Your Brain Makes Building Wealth Hard

One of the first steps to overcoming a challenge is to recognize there is a problem. If you do not know where your stumbling blocks lie it is often impossible to achieve the results you desire. In the wealth building process there are multiple challenges, but one that many people don't recognize is your own brain. Our brains developed to do a great job helping us hunt, gather, and reproduce. Unfortunately our brains are not particularly suited to the challenges of creating wealth.

There is [relatively speaking] a new field of study called Behavioral Finance. The basic idea is that investing decisions are made by people, and people are influenced by psychology in addition to the pure numbers of the markets. In fact, investors (being human) are subject to quarks of neurology, biochemistry, and evolutionary anthropology which in turn influence all of our money decisions.

So, now that we realize that there is more to investing than just the numbers, what does that mean? First off, it means that your brain is not always aligned with your aspiration to build wealth. In many cases your brain can drive you to do the wrong thing with staggering regularity. The best example is the tendency to sell your investments (in panic) during a market downturn.

Everyone knows that to make money a person must "buy low, sell high" but in practice most investors jump on the bandwagon when the market seems to go up, up, up and then sell to stop the pain as the market falls. What is the result? The average investor buys stocks when they have already gone way up and sells after they have dropped. This is a "sell low, buy high" strategy that will loose money every time. Why then do some many people follow this pattern?

The short answer is people "feel" the pain of a loss in the market much more strongly than they "feel" the joy of a gain in the market. Think about this, if you have saved a nest egg of $200,000 which would effect your emotions more, gaining $20,000 or loosing $20,000. The vast majority of people are more emotionally impacted by the loss. In order to stop the pain, they sell the stock. This effect is call Myopic Loss Aversion and has been studied and documented in the majority of people, professionals and amateurs alike.

Behavioral finance relates to several other important ways in which your brain sabotages your finances. It has uncovered important data about why people have such a difficult time saving, budgeting, and investing for the long term. It turns out we are nearly all subject to a Stone Age era inability to evaluate the benefits of long term returns versus instant gratification.

Centuries ago it was much better to have a bird in hand (to eat tonight) than to wait a few weeks or months to be able to eat two birds. If you starved now, doubling your "investment" isn't worth anything (you'd be dead). This is one key reason our instincts fail us when it comes to evaluating market returns. Market bubbles and crashes are another example of psychology creeping into our investing reasoning (and reaping havoc).

In other words, behavioral finance has some impact on nearly all aspects of our financial lives. Now that we know there is a problem, lets do what we can to create wealth for ourselves in spite of our brain.

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I Missed Out on a 517% Single Day Return

Yesterday I wrote about the Bear Stearns buyout announcement.  Had I been able to put in my options trade for BSC last night it would have worked out to a fat 517% return in mere seconds at the opening bell this morning.  As predicted the stock fell from $30 a share to $3.20 per share.  The March 19th puts with a $25 strike price went from $4.10 up to $21.20 in a matter of seconds at the open.  If I put in my order overnight I may not have gotten my trade done at the perfect price but I almost certainly would have still tripled my money.  My investment of $4,100 could now be worth $21,200.  I missed this boat this time, but it is still nice to know I made the correct call and would have made out like a bandit if I'd had the foresight to get my brokerage account approved for options trades.  Next time I won't be caught ill prepared. 

Please read last night's post to fully understand the how, what, and why of the options investment.  It will explain thing in more detail. 

I'd also briefly like to touch on the shady nature of this whole deal (which of course I was more than happy to try and cash in on).  It has also come to light that there were a number of very suspicious trading trends in BSC and its options in the 7-10 days preceding this announcement.  For example, there was a surge in volume for the $30 strike price March 19th options about a week ago that defies most logic.  The price charged from $0.65 to $3.25 and then to $4.10 in the week leading up to the announcement.  This very odd for an option that is both set to expire this Friday and way out of the money.  People who had caught wind of a potential crash would be the only ones likely to bid up the options to that degree and explain the sizable spike in options volume. 

Look for the SEC to investigate the sweetheart deal JP Morgan is getting ($2 per share is only $0.02 on the dollar based on 4th quarter 2007 equity of $11.7 billion), the potential insider trading, and the possible accounting fraud or mismanagement that led to such a massive destruction of shareholder value.  That's all for now.  Thanks for reading.

