Marketplace

Medical School

Question: I recently inherited a small life insurance from my mother's passing. There are no guidelines how I should spend the money, but it was hinted that I use it toward going to medical school. I'm about a year and a half away from starting med school, and wanted to know the best way invest the money until then. Is it actually better to invest the money until I graduate or to use it to help offset loans? Or should I, in all reality, use it to save for my retirement... something I have yet to do? Patrick, Detroit.

Answer: You're about to make the biggest investment in your life--a medical school education. And you'll reap a stream of healthy income off your career choice.

The cost of a medical school education is high. The average debt of graduates with debt from the class of 2006 (including pre-med borrowing) was nearly $131,000, according to the Association of American Medical Colleges. And 72% of medical school graduates have debt of at least $100,000. With numbers like these, I'd lean toward following your mother's wishes and use the money to limit how much you need to borrow for your medical education.

If you agree, I'd park the money in a low risk investment that preserves the value of your principal and earns you some interest. It isn't sexy--far from it--but boring money market mutual funds from a brand-name financial institution, or U.S. Treasury bills bought directly from the Treasury (www.treasurydirect.gov) would meet your needs. Plus, with inflation running at a 4.3% pace over the past 12 months, an additional advantage of these two investments is that they will match or even beat the rate of inflation with minimal risk.

Now, you could use the savings to limit how much you borrow. You could also husband the money until you graduate and then pay down debt. I lean toward the latter choice simply because it gives you a bit more financial leeway when you graduate. Either way, you'll reduce the debt burden from getting a medical education.

As for your retirement, I would look at getting a medical degree as the key investment in your long-term retirement savings plan. It will give you the income and the means to enjoy the latter stages of life.

12/26/07 by Chris Farrell

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Emergency stash

Question: I'm newly married and trying to put together a plan for budgeting and saving for our future. The book I've been reading suggests emergency savings of at least 3 months take-home pay, in addition to reserve savings for planned expenses. Additionally, it recommends keeping this money in a money market fund, or index fund with check-cashing privileges. In the past you've recommended index funds over other sorts of mutual funds. Can you talk more about this, and suggest some places to look? I will be making fairly small deposits, at least at first. Jeremiah, San Francisco

Answer: The advice to put the cash in a money market mutual fund is conventional and non-controversial. To use the Wall Street jargon, it's a very "liquid" investment, meaning you can write a check off your money market fund when you need funds in a pinch.

What I don't get is the index fund advice. When I talk about index funds, it's usually a broad-based domestic equity index fund, an international equity index fund, or a bond index fund. In each case, fees are razor thin and your investment will match the performance of the underlying index. However, these are riskier investments--you don't want your emergency savings tied to the movements of the stock or bond market. I think it's a great idea to put money into index funds in a taxable account, but I would reserve it for long-term savings, such as a child's college education.

12/27/07 by Chris Farrell

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How Safe Are Money Market Funds?

Question: In the past few years of following the financial news and your program, I've come to see the Money Market fund as a stable place for short-term emergency fund money. Very limited risk of loss of principle, and the very few times it has happened, investors got out with almost all of their money anyway.

Talking with a coworker recently, she said that she had experienced a money market fund dropping in value (presumably some 25-30 years ago). Was she just one of the unlucky ones or is the mantra of "only one money market fund failing" a story limited to the last 25 years? Adrian

Answer: Money market mutual funds, despite their billing, are not risk free. These funds are on the safe side of the risk spectrum because they invest in Treasury bills, short-term U.S. government agency securities, commercial paper certificates of deposit, and other very short-term debts. The security in the fund comes from diversification and the quality of the short-term debt the fund invests in.

There's the rub. In order to attract more money, some mutual fund companies take on riskier short-term debts to boost yields. And then the industry gets roiled by the risk that a money market mutual fund will "break a buck" during a market squall like now. In other words, the promise of a money market mutual fund is that if you put a dollar into it you will at minimum get a dollar back at withdrawal. As far as I am aware, the value of no major money market mutual fund has fallen so much that withdrawals have been worth less than a buck. However, I am aware that in some cases the parent company has injected cash into the money market mutual fund to preserve its value.

That's why I like money market mutual funds attached to a major brandname financial institution with the money to shore up a fund and a reputation to protect if there is a risk that the fund will break-a-buck. I also prefer lower yielding money market mutual funds composed primarily of U.S. Treasury securities and U.S. agency debt. I just don't think the risk of a slightly higher yield is worth it.

01/08/08 by Chris Farrell

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Trading Stocks and Taxes

Question: I'm a weekly listener via podcasts and thank you for all the good advice. So the question: My co-worker mentioned that I could trade my stocks in an IRA and not have to pay capital gains taxes with this type of account. Currently, I trade within a taxable account so my gains are taxed. Is there any drawbacks with trading stocks within an IRA and what is the best way to learn about the process. Thanks a bunch! David

Question: Your co-worker is right. You don't pay any capital gains taxes on trades within an IRA. If it is a traditional Individual Retirement Account, you will pay ordinary income taxes on the money when you withdraw it during your Golden Years.

Here's the main drawback to trading stocks in an IRA. When it comes to saving for the long haul there's no evidence that all that trading activity will line your pockets. There is abundant evidence that a disciplined, long-term approach with minimal trading and low fees will increase the odds that you'll reach your long-run financial goals. So, my response is restrain your trading impulses in an IRA--it's a hazardous habit for long-term wealth accumulation.

That said, I don't want to be a spoilsport. Picking stocks is fun. You get to match wits in the most competitive market in the world. But I think the tax code encourages you to do trades in a taxable account. Here's why: Let's say you make some unprofitable trades. The market goes against you. Uncle Sam limits your losses through the tax code. Now, let's say you have made some smart moves and share prices have moved up. You still get to decide when to trigger the capital gains tax rate. You could sell tomorrow--or 30 years from now. That's a powerful tax shelter. (There are a few complicated exceptions where you can take a tax loss on an investment in an IRA, but they're the exception, not the rule.)

