Uncommon Cents

I’m a social worker. I’ve been employed by either a social service agency or a hospital since 1989, so we’re looking at about 20 years in the profession shortly. My colleagues and I regularly serve clients who have significant illnesses, strained relationships, mental illness, and financial problems. Often my tasks include helping people enroll into various financial assistance programs.

Concentrating on the latter population for the purposes of this post and looking at similar situations… why are those on public assistance not required to learn about personal finance?

This is not a huge stretch. At least here, those on the WIC program are required to see a nutritionist; those on financial assistance are required to work or volunteer after a certain amount of time receiving assistance (although there are waivers available depending on the situation). Considering that those on public assistance tend to have less to spend than others, would education on frugality and personal finance be most effective here?

Or perhaps requiring financial literacy as a class in high schools? While this has some appeal (and doesn’t appear to be punitive, where some might see requiring those on assistance to attend such classes might be), there’s a long way to go to get it implemented–and it totally misses those who are not in school. However, this might prepare the soon-to-be independent with some knowledge and skills that could make a difference.

We have such a financial mess in this country from the individual level to the governmental level and it appears that people only start learning about it when they’re in crisis. What do we do to make things better?

Is there a solution for our financial literacy problem in the U.S.? What do you think?

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!

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.

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.

It’s the working on the weekend edition of the Link Payday! Yes, for the second time in three weeks I’m on call and working the weekend at my daytime job, this time on a ten day stretch, so I’m trying to get both of this weekend’s posts done early. I also have a bunch of paperwork due for my part time job on Monday, so it’s going to be a double decker of a working weekend!

Trent over at The Simple Dollar questions if investing in individual stocks is like gambling. You’ve already seen my take on the issue, but I think reading the original is a great idea.

The Frugal Duchess tells us what she’s willing to give up for financial security. It’s an interesting read, and a more interesting question to ask yourself. What am I willing to give up for financial security? I think I’ve already given up quite a bit, like television, more frequent purchases of computers, and most of my traveling.

Frugal Dad looks at the about to be completed NCAA Men’s Basketball Tourney (aka March Madness) and seeing Davidson reminds us that there are no financial Cinderellas, meaning that even success that appears to come overnight doesn’t come overnight–it comes through discipline, sacrifice, hard work, smart choices, and determination for a long period of time.

Paid Twice tells us how both sides of the financial equation are important, meaning that earning more doesn’t do much for you if you don’t spend less. This is one of the big truisms of personal finance–if you don’t take care of both of these issues, you’ll still be fighting an uphill battle.

And finally, Mrs. Micah discusses how putting a lot of your money into your own company stock, even in a retirement plan, can be disastrous. Think about diversification, but maybe more importantly, think of those Bear Stearns employees who had a substantial amount of their retirement money in company stock and what’s happened to their retirement plans.

And that’s your Link Payday for April 5, 2008!

CNN’s Money.com ran an article in Walter Updegrave’s “Ask the Expert” series last week called, “Avoid the market carnage: Stick to the plan”, which was an answer to a reader question on whether to adjust a portfolio according to an existing plan or waiting until the market rebounds–the assumption by Updegrave is that the author was asking about rebalancing the asset allocation in a portfolio and the answer was largely around that.

However, whether that was the case or not, the message delivered by Updegrave was loud, clear, and rang true:

Stick to the plan!

If your investing plan was sound to begin with–and the best ones are not just simple, but sound–there’s no reason to change. Diversify. Asset allocate. Dollar cost average. Take advantage of any employer assistance and tax breaks you can. Keep your costs low. The only time to change the plan is if your plan wasn’t sound in the first place; if it was, then just follow your plan. Be smart, don’t let your emotions get the best of you, be patient, and stick to the plan! Good planning, discipline, and patience is rewarded.

I hope you know what a broker is–in typical Uncommon Cents fashion it’ll be up for a Working Backwards article in the next few weeks. Suffice it to say that a broker trades stocks and other securities for investors (like you and me). By all means I hope you are using a discount brokerage account (hopefully an online one!) for your investing. Costs are such a critical part of your investment world that the lower costs are the better. But where can you go to get a great deal on your investment needs?

There are many, many options; so many it’s confusing. Some online brokers are “online only”; some are traditional brokers that have decided they must offer Internet options in order to compete on a level playing field. But when looking at online brokerage accounts, the primary factor to consider is cost.

Personally, I have a few online investment accounts–Firstrade for my IRAs, Vanguard for my 403(b), Sharebuilder for a taxable brokerage account, and Treasury Direct for savings bonds. With the Vanguard and Treasury Direct accounts, I had little choice; fortunately, I really like Vanguard (although I think for the beginning investor who wants an IRA, their fees are surprisingly high) and Treasury Direct has been decent.

Sharebuilder has IRAs as well as regular brokerage accounts; one of the things it offers that I found interesting was the ability to buy shares of stock by dollar amount rather than number of shares, meaning you could buy partial shares quite easily; they also encourage dollar cost averaging by allowing regular purchases of stock for a relatively low fee. I buy a few hundreds dollars of a single stock (right now it’s Apple) every month for a $4 fee with no other charges.

Firstrade is another online discount broker that offers brokerage accounts and IRAs; they have very low trading costs ($6.95 for stocks or ETFs, $9.95 for mutual funds) and no inactivity or maintenance fees. I have used them for years and like them tremendously.

I’d recommend shopping around, since there are so many other choices out there (E*Trade, Ameritrade, and Scottrade immediately come to mind), but I can tell you honestly that I like what I’ve gotten with Firstrade and Sharebuilder; if I had to do it all over again, I doubt I’d change a thing, and that might be the best thing an investor can say about their brokerages!

