Hey everybody.
My last two posts were about the differences between a Roth IRA, a traditional IRA, and a 401(K) plan. Today, we're going to talk about how to invest the most effectively within each of those investment vehicles. By effectively, I mean in order to achieve the maximum tax advantage since all of these investment vehicles are in fact tax savings vehicles. Let's begin.
ROTH IRA
As I mentioned in the second to last post, the Roth is the most flexible of the three. And when you withdraw your money from a Roth IRA at 59.5, you will not be taxed on any of the gains. The reason that you will not be taxed is because the dollars that you are putting into the Roth IRA are after-tax dollars. That is to say, they have already been taxed. Because you will never be taxed, you want to load up your Roth IRA with stocks that pay dividends and stocks of smaller companies with lots of room to grow. Let's start with dividends first.
Normally, dividends are taxed at 15%, so they already have preferential tax treatment and since you're not paying taxes on any capital gains, it doesn't matter that dividends have a lower rate of taxation than regular capital appreciation on a stock. However, dividends, when reinvested and coupled with capital appreciation on a stock can generate significant income. When you receive this income, you can choose to reinvest it and buy more of the same stock, or some other company's stock, or just take it out and spend it. But the idea is to create a stream of income that is nontaxable and that flows into your account no matter what the stock market does.
Take a company like Pepsi for example. At the beginning of 2001, Pepsi paid $.14 a share every quarter. So this means that whether Pepsi stock went up or down in the first 3 months of 2001, if you owned 100 shares, you got a guaranteed $14 (100 * $.14) in 3 months. If you owned 1000 shares, you received a guaranteed $140 ($.14 * 1000) in 3 months. In the second quarter of this year, Pepsi's dividend was approximately $.54. This means that if you owned 100 shares, you earned $54 whether Pepsi's stock went up or down. If you owned 1000 shares, you earned a guaranteed $540. And the longer you hold dividend paying stocks, the more dividends you get, which allows you to purchase more dividend paying shares without even having to sell anything from your portfolio to do so. Click here for a visual demonstration of what I was just saying about Pepsi. As you can see, Pepsi's dividend nearly quadrupled over 11 years. Companies whose stock price increases along with increasing their dividends are prime candidates for your Roth IRA.
Unfortunately most companies that have dividends like the ones that I'm referring to are really large, and as a result, do not provide as much potential for capital appreciation. However, small cap stocks (stocks of smaller companies) that have dividends are what you should really look for when trying to build up a nest egg. Small cap stocks can potentially provide for 10- to 20-fold gains over several year periods, and when the company grows, the dividend usually grows along with it. Further, since Roth IRAs only allow you to place a limited amount of money into them, you need to supercharge the gains that you receive within them to make up for the limited contributions. Small cap stocks allow you to achieve outsized gains that can help you achieve financial independence. And because you cannot access the money in full until 59.5, you can afford to sit back and let those small cap stocks you've chosen run their course to maturity.
Take Deckers Outdoor Corporation - the maker of UGG boots - for example. Had you bought $1000 worth of this company's stock in May 2005, you would have $7000 today, even after all of the stock market ups and downs from 2008 to 2010. The moral of the story is that even though you are always trying to achieve maximum returns when investing, you want to make sure you achieve the maximum amount when using a Roth IRA because your gains will never be taxed.
If you are looking for a stock newsletter that has recommendations of dividend paying stocks, I recommend
Dick Davis Dividend Digest or if you want a dividend exchange traded fund, check out the iShares Dow Jones Select ETF or the SPDR S&P Dividend ETF. For newsletters that recommend small cap stocks, I recommend Cabot's Small Cap Confidential or TheStreet.com's Stocks Under $10. I've just said a mouthful, so I'll continue talking about tax advantage maximization in the next post.
Thursday, August 30, 2012
Wednesday, August 29, 2012
The Difference Between a Roth IRA, a Traditional IRA, and a 401(k) Plan - Part 2
Hello everyone.
Last time, I spoke about what a Roth IRA is and all of the nuances of it regarding contribution limits, withdrawal restrictions, and how it is taxed. Today, we will discuss the traditional IRA and 401(k) plans. Let's dive in.
TRADITIONAL IRA
A traditional IRA is very similar to a Roth IRA in that its purpose is to help middle income Americans save for retirement and provide them with significant tax savings. However, the crucial distinction between a Roth IRA and a traditional IRA is that whereas a Roth IRA is funded with after tax dollars, a traditional IRA is funded with pretax dollars. That is to say, you can write your traditional IRA contribution off on your taxes, thereby lowering your annual income. This allows you take advantage of the power of compounding interest without being taxed until you withdraw your contributions and gains, if any, at 59.5. The chart below shows just how powerful the power of not being taxed is when coupled with the power of compound interest over an extended period of time.
(*Note: The example above assumes a tax bracket of 25%, a weekly investment of $25, an annual wage increase of 3%, and 8% annual investment growth.)
Because the money that you contribute to a traditional IRA is pretax money (money that you have never paid income taxes on), you will be taxed on your gains and contributions at the income tax bracket into which you fall at 59.5 - the age when you can withdraw your money without penalty. In contrast to a Roth IRA though, you may not withdraw your contributions at any time. If you withdraw your contributions prior to 59.5, you will be taxed on the withdrawal at your current income tax bracket, in addition to being hit with a 10% penalty on the withdrawal.
For single people who wish to contribute to a traditional IRA, in order to qualify, you must not make more than $58,000. For those who are married and filing jointly, you may not make more than $92,000 if you wish to make a full contribution. Also, just like a Roth IRA, you make only contribute up to $5,000 a year if you are under 50 and $6,000 a year if you are 50 or older. However, unlike a Roth IRA which has no age at which you must begin taking distributions from the account, in a traditional IRA, you must begin taking distributions at age 70.5.
