Final Stock Market Post...at least for awhile.

In the middle of the week that saw the Dow Jones index decline 500 points in one day due to the biggest financial institution collapse in history, i.e. the Lehman Brothers bankruptcy, I am continuing my series on the stock market, because I want to encourage everyone to keep their faith. Although the stock market will probably be down for awhile, try not to join in on the despair, but rather think of these times as potential opportunities to invest. I am not telling you to go out and buy a financial institution betting that it has bottomed, but stick with the game plan, i.e. what we went over in the previous posts in terms of buying the best of breeds and objectively determining the value of companies. The current general loss of confidence will bring down the stock prices of very good companies not related to the subprime and credit crises, allowing you to buy these companies at a discounted value. So onward we go. In this post, I will go over what you need to do after establishing your portfolio.  

After setting up your portfolio, the first thing you should do is identify exit points for your investments. Basically, there are two exit points, one for when to take profits, and one for when to cut your losses. I've already mentioned my personal exit point for taking profits, which is a 20% annual yield. Again, I came up with 20%, because the the best investor in the world, Warren Buffet averages about a 25% yield, and I don't presume to be as wise an investor as he is.  

So let's say one of your stocks goes up 20%. So should you sell all your shares, or just a portion in case the stock potentially goes up more? A common stock advice is to sell in increments, so that you capture the profits all the way up. I argue that this should not be a set method. Again, it comes down to valuation, and from our last post, we learned how to do that. If a stock goes up 20% and results in an overvalued P/E ratio, then you should sell all your shares. However, if the P/E ratio still seems cheap, you could sell a portion, perhaps half, and keep the rest for further profits.  

But then you ask, why shouldn't I just hold onto the shares if the company is still cheap? The answer is because the stock market can be extremely volatile. If, for some reason, investors lose short term confidence in a company, even if it is profitable, the stock price can drop substantially. We are seeing that this week with the investment brokers. Morgan Stanley just reported a very profitable last quarter, but after their earnings report, their stock price dropped over 20% on concerns about the profitability of the investment brokerage model in general. The bottom line is that you're in the stock market to make money, so it is prudent to lock up profits, or all your efforts could potentially be for naught.  

When to cut your losses is a little more difficult to determine. A cardinal rule that we've already established is that you shouldn't be in companies that aren't profitable. So for instance, if you bought a company that was in good shape when you bought it, but for some reason started losing money, that is an absolute time for you to get out. Apart from this cardinal rule, how much of a loss you can take depends on how much anxiety you can stomach.  

Let's look at an example. There are very few best of breeds among banks these days, but one of them is US Bancorp (USB). USB has been hovering around $33 a share for most of this year, but beginning in May, it began a decline due to the overall concern about the financial sector. If you had USB on your watch list, you would've seen it's P/E ratio fall during this decline. Looking at its historical P/E's, it is a great value at a ratio of 11, which translates to a price of around $27. If you had bought it at that point, you would've seen it drop further, reaching a low of $22 (-18%) on July 15, 2008. However, since then, it has rebounded to a 52 week high of $35. So what are the lessons to learn here?  

One is that if you are confident of your research before you buy a stock, you should have the conviction and patience to see your gains through. But yes, it's easy to say that in hindsight, so another lesson here is that you should think about these scenarios before you buy and decide how much you can take to lose. In the beginning of these stock posts, we established that when you are investing in individual stocks, you need to be using money that you can afford to lose. That being said, it still hurts when you are down hundreds to thousands of dollars, and if you are human, such significant losses will keep you up at night. That is no fun, so this is why you need to establish an exit point to cut your losses. This exit point may not be objectively the right investment decision, but it does address an even more important aspect of investing, i.e. preserving your state of mind. You need to determine an exit point that's comfortable for you, but I would make it at least -10%, since stock market volatility easily accounts for single digit percentage fluctuations. For me personally, I use -20%, as I have found, looking at historical price charts of most best of breed companies, rarely do the prices drop more than 20% if you buy at a discounted value.  

The last point I'm going to make in this article is that you need to keep on researching your stocks after you buy them. It's kind of like managing your finances--the more frequently you check your budget, the better. Keep up with current P/E ratios, earnings reports, earnings conference calls, and news reports. Every now and then, you'll get a game changing event, which won't necessarily show up on your local evening news. Earlier this year, when General Electric missed it's earnings for the first time in over two years, it was the beginning of a steep decline. If you listened to the conference call of those earnings, it was clear that the earnings miss was largely due to the financial arm, which makes up half of the company. GE, like Lehman Brothers and all the ailing financial institutions, was too involved in the real estate market, and the stock price is reflecting this even now. That conference call was the first glimpse of this reality, which should have alerted GE shareholders to the probable decline of the stock until the housing and credit crises resolve. When you are managing your portfolio, keeping up with these news events is essential.  

Believe it or not, I think I've covered most of the basics in stock investing. I think the only huge thing I've left out is the dividend, which is a direct payout to shareholders of a company's profits. Some people make a big deal about dividends, because sometimes even if the stock price is low, the dividend can still give you a good yield. But the stock price should not be that low if it reflects a good company. So, personally I treat the dividend as merely an addition to the annual yield...that is, if it is even paid out. Companies usually pay dividends every quarter, but that does not always happen. In fact, companies can easily change their dividend at any time, so for me the valuation of a company is a more reliable reason for me to buy the stock.  

Of course, there is a lot more to learn in the stock market, but there will always be more lessons in this game. The stock market will inevitably humble you over and over again, but hopefully, these posts have given you the tools to avoid huge mistakes, which of course, means less money in your pockets. Until next time, may you MAKE some moolah.

Best Investment Part 4: Bargain Hunting

So now you've looked at a few companies, made sure you have a diversified group, and that most of them are best of breeds. How do you decide WHEN to buy? Do you just dive in all at once, and set up your entire portfolio in one shot? Just like all of my rhetorical questions, you know what the answer is. You want to buy stocks in the same way hopefully you buy most things, that is, at a fair or, even better, at a discounted value. But how do you determine the value of stocks? We'll go over just that in this post.  

I think what confuses and potentially intimidates people about buying stocks is the risk or uncertainty of how they will perform.  People hear stories of how their friends buy stocks, and even though the companies do well, the stock price decreases in value.  That happens when the overall market thinks the company is not going to meet future expectations, even though they have met past ones.  You see, there are two components of the value of a stock. The first component is what's on paper, i.e. the earnings, profit, operating costs, revenue, etc. The second component is the estimate of potential growth, which is a bit more hazy, as nobody can really predict the future entirely.  

This second component of the stock value can be ascertained through several ways, namely the company's own forecasts, the expectations of third party financial analysts, and even the borderline speculative ideas we talked about in the previous post, e.g. "Apple will take over the smartphone market with it's Iphone."  Professional analysts come up with their estimates via various methods, including polls, very complex mathematical models, and talking with company insiders.  I've listened to a lot of analysts' arguments, and I have yet to find one where I didn't think was subjective in a way.    

You can probably ascertain that, in my opinion, the more dependable data in terms of valuing stocks is the factual and objective data of a company.  Like I said in the last article, estimates and predictions of a company's future can be useful as perhaps a catalyst, but the foundation of valuing stocks should be the company's actual performance.  In addition, if a company has historically performed well, they most likely will continue to do so.   

OK, so you need to look at the objective facts.  What are they?  The most important piece of data you should examine is the Price to Earnings ratio (P/E ratio). The P/E ratio is the stock price divided by the annual earnings per share. Sounds like a bunch of calculus, right? Well, the good thing is you don't really have to remember this formula, but you just have to know how to use it. The P/E ratio gives you an idea of how much you are paying for a company's profits. Let's say for the last 12 months, a company has made a profit of $1000. The company has 10,000 shares, so its earnings per share would be ten cents. If its stock price is $5, then its P/E ratio would be 50. In another words, you're paying $50 for every $1 the company makes. If that sounds like a lot, you're probably right. Most people consider a company fairly valued with a P/E ratio around 15-20, but the P/E ratio is also industry and history dependent. For example, an industry like the technology sector generally has higher average P/E ratios.  So if you're buying a company like Microsoft, you need to compare its P/E ratio with other big software companies.   

