Date: 2008-01-30 13:09 Subject: Money Management for the Middle Class: Investing Security: Public Tags: money

You're going to be working for a long, long time if your plan for having money at retirement is based on putting leftover cash in a glass jar under the bed.  Yet, many people don't look at what they could be doing with their money to help grow wealth and achieve a state of financial certainty (ie. all bills paid) without having to maintain employment.  The key is to be able to gain a return on investment of money.  Just as everything else works in finance, investing will ultimately be as successful as your risk tolerance and ability to hold true to a dedicated plan.  If you decide that the best way to grow your fortune is to buy and sell baseball cards, figure out how to do that and stick to it.  Just...don't really expect me to think that's the best thing you could be doing with your money.  Here are a few tips and ideas about investing that could help the average person better manage their financial growth.

Debt is the Same as a Negative Investment
It would seem like the best choice in a given situation would to be to always choose the investment opportunity that has the best Risk:Reward ratio, but what happens when you have debt, and possibly significant debt?  You have to consider interest on debt to be the same as interest on an investment.  If you are in a situation where your debt rate is significantly higher than your investment rate (and for most credit cards, this is very true), paying off a 22% loan will save you more money than investing in a 10% interest investment over the same period of time.  I can't argue with the fact that delaying an investment to pay off debt will impact your time-value of money (also known as your future worth);but, I must stress that debt always comes with a defined window.  You will have to pay off your debt at some point, and unless money pops out of the air for you, paying it off early will control your loss.  Yes, your earnings will not be as great as they could be, but your loss will also be mitigated while you also avoid entering a situation where your debt is greater than your capacity to pay it off.

For low interest items, and particularly debts that have tax advantages (such as your house and school loans), it is not as critical to pay off debt before investing; therefore, you will need to make value judgements regarding your ability to gain on positive investments versus your ability to pay off negative debt.  For credit cards, store loans, and the like, always attempt to pay these off prior to making investment choices.

Of Course, a 401k is somewhat of an Exception
The key to a company or government sponsored savings plan is that most will give you a matching contribution for money that you set aside before you pay income taxes.  A 401k or 403b investment account gives you two financial benefits in one package: free money and a lower tax amount (and possibly lower tax rate!).  Always, ALWAYS, contribute to a 401k type plan at least the minimum required to receive your employer's full investment match.  If you have additional funds available to save, strongly consider increasing your 401k contribution up to the pre-tax maximum before investing in other places.  There are worse strategies than maximizing your tax benefit, but bear in mind that you are only as diverse as your 401k options should you choose to do this.

Why does a Roth IRA make me think of Van Halen's golden years?
If and when you do decide to diversify your types of investment, a strong candidate for additional investment is a Roth IRA.  The concept of the Roth is basically the opposite of a 401k account - instead of delaying tax until the point when you withdraw from the account, a Roth is taxed when deposited while it is untaxed on withdrawal.  This means that a Roth account does not get taxed on any of the interest that you earn over the life of the account.  If that life is...say 30 years, you can have a substantial amount of investment growth that is tax free.  

The drawbacks to a Roth account are that the amount you can invest is currently limited to a smaller amount than other investment accounts and because it is taxed on entry, your principle amount that will grow interest is going to be less than if you invested an equivalent amount in a tax-deferred account.  At the current taxation rate, this is somewhat a wash of which is better between a tax-deferred acount and a Roth account with a slight edge to the tax-deferred acount.  However, most financial advisors agree that there is no way we can continue on the current taxation rate for investments; it is almost guaranteed to go up in the future.  As the taxation rate increases, a Roth account will become far more attractive than other investments.

Should I "Just Say No" to Stocks?
Well, the answer is not necessarily.  Single stock picking has its own challenges, not the least of which is volatility (that's a big word for "your investment can lose value") in the market.  Typically, a single stock is going to greatly outperform a Fund, but that applies both to it's gains and losses.  If you have a stock that you OMG, MUST BUY, go ahead and do it, but consider it to be the same or worse than your riskiest fund picks in the rest of your portfolio.  I'd urge you to consider not making stocks your full portfolio, of course.

When picking stocks, choosing stocks that have consistently paid dividends should be strongly considered.  Dividends will give you investment money (which you can either withdraw to spend or re-invest) without decreasing the number of shares you have purchased.  Because share quantity is as important if not more so than share value, keeping your quantity of shares stagnant while increasing your investment value will be of great benefit to you.  This becomes even more of a positive factor in a retirement scenario.

Allocation
The very first time you setup an investment portfolio, you will want to diversify the type of investments you make to protect yourself from negative impacts.  These could include decline in dollar value, increased cost due to regulatory issues, market changes, recessions, etc.  If you have all of your money in real estate funds when something happens like a sub-prime mortgage collapse, your investments will feel the full negative impact of the losses realized by those funds.  If you were only invested in government bonds at the time, you may not take heavy housing losses, but you aren't exactly burning down the bars with great interest returns.

