Uncommon Cents

May seems to have been another positive month in the stock market; my initial belief just looking at (but not actually running) the numbers is that it was not quite as positive of April but it was quite decent in and of itself. Let’s take a closer look:

The Vanguard Total Stock Market Index Fund (VTSMX), which makes up the largest portion of my portfolio, ended May at $34.16 a share after closing April at $33.46, a gain of a bit over 2%. The Vanguard Total Bond Market Index Fund closed May at $10.07 vs. $10.18 at the end of April, down just over a percent but putting out that nice 4.86% yield for the fixed income portion of your portfolio. Finally, the T. Rowe Price International Discovery Fund (PRIDX) finished May at $46.23 versus the $45.28 it finished April at, a nearly identical gain of a bit over 2% to VTSMX.

Hopefully, the market continues to stay on course for a positive end to 2008!

The last time we looked at “Basics”, I discussed the cash flow equation, which is:

income - expenses = cash flow

Now, once cash flow is positive (and the more positive, the better) the wealth equation is also simple:

(cash flow + sensible safeguards + wise investments) x time = wealth

Simple, but not necessarily easy. Once your cash flow is positive, it’s time to do some smart things with your money and let time do its thing.

What are these smart things?

Sensible safeguards: these are your emergency fund, term life insurance, long term care insurance, and disability insurance. You don’t want to toss money away, but you also don’t want to under insure. Keep a reasonable amount (many say a minimum of $1,000, others say six months of salary–personally, I split the difference and say three months of take home pay) in a money market account with check writing and an ATM card (Capital One Direct is the one I use). If you have dependents, get term life insurance; you may also want to consider disability and long term care insurance.

Wise investments: what we’ve been discussing on this blog forever. Passively managed, no load, low cost, tax efficient index funds and exchange traded funds. High quality bonds and bond funds. Traditional and Roth IRAs, 401(k)s, and their equivalents. Reasonable asset allocations. Investments made at regular intervals. Diversification, diversification, diversification.

Time: you know what this is, and the more you have the better.

Wealth: the dollars you end up with at the very end.

The one other thing that you need will be discipline. We’ll cover that later, but in the meantime, remember that formula. It’s a simple, get-rich-slowly, tried and true over time formula that will help you reach your goals–it’s helped me build a six figure portfolio in less than half a decade!

I firmly believe that the 401(k) and its equivalents are among the absolute best financial savings vehicles to come along ever. However, not everyone agrees with me, possibly including teachers in West Virginia.

According to this CNNMoney.com article, West Virginia teachers essentially got to vote on a “do over” decision for whether they want a 401(k) type plan or a traditional pension. Like the corporate world, some municipalities have gone away from the traditional pension system (which is very expensive for the employer) and to a 401(k) or similar system. The positive side of this is that the 401(k) is a great system for both the employer and the employee; the negative side is so many employees don’t use their 401(k) to maximum effect [and there is also the very real possibility that the custodians of the 401(k) are offering the kind of options that make the most sense in their plans--like no load, low expense, passively managed index funds].

Apparently, many of the teachers in the 401(k) style plan have not done very well with their savings and are now asking for a return to the traditional pension plan, which was voted on earlier this month. There is some feeling that the options offered in their plan were less than optimal and teachers were steered into them. Sadly, this points out a huge issue not just with 401(k)s, but personal finance in this country in general–even college educated professionals don’t necessarily make decent decisions about money.

Another issue is that if this happens, the bill will be footed by–yes, you guessed it–taxpayers. This is one of those things that couldn’t happen in the private sector, but could in the public sector.

This situation bears watching.

In response to the Total Portfolio Makeover II series of posts, I received the following email from a reader:

Hi, I like your website. Good post about investing in the Vanguard Total Stock Market Index Fund, however I think it’s important for people who are older to balance their equity holdings with a bond fund to soften the blow when the market goes down.”

The reader makes an excellent point here. Asset allocation, which we’ve discussed many times on this blog, can and probably ought to be influenced by your age and time until retirement. As you may recall, asset allocation is how you divide your portfolio among different types of securities; in this blog we have basically split our assets among domestic bonds, domestic stocks, and international stocks, although it certainly is possible to include other types of assets such as precious metals and real estate in the calculation. We allocate assets to attempt to mitigate risk, and part of the amount of risk someone can afford depends on the amount of time before they need to convert the portfolio into cash. For someone in their 20s with four decades until retirement, having more risk is appropriate; for someone in their late 50s approaching retirement within a decade, reducing risk makes sense.

