Don’t Feed the Alligators

A Personal Finance Blog from a Small-Scale Landlord’s Perspective

Archive for the 'Retirement' Category

10.14.2008
Overhang

Creative Commons License photo figure credit: Akuppa

With the recent market turmoil, there has been a lot of talk in the press and even around the water cooler about the nature of risk.  Most people seem to understand that investing in the stock market is risky.  They also understand that the more risk one takes, the greater the possible upside and downside of the investment.  What many don’t seem to understand is what, exactly, is risky about investing in the stock market as well as how risks can be mitigated.

A great book on this subject is A Random Walk Down Wall Street by Burton G. Malkiel.  This book details, for example, why a well diversified stock portfolio is less risky than a single stock.  Malkiel shows that it takes a minimum of 20 to 30 stocks across a number of asset classes to provide sufficient diversification for a typical investor.  For example, if one holds the 30 companies in the Dow Jones Industrial Average, a typical market cycle might have Coca-Cola announce a new product offering which boosts its stock price, while 3M announces layoffs.  These types of stock movements are offsetting and are generally the reason why a diversified portfolio is less risky than individual stocks.

A diversified portfolio is still exposed to “systemic” effects on the market — effects that are spread across the whole market.  This is most easily observed in the current market turmoil.  Clearly it’s not possible for every company to be doing poorly right now — somebody must be making money in a Bear market.  But the market average is down, and as a result, many good companies are getting hit hard on their stock prices simply because of the financial crisis.

Another aspect to risk, and the one about which I have been trying to remind my coworkers and friends, is the time factor.  When purchasing an investment, one has to be aware of both the time one can afford to tie up money in the investment, as well as the typical time for the investment to achieve the kind of return being sought.  This is fairly easy to see with a Certificate of Deposit: you buy a CD that pays a certain percentage yield and that has a limited lifetime of months or years.  There are penalties for withdrawing money early.  The equation is less well defined when it comes to investments such as houses, stocks, or tulips.  The risk with investments such as these (well, not the tulips as much…) is not that the investment won’t hold value or yield a return, but rather over what time period the investment will pay off.

Conventional wisdom suggests investors be prepared for minimum investment times to substantially reduce the chance that the investment will depreciate while held.  The purchaser of a house, for example, should be prepared to hold the house for 5 years or longer to have a high degree of certainty that the money invested can be recovered in full.  Diversified stock portfolios are more like 10 years of holding time.  In fact, (according to Malkiel) there has never been a 10 year period since 1926 in which the stock market has returned a negative yield, and there has never been a 25 year period in which the return was less than 8%.

The point in all of this is that you should not panic about the volatility of the current market.  In fact, the less you pay attention to it the better off I expect that you’ll be.  If you are investing for retirement and you have ten years or more left to invest, you shouldn’t even sweat during this crisis.  If you have less than 20 years until retirement, or are retired already, you should have made and be making annual or semi-annual changes to your portfolio to reduce your risk exposure by locking up your stock gains in less risky vehicles like bonds.  This is what’s known as rebalancing your portfolio.  If your time horizon for a certain pile of money is shorter than 10 years, then your exposure to the stock market should be minimal.

The absolute worst thing that you can do right about now is to get scared and change the way you are investing because of the market fluctuations.  Selling off stock now is the opposite of what everyone knows is the key to investment success: buy low, sell high.  Selling now is “selling low” and locks in your losses.  I have not lost any money in the current market, and I say this because all my losses are on paper so far.  I still own the same number of shares this week as I did last week.  Only by selling shares now can I be sure to lose money in this market.  History tells us that some of the greatest days in the stock market follow some of the worst, and Monday’s stock market performance is certainly evidence of this.  Selling when the market is low takes your money out of play and eliminates any chance of regaining the value lost in your portfolio as the market rebounds.

Are you concerned about the loss of value in your 401k plan?  Have you made any changes to stem your losses, or are you just gritting your teeth and bearing it?  Do you find yourself checking the value more frequently or less frequently because of the volatility?  How much risk can you stomach? I’d like to read your perspective on the situation in the Comments Section below.

ticker

Creative Commons License photo figure credit: zesmerelda

On Monday of this week, I had to leave the office early to visit the home of one of my company’s customers.  On the car ride, I listened to story after story on National Public Radio about the Financial Crisis, and more specifically the fact that despite the passage of the rescue bill over the weekend, stocks were falling through the floor.  The Dow Jones Industrial Average was set to close below 10,000 points for the first time in years.  And all the time I couldn’t think of anything else but to call ScrapperMom, who would likely be near a computer, and ask her to move some of our cash into equities.