The key is to put yourself into enough risky situations for your tolerance level without exposing yourself consistently to the same type(s) of risk.  If you want some oft-ignored areas to include in your risk portfolio, consider Gold exchange-traded funds (ETFs), international ETFs, global allocation, small-caps (target companies with low capitalization - 250M to 1B), and at the time of this post, large-cap equity funds (since they've tanked for so long, the odds of their value increasing in the future is great).

Re-allocation
One of the worst things you can do with your investments is to leave them alone.  Untouched, your worst investments will continue to not make as much money as you'd want (or even lose money) while your best investments will grow more than your other investments and change your market exposure.  After a period of time in this mode, you will become heavily leveraged only in your best investment areas.  Should the market change or new negative impacts come up, the impact to a heavily leveraged account could be very costly.  

By rebalancing the allocation back to your original plan for your risk tolerances, you will lock-in profits gained in overperforming accounts and increase your share value in underperforming accounts.  At the same time, you will experience no greater risk than what you signed up for in the first place.  Bear in mind that your risk tolerances should also change while you get closer to retirement, and therefore rebalancing will be a good way for you to evaluate how much risk you want as you go through your career.

Try to rebalance your allocation at least once a year, but no more than quarterly.

What else is there?
Well, the more I go through writing these, the more things I find I want to talk about...things like Paying It Black, Emergency Funds, and how to lower insurance premiums.  I have missed just putting up simple mundane posts, though.  I rather felt like I needed to get all of this out of my head before I talked about the latest Meganisms I've enjoyed.  From here forward I'll probably intersperse normal life posts and posts with the MMMC header (and money tag) for anyone that might want to follow or track this.  Thanks if you found any of this useful, and ask questions if you have any.  I don't have all the answers but I do so love to talk.

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Date: 2008-01-22 13:38 Subject: Money Management for the Middle Class: Insurance Planning Security: Public Tags: money

I know insurance is very important for a middle class family, but personally I’ve never really liked having to own it for the simple reason that it is a loser’s game.  That is, in order to make your money off insurance, things have to go wrong (and in some cases, very wrong).  Would Lissa rather have me beside her or a million bucks?  See, not a fun choice.

 

Despite its dark and morbid nature, insurance does have its uses when planned for and applied correctly.  There are a lot of different types of places where insurance can apply, but the most common types of insurance people experience are medical, life, disability, and AD&D (accidental death and dismemberment – woo, what a title!).  Do you need them all?  Well, just remember that insurance is setup as a fallback security.  So you need to couch everything in this post with your own risk behaviors and tolerances.  Smokers, sky-divers, and drag racers all need more insurance than your average desk jockey – granted they will also have to pay more for it.

 

At some point in time, your employer communicated to you just what, and how much, they offer as insurance benefits.  Factor this amount into how much insurance of each type you should purchase.  If your company provides $100,000 of insurance and your spouse would need $190,000 of supplementary income were you to die today, you need to buy $90,000 in life insurance.  If the cost of supporting you and supplementing your income would be $250,000 if you were to become disabled, and your company provides $150,000, you would need $100,000 in disability insurance.

 

I guess I should stop and say another important rule to remember about insurance.  Insurance companies are, by and large, in the business of making profit.  Note that this does not at all go well with handing over lots of money to you.  You will either be paying out the nose for it upfront, or in some cases - particularly on the medical side - they will delay or resist payment.  None of this makes insurance any less necessary, but it’s a fact to bear in mind.

 

MEDICAL

There’s not much to say here about medical insurance.  There are very few applications of medical insurance that can be considered a future investment other than medical savings accounts (MSA) and health savings accounts (HSA).  My understanding of MSAs is that they are being phased out into HSAs, and since they weren’t very common in the first place, I’ll take license to assume no one that will ever read this has one or wants advice about one.  The way an HSA works is that you have two pieces to your insurance: a savings account portion that accrues tax-free interest and a high deductible net to keep your medical expenses from hitting an excessive amount (say, $2,000 or $4,000).  If you are young, do not have a family history of sickness, and find yourself to be reasonably healthy each year, I recommend you considering an HSA as your medical insurance choice if it is available to you.  The key to success is to build your savings portion sufficiently in the early years to cover your costs with interest in the later years when you will need more medical care.  This is not necessarily a good plan to have with kids, but it is possible to be successful with it.

 

Outside of the savings account options, I think it’s important to stress having some kind of medical insurance.  Middle class families are typically not rich enough to support all of their medical costs alone, and can be bankrupted by unexpected or serious conditions.  I disagree with a lot of the way the insurance industry with medicine has gone, but I also don’t want to see someone lose everything because they need chemo treatments or develop a serious food allergy.  Coverage with an employer is the best way to go, but if you are self-employed (or your employer does not provide coverage) look closely at becoming self-insured.

