Economics for the Citizen

Yesterday, I posted a link to an article by Walter Williams about job outsourcing. Today, I found a series he has written called "Economics for the Citizen." It is a ten part series that will give readers a primer in economics. I went through it this morning and enjoyed it. Here are the links:

Economics for the Citizen:

Part 1
Part 2
Part 3
Part 4
Part 5
Part 6
Part 7
Part 8
Part 9
Part 10

Happy reading!

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The Timing of Retirement Planning Returns

Are all returns created equally? Does it matter when you get positive vs. negative returns? When you are saving for a long-term goal like retirement, the likelihood of you having some years with negative returns is pretty high.

The reason I bring all this up is that I have been having an interesting conversation about retirement planning with a fellow on the Saving Advice website. The topic of the conversation was whether or not it matters if you get negative returns the first few years of a long-term goal or the last few years. Here are the assumptions made:

The goal is $1,000,000 thirty years from now. The assumed rate of return is 8%, which requires an annual contribution of $8,827. So, I took that information and plugged it into two different scenarios. The first scenario assumed that the portfolio lost 2% per year for the first 5 years and gained 8% thereafter. The second scenario assumed that the portfolio gained 8% per year for the first 25 years and then lost 2% per year for the last 5 years. I think the chart below makes it pretty clear:

Retirement Savings

Here's what the annual numbers look like:

End of       Account        Account

 Year   ROR    Value   ROR    Value

     2   8%    $9,533  -2%    $8,650

     3   8%   $19,829  -2%   $17,128

     4   8%   $30,948  -2%   $25,436

     5   8%   $42,957  -2%   $33,578

     6   8%   $55,927  -2%   $41,556

     7   8%   $69,935   8%   $54,414

     8   8%   $85,063   8%   $68,300

     9   8%  $101,401   8%   $83,298

    10   8%  $119,046   8%   $99,495

    11   8%  $138,103   8%  $116,987

    12   8%  $158,684   8%  $135,879

    13   8%  $180,912   8%  $156,283

    14   8%  $204,918   8%  $178,319

    15   8%  $230,845   8%  $202,117

    16   8%  $258,845   8%  $227,820

    17   8%  $289,086   8%  $255,579

    18   8%  $321,746   8%  $285,558

    19   8%  $357,019   8%  $317,936

    20   8%  $395,114   8%  $352,904

    21   8%  $436,256   8%  $390,670

    22   8%  $480,690   8%  $431,456

    23   8%  $528,678   8%  $475,506

    24   8%  $580,506   8%  $523,080

    25  -2%  $577,546   8%  $574,459

    26  -2%  $574,645   8%  $629,949

    27  -2%  $571,803   8%  $689,878

    28  -2%  $569,017   8%  $754,602

    29  -2%  $566,287   8%  $824,503

So, from the looks of this, it is much better to have your losing years in the beginning rather than in the end.

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Social Security

I found this article (click on the above title) regarding what personal accounts could do for Social Security recipients in the future. I thought this was worth sharing. I welcome any comments you may have regarding Social Security and how to fix it.

Getting Personal

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Should We Save Jobs?

There has been a lot of talk about jobs and outsourcing lately. I thought this piece by Walter Williams was interesting. I thought this portion of the article was interesting:

"Let's look at some of the history of job loss described in Bradley's article. We might also ponder whether measures should have been taken to save these jobs. In 1858, Lyman Blake patented a shoemaking machine that ultimately destroyed jobs hand making shoes. In 1919, General Motors started selling Frigidaire. As Bradley says, "This 'electric ice box' wiped out a whole set of occupations, including ice-box manufacturers, ice gatherers, and the manufacturers of the tools and equipment needed to handle large blocks of ice.""

You won't find Mr. Williams' view espoused by the media. Anyway, this article is worth a read.

JLP

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One More Hit and I'll Break 1,000!

It only took me 3 months! Hopefully it won't take that long to break 2,000!

JLP

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You Still Have Time to Make an IRA Contribution for 2004

You have until April 15th (although I recommend you do it sooner than that) to make an IRA contribution for 2004! Also, here's a breakdown of how much you can contribute:

2004 - $3000 per person ($3500 per person if you are over age 50)
2005 - $4000 per person ($4500 per person if you are over age 50)

For more information, check out the IRS Website's Publication 590

Until next time...

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Taking Money Out of Your Retirement

I spent some time last night running the numbers on a hypothetical retirement withdrawal strategy.