Also keep in mind that every company is unique in how it grows, so you also need to look at historical P/E ratios. A good website among others to do that is Forbes.com.  As an example, let's look at the historical P/E ratios of General Electric.  

Current P/E Ratio 13.1  

P/E Ratio 1 Month Ago 13.4  

P/E Ratio 26 Weeks Ago 15.3  

P/E Ratio 52 Weeks Ago 18.5  

5-Year High P/E Ratio 24.2  

5-Year Avg. High P/E Ratio 21.5  

5-Year Low P/E Ratio 13.7  

5-Year Avg. Low P/E Ratio 16.9  

5-Year Avg. P/E Ratio 20.3  

You can even go back further on your own, but just looking at these values, you can see that GE is the cheapest than it's ever been in the last 5 years.  And when we look at similar companies, the industrial average is about 16.  So then should you buy GE now?  Yes, GE is a great buy right now, but let's examine my last point about P/E ratios before we make the decision.   

You may have heard recently that the stock market is a "bear" market. This means that the Dow Jones Index has lost at least 20% of it's value from it's most recent highest point. (The term "bear" is used to define a pessimistic investor, whereas an optimistic investor is called a "bull.") A bear market usually reflects a time of economic downturn. Most recent bear markets were the collapse of the silicon valley bubble, the savings and loan crisis in the 80's, and the oil crisis in the 70's. The reason I bring up the bear market is that in such a market, P/E ratios are often reset to lower values. This is because there is a general market-wide loss of confidence. So if you decide to invest today, you would probably benefit from lowering the P/E standards a few points. Going back to our example with GE, you can certainly buy it now, as it is very cheap compared to its historical value. However, because we are in a bear market, it may be wise to have a lower P/E standard, i.e wait until the P/E ratio approaches 12.  

But what if the P/E doesn't reach 12? Well, if you are set on buying GE, you can establish an upper limit for a fair value. The 5 year average P/E for GE is 20, but the industry average is 16, so I would say you could use the level of 16 as the upper limit to make sure you buy GE at a fair to discounted value. If the P/E ratio starts going up, you can make sure to buy before it reaches 16. So you see, it's not calculus after all.  

One last thing before you pull the trigger though. Try to get to know the companies you buy as much as you can. What are its products? Who are the main management personnel? How much business does it do overseas? What have been its growth rates in the past? What are the company's business strategies going forward? I've touched some on the importance of this research in previous posts. Again, all this info can be found on the web. Essentially, I want to make sure you have a good grip on the companies before you buy them.  

Alright, so the moment has arrived for you to set up your portfolio. However, it's not as simple as setting it up and then holding onto to it for a long time. In the next post, I'll go over how to MAINTAIN your portfolio. Til then, make you make some moolah!

Best Investment Part 3

Alright, you've set up your online brokerage account, and you've put in $2500 that you've saved.  How do you decide what to buy?  This can be daunting, given that there are thousands of stocks to choose from.  Let's establish some ground rules to see if we can narrow this decision process down.  

 

1) Only look at companies that are profitable.  Ultimately, the stock price is a reflection of how a company is performing, which means how much money they are making.  If a company has a positive cash flow, then they have the capability to grow, and that translates into a higher stock price.  There are some companies with negative cash flows that have growth potential as well, but it is hard to value such companies, because there is much uncertainty about when and how much their potential is.  Especially when you have a myriad of profitable companies to choose from, you don't need this additional risk.

 

2) Diversify, diversify, diversify!  OK, I've mentioned this concept already, but what does it exactly mean when it comes to individual stocks?  Does it merely imply that you buy five different companies?  No, because some companies are very similar to each other.  Diversification, when it comes to individual stocks, means that you buy companies in different business sectors.  Some of the more popular sectors are financials, industrials, transportation, technology, energy, healthcare, and retail.  For instance, you don't want to buy Dell Computers and then Hewlett Packard, because they both are in the computer hardware business.  And you don't even want to buy Dell and Microsoft, because even if Microsoft sells software, they are both in the Technology sector. 

 

Another aspect of diversification that people mention these days is investing globally. The concept is that it is a global economy today, and it's important to have investments in other countries besides the United States.  Global diversification became especially a popular strategy in the past few years due to the "emerging markets" of the world, those third world countries that are rapidly becoming economic powers.  The main emerging markets are the so called BRIC countries--Brazil, Russia, India, and China.  To give you some perspective, in 2007 these countries averaged about a 10% GDP growth rate, compared to the USA's 2%.  I would caution you to not get too excited though, because whenever economies grow so fast, they run into the problem of inflation, which is why despite the astronomical growth, the stock markets of Brazil, Russia, India, and China have fallen 20-60% year to date!  Yes, it is important to diversify globally, but don't do it because you hope to capture the huge growth of the emergent markets.  Do it for the sake of diversification, i.e. to protect yourself just in case your US investments don't do well.

In terms of the logistics of investing globally, there is a misperception, in my opinion, that you should go out and buy international companies.  Yes, you are able to do that through several international exchanges these days.  But I argue the better way to go about it is to buy US companies that do a lot of business overseas.  Why?  Because, it is more difficult to research international companies, in order to determine what exactly you are buying.  Stick with the familiar companies at home.  Many USA companies can give you great exposure globally.  Did you know that Hewlett Packard does about 68% of their business overseas, Mastercard 50%, and Caterpillar 60%?  So make sure you research this aspect when your are choosing your stocks.  

 

3) Be wary of stock tips!  It seems like whenever you talk stocks with people, everybody has an opinion of what to buy.  These opinions are great for conversation, but be careful about following stock recommendations.  Always do your own research, and if it comes to the same conclusion, then perhaps you can follow the advice.  Especially be cautious of people who give speculative reasoning.  For instance, don't buy a company because someone thinks it will be bought out by another.  How do they really know that?  If they really do, then it is considered insider trading (i.e. trading with beforehand knowledge of an impending event), which is illegal.  If they are insiders and you follow their advice, then you'd be breaking the law as well.  

Another common speculative tip is that a company has a new technology or product which will do well in the future.  One of the first stocks I bought was a company called Mechanical Technology, which manufactures methanol fuel cells, or essentially methanol batteries.  The reason I bought it was because I read several articles lauding the prominent future of methanol fuel cells in portable devices.  These articles were claiming that methanol fuel cells could potentially increase the battery life of a cell phone by days.  They also cited that companies like Samsung were on the verge of launching such batteries.  This was about 2 years ago, and I haven't yet seen or heard of a single device with methanol fuel cells.  I bought Mechanical Technology at around $10 a share, and it promptly fell 50% in the next 6 months, basically because the company did not make any money.  In fact, I don't think it's ever been profitable...that's how great of a company it is.  

How about stock tips on good companies?  Relevant current examples are, "You should invest in Apple because the Iphone is going to ROCK!"  Or "You should invest in Nike, because of their Olympics exposure."  These statements may be deemed speculations as well.  For all we know, there may be a huge flaw with the Iphone that has not been uncovered.  Likewise, with the ongoing recession, it's unclear even with the Olympics, if people are going to spend money on an expensive pair of Nike shoes.  But the difference here is that we're talking about two great companies that have proven their performance historically.  Good companies usually find a way to sell their products, and even when they have setbacks, they are managed so well that they often recover in an even better position.  So following the recommendations on good companies may not be bad, but be careful of buying them overvalued.  I.e, you still need to go further and decide whether or not the stock price fairly reflects their overall value.  I'll explain how to determine the valuation of a company in my subsequent articles.  Talking about good companies is a good segway into the next rule. 

4) Buy the 'best of breed.'  The best of breed is a phrase used by investors simply to describe the best companies in a certain sector.  These are companies which are usually large companies, which have been around for a long time, have grown consistently and along the same lines, have consistently beaten earnings estimates.  It is easy to determine the best of breeds.  You can probably just google 'best of breed+the business sector' to get an idea.  Most of these companies are ones you are familiar with, e.g. Walmart, General Mills, McDonalds, Goldman-Sachs, etc.  

