Too Many Carrots?

I came across a great article today that I felt compelled to write about.  The piece, Life and Taxes, was written by Yaron Brook for Forbes.  First, I would like each reader to stop for a moment and consider all of the impacts taxes have on your day-to-day life and on your financial decisions.  The most obvious effect of taxation is the large chunk of income tax withholding that drains cash from each paycheck.  Almost certainly you will recall the property tax, sales tax, FICA tax, gas tax, and sin taxes too.  What Dr. Brook made me realize is that taxes actually have a much larger impact that just draining away your money.

Taxes are a means for the government to control the people.  How is that possible you say?  By rewarding the behaviors that the government deems moral and punishing the behaviors that the government deems immoral.  There are carrots (ie rewards) for buying a home (mortgage interest deduction), saving for retirement (401(k) and IRA), having children (dependent and childcare deductions), and getting an education (Lifetime Learning Credit, Hope Credit, etc).  There are also penalties, extra taxes, for driving a car with poor gas mileage (guzzler tax) and smoking and drinking (sin taxes).  On the surface it appears that influencing or regulating these behaviors is indeed beneficial.  Instead, I would agree with Dr. Brook that in fact this system is terrible for both the individual and society as a whole.

For example, how can it be bad to incentivize saving for retirement?  The simple answer is because it distorts the free market mechanics of the economy.  A better answer, and the one I focus on, is how it affects the individual.  As a person intent on saving for my retirement I am going to save, invest, and prepare for the future no matter what.  Now, because there is a government tax structure called a 401(k) it controls my behavior.  Rather than select the investment brokerage I prefer, I am instead effectively handcuffed to a single provider.  To get my tax break I am forced to pay a third party, which I did not select, management fees and commissions.  Without this government intervention I'd be free to pick the lowest cost, best service provider and likely keep more of my money.  The market place would respond to the increased freedom and choice given to the individual and in response companies would compete for my business. 

Under the current system I am also limited in the investment vehicles available to me.  Mutual funds, often with high costs, are the investment of choice in most 401(k) plans.  The government and its retirement tax legislation discourages novel investment ideas and exotic asset classes.  I am also restricted as to when, why, and how I access my own money.  Again the government controls my behavior and my money by using the 401(k) legislation and the carrot of tax deductions.  There is also a stick, to punish me, should I need to spend my own money before I reach the government designated age (59 1/2).  Clearly early retirement is discouraged and the system is weighed against it.  There is in fact, an illusion created by the system that everyone should work until the designated age.  Why?  It could be because it is good for the government but not necessarily for the individual. 

Furthermore, not everyone has access to a 401(k) account.  This skews the system of rewards further by punishing people who fit outside the accepted worker/drone role that the government overtly encourages.  How many people would be more apt to take a different job, become an entrepreneur, or work as an independent consultant if the 401(k) system did not tip the scales.  The same is even more true when we consider the tax incentive toward employer centered health insurance.  Look at how much this government tinkering distorts our life choices!  I am an employee less because that is what is best for me, but more because the government has created a tax system to pigeonhole me into that role.

There is even an entire legion of white collar professionals that exist solely to deal with the implications of the tax code and our governments policies of taxation.   Accountants, tax preparers, IRA custodians, 401(k) plan providers, human resources benefits experts, and the entire IRS exist solely to execute this government moral agenda.   If there was a vastly simplified tax legislation none of these people would be needed.  In fact, most personal finance blogs too would have very little to talk about too if the government would butt out of our personal spending choices.  No more headlines like: 46 Tax Deductions that Bloggers Often Overlook, My 401(k) to IRA Rollover Decision Process, or Bush Proposes Health Insurance Tax Reform.  We could stop spending so much time reading blogs and analyzing the tax implications of our finances and simply make the best choice for us, as an individual.

There are dozens of other examples:  buying too much house, having too many children, being content with underemployment, paying inflated tuition, being less productive (work less) because of punitive tax rates.  These are all symptoms of tax policies which steer individuals to fall in line with the government determined ideal.  The conceit that government can better decide than individuals is at the heart of this issue.  Dr. Brook and I are in agreement that we are more than capable of making decisions for ourselves without any government meddling.

