A book that is 27' wide!

I recently passed another ChFC exam, this particular test was on Income Taxation. Let me tell you, there are way too many damn laws revolving around the tax code. In my opinion it is a complete mess. Just to give you an idea of how complex the laws are take a look at the graph below. This graph illustrates how many pages of rules there are in the “handbook” and how it has changed over the years. I put parentheses around the word handbook, because it is no longer an actual book. If you were to bind a book using the average sheets of copier paper (.0038 inches thick) the book would be nearly 23 feet thick! The average bible is no more than a few inches at most. I hope that gives you an idea of how complex the rules have become.

Here are some quick outrageous facts about the income tax thanks to my friends at CATO Institute:

1.       There are more tax preparers in this country than there are troops that went to Iraq

2.       There are over 526 tax forms, most of which are catered specifically for special interest i.e. “form 8845-Indian Employment Credit” or “form 6197-Gas Guzzler Tax”

3.       The tax code is discriminatory: Singles are worse off than married couples, homeowners are treated more favorably than renters, the list goes on and on.

4.       For 7 other wild facts check out CATO’s article http://www.cato.org/pub_display.php?pub_id=3063

Should you listen to the “pros”?

Nobody has a crystal ball, and for all their "science" you would think anybody who read a finance book or listened to the analysts on the internet would be rich. There are only theories out there in the finance world, nothing fully proven. The worst part about it is there are always contradicting theories, one professional will say the market is going up, the other professional will say it is going down. What are some of these theories in which they base their predictions on?

Fundamental Analysts – Expert Stock Picking: They use real data to evaluate the intrinsic value of a security, they believe by looking at financial statements of a company and plugging numbers into a formula they can somehow derive what a company is worth and find the ones that our undervalued. The problem with this: These analysts use numbers that are available to everyone else i.e. sales, cash flow, dividends, etc. Now with this information available to everybody how is it that so few have succeeded in “out-performing” the market. Problem #2: the stock market is affected by so many external factors outside of the company’s control, i.e. Europe’s debt and how it affects a declining stock markets can’t be found in Walmart’s balance sheet.

Technical Analysts – Expert Market Timing: They use historical data and statistics generated by market movements to try and predict future patterns. They disregard what a company is intrinsically worth and attempt to predict the markets activity. The problem with this: companies can outperform in a market, or can be uncorrelated, meaning that while the market as a whole might decline a successful company can still be profitable.

Efficient Market Hypothesis: It is impossible to “beat the market” because stock markets always incorporate and reflect all relevant information made available. Weaker forms of the theory suggests that only those who have “non-public” information can outperform consistently. Fortunately or unfortunately the government has made the latter statement illegal.

Some good articles to read for 2012

I missed the last two weeks for posting an educational blog, and I apologize for that. Thanksgiving week I was in Mexico, and last week I was simply trying to catch up.

Anyways, below are some great articles for you to read. These articles are simply some things to keep an eye out for in 2012, next year is going to be a big year in both budget decisions and reactions.

1. How The US Budget Process works.

2. How The Economy Would Change under Newt Gingrich

3. What retirement changes are occuring in 2012?

4. Europe's Debt is out of control...but we're actually the 4th most leveraged developed nation!

Things I'll be keeping my eye on is how Europe's leaders are going to handle their mess, whether or not Congress will try and do something the "not so super" Super-Committee failed to do, and how the 2012 Presidential race will go down.

Protect yourself from Uncle Sam!

Uncle Sam wants his money, and who can blame him? The government tells you that some of your money actually belongs to them. However they are willing to give you a break here or there if you are smart enough to utilize these benefits. You can defer taxes, reduce taxes, and even avoid some taxes…and in the long run this will save you literally thousands and thousands of dollars for your retirement. Last week I talked about qualified accounts being one of the 5 “buckets” of money; qualified accounts are simply accounts that hold certain tax-incentives in them, such as 401k’s and IRAs. Often retirement accounts will be sponsored by your employer, but accounts can be opened individually as well. When it comes to retirement accounts, or “qualified” accounts there are literally thousands of rules and regulations, but to keep things simple there is really only two types of accounts you need to know and understand. One is the tax-deductible account, these accounts allow you to put away money before it is taxed as income, and the other is a tax-free account, which is simply taxed up-front to avoid the taxes down the road. To demonstrate how effective this can be let us look at an example:

Joe makes $100,000 a year and wants to put away 5% for retirement. Joe can utilize his 401k at work, or an individual retirement account (IRA). In doing so Joe is able to deduct his 5% savings from his gross income. This means that not only is he putting away $5,000 but he is being taxed on only $95,000 rather than the full $100,000. How does this translate into savings? Well if Joe has a 20% income tax liability he would save $1,000. Think of all the things you can do with an extra $1,000!

