Feeling Financial

What Does Your 401k Statement Tell You?

2010-05-24T08:21:00.000-07:00

Hint: it’s not what you need to know.

It may be tempting to look at your 401k account, especially when markets go haywire. Before you do that, you may want to ask what you’re looking for.

If it’s just idle curiosity and you have some time to kill, there’s nothing wrong with looking at your account and reviewing statements. However, if you intend to actually do something, you’d better be careful.

Your 401k statement shows your account balance. You already knew that, but it may be novel to consider what is missing on those reports: your retirement income. Sure, some 401k and IRA providers print a retirement projection, but many don’t (and they’re usually not customized to you and your life).

What About Income?

Retirement income is probably the reason you have a 401k. Decide whether or not you think that’s true. Then, decide if you have a 401k for any of the following reasons:

To watch it go up and down
To only see it go up
To “make money”
To do better than your neighbors
To be a smart investor
To not make mistakes

It’s your money, and you can have any number of goals. Who’s to say if any of those goals are bad ones?

For most people, retirement income is the goal that matters. When it’s 3AM and they’re worried about money, they may be afraid of the market going down further. At 8AM, after a cup of coffee (and a muffin to help make better decisions), they’ll hopefully realize that the real problem is retirement income.

Looking at your 401k statement probably won’t help you get a handle on retirement income. For younger and/or aggressive investors, looks may be deceiving; a bad market is a good thing if you’re buying and not looking to retire anytime soon.

An account balance going up and down hardly tells you what you need to know. Zoom out and think about all the moving parts before you decide to do anything. Whether or not you take action, you’ll improve the chances of doing the right thing.

The New Merlin Mann and Authentic Happiness

2010-05-15T09:16:00.000-07:00

It may not be anything new, but I see him in a new light. Why might you care? You might get ideas that improve your life and finances.

If you’re not familiar with Merlin, he’s made a name for himself in the world of personal productivity. But that’s probably the least important of his work. Increasingly, he seems focused on doing things well (not just efficiently) and bringing authenticity into our lives. And he’s kind of entertaining.

The type of authenticity can turn out to be essential to your financial strength. For example, it touches:

Your job - what you do and how you do it
How much you spend
How much you save and invest
Your goals for the future
How much you enjoy all of the above (your experience of it)

The Goal Behind the Goal

Unless you understand what you do and why you do it, no amount of working, saving, and investing will make you happy. And that’s the real goal right?

If you’re not happy with what you do for a living or how each day goes, what’s the point? You can't buy happiness. You might not even make it to retirement age - stress will take you out before you even get close.

Get excited about stuff and do that stuff. The success (whatever that is), most likely, will follow. Yes, it sounds a bit on the new-age-motivational side, but it’s probably true. And if it turns out not to be, you’ll still enjoy the ride more.

In my mind, Merlin stresses the importance of why you do things and that you do them - not so much how you do them. Wanna get in shape? Move your body. Unfortunately most of us are more prone to fall into traps:

Thinking about how and where we’re going to exercise
Reading about how to exercise
Setting up a place to do it
Getting equipment (shoes, socks, sweatbands?) dialed in so we can work out
Designing a program to motivate and track progress

Some of those things have to be done from time to time, but not at the expense of moving around.

So… How's this About Money?

Why is this on a site about personal finance? It could be related.

Personal finance is about spending less than you earn, saving and investing, and enjoying life. Unfortunately, readers often get stuck:

Reading mass media (which is all news but never new)
Picking up tips and tricks to save a little money
Analyzing numbers and things they have little control over, and which may not matter over the long term
Finding things to hate without understanding them (which makes the required behavior less likely to happen)

Again, these things may have to happen periodically. However, if you spend too much time on them you’re a researcher or a professional - not a saver. Or you might be evading something else…

If you want to hear interesting things from an interesting person, try some of the links below. You don’t have to be a creative person or knowledge worker to get something out of it. You can even consider the basics of handling your finances as a “project”.

Fake Rocks, Salami Commanders, and Just Enough to Start
Audio and Video (or just a recent talk)
Write online? Try to be Better (I don't know if I am but I think I try)

Target Date Funds Compared

2010-05-07T16:09:00.000-07:00

Morningstar took a good look at target date funds recently, and listed the pros and cons of these controversial investments. The study looks at returns, fees, philosophy, and more in hopes of identifying the best target date funds and best ways to build them.

They end up straddling the fence between those who’d like to burn target date funds at the stake, and those who think they’re good enough as is.

Ultimately, the report may show that it doesn’t matter much which one you use. If we agree that investor behavior is more important than investment selection, than that’s no surprise. Even if you pick the best fund, you can be disappointed.

Good behavior includes having some understanding of how your fund works. There’s no real standard for these things, so a 2015 fund (which you might guess is a conservative one) can have anywhere from 36% to 84% in stock! 84% is usually not considered in the same zip code as conservative. It might be perfect - or it might not - but it’d probably surprise most investors.

Shining a Light

The study acknowledges that it isn’t taking a stand on either side of the target date fund debate. That’s OK. We’ve got more information, and that can only be a good thing for everybody involved.

More scrutiny led some target date funds to lower fees. Increased scrutiny means they’ll have to be even more competitive - not just in fees, but in a variety of ways that should benefit consumers.

These things are like vital organs; they’re supposed to do a good job by themselves and we don’t want to think about them unless something is wrong. They’re made for people who don’t or won’t spend all day messing with their investments.

Fund A or Fund B?

For most people, saving and investing is more important than picking a target date fund. Even worrying about strategy and philosophy may be a waste of time. The Morningstar study didn’t find huge advantages in active/passive, open/closed architecture, or other areas marketing campaigns hammer on.

Granted, the study is young so in future years the advantages may emerge. However, I doubt you’ll ever hear a retiree on the golf course say “I’m sure glad my target date funds were passively managed, otherwise I’d be eating dog food.” Now, you might see this on a commercial...

Look at today’s retirees; can you imagine one of them saying “I’m glad I had the stockpickers at American Funds instead of those silly Vanguard funds”? The only reasonable thing a successful retiree can say is: “I’m glad I saved and invested wisely”.

If they’re honest they’ll probably tell you they didn’t really look at - much less understand - exactly how the funds worked.

Getting a Refund? How's it feel?

2010-04-20T16:34:00.000-07:00

Hopefully your taxes are done by now.

This time of year everybody talks about tax refunds. Whether it makes sense to get one or not, a “tax-free loan to the government”, and so on.

It’s worth looking at the financial reasons for and against getting a refund. In general, you should probably try to pay just about as much as you owe over the year. One way to do that is to use the IRS withholding calculator where you can fine-tune how much your employer sends them each month.

It’s also worth looking at non-financial reasons. Why do you do what you do?

Some people enjoy getting a refund. They feel like it’s a “prize” after the end of the year, but that’s not quite accurate. It’s your money, and it always was. If you’re going to use it for a treat, why not just budget for treats instead? Go ahead, you’re worth it.

When you owe, things can get ugly. This may be why so many people err on the side of getting a refund. We tend to dislike losses more than we enjoy gains (even when the dollar amount of each is equal), and owing at tax time can feel like a loss.

These days you aren’t missing out on much by getting a refund. The bank would have paid you very little on any savings. But it’s still worth aiming for (more or less) accurate tax payments throughout the year. You’ll force yourself to understand your income, expenses, and taxes as you fine-tune your withholding - and knowing more about how your money comes and goes is always a good thing.

Live From the Floor of the Exchange

2010-04-09T15:38:00.000-07:00

Should you care? News outlets show reporters at various exchanges (NYSE, Chicago Merc, etc), promising to reveal breaking news.

However, those reporters are the last people who’ll hear about it.

Most things are electronic these days, and you’ll have access to better information if you’re in front of a computer. Anywhere. You might need a fancy subscription to get nitty-gritty details and bid/ask spreads, but most people get more than enough information for free.

On the Floor

The floor of an exchange is a fascinating place.

Traders may have valuable insight that could help make short-term decisions, but it’s not that valuable. Think about it: how long will it be obvious to a floor trader that a stock was going to skyrocket (more than about 10 seconds)? In short order, the opportunity is gone.

If there’s a reporter bumbling around trying to get information, any trader with valuable information is too busy to provide it. Especially to a guy on live TV.

Why the Field Trip?

Why do they send a reporter to the exchange? If he’s just standing in the way, wouldn’t it be better and cheaper to keep him at the studio?

The Last Psychiatrist explains it well, so you can read more there.

The news media are interested in keeping your eyeballs on the screen, not your success. They want you to believe you constantly have to “do something” with your investments. They want investing to be like flossing - something you to do every day or you’ll have an increased risk of heart problems and bad breath.

Imagine the following report from the exchange:

“If you’re not going to spend your money in the next few years and you’re not a day trader then there’s not much happening, really. Go give your kids a hug and maybe take ‘em to the park. You probably did a good job setting up your portfolio, and you reviewed it a few months ago, so I’ve got nothing. Sure, a few stocks are gonna go up and down but what else is new?”

You’d never tune in again. You’d also have a better chance of reaching your long term goals and keeping up with your own investments. Most importantly, you’d have more time and energy for more important things.

If they actually provided valuable insight, you wouldn’t have to suffer through the painful advertisements that keep them on the air. It’d be worth paying to watch.

Best Days Over for Bonds? What's Next?

2010-04-02T17:42:00.000-07:00

Last week bond guru Bill Gross voiced concerns about investors who’ve fled to bonds in the past year. He thinks they’ve “seen their best days” according to a Bloomberg report.

His fund, the PIMCO Total Return fund, is now the largest mutual fund in history. You have to hand it to him for being honest when it may mean less money in his product. Let’s hope his worries affect how he manages the fund.

Why All the Bonds?

Why have investors piled into bond funds like his? They didn’t like what was happening in stock funds. With miserable rates on money market funds and bank accounts, some also reach for a little more return by using bonds. Those are safe, right?

They tend to have less risk than stocks. Safer issuers like the US Government and other well-funded entities are reasonably likely to pay off bonds.

What’s the Concern?

Bond prices (not the interest payments or values at maturity) can move up and down over time as they’re traded on markets.

Bond and bond fund prices can suffer when interest rates rise. Think of where rates are now and if they’re likely to go up or down. We can’t know if or when rates will rise or how any investment will be affected, but odds are good that longer term bond funds will face hard times.

Some use “duration” as a way to gauge risk; a one percent rise in interest rates may result in a percentage loss equal to a fund’s duration. If the duration is 3, a 1% rate increase means you should brace for a 3% loss. Sometimes it doesn’t work out that way but it’s a rule of thumb.

There are lots of pictures and formulas here if you want to dig into this.