It could also simply be the unintended consequences and unfortunate side effects, but it all distorts the market none the less.  The more I learn the more I wish government would stay out of my finances and let us use our freedom to make our own decisions about what is right for our money.

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Anecdotes from the Downturn

CNN Money is running a series a short stories from those who are struggling financially.  In total there are 26 articles that cover a diverse mix of Americans.  The common theme is that broad swaths of our population have been hit by hard economic times.  However, all of these stories remind me how important it is to recognize the difference between a collection of anecdotes about individuals economic hardship and statistically important analysis of the whole economy.

After reading through all of the anecdotes, the most common hardships are job loss, health problems, and single parent households.   What struck me is that even in good economic times these problems are very real and likely to hurt the prosperity of ANY household.  As it turns out, unemployment is still at solid levels historically speaking, less than 5%.  A net loss of 63,000 jobs in February may significantly impact individual families, but it has almost no effect on the broader economy.   The past nine months of the credit crunch have not made it any harder to be a single parent or any more likely for health to prevent someone for working. 

There also seems to be a big difference in the outcomes for those who have prepared themselves and those who are oblivious to the basics of personal finance.  Simply having an emergency fund and a college degree can insulate most people from the threat of unemployment.  Those who have a degree are less than half as likely as the general population to become unemployed and with a graduate degree or beyond it is less than a 2% chance of becoming unemployed. Finally, if you have little or no debt, there is almost no risk of having significant hardship during a downturn.  Even part time work can put food on your table as long as you don't have debt payments getting in the way.

Another observation I have made recently is that the media, in all of its forms, is fixated on the bad news rather than the reality of the situation.  By reporting on the misfortune of a tiny subset of the population, it skews our confidence in both the system and our own prospects.  We empathize with those who are struggling and worry that we may be next.  By reporting the monthly job data with a headline of 63,000 Jobs Lost in February rather than Unemployment Remains Virtually Unchanged at Historic Lows a reporter gets more attention but also puts a huge spin on the "news."  While the spin may sell more papers and drum up more readers, it is not a good basis for making financial decisions.

Another observation I made is that not everyone on the series was actually struggling.  One profile is about a middle class family with a self employed bread winner.  They bought a house they could afford with a 30 year fixed mortgage and have taken personal responsibility for their financial future.  Future tax increases are their biggest financial worry.  Another profile covers a couple who are nearing retirement.  They have saved diligently and lived a life within their means.  Their biggest financial concern is not about today, but rather the impact of loose fiscal policy and Wall Street shenanigans which may eat into their buying power.  These people are responsible with their money and are in a position to prosper in the future.  Their worries about politics and economic policy are ones that I share, but because of their good financial choices they are far ahead of the game.  Even in tough times they are likely to have a roof over their heads and food on the table.  It is simply a question of whether they will live "the dream" or "just get by."  That is a good problem to have.

The point of this post is to point out that there are reasons that some people are struggling and others are not, and very little of it has to do with what is found in newspaper headlines.  Rather than worrying about national or global economic conditions we should instead focus on the things we can control: living within our means and making good life choices.  If we do that individually then there is little need for pessimism or doubt about the future.

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How High is Inflation Really?

If we stop at the gas station to fill up the tank it is obvious that prices have done nothing but go up, up, up these days.  What is even more worrying is that it isn't only fuel costs that have skyrocketed.  Two years ago it would cost about $100 for a trip to the grocery store.  This would provide all of the staples for two weeks.  In a month, the total bill would be about $250.  Lately I am budgeting $300 a month and finding that I consistently go over budget.   It isn't a scientific measure by any means but it feels to me like my buying power has dropped by as much as 25% in two years.  How is that possible?