Income	$100,000		Income	$100,000
Deduction	$5,000	Vs.	Taxable Income	$100,000
Taxable Income	$95,000		Tax Rate	20%
Tax Rate	20%		Taxes Paid	$20,000
Taxes Paid	$19,000

Extra benefits of qualified plans are that these accounts grow tax-deferred, which means that any capital gains that are experienced aren’t taxed until they are withdrawn. This is a huge benefit, imagine a snowball rolling down a hill, as it gets bigger it rolls faster, and as it rolls faster it gets bigger. (That is my analogy to compounding interest) Now, if you were to constantly take out little chucks of snow every couple of feet or so, you would be slowing down the process…this is what taxes do to a portfolio and that is why it is important to protect yourself from taxes.

Another popular qualified account is the Roth IRA or Roth 401k. These differ from the previously mentioned accounts in the fact that these are post-tax savings rather than pre-tax savings. Instead of deducting your savings and being taxed down the road (saving extra money today) you can pay the taxes now, and not be taxed on any withdrawals. Take a look at the photo below to help understand how it works.

As always if you have any questions let me know!

Take advantage of your buckets...don't end up like this guy in the photo!



Buckets of Money

There are thousands of articles on the web about personal finance, hundreds of books written on the subject, and even classes taught on college campuses. In my opinion it shouldn’t be that complicated. Someone once explained to me that there are five buckets of money for personal finance and I was amazed at how simple he made it. The idea is to fill each bucket up first in order and then as the bucket starts to fill up and overflow the funds will then spill into the next bucket.

Each week I plan on going into more detail about each "bucket"

1.       Cash – Liquid investments that you can use for your day-to-day living expenses.

a.       Checking Account – typically have 1-2 month’s worth of expenses in here as this is used for your everyday transactions.

b.      Savings Account – typically have 3-6 month’s worth of expenses in here as this is your emergency/opportunity fund.

2.       Insurance – Illiquid investments that you use for protection

a.       Disability Insurance – typically replaces income in the event that you become sick or injured beyond a 3-month period. Benefits typically don’t start until 3 months after the incident first occurs, hence the reason for the 3-6 months emergency fund in your savings

b.      Life Insurance – in case you pass away this typically is used for three things; cover any existing debt or obligations you might have i.e. cars, mortgages, credit etc. replace any income to dependents, and lastly to leave a legacy whether it is your kids college education, a charity you wish to support, or anything you were passionate about

c.       Health Insurance – to cover the costs of diagnostic tests, surgeries, medicine, etc.

d.      Property Insurance – to cover the costs of any damages done to expensive property i.e. cars, homes, equipment, etc.

3.       Qualified Retirement Accounts – Tax favorable savings for retirement. Typically you’ll want to put away 5-10% of your income into each account. Deferring taxes, lowering taxes, or avoiding taxes all together saves you tons of money in the long run.

a.       Pre-tax savings – 401k’s and IRA’s offer a way to put money away while lowering your current year tax liability.

b.      Post-tax savings – Roth IRA’s offer a way to put money away while lowering your future year’s tax liability

4.       Real Estate – you have to have a place to live with a roof over your head, why not make it profitable for you?

a.       Most buyers will put anywhere between 10-20% down on a home

b.      The idea is to own a home so that each month you are paying for housing you’ll see that money back in the form of equity, where as with renting it simply is an expense you’ll never see again

5.       Non-Qualified Investments – Typically your last bucket to fill, which I like to call your “strike it rich” bucket

a.       Non-Qualified Investments can be anything you want, whether it is a small business you want to start up, or a business you want to invest in there are little restrictions. Typically this bucket is the bucket in which we use “other people’s money” and leverage our investments and take slightly more of a risk. We are allowed to take bigger risks here since all the other buckets are filled and secure.

Why is diversification so important?

Let’s face it, in today’s environment the world of finance has gotten so overly complicated and convoluted that the majority of us have no clue what to expect. It is a gamble out there. Even the professionals who claim to be prophets are contradicting each other’s statements. If you just spend 5 minutes on yahoo finance or any other finance website you’ll see 2 articles written by two different professionals with completely opposite predictions albeit each of them having years of education and experience. Just take a look at my last post to see how the “professionals” have performed in recent history…it doesn’t take long to realize that you as an individual investor with little to no experience can do just as well.

What exactly is diversification?