So What?

Over the long term, it may not matter. But PIMCO Total Return didn’t get to be the largest fund in history by people thinking about the long term.

This may be nonsense, but see what you think:

Stocks lost money in the dot-com bust
People flocked to real estate because it was doing better
Real estate lost money in the subprime crisis
Briefly, people flocked to banks and short term treasuries for safety
People move to bonds because they’re “doing better”
Interest rates will rise someday

Is there a pattern here?

It’s not that you shouldn’t own bonds. Just consider why you own them.

401k Money Markets - Losing Money

2010-03-29T17:27:00.000-07:00

One of the safest investment options in the 401k, some money market funds are losing money.

Increasingly, investors in 401k money market funds look at their statements and find they have less money than they put into the fund.

Negative returns in a money market fund? How can that be? It’s probably not due to market losses. Most money market funds manage to keep the share price at a constant $1 per share.

The cause is low returns combined with fees.

Sign of the Times

It’s hard to make money in a money market fund these days. Interest rates in general are low, and money market fund yields tend to move more or less with rates.

A money market fund is a mutual fund. No mutual fund is without fees. Managers have expenses, and they have to get paid. Money market funds are generally low fee funds, but miserable yields can lead to trouble.

Some money market funds and 401k providers have waived fees or subsidized the funds. Some have recently decided they can't afford to keep it up.

401k Money Markets

In 401k plans, money market funds have to overcome additional fees. A 401k is more expensive to administer than individual accounts, and you may be paying part of the freight.

Fees are not necessarily bad. If you get something of value, you should expect to trade something in return. This page isn’t about high 401k fees; you can find rants about 401k fees elsewhere.

Take those rants with a grain of salt. With a competent and attentive employer, it’s unlikely that your fees are too high. Ask for details if you want them, and expect honest answers. If you get anything else, get advice from the Department of Labor.

Even reasonably priced small 401k plans are seeing money market fund losses. Emphasis on the word “small”. Smaller 401k’s are more expensive than large 401k plans that can buy in bulk, so they’re most likely to have negative returns in the money market fund.

What to do, if Anything

There are several things you can do about money market fund losses. Before doing anything, consider why you are in a money market fund. The funds are generally suitable for more conservative investors and/or those with a short time horizon. Are you one of those? Should you be?

The easiest solution: do nothing and wait it out. If you belong in the money market fund, you’re getting low returns along with a low level of risk. While you’re losing money this year, you didn’t lose 60% a few years ago.

A short period of low-to-negative returns may not have a significant effect on your retirement income (supposedly that’s the goal of a 401k plan). Will it have an effect? Yes. Will it be significant? Only you can decide.

Fixed Accounts

Another solution: use a fixed account. Some 401k plans have a Fixed Account that currently pays more than the money market fund. The account, like a money market fund, is not guaranteed by any government agency; it has some risk, but not as much as the stock market.

Unfortunately, fixed accounts have restrictions. Just when everybody wants to jump into them (right now), interest rates are low. When interest rates rise, fixed-income investments suffer. You probably won’t notice losses, but the fixed account provider is likely to enforce restrictions.

Adding Risk

A third idea is to take more risk, if you're comfortable doing so. Don’t just do it because you hate losing money in the money market fund. Only do it if it makes sense with respect to your goals. You might look for ultra-short-term bond funds issued by strong organizations (like the US government). Longer term bond funds will suffer when interest rates rise.

If you want to spice things up, you can move to a more diversified mix of investments. Your plan may offer a “Conservative” fund that invests in a broad variety of places. You’ll have to look under the hood and decide if it is conservative enough for you.

401k Fixed Account Risks

2010-03-29T16:23:00.000-07:00

The fixed account is a conservative investment option in some 401k plans. Typically found in plans administered by insurance companies, the fixed account is a fixed-income option that sometimes pays more than Money Market Funds.

While the fixed account may be tempting, you should read your plan’s disclosures to understand any risks. Fixed accounts are generally not insured by any government agency; they’re only as solid as the company running them and the underlying investments.

Limiting the Flow

Some 401k providers restrict how much you can move out of the fixed account. Just when you’ll want to get out, you may find yourself locked in. As interest rates rise and the economy improves, other investments including the money market fund may return more than the fixed account.

The rules may say that you can only move a small amount out of the fixed account each year, month, etc. For example, you might be limited to moving up to 20% of your fixed account balance to another investment each period.

That 20% may apply to the entire company 401k plan - not just your own assets! That means one person with a large balance may be the first one to hit the exits and ruin it for everybody else. You’ll have to wait until the next exit period and hope you’re at the front of the line.

If you leave your employer and try to liquidate the fixed account, you can still have problems. Some providers reserve the right to pay your fixed account balance out over 5 years, for example. You’ll earn interest, but you might not be happy about losing control of your money.

Taking a Loss

Another risk of the fixed account is a Market Value Adjustment (MVA). If your holdings in the fixed account are liquidated (because your plan moves to a different provider, for example), you may lose money. Especially if interest rates have been rising.

With an MVA, your 401k provider reduces your balance in the fixed account to reflect losses they’ll take when cashing you out. Your employer might cover the MVA, or it might be your problem. Something to consider before loading up on the fixed account.

How we Pay for Dinner Affects How we Enjoy It

2010-03-21T08:56:00.000-07:00

When you go out with friends, is there a “best” way to pay for dinner? Some people split the bill, some pay for what they consumed, some sneak off to the restroom, and some play gambling games in hopes of getting a free dinner.

There may be a way to pay for dinner that optimizes the experience.

Behavioral economists study how we react emotionally to everyday situations. Some of their research suggests that one person should pay for everybody’s dinner, resulting in the best overall experience for all (assuming the same person doesn’t always pay for dinner).

Pain of Paying

Most of us don’t like to pay. We’d rather get something for free, or as little as possible. Paying makes us feel less happy than not paying.

Consider the experience of a group dinner as it unfolds. This is a fantastic restaurant we’re talking about (with prices to match the experience). Imagine how much you’re enjoying each moment. Assuming all goes reasonably well, you have a nice time. The food and company are good, and you’re happy to be there.

When the check arrives and you pay for your good time, does your pleasure-meter drop a few points? The inevitable need to pay can put a minor damper on our experience in the moment.

We all expect to pay for what we get; it just takes a bit of the bloom off the rose.

Generous people who enjoy treating their friends and loved ones are an exception. They’d prefer to pay for dinner. The rest of us enjoy being treated from time to time, but we realize that you can’t always take without giving.

Give and Take

That realization may provide an answer on how to pay for dinner.

If everybody pays, everybody suffers a little bit. If one person pays, only that person suffers. And they may not suffer much more than they would have if they only paid their share.

Drazen Prelec shows how this might work in a fascinating video on his study of the brain. The discussion of paying for dinner is about 30 minutes in.

The sum total of “good experience” is maximized when one person pays for dinner (and everybody’s remembered experience will be good as well). As long as everybody has to pay sometime, the numbers should balance themselves out.

Which Happiness Does Money Buy?

2010-03-12T18:14:00.000-08:00

There’s always debate about whether or not money can buy happiness. The problem may be we're not clear enough on what we mean by “happiness.”

It turns out there are different types of happiness. How can you decide if you’re happy with your life? Is it what you’re feeling right now, or is it a general sense of how things are?

Experienced and Remembered

Daniel Kahneman sees the two types of happiness, and thinks it’s important to make a distinction when we talk about happiness.

Experienced happiness is a sense of well-being in the present
Remembered happiness is how happy we think we've been in life

The two can influence each other, but they really are different. For a better explanation, see Kahneman’s TED talk: The riddle of experience vs. memory. Kahneman is an entertaining speaker who won the Nobel Prize in Economics in 2002.

Does Money Buy Happiness?

It depends. You’ve probably heard that money does not buy happiness above a certain level. The number Kahneman mentions in the TED talk is $60,000 per year of income in the United States of America, which is about what other studies find.

Above that income level your happiness level may increase, but at a decreasing rate. In other words, earning $120,000 per year does not make you twice as happy as if you earned $60,000; it's nothing to sneeze at but it just makes things a little better.

Kahneman emphasizes that the increase in happiness is surprisingly flat above $60,000. Also, while money does not buy happiness for your experienced self, a lack of money can make things unpleasant.

What about remembered happiness? With higher incomes, remembered happiness increases more dramatically. You can look back on luxuries and experiences that “should” have made you happy, and decide that you actually were.

Which type of happiness is more important to you: experienced or remembered?

Happy Anniversary!

2010-03-09T11:08:00.000-08:00

You forgot? This is the one year anniversary of the market lows of March 2009. The greatest bear market of most of our lifetimes, and hopefully it’ll stay that way.

From October of 2007 to March of 2009, the “stock market” lost almost 60% and some investors lost a lot more.

Do you remember March 9th of 2009? I might; it wasn’t a good day. It pretty much looked like we were done for. Doom and gloom. Heading all the way down to zero. Time to learn how to grow crops and barter.

The next morning, the sun came out and the market went up. And it kind of kept on going up. Up and up for 60-70% gains over the last year. Who’d have guessed?

So What?

Who cares about some statistical nonsense? One year doesn’t mean anything, and we may not be out of the woods yet.

While short term market behavior may be irrelevant, human behavior is always relevant. Think back to that day one year ago. How did you feel and what were you thinking that day? What were you doing about it?

For most people, doing anything that day was a mistake. The old saying “don’t just stand there, do something!” should have been “don’t just do something, stand there!”

However, many were scrambling to stop the bleeding. Some did it a few months before March of 2009, but they didn’t fare much better (when did they get back into the market - if ever?). Investors often lag behind their investments.

The anniversary is not important as a celebration of market gains, but as a reminder of who we were one year ago. It’s a chance to do a postmortem on our thoughts and feelings - and the actions they spurred - during that difficult time.

Of course it was scary. Don't let anybody tell you otherwise.

Still… So What?

So most people (I don’t exclude myself) did and thought wacky things one year ago today. Not “wacky” in a bad way, but in an unhelpful way. Look at what you did and why (be honest now), and learn something.

Were you actually doing helpful things and controlling what you can control, or were you just distracting yourself from the pain and possibly making things worse?

Maybe there’s nothing for you to learn. If so, then Happy Happy Anniversary.

Your Job and Personality - Kind of Important

2010-03-04T18:13:00.000-08:00

A lot of people are out of work looking for a job. Once the economy heats up, people stuck in nightmare jobs will make like a banana and split.

You spend a healthy chunk of your waking hours at work. Do you think it’s important to have a job that fits your personality - or that you can at least tolerate?

If you don’t want to go crazy, the answer is probably yes.