The official figures for the Producer Price Index, which measures the cost of goods at the wholesale level, rose 0.3% in February and 1.0% in January as reported by Forbes.  Year over year inflation clocked in at a 6.4% rate.  This trend seems to be accelerating to an annual rate in the neighborhood of 7.8% for 2008 based on the most recent readings.  Of course, the policy makers and talking heads bring up that "core" inflation increased at a 2.4% rate year over year.  Core inflation my @$$.  The core inflation rate excludes the cost of food and energy, and be honest, that is completely idiotic.  Exactly what matters to the average person is the cost of FOOD and ENERGY.

Now, what do these inflation numbers mean to you?  It means that if you haven't gotten a 6.4% raise in the last 12 months that you are loosing ground, going backwards, in the earnings game.  Are you in line for a 7.8% raise in 2008?  If not you should start planning now for how you will cut your spending and reduce fixed expenses.  The money won't go as far as it once did and something has got to go.  I feel fortunate, in that it is very likely I will get a raise during 2008 that will be somewhere around 4-5%, but my plan to increase my Roth IRA savings by half that amount (2.5%) may be sidelined in the effort to keep up with rapidly rising prices.   If that is happening to me, I know it is happening to many people all around the country.  We will be the lucky ones; I don't even want to think about how tough it would be to face this inflation on a fixed income.

Another important note is that I have heard a great deal of chatter and online commentary that inflation numbers (which already appear elevated) from the Labor Department are still understating inflation.   I am not prepared or qualified to debate the issue of exactly what the rate may be, but obviously it could be a scary time we do indeed return to double digit inflation as some have suggested.  The bottom line is that inflation has reared its ugly head and if it is 5%, 10%, or 15% it will play a big part in the economic story of the next several years.

Now I want to point out that the media and the government are often wrong about these things as much as they are right.  There is also a component of self fulfilling prophesy whereby the more we talk about high inflation the more it happens.  I don't want to be a Chicken Little and add more fuel to the fire so here is my advice, "prepare for the worst but hope for the best." 

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I Am a Perma-Bull

In case you have missed the latest development in business news, Bear Stearns Companies Inc has brokered a deal with JP Morgan Chase to be purchased for $2 per share. At the start of 2008 the stock was trading at $88 per share. This deal is expected to rock the global financial markets and completely crush the stock price of the financial firms. It is likely to be very ugly.

On the flips side of this pain there are two great ways to find profit. First and the method I plan to take advantage of is to continue to invest into the broad market indexes and dollar cost average more money into the market. This route will profit when the market recovers.

The other way to profit from this situation is to delve into more complex investment concepts like options or short sales. I personally tried to buy put options on BSC (Bear Stearns ticker symbol) this evening. Unfortunately my broker requires an additional signature on paper in order to add options trading to my account. With a small investment (and a high level of risk) an outsized profit can be created from large drops like Bear is certain to experience tomorrow.

This post is not intended to a complete primer on options, but briefly a "put" option is the right to sell a security at a given price during a fixed period of time. What that means is that the purchase of a put option is a bet that the price of a security will fall. As of Friday's closing price BVDOE.X is a BSC put option with an exercise price of $25 and March 19th expiration. These options are priced at $4.10. That means to make a profit the stock would need to fall below $20.90 ($25 - $4.10) before March 19th. If the Bear falls to the $3 range I would predict, one $4.10 investment could generate a $17 profit. That is a pretty sweet return for one day, but as the market opens it is almost certain that the cost of the options will skyrocket and remove most of that potential return for everyone but the fastest movers.

I do not endorse this specific investment for all people in all situations! It is important to note that options are a risky business and there is a decent chance that your entire investment can be lost. If the stock does not go below the $25 strike price the entire investment is worth nothing. Also, it is important to note that these prices and estimates are approximate and the product of my personal analysis, be sure to do your own analysis before investing. All of that said, $4,100 invested at Fridays closing price could turn into $17,000 in a single day. Wow!

I'm a bit bummed that the market is likely to tank but it is important to know that there are always ways to make money. Keep investing in the market and in the long run you won't regret your steadfast decision. For more information about these topics I recommend more reading:

Bear Stearns Options at Yahoo Finance
Market Watch News Coverage of BSC
Investopedia Options and Futures Articles

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Frugality Making a Come Back?