One more point: Bill Gross, the investment guru and founder of the mutual fund giant Pimco, once suggested that investors play with no more than 10% of their portfolio. He reasoned that it's just enough to make a difference if you win on the upside, and not enough to make a difference if you are wrong on the downside. I've always found that sound advice. This way you're not putting your standard of living in retirement at risk.

01/11/08 by Chris Farrell

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The Market Fall-Out

Question: Help! I retired a couple years ago and the market was going up. Now it's going down, down, and more down. How do I stabilize my savings and IRA money that I'm living on? I'm not on Social Security just yet (I'm 61). Do I need to go back to work for awhile? Ickkkk, I hope not! Kojis

Answer: You're far from alone in your concerns. It's frightening right now with the stock market wildly plunging one day, recovering the next, only to lose even more ground in following days. The housing market continues to tank. The consumer credit default wave is spreading from subprime mortgages to home equity loans, credit cards, auto loans, and other types of consumer credit. A recession is likely.

Truth is, while we're in the midst of turmoil, it's usually a mistake to make any dramatic moves. That doesn't mean you shouldn't go more conservative. But I would use this as a wake-up call to reassess your whole portfolio. You should always pay attention to the downside--what could go wrong. And if you lock in the essentials by investing safely you can sleep at night.

So, as you know, one way to protect yourself is to diversify. Right now, while the stock market is down about 16% from its October 2007 high, the U.S. government bond market has strongly rallied.

It can also mean putting money into cash (by cash I mean U.S. Treasury bills, conservative money market mutual funds, and other creditworthy short-term securities). To be sure, the investment price you pay for credit quality is a lower yield. But cash will hold its value.

My next thought has to do with this question: What is the biggest risk confronting savers? Recessions? Bubbles? Bear market? Yes, all these traumatic events batter savings and undermine confidence. But inflation, a sustained rise in the overall price level, tops the list. The purchasing power of a dollar declines year after year when inflation drives up the costs of goods and services. One hundred dollars loses half its value in 20 years with a 3.5% average annual rate of inflation. The same sum falls by about a third over two decades even at a modest 2% inflation rate.

That's why I'd put money into Treasury inflation protected securities, or Tips. For practical purposes, it's a completely safe asset that adjusts to changes in the consumer price index. The CPI might not exactly match your basket of spending, but its pretty close. Tips can protect your money from inflation for 20 years.

Now, a well-known drawback to TIPS for individual investors is that taxes are paid on the unrealized annual inflation-adjusted gains. Yet there are plenty of ways to avoid the tax on phantom income, such as owning TIPS in a tax-sheltered account like an IRA. Another alternative is the inflation-protected U.S. savings bond, the so-called I-bond. The investment compounds tax deferred until the bonds are cashed in.

Certified financial planners (CFPs) are expensive. There's no way around it. But one of the best investments someone can make in your circumstances is to spend the time finding a fee-only certified financial planer that can go over your portfolio, assets, goals, dreams, and give you a true sense of the trade-offs you face.

And, yes, going back to work may be one of those options.

01/24/08 by Chris Farrell

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Treasury Direct

Question: I am rather new investor, and am interested in buying the T-Bills from Treasury Direct website. I am particularly interested in the short term T-Bills which mature in 4-6 weeks. The question I have is about the bidding process - should I opt for the Competitive Bid or the Non-Competitive bid, and which one should be used for what kind of situation. I plan to start by investing the minimum amount required i.e., 1000 USD. I have too much exposure in Stocks, so I want to park 2/3'rds of my wealth into non-equity instruments like T-Bills, TIPS, CD's, Real-Estate etc. Raveen

Answer: Buying U.S. government securities directly from the Treasury is a terrific deal for individual investors like you. It's easy to set up an account by going to www.treasurydirect.gov. It's simple to buy securities, and you cut out the costs of paying a middleman. However, since it's a bit complicated to sell the securities, Treasury Direct works best for buy-and-hold investors.

There is no shortage of bills and bonds to purchase. The federal government has a voracious appetite for cash. The government sells Treasury bills at auction every week with maturities of 4 weeks, 13 weeks, and 26 weeks. The auction schedule for longer-term notes (3, 5, and 10 year maturities), bonds (30-year maturity), and Treasury inflation-protected securities (5,10, and 20 year maturities) is weekly, monthly, quarterly, or bi-annual, depending on the security.

What you want to do is make a "noncompetitive" bid. The interest rate on the T-bill is determined at auction by all the "competitive" bids made by financial institutions, investment banks, pension funds, hedge funds and the like from around the world. The government established the noncompetitive bid category for individuals and small institutions. The noncompetitive bidders automatically get the rate set by all the competitive bidding activity by the giants. Individual investors who make noncompetitive bids are guaranteed to get the Treasury bill they want in the amount they want.

02/01/08 by Chris Farrell

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Have Fun

Question: My husband and I are in our mid 30's, no kids, both have good incomes and we're putting money away towards our retirement through our employers (so pretax) as well as other sources (Roth). My husband has about maxed the amount he can contribute. I have not, but my employer puts in a substantial amount as long as I put in the minimum required. My husband thinks I should try and max mine out as well, but I want us to put some in shorter term investments so we can enjoy some of the money now to travel, etc. We have a decent amount in savings for emergencies. First, as long as both of us are putting away at least 15% of our income, is it fine to stockpile our savings so we can enjoy some of it now? And second, is there something else besides savings/CD that have a better return rate, but that we can access (within a few months to a year like CD). Thanks. Heather

Answer: My standard advice is to max out your retirement savings plans, and you clearly can afford to do it. However, you and your husband are saving a good chunk of your income every year. You're money smart with a good financial safety net. In this case, I'm on your side. Take that trip (or trips). Go out to dinner. Have fun.

Where to put this money? I would take two very different approaches with the money. First, I'd put the bulk of it into a conservative money market mutual fund with brandname national or international financial institution. (These big companies have a reputation to protect, so the odds are good they'll do whatever it takes to preserve the value of the fund, even if it faces financial difficulties).

