Posts Tagged ‘personal finance


You are not Buffet

What’s interesting around the interwebz and personal finance blüg-o-sphere are the individuals who think they can beat the market.  While not impossible to do so, we can’t help but ask ourselves, is this from luck? or is this because of skill?

Many point to the “Oracle of Omaha” as the poster child of being able to analyze a company, pick the winners and reap the benefits with your feet kicked up as the cabana girl/pool boy bring you fruity drinks with those little umbrellas.  But another question we would like to delve into is, “Is how Warren Buffet invests the same way we invest?”

We (the working stiffs of the world) are retail investors.  We pay a premium to invest.  And when we do invest, we are given the scraps and leftovers that those higher in the pecking order have left us.  No one calls us about investing in oil wells in North Dakota, no one calls us with great business deals needing capital without the opportunities first being picked over.

When we buy a security, we don’t get invited to the board meetings.  We don’t get a say in what the company does, when it does something or how it does something.  We pay a premium for the privilege of investing in a company and we are asked to stand on the street with all the other working stiffs.

When debt becomes due, we may be the first to line up to get paid.  But we are quickly shuffled to the back of the line.

When Warren Buffet invests in a company, he is usually issued preferred shares of a company, often times reaping unheard of dividends.  He is invited to the board meetings and very much has a say in how business is conducted.  This contrasts from how we working stiffs get to invest.  So, on that level, it’s not fair to think Warren Buffet is the poster child of all retail investors.

This is not to say where Buffet is today wasn’t from the bottom and without hard work.  He certainly wasn’t fed with a silver spoon and truly started by delivering newspapers.  And maybe that is why so many people aspire to be like him, where he came from is the same as the majority of us and we desire to be known as an Oracle.  And surely, someone will eventually rise to his level if they haven’t already.  And some will pick some winners and profit handsomely.  But, we shouldn’t be fooled into thinking we can follow in their footsteps.  More than likely, a stock picker’s success is in luck, although they may think it is skill.  And if it truly is skill, why would you tell everyone about it, as that will most likely ruin your success?

In conclusion, we’ll leave you with Warren Buffet’s own advice to the working stiff, retail investor like ourselves.  In Berkshire Hathaway’s 1996 annual report, the following was said in the Chairman’s Letter:

Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

misconception about roth IRA first time home buyer distribution

Well, with April here, spring in the air, flowers blooming and tax time looming, we thought we would dispel a misconception about the Roth IRA first time home buyer’s reduction in earnings while taxes are fresh in the mind of half the population.

We’ve seen this lately being mentioned as an advantage of a Roth IRA here, here and here.  And, we’ve attempted to alert some of them to the complexity of this acrobatic maneuver they suggest.  Some willing to learn, but mostly with us being shrugged off.  So, we thought we would move it to a stage where we can fully (at least attempt to) explain this complex tax move.

First, we should point out, that we think using an IRA for anything else other than retirement is a mistake.  GASP!  A blanket statement.  They are powerful tools which help people to retire.  In an indirect way, yes, buying a home does help one to retire, or paying for a child’s college education (if that is an expense you decide to bear) does help you to retire.  But, there are other ways to help you save for those things.  Look at it this way, you only get $5000/yr (under current rules) to contribute.  Maxing this out year after year will barely get you into retirement, if ever.  Use a wrench to turn nuts & bolts, and a hammer to pound nails.  So, even if you read through what we are about to say and still think saving for a home in a Roth IRA is a good idea, you certainly don’t have our endorsement.  But, our opinion is worth what you paid for it (should we set up a paypal link for some luv?).

The origin of the Roth IRA first time home buyer’s earnings distribution misconception is the interwebz.  It is undoubtedly true that you can withdraw from a Roth IRA, an amount up to $10,000 for the purchase of a primary residence to be your “first” home (usually if you haven’t owned a home in two years, you are a born again “first” time home buyer).  We would certainly hope everyone would due their do diligence (why do we feel like we messed something up there?).  And, if you want a great summary of why most people think this is an easy peasy tax move, read Publication 590, page 62, bottom right of the page.  It is right there, plain as day under big bold words that say, “What are Qualified Distributions”:

One that meets the requirements listed under First home under Exceptions in chapter 1 (up to a $10,000 lifetime limit).

