February
8
2010
Holding on When the Winds Blow
Pillar V: Asset Protection
Level: Basic
“I’m not so much concerned about the return on my money as the return of my money.” This oft-quoted maxim, spoken by Will Rogers in 1933 during the depths of the depression, is timeless. Although most often associated with the perils of investing, I believe it may be generalized to all financial risks we assume in our daily lives. Frequently, the more important challenge to our financial security is not in climbing the ladder to financial success, but in avoiding a painful fall off the ladder during the climb, caused by a sudden gust of misfortune.
Human nature leads us to assume that we are somehow exempt from all those unfortunate reversals experienced by the “other guys.” In reality, the more success we achieve, the more likely we are to stumble into misfortune that can undo all the rewards of our hard work and discipline.
Risks That Could Erase Our Gains
- Catastrophic Investment Loss
- Lawsuit (94% of all lawsuits filed in the world are filed in the U.S.)
- Medical Expenses Due to Illness or Injury of a Family Member
- Death of the Breadwinner
- Loss of Income Due to Disability
- Catastrophic Property Loss, as in a Fire
Any item on the list could suddenly threaten our financial survival. However, each of the perils listed may be managed easily and economically as follows:
Catastrophic Investment Loss
Investment success breeds an unhealthy appetite for risk. The truth is, if you do not properly manage risk, you can be right 99 times, amassing wonderful gains, then lose it all the one time you are wrong. I know, because I have done it.
For investors, holding on to our gains means:
- Diversification - spread your investments broadly across a variety of investment classes, industries, and geographies. This corresponds to basic finance theory and is how the pros manage portfolio risk.
- Timing – buy at or near “support,” which is a little technical, but means that a quality investment instrument is safer to buy when it has dropped in price enough to be supported by its trend line. A little patience will pay off – there is nothing wrong with holding cash long enough to buy right.
- Position size planning – limit your exposure in any single investment position to a maximum of 5% of your investment capital. The percentage you choose will depend on the size of your investment portfolio. For larger portfolios, 1-2% maximum position size is desirable. For very small investment portfolios, it may not be practical to limit position sizes to much less than 10%.
- Stop-loss – (this is critical) – decide how much you are willing to lose on any position before you invest, then stick with it – sell when the investment drops to the “trigger” stop-loss level. Dump it and move on. If you keep the position size small enough, you can afford to lose 10-20% on a single position without experiencing financial disaster. I believe that “buy and hold” is very dangerous. Likewise, stops that are too tight will hurt performance as all securities experience normal pricing fluctuations. There is no generally-accepted formula, but I have constructed one that works reasonably well for me. Determining appropriate stop-loss levels for individual securities demands a discussion all its own.
This list may be hard to understand for the novice investor. I will provide much more detailed discussions of managing investment risk in other posts under the Prudent Investing pillar. For now, it will do to say that following the four suggestions above will help you sleep when the wind blows.
For Other Financial Risks, We Employ Insurance.
Insurance is a surprisingly broad and complex subject. It encompasses liability, property, casualty, medical, life, disability, annuities, and many more narrowly focused products. Each item in the list demands a thorough exploration in order to begin to attain competence. Frequently, financial advisers gloss over or propose simplistic views on this subject. However, the average family spends a great deal on insurance and it should be treated with the same diligence as every other major expenditure.
For the purposes of this discussion, I will offer a few general suggestions, to be followed with more detailed subsequent posts.
- First, do not waste your money on:
- Travel insurance (pay by credit card that includes this as a free benefit)
- Critical illness insurance (too specific – rarely does one collect)
- Mortgage insurance (use term life)
- Low deductibles on auto and homeowners (you can save hundreds in premiums – much more than you may gain with a low deductible)
- Guaranteed issue term insurance (usually significantly more expensive than regular term)
- Buy term life insurance for term needs (home mortgage, children at home, etc.).
- Buy permanent insurance for permanent needs (financial needs of surviving spouse, even into retirement…it will cost less than term).
- Eliminate collision and comprehensive insurance on old vehicles.
- You may consider a $1 million umbrella liability policy for lawsuit protection ($250-300 per year).