Finding the Answer

So, what type of job fits your personality? It depends who you are, and it’s worth figuring that out before you settle for a paycheck.

Fine, if you need to put food on the table, take whatever you can get today. However, there are large rewards for those who find a job that fits their personality and values.

How do you do it? The classic What Color is Your Parachute is a book that’s helped many to marry their job and personality. You can also do a variety of tests online.

Job Personality Tests

Take the results of these tests with a grain of salt. They can be like reading the horoscope: a bit flattering, a bit insightful, and vague enough to be wrong but still “accurate”.

One of the most popular is the Myers-Briggs Type Indicator. Based on the work of psychologist Carl Jung, the test tries to determine basic personality traits. You can take an abbreviated Jung Typology test to get your personality type here.

Some job personality tests cost money, and prospective employers may require you to take them (but cover the cost for you). Kolbe and Caliper tests come to mind. Ask for a copy of the results. If you’re a student, you may be able to take these tests for free or at a reduced price through your university.

Accuracy

Again, the results may or may not be helpful. The most value you get from job personality tests may be from using them as a starting point. You can rule things out, agree or disagree with the results, and think about who you are and how you might want to trade your time for money.

You might also consider taking the tests at different periods through your life, and when you’re in different moods. Read about the “type” you are, as well as the types you’re not. Compare and contrast. You probably have elements of each type; depending on the questionnaire and your situation when you take the test, different types may be dominant.

Consider taking the time to figure out what job might be a fit for you - even in these tough times. Imagine people who spend lifetimes doing something they hate, and dreading Monday mornings. Try not to be one of those people.

Dollar Cost Averaging Decides when to Invest

2010-02-27T16:31:00.000-08:00

Not sure when to invest? It’d be nice to always buy at the bottom and sell at the top. Once you figure that out, let the rest of us know and enjoy your time on the beach.

It may be that you don’t really need to know the “best” time to invest. It may be that the best time to invest is whenever you think you should make a change and you get around to doing it.

Dollar Cost Averaging

A traditional approach to investing is to use dollar cost averaging. This is a system of making periodic purchases regardless of what’s happening out there.

Example: investing $100/month into a mutual fund - every month.

Month	Share Price	Shares Purchased
1	9	11.11
2	9.25	10.81
3	8	12.50
4	8.75	11.43
5	9.1	10.99
6	9.65	10.36
7	10	10.00

The strategy helps you avoid investing all of your money at the “worst” time - when the market is at its peak for the month, year, or decade. Alas, it also means you won’t buy at the bottom.

Dollar cost averaging takes the emotion out of investing and allows you to simply follow a system. You can dollar cost average over your lifetime or over a few months depending on your goals.

Numbers without the Math

It turns out that dollar cost averaging can make the numbers work in your favor. Make no mistake: you can lose money when you dollar cost average. However, in typical rising markets over long periods of time, it tends to help you out.

Now, if the market only goes up, you should not dollar cost average. You'll miss out on today's low prices and continually pay more for each share. However, you may not know what the market is going to do, and you may not have a lump-sum of money to invest.

Think about the example of monthly $100 investments. As the market falls, your $100 buys a larger quantity of shares than it did the month before. You’re essentially saying “I love it! I’ll take even more now that it’s on sale.” When the market goes up, you say “Eh, I don’t want to buy as many shares this month.”

Actually, you don’t do any of this. It happens automatically through your dollar cost averaging system. You have time to do other, more important things with your life. You also avoid getting bumped off your investment program by your emotions.

So, if you don’t know when to invest, figure out if there’s any reason not to invest right now. Maybe there is, maybe there isn’t. Then, consider if you’d be more comfortable investing some of your money today, and dribbling the rest of it in over time.

Keep transaction costs in mind as you dollar cost average. If you pay a transaction fee for each purchase, you may consider larger and less frequent purchases (quarterly vs monthly, for example).

Extrapolation

2010-02-21T17:16:00.000-08:00

There’s a fancy word for you. Fortunately, you don’t have to be too fancy to do it; almost all of us practice extrapolation when we guess where the market is headed.

Extrapolation is a process of predicting the unknown. We use information we have to make guesses since we can’t know everything about everything.

Example: assume you have some information and you want to make predictions with it. The information might be a chart of the stock market over a long painful decline, say July of 2008 to February of 2009.

At the end of February 2009, there appeared to be a downward trend in stock markets - to say the least. If you wanted to predict the future with that limited dataset (July 2008 to February 2009), you might reasonably guess that the market would continue on down to zero. And we’d all go back to farming…

It sure felt like it.

Another example would be the housing market. Pretty much everybody thought home prices only go up - after all, that’s what they did for years and years.

How We Extrapolate

When we predict what will happen based on limited data (since we don’t have data from the future yet), we extrapolate. Some extrapolation is sophisticated and based on complex math, but that doesn’t mean it’s perfect; investment banks hired rocket scientists to build models estimating risks from falling home prices, and even they missed a few details.

Some extrapolation is more of a gut feeling.

When you date somebody for a few months and they seem friendly, honest, caring, and smart, you may assume they’ll be a good mate. If they’ve been nice for a few months, odds are decent they’ll be nice for much longer. If you have doubts or reservations, eventually you’ll decide whether or not to move forward.

When you assume prices will go up or down based on what they’ve been doing, you’re not running calculations in your head. You’re assuming some momentum will keep things going the way they’ve been going. This is why some people say “I want to get out until things look better”.

Most of us extrapolate with our “gut” when we predict what the market will do. We don’t really know - nobody does. However, we like to find patterns and categorize things: “the market is declining” or “house prices only go up”.

As we imagine the future our drives and feelings emerge (“I’ll be upset if I keep losing money” or “I’d really like to make some money in real estate”). Fear or desire may give us tunnel vision, making it harder to abandon the future we predicted and driving irrational behavior.

It happens to all of us.

The End of Extrapolation

Extrapolation comes in handy, so we shouldn’t abandon it. Cowboys refer to “horse sense”, a state where decisions are made without high-fallutin’ analysis of ridiculous details. It comes in handy.

When you’re driving in the winter and you see that a few cars slid off the road recently, you may extrapolate and assume that conditions are dangerous. It’s more likely that you’ll slide off the road if you don’t use extra caution.

How can we stop when it’s not helpful? I don’t have the answers, but here are a few ideas:

Acknowledge that we don’t know what we don’t know
Wonder why we believe what we believe
Seek answers from objective sources
Identify what role your emotions play in predictions (they are helpful and vital, but not necessarily useful when it comes to business decisions)
Use systems that make it so you don’t have to predict the future (such as dollar cost averaging)

Explore:

Asset Price Bubbles and extrapolation rules

Credit Score = Relationship Score?

2010-02-15T15:03:00.000-08:00

Does a credit score or income predict whether or not somebody will be a good lover? It’s difficult to acknowledge, but they may give insight into your potential partner.

More and more people focus on financial behavior when evaluating mates thanks to the Great Recession. For a long time it’s been said that money problems cause a majority of divorces (although that may not be entirely accurate; money’s more likely an excuse or a symptom).

Your mate’s credit score and income can provide hints about reliability, goals, and financial situation. While mistakes and unexpected life events can happen, a credit score is one piece of data about somebody’s financial behavior.

Insurance companies and employers use credit scores to judge you, and they seem to think it works. Does this work for relationships too?

The Numbers

This year’s “Valentines Day studies” show that singles are more interested in financially secure mates. The results may be skewed due to tough economic conditions and the nature of these surveys, but they’re worth a look.

Singles don’t necessarily want the ultra-rich or a FICO score of 800+, although it wouldn’t hurt. They’re interested in protecting themselves financially, and catching red flags that may reveal personality traits that’ll inevitably lead to difficult times.

In short, yes - money does matter.

See a synopsis of the studies for more details.

So What?

If you and your mate have different financial philosophies or situations, you’d better have great communication.

If you know money will be an issue, bring it up early. Be open and honest about it, and perhaps your vulnerability (along with kindness, charm, sense of humor, and good looks - if applicable) will compensate for your balance sheet.

If you’re on solid ground but you don’t know about your potential sweetheart, figure it out. You can always talk about it, and you can also watch for behaviors that say much more than you’ll get from any discussion. Eventually, you might speak up about your concerns, but asking for a credit report on your first date may be pushing it.

These days, more and more people are in a bad situation. How they handle it - not where they are - should be most important.

Arguments About Money

According to the most recent PayPal study, most arguments among couples were due to money problems. If this sounds familiar to you, double check to make sure you’re really fighting about money. Is there something else going on, but money is the “safe” way to approach it?

If money - and only money - is truly the issue, in what ways will arguing about it help make your life better?

Image by mrhayata.

Better Investments - Worth it?

2010-02-05T14:11:00.000-08:00

Can you reach your goals more easily with better investments? Probably. The hard part is knowing what to use and when.

Better investments might return an extra percent or ten over a given period, or they may have better measurements such as Alpha.

But really, what do you get from chasing better investments?

For many people with long term goals, the answer is not much. As long as you do a decent job setting up an investment mix and use decent investments, you’ve done most of the hard work. The other important part, by the way, is actually putting enough money into those investments over time.

What’s the Point?

Some people want to constantly switch to better investments. They may have better ratings from research companies, different fee structures, or a higher measurement (such as Alpha).

What’s the point of all this switching? To reach your long term goals? A retirement that’s 20 years away? If so, you probably won’t accomplish much.

Granted, anything’s possible. Your activity might yield tremendous results, repeatedly do wonderful things, and have a knack for finding better investments year after year. Just be aware that most people don’t. Your neighbors might not appreciate if you tell them how well you’ve done.

What’s the Alternative?

For long term goals like accumulating funds for retirement, a textbook strategy will often do the trick. Diversify within and among asset classes, and among investment strategies (fine, include a little tactical asset allocation if you want, but don’t bet the farm).

Do a good job setting it up, and don’t change your system unless you have a really good reason to do so. Major lifetime events and carefully considered philosophical changes fall into this category. Something you read in a magazine does not.

Over long periods, chasing better investments can actually harm investors (see Investor vs Investment Returns).

You can’t eat a higher alpha, and an extra percent or few this year is not likely to change your monthly retirement income. Unless you’re working a repeatable system, you’re probably just overworking your brain.

If you insist on chasing better investments, take an honest inventory of your success periodically. Were you successful? Was it worth the time and energy you put into it?

Death Benefits - Annuity Guarantees

2010-01-27T17:34:00.000-08:00

Annuity death benefits are promises to pay something to your beneficiaries.

When you invest in an annuity, the account value may decline if the investments inside lose value. What happens if you die while the account value is down?

