Against the Standard Advice

Go to a standard advisor, or read an article from a magazine on how to invest, and you will likely get the standard advice:

1) Buy mutual funds (individual stocks are too risky)

2) Diversify as much as possible (to limit volatility risk)

3) Don’t try to pick individual stocks or time the market.

4)  Find stocks with good dividends to supplement growth.

5) Have a portion of your account in bonds (usually a percentage equal to your age, or your age minus 10).

This advice is perfectly good and will nearly ensure that you preserve your money and do better than inflation.  If you properly diversify and rebalance correctly, you should receive around the market average, minus fees on the funds you own.  Long term averages have been around 10% using that strategy.

But what if you only have about $2,000 to invest?  Maybe you’re just out of college, have graduated with no debt and have no credit cards, and you’ve just started your first job.  After a year of careful living you’ve saved up a good, $10,000 emergency fund, and now have a couple of thousand dollars left over for investing.  You’ve also allocated 15% of your paycheck directly into your 401K, which is invested in mutual funds using the standard advice above.  If you put that $2,000 in mutual funds, you would only be able to buy one fund, and then probably only after agreeing to automated payroll deductions.

Let’s say instead that you decided to buy an individual stock with that money.  What is the worst that could happen?  The company you bought could go bankrupt and your $2000 would disappear.  You’d only be left with a worthless stock certificate to frame and put on your wall (if you even sent for the certificate).  You’d have a $2,000 piece of art work.

You could probably re-earn that $2,000 in a few months.  In fact, you could start directing a portion of your paycheck to investing, and come up with a few thousand dollars every 3-6 months.  In that case the loss of the $2,000 would become a distant memory after a few years.  Just a war story to tell.

So what kind of stocks would you buy with your $2000?  Many people get caught up in the dynamics of the market.  If they used that $2000 to buy 100 shares of XYZ stock and $20 per share, they would sell it if it went to $22 per share.  After all, that was a 10% profit.  They might also look at the fluctuations in price, see that XYZ traded between about $18 and $23, and decide to sell at $22.50, hoping the stock would then drop to around $18 so that they could buy the shares back and do it again.  People who did this might make a small gain here and there, but they would never really make a lot of money.  Not as much as they should.

What if you could go find a professional business manager.  The kind who went to a fancy Ivy league school, and invest your $2000 with him.  Maybe with a whole team of fancy managers.  Or maybe you could find someone who has a great idea and invest with him.  Let him take care of running the business.  You’d just be a silent partner.  But wait – those sorts of people are only interested in people with hundreds of thousands of dollars to invest.  They wouldn’t be interested in you and your lousy $2000, right?

In fact, that is just what the stock market allows you to do.  If you stop following the prices and really look at the companies, you can find all sorts of businesses out there to put your $2000 into.  These are all businesses with great ideas and professional, battle-scarred managers.  You could be part of the next Google, or Apple, or Ford Motors.

You’d want to approach it just as you would if you were putting your money into a business.  You would find a business with great prospects and a great management team.  A company that had room to grow for years to come.  Maybe one that had just started to make it big, but was not so big as to be high in price yet.

You would then invest your money and expect to leave it there for years while the business grew.  You would expect up and down years – after all you have no control over what the economy will do or what people will decide to price the company at on any given day.  You would plan to stay with the company though as long as it still has the promise of growth.

Because you could not be sure that your first pick was right – after all, things happen even to great companies – you might want to put your next $2000 into another company.  And then your next $2000 into yet another company.  That way you would have three chances of picking a big winner instead of just one.

Eventually, if you picked the right company, your meager $2000 would be worth tens or hundreds of thousands of dollars, and you’d be receiving a huge dividend.  Maybe you’d get paid back your $2000 every month in a dividend.  Hopefully as the business grew you would have sold off part of your interest.  After all, if you owned $50,000 worth of a company, you’d hate to see something happen and get nothing out of it.  Maybe you’d sell of $10,000 worth every now and then, and use the money to pay your house off early or buy some mutual funds.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Picture Credits: Jorge Vicente, downloaded from stock.xchng

How a Tax Hike for Dividends will Affect your 401K

The current class warfare being stirred may have collateral damage well beyond the targets.  While at first it seems like a good idea to raise taxes on dividends (after all, who but an avaricious, Scrooge McDuck-types would collect dividends?) raising dividend taxes may affect everyone who has shares in a 401K or even a pension plan.

