Smartest Money Book You'll Ever Read
Dire situation with personal wealth of the U.S. population
Less than 3% of U.S. population has $1.5 million or more in assets and is free of debt (with equity in their house)
Half of Americans can't come up with $2,000 in 30 days
The book says that if you have a "good starting base of assets, I can show you how to become wealthy"
For most people the lack of planning and budgeting is precisely the problem (it's boring, a hassle, and time-consuming)
What can be done on the Internet
Planning and budgeting can be done online
Lets you find, compare, get the best deals available on financial services you are already using
Get to financial independence by harness the power of the Internet with
Solid goal setting
Financial planning
Budgeting
Saving
Investing
Financial independence is
Not working (unless you desire to)
Be able to live on interest
Dividends
Reasonable withdrawals of capital
Key things you'll be doing with this book (all can be done with pencil, paper, calculator, and phone)
Setting financial goals
Developing approach to risk
Allocating your investments
Deciding where to spend your money
Mint.com - free online financial planning site
6 million people signed up
Budgeting
Planning
Tracking
Shopping tools
You will only build wealth by "investing in a portfolio of solid, diversified stock and bond index funds"
Don't give responsibility to financial planner who doesn't have your interest at heart
There are some, but few and far between
Some goals by the author
Rebuild from devastating several years (the great recession)
How to free up money to invest to achieve financial independence
Access tools at mint.com (tracking, budgeting, investing, shopping for financial services)
How to avoid being a victim of financial services
Find out why financial planning is an absolute necessity
Decide on the future you want to live in
Make decisions
Translate into goals
Create a plan to move forward
Lenders don't ask about net worth because they don't want you to think about that, because borrowing reduces it
Lenders only ask you how much you make, so you can pay off the debt plus interest
Net worth is the number you want to maximize
Net worth is your assets (your money and property) minus your liabilities (debts)
Net worth = Assets - Liabilities
How U.S. Census Bureau looks at net worth (same formula)
Borrowing always reduces net worth
Typical balance sheet shows
Assets
Liabilities
Net worth
Certain date in time
Assets
All bank accounts
CDs
Stocks and bonds
Money market funds
Mutual funds
Savings bonds
Treasury securities
IRAs
401(k)s
Any other retirement accounts
Property (house, cars, any valuables) at current market value (no appraisals needed)
Liabilities
Your debts (use total amounts from most recent statements)
Three main things should be clearer
Debt is enemy of your wealth
No matter how many millions you have in assets, if you have more millions in liabilities, you have no wealth
There are non-cash assets and liquid assets
Many non-cash assets cost money to own and maintain (operate and insure)
Your home may or may not be a great investment
If you paid off your mortgage, and can sell it for good value, and property taxes are reasonable, it may be a great investment. If not, it's a drag on your finances
The sample in the book shows a family on a heavily mortgaged home
Your focus should be on increasing your net worth
Long term goals energize your efforts
You must picture a scenario of your wealth in the future and set long term goal
Goals help you minimize the debt you have to take on when the goals are to purchase something
Target certain amounts by certain dates for specific purposes, this helps you measure progress
You must set short- and long-term goals
Long term goals through investments will give you a higher appreciation
Short term goals will help with expenses you will have in the meantime (and you won't incur penalties taking money out of long-term investments if you need it)
Always get out and stay out of debt (some exceptions exist, but consider them carefully - Parth Three of this book)
Don't put off longer-term goal setting
Short-term goals as those you can achieve in less than 5 years
Long-term goals as those you can achieve in more than 5 years
Write down any goals. Examples:
Retiring in 20 years instead of 30
Home in a certain community
Spending a year in a foreign country, etc.
Being independently wealthy
What's the Point?
Key is to have motivating goals
Don't put off longer-term goals
Setting specific, actionable, motivating goals will turbocharge your wealth-building efforts
In 2009 a record of 1 in 8 Americans was receiving food stamps
Home foreclosures set new highs in 2010 - 1.6 million homes in the first half of that year
Economic landscape had a major shift if food and shelter become problems for millions of Americans
Middle-class life isn't what it used to be
Middle-class knew where they had roof over their heads and where their next meal was coming from; all this has changed
Increasingly complex problems across all industries (real estate, healthcare, retail, etc), or in Washington or on Wall Street
No straight-talk from policy makers about ways to solve problems and reverse decline of middle class
Average baby boomer (46 - 65) has under $100,000 saved for retirement
1990's and 2000's saw people overspend and incur debts they couldn't repay, and took risks they couldn't handle
The first rule of money management is knowing yourself
Decide on the future you want to live in
Make decisions
Translate into goals
Create a plan to move forward
Lenders don't ask about net worth because they don't want you to think about that, because borrowing reduces it
Lenders only ask you how much you make, so you can pay off the debt plus interest
Net worth is the number you want to maximize
Net worth is your assets (your money and property) minus your liabilities (debts)
Net worth = Assets - Liabilities
How U.S. Census Bureau looks at net worth (same formula)
Borrowing always reduces net worth
Typical balance sheet shows
Assets
Liabilities
Net worth
Certain date in time
Assets
All bank accounts
CDs
Stocks and bonds
Money market funds
Mutual funds
Savings bonds
Treasury securities
IRAs
401(k)s
Any other retirement accounts
Property (house, cars, any valuables) at current market value (no appraisals needed)
Liabilities
Your debts (use total amounts from most recent statements)
A budget is just a way to make conscious decisions instead of unconscious decisions
With budgets you make better decisions
You're on a budget whether you know it or not
Thinking you aren't on a budget leads to overspending on things you can't afford
Budgeting
How to allocate monthly income towards expenses
What the expenses will be
How much you save each month
Budgeting starts with getting information on
Income
Spending
Getting the info on income and spending comes from
Savings and checking deposits
Withdrawals
Checkbook
Credit card statements
Cash receipts (if you save them...)