401(K) Plan
A 401(K) plan - or for those who work for non-profit institutions, a 403(b) plan - is an employer sponsored retirement savings plan where usually an employer matches (puts the same amount of money in for every dollar that you put in) your contributions up to a certain point. Usually this match from the employer goes up to 5 - 6% of your salary. Let's say you make $100,000 a year and are 35 years old. The maximum amount that an individual under 50 can contribute is $17,000 in 2012 and $22,500 for those 50 or older. Let's say you contribute the maximum of $17,000 per year. Your company will usually match no more than $5,000 to $6,000 a year of your contribution. Because 401(K) plans usually have mediocre investment options, are relatively inflexible, and concentrate all of your wealth in your job, I recommend only contributing just enough to your 401(K) to get the company match. Any left over money that you would like to invest should be socked away into a Roth IRA.
401(K)s are inflexible because if you want to make an early withdrawal, just like the traditional IRA, you cannot withdraw your contributions without being hit with a 10% penalty and federal income taxes. You may however take a loan from your 401(k) plan, provided that you pay it back within 60 to 90 days (the amount of time varies from employer to employer). However, you are paying interest on this loan while it is outstanding. Also, if you quit or lose your job, then the loan becomes immediately payable. Lastly, if hardship withdrawals are allowed in the plan, you may be able to withdraw money to prevent foreclosure/eviction, pay for qualifying educational expenses, and cover any medical expenses not covered by the company insurance plan. However, a 10% withdrawal penalty will still apply to any distribution.
In my next post, I will discuss how to choose investments for each of these vehicles so as to maximize the tax advantage you receive in each. But if you would like a chart view of the distinctions between a 401(K), a Roth IRA, and a traditional IRA, click here. Until next time....
Last time, I spoke about what a Roth IRA is and all of the nuances of it regarding contribution limits, withdrawal restrictions, and how it is taxed. Today, we will discuss the traditional IRA and 401(k) plans. Let's dive in.
TRADITIONAL IRA
A traditional IRA is very similar to a Roth IRA in that its purpose is to help middle income Americans save for retirement and provide them with significant tax savings. However, the crucial distinction between a Roth IRA and a traditional IRA is that whereas a Roth IRA is funded with after tax dollars, a traditional IRA is funded with pretax dollars. That is to say, you can write your traditional IRA contribution off on your taxes, thereby lowering your annual income. This allows you take advantage of the power of compounding interest without being taxed until you withdraw your contributions and gains, if any, at 59.5. The chart below shows just how powerful the power of not being taxed is when coupled with the power of compound interest over an extended period of time.
Because the money that you contribute to a traditional IRA is pretax money (money that you have never paid income taxes on), you will be taxed on your gains and contributions at the income tax bracket into which you fall at 59.5 - the age when you can withdraw your money without penalty. In contrast to a Roth IRA though, you may not withdraw your contributions at any time. If you withdraw your contributions prior to 59.5, you will be taxed on the withdrawal at your current income tax bracket, in addition to being hit with a 10% penalty on the withdrawal.
For single people who wish to contribute to a traditional IRA, in order to qualify, you must not make more than $58,000. For those who are married and filing jointly, you may not make more than $92,000 if you wish to make a full contribution. Also, just like a Roth IRA, you make only contribute up to $5,000 a year if you are under 50 and $6,000 a year if you are 50 or older. However, unlike a Roth IRA which has no age at which you must begin taking distributions from the account, in a traditional IRA, you must begin taking distributions at age 70.5.
401(K) Plan
A 401(K) plan - or for those who work for non-profit institutions, a 403(b) plan - is an employer sponsored retirement savings plan where usually an employer matches (puts the same amount of money in for every dollar that you put in) your contributions up to a certain point. Usually this match from the employer goes up to 5 - 6% of your salary. Let's say you make $100,000 a year and are 35 years old. The maximum amount that an individual under 50 can contribute is $17,000 in 2012 and $22,500 for those 50 or older. Let's say you contribute the maximum of $17,000 per year. Your company will usually match no more than $5,000 to $6,000 a year of your contribution. Because 401(K) plans usually have mediocre investment options, are relatively inflexible, and concentrate all of your wealth in your job, I recommend only contributing just enough to your 401(K) to get the company match. Any left over money that you would like to invest should be socked away into a Roth IRA.
401(K)s are inflexible because if you want to make an early withdrawal, just like the traditional IRA, you cannot withdraw your contributions without being hit with a 10% penalty and federal income taxes. You may however take a loan from your 401(k) plan, provided that you pay it back within 60 to 90 days (the amount of time varies from employer to employer). However, you are paying interest on this loan while it is outstanding. Also, if you quit or lose your job, then the loan becomes immediately payable. Lastly, if hardship withdrawals are allowed in the plan, you may be able to withdraw money to prevent foreclosure/eviction, pay for qualifying educational expenses, and cover any medical expenses not covered by the company insurance plan. However, a 10% withdrawal penalty will still apply to any distribution.
In my next post, I will discuss how to choose investments for each of these vehicles so as to maximize the tax advantage you receive in each. But if you would like a chart view of the distinctions between a 401(K), a Roth IRA, and a traditional IRA, click here. Until next time....
Tuesday, August 28, 2012
The Difference Between a Roth IRA, a Traditional IRA, and a 401(k) Plan - Part 1
Hey everybody.
Today I'll be discussing the difference between a Roth IRA, a traditional IRA, and a 401(k) plan. But before I get into the nuanced differences between the things listed above, let me briefly discuss the one thing all of the above have in common - a Roth IRA, a traditional IRA, and a 401(k) plan are all investment vehicles and not investments themselves. They are not something that you invest in. Rather, they are a place for you to park your money, like a checking or a savings account, but within each you can choose to invest in either stocks, bonds, mutual funds, and ETFs (exchange traded funds). The flexibility of the investment options within each investment vehicle and the restrictions on when withdrawals can be made and how such withdrawals are made is where the distinctions come in. So now that we know the overarching similarity between the accounts, let's dive into what each one is.
