401k Lump Sum Contribution: Dollar Cost Averaging Looking Good Right Now

Posted on September 15, 2007 // 37 Comments

I’ve been really bad at regularly making contributions to my Self-Employed 401k from Fidelity. I had only planned to put $500 a month into it for the first part of the year, since I wanted to keep as much liquid cash as possible in case I bought a house. Now that it seems like (1) we’ll have enough money both buy a house and contribute to the 401k, (2) we’ve may not buy right away anyhow since we can’t agree on what we want, and (3) the year is quickly coming to an end, I went ahead and sent in a lump sum of $10,000 to catch up!

My problem: The money just showed up on my account today, so I will have to wait until Monday to trade. This is the same day Mr. Bernanke plans on making his Fed Funds rate announcement, which will either calm the market down (drop 0.25%), make it really unhappy (keep it the same), or make it really happy (drop 0.5%). Even with the subprime mess, I am definitely still going invest my money into the stock market… but should I do it all at once?

Usually, in the arena of dollar cost average vs. lump sum my position has been:

If you already have all the money available (not if you’re just taking a set amount out of each paycheck) and you are well away from retirement, you should just invest the lump sum all at once.

This is supported by several studies, including this FPA Journal article Lump Sum Beats Dollar-Cost Averaging, which concludes:

Given a lump sum, is it better to invest the entire amount immediately, or spread it out in equal installments? Based on historical evidence, the major conclusion of our study is that the odds strongly favor investing the lump sum immediately. This conclusion emerges after comparing annualized monthly returns for both DCA and LS strategies for all possible 12-month periods from 1926 to 1991. For the entire 65-year period, the LS strategy produced superior returns approximately two-thirds of the time, and the superior returns were statistically significant.

So it turns out 2/3rds of the time you win out, and 1/3rd of the time you lose. Not bad. The next argument that some people make is DCA is more of a risk-reduction method than anything else. Again, multiple academic articles suggest that DCA may not be a very efficient way to reduce risk, either! Bummer.

Still, given the Bernanke situation, I am considering dollar-cost-averaging $1000 a day over the next two weeks instead of $10,000 all at once on Monday. Prudent idea, or backtracking?

Filed Under: Investing, Retirement //

401k to IRA Rollover Decision Process, Prosper Lending Review

Posted on September 14, 2007 // 13 Comments

I’m swamped today, so here are some posts from the past that fill requests from my suggestion box:

My 401k to IRA Rollover Decision Process
Part 1 – Stay put with old 401k?
Part 2 – Roll over into Fidelity?
Part 3 – What about Vanguard?
Part 4 – My Final Decision

Although this was done two years ago with my previous job, I think it still contains a lot of pertinent information. Note that Vanguard has since gotten rid of their low-balance fee if you accept electronic delivery of statements.

Also, since then there are now brokers that have free ETF trades, most prominently Zecco Trading (no minimum balance, $30 IRA annual fee) and WellsTrade ($25,000 minimum equity, no annual fee).

About Prosper.com – Person-to-Person Lending
Prosper Lending Review, Part 1: First Looks
Prosper Lending Review, Part 2: The Numbers
Prosper Revisited: Will Returns Drop As Defaults Increase Over Time?

I’m still not sold on Prosper’s risk/return characteristics to consider it a prudent part of my investment portfolio, but it can certainly be a fun diversion if you like that sort of thing.

Filed Under: Investing, Retirement //

Why Paying Down Your Mortgage Early Can Be A Smart Investment

Posted on August 26, 2007 // 75 Comments

Still no house yet. But I have been reading about mortgages, and one common debate amongst mortgage holders is whether to send in extra money towards the principal in addition to the required monthly payments. Usually, the argument evolves into these two opposing views:

No, you shouldn’t pay extra because:

If you put that money in stocks instead, you would most likely get a higher return on your money in the long term. Mathematically, paying down a mortgage is like leaving money on the table.

Yes, you should pay it down because:

Stock market returns aren’t guaranteed, whereas paying down the mortgage is guaranteed savings. Debt is a burden, and it’s hard to put a price tag on the psychological benefit of owning your house free and clear.

Now, I understand both of these views, and in the big picture, I really think if this is what you’re worrying about then you’re already ahead of the game. You might even think you already know which view I personally lean towards. But what if there was another perspective that satisfied both sides?

What happens when you pay extra towards your mortgage?
With a mortgage, your monthly payments are amortized, which means each one includes a portion that goes to pay interest and a portion to pay down your remaining loan balance, or the principal. If you make an extra payment towards principal, then this in turn directly decreases the amount of interest you’ll be paying in the future.