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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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Oops. Net Worth "Fix"

I jumped the gun last week to update my net worth.  It was the last day of the month and I went ahead and posted.  Well... those who follow the markets day-to-day may have noticed that Leap Day did not turn out so well for stocks.  I lost 2.14% off my 401(k) and Roth IRA portfolios and had to revise my February results downward a tad.  As a result my investments were nearly flat for the month and I have have now adjusted my net worth downward by about $350. Oops.

Now, what is important is that this little hiccup doesn't really bother me.  Other than for record keeping purposes I try not to even follow the day-to-day movements of the market.  I turn 25 later this month so my retirement is still decades away.  That long time horizon means that this 2% drop is nothing but an opportunity to buy more stock "on sale."  I don't know where the market will be tomorrow, next week, or next year, but I do know it will be higher - much higher - in 40 years.  That is all that matters.

Lets all close our eyes, cross our fingers, put saving on autopilot, and check in once a year to rebalance.  Our future selves will thank us for our good habits and resolve.

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Peer to Peer Lending: Neat Idea, Bad Investment

I first learned about peer to peer lending almost two years ago when I came across an article about Prosper.com. I immediately got fired up about how the power of eBay was going to be brought to the world of finance. I could not wait to dive in and make my first loan. But I didn't. I never made a loan, and here is why: peer to peer lending is a bad investment.

I know lots of people in the personal finance blog world are hyping up this paradigm shift in lending. They write post after post about how it works, how to get started, and how they personally invest in peer to peer. Now for the big shocker... the bloggers are getting paid by Prosper and Lending Club (the two primary companies in the field). I'm not trying to say that everything they have posted is tainted and trying to mislead the reader, but their motives are not 100% pure either. Some bloggers are more honest or at least less naive about these companies and their product, and others seem to write nothing but a puff piece full of hype. Some bloggers are very clear and up front about how they are paid for advertising, referrals, and in some cases pay-per-post. Others stick to the marketing material and disclose that they get paid with a referral, but do not offer a balanced review to go with it. None of the reputable, best-in-class bloggers have done this, but some even hide the fact that there is any financial relationship with these vendors, all while collecting sizable cash by steering their readers to a poor investment.

Why is peer to peer a bad investment? There are several reasons. The first and most obvious is the default rates for borrowers. A default is when someone you loaned money to stops paying, and obviously that is terrible for the health of your investment. While there are ramifications for borrowers who default, it is somewhat limited. First, their credit score will go down. We all know the importance of a good credit score, but many people do not know or do not care. Next, a collection agency assigned by the vendor (term I will use for Prosper.com or Lending Club) to get back your money. This is not the mafia in old New York, so there will be no broken knees or threatening visits for defaulting. Laws are very strict about what the collection agencies can do, and it isn't much. These folks also charge a fee for their services that comes out of any funds the collect. Finally, there is no real property that secures the loan. It is not like a mortgage where you can take their house or a car loan were you can take their car. Compare this with corporate bonds which are backed by the real assets of a company. If they default a judge can liquidate the company and return the proceeds to bond holders. That will not happen with a peer to peer loan.

So what is the real risk of default. It happens rarely right? Unfortunately that is not the case. For the highest rated AA loans on Prosper.com 1.75% of the investing return was eaten up by defaults on average. In total 0.15% of all AA loans had stopped payment and another 1.66% were late. That means for about 1 out of every 666 loans the borrow has completely stopped paying the loan and 1 in 60 are late. Remember this is for the creme de la creme of borrowers, those rated at AA.

Now I'm going to rattle off the amount of return lost to defaults for the other credit grades: A - 4.76%, B - 7.45%, C - 10.78%, D - 10.58%, E - 16.52%, HR - 21.48%. Those numbers seem pretty high right? To make any money at all you have to charge some pretty stiff interest rates, even for moderate risk borrowers. The actual average returns for loans in each credit grade are as follows: AA - 8.14, A - 6.95, B - 5.92, C - 4.77, D - 7.83, E - 4.49, HR - (0.74)%. Those returns do not look that impressive to me. I also learned in basic Econ 101 that as the risk of an investment goes up, an investor should earn a higher return to compensate. It seems that instead, as risk goes up the real return goes down. There is no risk premium for loaning to poor credit borrowers. As such, DO NOT DO IT!