Strive to identify 95% of expenses
Major expenses
Recurrent minor ones
Many people waste 20 - 30% of their money without knowing where it goes
This happens when you have automatically deducted payments for things without checking for inctreases or the totaling amounts
You have to monitor these automatic payments and shop for better deals
Un-tracked cash or credit card purchases - online shopping, daily lattes, etc
A sample budget
List your monthly income and expenses to know where money comes from and where it goes
Identify areas where to reduce spending
Areas where you should allocate more money
Savings
Maybe insurance, maybe auto maintenance (this is if you're spending too much on useless things, but would benefit from more reliable car -- very basic approach at that level)
Do an analysis on pre-tax and post-tax basis
If you are debt-free or close to it, dedicate debt payments to savings or better uses
"Mystery cash" is an expense 1% of income that is impossible to track
Try to save at first 7% - 10% of your gross (pre-tax), then go up to 20%
Build a budget
Get income and spending records for last 6 or preferably 12 months
Divide any expenses by 12 to get monthly average for a particular category
Create my own expense categories for budgeting
Idea is to see where money is going and how you're stacking up against the ideal allocations
Reallocate or reduce your expenses per the ideal scenarios
This is the planning part of budgeting
It may take weeks or even a year or two to reach an ideal situation, but it's extremely imperative to arrive at ideal expenditure percentages
No matter how long it takes, it's worth to get finances under control to save and invest for the future
It increases your net worth
Putting money away is the best way to "dollar cost average" and save for retirement
Any bank can set up automatic savings plans
Surest way to save money is from checking to savings on specific days of the month
"Paying yourself first" means using an automatic savings that keeps money out of your hands, off the top of your income (just like IRS takes taxes)
To meet goals set in Part One of this book
Set up an interest-bearing account
Designate another account for periodic expenses (car repairs, replacement of appliances, dental care)
Set up a 5% automatic income savings to an interest bearing account
Keep shopping for better interest savings accounts, direct your % of savings to that account right away whenever changed
Do not lock up money for long term
Money market accounts pay competitive rates without long term lock up
At first the amounts you earn seem small, but they add up
Develop a habit of how hard the money is working (or isn't) for you
Keep checking and savings in separate banks
Discourages you from dipping into savings
Allows you for mobility to divert savings into a separate bank that pays better interest rates
Avoid banks that charge fees and fees for bank transfers
Automatic savings plans can help you achieve your goals
60 - 80% of your daily calories are burned up by doing nothing
10 - 30% of your daily calories are burned by digestion alone
10 - 15% of your daily calories are burned by exercise
The 60 - 80% daily calories are attributed to the metabolism
In comparison, most of the money goes out the door on autopilot (mortgage, phone, insurance...)
Emergency expenses and untracked out-of-pocket spending accounts for everything else
The goal is to burn fewer dollars
Trade your car for one that burns fewer dollars (insurance, repairs, etc)
This has nothing with losing fat, but with "burning fewer calories by itself"
Subject your mortgage payments to scrutiny (how can I lower it without it costing more in the end?)
Eating out and socializing at bars are expensive bad habits, only for special occasions
Constantly ask yourself how to free up more money for savings and retirement?
Firmly commit to your goals and to changing your behavior to meet them
Pick a cost-cutting method that you'll actually use
There's a "financial siege" mentality when you're in crushing debt
People and companies go bankrupt because they don't adjust quickly to major financial setbacks or mistakes
Eliminate every nonessential expense
Move to a cheaper area if an option
If you're in good financial shape, focus on areas where to free up money
Crawling malls
Frequent stops at cafes or bars
Online shopping
Some favorite indulgence, whatever it may be
Expensive vacations
Two main buckets of expenses
Monthly expenses
Out-of-pocket spending, including unconscious spending
Pay in cash if it doesn't cost you (ATM fees), otherwise use no-transaction-fee credit or debit cards for all purchases
Keep your goals in mind at all times
Change your thinking and spending to save systematically
The feeling of moving toward financial freedom is more than worth the effort
Debt in all forms undermines financial future
Debt interest can exponentially increase the price of a purchase
Very, very few wise uses of debt
"A man in debt is so far a slave", Ralph Waldo Emerson
The 2000s boom was fueled largely by debt
People's borrowings have outpaced their income for a very long time
Just because it's easy to borrow it doesn't mean you should
Every time you borrow
You erode your financial future
You immediately reduce your net worth, except when you use the loan to buy something of equal or greater value
The term of the loan must mean that its cost has to match or be lower than the item being financed
Long-term loans, short-term loans
Long-term: for long-term assets, like productive-equipment
Short-term: for short-term assets, like inventories, etc
Student loans?
Theoretically good in the long-term loan, education stays for life as it increases your earnings
But only if it does increase your earnings, and you must make sure of that and the faster you pay it off the better
In the end student loans must be paid off fast
Shop for the best rate. The rate is the effective annual rate on the student loan
Always calculate
Cost of what you are purchasing
The amount you are borrowing
Total amount you will have to repay including interest (eye opener!)
Any fees are part of the total cost of borrowing
Add fees to any loans you are comparing to get the total cost; be aware of application origination fees, prepayment penalties, and late payment fees. Late payment fees are terrible on credit cards
If you've a good credit history you can negotiate better rates and terms and waive fees
Ask other lenders to beat the terms
Service reps and / or their supervisors can get you better deals, but you have to ask
Best way to manage debt is to avoid or eliminate it
Use credit card only when balances are paid in full each month and there is an interest-free "grace period" on purchases
No cash advances on credit cards, ever. If you have no money, the more in debt you will be with money from advances on credit cards, and what's worse is that balance will increase exponentially
Never co-sign a loan unless you can afford and want to make payments yourself (make always safe assumption your co-signer may default)
Don't do "margin trading", which is exactly gambling
People who "flip houses", play with stock options or commodities trading (after reading a book) always lose money, and if they borrowed they end up in very bad financial trouble
Make estimated federal and state income tax payments on time if you're self-employed
(I assume) that exact taxes due may come at a time you may not have the money, so it's better to make estimate payments when they'll soon be due, while you do have the money. If you don't pay when taxes are due, IRS charges higher interest rates than consumer loans. So it's better to borrow to pay earlier estimate payments than getting charged by IRS.