- An alternative to the umbrella coverage is to place high-liability assets such as cars and your home in a family business – either limited partnership or limited liability corporation (shielding your personal assets from lawsuits tied to these assets).
- Periodically shop your term life, auto, and homeowners insurances, especially in response to rate increases (insurance companies get comfortable and tend to treat existing customers less favorably than when courting new customers).
- Look into buying auto and homeowners insurance from the same company (10-15% savings).
- Do not overlook disability insurance (you are several times more likely to become disabled than to die, and disability is more financially burdensome than death).
- If you are not covered by an employer health plan, shop carefully for a high-deductible plan and put the premium savings into a health savings plan.
Keep Climbing
Of course, there is one major risk that I have not addressed: that experienced by millions of Americans recently, the loss of employment. The best safeguard for that peril is personal savings. That is why savings, The Golden Key, supersedes even the very worthy and necessary pursuit of debt-reduction in our list of financial security priorities. Secondarily, home-based entrepreneurship (The American Dream) may be a path to greater independence.
For the other threats we face, the solutions listed above will keep us as safe as we need to be as we continue our climb up the ladder of financial achievement and security.
January
18
2010
Pillar IV: Tax Reduction
Level: Basic
If I were to pose the question, ‘What expense category consumes the largest share of your budget?’, most would answer housing. However, for most people, taxes are their biggest expenditure. According to the Tax Foundation, in 2009 Americans paid “more in taxes than they [spent] on food, clothing, and housing combined.” In fact, nearly 30% of every dollar earned in America is consumed by combined taxation of federal, state, and local governments. Finding ways to reduce your tax burden is an important ingredient in reducing your cost of living and freeing up precious dollars to save and invest for financial security.
Moral Implications of Tax Reduction
Before addressing approaches to reducing your tax bite, is tax reduction a worthy pursuit of loyal citizens? Arthur Godfrey put it this way: “I’m proud to be paying taxes in the United States. The thing is, I could be just as proud for half the money.” The Tax Foundation (www.TaxFoundation.org) has been tracking the impact of taxes levied by all levels of government on U.S citizens since 1948. Combining research back to 1900 with year-by-year data since its founding, the Tax Foundation has utilized a simple formula to derive the national Tax Freedom Day for each year. Here is the formula: Total Federal, State, & Local Tax Collections/Total income = Total taxes as a % of income. Multiplying this percentage by 365, they arrive at the number of days the average citizen must work for the government until becoming free of their tax burden for the year. Here are a few of the years’ results:
| Year | Tax Freedom Day | Total Tax % |
| 1900 | 22-Jan | 5.90% |
| 1950 | 31-Mar | 24.60% |
| 2000 | 3-May | 33.60% |
| 2009* | 13-Apr | 28.20% |
*A more realistic calculation for 2009 that includes government spending not paid for, ala deficit spending, would result in a Tax Freedom Day of May 29 – the latest date ever. This inclusive calculation would drive the 2009 total tax % to 40.5%
Given the data above, where does our patriotic duty place us? This is a personal question that we can only answer for ourselves. My answer is this: I feel obligated to pay the minimum possible legally-derived tax obligation, and Not One Penny More. Tax evasion is illegal and can get you into a lot of trouble. Tax avoidance is perfectly legal and should be practiced by anyone who is serious about personal and family financial security.
So Many Taxes, So Little Awareness
The steady creep of taxes into all phases of our lives reminds me of the anecdotal story of the frog barely noticing as the heat is slowly increased in a pot. Had the frog been thrust into boiling water, it would quickly struggle to escape. However, being placed in cool water that is slowly heated causes the frog no alarm, until it is cooked with no attempt to escape. Income taxes, payroll taxes, sales, excise, property, corporate, estate, gift, fuel and many more taxes surround and nearly smother us. Like the frog, the common response is to simply pay the taxes, never working on an escape.
Perhaps if we had a greater perception of the impact on our lives, we would take the threat more seriously. For example, that $25,000 car doesn’t really cost us the sticker price. First, we add sales tax in most states. That raises the price to $26,500 (assumes 6% sales tax). Then, since most of us are in the 25% federal tax bracket, when we add state, social security, and medicare taxes, most of us end up surrendering 35 cents out of every dollar in our paychecks. Adding this factor to the calculation, we need to earn $40,769 in order to pay for the car. One final bit of salt in the wound: if we finance the car, say at 6% for 3 years, add $2,522 interest, which requires $3,880 in gross income to pay for the interest. Now the total cost of this $25,000 car is $44,649…Pretty depressing. No wonder it is such a struggle to get ahead.
