Kiplinger’s recommends target date funds

Long-time readers will know that I recommend these funds for people who don’t want to spend too much time on investing. See Kiplinger’s article.

I like Vanguard’s target-date funds because of their low costs. While they tend to be more conservative than other company’s target-date funds, an investor willing to take on more risk could easily do so by investing only in the longest-date fund, no matter when that investor plans to retire, or by supplementing the target-date fund with a pure-stock index fund.

Tracking your finances in Quicken or Money

If you do not use Intuit Quicken or Microsoft Money (or a similar program) to track your finances, you should start. I take about 30 minutes each week to update my bank accounts, as well as 5 minutes each trading day to update my brokerage accounts. If you just hold index funds and ETFs or long-term investments in individual stock you would not have to update your transactions very often, maybe only once a month.

Most credit cards offer downloading into Quicken. I like using my Discover card because it will download the most easily into Quicken. Most other cards (such as those by Chase) require a visit to the website to download transactions.

A number of brokerages offer automatic downloading into Quicken of transactions, including E*trade, Scottrade, and Ameritrade. My main broker, Interactive Brokers, requires a visit to its website to download trades to Quicken. Of course, buy-and-hold investors should not use IB; the only reason I use it is because it has a good platform for short selling.

A few hints:

  • Track depreciation of assets such as cars. I track all my large assets in Quicken. Each year I have depreciated my car, a 2003 Mazda Protege, using a straight-line 8-year depreciation schedule. This tracks the real loss of value of the car.
  • Use mark-to-market accounting. I own a rental property, a house, and a chunk of land. I anticipate selling the rental property sooner rather than later and have reduced its value in Quicken by the 6% commission I will likely pay. I have also reduced its value by an extra $10,000 in market-value losses I have suffered. I have likewise reduced the value of my house by about $30,000 in market value that it has lost since I bought in 2003. I have increased the value of the land by a couple percent a year. I am still carrying it at a price below what I could get by selling it.
  • Capitalize home improvements. Home improvements (not repairs) increase the value of your home. Capitalize them by transferring the money you pay (in the program) to the asset account of your house. Do not do this for improvements that will not increase the value of the house.
  • Track your net worth. This can be a good motivator. My financial goal is to grow my net worth by over 10% per year. For those with significant debt, seeing a large negative net worth can be a good incentive to save.

Doing all the above lets me track my net worth very closely so that I can see if I am making progress towards my financial goals. If you wish to improve your financial performance it pays to track it. Tracking your finances closely will help you know how you are doing and it will motivate you to do better.

It pays to save

I just saw an ad for Guaranteed Consumer Funding, which offers to sell electronics (they were hawking a computer) for cheap payments to people with bad credit. For the computer they were offering (worth about $400 on a good day, although it is easy to find a computer for $500 that is far superior), the consumer would have to pay $1569 over one year. This works out to a 400% APR. Ouch. The company hides this fact in its ads and mentions only the $30 weekly payment without saying how many payments are owed.

In comparison, buying a superior computer for $500 and then paying 30% on credit cards for one year would cost $650. Of course, my favorite method, saving the money in a bank account, would cost only $500. It would only take 17 weeks of saving at $30 per week to be able to pay cash for a superior computer than the one issued by Guaranteed Consumer Funding.

Some people wonder why many poor people are poor. Medical problems and job problems are often reasons, but the largest single reason is an unwillingness to delay gratification and save. While income matters, avoiding spending matters even more. I know a man who makes $200,000 per year as a financial adviser who has saved less for retirement than a woman who never made more than $30,000 per year (and who put a kid through college as a single mother).

The best way to save is to make sure you are not tempted to spend. If you get a raise or a better-paying job, increase the proportion of your income that you put into your 401(k) and IRA. You do not need a fancy house or a new car. As for myself and my dear wife, we are taking my advice. My wife will be putting 50% of her income at her new job into her 401(k) and I am putting 100% of my eligible income into a solo 401(k). We will also contribute the maximum to our IRAs. From income that we are not eligible to stick in a tax-deferred account we will have just enough left over for living expenses. That way we will not be tempted to buy unnecessary things such as my next car.

How can we afford that? We have a modest home, drive a 4.5 year old compact car, and because I work from home, we only need one car (that saves us about $5,000 per year). We still have plenty of money left for the good things in life, such as a 7-year old $60 bottle of Tokaji wine I just opened today (which is rated 95 by Wine Spectator; I find it to be marvelous).

Zopa USA is here!

Zopa is now in the USA. For those not in the know, Zopa is the British version of (they actually pioneered person to person lending). Unfortunately, because of US regulation, Zopa cannot do in the US what it does in Britain. Rather, it can only offer a CD at 5.1% while letting credit unions do the actual lending. Not very p2p, but a 5.1% return beats the -1% return I have received on my loans over the last 1.6 years.

