Investing Prerequisite #1: How To Deal With Debt

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This post is step 1 in our Investing Template.

Deciding when and how to pay off your debts is not a simple matter.  While it can be comforting to be debt-free, that may not always be the most financially expedient approach-nor is it the whole picture. Here are a few steps, including analyzing and paying off debt, that really make your money work FOR you.

Step One: The Basic Emergency Fund

The absolute first thing you need to have is something to pay for unforeseen events.  I personally recommend keeping this fund as small as possible at the beginning.  We’ll get to creating a larger cushion later, but right now the goal is simply to get enough money so that you’re covered if your car breaks down or something else untoward happens.  In fact, in some cases I’d recommend skipping this step altogether.  If you have friends or family you believe you can reliably rely on in case of an emergency, get right down to paying off any debts.  Once your debts are paid off, go on to creating an expanded emergency fund.

Step Two: Minimum Payments

Paying off your debts is one of the best investments you can make, but it isn’t always the best.  You need to take a lot of things into account to decide when and how to pay off your debts, and the analysis isn’t always simple.  One main rule is this:

Always Pay Your Minimums

You cannot possibly hope to match the interest rate you will be charged with late fees and penalties, so you have to pay at least the minimum to every debt you have.  So no matter what other options are open to you, do not let yourself be subjected to these kinds of charges.  If you cannot meet your minimum payments, it’s time for another job, or to sell some things.  Getting your head above water is a separate subject, but make sure to do it.

Step Three: Tax-Deferred Options

Now despite the allure of being debt-free, there are some rare occasions that your bottom line will be better served by contributing to your tax-deferred savings.  Quite simply, if your company matches your tax-deferred account at 50% or better, you may be better off contributing to that account.  This is of course only true up to the amount that they match. Do not contribute more than they match until your debts are all paid off.

For example, if my company will match up to 3% of my salary in my 401(k) at 100%, I am possibly better off making this contribution instead of paying off my debts.  I will make 100% return on that money put into my 401(k), while I will probably be charged 20% on the debts I leave unpaid.

Generally speaking however, unless your debt is relatively small compared to your income, or you are very secure that your income will continue, you are probably still better off just paying the debt.

Step Four: Pay Off Your Debts

There is no sense investing in anything when you have the option of paying off your debts.  The only debt you may want to carry is a house or a car, and even those are questionable.  Even beyond the dangers of high-interest debt, it simply provides a security blanket to have your debt cleared.  There are various approaches to paying off your debt, but get it done before you start investing your money elsewhere.  Moreover, when in doubt: pay off your debts sooner than later.

Basic Investment Template

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My next several posts will be attempting to define a basic investment template.  Basically I’d like to develop a checklist to help anyone figure out where and how their money should be invested.  Most investment advice I read is very vague.  While most contain good advice it is usually in a vacuum.  You’d have to read hundreds of these articles to develop a coherent strategy and you still might miss a key point.  I will update this post as I create each installment and may reorder and edit them based on your input and questions.  I will also be posting much more frequently until the template starts to take shape.  Please feel free to start putting any questions below and I will attempt to answer them as I go.

Investing Prerequisites

• Step 1: Dealing With Debt
• Step 2: Your Expanded Emergency Fund
• Step 3: Goals and Time Horizon

Tax-Deferred Accounts

• Step 4: Tax-Advantaged Overview
• Step 5: Retirement Accounts
• Step 6: College Saving Accounts
• Step 7: Homeownership Accounts
• Step 8: Health Spending Accounts

Implementation

• Step 9: Allocation
• Step 10: Techniques

 

Protectionism: A Prisoner’s Dilemma?

Photo by: Kyle May

In game theory there is a “game” called the “Prisoner’s Dilemma.”  In the game, two players have been arrested.  If they cooperate and neither “rats” on the other, they will both go free. If one “rats” on the other, he receives a light penalty while the forsaken prisoner receives a stiff penalty.  If they both turn on each other, they both get a moderate penalty. 1  The basic lesson? Each of the parties would be best served if neither of them participated, but least served if they don’t participate while the other party does.

A real-world example of this could be a sporting event:  say something interesting happens and a spectator stands up to get a better view.  This causes more and more people behind him to stand up, just to get the view they had before.  At the end of this process, everyone essentially has the same view they had before, but now they’re exerting the effort of standing.  If they’d all just remained seated in the first place, they’d all be a bit better off. 2

What Does This Have To Do With Economics?

