Getting Personal
Investing Archives
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 FarrellEmergency 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.
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.
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 FarrellThe 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 FarrellTreasury 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.
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.
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.
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.
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.
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.
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.
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 FarrellBank 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
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 FarrellThe 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.
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
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."
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.
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.
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.
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.
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.
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 FarrellRoth 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.
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.
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.
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 FarrellInitial 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.
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
The CPI and Inflation Hedges
Question: I'm interested in I-bonds and TIPS, but I don't trust our government to honestly calculate our rate of inflation (much as it uses a measure of unemployment that is highly unrealistic---if we used the French measure, our rate would look like France's). Are there any First World nations whose equivalents of the CPI are more to be trusted?
But maybe inflation-protected instruments only come into their own when the inflation rate is so high that missing a few percentage points won't matter too much, compared with having no hedge at all.
A similarly paranoid question: Why should I trust the government's promise not to tax Roth IRA or 401(k) earnings when they're cashed in? We've allowed tremendous mismanagement of our spending, taxation, and the national credibility that backs our currency, and I think the bill is already coming due. In twenty or thirty years, Roth-backed wealth may be too tempting a target for Congress to ignore. If it were an instrument popular among the rich, I'd think it safer, but by necessity they don't use Roth accounts that much. Michael. Boston, MA
Answer: By definition, the Consumer Price index (CPI) falls short at measuring changes in the overall price level. It only reflects price changes of a representative basket of goods. There are a some assumptions about housing that are quirky at best, and prices are difficult to measure in certain parts of the economy, like medical services. Our personal inflation rate and the CPI can diverge significantly.
In Bad Money, a new book by political analyst and author Kevin Phillips, he traces the current "global crisis of American capitalism" to the politics of peak oil, the rise of financial mercantilism, the triumph of market fundamentalism, and even the spread of religious conservatism. He devotes a lot of space arguing inflation is higher than we know and that the government has deliberately changed the CPI calculation in ways that keep the figure artificially low. It's basically bunk. Put it this way: Investors from the around the world have their capital at risk, and if the CPI we manipulated in such a way, the markets would see through the ploy and drive up interest rates. The message of the market seems to be that over time the CPI offers a reasonable measure for gauging inflation pressures and rates.
Treasury Inflation-Indexed securities and I-bonds are both good hedges against inflation ravaging the value of your fixed income portfolio. Both are good insurance policies against a depreciating dollar.
As for your second question, the safest forecast in politics and economics is that Congress and the White House will tinker with the tax code. Both John McCain and Barack Obama are proposing major tax initiatives.
That said, there is so much money tied up in both Roth-IRAs, 401(k)s, 403(b)s and the like that Washington will tread carefully-very carefully. My guess is if there are any major rule change involved retirement savings and taxes that it will be on the liberalizing side of the fiscal equation. Society is aging, after all.
Invest for the Long Haul
Question: I'm a 27-year old investor with about $3,000 in a $13,500 retirement portfolio in cash and probably another $1,500 in employer contributions coming in the next few weeks. I'm stumped about how to invest the money (they are all Fidelity accounts by the way) since my existing mutual funds have all lost value and I feel like I'm doing better by just sitting on the cash. Any suggestions? Anna. Oakland, CA.
Answer: Cash will always do well when the stock market is tumbling lower as corporate profits evaporate and bond investors are swept with periodic inflation panics. That's why it pays for everyone to build up their cash holding during tough times like this.
Problem is, you're young and you have a long time to invest for your retirement years.
The recent decline in the stock market is a reminder that stocks are risky--it's the nature of the beast. So should you now steer clear of domestic and international equities because they're too risky? Not at all. Rather than shun equity risk, the right approach would be to continue to include stocks in a portfolio diversified across a variety of assets. Diversification creates a margin of safety. And since no one knows which markets will soar or sink, diversifying gives investors an opportunity to catch the next big market upturn.
Going forward, if you can envision the American economy remaining a leader among major industrial nations, full of dynamic companies and bold entrepreneurs, you'll want to own stocks. If you believe the global economy will continue to expand--despite stomach-churning fits and starts--you'll probably want a slice of international equities.
Life, after all, is risky. Every time you cross the street, you take a risk. But that probably doesn't stop you from reaching your goal on the other side. Saving for retirement is risky, too. Sure, you can put all your money in Treasury bills. They're risk-free, but that doesn't mean your portfolio will be. With their low return (the trade-off for no investment risk), T-bills may not generate enough income to provide adequately for your retirement. That's why you still need to diversify. This will expose parts of your portfolio to volatility, but that's the trade-off you need to make if you want to achieve higher returns for the long haul.
I'd research putting the money in index funds. You could also look the Fidelity target funds, diversified portfolios with different shades of risk designed for retirees looking for a one-stop-shop when it comes to their core portfolio.
Borrowing Against 403(b)
Question: Most of my 403B money (Thrift Savings Plan) is in the government securities (G) fund. I have a mortgage on a commercial real estate investment property that has a 3 year variable interest rate currently 4% above the rate I can borrow from the TSP. Should I borrow against the TSP, moving the limit of $50,000 to a general loan against the TSP, saving on interest by applying the amount to the mortgage? No prepayment penalty, the property has a positive cash flow, and I can make both payments (TSP loan & the ongoing mortgage payment) Mark. Billings, MT
Answer: I wouldn't do it. I think there is too much risk and not enough reward to this maneuver. You have a solid retirement savings plan. You have a commercial real estate investment property with a positive cash flow. I'd leave them be.
Borrowing against a retirement savings plan is more expensive than it appears. For one thing, you repay the loan with after-tax dollars. You're also losing the benefit of compounding. If you do lose your job you have to repay the loan quickly or it's treated as an early distribution. That means you'll pay a 10% penalty (assuming your under 59 ½) plus ordinary income taxes on the money you've taken out. You're also leveraging up your investments, putting a portion of your retirement money at risk to the property.
Out of Debt. Now What?
Question: I just paid off the last of all my debts! After getting into some serious spending problems in my 20s, I've poured everything extra over the last three years to pay off nearly $25,000 in personal debt. I've been so focused on that goal that I haven't considered much else. So, my question for you is: What do I do now?
A few extra pieces of information: I'm 30 years old. I'm currently putting 8% of my pre-tax income to retirement, and my job as a public school teacher includes a pension. I'm not married, have no kids, and rent my apartment in New York City, though I'd like kids and a house at some point.
I'm building an emergency fund. (Right now, it's about one paycheck. I'm working for three months' salary.) After that, what else should I be doing now that the debt is gone? Thanks for your insight, Kara. Astoria, NY
Answer: Congratulations. In the current environment I think you should continue what you're doing: Build up your cash savings in a mix of FDIC insured savings accounts and conservatively run money market mutual funds. Your savings will hold its value, although it might lag inflation a bit.
This approach also gives you time to see how you manage your money now that your out of debt. I'm sure you have some delayed purchases--clothes, vacation, maybe a bike. I would slowly buy some stuff and see how you do. You might also use this time to research the real estate market, see what you like, how buying would affect your income, and whether it makes financial sense or not.
Last, I'm a big believer in investing in long-term savings in a taxable account. That could mean regularly putting some money into a broad-based equity index fund. The advantage of this approach is that money compounds over the long haul, but if you do need it you can sell some stock and pay capital taxes on it. But unlike money held in a tax-deferred retirement savings account, you won't pay the 10% penalty if you take the money out when you're under age 59 ½.
Treasury Bills--Safe?
Question: Given the national debt, the federal deficit, the bailouts, the war, the sliding stock market, etc., are T-bills still a safe place to put a retiree's money?... Pat, Lakeville, MN
Answer: Yes. Treasury bills, notes and bonds are backed by the full faith and credit of the federal government. They are a default-free investment, a bedrock investment. Your money in Treasury bills is safe.
08/02/08 by Chris FarrellCatching Up on Retirement Savings
Question: I have a unique "problem" when it comes to planning for my retirement. In my early 20s, I struggled to overcome a life threatening illness. In my 30s, I was only able to work part time. I also went through a financially debilitating divorce. Now, I am in my late 40s, healthy and 10 years into good career. However, because of my health I had no chance to save any money. Though I'm thrilled to be alive, I realize that I may face a bleak retirement. Where do I start? Marianna. Liberty. NY.
Answer: I'm glad that you're now healthy and enjoying a good career. While the particulars of your situation are unique to you, you'd be surprised how many people in their late 40s are in similar financial circumstances when it comes to retirement savings.
There's no reason why your retirement should be bleak. Yes, you're starting late with your savings. That means you'll have to try and salt aside more going forward. There's no getting around it.
Even more important is the demand on you to plan ahead. Specifically, you'll need to work longer than someone who has been savings the maximum every year since she was 20. The real financial kick comes from working during those years when a number of your peers are retiring. That's not necessarily a bad thing, either. For many of us, work isn't just a paycheck. It's also a social environment with colleagues and friends. Work keeps our minds active and our outlook young.
A couple of "investment" implications follow from this: First, invest in your health. Eat right and exercise. Second, invest in your network--colleagues, friends, and acquaintances. This way, if you lose your job other opportunities will open up to you. And if you want to make a career shift your network will help make it happen. Third, invest in your job and career. Is this something you'll want to do in your 60s. If not, start investigating other options now while you're still young. Finally, invest the time to understand your Social Security benefits.
I've recommended this book before, Get A Life by Ralph Warner. It's for anyone without a lot of savings and plenty of zest. Warner gets you thinking about creative solutions for your later years. The book's sub-title says it all: You don't need a million dollars to retire well. Amen to that, no?
08/07/08 by Chris FarrellCDs
Question: Lately, I've been noticing lots of ads for CDs at various rates. What advice do you have to help me (and others) make a decision? What questions should we ask the financial institutions? How safe is our money? Many thanks. Anonymous. Gaithersburg , MD
Answer: Investors are putting more of their safe money into certificates of deposit. For one thing, so long as your investment is under $100,000 you're money is backed by the FDIC. That's a real relief in these turbulent financial times. For another, CD yields are on the rise. However, compare the after-tax return or yield on a CD to owning a comparable U.S. Treasury (which also has no default risk). Put your money where you get the higher after-tax yield.
One well-known place to check out CD rates around the country online is at www.bankrate.com.. When shopping for a CD make sure you understand the terms of the contract. Only put in money you can afford to lock up until maturity--6 months, 1 year, 2 years and so on. There are penalties if you need to get the money early.
Diversify Financial Companies?
Question: We have just finished our annual retirement portfolio re-balancing. All of our accounts are with Vanguard. Should we consider having some accounts at a different company to spread the broker risk around? Howard, Bozeman, MT.
Answer: This question is coming up a lot recently, and with good reason: The collapse of the investment bank Bear Stearns, the handful of bank failures, the frozen auction rate preferred market, and the ongoing turmoil from the credit crunch.
What do I think? For many of us, it's easier to manage our retirement portfolio if the money is at one institution that offers good service, low fees and investment choice. But does convenience increase your risk? It does a bit, but not by much in most cases. I've gone back and forth on this issue several times over the past couple of years. In essence, my answer is "no", but...
First of all, the biggest protection you have is that your money is invested in securities. So, even if Vanguard, Fidelity, or some other major financial institution got into trouble you still own the securities. (Of course, ownership doesn't prevent the value of your portfolio from going down.) There is also Securities Industry Protection Corp. backing that provides an additional layer of security in case of fraud and malfeasance. (You can learn more about it at www.sipc.org.)
What's more, most of us end up with a kind of natural financial institution diversification. You have your retirement portfolios with Vanguard. I bet you have savings at a bank or credit union, a life insurance policy with a life insurance company, and so on. If you look at your household as a single entity you're probably reasonably diversified overall--even if your retirement portfolios are managed by one firm.
Now for the proverbial "but." In an era of financial supermarkets and one-stop-shopping it's possible to concentrate amost all your financial assets with one firm. At that point say "stop," and diversify. The lack of diversification is one reason why I have never been enamored with the financial supermarket idea. The other is that experience shows a firm good at managing mutual funds isn't necessarily the best at creating other competitive financial products. It always pays to shop around.
It's Not Fair, Right?
Question: Everything in the news and from Congress is about bailing out subprime mortgages and people with poor credit. Are there any programs out there for people who have very good credit and are a seeming good risk for lenders? I heard that lenders are going to try and recoup their losses on the backs of less-risky borrowers. I would think it would be the opposite. For those of us with excellent credit numbers, why aren't we being courted by lenders? Thank you. Brian, Ortonville, MI
Answer: I wrote about this on my other blog, My Two Cents.
Why should folks who didn't get caught up in the real estate frenzy of the 2000s pay for the financial mistakes of those that did? Many people didn't stretch their finances to buy as big a house as possible or invest in several "sure-fire" properties. They didn't take out interest-only mortgages, option ARMs, or apply for so-called liar loans. They were prudent with their money, perhaps continuing to rent while their friends bought homes or maybe staying in their smallish abode because the mortgage payments were affordable. Now they're on the hook for bailing out Wall Street, bankers, and irresponsible borrowers. That's not fair, is it?
No, it isn't.
That said, I'm in the camp that believes the bailout hasn't been a mistake. Would it be fair to put the economy into a deep recession or depression? I don't think so.
What about people like you who have been prudent with their money? In essence, I believe you'll have plenty of opportunity to buy good assets or attractive investments at a good price while others are struggling to pay down their debts. You have money and good credit which are invaluable right now. Eventually, creditors will loosen their lending policies a bit, and you're just the kind of borrower they'll want. I would use this time to think about and research where would you like to invest your money?
That's fair play, no?
What now?
Question: I am notoriously bad with my finances, and for basically the past five years since I graduated college, I have ignored them. Of course that never works out well. I found myself in about $4000 of credit card debt on top of my student loan of $22,000 which I had deferred for as long as I was able to. About a couple of years ago, it all caught up with me and I enrolled in a debt management plan, consolidated my student loan, and have been making paying both regularly each month.
Now I have paid most of my credit card debt with less than $1000 left to go, and I have stopped the debt management program because I realized that I was simply paying them to write one check a month. I have a 401K plan with a couple of thousand and a couple of hundred in cash savings. I also listen to your show to try and understand my relationship with money.
Finally here's my question: I am young and live on my own in New York. Where should my next financial goals be placed? My expenses are still pretty high but luckily manageable. How do I keep moving forward financially? Thanks, Amelia, Brooklyn, NY
Answer: Congratulations for seizing control of your finances and paying down the credit card debt. That's terrific. I'm always distressed when I hear about debt management programs that essentially take money from people who can't afford it.
How you should move forward financially is a big question, and the answer will evolve over time. But here are some thoughts. I'd continue with whatever system you devised to pay down your credit card debt, but use it to build up savings from this point on.
I want to share this email I got the other day (in a different context). It's from John. He's 69 years old and lives in Ham Lake, Minnesota.
... Some advice I was given when I was 20 years old in 1959 was to save something out of every pay check, having it invested before I ever saw it. AKA, Stock purchase for one company, savings bonds with another and the 401K the last 20 or so years. It has put our children through college, help up purchase a home and gives us retirement income without losing the funds necessary to keep the $$ coming....
You want to save for retirement, which you're already doing. Keep building up that nest egg. By the way, are you putting away the maximum?
We live in a harsh economy. I would also focus on building up your "emergency" savings. This will give you a cushion in case you lose your job. It will also give you the freedom to take a risk and try another employer, to buy a home, or to seize some other investment opportunity that might present itself.
