Author: Stocky

Dear 2017, You were pretty awesome

Stocky Leave a comment

As the door closes on 2017, let’s take a few minutes to reminisce about what an incredible year 2017 was for investors.  For the Fox family it’s awesomeness was especially welcome given that our careers have shifted quite a bit, moving away from working for the man to working for ourselves (though, one of us happens to be a man).

Let’s look at the numbers, and figure out what it all means.

 

A tale of the tape

Like most investors, we had a really good 2017.  Here is how our portfolio broke down:

Investment

Portfolio weight

2017 return
US stocks (VTSAX)

52%

19%
International stocks (VTIAX)

37%

24%
Real Estate Investment Trusts (VGSLX)

7%

1%
Commodities (DJP)

2%

1%
Lending Club

2%

2%
TOTAL

100%

19%

 

Cha-ching

No matter how you look at it, 2017 was a GREAT year for stocks.  The US stock market did really well, growing 19%.  This can become really political really quickly when assigning credit/blame for such things to politicians.  However, I think it’s fair to say the Trump administration has been fairly pro-business.  That, along with the massive tax cut, definitely gave a boost to stocks.

Also, we saw economic growth really pick up while unemployment went to historic lows.  And all that was happening while inflation remained very low (more on this in a second).  If you put all that together, that’s a perfect recipe for awesome stock performances, and that’s exactly what we had.

Not to be outdone, international markets really kicked it into high gear.  Coming into 2017, US stocks had outperformed international stocks (pretty dramatically, actually) for four years in a row, every year since 2012.  That ended this year.  International stocks were up an astounding 24% compared to the paltry 19% that US stocks were able to muster.

I think that’s a good reminder that you can never really outsmart the market.  At the beginning of 2017 there was every reason to believe that US stocks would do better.  There was a ton of momentum in the US coming off of Trump’s election.  Plus, Europe seemed embroiled in political quagmires—Brexit, French elections with extreme candidates polling well, Greece being Greece.  Asia similarly seemed poised for another yawn of a year—Japan remain in a deflationary stagnation, Noth Korea being a total wild card, and it looked like China’s economy would slow down.

Our interpretations were dead wrong and those markets kicked butt, and international markets outpaced the US markets by 5%.  5%!!!  That’s a lot actually.

 

Inflation remains dormant

While all this was happening, inflation remained remarkably tame.  You know I spend a ton of time and energy talking about inflation because it has such a big impact on the purchasing power of your savings.

Huge returns like we had in 2017 are great, but what’s the point if those gains are all eaten away by higher prices?  The final reading for December will come out in mid-January, but preliminary readings indicate that inflation for the year will come in at about 2.1%.  2.1%!!!  As high as those 20-ish% returns were, that’s how low 2% inflation is.

As an investor, it really doesn’t get much better than that—high returns and low inflation.

 

Regrets, I’ve had a few

As you know, I always use New Years as a natural time to take stock (no pun intended) of things.  Now is a really good time to look at how we did, thinking about the things we did well with our investments and what we could have done better.

The high points of our investments were the US and International stocks.  We invested in all index mutual funds so we really didn’t do anything here.  Just “set it, and forget it”.  I suppose that speaks to how useless I am as an investor—the best part of our portfolio is the one that I did the least for.

Certainly, we did have some not-so-great investments.  I hate to be picky in a year where our portfolio grew 19%, but 2017 really exposed some stupid decisions that I had made.  Look at our returns, and the two “basic” investments that everyone should have (I even wrote a whole post on this very subject).  Those did the best.

The investments that did the worst were those “other” investments that aren’t one of the three basic ingredients.  I’m stupid, and that stupidity probably cost us $50,000 this year.  Ouch.

I’ve chatted about our commodities investment and our Lending Club investment, both of which have been incredible duds.  Currently, we’re in the process of eliminating those from our portfolio, so hopefully in 2018 we won’t have to deal with that crap.  Of course, because the investing gods like to humble stupid people, I am sure those two will perform spectacularly this year.

As for the REIT, over the longer-term it’s done fairly well (not as good as US stocks but better than International stocks).  This was just a down year, so that happens sometimes.  Still, it begs the question why we got into this instead of just sticking to the three ingredients, and I have some lame excuses, but nothing worth mentioning.  Hmmmm.

 

So there you have it.  2017 was an incredible year for being an investor.  Despite the couple misses we had, our two biggest investments really did well, so we’re happy.

How about you?  How did your portfolio do in 2017?

RIP Inflation

Stocky 2 Comments

I’m trying to build my audience, so if you like this post, please share it on social media using the buttons right above.

Inflation is dead!!!  That’s quite a proclamation.  Is the stress of the holidays getting to me, making my mind soft?  Or is there something really to it?

If you are a regular reader of this column, you know that inflation can have an enormous impact on your financial plan.  You also know that I think that the government’s official measure of inflation (CPI) is way overstated.  No matter what you think, it’s undeniable that inflation is important and generally the lower the better.

If you don’t want to read the whole column, I’ll give you the answer: robots and engineering.  If you’re interested in my reasoning, read on.

Quick Crash Course

Inflation basically comes from one of two places:

  1. The government going insane and turning the presses on to print more money. This is hyperinflation and Zimbabwe and Venezuela lately and the Weimar Republic in the 1920s are good examples of this.
  2. The general rise in prices as people demand more for their labor and raw materials get more scarce, leading to increased prices.

Say what you will about the insanity of Washington, but #1 really isn’t a concern.  So inflation for the rich countries of the world really comes from #2.

Oil

The latest bout of really bad inflation in the US was in the 1970s and carried over to the early 1980s until Ronald Reagan and Paul Volker punched inflation in the face.  That was started by the oil shocks that OPEC imposed on the world.

Oil production was curtailed which drove prices higher.  Oil is a bit of a unique commodity in that we used it (and continue to do so although to a lesser degree) in nearly every aspect of life.  More on that in a minute.  Our world was based on oil so we really couldn’t do with less, so we had to pay more.  We really didn’t have a choice.  Prices rose (inflation).

Thirty years later in the mid-2000s oil prices dramatically rose again to $150 per barrel as demand from India and China shook the markets.  Again we had to use oil so we paid the higher prices, but then that story ended differently.  Technology had advanced so we could use less oil—natural gas powerplants, hybrid cars, solar panels, etc.—which took a bite out of the 2007 oil shock.

Also, and more importantly, technology also allowed fracking and oil sands to produce amazing amounts of oil in the US and Canada.  All the teeth were taken out of the OPEC threat.  Prices cratered over the next few years and have remained at very low levels.  If oil ever goes up again, more fracking and shale sands will be mined to bring prices back down.  We’re probably set with oil prices being moderately controlled for the next 100 years.