Random fact: ZOPA stands for “zone of possible agreement

Disclosure: I ‘invested’ money in p2p loans at I have no connection to either Prosper or Zopa.

It is Year End Tax Planning Time

There is only one month left until the end of the year. It is now time to buy a copy of Turbotax or Taxcut and to work out how much you will owe in your taxes. I just downloaded my copy of Taxcut 2007 and have started to enter estimates into it to find out what my AGI and MAGI will be. This kind of tax estimation becomes important as your income gets close to $100,000 a year and it becomes even more important as your income hits $150,000 a year (all numbers I use are for married filing jointly).

Here are some important numbers to think about:

  • Above $100,000 you lose the ability to convert a normal IRA to a Roth IRA. If you have already done that this year you want to make sure your MAGI stays under $100,000, otherwise you will have to recharacterize the converted Roth IRA into a normal IRA.
  • Between $100,000 and $150,000 you start to lose the active rental real estate owner loss deduction. This is a big one if you own rental real estate, as depreciation charges will usually give you a taxable loss even if you are cash flow positive.
  • Above $150,000 you start to lose the ability to contribute to a Roth IRA
  • Above $150,000 if you have few itemized deductions and above $100,000 if you have many, you run the risk of getting hit with the AMT.

Tax planning should be year-round. I keep a spreadsheet for that purpose before the tax programs become available. But now is crunch time and it will soon be too late to adjust your income. The recent stock and bond market turmoil gives ample opportunity to harvest taxable losses. While you need to wait 31 days to buy back any sold stock you can buy a broad-market ETF to maintain your market exposure in the meantime. If what you sold was not a broad-market ETF you run almost no risk of the IRS questioning your actions.

If your income is too high this year and you own rental real estate you bought in the last couple years, you could choose to sell it off at a loss. The bad real estate market has already reduced the value of your holding so why not reap the tax benefits of a realized loss?

Disclosure: I am not an attorney or accountant or tax professional. These are just my opinions and not individualized advice. Please consult a CPA or tax attorney for tax advice.

The best retirement account for the self-employed

What is the best retirement plan for a self-employed person with no employees and modest income? With SIMPLE IRAs, KEOGH plans, SEP IRAs, and 401(k)s, the choices abound and they are all confusing. Now there is a clear winner.

Without a doubt, the winner is the 401(k), with Roth 401(k) option available, from T. Rowe Price. This is a great option for a few reasons:

  1. Low costs. There are no setup fees. There are no ongoing fees except for a $10 yearly fee for each fund with under $4,000. I would investing in just one fund until it is over $4,000 and then starting other funds for diversification. This should keep fees under $10 per year for the first couple years (you should need no more than a couple different funds).
  2. There are a couple decent index funds and other funds with low expense ratios. I’d prefer there to be more and cheaper index funds, but there are some. I like the International Equity Index Fund (PIEQX) with an expense ratio of 0.50%, the US Total Equity Index Fund (POMIX) with expenses of 0.40%, and I like a little less the target date funds (such as the 2055 fund, TRRNX, with expenses at 0.74%).
  3. Roth 401(k) option. For most people, Roth IRAs and Roth 401(k)s are better than the normal options. With a Roth option, you invest post-tax money. You get no deduction, but your retirement money (including the money you make in it) is never ever taxed again.
  4. 401(k)s allow for greater contributions as a percentage of income (particularly for low-income people) and greater total contributions for high earners than SEP IRAs or SIMPLE IRAs.

For those making a lot of money, it may make since to choose another 401(k) provider that charges higher fees but offers funds with lower expense ratios. While Fidelity offers a good solo 401(k) plan, it currently does not offer the Roth option. If Fidelity does offer that, it would probably be a better choice.

The one problem with 401(k)s is that they were designed for bigger businesses. The paperwork is a hassle but the increased contribution limits relative to SIMPLE and SEP IRAs is worth the effort. Remember to also contribute the maximum to a Roth IRA as well as to a 401(k).

Disclosure: I use T. Rowe Price for my solo 401(k) for my freelance writing business.

Should you buy individual stocks?

Before you go out and start buying stocks on your own, let me say that not everyone should invest on their own. Only those that Ben Graham called ‘enterprising investors’ should do this. Those that fit in the category of ‘defensive investors’ should only own broad-based index funds or ETFs.

If you are not willing to spend at least five hours per week on your investments, then you are a defensive investor. If the thought of losing large amounts of money scares you greatly, then you are a defensive investor. If you do not know anything about investing and do not want to take the time to learn, then you are a defensive investor. If the thought of making a fortune in the stock market makes you giddy, then your emotions will interfere with your intellect, and you would be better off as a defensive investor.