It's imperative to track you balances every month if you're in debt
Minimum monthly payments are designed to keep you in debit for years. If you know how entire cost you will make every effort to pay sooner
No debt is recommended strongly, except for mortgage, which should be pre-paid as much as can be afforded
Commit to debt repayment and do it quickly
"Debt is the worst poverty." - Thomas Fuller
Avoiding debt is avoiding poverty it can generate
To build wealth, you must get out of debt
Most people see credit important to their lives, but have no idea how it undermines their future
Create motivation to get out of debt
Find out the total cost
Develop a plan
To begin creating the plan to get out of debt
Have a budget prepared
Have net worth figured out
Know how much your debt reduced your net worth
Steps to freedom from debt
Step 1
Stop buying whatever you want when you want it
Re-commit to activities in Part One of the book - the budget, and finding exactly how much debt reduces your net worth
Realize debt breeds poverty
Step 2
If you already have debt, get rid of all credit cards except one (even if balances remain, cut them up)
If car is a problem (or car loan) then sell your car, get a cheaper one
Mortgage is the only acceptable debt
Step 3
Sum up the loan and card balances and monthly payments
Learn how much payment is going to interest and principal
Identify what costs the most in interest
Step 4
Put as much credit card debt as possible on the lowest-cost credit card that you can find, if possible, and move the balances to that card. Then pay it off before the higher interest rate kicks in (minimize the number of times you do this as it affects your credit rating)
Step 5
Use money budgeted for saving in Part Two to pay more than minimum on highest cost loans (or credit) until it's paid off
Do this until you have paid off all your borrowings
Some other alternatives to consider
You may also consider tapping low-cost sources of funds - if you own your home an equity loan could be the answer if it has a lower interest over the life of the loan. You can deduct the interest from your income for tax purposes. Even if it takes long time, it may be the answer if you're at lower interest rate and not taking on any new debt
Last ditch effort may be borrowing against your 401k or IRA at a low rate. Don't withdraw money from tax-advantaged accounts to pay off debt
Stronger action to fight off debt is described in chapter 11
Once debt free, you can save and invest
You'll see asset side grow and liabilities shrink (bigger net worth)
Feeling of freedom may be more addictive than shopping!
When hopelessly in debt, your only option may be to declare bankruptcy
Declaring bankruptcy affects your credit history significantly, it may take 2 - 3 years to rebuild it
If bankruptcy is the only option, then steps have to be taken very quickly
Keeps you from incurring more debt
Helps you recover sooner
You find dealing with credit counselor easier than creditors, but you have to be professional either way
You must have your records and budget in order first (previous chapters of this book)
You must know the terms of your mortgage and loans and credit cards, and what you have paid already
Decide
Restructure the debt (lower interest, longer term) and hopefully eliminating fees
Settle for smaller sum, if possible
Lender submits info to IRS on the amount forgiven and you pay the taxes
Not sure if 2nd option is better at this point, it may be a lot harder on your credit rating
Deal with people who can participate in actual remediation
Try to build relationship with them, be businesslike, meet in person if possible
Visit http://www.nfcc.org, you may involve a credit counselor in the negotiations, and find someone reputable near your location
Watch out, there are many wrong people to deal with who portray themselves as credit counselors
Use credit counselor if you find financial matters confusing or it's hard to negotiate with creditors
Good counselors will help you understand your situation and deal with creditors
Credit counselors are interested in getting troubled borrowers into debt management plans, so be wary of that as well
Debt management plans
You make monthly payments to credit counseling agency (which pays to your creditors)
Through i.e. NFCC agency all your payments go to your creditors (other agencies may charge something in addition to helping you negotiate with creditors)
Debt management plan is worked out by the credit counseling agency
They can negotiate a better deal for you with the creditors, and help you reestablish your credit afterwards
Counseling agencies don't show up on your credit report
A settlement with creditors or going into debt management plan will be disclosed to credit rating agency, and payments will be reported as current
Takes 3 - 5 years to become debt free under debt management plan, and credit can be rebuilt quite quickly after that
Declaring bankruptcy
Don't consider this unless you get credit and legal advice
Get a lawyer that specializes in bankruptcy matters
It's a court-supervised way to get debt wiped out because of inability to pay
Any legislation that exists at this point favors creditors
Bankruptcy is not a fresh start (as it once was)
Some credit card debt and most student debt is not discharged with new law
You must do credit counseling before declaring bankruptcy
Consult a competent nonprofit credit counselor before consulting attorney
Number of people declaring bankruptcy has been rising since the new law in 2005 (5 million consumers between 2006 - 2010)
If you have high debt address the problem now
You need good credit for
Potential employers
Business partners
Landlords
A credit report shows your information
Date accounts opened and dates closed
Balances
Payment history on mortgages, credit cards, auto, student and any other loans
Late payments
Parties inquiring in your credit
Other items such as foreclosure, suits, judgements (satisfied or not), liens, bankruptcies, accounts referred to collection agencies
Not reported to credit rating agencies
Checking accounts
Savings accounts
Late credit card payments affect your score
Credit ratings agencies use FICO score, 300 - 850
Over 750 is generally considered good
It considers payment records
Loan balances
Number of accounts
Age of accounts
Collection amounts
Bankruptcies, and other factors
650 is sometimes considered the dividing line between prime and sub-prime
Lenders use credit because it helps predict loan losses
Realize there's no way to game the system
Credit data is supplied and gathered by credit agencies in computerized, reliable ways
Credit scores are calculated on that data
Stay current on bills
Use debt reduction program if necessary
Pay more than minimum on costliest debt
Never let an account go past due, unless you must, but then get current as soon as possible
Be diligent and consistent, it takes 2 - 3 years to rebuild credit
Take only credit you need, don't take multiple loans or cards. This can hurt your credit score as you increase your lender's exposure and lower your score, and lower your average account age
Older account age is better for your score
Looking for loan rates, shop within 30 days before you accept mortgage, loan or credit card. Each lender you approach registers a credit inquiry
Don't make your situation worse, if you need credit counseling then get it
Don't move balances around credit cards (when in debt reduction program), this lowers your credit score
The goal of debt management program is to lower debt, not move balances around
Paying loans off or closing cards doesn't remove it from credit history
Lenders view you better having handled loans responsibly rather than not having had credit at all
Part Four intro
Home is largest purchase and most important investment you'll make
Buying a home is not the sure thing many people thought it was
Even in good times buying a home creates ongoing expenses, a mortgage that can double the purchase price
As investment a house creates risk, no diversification, and returns well below of other investments
2000s left lessons and opportunities to make better decisions
You don't need to own your home to become wealthy
You must answer these questions
What role do you see your home playing in your investment plans?
