Month: March 2015

This is what we’ve all been waiting for.  After two weeks of amazing investing tournament challenge action (just indulge me, will you?), in this post we will crown the champion of investing strategies.  Here we have Asset allocation taking on Tax optimization.  In the Final Four, Asset allocation pounded Index mutual funds with higher returns early on and limiting risk as you approach retirement.  Tax optimization made it two thrillers in a row, beating Savings rate on the strength of major tax savings with a little bit of work and education, but not a lot of monetary sacrifice.  As always, see the disclaimer.

Obviously both these strategies have tremendous upside, otherwise they wouldn’t be here.  So how do you pick between them?  It’s no easy task, but for you, my loyal readers, I’m ready to take it on.  Let’s see who cuts down the nets.

 

Reasons for picking Asset allocation:

In some ways Asset allocation seems really easy, since all you’re doing is figuring out what percentage of your portfolio goes into stocks, bonds, and cash.  90% Stocks, 10% bonds, and 0% cash; there, I’m done.  That didn’t seem so hard.  Obviously it’s more complicated than that.  We already know that Asset allocation is critically important throughout your investing time horizon.  When you’re younger you probably want to be mostly in stocks (even now the Fox family is 99% in stocks).  As you approach and ultimately enter retirement you want to be more in bonds, but stocks still probably need to be a significant part of your portfolio.

About 10 or so years ago, the mutual fund companies came out with a really cool innovation called target-date funds.  The basic idea is that these handle your Asset allocation for you.  Imagine today you’re 35 and you want to retire when you’re 60, in 2040.  You could invest in a fund like Vanguard’s Target Retirement 2040, and it will automatically shift your Asset allocation from mostly stocks today (currently it’s about 90% stocks, 10% bonds) to gradually less stocks and more bonds as you get closer to retirement.  It’s been a wonderful innovation that has proven extremely popular among investors.

So there you go.  Problem solved, right?  Well, not so fast.  I actually don’t think these really solve the Asset allocation problem because they figure everyone retiring in 2040 is in the same situation, but that’s definitely not the case.  Let’s say you and your twin retire in 2040, but you will get $1000 from Social Security while she’ll get $3000.  What if she had her house paid off completely while you have always rented?  What if you worked for a company with a 401k and she worked for a company with a pension?

All those scenarios are very real for investors, and require more individualization than knowing you want to retire in 2040 can give.  For all those, conventional wisdom would say that your twin should take on more risk (French for “invest in more stocks”) than you because she has other “assets” that are generating more cash.  Reasonable people can debate that last point, but clearly the idea is that Asset allocation is much more complex than just picking a year and being done with it.

So where does that leave us?  I am a firm believer in investing DIY, and Asset allocation is no different.  But I think this is one of the areas where the degree of difficulty is much higher just because you’re balancing a couple opposing forces and there’s never a clearly “right answer”.  You want to be in stocks but not too much in stocks, and then that changes over time.  Oh yeah, and the stakes are super-high.  Getting it “right” whatever that means could give you an extra few percentage points in return and it could also save your nestegg from catastrophic failure if another 2008 rolls around.  When I work on the Fox’s nestegg, this is probably where I spend the most time.

 

Reasons for picking Tax optimization:

As we’ve said ad nauseam, Tax optimization is important and can lead to enormous savings.  What makes taxes so difficult is that the tax code is constantly changing and the stakes are super-duper high (the stakes for Asset allocation were only “super high”).

Every year there are hundreds of changes to the tax code which keeps accountants employed and programs like Turbo Tax (the Fox family uses Turbo Tax) flying off the shelves.  Just a couple weeks ago, President Obama floated the idea of eliminating the tax-free features of 529 accounts, only to see the public outcry and pull back on that.  But imagine if he went through with that; your whole approach to saving for your kids’ college education would have completely changed.  And that one made the news.  What about the others that do hit the media’s radar and you never hear about?

There’s always talk about possibly means-testing the interest deduction on home Mortgages or changing the income levels to qualify for IRAs.  You have to keep up.  Also, it can get really confusing.  I think I’m fairly knowledgeable on these matters but I am still befuddled by the Alternative Minimum Tax, and I know I screw up the foreign interest paid on my international mutual funds.  This stuff definitely isn’t easy.

Also, look at the stakes.  If you screw up on your taxes, theoretically you could go to prison.  If it’s an honest mistake I don’t think the Internal Revenue Service will push it that far, but horizontal stripes are definitely in play as Wesley Snipes can attest.  What is more likely is the IRS will hit you with a fine composed of a penalty plus interest.  Oh, by the way, that interest rate is about 6%; that’s not “Pay-day Loan” high, but it’s still pretty freaking high these days.  That certainly can make someone cautious about how far to push Tax optimization, even when they’re clearly in the right.

However, there is a silver lining.  If you want professional help, there are thousands of Certified Public Accountants who are there to help you out.  For under a few hundred dollars most people can probably have their taxes done by a CPA who can make sure that you stay on the IRS’s good side.  Unfortunately, when it comes to developing creative Tax optimization strategies, my experience says there’s a huge range in quality that you’ll get from CPAs.  Several years back I had a horrible experience with H&R Block and thought they were border-line incompetent.  No way would I trust them to advise me on the finer points of maximizing the tax advantages of investing.  But there are amazing CPAs out there right now (like David Silkman who currently does our small business’s taxes) who I do think can really help.  But this is a real caveat emptor situation.  Maybe Angie’s List might help.

 

Who wins it all?