People say that our current financial crisis will not be as bad as the Great Depression because “we make much better decisions now.”  We know better than to resort to things like high interest rates and protectionism.  We won’t make the mistakes of Smoot-Hawley again.  But history shows that, in general, we were actually smart enough to know that at the time.  While economists rarely agree on anything, they were universally opposed to the Smoot-Hawley Tariffs.3 Yet they happened anyway.

Meanwhile, looking to the present, we see signs of the same kind of thinking again.  We know better than to adopt protectionist policies, but the new administration is already discussing whether to “punish” China with tariffs due to their manipulation of their currency value.4 This justification seems particularly unrealistic as we are creating 0% interest rates and pondering bailing out our auto-makers.  Bad decisions are often deemed bad only in retrospect.  People don’t plan to make bad decisions, they make what they think are good decisions in the vain pursuit of “fairness,” a concept that is ephemeral and non-existent.

So are we faced with a Prisoner’s Dilemma?  Will it deal a crushing blow to our economy if we do not “fight” other countries protectionism with our own.  History has little to say, except that free trade has usually been good for all the parties involved.  If we can buy something cheaper than we can produce it ourselves, then we are better off than if we make it at an inflated price.  It may not necessarily be the case that we need to follow suit if everyone else in the world starts pursuing protectionist policies.

How Does This Affect Me?

As Geithner and his fellows debate whether or not to implement tariffs on China, the most likely action item for you is to be very cautious.  While many may be telling you that this recession will not rival the Great Depression, you can watch as we take the same steps that we’ve decried before, thinking that “things are different this time.”  Almost any negative outcome is a possibility in the short and medium term, and it pays to have something that protects you in each case.  In the short term, deflation seems to be a likely demon, but longer term inflation seems to be the opponent.  Meanwhile, it’s difficult to know whether stocks can be expected to perform.  Ultimately, it is pivotal that you develop an investing strategy that involves protecting yourself and optimizing for your personal situation.

1. Stanford Encyclopedia of Philosophy – Prisoner’s Dilemma [↩]
2. Landsburg, Steven – More Sex Is Safer Sex: The Unconventional Wisdom of Economics [↩]
3. The Economist – The Battle Of Smoot-Hawley [↩]
4. The Washington Post – Geithner Say China Manipulates Its Currency [↩]

What We Should Fear Volume One: Inflation

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The economy is always fraught with peril.  Your savings and investments are always subject to risk, and it’s your job to protect them.  Unfortunately, if it were easy to identify the risks out there, we’d do a better job of avoiding them.  One problem that seems to loom in the future of every investment decision is monetary policy.

Depreciation

The current crisis is one of deflation.  People have less money and feel less secure, so they spend less money.  This means that companies have to charge lower prices and make less money, which leads to layoffs, which leads to people having less money and feeling less secure. 1 This cycle is very much like the reverse of the bubbles that we’ve seen in various markets.  The bust is the logical opposite of the boom.

The key difference between the boom and the bust is that the government feels compelled to step in and try to ameliorate the effects of the bust.  They may give lip-service to trying to prevent bubbles, but ultimately their jobs depend on appearing to help “solve” a suffering economy.  Whether or not they can be effective is really beside the point, they have to be seen as “trying.”

The Consequences

The natural upshot of all of this is what is referred to as counter-cyclical policy.  When the private sector is not spending, the government steps up to fill the gap.  Hopefully, the things the government spends its money on providing long term benefits, as well as the short term benefit of creating jobs and demand.  While it may seem like any kind of spending will help break the vicious cycle of depreciation, hopefully you can also reap lasting benefits out of it.  A good example is updating infrastructure like highways or utility grids.  Whether this is the best application is debatable, but ultimately the idea of counter-cyclical spending is a fairly well accepted one.

What this ultimately means however is that in the long term the real threat to your wealth is not the deflation cycle.  In fact the deflation cycle is actually making your savings worth more, while devaluing your assets like your house.  What you ultimately have to fear is the eroding power of inflation. While the government has always sought to keep inflation in check, there are several reasons to think its toolbox will be empty when the time comes.

