This is the twelfth in an indeterminate series of entries that provides my “real world” lessons to young adults. It is my conviction that these lessons are rarely taught either at home or in the schools. For those who did not get them growing up you can get them from me for free. This is part of my way of giving back to the universe on the occasion of my 50th birthday.
Way back in Lesson 2, I covered the fundamentals of personal finance. I hope you used the intervening two and a half years to make yourself financially solvent. Good news: if you are not carrying a credit card debt, you are doing better than many Americans. Your net worth may hardly be in the positive numbers but at least it is positive. Even if you have student loans, providing it has helped you get a decent paying job, this is good debt.
You may be young but you might also have the feeling that old age is going to visit you someday. When it arrives, you know you would not prefer living in a cardboard box under a freeway. You know that to avoid this fate you need to start investing money now, although you might not have a whole lot to invest except for the spare change inside your sofa. Most likely you kind of resent having to save anything at all, but you know that like taking vitamins its one of these things that prudent people do. Where to start? Buy a share of Wal-Mart stock? Open a money market account? Buy gold on the assumption that its value will stay steady during inflationary times? There are an infinite number of choices and it’s so darn confusing!
I can make it easy for you: start with your employer’s 401-K plan. Why? Start there because if your employer offers a 401-K plan they will often match your contributions up to a certain percent of your salary. In other words, it’s free money. It’s true that except in cases of dire emergencies you cannot take out the money before retirement, but you still get to invest more money than you can contribute. In short, you should contribute as much money as you possibly can into your 401-K or similar plan, particularly if you get matching contributions.
Start contributing today and never, ever stop until you are fully retired. This is the golden rule of investing: start early and contribute regularly. Do not contribute a fixed dollar amount. Contribute a percentage of your income automatically with every paycheck. Your income should naturally rise as you age so at the very least you want your contributions to rise proportionately. It is never to late to start investing but the multiplicative factor for starting early is mind-boggling. Starting early means that you have more time to invest and your money has more time to grow. Give until it hurts. Give until the financial pain is just short of excruciating. As your income goes up, try your best to put a greater percentage of your income into retirement funds as well. There is an additional piece of good news: the IRS pretends your salary is your actual salary less your 401-K contributions. In other words, you end up paying less in taxes because you “earn” less. The net effect is you have a little more money available to put into your 401-K than if the money was taxed up front.
If your employer does not offer a 401-K, or even if they do, you can still open an Individual Retirement Account (IRA). In 2009, you can contribute up to $4000 and write it off your taxes, at least if you place your money into a “traditional” IRA. You can also choose a Roth IRA. The difference with a Roth IRA is your contribution is not subtracted from your income for tax purposes: you pay the tax upfront but can withdraw it later tax-free. With a traditional IRA, you pay the taxes on the income much later when you retire for the privilege of paying fewer taxes now. If you can swing it, because younger people tend to earn a lot less than older workers, the Roth IRA is the better deal. As you age you might want to open a Traditional IRA because then you are likely to be taxed at a higher rate than you will as a retiree.
The general guidance for investing is tried and true and fairly well known. In the very long term, invest in stocks or stock funds as history shows that overall they will provide higher returns. In the medium term, buy bonds. In the short term, stick with savings, checking and money market accounts for their liquidity and safety.
What else should you save for? Many smart young people find plenty of incentive to save for their own digs. They would prefer being tied down by a mortgage instead of renting a U-Haul every few years and moving all their possessions. They also have expectations that if they own property, it will appreciate, and their net worth will grow. (The mortgage interest deduction is also a nice tax break, although you may find the cost of maintaining your home can eat up the tax break.) Obviously, you don’t invest this sort of money into retirement accounts. Where to put it depends on how long you think it will take you to buy some property. Most likely, you don’t want to put it into some sort of stock-oriented mutual fund because there is likely to be too much volatility in the stock by the time you need the money. The safest bets are savings and money market accounts, but they produce almost no interest. A good choice looking several years out would be a well-rated corporate bond fund. Also consider a fund that buys Ginnie Mae bonds. Ginnie Mae bonds actually help homebuyers like you buy houses. There is risk of losing money, but it is very small, along with decent potential of above average market returns.
Okay, you are thinking. Where do I buy these sorts of funds? In addition, which ones are good and which are bad? Unfortunately, there is a lot of smoke and mirrors among investment firms and brokerage houses, which they gleefully help create. Real return is hard to figure out, given that returns are rarely guaranteed and many funds charge fees to buy and sell funds. Many funds come with certain minimums and contribution requirements. Billions are spent to shape your perception that firms like Vanguard and T. Rowe Price are smart places to put your money. You would be right to be skeptical.