A Merger
Question: I own about 400 shares of Anheuser Busch common stock. I have been accumulating the stock slowly since 1976 mostly through a DRIP program. So my tax basis is relatively low. A company, I think it is "In Bev" is offering to buy out Anheuser Busch stock holders for about $70 per share. I would like to avoid paying taxes on the gain by putting the proceeds from the sale into some vehicle where the principle and interest will be available for my 8-ear-old child in the future, say college or high school expenses. Do you have any suggestions? Thank you. Brian, Brooklyn, NY
Answer: Yes, it's the Belgium multinational InBev that is buying Busch. You won the stock-owners lottery. . The price tag for your good fortune is that Uncle Sam will take part of your gain. Most of the tax bite should be long-term capital gains, which is currently at 15%. One time-honored method of limiting the tax take is to comb through your portfolio and see if there are any stocks or mutual fund you'd like to get rid of at a loss. You can use a capital loss to offset a capital gain. You may be able to avoid paying capital gains altogether. The long-term capital gains rate for investors in the 10% and 15% income tax bracket will drop to zero between 2008 and 2010. The same zero rate holds for dividends.
My tax reactions are just quick ideas. It is well worth your while to work with a professional accountant to delve into the details of your portfolio to see how to best handle the gain.
In terms of taking the gain and saving for your 8 year olds college education, I'd vote for putting at least some money into a 529 college savings plan. The contribution must be in cash, and it's made with after-tax dollars. But the money compounds free of taxes. The gain is also tax free when the money is withdrawn to pay for qualified educational expenses. A 529 plan is treated favorably when it comes to the basic financial aid formula.
08/21/08 by Chris Farrell
Investing in China
Question: Big fan of your show on Saturday mornings here in Cincy. Unfortunately, only caught last few seconds on 8/23 when heard you talking about ADRs and possible tie in with ETFs? Anyway, I'm thinking of investing in China as there's been a significant correction in their markets. I was trying to figure out the most efficient, cost-effective way to do that so I'll start researching on the 'Net for a good ETF. But, maybe you had a better idea? Thank you, Ruth. Cincinnati, OH
Answer: Check out From Wall Street to the Great Wall by Burton Malkiel and several co-authors. Malkiel, an economist at Princeton University and author of the well-known investment A Random Wall Down Wall Street, believes China will become the "world's mightiest economic power". However, while investing in China should be lucrative over the long haul, the ride will be wild and hazardous.
There is no shortage of investment opportunities when it comes to China. For instance, a number of exchange traded funds (ETFs) have been created, and it seems that more are being created nearly every week. Among the better known ETFs are the SPDR S&P China ETF (GXC), the Vanguard Pacific Index Viper (VPL), the iShares MSCI Hong Kong (EWH), iShares FTSE/Xinhua China 25 Index (FXI) and PowerShares Golden Dragon Halter USX China (PGJ). They are all down sharply so far this year. There are traditional open-ended mutual fund companies that specialize in the China and the Far East, and you can also research the "H" and "N" shares of Chinese companies. The H shares are traded in Hong Kong and the N shares in New York.
Malkiel and his co-authors don't only make the case for investing in China, but they offer up plenty of investment examples and strategies. Good luck.
Sell the Farm?
Question: My mother, (who is in a nursing home in ND with dementia) and I own as a life estate/remainder, approx 150 tillable acres of North Dakota Red River valley farmland--The farm building site, which includes a house in severe disrepair, is an additional 9+ acres. I had the tillable land appraised and it came back at $367,000 which is just over $2400 per acre. Mother will soon exhaust assets and be eligible for medicaid (In ND, owning farmland is not a disqualifying asset). She has no long term care insurance. I am wondering if it would be the right time to sell--prices at an alltime high. Some friends say I should play it for a year and then sell. Another factor, our tenants have farmed it for over 25 years and I would give them right of first refusal. They are interested in buying, but they are my age (50+) with no children to pass farm onto--right now they are interested, they may not be in a year due to being older. Of course, it is as much an investment for them also. I looked at IRS tables a couple of years ago and mother's share would be approx. 41%. She is now 82 years old. I came late to my current position and don't have a lot allocated for retirement. I rent an apartment and am single. I have not paid to have the building site appraised yet. The tenants would be interested in buying it also, but only for the grain storage bins and storage shed. The advantage of selling it as part of the farm is that I lower risk of inadvertantly missing something in disclosing about condition of house--I can think of at least 9 things, four of which are severe basement water leakage, needs new roof, and needs new windows and furnace.
The alternative would be to continue to rent it to tenants, but when mother goes on medicaid, no land income can be used to pay taxes and utilities. Approximate tax and utilities Tax: $1600, utilities about $50 per month. I either find a way to come up with that amount or I enter into a "net lease" with renters who would at least pay taxes. I could find the money to probably keep utility payments up. The big question, take the chance that grain commodities go up and land prices go up for another year and put it up for bids--or sell to tenants this year? Remember tenants are interested buyers. I grew up on farm and it is very hard to think about selling it because, I feel I am letting my late father and mother down, by not holding onto it. When they built house and married in 1948, I am sure they did not forsee the change in agriculture that would see family farms get bigger and fewer. K, St. Paul, MN
Answer: I can imagine how hard it is for you to sell. But I'm glad for you and your Mom that farm prices have soared in recent years. My own sense is that farmland has made a step up in value with the growing wealth and better food consumption in China, India and the rest of the emerging markets. That doesn't mean there won't be violent changes in prices
To be clear, you need more expertise on the farm value side than I can offer. It reads as if you are up on the Medicaid rules, but if not that's another complicated area to invest in getting some expert help.
However, since you're in the market for gathering information I had a couple of reactions.
When it comes to investing, buying and selling, we can't pierce the fog of the future. As Peter Bernstein, the dean of finance economists likes to put it, it's in the nature of the beast. Still, one way to grapple with a question like this involves regret. Let's say you sell now to the tenants, and a year later prices are up another 10% to 20%. You'll regret selling to early. Now imagine you don't sell but hold on. Prices for farmland fall by 10% to 20%. You'll regret not selling. Question is, which regret would you--and your Mom-- rather live with?
Even more important is your aging mother and her dementia. You have a very specific reason for contemplating a sale now: To help her out financially. If you sell today, you essentially know what you'll get. Will this money make a difference for her once you've taken taxes and Medicaid into account? Assuming the answer is yes, if it were me her condition would push me toward cashing in my known chips rather than gamble on an unknown future.
I lean on the conservative side with financial matters, and I'd rather sell early at a profit and into a strong market (missing the market's peak) than wait and take the chance of selling into a weak or falling market even if I still end up with a profit. One reason is that the seller has negotiating power in a strong market, while its the buyer that wields more influence in a weak market.
The condition of the house makes me nervous.
By the way, in 1948 your Mom got married and your parents built a home. Now, 60 years later, what they built and nurtured will go toward making sure she gets the kind of care she needs in old age. That's a moving arc to a life story.
After gathering more information and thinking it through, let us know what you decide.
08/29/08 by Chris Farrell
Worried about financial safety
Question: My husband and I are 32 and 31. We have approximately 80K in retirement investments (SEP IRA, mutual funds) with Wells Fargo. We noticed recently that they have a disclaimer on their forms stating that investments are not FDIC insured. With the recent collapsing of investment firms and banks, and with the Lehmann Bros not being bailed out by the government, the uninsured FDIC investment makes me somewhat nervous. How do we know that our investment is "safe"? Should we consider doing something else with our money until we know Wells Fargo makes it through this time of turmoil? Renee, St. Paul, MN
Answer: I'm getting variations of your question from a number of folks. Checking, savings, money market deposit accounts, certificates of deposit, and other bank products are insured by the FDIC up to $100,000. (A CD in an IRA is insured up to $250,000.) You're absolutely right: There is no FDIC insurance when it comes to stocks, bonds, mutual funds, ETFs, commodities, and other market investments even if you bought them through a bank or a similar financial institution.
Still, there is a safety net. The biggest protection for your investments comes from the segregation of customer accounts from the finances of the bank or brokerage house. If a bank or brokerage house goes under, you still own the securities and your account will be sold or transferred to another institution. The Securities Investors Protection Corp. (SIPC) offers additional protection in case of fraud or malfeasance.
None of this investment safety net preserves the value of your money in the market. For example, if you own a stock mutual fund it's probably way down and odds are it's headed even lower. But you won't be wiped out if the financial institution you do business with fails.
That's only one aspect of financial safety. Another is taking a close look at the actual investments you're in. The key question is how well diversified are you? And, with all the turmoil in the market and no end in sight, do you feel that you have too much in stocks or some volatile asset. If the answer is yes, by all means trim back to a more conservative portfolio. .
Tax exempt money market mutual funds
Question: I have a municipal mm mutual fund with Fidelity. It is spread across all 50 states. The prospectus shows that for instance Lehman is the "liquidity facility" sometimes Bof A is mentioned or Morgan or JP Morgan Chase. What does that mean about the safety of this mm fund? Susan, Irvine, CA.
Answer: Right now, money market mutual funds are among the safest parking places for cash available. That's because the U.S. Treasury has decided that the American taxpayer backstops the business. The details are still being worked out, but the guarantee is that any publically traded money market mutual funds won't "break-a-buck," the financial pledge that at a minimum the dollar you've invested in a fund will be worth at least a dollar tomorrow. Funds will pay a fee to participate in the program, and the insurance plan has been funded with up to $50 billion. It only includes money invested before Sept. 19.
The Treasury has also clarified that the insurance pledge includes tax exempt money market funds. So, your very short-term fund has the protection of diversification (across all 50 states), the financial soundness of Fidelity and the Treasury's insurance guarantee.
The Federal Reserve has also adopted several rules to make sure that there is sufficient liquidity in the market. (More liquidity means it is easy to buy and sell assets at their fair market value, and less liquidity means it gets harder to buy and sell.)
Stockholders and a failed bank
Question: I know WaMu depositors are insured, but what can WaMu stock holders do now? I’m relatively new to investing, and this is the first time I’ve seen my stock drop to $0.16! Andy, Ankeny, IA
Answer: The FDIC engineered takeover of Washington Mutual by JPMorgan Chase protects depositors, not shareholders. Shareholders are essentially wiped out. At this point, the real value of your WaMu stock could come on your tax bill, using the loss to shelter capital gains or ordinary income from Uncle Sam.
09/29/08 by Chris FarrellInvesting during a Great Depression
Question: How do you *depression-proof* your assets. My husband says there's no way; that's what a depression means. My grandmother who survived the Depression said to just keep working and hang onto what ever real property you can; she never has believed in stocks, bonds, or anything "that I can't see". Nancy, Columbus, OH
Answer: I don't think we are going into another Great Depression. That said, it's a question I've been getting more and more. The bottom line is that if we were heading into another deflationary depression the best assets to own are default-free Treasury bills and Treasury bonds, with some other very high quality fixed income securities thrown into the mix.
In my book, "Deflation: What Happens When Prices Fall", I looked into what investments did well during the Great Depression. Here's what I found out:
Now, mention deflation and the markets, and most people will recall the stock market crash of 1929. Stocks had been lurching lower after reaching a peak in September, and on October 29th the Dow plunged by 30%. Volume reached a record 16.4 million shares, an infamous benchmark that held for 40 years. From its 1929 peak of 381.17, the Dow Jones industrial average plunged to 41.22 in July 1932. At the end of the decade the Dow stood around the 150 mark, and equity investors had earned a mere real 1.43% from 1929 to 1939. It wasn't until 1954 that the benchmark index passed the level it had reached before the 1929 Crash.
Like the 1990s, the stock market seemed everywhere during the go-go years of the 1920s. Yet despite colorful tales of cab drivers, bootblacks, clerks, housewives, doctors, lawyers, and other ordinary folk gambling their life savings in the stock market, historians now believe that no more than 8% of the population owned stocks, and most of those investors were well heeled. Wealthy or not, many investors lost fortunes. Comedian and singer Eddie Cantor supposedly lost a million dollars. Songwriter Irving Berlin didn't heed the advice of Charlie Chaplin to get out and lost a bundle. Irving Fisher, widely ranked among America's greatest economists, damaged his reputation by loftily predicting shortly before the 1929 crash that stock prices had reached "a permanently high plateau." Worse, a large part of his wealth disappeared in the crash.
Again, reminiscent of Enron, WorldCom, Global Crossing, and other current examples of corporate greed and malfeasance, the reputations of Wall Street's leading lights were also tattered. Richard Whitney, acting president of the New York Stock Exchange during the crash and a famous broker with the prestigious firm J.P. Morgan as his client, grandly lived well above his means. When insolvency loomed, he defrauded customers, his wife's trust fund, and the New York Yacht Club. He was caught, convicted, and sentenced to Sing-Sing prison. Charles Mitchell, known as "Sunshine Charley" and head of National City Bank, relentlessly pushed the salesmen in his financial supermarket with branches in more than 50 cities to peddle junk bonds and junk stocks on to an unsuspecting public. He was forced to resign in 1933, and indicted for income tax evasion the following year, although acquitted.
Obviously, stocks did horribly during the Great Depression. But bonds did well. Interest rates and bond prices are two ends of a seesaw. When bond yields are rising (usually from investors anticipating higher inflation), bond prices go down--and vice versa. Bond prices soared as bond yields came down sharply during the depression. For instance, the prime corporate bond yield average went from 4.59% in September 1929 to 3.99% in May of 1931. By June of 1938 the average corporate bond yield fell to a new low of 2.94%. Bonds returned 6.04% during the 1930s. Short-term fixed income securities or bills returned 3.39% over the same time period. But even fixed income investors are wary of deflation since unwary creditors absorbed huge losses during the 1930s as cash-strapped corporations and municipal governments defaulted on their debts.
Two Wall Street tycoons that ended up with "pockets full of money" after the Crash were Alfred Lee Loomis and his partner and brother-in-law Landon Thorne. The two had been leading financiers for the new electric power industry in the 1920s. Loomis was also a scientist, and he became a major supporter of some of the century's greatest scientific minds at his Tuxedo Park home. By early 1929, the two partners had liquidated all their stock holdings and put the gains into long-term Treasury bonds and cash. The reaction by their peers, so many of them forced out of business, seemed more like envy than admiration since "in the midst of so much despair, with the economic situation deteriorating day after day, Loomis and Thorne continued to profit handsomely," writes Jennet Conant, author of the Loomis Biography Tuxedo Park: A Wall Street tycoon and the Secret Palace That Changed the Course of World War ll.
Continue reading "Investing during a Great Depression" »
09/30/08 by Chris FarrellTax exempt bond funds
Question: Almost all of my fixed income holdings are in municipal bond funds, since my wife and I are in the 28% tax bracket. I’m wondering about the safety of municipal bonds at this time, given the current economic environment, and whether we would be better off diversifying into government short or intermediate term bond funds. Any thoughts you have about this matter would be greatly appreciated. Larry. Hurleyville, NY
Answer: The 13-month old credit crunch has taken its toll on tax exempt bond funds. The state of California is facing a cash crunch, and may need a $7 billion federal bailout. (Isn’t it amazing how we’re just tossing around the term “billions”?) New York City plans to cut its budget. States and localities across the country are dealing with declining revenues, and the fiscal situation will only worsen as the economy sinks into recession. Many economists are changing their forecasts for the economy. They’re predicting a higher unemployment rate and a lower GDP number than before. Investors are fleeing even high quality munis for the safety of U.S. Treasury securities. According to the mutual fund rating service Morningstar, muni bond funds are in the red, with the typical fund down 5.6%. Much of that decline has happened over the past year.
There is another factor haunting the market: The unthinkable is increasingly thinkable. Default rates have been low in recent decades in the state and local government tax exempt market. Yet this credit crunch has overturned many historically based rules-of-thumb. The combination of a recession and credit crunch could drive the muni default rate higher. Are muni’s less safe than recent experience would suggest?