But don't just go out and buy these companies because they are labeled best of breed.  Remember to do your own research.  Look at the historical data on earnings, growth, and stock price.  When you research this data, also look at how they have met market expectations in the past.  Financial analysts on Wall Street are always coming out with estimates which, taken together, become market consensus estimates.  All this data can be found these days on your brokerage website or other investment websites like Yahoo or Google Finance.  It is important to see how a company's performance matches the market estimates, because it gives you an idea of how well that company is being managed.  A company can have great products, but without a good CEO, CFO, and other management personnel, the company won't be able to grow to their potential.  

The other advantage with best of breeds is that in times of economic downturn, these are the companies that will be able to survive, because they have enough capital to weather the storm, so to speak.  A lot of investors often think these companies are boring, i.e. their stock price goes up very slowly.  But remember that your ultimate goal is to just beat the market, which means greater than 9% return a year in the long run, which best of breeds usually do.  

Ok, so go look at some best of breed companies in the different sectors, but don't pull the trigger yet, because there is a further step of determining their value, which we'll go over in the next post.  

Until next time, make you make some moolah.

Your Best Investment Part 2

Alright, hopefully I've convinced you that investing in the stock market should be essential for beginning professionals. So how do you get started? First, you're going to need some way of purchasing stocks. The best way for individuals these days is to buy them through online brokers. Before Al Gore invented the internet, people who wanted to buy stocks would have to go through actual brokers, which meant a phone call and significant commissions. Now you can purchase a stock yourself instantaneously online, still with trading fees, but not as high. In addition, individual investors these days are able to research the companies they buy via tools online brokerages and other investing sites offer. The internet has truly revolutionized investing in the stock market by making it easier for individuals to follow their investments, which is another reason to get into stocks. Some of the better online brokerages are TDAmeritrade, Scottrade, and Charles Schwab. (I didn't mention E-Trade, because even though that baby in the commercials is damn cute, they are not doing well as a company and may be going bankrupt...not where you want to put your money!)

Before we get started, we have to go over the principle of diversification. I had mentioned it in a few of my earlier posts, and it's quite a simple idea. The more varied your investments are, the less chance you'll be seriously hurt if one of your investments goes sour. We talked about index funds the last time, which are a great way to diversify. Remember also that I recommended your retirement money should just be in index funds. Then you can leave some nonretirement money to invest in individual stocks. Because of the concept of diversification, ideally the more companies you have in your portfolio, the better. But the problem is that you can't have too many stocks, because then it becomes difficult to do the research in order to actively manage them. A good start would be to pick about 5 companies, and then go up as you feel comfortable.

Another consideration before you buy stocks is how much you should buy. Because a broker will charge you a fee each time you buy or sell stocks, it's important to think about how much your total yield would be with each stock purchase. Most online brokers these days will charge you a fee of $10 per transaction, so ideally if you make a profit on your investment, subtract $20 ($10 for the purchase and $10 for the sale). That doesn't seem like a lot, and it's not really significant in the long term, but I bring it up because it factors into the minimum you should put into each company, which is in my opinion, $500, more or less.

How did I come up with $500? It's kind of a personalized number, but the concept here is that when you invest in individual stocks, you need to plan out as much as you can beforehand, especially when to buy and when to sell. You need to have a goal of making a certain yield on each of your investments. The goal I use is 20%. Why? Because I told you before that on average, the stock market gives you a 9% annual return. So you need to pick a number higher than that to make buying individual stocks worth more than just investing in the Dow Jones index. In addition, the best investor in the world, Warren Buffet, has averaged about a 20-25% return. So I pick 20%, and let's say you put $500 into a company. A 20% yield would be $100. Minus the $20 transaction fee and then taxes, it comes out to be around $50, which I feel like is the minimum profit I'd be OK with. That's how I think about it, and you can come up with something different, but the important idea once again is that you need to plan it out beforehand.

So if you were to buy a minimum of 5 stocks in order to diversify your portfolio, and you think my thought process behind the $500 minimum is legit, you would need at least $2500 to get started. This minimum is very important, because a lot of people get caught up with buying "penny stocks," since they can't afford anything else. Penny stocks are cheap because they represent bad companies, ones that often are not profitable and are just pure speculation, which makes penny stocks very risky. Save up the $2500, or whatever minimum you come up with, so that you can invest in GOOD companies.

Not investing in penny stocks ties into the last point of this post--don't use the stock price by itself to decide whether or not to buy. Let's look at an example. Let's say you're choosing between two stocks. One costs $10 per share, and the other $100. If you are going to invest $500, it's easier to lean towards buying the $10 share. But think about it--if both stocks go up, say 5%, it really doesn't matter if you have 50 shares, versus 5. Overall, your yield is $25, 5% of your total. The stock price by itself is really irrelevant (unless it's more than you can afford to put in, but most stocks are under $500). What's more important is how it represents the value of a company. I'll go over how to assess that in the next post.

Until then, make you make some moolah.

It is Time

Of all investment options, the stock market will give you the greatest returns in the long run.  Yes, it's time to talk about the stock market, not only because I feel like doing so as part of the chronology of the blog, but because it is oh so relevant these days.  As we all know, the economy is in a downturn, and the stock market has reflected that in a huge way.  These economic downturns only come about once a decade, and are unprecedented opportunities for investors.  But then you ask, "Why should I buy stocks now, only to see them lose value in the next few months?"  A valid question, and through these next few posts, I actually won't answer it!  Instead, I'll give you a sense of when and how to invest in the stock market in a confident enough way, such that you won't need to ask this question.  

First, let's go over the basics.  What's a stock?  A stock, or "share," is what it inherently means...it's an ownership piece of a public corporation.  Hmm, that's an odd concept...imagine if you started a business, and then decided that you would give up the ownership of your business to a bunch of strangers.  Why would you ever want to do that?  Because yes, you're relinquishing ownership, but also selling it to raise a huge sum of money you can then use to grow the company.  And these people who are buying ownership, these shareholders, usually don't want to run the company, so you still get to do that (as long as they're ok with it).
 

When you flip on the news and they talk about the stock market, they usually refer to the Dow Jones Industrial Index (DJI).  What the heck is that?  Who's Dow Jones?  Well, actually Dow Jones refers to two people, Charles Dow and Edward Jones, two reporters who founded the publishing and financial firm, Dow Jones and Company, in the 19th century.  It was Charles Dow who established the DJI, a weighted average of a group of companies that would accurately reflect the performance of the industrial sector of the stock market.  The DJI since has evolved to capture the stock market as a whole, rather than just the industrial component.  It is important to understand, when you are investing in stocks, that you have the option of putting your money in an index fund, i.e. a fund which follows the performance of an index like the DJI.  This a more conservative way of investing in stocks, because you are more diversified by capturing many companies instead of picking a few. 

 

Other common indices are the Standard and Poor (S&P) 500 and Russell 3000.  To understand them, we have to define the term "market capitalization (market cap)," which is essentially the total value of a company as determined by the market.  The biggest companies are termed, "large cap" companies, and they, give and take, have a market cap of >$5 billion.  Mid cap companies are between $1-5 billion, and small cap ones are <$1 billion roughly.  The S&P 500 index is comprised of 500 of the largest companies, and is supposed to capture the performance of large cap companies as a whole.  Likewise, the Russell 3000 does that for small cap companies.  Standard and Poor and Russell also have indices reflecting mid caps.  Whether to invest in large vs. small cap indices is controversial.  The historical returns have been similar, but personally, I prefer the large cap companies, as they are more well known and easier to research.  If you are investing in individual stocks, large cap is definitely the way to go, at least for beginners.

 

So should you invest in index funds vs. individual stocks?  Most personal finance books would say index funds, because they want to give you the most conservative advice, so that you are not able to sue them if you lose a lot of money on individual stocks.  In my earlier posts, I mentioned that you get about a 9% return over a long term in the stock market.  That is referring to the DJI, and indeed, most average investors do not "beat the market," i.e. make more than a 9% yield investing in individual stocks.  Personally, I don't like to be very risky with my retirement money, so I put it in the DJI.  I would recommend you do the same.  However, you can allocate a portion of your non-retirement money for investing in individual stocks.  This portion of your non-retirement money has to be money you are willing to lose, because that definitely can be a possibility when you are dealing with individual stocks.  However, the probability of losing everything becomes very minimal, if you do your research and invest correctly, and often times, you will beat the market.  It is more rewarding as well, because you are actively managing your portfolio, rather than just passively following the stock market. 