It depends on what type of death benefit the annuity offers.

Note: this is part of a series on annuity guarantees.

Some annuities have special death benefits that promise to return your original investment amount (or "premium") - even if the investments lost money since you started. Others take a periodic snapshot (every quarter or year, for example) and you lock in a "high-water mark" if the account value is higher than it was at the previous snapshot. If you die, you get the highest anniversary value.

Of course, some annuities don't offer any of these features; you'll have to look closely to see what each product can do and how to choose death benefit options. There are a million varieties, so read your prospectus carefully.

Drawbacks of Annuity Death Benefits

Death benefits can be valuable, especially if you pass away while markets are down. However, there are some drawbacks.

Death benefit options may cost extra, so your investments have to work harder to grow. The cost may be worth it to you, but you should be aware of the costs and tradeoffs.

The death benefit may also be taxable. When you use pure life insurance, the death benefit is generally tax-free to beneficiaries (but you should always check with a CPA just to be sure). Annuity death benefits are different. The entire amount or just some portion may be taxed, so you might not be able to spend 100% of the death benefit.

Finally, death benefit guarantees are only as strong as the insurance company. If the company goes under, you may not get what you expected. Stick with strong conservative annuity providers to improve your chances.

Explore:

Variable Annuity Death Benefits

Index Fund Investor vs Investment Returns

2010-01-17T09:49:00.000-08:00

Do index fund investors do as well as their investments?

I’m not much of an indexer. For large company US holdings, I could flip a coin and be okay with either active or passive funds. I might come out a little behind or ahead depending on what happens, but I don’t believe it’ll affect my big-picture goals.

In my mind, behavior matters a lot more than investment selection.

Nevertheless, Vanguard S & P 500 index fund investors matched their investment fairly well over the past 10 years. The 10 year average annual return (as of 12/31/09) for VFINX was -1.03%, while the investor return was -0.99%. Investors actually did a little better.

Compare this to those who invested in the decade’s best mutual fund and lagged by 29% per year.

Even in the Best Fund, Behavior Hurt Investors

Is Indexing Better?

It may be tempting to say that index funds are better than actively managed funds because investor returns more closely match investment returns. This may be true, but I don’t think it is.

I’d propose that index investors tend to be less active in general. They believe that “doing stuff” all the time will not help their investment returns. As a result, they pick a program and stick with it. What are they going to do - switch to a better index fund?

They also tend to be fee conscious. Even if a fund manager is beating the market, they may be turned off by the concept of paying higher management fees. “The tortoise and the hare…” they’ll say.

In short, they do less.

The Head Fake

Randy Pausch discusses the “head fake” in his Last Lecture. The idea is that we can benefit from things in ways we didn’t expect. When children play sports, they don’t just learn the rules and motor skills specific to that sport. They learn about teamwork, perseverance, success and failure, strategy, and more.

Index investing may be similar. By deciding to be passive, index investors benefit from staying put in investments and matching their performance. It sure beats lagging behind.

Explore:

Even in the Best Fund, Behavior Hurt Investors

2010-01-16T09:28:00.000-08:00

What if you invested in the best mutual fund of the past decade - how would you have done?

It depends what you did.

The CGM Focus Fund was the top US stock fund over the past 10 years. I have no idea if it’s a good fund or not, but it did better than the others. 10 year average annual returns were about 18% - not bad for a lost decade.

But, you say, that’s only if you invested 10 years ago and stayed put.

Unfortunately, investors didn’t. Morningstar calculates investor returns by analyzing flows in and out of the fund. Take a guess at what you think the 10 year average annual return was for investors.

When to Buy and Sell

Investors always have reasons to invest in a fund and take money out. Some reasons are better than others.

They may purchase shares as part of an automatic monthly purchase plan, or they may buy shares because they saw how the fund did recently and they want on board.

They may sell shares because they need money (or want to rebalance), or they may sell because they think the manager lost his magic touch (or the world is coming to an end).

On average, it seems like good reasons for buying and selling (automatic purchase plans, rebalancing, spending) would not come up at the worst possible time. Over a 10 year period, sometimes timing would be great and sometimes it’d be horrible.

The Cost of Behavior

Investors in the best fund of the decade either have very bad luck or very bad behavior. Investor returns for the 10 year period were roughly -11% per year. That’s a difference of 29% per year. Missed it by a mile.

I’m not saying they’re bad people. I truly sympathize and wish everybody participated in more of the gains.

Each year from 2008 to 2002, investors did worse than the fund. Every year. And averaged out over 10 years. That’s not bad luck.

Not everybody jumped in and out at the wrong time, but it happened enough to mess up the average.

Explore:

Minimum Withdrawal Benefits - Annuity Guarantees

2010-01-14T22:42:00.000-08:00

Minimum guaranteed withdrawal benefits guarantee that you can take a certain amount from your annuity over time.

Your assets may be invested in the markets, giving you the potential for market-like gains and losses, and you do not have to irrevocably give up control of your money. Even if your investments lose money and your contract value evaporates (leaving you with a zero account balance), income does not stop.

This is part of a series on annuity guarantees.

Guaranteed Withdrawal Example

An annuity might provide a guaranteed withdrawal feature that allows you to take 7% of your total investment each year over 14 years. If you’re quick with numbers, you know that 7 times 14 is just about 100. The insurance company guarantees that you’ll get 100% of your money back over 14 years (plus a few months) no matter how investments perform.

During that time, you can always walk away (but watch out for surrender fees before you go). You don’t have to keep your money in the annuity for entire 14 years; that’s just how long you’d have to wait to get the full guarantee. Walking with your money is more attractive if your investments have done well. You can reinvest elsewhere, leave the money where it is, or spend it.

Drawbacks of Guaranteed Withdrawal Features

The main problem with guaranteed withdrawal benefits is that you have to pay for them. You rarely get anything for free, and annuity guarantees are no exception. You have to decide if you think the feature is worth the extra cost, which will erode your assets more quickly than if you didn’t have the guarantee.

It may be worth your money, or it may not. Only time will tell. Without knowing the future, you have to decide if the guarantee will make you feel better, if you can afford it, and if you’re willing to pay even if it turns out that you didn’t need it.

As with all annuity guarantees, the promise is only as strong as the insurance company. Stick with financially strong and conservative companies.

Don’t Just Invest in What You Know

2010-01-05T22:59:00.000-08:00

One of the most quoted bits of investment advice is to invest in what you know.

The theory goes like this: there are things you like; you’ve got horse sense; therefore, if you invest in things you like and are familiar with, you’ll do well.

Do you like a particular kind of car? You might consider investing in the company that builds the car. Do you work in healthcare and think it’s fantastic? You might consider investing in healthcare.

At first glance it makes sense, and it may be a way to get familiar with investing while keeping it interesting (with small amounts of money). However, the strategy has some major problems.

What You Know Can Hurt You

There are several risks with investing in what you know.

Some people invest in their company stock because they like their job and think their company is great. You can expand this concept to those who invest in their industry (healthcare or technology, for example).

What’s the problem? If something bad happens to your job or industry, something bad happens to your investment. Your paycheck disappears, and your investments lose value.

Diversification is Good

Too much dependence on “what you know” violates the rules of diversification. You’ve got some important eggs - your income and your investments - in the same basket. Spreading things around is a better bet.

You don’t know what you don’t know. That’s another reason it doesn’t always make sense to invest in what you know. Let’s assume healthcare is a great place to invest, but you happen to work in the auto industry. Will you miss out on potential benefits of healthcare just because you don’t know anything about it?

To extend that idea, consider investments outside of your country. Chances are you know very little about the potential investments on foreign soil, risks associated with those countries, and intricacies of currency exchange. Is that a good reason to stay away from foreign investments?

The goal of diversification is to reduce the chances of having everything in the wrong place at the wrong time, and to improve the chances of having something in the right place at the right time.

You can’t know everything about everything, so investing in what you know limits your ability to diversify.

An Idea

What can you do? Diversify. See if there’s a reasonable way to get exposure to things you don’t know about. For most people, mutual funds do the trick. Learn how they work, read the disclosures, and decide if a fund makes sense for you. Most broadly diversified mutual funds have exposure to different industries and countries, so you don’t need to dive into sector funds.

Investor vs Investment Returns

2009-12-28T18:25:00.000-08:00

Is there any proof that behavior matters in investing?

One way to find out is to see how investors’ actual returns compare to the investments they use.

A study by Dalbar, Inc has shown year after year that investors don't do as well as their investments. They’d do better if they did less.

Assume that investments are “the stock market”. Investors try to earn market-like returns by investing in the markets, but they generally fail.

Instead, they earn about 7% less per year on average - give or take a percent depending on which year’s study you look at.

For example, if the markets provided average annual returns of 11% over a 20 year period, people investing in the markets might have earned a 4% average annual return. These are just rough numbers, but they haven’t changed much over time. What happened to that 7%?

Bad behavior took it away. The study shows that investors switched investments frequently, and only stayed for relatively short periods of time - three years or so. The idea is to buy low and sell high, not the other way ‘round. However, switching investments frequently makes success less likely.

Sure, emergencies come up from time to time and you may need to sell. But the study shows the problem is widespread. In a world where the TV tells you that you should constantly do something about your investments, it’s not a big surprise.

You can view a summary of the Dalbar study for specifics (yes, it’s a few years old, but the lesson doesn’t change much from year to year).

The lesson: your behavior is important. Get a strategy and stick to it unless there’s a really good reason not to.

Changing the Brain for Financial Gain

2009-12-24T14:01:00.000-08:00

Financial success is partly dependent on making good decisions.

Sometimes it’s hard to make good decisions, and sometimes bad habits sabotage us.

Are you trying to be more frugal? More disciplined with your investments? Develop the mindset of a businessperson? How can you do it if you’ve never been able to do so in the past?

It may all be in your mind. Literally.

Make a habit of paying attention to those things you’re trying to develop. You’ll “exercise muscles” in your brain, and get a little better each time. Just as if you were training to run 5 miles.

Neruoplasticity

See that six-syllable word above? That’s how it happens. The brain can change over time - it’s just a matter of making it change. It won’t happen overnight, and it won’t happen by itself, but you can help make it happen.

As you practice paying attention to your financial behavior - whatever it is that you need to change - you slowly build awareness. Your behavior won’t change immediately, but you’ll build the foundation that allows it to change.

The old saying is “neurons that fire together wire together.” Or, as Daniel Siegel puts it, “states become traits.” As you regularly practice and tune into your goal, you change the structure of your brain - physically - so it becomes easier to reach that goal.