While reading through my long list of online news sources I found an interesting article that I felt merited some further analysis and discussion.  The article Why America Has Too Many Stores from Slate.com talks about overbuilding and dropping consumer spending in the retail sector.  In real dollars, after adjusting for inflation, sales were down over 2007 for the first time in years.  At the same time, strip malls and shopping plazas have sprouted up all over the cityscape (and Main Street USA too).

I can certainly see this trend in our neck of the woods.  My wife started working a part time retail job at a brand new upscale development when it opened back in December.  This complex has about 60 high end stores like Lucky Jeans, J.Crew, and Anthropologie.  While visiting my in-laws over the weekend we noticed that a new collection of big box stores anchored by a Super Target and Circuit City that popped up a few miles from their house too.  There were also several other large retail projects along the inter-state that we drove past during our trip which have all been completed in the last two and half years since I started regularly driving the route to their house.  I'm sure that something has to give, either the consumer gives in to the temptation or there will be a massive overstock of retail space. 

Aside from making me reluctant to sink any cash into commercial or retail focused REITs, the ultimate take away from the piece was a question of whether frugality might be due for a resurgence.   The popularity of personal finance blogs and the host of books rail against consumerism makes me think there may be something of a sea change coming in the spending habits of many Americans.  The Freegan movement seems to be an extreme anti-consumerism response that even seems to be gaining ground (and press coverage). 

The article seems to doubt the staying power of the trend in reduced retail buying stating, "The eleva­tion of frugality into a virtue seems likely to last about as long as modern recessions do—about eight months."  What struck me most about this quote is the idea of frugality as a virtue which certainly fits with the current trend I've seen in the blog-o-sphere.  The Boy Scouts (I'm an  Eagle Scout) may have something with the inclusion of "Thrifty" in the Scout Law.  I fully support the spreading frugality and thrift and indeed elevating it to the level of a virtue.

While I don't see a sweeping change that will fundamentally change the wider economy, an eight month breather seems too conservative an estimate of the impact of these changes.  If an additional 10% of the population increased their cash savings rate (which is near zero) up to 10% it would decrease GDP by as much as $93.8 billion a year.  That is only 0.7% of the total economy but it isn't a trivial sum either.  The survivors of the Depression were fundamentally changed for a lifetime, and while I certainly don't want to see that type of suffering ever again, I hope that some of Gen X and Gen Y can permanently incorporate frugality into our lifestyle.

As always, comments are welcomed.      

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Tax the Unhealthy?

Lazy Man and Money was kind enough to ask me to contribute a guest post.  I was happy to oblige and today the post went live.  Please check out Tax the Unhealthy? (Part 1).  Be sure to read the post and check out the debate in the comments.  Check back tomorrow to see Part 2 and again later in the week for a possible rebuttal on the other side of the debate.

Welcome to those who are new to Aspire 2 Wealth.  This blog was started to chronicle my path to wealth and keep me moving forward toward my goals.  I share my detailed personal finance history and articles on the topic of personal finance.  Be sure to check out my Millionaire Rules Series, Archives, and subscribe to my RSS feed.  Thanks for stopping by.

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Class In America

I stumbled onto a special feature from the New York Times about Class in America. It seemed like a good follow up to my post last week about Wealth Porn. I learned some interesting things by reading the articles and running some numbers in their tools. First, based on the How Class Works calculator I rank in the 74th percentile of Americans. My education and salary both push me high up the scale while my net worth brings me down a good bit. If I put my parents on the same scale, they both have masters degrees and make upper middle class salaries; they are at the 90th percentile. I think with enough time I will catch up to them, but I think it is unlikely for me to surpass the level of my parents. I started near the top and I have followed in my parents foot steps.

Another graphic shows income mobility in America from 1988 to 1998. It clearly demonstrates that a number of people from the very bottom are able to rise to the very top of the scale. It also shows that those in the middle and lower middle ranges have an equal probability to end up in any of the income categories with about half improving their standing. However, this does not mean that everyone has an equal likelihood to end up at the top. Only about half of those in the lowest group are able to move up the scale. Those who had the early advantage of starting in the top bracket continue to populate about half of the of the top bracket 10 years later. Thus, it is equally likely for someone at the top to fall as it it for someone at the bottom to move up. That seems to me like the American Dream is alive and well.