Troubling questions like this and the worsening fiscal situation are behind some crazy moves in the market. For example, investors are pocketing a higher yield from tax-exempt money-market mutual funds than from their taxable counterparts. Normally, tax-exempt yields are lower than taxable yields, since the tax hit is so much less. Money market funds that invest only in short-term U.S. Treasuries yield about 1.5% compared to a yield of about 5% or more on tax-exempt money market funds. So an investor in the 35% federal tax bracket filing jointly and paying what the Tax Foundation calculates is an average 9.7% state and local tax burden (since the securities come from municipalities around the country) earns somewhere around a 5% yield on the tax-exempt fund compared with around 1% on the taxable money market Treasury fund. In the 28% tax bracket the taxable yield jumps to 1.08%.
What to do? I know a number of smart people who are putting some of their risk money into high-quality tax exempts, especially into tax exempt money market mutual funds (and the tax exempt money market mutual fund money that was invested before September 19 comes under the Treasury’s new stabilization fund program). These investors believe the risk is worth the reward. They are comfortable with the risk..
Your investment issue isn’t a case where I can easily tell you to “do this, but don’t do that”. Instead, here’s my advice for a portfolio issue like yours: Make sure that you’re in the conservative portion of the tax exempt universe.
It pays to stay with high quality in the municipal bond market (as well as the corporate bond market), even though yields are lower. Safety matters. That’s why diversification also pays. I like tax exempt funds that invest around the country rather than in one locality—even though that means you give up some tax advantage. The added protection is well worth the small tax hit you’ll pay.
Larry, I am a strong believer in diversifying down to the sleeping point. If you’re comfortable with your fixed income portfolio after thinking it through, fine. If you are still worried, then diversify into Treasuries—enough so that you can relax
10/06/08 by Chris FarrellGold, again
Question: If very high inflation is in our future due to the Great Bailout, would your same advice re gold in a IRA still hold? Ned, Melbourne FL
Answer: Gold will do well if the massive government bailout does lead to a high and rising increase in the overall price level or inflation rate. Gold is a traditional hedge against the debasing of the currency, and gold did spectacularly well during the Great Inflation of the 1970s. The price of gold soared in recent years along with skyrocketing prices for food and energy.
When investors get truly nervous about the U.S. economy many seek refuge in gold. Considering how scared so many people are today even after the Treasury announced the semi-nationalization of 9 major U.S. banks it's no surprise that gold is trading at $842 an ounce. That's down from a peak of more than $900 an ounce, but still high.
By the way, gold's previous peak was $850 in 1980. Adjusted for inflation, gold would have to reach over $2224 an ounce to best that price.
That said, I don't think we're going to have another Great Depression because the actions being taken by the monetary and fiscal authorities will succeed at restoring trust in the credit markets. I do believe the recession in the U.S. will be long and severe. I am more worried about the prospect of deflation or a decline in the overall price level than I am over inflation. Asset prices are sharply lower. The banking system is damaged. The competition for markets and profits will heat up in the global economy with growth slowing worldwide. Taken altogether, it seems like a recipe for falling prices. Even the International Monetary Fund has also weighed in on the topic, arguing that deflation is a real risk in a decelerating global economy.
But you could be right. Forecasting is a hazardous business. I still consider putting money into commodities a speculation and not an investment, especially in a retirement savings account. It's a gamble that you'll be able to sell the metal at a higher price in the future.
The traditional European idea of keeping a small percentage of an overall portfolio in gold as a hedge against political and economic crisis doesn't bother me. But I still prefer investing my "insurance money" in Treasury Inflation Protected Securities or TIPS. It's a default free security. You'll earn a rate of interest. You'll preserve the value of your capital with the inflation adjustment (based on changes in the CPI.) TIPS are also designed to act as a hedge against deflation, too. (While some commentators believe the Consumer Price Index is manipulated by the government I've never found the argument particularly convincing.)
The bottom line: I'm not a speculator with my retirement money. I prefer investing in my IRA. If you want to bet on the future price of gold I'd recommend doing it outside a retirement account.
10/14/08 by Chris FarrellTax exempt bonds
Question: Can you explain why an ETF that invests in 100% government insured revenue and general obligation municipal bonds would be sliding so precipitously on good days and bad ones? Thank you. Marysa. Delray Beach, FL
Answer: The tax exempt market still has a stodgy image of a market that barely moves with wealthy investors complacently clipping their coupons. The market hasn't been that way for a long time and lately it has been on a wild ride. The slide in value in your exchange traded fund or ETF reflects investor nervousness over credit quality, state and local government finances and the recession.
First, a brief definition: Tax exempt or municipal bonds are sold by state and local governments to fund roads, sewers, schools, stadiums and the like. General obligation bonds (GOs) are backed by the full taxing power of the state. It's the safest sector of the tax exempt market. Revenue bonds are typically backed by a stream of income, say, from a toll road. The income backing a revenue bond can be fairly assured or very risky.
In recent decades, state and local governments boosted the rating--and lowered the yield--mostly of their revenue bonds by buying private insurance that protected investors in case of default. It was a great business for the private insurance companies since default rates in the muni market have been traditionally low in recent decades. (I always thought the business was a scam but that's a story for another day.) In recent years, the insurance companies decided to make even more money by getting into riskier businesses where they could charge higher fees--including exposing their balance sheets to subprime loans. The move backfired badly with the housing market implosion and the credit crunch. The insurance company debacle has roiled the market.
What's more, state and local government revenues are crimped by the downturn in the economy. The consensus is that the tax revenue situation will only get worse since we are either in a recession that is spiraling downward fast (as I think) or the country is about to enter a recession that could get severe (the opinion of many economists). The expectation is that the tax exempt market default rates will be higher than recent experience, too. The last time the there were a lot of state and local government defaults was during the Great Depression.
Taken altogether, the uncertainty has driven bond prices down and bond yields up. The nervousness in the market is so great that muni bond yields are now higher than comparable U.S. Treasuries. That's amazing considering that muni bond yields are exempt from federal taxes. (Many muni bonds sold within a state are also exempt from state and local taxes. But since many muni bond mutual funds and ETFs buy bonds issued across the country you'll pay state income taxes on that kind of investment.)
Let's assume you're in the 35% federal income tax bracket. You also pay a 10% state and local tax rate (the national average). Today, the 3-year Treasury note yields about 3%. The highest quality muni bond with a comparable maturity yields some 3.6%. The muni bond yield is the equivalent of a 5.5% taxable yield. If you're in the 28% tax bracket the muni bond is still paying the equivalent of a 5.1% taxable yield.
Munis are offering their investors attractive yields, but the higher yield reflects greater risk.
Fannie and Freddie?
Question: Many of us know about the woes being felt by Fannie Mae and Freddie Mac, and their stock performance tells it well. But is now the time to buy them? I mean, with a history of a 40-60 point value, a low current value, and (seemingly) a government assurance of not failing, it seems pretty attractive to this novice investor. Thanks! Mark, Charlotte, NC
Answer: You're right that the stock of Fannie Mae and Freddie Mac are still trading. But "low" seems too mild a word. As I'm writing this, Fannie Mae is trading at.880 a share--down 97.7% year-to-date. The comparable market figures for Freddie Mac are .940 and -97.1%, respectively. That's a disaster for shareholders.
Here's what the market service Morningstar said about Fannie Mae last month:
"The magnitude and duration of the housing bust and job losses will largely determine Fannie Mae's fate. If the spiral of downward home prices, negative equity, foreclosures, and lack of financing alternatives continues, Fannie Mae might need substantial additional equity capital in order to operate. Not only are higher minimum capital standards and additional dilution a risk, the firm appears to be losing control over pricing, growth, and underwriting decisions to its conservator. The firm could also be nationalized outright based on future political decisions."
The same holds for Freddie Mac.
I'm not a stock picker. I don't think novice investors should be speculating. I guess if you have some entertainment money that might go toward an evening out, the slots at Las Vegas, or the stock of Freddie Mac and Fannie Mae, then by all means take a flyer. But its not an investment. It's a speculation.
TIPS
Question: On a recent show, you suggested that investors should hold a significant amount of TIPS in their IRAs. I think this is a reasonable idea so I started looking into doing this. I believe that the best way to purchase and own TIPS is to own the bonds directly, since then you are locking in the maturity date. The best way I found to buy TIPS in this way is through TreasuryDirect. However, I could find no way to be able to purchase through TreasuryDirect from an IRA. So my question is: Is there a way to buy TIPS from an IRA using TreasuryDirect? Robert, Shoreview, MN.
The alternatives are
1)Buying TIPS on the secondary market from a brokerage account in an IRA. This is inferior for three reasons : you pay a commission, you will get hit with a heavy spread, it is difficult to calculate the actual "base" interest rate you will be getting.
2) Buying a TIPS mutual fund in your IRA. This is inferior because TIPS funds actually act much like bond funds, and fluctuate based on current interest rates. Also, there's the added complexity that they also will fluctuate based on inflation expectations. And there is no fixed maturity.
Answer: You're absolutely right, and it's a disgrace. I know a number of finance academics like Zvi Bodie of Boston University have lobbied for the Treasury to let individuals buy from Treasury Direct in their IRAs. But it looks like Treasury is more concerned about Wall Street commissions than the retirement security of the individual saver. The same goes for their decision to limit the amount of tax sheltered I-bonds that an individual could buy in any one year. (The limit is $5,000 electronically and $5,000 in paper bonds.)
I still like TIPS. I prefer buying on the secondary market because then you know what you have and when it will mature. But a lot of people are uncomfortable with that. In that case, I would go the mutual fund route.
Borrow to buy?
Question: The stock market meltdown that we're facing today looks like one of the best stock buying opportunities that I am likely to face in my lifetime. I don't have a lot of spare cash, so I'm considering borrowing some money to buy some mutual funds. I'm 34, have a stable job in a good company. I have a 30-year fixed mortgage and a HELOC that currently offers an interest rate of 5.25%. I don't have much debt other than a car loan that I'm paying down. I am going to school part time on a student loan. I'm thinking about taking $4,000 or $5,000 out of the HELOC and buying an index fund or a financial sector fund. What do you think? Patrick, Atlanta GA
Answer: Big mistake. Yes, stocks may offer a high potential return, but only by taking on a considerable amount of risk. Remember, stock market returns are not guaranteed, but you will have to meet the interest payments on your loan no matter what--or put your house at risk. Borrowing on your home to invest in the stock market is always a bad bet. And in the current environment people need to be paying down debt, not adding to it.
That said, you could be right about the stock market. I don't know when or where the stock market will hit bottom, but there is value in the market. And there was a spectacular raly today of some 11%.
Warren Buffet, the famous stock picker, is buying. So is Marty Whitman, another well-known value investor of Third Avenue Management. Jeremy Grantham, the legendary investor at Boston-based GMO told Business Week that stocks are now cheaper than they've been since 1987. "You are looking at the best prices in 20 years, and you should be making 7% to 8% to 9% real [inflation-adjusted] returns," he said. "The last time I was this optimistic was in the summer of 1982."
These three long-time investors have built sterling money making reputations over a long period of time. Here's what Jack Bogle, the octogenarian founder of the mutual fund giant Vanguard, told me in a recent interview: "We can, however, look ahead and make reasonable predictions. In the bond market, we know with 90% probability that return in the next 10 years will be 4.5% to 5%. That's the historical number. If we have huge inflation and a Great Depression, and lots of bonds default--this is why I like Treasuries--then that's something else again. In stocks, we know the sources of stock returns. Dividend yield is almost 2.5%, and earnings growth from these levels ought to be 6% over the next decade. That's an 8.5% return."
Grantham notes that when bubbles burst markets historically overcorrect by a lot. Your idea is a reasonable bet. But don't borrow the money. Use cash.
10/28/08 by Chris FarrellThe end of indexing?
Question: Chris, My wife and I have been following your advice (and the advice of many others) for retirement investing for years. We have about 15 years until we hope to retire (of course, hope is the operative word there, since the gallows humor going around these days is that "80 is the new 65"). Basically, we buy broadly diversified index funds on a monthly, dollar-cost averaged basis, and we hold (about 65% equities and 35% bonds). I'm watching the beginning of yet another bloodbath day for the stock market this morning (October 24) and I've recently started to question this buy and hold strategy. It really hasn't work for the S & P over the last decade or so. With pundits throwing around opinions like "there won't be another secular bull market for a long time, but there will be cyclical bull markets in the coming years," isn't an active buy and sell approach a better one, and, if so, how does the average investor participate in that approach? Richard, Bozeman, MT
Answer: Another gallows joke I've heard is that a "walker" is the new corporate benefit.
On to your question: One personal finance lesson not to take away from recent experience is that indexing is a mistake. Yes, I imagine you're hearing talk about how professional money managers can avoid the investment carnage by trading adroitly. That's reminiscent, at least to me, of comedian Will Rogers famous quip, "Buy stocks that are going up. After they have done that, sell them. If they ain't going to go up, don't have bought them." Or, as Rex Sinquefield, chairman and chief investment officer at Dimensional Fund Advisors, once said: "There are three classes of people who do not believe that markets work: the Cubans, the North Koreans, and active managers."
There's no reason to believe that actively managed mutual funds will systematically do better after fees in this market--or any other market for that matter. (And a lot of hedge funds--managed by the best and brightest--are getting wiped out these days. It's one reason the stock market is so volatile.) In a sense, Wall Street takes its cut everytime an actively traded mutual fund or managed account makes a bet, and their take slices into returns. "Meanwhile, Wall Street's Pied Pipers of Performance will have encouraged the futile hopes of the family. ... will be assured that they all can achieve above-average investment performance - but only by paying ever-higher fees. Call this promise the adult version of Lake Woebegon."
Who wrote that? Ralph Nader? No, it was Warren Buffett, the greatest stock picker in modern times. He's spot on.
The expense ratios on index funds are razor thin--ranging between, say, 0.10% and 0.20% for a broad-based equity index fund vs. 1.0% to 1.5% for a comparable actively managed funds. Over the years, that fee advantage adds up. Then there is the cost of time. You have to ferret out good mutual fund money managers, or pick out stocks on your own, and then monitor them closely. That's tough to do. In a letter to shareholders Buffett made a strong case for the kind of value oriented stock picking approach that he practices--which is knowledgeably poring over balance sheets and studying management. But if truly understanding a company isn't your passion, then use index funds, he advised. "By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals," Buffett wrote. "Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."
Green investing
Question: Can you suggest some places to search for good environmental/green energy mutual funds? My REIT (PLD) has plummeted to an unbelievable low and I was thinking of riding it back up, but also wonder if a change to renewable energy fund or some other environmental fund would be a better choice. I listen to the show most every week. Thanks Chris, Kathleen, Carmel CA
Answer: Investor interest in putting money into green mutual funds has been growing in recent years. However, the sector has been hit hard along with the rest of the stock market so far this year. What's more, the sharp drop in oil prices has put additional downward pressure on the alternative energy and green universe.
For instance, I just looked up some return figures on a handful of the better known green mutual funds and companies. The total return to investors on the Winslow Green Growth fund is -56%, year-to-date. The comparable figure over the same time period for the Calvert Global Alternative Energy Fund is -54%, the Guinness Atkinson Funds -57% and the New Alternative Funds -45%. A number of small alternative energy companies have cratered recently, especially after Verasun Energy, the large ethanol producer, recently filed for Chapter 11 bankruptcy protection. For example, AE Biofuels is down 52% and Clean Energy by -50%, year to date.
Still, it's an intriguing investment play. I can't imagine that the enthusiasm for green companies and alternative energy will wane over the long haul, especially once global growth picks up and worries about climate change move back to the fore. Indeed, President-elect Barack Obama said his Administration would "invest $15 billion a year over the next decade in renewable energy" in a recent Wall Street Journal Op-Ed piece. .
As an aside, the biggest rap against socially responsible investing 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 academic 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 (yes, I still favor index funds) is roughly comparable to the Standard & Poor's 500 index. The performance of actively managed socially responsible mutual funds is about equal to their conventional actively managed mutual fund peers.
