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Are You Really Diversified?

Oct 25th, 2010
by jblankenship.
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alter eggo by turtlemom4baconSometimes we fool ourselves.  Sometimes we think we’re doing the right thing, when in fact the result is that we’re not doing what we think we are.

I’m talking about your investment diversification.  Within your 401(k) you have certain options available for you to choose from:  a large cap stock fund, a mid cap stock fund, an international stock fund, and a bond fund.  Recalling an article you read somewhere… you know you need to split up your investments among many allocation options.  So, wanting to do this diversification thing right, you split up your 401(k) contributions with 25% in each of the funds available.  You’re well-diversified, right?

Wrong city, bucko.

Correlation

Welcome to correlation.  Investopedia defines correlation as: a statistical measure of how two securities move in relation to each other.  It’s pretty complicated, but the gist is this – if two securities are perfectly correlated, when one moves up or down, the other moves up or down in perfect relation to the other.  Such securities are said to have a correlation coefficient of +1.

On the other hand, if one security moves up and the other moves down (and vice versa, by the same proportions), they are said to be negatively correlated, with a correlation coefficient of -1.

Lastly, if one security’s movement has no relationship whatsoever to the other security – that is, any particular movement by one of the securities may or may not result in a movement in the same direction, the opposite direction or no movement at all.  These two securities have a correlation coefficient of 0 (zero).

Most pairs of common securities fit somewhere along the spectrum between +1 and 0, since very few are perfectly correlated.  Negative correlation is typically found in hedge funds – which are a costly, complex sort of asset to hold, being designed to work opposite of the general market movements.

With the above explanation, hopefully it becomes clearer to you why we want securities in our portfolio that are not correlated closely to one another… having such pairs of securities spreads out our risk of any single market event having adverse impact on everything in our portfolio.

Examples of Correlation

Back to our example portfolio, here are the correlation coefficients for your four choices, shown in a matrix:

1 2 3 4
1. Large-Cap Stock 1.00 0.96 0.93 0.28
2. Mid-Cap Stock 0.96 1.00 0.91 0.27
3. International Stock 0.93 0.91 1.00 0.44
4. Bond Fund 0.28 0.27 0.44 1.00

As you can see, the large cap, mid cap, and international stock choices are very closely related to one another.  That’s why, even though you thought you were well-diversified during the market slump a couple of years ago, everything you had took a dive.

This is why the first, most important allocation choice you can make is between stocks and bonds (we’ll get to some other allocation options later).  These two, of the choices you have, are the least correlated, so it’s very important to include these non-correlated assets together in your allocation scheme.  And then within your chosen split into stocks, you can choose some of the other asset options – large cap, mid cap, small cap, international – since those assets aren’t perfectly correlated, it can be beneficial to include diversification among these options as well.

The same goes for bonds – other types of bonds, such as Treasury Inflation-Protected bonds, are not perfectly correlated with the total bond market, so it might make sense to include some of these as allocation options as well.

What about other types of assets?

We’ve talked about some very basic allocations – but what about other types of assets?  There’s real estate (both domestic and international), emerging markets stocks, commodities, and others.  How does the correlation of these assets look?

The table below details the correlation matrix for these additional assets in relation to domestic stocks, international stocks, and bonds.

1 2 3 4 5 6 7
1. Domestic Stock 1.00 0.93 0.27 0.84 0.93 0.89 0.60
2. Int’l Stock 0.93 1.00 0.44 0.79 0.96 0.93 0.65
3. Domestic Bond 0.27 0.44 1.00 0.33 0.39 0.32 0.25
4. Domestic RE 0.84 0.79 0.33 1.00 0.83 0.68 0.44
5. Int’l RE 0.93 0.96 0.39 0.83 1.00 0.88 0.65
6. Emerging Stock 0.89 0.93 0.32 0.68 0.88 1.00 0.71
7. Commodities 0.60 0.65 0.25 0.44 0.65 0.71 1.00

As you can see in the matrix, adding these additional asset classes gives you even more diversification (per the correlation).  Commodities show up as the next most non-correlated, after bonds, which explains why this is an important asset class to include.  Not only are commodities not well correlated with stocks, they are even more non-correlated to bonds.