I would also consider putting a sliver of the money into a broadbased equity index fund or a tax-managed fund. Your annual tax burden on the savings is low with either product. The money should compound over the years. When you do tap into it, you'll pay low capital gains taxes on the gain.

02/06/08 by Chris Farrell

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UGMA

Question: Years ago, we bought zero-coupon bonds for our son's college fund. They were timed to mature as he went through college, which has worked out great. They were purchased under the Uniform Gifts to Minors and are held in a custodial account. The last one has recently been called early, which is great because our son is graduating this May. I have just stuck it in a Money market account for now. My question is this: after I pay the last semester's tuition, there will be about $15,000 left. Can my husband and I keep it? Are there tax consequences for us or for our son? (More detail: our son will be entering the Navy's officer training program to be a nuclear engineer and will not be in need of the money. We have another son who's 8--would it make any difference if we keep the money or put it in a 529 for son #2?)

Answer: You did really well by your son. But now it's your son's money. You gave up ownership of the money when you put it into a custodial account. I'm sure he'll find some use for it down the road, like a car loan or a down payment on a home later on. For your other son, a 529 is good way to save for college.

02/11/08 by Chris Farrell

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Living and Investing Abroad

Question: I'm an American living in Germany married to a German. I do not work, except for small English teaching jobs. My husband works in the German tax field with some international tax aspects. He does not have the time or the interest to invest any money except in a normal German savings account which does not give a good interest rate. I am 38 years old, my husband is 44, and we have 5 children. We are working to get out of a tremendous amount of debt, but I would like to really get serious about putting aside a nest egg. What can I do as an expat who doesn't have a lot of money but would like to begin to get in on the many savings plans in the States that don't seem to be available here in Germany? I am also concerned a bit about the exchange rate.

Answer: It's a good time for you to be investing, considering how strong the Euro is against the dollar right now. Investing in Europe, the U.S., or anywhere in the world is remarkably easy in today's Internet-linked economy. You can work with full service brokers, discount brokers, online firms, plus all the banks and major mutual fund companies will open up an account for you--no matter where you live.

In your case, I think the bigger issue is figuring out how to invest. I have two books to suggest. The first is "The Random Walk Guide to Investing: Ten Rules for Financial Success" by Burton Malkiel. It's a very simple, straight forward book covering the main personal finance topics. I recommend this book a lot to people who want to quick read and introduction to the topic.

The other is a bit dated, but it covers a lot of ground: "The Wall Street Journal Book of International Investing: Everything You Need to Know About Investing in Foreign Markets" by John A. Prestbo and Douglas R. Sease.

02/21/08 by Chris Farrell

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Investing for Son

Question: I am thinking of investing my sons' money (from gifts over the years) in index funds. My sons are 12 and 14 years old. Is this a good idea and would you recommend some low fee/no fee index funds? Thank you, Phyllis

Answer: It's an excellent idea for long-term savings. (However, if you want them to learn how to invest, it's usually better to open up a discount or online brokerage account for them and let them research and invest in individual stocks.) A number of the major mutual fund companies offer low fee broad-based equity index funds, such as Vanguard and Fidelity. To give you a benchmark, you're paying too much if the expense ratio is more than 0.25% for a Standard & Poor's 500 equity index fund.

02/22/08 by Chris Farrell

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A Cautious Investor

Question: I'm 44, working at a university. My position is not secure nor stable. I have $40,000 in CD. How do I make my money grow? I would like to have a short term investment. Where should I put my money? I hate to think about retirement... saw many people try to save money for their retirement but it turns out they die before they can use their money. Sorry if my idea is strange. Thanks. Lekas

Answer: Your idea isn't strange. You've focused on a risk all of us take when we set aside money for the long-haul. However, your question also highlights how limited your choices are when you want to stick to short-term investments. There is a trade-off between risk and return. And by limiting the risk you're willing to take in the market, you're also limiting your potential return.

That said, the way for your money to grow is to add to savings. You can then preserve the value of your savings by investing in certificates of deposit (as you're doing), Treasury bills, money market mutual funds, and the like. And, of course, this money is available to you if you lose your job.

Still, how about putting a small slice of money into your university's retirement savings plan? Most universities offer their employees a good pension plan made up of low cost mutual funds.

03/10/08 by Chris Farrell

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Flight to Safety

Question: My wife and I are very cautious with our money--we have only one loan (our mortgage), we pay off credit cards every month, and we have more than 6 months of living expenses saved... BUT it's in a financial firm's money market account. We also have IRAs and "deferred compensation" saved in mutual funds.

The recent near collapse of Bear Stearns echoed the bank runs of '29 and the collapse of markets. It's an uneasy time--world markets seem unstable, inflation in energy and food costs etc... Should we be worried about having money saved in non-FDIC backed instruments? Worried in Ann Arbor. Jim

Answer: It is an uneasy time, especially with the Bear Stearns meltdown and takeover. But you are in a good financial situation to ride out the storm.

The answer to your question involves shades of risk. Let's look at your money market mutual fund. Every once in awhile, during tumultuous financial periods like now, the mutual fund industry is roiled by fear that a fund will "break a buck." The promise of a money market mutual fund is that if you put a dollar into it, you will at minimum get a buck back at withdrawal. As far as I am aware, no major money market mutual fund has fallen so much that withdrawals have been worth less than a buck. However, I am aware that in some cases where the parent company has injected cash into the money market mutual fund to preserve its value.

What to do about this? I always recommend a two-fold strategy. First, investors should put their money market money into a brand-name financial institution with the resources to support a money market mutual fund if it becomes necessary. Second, I would put my money into the most conservative money market option offered by the financial institution. The fund's assets should be primarily in very high quality short-term securities, such as U.S. government short-term debt and U.S. government agency debt.

If you believe that even after these two safety screens, a money market mutual fund is too risky, I would put my money in one of two places (or both): Keep it at a bank in FDIC insured accounts, such as certificates of deposit, a savings account or a bank money market deposit account. Or buy default-free U.S. Treasury bills directly from the government. It's easy to do. Check it out at www.treasurydirect.gov.