Inflation is a rise in prices of goods and services over a period of time. Due to inflation, purchasing power of a set unit of money declines. If the current rate of inflation is 3 percent, what a dollar can buy today will require $1.03 to buy next year at this time.

Inflation is measured in many ways. The Federal Open Market Committee (also known as “the Fed”) looks at the Consumer Price Index (CPI) as a gauge of inflation, both the “headline” CPI which attempts to measure total inflation, and the “core” CPI which eliminates the volatile energy and food areas. This is important because the Federal Open Market Committee sets policies which directly and indirectly affect interest rates.

As you can see, inflation influences interest rates (and vice versa). When inflation appears to be rising, the Fed tends to raise interest rates; when inflation appears to be at bay, the Fed either will keep interest rates as they are or lower them. As interest rates rise, people and businesses are less likely to spend or borrow money and more likely to save money; as interest rates fall, the opposite happens. When people and businesses spend more, the economy tends to expand; when they spend less, the economy tends to contract.

Inflation is also influenced by supply and demand. If goods are scarce and in high demand, their price tends to increase; if goods are in abundant supply or in low demand, their price tends to decrease.

Understanding inflation can help consumers and investors understand fiscal policy and what their effects are on the economy, which may help them make better decisions about what to do with their money. If inflation is high, it is likely that interest rates will be raised higher, which would behoove the financially savvy to pay down their debt and pour money into savings; if inflation is low, it’s likely interest rates will become lower, which might indicate a time to refinance debt and try to lock in higher interest rates (perhaps in certificates of deposit). If inflation is high, it becomes even more important to seek out frugal ways to make your dollars stretch farther; when inflation is lower, this is not as much an issue. In any case, trying to understand what inflation is and its effects on your dollars can help you deal with your financial situation.

I first learned of The Coffeehouse Portfolio while reading The Lazy Person’s Guide to Investing by Paul Ferrell, one of the better beginning investor books I’ve read. While this portfolio has more funds than my personal model portfolio, I liked its diversification and performance enough to study it and discuss it with many of my friends.

The Coffeehouse Portfolio consists of seven different funds, each of which is a bit different than the others.

Fixed income represents 40% of the portfolio; the remaining 60% of the portfolio is divided equally (10% each) among six funds: large cap U.S. stock market, large cap value U.S. stock market, small cap U.S. stock market, small cap value U.S. stock market, international stock index, and real estate investment trust. As you can tell, this is a pretty widely diversified portfolio, including both domestic and international exposure and also includes exposure to the real estate market (which is not doing well right now but was going gangbusters a few years ago).

Appropriate funds for this portfolio from Vanguard would include:

Fixed income: Total Bond Market Index (VBMFX), Total Bond Market ETF (BND) or GNMA Fund (VFIIX)

Large cap: Large Cap Index (VLACX) or Large Cap ETF (VV)

Large cap value: U.S. Value Fund (VUVLX) or Value ETF (VTV)

Small cap: Small Cap Index Fund (NAESX) or Small Cap ETF (VB)

Small cap value: Small Cap Value Index (VISVX) or Small Cap Value ETF (VBR)

International: Total International Stock Index (VGTSX) or International Equity Index ETF (VEU)

REIT: REIT Index Fund (VGSNX) or REIT ETF (VNQ)

There are, of course, other options, like the T. Rowe Price GNMA Fund (PRGMX) for fixed income or Fidelity Spartan International Index (FSIIX) for an international fund.

I like the diversification offered by this fund, especially the REIT exposure, although REITs have not performed well in the current housing market. While the portfolio didn’t do so well in 2007, its average over three and five years beats the S&P 500 handily. I also like the fact that the portfolio can be comprised entirely of ETFs, both in terms of low cost and low barrier to entry. On the downside, seven funds are more to look at than the three in my personal model portfolio, and can result in a few more trading costs when it’s time to rebalance. Still, it’s hard to argue with the performance of this portfolio over the last few years. I would strongly consider this model if I was assembling my own model portfolio–in fact, I did, and the main reason I did not go with it was that I could not replicate the funds in my 403(b) plan. The Coffeehouse Portfolio might help you afford relaxing mugs of iced latte in your retirement future.

Here’s some of my favorite posts as of late in the personal finance blogosphere:

The Simple Dollar is right on the money (no pun intended) on investing in yourself. This post discusses exercise; I don’t talk about it much on this blog, but in 2002 I weighed (according to my doctor’s scale) 272 pounds; today I’m right around 180, so I do believe that this is something that can seriously pay off!

Lynnae over at BeingFrugal.net talks about something I preach to parents regularly: read to your kids! Talk about investing in your family; this is something I believe pays off big. Nothing is equal to the amount of time you spend reading to your kids.

Debt Free looks at reasons why most people can but few people will get rich. I’ve long believed that it’s certainly possible for the working class/middle class person to save enough and invest enough wisely enough spending very little time and energy to do well, if not “get rich” (I guess it depends on the true definition of “rich” today).

I’ve Paid For This Twice Already again discusses the art of snowflaking, which I’ve discussed here and many other personal finance bloggers have discussed over and over again. Snowflaking pays off, trust me!

Making Money Journal has a similar interest to me: photography. This week they look at making a zero cost macro lightbox. I’m going to work on making one myself when I get a few minutes!

Finally, Mrs. Micah asks a question that many may be afraid to ask: who do your financial decisions reflect on?