For Now, Let’s Focus on Income Taxes
So, what can we do? Since income taxes constitute the largest component of our total tax bill, let’s begin there. The following are my top five strategies for reducing income taxes:
- Contribute all you can to tax-deferred retirement plans. This is a way to turn the system to your advantage. Each dollar you contribute to a retirement savings plan reduces your income taxes by the percentage of your federal and state tax bracket. You are paying yourself and saving on taxes at the same time.
- Own a home. Congress has always encouraged home ownership by making mortgage interest and property taxes deductible. Rent is not deductible. But by far, the most lucrative tax benefit comes down the road when you sell the home for a gain. Yes, I know that many homes are at present “upside-down,” or worth less than what you owe. However, this is cyclical. It has occurred many times. Over the long-run homes appreciate in value 4-5% per year, so things eventually work out. Current tax law allows you to sell your home and walk away with up to a $500,000 gain (for married couples), completely tax-free. That is an extraordinary benefit, unmatched by any other possible investment.
- Start a family business. Like home ownership, the tax code is extremely generous when it comes to owning your own business. Without going into all the details, the two main tax benefits of owning a business are the ability to “write-off” many ordinary expenses that would otherwise not be deductible, such as home office expenses, medical expenses, travel & entertainment, supplies, utilities, etc. You may even employ your children and deduct their wages as a tax-saving alternative to allowances. Secondly, self-employment retirement plan contribution limits are significantly higher than those available to employees. This permits those who can afford it to shelter substantially more income from taxation than is possible merely as an employee.
- Make tax-wise contributions to charities. As with the previous three items, the tax code encourages charitable giving. In addition to having the ability to deduct cash contributions, you may also deduct the fair market value of no longer needed clothing, furniture, etc. The best strategy is to donate appreciated property. Say, for example you own stock that you purchased for $5,000 and now it is worth $10,000. Normally, you are liable for capital gains taxes when you sell. However, if you donate the stock as an alternative to a cash donation that you would normally make, you may take a deduction for the full current market value of the stock without having to pay tax on the gain.
- Do your own tax returns. This may seem like an odd suggestion, especially for those who enjoy working on their taxes about as much as a root canal. However, the tax preparation software that is available (I have personally used Quicken for years) is so easy to use, that you should give it a try. The reason for suggesting this is that there are dozens of tax deductions and credits that you need to learn about in order to really gain control of your tax strategies. Turning tax preparation over to a third party robs you of the education available by going through the process step-by-step on your own.
Just the Beginning
This introductory discussion barely scratches the surface of the possibilities available to pursue the pillar of tax reduction. Be assured that it is not a betrayal of our duties as citizens to reduce our taxes to our fair share and Not One Penny More. Hopefully, this introduction to the subject will awaken in you a resolve to add this pillar to your financial security game plan.
January
8
2010
Pillar III: Entrepreneurship
Level: Basic
A multitude of definitions exist for The American Dream. Common to most, however, are the concepts of freedom and opportunity. This link opens a brief discussion on the subject by Steve Forbes, Editor and CEO of Forbes, Inc.:
Steve Forbes on The American Dream
So what does this have to do with entrepreneurship, and how does entrepreneurship fit into the general discussion of financial security? I will answer these questions first in a negative way, and then with an injection of hope and encouragement.
Traditional Employment is Becoming Less Dependable and Rewarding
For much of the 20th century, as the family farm became an endangered species, most Americans became city-dwellers. For the majority of urban and suburban residents, the American Dream included a long career with a single employer, home, family, and a guaranteed retirement. Now the stark realities of life in post-millennial America have forged a very different outlook. Consider these facts:
- At the end of 2009, nearly 15.3 million people were unemployed, an increase of 3.9 million during 2009.
- For those fortunate enough to have a job, only 45% of those surveyed reported satisfaction with their jobs. This was the lowest level ever recorded by the Conference Board research group.