Should you buy your home or rent?
Housing will be your largest living expense, so these questions are very significant
Last few decades home appreciation is good, except since the 2008 housing bust
It's difficult to compare home ownership to other investments
You can't live in S&P 500
Paying down principal creates equity in the house
Tax deduction of mortgage interest subsidizes home-ownership, only if you itemize these as deduction
If congress changed the rules for tax deduction then values of houses would decline
Even without the housing bust, the long-term returns on housing generally fall well below returns on stocks (this is without rental income)
There are carrying costs with homeownership
Mortgage interest
Property taxes
Insurance
Maintenance
When you sell a house you face substantial costs, and you can't sell part of your house
You can sell part of your investments whenever you want to, with small costs
Between 2001 and 2006 home prices rose by 12.4% while S&P 500 rose 4.3%, both annually
But over longer term stocks win easily
Between 1978 and 2004 housing appreciated 8.6% and S&P rose by 13.4% (longer term)
Owning a home is great but as investment it's overrated when compared to broadly diversified periodically balanced portfolio of high-quality, low management fee stock and bond index funds
Selling your house later for a big gain is a gamble as an investment strategy
76% say renting is better than buying a home in 2010, up from 71% in 2008
78% of the 76% were home owners
Decision to buy vs. rent has to be thought about carefully
Price to Rent Ratio
Simple analysis can help decide
Price of a home to the annual rent of an equivalent home
Not precise but overall good indicator
i.e. home price $765,000 / 36,000 = 21.25
National average was 16 for most of the past century
The higher the ratio the more it makes sense to rent
When ratio drops below 20 then buying makes more sense
Around ratio 20 you should at least consider renting, especially if you'll move
Costs of owning versus renting
Down payment
Mortgage interest *
Insurance
Maintenance *
Fees
Taxes *
Renter incurs none of the above costs
Fails to match the returns on a balanced portfolio of low-cost stock and bond index funds
Benefits of ownership
Price appreciation
If any - rental income
Personal benefits
Customize your yard
Pride of ownership
Customizing your house interior is expensive so it's an intangible benefit (outside the scope of any financial consideration, book, etc)
What can you afford?
Instead of 20 - 25% of yearly income, many people allocate 30 - 35% to housing
Your income is what counts
With fixed income your housing costs should diminish as percentage of your income, but future earnings and even employment can be uncertain
There are numbers to crunch before you buy or rent your home
* - Very high amounts over the life of a house (hundreds of thousands)
Housing has become generally more speculative in most places
The new bubble and burst cycle is new
Foreclosures: fraught with pitfalls
You must have cash on hand available right away
You must have financing lined up beforehand
Better to do short-sales
Short sales: proceed with caution
Happens when owner sells for house less than his outstanding mortgage
If you're the buyer you have to make sure the bank will relinquish the outstanding debt, and allow the sale to occur
That's why it's called a "short sale"
Watch out
You must have enough cash or large down payment - usually 50% - for short sales or foreclosures
Must work with a professional who have experience in foreclosures and short sales
Neither is a traditional closing
Before you make offer on any condo, make sure reserves and association is strong
When people walk away from outstanding debt, the remaining owners often share increased responsibility for maintenance, taxes, and other costs
Read all financial information about a property or condo association (or co-op), and if something isn't clear walk away
There is lots of support for the view that most Americans are underinsured
LIMRA says US households more than ever before need more life insurance, including one-third of households with $100,000 or more in income
1 in 4 households rely on group life insurance (through employer)
70% of households with children under 18 would be in trouble if primary breadwinner died
The main questions to get insurance
Do you need life insurance?
How much do you need?
How long do you need it?
Two types of insurance policies
Cash value insurance (has investment component to it)
Term insurance (only for specific period of time)
Two approaches
Income-replacement approach
How many X your income? The X will cover that many years of your yearly income
Some calculations include inflation, add up your after-tax earnings over your remaining working years, and discount results to current value
Not very individualized approach, generally produces higher estimate than needs-based approach
Needs-based approach
Measure impact of your death on dependents, and what you want to do for them
Is there a mortgage to pay off?
For how long spouse would return to work, or how much longer would the spouse work?
Would day care be affordable?
Would you want to fund your children's college tuition?
How much money do survivors need if you die?
Would they use it as intended?
If not, set up a trust as recommended elsewhere in the book
If death benefit is to be invested, perhaps this will lower the coverage that needs to be bought
Needs based approach is recommended over income-replacement approach, as it more accurately (and sometimes in big difference) approximates the needed coverage
Which one to buy?