 

Let's define one more term and call it a day.  The stock price is obviously what you pay for a share of the company.  Well, how does that get determined?  The stock price, if you think about, is basically the market cap divided by the number of shares of the company.  If a company is worth $100 (e.g. my lemonade stand when I was a kid) and there are 100 shares, the stock price would be $1.  Understanding this is important, because then you realize that the stock price is not just affected by how well the company does, but is also dependent on movements in the number of outstanding shares.  Sometimes a company, in order to raise additional capital, will put more shares in the market.  This is called a secondary offering, and it almost always results in a decrease of the stock price, because the market cap is being "diluted" with more shares.  Vice versa, if a company buys back stock, termed a share repurchase or share buyback, that usually results in an increase of the stock price, as there are less shares available.
 

Alright, that's enough for this post.  Til next time, may you make some moolah.

In Case Sh%$^

One of my favorite stand up acts of all time is Chris Rock's "Bigger and Blacker." In one of the segments, he talks about insurance, or what he terms, "In Case Sh%^&" He says, "I give a company some money in case sh*%& happens....Now if sh&%* don't happen, shouldn't I get my money back?" Yes, Chris, from a moral standpoint you should. But in terms of business, if you got your money back, there would be no insurance company in the first place. Insurance is an interesting concept, brilliant actually. Insurance companies play the odds. Basically, they charge their clients premiums (periodic sums of money), aggregate them to decrease risk, and then use the pot of money to compensate situations in case sh*%&^. Most of the time nothing happens, and that's how insurance companies profit. As a starting professional, how should you approach insurance?

Now you can insure anything...that's right, if you wanted to purchase insurance for your right little toe, you could do it. So the question is, should you? I don't care how much you value your toe...the answer is, NOOOO. Do not insure your toe. Why? Because even if you lose it, you'll be fine...unless you're a foot model, in which case you have other issues. So the principle here is, only insure those things that are significant to you, and in personal finance, that translates into things which could potentially devastate you financially if they were damaged or lost. Maybe you've heard this already, but how is it different for a starting professional?

Well, for most people, when they are starting out, they don't have much in assets. Remember we talked about the fact that human capital is far more abundant than financial capital in the beginning. So the number one thing to insure for starting professionals is health. Most people don't realize how important health is when it comes to finances. I'm not just biased because I'm a doctor, but if you came down with a serious illness, it would not only impede your capability of making money, but healthcare these days is ridiculously expensive. As doctors, we write prescriptions every day, incognizant of how much they cost. But when I started a small clinic last year and actually had to buy medicine to stock my office, I realized just how expensive they were. Also, did you know that the average cost of a day in the hospital is in the thousands? So it is important to take care of yourself--to eat, sleep well, and exercise, so that you can prevent illness. And it's important to have health insurance.

Some people may say, why do you need health insurance when you're young? Yes, it's true that insurance is more important as you age, because the chance of getting sick increases. But remember, all it takes is one car accident or one obstruction of your appendix to land you in a hospital, and if you had no insurance, that's thousands of dollars a day leaving your bank account. That would be considered a financially devastating situation for most starting professionals. In terms of what type of plan you should purchase, for most insurance plans, the more extra benefits they cover, the higher the premium. For instance, most plans cover hospital stays, but if you wanted a plan to cover regular office visits or prescriptions, the premium would be higher. To start, choose a plan which is weighted more on covering hospital stays, and these conveniently are the cheapest in terms of the premium. Because you don't want to give the insurance company more money to cover office visits, when you are only going one or two times a year to the doctor. And even if, for some reason, you were sick more than usual and had to go ten times a year, that would not ruin you financially.

When we talk about insurance, we need to talk about deductibles as well. A deductible is an amount that you agree to pay before the insurance plan kicks in. For instance, if you were admitted to a hospital, and your hospital deductible is $1000, the hospital expenses would have to reach $1000, before your insurance company starts paying the bill. The deductible affects the premium such that lower deductibles usually mean higher premiums. When deciding on a deductible, again think about how much you can potentially afford to pay and not devastate yourself financially.

Ok, so what else should you cover?...no, we're not insuring the other toe... Probably the only other important asset most starting professionals have is their car. Not to mention that it is the law in most states, but yes, everyone should have auto insurance. For cars, you pay a premium for an agreed-on maximum amount the insurance company will pay for an accident. There are a bagillion different types of auto insurance, so I would recommend you discuss it fully with your insurance agent, but try to get as much as you can afford, the minimum being comprehensive, liability, and collision coverage.

What about life insurance? That sounds like a good idea, right? What's more important than your life? As far as most beginning professionals are concerned, the answer is NOOO. "The answer is NOOOO!"--that should've been the title of this post. Life insurance is only practical if you have dependents, people like your children whose lives rely on your income. Now, there will be insurance agents who will try to sell you a variable policy, which is one in which they invest your money for you. They will tell you that in 40 years when you pass away, your money will have grown and your children then can benefit from the policy payout. I'm sorry, but 40 years is a long time to accurately predict what your situation will be. Even if you're a hundred percent sure you're going to have kids, how do you know they will be dependent on you? How do you even know you'll live that long? God forbid, but what if you die next week? And why do you need an insurance policy to invest your money, when you can do it on your own? The answer is NOOOOO!

One last example. Let's go back to our TV shopping experience. When you are paying for the TV, the salesman tells you about an insurance plan, that for an extra two hundred dollars, extends the existing warranty by 3 years. That happens all the time, right? By now, you know what the answer is. Don't think about how much more than $200 it may take to fix or replace the TV, but instead, ask yourself if that is going to cripple your finances, and usually the answer's NOOOO.

I feel like I made a lot of friends with insurance agents with this post. Anyway, until next time, may you make some moolah.

Gas X

Alright, I'm going to diverge somewhat from core personal finance issues in this post and devote it to our other big problem in the economy besides the credit crisis--President Bush...oops, I mean the oil crisis.  I figure I should talk about it before gas prices plummet, and yes they will...sooner than you think.  Don't worry, I'm not going to subject you to a long rant about whether the high price of oil is due to speculation or supply and demand.  It seems like everybody has an opinion, and who knows who's right.  I'll just leave it with the observation that in our last oil crisis, we had long lines at gas stations due to a TRUE lack of supply, and it's hard to believe demand in the last 6 months increased parabolically.  Anyway, let's take a look at how one can productively deal with the problem of high gas prices.  I'll talk about ways to save on gas, increase the gas efficiency of your car, and even potentially profit from this whole oil mess.  

I'm from LA, and if there is one part of the country where gas prices are hurting the most, it's LA.  Los Angelans luuuvvvv their cars.  This is the place where people drive 2 blocks to the supermarket, where we have a total of 4 subway lines, and where we possessively refer to our freeways as "the 5, the 405, the...."  OK, I may have been guilty of some of these qualities...but at least I'm passed the stage of denial.  Anyway, for Los Angelans you can imagine that gas is a major expense.  It's easy to tell people to take public transportation instead of driving.  Really?  That saves you gas?  Let's think beyond that, and if for some reason you can't escape driving, here are some ways to lessen the financial pain.

My first tip is to consolidate your driving.  Every time you take your car out, think of how you can accomplish all your outstanding errands in one spin.  On your way back from work, if you drive past the supermarket, take that as a chance to do your grocery shopping.  But make sure that your stops are on the way.  You won't be saving gas if you're going off your way, even if you do everything in one trip.  Fortunately, I've been adhering to this tip even before this oil crisis.  I live in an apartment with a small garage, and getting in and out of it is not the most convenient.  Maybe the tip should really be to find an apartment with a tiny, overcrowded garage.

Tip number two is...have you noticed all those credit cards that give you gas benefits?  All you have to do is google 'gas credit cards,' and there are multiple web sites that direct you on how to get a credit card which can give you gas rebates.  As with any credit card, you want to make sure you read the fine print, and avoid silly things like annual fees, ridiculous interest rates (not that you're going to miss your payments), and certain other restrictions like you can only use the card at specific gas stations.  