It all comes down to this.  In the end, I have Asset allocation pulling it out 76-70.  Obviously both investing strategies are amazingly important and getting them right can have an exponential impact on your portfolio.  For me I gave the nod to Asset allocation over Tax optimization for a couple of reasons:

First, if I met a total train wreck of an investor (he was just stuffing cash in his mattress) and I could only give him one piece of advice, I think it would be to get that money invested in some combination of stocks and bonds.  Tax optimization strategies like an IRA or 401k are nice, but first things first.

Second, I think the big rocks for Tax optimization seem to me better understood and more accessible than for Asset allocation.  Most investors probably know that investing in your 401k or an IRA is a good idea, and probably most could tell you why (at least be able to say “it helps with taxes”).  I think that’s different for Asset allocation where you have a lot of investors who are totally off on what is probably appropriate for their situation (age, income, other assets, etc.).

Third, there’s no real “right” answer for Asset allocation.  I could have a lively debate with my dear friends/loyal readers who work in the financial industry like Jessamyn and Mike, where we argued whether the Fox family should be more in stocks or more in bonds.  But there’s no right answer (other than if stocks go up a year from now, then you know you should have been more in stocks).  It depends on so many variables as well as risk tolerance which are super-hard to quantify.  With Tax optimization you can get closer to a right answer—either the tax code allows you to do that or not.  Of course, you typically sacrifice ease of access to your money for tax benefits, so that does add a complication.

Finally, I think it’s easier and cheaper to get expert advice on Tax optimization.  As I mentioned, a good CPA can probably really help guide you on Tax optimization.  Sure, the quality of CPAs is pretty wide, but good ones are out there, and probably they’ll charge you something with in the three-digit range.  With Asset allocation if you want professional help you typically need a financial adviser.  Unfortunately, and this is just my opinion, it’s a little more Wild West for financial advisers than CPAs.  A really good financial adviser is probably worth her weight in gold (140 pound of gold is worth about $2.6 million, so maybe they aren’t worth quite that much), but the range of quality is staggering; there are some real shysters out there.  Also, they’ll probably charge you in the four- or five-digits range.

So there you go.  Put that all together and I think Asset allocation comes out on top, finishing the sentence, “if you only do one thing in investing make sure you get Asset allocation right.”

 

I hope you have enjoyed reading all these posts on investing as much as I have enjoyed writing them.  While Asset allocation “won” remember that all eight of these are important and should be definitely be considered as you think about bulking up your portfolio.

Welcome to the second game of the Final Four of my investing strategies tournament.  Here we have Savings rate taking on Tax optimization.  In the first round, Savings rate beat Mortgage just on the sheer power that saving more money can have on the ultimate size of your nestegg.  Tax optimization squeaked by Starting early due to the enormous value created with minimal sacrifice by setting up the accounts to minimize your taxes.  As always, give the disclaimer a peek.  With that out of the way, let’s see who wins.

 

Reasons for picking Savings rate:

Savings rate is a simple but overwhelming force, maybe like Patrick Ewing when he dominated the Final Fours during his years at Georgetown (I don’t mean to call Ewing’s game simple, but you’ll see what I mean).  Ewing just owned the basket—any shot you put up he blocked, if you did get the shot up he got the rebound, when he got the ball you weren’t stopping him.  It all revolved around Ewing, and his dominance on the inside covered up for his shortcomings (outside shot, passing) as well as those of his teammates.

In the investing world, the sun really rises and sets with Savings rate.  Without any savings, you can’t invest so it really doesn’t matter what you do with things like Index mutual funds, Asset allocation, or Free money.

Also, unlike any other investing strategy, Savings rate can make up for any other mistakes you make along the way.  It’s a lot like Ewing protecting the rim on defense; if your guy beat you, you could be pretty confident that Ewing would bail you out by blocking his shot.  You could completely screw up Asset allocation and stuff all your money in a mattress—just crank up your Savings rate and there’s no problem.  Don’t participate in your 401k and walk away from the Free Money—save a little more and you’re okay.  You get my point.

Let’s use the same example of Mr Grizzly starting out at age 22, making $50,000 which will eventually rise to $100,000, and who wants to be a millionaire by the time he’s 60.  Let’s say he does everything right, plus he has a horseshoe growing out of his rear end, and over his investing career he averages a 10% return; he would only need to save about  3% of his income.  That’s probably a breeze.  Now, instead he has an average investing track record with returns of about 6%, he would need to save about 9% of his income.  So Savings rate was able to make up for his lack for tremendous luck.  Keep going down that path and let’s say he put all is portfolio in a local bank earning 1% interest, which I think we would all agree is a pretty terrible investing strategy, and he still becomes a millionaire so long as he saves about 24%.

 

Return	Savings rate
10%	3%
6%	9%
2%	20%
1%	24%
0%	29%

 

So you can see that Savings rate can make up for all manner of investing sin.  Pretty much any other investing strategy has its limits to how far it can take you before you exhaust its benefits.  But of course there are no free lunches.  Increasing your Savings rate comes at a much higher cost than other investing strategies, namely all that money you’re saving means you can’t spend it on other things.  So when Mr Grizzly needs to crank up his Savings rate, that money has to come from somewhere—he passes up on that salmon fishing trip, or buying Mrs Grizzly some artisan honey from the farmer’s market, or getting some detangling shampoo for his coat.  We can debate whether those purchases are worth the money, but to Mr Grizzly they are (cut to Lady Fox nodding and pulling out a Pottery Barn catalog).  Sure, you can start by cutting away the layer of winter fat, but the higher you make your Savings rate the more you start cutting into muscle and eventually into bone.  That, my friends, is the rub with Savings rate.