To make it work, you should probably spend time on your financial goals every day. 5 or 10 minutes each day is a good start, and you may not need to spend much more time than that. The more frequently you practice, the better. Listen to the Dan Siegel lecture linked above (or an interview with him) to get ideas on how to be aware of your awareness.

You should eventually develop the “grit” Siegel talks about that helps you overcome challenges. You’ll probably also be aware of thoughts and feelings that throw you off course and lead to bad financial decisions.

Why Bernanke Shouldn’t be Person of the Year

2009-12-20T18:27:00.000-08:00

You should take the title.

Don’t get me wrong. He has a job to do and does it as well as anybody could. He’s been under extreme pressure. Whether you agree or disagree with the philosophy of government intervention, they (including Bernanke) helped create tailwinds that will bring us out of the financial crisis.

In 2006, the Person of the Year was You. That’s right. You.

The concept was that You did amazing things (mostly online):

Created a wealth of content
Provided open source software
Cultivated and enhanced networks and communities
And so on…

I think You should be the person of the year again. Why? You did much more this year.

Instead of creating a bunch of 1’s and 0’s (that's "data" if you're not a geek), you propped up the economy. You pay taxes right? You suffered and watched your friends and family face one of the scariest financial environments in generations. You’ll continue to live with this for a while. What did Ben do besides enlist us?

Is This Just About Investments?

This has little to do with 401k balances and Wall Street bonuses. It’s about human suffering.

Not for TIME magazine, though. For them it's definitely about the investments. What if stock markets didn't bounce some 60ish percent off their March lows? Who would be Person of the Year then?

I’ve spoken with people who run domestic violence shelters. Their resources (contributions and donations) are sharply down, while demand is up. When the going gets tough, some people misbehave.

I’ve spoken to paramedics. People in need of medical help increasingly refuse to be treated because they can’t afford it.

You get the idea. You’ve suffered tremendously, and Ben Bernanke has just been doing his job. Kudos to You - and thanks for working through this and propping up the economy with your tax dollars. Happy new year, and let’s hope next year is a better one.

Does Sugar Affect Your Finances?

2009-12-16T18:02:00.000-08:00

It could - in a variety of ways.

Let’s ignore for the moment that a hankering for sugar can make health care more expensive. Plus, dark chocolate (the good stuff) is not cheap.

Sugar can actually be beneficial to your financial health. How? It may help you make better decisions.

We’ve known for a while that sugar helps us do stuff - think, move our muscles, etc. As we learn more, we see that it can be important in helping us do things we’d rather not do. Some people refer to this as “willpower.”

As we do difficult things in life, we use sugar. What happens if you use a bunch of sugar but you still have some difficult tasks ahead? As you might have guessed, it’s harder to accomplish those difficult tasks. The hurdles get bigger, the wind comes at your face, and the uphill battles seem longer.

This is where your finances come in. Developing a budget, building an investment mix, reducing expenses, and balancing the books are not generally described as “enjoyable.” You won’t do them unless you’re mentally ready to. If you start doing them, your performance will probably diminish a bit over time.

Going to buy a car? Choose a mortgage? Don’t do it when you’re out of gas.

What can you do to make sure you do the best you can at managing your finances? Take your time, be thorough, and look at the big picture. And maybe have a muffin while you’re at it.

I’m not saying you should go crazy, but be aware of your energy levels, motivation, and willpower when managing your finances. If you need to stop and take a break, that’s fine. It may be a great idea to get outside, exercise, and return to the task later. In fact, I’m sure that’s a great idea. However, time constraints may limit your options, and that’s where sugar comes in.

Again, this is not a claim that Sugar Will Change Your Life. However, without sugar in your system, your ability to do things may suffer. You might cut corners, miss details, and call it quits early. What’s the harm in eating something sweet on occasion if it helps you accomplish important tasks?

OK, if you have diabetes or other health issues this may be a bad idea. Get creative and find other ways to make sure you don’t grind down your ability to make smart decisions and manage your willpower.

Explore:

Taxes Affect Your Behavior

2009-10-24T08:04:00.000-07:00

You may think they're boring, but taxes influence our behavior. Through "social policy", the tax code nudges us in different directions - even in our personal lives.

Start with the obvious examples of how policy can work in business. Businesses are encouraged to buy new assets and invest. How? They get to deduct those expenses, and sometimes they get to "accelerate" the deductions for expensive items with long lifetimes.

Let's move one step closer to your personal behavior. You get a deduction for making charitable contributions. What exactly is a charity? It's whatever the IRS decides is a charity. You may or may not agree with that definition, and there's one place where the tax code can conflict with your values.

For example, giving money to a church or university may create deductions. That means a taxpayer gets to keep more money in his pocket while helping a cause he believes in. What about the nonbelievers? They can donate to scientific organizations that do work research religious followers may not agree with. And we run into the same problem.

The subprime mortgage crisis may also be (at least a little bit) related to social policy. There are many other contributing factors as well, but those are for another discussion. In the tax code, homeowners are allowed to deduct interest paid on a mortgage. This makes it less expensive to own a home. Of course, the government wants us to own homes because homeowners stick around and take an interest in their community. Is this good or bad? I can't say.

Just as social policy - in many forms, not just the tax code - may have helped us into the mortgage crisis, it may help us out. Programs like the first-time home buyers credit use the tax code to help prop up housing markets.

In a semi-related story, AIG executives were threatened with retroactive 90% taxation on bonuses. Of course this is an extreme example, but it goes to show that sometimes you don't even know what the rules are ahead of time.

Tax law is used to affect individual behavior in many different ways. Just something to remember as you think about your finances and your behavior.

CD Knockout - Knockout Barriers Explained

2009-10-20T18:40:00.000-07:00

When using investment CDs, you may come across the term knockout (or "knock out").

What is a market knockout on a CD?

The knockout level is where you don't want the market to go. If the market reaches your knockout level, you are "knocked out" of market participation. Instead of enjoying future gains, you'll only receive the "guaranteed return" from your investment CD.

In most cases, the guaranteed return is just that you get all of your money back. If the market went straight down and stayed there, this is not a bad thing. However, market-linked CDs may have long lives, and the market may end up much higher than where it was when you got knocked out.

Even worse, you can get knocked out if the market does too well. In that case, you would have been better off putting your money in the market instead of using a market-linked CD.

EXAMPLE PLEASE

So, how do these knockouts work?

You are market-linked CD is described in various disclosure documents. In those documents, look for the knockout terms. It may be called a "knockout level" or "upper/lower barrier".

The knockout barrier is usually described as a percentage change in me the underlying investment. For example, your market-linked CD may have an upper barrier of 150%, and the lower barrier of 85%. Let's assume the underlying investment (perhaps it's a stock market index) is at 1000 when your CD is issued. If the investment moves above 1500 or below 850, you are knocked out.

If that happens, you'll have to wait until your CD matures to get the "minimum guaranteed" return. In most cases, you'll just get 100% of your money back. If you're lucky, they'll pay you a minuscule interest rate on your initial deposit.

As you can see, your goal is to have the market move up slowly. In an ideal world, it would go up 149% - giving you about as much return as you can get without hitting the knockout barrier.

FUNKY KNOCKOUTS

Knockouts can be simple or complex. You may have one knockout level, or you may have many. Again, you have to read the fine print (ever heard that one before?). The knockout could be 150% from the starting level, where there could be different knockout levels calculated each year.

Likewise, knockouts can be biased towards the upside or the downside. An upper barrier of 200% and a lower barrier of 95% makes sense if you think the market will go up. However, a different market-linked CD may have an upper barrier of 150% and a lower barrier to 50% (a more neutral setup).

You might also enjoy:

Be wary of market-indexed CDs

Investment CDs - The Catch

2009-10-20T18:35:00.000-07:00

Some people wonder if they can get the best of both worlds.

Is it possible to participate in the stock markets without losing your money?

The answer, as usual, is "it depends". You are able to earn market-like returns without losing your money, but there are some strings attached. One way to do this is with a variable annuity that has certain guarantees, and we've discussed those in the past.

Another option is an investment CD, sometimes known as market-linked CDs. These are FDIC insured certificates of deposit that are somehow linked to the markets.

Every CD is different, so you'll have to read the offering disclosures and fine print, but here's the gist of how they work: you win if the market does well, and in the worst-case-scenario in most cases is that you get your money back.

Doesn't sound too bad, right?

It may be a perfect fit. However, you need to understand the drawbacks. Again, you also need to read the fine print and understand what you're buying.

Since the allure of investment CDs is fairly obvious, let's focus on the drawbacks.

You might get all your money back, but you have to wait until the CD matures (which could be several years)

The particular investments linked to your CD may not do as well as the market in general
If the market does too well, you might get "knocked out" and you only get your money back
It is very difficult to sell an investment CD in the secondary market before it matures
Market volatility (up or down) can knock you out, even if the market ends up higher

If you're going to use an investment CD, investigate how you can get tripped up. Make sure it is FDIC insured unless you're really willing to roll the dice.

These products are sophisticated, and they're a perfect fit for some people. For example, if you have the time (many years until you need the money) to take risk that you don't have the stomach for it, an investment CD may give you the potential for higher returns with the peace of mind that comes with a guarantee.

As always, remember there is no such thing as a free lunch. Financial products can help you sleep at night, but you pay a price. With annuities, he pay fees and sacrifice flexibility. With investment CDs, you have to commit and hope the market doesn't knock you out.

For more, see what the SEC says about investment CD products.

Roth Conversion - An Opportunity?

2009-10-12T18:04:00.000-07:00

In 2010, more and more people will be able to make Roth IRA conversions.

Previously, these people were unable to do so because they made more than $100,000 per year. However, lawmakers have temporarily removed this restriction. Some view this as a fantastic opportunity. Is it?

Based on the hype, it's hard to think otherwise. There are plenty of benefits to Roth IRA, which we don't need to go into right now. However, conversion could be a great mistake.

The oddest thing is that people who make more than $100,000 per year are currently in a fairly high tax bracket. If they convert traditional retirement assets to Roth assets, they'll pay dearly. In a way, it is brilliant for the government to offer this "opportunity" - they'll collect nice tax revenues over the next few years.

However, maybe it really does make sense to convert (even if you're currently in a high tax bracket). It depends on what you think, believe, and need. The following factors would make it more attractive to convert:

tax rates are at historically low levels
you don't want to be forced to take required minimum distributions at age 70.5
you believe that tax rates will increase dramatically
you want to diversify the tax status of your money (if you have little or no Roth money)
you want to reduce the likelihood of your Social Security benefits being taxed

However, if the factors above do not apply to you (or not to a great degree), you should hesitate before jumping on the conversion bandwagon.

No matter what your situation, run the numbers before converting. Talk with your tax advisor to see what the trade-offs are.