There is nothing wrong with being a defensive investor. There is more to life than investing. If you fit the profile of a defensive investor, then stick your money in a low-cost stock index fund (such as those run by Vanguard). I particularly like Vanguard’s target-date funds. You will not beat the market, but you will do about as well as the market as a whole, and you will have plenty of time to enjoy life.

Now, for those of you who fancy yourselves as enterprising investors. Picking stocks is not for the faint-hearted. There will be times when your stocks will decrease in value. You will need the courage to either hang on to them (if they are still good companies) or sell them (if they are becoming bad companies). If you do wish to continue, though, you should know that value investing is the most tried and true approach to investing in the stock market.

Ben Graham averaged over 20% returns per year for two decades. Besides his two partners, there were four employees of Graham-Newman Investing. Three of those four later made incredible money investing on their own. Walter Schloss was one; he averaged a 16% annual return over 25 years, doubling the average yearly return of the S&P 500 of 8%. Tom Knapp was another; his investment firm doubled the average yearly return of the S&P over 15 years (16% per year). The third was Warren Buffett. Over the last 28 years, his Berkshire Hathaway has averaged over 20% annual returns.

So, if you choose to be an enterprising investor, know that in investing based only on value and price, you will do well. You may not always beat the stock market averages, but if you work hard and are willing to learn from your mistakes, you just might be the next great value investor.

Before you begin buying stocks, think about how much money you have to invest. If you do not have more than $10,000 to invest, then take that money and put it in a low-cost index fund (again, I like Vanguard). If you have less than $10,000, you will not be able to achieve adequate diversification, and the ups and downs of your portfolio will be harder for you to take.

Once you have your $10,000 in the mutual fund, keep it there. As you get more money, you can take that money and buy individual stocks. That way, if you do some really stupid things and lose a lot of money on your individual stocks, you will still have money sitting in your mutual fund. This will also help you sleep at night.

Now, as to buying individual stocks, the key is diversification. There are three kinds of diversification. First, diversify in time. If you buy all your stocks at one time, events that harm the market in general could cause your investments harm. Since you know value investing works in the long run, buying stocks for the rest of your life will give you this diversification. The next kind of diversification is industry diversification. If you were in tech stocks in 2000 you know what I mean. Also, certain industries can do badly for long periods (like the airline industry).

The last kind of diversification is diversification as to country. It is hard to buy many foreign stocks, so I recommend putting some money in an international index fund or two (Vanguard has those as well).

Disclosure: I invest in Vanguard ETFs. I have no connection to the company. My disclosure policy wears a wombat on its head to keep warm.

Personal Finance and Happiness

Most people need at least a little help getting their finances in order — the personal finances of the average American are in a horrendous condition. One thing that most people do not consider when talking about personal finances is when spending actually makes us happier and when it does not. The key is to avoid spending money when we get little joy from spending and to freely spend it when it is on something that will give us joy (as long as we have the money — debt and worry are two of the greatest causes of unhappiness).

So what gives us happiness? First and foremost, our relationships make us happy. Giving to our friends and to our spouse can be very important, especially when you consider the pain of loneliness or divorce. So never hesitate to spend money to go on dates with your spouse or to get him or her gifts (again, as long as the spending is reasonable). Now think of what you do during your free time. You probably sleep: we all spend much of our time doing it and yet how much time or money have we invested in a good mattress and good pillow so that we sleep well? Speaking of which, if you do not get enough sleep, you will be unhappier, stupider, and less productive than if you get enough sleep. What is another thing that people spend a lot of their time on? How about TV? I find it odd that people who spend much of their free time watching TV are often unwilling to spend money on getting a good TV, such as a large screen LCD HDTV. (Of course, I would argue that most people would probably be happier and healthier if they spent less of their time watching TV).

Now that I have encouraged everybody to spend some money, it is time to look at those things that we spend much money on that do not really make us any happier or better. The first item on this list is going to restaurants. Eating at restaurants is expensive relative to cooking a meal yourself and restaurant meals are more unhealthy than home-cooked meals. Eat at home more often, and use some of the money that you save to splurge occasionally for really nice meals at fancy restaurants on dates with your spouse.

Another thing that people spend money on but derive little enjoyment from is expensive or deluxe versions of everyday items, whether clothes, appliances, electronics, or computers. Do you really derive more happiness from having a $5,000 stainless steel refrigerator than from having a more average model? The same can be said of many of the things we buy. Are you really happier because you have $300 purse? Or would a cheap knockoff that looked almost as good be good enough? Some people do actually get more enjoyment from the more expensive items, whether they are an audiophile who can tell the difference between a $10,000 and a $20,000 speaker, or whether they are an aesthete who finds happiness in having the perfectly decorated home. But for most of us and for most consumer goods, we are just fooling ourselves into believing that we must have the more expensive item.