BOLD PREDICTION—Oil prices will never rise faster than 2% for the rest of my lifetime.

Other raw materials

Oil is a very unique raw material in that it is used everywhere.  Others aren’t nearly so ubiquitous.  That said, raw materials can increase in price.  However, when that happens our dynamic economy has shown an amazing ability to engineer products to substitute the more expensive raw materials for cheaper ones.

The price of copper has doubled over the last 30 years (from about $1.50 per pound to $3.00 per pound).  That should cause inflation yet think about engineering.  Thirty years ago how much copper was used in telephone line—a ton (literally)?  Now that’s all fiber-optic cable (mostly plastic—which is cheap) that carries a 1000x information at marginally higher prices.  Copper pipes used to be used exclusively in homes.  Now it’s PVC which is cheaper and more durable.  You get my point.

You can also have commodities like foodstuffs (cows and bushels of corn).  In the past those have increased in price significantly.  However, as an economist would predict, as the price goes up farmers plant more corn and ranchers husband more cattle.  That keeps everything at relatively steady prices.

When ever anything gets more expensive, businesses, with their profit motive, will find alternatives to do the job better at a lower price.  That is going to keep a major cap on inflation.

BOLD PREDICTION—There won’t be raw material whose price goes up significantly while also whose use increases significantly.

Robots

The largest component of inflation is human labor.  In the past, there has always been a general pull towards higher wages.  When the economy is weak (unemployment is high) that tends to slow or even stop.  When the economy is strong (unemployment is low) companies have to compete for workers and they do so by raising wages.  That leads to higher prices.

Of course, higher prices don’t always translate to inflation.  If a person is paid more but is much more productive (thanks to computers or other tools) that doesn’t lead to inflation, and if the productivity improvements are large enough will often lead to deflation.

However, and here’s the political hot potato, those productivity advances tend to be focused on the highest-skill workers.  Engineers now have computers to make them more productive; airline pilots have more advanced aircraft; construction workers have better tractors.  When most of those people got pay increases it was because they were more productive, no their impact on inflation was minimal.

The low-skill workers really haven’t gotten productivity enhancements, so any pay increases they got typically led to inflation.  But look at what has happened to all those low-skill jobs.  They have disappeared or are disappearing.  You don’t have gas-station attendants and grocery-store baggers anymore.  Cashiers are quickly disappearing.  Soon waitresses are going to disappear.

Most of the time the extinction of these jobs is because technology (robots) can replace them at a fraction of the cost.  Politically and socially this is deep water and we could debate this for hours whether this is good or bad.  But from an inflation perspective this is definitely keeping a cap on inflation.  If the wage for a low-skill job rises to fast, a robot or computer replaces it at a cost of pennies on the dollar.

Go to your grocery store and see all the self-checkout lines.  Each of those used to be manned by a low-skill worker.  Now one worker is overseeing 8 lines.  Many restaurants have self-order tablets which eliminate the need for waitresses (now you only need servers).  Of course countless low-skill factory jobs have been eliminated by robots.  You could go on and on.

This puts a huge cap on inflation, leading to much of what we see:

  1. Stagnant wages for low-skill workers
  2. Exponential growth of people-replacing machines
  3. Persistently low inflation.

BOLD PREDICTION—Wages for skilled workers will continue to increase while unskilled workers will decrease. Only a minimum wage will keep wages at the low end up, but that will lead to fewer low-skill jobs available.

The Federal Reserve has said it is baffled by the persistent low inflation in the face of fast economic growth, historically low interest rates, a low unemployment.  In the past those three ingredients always led to inflation, something that the Fed is chartered to control.  To me it seems like an easy situation to figure out, but I am smarter than a Nobel Prize winner ?.

It’s pretty simple—we aren’t going to have inflation because there are so many amazingly smart (and very well paid) engineers that can find any product (including people) whose prices are rising and replace them with cheaper substitutes.

Like I said before, there are social implications for this which make these issues very gray.  However, keeping to the black and white areas, I believe this means inflation will probably remain low for years to come.  As an investor that’s GREAT NEWS.

Bitcoin—Top 5 WTF

Stocky 1 Comment

A few of you have written in asking what I think of Bitcoin and its crazy ride.  Here are my Top 5 observations on Bitcoin.

 

5. Unprecedented wild ride

What has happened with Bitcoin in 2017 is really unprecedented.  Its price has risen about 17x which obviously is a lot.  To me, the more astounding point is that it has risen that high given it has a market cap of $300 billion (that is the total value if you added up all the bitcoins in the world).

If you think of bitcoin as a stock, that combination is pretty incredible.  A lot of stocks have had crazy good years where they increased 17x.  However, most of those are off a really low base: so maybe a $50 million company grew to a $1 billion company.  Obviously, that is much easier to do off a smaller base.

However, with Bitcoin, continuing with that analogy, it grew from a $15 billion company (that’s about in the top 2000 globally) so that isn’t exactly small.  Then it vaulted to $300 billion which would put it at about top 10.  Think about that for a minute.  Crazy.

 

4. I still don’t get it

I feel like some old man who doesn’t get the world around him.  Damn kids won’t get off my lawn.

I couldn’t tell you with any specificity what Bitcoin is (there are buzzwords like “blockchain” but I don’t know what that means either).  I certainly couldn’t tell you how I could “buy” them or “mine” them.  I don’t know a single vendor who would accept Bitcoins, and if they did I wouldn’t know how you do that transaction.

And I think I tend to be fairly knowledgeable about these things.  I can pay for stuff using my watch which proves I’m at the forefront of technology, but Bitcoin is just beyond me.  I think that applies to most people—the story of Bitcoin is exciting but the details are pretty fuzzy.

 

3. Not surprising run-up

Given the incredible run-up, I am not surprised of it’s continued push higher in the past couple weeks, thanks to it’s listing on the Chicago Mercantile Exchange earlier in the month.

Being listed (or having your futures listed) on a very legitimate financial exchange obviously lends some credibility to something that up to this point had very little of it in respected financial circles.  Also, it somewhat addresses #4.  You can buy Bitcoin futures on the CME and I think many more people know how to do that than knew how to buy Bitcoins on their own two weeks before.

I still think Bitcoin is built on quicksand and will eventually collapse (more on this in a second), but in the short term it’s not surprising that it’s value has gotten a huge bump as it has been listed.

 

2. Ticking timebomb

There are a lot of people extremely bearish on Bitcoins, and many can give you a ton of reasons why it’s just an eyelash away from collapse.  I predict that eventually a central bank will crush it like an elephant finally getting annoyed by a gnat.

What would provoke such action by the US Treasury?  A terrorist attack.  It seems likely that given Bitcoins anonymity features, it will be used to fund some type of terrorist attack that will kill innocent Americans.  When that happens you can easily imagine the headlines, and then easily imagine the government’s response.