One note of caution: Socially responsible funds tend to have high fees that cut into returns. For instance, the mutual fund rating service Morningstar says the levy on green mutual funds range from 1.25% to 1.98%. "We're generally wary of pricey funds because high fees are one of the most powerful predictors of future underperformance," writes Michael Herbst, mutual fund analyst with Morningstar.
Two good places for additional research are socialinvest.org and socialfunds.com.
Municipal bonds
Question: Would you suggest waiting until the "dust" settles before starting to invest in muni bond funds, as opposed to CDs at this point? We would like to have some more tax exempt investments. I worry that some local govts still have trouble renegotiating insurance on their bonds. We are almost at retirement age, and have our money at this point, in Treasuries and CDs. Beth, Indianapolis, IN
Answer: Tax exempt bond yields are still very attractive relative to taxable fixed income securities like U.S. Treasuries and certificates of deposit. But that higher yield reflects greater risks. State and local government revenues are falling with the economy in recession. There are concerns that the muni bond default rate could be unusually high during the latest downturn. The insurance on tax exempts is essentially worthless. For example, on November 4, Vanguard announced plans to merge its $3.2 billion Insured Long-Term Tax-Exempt Fund into its $2.8 billion Long-Term Tax-Exempt Fund. "The municipal bond market has changed to a point where insured bonds provide little, if any, additional benefit over high-quality uninsured credits. We concluded that a fund focused solely on insured bonds no longer provides tangible benefits," said Gus Sauter, Vanguard's Chief Investment Officer. "Shareholders will be better served by merging the two portfolios to create a single, well-diversified, high-quality fund."
So, part of the answer is whether you want to move your money out of default free securities--U.S. Treasuries and CDs if under the $250,000 FDIC limit--into a slightly riskier investment. My bias is toward conservatism. If you think the extra yield is worth the risk with at least some of your money I would stick to a high-quality broadly diversified tax exempt mutual fund portfolio. Don't reach for even higher yields by investing in the riskier sectors of the muni market.
Stay the course?
Question: Hi, Chris. Like everyone else, my company retirement savings plan is way way down--56% off, to be exact. I'm 38 so I don't need the money right now, but it is incredibly painful to keep shoveling money into this hole. Through a generous company match, I'm investing almost 30% of my income into an target date (and therefore aggressive) mutual fund. I've heard you say that we should all just keep investing through the ups and downs but is that still true in this prolonged crisis? Won't it take these funds years and years to recover from losing half of their value? I'm not going to sell anything--that would be locking in the losses--but I'd sleep a lot better at night if a much bigger chunk of my future retirement savings was going into bonds or a money-market. What do you say? Thanks for all your help in this crisis. Erin New York, NY
Answer: Uncertainty is the overarching concept that rules our lives. We may have hunches and even mathematical probabilities, but we never know for sure what the future holds. Peter Bernstein.
Your portfolio is down even more after today's carnage, with the Dow Jones Industrial average plummeting by 445 points, or 5.6%. Citigroup shares lost 26% and J.P. Morgan Chase fell by 19%. Month after month, week after week, day after day it seems that the stock market falls ever lower. We keep hearing that this is the worst financial crisis since the Great Depression. Does that mean an 89% decline is in our future, which is what happened to the blue chip index in the early 1930s? Or, even though the timing is uncertain, is this a once-in-a-lifetime buying opportunity?
Like soothsayers of old, working people of all ages are struggling to peer into the future. That's because, over the past three decades, the 401(k) has become the mainstay retirement savings plan for private sector workers. Their nonprofit peers save in 403(b)s and government workers in 457 plans. Whatever the label, workers throughout the economy are confronting difficult investment choices. And the answers matter since investment decisions made today will influence whether a worker enjoys caviar or roe two-to-three decades from now.
This is no way to run a retirement system. But it's the one we got and it's the one you're invested in. My judgment is that you have time on your side so I would stay the course. I essentially agree with what Zvi Bodie, finance professor at Boston University, recently told me: "I would characterize my approach to investing as cautious optimism with the emphasis on cautious and the optimism faith in the progress of the U.S. economy," he said. "Another way of saying this, we have to be careful of wishful thinking, the belief that we can get high returns without higher risks, and on the other hand catastrophyzing, if that's a word."
In a recent article for the Wall Street Journal, University of Chicago finance professor John Cochrane made a compelling case for taking a more positive slant on the stock market's future, without going overboard. It's a cautious, well-grounded argument. (You can read it at his website. It's a good website for learning and researching finance, too.) Here's the kernel of Cochrane's position:
In a recession, or following losses, many investors become more averse to holding risks. They want to sell. But we can't all sell -- a fact routinely ignored in much financial advice and commentary. Instead, prices must fall and prospective returns rise until some investors are willing to buy. Unsurprisingly, upward spikes in the dividend yield came in bad economic times.
History is not a guarantee -- this time could be different. Rather than a higher return going forward, this price decline could reflect a consensus opinion that a massive depression is coming -- a 34% permanent decline in earnings and dividends and a massive wave of bankruptcies.
But as I read the news, the "risk aversion" story seems more plausible. We are in, or headed for, a recession. Anyone whose job or business will be impacted can't take stock-market risks, and should be selling despite low prices. We are seeing lots of "deleveraging," "disintermediation" and "forced selling." As losses mount, investors or institutions that have borrowed money must sell to avoid bankruptcy. Others, such as some university endowments or defined-benefit pension funds, have backstop commitments that must be honored, and they too must "capitulate" at some point. Still others may just be less willing to take risks after suffering a huge loss, a sensible "once burned, twice shy" mentality.
All of these actors become more averse to holding risks as the market declines, so they sell. This increasing risk aversion amplifies an initial price decline -- coming from bad earnings news or the huge rise in credit spreads -- into a rout.
If this is indeed what's going on, it also means that unleveraged, long-term investors should be buying, since prospective returns are better. They must be able to suffer through further mark-to-market losses, and not have recession-sensitive jobs or businesses. They must still have some money left to invest, so they can exchange some of their valuable Treasurys for assets that the suddenly risk-averse are trying to unload. The more these investors can understand and digest slightly exotic securities being dumped by leveraged intermediaries, the better. Warren Buffett is in the news, and he should be.
That said, you are putting a lot of money into the fund. If it were me, I'd be okay with it. (But I haven't changed my retirement asset allocation at all during this time; all the shifts have come outside the tax-sheltered retirement accounts.) You clearly want to take full advantage of your company's match. But you also said you aren't at the sleeping point. Why not direct future contributions into the high quality bonds and money market fund? This way you don't lock in any losses in the Target fund, but you build up a more conservative overall portfolio. Rather than selling down to the sleeping point, its more like redirecting your savings to the sleeping point.
Investing a windfall
Question: I am 63 and have enough to live on from Social Security, some bonds, the rental of a small cottage and the annuity I purchased when I bailed out of the stock market in March. (My intuition about things to come was causing pretty high anxiety when I'd wake up in the middle of the night, because I had half of all I possess in mutual funds.)
Last year my brother and I inherited 2/3 share of a house from our cousin. It's now worth approximately $270,000 but for many reasons probably won't be sold any time soon.
I asked my brother, who is a wonderful and generous person, if he would buy me out so I could use the money for investment, charitable giving and travel. (One further note about my situation: I don't own a home but live in a rent-controlled apartment I love in the busy, interesting downtown area of my small city.)
Long story short, soon I will have some $45,000 to invest! I feel happy and grateful and sometimes even giddy.
Chris, I really admire your knowledge, insight and wisdom. If you were in my place, what would you do with the money in this economic climate. I've thought about putting $5,000 into gold just in case things get much worse. Thanks SO much for any help you can give. Sarah, Berkeley, CA
Answer: I'm going to give you a very conservative answer (no surprise there, I guess!). First, however, I would strongly recommend taking some of the money and start planning for and then going on a trip that you've dreamed about for years. Enjoy a portion of this windfall.
Then I would take all or most of the remaining money and put it into a certificate of deposit at an FDIC insured bank (or a federally insured credit union), an online savings account with a good yield (again, backed by federal deposit insurance), or a mix of short-term Treasury bills. All of these options will preserve the value of your principal, and earn you a slender amount in interest payments. I would then use the year to figure out how you want to invest this money, what might be the right trade-offs between risk/growth investments and safety/income investments. What about owning some blue chip dividend paying stocks? How about Treasury inflation protected securities? Another annuity? Or keep it in easily accessible, safe investments? There's no rush to decide, and at the end of the year (or some period of time) you'll figure out what's the smart financial decision for yourself.
Last, you mentioned putting a sliver of the money into gold. Here's my two cents: I'm not a fan of speculating in gold. Eyeballing a one year chart, the price of the precious metal is down from its March peak of around $1,000 an ounce to about $777 as I'm writing this. To be sure, the price of gold has risen dramatically in recent years. But if you want to speculate on future prices, I'd prefer that you make a comparable bet on a blue chip stock market index. Yes, the index may go lower--a lot lower as the economic gets worse--but the index will reflect real earnings, employees, profits and markets in the underlying companies. Investors will eventually decide prices have been beaten down too far, that there is value in the market, and start investing more aggressively.
To me, buying gold is simply a bet that you'll be able to sell the precious metal at a higher price in the future than what you paid for it. You might win. You might lose. Other people are more comfortable with that kind of bet than me.
What do listeners and readers suggest she do with the money? (To send us your ideas, just scroll up to the top of the page and click on "Contact")
Trading in Lehman
Question: So, I'm confused as to why people are still buying and selling Lehman Brothers stock. They're bankrupt, why are people trading it, the stock reached as high as 30 cents after filing for chapter 11 protection. Why do their quotes online indicate a dividend (of nearly ten times the share price), why, why, why? I'll gladly buy you guys a round lot of Lehman brothers for an answer. Corwin, Cleveland, OH
Answer: Gee, thanks, Lehman Brothers wallpaper. I think not.
The stock closed at $0.04 today, and year-to-date its performance is -99.9%. It fell from a high of over $84 a share in January 2007 to pennies today. Take a look at this chart, courtesy of Marketwatch:
The Lehman bankruptcy in September--the largest in U.S. history--shook the global capital markets this year. According to news stories at the time, it had $639 billion in assets and $613 billion in liabilities. It's a complicated bankruptcy, and the firm is being dismembered in pieces.
The dividend information you see refkects the last dividend payment by Lehman for the third quarter of 2008, and paid toward the end of August.
By the way, thanks to Emily Brandon's blog at U.S. News & World Report, I see that the Pension Benefit Guarantee Corp. the government agency that insures private-sector pensions, filed today to take over Lehman's pension plan. The pension covers more than 26,500 employees and retirees, and it's 95% funded. If there is a shortfall the PBGC will make good on it. In its statement the PBGC said:
The pension insurer's move comes ahead of a Dec. 22 bankruptcy court hearing on the sale of Lehman subsidiaries that make up the firm's investment management business. The agency acted to end Lehman's pension plan prior to the sale so that the subsidiaries being sold remain liable for the pension plan's unfunded benefit liabilities.... The PBGC acted to end Lehman's plan because it stands to be abandoned following the liquidation of substantially all the firm's assets, and the increased financial risk to the PBGC if the subsidiaries involved in the current sale exit the controlled group and escape liability for the pension plan....
You're right. Shareholders have been wiped out. There's no value left in the equity. The company's stock no longer trades on the New York Stock Exchange. The PBGC is taking over the pension.
But we've seen this trading in bankrupt companies over and over again. Shareholders are out of luck, yet the stock trades as a "penny stock." A penny stock is essentially funny money for speculators and unwary investors. Buying penny stocks is not an investment. It isn't a sensible speculation. It's a mystery to me why anyone would buy a penny stock.
Wachovia
Question: We have inherited a substantial amount of stock's from Wachovia, (value around $50,000). Our question is should we keep these stocks knowing how unstable the market is, or, should we liquidate the stocks and pay off our credit card debt. Our current balance is approximately $25,000. So far we have spent around $35,000 of this inheritance from other sources. Thanks, Bev & Mike, Augusta, KS
Answer: I can't say if it makes more sense for you to hold or sell the stock. There are a lot of factors that go into a decision like that, from how patient you can be with the stock to how pressing is the financial needs you currently face. However, in the current environment (actually in any economic scenario) getting rid of credit card debt and staying out of credit card debt is a good thing.
That said, I want to highlight a critical aspect of the answer: Do you want to be a shareholder in Wells Fargo over the long haul? That's what you shortly will be since on Dec. 23rd the shareholders of Wells and Wachovia gave the thumbs up to a previously negotiated merger agreement.
The merger creates one of the country's largest banks with over $1.42 trillion in assets and some $800 million in deposits. The merger is part of a wave of consolidation sweeping the banking industry in response to the ongoing financial crisis. Vulnerable and weak institutions (like Wachovia) are seeking shelter by hooking up with sound and strong banks (such as Wells Fargo). San Francisco-based Wells struck the government brokered deal for Charlotte-based Wachovia back in October after a brief but bitter battle for control with Citigroup.
It's not surprising that the value of the merger has fallen since last October. It was originally estimated as a $15-plus billion deal, or around $7 a share. (Wachovia shareholders will receive 0.1991 shares of Wells Fargo common stock for each share of Wachovia they hold. ) But as I am writing this, Wachovia's stock is down to $5.43 a share, putting the value of the merger at a bit under $12 billion.
Again, if you hold on to the stock your making a bet on the long-term future of Wells Fargo, and that it will succeed over the next several years in integrating the operations of the two companies. The other factor is that you're betting you will earn a higher return on the equity than the "return" you would get on your money by paying off the credit card debt.
Leverage up?
Question: I can tap my home equity line of credit at an interest rate of 4%. I'm thinking about using my HELOC to fund an investment in a no-load tax-free bond fund earning a dividend of 5%. The dividend income would be tax-free, and the interest expense would be tax-deductible. What are the downsides or risks to this idea? Andy, Ankeny, IA
Answer: I am consistently against individual investors borrowing to invest. Borrowing against your home to invest in the financial markets is a bad speculation. Remember, market returns aren't guaranteed. But you will have to meet those interest payments on your loan no matter what.
We've gotten variations of this question over the years. Several years ago, a typical question involved taking out home equity and invest in stocks. After all, stocks have an average annual long-term return of 10% or so. Problem is, on average Lake Eerie never freezes and the stock market doesn't plummet by more than 40%--as it did last year. The numbers always appear to work on paper, but the investment history says leveraging up (the jargon term for borrowing) is a recipe for financial trouble.
To be sure, muni yields are intriguing. Since Uncle Sam doesn't impose a levy on muni bond interest payments. Tax exempt securities typically yield between 75% and 90% of their taxable Treasury equivalent. Yet muni's now yield more--considerably more. For instance, the yield on a 30-year general obligation (GO) single-A+ rated muni bond is around 5.5%. (General obligation bonds or GOs are considered especially safe since they're backed by the state's taxing power.) For an investor in the 35% federal tax bracket that's the equivalent of an 8.46% yield--instead of the less than 3% taxable yield on the 30 year Treasury bond.
The catch: The worst financial crisis since the Great Depression is fanning fears of widespread municipal bond defaults. Credit risk is an anathema to investors.
You want to put some risk money into a muni mutual fund? That's fine, but tap into savings. Don't double down on your bet.
Sell property to invest in stocks?