Go through the money that you spend each month and ask yourself if spending that money makes you happier, healthier, or wiser. If it does not, do not spend the money. Save a portion of the money that you save, and feel free to spend a portion of that money on things that will actually make you happier, healthier, or wiser.

An ETF Asset Allocation Plan for Everyone

If I have not said it much before, I will certainly say it in the future: the best way to invest is with low-cost index mutual funds or low cost index ETFs. I like Vanguard, but it is even cheaper to get an account at and then invest in low-cost ETFs. They give you a certain number of free trades per month which is more than adequate for a long-term buy-and-hold investor. What I suggest below is not quite as simple as one of Vanguard’s excellent low-cost target date funds (see The Default Investment), but it will give you a portfolio that is more appropriate for your individual circumstances.

In the article on the default investment, I suggested talking to a financial planner if you wanted a tailor-made portfolio. However, the problem with financial planners is that they cost a lot of money relative to investable assets, particularly if you are not rich. A couple hundred dollars an hour or .5% of invested assets adds up quickly if you have a small portfolio. So for those with under a few hundred thousand dollars, it may be best to go it alone. You will need to first determine your risk tolerance. Buy Index Funds: The 12-Step Program for Active Investors; this book will help you think through how much risk you can handle. There are also 20 sample portfolios in the appendix for all different risk profiles. Those portfolios are designed for DFA mutual funds (which can only be accessed through a financial advisor). So I found suitable ETF substitutes for those funds and they are listed below along with their ticker and annual expense ratio. So buy the book, choose an appropriate portfolio for the amount of risk you can handle, get an account with Zecco, and then buy the following ETFs in the proportions recommended for your risk profile in the book. You will pay very few fees, your portfolios will be tax-efficient, and you will not have to think very much about your investments.

US Large Company: Vanguard Large Cap (VV), 0.07%
US Large Cap Value: Vanguard Value (VTV or VIVAX), 0.11%

US Microcap Index: iShares Russell Microcap Index (IWC), 0.60%
US Small Cap Value Index: Rydex S&P Smallcap 600 Pure Value (RZV), 0.35% or Vanguard Smallcap Value (VBR), 0.12%

Real Estate Index: Vanguard REIT ETF (VNQ), 0.12%

International Value Index: iShares MSCI EAFE Value Index (EFV), 0.40%
International Small Company Index: SPDR International Small Cap (GWX), 0.60%
International Small Value Index: WisdomTree Small Cap Dividend Fund (DLS), 0.58%

Emerging Markets Index: Vanguard Emerging Markets Index (VWO), 0.30%
Emerging Markets Value Index: WisdomTree Emerging Markets High-Yielding Equity (DEM), 0.63%
Emerging Markets Small-Cap Index: WisdomTree Emerging Markets Small-Cap Dividend Fund (DGS), 0.63%

One-Year Fixed Income Index: (see below)
Two-Year Global Fixed Income Index:
Five-Year Government Income Index:
Five-Year Global Fixed Income Index:

There are no funds that are very close to the above, but you can use different weights on Vanguard’s bond funds to approximate the average duration of the mix of the above funds. Vanguard Short-Term Bond Index (BSV), 0.11%, has an average maturity of 2.7 years, while Vanguard Intermediate-Term Bond Index (BIV), 0.11%, has an average maturity of 5.7 years. Both are invested primarily in Treasury and government agency securities. For very-short term bonds (or just buying government bonds of any maturity), you could enroll in Treasury Direct and buy 1-year treasuries direct from the US Government. If you hold them to maturity you pay no fees.

I see no great need to invest in foreign bonds, considering the safety of the Vanguard funds. While more diversification is good, there is a limit to how safe something can get–and it doesn’t get much safer than one to five year government and AAA-rated bonds. So if Index Funds says that you should have 10% in each of the four bond categories, your weighted-average maturity would be 3.3 years. So you could put 10% of your investable assets in 1-year bonds through Treasury Direct, 15% in the Vanguard Short-Term Bond Index, and 15% in the Vanguard Intermediate-Term Bond Index. This gives you an average maturity of 3.4 years.

When investing in these ETFs, you should rebalance every year. You could also choose to put a portion of your funds in one or more of Vanguard’s target date funds and then just add on the extra funds (value, small-cap) to the main target date fund. Then you would not have to rebalance as often.

If you follow the above plan, you should expect to outperform 80% of other investors, because they will incur more taxes and more fees. You will also end up with investments tailored to your unique circumstances. And you will only have to think about your investments once a year. This sounds like a good deal to me.

Behavioral Finance

This comes courtesy of the World Beta Blog (post):

Whitney Tilson has a nice slidshow discussing how human decision-making causes investment problems.

Martin Sewell has a paper that is essentially a chronological annotated bibliography of behavioral finance research.

I know the literature fairly well and I believe it is imperative for investors to understand how their process of making decisions can lead them to making the wrong investment decisions.