Bear in mind the whole premise of Bitcoin is that governments aren’t responsible stewards of their fiat currencies, so society needed some type of currency that the government can’t screw up.  That’s a bit of a “Screw-you” to Washington, so I think if there’s any connection between Bitcoin and a terrorist attack, the government will come down HARD.

 

1. Go left when everyone else says “go right”

There’s a famous saying in investing that saying when everyone believes one thing, the opposite tends to happen.  Right now, EVERYONE is saying that Bitcoin is a bubble and its value will crater.  People have been saying that when it was at $1000 and then the chatter exploded when it crossed the $10,000 threshold.  Now it’s at about $18,000.

Seriously, can you think of one serious, respected analyst who is bullish on Bitcoin?  I can’t.  Can you think of highly-regarded financial people who said Bitcoin is a crazy bubble that will crash HARD.  I can think of about a thousand.

Given that, it makes me think that Bitcoin might still have some upside.

 

Who knows with all of this?  I know I certainly don’t.  Personally, we don’t invest our money in Bitcoin, mostly because of #4 and a bit because of #2.  That said, I am enjoying the crazy ride that makes for fun reading in The Wall Street Journal.

 

Inflation–the big scary monster hiding under your bed

Stocky Leave a comment

wheelbarrow-of-cash

“Ocean waves will grind the greatest boulder into sand if given enough time”

Inflation, the general rise in prices over time, is a powerful and unrelenting force which is eroding the value of your money every year, every month, every day.  How powerful is inflation?  Look at this simple example with my neighbors, Mr and Mrs Grizzly.

If they want to spend $50,000 per year (in today’s dollars) in retirement they’ll need about $1.2 million on the day they retire (40 year retirement, 6% return, 3% inflation).  Every year in retirement they’ll spend a little more than $50,000 to buy what $50,000 buys today because of inflation.  However, if you crank the inflation knob up a notch from 3% to 4%, they’ll need $1.5 million.  Up to 5%, they’ll need $1.8 million.  What makes inflation so scary is that the impact is huge—a 2% increase requires your nest egg to be $600,000 larger—and it’s also completely out of your control.

In the US, inflation is tracked by the Bureau of Labor Statistics, a division of the Department of Labor, with a tool called the Consumer Price Index (CPI).  Basically (I know it’s much more complex, but for brevity’s sake) it looks at a general basket of goods that people buy and tracks how those prices change over time.  It’s meant to track EVERYTHING that consumers buy: food, housing, cars, airline tickets, medical expenses, entertainment, and on and on and on.  The US boasts an amazing record of tame inflation over the decades, but even then it’s been quite a roller coaster: in the early 1980s, according to the CPI, inflation was averaging about 12%, and it has averaged about 1.6% since 2009.

That just ruined Mr Grizzly’s day.  So he needs $1.2 million today to retire, but depending on inflation it could range from $1 million to $8 million if it got as high as it did in the early 1980s?!?!?!  No bueno.  How the heck is he supposed to plan for a range like that?

What to do with inflation.  It’s like that big, scary monster living under your bed.  It can be a powerful force that can completely turn your financial world upside down.  Or, it can be something that is built up in our imagination that in reality isn’t that bad at all.  Let’s figure this out.

 

Inflation is going to do what it will do, and there isn’t a lot you can do about it as an investor.  The US government sets an inflation target at 2%, but reasonable people can debate how good Washington is at managing stuff like this.  When I do my planning for the Fox family, I personally use 3%.  But there is some good news—I actually think the CPI waaaaaaay over estimates inflation and that it is going to be on the lower side of historic averages, which is a good thing for those of us saving for retirement (as always, this is just my opinion and may turn out to be quite wrong, also with my projections I am not predicting the future).

The CPI is supposed to compare apples to apples, so basically what did you buy last year and how much would that cost if you bought the exact same stuff this year.  I think over the short-term the CPI works pretty well; I’d believe that prices in 2017 were about 2% higher than in 2016 (in line with the CPI’s figures).  But over longer periods of time, the CPI really fails because I think it does a really lousy job of dealing with major technological advances.  So when you look at 10 or 20 or 50 years, which happens to be the time horizon we’re looking at for retirement, I think the CPI really overestimates inflation.

If you go back to 1965 (I picked 50 years ago, because I figure I have 50 years to live, so that’s my time horizon), the CPI says prices have risen about 7.5 times.  So something that cost $100 in 1965 would cost about $750 today.  If you do the math, that equates to about 4.1% per year.  We saw the impact that the level of inflation has in the above examples (pretty major impact), yet let me tell you why I think the government is getting it wrong and there is some real relief.  This is going to be a long post (but I hope a valuable post), so get comfortable.

 

1965_Chevrolet_Impala

Cars

In 1965 you could get a new 4-door sedan like the Chevy Impala for about $3000.  Today you could get a new 4-door sedan like the Honda Civic for about $20,000.  If you do the math, that calculates to about 3.9% inflation per year, right around what the CPI says (I know, you’re saying: “Stocky, so far I’m not impressed.”)  But remember, the CPI is supposed to compare apples to apples; when you compare a 1965 Impala to a 2015 Civic, the Civic has a ton of advantages.

The Civic gets 35 miles to the gallon, while the Impala got about 12.  The Civic has incredible safety features like airbags, antilock brakes, backup camera, and on and on; the Impala has seat belts across your lap (they didn’t even have the shoulder ones).  The Civic has Bluetooth to connect to your MP3 player, while AM/FM was an option on the Impala.  A new Civic will probably last you 200,000 miles or more, but your Impala would be lucky to get to 100,000 (like “go-out-and-buy-a-lottery-ticket” lucky).

Put all that together and how much of that 3.9% annual price increase is due to inflation, and how much is due to the Civic just being a better car?  It’s not an easy question to answer, but I would think an awful lot of the price increase is because you’re getting a safer, more fuel-efficient, and more durable car . . . just a better car.

To look at it from a different angle, we know $3000 in 1965 would buy you a new Chevy Impala.  What would $3000 buy you in 2015?  A quick look at Autotrader.com shows that for $3000 you could get a 1998 Honda Civic with 150,000 miles.  Between those two choices, each of which is $3000, don’t you have to pick the Civic as the better car?  It’s safer, much more fuel efficient, has more convenient features (cruise control, automatic windows), and it will probably last longer.  All that says that inflation was actually a lot less than the 4.1% the CPI said or the 3.9% we calculated.

 

Rent

Housing is the biggest expense that people have, so how does that come into play?  In 1965 the average rent was about $90 per month while in 2011 it was around $870 which calculates to about 5.1%.  That’s higher than the CPI, but before we freak out about runaway inflation in the housing market, let’s do the apples-to-apples comparison.  In 1965 you were getting a place where you might have shared a bathroom with your neighbor and a phone too.  You had an icebox instead of a fridge (literally a cabinet that you kept cool with blocks of ice), and radiator heating.