Most likely cash value life insurance with needs-based approach
Consider term insurance only if you need the most affordable coverage in the near term, or over the long term you know that you will invest the difference (the amount between term and cash value life)
Other considerations
Group insurance from employers may be cheaper, worth the time comparing to individual plans
See if alumni associations or AARP offer better life insurance premiums
Check out Savings Bank life insurance (SBLI, http://www.sbli.com)
Many reasons exist for cash value policies
More than 90% of term policies never pay death benefit (requirements are that you've to continue paying premiums after death and it's not affordable anymore)
Hard to understand, and so salespeople take advantage of this to get high sales commissions
Two types
Whole life insurance
Universal life insurance
They are similar
Higher than term life insurance with same death benefit
Portion of the higher premium invested so the policy accrues cash value
High percentage of first year's premium (50%) goes to salespeople as commission
Great incentive for salespeople to sell cash value policies
Whole life
You pay premium for a set period of time, often for life
No control over investment component
When you die your beneficiaries get the death benefit value in the policy at the time of your death, not the cash value of the policy
If dividends are used to increase the cash value over the years, they can later pay the future premiums
You pay more for whole life insurance than universal because it guarantees the death benefit, a level premium, and a guaranteed growth rate in cash value
Pay your premiums and the policy will remain in force for life
Universal life
Premium payments are more flexible because you only for the cost of the life insurance policy and then contribute as much as you like to the investment component
No control over investment component unless you've a variable policy where you can select options offered by the insurer
You can have premiums paid out of your policy if you've enough balance
Consult a fee-only adviser if you if you're considering an annual premium of $2,500 or more for cash value policy
Fee-only advisers are paid flat fee for their advice and don't benefit fro any decision you make about life insurance
Fee-only advisers can be objective
Approach cash value policies cautiously
Things that may trip you when buying life insurance
The options for cash value policies are mind-boggling
Whole life
graded-premium
interest-sensitive
modified-premium
participating
variable
single-premium whole life
Universal life
no-lapse
indexed
variable
Without fee-based adviser you must depend on salespeople who have conflict of interest to explain which is best for you
Unequal treatment of policyholders
Get life insurance from mutual fund companies versus stock companies, because stock companies have both shareholders and policyholders, while mutual companies only have policyholders (that own the company)
If you get a good deal from a stock company only buy a guaranteed policy (do not buy nonguaranteed one)
Costs and returns: an insurer investing your money is like active fund manager doing it - you face higher fees and lower returns
Good reasons for cash value insurance
Like owning a home cash value life insurance encourages forced savings
Whole life is preferable if you know you'll be able to pay premiums, and you'll get higher return than universal life insurance. If you want flexibility in premiums then universal is a better choice
Blended policy includes whole life and term life into a single policy - should produce higher cash values because of lower sales costs (term life costs)
Insurance agent may not mention some policies because commissions are much lower, but they are sold through many highly rated companies (Northwester Mutual, Mass Mutual, New York Life, Guardian)
You can come up with a fixed-income portfolio (with the right investments) along with a death benefit (which an investment portfolio can't do), if you work with a fee-only advisor. It's possible to put your entire fixed-income portion of your portfolio in this
Cash value policies cannot generate returns comparable to equities (only fixed returns)
But they can, with caveats in this chapter, provide a higher after-tax yield with less volatility than a fixed-income portfolio
Cash value life insurance can be a useful financial planning tool if you have a fee-only adviser to help you choose the best one for your needs
Annuities are dominated by financial planners and insurance agents, making it very difficult to comparison shop
You pay a lump sum to a company, continue with regular payments, then receive it all back in stream of payments
First phase is 'accumulation phase'
Second phase is 'distribution phase', or income phase
You do not have to have the annuity at the same company in each phase (people don't realize that)
When you cash in, you pay taxes
You can exchange for another annuity - 1035 Exchange
You can buy another annuity with same company or other companies
They can be the worst products in the financial marketplace
Complex
High-cost
Low-return
If you ever buy one, get advice from fee-only adviser
Key types of annuities
Deferred annuity
You may payments which are invested and at maturity starts making payments to you
Taxes on the returns are deferred
Lower returns than on a balanced portfolio of equities
Deferred annuities can offer fixed, variable or indexed rate of return
Variable annuities
Let you invest in specific funds, which vary by insurer
If you die they at least pay total contributions (less withdrawals) to beneficiaries, even if lower in value than the sum of contributions
They feature high costs (2%), and have penalties for taking out too early
Bad investment by any means
Equity indexed annuities
Offer guaranteed rate of return, and allow for upside gains in a rising stock market
Lower than comparable immediate annuity
Usually tied to market index like the S&P 500
Highly complex, hiding the fact they've low returns
Contract terms can change mid-way without your knowledge
Usually 10 to 17 years long with 10% or more in penalties for early withdrawals
Not a good investment overall
Immediate annuity
Pay lump payment and immediately start getting monthly, quarterly or yearly payments for life ("immediate" annuity)
Similar to IPA (inflation protected annuities), which are indexed to the rate of inflation and a valuable option even if more expensive
Immediate variable annuities offer guaranteed income and upside potential. Not recommended because these have higher costs than the alternative of a balanced portfolio
Immediate fixed annuity has a known income stream and no exposure to loss of principal
Immediate annuities are under utilized because people fear they'll lose them upon death
You can use these to pay yourself a "pension" to supplement social security and other retirement income
Vanguard and TIAA-CREF are industry leaders in low-cost immediate annuities
All variable annuities are bad choices, and equity indexed ones are least "favorite"
Variable annuities aren't often understood by salespeople
Variable annuity withdrawals are taxed at income tax levels (versus using a mutual fund for more than 1 year and paying capital gains taxes at much lower rate)
No reason whatsoever to have annuity in your retirement plan. You have tax deferment already, and you pay lower taxes on capital gains rather than regular income from an annuity, and mutual funds have lower costs
Only immediate annuities can play important role (create a "pension")
Immediate annuities are lower cost, and reduce assets under management for brokers or advisers, so they're under utilized by people ("undersold")
Avoid all annuities except immediate fixed annuities
There is a lot of nonsense that you can be sure will never end from healthcare and health insurance industries that profit from the current system
To get healthcare
Medicare
private insurance
Go to ER and get billed
85% on medicare are satisfied, and 67% are as or more satisfied as they were with previous employer sponsored program
You cannot get medicare until age 65 (and that age could be affected by legislation)
Medicaid is the state run program for the needy
You or someone has to advocate for you with your caregivers or insurer
To advocate for you, you can hire a patient advocate
http://advoconnection.com - AdvoConnection
http://www.nahc.com - National Association for Home Care & Hospice
Key types of plans
Indemnity
Insurer usually pays 80%, you pay 20%
These plans are priced out of the market now
Managed care plans
PPOs and HMOs control costs by controlling access to care
They assemble a network of providers and negotiate rates
HMO: need referral form from primary care physician for more expensive visits and may be a limited number of visits. HMOs also strictly limit access to providers.