- Only 51% of workers surveyed found their jobs “interesting.”
- Forty-three percent of workers feel secure in their jobs.
- Fifty-one percent say they are satisfied with their boss, leaving the other half dissatisfied to some degree.
- After decades of steady growth, average household incomes adjusted for inflation have been shrinking since 2000.
- A study of baby-boomers by the Department of Labor indicated an average of 10.8 different jobs held between the ages of 18 and 42. This means, on average, a job change every 2.2 years for the baby-boomer generation.
What does the foregoing suggest about financial security and the American Dream? Pretty clearly, the system is not supplying security or fulfilling dreams for all Americans. Indeed, the unstable and unsatisfying status of conventional employment in 21st century America is a root cause of financial stress for millions of families. There may have never been a better time to make a plan to supplement your income through a home-based or other personal business. Further, for those who have the requisite personal traits, now is a good time to consider a serious effort to explore entrepreneurship as a career direction.
Get on the Path to Independence
It may be something as low-key as English, science, or math tutoring, music lessons, or sharing some other skill in your home. Another direction is an internet-based business. As Steve Forbes mentioned, nearly a million individuals make a living buying and selling on E-Bay. There are 1001 different approaches to entrepreneurship, most of which can be started with very little investment or risk. The opportunities are limitless, and you do not have to quit your day job to begin. Combining creativity, persistence, the willingness to take calculated risks, and yes, some luck may open the door to astounding opportunities.
As you may have noticed, I have begun to fulfill my promise to turn the discussion from negative to positive. Consider these facts:
- Self-employment in the U.S. has been growing by 1 million people per year.
- Enrollment in entrepreneurship programs is booming. There were just a handful of programs 10 years ago. Now more than 500 higher-ed institutions offer degrees or certificates in entrepreneurship.
- The cost of entry into many businesses is approaching zero. The internet has been the launching-pad for millions of successful businesses, creating many millionaires.
- The U.S. tax system is loaded with incentives, literally begging us to set up small businesses.
- Nearly all communities have a vast array of resources and support systems, including grants, low-interest loans, mentoring, and free consulting, all in support of business formation.
- The internet is loaded with resources, including marketing research, to support the creation and success of new businesses (see some of my favorites on my Links page).
Small businesses …
- represent more than 99% of all employers
- provide 60% to 80% of the net new jobs annually
- are 53% home-based and 3% franchises
- account for 97% of all U.S. exporters of goods
- produce 13 to 14 times more patents per employee than large patenting firms
Source:
January
4
2010
Pillar II: Systematic Saving
Level: Basic
The Golden Key is a 19th century fairy tale by George MacDonald. Inspired by his grandmother, a young boy finds a golden key at the end of a rainbow. The focus of the tale then turns to finding the lock which the key will open. This is an interesting twist on the more common theme of finding treasure (pot of gold) at the end of a rainbow.
The story of the golden key provides a fitting image to introduce my thoughts about the prime directive regarding financial security. Simply stated, there is nothing more vital to attaining financial goals than this simple key: Spend less than you earn, invest the difference prudently, and stay on this path for a long time. This is not very sexy, but I repeat, nothing is more important to opening the door to long-term security than adopting this golden key.
Returning to the fairy tale, the key is more important than treasure. Great fortunes come and go. A glimpse at lottery winners, fading Hollywood stars, and professional athletes prove this point. Sudden wealth (treasure) generally doesn’t last long. Massive debt, bankruptcy, and broken families are found in the wake of financial windfalls. Riches obtained without first securing the key will evaporate as the dew before the morning sun. Unlike the fairy tale, there is no mystery attached to this key. The golden key to financial security, if used continuously through your lifetime, will unlock the door to sustainable wealth and security.
Becoming, and remaining, financially secure is essentially a boring process. Learn to adjust spending habits so as to make systematic saving your highest priority. Set a goal to save a certain percentage of each paycheck before any other spending. Second in line is debt reduction. That’s right, debt reduction is second in line. It is more important to save than to pay off debts, although many “experts” would respectfully disagree. Paying off those credit cards first sounds like a good idea, but is in reality the number one reason why so many of us never begin a serious savings program. Every year saving is delayed translates into huge losses of compounded savings and investments down the road (see the numbers below). Of course, becoming debt-free is important and should be an integral part of any personal and family financial plan. But saving comes first.