Real estate, both domestic and international, gives you some diversification, but not nearly as much as bonds and commodities – turns out that real estate, while not a perfect match for stocks, does follow the movement of stocks somewhat closely.

How?

You might be saying “but I don’t have those kinds of options available in my 401(k)” – what can you do?  This is part of why it can be useful to have other savings plans in your scheme, such as a Roth IRA or a taxable account.  With these other accounts, you can have the flexibility to invest in whatever asset classes you like.

Photo by turtlemom4bacon

The Legislation Page

Oct 11th, 2010
by jblankenship.
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If you haven’t done so recently, you should check out the Legislation page on this blog.  I’ve recently updated the summaries listed here, plus this is where you’ll find the coming tax law changes that you should be aware of.

You can check back here regularly to find out about major legislation affecting your financial future, including healthcare, retirement plans, jobs, and taxes.

As always, if you have questions about any of the information listed, just let me know!

Expanded Adoption Credit Available for Tax Year 2010

Oct 4th, 2010
by jblankenship.
1 comment

child by mikebairdThe Affordable Care Act raises the maximum adoption credit to $13,170 per child, up from $12,150 in 2009.  It also makes the credit refundable, meaning that eligible taxpayers can get it even if they owe no tax for that year.  In general, the credit is based upon the reasonable and necessary expenses related to a legal adoption, including adoption fees, court costs, attorney’s fees and travel expenses.  Income limits and other special rules apply.

In addition to filling our Form 8839, Qualified Adoption Expenses, eligible taxpayers must include with their 2010 tax returns one or more adoption-related documents, detailed in the guidance from the IRS.

The documentation requirements, designed to ensure that taxpayers properly claim the credit, mean that taxpayers claiming the credit will have to file paper tax returns.  Normally, it takes six to eight weeks to get a refund claimed on a complete and accurate paper return where all required documents are attached.  The IRS encourages taxpayers to use direct deposit to speed their refund.

Photo by mikebaird

What to do with a Year-End Bonus

Sep 27th, 2010
by jblankenship.
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llamas by ChipThis article originated from a reader question…

For example, suppose I get, say, a $5000 bonus before the end of the year, would I be better off giving it away or putting it in 401k to avoid tax consequences, putting some in Roth IRA (if I still qualify), paying the tax bill on a conversion of some rollover IRA $$ to a Roth, paying my child’s tuition bill (too late for 529 now) to avoid debt, or replacing the 10-year old heating and A/C system to lower ongoing utility costs?

The specifics of this question are unique to the individual who asked the question, but the reasoning behind the response can be tailored to fit many other circumstances.  What follows is an example of the process that I typically go through to assist folks in the process of understanding the impacts of various choices…

Assumptions

To start off, we need to make some assumptions about the situation that will guide us through the process.  The reader who posted the question leaves us with a few clues that help us understand his tax situation – he’s made reference to income level with the “if I still qualify” parenthetical comment, so we should assume that the tax bracket for the bonus money is relatively high, close to the limit for Roth IRA contributions, which for 2010 is the 28% bracket.  In addition to the marginal tax rate, we’ll assume that the asker is married, filing taxes jointly.  We’ll also assume that the asker’s spouse is already contributing to a retirement plan (so a Spousal IRA contribution is not in play).  So in all cases the net after-tax bonus is assumed to be $3,600 (28% or $1,400 is withheld).

We also assume that in retirement, the tax bracket will be lower than it is currently, making tax deferral today more beneficial – meaning that we want to pay as little tax as we can today if we can pay tax on that income tomorrow.