 

DISABILITY AND AD&D

These two types of insurance are more commonly provided by a corporation than owned by an individual.  The key to remember with both disability and AD&D insurance is that the key to need is risk.  If your career and lifestyle are low risk, the need for these types of insurance goes down dramatically.  You don’t necessarily need to own them, and more often than not I steer away from saying anything about them.  Of course, as your risk increases your cost to purchase also is likely to go up.  In short, if you truly need to buy either of these, they probably aren’t going to be cheap.  If it is cheap, you may want to re-evaluate your risk tolerance.

 

LIFE

The ultimate of the loser’s game: you win the lottery as soon as you can’t spend it anymore!  However, as you grow your family, the people that are left behind will have greater loss than the already devastating loss of your presence in their lives.  You must consider your debts, unrealized retirement investments, paying for college, weddings, cars, homes, and any other expenses you had or were soon to realize when evaluating just how much life insurance to purchase.  Consider life insurance as a ripcord for your loved ones to subsidize your lost income, and consider it only as that.  Your money is better invested in “living” sources than it is in insurance for your death.  While it might be great to say you’ve got a million dollar Term plan, for example, if your need is $200,000 you will be overpaying for your insurance each payment.  If your plan is to make your loved ones richer than they currently are by your death, you may want to evaluate your outlook on life (and perhaps consider therapy – don’t be so in love with death that you want to make it an enterprising opportunity).

 

There are three main types of life insurance: Term, Whole, and Variable.  Term Life is set for a fixed period of time of contribution to insure that at any time during that contribution period (or other, pre-set period) a payout will be guaranteed.  At the end of the period of time, both parties walk away from the agreement; if you haven’t died by the end of the Term, they keep the money and congratulations, you’re still alive.  Whole life is exactly like term in its contribution period, but the contribution amounts will be much greater.  At the end of the contribution period, a whole life plan will then make an annuity-like periodic contribution back to you.  In most cases, Whole Life covers a payout for an extended period of time after contribution.  Typically, your contribution amount for Whole Life does not increase over time like the other two life insurance types.  Variable insurance has a Term Life period and an after-contribution payout like Whole Life but at a cost somewhere in between the two.  It’s somewhat of a hybrid of the two other types of insurance.  HOWEVER, variable insurance requires that the purchaser (that’s you) manage an investment account to grow the final payout amount.  Variable insurance also gets more expensive as you age, which will probably have an impact on your final investment account dollars.

 

If your savings in other places (investments, 401k, and savings account) are already significant, and you can afford it, consider purchasing Whole Life insurance as a supplementary retirement account.  Most likely, you cannot afford Whole Life and make significant investments as a member of the middle class.  Most insurance advisors recommend against purchasing Variable insurance.  The cost is somewhat significant and all of the risk of gaining a financial payout at the end is on the purchaser.  So basically, purchase Whole Life if you can afford it and are already fat with investments, purchase Term Life otherwise.

Like disability and AD&D, many companies will also provide optional supplementary insurance.  Before purchasing an independent insurance plan, evaluate whether your needs would be met through this supplementary insurance.  Typically, rates will be significantly lower through your employer than privately AND many times your deduction from your pay for supplementary insurance will be pre-tax.  However, most employers do not supply Whole or Variable life options – only Term.  If your plan is to purchase Whole Life, you will probably have to do this on your own.

Insurance for Your Kids

You should not buy life insurance for your children.  If you are looking at this issue from the perspective of  income subsidy, you have to ask if your children are bringing income into your family.  If the answer is yes, the odds that you are actually middle class are low and this post probably does not apply (and you will need a different sort of help on financial planning).  Since we’ll assume the answer is no, what is it you are doing when you buy children’s life insurance?  Too often I hear that people do it because the cost is low and they buy an add-on investment package (through a children’s Whole or Variable plan) to a term plan.  Cheap is not a good answer for whether or not it’s unnecessary.  The reason it is cheap is because the risk of a child dying is incredibly low, and therefore an insurance company rarely has to pay out.  As for an investment, there are many ways you could be better investing your money for your children.  Not the least of which would be a Roth IRA.  Honestly, I don’t have any other way to put this – is $10k or $20k really going to make you feel any better if you did lose your child?  Are you going to miss the hundreds of dollars you spent on insurance when the child moves out of the term life phase still living?  If you really take the time to think about these questions you'll probably see the ansewr is just don’t buy it.

 

What’s next?