Peer to peer loan returns aren't better than the average return of the stock market. They aren't better than the average return of many corporate bonds either. In fact, you can get a bond from Toyota that is AAA rated with a yield of 7.653%. This bond is backed by hard assets of the company. Why would you mess with peer to peer lending?

Here is an even scarier set of statistics, the probability of default on an individual loan from Prosper.com: A - 1 in 189, B - 1 in 85, C - 1 in 50, D - 1 in 41, E - 1 in 20, and HR - 1 in 18. What this means is that with every single loan you make, you have that chance of loosing nearly 100% of your investment when a borrower defaults. The values for net default, which is what is lost after including the funds recouped from those how default hardly improves over the default rate. The data shows that in default even with the vendor's best efforts to collect, on average 80% of the defaulted loan is lost. Are you willing to take those odds with an investment? I'm not.

When I quote a return of say 8.14% on average for A loans, that is over the entire sample size of A loans made. You are in no way guaranteed that return unless you fund around 100 times the expected number of defaults. That would be diversifying into many loans to reduce the risk. If you funded 189 loans you are most likely going to have exactly one default and your results will be very similar to the average. If you fund say one or two or even twenty, there is a chance, albeit small, that you will have one default and your investment would perform much much worse than the average. One default in a small or moderate loan portfolio kills all of your returns. In other words, it takes a huge amount of money to make peer to peer lending a reasonable proposition. A starting portfolio would need 189 * $50 or $9450 to have sufficient diversification to have results that matched the average return. Invest less and you run the risk of substantially lower returns and also little likelihood of out-performing the average either (again despite your higher risk).

Another factor will drastically drag down returns from peer to peer lending. The way the system is structured, about half of the time your money is actually sitting on the sidelines not earning any return at all! Here is why, when you loan out say $100, each month you will get a tiny amount returned in principle and interest. This amount is far too low to fund another loan so it sits there collecting no return at all. This process continues for a very long while until you have $50 ready to invest in a new loan. This will also happen when you fund a loan and the borrower pays the loan back more rapidly than anticipated (called prepayment risk). This will sideline even more of your money very quickly and again keep it from making any return. What you will find is that your real annualized returns are far below the rate at which you make your loans. My estimates say that for small and moderate size portfolios your real return on capital (APY) is about 1/3 lower than the rates at which you make your loans (APR).

So here is an example: If you make a loan to a AA borrower at 8.69% and pay fees of 0.48% you will be left with a rate of 8.21%. Now you must realize there is some probability you will loose everything from default because you are not diversified, but ignoring that risk for a moment, assume after 3 years your whole loan has been paid back. Now it is time to calculate your annualized return and surprise, surprise, it will work out to be approximately 5.42%. Where did all of the return go? Well, the the opportunity cost of having your money on the sidelines waiting to be loaned ate it all up. If you factor in the real discounted risk of default, fees, and opportunity cost, your annualized return is more more like 4.26%. This drag on your investment can be mitigated somewhat by investing a large amount of money so that each month you are able to initiate a new loan using your returned capital. In this way you can keep more of your money working at any given time. This would require about $7500 to be able to start a new loan every month. Oh, I also forgot to include taxes which knock off another 25%.

This whole system seems neat and innovative but lenders almost universally would all be better off in corporate bonds. Honestly, almost any other investment vehicle is going to beat peer to peer lending. I started out very excited and the more I learned, the more I ran the other way. It is possible that one day all of the kinks can be worked out and the system will be better for both borrowers and lenders. I hope this has saved some people a great deal of frustration when they find their returns always lagging and they can't figure out why peer to peer is performing so poorly. Thanks for reading; comments are always welcome.

* The data used for my calculations is from June 1 2006 to Jan 14 2008 from Prosper.com if you want to recreate this yourself.

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Millionaire Rule #8

Fund a Roth IRA to the Limit
The Roth IRA is my second favorite type of account for retirement saving. Because I'm the type of guy that really gets excited about the prospect of have a massive amount of money in retirement, it means that I REALLY love the Roth IRA. If you are curious what my number one favorite type of account is check out Millionaire Rule #7. My goal for this post is for at least half of those who read it to get fired up and open a Roth IRA in less than 24 hours from reading this post. Now, to explain why a Roth is so great.