Other assumptions include:  the asker of the question has not maximized his contributions for the year to a 401(k), or a Roth IRA; the child (student) has not exhausted his student loan options, and funds can be borrowed at an unsubsidized rate of 6.8%; plus, the cost of purchasing a new heating and A/C system for the home in question is $7,000; and lastly, there are funds available to pay for the needed heating and A/C unit or the tuition bill (if a loan is not used).

Analysis (*2010 tax provisions in use)

Donating – This would give you a tax deduction, so it would reduce your overall tax by $1,008.

Contribute to 401(k) – In this case, given the relatively high tax bracket, there would be a tax reduction (from all other options) of $1,400, allowing you to put the entire $5,000 to work in the retirement account.  The assumption here includes the fact that you expect your tax bracket to be lower in retirement than it is presently – since when you take the money out of the 401(k), it’ll be taxed as ordinary income, thereby reducing the benefit of this tax reduction today.

Roth IRA contribution – If the asker of the question has not made his Roth IRA maximum contribution for the year and all other tax reduction and deferral options have been exhausted, this might make a great deal of sense.  However, since there are other alternatives to look at, the Roth IRA contribution might not be the best option to use in these circumstances – since the tax cost of the money is relatively high.

Paying the tax on a Roth IRA conversion – Again, given the tax bracket involved here, a Roth IRA conversion is probably not a good idea.  This amount of $3,600 could pay the tax for up to $12,850 of Roth Conversion, but as we have discussed in other articles, at the 28% bracket this is a somewhat costly conversion.  It is assumed that in retirement your tax bracket would be less than the 28% current bracket – so only a very long period of deferral in the Roth account would prove beneficial.

Paying your child’s tuition – Paying the tuition bill could be a good use of these funds, because you would likely be eligible to use the American Opportunity Tax Credit on the tuition payment, giving you a credit of up to $2,500 directly against your overall tax, although the amount attributable to the net $3,600 would be $2,400 at most.  This would eliminate the tax on the bonus altogether and give you an additional $1,000 in tax credit.

Replacing the aging heating and A/C – A 30% tax credit is available on the purchase price of eligible Qualified Residential Energy Property, up to $1,500.  The cost of the installation is not allowable for the credit, this would be added to the basis of the property.  For the net $3,600 from the bonus, the credit would be $1,080.  In addition, assuming that the current system in place is far less efficient than a new system, this might equate to as much as an annual reduction of $200 or so in your annual heating and cooling costs.

Putting it all together…

Now that we’ve looked at the tax benefits of the options available, let’s compare them all side-by-side:

Donation – $1,008 tax reduction

401(k) – $1,400 tax deferred

Roth Contribution or Conversion – no current tax benefit

Tuition – $2,400 tax credit

Heating & A/C – $1,080 tax credit, plus ongoing $200 reduction in heating/cooling costs

So – the best route to go with this bonus, purely from a tax benefit standpoint, is paying the tuition bill.  This would give you all of the withheld tax back, plus an additional $1,000 in tax credits.  However, if you already have other funds set aside to use to pay the tuition, you might use those instead, and then use the bonus for one of the other options.  (It should also be noted here that, if you haven’t taken advantage of your employer matching contributions in your 401(k), that would be the best possible place to use the bonus money.)

In the case of the heating and A/C system – this is a matter of priority… if the system truly needs replacing (beginning to show signs of failing), then you might put it higher in the priority order above the tuition or the 401(k) plan.  For example, the student or the parent could get unsubsidized loans to pay for the tuition bill, since the interest on these loans can be deducted from taxes in the future, and then use the bonus (and the tax credit) to pay for the heating and A/C system.

Other options that you might consider for these funds would be: pay down high interest debt (credit cards, auto loans, or student loans), spend it on your own education (a master’s degree could make a significant difference in your future income), improve your “emergency” fund, or consider starting your own small side business.  You could also use a portion of your funds to treat yourself and your family to a vacation, or perhaps some other leisure pursuit that will improve your life or provide other intangible benefits.