So, in Chris’s case, while I suggested an asset allocation of 50% domestic stocks, 25% international stocks, and 25% high quality domestic bonds, someone who was, say, 20 years older (meaning in their mid 50s), I’d probably be a bit more conservative, possibly 40% domestic stocks, 20% international stocks, and 40% high quality domestic bonds. In retirement, I’d likely be even more conservative as the emphasis switches from portfolio growth to preservation of capital–in that case I’d be looking at something more like 40% domestic stocks, 10% international stocks, and 50% high quality domestic bonds.

Are there cases when I would consider a more aggressive asset allocation as someone approaches retirement? Maybe. If the person was a late starter or just didn’t accumulate much in retirement savings and time is rapidly running out, I’d consider adopting a more aggressive stance, but the important word in all of that is consider. A lot would also have to do with the risk tolerance (or, rather, the volatility tolerance) of the person who owned the portfolio. If the portfolio owner had a high risk tolerance, then yes, I would consider a more aggressive stance. However, for the most part, I strongly agree with our reader: as the investor gets older, a more conservative asset allocation is definitely appropriate.

April was a fantastic stock market month. It was such a great month that it almost made up for the awful start to the year in the markets.

Recalling my previous articles in this series, my three portfolio fund consists of the Vanguard Total Stock Market Index Fund (VTSMX), the Vanguard Total Bond Market Index Fund (VBMFX), and the T. Rowe Price International Discovery Fund (PRIDX), with VTSMX making up the majority (approximately 50%) of the portfolio and the remaining being split about equally between VBMFX and PRIDX.

VTSMX started the month at $31.86 a share (as of the close of business March 31, 2008); it ended April at $33.46. That’s a gain of over 5% for the month. VBMFX started the month at $10.22 a share and ended at $10.18, a loss in net asset value of just .3% (yes, three tenths of a percent) but continues to put out monthly dividends, including one of almost four cents that month. Finally, PRIDX began the month at $43.96 and ended it at $45.28, a gain of a hair over 3%.

Hopefully, we’re over the funk that the markets have been in the last few months and we’ll continue to see gains in the months to come–and as much as I’d like to say, “big gains,” I try not to, because booms tend to be followed by busts–which is really what I don’t want. So instead of a boom, in keeping with our April theme, let’s hope for a bloom–like a rose.

I had hoped to look at doing a makeover on one of my physician friend’s portfolio, but she still has homework to do. So, in the meantime, another person I know has asked for help doing a portfolio makeover–on to makeover II!

Chris is a 36 year old single administrative assistant with no unsecured debt other than her vehicle. She has set aside $5,000 and wants to start investing. When asked what her goal is, she says, “I guess retirement.” She states she has minimal risk tolerance and was counseled about the risks of not just market trends and net asset valuation but inflation.

For her purposes with this lump sum of money, Chris would seem to be best served by a Roth IRA. She meets the income qualifications and already has a 403(b) plan which she contributes to; she has way more than the five year minimum before she’d withdraw from the Roth, and the amount of money she has saved up is perfect for the Roth IRA. It’s too late to contribute for 2007, but well early in the year for a 2008 contribution.

Where to start a Roth IRA? There are many, many choices; I would recommend a discount broker with online access. Firstrade is what I use and generally recommend, but there are lots of other choices like Scottrade, E*Trade, and TD Ameritrade. Unfortunately, while I highly recommend Vanguard funds, it’s hard for me to recommend them as an IRA choice because they have some fees that seem to be worse for the small individual investor starting out than the discount brokers.

What to buy with the Roth IRA? That’ll be in our next segment! Remember, though, that we’ve discussed asset allocation, costs, taxes, and diversification to the hilt over the last few months; with a Roth IRA, we’ve already addressed taxes and with Firstrade’s low fees we’ve already addressed costs. Next time we’ll look at asset allocation and diversification. We’ll get Chris on the road to retirement in a very simple way!