Tip number three and probably the most important--be a gas efficient driver.  Now there is a slew of ways to do this, but the bottom line is try not to be Jeff Gordon.  If you don't know who he is, that's ok...I don't understand the appeal of car racing either.  On most cars, there is a gauge that tells you how many RPMs (revolutions per minute) your engine is doing.  The idea is to keep the RPMs to a minimum, and the ways to do that are to 1) Drive more slowly.  Unlike most people, you can actually obey the law, and drive the speed limit.  2) Don't accelerate rapidly.  Avoid cutting in front of other drivers or stepping fully on the throttle when accelerating.  And 3) If you have a manual transmission, to upshift quickly.  Being in a higher gear results in less RPMs.  

Believe it or not, wind drag or resistance makes a difference.  Most people think turning on the air conditioner uses more gas, which is usually true.  But if it's a hot day, having the air conditioner on will actually save you gas on the freeways compared to rolling down your windows.  This is because of the amount of wind resistance you create with the windows open.  

The weight of your car matters as well.  The heavier your car is, the more gas your engine has to consume to move the car.  Hence, it'll help your miles per gallon if you emptied your trunk of unecessary things such as the case of bottled water, the bowling ball, or the suitcase of extra sticks of beef jerky just in case you get stranded in the middle of nowhere.

How about selling your car and getting another more gas efficient one?  That is a calculation you must do for yourself.  If it results in immediate savings, then it's worth it.  I personally don't understand the appeal of SUVs and pick-up trucks anyway.  In a way, high gas prices may serve the beneficial purpose of making us all more energy responsible.  I know I'm not making any friends saying that...especially in LA.  Anyway, but one thing is certain about changing cars--don't go out and buy a hybrid vehicle, because they still cost substantially more, and will take an average of at least 3 years just to recoup your additional cost.  

You've seen some ads for gasoline additives that increase efficiency.  One word--SHAM, don't believe them.  There have been no studies showing that any additives work in that manner, and we don't know yet how they could potentially harm your engine.  Along the same lines, is it worth getting high octane fuel?  High octane fuel does NOT increase gas efficiency, but some studies have shown that it does help with engine performance, e.g horsepower, torque.  Nonetheless, if you have a luxury car that is built for premium gas, to date there have been no conclusive studies showing that regular gas would harm the engine.  In fact, I drive a BMW and when I bought the car, the dealer revealed to me that's he's owned BMWs for a while and he's always bought 89 octane without any noticeable negative effect.  But again, this is anecdotal and you decide what's comfortable for yourself.  

Alright, here comes the juicy part of this post.  How can you actually MAKE money with high gas prices?  The surest way is to invest in alternative fuels.  We don't know if there really is a supply and demand issue with oil, but we know that the concern for energy has come to the forefront, and it is a certainty that we'll eventually run out of oil.  When that happens, we will have to depend on something else, and the usual suspects these days are natural gas, wind, and solar energy.  

There is also ethanol, coal, and nuclear power, but these for various reasons are not as attractive.  Can you really imagine shoveling coal in your car?...enough said about coal.  Regarding ethanol, it's a very controversial issue, but the bottom line is it's not as efficient to produce as the first alternatives I mentioned.  Lastly, nuclear energy still scares the sh*%^ out of people, so that's not coming along anytime soon. 

Natural gas is probably the best prospect to replace oil, as there is an abundance of it, especially in the US, and it is the cleanest burning fossil fuel.  Wind and solar though should play signficant roles.  The Department of Energy forecasts that by 2030, wind power should contribute about 30% to the country's energy needs.  So how do you invest in these alternative fuels?  For natural gas, you can invest in the fuel directly, by buying the US natural gas fund, symbol UNG.  Another way is to invest in natural gas companies, a few of the good ones being Chesapeake, XTO, Apache, and Anadarko.  In terms of wind, there is an exchange traded fund (ETF--we'll talk more about these funds later in my stock market posts) with symbol FAN, representing a pool of wind companies all around the world.  There is no public company that purely specializes in wind power, but a few who have substantial exposure are Trinity, Kaydon, and Owens Corning.  To invest in solar, there are only two companies worth looking at, which are First Solar and Energy Conversion Devices.  They are the only two companies that specialize in thin solar films, which is the best in solar technology these days.  Be aware that all these investments are for the long term, probably at least 5-10 years, as it will take time for these alternative fuels to emerge.

Waiting 10 years to make money doesn't sound too sexy, right?  Well, if you are more risk averse, an option would be to bet that oil prices will indeed fall and there are several ways to play that.  There is an ETF with symbol DUG that inversely correlates to how well the major oil companies do.  A better way may be to invest in oil refining companies, the best being Valero.  High oil prices are usually harmful to the oil refiners because that cuts into their profit margins.  As a result, refiner stocks have done very poorly in the last year, but when oil prices decline, they should be one of the best beneficiaries.  

Wow, that's a lot of gas in one post!  I'm gonna go and get myself a bean burrito now.  Until next time, may you make some moolah.  

Home Sweet Home

In my post about basic investment options, I purposely did not mention a huge one, real estate. Besides the fact that it's a post in itself, I left it out because I don't think real estate should be a major financial goal for professionals who are just starting out. Here is why.

Recently, there has been much debate about whether home ownership is a right or privilege. Today, 68% of US households own their home, which is the highest in history. To give you some perspective, 50 years ago, the number was around 55%. Now why the increase? Sure, there's no doubt the nation and its citizens have become more prosperous. The gross domestic product, the ultimate measure of the economy, has tripled in the last 30 years. The median household income has increased 20% during that time (hmmm...why hasn't it tripled?...a topic perhaps for later.). But I argue that the main reason more people own homes these days is because homeownership is more accessible. We really have Franklin Roosevelt to thank for that. When FDR created the institutions Fannie Mae and the Federal Housing Administration, increasing home ownership was precisely his intent. Props for Franky. Anyway, as a result, owning a home is as close to being a right as it's ever been. It's the American dream. But just because everyone has a home, does it mean you should include it in your financial planning? Is it always the right financial decision?

Before we answer this question, let's go over some of the benefits and disadvantages of buying a home. In my book, the biggest benefit is just the fact that you get to say you own the house you live in. You can have as many people as you want living in it, have as many dogs or even kimono dragons if you like, change a bedroom into a pilates gym, another one into a recording studio...you get the point. It's yours and you can do whatever the heck you want. I guess if you were financially inclined, you could also rent part of it out to make some money.

Another benefit of homeownership is that your mortgage interest and property tax payments are tax deductible, which means for every dollar you spend on those payments, you get anywhere between 20-35 cents back from the government, depending on your income tax rate. This is a great benefit, because remember the concept, "Not negative is positive." This tax deduction means you're essentially getting a 20-35% yield on the money you put into your mortgage interest and property taxes. As you may then conclude, this benefits the wealthiest more, because they are in the highest income tax brackets.

Still another benefit is home equity, which is the value of the home minus the debt. Let's say one of my friends bought his house for about $175K in 1998, and now it's worth $450K. He still owes about $50K, so he has $400K of equity. He can either sell his house today for that amount (good luck with that in these difficult times), or take out an equity loan to use for whatever he wants. For instance, he could renovate to add more value to a home, use the sum to live on (not recommended since it's like living off a credit card), use it in an emergency situation (e.g. medical bills), or use it to invest in a business venture like starting a restaurant. Be aware that equity is really only a good thing if your house appreciates. If your house value stayed the same or depreciated, sure you'd still get equity, but it'd be just the money you've paid. It'll be like putting money under your pillow (plus paying the interest as well), and we know we don't want to do that.

But then you ask me, don't houses ALWAYS appreciate? This is a good segway to the downsides of real estate. I know that in the past 10 years, people have made a killing investing in homes. But take a look at this chart by Robert Shiller, one of our most preeminent modern economists, who did a study examining average home prices adjusted for inflation from 1890-2006. http://www.1stmillionat33.com/posts/06-09-12/house_his.gif

As you can see, the appreciation in home prices historically has just been a bit better than inflation, with the exception of the years 2000-2006 when, for lack of a better phrase, they just went nuts. Ummm...I am going out on a limb and saying this period is an outlier, a bubble for which we are currently going through the corrective phase. I've seen people on TV recommending now is the time to snap up "bargain homes." I would argue against that, because the current median home price is still over $200K, and if you believe in Shiller's chart, there clearly is more room for prices to decline. (I am generalizing somewhat, because real estate is regional, and there are some parts of the country where housing prices have indeed bottomed already.) You don't want to buy a place, have it rapidly depreciate, and consequently have to stick with it for 10-20 years, waiting to generate some meaningful equity. Compounding this predicament is that homes are not as liquid as, say stocks. If one of your stocks tanks, you can easily sell shares whenever you want, but finding a buyer for a depreciating house and then going through all the logistics of a sale are far more difficult.