03/17/08 by Chris Farrell

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Cash is King

Question: I'm 35 and already maxing out my 401K and IRA options. My only debt is my mortgage. Half my paycheck automatically goes to a money market for savings. But I don't feel that's the wisest investment. Should I pay off my mortgage early? Or should I invest in variable annuity, mutual funds, stocks, etc.? Bernie, Clarks Summit, PA

Answer: This is a huge, open ended question and I can't focus on all the options open to you. Still, I wanted to deal with your question to make a simple point: Cash is king during an economic downturn. You've been making a wise investment. You'll have ample opportunities to put at least some of that cash to work buying good assets at bargain prices over the next year or so. I would use this time to research your financial opportunities.

For all of us, the trick during a recession is finding the right personal finance balance between safety and speculation. For households without much in the way of a money cushion the focus is on shoring up the household balance sheet. For savers like you with good credit the mantra is mantra is investigate, research, and preparation, all with an eye toward buying assets for pennies on the dollar. Good luck.

03/19/08 by Chris Farrell

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Bank Stocks

Question: Chris, could you elaborate on your comment made on 3/14 about the undesirability of buying bank stocks. Do you mean all bank stocks? We're several years away from retirement and are in the process of building an income-producing portfolio of stocks to supplement our pensions and other retirement savings. We carefully choose two bank stocks (USB and BAC) to be part of that portfolio because of their dividend payouts and perceived soundness. If banks such as these are not worth investing in, doesn't this signal that the whole system is in far bigger trouble than most investment experts are letting on? I realize the laws involving tax treatment of dividends may change in the future, and there is always a risk with any investment. But might the current situation be an opportunity to purchase bank stocks with good fundamentals at a reasonable price? Jeanne, Lauderdale, MN

Answer: I like what you are doing with dividend paying stocks. Period.

What concerns me is the advice peddled by some on Wall Street that individual investors should plunge into bank stocks because they've been beaten down so much. Yes, bank stocks are down a lot. But that doesn't mean they won't go lower.

For instance, Laurence Kotlikoff, economist at Boston University and head of the financial planning firm ESPlanner, is one of the smartest people I know. He recently took a flyer on beleaguered Citigroup. After all, last year it was trading at $60 a share. He recently bought some shares when it fell to $30 following a string of massive write-offs. It's now at $20. Of course, he can afford the bet, and there's nothing wrong with taking a flyer on a hunch with a small amount of money. But for most people, I'm skeptical that it's good advice. It's better for Wall Street's wallet rather than their customer's return.

What you're doing is part of a long-term, income producing retirement plan. Bravo.

03/20/08 by Chris Farrell

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Las Vegas? Hmmm

Question: I am lucky enough to receive some extra money from my parents for loans they took out in my name to help pay for my college education. I have about $30k in students loans (master's and bachelor's degree). About a third of that is what I am receiving from my parents.

My question is what should I do with it? I have almost no credit card debt, installment payments on a car loan and student loans but I am able to make those easily. However, I have very little liquid savings. Is this money something I should actually use to pay for my student loan debt? I would like to buy a house someday should I save it for that? Should I invest it in retirement? Or is something just to hold on to? The other option is always just have a very fun weekend in Vegas!

Any advice you would have on what to do with extra money in this economy/housing market would be greatly appreciated. Thanks! Chris, Madison WI

Answer: Las Vegas, huh? Well, let's put that option to one side. Now, all your thoughts about what to do with the money are good. You really can't go wrong.

But if I were you I would get rid of your small credit card debt, and then I would invest the rest of the money in a conservative money market mutual fund with a brand-name financial institution. For one thing, it's always a good idea to build up a reservoir of emergency savings, and the extra money from your parents lets you do that in one fell swoop. For another, investment bargains open up during tumultuous times like this, and you'll have a pool of cash to tap if an opportunity comes your way. These days, Cash is king.

03/24/08 by Chris Farrell

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The Whole Portfolio

Question: My wife and I each have retirement (401K, Roth IRA) and non-retirement (joint brokerage, ESPP, REIT) investment accounts. I also have a beneficiary IRA setup from an inherited qualified annuity. My question is whether we should consider each account independently in terms of balancing the investments, or view the combined accounts as one big portfolio? For example, an aggressive overall retirement portfolio balanced by a conservative non-retirement portfolio? Or an aggressive 401K with a conservative Roth. We are in our mid-40's and plan to retire in about twelve years. As we near retirement, we would re- balance things for a more conservative overall portfolio. Thanks, and we love your show! Pete, Golden Valley MN

Answer: This is an important question. A very common mistake in allocating your investment money is not looking at your portfolio as a whole. The reason is just what you suggest: You may be more aggressive than you realize or more conservative than you want.

Here's a hypothetical portfolio that makes the pojnt. Lets say a family has saved $100,000 in a 529 college savings plan and their child is off to college in just a few years. The asset allocation is 20% equity and 80% fixed income. The wife has another $100,000 in her retirement account, split into 75% equities and 25% bonds. The asset allocation in each account sounds about right on its own. But taken all together, the overall asset mix is 52% fixed income and 48% equity. Is that the right mix for the household? It's probably too conservative.

So, yes, every once in awhile strip away all the product names (401K, IRA, 529, and the like) and see what is the overall asset allocation for the household. It's a good discpline.

03/28/08 by Chris Farrell

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From CDs to Mortgage?

Question: I have a $240,000 fixed rate mortgage at 5.75%. My monthly PITI payment is a little under $1,900/month. And I get by OK on my retirement and cash flow from a rental. I'm 58 and single, and I'm able to file an itemized return.

Now that CD rates are falling, I was wondering if it made sense to divert some of the expiring CDs' funds into the mortgage. My mortgage is recastable, so I can lower my payment for every $10,000 I chunk into it. What's more, I can't get anything like 5.75% on any safe investments. I'm gun shy of The Market right now. What's more, I have also been turned off by most stocks' stingy dividends. I do have some mutual funds and some utility stocks.