 

Reasons for picking Tax optimization:

Taxes are to investing what water damage is to a house—unwelcome, can really ruin stuff if not attended to, and it gets into everything.  The tentacles of taxes traverse tremendous territory to touch your total transactions (I challenged myself to see how many “t-words” I could use in a sentence).  Seriously, taxes pretty much affect everything in investing.

There are the obvious big rocks, some of which we’ve already discussed, like a 401k and an IRA; using those accounts to defer taxes can save you hundreds of thousands of dollars.  Medium-sized rocks like 529s and tax-deductible interest on your mortgage can save you tens of thousands in taxes over a shorter time span.  Then there are tons of small rocks which can certainly add up—flex spending accounts and dependent care spending can save you thousands.  Add all that up and that’s a lot of clams (if you didn’t read yesterday’s post, I am trying to use as many slang phrases for money as I can).

And then you can get into the really obscure Tax optimization strategies.  “Loss harvesting” is when you sell investments at a loss so you don’t have to pay taxes on your winners.  “Dividend location” looks to put your high-dividend investments in tax deferred accounts like a 401k, so you don’t have to pay taxes on the dividends during your high-income/high-tax rate years.  There are millions of these little loopholes and strategies that allow you to pay less taxes.  A major part of the accounting industry is based on this fact.

Just to illustrate the point, I’ll share a story from Medtronic.  If you’re a high-compensation employee (I do not qualify, so I can’t take part in this) you can participate in the Capital Accumulation Program (CAP) which allows you to defer a portion or all of your bonus into a tax-advantaged account—think of it like an extra 401k without the match.  This is a veritable tax goldmine, and sadly very few of the people I talk to take advantage of this.  Let’s assume Mr Executive makes $300,000 per year, with $100,000 of that being his bonus; and assume that he’s working hard to build his nestegg, so after maxing out his 401k he saves $50,000 in his brokerage account.  That’s probably pretty close to the people I’m describing.

What Mr Executive could do but probably doesn’t is defer his entire bonus.  He’s already saving $50,000 per year and since he’s in a pretty high tax bracket, that’s probably pretty close to what his take-home would be on that $100,000 bonus.  However, by deferring his bonus he avoids paying the 40% on taxes now and only pays 5% in taxes when he pulls the money out in retirement.  If you do the math, that’s a potential savings of $35,000 ($100,000 x (40% – 5%)) on top of what he’s already saving.  When I ask executives why they don’t do CAP they tend to say they never thought of it or they didn’t understand it.  When I show them the math says they’re leaving at least $35,000 on the table, their eyes bug out and they need to sit down.

That’s just one example of the power of Tax optimization that is out there that goes largely unutilized, even by really successful people, even by those who have tax advisers helping them out.  And there are thousands of other examples like that out there.  That’s $35,000!!!  That’s a lot of money, even if you are pulling in $300k.

My point with this and the others is that in the US (and probably every other country) the tax code is super convoluted.  Add to that that when you’re making more and more money, you pay more and more in taxes, so the stakes start to get pretty high.  That’s a perfect recipe for hidden 1% coupons; some of them are easy to find, some a little hard, and some require serious digging—but they’re there.

 

Who goes on to the championship game?

Just like in the Elite Eight, I think Tax optimization pulls out a squeaker over Savings rate, 71-68.  While Saving rate has unlimited potential, it comes at a real cost of foregoing purchases today.  Tax optimization isn’t necessarily unlimited.  There are only so many wrinkles and loopholes you can take advantage of, but there are an awful lot of them and I bet you’d run out of time and energy before you’d run out of tax strategies.

But what tips the scale is that most of the Tax optimization gambits are free.   You’re already going to save for your retirement so why not do it with a 401k and not pay taxes on it right now?  You’re already going to save for your kids’ educations so why not use a 529 and not pay taxes on the appreciation?  You’re definitely going to need to pay for childcare so why not use a Flex spending account and do it tax free?  You and the family are going to get sick so why not use a Flex spending account for that, too?  None of those cost any more than you would have paid already, but you’re cutting Uncle Sam out of his 40% (legally, of course).

Tomorrow we will see who wins it all, Asset allocation or Tax optimization.

Welcome to the first game of the Final Four of my investing strategies tournament.  Here we have Asset allocation taking on Index mutual funds.  In the first round, Asset allocation blew out Diversifying mostly due to the higher returns that younger investors can get by investing more in stocks early in their investing career.  Index mutual funds upset Free money on the strength of lower management fees that can apply throughout an investor’s career and across every account type.  As always, check out the disclaimer.  With that out of the way, let’s see who wins.

Reasons for picking Asset allocation:

Last round we saw how being too conservative with Asset allocation can really reduce the returns of younger investors who aren’t as heavily invested in stocks as they should be.  If you go to the other end of the investor’s time horizon, when he or she is older and nearing retirement, you can make equally harmful mistakes.

On one end of the spectrum older investors can become way too risky.  As the years tick by and people get closer to retirement, they begin to take stock (pun intended) of where they are probably a little more closely than they did in their 20s or 30s.  If they aren’t quite where they want to be, knowing that on average stocks have higher returns than bonds, one natural response is to allocate more of their nestegg to stocks to “catch up”.  According to generally accepted investing theory, this is the exact wrong thing to do—as we get closer to retirement you should be reducing your allocation of stocks to lower your risk, not increase it.  Here you’re stepping away from the world of investing and into the world of gambling.  Maybe you’ll get lucky and ride a bull market up to get your portfolio back to where you want it, but you’re definitely putting yourself at risk of hitting a market pothole and putting yourself further behind.