Of course, all of these options require you to put your own priority system to work.  We’ve covered the tax implications – now it’s up to you to decide what makes the most sense for you.  If it is of a high priority for you to make donations to a charity of importance to you, this might be the best option for you.

Photo by Chip

Guidance from the IRS on Flex Spending Plans

Sep 6th, 2010
by jblankenship.
1 comment

drugs by gregorfischer.photographyHere’s one of the opening salvos, brought to you by the Affordable Care Act of 2010: the IRS has now issued guidance regarding changes to Flex-Spending plans (or Flex Spending Arrangements, FSAs), which has changed things for folks who use these plans – specifically the medical expense reimbursements.

In the past, these plans have been eligible to reimburse the owner of the account for a myriad of medical expenses, not only physician expenses, prescription drugs, and other health care expenditures, but also over-the-counter medicines or drugs (not controlled by prescription).

Beginning in 2011, due to the Affordable Care Act, over-the-counter drugs and medicines that are not ordered by prescription will no longer be eligible for reimbursement from a medical Flex-Spending plan.  The change does not affect insulin, even if purchased without a prescription, or other health care expenses such as medical devices, eye glasses and contact lenses, co-pays and deductibles.

This new standard goes into effect for purchases made January 1, 2011 or after, and a similar standard is due to be in place for Health Savings Accounts (HSAs) and Archer Medical Savings Accounts (Archer MSAs).  But never fear, reimbursements are still going to be available for your 2010 expenditures through March 2011 as always.

If you have one of these FSAs, you’ve probably gotten into a situation in the past (I know I have) where you had too much money set aside through the year for your “regular” medical expenses, and so at the end of the year you make up the difference by stocking up on standard over-the-counter drugs and medicines.  This option will no longer be available to you at year-end in 2011.

Stay tuned as more of this quite helpful guidance comes along.  I’m sure we’ll be collectively satisfied with the results – or but then again, probably not.

Photo by gregorfischer.photography

Your Retirement Plan and Where You Live

Aug 25th, 2010
by jblankenship.
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2006_zonesWe’ve covered a lot of ground with regard to how various tax laws impact your retirement plans: pensions, IRAs, 403(b) and 401(k) plans.  But we’ve primarily focused on the US income tax laws (the IRS) affect your plans – and there are many nuances that you need to take into account with regard to state tax laws.

State Tax

The big deal with state tax laws and retirement plans is that some states have special tax deals for money inside of retirement plans.  If you happen to live in (or are planning to move to) such a state, it makes good sense to understand any special nuances in the tax laws before doing anything.

This is due to the fact that, for example, it could make a huge difference in the tax impact if you cashed out a plan in one state versus another.  Here in Illinois, there is no state tax on retirement income – whether from a pension plan, from an IRA or from a 401(k).  The same is true for Hawaii, Illinois, Kentucky, Mississippi and Pennsylvania.  So if you are planning to move to Kentucky (for example) for retirement – it would pay off if you wait until you move to your new home before withdrawing IRA assets, especially if you’re moving from somewhere with a high state income tax.

In addition, certain states also provide exemption from estate tax for assets held in retirement plans (Ohio, Oklahoma, Kentucky, and Pennsylvania).

Moving Money

Not only should you know the state tax laws for taking distributions from your retirement plans, it may also be important to know the state tax laws for the various types of plans.  Here are a couple of examples:

  • Alabama exempted tax on defined benefit retirement plans, but not on other types of retirement plans
  • Maryland exempted Keogh plan distributions from income tax, but not distributions from other types of retirement plans.

So pay attention to, and get acquainted with, the tax laws in your state and any states you’re considering for a new home (either in retirement or at another time in your life) so that you don’t miss out on any tax treatment – or worse, make a move that precludes some tax treatment from being available.

