Hot Stock Tip…

Occasionally those who do not know what I do when I mention that I am in financial services ask me,”So, what is the hot stock tip?” This typically leads me to explain to them that I do not deal in hot stock tips. I do not even sell any product. I try to help people make sense of their financial situation by putting together a plan that addresses their goals and desires.

Often this is a fairly intensive process of getting to know the client, their goals and dreams, and then going through the grunt work of trying to assist them making it a reality by looking at their budget and spending habits and trying to put the proper pieces in place as indicated by a custom-tailored plan.

One thing that I have tended to notice regarding the “hot stock tips” that I have received is that they tend to be fairly risky, and quite probably a good way to lose money for the person who has received it. Rarely have I heard from get rich quick scenarios the caveat… “lose money quicker…” It simply does not tend to sound as good from a sales perspective, I guess.

Budgeting is not sexy to most people. However, it can assist people with being able to put aside money to help them achieve their long term hopes and dreams. But for those of you that are still itching for a hot stock tip, here it is… Be careful with “hot stock tips”… the reason why they are so hot, is that you just might get burned.

 

As always, please send your comments and questions to info@objectiveplanningllc.com

Tax Now or Tax Later?

Over the years I have heard discussion on whether one should invest in tax deferred structures where on is taxed now or where one is taxed later.

I would probably be able to give my typical response to this dilemma in one word. Yes.

This response does not seem to answer the question. After all the question is directed at where one should invest one’s money whether it be a pre-taxed arrangement that grows tax-deferred and is taxed on the withdrawals such as a traditional-IRA, 401(k), 403(b), etc. or one should direct one’s money to areas where one pays the tax now, it grows tax deferred, and one is able to pull the money out at a later time tax free such as Roth IRA, Roth 401(k), etc…

Normally one would take a look at a number of variables including what one’s tax rate is now and what one would predict one’s tax rate is going to be in the future in order to determine the different effects associated with whether one should prefer to invest in one or the other. Of course, this presupposes that one is under the income limit so that one can be able to invest in a Roth IRA or has the Roth 401(k) option available to them.

I would have questions in regards to these assumptions in that one may have great difficulty in prognosticating the future and what the future may hold in regards to tax rates… Such questions also assume that one would have saved enough to be affected by the same marginal tax rate in the future. Given the rampant lack of savings throughout this country especially with people nearing retirement, I question how truly important it is to distinguish where one saves as opposed to how much one saves. Save as much as you can in either place, or preferably both places if that option is available to you would be more my inclination.

If you have the option of receiving a match from your employer for your retirement, I would suggest taking advantage of any free money that you can get by contributing to the matching amount accordingly. Secondly, once you have taken advantage of a match, if you are eligible, consider investing in a Roth IRA. After you have taken advantage of both, you may want to contribute the rest that you are able to contribute to your retirement plan. The reason associated with encouraging contributions to a Roth IRA is that this could provide greater flexibility in the future in terms of how one is taxed. It is not because one will necessarily have the best return when one looks at the tax rate ramifications. There are no guarantees. Having one’s money invested in a variety of areas could provide flexibility in the future.

Thus my full explanation of my yes answer. One does not know the future. That being said  savings, free money, and flexibility often seem like positive things to pursue.

Please send your questions and comments to info@objectiveplanningllc.com

 

 

 

 

The Benefits of a Roommate

In previous articles, I have pointed out that Americans have more space than they had 100 years ago. I have also pointed out that this space tends to cost more in terms of taxes, upkeep, and utility costs. Besides living in a smaller space, what can one do to leverage the space that one has currently?

May I suggest the benefits of having a roommate or renting out a room as a possible alternative? Often I will hear people say that they would like to be able to have a rental, and yet question when I suggest starting by letting out a spare bedroom. Sometimes they may point out that this is for when family/friends come to visit. Or they may say that they value their privacy and do not want anyone else sharing a space with them.

Let us take a look at some of the financial implications of being able to rent out a room for $450/month. Let us assume that you have a vacancy rate of 10% or that it takes a little more than a month to find a roommate. Let us also assume that due to various reasons that it costs $600/year to have the roommate in terms of upkeep costs, etc. Doing the math in this situation we would come up with an additional $4,260 in income.

If we were to have multiple rooms available to let, this figure could be increased accordingly. It is acknowledged that this amount could vary depending on the room in question.

