The United States must be approaching the end of the recession when economists begin offering their retrospectives. Even if the data are pointing to an end to the recession, in technical terms, the economy is a long way from recovery. Just look around at the people out of work. Even those who have maintained their jobs are finding it difficult to qualify for mortgages, keeping the real estate industry itching for more handouts like the extension to the home buyers’ tax credit.

And some economists are not convinced that the worst is over. We may be in the lull of a double-dip recession. Wherever the economy is, making predictions, like critiquing wine, is often no more accurate than randomness.

For Fortune Magazine, economist and actor Ben Stein contributed four of the lessons he learned during the recession.

• Economic forecasting is still an extremely difficult gambit
• Financial market forecasting is even more troublesome
• The amount of lying and deception by the financial sector of this country has been breathtaking
• The government has no special abilities to forecast or predict a darned thing

Ben Stein is usually a strong supporter of the financial industry, so it’s nice to see him pointing out some of the flaws inherent in the system. He goes on to reassure investors that staying invested in stocks and bonds while keeping enough liquidity is the best way to weather recessions in the long term. If the second dip rears its head, I would like to believe it will provide more opportunities for investing for growth over the coming decades.

Are you prepared for the next recession?

Photo credit: simonhn
4 lessons from the recession, Ben Stein, Fortune, November 19, 2009

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Ben Stein Offers Four Lessons From the Recession

Over the next couple of weeks, six finalists will be auditioning for the opening of “staff writer” at Consumerism Commentary. Each will be providing two guest articles to share with readers. After the six writers have shared their guest articles, readers will have an opportunity to provide feedback before we select the staff writer.

This article is presented by J.J., a financial adviser and published financial author.

Roth IRA conversion rules are changing next year. Even if you make more than $100,000, you’ll be allowed to convert Traditional IRA money into after-tax Roth money. You can even spread the tax payments out over a few years to make it easier if you convert during 2010.

Does it make sense to do so?

We’ve touched on the 2010 Roth conversion rules before. Let’s dig deeper into why it may or may not make sense to convert.

Why convert?

The 2010 conversion rules may help some taxpayers. In general, the opportunity is more attractive if:

• You think tax rates are headed higher
• You’ve been making nondeductible IRA contributions
• You have a high net worth or you want to leave more for your heirs
• You want to diversify the tax status of your money, just like you diversify your investments

Higher tax rates

With higher tax rates in the future, you can get your tax payment out of the way now — at a lower rate. What might make tax rates higher in your retirement years? You could have higher earnings, lawmakers could raise tax rates overall, or both.

With all the talk of government bailouts and broken entitlement systems (like Social Security and Medicare) it’s easy to see why rates could go up. The government needs money, but the solution may not be as simple as an income tax rate increase. There are other ways they can drum up cash:

• Consumption or value added taxes (VAT)
• Change how much you and your employer pay for Social Security
• Change limits on retirement plan contributions
• “Forget” to change certain limits with inflation (IRA and retirement plan contributions, compensation recognized for Social Security and retirement plan calculations, etc)
• Change the laws and make Roth distributions taxable (or potentially taxable, like Social Security benefits)
• Other strategies I’m not smart enough to understand

If you’re betting on higher tax rates, make sure you understand how the bet can go wrong.

Nondeductible contributions

If you’ve been making nondeductible contributions, you’ve practically made Roth contributions anyway. In fact, you probably couldn’t deduct the contributions because you make too much money. For you, the conversion option is worth investigating because it would allow you to get the earnings out tax-free – as opposed to just the contributions.

Ideally, you’ve been making nondeductible contributions in recent years, and you have little or no earnings in the account after the recent market decline (sometimes there’s a silver lining). If so, the tax hit may be minimal. However, you should look at all your IRA accounts in aggregate to figure out how much it’ll cost.

Diversify, diversify, diversify

Diversification is another decent reason to consider converting. Most people have all (or a majority) of their retirement savings in Traditional pre-tax accounts. They’ll have to pay income tax as they spend that money. Since we don’t know what tax rates will do, it may make sense to hedge your bets.

If you have a choice of funds (pre-tax and post-tax) in retirement, you can choose whether or not to increase your tax bill in a given year. Suppose you do some consulting work and earn money – it may make sense to take a Roth distribution that year. On the other hand, you can take Traditional distributions when you have little or no taxable income.

Estate planning

If you’re fortunate enough to have an estate planning problem — or just more money than you need — then Roth money can come in handy. By converting, you pay taxes today so your heirs can take tax-free distributions (unless they change the rules and start taxing Roth distributions, of course). You also remove money from your estate when you pay the tax bill.

You’re required to take distributions from Traditional IRAs during your lifetime, starting after you reach age 70.5. The government wants you to generate some tax liability on all that money you’ve been protecting, so they force you to dribble it out over your remaining years. Roth IRAs do not have this requirement, so you can leave more for your heirs.

Proceed with caution

If the idea attracts you, don;t rush into anything. In the coming months, we’ll learn more about the complexities of the 2010 conversion rules, and how the landscape may change (for example, will tax rates increase in 2011 and 2012 — making it less attractive to spread the payments out?). Unless tax rates in your retirement years increase substantially, you probably won’t hit a home run by converting. However, you might come out ahead or just enjoy having more flexibility in retirement.

Remember that if you earn over $100,000, you’re already in a fairly high tax bracket (at today’s rates at least). A conversion won’t be cheap, and you should pay the taxes due from savings available to you outside of your retirement accounts.

Give your eyes a break and listen: a recent Consumerism Commentary podcast has more insight into the 2010 conversion rules.

Will you take advantage of the Roth conversion rules next year? Why or why not?

The Consumerism Commentary Podcast is in full swing with new episodes every Sunday. Listen and subscribe now!

2010 Roth Conversion: Good Idea?

Over the next couple of weeks, six finalists will be auditioning for the opening of “staff writer” at Consumerism Commentary. Each will be providing two guest articles to share with readers. After the six writers have shared their guest articles, readers will have an opportunity to provide feedback before we select the staff writer.

This article is presented by J.J., a financial adviser and published financial author.

Target date funds are under scrutiny in Washington as lawmakers figure out if they work the way they’re supposed to.

Also known as lifecycle funds, these funds become less risky as time goes on. They’re popular in 401(k) plans and other retirement plans because they make diversification easy. You select one target date fund from your plan’s menu, and that fund spreads your money among numerous underlying funds.

Most people are told to select the fund that has a number closest to their retirement year. Plan to retire soon? You might choose the “2010 Target Date Fund.” If you’re 26 years old, you might select the “2050 Target Date Fund.”

These funds are also common in 529 college savings programs where they may be called “age based” funds. The concepts are the same, so we’ll talk in terms of retirement for now.

For some, especially those who will not put time and energy into studying their investments, target date funds are a fine choice. They offer diversification and continuous re-balancing. They may have exposure to things (alternative strategies, commodities, or sector funds) you can’t find on your plan’s menu or that you don’t have enough money to buy into.

However, they’re far from perfect. Let’s cover a few of the major problems and what you can do about them.

What’s the right mix?

There are dramatic differences in how they’re constructed. For example, consider two funds with a target year of 2010. This would be a fund designed for an older investor — planning to start spending the money within a year — who presumably does not want to take much risk.

Fund Company A’s 2010 fund might have 26% in stocks, but Fund Company B’s 2010 fund might have 72% in stocks. Indeed, that’s exactly what happens. Morningstar published a study showing equity exposure in 2010 funds, and results are all over the board. Do most 65-year-olds want 72% of their money in the stock markets?