How Much to Save?
First, let’s take a look at how the U.S. compares to the rest of the world in setting aside money for savings. Between 1950 and 1985, Americans were pretty consistent, saving on average 9% of what we earned each year. Then, the savings rate went into a slide, actually going negative for the year 2005 (-.5%). Surprisingly, one bright spot to emerge from the smoke of recent financial turmoil is a movement toward increasing savings, bouncing back to 2.7% in 2008, and reaching 3.6% annual rate in December 2009.
How about our major economic rivals? Chinese save an average 40% and Europeans 10-14% of annual earnings. Here’s a rhetorical question with an obvious answer: How is it that the Chinese can afford to put away 40% …is it because they earn so much more than we do? Of course not! Earning just a fraction of the average American, the Chinese simply refuse to spend more than 60% of what they earn. According to a Merrill Lynch study, nearly all Americans earn enough to become wealthy. The problem is not in how much we earn, it is in how much we spend.
How much we set aside for savings is a personal decision, but clearly, the more we can squeeze out of our spending habits the better. It is more important to be consistent at a sustainable rate, than to embark on a crash course that is bound to… well, crash. The number may be 5%, 10%, or more. Start with a realistic goal, then plan on increasing your savings rate over time.
Here is one way of deriving a target that might strike a responsive chord: How about working for yourself the first hour of every day? Most of us work a full 8 hours for the government and our creditors. It seems only fair that for one hour each day, we work for ourselves and our families, rather than 3rd parties. This translates into a savings rate of 12.5% (one out of eight hours). What would this level of saving translate into over time? In order to do the math, we need to make a few assumptions, given below.
Assumptions:
Average Household Income (U.S. 2007): $50,233
Savings Rate: 12.5% ($523.26/month)
Average Annual Investment Return: 10%
Results:
10 Years: $107,187
20 Years: $397,348
30 Years: $1,182,824
How Do We Make it Happen?
Put simply, it has to be automatic. Once we determine a goal, the mechanics of saving must to go on cruise control. If at all possible, the best way is to have savings deposits come out of our paycheck before the assault of all other demands and wants. The second best is an automatic debit to our checking account on payday or the day after. The more we have to do to get the designated amount into our savings plan, the greater the hazard of delayed or skipped savings deposits. Think about how the government gets our tax money. We don’t have the privilege of using our money until the taxes are due on April 15. Deposits for federal, state, and local income and other taxes come right out of our checks before we can touch the money. Shouldn’t we treat our savings plan as seriously as the government handles our tax deposits?
Where Do We Find the Money to Save?
This is, of course, the tough one. If it were easy, the U.S. would be closer to the 40% Chinese savings rate than our dismal near-zero rate. Some “experts” insist that it begins with a detailed budget – track every expenditure, every day, and force your spending to conform to the budget. This approach is great for the detail-oriented and is preferred. But for the numerically challenged, the easier way is to simply set the saving target and let the rest of your spending self-adjust. The target of $500 per month sounds daunting, but in reality it amounts to just a little more than $100 per week. Taking this amount off the top as discussed above, then eating out less often, buying generic instead of name-brand, driving “pre-owned” instead of new cars, and a multitude of other small adjustments can add up to $100 per week pretty quickly.The best advice I have heard for controlling spending is this: if you think you can’t live without something you have your eye on, wait a week. If you are still alive after one week, you really don’t need it.
The easiest and best way to save is through a company-sponsored pre-tax savings plan like a 401-K or 403-B. In this case, the deposit comes directly out of your check, even before the government gets its hands on it. Because of this, a $500 savings deposit may only reduce your paycheck by $350 (assuming you are in the 30% withholding bracket). Everyone’s situation is different, but pre-tax is definitely the least painful. Further, many employers will match your deposits to a certain point. Depending on the employer match formula, this may cut another $100 or more out of the net pay bite. Your $500 monthly saving plan may only cost you $250…you double your money with each deposit!