Some background:  As part of the tax cut package of 2003, dividend tax rates were lowered to a flat 15% rate.  Before this point they were taxed as normal income, with rates as high as 38%.  The rationale behind having lower dividend tax rates than ordinary income rates is twofold:

1)  Lower rates encourage investing, which in turn lowers the cost of capital, thereby creating economic growth. 2)  The income received by investors is already taxed at rates up to 35% by the corporate tax.

Currently there is a movement to raise those rates back to where they were before 2003.  This would mean that those who pay the highest tax rate would see their taxes on dividends rise to 38% again (or perhaps even higher, depending on the political mood).  Those paying lower rates – mainly the middle class – would tend to pay more than they are now but would pay a lower rate than the highest earners.  For example, if you are in the 20% tax bracket you would pay 20% on dividend income.

So this would just mean that people would pay a bit of a higher amount on dividends, right?  Well, not exactly.

You see, when an investor buys a stock, the price he is willing to pay depends on the relative return of the investment when compared to other, less risky investments.  For example, if a bank account is paying 3% and investment grade bonds are paying 6%, investors might not buy stocks unless the potential return is at least 9%.

Determining the return for a stock is more complicated than determining that for a bank account.  One does not just look at the current dividend, but at what the dividend may be in the future.  Because the more a company earns, the higher a dividend they can pay, stocks tend to increase in price as the earnings rise and fall when they fall.  A stock that pays a $1.00 per year dividend now, but may see earnings double over the next several years, may see the payout of the dividend double as well.  If the stock price is currently $20 per share, the current yield would be 5% ($1.00/$20).  If the dividend is doubled, however, and one bought in now at $20, one would be receiving an effective dividend of 10% ($2.00/$20) when and if the dividend were raised.  The price of the stock may double as well over that time, but that does not affect the effective yield the investor who bought in at $20 is receiving.

Raising taxes on dividends lowers the effective return.  If you receive a 10% dividend but the dividend is taxed at 40%, you are only receiving a 6% dividend after taxes.  The effect of raising taxes on dividends is therefore to make future dividends less valuable and thereby lower future returns.  Investors react to this by reducing the price they are willing to pay for the stock currently, which will cause the price of the stock to drop.

So that will only affect dividend paying stocks, right?  No, remember that the price investors pay isn’t based entirely on current dividends, but on potential future dividends as well.  This is why investors are willing to buy stocks that pay no dividend at all.  They are hoping that eventually the stock will start paying a dividend, and they will then receive a really great return for the amount they originally invested.  All stocks will therefore drop in price, not just those that pay a dividend (although dividend paying stocks may be hurt more since investors may feel that tax rates may be lowered in the future before the stock that don’t currently pay dividends start to pay one).

So this will mainly affect those who make high incomes, right?  No, because the price of stocks will drop, those who own stocks in 401k accounts, IRAs, individual accounts, and even Pension Plans (which are invested heavily in equities) will see the value of their holdings drop.  States with large pension plans and a lot of workers who are retiring soon may need to divert resources to shore up holes created in their pension plans.  Private businesses that have pension plans may need to cut costs to cover increased pension plan payments.

How much will share prices drop?  Predicting an exact amount is difficult since there are many factors that affect the stock market.  If a tax increase is enacted the same week that peace is declared in the Middle East and oil drops to $10 a barrel, stocks may well go up in price.  The effect of a return to 38% rates, experienced without any other events, however, would probably be to cause stocks to decline by 10-20%.  Note that everyone’s rate would not increase to 38%, and there are institutional investors who hold a lot of the shares.  This would mute the effect of the tax increase.

So, be wary of calls for higher dividend taxes.  The effects may well extend well beyond those who own stocks that pay dividends.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Picture Credits: Thomas Picard, downloaded from stock.xchng

A Solution for the Underwater Loan Issue

Bank of America today announced a new plan by which individuals would turn over their deeds to the bank but then be allowed to stay in the homes as renters.  This idea has some merit and addresses some of the problems that banks face.  For one thing, banks would not have more homes sitting empty, being subject to vandalism and damage from natural events without someone being home to reduce the damage done.

The trouble is, however, that people who cannot afford to pay their payments may not be able to pay the rent.  This might just result in a default in rent and an eventual eviction anyway.  This also creates a renter’s mentality, in which they may not take care of the home.