Critics suggest fixing this problem by standardizing equity exposure for each target year, or at least requiring more understandable charts showing the fund’s risk level. Some investors may be comfortable with high risk portfolios, but they should at least know what they’re getting into.

Who’s running the money?

Target date funds are made up of 10 to 30 underlying funds. Are those funds any good?

Critics argue that some fund companies put poor funds into their target date funds to feed money into those poor funds. If that’s the case, the Large Cap Value portion of your target date fund may be run by an under-performing manager or team. Of course, this is less of a risk if the fund company only uses index (or passive) funds.

The best target date funds are probably multi-fund-family funds. For example, T. Rowe Price’s target date funds are composed entirely of T. Rowe Price mutual funds. John Hancock uses different money managers to subadvise pieces of their target date funds. This lets them use best-of-breed managers for some portions of the portfolio and index funds for other portions.

Note that I have nothing against (nor do I endorse) either of the above companies; this is just food for thought.

What about fees?

It’s always hard to tell how much you’re paying with a mutual fund. Target date funds are especially tricky because they’re made up of many underlying funds. Most companies disclose “overlay” fees, the fee for creating the mix of investments and managing it over time, in a prospectus, but few investors look under the hood.

Multi-fund-family funds may have arrangements that create potential conflicts of interest. Why is one manager used instead of another? Hopefully it’s because of superior management, but you know it’s not always that simple.

Finally, some say that target date funds have excessive equity exposure because equity funds generate more revenue. That may help explain why a 2010 fund has 72% in stocks.

What can you do?

Target date funds are designed to make life easy, so requiring you to do homework kind of defeats the purpose. However, they’re out there and they may be your only option (or the best option available to you). It pays to know how they work and how you can improve your chances:

• Ask for help. Your 401(k) provider, financial advisor, or DIY investment company should be able to help you figure out what you’re investing in.
• Look under the hood. Understand how much is in stocks, bonds, foreign assets, and other assets. Are you comfortable with that mix?
• Make changes. If you don’t like what you see, use something else. If you’re limited to your employer’s retirement plan menu, consider using other investments. Talk to the HR department about your concerns.
• Bend the rules. Target date funds are designed for you to put 100% of your money into a fund with a target date near your retirement date. You can always use a different year to increase or reduce risk, or you can put 80% into the target date fund and 20% into another fund.
• Lean on regulators. Let them know what’s important to you or hope for the best.

Tell us about your experience with target date funds. Why do you use them or avoid them?

This is a guest article by J.J., one of six finalists interested in being Consumerism Commentary’s staff writer.

Photo credit: eyeliam

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The Trouble With Target Date Funds

The Security and Exchange Commission (SEC) is setting up a new division to oversee new financial products, and this group is starting with target date funds. These are mutual funds usually taking the form of baskets of other mutual funds, designed to target a certain year of retirement. As the year approaches, the fund automatically changes asset allocation, usually between stocks and bonds, to become less risky.

I’ve pointed out some of my concerns with target date funds here before. Mainly, they could be too conservative and it’s easy to hide fees. Mary Schapiro, the head of the SEC, pointed to the exchanges from stocks to bonds. The cost of the sales and purchases is buried in the daily price of the target date fund, and there is currently no good way for customers to understand how much they are being charged for the re-balancing of the portfolio they could do on their own.

Schapiro also noted that there is no standard across companies. A target date fund designed for those who plan to retire in 2050 with one fund manager may have a different allocation between stocks and bonds than a 2050 target date fund with another fund manager.

Here is a comparison of the asset allocations for the funds designed for those retiring in 2050 from Vanguard, Fidelity, and T. Rowe Price.

The variation seems small but could have an significant effect on returns by retirement in 2050. If target retirement funds were standardized across companies, customers could accurately and easily compare returns between fund managers, understand the level of risk, and have the opportunity to make better investment decisions.

I am not convinced there is a need for this. Any fund’s composition is described in detail in the prospectus and in on a multitude of financial data websites like Yahoo Finance and Google Finance. What isn’t clear are the true fees. We do know that Vanguard’s fee for their 2050 fund is 0.19%, Fidelity’s is 0.82%, and T. Rowe Price’s is 0.79%, but that only tells part of the story. Whenever there is turnover — stocks are sold and other stocks, bonds, or other investments are purchases — fees are generated but wrapped tightly into the daily price of the fund so it is barely noticeable.

Asset re-allocation is the purpose of target date funds. Even if the underlying funds, those in the basket, are low-turnover index funds, the managers may be rearranging the index funds in the basket often. For those disciplined to handle the responsibility of occasional re-balancing themselves, and it’s not that difficult, I suggest avoiding target date funds.

Target date funds have lots of fans because it’s a form of automation, and automation in finances is usually a good thing. There is a danger of automation leading to complacency and a false sense of security. If you choose target date funds, familiarize yourself with the details and evaluate whether the pre-packaged re-allocation system is worth the thousands of dollars or more you could be losing in hidden fees and with a risk profile that doesn’t match your income needs and tolerance.

Would you like to see target date funds standardizes so a “2050 Fund” from one company matches a “2050 Fund” from another company? or should companies be left to determine what strategy is best for their customers?

Photo credit: viZZZual.com
‘Target Date’ Funds Get Senate Scrutiny, Daisy Maxey, Wall Street Journal, October 30, 2009
SEC to look at retirement investing risks, Marketplace, November 3, 2009

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Should Target Date Funds Be Standardized?

Peer-to-peer lending institution Prosper is offering a $50 bonus for new lenders who sign up for for the service and bid on two loans. Peer-to-peer lending is an interesting way for people to qualify for loans and to lend money to others. In an economy where savings account interest rates are under 3% or 2%, it’s tempting to put cash to better use through these direct loans. There is a possibility to earn much more than you would by putting cash in a savings account as long as loans are chosen carefully and you’re willing to accept risk.

There is something appealing about working outside the banking system. Peer-to-peer lending takes a specific power of the financial industry and puts in the hands of individuals.

I tried Prosper a few years ago. A friend of mine was looking to consolidate his credit card balances, but was looking for a better option that putting several thousand dollars onto one high-interest card. His plan was to apply for a loan on Prosper and use the funds to pay off his credit cards. He would then only need to worry about one payment each month with a lower total payment and a lower interest rate than what he would likely get with a credit card.

When he asked me about Propser, I offered to help him out by bidding to provide a portion of the funding for the loan. The idea of being an investor appealed to me, but unfortunately, the state of Texas prevented him from participating on Prosper at that time. It is my understanding that he would qualify only for an interest rate higher than allowed by the state.

My adventures with Prosper ended before they began. And I won’t be able to get started. As I began to research investing in a portfolio of loans at Prosper and bidding on individual loans, I was greeted by this message:

Unfortunately, at this time lenders in New Jersey are not able to bid or transfer money to Prosper. If you have portfolio plans, they have been paused. You may transfer money out of your Prosper account as they become available from loan payments.

If you reside in a state where Prosper is allowed to do business, consider signing up for an account and qualifying for the $50 bonus. What is your experience with Prosper?

The Consumerism Commentary Podcast is in full swing with new episodes every Sunday. Listen and subscribe now!

$50 Bonus for New Prosper Lenders

I’ve been investing in a 401(k) retirement account since I joined the ranks of the corporate employed seven years ago. I started with a small percentage of my income, just enough to take advantage of the full company match. As my income increased, I diverted a larger percentage to the 401(k) with the hopes of retiring with a sizable nest egg decades later. I’m at the point now where I am contributing the full amount allowed by law.

This plan has worked well for a while. But like most people in similar situations, my 401(k) suffered damage over the past year or two. I figured that over the course of my career, I’d hit a recession at some point, and I suppose I am lucky that I am not forced to retire and begin drawing income right now, with the account value depleted.