So if you pay $1,000 towards your mortgage with an interest rate of 6%, then you’re saving $60 of interest that you would have otherwise had to pay every single year for the rest of your mortgage term.

Put differently, it’s like you’re earning an after-tax return of 6% every year on your money.

But wait, what about the tax benefits of mortgage interest?
Yes, mortgage interest is tax-deductible, but you have to temper this with a few realizations:

  1. Everyone already gets the standard deduction, which in 2007 is $5,350 for singles, and $10,700 for married folks. Only the amount that your itemized deductions exceed this amount actually saves you money.
  2. The amount of interest you pay on your mortgage decreases every year, so your tax benefit will decrease as well over time.

For example, let’s say you are a married couple with a $250,000 mortgage loan balance for 30 years at a fixed 6% rate, and in the 25% income tax bracket. $250,000 x 6% is only about $15,000 of interest paid in the first year. Subtract out the standard deduction of $10,700, and your additional deduction is only $4,300. So you’re only saving 25% of $4,300 and not the whole $15,000. This means your 6% interest rate only goes down to the equivalent of about 5.6%. In addition, according to the standard amortization schedule your annual interest paid will go down to less than $11,000 in year 15. So after 10-15 years, your mortgage deduction will be less than the standard deduction, leaving you with possibly no benefit at all.

Now, if you have a large mortgage or have lots of other itemized deductions, then your tax benefits may be much more significant. In this case, your equivalent interest rate may be extraordinarily low. But for many homeowners, it’s not as large as they might think. (If you have a ton of other itemized deductions, also be wary of the AMT.)

For this example, you could be conservative and say that paying extra towards your mortgage is only earns about a 5.5% annual after-tax return for the rest of the scheduled term of the loan.

A fixed rate of return, every year, for a long time. Hmmm… that sounds like a bond! In comparison the 30-year Treasury bond is currently yielding only 4.88%. After a 25% federal tax, that return is only 3.66%! I choose Treasury bonds because they also contain essentially zero risk of default.

In other words, paying down your mortgage can very similar to holding an attractively-priced long-term bond. (If you have a rock-bottom rate, it could also be an unattractive bond.) So maybe that’s how we should treat it. Just like you don’t compare stocks directly to bonds because they have different risk/reward relationships, perhaps we shouldn’t compare paying down a mortgage to stocks either.

Right now, I currently hold about 10% bonds in my retirement investment portfolio. My prospective interest rate is around 6% if I get a mortgage. I could simply decrease my position in bond mutual funds and put that money instead towards paying extra towards a mortgage. When looking solely at my mutual fund accounts, this would result in my percentage of stocks increasing. This way, I can potentially get the best of both worlds:

  • I’m improving my overall investment portfolio. I am essentially buying a bond that brings me a return higher than what is otherwise available, perhaps by up to 1-2 percentage points. I do lose some liquidity as I can’t get my money out without taking a home equity line of credit and paying additional fees. But as long as it’s not my whole bond allocation, I can still rebalance as needed. My intended bond allocation will only increase as I get older, in any case.
  • I also pay my house off earlier, complete with all the happy fuzzy feelings attached. 😀

What if you don’t own any bonds? Well, if you’re the type of person who’s 100% stocks, then you’re probably so confident in the markets that you wouldn’t want to pay down your mortgage early anyhow. If you do want to pay it down, then consider it a small allocation to bonds that will lower the overall volatility of your portfolio.

Now, this doesn’t mean that paying down a mortgage should be a higher priority than things like maxing out your IRA, paying down higher-interest debt, or even an emergency fund. But it does provide me a way to pay down my future mortgage without having to worry that I am losing money somewhere else.

Filed Under: Investing, Real Estate, Retirement //

More Roth vs. Traditional 401k/IRA Data: Historical Marginal Tax Rates vs. Median Income

Posted on August 23, 2007 // 35 Comments

In my Roth or Traditional 401k decision process, I chose the Roth for the rest of this year. This essentially means that I’d rather pay up to 28% of tax right now on my contribution rather than pay whatever the going rate will be 30+ years from now. But why? I’m have relatively high income right now – Shouldn’t my income in retirement be less if I really want to be a beach bum? Probably, but here’s why I think 28% is still a pretty good deal based on history…

Having to guess what tax rates will be 40 years into the future is a daunting task! So let’s start by looking 40 years in the past. From 1967 to 2005, I found the both the median household income and the 95th percentile income from the U.S. Census Bureau. I chose these to roughly represent “middle” and “high” income levels.