What could you do with an extra $4,000+/year in income? What if you were to have this extra amount set aside for four or five years?  Would you then potentially be able to purchase a small rental unit of your own, or at the very least be in a position where the possibility is much more feasible?

For some people, the cost of loss of privacy is not worth it. I understand this. For those that do not mind, there may be some opportunity to be had in terms of improved cash flow and potential investment savings.

Let us take a look at the long term effects of having a roommate as described in our hypothetical example if you were able increase your rent by 3% per year and what would happen if you were able to get 3%, 5%, and 7% returns on your money respectively.

As you can see, we are talking about an opportunity cost that could be equal to several hundred thousand dollars over the course of 30 years. Now granted, this amount could vary based on returns and your tax rate. However, given the amount of money that is at stake, it behooves the question for many Americans, how much is your privacy really worth?

Please send your questions and comments to info@objectiveplanningllc.com.

Provocative: Your Home

Often I will hear people associated with real estate talk about someone’s most important asset being their home. For the sake of argument, let us forget the importance of health and the ability to work which I hope can easily be argued are more important than one’s home.

I will say this: if your home remains your most important asset, chances are that you will never become wealthy. Let me reiterate, if your home remains your most important asset, chances are that you will never become wealthy.

For some people this may come as a shock. After all, we have been taught about the importance of having a home and not flushing down money with rent. There is a certain degree of truth to this. I will even suggest that there is a large degree of truth to this if we are comparing similar spaces. The problem lies in that the average owned home is not similar to the average rental. They tend to be substantially larger, nicer and more expensive.

This may not in and of itself be a problem, but for the average American what value does a home provide other than a place to live? I will suggest not much. If you are skilled at restoring and fixing up houses in order to flip them, you may be an exception to this rule. If you rent out rooms of your place so that it is actually generating money for you, then definitely consider yourself an exception as well. For many, however their home is a box where they live that is taxed, subject to utilities, and serves as a storehouse for their stuff. If all you do is keep on upgrading to a larger and fancier box, and get used to a more expensive lifestyle correspondingly, you may be setting yourself up for failure.

The problem is simply this, for most people, one’s home does not serve as a source of generating wealth. It tends to rather be a means of forced savings assuming that one does not continually take out money in the forms of lines of credit, etc.

In order to become wealthy, you need to have assets that either grow or produce income in some fashion. This could be through a variety of means whether through the rental of real estate, a successful small business, or through the growth of securities in a portfolio. It is unlikely that this will occur

Please send your questions and comments to info@objectiveplanningllc.com.

An Introduction to Withdrawal Rates Part 2 of 2

The Issue of Rate of Return

If one were to assume that one could get an 8% average rate of return and that one were to retire at 65, and have to contend with 4% inflation, one could possibly argue for a 5% or 6% withdrawal rate since this could last until ages 103 or 92 respectively.  There are of course problems with this. One of the majorly cited problems is what if you have bad returns your first couple of years? The idea behind this is that if you are taking money out of a portfolio when it is down at the very beginning, one may never recover and become penniless well before one passes away. One of the other problems I alluded to in my article on rate of return. Long term rates of return have fluctuated significantly depending on the time period you examine.

It could be entirely possible to go through a long period of time with only a 6% average rate of return and have to contend with 4% inflation which changes the scenario significantly. In this case if one were to take out at a 5% or 6% withdrawal rate one would run out of money at ages 93 and 88 respectively.  A graphic representation of the effects of pulling out various percentages from a million dollar portfolio assuming a 6% average return and 4% inflation with various percentage withdrawal rates can be seen below. It must be noted that these rates do not assume fluctuation in performance of investments. To reiterate, down markets can happen at the beginning of one’s retirement and quite negatively affect the overall performance of one’s retirement portfolio. Having safeguards against this event would seem prudent. Without some form of safeguard, it could be possible that a 4% withdrawal rate would not be sustainable.

 

Withdrawal Rates

 

Please send your comments and questions to info@objectiveplanningllc.com.

 

Assumptions for Long Term Rates of Return

DJIA 30-Year Rate of Return

This graph shows the rolling 30-year rate of return for the DJIA around December 12th of each year from 1958 (i.e. from 1928-1958) to 2011 (i.e. from 1981-2011)

When I first started in this business, the common rate of return for a long term investment that I would hear touted  was 8% and sometimes as high as 10%. I recently decided to have some fun and check out what the investment return was for a number of periods looking at the DJIA. I gathered this information from the Dow Jones Industrial Active Learning Center under the Resource Center tab. Now, before the cries come out regarding using the DJIA, let me acknowledge some of the issues that I am sure that people will have:

  •  Looking at the DJIA does not reflect a balanced portfolio since it relates to very large cap if not mega-cap companies.
  • There are several allocations and investment strategies which long term have had better performance than the DJIA.