Here is a graph that depicts my 401(k) account value since January 2004.

The cost basis, or the amount I invested, is represented by the line and the market value of the account is represented by the bars. Ignore the bump in the cost basis at the end of 2004. That should be a smooth curve. From 2005 through most of 2007, my account was performing quite well. Soon after that, the value fell below my cost basis. I was losing money on paper.

I continued to invest in my 401(k) every other week. Even with increased investments, my account has not caught up to my cost basis. The Employee Benefit Research Institute and the Investment Company Institute recently released a report that shows that many investors have been able to bring their 401(k) account balances above the level recorded at the beginning of 2008. I fall into this group, but at the beginning of 2008 my account value was higher than my cost basis. As of today, the total value of my 401(k) is below my cost basis.

In other words, if I had been putting the portion of my paycheck that I had been investing in my 401(k) into a bank account — or even kept cash under my mattress — I would have fared better. So far. The good news is that while I was investing throughout the past few years, I was, I hope, purchasing funds at relative bargain prices. If stock market performance returns to average over a long period of time, I should be in luck; those bargains will pay off.

What is the state of your 401(k)?

401(k) investors: Hit hard in ‘08, doing better now, Jeanne Sahadi, CNNMoney.com, October 6, 2009

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How is Your 401(k) Retirement Account Performing?

Earlier this week, I reviewed common financial rules of thumb and offered a quick evaluation of how each rule would likely perform if accepted by an individual as the final word. One of these was the rule that convinces retirees they will be financially secure if they withdraw 4% of their nest egg for income one year and continue withdrawing the same amount adjusted for inflation each year.

Walter Updegrave has a much more detailed strategy for retirees who would like to make their money last from age 65 to 95 and beyond. He offers three alternatives that one can follow depending on their assets and their needs in retirement.

Three strategies for retirees

The first strategy is for retirees who have enough income from Social Security and pensions to cover basic expenses and who are confident in their ability to manage their portfolio.

For those in this situation the 4% withdrawal rule has a chance of succeeding — having your money last 30 years — 77% of the time. If you need more income than 4% would provide, you’re risking not having enough to last that long. For example, someone retiring today with a $1 million nest egg could withdraw $40,000 that first year. But if you’re 33 years old like me, you better plan on having much more than $1 million when you retire; thanks to inflation, an income of $40,000 thirty years from now will probably not be sufficient.

In order to maintain a 4% withdrawal rate, according to the article, is to maintain a portfolio of 50% stocks and 50% bonds. And by the way, a bad year in the stock market could wipe you out.

The second strategy offered by Walter Updegrave is for retirees who need more income for basic expenses than is provided by Social Security and pensions or who do not want to subject their portfolio to as much risk as required in the first strategy.

Take part of your nest egg and purchase a lifetime immediate annuity. This will provide you with steady paychecks for the rest of your life. According to the article, recent annuities pay out 8%, so you would only need $500,000 to make that $40,000 income mentioned earlier. These are most beneficial for people who live longer because money is pooled with other investors. Those who die earlier help fund the incomes of those who survive in retirement longer. The problem with annuities is your money is often locked inside them, and you can’t get it if you need it without paying steep penalties.

Walter Updegrave also offers a third strategy for retirees who need more income than Social Security and pensions provide but want access to more of their money. In addition to a portfolio of stocks and bonds, and an immediate lifetime annuity, add a variable annuity with a guaranteed lifetime withdrawal benefit to the mix.

Variable annuities are flexible but they are also expensive. Rather than 8% like the lifetime immediate annuity above, a 65 year old is likely to receive a 5% return. It is not rare for these accounts to charge a fee of 3% of your account balance each year. The author suggests that the optimal mix between these products and investments would be 25% of your portfolio in variable annuities, 25% in immediate annuities, and the remaining 50% in the diversified portfolio of stocks and bonds.

The problem with annuities

The sale of annuities, particularly variables annuities, is riddled with problems. These are very popular products for salespeople because they make a lot of money for the companies that sell them. It’s not rare for salespeople to misrepresent the product. Often customers are not given the full information regarding withdrawal penalties.

Here’s an example of an 86-year-old man who was pressured into buying a product he did not understand and would never benefit from. Dateline investigated annuities salespeople and found more deception in the industry. Ben Stein, however, credits variable annuities for making his parents rich, though it might be important to note that a Ben Stein’s long-time working partner is Phil DeMuth, a registered investment adviser (salesperson) who benefits financially when more people are convinced that annuities are good products.

How to make your money last, Walter Updegrave, Money Magazine, September 23, 2009

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Three Detailed Income Strategies for Retirement

This is a guest article written by Clare, the founder of MoneyEnergy, where she writes about international dividend investing, DRIPs, and increasing your cashflow. If you like this post, consider subscribing to her RSS feed to get others like it in your reader.

DRIPs (dividend reinvestment plans) were fairly popular back in the 1980s I am told, but now that there are so many low-cost discount brokers, the argument goes, DRIPs are less desirable. Some don’t see what’s so special about them. For others, they’re just plain boring.

I’d like to give you a few good reasons why you should take another look at DRIPs — or check them out for real if you have never done so and aren’t familiar with them. If you don’t know what DRIPs are, you are about to find out.

1. Even with low-cost brokers like Zecco, the best DRIP plans are still cheaper: they’re FREE. They have no commission or reinvestment fees whatsoever. There are no minimum trades you need to make or minimum amounts you need to keep in your account. The cost doesn’t rise after the introductory offer expires. This means you save a lot of money.

2. Networking and computer technologies have enabled transfer agents to store account information and make it available to you online. There is no longer any reason to be concerned about folders and folders of account information and paper records that you need to keep track of yourself. Purchase price information, downloadable forms and tax documents can now all be had online, if you choose to do it that way. You can still, of course, just elect to receive your account information in the mail as always.

4. DRIP plans run through transfer agents like Computershare will reinvest 100% of your dividends back into the stock, not just the amount that will purchase a new share. This has always been a feature of DRIPs. Most brokers do not do this. The ones that do will only reinvest your dividends if they are enough to purchase at least one new whole share. With fractional reinvestment, your money goes to work for you sooner than if you had to wait to own enough stock to buy new shares with those dividends. This means DRIPs are still the best choice for young people or those just starting investing who might not have huge sums of seed money.

4. DRIP stocks are “pre-screened,” so to speak. Let me explain: First, the only companies who can offer DRIPs are those with dividend payouts. Second, companies with DRIPs tend to be well-managed and are interested in keeping their cash flow within the company (simply having a DRIP plan can save them numerous fees). DRIPs give them more flexibility and leverage in times of need as well as times of opportunity (such as acquisitions). Being dividend-payers, they are probably slightly more mature companies and are likely to be less volatile than the market average. Common DRIP stocks, for example, are utilities and consumer goods companies, like Proctor & Gamble. None of this means your DRIP stock is without any risk or that you shouldn’t do your homework, but I believe it does narrow down your selection and make it easier to spot value.

5. The best reason of all, however, that DRIPs are still attractive investment vehicles, is the ongoing discounts many provide on share reinvestment and optional stock purchases. Some companies offer anywhere from a 2-4% discount off the market value of their shares on the day of purchase. You won’t find that anywhere else! Companies do this as an incentive for you to invest and to use their DRIP plan, which, as mentioned in #4 above, benefits them considerably. Compound this benefit with the savings you’ll have on commissions, and you can see how much farther your money can potentially go, and sooner, with DRIPs.

DRIPs are no longer much of a secret in the investing world, but organized information on them can be hard to find. For a more detailed primer on how to get started in DRIP investing, take a look at this guide I wrote to commission-free investing.