ROTH IRA
A Roth IRA is a great investment vehicle and is the most flexible of all of the accounts. It was created by Senator William Roth of Delaware back in 1997. Its purpose is to provide a tax advantaged account in which middle income Americans can save for retirement. This is how it works. In order to be eligible to fully contribute to it, if you are single, you cannot make more than $110,000 a year. If you are married and file taxes jointly with your spouse, you cannot fully contribute to it if you make more than $173,000 combined.
The maximum contribution that may be made to a Roth IRA by any individual who qualifies is $5,000 per year. (Note that as the cost of living rises, Congress and the Internal Revenue Service raise the amount that can be contributed every few years.) Individuals who are eligible to contribute and are 50 yrs. of age or older may contribute $6,000, instead of the $5,000 that everyone else is limited to, in the 2012 tax year. This is because people in their 50s are closer to retirement than the rest of us and the government wants to encourage them to sock away more money.
As I said before, there are many advantages to the Roth IRA, so let me elaborate on them. The first is that a Roth IRA is funded with after-tax dollars, which means that if you withdraw the money at 59.5 yrs. of age, all of the gains that you have accrued will not be taxed. I repeat, if you withdraw the contributions to and the gains accrued in your Roth IRA at 59.5, you will NEVER have to pay gains on that money! The downside to the Roth IRA is that because it's a retirement account and has such great tax savings, you cannot withdraw all of your gains and contributions before 59.5 without penalty. The penalty to withdrawing your money early and not having such withdrawal fall into a qualifying exception is that you will be taxed at your normal federal income tax rate on your gains, in addition to a penalty of 10% on the amount of the withdrawal.
On the flip side of things though, you can always withdraw however much money you contribute to your Roth IRA without penalty and without ever having to pay it back. You may not, however, withdraw your gains without penalty at any time. Here's an example of what I mean: Let's say you have contributed $5,000 a year to your Roth IRA for 3 years and over the course of that 3 years, your total $15,000 contribution has grown to $20,000. You are entitled to withdraw up to $15,000 without penalty, but you must leave the remaining $5,000 you have earned there until 59.5 or else you will be taxed.
On top of all of this, there are a few loopholes where you actually can withdraw contributions and gains without being penalized. Anyone who holds a Roth IRA is entitled to withdraw up to $10,000 (contributions and gains) in order to make a down payment on a first home. However, the Roth IRA holder must not have owned a home in the previous 24 months and must have held the Roth IRA for at least 5 years.
Lastly, you can invest in any type of security under the sun in a Roth IRA. This means stocks, mutual funds, bonds, stock options, index funds, and ETFs.
In sum, a Roth IRA is a great option for almost everyone, but especially for those who think they will be in a higher tax bracket as they near retirement age. This is because the money that you put into a Roth IRA, will never be taxed, provided you adhere to the restrictions regarding when you can withdraw money. In Part 2, we will discuss what a traditional IRA and a 401(k) plan are and how they are different from one another and from a Roth IRA.
Today I'll be discussing the difference between a Roth IRA, a traditional IRA, and a 401(k) plan. But before I get into the nuanced differences between the things listed above, let me briefly discuss the one thing all of the above have in common - a Roth IRA, a traditional IRA, and a 401(k) plan are all investment vehicles and not investments themselves. They are not something that you invest in. Rather, they are a place for you to park your money, like a checking or a savings account, but within each you can choose to invest in either stocks, bonds, mutual funds, and ETFs (exchange traded funds). The flexibility of the investment options within each investment vehicle and the restrictions on when withdrawals can be made and how such withdrawals are made is where the distinctions come in. So now that we know the overarching similarity between the accounts, let's dive into what each one is.
ROTH IRA
A Roth IRA is a great investment vehicle and is the most flexible of all of the accounts. It was created by Senator William Roth of Delaware back in 1997. Its purpose is to provide a tax advantaged account in which middle income Americans can save for retirement. This is how it works. In order to be eligible to fully contribute to it, if you are single, you cannot make more than $110,000 a year. If you are married and file taxes jointly with your spouse, you cannot fully contribute to it if you make more than $173,000 combined.
The maximum contribution that may be made to a Roth IRA by any individual who qualifies is $5,000 per year. (Note that as the cost of living rises, Congress and the Internal Revenue Service raise the amount that can be contributed every few years.) Individuals who are eligible to contribute and are 50 yrs. of age or older may contribute $6,000, instead of the $5,000 that everyone else is limited to, in the 2012 tax year. This is because people in their 50s are closer to retirement than the rest of us and the government wants to encourage them to sock away more money.
As I said before, there are many advantages to the Roth IRA, so let me elaborate on them. The first is that a Roth IRA is funded with after-tax dollars, which means that if you withdraw the money at 59.5 yrs. of age, all of the gains that you have accrued will not be taxed. I repeat, if you withdraw the contributions to and the gains accrued in your Roth IRA at 59.5, you will NEVER have to pay gains on that money! The downside to the Roth IRA is that because it's a retirement account and has such great tax savings, you cannot withdraw all of your gains and contributions before 59.5 without penalty. The penalty to withdrawing your money early and not having such withdrawal fall into a qualifying exception is that you will be taxed at your normal federal income tax rate on your gains, in addition to a penalty of 10% on the amount of the withdrawal.
On the flip side of things though, you can always withdraw however much money you contribute to your Roth IRA without penalty and without ever having to pay it back. You may not, however, withdraw your gains without penalty at any time. Here's an example of what I mean: Let's say you have contributed $5,000 a year to your Roth IRA for 3 years and over the course of that 3 years, your total $15,000 contribution has grown to $20,000. You are entitled to withdraw up to $15,000 without penalty, but you must leave the remaining $5,000 you have earned there until 59.5 or else you will be taxed.