On the other end of the spectrum, they can become way too conservative.  Some people have the natural instinct to want to get completely off the investing train in retirement because they don’t want to have any risk, so they put all their money in bonds or cash.  This is understandable because they’re going to be depending on that nestegg, so it’s got to last.  But the problem is that even in retirement, many people still need the higher returns that stocks provide to balance out the relative safety of their bonds.  This is especially true in a world where people are living longer and it’s not unreasonable to expect retirement to last a few decades or longer.  And actually, that time element also makes the case for stocks being a significant part of your retirement portfolio—you have time to ride out the storms, just not as much time as you had before.

These are what make Asset allocation one of the harder investing strategies to get right, because it’s changing over time and there are shades of grey (at least 50 shades of grey).  Other strategies like Diversification and Free money are much simpler because your strategy is absolute.  Diversification—you should be diversified at all times.  Free money—you should get as much of it as you can at all times.  But with Asset allocation, the right thing to do gradually changes from being mostly in stocks during your early years, and then slowly switching to more bonds and cash as you start to near retirement, but never shifting completely to bonds.

There’s no strict rule on what your Asset allocation should be at different stages of life, but I always look at Vanguard target retirement funds as a bit of a guide (although I’ll write about some of my issues with these types funds in a future post).  With 40 years until retirement, right around when you’re first starting out, Vanguard suggests about 90% stocks and 10% in bonds.  Once you hit retirement Vanguard suggests 40% stocks and 60% bonds.  Notice that even in retirement a very significant portion is still in stocks.

Vanguard target date funds	% in stocks	% in bonds
2055 (40 years to go)	90%	10%
2035 (20 years to go)	85%	15%
2025 (10 years to go)	70%	30%
In retirement	40%	60%

 

So what does that all mean?  Well early on Asset allocation done properly can get you higher returns over the long run, historically about 3-4% higher than if you completely screwed it up.  Later on, it’s going to help protect you from any market crashes, market corrections, or general market zaniness that occurs.

 

Reasons for picking Index mutual funds:

We know from the Elite Eight round, that one of the major advantages of Index mutual funds is their lower management fees, which are on average about 1% less than actively managed mutual funds.  We also know from The power of a single percentage that saving 1% of your portfolio year after year can lead to some serious ducats (I’ve decided to use as many slang terms for money over the next few posts, so prepare yourself).  But we’re in the Final Four now so we need something more than that.

Not above a little chicanery, Index mutual funds is going to steal a page from Asset allocation’s playbook.  Often with actively managed funds, they keep a significant portion of the fund’s assets in cash so they can buy an investment when the opportunity presents itself.  Of course we know from above that holding cash over the long term leads to lower returns than holding stocks.  Index mutual funds are able to be almost 100% invested in stocks (or whatever asset class you want) because they aren’t picking investments so much as just following the index.  Just doing some simple math, if actively managed funds have 5% of their assets in cash, and over the long term stocks return 6% more than cash let’s say, that comes to a long term benefit of about 0.3% (5% x 6%).  That’s not going to change the world, but even those little bits compounded over decades can make a huge difference.

Index mutual funds is also copying Tax optimization.  When your mutual fund sells shares there are tax implications on that (death and taxes, baby).  That’s why you get that statement every year from your mutual fund telling you what you need to report to the IRS. The more frequently your mutual fund trades stocks, the more likely it is that you’ll have short term gains which are taxed at higher rates.  But with Index mutual funds, trading is minimized because the fund is only following an index like the S&P 500 which doesn’t change that often.  That leads to lower taxes which we know can add up to some serious cheddar (see, I did it again).

There are also people who argue that Index mutual funds do better than actively managed funds because they take the human element out of it.  This is pretty controversial, and if you believe in the theories from A Random Walk Down Wall Street, which I unabashedly do, then shouldn’t active managers do just as well as a passive index?  Hmmm, that sounds like fodder for another post.  People debate this all the time and I’m not convinced that this really drives the needle.

The final major benefit of Index mutual funds is that they’re super easy, especially compared to some of the more difficult investing strategies like Asset allocation.  You can go to a place like Vanguard (that’s where the Fox family’s money is) or Fidelity or a dozen other places and sign up for one of their index funds, then as Ron Popeil says, “you set it and forget it.”  That means you’re getting pretty incredible value for a relatively small amount of work.

 

Who goes on to the championship game?

Index mutual funds pulled out all the stops, but in the end Asset allocation was just too strong.  Index mutual funds will definitely help build your nestegg, probably juicing your returns 1% compared to actively managed funds and maybe even 1.5% if you’re feeling charitable.  That’s nothing to sneeze at, but we’re talking about punching your ticket to the Championship round here, people.

Let’s say you completely abandoned the idea of Index mutual funds and went totally with actively managed funds.  How bad would that be?  It wouldn’t be ideal (just my opinion and one not shared by my good friend Mike), but you’d be fine in the end.  Actually this is what millions of people do all the time and it tends to work out.

Compare that worst-case scenario to Asset allocation’s and you see why they won.  Screwing up early on and investing too much in bonds and cash instead of stocks can cost 3-4% on your returns.  That dwarfs what Index mutual funds bring to the table.  Screwing up closer to retirement can put your whole financial plan at risk.  Ask near-retirees who were to heavily invested in stocks before the 2001 or 2008 crashes what they think.  In the immortal words of Winston Zeddemore “I have seen s%$t that will turn you white.”

With Asset allocation the stakes are just too high.  I have Asset allocation pulling away, 68-59.  Be sure to come back tomorrow to see who they take on in the final, either Savings rate or Tax optimization.