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5 Reasons to Take Another Look at DRIPs

I do very little stock trading. In fact, the only individual stocks I hold are Microsoft (MSFT) and Akamai (AKAM), both of which I purchased with free money for opening a brokerage account. Naturally, I think free cash is a perfect candidate for experimentation with the stock market and I most likely would not have made these purchases without this particular incentive.

Zecco Trading is offering a different incentive for those who have funds for trading stocks but would like to avoid pesky transaction fees that eat into your returns. For a very limited time, Zecco is offering 20 free traders. This discount brokerage normally offers 20 free trades each month for customers who maintain a $25,000 bonus in their account or execute 25 trades each month. Otherwise, each trade costs $4.50, still one of the lowest transaction fees available.

Here is how to receive 20 free trades without meeting the minimum balance or minimum trade volume. First, be a new customer. Only new Zecco customers are eligible. Apply for your Zecco account here, and use the code bonus1 when signing up for your account. Your application must be complete and approved by September 13, 2009.

As long as you meet the above criteria, you will see 20 free trades available in your account by September 16, 2009.

For more options, see this summary of five true discount brokerages.

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Zecco Trading Offering 20 Free Stock Trades

For the last few years, I have been participating in my company’s stock purchase plan at the maximum level. Every paycheck, ten percent of my gross salary is withheld. At the end of each quarter the funds are used to buy my company’s stock at a 15 percent discount from the lower price of either the first day or last day of the quarter. As my company’s stock declined mostly due to the economy at large and the industry in which I work, this was a losing proposition. I decided not to sell the company stock until prices returned, rather than selling at the first available opportunity as I had been earlier.

So now I have company stock that I have been holding since December 31, 2007. About half of the shared purchased then and since then are in a losing position while half are now in a winning position. My only opportunity to sell this quarter is closing soon, so I should decide what to do. Here are some of my options:

• Sell all of it. It’s risky to hold so much in one stock, and I already have company stock in my 401(k). I can write off the losses against the gains to reduce tax liability.
• Sell the shares in a losing position. I can write off the losses against any realized gains if I sell stocks later this year.
• Sell nothing until they are held for two years. The stock will probably go up, and after two years, they will be long-term capital gains, taxed at a lower rate.
• Sell the shares in a winning position. This would help my cash flow, but I’ll owe income tax.

What would you do?

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Employee Stock Purchase Plan Dilemma

The option to convert a Traditional IRA to a Roth IRA has been around for a while. Here are the differences between a Traditional IRA and a Roth IRA for those new to these retirement accounts. As long as your modified adjusted gross income (MAGI) is under $100,000 you have qualified for this conversion. Contributions to the Traditional IRA is tax-deductible, which means that your tax bill is calculated after ignoring the amount you deposit into the IRA. You will pay those taxes after you retire and begin withdrawing these funds. If you have a higher tax rate now than you will in retirement, the Traditional IRA is a good choice.

On the other hand, the Roth IRA is not tax-deductible, so the deposits into this type of IRA are not exempted from your total income calculation for tax purposes. In effect, you use “after-tax money” to invest in a Roth IRA. This is a great choice for people who believe their tax rate now will be lower than it will be in retirement once they begin taking distributions.

There are two other benefits to the Roth IRA that often go unnoticed. The Roth IRA does not require distributions after age 70 1/2 like the Traditional IRA, offering more flexibility in retirement. The Roth IRA is better for estate planning; choosing a Roth IRA rather than a Traditional IRA for funds passed onto your heirs will allow them to avoid tax bills.

These benefits come with a drawback: if your MAGI is above $105,000 ($166,000 for those who are married filing jointly) your maximum allowed contribution begins to reduce and will completely phase out at $120,000 ($176,000 for married filing jointly). But there is now a law that will help you get around this for a short time.

In 2010, the $100,000 maximum for Roth IRA conversions will temporarily disappear. If you believe the Roth IRA is a better option for you but you have been prevented from investing in this type of account due to income limitations, now is your chance to make the change. Here is why this will be allowed: When you convert from a Traditional IRA you owe taxes on the amount of the conversion, and the government would really like that income.

If you must pay those taxes using funds from your IRA, the conversion might not be a good idea, but if you have cash saved for the tax bill you will be better off.

You can also convert accounts known as SEP IRAs and SIMPLE IRAs.

Here are some quality resources regarding Roth IRA conversions.

• Schwab Center for Financial Research
• Vanguard
• The Motley Fool

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Roth IRA Conversion

Although I do not have children, I am considering starting to save for college. With the cost of tuition rising well above levels of inflation, the sooner I get started, even before any children exist, the higher the chance my child or children will be able to go to school without an insurmountable pile of debt. Unfortunately, most college savings plans are complicated. They are tax efficient, but only if some conditions are met. If you need to withdraw money from the funds for purposes other than education, you can face penalties. There are a number of variables to consider, least of all is the idea that I may not have children at all.

Kiplinger’s Personal Finance has named its top five 529 college-savings plans to help parents or possible future parents like me decide which options to pursue. None of these options sound perfect, however. I do not like the sound of any of these top five, either due to flexibility or fees. In addition to fees by the dollar, all plans charge a management expense, fees as a percentage of assets, in addition to the underlying funds’ management expense.

Illinois Bright Start College Savings Program. Pros: Low fees. Cons: Low fees only apply to actively-managed funds (poor performers). If you choose Vanguard funds you must pay $10 per fund.

Alaska’s T. Rowe Price College Savings Plan. Pros: Good investment options. Cons: $25 yearly fee for some accounts.

Michigan Education Savings Program. Pros: Plan includes a guaranteed return option. Cons: The plan is run by TIAA-Cref.

College Savings Plan of Nebraska. Pros: Investors can choose from a wide variety of mutual funds. Cons: Every account has a $20 annual maintenance fee.

Virginia CollegeAmerica. Pros: Kiplinger’s counts the fact that this plan is sold by financial advisers as a pro. Cons: The plan includes only funds from American Funds, which are expensive and underperform.

Kiplinger’s also includes a state-by-state guide to 529 plans. Use this guide to determine whether your state offers its own plan with tax benefits. The benefits may compensate for the other drawbacks of the plan. I live in New Jersey, which does not offer any 529 plans with tax benefits, but I could invest with another state’s plan. While I live in New Jersey, I would not be able to benefit in the other state’s tax advantages.

Best 529 College-Savings Plans, Thomas M. Anderson, Kiplinger’s Personal Finance, June 26, 2009

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Kiplinger’s Best 529 College Savings Plans

There is some speculation that Coca-Cola, General Electric, and Wal-Mart are seeking to raise capital by offering stock… in China. The companies have not responded to these rumors, but China seems open to allowing western companies to participate in the country’s stock exchanges once trading resumes.

If American companies want to be on the Shanghai Stock Exchange, American investors might want to be there, too. The way things stand now, it is difficult for foreign investors to participate in the Shanghai Stock Exchange. Any individual investor outside of China must be aligned with a Qualified Foreign Institutional Investor in order to trade companies listed on this exchange.

A more accessible way to access the China stock market may be through mutual funds offered domestically. The Fidelity China Region Fund (FHKCX) is a strong choice despite the 1.11% expense ratio. (Expense ratios will tend to be higher for international funds.) Vanguard does not have a comparable fund, and FHKCX is up 31.25% so far this year.

Funds like FHKCX invest in Chinese companies, and it’s unlikely, if western companies begin trading on the Shanghai Stock Exchange, that these funds will include shares of these western companies in their portfolios. So this doesn’t solve the problem of accessing the shares of these companies that would theoretically be traded in China.