If you want, you can be your own broker. You can in theory send a check to places like Ginnie Mae or the U.S. Treasury and they will send you bond certificates back. This is too much hassle for most people. When in doubt I go to the most trusted and unbiased source I know: Consumer Reports. I think any smart consumer should subscribe to the magazine, but you can also spend a little money to get access to their online web site. Periodically they rate various categories of mutual funds. Their ratings are not necessarily sure things, but they are good, unbiased bets.
Ultimately what you need is a personal financial advisor. Most likely, that will have to wait until you have enough income to also afford a financial advisor. Banks and brokerage firms will want to sell you their financial advice. Be wary because most likely they put their bottom line ahead of yours. When I finally had enough money to get a personal financial advisor and I chose someone local who was listed on the National Association of Personal Financial Advisors web site. My personal financial advisor makes recommendations to me. I do the actual paperwork to make them happen. He never gets a cut of my earnings, only a flat fee for sound and unbiased advice.
Until that time comes, it is probably a sound strategy to be your own financial advisor. You can supplement your knowledge not just by reading my advice but also by reading some of the many popular books on investing available at your local bookstore. By following the established investing rules I outlined, you are likely to do nearly as well as the financially sophisticated anyhow. The truth is there is always risk in investment, as well as rewards, and no financial guru is always right, not even Warren Buffett. Some approaches will prove to be luckier than others in the short term, but time seems to even out the playing field. Sticking to traditional rules should serve you well until you have the time and money to get your own personal financial advisor.
November 13th, 2009 at 08:06pm
Posted by
Mark |
Advice |
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Those of you who dared to read your brokerage statements probably have the same question that I did. Where the heck did all my money go? Some of my mutual funds are worth half what they were two years ago. Given the current dropping stock market, I am likely to see further losses in many of my funds.
If I had put my money into AIG stock then yes, I would expect to be able to get just pennies on the dollar. However, I own mutual funds. The whole point of owning mutual funds is to spread out the risk. Some stocks in the portfolio are bound to suffer but it should not matter because other funds will gain. It should all balance out somehow.
The short answer is that the financial industry came down with a bad case of the flu. Pretty much all of them are in the hospital and are being pumped with fluids from the U.S. Treasury and the Federal Reserve Board in the hopes that they will recover. Then they can resume that voodoo that Wall Street used to do so well: showing regular returns for investors.
This begs the question: how did they all come down with the flu and the same time? Here too we sort of know the answers. As best this non-economist can figure out there were two root causes. First, the Federal Reserve Board under Alan Greenspan had a low inflation policy, even at the cost of keeping credit artificially cheap for unusual lengths of time. This had the effect of encouraging borrowing and made it possible for many of us to live far beyond our means. This helped facilitate the second root cause: ever more complex financial securities tied to cheap credit provided to risky borrowers. They became popular because they required no government review. They had the effect of hiding the risk of investing in these securities while giving the cash-rich places to invest money that would otherwise go under a mattress or earn next to nothing in a bank account. They looked reasonably safe because they were packaged like a mutual fund and thus presumed less risky.
Like someone whose diet consists of nothing but nachos and cheese dip, there is eventually a day of reckoning. One day you find your bowels obstructed, your blood pressure high and your cholesterol levels are through the roof. The world now has all this and more. We gorged ourselves mindlessly on bad debt. Our coaches (Congress, President Bush and the Federal Reserve) encouraged us to consume even more nachos and cheese dip. Now we weigh five hundred pounds and can hardly move from side to side in our hospital bed. In fact, the orderlies are having a hard time moving us to change our bedpans.
It is technically possible for a five hundred pound man to get back to a slim one hundred fifty pounds with a diet lasting many years, but the odds are heavily against the patient. Once you are used to a diet of nachos and cheese dip, it is hard to eat salads. You might think though that those who are providing us the food might be at least providing us with healthy food. As best I can tell, when it comes to the financial industry, with some caveats, the answer is you are allowed to serve as much junk food as you want.
I looked up what it took to establish a bank in Virginia, the state where I live. You definitely need a lot of starting capital. You also need five directors who set the bank’s policy. In addition, you need to hire a CEO. Virginia does not specify criteria for such a manager, although it suggests:
a suitable background and adequate training, a strong, well documented record of accomplishment in banking at a comparable level, a capacity for leadership, familiarity with the current banking environment, analytical ability, and a realistic outlook.