Today you have granite countertops and stainless steel appliances, central air conditioning, and a fitness center downstairs if you’re lucky.  How much of that 5.1% increase is due to prices rising, and how much is due to you just getting a much, much nicer place with much better amenities?  Today, I’m sure if you tried hard enough you could get a total armpit of an apartment that was completely vintage 1965, and I bet you probably wouldn’t pay more than a few hundred bucks for it, showing that prices for apples-to-apples apartments haven’t risen near that 5.1% level.

 

Heart Stents

Healthcare

Ahhhh.  This is where you’re saying: “But what about healthcare?  Medical prices are spiraling out of control.  That’s where they get you.”  The Medical CPI shows that prices have increased an astounding 17 times since 1965—about 5.9% annually.  Mr Grizzly just had a minor aneurysm, which he knows is really going to cost him.  But before you despair, do the apples-to-apples comparison and realize that the quality of healthcare has gone up exponentially while costs it can be argued have come down.

Let’s say Grandpa Fox had a heart attack in 1965.  First, his chances of survival weren’t very good, but let’s assume he survives and gets coronary bypass surgery.  After two months of recovery he’s back at home living his normal life, but now with a sweet scar running all the way down his chest from the open-heart surgery.  That surgery back then would cost around $6000 (it’s hard to find exact numbers on this so I estimated; any reader who has better data please let me know) which is a drop in the bucket compared to the $100,000 price tag bypass surgery costs today.

Unfortunately, Grandpa Fox passed his lousy heart genes on to me.  However, instead of a heart attack hitting me out of the blue, my doctor discovers early on that I have high cholesterol and prescribes me Lipitor which costs about $300 per year, and that is even lower if you go generic.  My heart problems get taken care of for much less money, plus I didn’t have to go through a high-risk surgery and brutal recovery.

But maybe Lipitor doesn’t work, so after a while they find my coronary arteries are severely blocked and I get a stent (of course, I only use a Medtronic brand stent).  I have a non-invasive surgery where they insert the stent through a tiny incision in my hip, I go home that evening, and it all costs me about $20,000.  Like before I probably would have a much better outcome than Grandpa Fox, at about three times the cost which equates to about 2.4% inflation over the 50 years.

So while medical expenses have skyrocketed (and I totally agree they are out of control), if you look at the idea of taking someone with a heart problem and getting them back to health, prices have actually gone way down since 1965.  So much for aggressive inflation here; you could actually argue that there has been deflation.

 

Food

So let’s compare apples to apples, literally.  Apples in 1965 cost about 16¢ per pound while today they are about $1 per pound—that equates to inflation of about 3.6% inflation.  But there is actually a difference between 1965 apples and 2017 apples.  Back then there was this weird concept of fresh fruits and vegetables being “in season.”  You could only buy apples certain times of the year which was around late summer and fall (I had no idea so I actually had to look this up, which kind of proves my point).  Today fresh fruits and vegetables are in season when your grocery store is open and you have money.  So again, you’re paying more but you’re also getting a better product as well—year round fresh fruits and vegetables.

 

And there are many product categories whose prices have fallen drastically (air travel, anything with electronics), and others that we used to be charged for but are now free (telecommunications, news articles, books).  The whole point of all this is that depending on how you look at it, inflation isn’t going to be nearly as high as the CPI says which is a huge help to savers.  That means your dollar will stretch further in retirement than you might otherwise think, and that you’ll need less to retire on.  Consider this my gift to you.

Lending Club—No Bueno

Stocky Leave a comment

About two years ago we broadened our investment portfolio with this new-fangled things called peer-to-peer lending with Lending Club.  This has turned out to be a pretty major disappointment for us, and we are in the process of exiting the investment (which isn’t a quick process—more on this in a second).

Basically, the idea of peer-to-peer lending is like match.com for lenders and borrowers.  People who want to invest/lend money meet people who want to borrow money.  Borrows can get money they need at much lower rates and much less hassle than if they got a loan from a bank.  Lenders can earn interest at a much higher rate than they would get from a bank.  Banks are cut out of the process and everyone wins, right?

 

How it works

There are people looking to borrow money for debt consolidation/payoff credit cards (that’s about 80% of the loans), help their small business, pay for home renovations, etc.  Let’s say a given loan is for $10,000.  A bunch of lenders like us each kick in $50 or so, so you’ll be in this loan with hundreds of other people.  The person gets the money and then pays off the loan over 3-5 years.

Lending Club vets each loan and each applicant, and assigns a credit score.  That credit score determines the interest rate which can range from 5-20%.

As a lender you can go through all the thousands of loan application and pick which ones you want to lend to.  That’s fun at first, but quickly becomes a hassle, so you can just put it on auto-pilot and Lending Club will pick the loans for you.  That’s what we did.

 

What happened to us

In mid-2015 we opened our account, starting with $3000.  Of course, I watched the process like a hawk, from the loans I picked to when they started paying back.  At first it went great (isn’t that line in pretty much every movie, before everything goes to hell?).  We were getting paid back by all our loans, and our return was over 12%, which of course is amazing.  That’s free money.

We put more money in over the next couple months, and then when we sold our California house we put a big chunk ($60,000) in.  By that time, our account was worth about $100,000.  Through mid-2016 things were going well.  Our returns had inched down to about 10% (still spectacular), and I was congratulating myself on being a financial genius.

Towards the end of 2016 I started to see some of my loans default.  Of course, this is to be expected.  Some of the loans will go bad but those should be offset by the higher interest rate, and everything works out.  Still, it was a disturbing trend.

After a few months, the bad loans kept coming and my return steadily dropped, until it settled at 2.5% which is where it’s at today.  That’s crazy!!!  Obviously, there’s a huge difference between a 10% investment and a 2.5% one.

In early 2017 I decided to pull the plug, and stopped reinvesting my money.  Now, as the small loans (we have about 3000 out there) pay off, we take that money and put it back in our Vanguard account.  Unfortunately, this isn’t a fast process so it will take us about 5 years to unwind everything.  Oh well.

 

Why it works (or doesn’t)

On paper it sounds like one of those awesome ideas where the power of the internet changes an old business model for the better, and I think there’s a lot of truth in that.  It brings borrowers and lenders together and cuts out the middlemen, and lowers the borrowing costs substantially.

The problem lies in their ability to ensure payments are made.  Fundamentally, what is stopping borrowers from getting the money and then just going away and not paying?  It may not happen a lot, but it doesn’t take a lot of these to really kill your return.

I have a bit of insight here because I was a large enough account that I would get a call about once per quarter from them “seeing how I was doing”.  You can imagine the tone of these calls changed as my return dropped.