There are a number of ways to withdraw money from your retirement. All of them require you to make a decision as to how much money is necessary to support your lifestyle. The simplest way to make a withdrawal is to take a percentage of the account value out annually and leave the rest of the account to grow. So, if you have a bad year, you could possibly have to take a smaller amount out in the following years.

A more complex strategy is to figure out the amount of money you want to live on and make that your benchmark for year one. Then, each year, you add 3% (or the current inflation percentage) to that number to account for inflation. For example, say you require $50,000 the first year of your retirement. Here is what your annual income would like if you adjusted it for inflation:

Year  Income

   1  $50,000

   2  $51,500

   3  $53,045

   4  $54,636

   5  $56,275

   6  $57,964

   7  $59,703

   8  $61,494

   9  $63,339

  10  $65,239

  11  $67,196

  12  $69,212

  13  $71,288

  14  $73,427

  15  $75,629

  16  $77,898

  17  $80,235

  18  $82,642

  19  $85,122

  20  $87,675

It is amazing, and a little scary, to see the impact of inflation (and, I used a modest inflation percentage). What this tells us is that in 20 years at 3% inflation, $87,675 will only be worth what $50,000 is worth today. So, inflation has a BIG impact on retirement plans.

So, with this example, you would simply withdraw the above amounts from your retirement plan each year, regardless of what the account is worth. Some years, you may even eat into the principal.

Tomorrow, I'll discuss another option for taking withdrawals.

Until then,...

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What is a Safe Withdrawal Rate from Retirement Savings?

Good question. For some interesting conversation on this topic, check out Early-Retirement.org.

There is no one right answer. I've heard people say 2% (which seems really low to me) all the way up to 10% (which seems really high to me)! The main thing to keep in mind is that unless you want to eat into your principal, make sure you withdraw less than your rate of return. Naturally, the better your rate of return, the greater percentage you can withdraw without eating into your principal.

Of course your portfolio rate of return depends on your investment strategy and your risk tolerance. In order to define your risk tolerance, you must know what your defintion of risk is. To many people risk is defined as loss of principal. However, many people forget to factor in the effects of inflation, which results in the loss of purchasing power. For instance, you could take $100 and stick it under your mattress. Now, you probably don't face much risk of losing your $100. However, in one year, your $100 is only worth $97. That's a loss isn't it?

So, it is important to construct a retirement portfolio that is balanced, giving you the stability of income-producing investments and the growth of equities. The mix depends on how much portfolio fluctuation you can stomach.

In my next post, I'll discuss different withdrawal percentages and portfolio rates of return.

Until next time...

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A Portfolio For Retirement

Here is an idea of what a retirement portfolio using iShares exchange-traded funds might look like:

                                12/31/2003 12/31/2004

                                  Value      Value*

DJ US Basic Materials       IYM    $40,000    $44,835

DJ US Consumer Cyclical     IYC    $40,000    $44,283

DJ US Consumer Non-Cyclical IYK    $40,000    $44,759

DJ US Energy                IYE    $40,000    $52,626

DJ US Financial Services    IYF    $40,000    $45,158

DJ US Healthcare            IYH    $40,000    $41,678

DJ US Industrial            IYJ    $40,000    $46,508

DJ US Technology            IYW    $40,000    $40,534

DJ US Telecom               IYZ    $40,000    $47,225

DJ US Utilities             IDU    $40,000    $49,066

MSCI EAFE                   EFA   $200,000   $237,840

Lehman Aggregate Bond       IGG   $200,000   $207,413

GS $ InvestTop Corp Bond    LQD   $200,000   $211,131

                                $1,000,000 $1,113,057

*Including dividends

DISCLAIMER - This is only an example and not meant to be a recommendation. Invest at your own risk.

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All About Exchange-Traded Funds

Although exchange-traded funds have been around quite a while, they have only recently gained popularity among individual investors. ETFs are basically index funds that trade like shares of stock. For buy and hold investors*, they offer lower expense ratios than traditional index mutual funds.

There is a wealth of information regarding ETFs available on the internet. Here's some links to some of my favorite places with ETF information:

iShares - iShares has built a wonderful website with lots of information about their exchange-traded funds.

Ameritrade - Ameritrade has a section of their website dedicated exchange-traded funds.

Journal of Indexes - A magazine that is dedicated to index funds. You may have to sign up before you can gain complete access to this website. Also, this site may be a little on the technical side for most people.