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As you can see, both grow with time. (Yes, the gap between them is increasing. Let’s sidestep that hot potato right now.)

Next, I found the corresponding marginal tax rates that such incomes would have paid each year. Since we are looking at households, I used the tax information for the Married Filing Jointly status as an approximation. I ignored things like standard or itemized tax deductions across the board to keep it simple. With this information, we can roughly see how the marginal tax rates have changed over time, while still adjusting for the gradual increase in incomes:

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Results and Conclusions
We are currently experiencing some of the lowest marginal tax rates in recent history. The average marginal tax rate for a median, or “middle income”, household from 1967 to 2005 was 33%. The average marginal tax rate for a “high income” household was 44%. Today, we are only at at 15% and 28%, respectively. Assuming that today’s tax rates will continue on for the next 20, 30, 40 years may not be the best idea.

Will they get even lower? Or even flatten out? I don’t think so. Considering the historical rates we say above, and combining that with our continuing government deficits and the prospect of a nationalized health care system, I personally find it unlikely that in 2047 my marginal tax rate will be lower than 28%, even at median income levels. What do you think?

To be sure, this is a very simplified analysis. I am not even looking at total tax rates, just marginal ones for the express purpose of directing my IRA and 401k contributions. If you know of a better study done elsewhere that I missed, please do share.

Filed Under: Investing, Retirement, Taxes //

Choosing Between the Roth or Traditional 403b / 401k : Our Decision Process

Posted on August 21, 2007 // 29 Comments

My wife now has the new option of contributing to Roth 403b plan with her new position, and we had to make a decision on whether or not to go with it. Here is our thinking process, which should also apply to Roth 401ks.

I found a few good articles online, including Is the Roth 401(k) Right for You? by Emily Brandon at US News, and Choosing Between Traditional and Roth 401(k)s from Yahoo Finance. Here is a nice table outlining the major differences:

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As my last video post outlined, the main difference between a Roth 401k and a Traditional 401k is when you pay the taxes. With the Traditional, you get to defer your income taxes now, but you must pay taxes up on withdrawal. With the Roth, you pay tax now, but you don’t own any taxes upon withdrawal.

So the first question is – when do you want to pay the taxes? Obviously this takes a bit of guessing as who know what tax rates will be in the future. You can also try and look at the 2007 tax brackets for a little guidance. Historically, I believe our tax rates are actually on the low side. If your income is relatively low now compared to what you think you’ll make when withdrawing, you should lean towards the Roth. If you expect an especially high income this year, it may be better to go Traditional. Be sure to take into any big tax deductions that you might have now but not in retirement (think mortgages and child credits). If you think it will be the same, I think you’ll see below that the Roth tends to win any tie-breakers.

(There are also those that think Roth accounts will be double-taxed in the future, so you might as well get the tax break now.)

Before, when our incomes were lower, it was an easy choice to go with the Roth. Now, we may get bumped into the 33% bracket. I doubt we’ll be making this much in retirement, I just don’t plan on saving up long enough to generate that much income. But I have a suspicion that tax rates will also be higher later. And I haven’t even considered possible AMT consequences.

The Roth has “bigger” contribution limits. Sure, the official employee contribution limit for both of them is $15,500 for 2007, but you can see that $100 in post-tax contributions requires a bigger out-of-pocket sacrifice than $100 of pre-tax money. This means that maxing out a Roth effectively allows you to defer taxes on more money. Since we aren’t eligible for a Roth IRA anymore, perhaps we should take advantage of this additional opportunity.

Matching works the same either way. Employer matches can only go in your Traditional 401(k) pool of funds, so we don’t have to worry about this here.

Roth 401(k)s get rolled over into Roth IRAs, which don’t have Required Minimum Distributions (RMDs) and other attractive estate features. I like the idea being able to delay withdrawing any money until I want to, which I can’t do with a Traditional 401(k). I’m not really concerned with inheritance stuff right now.

Final Decision? I still need to look into AMT effects, but for now I think we will be going with the Roth. Here is our plan: I want to max out my Traditional 401k this year in order to lower our taxable income and keep us in the 28% marginal bracket. Then, I think we can take full advantage of the Roth 403(b) on my wife’s side. This also gives us some diversification between accounts – If we have a high-tax year in retirement, we can withdraw Roth funds. If we have a low-tax year, we can withdraw and pay tax on Traditional funds. Did I miss anything?