State chartered banks in Virginia also are required to undergo a “supervisory examination” no less than every three years. However, the state does not actually audit the bank. In fact, it goes out of its way to calm potential fears of the bank owners:
Although in some instances fraud has been discovered during the course of a supervisory examination, detecting dishonesty is not a primary purpose of an examination. An examination is concerned with a bank’s financial condition, its compliance with the various laws and regulations and the soundness of its operating policies; it cannot be relied on to detect fraud and embezzlement.
Presumably, before a bank charter is approved, Virginia will at least give it a sniff test to see if it smells, but it is clear that in Virginia’s case bank supervision is mostly superficial. Moreover, there are no requirements that I can find that the bank’s managers must have actual banking education. (I was hoping for something more than “I know how to use Quickbooks”.) On the federal level, most banks choose to be FDIC insured. Presumably, this brings some federal scrutiny, but clearly not enough to keep many of these institutions solvent. Even if the criteria are clear, enforcement can be problematical. Moreover, as the Washington Post reported recently, banks can and do “shop around” for friendlier bank regulators. It suggested that the federal Office of Thrift Supervision is one of the more lax federal banking regulators.
If my limited research is correct, banks can be managed and run by people who aren’t necessarily even qualified bankers. Even if they have experience in banking, it is not clear that they need a level of certification to be a banker. I would think the criteria for any banker would include being an accredited Certified Public Accountant. Presumably, a banker needs to know more than a CPA and should have a broad understanding of financial risk, credit worthiness, assets to debt ratios and the like. Maybe they do but apparently, most were asleep during the lectures in MBA School, as they gorged their balance sheets with dubious toxic assets, which were never accurately valued. Given that so many banks are teetering on the edge of insolvency, it is reasonable to think the problem exists both nationwide and worldwide.
Banking regulation may be scattershot but at least it exists. On Wall Street, apparently all sorts of new and creative financial instruments can be created with no government oversight. The Securities and Exchange Commission has many powers, but Congress limits its powers (and budget). Indeed, until recently we wanted to free Wall Street from the tedium of government oversight. By doing so, it was believe that they would be free to whip up the magic of the free market. I understand that if you do not manage a herd of cattle they tend to overgraze or could come down with ailments like Mad Cow Disease. The same appears to be true on Wall Street. All things being equal, Wall Street will look for ways to line their own pockets first and their shareholders’ second. This appears to be exactly what happened.
Where did all my money (and yours) go? Much of it went to buy stocks and funds at prices that were way too high because they were not accurately and independently valued. Much of it also went into the pockets of swindlers on Wall Street who used the money to buy estates in the Hamptons, private jets, and luxury yachts. The federal government largely looked the other way. We investors largely looked the other way too, assuming that we were “safe” if we spread our risk by doing things like investing in mutual funds. However, primarily it was those we entrusted with managing our money that deliberately looked the other way. They were anxious for a big bonus for making quick profits rather than to looking out for the long-term needs of investors. Take my financial adviser. He is a bright guy. He knows how to find a good bet on a mutual fund. Nevertheless, he like most of them was clueless about the size and scope of our current financial disaster. He should not have been.
Supposedly, animals know when an earthquake is coming and move to safer ground. Our financial industry needs to be like this. Our bankers are fiduciaries of a public trust: our money. They should all be certified to the highest standards, maintain current credentials and demonstrate their financial acumen by showing that their funds are invested prudently. They should take an oath to such effect, go to prison if they do otherwise as well as have their personal wealth returned to their customers in the event they fail.
Similar criteria are needed for fund managers. Before creating any fund, they need to demonstrate to the government that the fund accurately states the risk of ownership. Rating firms similarly need to be impartial; in fact, they should be nationalized. Our money is too important to leave its valuation entirely in the hands of the free market.
In short, these investments belong to those who own them. Fund managers are fiduciaries with a solemn obligation to act prudently in the best interest of the owners. Funds are not funny money; they represent real dollars and reasonable expectations of future income. Since they deserve a high level of scrutiny and oversight, these fund managers need sterling credentials, certifications and regular oversight too. As for new financial instruments, they should get an impartial government examination before they are allowed on the market.
These are the sorts of long-term steps we need to take to ensure we are never caught with our financial pants down again. Anything less means that we will see similar debacles like this again.