Some of what I read was encouraging. Some of it made me think. I recommend everyone take a minute to read some of the content and explore the tools. Comments about class in America and class mobility are welcomed.

I have been featured in the following carnivals lately that I would like to share with you:

• Carnival of Personal Finance hosted by The Financial Blogger
• Carnival of Homeowners hosted by Homeowners Insurance Lowdown
• Festival of Frugality hosted by Mighty Bargain Hunter

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Income for Life - What Are Your Chances?

Today I'm going to write my second installment in a series about generating an income for life from your nest egg. The first installment was all about generating income from bonds. That posts brings up two huge risk factors to creating a life long income: 1) inflation and 2) volatility.

Inflation is the term for the upward trend in prices over time. Do you remember when gas was a quarter? I don't because I'm too young, but I do remember when it was less than one dollar. I miss the days of $0.99 gas, but inflation has left that price in the dust. There was also a time (so I'm told) that a hamburger, fries, and a coke was only a quarter too. In other words, prices on everything increase over time.

The second risk factor for generating lifetime income is volatility. In layman's terms, volatility is unpredictability or randomness. From one day to the next the stock market can be up, down, or flat and there is no way to accurately and consistently predict which it will be. Sure the broad trend is for markets to go up, but that does not hold for short time frames. The implication of this randomness is that over short periods of time (even years) the market can return significantly less (or significantly more) than the often quoted average.

If all of this is unclear I'll use a few examples to try and help. My first example is a man Jack who retires with a tidy $1,000,000 today. He knows that a conservative mix of stocks and bonds has historically returned 6.0% per year. He then decides to withdraw at the start of each year 6% (or $60,000) on which to live. If we first consider inflation, after 10 years the $60,000 withdraw will now be worth only $45,000. Jack has seen the value of his money drop by 25% in only 10 years! If this process continues for 10 more years Jack will only be able to buy $33,000 worth of goods with his original withdraw. The value and purchasing power of his retirement savings will continue to drop every year.

Now, lets again consider Jack and his $1,000,000 nest egg. We will still assume his mix of stocks and bonds returns an annualized 6%, but now we see that in any given year he can have volatility of 9%. That means each year his returns will be anywhere from -3% to 15%. If Jack starts out with a string of good years and the size of his nest egg will initially go up; Great! he is now in a position where he can withstand an occasional bad year and still maintain his income. However, if Jack starts off with a few bad years (or even mediocre years) near the beginning his nest egg can shrink quickly. Lets say the first year Jack's return is 5%, then 0%, then 9%, and then 10%. The average of these four returns is 6% which would seem to point to a withdraw of $60,000 per year. However, look at what actually happens:

	Nest Egg	Return	Income
Start	$1,000,000
Year One	$987,000	5.00%	$60,000
Year Two	$927,000	0.00%	$60,000
Year Three	$945,030	9.00%	$60,000
Year Four	$973,533	10.00%	$60,000

As you can see after only four years the value of the portfolio has declined 2.6% and Jack's annualized return (even without income distributions) was 5.93%. This effect is called variance drag, where the volatility produces a real return that is less than the average rate of return. It can become even more pronounced if you were to start retirement shortly before a stock market correction in which you could see 30% or more of your nest egg disappear in a couple of bad years. Even without a crash, volatility pushes down the real return of your portfolio so that there must be a significant cushion built in to sustain withdraws over the typical 20-30 year retirement.

I recently came across a great resource to help understand how the effects of inflation and volatility will affect your probability of running out of money during retirement. This tool is called FIREcalc. It is a free calculator that uses the real historical data from the stock market to determine the likelihood of success for obtaining retirement income for life. The way it works is to take an initial assumption about the size of your nest egg, the amount of income you intend to withdraw each year, and how long you need the money to last. Next real historical data from the market is used to project what would happen if you had retired in each year from 1929 to the present. Each of these hypothetical retirements is calculated to determine if the money would run out before the assumed time period. You can see if your strategy would have made it through the Great Depression and the 2000 Tech Bubble and still be able to meet your income needs.