So as you go through the process of making your financial plan, you will hopefully have figured out your income and cost of living, and now the amount of money you will spend to secure your finances from problems and/or catastrophes.  The next step is to look at Investment Planning.  I need to think about how much I want to say about company plans and social security, so I may break it up into two posts.  I guess I’ll see as I get there.

 

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Date: 2008-01-14 17:10 Subject: Money Management for the Middle Class, part 1 Security: Public Tags: money

I've been putting this series of posts I've had about managing personal finances on the backburner for at least six months now, in no small part related to my efforts to find a new place of employment instead.  Well, since I just got my latest rejection letter, I figured I would go ahead and get started on writing them down.  The first thing I discovered in writing this post is that putting down the minute details of building a financial plan would hands-down be the most boring thing I ever put in my journal.  So, after a major post overhaul, this is mostly just a few tidbits that are important to consider.

So, I'm guessing that most people think of preparing a budget when, or even if, they decide to go about managing their money.  Unfortunately, there's really so much more that should go into a financial plan than simply how much money you will spend in the next year.  Alas, I'm jumping about; I guess the first thing we should talk about is “Why make a financial plan?”  Well, there are many reasons, but the best one is that making a plan gives you the knowledge of where your money is now, where your money will be in the future, and along the way between now and death (or retirement) what income or expenses you will have that you need to account for.  At the end of the day, it is a useful tool for evaluating the financial decisions you are making today and how they will impact you over the course of your lifetime.

How to Create a Financial Plan
Well, the stupidly easy answer is that you don't do it yourself.  You can, and I am really going to stress the word can here, go to one of two types of financial consultants to get it.  The first type of consultant wants you to pay them a large sum of money now, perhaps a few thousand dollars, but will supposedly give you impartial advice on your finances.  The second type of consultant performs a financial plan for free, but will try to hook you into using them for any financial purchases you will need to make based on the outcome of your financial plan.  The argument typically made, and expect it if you use a "free service" is, "Well, you're going to have to get those services from someone, so why not the person that helped you?"

There should probably be tons of disclaimers about good and bad financial advisers and which of the above professional services is better.  If you want to create a financial plan on your own we need to assume a few things here: you are reasonably good at excel, you have the ability to pull together a year's worth of expenses, payroll stubs, and current balances for investments, life insurance, and other assets, and you have a general sense of accounting or know how to build a budget. 

Ultimately, the financial plan is going to be looking at the goal of getting to retirement in the black (cash positive) and then some, and predicting the amount of money you need to live off of for the period you think you will survive after retirement.  Grim but true, the accuracy of your plan is directly related to your accuracy in predicting the age of your death and the age at which you would like to stop working.  If you are unsure of your family's history or your career path, good places to start are Age 65 for retirement and Age 85 (90 if you are Female) for death.

Now you, or your financial advisor will layout a map of all your annual incomes and debts from your current age to that magic retirement age you determine. 

Things to Keep in Mind

- One of the major pitfalls you may run into, and financial advisers will likely overlook or gloss over is that most people find their wages are capped close to retirement.  Since a lot of the time retirement costs are based off the last few years of employment, escalating during this period can force you to think you need to save more than you actually need.  A conservative assumption would be to assume all salary gains after age 55 are capped.  A more general approach would be to assume it is capped at age 60.  Other professions also have wage caps – such as an hourly worker hitting their maximum hourly wage – so be sure these are accounted for in your timeline.

- You have to be careful that you also don’t over-escalate investment contributions from your 401k.  Currently, the contribution maximum is $15,500 per year for 2008 unless you are over fifty years old (in which case you may take an additional $5,000 catch-up).  The government has been steadily increasing this amount year to year, but it is entirely possible, and probable, that you will hit this investment cap for your tax-free savings in the tail end of your career.  Failure to observe the cap could give you a false sense of how much tax-free savings you can make near retirement.  I couch that by saying that hopefully during your last few years of working your savings will not hinge on tax-free 401k contributions.  There are similar investment limits for a Roth IRA; however, these are after-tax investments.

- Most other after-tax investments allow unlimited contributions.

- You also want to factor in inflation in your earnings and expenditures.  Inflation will increase your cost of living by somewhere between 3-5% each year.  If you are getting help from a planner and they are recommending a number outside this range or near the border, be advised that they are likely too risk-prone (<3%) or too risk-adverse (>5%).

- You may want to think about how you could change your spending to create annual surpluses.  It is very critical to financial planning (and really, your financial future) that you have an annual surplus from your current wages in and your current expenses.  If you are already overspending your budget on an annual basis, it is imperative that you get your finances under control.  This will lead you down a path where you cannot gain financial independence, and you will quickly lose the ability to retain your assets.

Your Financial Map

So now you have a financial map, which looks like maybe just a few dozen columns and rows of financial data.  What is it that you do with that?  I’ll start with Insurance Planning and how that affects your financial plan in Part 2.

 

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