Should You Cash Out in a Crisis?

The market is obviously on a roller coaster ride and we're all hanging on for dear life. So should you cash out and wait out the turbulence?

T. Rowe Price says NO WAY!

See the clever graphs and data below, which they've graciously provided for their investors (probably so that we don't all run for the hills while they watch their management fees evaporate before their eyes):

The Time Value of Money: The “40 Year Investor”!

The time value of money is the most important concept in all of personal finance.

Instead of being a “40 Year Old Virgin” like Steve Carell, your goal should be a to become a “40 Year Investor”! It is the concept that a dollar today, invested wisely and left to compound, is worth far more come retirement.

You probably already understand this concept, but if you’re rusty, or new to the game, here’s a simple demonstration:

Scenario 1: Savings Account - 40 Years of Saving
You invest $100 per month into a savings account earning 3.5% interest compounded monthly. You start when your 25 years old and you end when you turn 65. You will have about: $105,000.

Scenario 2: Stock Market - 20 Years of Investing

You invest $100 per month into the stock market earning a 10% average annual return per year. You start when your 25 years old, but this time you retire early when you are 45. You will only have about: $69,000.

Scenario 3: Stock Market - 40 Years of Investing
You invest $100 per month into the stock market earning a 10% average annual return per year. You start when your 25 years old and you end when you turn 65. Look at the graph below and you can see the exponential growth in the later years (sorry about the poor quality). You will have about: $531,000!

What have we learned?
While the return that you are earning on your investment is clearly very important, what’s even more important is how long you let that investment grow and continue to earn a return, month after month, year after year. This compounding effect (earning a return on the previous period's return) is the key to success!

“So what about my specific scenario? When can I retire?”
Below is a very good calculator website (http://www.dinkytown.com/) that I use every once in a while. Drop in your assumptions and play away! There is even a nice graphical display of the results. Plus the site has tons of other great calculators to use in your investment planning. Remember though, the data is only as good as your assumptions...

http://www.dinkytown.net/java/Millionaire.html

So how long will it take you to earn one million bucks (OMB!)? I'd be very interested to know when my readers hope to retire...

Confidence: Lost!

As John Milton entitled his most famous piece of literature "Paradise Lost", so must we here at One Million Bucks! (OMB!) entitle the current economic "slow-crash" as:

CONFIDENCE: LOST!

Never fear though, T. Rowe Price once again has taken drastic measures to assuage my concerns with this stunning avant garde masterpiece of white text, right aligned, on dreary grey paper.

My confidence has completely returned now that I have this to clutch on to...

How Much Should I Invest in Stocks?

T. Rowe Price (my company uses them for our 401k plan) offered me this tidbit of information recently in a generic note:

Keep stocks in your portfolio:

"Make sure you have some exposure to stocks in your portfolio. Stocks have outperformed all other asset classes over the long term. Remember, retirement investing is a long-term goal. A quick rule of thumb for how much should be invested in stock is (110 - your age) x 1.25."

Example:

- I am 29, soon to turn 30.

- 110 minus 29 = 81

- 81 times 1.25 = 101%

Conclusion:

I should be investing more money then I even make in stocks.

This is kind of stupid:

While I think perhaps it's time to buy, I personally think that one should always keep some investments in bonds and/or cash reserves as a hedge in falling stock markets or if you lose your job. This 'wisdom' also assumes you aren't going to retire until a 'normal' retirement age of about 62 or so.

Chances are, if you are reading this and similar blogs, you are going to retire early, so conventional wisdom may not apply to you (you are special :-).

Tax Loss Carryforwards = Huge Tax Savings Ya' Jerk!

If you're like me, your portfolio has taken some big hits in recent weeks / months.

Well, you should at least get some benefit out of this painful period in the form of a Tax Loss Carryforward. (Note: If you're holding your investments only in a retirement account such as an IRA or 401k, you probably don't need to worry about this).

How Does a Tax Loss Carryforward Work?

You can deduct losses from investments up to $3,000 per year against your ordinary income. Therefore, when you file your taxes at the end the year, you can actually reduce your taxable income by $3,000 per year! If you are in the 28% tax bracket, this translates into a tax savings of $840! It's like FREE money!

What happens if you have more then $3,000 in losses?

Well, that's why they are called carryforwards (plural). Let's say that you have$9,000 in losses. You can deduct $3,000 in losses each year for the next three years! Typically you may carry a loss forward up to seven years.

Can I sell my stock for a loss and then buy it right back to capture the upswing?