When the previous example about Jack and his $1,000,000 portfolio is plugged into FIREcalc it reveals some scary results. With a $60,000 annual withdraw and a 23 year life expectancy (such as age 62 to 85) the result is a 64.9% success rate out of 114 trials. Simply put, in 40 of the trials Jack ran out of money before he hit 85. The tool is based on real life data, and it clearly shows how volatility and inflation are able to sink a seemingly robust retirement portfolio. If you lower the annual withdraw to $40,000 or 4% of the total, the success rate jumps to 100%. In other words, in the entire history of the market you would not have gone broke during your retirement if you keep withdraws down to 4% per year.

I spent some time running dozens of scenarios since I discovered this great tool and I recommend everyone take some time and do the same. You can learn a lot about the your realistic chances for retiring with income for life. For another take on this topic that comes to very similar conclusions using a different approach (a statistical model called Monte Carlo analysis) check out this article called The Retirement Calculator From Hell. Also be sure to check back with Aspire 2 Wealth to follow my path to wealth and read more articles about personal finance.

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Is the Market Rigged?

Ben Stein, a lawyer, economist, actor, and commentator wrote an article for the New York Times that was published yesterday titled Can Their Wish be the Market's Command. It alleges that the direction of the stock market can be (and is) controlled by the elite and powerful of the investment banks and hedge funds on Wall Street. I will readily admit that the market is not rational and does not always function as a perfectly efficient market. I see this illogical and emotional movement of the market manifest itself in the bubble and bust pattern that appears several times throughout history. I have difficulty wrapping my mind around what seems to be a paranoid conspiracy theory to explain these periods of irrational market behavior. My problem is that I respect Ben Stein and he lays out at least a logical and plausible case for this supposition.

The basic premise of the article is that despair is a virtually bottomless pit. When stocks drop there is a massive money making opportunity for those who might set off the downward stampede (and place the applicable bets). The power of this despair fueled selling is that, while money can be made on unbridled optimism, it is limited by the available funds sitting on the sidelines of Main Street America (once the market has gone up there is no more money to push it higher). As the market falls, the right investment can pick the pockets of individual investors all the way down to zero.

I've covered the what and the why of Mr. Stein's theory, but more importantly HOW might this be done. The primary tool utilized by a small number of people who are attempting to drastically move the market would be the media. Ben writes that at any given time, facts can be found to support both buying and selling a particular stock. In fact, for every stock transaction there is both a buyer and seller. One believes the stock is worth more than its current value and another believes it is worth less. All a stock manipulator would need to do is use rumors or selective facts to create more sellers than buyers. Convince the masses through the media and the sellers will materialize.

The other way markets can be moved downward is again based on creating an imbalance of buyers and sellers. If an institution or hedge fund sells a large chunk of a security (particularly ones with low daily volume) the price will drop. If the everyday investor sees the start of this precipitous drop, they too will be include to "get out while the getting is good." This mass selling can be coupled with a short sale (selling borrowed shares with the plan to buy them back later at a lower price) to profit from this induced panic.

If the two methods are combined, the powerful effect can indeed decimate A STOCK. It is more difficult to see this happening on the entire stock market worth roughly 50 TRILLION dollars. Manipulating the market as a whole would require vast amounts of money and a great deal of media-hyped fear. The depth and breadth of resources needed to complete this task brings to mind Occam's Razor (briefly: simplest explanation is the most likely solution). Conspiracy theories are far from simple. A final knock against the large scale manipulation of the stock market is that this behavior is patently illegal. The SEC looks out for manipulation of this kind and actively punishes (include fines and jail time) those associated with market manipulation.

One great message I took from Ben Stein's article is the fact that, "Stated reasons are often not the real reasons." In other words, the markets may not move for the superficial reasons that are given by the media (or bloggers too for that matter). On any given day the commentators are quick to explain away the movement in the market because of a move in the price of oil or the blow out results reported by XYZ firm. These assertions are weak associations and NOT causal relationships. What that means is that news headlines rarely have the data and statistics to back up any of their expert opinions.