Thank goodness I didn’t, because the market has lost almost 15% since then.  But now I’m just salivating more at the prospect of picking up some market index funds at such low prices.  Am I crazy?  I’m not sure.  Everyone is reacting to the market — and all in different ways.  But the truth of the matter is that the rational me knows that I probably should not change my long term investment plan based on what the market did today.  So it really requires me to take another look at my investment plan and then act accordingly.

Here’s where the problem comes in: I don’t really know what my long term investing plan is.  We’ve written here before about many of our financial goals and priorities. Since visiting a financial planner for a free consultation about a month and a half ago (Side story: The planner at the time had hinted at the suggestion of bonds issued by Lehman Brothers since they were paying something like 7% interest… I wonder why I haven’t heard from the planner since our meeting…), we finally decided to reduce the aggressive paydown of our low interest debt in favor of other priorities.

Saving for retirement is certainly one of those priorities, and given this, the current market is the perfect time to invest in order to capitalize on the “buy low” strategy.  Sure, the market could go lower still, but the rebound, whenever it does occur, will almost certainly end up higher than the current market within 20 to 30 years, and therefore money put into the market now should be a good investment.

However, building a substantial emergency fund is also one of our priorities, and given the current state of the economy, cash is probably not the worst position for our money.  While both of our jobs seem fairly secure over the next year or so, the truth is that anything could happen at any time.  I actually have no idea whether my paycheck is dependent on the ability of our parent company to borrow money, and if so, what will happen if it becomes unable to do so.  ScrapperMom works in a field that caters to higher-end tastes, and so far the only effect the slumping economy has had on her line of work is the choice of whether to build the garage to the vacation home now, or hold off until the market rebounds a bit.

I have considered our income position a number of times over the last year or so, and the diversity seemed to pretty much assure that we would continue to have at least 1 out of 3 major incomes at any given time.  I think that is still true, but I’m not as sure as I used to be.  It is unfortunate that it has taken a serious financial crisis to finally drill into my head the need for a substantial emergency fund.

To that end, I think that I will hold off on moving from cash to equities, at least for now.  But, if the market starts to rise quickly, soon, I know I’m going to feel a bit sick over not taking advantage of it when I had the chance.  What’s interesting is that people are often told to take on as much risk such that they will still be able to sleep at night.  For me right now, I feel like not taking on sufficient risk is going to keep me up nights…

What about you?  Are you hanging on tight to the roller coaster ride?  Did you get out of the market already?  Are you plowing cash in?  What would you do in our situation?  Let us know in the Comments Section below!

09.07.2008
Cardinals

Creative Commons License photo figure credit: linda_yvonne

It’s been a few weeks since I’ve had a chance to highlight some of my favorite articles in the rest of the blogosphere, so here’s what’s been going on:

Gather Little by Little tells us what the dumbest thing on which he ever spent money is.  He asks what others’ dumbest purchases are.  The first thing that comes to mind for me is a Bowflex machine.  It really did seem like a good “investment” in our health at the time, but like many things, it was too good to be true, and in retrospect way overpriced for what you get (a lot like a certain speaker company’s products that rhyme with “nose”).  A close second is a pair of those Ionic Breeze air cleaners.  At least we bought them on Ebay and saved a lot of money off of the MSRP.

GLBL also has a great guest write up on how to start an envelope budget system.  This is not the system that we use, but the best system for you is the one that works, so if you’re still looking, give this a read.

FrugalBabe writes about missing a home owners’ association payment and getting hit with a late payment as a consequence.  Her excuse is that they don’t actually bill her.  I’m a big fan of making things automatic, and I suggested setting up an automatic bill payment with her bank.  Few people realize that they can set up a billpay payment for things other than utility, credit card, mortgage, and other “typical bills”.  Heck, you can often send your friend a payment for the dinner you split last week.

J.D. at Get Rich Slowly puts it to his readers for suggestions on how to cope with a spending addition.  I don’t think the young woman in this case has an addiction as much as a bad habit.  My advice here again would be: Make it automatic.  Set up a Debt Snowball and then set up automatic payments that take effect the day after she can be sure that her paycheck gets deposited.  Of course she has to cut up her credit cards as well for now, but once she does this, if she doesn’t have the money in her bank account, she won’t be able to spend it.