Regardless, if companies see China as an opportunity for growth and capital, it might not hurt to follow them by investing overseas.

Photo credit: SmokingPermitted
Coca-Cola, GE, Wal-Mart May Seek China IPO, UBS Says, Allen Wan and Veronica Navarro Espinosa, Bloomberg, June 17, 2009
Shanghai Stock Exchange, Wikipedia, June 17, 2009

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American Companies May Want to Trade on Shanghai Stock Exchange

Well, I sold my first stock. I agonized over when would be the right time, but then I just pulled the trigger, anyway.

Earlier this year, I started using the “free money” I was getting from this credit card to buy some stocks.

In March, we paid our tax bill of over $3,300 using that card, so the 2% rewards were higher than normal. I asked a friend of mine who knows a lot more about the stock market than me what stocks were catching her eye, and on her unofficial recommendation I bought 60 shares of CAR, the Avis car rental people.

That was April 17th. The stock price was $1.50. With a $9.95 commission at Sharebuilder, I ended up “spending” a total of $99.95.

And then I watched as the stock price just rose and rose and rose.

On about May 20th I started wondering if I should sell my proceeds. We’ve had rather more pet problems than usual and I was a little worried that our upcoming vacation might suffer as a result. The “overall return” on that investment, according to Google Finance, was hovering around 200%, which is a heck of a lot more than the 7 to 9% we’re taught to expect from long-term investments.

So I sold it on May 27th. I was a bit alarmed to see that there was yet another commission of $9.95. To me, that’s like paying a toll over a bridge going in each direction.

Stock proceeds: $282.24
Minus original investment of $99.95: $182.29

Now, if I’m reading this Capital Gains Tax table correctly, we’re going to be hit with a 25% of the “cost basis” come next April. If the cost basis is the amount I spent on the investment, that’d be the $99.95 number again, which means a tax of about $25.

Profit minus upcoming tax: $157.29

So I spent $99.95 and got $157.29, a real profit of 157%. Not the nearly 200% that Google Finance was teasing me with, but not shabby, either.

The other way to look at it is that since the $99.95 was free money in the first place, I made a profit of infinity dollars.

More importantly, when we take our vacation next month, we’ll have $157 that we otherwise wouldn’t have had. That’s one fancy dinner with some very good wine. I’m looking forward to it.

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Smithee’s First Stock Sale

March 9, 2009 was a bad day to retire. On that day, the Dow Jones Industrial Average hit its bottom of 6,547, a low not seen since 1997. If you followed mass-market retirement investing advice, you may have entered retirement with a portfolio 100% invested in a stock market index, like the S&P 500, whose pattern is similar to the Dow.

If you began formally planning a year in advance on March 9, 2008 with a portfolio worth $1,000,000, by the time you retired one year later, that portfolio may have only been worth $600,000. This market drop has left investors feeling betrayed by the long-term promises of a diversified portfolio stocks, usually touting an eight to twelve percent return over long periods of time, depending on whom you ask.

This is no consolation to new retirees who lost 40% or more of their portfolio and have had to change their plans. Unless you cash out your entire investment portfolio on the day you retire, the market drop won’t have a permanent effect on your finances. If you are healthy, you can expect to live several decades in retirement. Your portfolio must be aggressive enough, even in retirement, to last as long as you need it. Stocks might still be an important part of your portfolio in order to achieve the growth necessary for your income from investments to last at least as long as you continue live.

The recent downturn has forced people re-evaluate the level of risk they are willing to accept in their portfolios. When the market experiences a multi-year rally, investors are more likely to say they are willing to accept risk if it will increase the chances of long-term growth, while economic recessions frighten investors away from the riskier choices. While these are human instincts, the more you can separate your emotions from your finances, the better you will be off in the long run.

This is a difficult task thanks to the exabytes of information we can access about our own money with the click of a button. We receive quarterly statements from our investment accounts in the mail explaining in plain text how much money we have lost on paper, and these statements do not apologize nor do they include just one frowning emoticon to make us feel better.

While stocks are the best bet for long-term growth, a balanced portfolio should include some bonds to cover retirement funds you may need within ten years. On the date you retire, you should know how much money you’ll need to draw from your investments each year. Your bonds should cover that amount, leaving room for some growth. But that needs to be balanced by your long-term needs in retirement. Having too much invested in bonds runs the risk that your investments will not last throughout the remainder of your life. If your nest egg is small, keeping ten years’ worth of income in bonds may not leave enough of your portfolio left for stocks, if any.

This difficulty is one of the primary reasons people often choose annuities for retirement. You can take a part of your retirement nest egg and buy an insurance product that “promises” a certain absolute return for a set period of time or the remainder of your life. Buying an annuity when you’ve all ready lost 40% of your account value can result in a smaller benefit than you were planning to live on, and that could be a problem.

There is no easy solution to this problem. Even if you don’t retire on the day the stock market hits its lowest point, chances are good the stock market will be significantly down during some point during the next few decades. Here is what I plan on doing:

• Approaching retirement with an investment allocation among stocks and bonds that matches by true level of risk tolerance. It’s best to measure your risk tolerance during a period in which you are experiencing neither high or low returns on your investments to keep emotions and short-term memory out of the equation.
• Rebalancing my portfolio periodically to ensure I’m not more exposed to any investment type. As stocks experience a boom, it’s natural to keep money in stocks to ride the wave. Avoid a crash by keeping an eye on the percentages and move money around when the portfolio is unbalanced.
• Adjusting my asset allocation using the lowest risk investments that will provide the needed returns. Suze Orman, with a portfolio value of $25 million, keeps $24 million invested in bonds. These investments results likely approach $1 million each year. She also investments another $1 million in stocks, an amount she can afford to lose. If annual needs are provided for by an investment offering a lower but more stable return, stick with the lower-risk investments rather than accepting unneeded risks.

What will your portfolio look like when you entire retirement?

Photo credit: Scubabix

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How Much of Your Portfolio Should Be in Stocks When You Enter Retirement?

It is human nature to search for Truths that describe the world we live in. This is one reason why personal finance gurus are so popular amongst a group of individuals that listens. Many of the more popular authors, seminar leaders, and cult favorites stick by their mantras, Grand Unifying Theories, such as “credit cards are evil,” “invest in stock index funds for the long term,” and “always buy a used car.”

Any individual who has been able to build a following, cult or otherwise, within the subject of personal finance would do well not to let others peek inside the leader’s own. The advice doles out to the public is usually for a specific intended audience, and it is rare for a guru to fit within the audience he or she is addressing.

In her book, Women and Money, Suze Orman explains that everyone should be invested 100% in stock index funds until close to retirement. This is solid, definitive advice for Suze’s audience, and in this case, men as well. There are some instances where this statement may cause trouble, such as the recent stock market collapse. The book was published in February 2007, as the stock market was reaching a recent peak.

Yet, the average person entering retirement will still have several decades to live, several decades in which the nest egg must last even when being drawn upon. The best way to do this is with a stock index fund. But if we look at Suze Orman’s own portfolio, she doesn’t follow her own advice. As of last year, Orman had $1 million invested in the stock market, a lot of money but only 4% of her own portfolio. The rest was mostly invested in municipal bonds which are very safe but earn less over time. In an interview, she stated she only invests in the stock market what she can afford to lose.

The rules, defined and proliferated by Suze Orman do not apply to her. And they shouldn’t. Why would someone with assets of $25 million follow the same advice as Suze’s audience, in which members might have a net worth anywhere from several hundred thousand dollars below zero, in debt, to several hundred thousand dollars above zero?