First, we have the benefit common to all forms of IRAs, tax free compounding. That means from year to year an investor does not have to pay taxes on the income generated within the account. So for example consider the following sequence of events: you use the money in your IRA to buy some stock, the value of the stock goes up, and then you sell it for a profit. In a normal taxable account when you file your taxes the IRS will want its share of your profits (called capital gains) which can range from 15% (shares held more than a year) up to 35% or the top income tax rate (shares held less than a year). The tax man would also stick his hand out for income generated from dividends and interest (at the top tax rate) as well. Obviously these taxes can be a massive drag on your portfolio except that an IRA keeps the money safe from Uncle Sam.

The money stashed in a Roth is after tax dollars which means you can not deduct your contributions from your income when it is contributed; while on the other hand, a Traditional IRA is tax deductible. This may seem like a bad thing, except to make up for it, when money is withdrawn from the Roth it is tax free. Yep, as amazing as it sounds, all of the money you manage to build up (from both contributions and earnings) in your Roth IRA is completely tax free when withdrawn in retirement. Zero taxes in retirement give the Roth IRA a huge advantage in my retirement planning strategy.

The next great thing about an Roth IRA is that it allows you to shelter more money from taxes than a Traditional IRA. The reason is slightly complex, but here it goes. Both accounts have a maximum contribution in 2008 of $5,000. I already explained how a Roth is after tax income and a Traditional IRA is pretax income that is taxed instead at withdraw. So the effective amount of savings in a Roth that are sheltered from taxes is the full $5000 (post tax) based on an investment of $6666 in pretax dollars. The Traditional IRA can take a $5000 pretax contribution but will only be able to ultimately shelter $3750 because that $5000 gets taxed at withdraw in retirement. If that is confusing keep on reading.

Here is an example, we start with the same $5000 investment and assume the 25% tax bracket both now and in retirement. The Traditional IRA will get a contribution of the full $5000 and then compounds until retirement. At retirement the money is withdrawn and the 25% tax is paid. The Roth will get a contribution of $3570 (remember it is after tax so $5000 * 0.75) and then compounds until retirement where it is tax free. In this scenario both types of account wind up with the exact same amount of spendable cash in retirement (take the tax before or after it is all the same). However, if you have $6666 that you are able to save, you can put the full $5000 into a Roth you will end up with more money tax free in retirement. In effect, the Roth is able to shelter 25% more money from taxes than the Traditional IRA (assuming you have the extra money to save).

Tax rates change over time. Many people believe (and history would seem to support) that current tax rates are well below their normal levels. Many people (myself included) also expect to be in a much higher tax bracket in retirement than they are now. Early in a person's career they may have a lower income coupled with tax deductions for mortgage interest, dependents, and student loan interest that will disappear by retirement time. I expect to go from the 25% tax bracket now to the 35% bracket in retirement (I'm ambitious what can I say?). A Roth IRA protects your retirement income from the risk of higher tax rates in the future. That means a Roth IRA effectively adds 10% on to its value relative to other tax sheltered retirement accounts like a 401(k) or Traditional IRA for someone like me.

The Roth IRA has a few more benefits I just want to quickly address. The contribution maximum is index to inflation so the amount you can save will increase over time. Roth IRAs are given special treatment in the unfortunate even of their owner's death. A non-spouse inheritor can take withdraws from the Roth over the course of their lifetime while maintaining the tax deferral of capital gains and interest. Normally stocks, bonds, or 401(k)s in an estate incur the full tax burden at the time they are inherited (so no continued tax free growth). Lastly, Roth IRAs can be opened with many different banks and brokerages which provide a massive selection of possible investments. Individual stocks, bonds, options, commodities, futures, mutual funds, ETFs, real estate, art and darn near any thing else you can think of can be used an investment in a Roth IRA. This is very different from a 401(k) which is limited to a single management company selected by the employer and only a limited selection of mutual funds in which to invest. Investments in the Roth can cover all asset classes and are completely controlled by the investor.

It may seem like this list could go on and on, but I have one last special benefit of the Roth IRA. Because the contributions to the account are after tax, there are no penalties or taxes from withdrawing your contributions from the account in the event of an emergency. This is very different from a 401(k) where pulling money out before age 59 1/2 would result in paying taxes on the withdraw plus a 10% penalty. The Roth IRA does not have this problem, and it can give you extra piece of mind and a source of cash in a pinch. I really recommend you stay out of your retirement funds if at all possible but at least you know it is there if you need it.