On top of all of this, there are a few loopholes where you actually can withdraw contributions and gains without being penalized. Anyone who holds a Roth IRA is entitled to withdraw up to $10,000 (contributions and gains) in order to make a down payment on a first home. However, the Roth IRA holder must not have owned a home in the previous 24 months and must have held the Roth IRA for at least 5 years.
Lastly, you can invest in any type of security under the sun in a Roth IRA. This means stocks, mutual funds, bonds, stock options, index funds, and ETFs.
In sum, a Roth IRA is a great option for almost everyone, but especially for those who think they will be in a higher tax bracket as they near retirement age. This is because the money that you put into a Roth IRA, will never be taxed, provided you adhere to the restrictions regarding when you can withdraw money. In Part 2, we will discuss what a traditional IRA and a 401(k) plan are and how they are different from one another and from a Roth IRA.
Thursday, August 23, 2012
When to Ignore Conventional Financial Advice
Hey everybody.
So nowadays, with the internet providing everybody and her mom with access to financial advice, I'm sure that everyone who aspires to be more financially savvy has come across "conventional financial advice". Conventional financial advice is stuff like "pay off your credit card debt", "establish an 8-month emergency savings fund", "contribute the maximum to your 401(k) plan" and "start saving for retirement in utero". :-) And for the most part, this "conventional" financial advice is tried and true and sound. It's well meaning. It's meant to keep you out of financial trouble and it usually does. I mean, how can effectively earning a rate of return of 20% on your money by paying down high interest credit cards hurt you? The problem with most financial advice is that it doesn't take into account your emotions and how you feel about your money.
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This isn't exactly a novel concept, but a lot of times, our money issues are not so much economic in nature, as they are emotional in nature. And I've found, in my own life, that's it's important to make decisions that make me feel particularly empowered - whether or not they are the most direct path to a financial goal.In keeping with the title of this post, here are some pieces of financial advice you can ignore and I will also state when you can ignore them.
1. PAY OFF ALL OF YOUR DEBT AS QUICKLY AS POSSIBLE
You'll hear the financial experts spouting this maxim all of the time. And with good reason, the high interest rates that credit card companies charge you, coupled with the fact that such interest is compounded so quickly, makes it in your best interest to get it out of your hair as quickly as possible. But this maxim neglects to take into account the fact that a lot of times, people get into credit card debt not because of outrageous spending habits, but because they had an unexpected expense and didn't have savings to cover it.
In these harsh economic times, people might have to rely on their credit cards to get them through to the next payday. Although it's not preferable, it makes sense to use a line of credit when you have nowhere else to turn financially. But there's a way to avoid this situation altogether. I recommend that you pay as much as you can to your credit card company, but that you save 10% of your income religiously. Part of my rule comes from the conventional financial advice of pay yourself first, but it has a different rationale. When you save 10% of your income and build up an emergency fund, you can take a portion of that emergency fund (let's say half) at some point in the future and make an even more substantial payment toward your credit card balance(s). Also, as a result of having an emergency fund, you won't have to rack up credit card debt every time something unexpected comes up.
Moral of the story: if you find yourself always having to rely on your credit card for necessities even though you pay more than the minimum every month, try continuing to pay more than the minimum, but saving as much as you possibly can (using what extra money you would have put toward your credit card debt to build up decent savings for a rainy day). Having a savings fund will make you feel more empowered and in charge of your financial future, even if you take slightly longer to pay off your debt. And when you feel empowered about your financial situation, you are much more likely to make positive decisions regarding your money.
2. LIVING BELOW YOUR MEANS IS THE BEST WAY TO SAVE.
Once again, this maxim above is well-intentioned and is preached in order to prevent people from "balling out of control" or living a profligate lifestyle. But it just isn't true. I'm sure all of us have tried cutting expenses, clipping coupons, and denying ourselves the little wordly pleasures. But the problem with this is that aside from it being no fun, you can only cut expenses so much. Mr. Inflation - the father of all evil - will not look at your paycheck and say hey, "she's living below her means, so I guess I'll cut her a break and stop making prices go up". Things will keep on getting expensive no matter how much we cut back on luxuries. So, the best way to save and get ahead is to expand those means, while continuing to live beneath them.
How can you go about expanding those means? Well, usually taking on another job is no fun, so try to find something that you enjoy doing to earn extra income. Sell old items on eBay. Try babysitting your neighbor's child or DJ'ing at your local bar. If you played in a band in college, start playing around your city again. I know a whole lot of people are cobbling together multiple jobs nowadays, but if you're one of those fortunate souls who has a job that pays enough to live on, having a side gig might help you expand those means even more in addition to your annual raise.
Moral of the story: if you're feeling squeezed financially, continue living below your means, but constantly be on the look out for ways to increase your income. Treat your own personal finances like a business and always grow your revenue. A company that had to rely solely on cutting expenses would soon go out of business because it would have to eventually begin cutting employees. And of course you can't run a company without employees. Similarly, you can't outpace inflation indefinitely by trying to do more with less.
3. CONTRIBUTE THE MAXIMUM AMOUNT POSSIBLE TO YOUR 401(K).
As with all of the other conventional financial advice, I understand why the experts spout this piece too. Most 401(k) plans have a matching plan where they will put in a certain amount of money if you contribute a certain amount. And although I advocate contributing to your 401(k) plan and preparing for retirement, I'm also an advocate of only contributing the amount necessary to get the company match. After that, I recommend contributing the maximum amount possible ($5,000 in 2012) to a Roth IRA, for multiple reasons. A 401(k) usually has very limited investing options, and the more limited you are, the less likely you are to earn an outsized return on your money. Second, because 401(k)s are tax deferred as opposed to tax exempt Roth IRAs, there are withdrawal penalties even for the money that one has contributed, in addition to tax penalties for money withdrawn before 59.5 yrs. old. Roth IRAs have penalties for early withdrawals also, but you can withdraw all of the money that you contribute to it without penalty because the money you contribute is after-tax money. Moreover, you can use up to $10,000 in contributions and capital gains to purchase your first home or pay for qualifying educational expenses.