Question: We are both 44 years old. Single income, Clay is in the military, we will probably be living overseas for another 7 years (until 2016) before starting our next life. We've been thinking about selling properties to free up money to invest in the stock market now that it is low. We own a modest fixer upper in a great location (near Whitman College and downtown) in Walla Walla WA and a piece of land at the Oregon Coast. We have no kids and will continue to work after leaving the military until financially independent. We are not tied to living in Walla Walla, but bought the house with the idea of giving it a try when we return. We have no debts other than the one mortgage, and put 12% of base pay into TSP. If we return to Walla Walla in 6 years, we need a minimum of 50K to update the home. Here's how it breaks down: Walla Walla house: 190K remaining to pay, worth around 240K Mortgage is 30 yr. fixed at 6.5 with total monthly payment of around 1600 Rent income after management fee and costs around 800 per month 2 acres of land at the coast was purchase for 102K in 2006 (cash), it may be worth 150k today. Taxes are 1200/yr. Take home income today is about 50K (not counting housing allowance). Will retire at around 26 years of service. Sell and invest the cash in stocks, (willing to hold long term-15 years)? Or hold onto the house and land? Or some other combination? Clay and Lori, Beijing
Answer: You're in a good financial position. My main reaction is more along the lines of a question or series of questions. First, do you want to have so much of your wealth tied up in real estate far from where you live? What could go wrong, and what is your downside risk? Second, what kind of return do you think you can get from the land if you do hold on to it? The home in Walla Walla is an income producing rental property for now, and you're earning a decent cash flow from it. But the land is probably costing you money every year. That doesn't mean it isn't worth it, but what is a realistic expectation on a rate of return over time.
The reason I wonder about the land is that, like you, I'm intrigued by the stock market and whether it offers a better money making opportunity. These are unnerving times, with talk of a recession replaced by growing fears of a Depression. A first glance at market history during deeply unsettled times isn't pretty-you see numbers like the Dow's 89% plunge from its 1929 high to its 1932 low, followed by its partial recovery and subsequent 52% tumble from 1937 to 1942. But keep looking, though, and you can find lessons more valuable than the fact that the Dow's volatility is nothing new. There is a discernable rhythm over the long history of the markets, and it offers glimmers of hope to harried investors. Specifically, the despair and low prices that mark financial catastrophes set the stage for higher prices and loftier returns later on. "Markets tend to overshoot in both directions," the late financier Leon Levy wrote in his memoir, The Mind of Wall Street. "Just as we saw stock prices rise far above the value of the companies, we are likely to see the reverse. Stocks will then be undervalued, and there will be new opportunities for investors."
Here's the rub: The timing of the recovery is uncertain. Timing aside, stock market data support the notion that it's smart to own riskier assets after a long stretch of poor performance, and the S&P 500 has had an average annual return of 0.9% over the past decade.
So, my main recommendation is to think through the downside, and then take a close look at the land. But no matter what you two are in a good financial situation.
Inheritance
Question: My boyfriend's father recently lost his 8-year battle with cancer. He received approximately $300k from his father's life insurance policy; a benefit that he feels was meant for him later in life, not at the age of 27. Though under unfortunate circumstances, the reality is that he now has this chunk of money.
What to do?
He has no intention to buy property at this time because, he just started going to school for paramedic firefighting and will not be looking for a job for two years (and may have to relocate for such job).
He is considering dividing the money in various investment/savings options, including CDs, a money market account, and a Roth IRA.
But, what about investing in stocks or mutual funds? Given the current state of financial affairs and his age, what advice could you give on investing a portion of his money now, for the long term? Rachel, Lauderdale-by-the-Sea, FL
Answer: I'm so sorry for your friend's loss. It's hard losing a parent. I have three main thoughts on what to do.
First, take the inheritance and put it into government backed products. He should preserve the value of the money while he figures out what to do with it. That means investing in FDIC-insured products such as certificates of deposit. Since the Federal Deposit Insurance Corporation backs up to $250,000 per account at a bank, I would divvy up money so that it's all insured. The FDIC's website at www.fdic.gov has a good pamphlet that clearly explains its coverage. (The same holds for federally insured credit unions.) He could also invest some or all of the money in U.S. Treasury bills. This way he won't lose any money to the vagaries of the bear market and recession that looks increasingly like a mini-depression.
Second, he should take his time deciding what to do with his inheritance. It might take a year or two or three to figure out the best course of action. That's fine. He should use the time to learn what investing and savings strategy will work for him over the long-haul, what risks is he is comfortable taking with the money, and what are his financial goals and ambitions. In addition, by taking his time he'll have launched his career as paramedic firefighter and have a better sense of his job and income prospects.
Third, he needs to trust himself and not the army of money advisors that will knock on his door. Sad to say, there are far too many smooth-talking sharks that prey on people with a financial windfall and not much knowledge of how to manage it. Of course, there terrific finance professionals, and an advantage of going slow and understanding his options is that he'll be better equipped to judge an honest financial planner versus a fee-hungry scalper.
Investing in toxic assets
Question: Is it possible for a small investor to invest in the toxic assets that the federal government is buying and loaning money against? I think they have the potential for high returns and I would like the opportunity to invest a small part of my savings in them, but I don't know where, or if, they will be available. Most of what I have read about them suggests they are available to high income investors only. Thank you, Mary, Seattle, WA
Answer: It sure looks like individual investors will get the chance to invest in toxic assets. It will be an extremely high risk bet, especially after taking into account the cost of entry, fees, and the uncertain value of the underlying assets.
A trip to Las Vegas might be more fun.
Of course, the big players in this market will be hedge funds, giant institutional investors, and high-flyers from the multi-millionaire and billionaire club. Still, a number of major fund companies, such as Pimco and BlackRock, are interested in creating funds open to individuals. The funds wouldn't welcome the Joe the Plumber investor, however. So far, it appears that the basic blueprint is a closed end mutual fund with a hefty minimum investment in the $25,000 to $30,000 range. A closed-end fund sells stock to investors, and then the fund takes that money and invests it. In this case, the investment would go toward toxic assets. The shares of a closed end fund often trade on an exchange, such as the New York Stock Exchange or the American Stock Exchange.
Stay tuned.
Buy GM
Question: I have a little bit of money that I wouldn't mind speculating with. (Nice way to say gambling) But I don't want to just throw it away. For that I can go to the casino. I was actually thinking of buying GM stock. It's certainly cheap enough. But I wonder about bankruptcy and how that affects stock owners. I understand bankruptcy is not the same as ceasing to exist, indeed if I understand it correctly it is one of the first steps to ensure it continues to exist, but how do stock holders fare in the process? Do they face the same kinds of risk that bondholders and creditors do? Thanks for taking the time. Michael, Harshaw, WI
Answer: Putting money into the battered, beleaguered automaker is speculating at the extreme. As you well know, this is making a bet on a wing and a prayer, pulling the slots on the corner of Wall Street and Broad.
On October 1, 2007 GM's stock price peaked at $42.64 a share. Today it trades a few pennies over $2.00 a share. Here's a chart of GM's stock price over the last two years from Marketwatch.com.
The risk of GM declaring bankruptcy is very high. If GM does go into Chapter 11 bankruptcy existing shareholders will probably be wiped out. That's what typically happens with Chapter 11.
Creditors usually come out much better. Depending on the terms of the loan contract, bondholders, bankers and other creditors have far better financial protections. Still, odds are that many creditors won't recover their whole investment in GM. Creditors will negotiate for a big chunk of the new equity in a reorganized GM. These former-debtors turned equity-holders will own much of the company when it emerges from bankruptcy.
If you want to speculate in the stock market how about putting the money into a broad-based low-fee equity index fund. I know it isn't exciting. But if the recent market rebound--the best four weeks since 1933--is for real you'll pocket a nice gain. Of course, it's impossible to know if the market has hit bottom or whether the gain is nothing more than a traditional sucker's rally in a bear market. If it's the latter, at least you'll own a stake in real companies while you wait for the recovery.
Of course, if you bet on GM and it avoids bankruptcy its stock should sizzle, at least or awhile. But I'd bet on the market and not a fallen giant.
I-bonds vs TIPS
Question: I have the opportunity to buy $10,000 worth of I-bonds this year, or $10,000 worth of TIPS in an IRA account. Which is better--or is it more or less the same risk and return? Is it better to by a TIPS bond directly, or in a bond fund?
PS: Your book was great and I enjoy hearing you on public radio. Ken, Swarthmore, PA
Answer: Thanks a lot. Just a quick definition: TIPS are Treasury Inflation Protected Securities. These inflation-indexed bonds come in 5, 10 and 20 year maturities. TIPS offer a fixed interest rate above inflation, as measured by the consumer price index. TIPS are designed to protect the value of an investment dollar against the ravages of inflation (as measured by the CPI). Uncle Sam levies income taxes on the inflation-adjusted gains before you get any of the inflation-adjusted money at maturity. That's why you're right to see TIPS as the better investment in a tax-sheltered account, like your IRA.
Taxes aren't an issue with I-Bonds, a savings bond that is the federal government's other inflation-protected security. There are no commission costs when you buy or sell savings bonds, and your savings compound tax deferred. I-bonds redeemed before the 5 year mark forfeit the 3 most recent months' interest, but after 5 years that there is no penalty at redemption.
The key to answering this question is when do you need the money? It's advantage I-bond if you might tap the savings at some point in the future but before retirement. You can sell the I-bonds without incurring a penalty even if you're under 59 ½. You just pay Uncle Sam whatever you owe in taxes after the sale (and I'm assuming you'll own them for 5 years).
In sharp contrast, if you buy TIPS in your IRA, you can't get at that money without paying taxes on it plus a 10% early withdrawal penalty if you're under 59 ½. You'll have to pay a broker a fee to purchase the TIPS for you in an IRA (although the charge should be very small.) If you're okay with the extra work and monitoring the bonds then I would lean slightly toward owning individual TIPS. This way you know what you have and when the bond will mature. You could care less about fluctuations in the bond market. But a very low cost TIPS mutual fund is just fine for those who favor its convenience.
Long term stock market returns
Question: I have just read several books on investing in mutual funds for retirement. I am 35 and would be investing about $300 a month. I want to invest in a Vanguard mutual fund and am having a hard time deciding on one. Part of the problem is that I am suspicious of the yearly return figures that are always used as examples in these books and that are posted on the "performance" window of a mutual fund's overview (like on the Vanguard website). So many authors say things like, "your investment should be able to average an 8% return per year". The historical return charts on a typical mutual fund seem to support this statement, but when I played a few examples out on paper it didn't add up!.... My question is...Are proponents of mutual fund investing misleading me with their claims of 8% yearly returns?? Does the 5 or 10 year return percentage (found in the performance section of mutual found websites) actually give me any valuable info in selecting a fund? Natalie, Sedro Woolley, WA
Answer: You're right to be suspicious. There are a number of different series that capture long-term stock market returns. My favorite is the series put together by Professor Jeremy Siegel of the Wharton School. Since 1802, he figures, the compound average annual return on stocks adjusted for inflation has been about 7%. The same average return figure holds for the post World War 11 era. However, on average Lake Eerie never freezes. For instance, the bull market of the 1990s lasted for much of the decade and the stock market rose by some 300%. But the stock market is currently down 45% from its October 2007 high. Yet it's up 27% from its March, 2009 low. Even a cursory glance at history shows that stocks fluctuate wildly.
The return figures you're seeing at the mutual fund websites do tell you how the fund has done over time. It's useful information. I also like to send time studying even more detailed return figures published by mutual fund rating services Morningstar. A number of factors account for the difference between an equity mutual fund performance and the stock market. Among the most important are fees and the composition of the portfolio.
Congratulations on setting up an automatic savings plan. For the stock market portion of your portfolio I am an advocate of investing in a broad-based equity index mutual fund. The fund will mirror the results of the underlying index, such as the total stock market index or the Standard & Poor's 500. It's also important to diversify among a number of different assets. A good, short primer on the investing basics is The Random Walk Guide to Investing: Ten Rules for Financial Success by Burton Malkiel.
04/14/09 by Chris FarrellSocially responsible retirement savings
Question: My retirement begins 01/10. I will receive $148,000 in Feb. 10 and my monthly state retirement check will begin. I must roll-over the lump sum into an IRA, which I do not have. I've never heard of a socially conscious IRA! How can I be sure my hard earned money is only invested in socially responsible ways? (I will be 60 this summer and want to wait til 66 to get my whole SS.) Diane, Perry, FL
Answer: You want to be part of a growth business. The Social Investment Forum estimates that total industry assets were closing in on $3 trillion in 2007 (the latest data available). That's up from $639 billion in 1995. Most of the socially responsible money is managed for institutional investors and high net worth individuals. But assets managed by socially responsible mutual funds, exchange traded funds (ETFs), and the like are also up, to over $200 billion in 260 funds last year. Investing in socially responsible funds remains popular despite the bear market in stocks.
To take a slight detour, 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. His research also showed that the performance of actively managed socially responsible mutual funds is about equal to their conventional mutual fund peers.
Put somewhat differently, socially responsible index funds do better than their actively managed socially responsible peers. One troublesome aspect of the industry is that socially responsible funds tend to have high fees that cut into returns. It always pays to shop around, but it's especially true with these funds.
To your specific question, any socially responsible mutual fund company will open a rollover IRA for you. Two websites for researching socially responsible investing from your computer are socialinvest.org and socialfunds.com. The mutual fund and investment research company morningstar.com also has good information on socially responsible funds and ETFs.
04/15/09 by Chris FarrellCash is king--for now
Question: I have saved up about $50K in after tax money that, after selling some battered Stocks recently, is now sitting in Money Market fund. I want to keep about $20K for the rainy day fund and would probably need easy access to $20K of it. I have considered ETFs, Mutual Funds, Bond Funds, TIPS, Money Market Fund, and other such products but cannot make my mind. I am also afraid that if this keeps sitting as is, as the Market picks up, I may venture into Stocks again. Could you advice what are best choices for investing all of this $50K with pros/cons? Vivek, Charlotte, NC
Answer: I don't know what the best investment choice is for your money. Any of the investment choices you mention could make sense, depending on your circumstances and your financial goals. There are plenty of pros and cons to each. But here are three ways of thinking about investments that might help narrow the choice for you.
It's useful every once in awhile to look at your household portfolio as a whole. All of us tend to segregate our money by its purpose--retirement, college, emergency savings, and so forth. Fact is, such "mental accounting" helps us save. But years ago, Jeffrey Schwartz of the asset allocation firm Ibbotson Associates, gave me this example to illustrate the advantage of taking a step back. Let's say you've saved $100,000 in your college education account. Your child is going off to college in five years, and you have divvied up the portfolio into 20% equity and 80% fixed income. You also have $100,000 in a 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, your overall asset mix is 52% fixed income and 48% equity. That may be too aggressive overall. It might be too conservative. But a calculation like this is one way to figure out where the money might best shore up your household finances.
What are you trying to accomplish with this savings? Forget the market and the specific investment products. Instead, what are you planning on spending the money on and when? Is this savings eyed for home improvements, college expenses, retirement goals, funding a career shift? The eventual use of the money often dictates the smart way to save it.
While you're mulling over what to do with the money I would keep it as safe as possible. A money market fund that invests primarily in U.S. government securities and federal agency debt is fine. So are buying Treasury bills and FDIC insured CDs. Cash is king during downturns. And it seems that your need to get easy access to the money suggests that these are probably the right kind of investment for you.
A target date fund or CD?
Question: I retired from teaching in Michigan in 2005 and immediately took a job teaching in China. I'm now 62 and currently receive my teaching pension of $30,000. I'm fortunate to still have approx. $350,000 in high-fee mutual funds, 403(b), and IRA.
I'm also fortunate to be able to save approx. $20,000/year from my job in China. I want to invest this money and would like to hear your opinion about CDs versus a target retirement fund. Is it "too late" for me to do a target retirement fund? I don't think I will need this money for several years and I plan to teach for another two years. What are the advantages and disadvantages of each - other than the obvious one that the CD will hold its value and the target fund might not? Should I be considering something else instead of these two investments? Thank you. Janet, Kalamazoo, MI
Answer: Teaching in China must be a fascinating job. On the financial side, target date funds and a CD are two very different investments. You've hit on the key distinction: Risk.
