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Wednesday Links — March 16, 2010

Links ImageWe’ll all just agree to pretend last weeks Wednesday had some links in it, okay? Haven’t been reading as much this week so I thought I’d go with fewer links and more discussion:

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Should You Be In the Stock Market?

Photo by: mvhargan

I often hear people tell me that they’ve stopped contributing to their retirement account because they don’t think the stock market is going to go up.  It seems many of these people assume that a retirement account and the stock market are one and the same.  Most plans have many options, and nearly 64% have actively managed bond funds as an alternative.[1]

The fact that many people don’t even know what their options are in their retirement accounts suggests to me that they probably shouldn’t have been in the stock market in the first place.  Many people were initially sold on stock market-based retirement account options by claims that the stock market returned 8%, or 11%, or whatever their advisor was telling them. They put their finances on autopilot and never looked back.  At least they never looked back until 2008.

The Risk Premium

The philosophical rationale for why stocks should outperform “safe” investments, like government treasuries, is something called the risk premium.  In theory, if equities did not outperform safe investments, then rational actors would cease to buy the equities. The prices would decrease to a level where there would be an adequate risk premium.

This theory was put to the test during the recent financial crisis when, at the nadir of stock prices, there essentially was no risk premium for the previous thirty years.[2]  Since then, stocks have rebounded a good deal and the risk premium has returned. However, it points out an important fact: the risk premium is only likely in the long term and is not guaranteed.

Risk Tolerance

Because of the wild variability of the risk premium, the value proposition of equities decreases as you get closer to an expected retirement date.  Once you have a near-term window for beginning withdrawals, the amount of time your returns have to “average out” decreases, and your exposure increases.  As you get closer and closer to retirement, equities should become a smaller and smaller portion of your portfolio. (more…)

  1. PSCA.org51st Annual Survey of Profit Sharing and 401(k) Plans []
  2. Bloomberg.com – Bonds Beat Stocks in ‘Earth-Shattering’ Reversal: Chart of Day []
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Investing Step #5: Retirement Accounts

Photo by: rutlo

This post is step 5 in our Investing Template.

Retirement accounts are probably the type of tax-deferred vehicle with which people are the most familiar.  The number of people invested in the stock market has skyrocketed in the past two decades, much of which is owed to tax-deferred retirement accounts.  Some examples of these types of plans are:

401(k) – The most common type of plan.  They are generally offered through for-profit companies and often include matching.

403(b) – 403(b) plans are similar to 401(k) plans, but are offered by public schools and some non-profit organizations.  There are other differences, but that is the most obvious one.

Traditional IRA – IRAs are also tax-deferred accounts, but are not implemented through an employer.  You are able to deduct the amount contributed and it grows tax-free.  You pay taxes on the funds when you withdraw them. 

Roth IRA – A Roth IRA is different from a traditional IRA in that you do not get to deduct your contributions from your income from this year.  However, like an IRA the money grows tax free and you can withdraw it without paying taxes when you withdraw.  Additionally, there are a few exemptions available to withdraw from a Roth IRA before retirement that are not available with other vehicles.

Self Employed IRAs – There are several other types of IRAs, such as a SEP-IRA and SIMPLE IRA,  available to people who are self-employed, which can allow them significant deductions as well.

All of these programs have different income limits and contribution limits, and a wide variety of details.  Make sure to do considerable research and consult with a tax professional before deciding which one is appropriate for you.

Your Strategy

Which of these accounts make the most sense for you can be complicated, but keep these things in mind:

If your company matches your contribution, it is almost always wise to maximize your contribution to the point at which they match.  Even if they only match 33% or 50%, you are still making an amazing return immediately. Many companies match up 100%!  Imagine a guaranteed return of 100% instantly.  It’s an incomparable investment.  This should usually be your number one investment destination after you’ve established your emergency fund. 

With the exception of the Roth IRA, these are funds you should be setting aside for retirement.  That means that this is the longest window in your time horizon.  These are essentially your funds for when you don’t want to work anymore.  Thus, you should only tie money up in these funds that you will not need for a long time.  There can be severe penalties for withdrawing this money before you reach retirement.

