundation to base our guess on.

First off, we should give credit, where credit is due.  The Tax Foundation did some of the heavy lifting for us.  And you can download the same data which we built our tool around here.  We also did some high level research into the Tax Foundation’s data and found it to be accurate to a degree suitable for understanding trends in Federal income taxation.  Furthermore, if you are into minutiae like we are, you should see why the Tax Foundation’s numbers will differ slightly from the IRS’.

Second, we should clear up a common misconception about how American’s are taxed.  The U.S. has a progressive tax system, meaning the more you make, the more you pay.  And more often than not, at a higher tax rate.  If an individual(s) is in the 25% tax bracket, that does not mean you multiply their income by 25%.  All American’s pay the same amount of tax on their first $10,000 (or insert whatever number you like) regardless of what their marginal tax bracket is, so on and so forth.  If this is unknown to you, please see this Wikipedia article, which even includes a sample calculation under the obvious heading.  Now that we all know our marginal tax rate is the amount of tax we pay on our next dollar, not our entire ordinary income, we can proceed.

But why is knowing our marginal tax rate helpful?  For those working stiffs like ourselves, it helps one to determine if the effort of making more income is worth the after tax payout.  It can also help in making decisions such as how much money you should convert to a Roth IRA.  These two reasons are by no means exhaustive.  Let’s pop some incomes into our handy tool and see what poops out the other end.  For this article, we are using $50k, $100k and $200k in 2011 dollars (so, your 2011 $50k spending power was the same in 1913) and a Married Filing Jointly status.

We learn a couple of things from this chart.  First, as stated previously, the more money you make, the higher your marginal tax rate.  And historically, we learn two things: 1) The tax structure changed dramatically in 1941.  We are not history buffs, but there was a war around that time.  We just merely wish to point out this change associated with major events, not to discuss every reason why this change came about (and knowing why is applicable, but a different conversation).  We would not suggest using any tax rate before 1941 for tax planning purposes.  And 2) the late 80’s early 90’s had a “rate bubble,” where higher incomes actually had a marginal tax rate less than some lower incomes.

It is also interesting to note, that for a family making $50k, the marginal tax rate has not changed for the last 25 years!  And the highest it’s ever been is 29% in 1945 and 28% in 1981.  A couple’s effective (or total dollar paid) peaked in 1945 when they had to pay $12,077 (2011 dollars) in taxes for an effective tax rate of 24%.  Oddly enough, the marginal tax rate dropped in 1954 to 22% and held there for 10 years, but less tax was paid in 1981 (marginal tax rate of 28%).

While there is an effective rate localized maximum in 1981, it is interesting that it is less than the 35 year period of 1942 to 1976.  And in fact, a couple has paid approximately 20% to 30% less in taxes the last 35 years than they would have the 35 years prior!

What about those couples making $100k and $200k?  Well, here is a chart with their marginal and effective tax rates.

The conclusion we draw from this chart is, the lower your income, the less variability for effective tax rates.  Also, as you are less likely to have significant tax increases, you also are less likely to have significant tax decreases (we all knew that already, this is just the history to prove it).

If we were to look at even higher incomes, the variability would be even higher!  So, this is another reason to keep your expenses low, you are less likely to experience large variations in your income tax.

So, what to use for your retirement tax rate assumption?  The real risk is a significant change during retirement, not during the accumulation phase.  Most people will be able to react, tack on a few years of saving to account for changes during the accumulation phase.  We suggest entering your income into our tool below to see what you would have paid historically.  And make sure there is enough wiggle room in your plan to cover the highest tax rate since 1941, plus a few percentage points (more if you are a “high” earner).  And if you often sport a tin foil hat, perhaps a few more.  There is some point where enough is enough and you’ll have to accept some risk, unless you want to work into the grave.  We’ll go over how to build in wiggle room in another post (psst…it doesn’t always mean accumulating more).

What we don’t account for

Tax deductions.  We input no tax deductions.  So an interesting exercise would be to compare your annual effective tax rate in these years and see how much you are reducing your taxes through deductions.  If you have dependents or large deductions (e.g. mortgage interest), we would caution you from extrapolating straight into retirement, as those will (HOPEFULLY!!) go away.  State income tax is something we didn’t look at either.  Doing 40 something states didn’t seem like too much fun.  And, there are other ways the gubmint can tax individuals.  Social Security is a prime example and one which is not included in our tool.  Long term capital gains and dividends are not covered and in our opinion, deserve their own post.  Also, some years, for REALLY high income earners, there is a max effective rate that we did not put into our tool (sorry uber rich!).