PPO: more choice and access than HMO, has co-pay of usually $10 - $25, and for out-of-network you need referral form form PCP and may also have higher co-pay
POS (point-of-service) allows going out of network without referral but has higher co-pay (or indemnity model)
You must understand whatever plan you go with, it's critical to understand
Key questions to ask
Monthly / annual premium?
Discounts?
Co-pay per visit?
Procedures covered / not covered (explicitly)?
What payment for procedures not covered?
Referrals needed to see specialist?
Deductible?
Stop-loss / max amount in a year?
Definition of preexisting condition
In-home equipment covered?
Drug benefit covered? What's the cost?
Self-employed: look for affiliate groups / professional associations, that have healthcare at group rates
Don't have as good rates as employers (no aggressive negotiation)
Not subsidized like employers
COBRA
Up to 18 months of coverage at former employer's rates
Sometimes eligible up to 3 years
Expensive
Catastrophic Health Insurance (HDHP)
High Deductible Health Plan (HDHP)
If you can't pay high premiums, but can pay high deductibles
Forego routine care, hoping you won't fall ill
HDHP limits your exposure to big health care bills
http://www.high-deductible-health-insurance.org
IRS Publication 969 "Health Savings Accounts (HSA) and Other Tax-Favored Health Plans
Must be enrolled in HDHP for HSA
Gov't programs
Medicare - http://www.medicare.gov
Medicaid - check state for income brackets (plan for needy)
Veterans have VA
Search state's website for healthcare options, i.e. several-month options
Consider dental insurance
Delta Dental Plans - http://www.deltadental.com
Take time to find right health insurance and never go without it
When a company is performing well in the markets, it then gets picked as a best example when its industry starts experiencing issues
In 2008 Goldman Sachs experienced such criticism, getting some blame for financial woes, even though the company itself was making healthy profits
Always a good move to have shorter mortgage, or pay ahead of schedule
30-year, 20% down mortgage grew out of Great Depression, before then 50% down payment was common
Recommended is a fixed rate mortgage with 20% down payment, but not necessarily 30 years
Interest-only mortgages are a terrible idea
ARM mortgages expose you to higher payments if interest rates rise, they're also a terrible idea
If you take out 30 year mortgage, make one or two extra payments a year at least
Extra payments increase your net worth by decreasing your debt (and increasing your equity)
Your net worth then increases more certainly than rising home prices
House as hedge against inflation? Inflation raises home prices, and interest rates, which reduce demand for housing - so home prices become stagnant (?) The argument here is that expectation of inflation is not a good reason to buy a home
Four tips on homes
Don't try to call the top or bottom of the market
Shop mortgages when you're in good financial shape
Understand who's working for whom
Don't use your home as an ATM
Don't tap the paper gains on your house, this erodes your wealth
To lower your debts take equity line to consolidate your loans and lower interest
FINRA is not an investor protection agency, it is not there to protect investors from all losses
FINRA is a merger of NASD and NYSE, neither of which are in any business to protect investors
FINRA imposes some recovery for investors but only on things that should've not happened in the first place, not downs in the market without proven malice
Banks that are 'too big to fail' are still out there, without much oversight by boards of directors or government regulation
No interest from federal government in protecting consumers in the financial markets
Financial services industry profits from boom and bust cycles
Not a good story for investors, consumers or homeowners
Financial services industry takes advantage within specific periods in time (and when it fails it only impacts investors unbeknownst to them)
The success and failures of financial industry are related. The failures of investors are the disadvantaged side of the successful agenda of the bank executives
Even some players in the casinos know how to safely play
Set reasonable goals
Know the odds on the game they're playing
Understand the house's advantage
Use a system to limit losses
In investing there's a lot less chance involved when you purchase index funds
Why casinos are similar to wall street
Don't want you to think about money (especially losing it)
Action / activity - they make money on transactions
Perks for "elephants" or "whales" (high net worth individuals)
No regulation (i.e. FINRA or SEC are very ineffective, and so is Nevada Gaming Commission)
Each industry wants to separate you from money (with nothing at all to show in return)
Many investors want to do something with investments (while they should not) to try to boost their returns
All are better off with index funds which are
Low-cost
Tax efficient
Highly diversified
When we buy groceries or products we need, we find a place where it costs least and buy in bulk
Most people do this with investing, risking the returns and overpaying
Research into high return investments is costly and unjustified
Active fund managers always want investors to believe are smarter than the market
Active fund managers don't have consistent insight to bring about higher returns than index funds
There is no rational case for active fund management
Discipline to do nothing
Even nonhyperactive investors want to be involved (because they care)
You must care enough to reign in your impulses
Exercise dicipline
Let the market do its job
Millions of investors still invest in actively managed funds
Reasons
Outlandish promises or advertisements (why would this need to be advertised anyway? Institutional funds would flow into these funds right away. High returns involve higher risk.)
