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When Large Institutions Hoard Cash, Start Investing

by Flexo on April 28, 2009

in Investing

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

by Flexo on April 24, 2009

in 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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Has the Economic Collapse Changed the Rules of Investing?

by Flexo on March 23, 2009

in Investing

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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How to Qualify for Vanguard Admiral Shares

by Flexo on March 21, 2009

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

by Flexo on March 19, 2009

in Investing

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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Investors in Bernard Madoff’s Ponzi Scheme

by Flexo on March 13, 2009

in Investing

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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Traditional vs. Roth IRA: An Introduction and Comparison

by Flexo on March 11, 2009

in Investing

The Individual Retirement Account (IRA) allows anyone who earns income the opportunity to save for retirement, regardless of the plans offered by his or her employer. An IRA is not an investment in itself, it’s an account type. Within the IRA, you can keep your money for the future in money market funds, CDs, stocks, even gold. The government limits how much you’re allowed to invest in an IRA each year. Here are the contribution limits for 2009. In addition, the government also reduces these contribution limits for certain types of IRAs depending on your income. For individuals over the age of 50, the government raises the contribution limit to help “catch-up.”

Traditional and Roth IRAs

There are two main “flavors” of IRAs: traditional and Roth. Both types include the benefit of allowing money to grow tax-free while invested and untouched. That means that even while your account grows, you won’t have to pay taxes on capital gains or interest. That leaves more money in the account, with returns possibly compounding upon returns. A traditional IRA adds the benefit of tax-deductible contributions. In other words, if you contribute $5,000 to your traditional IRA, if you aren’t excluded by your level of income, you can deduct the $5,000 from the income you report on your tax return. You will pay tax, however, when you are retired and take a distribution from the account.

Contributions to a Roth IRA are not tax-deductible. The most common way of describing this is that you invest in Roth IRAs with “after-tax” money and traditional IRAs with “pre-tax” or “before-tax” money. When you take a distribution from your Roth IRA after you’ve retired, you will not pay tax on your capital gains, of which the plan is to have many.

You can withdraw money from an IRA at any time, but if you do so before age 59 1/2, you may face some penalties. First, with a traditional IRA, you will be taxed on your contribution and gains withdrawn, plus be subject to a 10% penalty in the form of a tax for “early withdrawal.”

Which IRA to choose?

In general, when deciding between a Roth IRA and traditional IRA, the choices comes down to your tax bracket. If you think you have a lower tax rate now than you will when you retire, the Roth IRA will keep you from paying tax on your contributions when you withdraw after age 59 1/2. If you think you will have a lower tax rate in retirement, take the deduction in a traditional IRA now and pay the tax on contributions when you withdraw after 59 1/2. Sounds simple, right? There are a lot of variables to consider. For example, will this country’s tax rates be much higher by the time you retire?

More importantly, will the government decide to change the tax advantaged status of these accounts, and will that change affect current investors, before you reach retirement? Many people hedge their bets on the future tax rates by investing a portion of their maximum allowed contribution in a traditional IRA and the remaining portion in a Roth IRA.

There are numerous nuances to consider as well. If your income is too high to qualify for a Roth IRA right now, you can contribute to a non-deductible traditional IRA and “recharacterize” the IRA as a “Roth IRA” by paying taxes next year, regardless of your income level in 2010. There are certain circumstances in which you can withdraw your money from a Roth IRA without paying the 10% penalty. Using your Roth IRA to pay for your first house is one of the qualifying cases. Furthermore, you can re-contribute to a Roth IRA if you withdraw your contributions.

If you’re self-employed, even if only as a side job to complement your main career, you can also contribute to a SEP IRA as your own employer. This greatly increases the amount you can save for retirement.

Setting up your initial IRA

I find it important to look for low-cost investments for IRAs. Since they are tax-advantaged — you don’t pay taxes on gains and interest while your money stays with the IRA — you can freely trade without having to report your income to the government, leaving more money working for you. For the last few years, I have been using Vanguard exclusively for my IRAs. They have low cost index funds and solid money market funds available. The account opening process is straightforward, and once your initial account is active, it takes only a few clicks to contribute, transfer money from one fund to another, and create automatic investment plans.

Another popular company for IRAs is Fidelity.

This is only n introduction to Individual Retirement Accounts. Please feel free to share any tips you have or experiences you’ve had with IRAs.

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Some Money Market Funds are Insured

by Flexo on March 8, 2009

in Investing

Through December 31, 2009, the Federal Deposit Insurance Corporation (FDIC) insures bank deposit accounts up to $250,000, with the limits returning to $100,000 after that. This includes checking accounts, savings accounts, money market accounts, and certificates of deposit. There are a few nuances to this coverage, so ensure you know the full details of FDIC coverage. This does not cover money market funds, which are occasionally called money market mutual funds.

Money market accounts are similar to savings accounts, and the names are often interchangeable. The main difference is that money market accounts are limited to six withdrawals per month. In my experience, many banks that call their products “savings accounts,” like ING Direct, still enforce this limit.

Money market funds are different than money market accounts and savings accounts. Money market funds are mutual funds offered by banks and brokerages. These products invest in bonds and commercial paper, which make them riskier than money market accounts. Since this type of fund carries more risk, the FDIC does offer insurance. Therefore, if a money market fund loses value or the bank can’t pay funds on withdrawal, the money is lost.

This rarely happens, but it did happen in 2008. At that point, the Treasury Department stepped in and covered the loss. The Treasury now offers an insurance program for money market mutual funds that agree to participate (details here). If the offering bank pays an insurance fee to the Treasury, their money market fund will be guaranteed against losing money. Specifically, the value of the fund will be protect against falling below one dollar per share.

Many banks and brokerages have opted not to participate in this program. Those that do participate, like Vanguard and Fidelity, cover money invested in the funds as of September 12, 2008, and unless extended by a new law the coverage will end in April 2009.

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