If you remember in my first post, I mentioned that I almost bought a house last year. I was fresh out of residency, had just landed a nice job, and was caught up with the idea that every semi-successful person should own a house. I found a property close to work. The selling price was $480K, my offer was $450K, and the owners rejected it. After 6 months, I was curious and looked up the house again, and to my relief, it was worth $370K. Adding to my relief was that I had left my job and moved like 100 miles away! Thank baby Jesus, with his fleece diapers and all. (Name that movie reference!) If I had bought that house, I would've been left with a huge debt, on a rapidly depreciating property, in a location where I didn't want to be. So you see, buying a house is not meant for those who are still unsettled and unsure about their career specifics, people who don't know for sure where they want to be and how the next good chunk of their life is going to turn out. Hey, isn't that the majority of professionals who are just starting out?

Now you see why I don't recommend real estate as a major investment goal for beginning professionals. It is a huge investment, requiring not only enormous capital but deep life commitments as well. In addition, the return you'll get, even with the tax deductions, is inferior over the long run compared to stocks. And if you are unlucky enough to run into a housing downturn, a house would be more difficult to unload. I'm not saying never think about real estate, but it should be at a later point where you are more sure of your life situation, and are ready to own where you live. When you are at that point, you can make financial goals to save more money for a down payment, and the money in your savings account should be a good start towards that.

A side advantage I haven't mentioned is that real estate does diversify your investments, making sure that you'll still be ok, say if the stock market crashes. But this is a small benefit, because the stock market will recover over the long run, and you are already diversified through your savings accounts and your bonds.

And what about the money you'll save or would otherwise "give away" to your landlord if you rent? Well, unless you're living in a luxury apartment, you'll always have to pay more in the long term for a house than if you rented. So really, think of homeownership as more of a life upgrade.

I know that there will be some people who'll disagree with my perspective on real estate investing. I have friends who have done really well buying properties, selling them a couple of years later, and earning handsome profits. I don't know about you, but that sounds like Donald Trump. Just like we shouldn't try to be bankers and take on every great loan that comes our way, I don't think we should be real estate businessmen when we're not. Especially given how housing has declined in the last 2 years, you could potentially lose a lot of money trying to be the Donald...and he probably can afford to lose more money than you.

Until next time, may you make some moolah, just not on real estate...at least not yet.

GOOAAAAAALLLLLL!!!!!

Hi there. If you're reading this, you're probably curious about the title or are somehow interested in better managing your finances in some way. Let me start off by saying that I'm not a financial advisor in occupation. In fact, I'm as far from that as you get. I'm a physician, and no, medical school did not have economics electives...I guess memorizing all of the muscles, nerves, and bones in the body took the bulk of our school time.

So then why am I starting this blog? Well, obviously I have some interest in personal finance, and I think I can help people like me who aren't in business and were never really introduced through their education or training how to manage their money. I certainly have many friends and family who are like that. I've had to learn through trial and error many of the topics I'm going to talk about, and I wished that someone could have told me beforehand, so that I didn't waste the money and time. Well, actually some of it was kind of fun, so I guess the money went to something.

So I myself am a baby professional, my term for those young professionals who are just starting out. I've been out of residency (that's the 'training period' for doctors...for those who don't watch Grey's Anatomy) for about a year. As a resident, I still got paid, but I don't think that period counted, since I was much too preoccupied with averaging at least 4 hrs of sleep a night, and was also paid less than minimum wage, if you did the calculation. Anyway, after residency (and after taking a month off to hibernate and catch up on my sleep debt) I found myself with some actual income and savings potential, which then led to the logical question--what should i do with this money? I did buy a nice car, which is probably the worst financial thing you can do, but hey, that's what I meant by trial and error. I do like my car though....

Since the end of my residency, I've played the stock market, started a business, switched jobs twice, and almost bought a house which would certainly have lost half of its value by now. I've made a lot of mistakes this year, but the good thing is that I've learned from them, and I hope to impart to you some of what I've learned.

So I know you're dying to ask, "What's up with the title?" It's a reference to those brilliant mexican soccer broadcasters. To be entertaining, they really don't have to say anything besides, "GOOOOOAAAALLLL!". Well, maybe if I understood a bit more spanish, I would think differently. Anyway, the title also refers to the subject of this first post, which is the importance of setting goals, financial goals.

Realistically, what should be everyone's ultimate financial goal? To be a millionaire, right? Ok, good luck, you could keep buying lottery tickets every day and maybe you could have a 0.1% chance of winning. Actually, let me backtrack. I feel like Dr. Evil in Austin Powers..."I am holding you ransom for....a BILLION dollars, woohahahaha." Because in reality, a million dollars isn't that much money these days. For most people, you need at least a million probably to retire comfortably. Ok, I just gave away the answer to the ultimate financial goal. The ultimate goal should be to save enough that you can retire comfortably. Depending on your lifestyle, for some it may be a million, for others ten million. You have to figure that for yourself.

Alright, so we've come up with our ultimate goal. How do we get there? So you figure that you have about 40 years before retirement, and let's say you decide you need a million bucks by then. You would then need to save about $25K a year...great, looks like you have to eat Ramen every meal for the next 40 years. But don't despair, because you forget that your investments grow and compound year after year. You don't have to put in quite as much as $25K. So don't get caught up too much with the ultimate goal. Basically, focus more on making good financial decisions. And perhaps more importantly, you should think about mini-goals.

Financial mini-goals are endpoints you want to meet every year, month, week, or even day. You've probably heard that it's important to budget. Well, the reason is because when you budget, you're actually setting mini-goals of how much you can spend. And the more closely you budget, the better. If you set a mini-goal of not exceeding $20 for food every day, those times when you go over, you'll be aware of it and can try to make up for it the next day. If you had only made a mini-goal of checking your expenses once a month and you found that you spent an extra $500, that's harder to make up.

Ok, I think that's it for the first post. The lesson to take home is that it is important to set financial goals, the ultimate being an adequate retirement sum, but more practically along the way, to have mini-goals. One of the most important mini-goals is to just check your finances periodically, the more often the better. I would recommend that you at least do it once a month.

Alright, until next time, may you make some moolah.

Do you know where your money is?

Too often I've asked my friends and family the question, "Do you know where your money is?" I guess that's not exactly a popular cocktail party question, but that's why they are my friends and family. They love me no matter what...awww...ok, so too often I ask that question, and too often I get the answer, "You know, in the bank and in a mutual fund...I don't know, I'm gonna have to check with my financial advisor."


This answer bothers me in a couple ways. Take my friend who does fairly well. I don't know how much she has saved up, but it has to be in the thousands. So based on that answer, she has several thousands of dollars invested in something, evidently called a "fund", and she is entrusting the management of this "fund" to somebody who claims to be an expert because they say they are. I don't know about you, but wouldn't you feel better if YOU took care of your own money? I'm not trying to knock financial advisors. I'm sure there are a lot of terrific ones out there, and it may be useful to have someone to discuss ideas with from time to time. But I think it's important to have some clue of where your money is. So in this blog, I'm gonna go over some basic investment options.

So you have some money in your piggy bank. What should you do with it? Well, one option is nothing (leave it in the piggy), which is always the wrong answer, because money depreciates due to inflation. That's why it costs more to buy a soda today then it did ten years ago. So please, never put your money under your pillow.

Before you decide where to put your money, you have to separate your savings into two pots. In one pot is your retirement savings, money you do not anticipate needing until you are 59 1/2 years old. In the other pot is money you want still to grow, but may need to use in the next 40 years. This distinction is important, because if you put all your savings into an Investment Retirement Account (IRA), and you want to withdraw some of it before 59 1/2 years old, you will have to pay hefty early withdrawal fees. First, we'll talk about your non-retirement savings.