There are target date funds for people at or near retirement. Yet it's apparent the risks of these funds are greater than the marketing of their conservative reputation suggests. A number of target date funds dropped 25% or so in value during the bear market thanks to a hefty exposure to stocks. The fund companies justify the large stock portion by emphasizing that most retirees live another 20 years or so, a fairly long time horizon. The observation about longevity is right. That doesn't mean the "conservative" target fund portfolio should hold much in the way of stocks. Remember, this is supposed to be the retiree's conservative investment option. As one money manager put it to me, maybe the mutual fund companies should market target date funds as death funds instead. Somehow, I don't think savers would embrace them as readily.
The advantage of the CD in an FDIC insured institution is that the safety of those savings is guaranteed. The drawback: You'll make a pittance in interest on your money.
The question of "how to invest the money" is actually quite complicated, depending on how your going to spend money when you get back to the States. You have a pension, savings, you'll eventually start taking Social Security, and so on.
That said, one thought is to take the savings from teaching in China and decide how much of it you want to be safe for when you come home and how much you'd like to put at risk to the stock market. The "safe" money could go into Treasury bills (no default risk; will hold its value against inflation if it rises), short-term CDs (no default risk; can reinvest at higher interest rates if inflation surges) and teh U.S. Treasuries I-bonds (no commission costs; no inflation risk; compunds tax deferred but should be held for at least 5 years to get the full interest benefit). Then, with the remaining portion you're comfortable with putting at risk to the vagaries of the stock market, invest it in a very low cost broad-based stock equity index fund. This way you can tailor a low-fee portfolio to what you'll need over the next several years.
04/27/09 by Chris FarrellDividend funds
Question: Hey Chris, I'm just finishing up my second year at Wake Forest University, and I recently started investing in the stock market with the belief that it will rebound eventually. One of my friends recommended that I invest in dividend funds. From the research I've done and they seem like a very profitable with relatively low risk option compared to individual stocks. But, I feel like they are too good to be true. Can a dividend fund collapse or go bankrupt? Besides looking at there individual holdings what are other indicators that might indicate if a dividend fund is safe? Patrick, Cranston, RI
Answer: It's great that you're investing so early. Terrific. Here's a grief look at dividend funds, also known as equity income funds.
The income from dividend payments typically moderates the volatility of mutual funds that focus on owning dividend paying stocks. That's why these funds are often recommended to retirees that want to stay exposed to the stock market and earn an income. Dividends are a big part of the long-term return of stocks. However, the importance of dividends shrank during the Go-Go '90s when the investing game became a matter of chasing high flying growth stocks that didn't pay dividends. Think dot.com. Companies started hiking their dividends around 2003, and investors have been eager buyers with the tax rate on dividends reduced to a low 15%. That favorable rate is scheduled to disappear in 2011. Dividends will be taxed as ordinary income, although who knows what Congress will do between now and then.
I don't see a dividend fund collapsing or going bankrupt. (It is far more common for a poorly performing mutual fund to be quietly closed or merged with a better performing peer.)
That said, there are risks. The bear market has mauled these funds this year. For instance, the T. Rowe Price Equity Income Fund is down 3.97% year-to-date and it has fallen 35.41% over the past year. The Vanguard Equity Income fund is down 9.11% year-to-date and -34.16 for the past year. What's more, companies usually raise their dividend to keep shareholders happy in good times and bad. But the Great Contraction is forcing a swelling number of companies, especially financial services firms, to slash or eliminate their dividend. According to the Wall Street Journal, there have been 45 dividend reductions and six dividend suspensions among the Standard & Poor's 500 companies.
When it comes to picking an equity income fund the single most common mistake is putting money into the highest yielding funds. The yield is nice, but it also means there is a lot of risk built into that portfolio. I would stick to well-diversified equity income mutual funds with a track record. Better yet, there are equity index funds that focus dividend paying stocks and exchange traded funds (ETFs) that do the same. You research your choices at Morningstar.com. Good luck.
05/01/09 by Chris FarrellA bond ladder
Question: I am 42 and have never ventured beyond CD's so obviously my tolerance for risk is very low; I don't like anything I don't understand - compound interest is something I do understand! I have a 90K CD that just matured at one of the national big banks on "shaky ground" and I plan on transferring it to a local bank for my own peace of mind. I will put 5K in the "rainy day" fund, and then have 85K left. The only way I can get a rate of 3% or higher is to go for a CD of 50 months or longer. Our circumstances right now are such that I need to use this money as a "monthly income generator;" I have the monthly interest transferred into a checking account and use it for expenses (so I don't ever get the full APY, just the interest rate). Our son has autism and I need to be home with him in order to take him to a special preschool and get him the therapies that he needs. If I was working, I would let the interest accrue. Are there any safe alternatives to CD's where I could get a monthly payment at 3 to 4% or higher on my 85K without committing to 4 or 5 years???.... Thanks in advance for your reply and I'm grateful for your advice! Cheryl, Akron, OH
Answer: First of all, you're right to steer clear of anything you don't understand. Secondly, you are risk averse and you have good reason to be cautious with the money. It's an axiom of finance that you can't get a higher yield without taking on more risk, and right now safe securities pay a paltry rate of interest. Third, I am worried about tying up money in a CD for four or more years. What if rates jump higher next year if the economy recovers, inflation rears its head--or both?
How about creating a laddered portfolio out of FDIC-insured CDs or U.S. Treasuries? It's both a savvy and safe way to invest. The basic idea behind a ladder is that you buy some 3-month, 6-month, 1-year, 2-year, 3-year and 5 year securities. If rates go up you reinvest your short-term securities when they mature at the higher rate. If rates stay where they are you still get the higher yield from the 4 to 5 year securities. You'll get the average yield of all securities you buy, and as long as you hold it until the CD or Treasuries mature, you can't use lose money.
By the way, it's the after-tax yield that matters. So, I would compare the after-tax yield on CDs to the after-tax yield on Treasuries (you don't pay state and local taxes on the latter). You can buy Treasuries without commission--in other words, for free--from the U.S. government at www.treasurydirect.gov. The website www.analyzenow.com has a web-based program for monitoring bond ladders. Just go to the free programs section and click on the "investment Manager" program. Smart Money has a nice article on bond ladders here.
Inflation and an IRA
Question: I'm interested in finding a good investment for inflationary times. This would be about 7% of my retirement portfolio; around 10,000 in cash languishing in 2 different IRA accounts. I am 42, and will probably have to work until I croak. I am guessing I'll retire at 75 or so. I considered purchasing some I Bonds in an IRA account. I'd like to be able to sweep the proceeds of a dividend-yielding investment into the bonds once a year. I contacted my stock-trading account - no dice on holding I Bonds in my account there. I contacted Treasury Direct and they told me I needed to find a bank that would hold the bonds in an IRA and also contact the IRS. Do I need to call all the banks in town to see if anyone will do this? Is there a kind of bank that I should focus on? A directory that would help? Am I trying to do something completely wacko and ill-advised? Jill, Northfield, MN
Answer: I wouldn't say "wacko". But ill-advised? Yes. For a number of technical and legal reasons you can't get I-bonds into an IRA. More importantly, you wouldn't want to do that anyway. In a sense, an I-bond acts like an IRA. The money you put into an I-bond compounds tax deferred until you cash it in. At that point you owe ordinary income taxes on the gain. With an IRA, your investment grows tax deferred until you pull it out in retirement and pay ordinary incomes taxes on the withdrawal. You'd be wasting the tax shelter if you could invest it in an IRA.
That said, I like I-bonds. I would just buy them directly from the Treasury.
Inflation isn't much of a problem right now. The government reported this morning that the Consumer Price Index for the 12 months ending in May was down 1.3%, the biggest decline since 1950. I'm not very concerned that the Federal Reserve extraordinary actions to shore up the economy will end in a bout of hyperinflation, either. The formidable combination of an intensely competitive global economy and a competent central bank will keep inflation around its target level of 1% to 2%.
Of course, that forecast could be horribly wrong and a reprise of the inflationary '70s awaits us. Even if I am right low levels of inflation erode the value of a dollar over time. Long-term savers should worry about inflation a lot. That's why I like Treasury Inflation Protected Securities or TIPS. It's an ideal security for an IRA, although you'll have to buy them from a broker. I've written a fair amount about TIPS elsewhere on the Getting Personal site. The best overall source of information for investing in TIPS and similar securities for safety and security is Worry Free Investing by Zvi Bodie, finance professor at Boston University. You can check it out here.
06/17/09 by Chris FarrellBorrow to invest?
Question: My husband and I are both 50+, with two children of college age. Our house is paid off and we are without debt. He wants to take out a mortgage for 1/2 of the appraised value of our home, betting that inflation is inevitable and invest it in higher interest CDs.
Safe bet or stupid investment? Thanks Mary, Towson, MD
Answer: I get variations of this question all the time and my answer is always the same: I don't like it. I wouldn't do it. It's an extremely risky investment strategy. I don't even consider it an investment. It's a speculative bet.
Right now, millions and millions of Americans are envious of your financial situation. You have no debt. You own your house free and clear. You have a great deal of financial security. Why gamble away your security?
If you borrow half the value of your home to invest in CDs you'll have to make those interest and principal payments no matter what. The interest payments on the debt will be higher than what you can earn on a short-term CD at the moment. You'll pay a steep "fee" while you wait to profit from your strategy.
Of course, there is a school of Wall Street thought that believes high and rising inflation lies in our future. A number of economists worry we could suffer through a reprise of the 1970s inflation rates following the extraordinary actions the Federal Reserve has taken to bail out the banking system and avoid a depression. It could happen. It's a real risk. Thing is, it might not happen. Inflation could stay tame.
Instead of borrowing I would buy shelter from the potential inflation storm by investing in safe, high-quality securities that offer a hedge against inflation. Treasury bills, for example, hold their value even during inflationary times because you can reinvest the money at higher interest rates if inflation does stir. The same holds for a mix of savings accounts, short-term CDs, I-bonds and Treasury Inflation Protected Securities.
Best of all, you'll still be debt free and own your home.
Investing with the Wizard of Omaha
Question: I'd like to buy Warrren Buffet's Berkshire Hathaway shares. I understand that there 2 kinds brk-a and brk-b. The b-share costs about 1/30 of an a-share but it isn't not convertible to a-shares. My friend advises me to buy a-share but cannot give me a reason. Is b-share really inferior to a-share other than the cost? Please help me. Chris, St. Paul MN
Answer: Billionaire Warren Buffett, the Wizard of Omaha, is perhaps the greatest stock picker of all time. He runs Berkshire Hathaway, a holding company with more than 70 businesses. The price difference between the two kinds of stock is astounding when translated into dollars and cents. As I am writing this an A-shares is worth $92,000 and a B-share $3001.50.
I can't say whether you should prefer Class A to Class B, but the key difference between the two classes of stock has to do with ownership rights.Class A shareholders have the full voting rights of stock ownership. A Class B shareholder gets 1/200th the voting rights of a Class A share. In essence, Class B shareholders have a stake in how well Buffett does as stock picker and chief executive, but they're largely disenfranchised as owners. For instance, if someone made a takeover offer for Berkshire the Class A shareholders get to decide whether the deal goes through or not. The Class B shareholders are along for the ride. Question is, does that matter to you?
The Wizard of Omaha describes the difference between the two shares here.
07/22/09 by Chris FarrellHow to protect against inflation
Question: I hate to see this happen to the Obama administration; however, if you combine the debt created by the Bush era and the deficit spending (a.k.a. Stimulus Package and Bail Out packages) that Washington is embarking on, how can we not repeat the sky high interest rates that folded the Carter administration where cash was king accompanied by nose bleed inflation rates--especially since manufacturing has all but left these shores for cheap overseas labor? Thank you. Stephen, Cape Neddick, ME
Answer: Many people in the markets are worried that the Fed's quantitative easing will end in a bout of high and rising inflation. Still, it seems to me the fear that inflation lies around the corner is exaggerated. The economy is still weak if not in recession and unemployment is rising. Now, it's likely that inflationary pressures will emerge when the economy finally regains its footing. It's a safe forecast that at some point down the road the Fed will confront a tricky monetary policy act. I'm sure we'll go through some inflation scares. But the Fed is well aware of the risks and, while the conduct of monetary policy is as much an art as a science, Chairman Ben Bernanke thoughtfully discussed the central bank's "exit strategy" in Congressional testimony earlier this week.
But high and rising inflation or hyperinflation? Personally, I don't see it. For instance, the U.S. government's Treasury Inflation Protected Securities or TIPS are forecasting that inflation will average less than 2% over the next decade. You would think investors would demand more of an inflation hedge if the threat of hyperinflation was real. The global competition for profits and markets is intense and that competition will aid central banks around the world in keeping inflation tame. I still think the long term trend is toward minimal inflation rates in an increasingly integrated world economy. Plus, central bankers have a pretty good intellectual tool kit when it comes to bringing inflation under control. What central bankers don't really understand, what they disagree on is how to handle bubbles, market booms and market busts.
That said, the risk of high and rising inflation exists over the next 5 years or so considering the extraordinary actions the Fed has taken to bail out the banking system and avoid a depression. Even small rates of inflation, say, in the 2% to 3% range, reduce the purchasing power of savings with time.
So, since we're dealing with personal finance questions here what's a good way to protect your savings from inflation? A portfolio made up of mostly Treasury bills does an excellent job of keeping pace with inflation. However, the price for that inflation hedge is no growth or no earnings premium over inflation. Most of us would like to make some money on our money. That's why the key investment product for long-term savers is TIPS. Everything can be built on top of a foundation of TIPS. For those who want to take greater risk in the search for higher rewards should allocate a larger portion of their portfolio to stocks. For those who are more risk adverse a larger investment in Treasury bills makes sense.
Buying a few shares
Question: I am 20 years old and am working and going to school part time. My question is, I want to invest a little money, somewhere between 100 and 200 dollars. The purpose would be to buy into some of these historically low stocks in company's that are still pretty solid. It would be for the personal fun of watching what will happen over the upcoming years since I don't plan on doing and serious monetary investments for several years. Now to get to the question. Is there an easy way for me to do that myself online? And what sites would that be? And can I even by shares with such a little investment? Thank you for your advice. I really enjoy your program. TJ, Finlayson, MN
Answer: I like your idea and your approach. Investing a small amount of money is a good way to learn about the markets and to have some fun. However, if you could up the amount you can invest a bit it would help. The cost of an online trade will run you about $10 or so. But I don't want to discourage you. It's the kind of curiosity and educational opportunity I'd love more young adults to pursue. Its money well spent. I also agree that there are intriguing values in the market.
You can do what you want to do online. One low cost provider is sharebuilder.com. It's owned by the ING Direct, a U.S. subsidiary of the giant Dutch financial conglomerate.
Another option if you're going the buy-and-hold route is to purchase stock directly from a company rather than through a broker. "Direct Purchase Plans" are mostly offered by large, blue chip companies. The typical plan allows you to buy stock for small amounts of money, usually the value of a share. You can get more information about companies that offer a DPP option at enrolldirect.com.
There are a number of good options for researching stocks. The major business newspapers and magazines like the Wall Street Journal and Businessweek offer a wealth of detailed information, as do online sites like morningstar.com, finance.yahoo.com, and google.com/finance. Have fun.
I'm curious. Does anyone have a different suggestion or alternative for a novice investor who wants to learn about the markets with a small amount of money?
Tax-exempt bonds vs. taxable bonds
Question: If a corporate bond paid 9% interest, and you are in the 28% income tax bracket, what rate would you have to earn on a general obligation municipal bond of equivalent risk and maturity in order to be equally well off? Given that municipal bonds are often not easily marketable, would you want to earn a higher or lower rate than the rate you just calculated? Sandra, Upper Marlboro, MD
Answer: Ah, this is the kind of question that number-crunchers love and everyone else hates. So, I'll keep it simple. The good news is that I don't need to write out the basic formula and you don't need to do the math. There are calculators on the web that will do it for you.