If you do not have an employer-sponsored plan, use an IRA to accomplish the same thing. There is much discussion about the relative merits of Roth vs. traditional IRA’s. In many ways, Roth is better. But if finding a source of money to fund your IRA is a struggle, I suggest using a traditional IRA. My reasoning: you can use the tax-saving feature of a traditional IRA to justify increasing the number of exemptions used to calculate your payroll tax withholding, thus increasing your take-home pay. Use this increase to set up a monthly IRA contribution through a broker or other IRA provider, including automatic checking debit.
Summing It Up
There is so much more to say on this subject. I have barely scratched the surface. Then there is the matter of what to do with the money you are setting aside…how to invest it prudently, allowing the magic of compounding to multiply your savings; how to balance risk and reward in the baffling arena of investment strategy. That is a subject for an entirely different discussion. For now, my advice is to adopt my golden key and use it to unlock the gate to your financial goals. Learn to spend less than you earn, begin a savings plan, and put the plan on cruise control.
December
17
2009
Pillar I: Debt Management
Level: Basic
I found it amusing and a little surprising to recently view a personal finance “expert,” on national television, participating in a credit card blending ceremony. In case you missed it, disciples of this prominent adviser proudly deposited their credit cards in a blender, thereby freeing themselves from the chains of bondage imposed by those evil cards.
If you perceive the foregoing to be a bit sarcastic, you would be correct. While I have no doubt that there are many (OK, more than many) individuals and families who have dug a hole for themselves through the misuse and abuse of credit cards, I cannot support the extreme stance promoted by celebrity-status financial gurus who evangelize the gospel of credit card elimination as an essential ingredient in constructive personal finance management. Their preaching extends not just to those who have had trouble controlling their credit card use, but to everyone. They advocate destroying all credit cards and paying cash for every purchase.
Credit cards are simply a tool. Like any tool, they can be used properly or misused. Examples:
- In 2008, according to the U.S. Department of Transportation, 37,000 people died in auto accidents…clearly cars are more dangerous than credit cards. Wouldn’t it be prudent for everyone to play it safe and give up driving?
- Garden tools may be used as implements of the harvest or as weapons…why would we want to keep items around that could cause injury?
- A leading public health concern in the U.S. is obesity…should we all stop eating?
These absurd examples are not at all irrelevant. To me, it is insulting to label all of us as incapable of managing the perils of credit card use. Credit cards, properly used, can be a convenient and even profitable tool of personal finance. On the other hand, like so many other components of modern living, they have the potential to be misused.
If credit cards did not exist, how attractive would you consider an instrument with the following benefits:
- Safety – eliminates the need to carry large amounts of cash.
- If lost, it can be easily replaced with minimal risk of exposure to illegitimate use.
- You may take up to 60 days to pay for purchases made today with no interest if paid on time.
- You may receive cash back or other rewards for up to 5% of each purchase made.
- Properly used, your credit rating, and thus your ability to finance major purchases, such as your home, will be enhanced.
Truly, these are the benefits to intelligent credit card management. As with all aspects of our lives, in order to enjoy the benefits and avoid the pitfalls, we need to exercise common sense and self-control.
I offer the following guidelines for the prudent management of credit cards:
- Use credit cards that have cash-back or other reward programs, such as airline miles, hotel room credits, etc.
- Pay for everything you can using these reward-earning cards.
- Don’t charge anything that you can’t pay for when the bill is due, unless the card has a zero or low interest promotion. Pay off the entire balance when due. Failure to abide by this rule is what gets people into trouble with credit cards.
- Be careful with cash advances. They used to be very attractive, but most cards now have a 4-5% up-front fee, which equates to a high interest rate, regardless of the stated rate.
- If you have multiple cards, you can enhance your use of “other people’s money” by staggering the use of cards, based on the cutoff dates and grace periods. I will discuss this in greater detail in another post.
If you have already gotten yourself into trouble with credit cards, carrying balances and paying high rates of interest, you will need to devise a plan to extricate yourself from the problem before you can properly use the suggestions above. I will share my thoughts on this subject in another post.
To summarize, credit cards are not inherently evil. Like other tools and choices in our lives, they can help or harm us, based upon the wisdom we apply to their use. Choosing to do it right makes your wallet or purse the proper location for your credit cards, rather than the blender.