Photo by Arbor Day Foundation

What Does A Fidelity Target Date (Freedom) Fund Invest In?

Aug 11th, 2010
by jblankenship.
3 comments

Note from Jim:  I’m on vacation this week – hope you enjoy the following post from my friend and colleague, Roger Wohlner, CFP® who writes at the blog Chicago Financial Planner.  Roger operates his Fee-Only financial planning practice out of Arlington Heights, Illinois.

Fidelity is one of the largest providers of 401(k) plans and like many fund company platforms it is common for their plan sponsor clients to offer several or all of Fidelity’s Target Date funds known as the Fidelity Freedom funds. These funds have target dates from 2005 every five years out to 2050 with an even shorter-term Retirement Income fund. The premise behind these and other Target Date funds is that a plan participant will choose a fund with a date close to when he or she might retire, invest their contributions and let the fund manager do the rest. The funds typically lighten up on equity investments as the target date draws nearer, at some point they go to a “glide path” into retirement typically at the target year. This means the fund at that point is geared to the typical life expectancy of someone retiring in that year, the allocation allows the fund shareholder to “glide” into retirement.

There has been much controversy as to whether Target Date funds work as advertised. My purpose in writing this post is not to comment on these issues one way or the other. Rather I want to take a look at how the Fidelity Freedom Funds actually invest shareholder’s money.

The Freedom Funds like many Target Date funds are funds of funds. Each Freedom Fund has its own mutual fund ticker symbol. Unlike many mutual funds which make direct investments into individual stocks or bonds, the Freedom Funds invest in a variety of Fidelity mutual funds. Which funds and the percentage held of each fund will vary by Freedom Fund. I made a list of their underlying holdings using Morningstar’s Advisor Workstation. I then used the Fi360 Toolkit to rate these funds based on their 11 point criteria:

• Fund inception date (at least three years)
• Manager Tenure (min. 2 years)
• Minimum fund size
• 2 measures relating to fund investment style and asset composition
• Expense ratio
• 2 measurements of risk-adjusted return
• Trailing 1,3,5 year returns

All funds are rated relative to other funds in their peer group.

In looking at the 26 Fidelity mutual funds that I found as holdings of the various Freedom Funds I found the following for the ranking period ending 12/31/09:

• Three of the funds received the highest ranking of 0. This means no deficiencies, they passed all criteria.
• An additional four funds earned a score ranging from 1-25 indicating that they passed most of the criteria. This would indicate that these funds rank in the top 25% of all funds in their peer group with enough data to be ranked.
• Four funds had scores ranging from 26-50 indicating that they did not pass in a couple of areas but these funds overall rank in the top half of their respective peer groups based upon the ranking criteria.
• Five of the funds had a ranking in the 51-74 range indicating that they were deficient in several of the criteria and overall place in the lower half of their peers with enough history to be ranked.
• One fund had a score of 87 meaning that it was deficient in most areas and ranked in the bottom 13% of its peers. A ranking in this range indicates that strong consideration should be given to replacing such a fund.
• Nine of the funds did not have enough history to be ranked. These funds are all Fidelity Series funds. This appears to be a new group of funds that Fidelity has designed for use in their Freedom Funds. The funds all have anywhere from a month’s worth of history out to about a year. They would flunk the inception date test for the amount of time the fund has been around. These may ultimately prove to be good funds over time, but as an advisor I am generally loath to invest client money in new, untested funds unless there is a compelling reason to do so.
• Noticeably absent from the underlying funds within the Freedom Funds are any of Fidelity’s low cost core index funds covering areas such as the S&P 500; total domestic stock market; international equities; or their total bond market index fund. These are by and large solid, low cost holdings. Also absent are several top Fidelity funds such as Contra, Low-Priced Stock, and others.