IndexUniverse - This is the sister site to the Journal of Indexes Site. Your logon information for the Journal of Indexes website also works on Index Universe.

That should be enough to get you started in learning about exchange-traded funds. I will add more information from time to time.

Until next time...

*The purchase exchange-traded funds may require brokerage commissions. Therefore, they be best suited for lump sum investing or a discount brokerage firm to keep expenses low.

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Exchange-Traded Funds in a 401K?

Exchange-traded funds have now found their way into 401k plans. According to an article on the Index Universe website, several companies are now offering 401k plans that utilize exchange-traded funds rather than mutual funds.

Today I will work on putting together a post that is all about Exchange-traded funds.

Until next time...

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Website of the Day

Early-Retirement.org

I found this website today and thought I'd share it with my readers. It is a really nice forum, full of good ideas and very helpful posters.

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There is no Free Lunch!

The other day, I was surfing the different financial forums and boards and I came across this one board where this guy said that fixed annuities do not have expenses. Basically, he was saying that fixed annuities are FREE!

My question is: if they are free, then how is the insurance salesman getting paid?

The "fee" that a person pays on a fixed annuity is hidden. It is the DIFFERENCE in what the annuity holder is paid and what the insurance company can earn. For example, if an insurance company can get an 8% return out in the market, they will pay out 6% or so and keep the 2% difference. So, THERE IS A FEE!

Now, all of this makes it sound like I am against annuities. That's not true. What I am against is decieving people into thinking that they are getting something for free, when in fact they are not. Fixed annuities can give some people peace of mind knowing that they will recieve a check each month for a specified amount. They don't have to worry about it. I don't have a problem with that as long as they know what it is costing them.

There is no free lunch!

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Social Insecurity?

One of my favorite economists is Thomas Sowell. He has just written an excellent piece on Social Security. You can read it by clicking on the above title or by following this link:

Social Insecurity?

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7 Most Common 401K Blunders

I found an article entitled "7 Most Common 401K Blunders" about the most common mistakes that people make when managing or mismanaging their 401K. I thought it was worth posting a link to.

If people can avoid making these mistakes, they should have a much larger 401K balance when they retire.

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Why You Need an Investment Policy Statement

I'm sure you've probably heard the term "investment policy statement" before and wondered what it meant. An investment policy statement (IPS) is simply a written statement that lays out the do's and don'ts, chosen allocation, expected returns, and goals of your investment plan.

Why is this important to have? Because it is a great tool to help you stay focused when things are not going right. Perhaps the "market" is outperforming your asset allocation. Or, your brother-in-law is making money "hand-over-fist" in some little tech company. You may get the itch to do something you will regret later. Referring to your IPS will help you stay focused on your goal.

Here's a really cool tutorial on writing an IPS: Morningstar Investing Classroom

Until next time...

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Business Week - Well Spent Blog

Here's an interesting blog on Business Week called "Well Spent." Now if they would just put a link to this site!

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How Much Do You Need During Retirement?

For many people, one of the scariest aspects of retirement planning is figuring out how much money will be needed to fund a comfortable retirement. After all, nobody wants to work their entire lives, retire, and then have to live on a shoestring. So, how much is necessary to support a comfortable retirement.

If retirement is far off, estimating how much you will need is difficult to estimate. One rule of thumb is to assume you will need what you are currently living on. So, if you are living on $50,000 now, you will need or want $50,000 (in today's dollars) when you retire. Here is an illustration of the effects of inflation on the amount that will be necessary during retirement, assuming the desired income is $50,000 in today's dollars and the income will be needed in 30 years.

                      Num of    Actual

Income in Inflation  Years to   Amount

Today's $   Rate    Retirement  Needed

  $50,000     3.00%         30 $121,363

  $50,000     3.50%         30 $140,340

  $50,000     4.00%         30 $162,170

  $50,000     4.50%         30 $187,266

As you can see, inflation plays a significant roll in retirement planning. Failing to factor in the effects of inflation can be devastating to a retirement plan.

Once you have figured out how much income you desire during retirement, you can then estimate the size of the nest egg you will need to fund that particular income need. So, if you need an income of $121,000 in 30 years, and you want to withdraw no more than 5% of your nest egg, you will need $2,400,000 (121,000/.05 = 2,400,000).

Now, why did I say that you don't to withdraw more than 5% from your nestegg? Because, you don't want to run the risk of eating into your nest egg. If you have your portfolio (or nest egg) allocated so that you can grow your money at 8% per year, you can take out 5% and not eat into your nest egg and still have a 3% cushion for inflation.