These loans are unsecured, so the only thing that makes borrows pay back is morality (I never want to count on that when it comes to money), the threat of negative marks on their credit rating, and the general badgering from Lending Club as it tries to collect.  With traditional bank loans that are collateralized, the threat of repossessing something seems a lot stronger.

Not difficult to predict, there was a large portion of the borrowers who would take the money and then not pay it back.  Some might be thieves who borrowed the money in a scam and never intended on paying back.  Others certainly intended on doing it but things didn’t work out.  Given the economy has been super strong the past couple years, this is especially troubling because it should be as good as it gets right now.

When someone stops paying Lending Club goes after them with phone calls, but those don’t seem really effective.  Seriously, what are they going to do?  Some delinquent borrows do starting paying back but most either never answer the phone, or they do and say/demand that Lending Club quit bothering them (there are actually notes lenders can see on all this activity).

I personally think that in our litigious environment today, lenders don’t have that much leverage.  Also, to avoid claims of bias or discrimination, it’s probably not easy to turn down borrower applications.  That leads to a perfect storm of crap that I think I got caught up in.

 

What is the lesson?

Investing is an interesting psychological experiment.  The simple approach of buy-and-hold broad index mutual funds is almost certainly the best, yet it’s the most boring.  When you’re doing that and things are going well, there’s that itch to see “what else you can do” and “what you can do better”.

That’s what happened to me, and most of the time that’s death.  That’s what happened with us and our commodities investment, which has been a major loser.  That was also the case with Lending Club, and we’ve had disappointing results (especially since stocks are up about 15% annually in the time we’ve invested in it).

So the lesson here is that it’s probably always better to stick with the boring but tried-and-true approach.  History is on your side here.  We have over 100 years of data on how stocks behave, in good times and bad.  Peer-to-peer lending is fairly new so you don’t really know how it will play out.  Maybe you’ll miss out on something that’s new but amazing (see: Bitcoin), but that leads to an interesting second point.

Many leaders—NFL head coaches, CEOs, politicians—say that success finding all the great things, but more avoiding the bad things.  Stocks are similar.  It’s a game rigged in your favor, but there are pitfalls along the way that are so tempting.  That’s where I think I tripped up.  Lending Club and commodities were sexy investments at the time, and it scratched that itch for me to be “doing something.”  And it hurt me.

Of course, that doesn’t mean we never innovate.  Peer-to-peer lending may turn into something big; digital currencies might turn into something big.  They might be important parts of a financial portfolio, but I think now is way too early a time to be putting my money down on that bet.  I know I’ll miss some big wins, but hopefully I’ll also avoid big losses and come out ahead.

Top 5 reasons to be thankful as an investor

Stocky Leave a comment

Today is a special day in the United States.  We reflect on all the amazing blessings we have in life—our families, our jobs, our friends.  For me it’s Foxy Lady, Lil’ Fox, and Mini Fox in some order.  There’s also world peace (more on that in a second), technology that has immeasurably improved our lives, and a little place called the United States of America.

However this is a personal finance blog, so what are the Top 5 reasons to be thankful (wearing an investing lens) for:

 

5. No wars—This is a pretty humanitarian one. In my lifetime, the biggest war the US (and the developed world for that matter) has fought is probably the Second Iraq War with 4500 deaths. That’s a tragedy for sure, but compare that to the generational death toll of US soldiers from war pre-1975: Vietnam-58,000; Korean War-37,000; World War II-405,000; World War I-117,000.  That alone is SO, SO much to be thankful for.

Of course, war is bad for investing.  It destroys buildings and infrastructure that is meant to produce things.  Once the war is over those things either need to be rebuilt which costs a lot, or people just move on and all that productivity is lost.  And that’s not even mentioning the dead, many of whom are educated and highly productive people.  No matter how you cut it, armed conflict is bad, and we’ve enjoyed an amazingly peaceful 40 years, even with those periodic skirmishes. That’s great for investing.

 

4. Tame inflation—When I was growing up, and even when I was in college in the late 1990s, we always thought inflation would naturally settle around 4-5%. Before then, expectations were even higher.

We all know that inflation relentlessly eats away at the purchasing power of our savings.  Some economists argue whether too low of inflation is good or bad (I think the lower the better), but everyone agrees that too high inflation is a bad thing.

For the past 10 years we’ve had inflation hovering around 1.5%, including 2015.  This year looks like it will be around 2.1% or so; that’s higher than it’s been in nearly a decade which speaks to how low inflation has been.

When you look at economic disasters over history, more often than not, they involve crazy inflation that has run out of control.  We’ve had a great run on this, and there’s no reason to think it will end any time soon.

 

3. A nation of laws—It’s easy to get caught up in all the BS of politics and a 24-hour newscycle that our nation is facing right now. One might think that the country’s going to hell, but it’s not.

Things work.  We have rules that 99.99% of the people follow 99.99% of the time, and the system works.  This is especially true in the stock market where by and large it’s a fair game.  There haven’t been any major scandals or houses of cards like we saw in 2008 or 2001 or even 1929.

There’s always going to be some level of shenanigans just based on the nature of greed, but as an investor I do feel things are on the up and up.  So long as that’s the case, we’ll make money.

 

2. A 9-year bull market—So far in 2017, stocks are up about 20%. That’s pretty astounding. That has created a tremendous amount of wealth for common investors.  That’s an incredibly democratizing process.

As good as this year has been, it’s just the latest in a string of amazing years since 2008.  However, if you take a longer view, over the last 40-years, things have been equally spectacular.  The average return since the year of my birth (1977) . . . over 11%.  And that’s compounded annually which is something all those 4th and 5th graders from the Summerfield Open will appreciate.

We’re on a good run right now, and of course it will slow down at some point, the timing which Robert Schiller and I disagree on (and I’ve been proved right so far).  But even a longer-term view shows how good things have been, and really there’s no reason to think the future will be otherwise.

 

1. Internet—I’ve mentioned this a number of times, but it’s hard to overstate the amazingly positive impact the internet has had on investing. First, it makes actual investing so much easier. You can research companies more efficiently than could have been imagined pre-1995.  Also, you can actually conduct transactions so much easier, compared to before when you had to do everything over the phone with a broker.

Also, there are those little companies called Amazon, Microsoft, Apple, Google, Facebook, and a slew of others.  Those all have business models based on the internet.  They have brought tremendous benefits to society, and along the way have made tons of money which has gone to their investors, this one included.

 

So many things are more important than money and investing, and those are at the top of my list of things I am thankful for as I dig into my turkey today.  However, wealth is a great enabler.  For me it allowed me to quit my job to become a full-time stay at home fox for my two cubs.  To the degree that my investments facilitate that, I am thankful for investment tailwinds like the five I just mentioned.