Like many things, the 2010 Roth conversion opportunity is not an all-or-nothing thing. It may make sense to convert some of your traditional assets, but you don't have to convert everything.

Food for thought:

The Roth Conversion Play
Post-Retirement Roth Conversion
Remember you can make Roth 401k contributions

Did You Rebalance?

2009-07-01T19:36:00.000-07:00

As we reach a new quarter, this is a time when many choose to rebalance.

You also hear about mutual funds changing their holdings for "window dressing" (or making it look like they only own good stuff).

So, what did you do during the recent financial crisis? Did you rebalance when your stock allocation shrunk (violently) relative to your target bond allocation?

For many, the answer is no. We all know that the textbook says to rebalance. But "this time it's different" did not just apply to the causes of turmoil, it applied to our reaction as well. Too many decided not to get their pie chart back into shape and get back to a risk level they once thought was reasonable. Instead, they held tight to see how things would shake out.

What would happen if you did rebalance? It depends. Had you rebalanced at the beginning of March, you'd feel pretty smart right now. Heck, you might even have to re-rebalance and sell some of the stocks you recently bought after taking a 30% gain! Rebalancing sooner and/or more frequently wouldn't have been dramatic, and I'm too lazy to do the math, but I think you'd still have done OK (I'm much more confident that 10 years from now you'd be thanking yourself).

The suffering is not over. Hopefully we've seen the lowest lows that you and I will ever see in our lives, but the market could nosedive again and go even lower. In any case, it probably won't be as smooth as the last few months have been. We won't have a hard time finding bad news in the coming months.

Nevertheless, this is a time to ask yourself what you did - if anything - and why.

Too Late to Sell?

2009-03-05T18:12:00.000-08:00

It feels like a trap down here.

It's probably too late to sell, but who knows. The doom-and-gloomers predict a Dow near 4000 or 5000. Well, we're not too far above that now.

Does trying to sidestep another thousand points or two make any sense? I don't know, but it doesn't feel like it. I mean, the upside potential has to be better than the downside, no?

Of course, I really have no clue what's going to happen, how far we could go in either direction, or when anything might actually happen (or how fast - if it ever happens).

In any case, it's an idea I feel very uncomfortable with but I can't think of anything better: too late to sell?

This might help with an answer. You can ask yourself: what would hurt more - missing out on a potential rebound (if it ever comes) or experiencing further losses?

Partying Like it's 1997

2009-03-03T18:49:00.000-08:00

Stock markets closed at levels not seen since 1997.

I gotta say, I was happy to see 1997 go and I'm not happy to see it come back. Not that it was a terrible year, but I was younger and less developed at that time.

I wish the future was here now. This is tough.

Investments are Not Like People's Lives

2009-02-22T10:49:00.000-08:00

An interesting way to think of Investments is that they are not like people's lives.

When you see investment values heading down, as you may have seen recently, you may assume that they'll continue heading in that direction.

The same was true when investment values went up, right? "House prices never go down". "I don't need 200% in Internet stocks, I'm happy with 40% returns in safer stocks".

It's called extrapolation. We take some information (the most recent information seems most important) and try to make predictions. We assume that if stocks have been heading down, they'll keep going down forever - until they reach zero.

Your Blood Pressure at Zero

We assume that investments are like human life. When your blood pressure heads down towards zero and eventually reaches it, you're dead. Nothing will bring you back, except in a few rare cases where somebody with medical knowledge and equipment can revive you.

Investments are not like that. They go up and down. Just because they're valued (or heading) near zero does not mean they're worthless or that their life is over. For good.

Unlike life, which is subject to physical and biological laws, investments are subject to human emotion. They may seem worthless now, but they may not be later.

Will they ever come back? Which ones will come back? Nobody knows. However, I'm certain that investment values just reflect how buyers and sellers feel today. There will be different buyers and sellers in the markets tomorrow and 10 years from now.

Clean Credit - Can You Clean Your Credit?

2009-02-19T18:36:00.000-08:00

Credit is extremely important. If you’ve got good credit, you can get good loans.

If you’ve got bad credit, the best you can do is get a bad loan – if any. You might also have a hard time getting a job or insurance. Some try to clean their credit to fix things.

There’s no way to clean your credit if you genuinely have bad credit. Sure, if there are mistakes in your credit files you can get those corrected, but you can’t have legitimate items removed.

Rebuild – Don’t Clean Your Credit

The best you can do is improve your credit. Rebuild it. Nourish it and spruce it up a bit. But the process takes time.

First, you might have to wait for negative items to fall off your credit reports. That takes about 7 years. However, they don’t have to completely disappear – as long as you didn’t make a big mistake in the last year or 2 you may not have any difficulties.

You also have to show that you’ve been using credit responsibly for a while. If somebody loaned you money and you’ve been paying just like you said you would, that’s a good thing. Others will be more willing to do the same.

Promises to Clean Your Credit

You’ll get plenty of promises to clean your credit. Most of these are bogus. Nobody can get legitimate information out of your credit files. They may be able to clean your credit temporarily by disputing items, but the items will return – and the credit agencies will be on to you quickly.

Another trick to clean your credit is to apply for a new Social Security Number. Bad idea. Instead of clean credit, you get a dark spot on your criminal record. It’s illegal and not worth the risk.

Lifetime Annuity Income Guarantees - What Are They?

2009-02-13T13:48:00.000-08:00

Some annuity products promise lifetime annuity income. How do these products work, and what do you need to watch out for?

This is part of a series on annuity guarantees.

Lifetime annuity income products help you make sure that you (or somebody you care about) do not run out of money. With a lifetime annuity income guarantee, you get payments from the insurance company for as long as you live – whether it’s 150 days or 150 years.

Option 1: Annuitize for Lifetime Annuity Income

You can set up a lifetime annuity income stream in several ways. The traditional way is to “annuitize” or irrevocably tell the insurance company to make payments for life. You’ll get the highest monthly lifetime annuity income if you take this choice.

If you annuitize, you’ll give up all control over your money, but at least you can count on the income.

Option 2: Set Up Lifetime Annuity Income Without Annuitizing

A newer option is to take a lifetime annuity income stream without annuitizing. Some insurance companies offer something like a ‘5% for life’ product. This promises a lifetime annuity income stream of 5% of your initial purchase amount until you die. Assuming you buy an annuity with $100,000, they’d guarantee at least $5,000 (or 5%) of income per year.

Unlike options where you annuitize, a ‘5 for life’ option allows you to take more or less than the promised lifetime annuity income amount each year. If you take less, there’s more in your account for later. If you take more, you run the risk of reducing future income streams.

You can also walk away with your remaining account balance if you don’t annuitize. You get to change your mind and do something else with the money if you want.

Lifetime Annuity Income Payments

The best lifetime annuity income stream will keep up with inflation. As a result, you should look for options that adjust payments and/or automatically increase your annual payments. Of course, there are always tradeoffs – so adding this feature will take away from something else.

Lifetime Annuity Income Options

You can choose several ways to set up your income stream. You can get lifetime annuity income payments for your life, or for the life of yourself and your spouse. Again, look at the tradeoffs.

Be Aware

As with all annuity guarantees, lifetime annuity income promises are only as good as the insurance company that makes the promise. If the insurance company goes belly up, your income could go away.

Annuity Guarantees – Guaranteed Principal Protection (Money Back Guarantees)

2009-02-12T15:47:00.000-08:00

Some annuities offer a money back guarantee. They might call this a principal protection guarantee or something similar. How do guaranteed principal annuities work?

This page is part of a series on annuity guarantees.

The general idea is that you’re guaranteed to get all of your money back from the insurance company at some point in the future. If you invest in a variable annuity and the investments lose money, they’ll make up your losses and give you all your money back.

The Price of Guaranteed Principal Protection

Of course, there’s a price to pay for guaranteed principal protection. The protection usually comes in the form of a ‘rider’, or an added feature that you purchase with your annuity. The rider costs extra – perhaps .65% per year in increased expenses.

When Will the Annuity Guarantee Pay?

Most guaranteed principal protection programs require that you wait 5-10 years before you can take advantage of the guarantee. You generally can’t put your money in at year 1, see a loss in year 2, and get all your money back immediately. You have to wait until certain agreed upon milestones before you can get your money back.

This gives the insurance company time to let the markets work in their favor. If you could take advantage of every weekly loss, the insurance companies would be out of business fast – or the cost of guaranteed principal protection would get too high.

The longer you have to wait for your guaranteed principal protection feature, the less likely it is that you’ll need it. Losses over 10 year periods are rare, but they certainly happen. It’s extra peace of mind – just be aware that you’re paying for guaranteed principal protection.

What Happens After Guaranteed Principal Protection Pays Off?

In most cases you can walk with the money. You can take it out of the annuity and spend it, you can transfer to another annuity or annuity company, or you can put it into a brokerage or bank account. You may have to pay taxes and/or tax penalties, so talk with a tax preparer before you do anything.

What are the Drawbacks of Guaranteed Principal Protection Annuities?

The main drawback is the cost. However, there’s no such thing as a free lunch, so you might feel that guaranteed principal protection is well worth the cost. There are plenty of examples when you would have come out more than ahead with guaranteed principal protection. There are also times where you would have wasted the money. Think of it as 'market loss insurance' and decide if it's worth the cost.

Another thing to watch for is the period of time that you have to wait. The guarantee only applies if you can wait long enough. If you need to cash out early, you don’t benefit from the guarantee.

You should also make sure you only use strong insurance companies. The annuity’s guaranteed principal protection promise is only as good as the company making the promise. If the insurance company goes belly up, your guarantee goes away.

Investment History – How to See Investment History in Technicolor

2009-02-11T10:17:00.000-08:00

So how do you get a view of investment history by asset classes?

An easy way to see how different investments have done is to view a Callan Chart. The Callan Chart shows investment history for each year, and different types of investments are displayed from best to worst.

Callan Charts are especially handy for showing investment history because they are brightly colored. By looking at one, you’ll see that the best performing investments change from year to year.

You can go to Callan’s website to see the chart including 2008.

Callan puts together a nice chart, but some of my favorites include alternative asset classes such as REITs, commodities, and a classification for “Diversified Portfolio”. As you might imagine, the diversified portfolio emerges as a decent looking option – typically around or above the middle, but never at the bottom. The bottom is bad.

So, if you say “what does investment history tell me about the coming year?”, check out a Callan Chart. The answer: not much.

Annuity Guarantees – What Kind of Annuity Guarantees are There?

2009-02-10T18:42:00.000-08:00

Annuities are complex beasts. One reason they’re popular is the variety of annuity guarantees. One reason they’re unpopular is cost.