I've covered most of the great benefits of the Roth IRA. In all honesty there aren't many drawbacks. Over 40 years of contributions at the $5,000 and earn an 8% return your account will grow to over $1.4 million. I highly recommend the Roth IRA as Millionaire Rule #8. Check out the rest of the Millionaire Rules and be sure to subscribe to my RSS feed.

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Investing to Beat Inflation!

Today I read an article over at Consumerism Commentary about How to Save a Million Dollars at Any Age. I noticed immediately, and so did several other readers, that $1 million isn't all its cracked up to be 30 or 40 years from now. Inflation is the nasty beast the keeps prices going up year after year. A seemingly tiny 3% annual inflation rate cuts the value of your investment by 326% in 40 years. However, by starting to save early we have one powerful tool to fight inflation, career growth!

It is important to realize that as you progress through your career (and as your salary grows with inflation) the amount you are able to save goes up drastically. Wages tend to increase at a rate that slightly beats the inflation rate. While we don't always get a raise every year, on the whole almost everyone grows their income over time. The trick to beating inflation in your retirement savings is to adjust what you save each year to keep up with inflation. You need to take at least half of any raise you get and use it to increase your retirement savings. For example, if you get a 4% raise, increase your 401(k) contribution by 2% until you get to at least 10% (my goal is 20%). Then once you reach your target rate, in successive years continue to increase the dollar amount so you maintain that percentage.

Example: Lets say you make $40k now at age 25 and save 6% of your salary. Each year during your career you get a 4% raise (matching the average growth of the economy long term). With the first seven raises of your career you bank half of it and keep the other half to spend. Here is what it would look like:

Salary	401(k) Contribution		Income After Saving		401(k) Balance
$40,000.00	$2,400.00		$37,600.00		$2,400.00
$41,600.00	$3,328.00		$38,272.00		$5,920.00
$43,264.00	$4,326.40		$38,937.60		$10,720.00
$44,994.56	$5,399.35		$39,595.21		$16,976.95
$46,794.34	$6,551.21		$40,243.13		$24,886.31
$48,666.12	$7,786.58		$40,879.54		$34,663.79
$50,612.76	$9,110.30		$41,502.46		$46,547.19
$52,637.27	$10,527.45		$42,109.82		$60,798.42
$54,742.76	$10,948.55		$43,794.21		$76,610.85

After doing this eight times you will be savings 20% of your income for retirement and be making $52,742. You will have lost some ground to inflation but not too much.

Here is the great part, if you keep your savings percentage the same over the rest of your 40 year career you will end up with over $3.24 million! Even adjusted for inflation this is roughly equal to $1,000,000 today. You never miss the money you saved either!

If you add into the mix a maxed out Roth IRA this is what your results would look like after 40 years:

Salary	401(k) Balance		Roth Balance
$192,040.83	$3,241,681.40		$1,403,905.20

Total Savings: $4,645,586.60

Income @ 4% Withdraw: $185,823.46

You can draw $185,823 each year in retirement and never touch the principle. This would be more than 96% of your $192,040 pre-retirement salary and equal to about $57,000 today adjusted for inflation.

As you can see, inflation does not have to ruin your hopes of retiring in comfort. Keep this in mind when you get your next raise and you feel the temptation to increase you lifestyle. Lifestyle creep is a far more ugly beast than inflation. Spending more than you make is the sure-fire way to a disappointing retirement.

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Is Social Security a Rip Off?

Today I came across a great article on The Dough Roller about Social Security. The post includes a great table that shows how much people at different incomes can expect to reap during retirement from everybody's favorite entitlement program. I have always resented the amount taken out of each check for social security, but today I learned something new. It really isn't all that bad for most people. The average person can expect to get $15,570 each year. This is is equivalent to buying an annuity which would cost $225,000. So at least you get something for all of the money that disappears from each check. Based on the present numbers it seems the social security isn't quite as big a rip off as I had thought. As it stands now, paying 6.2% of your gross earnings over your career gives a high earner 28% back every year for life.

I ran some of my own numbers assuming both no investment returns and an 8% return on contributions. An important thing to remember, which I originally forgot to include, is that your employer contributes an equal amount to Social Security in addition to the employee amount. My salary projections started at $97,500 (the Social Security ceiling for 2007) and, adjusted for inflation of 3% per year, topped out at $299,000 by 2045. I will pay $437k into social security before I hit retirement at age 62 (and my employer will match that amount). Assuming an 8% return that money would compound to $4.37 million dollars. That is equal to $1.42 million today. Wow! How does that compare to what Social Security actually pays out?