Moral of the story: a Roth IRA is a much more flexible home for your investment dollars, so it's better to max that out than tying up your money in a 401(k) plan just because you get a company match. What's more, you feel so much more empowered when you know that you are saving for retirement AND have ready access to your money when you need it. In fact, although I recommend having a separate savings account, I think it's okay to use your Roth IRA as a savings fund. In the worst case scenario, you will only incur trading costs and maybe miss out on potential stock gains, but this negative series of events doesn't compare to the harsh financial penalties of withdrawing from your 401(k) prematurely.
There are plenty of other pieces of conventional financial advice that one should ignore, even though in general I think the conventional wisdom is right. But when making financial decisions, you should try to strike a balance between achieving the highest rate of return on your money and feeling more secure/confident/stronger about your financial situation as a result of your decisions. Let me know if you think of any piece of financial advice that doesn't make sense to you and we can try to figure out together if you should disregard it. Until next time...
So nowadays, with the internet providing everybody and her mom with access to financial advice, I'm sure that everyone who aspires to be more financially savvy has come across "conventional financial advice". Conventional financial advice is stuff like "pay off your credit card debt", "establish an 8-month emergency savings fund", "contribute the maximum to your 401(k) plan" and "start saving for retirement in utero". :-) And for the most part, this "conventional" financial advice is tried and true and sound. It's well meaning. It's meant to keep you out of financial trouble and it usually does. I mean, how can effectively earning a rate of return of 20% on your money by paying down high interest credit cards hurt you? The problem with most financial advice is that it doesn't take into account your emotions and how you feel about your money.
This isn't exactly a novel concept, but a lot of times, our money issues are not so much economic in nature, as they are emotional in nature. And I've found, in my own life, that's it's important to make decisions that make me feel particularly empowered - whether or not they are the most direct path to a financial goal.In keeping with the title of this post, here are some pieces of financial advice you can ignore and I will also state when you can ignore them.
1. PAY OFF ALL OF YOUR DEBT AS QUICKLY AS POSSIBLE
You'll hear the financial experts spouting this maxim all of the time. And with good reason, the high interest rates that credit card companies charge you, coupled with the fact that such interest is compounded so quickly, makes it in your best interest to get it out of your hair as quickly as possible. But this maxim neglects to take into account the fact that a lot of times, people get into credit card debt not because of outrageous spending habits, but because they had an unexpected expense and didn't have savings to cover it.
In these harsh economic times, people might have to rely on their credit cards to get them through to the next payday. Although it's not preferable, it makes sense to use a line of credit when you have nowhere else to turn financially. But there's a way to avoid this situation altogether. I recommend that you pay as much as you can to your credit card company, but that you save 10% of your income religiously. Part of my rule comes from the conventional financial advice of pay yourself first, but it has a different rationale. When you save 10% of your income and build up an emergency fund, you can take a portion of that emergency fund (let's say half) at some point in the future and make an even more substantial payment toward your credit card balance(s). Also, as a result of having an emergency fund, you won't have to rack up credit card debt every time something unexpected comes up.
Moral of the story: if you find yourself always having to rely on your credit card for necessities even though you pay more than the minimum every month, try continuing to pay more than the minimum, but saving as much as you possibly can (using what extra money you would have put toward your credit card debt to build up decent savings for a rainy day). Having a savings fund will make you feel more empowered and in charge of your financial future, even if you take slightly longer to pay off your debt. And when you feel empowered about your financial situation, you are much more likely to make positive decisions regarding your money.
2. LIVING BELOW YOUR MEANS IS THE BEST WAY TO SAVE.
Once again, this maxim above is well-intentioned and is preached in order to prevent people from "balling out of control" or living a profligate lifestyle. But it just isn't true. I'm sure all of us have tried cutting expenses, clipping coupons, and denying ourselves the little wordly pleasures. But the problem with this is that aside from it being no fun, you can only cut expenses so much. Mr. Inflation - the father of all evil - will not look at your paycheck and say hey, "she's living below her means, so I guess I'll cut her a break and stop making prices go up". Things will keep on getting expensive no matter how much we cut back on luxuries. So, the best way to save and get ahead is to expand those means, while continuing to live beneath them.
How can you go about expanding those means? Well, usually taking on another job is no fun, so try to find something that you enjoy doing to earn extra income. Sell old items on eBay. Try babysitting your neighbor's child or DJ'ing at your local bar. If you played in a band in college, start playing around your city again. I know a whole lot of people are cobbling together multiple jobs nowadays, but if you're one of those fortunate souls who has a job that pays enough to live on, having a side gig might help you expand those means even more in addition to your annual raise.
Moral of the story: if you're feeling squeezed financially, continue living below your means, but constantly be on the look out for ways to increase your income. Treat your own personal finances like a business and always grow your revenue. A company that had to rely solely on cutting expenses would soon go out of business because it would have to eventually begin cutting employees. And of course you can't run a company without employees. Similarly, you can't outpace inflation indefinitely by trying to do more with less.