In their defense of the 11 numbered Freedom Funds, 10 earned a score of 0 for the most recent ranking period and the other one earned a top quartile score of 20. Keep in mind; however, these rankings are within the target date peer groups via Morningstar. All of these groupings have a small number of funds and there is not a lot of history in some cases. A really good or really bad quarter or two can skew a target fund’s relative ranking. Additionally the peer groupings have changed and been revamped at least twice in the past several years.

Should you invest in these funds? As a plan participant you need to understand the fund’s investment philosophy, the glide path concept, and the fund’s underlying investments. Remember just because a particular fund has a target date closest to when you might retire, you can go with a closer date fund if you want to be a little less aggressive or a longer-dated fund if you want to be a bit more aggressive.

Plan sponsors it is incumbent upon you to monitor the Target Date funds in your plan as closely as you would review any plan investment choice. In the case of a Fidelity plan you may or may not be limited to the Freedom Funds.

Again I am not saying the Freedom funds are good or bad. Clearly they did well relative to their peers in 2009. Participants and Sponsors need to understand these funds and what they can and cannot offer.

Photo by Paul Keleher

Principles of Pollex: Debt Reduction

Aug 2nd, 2010
by jblankenship.
1 comment

thumbprint_person_face-t2(In case you’re confused by the headline: a principle is a rule, and pollex is an obscure term for thumb. Therefore, this on-going series is all about Financial Rules of Thumb.)

Try as we might, there are times when debts just overtake us.  Quite often it is one of several things that causes this to happen – either we’ve had unexpected expenses hit us “alla sudden-like”, or perhaps a layoff or lean time with income.  Or maybe we just didn’t pay attention and debt grew out of control.

How’d I Get Here?

The reason we’re in this position is important, because we can’t let the debts continue to increase – so the first order of business in reducing your debts is to stop the bleeding.  Figure out what the cause of the debt was, and work out a way to stop increasing the debt (if possible).  If it’s just regular spending, shopping and the like, you need to get a handle on your outflows, or come up  with a way to increase your income so that you’re not adding to the debt load.  Whatever the cause of the debt in the first place, you need to stop it from increasing.

After you’ve stopped your debt from increasing, it’s time to come up with a plan to start reducing the debt load.  In order to do this, we go back to the time-honored method of Organization, Efficiency, and Discipline to work through the debt reduction.

Organization

To start off with, you need to Organize.  List all of your debts, including the balance, interest rate and minimum payment for each.  You can do this on a sheet of tablet paper, or on a spreadsheet like Excel or Google docs.  By doing this, you can tally up your total amount that you owe, as well as how much your monthly cost is at a minimum.

For many folks this is the first time they’ve put it all together in one place, and it can be a bit scary.  What’s important is that now you know where you are… and of course, where you’re going is to take that balance down to zero.  It becomes a matter of filling in the space in between.

One way to do this is to just make the minimum payments every month, and eventually you’d pay it all off.  But there are better ways to go about this, more efficient ways, if you have a little extra to pay each month above the minimum.

Efficiency

Let’s use an example – say you have three debts, totaling $200 each, at rates of 10%, 15%, and 20% respectively.  These three debts each have a monthly minimum payment of $10 each.  If you paid the minimum on each debt every month, you’d pay off the 10% debt in 24 months, the 15% debt in 26 months, and the 20% debt in 27 months.  But let’s say you have a total of $40 to apply toward debt each month…

If you split the $40 evenly between the debts, now your 10% and 15% debts would be paid off in 19 months and the 20% debt in 20 months.  Pretty good deal, right?  You’ve shaved 8 months off the time to pay it all off.  But there’s a better way to do this.

What if you took the extra $10 and paid it toward the highest rate first?  Now the 20% loan would be paid off in 14 months.  Then, if you took the $20 that you’d been paying toward the 20% debt and added that to the $10 minimum that you’d been paying on the 15% debt (total payment now is $30), that debt would be eliminated by the 17th month.  Adding that $30 to your 10% debt payment, you’d be finished paying off that debt by the 18th month.