If I get 28% of my final salary in social security payments it would be approximately $83,000 per year. An equivalent annuity, would pay $83 per year for life starting at retirement and would cost $2.09 million dollars. In other words, I loose about half of the [$4.37 million] compounded contributions . Social security also includes disability and life insurance benefits, however these amount for only a tiny fraction of the $2,280,000 that disappeared.

The actual annual rate of return on contributions made to social security is around 4.75%. This is slightly below the historical average for government bond yields. If you factor in the tax deduction (SS taxes are deducted from gross income), assuming the 25% bracket, the return moves to a slightly more respectable 6%. This rate does indeed beat government bonds by a small margin so I'd consider it to be only a moderate rip off.

I am still young (24 years old) so I fully expect social security to change A LOT from now until I retire. Current projections indicate that there will be a shortfall of funding for the program of about a quarter of promised benefits starting in 2041 (4 years before I plan to retire). A 25% reduction in benefits seems almost certain but the cut may be even more by the time I retire.

If benefits are cut 25% and I only get 21% of my final salary I could take home $63,000 each year in retirement. Even in the best case, with a 25% tax deduction included, it would add up to a mere 4.7% annual return. That is a pretty sad return when you consider government bonds have averaged ~5.75% since World War II. If benefits get rolled back and no change is made to the payroll tax rates, it will dramatically reduce the value of Social Security to the middle and upper middle class.

Creating private accounts is one solution which could allow for returns of better than 4.7%. It may be a free market solution to the poor performance of Social Security. I would suggest taking a fixed percentage from all employees paycheck (tax free) and placing it into a fund similar to the government employees Thrift Savings Plan. It would offer a limited selection of broadly diversified index funds in which retirement money would be invested. The additional risk will need to be counter-balanced with a true insurance program that protects against market failures. This system would then replace our our current fixed check-a-month system of entitlement.

For now, Social Security is not as big a rip off as I had thought, even for those at the top end of the earning scale like I am. However, the 25% reduction in benefits would hurt the fairness of the program a great deal and drop rates to an intolerable level. We need to recognize now how unfair it would be to our workers to force them to earn below market returns on their contributions because we do not have the political will to make the needed changes. A free market return on all of their retirement investments, including Social Security, is the only fair way to fund retirement.

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Income for Life - Part 1 - Bonds

I talk a lot on this site about the process of accumulating wealth, but today I will expand that focus to include a realistic picture of how much wealth is actually needed to create a steady income for life. There are a few commonly accepted ways to draw income from one's wealth and over the next few posts I will try to I will explain the most common methods. I will also try to address the most important risk factors to your nest egg. These risks turn a seemingly simple process into a mine field of problems that can snag even a well prepared retiree.

Bonds:
It is simple to look up the historical rate of return for bonds and say, "I will put all of money into bonds that pay X% interest and spend the interest each year." Based on data from the Federal Reserve from 1955 to 2007 government bonds averaged 5.735% return. Bonds are suppose to be a safe and stable source of income right? In fact if you look at the data the returns of bonds are actually are fairly choppy. The standard deviation (measure of volatility or predictability of returns) for the government bond data is 3.214. What this means is that in most years the returns from bonds will end up between 5.735% minus 3.214% (or 2.521%) and 5.735% plus 3.214% (or 8.949%). Around 1/3 of the time the returns will even fall outside this broad range (2.521-8.949%) to be very large (like 16.39% in 1981) or very small (like 1.13% in 2003). In other words, from year to year the returns of bonds can still be unpredictable, so you can not count on drawing the same amount year after year without significant risk of dipping into the balance and potentially running out of money.

Another important risk factor for drawing income from your wealth is inflation. Each year prices for all types of goods and services increase, which will cause income needs to increase over time to maintain the same purchasing power ($1.00 in 1987 would require $1.83 in 2007). That means in order to keep up with inflation, the size of your nest egg still must grow in retirement to keep up. Using the same time period as above from 1955 to 2007, inflation took away 1.8% per year of the average 5.725% return. That leaves us with at the most a 3.935% withdraw rate to generate income to account for inflation. There can be some years where the inflation rate even exceeds the return of government bonds. This would also require dipping into the balance to maintain a stable income.