 

We’ve made it to the last contest of the first round, and this one is a doozy.  In true Kentucky versus Duke-style, this is a match of the real bluebloods of the investing world.  As always, check out the disclaimer.  Let’s go to the game.

Reasons for picking Starting early:

Starting early is one of the sage pieces of wisdom everyone gives, and for good reason.  The earlier you start investing, the more time you give the incredible power of compounding.  In this way, Starting early is very similar to Savings rate which we saw won the last game.  Because of the compounding the numbers seem to act “funny” (not funny “ha ha,” but funny as in not a way you would expect unless you are an expert in exponential algebra).

So let’s say Mr Grizzly just got his engineering degree at age 22 and wants to retire with $1 million on his 60^th birthday.  Similar to the previous examples his starting salary is $50,000 and it gradually increases to $100,000, and he can get a 6% return on his investments.

If he starts saving at age 22, he will need to save about 9% of his salary to get to the $1 million mark by 60.  However, let’s say he can’t start right away, and instead he starts saving at age 30; now to become a millionaire by age 60 he needs to save about 13% of his income.  Wow!!!  By delaying a measly 8 years early on, he has to increase his savings rate about 4%.  If he puts it off until he’s 40, he needs to save 25%–that’s doubled his savings rate compared to starting at 30!!!  And if he delays starting until he’s 50, it will require he save about 67% to become a millionaire by the time he’s 60.

Starting age	Savings rate to become millionaire by age 60
22	9%
30	13%
40	25%
50	67%

 

Clearly the earlier you start, the easier it is.  9% of your income isn’t trivial, but it certainly seems manageable.  On the other end of the spectrum, it seems just plain unrealistic to be able to save 67% of your income; even 25% would be a tall order for most.  So everyone can agree it’s better to start earlier rather than later.  Done deal.

But the problem with these types of analyses is saving more comes at a cost.  That $4500 you saved at age 22 (9% of your $50,000 starting salary) meant you couldn’t spend that.  Perhaps that’s not so bad if you were wasting it on clubbing and mani-pedis, but who am I to judge?  But maybe clubbing and mani-pedis are what makes life worth living.  Broadening that out, nearly all of us are making less early in our careers, so how realistic is it for us to be saving right away?

Also, early on you actually have higher expenses like repaying student debt, buying furniture for your new place, buying a work wardrobe, and just kind of experiencing life.  That’s not to say that people can’t be disciplined about those things, but there’s got to be a balance.  I personally started saving about 30% when I first started working and I think maybe I should have traveled a little bit more and enjoyed that time of my life (I was living right outside of New York City after all).

Nonetheless, Saving early is a tremendously powerful force if you can afford to do it.  There’s no doubt in my mind that the Fox family is at a comfortable place right now in large part due to the fact that I started squirreling money away so early.

 

Reasons for picking Tax optimization:

Taxes are a tremendously important part of investing.  It is a dominant force like Shaquille O’Neal on those LSU teams from the early 1990s.  Taxes impact every facet of investing—whether you’re young or old, no matter the type of account you have (401k, IRA, brokerage, Mortgage).

Obviously taxes take a chunk out of nearly every financial transaction you do.  What makes Tax optimization so important is that during your earning years, that chunk can be in the 30-50% range, obviously depending on a number of factors like your income and the state you live in.  However, in retirement when you’re income is lower, that tax rate might fall to 10% or even less (of course, as my good friends Rich and Mike pointed out, no one knows what future tax rates will be—I am just assuming that tax brackets remain the same as they are today).  Many of the Tax optimization strategies to some degree involve finding ways to not pay taxes at the higher rate when you’re working, but rather pay when you’re retired and your rate is lower.

Just how big of a deal can taxes be?  Let’s look back at that example from The tax man cometh.  Mr and Mrs Grizzly are ready to save $1000 per month, either in a taxable account like a brokerage account or a tax deferred account like a 401k.  Using a regular brokerage account after 30 years (let’s assume a 2% dividend and a 5% stock increase) they have about $815k—certainly nothing to sneeze at.  However, had they invested the exact same amounts in the exact same stocks but instead in a tax deferred account, they would have had $1.12 million.  That’s almost $300k more, just for Tax optimization!!!

The only difference is when they paid taxes on the money and at what rate.  In a taxable account they were paying taxes on the $12,000 each year at their high-income tax rate (34%) and they were paying taxes on qualified dividends (thanks Rich) at a pretty high rate too.  In the tax deferred scenario, they were paying taxes on the money after they were retired which I estimated at about 2% because at that time their income is only what they are spending.

That’s just one example, and there are tons just like that where Tax Optimization can really add up to tons of money.  There’s no such thing as a free lunch, but this gets pretty darn close.  When you put your money in a tax deferred account, it gets more difficult to access if you need it right away, but that seems a pretty small price to pay compared to the massive benefits of tax deferral.

 

Who wins?

This clash of the titans was super close.  In the end I have Tax optimization winning on a Christian Laettner-esque (sorry to all my Kentucky friends) miracle shot to push it to the Final Four.

To me I think this comes down between something that is not very complex but involved sacrifice (Starting early) and something that is fairly complex to pull off but doesn’t involve a lot of sacrifice (Tax optimization).  Ultimately, when Starting early you’re taking money that could have been spent on something else and started investing it.  So long as you weren’t planning on setting the money on fire, that will involve a sacrifice.  Conversely if you do Tax optimization you really aren’t foregoing anything, except a little bit of liquidity.  All it is is being smart with taxes and setting up the right accounts.