I could throw-in up to $100K and still have around $200K in cash left in CDs (not including IRAs). That amount would take the mortgage down by around $700/month. Basically, that extra money would provide me with extra spending money or money to pay off the mortgage principal. I have around 25 years left on the mortgage.

Does this make sense from the perspective of "tax savings?" I would have less taxable income at non-preferential rates from the CDs, but I would have a smaller interest deduction. Is this deduction worth it? Anonymous.

Answer: I think you have already answered your question. There is nothing wrong with paying down your mortgage early and, you're absolutely right, you lock in a 5.75% rate of return. And while the tax deduction helps, it isn't that valuable compared to the what you will save in interest. If you scroll through my previous answers on this question you'll see that I worry about homeowners putting too much of their savings into one asset--their home--and not enough into stocks, bonds, international securities, and cash. But you have accumulated a good amount of savings, and accelerating payments on a mortgage (or any debt) is a sound strategy for the risk averse--especially in this market.

04/03/08 by Chris Farrell

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Stock Market Risk

Question: I listen to your podcast every week and enjoy your show, but one thing continues to confuse me. Often someone states that investing in the stock market will return 7% or 9% per year over the long haul. That may be historically true, but what if this is no longer true? What, for instance, is the average return over the past decade? If it isn't 7 or 9 percent, shouldn't Marketplace Money at least consider that a long term investment in stocks may not necessarily result in gains? Yours, Rob, Erie, PA.

Answer: You're right. Stocks have languished for long periods of time. For instance, in 1966 the Dow Jones industrial average was at 744 and in 1981 it was at 776. The stock market then turned up for a long-term bull market run.

Most people saving for their retirement have a meaningful definition of risk; it's the chance of a meager and demoralizing reward from investing in stocks or, even worse, actually losing money "Stocks are risky because the good returns might not cancel out the bad ones. Instead, stock prices (or real stock prices) might deteriorate even over very long periods of time, impoverishing the investor. I do not expect this, but it could happen. That is what I mean by risk," wrote Laurence B. Siegel, director, investment policy research for the Ford Foundation in an article several years ago "Thus risk is not short-term volatility, for the long-term investor can afford to ignore that. Rather, because there is no predestined rate of return, only an expected one that may not be realized, the risk is the possibility that in the long run, stock returns will be terrible."

Still, doesn't time also eliminate that risk? The probability of doing poorly in stocks does shrink with time; but it doesn't disappear. Think of it this way. Stocks wouldn't beat out bonds in the performance sweepstakes if there wasn't a chance that bonds could do better than stocks for lengthy periods. Indeed, before 1900, stocks lagged railroad bonds and matched commercial paper returns. Since 1871, there have been many ten year periods when bonds outperformed stocks.

Nevertheless, the wrong lesson for anyone chastened by the recent global financial crisis is to steer clear of equities because they are too risky. The rewards are worth the risks. Put it this way: If you can envision in ten years time that the U.S. economy still remain a leader among the major industrial nations, full of dynamic companies and bold entrepreneurs, then you will want to own stocks. Similarly, if you believe global economy will expand despite stomach-churning fits and starts, then you'll want a slice of international equities. The right lesson is diversifying your money across a variety of assets. Miguel de Cervantes in Don Quixote de la Mancha put it this way: "'Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket."

04/07/08 by Chris Farrell

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Equity Investment Life Insurance?

Question: Chris---We have recently been advised by a financial consultant to begin to invest in an Indexed Universal Life Insurance Contract, also called an equity investment life insurance policy. After reviewing our financial situation with retirement in mind, the advisor told my husband and me, 55 years and 58 years of age, respectively, that we should stop putting our discretionary income into the qualified plans that we both have at work. He argues that we have enough in our qualified plans to maintain our current lifestyle and that we should begin to look for investments that shelter income from taxes for the future. The vehicle he suggests is an "equity investment life insurance policy". He argues this vehicle is a "Roth look-alike" and will allow us to grow our investments tax free, including the earnings that accrue in the account, and it will be tax free when it is withdrawn. The theory is that because tax rates will continue to grow higher, it would be better for us to be paying the taxes now on the money rather than after we retire, as current tax rates for us likely will be lower than future tax rates. Since our qualified plans defer taxes, he argues we have more tax deferred income than may make sense for us. The type of vehicle he suggests would have a cap on how much it would earn in a given period of time but it will also not go below the start level in any given year..... So, for example, we might buy a policy for $500,000 which would then have a monthly fee associated with it. He argues that we should not be overly alarmed by the monthly fee which includes all fees for transactions, etc. He argues we are paying mutual fund companies plenty of fees and the fees associated with this vehicle won't be higher than the total we're already paying various mutual fund companies.

We are cautious people and will not rush into any major change without thoroughly investigating its pros and cons. I told the guy we'll seek multiple points of view, as he will make his money from selling us on this product. Any guidance you can provide will be appreciated. Greg and Carol, Minneapolis

Answer: I'm not a fan of these plans, although they are a niche product that can work for some people. The fees are high (much higher than equity index funds, bond index funds, Treasury securities and the like). The equity formula is a complicated black box, which runs counter to my "keep it simple" mantra. And you can limit your downside portfolio risk through diversification, inflation-protected securities, and the like.

If it were me, and if I had the assets you have, I would hire a fee-only certified financial planner to look 1) at your overall financial situation and 2) evaluate this policy proposal in light of your assets, liabilities, goals and desires. Yes, a CFP isn't cheap. I could be wrong, but my bet is that she'll come up with a more cost-effective way to build a conservative portfolio.

04/10/08 by Chris Farrell

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Channeling Warren Buffett

Question: Mr. Buffet discusses "Fanciful Figures..." in the Berkshire Hathaway 2007 Annual Report (pp. 18-20). He asserts that the compounded annual gain for the DJIA in the 20th century was 5.3%. He goes on to say that in order for both individual and institutional investors to match a 5.3% compounded return on investment during the 21st century, the DJIA, "...would need to to close at about 2,000,000 on December 31, 2099." This is a possibility which he rejects.