And if you’re looking at the Pub 590 document that we link to, page 62 and you click on the hyperlink of “first home,” then it takes you to the part where it defines who you can buy a home for, what defines a “first” home and even points out that you and your spouse can both do this for the same home!

This is a qualified distribution, so the normal roth ordering rules don’t apply (rules which say when there is a non-qualified distribution that you first take out your contributions, then conversions-this has a few caveats-and then earnings).  Being a qualified distribution, you can take from the earnings.  If you think you can have your cake and eat it too by keeping your contributions as an emergency fund and reducing your earnings for the home purchase you are WRONG!  You will have to reduce your basis (or contributions) by the amount of earnings you withdrew the prior year for a first time home purchase, up to $10,000.

Sounds confusing, well it is.  Let’s look at some tax forms.  To do this, we must go back to 2010 so you can see how this works.  For our example we’ll assume you have $30,000 in a Roth IRA, $10K of earnings and $20k of contributions.  Let’s say you want to tap that $10k of earnings for a home in 2010.  First off, you must have a Roth IRA account at least 5 years old.  Withdrawing anything before that can trigger taxes and penalties.  But, what is so lucrative about using the earnings instead of the contributions?  The main reason is so in our example, you could take all $30k out for a home purchase, tax and penalty free.  But, if you aren’t going to completely wipe out the account, you are not gaining anything (and some would argue you are loosing things).

One of the hard sells of Roth IRA’s are their flexibility.  And they are the Gumby of retirement investment vehicles because contributions can be tapped, tax and penalty free.  If you like this about a Roth, here is why you need to be cautious with this first time home buyer deal.  Let’s assume you take the $10k of earnings in our example above in 2010 for the purchase of your first home.  You would fill out the 2010 form 8606 like so…

That’s it.  You can download this 2010 8606 form here.  The 2010 form is a little more complicated than other years because of being able to allocate taxes due on conversions over two years, but all that is in Part III.

So, in 2011 (or any year into the future), let’s say you want to take out the $20k of contributions, for whatever reason.  Let’s fill out your form 8606 in 2011.  This is what it would look like (oh, and you’ll need the instructions, linked here for your pleasure).

WHOA! What just happened?  How did you end up with taxable money in line 36?  Should line 22 be $10,000?!  OR $20,000?  As they say, the devil is in the details.  Let’s look at those instructions for the 2011 8606, line 22.

Figure the amount to enter on line 22 as follows.

  • If you did not take a Roth IRA distribution before 2011 (other than an amount rolled over or recharacterized or a returned contribution), enter on line 22 the total of all your regular contributions to Roth IRAs for 1998 through 2011 (excluding rollovers from other Roth IRAs and any contributions that you had returned to you), adjusted for any recharacterizations.
  • If you did take such a distribution before 2011, use the chart on page 9 to figure the amount to enter.

We hop to page 9 and find the following chart.

So, using this chart on page 9 of form 8606 instructions for 2011, if we took a distribution for a first time home buyer in a prior year, we must take that off of our Roth basis in the following year (2010 8606 line 29 less line 26).  Essentially, the Roth ordering rules are restored and the Roth basis (contributions) is reduced by the amount used for the home buyer’s distribution in any following year you take a distribution.  You can find the 2011 8606 form here.

If you were planning on having an emergency fund and use a home buyer distribution within your Roth accounts, it would be wise to treat the home buyer distribution as being from the basis.  In fact, it would be wise, if you aren’t wiping out the entire amount of Roth funds, to take from the basis and save yourself not only a headache, but your lifetime $10,000 home buyer  distribution from any IRA.  The wisest thing you could do, however, is not touch your retirement accounts until needed in retirement.

And you should check out our legalese page to know we are not professionals at anything, except maybe at barking.  H&R block won’t even hire us to prepare 1040EZ’s.  So, talk to them or a real tax professional.  


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?


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  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.



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.


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.


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).