The simplest way to save your non-retirement money is probably your good ole savings account. These are straight forward accounts set up by banks which allow you to deposit or withdraw at anytime, without any fees. The problem with these accounts is that their interest rates are usually the lowest of any investment options, often between 0.1%-5%. These rates are dependent on the borrowing rates set by the Federal Reserve, the government institution which oversees all banks. The rates are higher usually in good economic times, and lower in poor times. One pearl is that online savings accounts usually have higher rates, since they require no maintenance costs for the banks, so check them out. A similar entity to a savings account is a money market account. For our purposes, they are the same.

The only other way to save your non-retirement money and have it available at any time is the stock market. Now, the stock market is so complex that I'm going to devote several posts to it. Suffice to say for now that it's not really meant for frequent deposits and withdrawals...that would be called DAY TRADING, which is only a little bit better than gambling. Actually, gambling probably has better odds, since about 90% of day traders lose money. Investing in the stock market should be viewed as a long term strategy, because stocks can be very volatile in the short run.

Another option for your non-retirement money includes certificates of deposit (CDs) and bonds. CDs and bonds are money you lend to a bank or the government, respectively, but there is a specified period of time, anywhere from 6 months to years, before you can take the money out. They have unique interest rates to them, which are usually higher than interest rates of savings accounts. For example, currently a ten year bond yields about 4%, whereas an average savings account these days gives you 1%.

OK, on to your retirement savings. There is no question when it comes to retirement savings, IRAs are the way to go. The reason is that the returns you get are not taxed, and hence they will give you the best yield of any of your investments. For instance, if you put $1000 in a one year CD with a 3% interest rate, at the end of the year you expect to earn $30, right? Wrong, because you are forgetting that you'll be taxed on that $30, so what you're really gonna make is around $20. But if you had put that CD in the form of an IRA, you would be able to keep that full $30. This example also brings up another point. You can't just dump money into an IRA and leave it there. You have to specify to the financial institution managing your IRA what investment vehicle you want the money in. In my example, I used a CD. You could use anything really, even a savings account, but that would be oxymoronical as savings accounts are meant to give you the capability of moving money in and out whenver you want.

There are different types of IRAs, but for all intents and purposes, if you're a beginning professional, you need only be concerned with the Roth and the Traditional IRAs.

If you are single and making less than six figures, the Roth IRA should be your first choice. You can't open one if you're making more than $116K, and there is a maximum contribution of $5000 a year if you're making less than $101K. If your income is between $101-$116K, you can make a partial contribution, and there is a chart from the Internal Revenue Service (IRS) on those limits. These income limits are higher if you have a spouse. The best thing about a Roth is that you can withdraw your money tax free, at the age of 59 1/2, of course. A disadvantage is that your contributions are not tax deductible, so essentially you're taxed in the front end, which if you think, is better than being taxed in the back end. For instance if you put in $5000, you're really putting in $1000-$2000 more, because the $5000 is post-tax. But in 40 years, when your $5000 grows into $25K, taxes on that would be approximately $7000-$8000. So you don't want to be taxed then.

For a traditional IRA, there are no income limits. Contribution limits are based on age. If you're younger than 50, than the limit is $5,000. The advantage of the traditional IRA is that your contributions are tax deductible...but only for certain incomes, e.g. <$62K for a single person. Withdrawals are subject to income tax, so not as good as a Roth. There are other subtleties to IRAs, but I've given you the basics. If you want to read more about them, go to the website of the IRS.

There are several investment vehicles I haven't mentioned. One is the popular mutual fund. A mutual fund is simply a portfolio of stocks and bonds that investment managers have created. They are for investors who don't really want to spend the time to create their own portfolios. An important point is that when it comes down to your retirement savings, mutual funds should not be relevant when you are starting out. When you are a beginning professional, you want to put your retirement savings in stocks, because they will give you the best return in 40 years. But as you age, more of your retirement pot should be shifted to bonds, which give you less return, but are less risky. So you could potentially use mutual funds to adjust your stock/bond ratio. A good rule of thumb is that every ten years, you should shift about 25-30% of your retirement savings into bonds.

Another investment vehicle is the employer sponsored plans, and these are basically 401Ks and Keoghs. 401Ks and Keoghs are similar to IRAs, but come from your employer, so that you can elect to reserve a portion of your paycheck for your retirement. The tax implications can vary like IRAs, and in fact there is a Roth 401K, which allows for tax free withdrawals. There are even 401Ks where your employer will match dollar for dollar, your contributions. In terms of Keoghs, they are generally unique in that they have the highest contribution limits of all the investment vehicles. Different employers will offer different 401Ks and Keoghs, so make sure to inquire about them!

You also may have heard of an investment vehicle called an annuity. Essentially, this is a contract between an individual and an insurance company, where initially the person pays the company a sum of money, and agrees on an interest rate which can be fixed or variable, until a specified time upon which then the company starts paying the individual an agreed amount periodically. Annuities are attractive, because they give individuals a "steady income" after they retire, sort of like a pension plan. Also, there are annuities, in which their returns are tax free. There's nothing that's a free lunch though, because the knock on annuities is that they often have expensive management fees attached to them. A good rule is that for your retirement money, you should maximize your contributions to your IRAs first, then if you have money left over, a tax-sheltered annuity would be reasonable. However, if you do have a 401K which does not have a contribution limit, there is no reason to set up an annuity.

Whew! So many choices, right? Well, let's see if we can't simplify things.

Back to the money in your piggy bank. So, remember the ultimate goal is to save for retirement. But at the same time, it's not a good idea to put all your money into retirement accounts, again because you can't use it until 40 years later. You want an emergency fund you can access anytime, just in case you need it. If you have enough savings to maximize your IRA account(s) (you could potentially have BOTH a Roth and a traditional IRA), and still have some money left over, you should maximize those accounts. The left over money, you can then use to put a portion in your 401K if you have one, and the rest into a savings account. I personally am not a big fan of CDs and bonds for your nonretirement money, because their yields are usually not that much higher than online savings accounts, and also you have to wait these certain time periods to take your money out. If you don't have enough to maximize your IRAs and have some money left over, just split what you have. Put 3/4 into the IRAs and 1/4 into a savings account.

So that's it really, a portion in your retirement accounts, and the rest in a savings account...all you really need! If you are more risk averse, you can reserve some money to play the stock market. I don't recommend doing that if you can instead maximize the IRAs.

Alright, until next time, may you make some moolah.

Not Negative is Positive

No doubt you've heard a lot about the current "credit crisis." For those who haven't watched TV, picked up a newspaper, or opened a website in the last 2 years, the current credit crisis briefly refers to the fact that many borrowers today aren't able to make their loan payments, and consequently the lenders are losing money, which causes them to be more hesitant in lending. You see that this is a potentially vicious cycle, which is why everybody is worried that it is going to just cripple our economy. I don't want to make this blog into a Wall Street Journal article, but I think that we can all take away some lessons from this current crisis. First of all, let's go back and examine the origins of credit.



Did you know that about 40% of Americans are in debt, 75% of households have at least one credit card, and 70% of homeowners have a mortgage? Now most personal finance books will tell you that a core principle is to not spend what you don't have. That seems like intuitively prudent advice, but why then do most people not follow it? Why is there even credit to begin with? The answer is that credit generates business. Credit is a concept engendered by businessmen, because they can make make money lending, through the interest they charge. But it is not just the fault of the lenders. Borrowers generally welcome credit (hence the high number of people in debt), because there are 2 types of borrowers. One is other businessmen who feel that they can make money borrowing at a low interest rate, and then using the money to make profits that are more than their interest payments. And then there's the type of borrower who thinks that this is a chance for them to own something they really want but can't afford at the moment...ummm, if that's not the classic spend-more-than-what-you-have, I don't know what is. This latter type of borrower unfortunately is your average consumer...yes, come out from behind the tree, you know who we're talking about.



Debt gets a bad rap...I mean, it kind of sounds like "death," (and feels like it sometimes) but not all debt is bad...just most of it. You've heard people say student loans are good debt. Why? Because usually they have very low interest rates. But be careful to generalize, because I've taken out some loans during my schooling with interest rates as high as 10%. When you look at debt, you are confronted with two scenarios: 1) what do you do with your current debt, and 2) when should you take out new debt?