There are a lot of pretty easy Tax optimization maneuvers like 401k, IRAs, etc., that only take a few hours to figure out and then you’re set for decades.  So you’re getting those huge benefits without a lot of effort.  But Starting early is requiring a fairly significant sacrifice in your early years that could cause quite a sting.  Put all that together and I have Tax optimization coming out on top 83-82.  I have to confess though, I think Starting early would have beaten a few of these other strategies if it had lucked out a little bit in the draw.

Well, that was a wild first round.  I hope you enjoyed this and we’ll see you tomorrow for the first match of the Final Four, Asset allocation versus Index mutual funds.

 

 

 

After a thrilling contest between Index mutual funds and Free money yesterday, we are now pitting Mortgage against Savings rate.  As always, I am not an expert on these matters.

 

Reasons for picking mortgage:

For most families, their Mortgage payment on their home is the single largest expenditure they have.  Also, due to its nature as a commodity, it’s also one of the easiest places to really save a lot of money pretty painlessly.  For a lot of products there’s a trade off between price and quality.  A BMW 325 owner could pay $20,000 less and drive a Honda Civic, but there is a trade-off, either real or perceived, between those two cars.  Sure you’re saving a lot of money, but you’re also getting not nearly as nice a car.

Mortgages are very different because money is a commodity, so there’s no difference.  If you get a Mortgage from Bank of America it acts pretty much identically as the Mortgage you get from Roundpoint (incidentally, the Fox family refinanced our mortgage—we used to be with BofA and now we’re with Roundpoint).  Money is money so here you want to go with whoever can give you the lowest rate (there are some features that might be important like prepayment penalties or ability to refinance within a certain period of time, but in my experience those are pretty rare).

Here we’ll use the Grizzly family as an example; they owe $400,000 on their home.  One of the easiest ways to save money on a mortgage is by refinancing when interest rates go down.  In the past few years, rates have been at historic lows and that means Mortgage interest rates have been similarly low.  Let’s say the Grizzlys got their mortgage 5 years ago with a rate of 6%, but now they can refinance at about 4%.  That alone would reduce the interest payments over the life of their mortgage about $175,000!!!  That’s an incredible amount of money for going through a process that takes maybe a month from beginning to end, and probably about 5 hours of work on your part.  As easy as this is, there are millions of homeowners out there who haven’t done this yet.

You can move a little up the difficulty spectrum and save even more.  Some Mortgages are sold with “points” which is basically prepaying interest; for example you might pay an extra $5000 when you get your loan and for that you would have an interest rate of 3.5% instead of 4.0%.  Points aren’t very well understood and because of that a lot of people tend to stay away, but if you are planning on staying in your house for a long time, they can be the best money you ever spent.  Using that above example, paying the $5000 to get the lower interest rate would net you a savings of about $35,000 over the life of the loan.

Kind of the opposite of points are adjustable rate mortgages (ARMs).  Instead of a 30-year fixed loan (the interest rate stays constant for the 30 year life of the loan) you could get a 5-year ARM where the interest rate is fixed for the first 5 years of the loan and then adjusts based on market conditions for the remaining 25 years.  The benefit of these is ARMs tend to be about 1% less than fixed rates, but the major concern is that rates could rise after the 5 years is up and that could increase the cost of your Mortgage.  In my opinion ARMs make sense if you don’t think you’ll be in your home for very long.

In fact the Fox family is anticipating moving in the next few years, so we refinanced from a 30-year fixed at 4.0% to a 5-year ARM at 2.75%.  Let’s say the Grizzly family did the same thing with their loan; that would equate to savings of about $15,000 for the first five years.  Of course, after that they would either need to move, refinance their Mortgage, or deal with the uncertainty of a floating rate Mortgage.

	What it does?
Refinance	Take out a new loan at a lower interest rate to decrease the amount of interest you pay
Buy points	Pay more in closing costs to get a lower interest rate
ARM	Get a lower interest rate that is fixed in the beginning but then becomes adjustable (usually after 5 years)

 

So all these seem to be pretty big numbers, especially since you aren’t really giving anything up to achieve them.  But they aren’t going to be quite that big because interest on mortgages is tax deductible, so saving $100,000 in interest on the life of your mortgage may only put you ahead $60,000 because of the tax deduction.  On the other side of the spectrum, you might end up with significantly more if you took those savings and invested them.  Either way, your Mortgage is a great way to pad your nestegg.

 

Reasons for picking savings rate:

Savings rate is probably the most fundamental element of investing.  You can’t really invest until you have saved some money to invest with (Gee Stocky, thanks for that tremendous insight into what we already know).  And certainly, the more you save, the more you can invest, and the larger your nestegg will become.  But how much can saving more really move the need?

The impact can be pretty staggering.  Over a 38-year period, from 22 when most of us enter the workforce, until we turn 60 and hopefully retire, if you invest $100 per month (assume a 6% return) you will end up with about $175,000!!!  It’s not that $100 isn’t a lot of money (it definitely isn’t chump change), but that seems pretty incredible that such a modest amount every month can lead to such a large number at the end of the run.  Over those 38 years, you would have invested a total of about $47,000, and because of investing returns you would have ended up with about 4 times that amount.

And the math works so if you save $200 per month, you end up with about $350,000; $1000 per month, you end up with $1.75 million.  Ladies and gentleman, say “hello” to the power of compounding.

 

Who wins?

Mortgage gives it a good fight, but in the end Savings rate is able to generate numbers that are so much bigger.  Also, while refinancing at a lower rate is a pretty sure-fire way to save money with your Mortgage, the more complicated maneuvers like buying points or using an ARM do entail some risk which could cost you serious dollars if you move too early or too late.  On the other hand, there is really no way that saving more can hurt your nestegg.  In the end Savings rate crushes Mortgage 65-51.