3. CONTRIBUTE THE MAXIMUM AMOUNT POSSIBLE TO YOUR 401(K).
As with all of the other conventional financial advice, I understand why the experts spout this piece too. Most 401(k) plans have a matching plan where they will put in a certain amount of money if you contribute a certain amount. And although I advocate contributing to your 401(k) plan and preparing for retirement, I'm also an advocate of only contributing the amount necessary to get the company match. After that, I recommend contributing the maximum amount possible ($5,000 in 2012) to a Roth IRA, for multiple reasons. A 401(k) usually has very limited investing options, and the more limited you are, the less likely you are to earn an outsized return on your money. Second, because 401(k)s are tax deferred as opposed to tax exempt Roth IRAs, there are withdrawal penalties even for the money that one has contributed, in addition to tax penalties for money withdrawn before 59.5 yrs. old. Roth IRAs have penalties for early withdrawals also, but you can withdraw all of the money that you contribute to it without penalty because the money you contribute is after-tax money. Moreover, you can use up to $10,000 in contributions and capital gains to purchase your first home or pay for qualifying educational expenses.
Moral of the story: a Roth IRA is a much more flexible home for your investment dollars, so it's better to max that out than tying up your money in a 401(k) plan just because you get a company match. What's more, you feel so much more empowered when you know that you are saving for retirement AND have ready access to your money when you need it. In fact, although I recommend having a separate savings account, I think it's okay to use your Roth IRA as a savings fund. In the worst case scenario, you will only incur trading costs and maybe miss out on potential stock gains, but this negative series of events doesn't compare to the harsh financial penalties of withdrawing from your 401(k) prematurely.
There are plenty of other pieces of conventional financial advice that one should ignore, even though in general I think the conventional wisdom is right. But when making financial decisions, you should try to strike a balance between achieving the highest rate of return on your money and feeling more secure/confident/stronger about your financial situation as a result of your decisions. Let me know if you think of any piece of financial advice that doesn't make sense to you and we can try to figure out together if you should disregard it. Until next time...
Tuesday, August 21, 2012
Investing Tutorial - Part 4 (Stock Valuation)
Last post, we were still talking about valuation metrics. We stopped on the metric of price to book value and today, we will discuss what I believe to be the most useful valuation metric of all when valuing a stock - price to free cash flow (FCF).
I will be explicit about the definition of free cash flow, but let me first explain why I think the other metrics are inferior to it. The reason that I believe price to free cash flow is the most useful metric of margin of safety, or how expensive a stock is, is because there are a whole lot of really intelligent and clever accountants who work in the corporate finance departments of major companies. These very intelligent accountants also have a mandate from corporate management to make earnings numbers look as good as they are allowed to, within the legal boundaries of "GAAP" (Generally Accepted Accounting Principles). When accountants "massage" earnings numbers or engage in other financial sleight of hand, it's hard to get a true grasp on the "E" in the P/E ratio. Similarly, these same accountants can manipulate the value of assets and liabilities on a corporate balance sheet (at least temporarily), and this means it's hard to trust the price to book value ratio. Recall that in our last post, we defined book value as total assets minus total liabilities. Free cash flow on the other hand - well, it's hard to fake that. To paraphrase the saying, free cash flow is king!
I will be explicit about the definition of free cash flow, but let me first explain why I think the other metrics are inferior to it. The reason that I believe price to free cash flow is the most useful metric of margin of safety, or how expensive a stock is, is because there are a whole lot of really intelligent and clever accountants who work in the corporate finance departments of major companies. These very intelligent accountants also have a mandate from corporate management to make earnings numbers look as good as they are allowed to, within the legal boundaries of "GAAP" (Generally Accepted Accounting Principles). When accountants "massage" earnings numbers or engage in other financial sleight of hand, it's hard to get a true grasp on the "E" in the P/E ratio. Similarly, these same accountants can manipulate the value of assets and liabilities on a corporate balance sheet (at least temporarily), and this means it's hard to trust the price to book value ratio. Recall that in our last post, we defined book value as total assets minus total liabilities. Free cash flow on the other hand - well, it's hard to fake that. To paraphrase the saying, free cash flow is king!
So, what exactly is free cash flow? Well, there's a complex formula that's used to calculate it and if you're a stickler for details, you can find it here. But in layman's terms, it is the money that is left over to pay shareholders dividends after the company has used the money necessary to continue day to day operations. Here's an example. Let's say you own a small trucking company with a fleet of five trucks, all of which you use on a daily basis. Let's also assume that 3 of the 5 trucks break down. If you absolutely must have all 5 trucks in order to conduct business, then you have to either fix the 3 trucks that are not working or buy 3 new trucks. The money that is left over at the end of the year after making the necessary repairs/new purchases is free cash flow.
Some investing experts suggest that a thumbnail method of calculating free cash flow is by subtracting "capex" or capital expenditures from operating cash flow. (It should be noted that capex can be found in the investing section of a company's statement of cash flows. Operating cash flow can be found at the bottom of the "Operating Activities" of a company's statement of cash flows. And all of a company's financial statements can be found in its quarterly and annual filings at the Securities and Exchange Commission's website.
To bring it all together, when you use the price to free cash flow metric, you are essentially figuring out how much a company is charging you for it to make money for you. It's kinda like a recent college graduate asking you how many times his yearly salary of $40,000 are you willing to pay for him to fork over his entire lifetime earnings. I believe that most people would say that paying $160,000 (4x his current salary) for his life time earnings would be a steal. Even $200,000 or $240,000 still seems like a steal. But the higher the multiple of his current salary gets, the harder it is to justify paying for that stream of income. The same goes for stocks as their multiples of price to free cash flow goes higher and higher.
Remember, with the price to free cash flow ratio, you are paying a certain factor of a company's earnings stream. When you are getting a large earnings stream for really cheap or a reasonable price, you do not have to worry as much about your growth projections being wrong - so long as the company has a history of steady production of a certain amount of cash flow.
In our next post, we will talk about some common personal finance wisdom that you can go against because doing so actually empowers you. Until next time...
