Archive for October, 2009

Which Wins, 401K Match or High Interest CC Debt?

Friday, October 30th, 2009

Dave Ramsey advises people to not contribute to retirement accounts while repaying credit card debt.  This advise seems sound because credit cards charge high interest rates and your investments may not make 10 or 20%.  But is this idea still correct when there is a company match, after all an immediate 50% or 100% return is pretty hard to pass up?

Your Choices

To simplify a bit I want to look at two choices: You could put $1000 dollars in 401K with a 50% match or you could take the $1000 pay 25% in taxes and put the remaining $750 toward your credit card.  After your credit card is paid off you take the monthly payment and contribute that much to your 401K and getting the employer match and a tax deduction.  Because of the tax break you can afford to contribute 25% more without lowering your income.  After five years which option earns you more?

And the Winner is…

It depends on the interest rates, but here is a graph that simplifies a lot of complex math:

It turns out that the expected interest rate on the credit card has to be a few percent higher than the expected interest rate from the 401K.    I tabulate the numbers below, an example if you expect to get a 6% return on your 401K investment then you should pay off a credit card that is 8.72% or higher.

Interest 401K Interest Card
1.00% 3.59%
2.00% 4.62%
3.00% 5.64%
4.00% 6.67%
5.00% 7.69%
6.00% 8.72%
7.00% 9.74%
8.00% 10.77%
9.00% 11.80%
10.00% 12.82%

What about 100% Match or 0% Match?

The results are the same- I was actually a bit surprised but the match % cancels out of the calculations.  The above chart does not depend on how much your employer matches- or if they match at all!

The Math

For anyone interested, I can send you a spread sheet with the calculations.  It’s a bit of a mess because the solution can’t be solved algebraically.  You make an initial guess and do repeated iterations that get an ever improving result.

Is Your Future Self Getting Sweat Shop Wages?

Wednesday, October 28th, 2009

You Pay Yourself How Little?

A different way to think of your investments is that it is the salary you give your future self. Consider the following example: Joe makes $50,000/year and invests 10% of his income a ($5,000/year).  There are about 2000 hours in a year of work so that means only about $2.5/hr goes to the future Joe.  That’s about one third of the minimum wage!

Give Your Future Self a Raise

If you find that your future self is working for sweat shop wages consider the following:  If you could cut back some expenses and invest the savings it’s like working a lot more… For example cutting $50/month on cable would be like working an extra twenty hours for your future self.If you are the type of person that always spends any available cash try boosting your investment rate by one percent and see if you really notice, because your future self really will!  If Joe invests another 1% ($41.67/month) his future just got a 10% raise! You will be your future self soon enough, so be kind and give yourself a raise today!

One Stock I Will Probably Never Sell

Monday, October 26th, 2009

Buying a stock on a hot tip is exciting, but it can be very expensive excitement don’t make the same kind of mistake I did…

Turning Back the Clock

In 2000 I sadly followed a hot tip and bought 15 shares of Sycamore Systems for about $1000. Pure speculation and not very wise on my part I was caught up in the irrational exuberance of the Internet bubble. It was pretty exciting, especially when the stock more than doubled!

What goes up…

The internet bubble popped sending stock prices through the floor. As it plunged I could have at least my original investment back… but I hung on, and on, and on… Hindsight is 20/20, so I know I should have sold, but who knew at the time that it really was the end of the bubble? Today, it’s a stock I’m likely to never sell. Don’t misunderstand, it isn’t that that it’s a wonderful investment. It’s that it is worth so little now (~$42.30) that it is worth more as a reminder to NEVER again buy a stock on a hot tip!

A Saner Alternative

What if instead I had bought $1000 of the S&P 500? Today it wold still be worth $760. Yes, that seems like a pretty big loss but when you include nine years of dividends I would actually be pretty close to break even… That’s even after buying at a truly terrible time to buy stocks!