I’ll do my usual week in review on Friday.  Then come back on Monday to see the final match of the first round, Starting early against Tax optimization.

 

After a thrilling first day where we saw Asset allocation blow out Diversification, we are now on to day two where Free money will face off against Index mutual funds.  As always, I am not an expert on these matters.

 

Reasons for picking free money:

Free money is . . . well . . . FREE.  And obviously the more money you can contribute to your portfolio the closer you’ll be to retirement, the better you’ll be able to ride out stock market downturns, and the more financial flexibility you’ll have generally.  I’m not telling you anything you don’t already know.

In the US, by far the most common opportunity for Free money is the company match for your 401k.  Typically it looks something like they will match $0.50 for every dollar you contribute up to 6% of your pay.  And there are some companies that are even more generous; Medtronic has historically matched about $0.90 for every dollar up to 6% of your pay.  Do the simple math and your average 401k match comes in at about 3% ($0.50 * 6%).  Ever since I started working in 1999 I have always contributed at least enough to get the entire company match.

If you do a quick calculation (assume you work from 22 to 60, with a salary that starts at $50,000 and rises to $100,000 over the years, with a 6% investment return), the value of that match is about $350,000.  That’s not what your whole 401k would be worth, that’s just the value of the match!!!  Not bad considering the median nestegg for a 60-year-old living in the US is about $140,000.

So who says no to this?  Sadly, about one-third of employees who have access to a 401k plan are “leaving money on the table” by not contributing up to the amount that their employer will match.  This is some really low hanging fruit that is going unpicked.  I get that there is only so much money to go around, but man, every dollar you’re putting in gets you another $0.50 of FREE MONEY.  That’s a guaranteed 50% return; there are a lot of investors who would give their first born for something like that (Foxy Lady just instructed me that I am not allowed to give away Lil’ Fox for a 50% return–damn).

 

Reasons for picking index mutual funds:

Index mutual funds are mutual funds that mimic an index like the S&P 500, Barclays Bond index, FTSE Global Cap, or the MSCI US REIT index.  That may sound confusing—the point is these mutual funds find an index already established in the market and do their best to copy it exactly.

Index fund advocates, and I count myself among them with probably about 95% of the Fox’s nestegg in Index mutual funds, believe that these funds actually perform better than actively-managed mutual funds (an actively managed fund is one where the mutual fund manager picks individual stocks or bonds that he or she believes will out-perform the general market).  I personally think the data here is mixed to slightly favorable for index mutual funds (mostly because of tax implications), but that is a pretty deep discussion probably for another blog post.  For this analysis, I’ll assume that actively managed mutual funds and index mutual funds return the same amount.

The undeniable advantage of Index mutual funds is their lower management fee.  Like all things, mutual funds charge a fee for their services; it is a percentage that the fund managers skim off the top to pay for managing the fund.  For actively managed funds that fee averages to about 1% with some higher and some lower.  This goes to paying for all the research done, salaries for the different teams, brochures and disclosures, travel to different conferences, etc., and it tends to be a pretty decent chunk of change.  For Index mutual funds, you really don’t need all that because all the team is doing is tracking a pre-existing index; because of this management fees tends to be fairly low—in the 0.05% to 0.2% range.

Remember The power of a single percentage?  We actually called out mutual fund management fees there as ripe for a 1% coupon.  Running the numbers using the same scenario we just used for Free money (assume you work from 22 to 60, with a salary that starts at $50,000 and rises to $100,000 over the years, with a 6% investment return), that 401k account using a index mutual fund with a fee of 0.2% would leave you with about $990,000.  An actively managed account with a fee of 1% would leave you with about $820,000.  That a difference of $170,000 in your 401k over the course of your investing career.

But that’s just for one account.  Index mutual funds can be used for pretty much all your investing accounts—401k, IRA, 529, brokerage.  Also, they can be used throughout for investing career, from the time you open your first account as a youngster all the way through the end when you shuffle off this mortal coil and leave some cash to your loved ones (more cash than you would otherwise because you were paying lower fees).

 

Who wins?

This turned out to be much closer than I anticipated.  At first I figured that Free money would win this going away, but Index mutual funds definitely came to play.  Free money has a power effect (about 3% of your salary on average), but that is generally limited only to 401k accounts, only to the first 6% of your compensation, and only while you are working.  Even with all those limitations, it makes an enormous difference over your investing lifetime.  Index mutual funds have a smaller impact but a much broader application.  You can use them on every account, with every dollar invested, for every year you’re investing.

In a game that came down to the absolute wire, I think Index mutual funds barely edges out Free money in a Bryce Drew-style miracle finish.  The final score, Index mutual funds 70, Free money 69.  Ultimately I think Index mutual funds and that lower management fee will save more of your money in every corner of your investing portfolio, and that will ultimately lead to a bigger impact on your nest egg.  I hope to see you tomorrow when your Mortgage takes on Savings rate.

We’re ready to kick off the investing strategy tournament to determine which is the single best investing strategy if you could only pick one (which fortunately isn’t the case–you can pick all these).  As always, I am not an expert.  So without further ado, we’ll start with the contest between Asset allocation and Diversification.

Reasons for picking Asset allocation:

Asset allocation is picking the right mix of stocks, bonds, and cash which maximize your investment returns while also limiting that chances that you hit a bad patch of time which cripples your portfolio beyond recovery.  The basis of the concept of asset allocation is the fact that as your expected investment returns increase, so does its volatility.