Monday, August 20, 2012
Investing Tutorial - Part 3 (Stock Valuation)
Last post, we talked about stock valuation metrics and how they relate to the concept of "margin of safety". I said I would give a clearer idea of what this is in my last post, so here goes. Margin of safety is assurance, by a specific margin (usually in the 20 to 40% range, but the larger the better), that the stock or bond you are buying is worth significantly more than what you are paying (i.e. its current price). But, margin of safety is a very amorphous term because it is difficult, if not impossible, to determine the true intrinsic value of a company (what the company is truly worth).
The process by which stock analysts and others who invest for a living determine what a stock is actually worth is called discounted cash flow analysis. This process is based on the premise that a company is only worth the sum of its earnings discounted back to some present value, where the discounting factor is the sum of the yield on U.S. treasury bonds plus some desired additional rate of return. For a visual lesson on how to perform a discounted cash flow analysis on your own, check out the video below.
After determining how much a company is worth using a discounted cash flow analysis, you should compare that value (make sure to divide the company value by the number of shares outstanding) to the actual stock value. For instance, if your DCF analysis tells you that a company is worth $34 a share, but it is trading at $22 a share on a stock exchange, then the stock is trading at a 36% discount (($34 - $22)/$34) to its intrinsic value. In other words, this stock has a 36% margin of safety. If on the other hand, your DCF stated that the stock was worth $15 and it was trading at $24, there would be no margin of safety. Benjamin Graham and Warren Buffett warn against buying stocks with no margin of safety or even small margins of safety since the margin of safety concept is intended to shield the investor from his own errors.
If you watched the video above, you saw that the stock analyst has to make lots of projections as to the growth rate of a company, potential tax rates, and the rates at which operating expenses will grow. And the more things one has to project, the easier it is to get things wrong. Fortunately, one doesn't have to use a DCF analysis in order to determine if a stock provides adequate margin of safety. She can just look at the metrics that I pointed to in the last post: P/E, P/BV, and P/FCF.
P/E
The faster that a company is growing, the higher that its P/E will usually be. As a general rule, the investor should look for companies that are growing fast, but have comparatively low P/Es (under 15x). A comparatively low P/E ratio, along with a growth rate that is equal to or higher than the nominal P/E (the actual number for the P/E), is indicative of a margin of safety.
Here's a quick example because I know that last sentence was a little confusing. Let's say you find a stock with a P/E ratio of 10. This is a great start, but if it the underlying company is growing at 5% a year, there might not be a margin of safety. Conversely, if a stock is trading at 10x earnings, but growing at 14% a year, this is certainly indicative of a margin of safety and it means the stock warrants further investigation!
Price to Book Value
As I mentioned last post, the book value of a company is the total amount of assets minus the total amount of liabilities. Essentially, it is the surplus, or what really makes a company valuable. When looking for margin of safety using this metric, just as when you are using the P/E, lower numbers are better. (Usually a multiple in between 2x and 4x is considered low.) When a company has a low price to book value, often times its assets - such as land that is being accounted for on the balance sheet at cost - are being woefully undervalued. The trick though, is to find companies with low P/BV and low, but steady growth and a dividend. The stock market treats steady growers very well, especially if they have a dividend. Low P/BV with a dividend usually means a margin of safety because even if you are wrong about the assets being undervalued, the dividend will provide downside cushion, AND, the market will probably not punish the stock for missing earnings estimates since its multiple is already so low.
In the next post, I will talk about the last major valuation metric, which is Price to Free Cash Flow. We'll get a little into the weeds, but it will be worth it.
The process by which stock analysts and others who invest for a living determine what a stock is actually worth is called discounted cash flow analysis. This process is based on the premise that a company is only worth the sum of its earnings discounted back to some present value, where the discounting factor is the sum of the yield on U.S. treasury bonds plus some desired additional rate of return. For a visual lesson on how to perform a discounted cash flow analysis on your own, check out the video below.
After determining how much a company is worth using a discounted cash flow analysis, you should compare that value (make sure to divide the company value by the number of shares outstanding) to the actual stock value. For instance, if your DCF analysis tells you that a company is worth $34 a share, but it is trading at $22 a share on a stock exchange, then the stock is trading at a 36% discount (($34 - $22)/$34) to its intrinsic value. In other words, this stock has a 36% margin of safety. If on the other hand, your DCF stated that the stock was worth $15 and it was trading at $24, there would be no margin of safety. Benjamin Graham and Warren Buffett warn against buying stocks with no margin of safety or even small margins of safety since the margin of safety concept is intended to shield the investor from his own errors.
If you watched the video above, you saw that the stock analyst has to make lots of projections as to the growth rate of a company, potential tax rates, and the rates at which operating expenses will grow. And the more things one has to project, the easier it is to get things wrong. Fortunately, one doesn't have to use a DCF analysis in order to determine if a stock provides adequate margin of safety. She can just look at the metrics that I pointed to in the last post: P/E, P/BV, and P/FCF.
P/E
The faster that a company is growing, the higher that its P/E will usually be. As a general rule, the investor should look for companies that are growing fast, but have comparatively low P/Es (under 15x). A comparatively low P/E ratio, along with a growth rate that is equal to or higher than the nominal P/E (the actual number for the P/E), is indicative of a margin of safety.
Here's a quick example because I know that last sentence was a little confusing. Let's say you find a stock with a P/E ratio of 10. This is a great start, but if it the underlying company is growing at 5% a year, there might not be a margin of safety. Conversely, if a stock is trading at 10x earnings, but growing at 14% a year, this is certainly indicative of a margin of safety and it means the stock warrants further investigation!