I took away from this article and researching this post several important lessons that I will keep in mind for all of my future investing decisions: (1) Completely free markets can and will be abused. (2) Ignore the day-to-day and even month-to-month movements of the market; it is all just noise in the system. (3) Invest broadly to keep you exposure diversified and manipulation potential limited; I use index funds. (4) Ignore the media! They don't know what they are talking about any more than does your neighbor or hairdresser. (5) Conspiracy theories are often silly, but may reveal interesting truths.

I hope you enjoyed reading this post. Please subscribe to my RSS feed and check back soon.

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$1,200 Out of Thin Air

What would you do if $1,200 appeared in your bank account out of thin air? How about $600? If most American's answer this question honestly, we would admit that our money is spent on "things." Extra cash is rarely used to advance our financial situation. Windfalls trigger a psychological reaction in most people that makes them feel like the money is more expendable or somehow less important than regular earnings.

A windfall is currently in the works for most Americans. According to media reports legislation will soon be passed for an economic stimulus package that will provide a tax rebate $1,200 for married couples, $600 for single filers, and $300 for each child in the household. Filers which were exempt from federal taxes but had earned income of $3,000 or more will receive $300.

I am not a (trained) economist but here is my "back of the envelope" analysis of the efficacy of this proposal. For every rebate dollar that is spent, America would need to grow the economy that much, plus the interest rate from the treasury bonds that it issues to cover the national debt. If the goods bought by consumers with the rebate mirror that of the broad economy approximately 6.15% of the total funds will flow outside the United States via the trade imbalance ($800 Billion trade deficit / $13,000 Billion GDP). For a $150 Billion rebate plan, domestic spending would then amount to roughly $140 Billion. The the interest rate for the borrowed money is roughly approximated by the 30 year treasury rate, which as of today was 4.36%. The overall result is that in order to break even the domestic economy would need to sustain a 4.6% return on the $140 Billion spent on US goods over 30 years in order to break even.

I was highly skeptical when I first read of this plan for a number of reasons, but as it turns out creating the needed 4.6% return is historically very realistic. It would seem that borrowing money to increase consumer spending at current rates may in fact be a bargain. While it may not fix the immediate credit crunch, slumping real estate market, or a broad recession this plan can have some positive effects.

I know that I will be sure to make any windfall I receive a part of my total financial plan to pay down debt, save for retirement, and build my emergency fund. I will also take about 10% and guiltlessly buy myself a new toy or gadget. I mean hey, spending helps the economy right?

* Update 2/11/08 *

The stimulus package has been passed by both the House and Senate in a form nearly identical to the one outlined in my original post. The primary change is that retirees on Social Security and disabled veterans are now included in the bill and will get rebate checks too. The bill is set to be signed into law on Wednesday. I have not changed my overall position, that this move will be beneficial to the growth of our economy. If you have an opinion please feel free to add comments below.

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Ignore the Stock Market Pain

Right now I am feeling the stock market pain. Since my January Net Worth Update my investments have taken a beating. I am down a little over 4% in a week. That is on top of a 3.5% loss during the month of December. Pundits and prognosticators are predicting a recession, run away inflation, and a plummeting dollar. Is now the time to move money into bonds and cash to stop the pain? Absolutely NOT!

I follow a few simple rules that let me sleep at night even as the market nose dives:

1. Diversify
2. Buy the Market through Index Funds
3. Dollar Cost Average
4. Invest for the Long Haul
   

Diversification means to own assets (and asset classes) which tend to move in different directions. A non-exhaustive list of possible asset classes includes: foreign stock, domestic stock, corporate bonds, government bonds, real estate, and commodities. I have spread my investments over all of these categories so that when one drops the others may go up to keep the total portfolio stable. By always keeping a diversified portfolio, I won't feel the need to move all of my money in and out of stocks with market gyrations. Jumping between asset classes almost always means selling stocks after they have fallen and buying bonds after they have increased in value. That is the exact opposite of the buy-low-sell-high strategy that makes money in the market.