The mathematics don’t magically change when you are rich, but the only chance for average individuals to survive through retirement is to take relatively risky bets on the stock market. While the stock market has failed to disappoint in the long term if you look at the numbers, real performance doesn’t always match the statistics thanks to timing. Wealthy individuals, like Suze, can afford to accept less risk. A bond return of 4% on $24 million invested results in an income of $960,000 a year — and that doesn’t include speaking engagements, royalties and television deals. Suze, who is quite comfortable at this stage in her life and career, should not be required to live by the same philosophies she preaches for her callers.

Should you stop following her advice? Suze Orman has helped many people come to terms with their financial condition. But unless you’ve spoken to her about your specific situation, take her mass-market advice with a grain of salt. Yes, her nuggets of wisdom are in many cases helpful, but not everyone falls neatly into the same category.

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Personal Finance Advice: One Size Does Not Fit All

While researching companies for possible career moves — an occasional hobby of mine before all of my extracurricular time was spent working on Consumerism Commentary — it has been difficult to find reliable information about one of the biggest benefits companies can offer, the 401(k) retirement plan. As an outsider to the company, you cannot access juicy benefits information. You can find out whether a company offers a 401(k), but some plans are decidedly worse than others.

The information I’d like to see available includes a list of available investment options. If my 401(k) contributions are locked into only expensive managed mutual funds, I would prefer to know this before applying for a position. No company match? That’s a deal-breaker. If the company requires an excessive portion of the contributions to be invested in company stock without a reasonable choice to sell, I would have doubts about the company’s future.

The 401(k) may not be the biggest driver in the decision to apply for or accept a position at a company, but this is an example where more information results in more informed applicants and a better chance of finding a mutually-beneficial employment match.

BrightScope is one website that approaches the kind of functionality I am searching for. It allows each visitor to provide limited information about his or her company’s 401(k) plan in order to develop a variety of ratings. Thanks to other employees who have uploaded plan information, BrightScope was able to evaluate my employer. The company I work for scores a 72 overall out of 100, better than average for my industry and only a few points away from the highest score.

In addition to the overall rating, BrightScope evaluates plan cost (like expense ratios and fees), company generosity (quality of the employer match), and investment menu quality.

How does your company’s 401(k) plan stack up against the competition?

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Compare Your Company’s 401(k) Retirement Plan

A recent question-and-answer article from Money Magazine illustrates the problem with timing the market. While making money in the stock market is as “simple” as buying low and selling high, emotional reactions to the market often prevent that from being a feasible strategy. The question comes from an individual close to retirement, Heidi. She lost several thousand dollars of value in her 401(k) and reacted by selling her equities and keeping the cash in her retirement account.

By the time you lose a good portion of your investment — Heidi doesn’t specify the percentage of loss she experienced — it’s too late. It’s common and expected to sell in a panic, scared to lose more value. A market downturn and quarterly statement after quarterly statement with decreasing bottom lines turn someone who thought they were immune to market swings, a risk taken to increase the chance of higher returns, into a conservative investor. And the reaction comes at the long time.

Invariably, people now scared of the stock market will wait for “positive signs” before diving back into the pool. One such positive sign is a sustained market rebound. But once again, if you wait and react to the positive rebound, you’ve missed the chance to earn the best returns — the kind that drive the statistics that claim the stock market retuns 8% over the very long term. If you are not in the stock market when the market rebounds, and wait until the rest of the world starts buying stocks again, you won’t experience the increase that makes the stock market famous.

With this in mind, it’s better not to try to time the market and react to short-term market conditions. Stay invested, but maintain (and rebalance) an asset allocation that makes sense for your future financial needs. If you need your money to last another three decades, even if you’re starting retiremement and expect to live longer, you may need the boost that the stock market can provide over those 30 years, but it doesn’t hurt to keep a portion of your portfolio — what you will need in the first ten years of retirement, for example — in something less risky.

I’m not a financial adviser, and these thoughts are just based on my observations.

The trouble with market timing, Walter Updegrave, Money Magazine, May 7, 2009.

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Market Timing: You’re Doing it Wrong

Here is some good news for investors. Schwab, competing for investment business with other low-cost mutual fund operations like Vanguard, Fidelity, and TIAA-Cref, has lowered the expenses on a number of their mutual funds.

The Schwab S&P 500 Index Fund (SWPIX), which competes directly with the Vanguard S&P 500 Index Funds (VFINX), now sports a net expense ratio of 0.09%, compared with Vanguard’s 0.16% (or 0.15% or 0.18%, depending on who you ask). Additionally, the minimum investment at Schwab is only $100. You will need $3,000 to open an account at Vanguard. Schwab’s Total Stock Market Index Fund (SWTSX) has also been reduced to 0.09%, which is lower than Vanguard’s expense ratio for the equivalent VTSMX of 0.16%.

Theoretically, the performance of an index fund “managed” by one company before fees should be identical to the returns provided by an equivalent fund “managed” elsewhere. With index funds, the fees matter because everything else is theoretically equal; lower expenses could save you many thousands of dollars over long stretches of time. With this news, I may consider at least investing new money with Schwab, and I will possibly consider moving some funds from Vanguard to Schwab.

I should point out that if you qualify for Vanguard’s Admiral Shares, your expense ratios will be lower than Schwab’s new rates. You need to have $100,000 in one mutual fund (or $50,000 in one fund and a ten-year history with that fund) to qualify.

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Schwab Brokerage Lowers Expense Ratios, Beats Vanguard

Rather than lending and investing, banks are holding onto large amounts of cash. For large companies, particularly companies whose stocks trade publicly, now is a good time to keep cash on hand for excess liquidity and to look strong for investors and analysts. The liquidity allows the bank to be ready to strike when they believe it’s time to invest their own assets. And they will invest, it’s only a matter of time.

Even though I usually stay away from predicting shorter-term stock market performance, I can safely say that when large financial institutions begin lending and investing en masse, the stock market will go up. So now, before the banks make their moves, it might be a good time to move some of your excess cash into equities. The economic environment right now, in the midst of a recession, might eventually prove to be a once-in-a-generation opportunity for investing once we are far enough away to view the longer-term trends and place day-to-day experiences in perspective.

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When Large Institutions Hoard Cash, Start Investing

A reader and friend is looking for some basic financial advice. It just so happens that April is National Financial Literacy Month, so the timing is perfect because I am in a sharing mood. I get to share his situation and my suggestions with Consumerism Commentary readers, and readers have the option of offering their own thoughts.

I’m neither a financial adviser nor a financial planner, but I thought I could help by sharing my philosophy, my approach, and what will, I hope, pay off for me in the long run. Here is a little about my friend: He owns his own business and his wife is a public high school teacher. They are both 33 years old, living in New Jersey. Right now, most of their money is in a high-yield online savings account. First, he asked me how he could earn more on that money and I suggested switching to a bank offering a higher interest rate like FNBO Direct and we touched on certificates of deposit, but he is looking for more.

So I asked him what his goals are and what kind of money we were talking about. He wants to save for retirement and for his child’s education, and he would like all his money to be earning more in general.

Here was most of my response. If you have anything to add or change, please feel free to leave a comment at the bottom of this article. Don’t consider this financial advice. If you take action on my suggestions, you do so at your own risk.

Email begins here:

For retirement, you should be putting some money into an Individual 401(k). Since you work for yourself, you don’t have an employer offering you a 401(k), so you can just set one up for yourself.

You can invest up to $16,500 in that account in 2009. The 401(k) is the best option for retirement if you don’t do anything else. You should only invest money in this account that you’re 98% sure you won’t need until you’re 59 1/2. You can borrow from it before then if you need to, but if you don’t pay yourself back, you’ll owe penalties. Since this is a long way off, you should choose a stock index fund like VTSMX.