He goes on to point out that any financial adviser suggesting that an investor expect 10% annually from equities in this century are "...direct descendants of the queen in Alice in Wonderland."

Are corporate pension managers, the financial planning community, and those of us investing in stocks, bonds, ETFs, etc., kidding ourselves regarding our true ability to predict and save for our financial future? Or are we better off emulating those who take on 120% LTV subprime mortgages and living on minimum payment credit cards? Tim Longmont, CO

Answer: I love Warren Buffets annual report. Any saver or investor can profit by reading the Letter from the Chairman. You can read them at www.berkshirehathaway.com. I think his message is conservative. Yes, invest in the markets (and for most people he has written that smart investing means putting stock market savings into a broad-based equity index fund). Diversify your portfolio. Stick with quality companies. Save, don't take on frivolous debts (yes to a mortage, no to credit card debt). And keep your expectations realistic when it comes to investment returns--after taxes and after inflation. But don't go the highly leveraged route. That's a path for financial catastrophe for most of us.

04/11/08 by Chris Farrell

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Managing Money for 10 Years

Question: My husband, Gregg, runs a non-profit literary arts organization called the Citylit project (create link to www.citylitproject.org). He inherited a nice car from someone he published, Adele Holden, a poet/English teacher who grew up during the segregated 1930s on the Maryland's Eastern Shore, scene of Maryland's last lynchings. When her memoir book published, she bought a black Infiniti I-30 cash outright since, she explained, Gregg would be driving her all over the state to readings and events. He did, and when she passed away she left him the car. We plan to donate the proceeds from selling the car to CityLit Project and publish African-American poets, likely young emerging poets, given Adele's passion for teaching. So my question is, what's the best way to invest $10,000 for the most gains which also allows access to proceeds within the next 10 years? Thanks. Marik, Baltimore MD.

Answer: This is a wonderful story, and a terrific use of the money. Now, in terms of investing the $10,000, the key concept is the relationship between risk and return. It's an axiom of modern finance that the only way to create the opportunity to earn a higher return is to take greater risks--and vice versa. The trick will be to mix and match investments to create a portfolio that gives you the chance for a decent return for the amount of risk that makes sense to accomplish your goals. Another factor to consider is how much of this money will you draw on during the 10 year time horizon? The more you want to tap into it on a regular basis the more conservative the portfolio choices become.

One way to structure the portfolio is to build a layer investment cake. The foundation would be "cash", which is Wall Street jargon for short-term securities, such as a three month to 1 year certificate of deposit, Treasury bills, money market mutual funds, and the like. With these investments your principal is safe, you'll make some interest on it, and the money will be easily drawn on when you need it. You could boost the income you earn by then putting some money into longer term fixed income securities. Since you have a 10 year time horizon, I would consider a adding a final layer of stocks through an broad-based equity index fund such as the Standard & Poor's 500. That would be your riskiest investment, but it would also offer the best opportunity for growth. You can play around with the percentages (or skip the stocks altogether) depending on how much--or little--risk you're willing to take.

I'm curious if any readers have other suggestions about how they might manage the money. Please send them in the comments section.

04/15/08 by Chris Farrell

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Saving for College

Question: On average, we save about $1000 a month. $500 of it goes to a 529 college savings plan for our son (he's about two years old). $200 goes to two Vanguard index funds (Total Stock Market and Total International) in our regular taxable account. And we put $300 in a money market fund with our bank.

The money market is now at about $7000, and we realize we don't have a good option to invest that money. We don't want to have the money sit in a money market account. Certainly not for 16 more years. Neither do I feel comfortable putting all of it in 529. Hence, I am looking for an option that (1) provides growth opportunities, (2) has low tax impact, and (3) has some mechanisms built in for age-appropriate auto-(re)balance.

In the last show, Chris mentioned tax-managed mutual funds as an option for semi-long term tax efficient investment. I looked at Vanguard's tax-managed funds. They all cost quite a bit to start, $10,000. So this doesn't seem to be a valid option.

What other options are available? I suppose that I can buy ETFs at a discount on-line brokerage as a way to boost tax efficiency and hold diversified investment stocks. I am not sure if, given the amount of dollars we are talking about here, ETF would be a good choice, e.g. the amount of saving on tax efficiency would offset other shortcomings of ETFs. I have a hard time thinking about or comparing ETFs with index funds. In addition, I will have to do age-appropriate asset re-allocation myself with the ETF funds. Because that would take time and discipline, it might not be an attractive option 10 or 15 years from now.

Another thought is to buy a Vanguard target retirement fund that sets my son's college entrance year as the retirement target year, say 2020. With this, I at least can have stochastic asset reallocation as a means to reduce portfolio risks. But I have no idea how tax efficient that fund is. And it probably is not. Thanks. Key, Cary, NC

Answer: Your question is extremely thoughtful, and just reading how you're thinking through the various options and trade-offs might help someone else decide what to do.

Fact is, I like what you're doing: a mix of a 529 plan, index funds and a money market fund. I hope that the index funds and money market fund are in your name so that if your son gets scholarship money, you can tap the savings for your retirement. I prefer the index mutual funds over ETFs because the former are ideal for adding money on a monthly or quarterly basis without paying the brokerage fees or commissions. So I would take some of the money market fund money and put it to work in the index funds.

One other thought: You could buy some I-bonds to add into the mix. The fixed 30-year rate of interest on the inflation-protected savings bond is currently 1.2% per year (plus the actual rate of inflation). But it will almost certainly fall when the rate is reset on May 1. The limit per person is $5,000 in electronic form at www.treasurydirect.gov and another $5,000 per person in paper form at banks. Still, you get a guarantee that a dollar saved today will be worth a dollar plus interest 16 years from now when your child goes to college. And the money compounds tax-deferred until you cash it in.