J.D. also wrote another great post on “The Idea of Having.”  I hear him on this one.  Having “stuff” is a constant struggle for us.  We’re always going through closets and bookshelves and can usually bring ourselves to part with some stuff, but not other stuff that we don’t ever use but that we can’t bring ourselves to throw or give away either.  Sometimes I wish we had to live in just one room so that it would force us to pair things down to that which is truly important.

Pinyo wrote an analysis of when to start taking social security benefits.  He argues that while the starting benefit goes up as you age, you might not live long enough to recoup the difference.  However he missed the fact that a given person’s lifespan also increases with age.  A person born today in the US can be expected to live to 75 on average.  But a person who is already 62 can be expected to live into her 80s.  A person who is already 70 is likely to live into his late 80s.  This has to be factored into a full analysis on when to begin social security benefits.

Lastly, filed under the “just for fun” category, Freakonomics published an article detailing the correlation between states that have high occurrences of Bigfoot sightings and those with high occurrences of UFO sightings.  The best explanation given for this was in the comments section:

It strongly suggests to me that the aliens are Wookies.

— Posted by Doug

PS: I have a deeply discounted Bowflex machine for sale. Seriously.

Central Emergency Response Fund

Creative Commons License photo figure credit:
mark.groves

One of the keys to spending less than you earn and staying out of debt is having an emergency fund.  Personal finance gurus like Dave Ramsey suggest that your very first step down the path to financial freedom is to put $1000 into a designated emergency fund.  This should be done before beginning any kind of aggressive debt pay down.

We created our first official emergency fund just a couple of years ago. Before that we just tried to keep some amount of extra money available in our money market account. I don’t remember specifically how we created the emergency fund, aside from just diverting some debt reduction money towards this purpose.

To separate the emergency fund from our everyday money, I created a CD ladder by dividing the money in the fund into 5 equal parts and buying 1, 2, 3, 4, and 5 year CDs. Since then, every time a CD matures, I roll it into a new 5 year CD. This generally allows us to enjoy the highest interest rates available while still frequently providing us with liquidity to some portion of our money. I like using CDs in this way because it places a penalty on the withdrawal of the money, which makes it far less likely that we will raid this fund for anything less than a true emergency. The penalty that we would have to pay to access the money is small compared to the security that the fund provides.

So what’s the problem? When we created the emergency fund, we did so by contributing the minimum amount allowed by our bank to each CD. Since that time, we have added some additional money to each CD when it matured and rolled over, but the overall amount of money currently available for an emergency amounts to only 2.3 times our basic monthly expenses.

On the one hand, we’ve got more than the recommended amount while still paying down debts. On the other hand, we don’t have the recommended minimum of 3 months of expense for a true emergency fund, and nowhere near the 6+ months that’s really advisable, especially in a soft economy. We’re not as worried as others might be, however, since ScrapperMom is working part time, and in the event I lost or left my job, she could go to full time immediately and her salary alone would cover our needs. Nonetheless, it may not always be possible for her to work given that her first job is that of stay-at-home mommy. It’s time for us to get serious again about an emergency fund.

So where do we go from here? Well, since our Roth IRAs are fully funded for the year, that is one possible source of funding for a larger emergency fund. We would like to save more towards retirement this year, however. Another source is the extra money that we have been devoting to the aggressive reduction of the balance on our car loan. I believe that this is one of the real tricks to effective personal finance: attempting to meet several goals simultaneously. In this case, we want to increase our available emergency funds, save as much as possible for retirement, and pay off our car loan and existing business credit card. The bottom line is that we will have to compromise something to meet all of these goals, and it’s not clear to me what that should be yet.

How is your emergency fund doing?  What would you sacrifice in our case — retirement savings or debt reduction?  Perhaps a little of both?  Or would you be comfortable for now if you were in our shoes?  We’d love to hear your comments below!

07.29.2008
Nudge

photo figure credit: http://www.nudges.org/

Last month I finished reading a great book called Nudge: Improving Decisions about Health, Wealth, and Happiness by Richard H. Thaler and Cass R. Sunstein.  In short, this book was fantastic and I highly recommend it.