Everyone, have a great Thanksgiving.

Should you use an investment adviser?

Stocky 2 Comments

I started writing this blog because I wanted to share my own experiences with investing, including how to navigate the complex world of investing on your own.  I am a firm believer in DIY financial management.  That is what worked for me, and I believe all people can get really great results doing it on their own.  That said, many readers ask about using a broker or investment adviser or financial planner.  Here’s my take.

Quick disclosure: I am an investment adviser.  I passed my Series 65 and work with a small number of friends, helping them with their finances.

 

Are financial professionals worth it?

As with any purchase you make, you need to evaluate a investment adviser on the basis of how much she costs, and how much value you get in return.  On the surface I would say “no, it probably isn’t worth it,” however there are definitely some factors which may reverse that decision.

First, let’s look at how much investment advisers cost.  The rates range widely.  Plus there isn’t a lot of transparency in the marketplace so it’s not always easy to know what the going rate is.  My experience says that 1-2% is typical.  This can come in many forms—typically brokers get paid fees from the mutual funds they suggest for you or from the transaction costs for trades.  Advisers tend to charge a percentage of your portfolio.  We know that 1% coupons are really valuable, so those fees are a lot.  Over an investing career they can add up to hundreds of thousands of dollars.  That’s a pretty big deal.

Of course, if you’re getting a lot of value from your investment adviser, maybe it’s worth it.  One of the main missions of this blog is to show you how you can invest successfully on your own, and I think most people can do that without having to hire a professional.  Sure you have to make decisions on asset allocation, which accounts to use, what investments to make; but those aren’t really all that complex.  Also, thanks to the efficient market lessons from A Random Walk Down Wall Street we know that you’re as good a stock picker as anyone.

So my general feeling is that investment professionals aren’t worth the money; a motivated investor can do just as well on their own and pocket the fees.  Wait, what???  You said “motivated”.  As it turns out, a lot of people, despite their best intentions, aren’t able to put their financial plan in motion.  If you’re one of those people, and if an investment adviser can help motivate you to do the right things, then I do think they are more than worth it.

In this way, investment advisers are a lot like personal trainers.  Most of us know that exercise is good for us, and most of us know how to run on the treadmill and lift weights properly (or you can find out by watching a 3-minute video on Youtube).  But if a trainer can motivate you to actually hit the treadmill and the weights, they’re definitely worth the money, right?  How much is your physical health worth to you?  Same thing with finances.  If you know what you should be doing, but for one of a million reasons you never end up actually doing it, maybe you should get an investment adviser to help you out.

Nearly every post I’ve done shows that there is a ton of value out there if you invest properly, taking into account things like time horizon, taxes, etc.  But if you don’t do anything, you’re losing ALL that value.  In fact, loyal reader Jessamyn noted that studies show that investment advisors do increase returns about 3%.  That’s a ton, especially because we know how much a 1% coupon is worth.  Are they magic?  Can they predict the future?  No.  The data shows that investment advisors help people do what they are supposed to–keep track with their plan, invest regularly, don’t panic when the market goes crazy, etc.

If an investment adviser helps you in ways you won’t or can’t, then you’ll probably end up ahead of the game, even after you take his fees into account.

 

How would you pick a financial professional?

So let’s say you’ve decided that an investment adviser makes sense for you.  How do you pick a good one?  This is one of the biggest challenges, and in my opinion one of the reasons a lot of people don’t get investment advisers: They don’t know a good one they can trust.  The problem is there are a ton of them and the quality varies greatly.  Sadly, there are a lot of unskilled people in the industry who don’t know what they’re doing.  Even worse, there are some real shysters who might take your money, either overtly steal it or use other schemes to siphon away your money and put it in their pockets.  It’s a legitimate concern.

First, you need to find someone you can trust.  Ideally, this would come from a personal reference.  Today you also have things like yelp.com or Angie’s List that gives ratings.  Additionally, there are government agencies like FINRA.org that track these people so you can look them up to see how long they have been around and any complaints that have been files against them, etc.  These are okay, but for my money, nothing beats a personal reference from someone you trust.  Of course, it’s not always easy to have those conversations with friends: “So Mary, who is helping you with your money, and can I talk to them?”

Second, you need to find someone who is good.  Of course, knowing this isn’t always easy.  Using that same personal trainer analogy, you probably wouldn’t hire an obese trainer.  You’d want someone who is ripped, someone who has shown they have been successful at physical fitness themselves (like my totally buff friends Christel and Tobias).

Tobias
If you have a personal trainer, he should be ripped like Tobias here. Similarly, if you have an investment adviser, that person should be somewhat wealthy.

 

Similarly, you want a rich investment adviser.  You want someone who has been successful creating wealth for themselves.  But this is where the challenge comes in: if the investment adviser is wealthy then why is he working with you?  Seriously.  You have a lot of young kids who are doing this (let’s say less than 30).  I’m sure there are some good ones, but I’m not trusting my family’s financial wellbeing to someone without a lot of experience.  You also have a lot of people who just aren’t that good.  If someone has been an investment adviser for 10 or 20 years and they aren’t a multi-millionaire, how good can they really be?  I’m not trying to be mean, but shouldn’t that be more than enough time to accumulate some serious wealth?

 

Questions to ask:

If you do decide to go with a investment adviser, make sure you ask a lot, A LOT, of questions.  Beyond your doctor or minister/rabbi, this person will probably have the biggest impact on your wellbeing.  Take the time to make sure you find a good one.

How long have you been doing this?  This is an area where experience definitely matters.  In particular, you want her to have lived through a few bear markets.  At a minimum she should have been doing advising people since 2008 and even better if she’s been doing it since 2001.

What did you do during 2001 and 2008?  Investing is a lot easier when things are going well.  You prove your mettle during the tough times.  Figure out how he handled himself when everyone thought the world was coming to an end.

What are you paid?  This should be answered in excruciating detail.  Does he get paid by you (how is the amount determined, when is it paid), by others like mutual fund companies (how much, how do you make sure you serve my interests ahead of theirs)?

What is your personal financial situation?  No point sugar-coating it.  Find what his financial situation is like.  As mentioned above, if he isn’t pretty well off, how good is he really?  Also, the relationship you have with him needs to be based on trust because you’re going to be sharing everything with him.  If he isn’t willing to reciprocate in some way, that might tell you something.

How will you ensure you serve my best interests?  This is a biggie.  Ideally you want her to have a fiduciary relationship which is a legal standard where she serves your interests ahead of anyone else’s, including her own.  No matter how this turns out, you’re going to need to trust this person, but you should get a sense of how she will ensure that you are #1.