Don’t Try This at Home

Being older and wiser, I’m not planning on repeating this folly. I’ve realized that I don’t need to get 100% yearly returns to reach my goals.   Slow and steady is far more likely to get me there- even if it is boring!  Please take my advise- forget the hot stock tips, buy low cost index funds and reap the rewards of owning a piece of capitalism.  The alternative is that you have your own $1000 reminder.

You Need Half a Million Dollars to Pick Individual Stocks!

Friday, October 23rd, 2009

Even if you are the next Warren Buffett unless you have about half a million dollars you are still better off investing in index funds.  How could it be that the worlds greatest investor should still buy index funds?  Picking an index takes almost no effort and thus virtually no time, while finding superior stocks is a LOT of work!

Just Supporting Yourself is Costly

Let’s pretend that you are just as good as Warren at picking stocks.  But don’t fool yourself it will be a full time job for you- he didn’t become a billionaire by lounging around!  Since finding superior stocks will take all your time it must provide all of your income.  According to Berkshire Hathaway’s 2008 annual letter to the stock holders, their average compound annual gains are 20.3% which beat the S&P500 index by an impressive 11.4%.  If you can’t pay your salary from that 11.4% premium you would be better off with some other job and investing in a S&P500 index fund.   How much money do you need to invest to make it worthwhile?   Let’s just assume you are so good that you can do everything all on your own- no research staff, no special software, no special databases, just your time.  If your salary is $57,000/year, then you need $500,000 to invest to pay yourself and still match the returns of the S&P500!   Of course if you are that good at picking stocks you then go work for a mutual fund company earn a lot more than $57,000/year and invest in your own fund!

What About Dumb Luck?

I’m sure that someone reading this post will say- I didn’t need any work I picked stock XYZ and make an outrageous amount… That’s called luck, I’m happy for you but do you really think you are going to be lucky each and every year for thirty years?  If you really are that lucky forget the stock market- go to Vegas and win your fortune in a weekend it will be a lot more fun!

Reality Check

In reality we are almost certainly far less skilled than Warren Buffett, we don’t have millions to invest, we aren’t incredibly lucky, and we have far less resources than a mutual fund manager and the majority of actively managed mutual funds fail to beat the market.    Doe you still think it makes sense to try picking individual stocks?

Lessons of Compound Interest:Interest Rates Matter!

Wednesday, October 21st, 2009

 A seemingly small change in interest rates makes a  huge difference in the long term returns of your investments.  To get the most from compound interest you need to pay close attention to the rates of return of your investments.  There are so many possible ways to increase returns that I only want to touch on the major factors here.

Reasonable Risk

If you speculate wildly or stuff your money in a mattress you are likely to end up with far less than taking calculated risks.

Safety in Numbers

Buying individual stocks is always riskier than buying a group of stocks. What are the chances that a single company will fail and lose all of it’s value? Now consider what are the chances that a group of 500 companies will?  The down side is that a single company may grow by leaps and bounds while the average of 500 aren’t nearly as likely.  If you bet all your retirement savings on the fortunes of one company you may end up very rich… you may also end up eating cat food during retirement.  I think most people are better served accepting the average market return rather than gambling on a single company.   Mutual funds offer a way to buy large collections of companies, without the trouble and expenses of hundreds of transactions.

Thinking Long Term

The last few years have been pretty brutal for the stock market, but that is over a short term.   If you look at longer terms say- 20 years or more diverse collections of stocks have done very well. Take a look at this table at All Financial Matters, showing the returns from the S&P500, a group of stocks of the 500 largest companies traded in the US.  Note many of the 20 year periods the returns from the S&P500 have had average compound returns of 10% or more. Even considering the terrible performance of stocks in 2008, over the last 20 years the SP&P500 still had a 8.41% average growth rate. The future is never certain, but I don’t believe the economy is in a death spiral and will never recover.  I think it makes some sense to invest in both stocks and bonds.