Let's examine the first scenario--what to do with your current debt. Is it as simple as, "Pay it off!?" Well, it could be that simple, but if you followed that rule, you wouldn't be maximizing your investment returns. Let's look at an example. Let's say you have a student loan debt of $1000 at a 2% interest rate. You have just received your latest paycheck, and you've been paying attention to the previous blogs, setting a mini-goal of saving $400 a month. You plan to put $300 in your retirement account and $100 in a savings account. Your retirement account is invested in the stock market, and that generates on average a 9% annual return. Your savings account gives you 2%. So, given this situation, should you use some of your savings to pay off your student debt? (I have to interject here and clarify that you should always pay at least the monthly minimum, if you want to have a semi-decent credit score. What we are talking about here are payments on top of the minimum, so you can actually pay off the debt.)




One can make an argument that instead of putting $100 into your savings account, you should use it to pay off your debt. The reason is that your savings account return will be taxed, and so you're going to really earn about 1.5%, and then it's a queston of owing 2% more vs. gaining 1.5%. However, my recommendation would be to not touch your savings account, since that is your emergency fund. What about your IRA? That's a no brainer--owing 2% more or gaining 9%. Contributing to your IRA will give you a net result of gaining 7% of your savings at the end of the year, and paying off your debt will cost you a potential gain of 7%. So you see, paying off debt is not always the right move.



Let's change the example. Let's say instead of a student loan debt, you had a credit card debt at an interest rate of 15%. Again, in my book, your savings account should be hands off for emergency purposes. Should you pay off your credit card debt or contribute to your IRA? And the answer is pay off your credit card debt. Think about it, it's a question of owing 15% more vs. gaining 9%. The end result would be you owing 6% more in a year. Not negative is positive--sometimes not owing more is as good as gaining. The take home point is, if you have any debt that has an interest rate>9%, paying that off takes priority over saving.




OK, now you know how to deal with your current debt. What about situations where you're thinking about borrowing more? Let's say you're interested in buying a TV, and these days it's gotta be a flatscreen, right? OK, a flat screen it is, which will set you back anywhere from $500-$2000. Let's just pick an easy number, $1000. You have $500 in the bank, so there's no way you're getting the TV, right? The salesman sees a moment of hesitation in you, and offers you a way to finance it. He/she says the store will lend you $500 at a 10% interest rate. Sound like a good deal? Yes...to the salesman. Not only will he/she profit from your purchase of the TV, he/she reaps the interest from this loan. This is clearly not a situation where you should borrow money.




You tell the salesman that you refuse. Then he/she comes back to you with a deal where you can borrow money at an introductory 0% annual percentage rate for the first 12 months. That means you won't have to make any payments for a year, plus there is no interest added to your loan during that time. They run your credit score, and you're approved for a $1000 loan. What now?




Being this is a personal finance blog, the best thing obviously is to not to buy anything you don't really need, but you've already heard that one. Hopefully, we're past the stage where we seriously shop for things we don't really want.



So I say you take the TV home, but at what cost to your bank account? The correct answer is zero, because think about it. Someone is giving you a free sum of money for a year. Why are they doing this? Because they're betting on the fact that you won't have the $1000 after a year to pay them back, in which case, they can then charge you a gagillion percent interest. But we won't be that negligent, and we are checking our finances at least once a month, setting the mini-goal of paying back the $1000 after a year. Plus, we're going to set this free money to use, putting it in a savings account throughout the year and generating a profit for ourselves!



See, there are times when it's actually OK to borrow. But don't go out and agree to every great loan that comes your way, because accumulation of debt leads to a bad credit score, and plus, you're not a banker who actually has the time to manage all these loans. The credit score is a weird thing...too much debt is bad, but moderated debt that you pay off consistently increases your score. Anyway, that could be a topic in itself.




So let's go full circle back to the current credit crisis. Many people blame the lenders, the banks, for offering all these aggressive "subprime" loans, ones which borrowers would unlikely be able to pay in the long run. But from our credit discussion, credit is embraced by both lenders and borrowers. Borrowers also had a responsibility to make sure they could afford the loan. That is the main lesson for us. Credit has become an essential in personal finance, and managing your money not only includes how you deal with what's in the bank, but how you manage your debt as well.




Until next time, may you make some moolah.

How much are you worth?

So who's the richest person in the world today?  Sorry Bill Gates, it's Warren Buffet, the CEO of the investment firm, Berkshire Hathaway.  I don't think Bill Gates is that sorry, actually.  He's still the third richest in the world.  Anyway, these guys' fortunes are measured by their financial capital, how much is in the bank and in their investments.  Accordingly, Warren Buffet's net worth is estimated at 62 billion dollars.  When I started residency, my net worth was negative six figures due to all my school loans...sigh.  But there's one thing I have over Warren Buffet, and that is, I may have more human capital than he does...maybe. 

Let's examine the concept of capital. According to dictionary.com, capital is defined as "the wealth, whether in money or property, owned or employed in business by an individual, firm, corporation, etc." I don't think this definition is entirely accurate. It leaves out a very important type of capital, that is, human capital. I would add to the definition, "the wealth, whether in money, property, or earning potential..."

You see, there are really two types of capital, financial and human capital. There's the money you have in your wallet, your checking/savings account, or that invested in your house/stocks/bonds. Then there's the money you can potentially generate every day with your time--your human capital. Let's say you wanted to buy something...oh, I don't know, maybe a Guitar Hero video game set, as that seems to be the rage these days. You could take out a wad of cash to pay for it, or you could whip out your credit card. Either way, you're purchasing something with your capital, because you'll eventually pay off the credit card later (hopefully) with what you've earned at your job. This distinction of capital is important, because to set financial goals you have to know what you have to work with.  

[Before I go further, I have to disclose that I did not coin the term "human capital," not by a long shot. In fact, the father of economics, Adam Smith himself, has used the term, in addition to subsequent other economists, the names of whom I'm sure you're dying to know for the next Jeopardy round. OK, back to the real blog...]

It is especially important for beginning professionals to realize the concept of human capital, because when you are starting out, you have vastly more human than financial capital...unless you've inherited a fortune from your parents. In that case, this discussion is less relevant to you, but not to say that wealthy people don't need financial advice. I would argue that they need MORE savvy financial management, as they have more to lose. Just look at Ed McMahon, Evander Holyfield....anyway, back to us folks who don't have huge sums in the bank. 

Let's delve into a hypothetical. Let's say you make $20/hr. A work year is 52 weeks, and if we assume a 40 hour week, your annual salary would be about $42K. You decide that you want to save at least $5,000 a year to put into your IRA.  To save $5,000 a year, you would need to put away about $415 a month. 

So how are you going to come up with $415 per month? Most people think the only way to save is to spend less, but I submit to you that as a beginning professional, another great way to save is to utilize your human capital. When you are young, you have the stamina, the health, and if you aren't married yet, the freedom and lack of family responsibilities, to make the most of your human capital. In our example, if you were to work an extra 5 hours a week, you would make your financial mini-goal of saving $415 a month. To some, that may sound like a lot of extra work, but think about the fact that there are 168 hours in a week, and most people work 40. True, we also sleep about 40-60 hours on average, but that still leaves 60-80 hours for potential human capital. Of course, you need a balance between work and a social life. I'm not saying you should be a workoholic and neglect your family and friends, but my point is that there is not a surer thing (besides death and taxes) than human capital. If you have the capability to maximize your human capital, it is better than knowing which mutual funds, stocks, or pieces of real estate to buy. You don't know if your investments will generate you money tomorrow or even in ten years. Did you know the stock market today is essentially at the same level it was in 2000? But work, or human capital=money, instantaneously...well, until it shows up in your next paycheck.

Being young is the time to work hard. To be successful, one has to leverage their unique strengths and opportunities, and a universal one for beginning professionals is that they are able to work more than say, someone twenty years older. I said earlier that when we start out, we have vastly more human than financial capital, so we need to take advantage of that. Because as we age, our human capital will decline. In fact, when we retire, our human capital, assuming we stop working entirely, will be zero. But that's ok, because if you manage your finances well, it's a mere matter of shifting the pendulum to your financial capital. Your investments grow, and the yield from them will eventually provide for you in the future.

Warren Buffet, you have nothing on me!  Until next time, may you make some moolah.