04/22/08 by Chris Farrell

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Socially responsible Investing

Question: I'd like to invest in a green mutual fund, one that develops wind and solar energies, electric cars etc. I've been looking at Winslow green growth. Any thoughts or suggestions? Kate, Sheridan, WY

Answer: I looked up the Winslow Green Growth fund on the www.morningstar.com website. As of writing this column, the fund's year-to-date return was down -22.50%. Its one-year return is -5.60% and its 5-year return annualized is 17.73%. Its net expense ratio is 1.45%, which is on the high side. (According to Morningstar fees on green funds range between 1.25% and 1.98%.)

I typically prefer index funds that cover a range of industries and charge low fees, and there are a number of "green" index funds. Once you've created a broadly diversified portfolio and you then want to place a bet on a sector or a fund or a company with a small percentage of your portfolio, well, by all means go ahead--have some fun. If you're interested in doing more research about socially responsible investing two good websites are www.socialinvest.org and www.socialfunds.com.

The biggest rap against the movement is the belief that marrying personal values to an investment portfolio cuts into returns. In other words, doing good and making money don't mix. I don't agree. A number of studies suggest there's little difference between pooling money to make money and pooling money to make money and express values. This came home to me in a series of papers by Meir Statman, a finance economist at Santa Clara University. Among his conclusions, the risk-adjusted return on socially conscious index funds is roughly comparable to the Standard & Poor's 500 index and the performance of actively managed socially responsible mutual funds is about equal to their conventional mutual fund peers. (You can read his papers on the subject at www.scu.edu/business/finance/research/sristatman.cfm.)

One note of caution: Socially responsible funds tend to have high fees that cut into returns. So while it always pays to shop around it's especially true in this industry.

04/30/08 by Chris Farrell

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I-Bonds

Question; I have been a long term investor in I-Bonds especially when inflation is strong since it is inflation adjusted. But just when inflation and market choppiness should push citizens to start saving more the treasury department cut the upper limit of yearly contributions to $5000 from $30000..... Do you have any idea why they would do this now? It seem counterintuitive if they are trying to help people protect their principle in an inflationary period. Thanks! Maximia, Portland, OR

Answer: I think it's a terrible move. Here's the breakdown: Savers can now buy a total of $20,000 in U.S. savings bonds. That's $5,000 each of Series EE (the traditional savings bond) and Series I savings bonds (the inflation-indexed security you mentioned) online and another $5,000 each in paper. In sharp contrast, before the turn of the year individual savers could sock away a total of $120,000 in U.S. savings bonds.

The shift is even more significant than these dollar figures suggest. The change makes it that much harder for individual investors to hedge a substantial portion of their savings against the ravages of inflation over time. Yet many finance scholars advocate that inflation-indexed bonds should be the foundation of a long-term retirement portfolio. The big attraction for individuals of the inflation-indexed savings bonds is that savings compound tax deferred until the bonds are cashed in a 30 year period. Plus, you don't pay any commission to buy and sell savings bonds.

As you found out, the Treasury has consistently denied its message is "save less." Treasury says it's trying to redefine the program toward the small investor. That may be. Still, the timing is odd. At a time when inflation is picking up, the government sees fit to reduce the attractiveness of one of the safest inflation hedges around. The only theory that makes sense to me is that Treasury and the Administration would prefer to swell the commissions and profits of Wall Street than sell a terrific inflation hedge for individual investors. Too bad.

05/01/08 by Chris Farrell

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Roth vs Pay Down Debt

Question: I'm 26 years old, and have no credit card debt, no car loans, no student loans. I max out my 401(k), and have a six-month emergency fund. Pretty good, right? But I also have a mortgage and a $40,000 second mortgage (which is structured as a home equity line of credit).

Over the past year, I've saved up about $5,000. My question is, should I put this money into paying off the home equity line of credit, or should I start a Roth IRA? I know the Roth IRA has higher returns over the long-term, but in my gut, I REALLY want to knock off that home equity line of credit. What should I do with the $5,000. Seattle, WA

Answer: First of all, I admire your financial acumen. I know that I was nowhere near as financially savvy as you are at your age. You're saving for retirement. You have a nice emergency stash. And no debt other than your mortgage and home equity line of credit. It's great.

If I were you, I would pay attention to your instincts: Go ahead and tackle that home equity line of credit. It's a smart move.

05/06/08 by Chris Farrell

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CDs?

I want to apologize. I am in the communications capital of the world--New York City--but I had all kinds of problems hooking into the Internet, at the hotel and elsewhere. So, here is a belated post from a weary road warrior.

Question: We always hear that Americans aren't saving enough. I currently have a sizable amount invested in two CD's earning 4.9% interest. These CD's will come due in June and I notice the current rates at the bank are from 2.5 to 3.2% for terms less than 2 years. With inflation running well above 3%, what incentive do I have for putting these funds back into a CD where they will tread water at best or more likely lose value? I am also invested in stocks, but wonder what should I do with the money from the CD's? Buy more stock, bonds, utilities, or head for Las Vegas? Frank, Kingsport, TN

Answer: Well, at least heading to Las Vegas would be fun.

You're absolutely right: Savers aren't getting paid much interest for their money these days. Still, the big question is how do you look at this money? Is it an anchor, part of your overall safety net? To put it somewhat differently, how much risk are you willing to take with the money?

If it's an anchor, then I would keep the investment money safe, perhaps in a shorter-term CD or a conservatively run money market mutual fund. Yes, you won't make much interest, but you won't lose much--if at all--to inflation. The money will be there if you need it in an emergency or if an opportunity comes along. You could take a bit more risk and go into a low-fee broad-based high-quality short-term bond fund.

The other options you mentioned are riskier. Stocks are riskier than CDs. It all depends on what role you see this money playing in your overall portfolio.