Don’t be Taxed by Taxes

Is there anything worse than making sacrifices to invest then giving a large portion of the return to the tax man? If you don’t consider the impact of taxes on your investments you could lose a quarter or more of your yearly returns! Fortunately there are strategies that will help you minimize your taxes.

Tax Shelters

The US government wants you to invest for both your retirement and for your kid’s college expenses.   It have created special accounts for these purposes that give you tax breaks as an incentive.    The gotcha is that they also impose fees if you use the money for other purposes!  You probably have heard of at least some of these accounts- 401K, Roth IRA, 529 Plan, 403B, or SEP.  The exact rules differ from account to account but the purpose of all of them is to avoid or at least delay paying taxes.

Tax Efficiency

Not all investments are taxed equally, for example the gains on corporate bonds are taxed at the higher ordinary income rate while the gains of stocks are taxed at lower capital gains rates.  If you can’t put all of your investments into a tax sheltered account, then you want to put the tax inefficient investments in the tax sheltered account and the tax efficient investments outside of the tax sheltered account.  You may even choose an investment that has lower pre-tax return such as a municipal bond in order to get a better after tax return.

Cut Investment Costs to the Bone

Would you be willing to examine your mutual fund fees for a quarter of a million dollars?  Could it make that big a difference?    Say you invest $5000 per year in a mutual fund that returns 8% over 40 years with a 1% fee, how much would you have?  Over a million dollars ($1,093,898)- compound interest is a wonderful thing! However, if you could invest in a different mutual fund that returns 8% over 40 years but has a 0.25% fee then your total grows by 23% to $1,351,458.93. That’s a $257,560 increase for a 0.75% lower fee! Every penny paid in fees or transaction costs is money that isn’t going to grow for you.  In many area of life you get what you pay for, but in investing you get what you don’t pay for!

Buying vs Being Sold

Friday, October 16th, 2009

I always find that I get much better deals when I first decide what I want to buy then hunt for a price rather than letting someone else sells me something, but would you believe it could be a 90% difference?About either years ago two Kirby Vacuum cleaner salesmen came and demonstrated their g-six vacuum.   I have to give them credit as they showed off their product very well- or I wouldn’t remember this story!   It was an impressive cleaning machine – it picked up the Carpet Fresh that our vacuum had left over a year of weekly vacuuming!  I was convinced that it was a nice vacuum- but the price was just too high.  They starting at $1000 and the best I could haggle down to was $800.  In the end we didn’t buy it.  I also remember being very happy we didn’t as finances were a bit tight in the next few months and would have been a lot harder with $800 less.  I actually feel a bit guilty though…  The salesmen went to the extreme of eating some of the carpet shampoo to demonstrate that it was non toxic.  I really feel someone willing to eat carpet foam should get some compensation!This summer I was looking to replace our old vacuum and I remembered their demo.  I did my own search and found an even newer model Kirby selling for $150 on craigslist.   I asked if the buyer would take $100- it never hurts to ask for a discount and I noticed it had been posted for over a month.  She agreed, so I showed up with $100 cash and picked it up that day.   She told me that she was willing to accept only $100 because several people already expressed interest then never show up to finalize the deal.In the end I discovered a few things I didn’t like about the vacuum; it weighs a ton and is too big to get under some furniture but for $100 I’m satisfied with my purchase.  The next time someone is trying to sell you something- think about how much you could get selling it in a few years.  If you do still decide to buy ask for a discount- the worst they can do is say no!

Lessons of Compound Interest: Time is money

Wednesday, October 14th, 2009

Time is a required ingredient to put compound interest to work for you.   Here is how you can maximize the time for your investments to grow:

Invest now

You need decades for compounding to really kick in.  Sadly, none of us are getting any younger so we better invest as much as we can today!  Say Bob starts working at 22 and invests $6000 each year.  If he earns 8% compounded quarterly until he is 65, his final total is $2,229,668.  If he starts investing just five years later his total drops by more than $750,000 to $1,475,485. Time really is money, with compound interest each $1 you invest today will be worth a lot more than if you waited even a few years to start.   So, consider what expenses could you reduce today for a better tomorrow?