February 25th, 2009 at 05:58pm
Posted by
Mark |
Politics 2009 |
no comments
I can understand why most Americans do not want to look at their financial statements. If you take the time as I did yesterday, it is scary. I do not have all the numbers for my household yet but a year ago, our net worth was around $938,000. Today our net worth is about $771,000. That means in just one year about eighteen percent of our wealth has vanished.
Our real net worth is probably lower. How much is our house really worth? I will not know unless I actually sell it, so I go with our county’s assessed value, which was done before the sub-prime mess fully exploded. There are no bright spots in my portfolio. Our T. Rowe Price New Era fund is worth just 52% of what we paid for it. If this is what our “new era” will look like, it does not sound hopeful. This fund was supposed to be used for our daughter’s college education. We are drawing on other funds for now but unless stocks turn around dramatically over the next few years, we will have lost money set aside for her education, despite investing consistently for fifteen years. It suggests that we would have been much better off putting the money in a mattress.
Our other funds show a similar but less dramatic story. I can only hope that since most of our investments are for the long term that they will actually turn out to be investments rather than places to throw away our good money. Perhaps Michael Moore had it right all along: keep your money in government insured accounts only. Granted, the money may not grow that much, but at least it is unlikely to disappear when you need it.
A year ago, my personal financial adviser forecast that there would be a significant economic upturn toward the end of 2008. This was based on reading and listening to other people he respects. He was proven wrong of course. I cannot hold it against him. Even Warren Buffet lost money in 2008. This was a year when no matter what financial strategy you chose, unless you invested solely in bonds, you were going to lose money. The Washington Post today crunched the numbers and put the total loss on Wall Street during 2008 at $6.9 trillion. How much money is that? Consider that the federal government spent about $2.9 trillion in fiscal year 2008. In one year our investments, and consequently our national net worth, dropped by more than the federal government spends every two years. Gone. Poof.
Despite his prediction a year ago, my personal financial adviser is optimistic for 2009. “We are now convinced that the stock market has either hit its low, or is very close to it,” he tells me in his latest newsletter. He may have something this time. One measure, the Dow Jones Industrial Average, shows signs of bottoming out. It slipped briefly below 8000 and has floated between 8000 and 9000 for a while now. If we have hit a bottom in the stock market then now is the time wise investors should be purchasing stocks. Of course, there is no way to know. With all due respect to my financial adviser, anyone who tells you they do know for sure is bluffing. We will only know in hindsight when the bottom occurred.
Unless you need money from your investments right away, the current value of your investments should not matter too much. What is more important is whether you retain your job and lifestyle. One thing we have noticed in our family is that many information technology jobs have become commoditized. This is not good news for someone like my wife, who lost her full time job on an IT Help Desk in 2004. She was making close to $50K a year. Her job was outsourced to someone who did the same work for a lot less money and who conveniently was not on “staff”. She now has a part time job doing similar work but took a substantial pay cut to get the job. As for benefits, the doctor’s office she works for has little in the way of a 401-K other than a general profit sharing plan. Unfortunately, the money they contribute toward it would not let you live on dog food in retirement. I am more fortunate but even in the software and systems development area where earn my living, many people are hurting. The bottom line is that our standard of living was hurt too and our income (adjusted for inflation) is down substantially from the start of the Bush Administration.
Perhaps this explains why three out of four Americans are glad to see President Bush leave office in nineteen more days. Bush has been saying in interviews that he will be judged by history as a far wiser president than we give him credit for now. I would suspect him of sniffing glue but I think hitting the bottle is more likely. I am confident that historians will not be kind, for reasons I outlined here, but which you already understand.
Our falling net worth is a meaningful measure of the price of incompetence and of the failure of government to, well, govern. It is not as if we were doing stupid or risky things. Rather, our government was doing stupid and risky things by placing inordinate faith in a free market and by actively reducing its oversight role. Frankly though in this economy I feel lucky. $166K of my family’s worth may have vanished in the last year, but we are both gainfully employed and we have maintained our standard of living.
Like most Americans, I feel that January 20th cannot come soon enough. I admire Barack Obama for having the audacity to believe that he can move us out of the national wreckage of these last eight years. When the dung is piled this high, it is hard to see daylight. While I hope my financial adviser is right, my intuition tells me that the dung is much higher than we think. I suspect it will be quite a while before we see the sun. Good luck, President Obama. You will need not just exceptional competence but extraordinary luck if our country is to successfully emerge from the wreckage of the Bush Administration.
January 1st, 2009 at 07:58pm
Posted by
Mark |
Politics 2009 |
no comments