Filed Under: Investing, Retirement, Taxes //

Video Post: Basics of Comparing Investing in a Roth 401k vs. a Traditional 401k

Posted on August 21, 2007 // 22 Comments

I just made my first video blog post which covers part of choosing between a Traditional and a Roth-type of retirement account, be it IRA, 401(k), or 403(b). I’ve covered this topic before, but I wanted to start out with something that I get asked often and also can benefit from the additional information available from a video format.

There are a couple of reasons why I decided to do this:

  1. No Credit Needed made his own first video about the Envelope System of budgeting. I thought it was a good way to explain the concept.
  2. At the same time, my father said that my blog should be more interactive (read: it was dull). When your own father says your blog isn’t cool enough, you know you have to do something!

I don’t think my servers can handle the bandwidth, so I had to throw it up on YouTube. Hopefully it’s not too blurry. It’s certainly a lot more work making a video than typing, so please let me know what you think.

Filed Under: Investing, Retirement, Taxes //

Bogle On Credit Troubles, Market Timing, And More

Posted on August 20, 2007 // 5 Comments

Via the Diehards forum, Businessweek recently posted an interview with John Bogle which covers many of the questions that people are asking about investing right now. As usual, he provides a balanced and big-picture perspective on things. I recommend reading through the whole thing, but here are some excerpts:

[…] if I was going to give advice to an individual investor?and I make a very important distinction here?if they have come into this market and have invested the way people should invest, and that means they have a little bond position if they’re young, and an average bond position if they’re in their middle years, and a substantial bond position in their retirement years, then I would do absolutely nothing. They will be protected by the fact that bonds are going up and bonds generate income. No one will take that income from them. They should just hang in there and do nothing.

Even if I was pretty confident that the decline will continue?and I think it’s more likely than not?you’ve not only got to get out right, you’ve also got to get in right. You must be right twice. So if you get out now, and the market goes way down another 15 or 20%, which is quite possible, they will be so scared they won’t get in.

[…] It’s not a good idea to time the market. In the long run, investing is not about markets at all. Investing is about enjoying the returns earned by businesses. And the stock market is nothing but a giant distraction in that quest to acquire returns that business earns. It overmagnifies everything. Investors get scared. Their advisors get scared. And you get exactly what we’re having?a bit of a mess.

Filed Under: Investing //

Money Magazine Can’t Time The Market, But Doesn’t Give Up

Posted on August 19, 2007 // 8 Comments

Like many people, I like reading personal finance magazines and subscribe to many of them. But you have to remember that in order to sell magazines, they also have to give people what they want, even if it isn’t sound advice. A great example of this is the recent Money magazine article titled 5 ways to know if the bull is over. The introduction reads:

Since Money Magazine last examined the health of the bull market (and pronounced it sound), consumer spending began slowing, several prominent buyout deals unraveled, and oh yeah – concerns about subprime mortgage loans going bad caused stocks to fall off a cliff.

After closing above 14,000 for the first time in late July, the Dow has since plunged nearly 1400 points, or 9.8 percent, close to an official correction. The S&P 500 has given up all of its gains for the year.

All this has added a certain cogency to the view that the five-year-old bull could be closer to the end of its road. So while you know better than to try to time the market – and you do, don’t you? – now is a good moment to check that your portfolio truly matches your appetite for risk.

In the meantime, keep an eye out for five signs that often precede a sharp turn ahead.

Now, let’s place this text through my patent-pending Financial Double-Talk Filter, and try reading it again:

We said the bull market would continue for a long time. We wrote entire articles just like this about it. We were wrong.

Yep. Wrong.

Remember, you shouldn’t try to time the market. Wait, what is that? You’re scared?

In that case, here are some ways to try and time the market!

Sigh. Did you see how smoothly they covered up their mistakes and moved on to the next hot topic? If everyone decided to hang themselves, I bet you’d see articles on how to get the best deal on rope!

(If you liked this, you might also enjoy my Anatomy of a Personal Finance Magazine Article.)

Filed Under: Investing //

Stock Markets Got You Stressed? Here’s A Calming Chart For You

Posted on August 16, 2007 // 19 Comments

I don’t do market predictions, but I wanted to keep some things in perspective. In the most recent edition of A Random Walk Down Wall Street, there is an updated version of a chart which I have used before to show how important time horizon is to reducing your projected risk. I have replicated it below:

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The fact that the variability in returns decreases the longer one stays in the market is very encouraging news for the long-term investor. But it is critical to remember that this data assumes you buy and hold a diversified portfolio. If you buy or sell stocks based on fear or hype, all bets are off.