By the same token, if you are setting money aside for retirement, there is no reason not to get it into some kind of tax-deferred vehicle.  Once you are comfortable that you can afford to deisgnate this money for retirement, at a bare minimum you want it to be able to grow tax-free.

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Investing Step #4: Tax-Advantaged Accounts

This post is step 4 in our Investing Template.

Why pay taxes?  A lot of people claim they wouldn’t if they didn’t have to. However many of us are voluntarily paying taxes on money we could be pocketing tax-free with tax-advantaged accounts.  These are investment accounts where your taxes are either paid when you take the money out, or sometimes not at all.  Many people are familiar with retirement accounts like 401(k)s or IRAs, but there are other options that are often overlooked entirely.  Many times, if you know you’re going to have an expense in the near future, you can pay for that expense tax-free.  This many not seem like a big deal to you, but let’s do some simple math.

If I have a $100 expense this year and I’m in the 33% tax bracket, I have to earn $150 to pay for this expense if I have to pay taxes on the income.  If, on the other hand, I don’t have to pay taxes, I only have to spend $100.  This means that if I “invest” that money in tax-advantaged accounts that allow me the option to put away a certain amount pre-tax, I’ve immediately made 50% on that money.  A 50% guaranteed return is unheard of anywhere else, yet many of us overlook opportunities to achieve these same returns daily.  We’ll look at 4 broad categories of accounts that allow you to either defer, or completely avoid taxation on your income.

Tax-Deferred Accounts

  • Retirement Accounts
  • College Tuition Accounts
  • Home Investment Accounts
  • Health Savings Accounts

While each of these programs have nuances, they are closely related to your investing timeline.  Health Spending Accounts are for near-immediate expenses, home accounts are usually a fairly short timeline, college programs can be quite a while in the future, and retirment accounts are often the furthest off.   This collection of accounts can save you a great deal of money if used properly, so we’ll look at them individually over the coming days.

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Investing Prerequisite #3: Goals and Time Horizon

Photo by: Patrick Smith Photography

This post is step 3 in our Investing Template.

Once you have cleared out all your debt and created an emergency fund, it’s time to think about why you’re investing.  It is impossible to have a strategy without knowing what the strategy is intended to accomplish.  The investment strategy of a 20-something trying to buy a house, a 40-something trying to save for their children’s college, and a 50-something trying to catch up for retirement are very different.

The key component of all these things is this:

How Soon Do You Need The Money

The sooner you need the money, the less risky that segment of your portfolio should be.  Riskier investments typically give better returns over the long haul, but in the short term they can be disastrous.  The when of your strategy will be the single most important question in determining an investment strategy.

Milestones

Lay out your investing milestones.  Think about all the major life changes you would like to have and write them down.  This can be invaluable in deciding what investments are appropriate for you.  If you are going to need a certain amount of money for a house in 5 years, at which point you also want to have kids, you should be very cautious until you have a comfortable cushion to make those plans happen.  Look for all the major events that are going to affect your investing strategy and note them in a time line.

Be Realistic

When you’re designing your strategy make sure that your goals are realistic.  If you’re 55 and you have nothing saved, retiring in 5 years is probably not a viable option unless you want to move to a much cheaper country.  Similarly, do not be anxious to undertake major investments like a house.  Plan for the long run, and don’t overextend yourself.  You may not be able to retire as soon as you like, but taking gambles in the hope to get there faster can lead you to never getting to retire at all.

Other Considerations

Some other things to factor in your goals include:

Risk Aversion:  Some people are simply averse to risk.  They might want the returns a more risky investment could give them, but aren’t willing to take the additional risk.  There’s nothing wrong with this, and it’s important to realize if you are this kind of person.

Comfort: In addition to being realistic in your goals, you should be realistic in how much of your income you will be able to put toward investments.  At the same time, you need to be realistic about which expenses are necessities and which should be deferred.

Conclusion

This step of strategy building is simply to get a broad idea of your goals.  You need to know how much risk you should be willing to take and how soon you are going to need your money.  You don’t want to commit yourself to a 30-year bond if you’re going to need the money to buy a house in 5 years.   Create your milestone timeline and be diligent in assessing what makes the most sense for you.