401(k) loans drive me crazy; you immediately lose the big advantage of the 401(k), the immediate tax break, because when you borrow from your 401(k)–which is filled with pre-tax dollars–you must pay them back with post-tax dollars. Still, many people consider their 401(k) to be a kind of piggy bank for withdrawals for whatever reason.

But the danger of the 401(k) loan is not just in the loss of the tax break–it’s in the possibility of a job loss. For whatever reason, a relative of mine decided to take a loan out on her 401(k) of $7,000. She was about 1/3 through repayment of the loan when the job ended because the company folded. This leaves her in a bind–pay the loan back immediately [which she can't do--and pretty much no one with a 401(k) loan would be able to do--or she already would have done it] or consider it a payout rather than a loan–with the accompanying taxes and 10% penalty! For someone who is in dire straits enough financially with a loan like this and a job loss, this is devastating.

So consider more than just whether or not you can pay back a 401(k) loan if you’re on the fence about taking one; also consider whether or not your job (or your entire company) is in jeopardy. If your job goes away, the loan might too–not in the sense that you don’t owe on it anymore, but in the sense that it becomes income, and usually not in the way you want.

It’s likely that your 401(k) will be your largest investment account. Knowing that, it’s prudent to determine what asset allocation you want in that account, as well as what mutual funds you’d like to be included.

We’ve discussed asset allocation before; basically it’s how much money you would like in certain kinds of investments. I’ve pretty much standardized on a mix of 50% domestic stocks, 25% high quality bonds, and 25% international stocks. This makes the math easy and builds you a fantastic portfolio with just three funds. If I was very close to retirement (or in it) I’d likely be closer to 35% domestic stocks, 15% international stocks, and 50% high quality bonds, but your mileage may vary. This is, in fact, the way my portfolio is currently constructed.

In an ideal world, I’d construct this portfolio with these three funds:

Vanguard Total Stock Market Index (VTSMX)
Vanguard GNMA Fund
Vanguard Bond Index

That said, there are many, many fine mutual funds out there, and your 401(k) plan may not offer the ones you want most. In my case, they only offer one of the three funds, so I have substituted a couple of other funds [given that my plan, which is actually a 403(b) because I work for a non-profit, has a brokerage option which I am still investigating, I may in fact someday get exactly the funds I want]. In any case, my first choice for the portfolio in principal would be low cost, passively managed, no load index funds–while Vanguard is the king of these, there are many alternatives such as T. Rowe Price, Fidelity, and TIAA-CREF.

While I am not a fan of actively managed funds, if you for some reason do want to include them in your investments, the best place to keep them is in a tax sheltered account of some kind like a 401(k). The reason for this is that these funds tend to generate taxable capital gains every year which are much larger than the negligible capital gains generated by passively managed funds, so if you for some reason want to have a few actively managed funds in some segment of your total holdings, this may be the place to do it (this concept is known as asset location, which is similar to but definitely not the same as asset allocation). I would, however, totally recommend staying away from load funds–there’s no reason to pay a load, ever.

One other issue to consider is your employer match. If your employer matches you using the stock of the company you work for, it is quite likely you will quickly become overweighted in your company stock. This becomes one of the basic issues of diversification; all is well while the company is doing well, yet if the company falls on hard times (Bear Sterns, anyone?) so will your portfolio. Strive to keep your own company stock under 5% of your total if at all possible.

Thinking about what you will have in your 401(k) is almost as important as starting it in the first place. Consider asset allocation, asset location, and diversification while working on this aspect of your portfolio and you will do just fine–with only three funds, too!

A 401(k) is an employer sponsored retirement savings plan that is common in for profit companies. Non profits have a largely equivalent plan known as a 403(b) and public sector employees often have the also largely equivalent 457.

Dollars contributed to the 401(k) plan are pre-tax [although there has recently emerged a "Roth 401(k) which allows the contribution of post-tax dollars allowing withdrawals past age 59.5 tax free], meaning the employee receives an immediate tax break which could be substantial. For myself, this tax break amounts to approximately 30%; if I was to invest the same amount of dollars post tax, I would require about 30% more earned income, meaning that the $15,500 I put away last year would take more than $20,000 in earned income. Contributions also grow tax deferred–no need to pay taxes on interest, dividends, or capital gains every year!