If you invest in an index like VTSMX, you would have to change your allocation as you get close to retirement to move away from stocks and more towards bonds. Bonds have a lower return (over the long term — they can beat stocks over the short term) but are safer, stocks are riskier but can provide a higher return. A “lifecycle” or Target Retirement Fund changes the allocation between stocks and bonds automatically as you get older. So if you invest in a lifecycle fund now, it will be mostly stocks, but as you get older, it will gradually shift towards bonds. This will help you preserve your money and you’ll be less exposed to stock market crashes and recessions when you’re getting closer to making a withdrawal.

You might choose the Target Retirement 2040 Fund or if you want to be more aggressive (more risk, possibly higher return), you could choose the Target Retirement 2045 Fund.

I’m not sure what your wife’s options are, but she probably has a pension which will help out in retirement and she probably has an option for a retirement contribution plan such as a 403(b), basically a “non-profit” 401(k).

The next priority would be education for your daughter or any other future kids you decide to have. The most popular option here is a 529 Account. Again there are low-cost options with Vanguard. But if you’re pretty sure your kids will go to school in New Jersey, you can invest in a New Jersey state 529 plan because you’ll save on taxes. If you invest in a 529, you must withdraw the money for education expenses only. If you withdraw it for some other purpose, you’ll owe taxes.

The next priority would be everything else you want to save for. Make sure you have enough in an emergency fund (in a high-yield savings account like ING or FNBO Direct) to cover your expenses for a few months in case you’re not working and Ali loses her job. If your mortgage interest rate is high, you might want to pay that off faster because that will save you money down the road. Otherwise use that money to invest in a regular investment account. I would suggest stocks (VTSMX) even for your non-retirement investing because they’ve taken a beating recently, and while they might go down a little in the short term, they should recover nicely (unless the United States economy is fundamentally flawed, but I don’t think it is).

I’m suggesting Vanguard because they generally have the least expensive investment options. There are no account maintenance fees if you agree to email delivery of statements (rather than paper) and the funds’ expenses are lower than just about every other company. And low expenses means you keep more of your own money, which is good when you have lots of time for it to grow.

Most of Vanguard’s funds require an initial $3,000 investment. So when you set them up, you’d have to start with at least that much in your 401(k), your 529, and your regular investment account — that’s $3,000 initial investment (or more if you wish) in each of those. But after that you can set up automatic investments or just leave it alone for the rest of the year.

Don’t be seduced by investing directly in individual stocks. That’s like gambling. Stick to broad non-managed index funds like VTSMX because it will spread your risk around and it’s proven to beat stockpickers’ performance over the long term.

If you’ve maxed out your 401(k) and want to invest more for retirement, consider a Roth IRA and a SEP IRA.

End of email.

Do you agree or disagree with my suggestions? What did I leave out of this message?

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Reader Question: How Can My Money Earn More for Me?

Money Magazine published an article with the “7 new rules of financial security,” claiming that the recent economic collapse has changed the fundamentals that investors have relied upon for decades. The simultaneous meltdown of the stock, housing and credit markets resulted in a world in which investors must adjust their assumptions in order to succeed. Here is what the writers from Money Magazine have determined:

1. Risk isn’t about how much decline in value you can stomach, it’s about not missing important targets. When weighing the risks against the rewards of any particular investment, financial advisers generally ask about whether the investor is comfortable with losing 50% from one year to the next. Investors, realizing that risky investments are necessary in order to for money to grow, agree to volatile investments when the threat of decline seems unlikely, like when the stock market has had a few years of great performance.

The past few years has tried these investors who claimed to be able to deal with a short-term decline, and many have bowed out of the stock market entirely. Money’s “new rule” is just a different way of asking the same question, without taking emotions into account. If you want to hit your target, you need to take on the risk appropriate to reach your goal. Getting scared in a turbulent market is fine as long as it doesn’t make you question your tenacity.

2. Cash is for more than just typical emergency funds, you should have enough to cover “asset emergencies.” In the economy before last year, the typical recommendation was that you should use keep three to six months’ worth of expenses in an easily-accessible savings account, but not much more. Any extra cash should be invested to “let your money work harder for you.” According to Money Magazine, you should keep enough cash to cover asset emergencies. For example, if you are counting on a 529 education investment account to provide for your child’s education, if he or she attends college in a down market, you could find yourself with not as much money available for tuition as you had planned.

If you are effectively allocating your invested assets depending on your target date for withdrawal there is no danger in the above example. You might include stocks in your 529 when college is eighteen years away, but as freshman year approaches, the account should reflect more conservative investments. Don’t rely on the all-in-one “target date mutual funds” to automatically allocate your investment between stocks and other investments at percentages that make sense; it will take some effort by the investor to monitor.

3. In addition to using your time horizon to determine the percentage of stocks in your portfolio, consider your earnings potential. Your “human capital” should be considered part of your asset allocation strategy. If your ability to earn income is strong, you can afford to take risk with your assets. Money Magazine offers the example of a tenured professor who is in line for receiving a pension, who can invest aggressively in stocks with their retirement portfolio, and a commission-based mortgage broker, who may want to secure a safer retirement.

4. Borrow cautiously rather than using debt (leverage) to seek higher returns. A number of gurus strongly pushed the idea of leverage — using debt to finance investments. It was a shaky theory at that time, and now we’ve seen the results of over-leverage and over-speculation in the real estate market and in certain investments. This doesn’t seem like a new rule; it’s just a rule that not many people were following. Mortgages acquired with no money down provide a nice return when house prices increase well beyond inflation, but historically and on average, real estate performs only marginally better than inflation. In order to achieve that average, the years of skyrocketing prices need to balance with years of plummeting prices.

5. Your home won’t make you rich. Again, I thought this was an old rule that was simply ignored for a few years during the real estate boom. I can’t tell you how many people who previously had never invested in anything were excited to tell me, after buying their overpriced house, that they would be fine and home values never decline. Others told me that real estate earns more than 10% year after year on average. Neither of these statements are true. It’s possible that my acquaintances who justified their purchases to me with short-term historical data ended up earning money on their house, “supporting” these statements. Anything is possible. But long-term growth in the house in which you live isn’t as guaranteed as people seemed to think.

Even if the house you live in does skyrocket in value, you normally can’t take advantage of the increase without selling your house and moving to a location where you can find a house of significantly lower value.

6. You need more diversification than you think in order to lower your risk. My retirement portfolio is diversified. I have a large-cap stock fund, a mid-cap stock fund, a small-cap stock fund, an international stock fund, a commercial real estate (REIT) fund, and company stock. Actually, that’s not diversified at all. Money Magazine offers stocks from emerging markets, domestic bonds, foreign bonds, and even junk bonds as part as a fully diversified portfolio. I have no bonds because I followed the common advice that those who have a long enough time frame should invest exclusively in stocks and bonds up to 5% of the portfolio won’t reduce risk to make the loss of potential growth worthwhile.

7. Don’t focus on retiring early. Money Magazine points out that delaying retirement by just one year may increase your annual income in retirement by 9%. That’s a nice raise. Someone who retired early in 2007 with a sizable retirement fund in stocks, expecting to live another 25 or 30 years — a decent time horizon for remaining in stocks under the “old rules” — have likely found today that their nest egg won’t be providing the same amount of income in the near future. Could the economic collapse have been predicted when this hypothetical individual retired in 2007? Possibly, but the threat of a stock market decline might not have been enough to convince a retiree to change asset allocation.

Do you agree with Money Magazine? Have the rules of investing changed due to the global economic crisis?