What is your investing strategy?  Obviously, there are a lot of nuisances to this, especially as he customizes it to your specific situation.  But he should definitely have an approach and a philosophy that he can articulate clearly and understandably.

What type of power will you have over my money?  Will she be able to make trades and move money between accounts with your express permission, on her own, or not at all?  This is a tricky one because maybe you want to offload these activities completely, so her having a ton of control may be okay.  No matter, you should definitely understand this completely.

How will you take into account other assets that you won’t manage?  Most situations will have him managing an account like your IRA or brokerage account but not others like your 401k, mortgage, pension, etc.  Most times, he’s only paid on the accounts he manages, but to do his job well he’ll need to take into consideration those other accounts as well.

 

Those are what I came up with off the top of my head.  At the end of the day, if you do go with an investment adviser make sure you find someone who has demonstrated they have the skills to build your wealth.  Just as importantly, make sure you find someone who you can trust completely.

My, oh my, how money has changed

Stocky 1 Comment

We just got back from a trip to Disney with Lil’ Fox and Mini Fox.  As an aside, Disney World is a pretty amazing place and I highly recommend it to anyone.

While we were on the trip, I was thinking about similar trips my dad took with me and trips his parents took with him.  Because I always think about finance and money, it got me thinking how people paid for those trips—not necessarily how they saved for the trips (which is, of course, an important thing), but how they actually paid money at the point of sale.

Money seems like a real constant in our lives for decades and centuries and millennia.  However, it’s hard to think of something so central to our lives that has changed so drastically over such a short period of time.  In the past 100 years it has changed more than food or clothes or shelter.

 

Things used to be really risky and inconvenient

Back in the day, let’s say when my dad was a cub in the 1950s, everything was paid in for in cash.  There were innovations like Traveler’s Checks that substituted for cash, and I imagine many people thought of those the way today many people think of Bitcoin—kind of confusing and you aren’t really sure you “get it”.  It was just easier to use cash, something they understood and were used to.

Pretty much all of life revolved around having a ton of cash on hand to conduct your life- -groceries, gas, vacations, washing machines, everything.  That was hugely inconvenient and also incredibly risky.  I remember my grandfather taking about his money belt and false wallet, both tools meant to counteract enterprising pickpockets.

A couple decades later, let’s say the 1970s, charge cards hit the scene, first for department stores and gas stations.  Those could only be used at a specific store (your Sears card could only be used at Sears), so that wasn’t super convenient, but it was a major improvement.

In the 1980s, credit cards as we know them today became widespread.  Credit cards cousin, debit cards, which act in pretty much the same way but deduct straight from your checking account, were being used broadly by the 1990s.  Even though that’s where we are today, even credit cards have evolved in a major way.

 

The modern art of buying

Today the vast majority of retail transactions are done with credit cards, but the credit card you’re using is very different from the one my dad used in 1983.  Probably the biggest difference is that nearly every credit card offers a pretty substantial bonus of some sort.  It can be airline miles or hotel points or cash.  This can be a pretty big deal.

The Fox family plays credit card roulette (we get a new credit card every few months to take advantage of their initial purchase bonuses) and that nets us about $2,500 each year.  That just paid for our vacation.

All that said, we are very far from the cutting edge when it comes to this stuff.  In the mid-2000s this crazy thing called “Paypal” hit the scene.  When I was in grad school the cooler kids were using Paypal and paying each other for stuff.  I didn’t fully get it, and I admit that I don’t use it today.  Nonetheless peer-to-peer pay networks were here.

Fast-forward a few years and you got digital currencies like Bitcoin.  As much as I don’t fully understand Paypal, I understand Bitcoin even less.  What I do know is that Paypal was based on US dollars but offered a different and more convenient way to pay.  Now it seems Bitcoin is based on its own currency and then also offers a different and more convenient way to pay.

Add on to that, if you like a bit more risk in your investing portfolio, Bitcoins themselves, beyond just the ability to pay for stuff, can go up or down in value so it that way it looks like an investment (or gamble).  One Bitcoin was worth $1000 at the start of the year and now is worth about $7000.  Crazy.

 

What it all means?

For finance and history nerds like me, I think this is a really fascinating study.  I have always said that inflation is way overstated and I think we can find one of the reasons here.  Think about how much easier and faster things are for businesses now with credit cards and other electronic financing compared to the cash economy of my grandfather’s time.  That impacts nearly everything so the stakes are high.  That savings gets passed on to the consumer, and we get lower inflation.  Score.

Second, today, there’s a huge upside to using money innovations like credit card rewards.  It can pay for our Disney vacation every real.  That just became real.

If credit card rewards can do that for me today, and I admit I’m a late adopter when it comes to this stuff, what is the upside still out there.  Are there similar dollars provided by the Paypals and Bitcoins of the world that I just don’t understand enough yet to pick up off the ground?  Probably.

Are there going to be further money innovations in the future that will provide even more dollars?  Certainly.  I don’t know what they are in a similar way my dad in 1983 could never have imagined Paypal or Bitcoin, but they’ll certainly be there.  If today I’m basically getting a vacation for free, who knows what money innovations will bring me over the next few years.

Maybe that should motivate me to figure out this crazy, newfangled Paypal and Bitcoin things.

 

DIY oil changes and investing

Stocky 1 Comment

The Top 5 ways changing your own oil is like doing your own investments

Just the other day, I changed the oil in our 4Runner and our Honda.  It was the first time in my life I ever did that by myself instead of taking it to a dealership or one of those quick lube places.  First, I want to thank my new BFF Jesse Bearcat for helping me.

Second, as I was doing that and since, I have started to think how changing your own oil is a lot like doing your own investing.  In fact, a lot of the benefits of doing an oil change yourself are exactly the same as doing your investing yourself.

 

Here are my Top 5:

 

More conscientious:  No one cares more about you and your wellbeing than you.  Twice in my life I have had horror stories of the guy at the shop doing a crappy job and it leading to bad, bad results.  They were sloppy and forgot to connect a hose which led to my car breaking down and needing a tow.  Once I was driving on the road into the LINCOLN FREAKIN’ TUNNEL.

When I do the work on my own car, the car that hauls around my family, you can be sure that I check and double-check every screw and tube and everything.  Investing is the same.  Is someone else going to check the next day to make sure your fund transfer happened or that the change in your 401k allocation took?

 

Better materials/parts:  I buy name-brand oil and filters.  I don’t know if they are better than the discount stuff those quick-lube places use (normally I am a big fan of generics, but motor oil seems a little different).  It’s an open question.  At a quick lube place I never used synthetic oil because it was an extra $30 or so, and I’m too cheap for that.  When I do it myself, 5-quarts of oil costs about $3 more when you buy synthetic, so that’s a no-brainer.