These issues do not counter the one problem that is aptly illustrated in the graph above. Averages, even 30-year averages, change over time. I will assume that you may have come to realize that just because you have an average return of X, that it is not to say you will have a return of X every year. In fact the average will change each year as the numbers change. And this is well and good as long as things remain relatively the same. But what if they are different?

If you were to take the average of the DJIA 30 year average for the past 20 years, you would get something close to 8%, with numbers of 30 year returns ranging anywhere from 4.7% to 10.1%.But what if you were to include 30 year averages from beginning in 1958 until now? You then have a range of numbers from 2.45% to 10.1% with an average return of 6.36%. If we were to look at the “average 30-year return for the DJIA” not including the past twenty years, we would have a return of 5.43% with a range of 2.45% to 8.18%.

Given these numbers, is it truly fair to assume an 8% rate of return?

Could it be that if anything, we have experienced a “golden age” when it comes to investment return and that we are heading back to the usual? I am not certain. I do believe to only look at what have been relatively good times when it comes to investment returns as it relates to financial planning is somewhat similar to pretending that clients have the benefit of playing poker with a deck of cards stacked in their favor when they do not.

Financial planning software often provides a number of wonderful ways to test the probable success of a portfolio, including Monte Carlo testing. That being said, these wonderful opportunities to check how valid our retirement assumptions may be depends on us not using a stacked deck in our testing. My hope is that this quick glance into the DJIA returns will cause people to question the basic assumptions of any financial plan including what is a fair rate of return and understand that averages are not static.

Please send your comments or questions to info@objectiveplanningllc.com.

Inflation

Is a gallon of milk the same price it was when you were a kid? How does the price of an average car, house, etc. compare to that time? Does anyone else remember when gasoline could be had at the pump for less than $1/gallon? Chances are that things cost more now that when you were younger. This phenomenon is known as inflation which can be defined as the general increase in the price of goods and services over a period of time.

Inflation affects the amount of purchasing power that you will have, and should be of significant concern if you are planning to save for retirement. Why? For starters we are living longer, and this gives inflation a longer time to catch up and eat away at your purchasing power.

There are a number of people that mathematically define the real return as:

Interest rate of the investment – inflation rate = real return

Financial planners when figuring out the next effects of an investment will use the following formula to determine the real return:

(1+ interest rate of investment)/ (1+ inflation rate) = (real return + 1)

For the sake of argument, I will follow the formula preferred by financial planners.

Let us say you have an investment with a post-tax return of 7%, and that you believe that inflation which has been 3% for some time is actually going to be closer to 4% due to what is regarded as an increased inflation rate for seniors.

The net effect would look something like this:

(1+.07)/ (1+.04) = 1.02885 (rounded) OR a Real Return of 2.885%

Now the mathematically inclined will probably begin to see the problem relating to withdrawal rates. If you are only adding 2.885%/year in value, and are taking more than that out, eventually you are going to run out of money. As a famous Englishman once wrote “there’s the rub.”

Most people have nowhere near that amount of savings needed to deal with taxes, inflation, and a sustainable withdrawal rate.

If I needed the equivalent of $50,000 per year using the previous assumptions adjusted for inflation without having to worry about depletion of resources, I would need to save over $1,733,102.

If my after tax rate of return is worse than that or inflation is higher, this number is substantially increased.

For example, let us assume that I still need $50,000 per year and I can only find an investment with an after tax rate of return of 5% and inflation remains at 4%.

Now we have a real return of  .9615 (rounded)  or .962%.

To be able to not worry about funds running out at this rate, we would have to have $5,197,505.

Now perhaps you can see why financial planners are concerned.

On a positive note, if you are able to get a substantial return, of 9%. The amount you would need to have $50,000 per year is significantly reduced, because now you are getting a real return of approximately 4.808%

To be able to not worry about funds running out at this rate, we would have to have $1,039,933.

If we are not concerned about saving the principle, the amount of money that is needed is reduced as well. Given our increasing longevity, inflation should be a very real concern for retirees. The good news is that with proper planning and budgeting, it as a problem that can be solved.

Please send your comments or questions to info@objectiveplanningllc.com.