Price to Book Value
As I mentioned last post, the book value of a company is the total amount of assets minus the total amount of liabilities. Essentially, it is the surplus, or what really makes a company valuable. When looking for margin of safety using this metric, just as when you are using the P/E, lower numbers are better. (Usually a multiple in between 2x and 4x is considered low.) When a company has a low price to book value, often times its assets - such as land that is being accounted for on the balance sheet at cost - are being woefully undervalued. The trick though, is to find companies with low P/BV and low, but steady growth and a dividend. The stock market treats steady growers very well, especially if they have a dividend. Low P/BV with a dividend usually means a margin of safety because even if you are wrong about the assets being undervalued, the dividend will provide downside cushion, AND, the market will probably not punish the stock for missing earnings estimates since its multiple is already so low.
In the next post, I will talk about the last major valuation metric, which is Price to Free Cash Flow. We'll get a little into the weeds, but it will be worth it.
Sunday, August 19, 2012
Investing Tutorial - Part 2 (Stock Valuation)
In the last post, we were discussing the relationship of my analogy to companies, or their stocks as investments. If you haven't read the previous post, this post won't make much sense, so I encourage you to go back and read it. That being said, let's move forward.
What makes a great company great? Think about a company like Nike. It has great (cool and stylish) products, a large and loyal customer base, and great brand recognition. The same goes for Apple. And those aforementioned qualities are the reasons these companies' stock prices have soared over the last two decades. Great products and a loyal customer base usually translate into consistently high revenues, which also, for these companies, equals higher earnings.
Investment analysts determine whether or not a company is "expensive" by determining what multiple of earnings or some other metric of profitability/worth that the stock is trading at. For instance, if a company has $2.00 per share of earnings and its stock price is $20, its "price to earnings ratio" or P/E multiple, is 10. Similarly, if a company has the same $2.00 per share worth of earnings, but has a stock price of $100, that stock's P/E multiple is 50. An average P/E is about 20 -25 and the P/E ratio will vary depending on the industry that the company is in. Fast growing technology companies usually have nosebleed P/E ratios and more boring companies like car companies or waste removal companies trade at lower multiples. This is because investors are willing to pay more for companies that are growing really fast.
Facebook is an example of a fast growing company that trades at a high multiple, and is a cautionary tale about investing in high multiple stocks. Unless you live under a rock, you've probably heard that Facebook recently had an IPO (initial public offering). And when it came public, its P/E multiple was a whopping 155!! (This was calculated by dividing its initial price at the time of the IPO of $45 by its earnings of $.29.) Since then, the stock has lost approximately 60% of its value and it still trades at a multiple of 65! And remember that I said a normal P/E is in the 20 - 25 range.
Here we return to Graham's admonition regarding thorough research and ensuring to the best of one's ability that an investment will not lose money. Although it is impossible to determine whether an investment will lose money (unless of course you're a fortune teller, in which case, please call me), there are ways to mitigate risk certainly. It has been empirically proven that stocks with high multiples get treated more harshly by Wall Street (in terms of high volume selling that drives down the price) when they fail to meet expectations than below average multiple stocks. This is because high expectations are already taken into account by the price. So if high multiple stocks seem to be risky, then it follows that low multiple stocks should be less risky.
For the most part, that assertion is true and a whole body of investing has evolved around that very premise. The type of investing that focuses on stocks with low multiples of price to earnings, or price to free cash flow, or price to book value is called value investing.
Value investing, in keeping with Benjamin Graham's assertion about protecting principal, proposes that the best way to do so is to buy stocks with what's called a margin of safety. In the next post, I'll discuss this concept in greater depth and talk about how to calculate it.
What makes a great company great? Think about a company like Nike. It has great (cool and stylish) products, a large and loyal customer base, and great brand recognition. The same goes for Apple. And those aforementioned qualities are the reasons these companies' stock prices have soared over the last two decades. Great products and a loyal customer base usually translate into consistently high revenues, which also, for these companies, equals higher earnings.
Investment analysts determine whether or not a company is "expensive" by determining what multiple of earnings or some other metric of profitability/worth that the stock is trading at. For instance, if a company has $2.00 per share of earnings and its stock price is $20, its "price to earnings ratio" or P/E multiple, is 10. Similarly, if a company has the same $2.00 per share worth of earnings, but has a stock price of $100, that stock's P/E multiple is 50. An average P/E is about 20 -25 and the P/E ratio will vary depending on the industry that the company is in. Fast growing technology companies usually have nosebleed P/E ratios and more boring companies like car companies or waste removal companies trade at lower multiples. This is because investors are willing to pay more for companies that are growing really fast.
Facebook is an example of a fast growing company that trades at a high multiple, and is a cautionary tale about investing in high multiple stocks. Unless you live under a rock, you've probably heard that Facebook recently had an IPO (initial public offering). And when it came public, its P/E multiple was a whopping 155!! (This was calculated by dividing its initial price at the time of the IPO of $45 by its earnings of $.29.) Since then, the stock has lost approximately 60% of its value and it still trades at a multiple of 65! And remember that I said a normal P/E is in the 20 - 25 range.
Here we return to Graham's admonition regarding thorough research and ensuring to the best of one's ability that an investment will not lose money. Although it is impossible to determine whether an investment will lose money (unless of course you're a fortune teller, in which case, please call me), there are ways to mitigate risk certainly. It has been empirically proven that stocks with high multiples get treated more harshly by Wall Street (in terms of high volume selling that drives down the price) when they fail to meet expectations than below average multiple stocks. This is because high expectations are already taken into account by the price. So if high multiple stocks seem to be risky, then it follows that low multiple stocks should be less risky.
For the most part, that assertion is true and a whole body of investing has evolved around that very premise. The type of investing that focuses on stocks with low multiples of price to earnings, or price to free cash flow, or price to book value is called value investing.
Value investing, in keeping with Benjamin Graham's assertion about protecting principal, proposes that the best way to do so is to buy stocks with what's called a margin of safety. In the next post, I'll discuss this concept in greater depth and talk about how to calculate it.
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