I own index funds rather than individual stocks. There are two benefits to this strategy, the first is diversification which comes from owning hundreds of different stocks so that one bad apple can not cause a large loss. For example, the S&P 500 includes the stock Courtrywide Financial Corp (CFC). This company is at the heart of the current subprime mortgage debacle which has created much of the recent pain in the US market. The stock has lost 57.54% of its value in the last 3 months. During this time the S&P 500 has only lost 3.33% (source). An index fund captures the growth of the whole economy while muting the damage done by the few stocks that crater.

The second benefit of owning the index is that it removes the requirement for active management also known as "stock picking" from the investing equation. While most of us like to think we are "smarter than the average bear," only a tiny minority of investors are able to beat the index for extended periods of time. Index funds gain most of their advantage by reducing the taxes, management fees, and turnover expenses that come from actively buying individual stocks. Check out this article from Consumerism Commentary for more about why index investors get better returns.

Dollar cost averaging is the process of investing in small amounts on a regular schedule. If you have money invested into your 401(k) with every paycheck, you are dollar cost averaging. This process helps me ignore the pain of my current losses because I know that when my next payday arrives I will be buying up more stocks for less money. If the market drops, it is a buying opportunity for me to load up on more shares for the same money. In effect, stocks have gone on sale.

Finally, I am investing for the long haul. I have roughly 38 years until I retire, which is a LONG time for stock prices to recover. In fact, I will probably see several long bear markets and maybe even a crash or two between now and retirement. However, because I know that my money will be left to grow for decades there will always be time to recover. I will also keep in mind that as my time horizon shrinks it will be time to gradually move my money to a more and more conservative asset allocation with more bonds and cash as my retirement approaches.
Use these four rules and you end up with a huge nest egg no matter what the market does this week, month, or even over the next couple of years.

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Inflation and Falling Dollar and Recession... Oh My!

It would seem from reading the business pages of any newspaper that we are currently facing an economic triple-threat. Most journalists sound a lot like Dorothy from the Wizard of Oz, "Lions and tigers and bears! Oh, my!" My situation now is to try and separate the sensationalism from the level headed analysis, then more importantly decide what to do about it.

I worry about the ability of the Federal Reserve, Treasury Department, and our Federal Government to think long term (as I have). The Fed has shown through their recent actions that they may be willing to cut interest rates in response to turbulence in the equity market and the President (and several other interventionist officials) have proposed bailing out home owners that took out foolish mortgages. It seems that these people are all for capitalism up until it comes time for people to pay the price for their risky behavior.

Very few people realize that inflation is the largest risk factor most investors face. The time horizon for accumulating retirement assets is approximately 40 years. In that time a tame inflation reading of 2% annually will decrease your spending power by 220%. Inflation over the last century has been on the order of 3.25% annually (source). Over 40 years that rate would cut your next egg by 359%. Here is the real kicker, the current inflation rate is listed at 4.3% from November 2006 to November 2007 (CPI data source) and many feel this is grossly understated because it omits food and energy (two areas that have had the most run-up recently). If this rate continues, a dollar today will be worth less than $0.20 when I retire. Based on these numbers I worry that today's leaders are sacrificing the long term value of my investments and the security of my retirement for the sake of a bail out for Citibank and John Doe adjustable-rate-mortgage-holder.

Last week my portfolio took over a 3% nose dive. Taken at face value, it seems like all of the doom-sayers could be right. However, the conclusion I have come to (disclaimer: I am not giving financial advice. Seek the advice of a professional) is that the markets and economy will work out just fine. That is, IF our leaders are willing to make the choices that safeguard our long term economic system. This can only happen if we stop the bail outs and rate cuts that can undermine the system. I will keep buying stocks and investing. I am not going to change a thing just because there is turbulence and volatility. I hold a diversified portfolio of assets which will smooth out the sharp dips. In the long run, stocks produce great returns for investors. I sure hope I'm right...

Please leave comments on this post to let me know what you are thinking about the current economic turmoil. Subscribe my my RSS feed and remember to check back to see how I do on my path to wealth.

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