If you put 2 and 2 together, you may be able to see that annuity guarantees cost money. If you don’t need the guarantee, don’t spend the money. However, if you want annuity guarantees, figure out if you’re getting a good deal.

Types of Annuity Guarantees

In the coming days, we’ll discuss some of the most popular annuity guarantee programs that are currently offered. In general, we’ll discuss:

How Good are Annuity Guarantees?

You should be aware that all annuity guarantees are only as good as the insurance company that offers them. If the insurer goes belly up, your guarantees may be gone. Therefore, only do business with strong insurance companies.

If you see marketing and promises for annuity guarantees that are substantially ‘better’ than the competition, proceed with caution. The company may be making promises that it can’t keep, and it may be buying up market share in a way that will leave customers hurting someday in the future.

Jobs Will Get the Job Done

2009-02-10T10:09:00.000-08:00

Boy, is it ugly out there.

600,000 jobs lost, and an unemployment rate headed towards double digits. Unfortunately we're probably not at the end. Jobs are a lagging indicator, so they'll continue to suffer until after all the financial bleeding has stopped.

In fact, plenty of companies waited until after the new year to begin the process of cutting jobs, and some of those numbers aren't even included in the February report. Watch out for that jobs report in March!

The economy seems to rest on employment. We all know (or most of us believe, although there are some doom-and-gloomers out there) that the world is not coming to an end. We may believe that the stock markets will come back someday, and that there will be a job available for most of us down the road.

However, it's just scary today, and jobs are compounding the problem. We've talked about the spiral of fear - you hear about job losses, you think you might be next, you spend less, companies make less, companies have to cut jobs, and so on....

We gotta keep people employed. I don't know how, but it seems to be the factor that can tip us to one side or the other of disaster.

Borrow Against IRA - How do I Borrow Against my IRA?

2009-02-07T12:32:00.000-08:00

When you need to get a loan, sometimes you need collateral. People often ask, "can I borrow against my IRA?"

Technically, you can not borrow against IRA accounts. However, lenders often ask what your IRA account balance is. Why do they care if you can't borrow against an IRA?

In most cases, the lender wants to understand what type of safety buffer you have. If you were to fall on hard times, you might dip into your IRA (or other retirement account) savings to make your loan payments. It may be a better alternative than defaulting on a loan.

Even though they ask about your IRA balances, you're still not borrowing against your IRA. The account is not collateral, and the lender cannot force you to pay out of your IRA. In fact, IRAs and other retirement accounts are generally protected from creditors.

Creditor protection does not keep them from asking. If you've defaulted on a loan, you may get calls from collection agencies telling you to liquidate your IRAs and other retirement accounts to pay the bill. They're allowed to ask, but they cannot force you to liquidate the accounts. You didn't borrow against the IRA, so they have no rights to it.

Borrow From IRA – Is IRA Borrowing Allowed?

2009-02-06T16:21:00.000-08:00

Some retirement plans allow you to borrow against your account value. The question becomes, can you borrow from IRA's?

IRA borrowing is not allowed. However, you can do a few things that are very similar to IRA borrowing if you're in a cash crunch.

IRA Borrowing in 60 Days

If you want to borrow from your IRA, you can do something that is technically not a loan but accomplishes the same purpose. You need to be careful when you try to borrow from your IRA - check the tax laws and ask your tax advisor before you use this strategy.

You can effectively accomplished IRA borrowing by doing a 60 day rollover. With this strategy, you take a distribution from your IRA and return the funds to the account within 60 days. Although you don't technically borrow from your IRA, it will feel the same to your checkbook.

Again, you have to be careful. You're only allowed to do this one time per year, and you really should consult with your tax preparer to make sure you're not going to get in trouble with the IRS.

Borrow from IRA vs Borrow from 401(k)

Note that when you borrow from a 401(k) plan, it is actually a loan. You have an interest rate and repayment schedule. However this type of loan is not a feature of IRA accounts. It's not even a feature of all 401(k) accounts - it's an optional feature that your employer can choose to include or not.

Recession vs Depression

2009-02-04T17:48:00.000-08:00

“A recession is when your neighbor loses his job. A depression is when you lose your job”.

How true it is. So much of the economic crisis is based on fear and uncertainty. The closer it hits to home, the worse the definition. While talking about the dilemma of spending vs not spending, we can see that fear will help us spiral our way on down to depression. However, you can't spend recklessly...

As news of job cuts builds, so does fear. It keeps getting closer and closer to home. I've personally seen a major loss in income - and it hurts - but fortunately the rug has not been completely pulled out from under me. I hope the same is true for you.

I always thought Ronald Reagan said the thing about neighbors losing their job, but it sounds like maybe Harry Truman said it first. Let's hope we get a post-Reagan-like recovery (without the bad stuff of course).

The Japan Recession - Comparison

2009-02-03T17:04:00.001-08:00

Some are comparing current economic trouble in the US with Japan's recession in the early 1990's. Somehow I like hearing this comparison better than comparisons to the Great Depression.

There are certainly some similarities. A real estate bubble preceded a crash in all of the same asset classes we've seen get crushed. Japan was rich, and the living was good - until the music stopped.

Just like now, there was nowhere to hide. Bonds, commodities, real estate, and other non-stock-market assets have all lost value. Generally you'd think that you can diversify your way out of severelosses, but it just ain't always the case. Gold has held up reasonably, but it's been volatile and certainly lost money for a lot of investors.

Fortunately there are some promising lessons. NPR's Planet Money show featured Adam Posen, an author who has studied the Japanese recession extensively. He notes that a few mistakes that the Japanese government made, which prolonged the pain.

Views differ depending on who you ask, but Posen says that the recession should have lasted from 1992 until about 1995.

The government announced that taxes would increase in a few years - perhaps hoping to be nice and cushion the blow by giving advance notice. If you believe that higher tax rates will slow an economy, you can see why this was a bad idea.

The other problem is that the Japanese government did not deal with problems in the banking system. Banks held toxic assets on their books (like they do now), but the assets were allowed to fester for years and years. As banks got weaker, they got into a "nothing to lose" mentality and made continually worse decisions.

Instead of stimulating the economy by cutting taxes, spending, and lowering interest rates, the government let the problem get worse. They did not hold the banks' feet to the fire (not that we're doing much of that right now), so the banks never really got stronger.

Finally, leadership changed and the Japanese government started a huge stimulus program. Within a year, the Japanese economy started to recover. Of course, some of the recovery could have been the natural course of things, but Posen suggests that policy was the real lifesaver.

The Planet Money intverveiw is quite good. It's brief and down to earth, but we don't hear enough detail on how the Japanese government should have handled the banks.

To Spend or Not to Spend

2009-02-02T19:47:00.000-08:00

That is the question.

Right now, the world is full of fear. People and businesses are hitting the brakes and becoming tight fisted with their money.

In a way, that's a good thing. Being out of touch with reality is partly what got us into this mess. However, a complete lack of spending will help us spiral farther and farther down to a very ugly place.

By spending less, companies make less. When they make less, they have to cut costs and jobs. When we see job cuts, we worry about our own jobs and reduce spending...

The idea reminds me of Keynes' theory on the Paradox of Thrift. The main difference between now and the 'good old days' is that thrift and frugality may actually help us a little bit (even though it results in lower profits and potentially more unemployment). By saving more, people are stuffing money into the banks. The banks have been weak, and new deposits can only help. I just don't know if a little frugality is enough to shore up the banks - I suspect that it's not.

So, while part of our economic problems are undoubtedly financial and are all about the numbers, another part of our problems are due to fear. I don't know the way out of it, but something has to reduce the fear in consumers and businesses so that they start to spend reasonably and responsibly.

1099R And Roth Distributions

2009-01-31T12:40:00.000-08:00

One of the advantages of a Roth IRA is that you can take your contributions back without owing taxes.

In other words, if you put $2000 into a Roth IRA and it grows to $3000 in value, you can generally take $2000 back out of the account without tax consequences.

Roth 1099R - Only Taking Back Contributions

People are often surprised when they received a 1099R for a Roth distribution when they've taken out less than they've contributed. In their mind, the distribution is not taxable, so there's no reason for a 1099R form.

This is similar to the anxiety people feel when they get a 1099R after doing a 401(k) rollover.

Unfortunately, you'll still get a 1099R when you take less out of your Roth than you've contributed. The institution that holds your account leaves it up to you to determine whether or not the distribution is taxable. In other words, it's between you and the IRS.

Reporting Roth Distributions

To make sure that you do not have to pay taxes, you have to properly report everything to the IRS.

When you take your contributions back out from a Roth IRA, use form 8606. The form will ask what your "basis" in the account is. There, you'll report your contributions, and you can compare those contributions against the amount you took out. This helps you show the IRS that you're just taking your own money back.

1099-R And 401(k) Rollovers

2009-01-30T15:25:00.000-08:00

You may have done a 401(k) rollover recently and received a 1099-R in the mail. Is there some mistake? Will you owe taxes on the transaction?

1099-R Anxiety

A lot of people think that they should not receive a 1099-R on a 401(k) rollover. The thinking is that they've rolled the money directly to another retirement account, so the IRS should not be involved. Most people panic when they see the 1099-R because they think they'll owe income taxes.

In fact, you will receive a 1099-R when you do a 401(k) rollover and it's not a mistake. The investment company that held your money is required to send the form. If you roll the money over to another retirement account (such as an IRA, 401(k), 403B, etc.) you generally won't have to pay any income taxes.

Reporting 401(k) Rollovers on 1099-R

The important thing is to make sure that the 1099-R was prepared correctly. If you did a rollover, you should look in box number seven of your 1099-R. Ideally you will see the letter "G" in the box. If so, they have correctly reported the transaction as a rollover.

Errors in Reporting 401(k) Rollover

If you do not have a G in box number seven, you may have a problem. They may have reported the distribution incorrectly, and this could cause headaches for you. Find out how they coded the distribution and what it means for your taxes.

You may be able to fix the situation with a phone call. It's important to be proactive if you discover an error - if you wait you'll just forget all of the details of the transaction, who you talked to, and where things could have gone wrong.

How to Report 401(k) Rollover

To handle the transaction on your tax forms, follow the IRS instructions. If you have questions, talk to a tax adviser. They can help you avoid costly mistakes and get it done quickly.

Track Your Spending with Your PDA

2009-01-27T17:55:00.000-08:00

I hate budgeting. It's difficult for me to keep track of where I spend money unless I charge something on my credit card. If I do that, I can download transactions and categorize them to see where all the money goes.

Cash, other hand, is more difficult to track. Fortunately I rarely use cash, and I've started to use a system to keep track of my spending.