We'll talk more about this topic in the future. Until next time...

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A Book EVERYONE Should Read

George S. Clason's The Richest Man in Babylon is a classic. It is a short book that can be read in one sitting. I HIGHLY recommend it for everyone.

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Saving Advice

Saving Advice is an interesting website I ran across today. I like their message boards. Look for me there. I post under the name JLP. See you there!

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Subscribe to AllThingsFinancial

I found a cool service that will allow you to "subcribe" to your favorite blogs. The reason to do this is that by creating an account with Bloglines (which is free), and adding your favorite sites to your account, you simply have to log in to see which sites have been updated. This way you don't have to manually click on your favorite websites in order to get an update.

This process is called Syndication. If you will scroll down the left hand side of my blog, you will see the heading "Syndication," with an orange box directly underneath the heading. In order to be able to add a website to your Bloglines account, it must possess this technology. To learn more about syndication, check out this website: Learning Movable Type. This lady does a really good job explaining all this stuff.

I hope you find this helpful!

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Vanguard Diehards - Interesting Website

I was poking around on the internet today and I came across an interesting website called Vanguard Diehards that my readers may want to check out. I'm also going to add a link to the site on my sidebar.

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Be Careful Which Credit Card You Use

I'm not a fan of any credit cards. But, some are worse than others. You see, some cards use what's called two-cycle billing. Two-cycle billing means that the average daily balance is calculated on a two-month cycle rather than the 30-day cycle used by most credit card companies.

My big beef with two-cycle billing is that credit card holders are paying interest on money that they've already paid off. Here's a really good article called How Finance Charges are Calculated on Credit Cards that I found on the University of Kentucky College of Agriculture website. This article is definitely worth checking out.

One other thing to remember is that some charge interest DAILY. So, if you have carried a balance on your card for more than a month and you get a statement that says you owe $500 and you want to pay it off, you have to call the company and find out what your finance charges are BEFORE you send in your payment. If you just write a check for $500 and send it in, you will get another statement with a new balance on it for the amount of interest you owe.

So, how do I know all this? EXPERIENCE!

Just make sure you read ALL the small print BEFORE you sign up.

Until next time...

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The Barron's Challenge

Attention College Students! I saw this in Barron's today:

Students and teachers at accredited two- and four-year undergraduate U.S. colleges and universities and accredited graduate schools can participate in Barron's online investing/trading contest. Registration takes place through a link at www.barrons.com. Students and teachers compete in separate groups.

Dang! I wish I was in college!

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Magazine Portfolios

You probably see them all the time. You know, you're standing in line at the grocery store and you see Money, Kiplinger's, or Smart Money with the following cover stories or something similar: "Eight Stocks to Buy NOW!" or "The Ten Hottest Mutual Funds to Buy NOW!"

I always wonder just how well these magazine portfolios perform. So, I'm going to start keeping track and I'm going to post the results from time-to-time (as I have the time) on this site.

I'll start posting the results in the next day or two. Check back and see how they do.

Until next time...

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Social Security

Is there a more controversial topic these days?

I'm thirty-five and a capable investor. I'm not worried about not getting Social Security. In fact, I'm not planning on it. I'd prefer to do as much preparation for retirement on my own as I can and not worry about what the government is or is not going to do.

But, surely there is a way to fix this system. I have a few ideas that I'd like to share. Some are pretty obvious and others are quite drastic. Here we go:

1. Either cut future benefits or increase the qualifying age for receiving benefits.

2. Start educating people about the importance of saving for retirement. Start public service announcements discussing retirement planning. In other words, make people feel guilty if they aren't saving for retirement. Saving for retirement must be a priority for everyone.

3. Allow people to receive a tax break if they donate their Social Security payments back to the system. There are a lot of retirees who receive Social Security payments and don't really need them.

4. Turn Social Security into a sort of Medicaid program for retirees and only give benefits to those who qualify. Going this route would pave the way for a reduction in Social Security taxes. I would much rather manage my own money than have the government do it for me.

5. The most drastic of all: MAKE people save for their retirement. Deduct 10% from their earnings and make them invest it for retirement. If people are too stupid to do it for themselves, then perhaps someone must do it for them.

I would like to hear what you think. Either send me a comment or an email.

Until next time...