Don’t cash out

If you cash out your retirement savings, you sacrifice a small fortune in future growth.    After 3 years of contributing $6000 each year to a retirement account Bob’s investments are worth $20,520.  If Bob cashes out to buy a car, how much will that cost him in retirement?  Would you believe almost half a million dollars!   That’s a pretty expensive car isn’t it!  Investing for just three years less with 8% return totals $1,741,897 which is $487,771 less.

Keep Investing!

Even if you didn’t start early enough, or you made the mistake of cashing out you could catch up by investing longer.  Bob could try work for another three years and retire at 68 to pay off that half a million dollar car!  I wouldn’t want to count on this option for retirement as health problems could make it impossible.  However, delaying collage a year or two isn’t the end of the world.  Even a few more years could make a big difference in your final investment total.

Delay Withdrawing

If you can’t invest more, your investments can continue growing as long as you don’t withdraw too much.   In fact when you are nearing retirement the growth on you investments should be much larger than your contributions!  If Bob’s health isn’t too good and he has to retire at 65 his investment is growing by almost $150,000 a year.   Adding an extra $6,000 won’t have much of an effect at this point.  If Bob can live very frugally and work part time for three years without contributing anything his total is $2,209,147.

You Need to Understand Compound Interest

Monday, October 12th, 2009

Why should you care?

If you want to be wealthy or even just retire in comfort then you need to understand compound interest.   There are three factors that determine your results -the amount of time you invest, interest rate you earn, and compounding frequency.  To make the right investment choices you should know the effects of each of these factors.  Of them all time is the most important factor.  After a year compound interest amounts to pocket change but after forty years it can amount to a fortune!  The interest rate is also critical, a one percent difference in the interest rate will make a big difference in your final totals.  Finally, there is the frequency of compounding- the quicker the better but there isn’t much difference compounding faster than monthly.

What is it?

Compound Interest is earning interest both the amount of money you invested and the interest you have already earned.   I am going to look at compound interest graphically- if you want to read about the mathematical details I recommend reading this detailed description from Dr Math.

Time (with compound interest) is money!

Time is the biggest factor with compound interest, take a look at this graph of $1000 earning a 10% return with no compounding vs compounding monthly over 20 years:years:

  • Time is a huge factor
    • After two years only $20 more
    • After twenty years it is $4328 more!
    • After thirty years the difference is $16,837

The start investing as soon as you can.  Compound interest will only help you if you invest long enough to make a difference!

Interest Rates Matter!

As you can see compounding is a good thing, and pretty dramatic with a 10% interest rate.  Suppose, you get a lower interest rate for twenty years,  how does that affect your the returns?:

  • 1% is a big difference!
    • 10% -> 9% is more than the original investment ($1318)
    • 10% -> 8% is more than 2X the original investment ($2401)
    • 10% -> 7% is more than 3X the original investment ($3289)

Compounding Frequency the Least Significant Factor

The final factor is how frequently the earned interest starts earning interest.  Let’s look at the example of 20 years with a 10 % interest rate again, but compound it with different frequencies:

  • More frequent is always better but the effect diminishes rapidly
  • Never to yearly is a big difference
    • More than 3X original investment($3,727)
  • Yearly to quarterly is much smaller but significant difference
    • Not quite half the original investment ($482)
  •  Quarterly to Monthly even smaller
    • About a tenth of the original investment ($118.5)
    • This is at about 99% of compounding instantly
  • Monthly to Weekly still smaller increase
    • May buy you a dinner ($46)

I hope you found that you learned something,  I plan to follow up with a post onpractical investment lessons soon.   Unclear about something, Liked it, hated it?   Leave a comment, just be thoughtful.