Capturing Cash

Here's an idea on how you can track your spending using your cell phone or PDA. Every time you spend cash, enter the transaction as a new calendar entry or something along those lines.

I use Windows Mobile, so the quickest thing to do is create a new appointment on the calendar. And make it an all day appointment, and enter the dollar amount and description. The idea is to make it as easy as possible to get the information into a spreadsheet (or some personal finance software allows me to slice and dice the data and track my spending).

Comma Separated Values

For each transaction, I make an entry that can be easily entered into an Excel spreadsheet. So, if I spent five dollars at Starbucks, my appointment title is "5, Starbucks".

Using the comma allows me to divide information into different columns in Excel. After you sync to your desktop (sorry - no ideas for you Linux or Mac users) you can drag and drop calendar entries from Outlook into Excel. So you'd have a cell in Excel that says "5, Starbucks". Using the Text to Columns feature in Excel, you can have the dollar amount ($5) in one column and a description (Starbucks) in the next.

Of course, you can add as much descriptive information as you want by adding a comma for each column you want in your spreadsheet. You might include the date, the person you're with, and so on.

An Honest View

By watching my cash spending, I hope to have a more complete view of where my money goes. I'm trying to be more honest with myself about how I spend, and cash spending is a mystery. Hopefully this gives you an idea you can use or tweak.

You can get some more ideas on budgeting tools and technology from LifeHacker.com. They mention GnuCash on this page, which I use and like (because it's free).

Dow Points - What Are Stock Market Points?

2009-01-26T16:35:00.000-08:00

Stock markets have been especially volatile during the last year. We've had more significant moves in the markets during the past 12 months than we've had in the past 25 years. Now that's something to give you gray hair.

When we hear about market moves, we hear them reported in "points". What are market points?

Dow Points

Perhaps the most famous indicator for the market is the Dow Jones Industrial Average. Now, it may not be the best market indicator - but it gets a lot of press. When you hear the news each night, you'll hear that the Dow went up or down by X number of points. What are these Dell points?

Market points are simply an easy way to communicate market movements. You add up the value of all the stocks in a group, and divide the sum by another number. Let's look at Dow points for an example: since there are 30 stocks in the Dow, you add up the share price of each stock, and divide by 30.

Divisor Division

Unfortunately, the process is not so simple. Due to changes such as stock splits, you have to adjust the divisor (30 in the example above using Dow points). The divisor may have started at 30, but it constantly changes over time. At the end of 2008, it was 0.125552709.

To find out the current formula for calculating Dow points, you should visit the Dow Jones & Co. website for updated numbers. They also have more details and history on the Dow.

Marketplace Decoder: Market Points

Roth 401k - What is Roth 401k?

2009-01-22T16:00:00.000-08:00

More and more plans are offering Roth 401k. Is Roth 401k right for you?

How Roth 401k Works

Roth 401k is similar to a traditional 401k plan. However, your contributions go in after-tax. Therefore you don't get a deduction (or reduce your taxable income) when you make contributions to a Roth 401k plan.

Why Use Roth 401k?

The main reason to use Roth 401k (or a Roth IRA) is to try and pay taxes and lower bracket. If you believe that tax rates today are lower than they will be when you take funds out in retirement, then Roth 401k is a good idea.

Another reason to use Roth 401k is to have more predictability when you take money out of your retirement account. Assume you have $100,000 in a traditional 401k. You will not deal to spend all $100,000 because it's all pretax money. You have to pay income taxes on your distributions, so you might expect to only have $70,000 or so to spend. With Roth 401k, you'll be a little spend all $100,000 if you can take the money out tax free.

Why Avoid Roth 401k?

It could be that Roth 401k is not a good fit for you. A few reasons include:

You need to reduce taxable income
It is difficult for you to make sufficient contributions to get the maximum company match
You're in a relatively high tax bracket because you have a high income

What Would Make Tax Rates Change?

Tax rates might go up and down for several reasons. You should evaluate these possibilities when deciding whether or not Roth 401k is right for you.

The obvious reason for a change in tax rates is a change in your income. If you are relatively highly paid, you're presumably in a higher income tax bracket today. In retirement, you may take less income than you earn today, putting you in a lower tax bracket. In that case, Roth 401k would be a bad idea.

On the other hand, You might have a very low income today. Perhaps you're just starting out and you're very young. If you save aggressively, chances are that you'll have substantial retirement savings by the time you get older. You can pay the income taxes today at a fairly low rate, and take your money out tax free in retirement.

Finally, tax laws will change along with politicians. Remember that you will be saving for retirement for many years. With any luck, your retirement will last many years as well. If you retire at age 65, it's very possible that you'll take distributions for 30 years. During that time, tax rates will rise and fall as the political pendulum swings back and forth. You should consider this as you decide how much (if any) to contribute to your Roth 401k.

Roth 401k Contributions

How do you contribute to Roth 401k? if your plan offers a lot of 401k feature, you can decide how much if any to contribute. In 2009, the maximum 401k contribution is $16,500. You can put all $16,500 into Roth 401k, or you can mix and match by putting a portion of the $16,500 into a traditional 401k. Maybe you split it 50/50 - who knows?

Does Roth 401k Have Income Limits?

In the past, you may have been prevented from making Roth IRA contributions because you make too much money. This problem is eliminated with Roth 401k. As long as you are eligible to contribute to the plan, you can make Roth 401k contributions regardless of your income. Of course, if you are a Highly Compensated Employee there may be limitations on how much you can contribute if your company fails discrimination tests.

A Roth Curveball

Keep in mind that we don't know what the future brings. Some people prefer a bird in the hand versus two in the bush. In this case, some might prefer a guaranteed deduction today versus the promise (which could be broken) of tax-free distributions at retirement. As we said before, lawmakers may change tax laws and make Roth 401k contributions a mistake.

For example, the nation could move towards some sort of consumption tax such as the Fair Tax. In that case, distributions from traditional retirement accounts would not be taxable - and people who made those contributions would have enjoyed reduce taxation when making contributions.

As you evaluate Roth 401k, as with most other personal financial decisions, you need to remember that we have no idea what the future brings. The best we can do is make some assumptions and reevaluate over time.

Money Funds at Record Levels

2009-01-22T07:03:00.000-08:00

With recent stock market turmoil, people are scared. And there's nothing wrong with being scared.

However, investors seem to forget what their goals are. Many decided that they wanted to be on the riskier end of the risk/reward spectrum and invest in stocks - at least, that's what they thought before October of 2007.

Now, many of these 'investors' have run for the exits. They've put money in money market funds, CDs, and other 'safe' investments. Treasuries have even sold with negative returns, meaning investors are paying the government to hold their money - just because they know the government will be able to give it back.

My question about these safe investments: Safe from what? Not inflation. We've seen time and time again that riskier investments outperform inflation, but you have to put up with the risk.

Just when the going gets tough, people change their minds. They effectively change their objectives from wealth accumulation to emotional calmness. A few people can actually admit this and say "I know I'm doing the wrong thing, but I'm getting into cash". Most people don't - they just get mad.

Money market fund, treasury, and bank holdings are at record levels. Historically this means that the future returns from the stock market will be higher than average. Who knows, this time could be different and I can't predict what the future brings or when it'll bring it. But if this time is anything like every other time, lots of people are going to miss out.

It's Hip to Be Frugal

2009-01-21T19:13:00.001-08:00

Ahhh, for the days of gluttony.

Remember eating out all the time, sipping expensive drinks, and buying anything that looked fun? How cool was that?

Unfortunately, it wasn't so cool. In fact, it's a bit early-2000's if you ask me. Frugality is the new cool and everybody's doing it.

There's a difference between being frugal and cutting back for a while. When times get tough, anybody can cut back - you slam on the brakes until a few paychecks come in, and then you go full speed again. But frugality - that's a lifestyle choice.

With the economic meltdown, it's a choice that more of us are making. Job losses, pay cuts, and fear in general will do that to you. Hopefully we can all view it as a good thing - frugality requires a discipline and authenticity that's been lacking in the American consumer for years.

In a way, it's kind of cool that frugality is becoming hip. Of course, there is such a thing as too much frugality. After all, we gotta prop up the economy. So don't get too crazy OK? Everything in moderation.

And take the opportunity to see if spending is really your problem, or if you've got bigger issues - like you're not working as much/hard as you should. Yes, it's hard to earn more, and spending too much is the #1 problem for most people, but you should explore all the possibilities.

What Caused the Subprime Mortgage Crisis?

2009-01-21T18:49:00.001-08:00

A lot of things.

Poor risk modeling, greed, fraud, a desire to keep up with the Joneses, regulation, a lack of regulation, and more....

I can't claim to explain everything, but I know that there was a lot of denial involved. With a greater acceptance of reality (and the basic laws of math) we wouldn't be in this mess.

Homebuyers accepted something that was too good to be true. Yes, we all believe "I'll earn more later and be able to afford it", but it's often not the case. The myth of just a little more is common, but dangerous.

Mortgage brokers hung their clients out to dry. They may have thought they were doing them a favor by helping them get the a dream house, but do you think something nagged them in the back of their minds? Did they say "this really isn't right, but I'm going to do it anyway"?

Politicians made it easier for bad borrowers to get loans. They turned a blind eye to weakness at Fannie and Freddie. Is this the only time they've ignored problems to avoid rocking the boat? What are they afraid of?

Banks... I could flip a coin. On the one hand they probably had no clue what they were doing when they built toxic assets such as CDOs and CDSs. On the other hand, maybe somebody was hip to the scheme.

Investors, like homebuyers, took a deal that was too good to be true. AAA rated bonds with a high interest rate? Something had to be wrong, but as long as the music never stops who cares?

In the end, it was a bunch of people out of touch with reality. They did not step back and listen to their gut feelings. Some folks, like Warren Buffet, had the horse sense to stay away from something foreign and scary. However, most people took what they could get while the getting was good.

Now the chickens have come home to roost. Once again, it shows that it's always better to do what's right in the beginning so you can avoid heavy consequences later.

What is Feeling Financial?

2009-01-21T18:41:00.000-08:00

Welcome to Feeling Financial.

This blog is about personal finance and the mind. The main focus is on personal finance topics, but we'll keep a close eye on how psychology plays a role in our success or failure.

Our thoughts, feelings, and emotions are extremely important to our financial lives. Most of the mistakes we make are due to psychology (although quite a few of them are a result of ignorance - not knowing how things work).

This blog will explore and demystify how we make personal financial decisions, what the media is doing to help or hurt us, and how we can do a better job.

Money can't buy happiness, but it can make our lives easier. Financial stress leads to emotional stress and mistakes, and personal stress leads to financial stress and mistakes.