05/15/08 by Chris Farrell

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Mortage Paydown and Baby Boomer Retirement

Question: I am 55 years old, earn $62,000/year and I have a mortgage on my condo slated to pay off in six years (2014). My current mortgage balance is about $35,000 @ 5.25% APR. I have an account with a major brokerage house with a current value of approximately $54,000 and could sell some securities to pay off the balance on the mortgage now. (I have a 403B and an IRA in addition to the stocks I refer to above for my retirement.) I am wondering if the market might be in for a real bust as us baby boomers begin to retire. Should I pay off my mortgage now by some of selling my stock, and forfeit my mortgage interest tax deduction? I enjoy listening to your program. I am a member of my local NPR affiliate, WUOM, 91.7 Ann Arbor, MI. All the best, Mark

Answer: There is a popular idea that consistently pops up. Call it Malthus Visits Wall Street. Simply put, the notion is that there are too many baby boomers, and they will overtax the economy's resources. Home prices adjusted for inflation will fall for a long time with hordes of elderly home sellers and not enough young home buyers. When they retire and draw down their private pensions, the massive asset sale will depress stock and bond values, leaving boomers with less money in their golden years.

I don't think that investors should fear the march of time. For one thing, an aging population in a computer-dominated economy is working longer than previous generations. Far more important is the move toward market economies around the world. The spread of private property rights and openness to the world economy is encouraging vast amounts of capital to flow across borders. By the time boomers need to sell, markets will be far more international. Baby boomers will sell their stocks and bonds into a global economy full of Indian, Chinese, Brazilian, and other foreign investors.

When it comes to real estate, the picture is a bit more complicated. We're going through a tough downward cycle after the decade-long boom. But the market will eventually stabilize. Overall, I expect housing will remain an appreciating asset. However, here is one wrinkle to think about. I wouldn't be surprised if a surprising number of aging boomers decided to downsize. The demand for smaller homes could soar (since first time homebuyers will compete for the same properties) while the demand for McMansion type homes will lag. Overall, housing should be a healthy asset, but smaller homes could enjoy stronger demand than bigger ones (with the exception of the true luxury market).

For most people, I think it's important to be debt free in retirement (i.e. no mortgage). But it's also critical to enter your golden years with a well-diversified portfolio. There's nothing wrong with paying off your mortgage early. But you shouldn't feel that you have to. You have a good rate, and time is on your side.

05/19/08 by Chris Farrell

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I-Bonds

Question: The 5/12/08 question posed on your blog asking about the new 0.00 fixed rate on I- Bonds has not been answered. As an 83 year old whose nest egg is fast shrinking, this is an important question.... Irma, Berkeley, CA

Answer: I'm stunned that the fixed rate on the I-bond is now 0%. I don't get it. In light of the 0% fixed rate and the move to drastically limit how much savings individuals can put into savings bonds it's hard not to believe that the Treasury is on a campaign to make I-bonds a less attractive investment. My suspicion is that Treasury would prefer individuals invest through Wall Street firms rather than through the U.S. government.

The rate on an I-bond is determined by two things. First, the fixed rate that lasts until maturity, and the variable rate that is based on the rate of inflation over the previous six months. So, these bonds still offer a hedge against inflation. Taken altogether, the yield on I-bonds bought between May and October (when the rate sets again in November) is 4.8%, at an annualized rate.

Like all traditional inflation hedges at the moment--including commodities, real estate and Treasury Inflation Protected Securities or TIPs--I-bonds are not especially attractive. If you already own I-bonds, I would keep them. If you need some protection against inflation and don't have any, then go ahead and consider adding a few I-bonds. Still, it won't be an attractive investment unless inflation spirals sharply higher. In other words, I-bonds are nothing more than a hedge against an upward spiral in the Consumer Price Index.

05/22/08 by Chris Farrell

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Initial Public Offering

Question: I have reason to believe the company I work for is going public. If that happens I think the logical business maneuver would be to outsource everything possible and, most likely, that would leave my job directly in the line of fire. It is a fairly good gig and I don't want to go elsewhere however I also don't want to wait around until they request my departure. Are there public records that are filed with the SEC that I would have access to so that I may research their intent to go public and if yes how would I accomplish this? Thanks, Alan, Mt. Airy, GA

Answer: There's rumor. There are private meeting. But a company's decision to sell stock to the public becomes official when it files with the Securities & Exchange Commission. In most cases, your company will file a prospectus that includes all the revenue and earnings information about the business, its management and directors, disclose the competitive risks it faces in the marketplace, and describe any other information that will allow potential investors to evaluate the company. It can also file additional information. You can find any filing by the company at the SEC's electronic database, EDGAR. All public companies--foreign and domestic--are required to make their registration statements, periodic reports, and other official forms available to investors electronically through EDGAR. You can access EDGAR and learn how it works at www.sec.gov.

05/30/08 by Chris Farrell

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Book Recommendation on Investing

Question: Do you have a suggestion for a book on basic investing? I'm looking for something that covers the basic investment vehicles: stocks, bonds, CDs, and cash. I want to know how to analyze each type of investment and how best to determine and allocate risk. Thanks! Grant. Anaheim, CA.

Answer: I've swiveled in my chair to look at some choices for you. Of course, I can't just pick one. But here are several choices. I'd go to the library or bookstore and see which one you like:

A Random Walk Down Wall Street by Burton Malkiel. It's a classic. Malkiel translates the quantitative, highly abstract insights of modern finance theory into everyday language. He taps into the colorful vein of financial market history--booms, busts, bubbles, and castles in the air--to bring alive the capital markets. Lots of practical investment advice, too.

Informed Investor by Frank Armstrong. A former pilot, Frank sold insurance, became a broker, and, eventually, independent investment adviser. He detests Wall Streets steep commissions and high fees. He's a strong advocate of indexing. He is wary of Wall Street's insatiable appetite for picking the pocket of the individual investor. Dull, but comprehensive.

Stocks for the Long Run by Jeremy Siegel. First published in 1994 (there have been later editions), it remains one of the best introductions into the pluses and minuses of investing in stocks over long periods of time. He also deals with other investments.

Smart and Simple Financial Strategies for Busy People, by Jane Bryant Quinn. You can't go wrong with the Queen of Money. Written with wit and wisdom..

06/24/08 by Chris Farrell

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