So for example, cash (or money market accounts) are the least volatile investments around where the chances of you losing money are nearly zero, but they also offer the smallest return at about 1-2%.  On the other end of the spectrum are stocks which historically have averaged about an 8% return, but where about one-third of the years you lost money.  Bonds are between those two, both in terms of returns and risk of losing money.

In my experience screwing up Asset allocation, especially among young investors, is one of the most common missteps.  The conventional wisdom is that you want to take more investing risk when you’re younger because you have more time to “recover” from any market downturns (as was the case with me in 2001 when I was just starting out).  That means that typically (and of course, each individual is different) younger people should allocate more to stocks than bonds or cash.  However, so often I talk to younger investors who have a significant chunk of their 401k in bonds or worse yet, cash.

Why is this so bad?  Well, over a period of decades, the investment horizon when you’re in your twenties or thirties, you end up leaving a lot of money on the table.  Using historic averages, if the 25-year-old you invested your 401k in stocks and your twin invested in bonds, when it comes time to hang up the spurs, it’s no contest—you’re so far ahead of your twin.  Remember that historically, stocks have returned about 8% while bonds have returned 5% and money markets (cash) have returned about 2%.  Just doing some really simple math, the historic difference between stocks and bonds has been about 3%–that adds up to huge differences over an investing career (remember from “The power of a single percentage” how big a difference 3% can make?).  Who knows if it will be like that in the future, but based on history that could lead to hundreds of thousands or even millions of dollars over time.

Of course, you probably read A Random Walk Down Wall Street, so maybe you’re saying, “but when you invest in stocks you’re only getting a higher return because you’re talking on more risk.”  There’s no such thing as a free lunch, and right you are.  That argument is exactly why Asset allocation is so important.  If you were 60 years old and getting ready for retirement, it probably wouldn’t be a good idea to risk losing a big chunk of your portfolio by investing the majority of your money in stocks.  But if you’re 20 or 30 years old, then you can invest in stocks to get the higher return knowing you’re at less risk of a catastrophic loss because you have three or so decades to ride out any storms.

 

Reasons for picking Diversification:

Diversification is the strategy of picking multiple investments so that you can reduce the volatility of your portfolio.  When some of your investments are down, others will be up.  This is really Investment 101 stuff, and I don’t think you’ll find many legitimate investors who would not say it’s a good thing.  But if you think about it, how much is Diversification really doing to help you achieve your financial goals?

The fact of the matter is that Diversification does not increase your investment returns, on average (“on average” is a critical phrase here).  If that’s true, then why does everyone make such a big deal about diversification?  Because by diversifying with several stocks you even out the highs and lows that would occur with a single stock.  As an example let’s look at investing in an S&P 500 index mutual fund which is considered highly diversified, and compare that to investing in a single stock.  Here I picked Catepillar because from 1980 to today, it and the S&P 500 had largely the same performance (they were both up about 1000% over those 34 years).

Over that time both investments had their ups and downs, but the difference was that Caterpillar’s ups were much higher and its downs much lower.  Since 1980 (34 years), the S&P 500 index had seven negative years with its worst year being 2008 when it was down 39%.  It also had 11 years where it had a return of 20% or better with its best year being 1995 when it was up 39%.

Now compare that to Caterpillar over the same time, remembering that over the entire 34 years they both had total returns fairly similar to each other.  Caterpillar had 15 years with negative returns, the worst being 2008 when it fell 55%.  On the other side, it had five years where returns were over 55% (16% better than the best year of the S&P 500 index), with the best year being in 2010 when it increased 90%.

So think about that.  If you decided not to diversify and put all your money in Caterpillar, you would have ended up in pretty much the same place as your twin who diversified with the S&P 500 index, but you would have had a much crazier ride.  2008 would have sucked for both of you, but much more so for you than your twin.  Also, almost half of your years would have been negative (15 out of 34 years) where it was only about 7 out of 34 years for your twin.  Of course, that would have been offset by some real “bumper crop” years (I had to get a farming analogy in) like 2010 when your portfolio would have almost doubled.  No one is complaining about a year like that, but it that a good thing?  How do you plan for something like that?  Pre-2010 you were probably figuring you’d have a moderate retirement, and then 2010 rolled around and life all the sudden got a lot sweeter.  Just look at the graph—far and away the most common annual return for the S&P 500 index was the 0-20% bucket; for Caterpillar the returns were all over the board and the most common was -20% to 0%–a loss!!!

And of course, I picked Caterpillar because over the 34 years it was pretty close to the S&P 500.  Remember that if you picked a single stock randomly from a broad index like the S&P 500, you would expect the stock to do just as well as the index, because the index is just an average of a bunch of those stocks.  And it’s true that on average a single stock will do as well as an index, but what if I randomly picked United Airlines which went bankrupt just like many, many other companies do every year (there’s no real chance that the value of the S&P 500 would go down to zero in a similar way)?  Or if I picked Medtronic (one of the greatest companies ever) which outperformed the S&P 500 some 12x?

My personal preference with investing is that I want as much predictability as possible, and that is even tough to come by when you’re highly diversified; when you aren’t diversified, there’s no chance.  Maybe if you like those types of thrills that putting everything into a single stock brings, you may want to think about BASE jumping or free diving.

But assessing it honestly, Diversification does not lead to higher returns on average.  It just reduces the crazy swings up and down.

 

Who wins?

Asset allocation wins this one pretty easily, 86-59 (I just made that up to look like a basketball game score, but it seems about right).  Diversification definitely helps smooth things out, but Asset allocation can undeniably increase your returns which translates to real money.

So Asset allocation moves on to theFinal Four.  Make sure you come back tomorrow to see Free money take on Index mutual funds.