Contributions by an employee to a 401(k) plan are often matched by the employer up to a certain amount; for instance, for every dollar an employee contributes to the plan, the employer may also contribute a dollar up to a certain limit, typically 5%. That’s free money! Don’t leave that one unaccepted; it’s like your boss telling you they’ll give you a raise and your turning it down.

If you leave your employer, 401(k) plans can be rolled over into a traditional IRA without any tax penalty, which may give you a lot of flexibility in terms of what you can invest in. You can also roll an older 401(k) into a new one at your new employer, but this is more complicated.

401(k) plans tend to offer a choice of several different mutual funds; hopefully your plan allows you choices of passively managed, low cost index funds including the total stock market index, the total bond market index, international funds, and many, many others. I am fortunate in that our plan is managed by Vanguard, the king of low cost index funds, and we have a large selection of funds through them as well as other vendors.

Finally, when you are eligible to withdraw funds from your 401(k) without penalty at age 59.5, the money is taxed as ordinary income; if you are in a lower tax bracket than when you were working, you’ve made out like a bandit on your taxes. There are some circumstances under which you may be eligible to withdraw money from your 401(k) without penalty (but still with tax implications), such as a first time home purchase or for high medical expenses–check with your plan and your tax professional for details.

One controversial feature of a 401(k) is the ability to take a loan from them, for any reason. Avoiding this if at all possible tends to be the best idea–you lose your tax advantage when you do this! First, you will have to pay the loan back with post tax dollars (so much for the tax break contribution!), and second, you still have to pay taxes at the time of withdrawal, so you end up getting taxed twice on that money. It’s also less money to earn returns over time in your account.

All in all, however, I think the 401(k) is a great financial tool to save for retirement and if you’re not taking advantage of it, you’re leaving money on the table–and that’s not something many people can afford to do.

I was surprised to learn this past week that one of my blogging buddies who I consider a brilliant guy was not participating in his company’s 401(k) plan. I coincidentally got a request by a reader to cover some 401(k) basics, which has lead to this article.

In traditional Uncommon Cents fashion, I’ll discuss what a 401(k) actually is in a coming Working Backwards segment. In the meantime, just know that a 401(k) [or its equivalents, including the non-profit version 403(b)] is if not the best, at least one of the best ways to save for retirement. The 401(k) allows an employee to contribute a percentage of their gross income, typically up to a yearly maximum of (currently) $15,500 pre-tax (with “catch up” provisions for those who are a bit older allowing even more to be contributed) and let it grow tax deferred until you reach 59.5, at which time you can make withdrawals at your marginal tax rate (which is likely to be lower at retirement than when you’re working)–this means that if you’re someone like me, in the 25% Federal tax bracket with about a 5% state tax, I’m getting a 30% tax break on that money right off the top. In addition, employers often offer a “matching” contribution, meaning that, for example, for the first 5% of your money that you contribute to your 401(k), the company will contribute a matching 5%–which is, essentially, free money. Your employer is trying to give you free money!

For whatever reason, people don’t always use their 401(k) plans to their maximum, or, sadly, at all. That’s wild; can you imagine your boss telling you that they want to give you a raise and your turning them away? This is essentially the same thing!

If you are 401(k) eligible but haven’t started and want to–and it’s hard to imagine not wanting to–here are the steps you need to follow to get going:

1) Contact your human resources department and request to get started. They’ll likely send you some documentation and papers you need to sign.

2) Determine what kind of match your company offers. It may be in stock or in cash (hopefully the latter). Warning: if your company’s match is in stock, be very careful about having a high level of concentration in that particular stock! Diversification is key.

3) Contribute at least the amount needed to make the most of the match. If you can contribute more, that’s fantastic, but at the very least max out the match. If not, you’re leaving money on the table!

4) Determine your asset allocation and which funds to purchase to reach your allocation targets. Remember that costs are critical (as they always are); if you decide to have actively managed funds in your portfolio (and I typically don’t recommend them), this would be the place to have them, as the tax deferral of the 401(k) allows you to sleep easy with capital gains.

5) Pull the trigger. Go ahead with your plan and don’t worry about it!

Seriously, the 401(k) is one of the best investment vehicles available, and for most of the people who are offered it, not using it is essentially turning down free money. That’s really not something I want to do! We’ll look more at the 401(k) in the coming weeks, but if you haven’t gotten started, get started now.