Inflationary Policy

Anyone who has been paying close attention to government policy recently has seen monetary figures unlike any in recent memory.  The TARP is 700 billion, but represents only a fraction of the money that has already been spent to inject stability and liquidity into the system.  This is before all the counter-cyclical spending that the new administration is planning.  Regardless of the efficacy of these plans, there seems very little to prevent them from happening.  In fact the incoming President has told us to brace for TRILLION dollar deficits for some time to come.2

While the government can posture about how it will cut spending or find other sources for this money, ultimately it will be borrowing it.  It will create a huge debt and will have to escape from it.  The natural escape is through inflationary policy.  By “printing” more money (printing isn’t really necessary anymore, but it’s the same effect), the government will reduce the value of that debt.  This will make it easier to manage, but ultimately will punish those with cash in the bank.

How To Protect Your Cash

TIPS are a very attractive means to protect any savings you currently have.  TIPS, or Treasury Inflation Protected Securities, are like normal Treasury Bonds, but your principal is adjusted for the Consumer Price Index (a measure of inflation).  Obviously you will receive a lower interest rate than you would with normal Treasuries; but if you believe the inflation will exceed that difference, then they are a better deal.  Currently, because of deflationary pressures, this differential is not as great as current spending should suggest.

With the current deflationary effects, and no crystal ball to know where it ends, actually purchasing TIPS can provide you a very safe location for your money.  Not only will they be protected from inflationary pressures, they are guaranteed to retain their value.3 Even if inflation is negative, you will do no worse than your original investment, which means you still will have effectively made money.

For those who are feeling very risk averse and who are concerned about inflation as a result of the current levels of government spending, TIPS provide a safe place to make sure your money is safe.  While they aren’t going to provide fantastic net returns, they are at least going to keep up with inflation, which may not be such a bad deal.

1. NPR – The Economic Battle: Deflation Vs. Inflation [↩]
2. Washington Post – Obama Predicts Years of Deficits Over $1 Trillion [↩]
3. Treasury Direct – Treasury Inflation Protected Securities [↩]

The Best Investment In The World

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By this point in people’s lives they are well aware of the merits of 401(k)s and other retirement accounts.  Most people have wisely made them a part of their investment strategy, however many misconceptions still persist about them.  While most people do contribute, many of them spend very little time allocating their funds and instead make other hasty decisions based on misconceptions.  So here are some important things to know about the best investment in the world: tax-deferred retirement accounts.

Always Max Your Match

This advice is usually followed, but there remain people, particularly in this downturn, who have ceased contributions.  If your company matches your contributions at any level, this is one of the most amazing investments available to you.  Many times it may even behoove you to defer paying down debts to maximize your contribution.  While paying a debt may make you 20% tax-free on your money, a 33% match would make you…33%.  This doesn’t even take into account the fact that your contribution is pre-tax, which actually makes it an even more compelling option.  It is almost never a good idea to leave this kind of money on the table, barring extreme circumstances.

Be Aware of Your Options

The most common reason people are breaking the first rule is because of the markets.  Many people have ceased contributing to their retirement accounts because of the insecurity in the stock market.  They are waiting for things to “recover” before they contribute.  There are several problems with this approach, but not the least of which is that almost all retirement accounts have non-stock options.  That means you can usually put your retirement account money into a fund that is not dependent on the stock market.  There are exceptions, and I am not aware of all plans, but why forgo tax-deferment and employer matching when there’s an option to put that money into a secure fund?  It’s simply a question of having your cash in a taxed account or a non-taxed account.

Follow Your Strategy

If you were dollar cost averaging, don’t stop just because the market is down.  That’s the whole point of dollar cost averaging.  Now that prices are lower, you should bring your average cost down quickly if you continue contributing.  I can’t promise you that the markets will resume, but if you ever plan to resume dollar cost averaging, stopping because the market is down is counter-productive.

You also need to be aware of when it’s time to get out of stocks and move to less risky options.  As you get closer to retirement, you no longer have years for things to “average out.”  It’s time to start moving money to safer investments.  Don’t let the lure of additional returns keep you in the market for longer than is safe.  Many baby-boomers are learning that lesson right now.  While 3% may seem unappealing, it’s considerably better than losing money when at the doorway to retirement.

Never let temporary factors cause you to overlook the best investment in the world.  Tax-deferrment has huge implications on your eventual bottom line, so you should be making every effort to maximize your contribution.  Why save 65% of your net when you could save 100%?  And why pay taxes on the earnings of those investments?  You may have more limited options, but they would have to be severely inferior to overcome the huge benefits of preferential tax treatment.