Death by disclosure - 200-page prospectuses are designed to confuse you
No clarity in the disclosures
Active fund managers pick the wrong benchmark to compare to, while they should compare to something more appropriate which returns are usually higher anyway
Active funds often do not beat index funds over 5 - 10 years. If any do, they don't replicate the results over the next corresponding time period
Nobody can beat the market for 3 reasons
Most stocks and bonds are priced appropriately (difficult to find undervalued stocks even for professionals)
Markets are cyclical but unpredictable (you can't act upon them profitably before a slump)
Costs and fees reduce your returns (and taxes)
Stock picking, market timing, and actively managing funds benefit brokers only
Investors should avoid them
Whether markets are efficient or not, active managers will underperform the appropriate benchmark in the long run
An index fund is a mutual fund made up of the securities in the index with same proportions the index uses
Index is a measurement of an economic or financial change (based on a year)
For example, CPI (Consumer Price Index) measures prices of consumer goods in a given year
Most famous stock market indexes
DJIA - only 30 companies
S&P 500 - has 500 companies
Wilshire 5000 Total Market Index - broadest index for US stock market (all companies with available price data)
Risk types
Credit risk - company paying obligations
Inflation risk - eroding returns
Interest rate risk - bond prices go down due to rising rates
Foreign exchange risk - currency changes may change returns
Liquidity risk - cannot sell due to market conditions
Risk of principal - lose the amount invested
Market risk - cannot diversify away the volatility of an asset class
No perfect way to manage risk
Some ways are better than others
Individual investors place bets, do not manage risk
Most don't manage risk; have conservative investments
If inflation and taxes are higher than returns, then the investment is risky
Smart investing begins with understanding the relationship between risks and returns
Smart investing
Fairly predictable risks in anticipation of fairly predictable returns
How much in stocks
How much in bonds
The more in stocks the higher the risk
Standard deviation - basic measure of risk - it measures:
Volatility of stock, bond, and portfolio
Dispersion of returns (deviation from average for the asset class)
The higher the deviation the higher the dispersion, volatility, and risk of an asset or asset class
Standard deviations
Low - US Treasury bonds (low returns)
High - large company stock (higher returns)
Highest - small company stock (highest returns)
Target standard deviation:
8% - conservative investors
15% - moderately aggressive investors
20% max - very aggressive investors
Nobody's portfolio should aim more than 30% standard deviation
How is standard deviation calculated?
Find in fund's prospectus
Find in Stock prospectus website
Brokers not likely to understand standard deviation of a stock or fund (another reason to avoid stock brokers)
Risk stems from 3 main factors
Market - stocks are riskier than bonds; and foreign stocks riskier than domestic
Size - small company stocks riskier than large company
Price - value stocks are expected for higher returns than growth stocks (growth stocks are new, unproductive, planted and growing seeds)
"Value stocks" are stocks that are more efficient, older, leaner and meaner?
Constructing a portfolio
Combine asset classes with different levels of risk to attain a targeted return (price appreciation and dividends and interest) for a specific overall and acceptable level of risk (as measured by standard deviation).
Positive correlation - risk and return - the higher the risk the higher the return
Risk diminishes - across each portfolio, the standard deviation decreases as investment lengthens
Compounding is extremely powerful - check 20+ years of returns
How much risk depends on your
Age
Financial goals
Tolerance for risk
Brain imaging shows active investors experience dopamine when presented with an opportunity of a surging stock
Same effect when using drugs, gambling, or in alcohol addiction
Must have rational approach to be a successful investor
5 factors when assessing risk capacity
1. Time horizon and liquidity needs
Don't need to withdraw 20% for 10 years or more, you can weather market cycles and pick higher return asset classes
2. Income / savings rate ratio
The more you make and the more you save the higher your risk capacity
The less you make and the less you save the lower your risk capacity
Risk capacity increases with level of investment income
3. Net worth
The higher your net worth the greater your risk capacity (buffer against short term market volatility)
High net worth = high assets + low liabilities
4. Attitude towards risk
The more you tolerate short term loss in value of portfolio, the higher your risk capacity
If you can tolerate 50% loss in value, you have high tolerance for risk
If 20% causes you issues, you are risk averse
5. Investment theory knowledge
The greater knowledge the bigger capacity for risk
Take the risk capacity survey
To come up personal risk capacity to choose a portfolio, use:
The 5 factors above
Risk capacity survey
Self-knowledge, by answering the personal attitude questions
Knowing your risk capacity you'll invest by wisely creating a portfolio with risk you can take
Adjust your investments if your risk capacity changes
Increase risk capacity by (lessen the burden of a market tumble by)
Plan for longer term
Decrease the need for immediate cash if possible
Increase income and/or savings rate
Increase net worth (increasing assets and decreasing liabilities)
Learn to tolerate more risk for potential higher return
Learn about portfolio theory, risk, returns, and asset allocation
Approach risk rationally (short term market decreases) to avoid headaches, wasting time and money
Avoid house funds
i.e. Merrill Lynch Aggressive Growth Fund
JP Morgan fund, etc.
Make sure it's managed as a true index fund
54% of mutual funds drift from their stated style
Drifting away within index fund is more difficult because manager only has to track the index
If cash holding is increased however, fund can underperform due to performance drag
Avoid funds with share classes (ie. A, B, C)
A shares - commission fees upfront
B shares - commission fees on sale of shares (decrease over length of time shares held)
C shares - commission fees on sale of shares (increase over length of time shares held to encourage trading)
Index funds do not have multiple share classes (or aren't supposed to have)
Minimize costs
12b-1 fee - usually annual from 0.25% - 1% (max), big cost to investors
Wrap fees - 2% to 3% of portfolio's value
Trading costs - trade costs not included in expense ratio
Active funds have higher cost ratio
The more trading with active funds, the more costly it is
Minimize taxes
Tax deferred accounts (pay tax when withdraw): 401k, IRA
Tax depends on marginal tax rate when withdrawing money
Consider tax efficiency of long term investments
How do you "forgo the lower capital gains tax rates"? If you have low capital gains tax now but invest entirely in pre-tax, you'll pay taxes on more withdrawals later
Index funds are tax efficient because they have few transactions (no capital gains or loss taxes)
Withdrawals from index funds are taxed at the capital gains tax rate, and not higher income tax rate
Index fund's low activity almost equals IRA, or even better because it's taxed at capital gains tax rate and not income tax rate
Understand your 401k plan, they're "giant skimming operations" set up by employers and brokers to deprive employees
Point: enemies of high returns are high fees, costs, and taxes
Asset allocation (placing money into the right investment?) is key factor affecting returns (simple enough)
90 - 100% of value of portfolio over time is accounted by asset allocation
Dispersion of return compared to
Stocks
Bonds
Standard deviation is the measure of risk
Asset allocation
Stocks
Bonds
Cash equivalents (CDs, money market funds)
Percentages allocated to each enable you to choose risk-return profile
Combination of these percentages present a far different approach than holding individual securities
Individual securities account for 5% of variance in returns (clarification needed)
Argument being that active participation in stock picking only changes 5% of portfolio, all else being equal?