Similarly with investing, when you do it yourself you can pick the best mutual funds at the lowest price.  I have spent a ton of time on why I think index funds with a low management fee are the best.  When you do it yourself, you can pick anything you want.  When someone else does it for you, your choices tend to be more limited.

 

Better use of your time:  This is a bit counter-intuitive, but it’s absolutely true.  When you change your own oil or do your own investing, you actually save a lot of time.  To change your own oil, you take 5 minutes to set everything up, 1 minute to unscrew the oil plug, and 1 minute to unscrew the oil filter.  Then you let the car drain for 10 minutes or so while you’re doing something else.  You can come back, screw the new oil filter on (30 seconds), screw the drain plug in (30 seconds), fill the oil and check the levels (5 minutes).

If you go to a place it might take you 10 minutes to drive there, 10 minutes waiting time, 20 minutes for them to do it while you’re stuck in the car.  Doing it yourself saves a lot of time.

Investing is the same way.  If you have your investment advisor do it all, you still need to meet him, drive to his office or schedule a call, etc.  You can do it on your own at night in your pajamas after the kids have gone to bed while the World Series is on in the back ground.  I know which one I would choose.

 

Look at other things:  As I have started doing my own oil changes, I am becoming more knowledgeable and look at other things about my car as well.  When I went to a place to get my oil changed, they always say I need extra stuff down, and I totally shut them down because I think they’re just trying to fleece me (good analogy to personal finance there).  However, there are other maintenance things you need to do to your car.

Changing the air filter is one of those.  The oil change place says I always need to do it, and I actually do it every once in a while.  Now that I change my own oil, I have the confidence to check that and it’s surprisingly easy.  I can do it in 2 minutes (plus get a good price on the filter from amazon.com which is maybe 80% less than what they charge me).

Investing is the same.  It’s easy for an “expert” to come at you and tell you all the things you need to do.  It’s natural to resist that a little, knowing a lot of it you don’t need to do, but some of it you probably should do.  As you get more knowledgeable, you’ll know what does make sense (probably an IRA) and what doesn’t (probably an annuity).  That can pay HUGE dividends (figuratively and literally).

 

Lower cost:  It costs $40-60 to change our oil at one of those quick lube places, plus a lot more if they did my air filter and other stuff.  It’s much higher at a dealership.  My all-in cost for an oil filter and 5-quarts of synthetic oil are probably about $20.

Those are decent numbers for a car, but you know how that translates to your personal finances.  If you do investing yourself, you can save a boatload in costs and fees that would line the pockets of investment advisors, mutual fund companies, and everyone in between.

 

The tax man cometh

Stocky Leave a comment

“In this world nothing can be said to be certain, except death and taxes” –Benjamin Franklin

 

I love this woodcut from the 1600s.  I imagine the artist drew it so the skeleton’s hand is asking for the guy’s life, but it kind of looks like he has his hand out asking for money like he’s collecting taxes.  Either way, if you’re death or the tax man, you probably aren’t too popular.

Obviously taxes are important when you’re thinking about investments and your retirement.  Uncle Sam (for all you foreign readers, what is the name of the personified tax collector in your country?) is definitely going to take his share of your earnings and investments.  Given the progressive nature of most countries’ tax codes, as your nest-egg gets larger and larger, they take a bigger percentage, so that raises the stakes.

The government has built the tax code to offer huge tax breaks to people saving for retirement, particularly allowing people to defer taxes from their earning years to their retirement years. That’s really all that accounts like 401k’s and IRAs are doing, taking money you earn when your income is high and allowing you to pay taxes on it when your income is low.  It may not seem like a big deal at first but suffice it to say, optimally managing your tax situation can be the difference of hundreds of thousands of dollars.  As always, it’s important to remember that I’m not a tax expert; also I’ll be making assumptions on future stock returns which in no way guarantee that is what will actually happen in real life.

 

Working tax rate versus retirement tax rate

US tax rates go up pretty quickly the more money you make.  So when you’re in your prime earning years, that is when your tax rate is going to be the highest.  Take my old neighbors Mr and Mrs Grizzly as an example.  They both work and have a combined income of $150,000.  Throw in a couple assumptions like they have two cubs, a mortgage, and live in the great state of California, and they are paying a total of about $41,000 in taxes, about 27% (there’s a great website that I used for these estimates).  Look a little deeper and their marginal tax rate is 43%; that means if they earned one more dollar they would pay $0.43 in taxes, and conversely if they lowered their income by one dollar they would save $0.43 in taxes.  Wow!!!  That’s a lot in taxes.

Now let’s fast forward and think of Mr and Mrs Grizzly in retirement.  Their house is paid off and they don’t have to save for their cubs’ educations, so what they need to support their retirement lifestyle is $80,000 (believe me, I will have many future posts dedicated to estimating how much someone needs per year in retirement, but for now let’s just take the $80k on faith).  Each year they tap into their savings and the $80,000 breaks down into three buckets: $20,000 is interest and dividends; $30,000 is long-term capital gains on the profits from their investments over the years; and $30,000 is the basis, the original money they invested which doesn’t get taxed.  Run your tax calculator again and they’re paying a measly $1,200 in taxes!!!  Read that again; it’s not a misprint.  That’s only 2% compared to the 27% they were paying while they were working.  And their marginal tax rate is 4% in retirement instead of 43% while they were working.

That, my friends, is some powerful stuff!!!  Now, how do Mr and Mrs Grizzly translate that into cash money?

 

The value of deferring taxes

During their working years, Mr and Mrs Grizzly set up their budget to save $1000 per month.  Because they are avid readers of the Stocky Fox, they know they should save that through their 401k’s (in this unfortunate example, let’s assume their cheapskate company doesn’t offer any matching).  In a year they will have saved $12,000 but since 401k’s are tax deferred they don’t pay taxes on that money, saving themselves $5160 in taxes (remember, their marginal tax rate is 43%).  Nearly $5200!!!  That’s some serious honey comb.  They do that each year and after 30 years (let’s assume a 2% dividend and a 5% stock increase), and they have a nice little honey pot of $1.12 million for retirement.  They’ll withdraw their $80,000 per year and pay the lower tax rate on it, and life is good.

The Grizzleys are sitting pretty, but what would happen if didn’t use their 401k to defer taxes and instead invested their money in a normal brokerage account?  Each year, they’d pay the $5200 in taxes but then they would also have to pay taxes on the dividends.  If you assume the same investments as we did above, 2% dividends and 5% stock increase, after 30 years they would have $815k.  That’s nothing to sneeze at, but that’s about $300k less than what they had with their 401k.  Those numbers seem crazy, but that’s the power of tax deferral.

2015-02-16 deferred taxes graphic (qd)

So the lesson is that using tax deferred accounts offers a really powerful way to accelerate the growth of your nest-egg by cutting out the tax man (in a totally legal way, of course).