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Has the Economic Collapse Changed the Rules of Investing?

Whether right or wrong, having more money opens more doors and opportunities. Just look at the way casino hotels operate. If you are a high roller, the casino will shower you with free nights in the penthouse suite, free meals, and who knows what other perks unavailable to those of us without the cash to throw around. But it’s not just casinos who want to make the biggest customers happy.

Vanguard, a highly recommended low-cost brokerage, takes a similar approach. High rollers receive a special perk, and it’s a very valuable special perk, worth potentially tens or hundres of thousands of dollars over a lifetime. Certain customers qualify for half-price discounts. Those who belong in this special class have access to mutual funds with lower expense ratios. The more money you have, the more you are allowed to keep, and that’s more of your own money working for you through compounded returns.

This concept is the opposite of what a young investor wanting to save money might like. But investment companies, even Vanguard, are not in business to be charitable. They need to attract big clients.

So if you have at least $100,000 in a single account invested in a single mutual fund at Vanguard, you will qualify for the company’s “Admiral Shares” for that mutual fund. Vanguard has also instituted a policy to reward loyalty. If you have a single account invested in a single mutual fund with a balance of only $50,000, but you’ve owned that fund for over ten years and use Vanguard’s online account access tools, they will accept you into that fund’s Admiral Shares club without having to reach $100,000.

Keep in mind that if you have a new account at Vanguard with $50,000 in a Roth IRA invested in VTSMX and $50,000 in a regular taxable investment account invested in VTSMX, you still don’t qualify. Each account type and fund combination needs to be valued at least $100,000 (or $50,000 if the other conditions apply) for Vanguard to convert your shares to Admiral class.

Here are the Admiral Shares benefits as of today, the equivalent of a comped penthouse suite for the rest of your life:

• For the S&P 500 index fund, your expense ratio will be reduced from 0.15% to 0.07%.
• For the balanced index fund, your expense ratio will be reduced from 0.19% to 0.10%.
• For the growth and income fund, your expense ratio will be reduced from 0.37% to 0.23%.
• For the inflation-protected securities fund, your expense ratio will be reduced from 0.20% to 0.11%.
• For the large-cap index fund, your expense ratio will be reduced from 0.20% to 0.08%.
• For the total stock market index fund, your expense ratio will be reduced from 0.15% to 0.07%.

These are just a few examples of how Vanguard rewards its wealthier customers with lower fees.

If you do qualify in any of your Vanguard account types, the brokerage will automatically convert your shares to Admiral class on a quarterly basis. But if your fund’s balance later dips below the $100,000 (or $50,000) minimum, you will be given a chance to invest new money to make up the difference or your shares will be reclassified to the higher-cost Investor Shares.

The Investor Shares have many of the lowest expenses available in the market place, so small-time investors like me are still getting a reasonably decent deal. Casinos comp small-time players occasionally, too.

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How to Qualify for Vanguard Admiral Shares

Last year, hundreds of hedge funds, special mutual funds generally open to wealthy investors which specialize in alternative investments like derivatives, shut down due to the economic crisis. Three of the ten largest hedge funds to close were funds that invested exclusively or almost exclusively in Bernard Madoff’s Ponzi scheme, leaving investors with nothing. While I mention that hedge funds are investment vehicles for the rich and famous, it’s worthwhile to note that you don’t have to be rich to be affected by this. 971 employees in Connecticut, for example, are feeling the same pain wealthy clients like Steven Spielberg and Jeffrey Katzenberg feel because their pension funds were pooled together and invested, much like one wealthy client, in Madoff’s funds.

The lack of diversification played a roll for individual losses. But how much is the fault of the investors? Presumably, the firemen in Fairfield are not given any choices for their pension fund. Also, hedge funds promise or at least imply diversification; this is how investors “hedge” their bets. An investor in a hedge fund would then assume that although the money is held in one and managed by one individual, that individual is sufficiently providing the diversification they promised.

In the case of the feeder funds, the hedge funds invested almost exclusively with Bernie Madoff. This extra middle layer passed the responsibility of diversification on to Madoff, who was never sufficiently clear about his “investments.” Of course, we now know that there was no “investment” and thus no diversification.

How well are your investments diversified? Is it enough for a investors who has weighed risk against potential reward to diversify among stock investments, like large-cap, small-cap, international, etc.? Do you rely on one mutual fund, like an index fund or a target retirement date fund to handle your diversification? Are you diversified into precious metals, and are you satisfied with using exchange traded funds or do you own gold or silver in physical form?

Typical investors can at least trust that a mutual fund in their portfolio does not lie on the prospectus. But when you invest in a hedge fund that is supposedly diversified, how diversified is it?

Three of the largest hedge funds to fail last year, Fairfield Sentry (managed by Fairfield Greenwich Group), Rye Investment Management (managed by Tremont Group Holdings), and Kingate Global Fund (managed by Kingate Management), were Madoff feeder funds, designed to provide access for “smaller” wealthy investors to the exclusive Bernard Madoff. Investors trusted their financial advisers who suggested the invest in these hedge funds. Thse advisers trusted the hedge fund managers who in turn trusted Bernard Madoff, one person, to provide sufficient diversification within his secret “investment” scheme. Or perhaps “trust” isn’t an issue when reputation and the promise of sustainable, high returns is involved.

A Look at the Hedge Funds That Closed, New York Times, March 19, 2009

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Three of the Largest Closed Hedge Funds are “Madoff Feeder Funds”

Bernard Madoff is on his way to jail, having plead guilty to defrauding investors in a massive Ponzi scheme. While his victims thought they were investing with a legitimate manager, Madoff simply deposited clients’ money in a Chase Manhattan bank account and paid “returns” to earlier investors from the contributions of newer investors. The bulk of investors directly damaged by the failure of the scheme were banks, foundations, endowments, and trusts. Other investors include Kevin Bacon and Zsa Zsa Gabor.

Most investors didn’t invest with Bernie Madoff directly; usually, funds were invested through at least an additional layer, such as a wealth manager or two. The further someone is separated from their money, the harder it is to understand the investments. For example, Jeffrey Katzenberg and Steven Spielberg relied upon a financial adviser named Gerald Breslauer, who invested his own money with Madoff in addition to his investors’.

Even though investors and their asset managers who decided to invest with Madoff are due some blame for investing without requiring concrete details of their investment, I do feel bad about their situation. Madoff was obviously a professional; he was able to convince otherwise smart people that he was running a legitimate operation. I’m confident that many of the middle-men who had access to Madoff and were investing on behalf of wealthy clients didn’t care about the existence of underlying investments as long as the quarterly statements showed growth, even if this growth was merely a work of fiction.

I feel bad for investors who found themselves as victims of this Ponzi scheme. In their position, I can understand putting faith in highly recommended money managers which reportedly search for the best investments balancing risk and reward for wealthy clients. Someone should have made sure there was an understanding of the underlying investments, but in theory, that is why wealthy clients pay asset managers.

Even early investors who managed to withdraw more than they invested, the only investors other than Bernard Madoff who made money in this Ponzi scheme, might deserve some pity if they weren’t complicit. But I do not believe any investor who withdrew more than they contributed should deserve any more restitution. The most judicial way to resolve the issue should be for every investor to receive back only their contribution, and to do so, anyone who withdrew more than they invested should be ordered to return their false profits back to others who were not able to withdraw as much as they invested.

This will reset the clock, providing no advantage for anyone. I would imagine that most of that money is gone, spent by Madoff, so I’m not sure how viable this plan would be.

What are your thoughts on Bernard Madoff’s Ponzi scheme?

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Investors in Bernard Madoff’s Ponzi Scheme