To provide a truly guaranteed income from bonds that is protected from inflation there is a special product called a Treasury Inflation Protected Security (TIPS) that are issued by the Federal Government and pay interest at a rate that varies based on an index which tracks inflation called the Consumer Price Index. The bonds pay a fixed percentage of income historically from 2-3% above the CPI stated inflation rate. This approach will guarantee an income that keeps up with inflation and is fairly stable, but at a price of creating an income stream that is fairly small. A TIPS portfolio that pays a 2.5% premium over CPI the initial principle required for an annual income of $50,000 would be $2,000,000.

If you a person is able to accumulate $2,000,000 today and will need $50,000 income for life then they are all set. However, if you are like me and have decades until retirement (for me 38 years to be exact) then you have to also factor in the effect of inflation from now until then. I feel that the 1.8% average inflation presented before may be a little conservative, and I want a little wiggle room in my calculations, so instead I will use an inflation estimate of 3% for my calculations. This gives me an inflation factor of 3.07 (or a 307% increase in my income needs) at retirement as compared to now. Using these assumptions I calculate the following: ($50,000 * 3.07) / (2.5% TIPS premium) = $6.14 Million. That is a LOT of money to accumulate in my lifetime, but absolutely achievable! At an 8% annual return I would need to save about $1975 per month for 38 years which is roughly equal to taking maximum advantage of my 401(k) ($15,500 plus match) and Roth IRA ($5000).

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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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Millionaire Rule #7

Fund 401(k) to Get the Full Match
There is no better way to save for your financial future than to take advantage of a 401(k) which is matched by an employer. It is rare that I will state anything in the personal finance domain with this much certainty. An employer match is free money. No offense intended, but you would have to be an idiot to ignore FREE MONEY!

For those of you who have never heard of a 401(k) or don't really understand them I will give a quick primer. It is named after the section of the tax code which defines the rules of these accounts. A 401(k) is a savings account for the purpose of funding retirement. If you take money out before age 59 1/2 you will owe taxes and a 10% penalty to the IRS (DO NOT DO THIS). Money contributed is completely protected from taxes until you withdraw it. This tax benefit means that you can avoid taxes now. By avoiding taxes you will have more money to save, and each year your savings will continue to grow tax free until retirement.

A 401(k) account is set up by your employer, held at an independent financial services firm, and managed by YOU the investor. You choose how much goes into the account each pay check (call your HR department to set this up) and you pick your investments from a list of choices provided by the servicing firm. Lastly, and most importantly, many employers encourage employees to save by contributing money on the employee's behalf. This is called "matching" because it is normally arranged such that the employer will kick in a certain percentage of what the employee contributes. Common matching arrangements are 50% of every dollar up to a maximum of 3%; in this case an employee would contribute 6% of their gross pay and the employer would add an additional 3% (for a total of 9% of gross pay saved). Some employers are very generous and offer even more free money!

I will give a simple example to show the power of a 401(k). Lets consider Joe, a regular guy making $50,000 a year. Each year he will get a small raise of 3% and his investments return a moderate 8% per year. He is 30 years old and will work until he is 67 year old. The table below shows Joe's results depending on the type of investment account he uses.



I will say again, that not putting in the money necessary to get the full match is leaving free money on the table; don't do it. The best case shown in the table produced a nest egg of over $1.28 million which is roughly double what could have been saved in a taxable retirement account.

Now I realize that not every person has been lucky enough to find a job that offers a 401(k) and that a match is not offered in all 401(k) plans either. Do not loose hope! There are still other retirement saving options that are pretty good. If you want more information on your choices, continue reading the rest of my series Millionaire Rules.

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Investment Basics Carnival #5

The Investment Basics Carnival #5 was posted this morning and my post Ignore the Stock Market Pain was included. The host set the bar pretty high and selected 17 interesting posts (out of 35 submissions) for the carnival. I found two that were particularly interesting for me, Goal Based Investing by Raag Vamdatt and Common Stock Investing Mistakes by Investing Angel.

If you have been reading my posts this week you know that I've been sick (which lowered my posting output too). I'm back up to about 90% so I'm going to try and put some of my thoughts from this week into posts. With any luck you'll see a flurry of posts in the next 2-3 days. Make sure to subscribe to my RSS so you don't miss them.

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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