Our tool can be downloaded here.  Just remember, it was created by us and is therefore our property.  If you use the tool for any calculations or to generate any charts which will be published, we would appreciate a little linky love.  And as always, we are human dawgs, so we can make mistakes.  Please let us know of any errors or improvements that can be made.

09
Mar
12

You only need between 0.1% and 200% of your current income to retire

That’s our guess, and it should cover almost everyone, with a few outliers.

But the question of “how much money do you need based on current income” is an interesting and very complex question.  More specifically, a reader on one of our favorite blügs, Grumpy rumblings of the untenured, asked how much moolah does one need (and they wanted to know based on % of income)?

Well, there are rules of thumb (or heuristics as the Grumpies call them).  And you can read every financial magazine and blüg to your heart’s content.  Some will say 90%, some will say 100% (yikes!) and others will say 70%.  So on and so forth.  Applying their rules of thumb, a couple with a pre-retirement income of $50k will need their portfolio to yield anywhere from $35k to $50k annually.  If you’re lucky, this all works out for you.

We don’t like the percent of income approach.  Here is why:

  • Your taxes will be less in retirement.  Ok, we don’t wish to invoke a religious war (yet, we have a post coming up on future tax rates in retirement, our tea leaves were strong this morning), but generally speaking if someone retired today, they would be paying less in tax.  How?  First, you don’t have to pay that nasty Social Security and Medicare tax.  Second, if you were in, for example, the 25% marginal tax bracket pre-retirement, you could drop down into the next marginal tax bracket.  Or, if you are taking dividends and capital gains, currently that is only 15%.
  • You are no longer saving for retirement (because you are doing it!).  So, if you saved 15% of your gross income pre-retirement for retirement, that is 15% of your gross income you don’t need in retirement.  Or someone who arrived late to the saving-for-retirement party may save 50% of their gross income.  Or someone who wants to retire early may have a high savings rate as well.
  • Your pre-retirement expenses do not equal your retirement expenses.  Generally speaking, most people’s expenses will go down.  There are some basic needs people need to cover first – shelter, food, utilities etc.  And covering your basic needs will more than likely be less than your current income (at least we hope so, or retirement is the least of your worries).  Then there are expenses of having to go to work everyday – more miles on a vehicle, gasoline (have you noticed gasoline prices are rising?), clothes for work, eating out at lunch, dry cleaning etc.  In retirement, maybe you pick up your dawg’s poop from the yard instead of paying the neighbor’s kid to do it?  And with your new found time, maybe you fix the leaky toilet instead of hiring a plumber (this may not result in cost savings if your spouse is anything like mine!).  You  also won’t need those life insurance policies (unless you have some expensive estate planning tactic up your sleeve).  But, some things can increase your retirement expenses.  Maybe you want travel the world or pick up an expensive hobby (like fast cars and fast ______)?  Don’t even get us started on health insurance…

There are many variables which can have a huge impact.  Each person is unique.

What we suggest is to track every penny of your current expenses to help you form a retirement budget.  Not only will it show you the cost for your quality of life (generally, most people find some fat to cut out) but, it helps with solving the riddle of how much moolah you need in retirement.  Tracking your expenses will show the cost of your basic needs, it will show you things you won’t need to spend money on in retirement – like SS tax (We know you’ll miss that!), work expenses etc – and it will help you determine how much you want to spend for your retirement goals.  It can be difficult to forecast expenses for your retirement goals, since you may not see them fully represented in your expenses right now, but making an educated guess is better than ignoring them.  Tracking your expenses over multiple years also gives you an idea of the cost of less frequent events, such as home maintenance or tires for the car or whatever surprises life throws at you, which should also put into your retirement budget.

What we like most about this approach, is you more precisely know your income needs in retirement (also accounting for your retirement goals).  And you are highly unlikely to ever have to do the durdiest of durds, eat cat food go back to work, because your basic, everyday, bare bones living expenses should be less than your planned retirement income needs.  Meaning, you can tighten your belt and leave out that trip to Vegas with the gurls when life pees on your favorite tree.

So, doing this exercise of forecasting your current expenses into a retirement budget, do you find your retirement income needs are within the rule of thumb heuristic of 70% to 100% of gross pre-retirement income?  Or are you less?  What say ye?

Now, this only covers how much annual income you will need in retirement.  We’ll get to how you translate that into a total savings dollar value in another post…down the road…sometime.