Not only have you shortened the timeline by a month, but by paying the highest rate debt first, you’d reduce the overall cost of the debt.  This method is known as a “debt snowball”.

Discipline

The debt snowball will only work if you stick to it… and the whole idea of debt reduction requires discipline in order to make it work.  If you start off on the project and free up some of your credit line, only to build up the debt again, you’ll be back to square one before you know it.  This is why I mentioned at the start that you need to understand how you got into this debt position in the first place.  If you’re simply spending far more money than you can bring in with your income, you have to figure out a way to fix that situation.  There is no way to resolve this problem without either bringing in more money or reducing your expenditures.

Photo by Photos8.com

Know Thyself

Jul 19th, 2010
by jblankenship.
3 comments

'Pythagoras_Emerging_from_the_Underworld',_oil_on_canvas_painting_by_Salvator_RosaThis ancient two-word phrase, attributed to several Greek luminaries ranging from Socrates to Pythagoras, implores the reader toward introspection.  This introspection can be especially helpful when considering how we feel about our financial future – particularly when we are at extremes of emotion.

The recent stock market activity has given us plenty of opportunities to experience extremes of emotion… but then again, you can pretty much choose any time period and make a similar statement.  There are quite a few studies that have recently brought to the forefront several things that we need to understand about ourselves and how emotion could impact our decision-making process.

Loss Aversion – as investors in general, we feel the impact of a loss approximately twice as much as we experience the good feelings from a gain.  It has further been estimated that as we approach retirement, this ratio increases to a factor of five times more pain for a loss as opposed to the joy we experience for a gain.

This seems to be true no matter whether the loss is realized or simply on paper.  The problem is that, in stock market investing, short term losses and gains are simply normal market activity, and we need to temper our emotions to keep things in perspective.

We Want Control… or Do We? – it would seem to follow the train of thought that, if we are feeling pain in our investing activities that we’d appreciate some guarantees and protection of some sort in our choices of products.  However, guarantees come with a cost – that of giving up control.  And as investors we prefer control (or the perception of control) over guarantees, studies have shown.

On the other hand, other studies tell us that a guaranteed income from an investment is preferred over an assured return on investment over time.  These studies show that, given a choice between an annuity with a monthly income and an investment portfolio structured to provide the same sort of returns over time, if we’re near retirement we choose the annuity seven times out of ten.

This means that we value the concept of income, that of receiving a check every month over the excess costs and lack of control that an annuity represents.  At the same time, we prefer to feel like we’re in control of our investing activities.

Lack of Understanding of the Numbers – when presented with the outcome of financial calculators, many of us consider whatever calculations were done in the background to be tantamount to magic.  For example, the very concept of inflation and its impact on our future finances is a mystery to us – we work best when calculations are discounted to present values.

Even though it’s been decided that it was politically incorrect, one popular baby-boomer who is now age 51 once admitted that math is tough (Barbie, of the doll fame, who actually admitted that “Math class is tough”).  There’s no shame in admitting that fact – for a lot of us, math can be very tough.  And as we get older (some say by age 53) our understanding of mathematical numeracy begins to decline dramatically, making math even tougher.

This can lead to distrust of the very calculations that could help you make good decisions in your financial life.

So What Does All Of This Mean?

Mostly this just means that we’re carrying with us a lot of preconceived notions and emotional preferences that we must take into account as we make financial decisions.  “Know Thyself” means that we should understand how these various notions can paint our perceptions of situations, and if we understand these things, we can recognize when our own limitations are working against us and take actions to consider things in a new, less biased, light.

For example, it’s natural to feel the pain of losses.  But as explained in the article The Lost Decade and What It Means, the activity of investing, especially in the stock markets, is a long-term activity and short-term losses, even over a few years, are temporary in the scheme of things.  Keep this in mind before making any rash investment decisions – you’re likely to regret emotion-driven decisions.