Yes, you do want to make an apples-to-apples comparison. A key step is to put investment yields on a level playing field. When you're comparing a taxable bond to a municipal bond you'll use the tax-equivalent yield formula to do just that.
So, with your 9% corporate bond you would need a tax exempt bond that yielded at least 6.48% to match it. I plugged the numbers into this calculator. It only takes into account federal taxes. A more detailed calculator that lets you plug in state and local taxes is at CNNmoney.com.
You do want to make sure that you are comparing bonds with similar maturities and credit quality. I'm not a big fan of owning individual munis and corporates. I think most individuals will do better with low-fee bond mutual funds with these securities. With some 48 states in the red a bond fund is allows for prudent diversification.
I would stick to high-quality blue-chip corporate and muni bonds. I would steer clear of low-rated junk, especially with a long maturity. The lush yields you can earn on high yield corporates and high yield munis isn't enough to compensate for the risk of the investment going sour.
08/04/09 by Chris Farrell
IRA withdrawal
Question: If I borrowed amount $x from my IRA and invest it and make $x + 10% and return $x back into my IRA within the 60 day limit, what is the status and treatment of the 10% profit? Treated as ordinary income? Paul, Bethesda, MD.
Answer: Yes, short-term gains are taxed at your ordinary income tax rate. But for a whole host of reasons it's a really bad idea to take money out of your IRA and try this strategy.
08/06/09 by Chris FarrellI-bonds
Question: Do you agree with the U.S. Dept. of Public Debt that the current inflation rate is MINUS 5.56%? I have 3-I bonds purchased August 2000 with a 3% fixed rate. When I saw a zero interest rate for my bonds I asked Public Debt what happened to my 3%? They added the new MINUS 5.56% to my 3%. Are they manipulating the word inflation? I think of it as being zero at it lowest. Valerie, San Francisco, CA
Answer: It's a hard number to believe with the everyday pressures on our budgets to pay for gas, food, insurance, and the like. But the green-eyeshade brigade at the Bureau of Labor Statistics isn't manipulating the data. The government statisticians there live for these numbers. They take it seriously. So, although the price index IS incomplete and has flaws, no one is trying to be the number-crunching version of a Bernie Madoff.
What the decline in the consumer price index reflects is the downward momentum of the global recession, the longest, most severe recession since the Great Depression. It isn't just in the U.S., either. Inflation rates in almost all economies have fallen sharply along with declines in commodity prices, the lack of consumer demand at the mall, and the steep drops in housing values.
Against this backdrop, any increase in the overall price level is a long way off. Right now, I think the fear of deflation or a decline in the price level is haunting central bankers worldwide. But at some point--hopefully soon!--the economy will revive and we'll get a good inflation scare. Most economists expect one considering all the money the Fed has pumped into the system to shore up the economy over the past three years. That's the risk an I-bonds is designed to protect you against and it's why I think there is value for the long-term saver in owning I-bonds.
08/07/09 by Chris FarrellMedium-term savings
Question: I am a 24 year old engineer who has been extremely fortunate in this economic downturn. My wife and I have no college or credit card debt and a combined income of 100k. Up to this point the majority of our savings has been in retirement accounts, such as 401(k)'s and our Roth IRAs. We also have begun to build an emergency fund in a money market account for short-term savings. The glaring weakness I see currently is medium-term savings, such as for our next house or car in 5-10 years. My hunch is that some low-cost index funds are the way to go right now. Is this the right overall investment strategy to be taking in the short, medium, and long-terms? Adam, Hamilton, OH
Answer: You're smart with your money and you have a good savings strategy. Here's a suggestion for your medium term savings. I like the idea of investing in a low-cost broad-based equity index fund in a taxable account. Your annual tax liability is fairly small, most reflecting dividends payments. The capital gains impact is minimal since index funds mostly don't sell their holdings unless it's to take into account changes in the underlying index. You'll face the capital gains tax hit when you sell shares, assuming the investment has appreciated in value over the years. I like the idea of setting up an automatic investment plan so that every month a small sum of money goes out of your checking account and into the index fund.
You can complement this risky slice of your savings portfolio with an investment in I-bonds. It's an inflation-protected savings bond. There are no commission costs to buy and sell I-bonds. You can buy $5,000 online in electronic I-bonds directly from the U.S. Treasury and another $5,000 in paper I-bonds from your bank or credit union. Your money compounds tax-deferred and you don't pay Uncle Sam at your ordinary income tax rate until you cash them in. If you sell the I-bonds before 5 years you'll lose three months interest as a redemption penalty. There is no penalty after 5 years. To be sure, I-bonds aren't in favor right now because the rate is zero. That's right, 0%. The rate reflects the steep decline in the consumer price index during the Great Recession. The reason it doesn't bother me is what if inflation surges in a year, three years, or five years from now? The dollars you put aside today will be protected against inflation, at least as it is measured by the consumer price index.
By the way, I look at this approach as a 5+ years strategy, especially with the index fund. If your time horizon is less than 5 years the stock market is simply too volatile a place for savings. .
A bond ladder
Question: Looking for safe place for investing which pays a higher yield than CD's. As a senior, in these uncertain times, I am a conservative investor. Miriam, San Diego, CA
Answer: Today's low yields are tough on savers, especially seniors looking to live off their savings. However, even though it appears that the recession is ending there is still a lot of risk in the economy and markets. So, I think the risk of reaching for yield is too high. I'd stick with government-backed savings, from Treasury bills to CDs.
One time-tested strategy is to create a "ladder" of CDs or U.S. Treasuries. The idea is to invest in securities with different maturities. For example, using the national CD rates published in today's Wall Street Journal you could buy a 6-month CD at 1.25%, a 9-month CD at 1.45%, a one-year CD at 1.61% and a three-year CD at 2.61%. Now, let's imagine in six months that interest rates are higher. You will have a short-term CD maturing at that time and you can reinvest the money at the higher rate. What if rates go even lower over the next six months? You're still earning a relatively better return on your longer-term higher-yielding CDs. You can also do this with Treasuries bought directly from the federal government at treasurydirect.com.
08/17/09 by Chris FarrellSaving for retirement
Question: I am a 55 year old divorced female who owns my own fledging consulting business. I have no retirement savings except Social Security. As part of my divorce many years ago I will be shortly be receiving my portion of my ex-husband's retirement fund as determined by a QDRO. [A Qualified Domestic Relations Order allows for the division of retirement plan assets in a divorce.CF]
I must roll it into a 401K to avoid any penalties of course but wonder what is best to do with it once it is in a fund. What is the best kind of 401K? Should I invest in some medium risk stocks as long as I can do something to guarantee the principal?
I am very much a novice at this and as you can probably understand by the fact that I have virtually no retirement savings -- have not been especially good about savings in the past. Lucy, Baltimore, MD
Answer: Congratulations on getting your consulting business off the ground. You're already taking on a lot of financial risk by being an entrepreneur. That fact alone suggests your savings should lean toward the secure and cautious. What's more, you say you're a novice at investing. That, too, suggests investing conservatively in a retirement savings plan. Last, you want to avoid the temptation of rolling the stock market dice to make up for lost time. Stocks are simply too risky for that kind of bet.
In thinking about your question maybe the best advice I can give is for you to pick up a copy of "Worry-Free Investing" by Zvi Bodie and Michael J. Clowes. Bodie is a leading finance professor at Boston University. Michael Clowes is editor at large at Pensions & Investments, a trade publication. The book was published back in 2003 in the wake of an earlier bear market in stocks and it remains a book for the times. Instead of asking, "How much money will I make?" they're wondering about the more fundamental financial question, "How much can I afford to lose?" Their basic message fits in with your question.
What's the answer? Their preferred investment for long-term retirement savings is U.S. government inflation protected securities. These securities preserve the purchasing power of a dollar against the ravages of inflation. Inflation is the enemy of long-term savers. Think about it: 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. Of course, you'll take a lower payout on your savings in exchange for the inflation protection, but it's worth it. The authors deal with other conservative investments. They aren't stock-phobic, they'd just prefer that individuals roll the stock market dice only after looking after their baseline financial goals. I think a book like this might give you some needed guidance.
08/31/09 by Chris Farrell
Buying gold
Question: What is the best way to add some gold to your investment portfolio? It is best to buy shares in a mutual fund, or just buy gold? Andrew, New York, NY
Answer: Gold has been on a tear lately. The price of the precious metal meandered for much of the summer, and then it moved sharply up in September. Gold futures closed at a record high today of $1,004.90 a troy ounce. (That's a "nominal" price record; adjusted for inflation gold reached a peak of more than $2,200 in early 1980.) There are all kinds of theories being batted around the world's largest chat room--the global capital markets--for the run up in gold. The most popular explanations revolve around the prospect of surging inflation in the U.S., worries about global deflation, buying by the Chinese central bank, falling mining production, a weak dollar--and all of the above.
If you're optimistic about gold, I would be wary about buying the actual metal. The metal is volatile. Gold doesn't pay dividends. It doesn't create cash flow. It costs you to store it.
There are intriguing alternatives. There are some exchange traded funds (ETFs) that are a cost-effective option for the individual investor, such as the SPDR Gold Shares ETF. A number of mutual funds focus on owning the precious metal and mining company shares, like the Van Eck International Investors Gold. Another approach is shown by the mutual fund First Eagle Global. A small percentage of its portfolio is invested in gold bullion. It acts like an insurance policy. When the equity markets go down, the price of gold is supposed to go up, cushioning the impact on the portfolio's value.
By the way, if your nervous about inflation here in the U.S. I still prefer Treasury bills and Treasury Inflation Protected Securities. These are investments that preserve capital and make you some money. No one will get rich with these securities, but the value of a dollar will be preserved. Still, if you want to invest a small percentage of your portfolio in gold, I'd investigate the mutual fund and ETF options at a website like Morningstar.com.
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Stocks for the long haul
Question: First of all, I really like your steady and reliable counsel. You have a great style too. Here's my question: I believe someone released a study this summer saying that bonds have generally outperformed stocks in the U.S. for decades -- most notably from 1968 through the present. Is this report flawed? If not, why aren't more people talking about it? (It seems to turn the conventional wisdom on its head?)
This link may not be the primary source, but it seems to be citing the information I heard. Dave, Queenstown, MD
Answer: One of the wrong investing mantras in recent history was that stocks weren't really risky. Sure, stocks were more volatile than bonds with an investment horizon of a couple of years. But with time stocks always outperformed bonds, turning into the investment equivalent of diamonds while bonds were cubic zirconium. The height of this thinking came with the book Dow 36,000 by James K. Glassman and Kevin A. Hassert. It was published in 1999. "The Dow Jones industrial average was at 9000 when we began writing this book," they noted in their introduction. By their calculations "in order for stocks to be correctly priced, the Dow should rise by a factor of four--to 36,000... The Dow should rise to 36,000 immediately, but to be realistic, we believe the rise will take some time, perhaps three to five years."
Oops. A closer look at the data suggests that the notion of stocks as a riskless security over the long haul is wrong. Bonds have often outperformed stocks for 10 year periods of time. Stocks did not always do better than bonds even with a 30-year time horizon before 1871, notes Robert Shiller, economist at Yale University. You don't even have to reach into the history books. From 1983 to 2008, the annual total return on stocks was 9.8% a year versus an 11% average annual return on Treasury bonds. The study you mention cuts the data a different way, but the point remains the same: There have been long periods of time when bonds have outperformed stocks.
That said, the fundamental notion informing modern finance is the proposition that returns are only earned as compensation for taking on risk. Stocks are riskier than bonds since equities represent the uncertain rewards for entrepreneurship, while bonds are long-term contracts that spell out when borrowers must make principal and interest payments. "There is no predestined rate of return, only an expected one that may not be realized," says Laurence Siegel, director of investment policy research at the Ford Foundation. "The risk of holding stocks, then, is the possibility that in the long run, returns will be terrible."
I like stocks. Stocks should do better than bonds over a very long time period. But it's the return from taking on greater financial risk. And the risk is that stocks may do poorly for a considerable period of time. I think it's a risk worth taking.
But all the uncertainty is the reason behind my bottom line: Diversify.
09/16/09 by Chris FarrellA more conservative portfolio
Question: After listening twice to your recent commentary about Wall Street and having recently read Robert Reich's blog titled 'The Continuing Disaster of Wall Street, One Year Later' I'm concerned about our stock investments and retirement timeline.
We're looking at retiring at the earliest in 2012. Our present investment portfolio is weighted to 'aggressive' mutual funds. Given our (hopefully) short retirement timeline another major downturn of the market would put us in a serious retirement hole to dig out of. It seems to me that we'd be better off shifting our stock to bond ratio to a safer mix. As always, we enjoy your advice and commentary. Joe, Hagerstown, MD
Answer: You're right to be concerned. We've had two recessions, two bear markets, and a credit crunch in 8 years. My basic assumption is that everyone needs to build a substantial financial buffer with their savings. Economic downturns are as much a part of a capitalist system as expansions and bull markets.
I like the approach of Jack Bogle, the founder of the Vanguard mutual fund behemoth and a regular guest on Marketplace Money. (By the way, any of Bogle's books on investing and money are worth reading.) His rule of thumb is that the fixed income portion of your portfolio should equal your age. So, if you are 30 years old, fixed income securities should be 30% of your portfolio; 55 years old, the fixed income portion is 55% of your portfolio. Bogle walks his investment talk, too. When I talked to him several months ago he was 80 years old and with that much of his portfolio in fixed income securities he didn't really even feel the sharp drop in stocks.
Of course, like all rules of thumb your age is just a starting point. You can decide to be more or less conservative, depending on your circumstances and household wealth. And with your fixed income investments I would stay conservative. For instance, Treasury Inflation Protected Securities, Treasury bills, Treasury notes are default free investments. So are I-bonds. Certificates of deposit and savings accounts that come under the FDIC insurance limits are good, too.
So, I'd play with the numbers and see if this approach works for you.
A stock market winner
Question: My wife and I are in our mid 30s and we decided to take a gamble back in Jan 09 when everyone said the world was coming to an end. We took $20,000 out of our savings and plunged it into an established travel company we used to work for that was trading below its all time low (lower than after 9-11). Well the world did not end, and 9 months later we're sitting on a handsome sum of money thanks to a 4x growth in stock price. My question is what should we do with the money? Popular ideas are to slowly work the money into a Roth IRA or other investments, or to pay off our $120,000 7.2% 30 year mortgage (25 years remaining), which would free up $1200 in expense monthly.
I appreciate your help and love the program. Jonathan, Miami, FL
Answer: I love your story. We all know that being a contrarian investor is smart, but it isn't easy. As John Maynard Keynes famously wrote eight decades ago, "Worldly wisdom teaches it is better for reputation to fail conventionally than to succeed unconventionally."
What would I suggest doing with the money? You could always refinance your 7.2% mortgage with fixed rates to 5% these days. And then you could use the money to build up a broadly diversified portfolio. But, assuming you like your home and neighborhood, I'd lean toward taking advantage of your windfall to live debt free. Imagine, you're both in your mid-30s and from here on out you could live well off your income from work, add to your savings, and avoid borrowing. Being debt free at your age will give you a lot of financial flexibility and personal freedom down the road.
09/24/09 by Chris FarrellInvesting for retirement
Question: After many years of false starts, my wife and I will soon be able to finally start saving for retirement. I'm 38 years old, and after watching so many 401ks turn into 201ks, I'm more than a little worried about saving with this method. I've listened to the show for years, so I know about TIPS, I Bonds, etc, but I'm hoping you may provide some more advice about ways to save for retirement that don't involve taking on all of the risk of a 401k. Thank you very much. Andy, Spring Hill, TN
Answer: Congratulations on getting started. . Most of us are reluctant plungers in the market these days. We're supposed to figure out how to invest our money for when we retire in 10, 20 or 30 years. Yet in today's world, the biggest mistake you can make is not saving for the long haul. The financial penalty for not participating in a long-term savings plan is far bigger than the risk of picking a poorly performing mutual fund.