Yes and No. IRS Publication 550 states that this would be called a "wash sale". You are not allowed to deduct losses from a wash sale. BUT, there are ways to get around this wash sale rule. A wash sale occurs if you:

1. Buy, substantially identical stock or securities

2. Acquire substantially identical stock or securities in a fully taxable trade, or

3. Acquire a contract or option to buy substantially identical stock or securities.

How do I avoid the wash sale rule?

This is pretty easy actually. All you have to do is buy a similar security to the one you sold, but not too similar.

I recently exchanged a balanced mutual fund that owned (in order to achieve this tax loss carryforward) for another balanced mutual fund within the same fund class (sold Vanguard Wellington Fund - VWELX and bought Vanguard STAR Fund - VGSTX). Despite the similarities in these funds, they are different enough to achieve the two most important goals of this transaction:

1. Capture the tax loss carryforward for this year and future years

2. Don't miss the inevitable (hopefully) upswing in the markets by leaving cash on the sidelines

You should consult a tax professional for all the rules and details, but these are the nuts and bolts of a very powerful and important, yet relatively simple tax rule that can save you thousands of dollars over the next few years with very little brain damage. Even a real "Jerk" could figure these out!

NOTE: Businesses can also carryback losses up to three years as well and achieve the same effect, but get the money sooner! See the "loss carryback election" section of that link (about halfway down the page).

Like this post? Check out these other posts:

No Taxes on Rental Income for 14 Days!

Why Is My Bonus Taxed So Much?

Should I Pay Off My House?

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September Madness: Financial Institution Bracketology

The latest email floating around is a clever bracket mimicking the brackets that people fill out for the NCAA Basketball Round of 64 Brackets, except that it's with financial institutions instead of Hackman's Hoosiers (what a good speech)...

I've shown the bracket below. Click on it to enlarge. From the choices below, I'd vote for Bank of America; BUT, I don't think the ultimate winner is shown on the board actually.

I think the winner could be the sovereign investment authority of Abu Dhabi known as Mubadala Development Company. They currently have about 10 billion investments and they are funded by the government of Abu Dhabi. They are essentially in the process of converting their wealth borne from scarce natural resources (oil, etc.) into more sustainable investments (e.g. tourism).

Anyway - just a fun little file to remind us that even we aren't all Invincible.

Click here to see a larger version.

The Frugal Father-In-Law: The Driveway

I've decided to add a new element my blog inspired by my father in law. He's managed to take frugality to the next level - to the stratosphere I would say.

Each week or month I'll provide a tip or two for all those masterful-money-misers out there that I've learned from watching him.

The Driveway

So my father in law lives by the water and loves to go clamming, oystering and muscling (pretty sure those aren't all words). He's managed to use this passion to save money in multiple ways, my favorite of which is the driveway...

1. Don't pay for the seafood, go catch it!

2. Freeze what don't finish so you have seafood for the winter!

3. Finally, use the shells from the shell fish to make a unique and environmentally friendly driveway.

Yes, he actually uses crushed shells for his driveway. It's actually pretty cool looking. He eats the clams, etc. and says: "Make sure you toss those in the driveway!" No tar, or resealing to worry about just eat and toss.

The Frugal Father-In-Law strikes again...

What is Dollar Cost Averaging? A "Genius" Way To Invest!

Dollar Cost Averaging is a fancy term for a simple idea:

Invest the same amount of money every month (or week, or quarter, etc.) in the same investment vehicle (e.g. a indexed mutual fund) such that your dollars buy more shares when the price is cheap (the stock market declines) and fewer shares when the price of the fund is expensive (the stock market increases).

This approach ensures that you are essentially always "buying low". Later in life you can "sell high" - this a good milestone on the path to wealth.

This method helps reduce the risk of dumping all your cash into the market at once and then watching the market tank over the short term. Over the long term the market has shown to go up. This way you reduce your downside risk and maximize your upside potential.

Go ahead and setup your Roth IRA contributions or 401k contributions for automatic investments each month and sound like a Real Genius by tell all your friends: I invest using dollar cost averaging techniques - it's the only way to go!

The $700 Billion Bail Out: (Part 2 of 2) Why It's Important For You!!!

So there you are at the quasi-futuristic coffee machine in your offices faux kitchen and you find yourself uttering words to the effect of:

"I'm not paying for that bail out! I hope those greedy bastards on wall street get what they deserve!!!"

Unfortunately you haven't stopped to think how this will affect you and your personal finances.

Virtually everyone will be better off (in theory) from the bail out. Let's ask three people if they will be better off if the bail out that the house passed works.