Photo by Wikimedia

Principles of Pollex: Auto Purchases

Jul 12th, 2010
by jblankenship.
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new car by houdoken(In case you are confused by the headline: a principle is a rule, and pollex is an obscure term for thumb. Therefore, this on-going series is all about financial Rules of Thumb.)

Buying a car is such a common activity that many folks don’t give much effort to following any “rules” around this purchase.  I’ve often suggested a couple of rules that you may find useful or interesting…

The Decision to purchase a car in the first place

You need to be certain that your decision to purchase is based on a real need.  Too often we get caught up in our desires and “keeping up with the Jones’s” when it comes to auto purchases.  If your current car is providing you with service and isn’t beginning to fall apart, you should consider delaying a purchase until it actually makes sense for you.

The reason I say this is because a car is a depreciating asset – except in certain cases where you use your car to make money, such as in a delivery business, a car only costs you money – it doesn’t make money for you.  And the cost of the car itself isn’t the only cost you’ll incur, you also need to consider additional insurance costs… if you buy a new car, you’ll need to carry full coverage for the replacement of a much more expensive item than your current, depreciated value, vehicle.

But here’s a rule of thumb that you might use to determine the overall cost of owning a vehicle – to get an idea of the total cost of ownership, including insurance, maintenance, and all, double the price and divide by 60.  This is a rough guess of the cost, but you can probably do much better by going to a website like Edmunds.com and using their “Cost to Own” calculator.

Suggestions if you’re buying a new car

If you’ve chosen to purchase a new car, here are a few suggestions that will make your choice a better option for you in the long run:

Buy with cash.  You should save up and purchase your auto with cash if you can do it.  This way you are doing two things for yourself – 1) you’re able to negotiate specifically on the price of the new car and your trade-in’s value; and 2) you aren’t paying someone else for the use of the money.

There are exceptions to this rule, of course.  The first is if you don’t have the cash available… which means one of two things, either you will need to delay the purchase or borrow the money to buy.  Delaying is a good choice if your present auto still meets your needs (see my comment above regarding the decision to purchase a car in the first place).

Don’t finance for more than four years.  In today’s world it’s possible to finance a car for up to 72 months, or six years – but if that’s the only way you can afford to make payments, you’re taking on more than you can really afford.  This is because of the fact that a vehicle reduces in value dramatically over the first two or three years, and if you finance for much longer than three years, by the time you’ve reached the point where the car is starting to cost a lot of maintenance money (and therefore you’re thinking of trading for a newer model), it is worth much less than you still owe.  This is known as being “upside-down” with regard to the financial value of the vehicle.

Put at least 20% down.  This rule of thumb is helpful to ensure that you aren’t financing more than necessary.  This will also help you to follow the four-year rule above, all the while keeping your payments lower.  Just the same as in the “buy with cash” recommendation, if you can’t put at least 20% down in payment at the purchase, you should delay your purchase until you can do so.

Buy a used car

Another, possibly the best, rule of thumb with regard to auto purchases is to buy a used car, and drive it until it literally drops from exhaustion.  It may not be glamorous (what sound financial advice is?) but this is one of those recommendations that has passed the test of time, and has been a part of some of the world’s greatest financial success stories.

According to Stanley and Danko’s seminal book “The Millionaire Next Door”, in the chapter called “You Aren’t What You Drive” – the average millionaire doesn’t put much value on having a brand-spanking new car.  In fact, more than 37% of the millionaires that were surveyed purchased a used car most recently, and even if they bought it new, they held onto their car for a good while before trading:

Latest Model-Year
of Vehicle Owned		 Percent of
Millionaires
Current Year 23.5%
Last Year/One Year Old 22.8%
Two Years Old 16.1%
Three Years Old 12.4%
Four Years Old 6.3%
Five Years Old 6.6%
Six Years Old or Older 12.3%

Those purchasing motor vehicles accounted for 81% of the sample of millionaires; those leasing accounted for 19%.

Photo by houdoken
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