For those who are unable to pay the payments because of a job loss, there is really little that can be done except wait for the economy to recover.  There are others, however, who could make the payments but choose not to because the house is worth less than they borrowed.  The issue is that there is a perception that one could just walk away and not need to pay back the loan – that one would almost be a sucker to pay the loan in full.  While banks can chase borrowers for the difference if the house is foreclosed upon, many choose not to do so.  This leads to more people walking away, causing home prices to decline, and the cycle continues.

There are really three issues that a plan to solve the issue must address:

1) The plan must remove the incentive to walk away.

2) The plan must lower the payments to a level that the borrowers could afford and give them freedom to refinance and/or move to a different house, and

3) The plan must provide a way for the loans to be repaid in full.

Here is my plan, which I believe addresses all three issues:

Make a deal with the borrower in which their payment would be lowered to an amount they could afford (say 25% of their take-home pay).  In exchange, the borrower would sign an agreement with the bank that the bank would receive all appreciation on the property until the value of the house was high enough to repay the original loan in full.  At that point, the borrower could refinance the house into a standard loan, repaying the original lender.

If the homeowner chose to move, they could do so, but the lender would receive the appreciation on the original house when it sold, plus they would receive all appreciation on the new house until, once again, the loan was repaid.

The advantages to the borrower would be the following:

1) They would be free to move or sell their house if desired.  In the case of a job loss, they would be able to more where there were jobs and better pay.

2)  Their payments would be reduced to a reasonable amount.

3) They would be using the leverage of their home to repay their loan faster than they could with a standard loan.

 

The advantages for the bank would be as follows:

1) They would have people remaining in the homes, taking care of them.

2)  They would have a much better chance of the loans being repaid.

3)  They would not end up with foreclosed homes, with the accompanying cost for repairs, taxes, and sale.

 

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Picture Credits: Thomas Picard, downloaded from stock.xchng

I Can See the Future

I can see the future.  No, I’m not some sort of clairvoyant or something.  I mean that I have the ability to look at current events and predict how they will shape the future.  This has been a very useful gift in investing because it has allowed me to figure out how to invest (and what to invest in).

I’ve found that a lot of people don’t seem to have this gift, because most financially “normal” people, which is most people. tend to make bad financial choices.    They buy stocks that are clearly overpriced then sell those same stocks when they have fallen to the point of being a bargain.  They take out huge student loans then wonder why it is a struggle to pay them back.  They spend money like it is water when they are young and then wonder why they cannot afford basic necessities when they are old.

Actually they probably could see the future if they really looked, but they choose not to.  There is a sense of greed and the desire for immediate satisfaction that drives us all.  There is also a fear that clouds our judgement and causes us not to think about the long-term consequences of our actions.

Today I’d like to summon up my power of prediction and offer some insights about the future:

1.  If you are buying your first house and trying to get one comparable to what your parents have, you will struggle to pay the payments and build up large amounts of debt over time.  Instead, buy a smaller, starter home once you have built up a 20% down payment minimum.  Get a fifteen year fixed loan and pay it off in ten.  Once you have paid off the first home, save up for a couple of more years then find your dream home, using the equity in your starter home to make a huge down payment.

2.  If you take out home equity loans, you will not have any money when you are ready to retire.  If you find the need to take out equity in your home, it means you are trying to live beyond your means.  Even if you do nothing else, if you have paid off your home by the time you are ready to retire you’ll be able to sell and move into a smaller place and pay for living expenses with the left-over equity.

3.  If you are 20 and put all of your retirement savings in money market funds, you will have 100 times less at retirement than you should have.  Money in money market funds and CDs rots with time because of inflation.  If you don’t need to touch the money for a long period of time (more than 5 years), you must invest it just to preserve its value.

4.  Social Security as we know it will not exist in 15 years.  Social Security is a pay-as-you-go program, meaning that money collected today is used to pay benefits for people who are currently retired.  Anything left over is acquired for the general fund and spent.  With the large number of retirees drawing on the system over then next several years, it will quickly become unsustainable and collapse.  This has been accelerated by the recent payroll tax holiday, which reduced the amount current workers are contributing.  There may be some program for the elderly poor, and there may be some benefit that kicks in at a really old age, but it will be inconsequential in most people’s lives.  Don’t plan on receiving anything from the program.  Take that 2% you are saving by not paying the full payroll tax now and put it into an IRA.  If you are young enough, you’ll be able to easily replace the payment you were supposed to receive.  Put away 15% to have a comfortable retirement.