1. The Teacher: I'm a teacher and I want to go back to school to get my masters degree so that I can get my tenure or maybe teach college. Well guess what, I can't get a school loan because the credit markets are frozen because the banks have so much risky debt on their books that they are afraid to loan any more.

2. The Post Man: So the post man is tired of driving around in his old postal truck for the last few years and would love a new one. Unfortunately, no loans for cars either - different person, same story.

3. You... So hopefully you are getting the point here? The world revolves on credit, for better or for worse. You want a new house becuase you just had a baby? You want a new car because yours just broke down? You want that sweet new TV for the superbowl?

Well guess what, sorry, no loans!

So before you go cursing Wall Street keep in mind what's bad for them might also be bad for you - GREED IS GOOD!

The $700 Billion Bail Out: (Part 1 of 2) Where It Came From

In my opinion this whole economic problem is due to two main culprits:

1. Mortgage lenders who loaned people more money then they should have

2. Institutions who loaned investment bankers more money then they should have

This whole collapse stems from the fact that lenders were willing to lend desiring home owners too much money to buy a house. So the "desiring homeowner" offered more money then they should of to buy the house of their dreams, and housing prices sored!

These individual home loans were then bundled together and sold to large investment banks as RMBS: Residential Mortgage Backed Securities. The incoming cash flow streams (and the homes) from the home owner payments (where do you think your monthly payment goes?) were used as a source of collateral for these big investment banks to borrow more money and invest it in more RMBS.

This cycle was repeated until the leverage (debt) on these RMBS pools became 30 times that of the underlying collateral (the incoming stream of cash from you monthly mortgage payment).

So the shoe dropped. People who borrowed too much for that perfect house-in-the-hills couldn't actually afford that over-stuffed mortgage (or they sorrowfully lost their job, etc.) and they stopped paying the mortgage. In the worst cases they were foreclosed upon and they lost their house. So began the home price deflation...

Then, the man with one red shoe lost his other one (the other shoe dropped!). The value of these RMBS pools declined has home values declined. Suddenly the institutions who lent money to the banks that owned these mortgages wanted their loans paid down.

Imagine here that you told your lender you wanted a loan for a Mercedes so he gave you a big fat loan. In fact, the car you bought was only a used Ford Focus. Obviously the lender gave you too much money to buy the car; he found out, now he wants you to pay down the loan! This is essentially what happened on wall street...

Everyone asked for their money back at the same time, when that happened the banks literally rank out of cash, which is why they scrambled for equity infusions, massive new loans, sales of a business unit or two, or an outright company sale.

Some succeeded, some failed. Merrill ran into the arms of Bank of America and lived (sort of) while Lehman scrambled like a lame duck quarterback and was, alas, sacked for good...

In Part 2, I'll discuss the concept of the bail out and why it matters to you!!!

ONE MILLION BUCKS MONTHLY UPDATE: SEPTEMBER NET WORTH: $230,580

As Wesley Snipes would say "DEMOLITION, man..."

As you can see below, just a few short days ago I was worth north of $250K. Today our net worth is down over $20k (or 8%) mainly due to wild stock market fluctuations...

See the month over month chart below and commentary:

- Checking increased due to my and my wife's paychecks. I've not transferred them to savings because I plan on paying down some of the credit card expenses (even though I have not received my business expense reimbursements).

- Savings decreased, in part, by $4k because I transferred this amount to my business checking account which I may use towards a deposit on another investment property. The other $3k or so was used to pay down credit card debt, pay rent, pay down a family loan (I don't show this on my balance sheet - will explain later) and pay off a speeding ticket ($271!!! Brutal).

- Brokerage, Roth IRA, 401k all went down due to market down turns. The senate and house passed the $700 billion bailout, but the DJIA still tanked and ended the week at 10,325 (the Dow started the year at 13,043!!!). On September 1, the Dow was over 11,500: this translates into 1,175 point (+10%!) decline in just over 30 days. Crazy times...

- Real Estate went up since the $4k deposit money transferred into the real estate investment account.

Credit Card debt went up mainly due to business travel expenses (pumping up my free cash back!), which are shown as a reimbursable. Also I returned $600 suit that my wife bought bought me for our anniversary and exchanged it for some shoes that I paid for primarily with left over gift cards.

Other big credit card expenses:~$300 medical expenses associated with getting medicine for our upcoming overseas trip, ~$170 my wife bought some clothes, ~$240 for my wife's hair.

A tough month for sure, but I'm hoping we're near the bottom. My wife still auto-contributes to her 401k every month (so that she maxes out for the year at $15,500), so we're still buying cheap stocks right now and continuing to invest.

Don't be afraid - stay the course! The ship will right itself (I hope :-P)