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A Twist on Index Investing

I'm a spreadsheet kind of guy. In the spirit of spreadsheet madness, I did a little study using the Dow Jones Total Market Index from 1992 - 2004. The purpose of the study was to see if there was a way to index and still beat the index. Huh?

Before I get into the nitty gritty it is important to know a little about the Dow Jones Total Market Index (from now on I'll simply call it the DJTMI). The DJTMI is a market-weighted index, meaning larger companies (based on market value) make up a greater percentage of the index than do smaller companies. This is not unlike other indexes like the Standard & Poor's 500 Index. But, the cool thing about the DJTMI is that it is composed of the following ten sector indexes:

Basic Materials
Consumer, Cyclical
Consumer, Noncyclical
Energy
Financial
Healthcare
Industrial
Technology
Telecom
Utilities

For my study I put together a portfolio putting equal dollar amounts in each of the ten sector funds and rebalanced them at the end of each year. Here are my results:

                     DJTMI

                   Rebalanced

                    Annually    DJTMI

             1992       9.30%    8.74%

             1993      10.97%    9.78%

             1994       1.54%    0.21%

             1995      36.14%   36.62%

             1996      18.77%   22.08%

             1997      30.01%   31.75%

             1998      23.19%   24.90%

             1999      18.30%   22.72%

             2000       1.63%   -9.23%

             2001     -10.27%  -11.95%

             2002     -17.81%  -22.08%

             2003      26.03%   28.44%

             2004      12.53%   10.16%

          Average      12.33%   11.70%

Geometric Average      11.28%   10.24%

NOTE: I used Geometric Average instead of the simple arithemetic average because it is a more accurate measure of return. Just trust me on this! Also, I used the index returns for my calculations because the corresponding Exchange Traded Funds have not been around long enough. So, that means actual returns would have been less due to brokerage fees and Exchange Traded Fund expenses. Even so, this strategy would have still outperformed the DJTMI in 2004.

So, if you want to increase your returns but still want to index, consider this method. For those interested in learning more, send me an email using the link following this post. I'll send you an Excel 2003 Spreadsheet of my study.

Until next time...

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Do the Math BEFORE Refinancing a Mortgage!

I got an offer in the mail from a mortgage company in the Dallas area. Here's what it said:

"You now have the opportunity to refinance at "NO-COST" to a rate that is at or below 5.875% A.P.R. We will pay our closing costs because we are paid a percentage of the new loan from the new investor."

Since the offered APR was about 2% lower than the rate we are currently paying, I decided to check it out. We still owe about $80,000 on our original 30 year mortgage and another $11,800 on a home equity loan. My goal was to roll both of those loans together at a lower interest rate and therefore reduce our monthly payments.

I talked with a salesperson who was very eager to get my business. She sent me a packet with a Good Faith Estimate. Basically, their "NO-COST" line was a load of hooey. I just about fell out of my chair when I looked at all the costs associated with this loan (I'm just talking about the section entitled "Items Payable in Connection with Loan" on the Good Faith Estimate). They pretty much had a fee for everything. The fees were listed as follows:

Loan Origination Fee Due Lender          $1,013.00

Credit Report                               $12.05

Tax Service Fee                             $70.00

Processing Fee                             $495.00

Underwriting Fee                           $575.00

Loan Warehouse (what the heck is this?)    $150.00

Courier                                     $25.00

Flood Certificate                           $13.50

Grand Total                              $2,353.55

Just that portion alone was nearly $1,200 more than we paid with our original loan 5 years ago. And, all these fees were being rolled into the new loan, meaning I was going to be financing these expenses over 30 years. And, to top it off, I wasn't getting the 5.875% APR they stated in the letter.

By the time all the fees and reserves were calculated, the amount being financed was $101,300 and I was starting over with another 30 year mortgage! Needless to say, I didn't go for this mortgage.

That brings me to the point of this post: DO THE MATH BEFORE YOU REFINANCE! I'm afraid too many people don't take the time to really understand what they are getting into. Most people look at one number: the monthly payment. However, just because the monthly payment is lower does not mean it's a good deal.

Until next time...

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Check Out That Charity BEFORE You Give!

With efforts to help the tsunami victims, it is important to check out the charity before you make a donation. There were three websites mentioned in today's (Tuesday, January 4th) Wall Street Journal. Those sites are:

Charitywatch.org

CharityNavigator.org

Guidstar.org

So, before you make a donation, you might want to give these sites a look.

Until next time,...

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