That said, a 401(k), an IRA, and similar retirement savings plans are simply tax sheltered parking place for savings. You can put the money into more conservative investments, like Treasury securities and certificates of deposit, as well as riskier investments, such as stocks and junk bonds. So, the risk to your savings is minimal if you invest in Treasury Inflation Protected Securities, short-term CDs, and the like. The gain won't be much either. That's a reasonable trade-off for most people to make, especially anyone who doesn't want to see their 401(k) become a 201(K)--and is willing to give up the possibility that it becomes a 601(k).
When it comes to retirement savings the basic money question you should ask yourself is not "How much money will I make on my investments?" The real question is "How much can I afford to lose?" You then lock in a standard of living for your old age with a conservative investment strategy. You don't want to be 70 years old with a portfolio that has lost half its value.
I have two books to recommend. The main points of both books can be quickly absorbed, so this isn't like assigning homework. But you've raised a huge important topic and both of these books cut to the core issues in easily digestible chunks. Worry Free Investing by Zvi Bodie and Michael Clowes advocates a very conservative approach to retirement savings (largely based on TIPS). The Random Walk Guide to Investing by Burton Malkiel is also conservative (he strongly advocates for diversification) but he makes a stronger case for putting a portion of the portfolio into equities. Good luck.
A whole life policy
Question: My wife and I are in our early 50s. We have been told that we should have a whole life policy in our investment portfolio as a conservative investment vehicle (we currently carry $150,000 term life policies on each of us). Our combined gross annual income is approx. $155,000, and we are saving for retirement in 401Ks at approx. 15% of our annual income. We also invest in Roth IRAs and have two homes that are nearly paid off. So, about the whole life for us, what do you think? Thanks very much! - Tim, Indianapolis, IN
Answer: I'm skeptical. Do you need more life insurance than you are currently carrying? If yes, why not simply hike the amount of term life insurance you have currently. Or do you face a future that calls for a whole life policy?
A whole life policy combines a death benefit with a tax-sheltered savings account. In essence, you pay a premium for the coverage, the insurance company deducts insurance and expense charges, and then it credits the rest of money into a tax-sheltered interest-bearing checking account. It can quickly gets a lot more complicated than that, by the way, but that's still the essential idea.
I like judging whole life from the perspective of does it meet your life insurance needs better than term insurance?
To be clear, whole life fills a need. But I'm skeptical that its a conservative investment alternative for many people. If you need a stronger hedge against bad times in your overall portfolio why not put the money into all kinds of conservative savings choices, from CDs to Treasury notes to I-bonds. The cost of owning investments like these are minimal. (And if you buy I-bonds, bills, notes and bonds directly from the Treasury there are no commission costs to buy.) You don't have to worry about default risk. Interest rates won't always be at such razor thin levels, either. You can be tax smart with these alternatives, too.
Clearly, you're good savers with plenty of assets and almost no debt. I think I would just continue what you're doing.
If you do go the whole life route, take your time, shop around, and ask lots of questions.
Too much in retirement savings?
Question: This may be an odd question in this economy. I've always tried to max out my pre-tax retirement savings. However, I'm wondering if this philosophy still holds true when your employer's contribution is significant (i.e. it's over 10%)? This is a *contribution*, not a *match*.
This puts me at pretty much 25% pre-tax retirement savings. I'm 35. Am I better off taking some of my money and putting it into something post tax for more diversification? Or should I still contribute the maximum because of the pre-tax benefits?
Basically, is there such a thing as putting too much into pre-tax retirement? Renee, Minneapolis, MN
Answer: You're right--you are in a different situation than most people. It's a nice place to be, too. But yes, I do think it's possible to put too much into a particular tax-sheltered retirement savings plan. The reason is that you can't get access to the money without paying a steep 10% penalty as well as ordinary income taxes if you withdraw the money before 59 ½.
I have two suggestions for you to consider. Both assume that reducing the amount going into your pre-tax retirement plan doesn't affect the company's contribution, which is incredibly valuable. First, if you come under the income restrictions I would set up a Roth IRA. The contributions are funded with after-tax dollars, but the gains are tax-free on withdrawal in retirement. An additional benefit is that you can always withdraw the contributions without penalty or tax if you need the money.
The other is to set up a long-term savings plan that minimizes your annual tax hit. But you can always access the money. For instance, you could set up an automatic savings program--a set some of money is invested every month. Some of your savings could be regularly invested in a broad-based stock index fund, such as the Wilshire 5000, the Russell 3,000, or the Standard & Poor's 500. Uncle Sam annual levy is minimal since there isn't a lot of trading activity with an index fund and when you sell stocks much of the gain will come under the lower capital gains tax rate. You could also load up on tax-deferred inflation-protected I-bonds for the fixed income portion of your portfolio (or Treasury bills, certificates of deposit, and other safe investments). It provides an anchor to your savings.
A regular monthly investment into a mix of secure and riskier savings in taxable accounts accumulates with time. It may be tapped to fund a career change, a medical emergency, a home, or retirement. This approach is a simple strategy that gives you a lot of flexibility.
Participating in 401(k)
Question: My fiancée has about $40K in student federal loans outstanding and because of that, has yet to contribute to her company's 401k program. I think her company matches dollar for dollar up to $2000 and .50 cents up to $4000. What's the best "financial equation" to use to figure out how much to contribute to the 401k and how much to set up for monthly deductions for her student loan payments? DJ, San Francisco, CA
Answer: The simplest answer is that she should invest enough to take full advantage of the employer match. Warren Buffet, David Swensen, and any other investing superstar of recent decades can't come close to the kind of investment performance recorded by the match. Plus, most of the growth in a 401(k) plan doesn't come from investment earnings but from the match. (And that's why it's doubly devastating when employers reduce or eliminate the match.)
There are additional issues she could consider. For example, she could look at the interest rate she's paying on her student loans. She can put in more money than the match if she thinks she'll do better than that interest rate over time. She should also increase her contributions as her income grows.
Still, for now, the simplest equation is to "invest to the match."
10/20/09 by Chris FarrellRollover IRA
Question: I was recently laid off and told that because my 401k balance was below 5k I would need to move the money. I do not want to cash out and would like to avoid paying any taxes on the funds. I currently have 3 other 401k accounts with previous employers. What are some of my options for these investments? Natalie, West Chester, OH
Answer: You'll want to do what's called a "rollover IRA." There are no tax consequences or penalties so long as the money is transferred from your former employer directly into the rollover IRA account. Check with human resources before you do anything to make sure you understand any requirement the company may have about a rollover. The same goes with the company you've chosen to place your rollover IRA. And if you put the money into a comparable investment you shouldn't take much of a hit on the transfer, either.
Now, as to your other 401(k) accounts at 3 previous employers, why are you keeping the money there? If it's because you really like the plan options offered by these employers, fine. But my bias is for you to take control of the money through a rollover IRA. "It's great anytime you can take control of your money and take it out of your company plan," says Ed Slott, head of his eponymous company and a leading IRA expert.
You're no longer working for these companies. It's your money and if it's under your control you'll watch it carefully. Plus, you get to chose the investment company and investment options, not your former employer.
10/21/09 by Chris FarrellRoth conversion
Question: My wife has a combined income that is over the limit for a traditional IRA tax deduction or for contributing to Roth directly. We both also have employer sponsored retirement plans. Since there is no income limit for conversion from a traditional IRA to a Roth in 2010, I want to establish a traditional IRA now so that I can convert it to Roth next year. My question is, because I will be contributing to my traditional IRA after tax (or without any tax deduction), how I will be taxed when I convert my traditional IRA to a Roth coming 2010? Thanks. Andrew, Norman, OK
Answer: What you're planning on doing can be a smart move. Let me just give a bit of the background behind your question.
The Roth-IRA is a terrific retirement savings vehicle, probably the best available. The main reason is that all accumulated investment gains are free from Uncle Sam's clutches when withdrawn during retirement. The other attraction of the Roth is that it offers unusual flexibility for managing finances. For instance, there is no required minimum distribution at age 70 ½ with a Roth as there is with a 401(k) or a traditional IRA.
In the past, you could convert money stashed in a traditional IRA into a Roth, but you could only do it if your adjusted gross income was under $100,000. That earnings cap on conversion disappears next year. That's why the Roth conversion equivalent of a gold rush is about to be unleashed in 2010. Conversion calculators have sprung up all over the web. (The contribution limits to a Roth and the income phase-outs all remain essentially the same in 2010 and on. What have changed are the rules with conversion.) There are a lot of twists and turns to the Roth conversion question in 2010 and after. But it's an issue well worth researching.
Now, to your question. Many financial planners I've talked to are advising folks that earn too much to contribute to a Roth and a traditional IRA to open up what is called a non-deductible IRA. This is what you're planning to do. The non-deductible IRA is funded with after-tax dollars. The gain is tax-sheltered over the years and the earnings are taxed at your ordinary income tax rate on withdrawal during retirement.
But you're not going to wait that long. You'll convert the non-deductible IRA into a Roth in 2010. The only tax you will owe on conversion is on whatever gain you've earned in the meantime--in other words, not much. You won't owe anything on the contribution since you've already paid the tax tab on that money. And, of course, with this maneuver you won't pay any taxes on the investment earnings when you withdraw the money in your retirement years.
As I said, it can be a savvy move.
10/22/09 by Chris Farrell
Investment taxes
Question: Hi Chris, I have listening to Market place Money for the past several years and love to hear your views on the economy and your Q&A. Last year I bought some Municipal Bonds (MICHIGAN ST BLDG AUTH REV BDS CUSIP 594614W54) when the financial world was coming to an end (:((). I just did this as an experiment. (The post tax yield equivalent on these bonds were attractive at that time) If I were to sell these bonds after a year of holding them - what are the tax implications? Thank you and look forward to hearing your views in these historic times. Guru, Farmington Hills, MI
Answer: With the scenario you've laid out you would come under the capital gain and capital loss rules. You say you've owned the bonds for more than a year. Let's assume for illustration purposes that you paid $10,000 and you can sell the bonds for $10,400. You would have a capital gain of $400 with a maximum rate of 15%. (A long-term capital gain requires that the security be held for more than 12 months; the maximum rate on short-term capital gains is 35%.)
However, if you sold the bonds and could only get $9,800 for them you would have a capital loss of $200 that can be used to offset, first, a long-term capital gain and, second, if there is any loss left over any short-term capital gains.
Of course, there are a few other wrinkles, such as adjusting for selling costs and whether the bonds were sold at a discount. But that's the basic idea.
Thanks for listening.
Stock options
Question: My husband is a mid level executive and he receives stock options yearly as part of his compensation. Since the stock prices have been continually declining at his company, we now have five year's worth of options we are unable to exercise. Aside from the stock price increasing, is there any way we will be able to recoup this money? Mary, Milwaukee, WI
Answer: Your husband's situation isn't uncommon among publicly-traded companies. Many executives now hold stock options that are worthless because the "exercise" price is greater than the market value of the underlying stock. In other words, you'd lose money if you exercised the options. The Wall Street metaphor for this experience is that the options are "underwater". Descriptive, isn't it?
There's nothing your husband or you can do. It's really up to management and the board. They can decide to leave the current option awards program unchanged. In that case, everyone will have to wait and see if the stock price improves before the option grant expires. The employee optionholders remain in the same financial boat as shareholders. However, some companies have decided to take a different tact. They are rewarding employees by substituting their old underwater options for newer ones with a lower exercise price, retiring the options and issuing restricted stock, or by exchanging cash for the options.
Inflation indexed bonds
Question: Is there a way I can buy "I" series treasury bonds with pre-tax money? I would like to hedge a little bit against inflation with these bonds, but don't like buying them with after tax dollars. Does this make sense? I am open to suggestions. Jeff, Sparta, TN
Answer: Let me clarify the choices. In an IRA or comparable retirement savings plan you can't buy Treasury Inflation Protected Securities directly from the U.S. government. However, you can purchase them through a broker with pretax dollars in an IRA, 401(k), and the like. (And commission costs are low.) You can also buy mutual funds that invest in TIPS with pretax money.
The I-bond is a savings bond that also offers investors an inflation hedge. It is purchased with after-tax dollars. But the money compounds tax free until you cash them. You don't want to buy I-bonds with pretax dollars since it's already a tax-sheltered form of savings.
Both TIPS and I-bonds are good long-term investments for savers.
ETFs
Question: I've just opened a Roth IRA to start saving for retirement. However, as a graduate student, the amount I'm starting with and able to contribute monthly is well below the minimum investments for various mutual funds. I've been looking at ETF's, which seem to have the same diversification with lower expense ratios. Is there a reason to prefer one over the other that I'm not seeing? Thanks much. Drew, Atlanta, GA
Answer: The exchange traded fund (ETF) is a genuine innovation. ETFs are investment vehicles that track indexes but an ETF is traded like a stock. The most popular ETFs are based on broad stock indexes such as the S&P 500 and the Dow Jones Wilshire 5000. There are also a number of broad-based socially responsible ETFs. It's also another way for the small investor to take a plunge in windmill energy, solar and other energy alternatives.
Problem is, there has been an explosion of ETFs that slice and dice the market into smaller and smaller and smaller pieces. Intrigued by patents? There's an ETF for you. Think the Austrian economy is poised to rebound? Yes, there's an Austrian ETF. That's why I'm cautious with ETFs in general. It's a product increasingly designed for speculation, not investing.
That said, an ETF is fine if you want to buy a broad-based index all at once. You pay the brokerage fee, and then hold on to the investment. An ETF works for a buy-and-hold strategy. But a no-load equity index mutual fund is better if you're adding to the investment in small increments over time, say, $100 a month or a similar investment disciple.
Low risk and high yield?
Question: Over the past year I have saved about $3,500, stashing it in online savings accounts that are yielding lower and lower interest rates. My question is, what should I do with this money? I'm wary of putting it into tumultuous stock market, but CDs and other "safe" options are yielding abysmal returns. Is there a low-risk investment that would allow me to see a better return than 1.5 percent? Thanks! Casey, Portland, Maine
Answer: The interest rates on safe savings are paltry. It's hard to get much more than a fractional rate of interest on savings accounts, certificates of deposit, savings bonds and short-term Treasury securities. Little wonder many of the questions I get involve the desire for higher yields without abandoning the security of the federal government's full faith and credit. Fact is, you're not doing bad getting 1.5%!
It's an axiom of modern finance that you can only create the prospect for higher returns by taking greater risk. You've worked hard to save $3,500--congratulations. You say you're wary of putting it into the stock market since your $3,500 could plummet in value to $2,500 or worse if the stock market lurches lower. (Of course, it could grow in value if the rally continues.) You can pick up a higher yield by buying into corporate bonds, but there is still greater risk than in an online savings account or CD.
In most cases, my advice for now is if you don't want to embrace volatility stick with safety--and low yields. Eventually interest rates will rise when the economy is healthier and you'll be able to participate in those greater yields.
Another thought: Inflation erodes the purchasing power of savings. I'm skeptical that the outcome of the Federal Reserve's unprecedented efforts to prevent a financial collapse will end in a bout of hyperinflation as some Wall Street money mavens fear. Yet even if I am right, low rates of inflation still eat away at the value of a dollar. That's why many investors are adding to their portfolios securities that safeguard against inflation. You could put some of the money into I-bonds. It's a hedge against a rise in inflation and there's no credit risk.
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Chris Farrell Marketplace Money personal finance guru
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