Filed Under: Investing, Retirement //

Are The Markets Especially Volatile This Year?

Posted on August 16, 2007 // 26 Comments

Although it may feel like the markets are just bouncing around like crazy this year, Vanguard shares some data that shows that the markets are actually performing in line with history.

A common definition of volatile day is one where the market index moves at least 1% up or down. For example, yesterday all three major market indexes dropped between 1.3 and 1.6%, and it was considered a “pounding”. But, as you can see in the chart below, historically about a quarter of all days are volatile.

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In the past few years, we’ve been spoiled by a period of relatively low volatility, and now we’re simply reverting back towards the mean. It’s all part of owning stocks, and I don’t see any reason to make any changes if you already have a long-term plan.

Filed Under: Investing //

Model Portfolio #8: Ben Stein and Your Money

Posted on August 15, 2007 // 8 Comments

Next up is a model portfolio by actor and personal finance columnist Ben Stein. I have read and reviewed two books he wrote with Phil DeMuth – Yes, You Can Still Retire Comfortably! and Yes, You Can Time The Market!. I actually ran across this information last week while waiting at a Barnes and Noble for my companions to finish shopping. I wrote down that it was in Forbes magazine, but I found the article online under Fortune. Either way, here it is:

Ben Stein Model Portfolio

Ben

Asset Allocation For 80% Stocks/20% Bonds (with ETF examples)
25% Total US Stock Market (VTI, IYY)
25% S&P 500 Index (IVV, SPY)
15% Foreign Developed Equity (EFA, VEA)
5% Emerging Markets (VWO, EEM)
5% Real Estate (VNQ, ICF)
20% Cash

Commentary
On the equity side, I guess he’s leaning towards only having about 15% of the domestic equity portion being Small/Mid Cap stocks, since about 70% of the Total US Stock Market index is made up of the S&P 500 anyways. His exposure to Real Estate is very small, especially compared to the Swensen portfolio we just looked at. He does add a specific allocation to Energy sector stocks to the mix, which you don’t always see.

On the fixed-income side, Stein doesn’t recommend any type of bond, corporate or not. He thinks long-term bonds are too risky, while short-term bonds don’t offer enough yield to warrant not just holding cash instead. I’m not sure if this is solely due to the current flat interest rate curve. This may also be because he seems to take the view that your emergency fund cash should be included in your asset allocation. (I like to keep it separate.)

See here for other model portfolios from respected sources, part of my incomplete Rough Guide to Investing.

Filed Under: Investing, Retirement //

Model Portfolio #7: Unconventional Success by David Swensen

Posted on August 15, 2007 // 19 Comments

This model portfolio is taken from Unconventional Success by David Swensen. As mentioned before, Swensen is not a personal financial advisor, but is a respected institutional money manager who currently runs the Yale Endowment. In his book for individual investors, he writes that there are only a limited number of core asset classes in which one should invest in. Although he avoids giving specific asset allocation guidance, he does provide an “outline of a well-diversified, equity-oriented portfolio”, which is shown below.

Unconventional Success Model Portfolio Breakdown (Hurrah, I found my software disks so I can make pretty pie charts again!)

Asset Allocation For 70% Stocks/30% Bonds (with ETF examples)
30% Domestic Equity (VTI, IYY)
15% Foreign Developed Equity (EFA, VEA)
5% Emerging Markets (VWO, EEM)
20% Real Estate (VNQ, ICF)
15% U.S. Treasury Bonds (SHY, IEF)
15% Inflation-Protected Securities (TIP)

Commentary
There is a healthy portion devoted to real estate in the portfolio. The common way to track this asset class with REITs, which are considered a domestic stock. Instead of taking up less than 5% of the US stock market by capitalization, it is now taking up more than 40% of the domestic equity portion. I’m not really sure why there is so much, although he does write that if you own your home or other real estate, you may want to reduce your REIT exposure.

In addition, corporate and mortgage-backed bonds are left out, following his opinion that they aren’t the most desirable asset classes for individual portfolios due to added call risk and credit risk. (If you’ve been keeping up with the markets recently, it seems he may have been on to something here.)

As with all the model portfolios, the idea here isn’t just to follow any of them blindly. I do think it helps to see where different experts have similar components to their model portfolios, and where they differ. I also like breaking it down this way into pie charts of stocks-only and bonds-only in order to visualize them better.

See here for other model portfolios from respected sources, part of my incomplete Rough Guide to Investing.

Filed Under: Investing, Retirement //
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