Investing

Investors in Bernard Madoff’s Ponzi Scheme

by Flexo on March 13, 2009

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

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

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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My First Stock Purchase

by Smithee on February 27, 2009

So, I got this credit card that deposits 2% cash back into a brokerage account. I started using it for all my daily purchases, paying off the statement balance each month. At the end of January, my points on the card were redeemed for the first time, and a few impatient days later, I had $38 dollars to start investing.

I could just set up a transfer from the brokerage account to my regular checking account and use this free money for other purposes, but I’ve always wanted to try investing in the market, and because it’s free money, I’m allowing myself to do so.

I figured that I could buy 3 shares of an ETF called PBW, which is a collection of companies specializing in renewable energy, which seemed like a good fit because:

I didn’t feel like I have the time needed to do the right amount of research to buy shares in only one company
I’m an aspiring hippie
I knew that the American Recovery and Reinvestment Act of 2009 was in the works, and it set aside a serious amount of money for renewable energy projects

Here’s the funny part: that $38 dollars that Charles Schwab gave me for free? It was double the amount that they should have given me. So a few days later, I noticed in my portfolio that $19 was missing. It took me three tries to get the credit card and the free brokerage account linked in the first place, so this was extremely frustrating. I assume it was an honest mistake on Schwab’s part, but I had gotten myself in the position where I was investing with my own money, and not with free money, anymore.

I still think that this card/brokerage setup is a good idea, but if you’re setting this up for the first time, keep a close eye on the amounts being moved around.

Incidentally, I’ve only lost $17.66 on my investment so far, including the $12.95 commission. I can laugh about it, because it’s free money.

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E*TRADE Eliminating Index Funds

by Flexo on February 27, 2009

E*TRADE has decided to discontinue its collection of index mutual funds. If you hold shares of ETSPX (S&P 500 index fund), ETRUX (Russell 2000 index fund), ETTIX (technology sector index fund), or ETINX (international index fund), E*TRADE or your broker will automatically sell your shares by March 27, 2009.

Even though index funds are likely the best way for most people to invest in the stock market thanks to low fees and returns that match the index, brokerages don’t have much motivation to offer them. Thanks to the low fees, fund managers don’t generate that much income. Without that income, the managers can’t advertise as prominently. E*TRADE’s S&P 500 index fund is quite competitive, with a expense ratio of 0.09%, lower than Vanguard’s 0.15% for VFINX. But VFINX is much more popular.

E*TRADE will likely try to convert index fund customers to managed fund customers. That’s probably the only way for the company to make money. But keeping the customer in mind, I would recommend using the liquidated funds to buy the equivalent low-cost index fund from Vanguard or Fidelity.

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The Paradox of “Buy Low, Sell High”

by Flexo on February 24, 2009

If everyone could “buy low and sell high” when making investment decisions, everyone would be a successful investor. I would never give this advice to anyone. First, it is obvious to anyone who understands basic arithmetic. If you want to make money, you have to sell something for more than you paid for it. This is why people are reluctant to sell houses right now. Buyers are waiting for lower prices because they think the market will continue to go down for some time and sellers — unless they are highly motivated — don’t want to sell until prices go back up.

Second, it is impossible advice to follow. Unless you have inside information on a specific company — and that is very unlikely — you don’t know with certainty whether a stock price is going to up or down over the next month, year, or decade. The price set by the market, with so many buyers and sellers, is generally the accurate price for that stock at that time. The only way to know whether a price was a “low” or a “high” is to look at the numbers well after the fact.

On Friday, the S&P 500 index hit a low point not seen since the mid 1990s. But will future investors look at Friday’s price as a low? It depends on where the stock market goes from here. Many experts predict that the bottom has not yet arrived. Friday’s low might be high compared to what the future may hold if stocks retreat to levels not seen since the 1980s.

In reality, people don’t buy low and sell high. Yes, there is the argument that people follow trends (rather than lead trends), often resulting in buying high and selling low. But more importantly, investors buy when they have cash and sell when they need cash. As it happens, on average, people have cash when the economy is good and need cash when the economy falls. Stocks are often a victim of this same economy. The stock market generally follows the sentiment of the greater economy, so your cash moves into stocks when they are high and moves out back to cash when stocks are low.

This phenomenon is a result of looking at averages; on an individual level, anything can happen. You could be flush with cash while the rest of the economy suffers and more people are out of work, or you could be struggling while everyone else flourishes. On average, economic conditions force investors to buy high and sell low.

One way to turn this around for your own benefit is to try to understand what most people are doing, and do the opposite. If you buy stocks while there is a general tendency among the rest of the market to panic and sell stocks, you have a better chance of buying at a low point. If investing becomes the latest craze and you can’t go anywhere without having stock tips thrown at you, the exuberance could be irrational and you have a better chance of selling at a high point.

Rather than advising someone to “buy low and sell high,” a strategy which would involve knowledge of the future, perhaps it would make more sense to advise to “buy during panics and sell during exuberance.”

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Is “Buy and Hold” Still a Good Investing Strategy?

by Flexo on February 23, 2009

From the time I started investing for the long term, almost all the advice I’ve read has pointed towards buying stocks (usually in the form of index mutual funds) and holding them for decades, rather than following trends in the news and trying to buy and sell stocks frequently. The reasons for this strategy were always similar to these:

Stocks are risky and volatile, but provide the best opportunity for growth over the long term with annual average returns of 7% to 12%, depending on whom you ask, higher than any other type of investment.
Trading costs money thanks to fees, and these fees eat into your returns. They exist to help brokers get rich, so brokers encourage you to trade.
Index mutual funds allow you to invest in stocks for a low cost. Other mutual funds try and mostly fail to beat the indexes, and charge higher fees regardless of their success.
Index funds also allow you to broadly diversify, reducing your exposure to the success of any company you invest in.

Have these fundamentals changed? A recent article in MSN Money claims that the advice is a lie. The reason for this is that the “level of risk in the stock market changed violently” in 2007. If this were true, investors who believed they built a moderately risky portfolio including stocks and bonds or cash prior to 2007 would suddenly have a riskier portfolio. I was under the impression that stocks were always risky, which is why they provide the opportunity for the largest long-term growth.

Looking back at 2007, it’s quite easy to pinpoint the exact moment you should have sold stocks. It’s also easy to look at what was happening in the market, point at something, and declare it was a “sign” that it was time to get out of the market.

I am still sticking with “buy and hold” as a long-term growth strategy. Yes, if I were to sell my investments now, I would lose a large amount of invested money. But I’m not selling now, I’m still buying.

Have the fundamentals changed? Are stocks riskier now or is this volatility just a side effect of the risk that has been there all along? Is the “buy and hold” strategy just a fad that is no longer relevant for today’s stock market?

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ETFs or Index Funds: Which are Right for You?

by Flexo on February 6, 2009