Asset allocation instead of stock-picking is far more effective
Demystifying asset allocation
One basic formula
Subtract your age from 100, and allocate the resulting number as percentage in stocks
The remaining percentage to go into bonds
Formula at least recognizes that as you age your risk capacity decreases
Factors to consider for allocation
Age (the younger the more in stocks)
Savings (the more savings to retirement expenses the more can be in stocks)
Need for retirement income (the higher contributions and salary growth the more you can put in stocks)
Risk capacity (the higher capacity for risk the more can be in stocks)
70% should be in US index funds, 30% in international index funds
Percentage not in index funds should be in bond index funds
Why only index funds for retirement
You know what you're buying (all indexes list all companies)
Better to adjust the risk-return formula, no uncertainties about what risk you have in your portfolio
Easy to rebalance, by simply changing allocations as you already know what's in the available funds
No guarantee of future returns, but a globally diversified portfolio will beat active fund over long term almost certainly
They say invest in stocks, but don't invest in individual stocks. Individual stock returns won't beat the index and fees will erode returns more
They say invest in technology, healthcare, etc. There'll be too much to manage and sub-par returns over long term. Invest in three low management fee index funds from good fund families
They say bonds are for old people. Not a good advice - don't avoid bonds. Use low fee bond index funds help manage risk by offsetting aggressive investments
Accept only enough risk to obtain
Returns that meet your goals
Safety to not sustain major long-term losses
Point: switch focus from market timing and stock picking to asset allocation (more passive approach). Use low fee index funds (stocks, bonds).
Fund family companies like Vanguard, Fidelity or T. Rowe Price are easy to do business with online or on the phone
Charles Schwab can be considered but pick a fund with low fee and make sure fund benchmarks US stocks, or US bonds, or international stocks
Another term is "no-load fund family company"
Pick the stock/bond allocation per your risk capacity
Forgo international index fund if your amount does not meet minimum requirements among the 3 funds in a portfolio (US stock index, international stock index, US bond index)
US market index should be made up of (in case your fund family company doesn't have 1 fund to invest in all):
60% in S&P 500 inex fund
10% in US small stock index fund
30% in international equity fund
100% in US bond index fund
Look into ETFs if you can't meet minimum investment limits
Consider index funds in small and value stocks (higher yield)
Rebalance portfolio periodically
Due to rising stock prices
Due to allocation shift (your strategy by itself is shifting), and allocation defining your tolerance for risk
Due to change for investment need (i.e. you retire)
3 ways to rebalance portfolio
Invest additional money in assets underrepresented in portfolio
or, sell overrepresented assets and buy underrepresented ones
Re-evaluate every 3 to 6 months
Use target retirement fund, it rebalances itself
Vanguard target funds are all index funds with low fees
Keep 3 to 6 months of expenses in cash
Don't invest money you may need in short-term
Point: investing in index funds is straightforward and so is rebalancing a portfolio
Most experts say you'll need 75% of your pre-retirement income - annually
That's saving 15% every year for 40 years
Employee Benefits Research Institute
50% of workers did not find out how much needed for retirement
First step
Find out the income you want to retire on
Even if you don't retire plan anyway - you may not be able to work
Accident, illness, infirmity, career reversals, etc
Don't make yourself later worry about money when you can't work
To earn $60,000 a year in retirement
$1 million earning 6%
$750,000 earning 8%
Returns are the not the same every year
Don't withdraw all returns in a year early in retirement
Other sources
Social Security
Pension
Annuity
Evaluate expenses in retirement
Now also consider lowering your expenses to 65% or less of income
Expenses not in retirement
Smaller commuting expenses
No lunches or after-hours gatherings
Clothing and dry cleaning bills
No mortgage payments
Life insurance (paid up or expired)
With housing the biggest expense is the mortgage. Paying it off is the best thing you can do
Avoid high property taxes - if you like lower tax place, move there
Downsize your home for smaller utility bills
Keep engaged in life activities - sports, hobbies, culture, travel, socializing
Healthcare does increase
Medicare covers 80% of most procedures
Consider Medigap to cover the difference
Long-term care insurance may be worth it
Fees are
Too high
Buried deep in disclosure documents and impossible to find
Not revealed at all due to conflict of interest or pay-for-play kickbacks
The way you leave it can make life much better or much worse for heirs
Estate planning depends on amount and type of assets, and how you want to distribute them
Estate plan will be more complex if it has income-generating assets
Estate plan
Legal documents
Will
Trust - how your assets are to be distributed
Ongoing care of someone or something
How final wishes are to be carried out
Dying intestate means without a will - expensive for heirs
Without a will court distributes assets and settles claims -- expensively - you don't want that to happen
Distribution of wealth through will is private; without will it's public
Trust - which owns assets before or after death - also provides bigger flexibility and control
Need experienced estate planning attorney (don't do it yourself)
Mistakes lawyers make drawing up estate plan
Basing plan only on tax issues
Solution: Consider how family will specifically need and handle assets
Choosing wrong executor
Solution: Appoint someone with compassion, maturity, experience (consider professional trustee)
Leaving heirs unprepared
Solution: Prepare them for their responsibilities; don't leave assets to irresponsible ones
Putting a sibling in charge of other sibling's finances
Solution: Have the trustee ensure per trust's provisions
Leaving heirs unprepared to manage business
Solution: Plan succession ahead, or sell it if they can't or don't want to manage it
Failing to update documents as things change
Solution: Update documents and beneficiaries for marriages, divorces, births, etc.