5.  Several states will go bankrupt between 2013 and 2018 and be bailed out by the Federal Government.  Bond holders are likely to receive little if anything when this happens.  Be wary.

6.  There will be a shift from adult toys like motorcycles and gadgets to adult care as the Boomers enter retirement.  This means that stocks like Harley Davidson and Apple will see earnings decrease and stocks that provide healthcare and senior communities will thrive.  Look for a lot of hip and knee replacements over the next 20 years.

7.  Traditional health insurance will be replaced with Health Savings Accounts with high limit, major medical plans attached.  This will be a difficult transition at first, but eventually the cost of healthcare will drop dramatically, largely due to the reduction in the cost doctors need to pay to maintain a staff to file insurance claims and the reduction in the amount of unneeded procedures performed.  Expect a very rocky start as health insurers collapse under the Obamacare mandates and a brief, failed experiment with socialized medicine is attempted.

8.  There will be large amounts of inflation over the next few years.  The Federal Reserve is injecting huge amounts of money into the economy by keeping rates this low, but there is little reason for businesses to expand with continued weak demand.  Expect this money to cause prices for energy and food to continue to increase, eventually resulting in increases in wages and an inflationary spiral.  This is not the 1930′s, it’s the 1970′s we’re living through.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Picture Credits: Colin Brough , downloaded from stock.xchng

Paying Off Student Loan Debt

I read a blog post tonight that left me speechless.  The post, Tips to Trade Student Loan Debt and Save Money. caused my riskmeter to shoot through the roof.  The advice in the post is to get as many credit cards as possible while in college (what!?), the start transferring student loan debt to each of the cards in turn, taking advantage of zero interest rate introductory offers to pay off the loan faster.  The post shows how we often do things that make sense mathematically, but we don’t take risk into account.

First of all, most zero interest credit card offers I’ve seen start the clock immediately, so I don’t see how getting a bunch of credit cards while still in college would help.  Seems like it would just lead to a lot of “emergency” trips to the beach and the bars, leading to a non-zero balance on those cards when one left school.

Secondly, even if you were able to use the introductory periods for student loan debt, the level of risk is way, way too high.  The ideal situation would be that you transfer debt to the first card, pay on it for 6 months until the introductory offer ran out, then quickly move it to the next card, then the next, and so on.  Because you would not be paying interest, you would pay off the debt faster and end up paying less.

That is before Murphy (of Murphy’s law) enters the picture.  Here’s how it would really work out:

You just get your first job and move the student loan debt from a 5% loan to the credit cards.  You make the first couple of payments and everything is going great.  Then – bang!  There are layoffs at your job and you lose your job.  You no longer have the money to make the payments, so you miss one.  The interest rate instantly jumps to 35%, they charge you a $100 fee for missing the payment, and they add interest for the introductory period.  You now have no way to refinance the loan and your student loan now doubles in size every two years.

Instead, take out student loans only if it is absolutely the only way.  This is after:

1.  Choosing a school that is within your budget if possible.  No one will care if you got your accounting degree from State U or Harvard.  They’ll care about the skills you have and your commitment to your work.

2.  Considering if the major your choosing will allow you to pay off the loans.  If you go to a $40,000 per year seminary school, you’ll never be able to pay off the loans as a minister at a small church.  Unless you’re going to be a doctor or a lawyer, think low tuition.  Even if you are planning to be a doctor or a lawyer, what if you don’t make it through or you discover you hate those fields once you start working?  Avoiding loans will keep you from being trapped.

3.  Applying for every scholarship possible.  There are many small scholarships that get few applicants.  Get 20-40 of these and you may pay for everything.

4.  Planning to get through schools as fast as possible and minimize your lifestyle.  If you are using student loans, you don’t need to take 5 years to get your degree and spend each weekend night at the clubs.  You don’t need to have a social life.  You should be studying constantly, taking as many classes as you can, and maybe working a job while you are not studying.   You also should just rent a room at a house since all you’ll need is a place for sleeping.

5.  Accepting the fact that by getting something now (a college degree), you’ll need to put other things (like getting a house) on hold.   If you graduate owing a house in student loans, you’ll already have a house payment.  Before you’re ready to buy an actual house, you ‘ll need to concentrate your resources on getting rid of the loan.  This may mean waiting 10-20 years to get a house.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Picture Credits: Tiffany Szerpicki, Website http://www.tiffszerp.com downloaded from stock.xchng.