The authors indicate early on that they wanted to subtitle the book Libertarian Paternalism but didn’t think anyone would read it if they did. “Libertarian Paternalism?”  you may be asking, “isn’t that an oxymoron?”  Well, it is and it isn’t.  The central point of the book is that we all make choices on a daily basis.  Some choices are easy: which breakfast cereal to buy or what to have for dinner.  Some choices are hard: Who to marry or what house to buy or how much to save for retirement.  The authors argue that more choices are always better than fewer (libertarianism), but that most of us don’t have the information, context, or practice in making some of the hardest choices and that it would be great if there was some way to “nudge” us in the right direction (paternalism).

A classic “nudge” exists thanks to recent laws regarding how employers can handle 401(k) and other retirement benefits plans.  Employers can now automatically enroll new employees in the company 401(k) plan when they start.  So a new employee would, from paycheck #1 on, see a 5% contribution to a moderate blended fund in the 401(k) plan of the company.  At any time, the employee can march down to the Human Resources office and change the contribution or allocation or discontinue it altogether.  However, research has shown that inertia is a powerful factor that works equally well in keeping people in the plan as it does keeping them out when no such automatic enrollment is used.

Another great “nudge” was a recent law in New York City that requires restaurants to post their board of health ratings in the front window.  No change was made to the board of health standards, but almost overnight the average restaurant health rating rose substantially.  After all, who wants to eat in a restaurant with a D- posted in the front window?  As a result, NYC emergency rooms have seen a marked decline in food borne illness cases.  NYC could have had the same outcome by instituting more stringent restaurant hygiene laws and consequently increasing the time and money it would take to enforce those laws, but this solution avoids additional government intervention AND achieves the same outcome.  Plus, restaurants still have the choice of whether to clean up or not, but the “nudge” comes from their lack of business rather than a government edict.

Let’s face it, modern life is complicated, and we don’t have to look far to see the results of ordinary people making poor choices on really important things like mortgages, health care, etc.  Nudge argues that we get better at making good choices the more we practice (just like anything else).  We get lots of practice making choices about things that have relatively low consequences.  If you choose the wrong cereal, you’re out $4 or a week of dissatisfaction for 10 minutes every morning.  But most of us only purchase a few houses in our lifetimes, and the consequences for choosing poorly can be disasterous.  Just look at the current bankruptcy and foreclosure crises to be sure.

So how do we start “nudging”?  It starts with any person or organization who has the responsibility of presenting a list of options to someone else.  The book provides proof that just by the way choices are arranged in a list that the “choice architect” influences the outcome of the choice (this ranges from lunchrooms to polls).  All “choice architects” are going to influence the outcome of the choice, so they have a social responsibility to structure the choices in such a way so that most people will make the best choice if they know nothing else.  If possible, even, a default option should be available so that if a person makes no choice something will automatically happen.

The book cites the recent change in the Medicare Prescription drug benefit program as an example of how not to nudge.  People eligible for this program who made no selection from among the 43 separate plans available were randomly assigned to a plan.  The authors argue that at the very least a patient’s prescription history could have been surveyed to come up with a plan close to what they need, but this was not done.  Additionally, the tools for figuring out which plan was ideal for any given person were severely lacking and often contradictory.  While libertarianism was observed here, paternalism was not, and there are currently many people on drug plans that cost them too much or don’t deliver enough or the proper benefits.

One of the final recommendations in the book is for the development of “asymetric paternalism” in choice architecture.  The authors argue that “sophisticated” choosers should be free to make a well informed decision that best suits them and that “unsophisticated” choosers should have as much paternalistic intervention as necessary.  I agree, however what’s not clear to me is how one defines and sorts out the sophisticated from the non.  I remember trying to argue my way out of a mandatory youth group ski class because I had been skiing once before (and was, therefore, an expert!).  After the instructor pointed out that my ski boots weren’t buckled even though I was clicked into my bindings, I shut my mouth and took the class.  (Today I enjoy taking advanced level classes…)  The point is that most of us think we are sophisticated when we are not, so the choice architect has to be very careful when he applies his nudge…

The book defines the Jekyll and Hyde nature of the choosers within all of us.  The “Human” is akin to the Homer Simpson in all of us who has absolutely no impulse control and makes choices without thinking.  The “Econ” is akin to Mr. Spock of Star Trek fame who was always absolutely logical in making decisions.  The planning Econ in all of us makes great decisions on paper (by making a shopping list) but the Human comes home with donuts anyway (Mmm… donuts…).  Nudge offers us a new set of “tricks” for making difficult decisions easier.  It’s a great read and probably available at your local library.

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