In my first article I discussed taking away specific risk by holding more than one stock and illustrated a graph showing the effect of holding multiple stocks. Essentially what occurs is the risk of one company failing is dampened by the success of others…but it doesn’t mitigate the risk of all the companies failing at once -- that is called market risk. It isn’t that easy though, if you read the fine print (as you should learn to do in the finance world) and learn the assumptions made in the graph you’ll notice the word “uncorrelated”. Correlation is the biggest determinant in the success or failure of your attempt to diversify. Simply holding 20 stocks doesn’t necessarily mean you are better diversified than holding 10 stocks. Correlation is a statistical measure of how two securities, or asset classes, move in relation to each other. Say for instance every single time the S&P 500 goes up 5%, your stock also goes up 5%...well then you have a correlation of 1.00 (which means you aren’t diversified at all). The whole point of diversifying your portfolio is so that when the market crashes it doesn’t take your portfolio down with it. The opposite though can be true too, you don’t want a -1 correlation because then every time the market booms you’ll be losing money. The ideal situation would be to have no correlation at all to the market and yet still have positive returns. Take a look at the chart below comparing the correlations to the S&P 500 and each asset class return and risk. – Source: Morningstar

	Correlation	Return	Std Dev.
Large Cap	1	3.14	15.65
Mid Cap	0.97	7.5	18.38
Small Cap	0.96	7.4	20.72
International	0.9	6.62	19.58
Emerging Market	0.86	15.36	24.52
REIT	0.81	9.86	25.5
High Yield Bond	0.73	6.75	9.12
TIPS	0.25	6.93	6.92
Total Bond	0.08	5.25	3.79
Gold	0.07	21.9	20.29

As you can see Bonds and Gold do not have any relationship to the stock market. Correlation has no relationship to return or individual risk. So what is my suggestion? Why not just spread your bets evenly across the board and keep your life simple and safe. By spreading your bet evenly you’d have returned a little over 9% with half the amount of risk…not bad if you ask me.

Passive Investing vs. Active Investing

A popular debate investors like to squabble over is whether to invest passively into Index Funds or to utilize investment managers who take a more active approach to money management. There are going to be a few key differences between the two. First and foremost the index funds, like their name suggests, simply track an index (i.e. the S&P 500, or Russell 2000). Often times these funds utilize software devices to do the tracking for them. Active managers on the other hand will pick and choose stocks on their own requiring much more time and effort on their part. Due to the extra work required of active managers higher expense ratios can be expected. With these higher expenses come a required higher rate of return just to break even with their rival index. So the big question you have to ask yourself is not whether a manager can match his or her benchmark, but rather can he beat the benchmark by a greater amount than the expenses. Investment managers will often tell you yes they can because they got experience, and a piece of paper that says "CFA" (which merely means they read a lot theories and passed a couple tests) Now I'm not docking the CFA, it is an extremely hard test and requires a lot of work and knowledge, but a recent look at history will tell us that the certification doesn't equate to a crystal ball.

Take a look below at the stats from Morningstar to judge for yourself whether or not managers hit their mark in the past 12 months.

• Only 26% of large cap managers beat their benchmark
• 37% of mid cap funds beat their benchmark
• A measly 20% of small cap funds beat their's
• Worst of all only 17% of bond managers was higher than the benchmark
• Of the 18 sub-categories in this research only 3 categories outperformed

What does this mean? It means that a lazy investor could beat over 75% of professionals by simply choosing to go with index funds. How is this possible? It is possible because most actively managed funds over charge their customers in fees and commissions. Now am I suggesting to never go with an actively managed fund? Hell no...some fund managers are real professionals and are reasonable with their expenses. For example, Donald Yacktman of the Yacktman fund in the last 3 years have returned his clients nearly 23% compared to the S&P 500's 8%. Yacktman has outperformed the index nearly every single year and charges less than 1% to investors.

If you are going to choose an actively managed fund you have to do your homework. There are a few all-stars here and there that consistently beat the market, but remember historical performance is not always an indicator of future outcomes.

Next week I'll share with you how a lazy man can not only diversify risk, but outperform the market. Remember it is better to think smarter than to work harder.

Utilizing No-Load Funds

Some of the big questions in investing include, should I use mutual funds or individual stocks?

99% of investors use mutual funds because that is what they were told to do, or because that is all that is offered to them. There are certainly some advantages to them that advisors will boast about, such as the instant diversification, the simpler handling of transactions, etc.

Here is the problem I see with them, they don't actually give you the diversification advisors claim they do and on top of that they'll charge you for it. Mutual Funds in addition to having commissions they charge an annual expense ratio typically around 1%. So not only do most funds take 5.75% right off the top for commission, but they also take 1% each year, meaning, just to match the benchmark you have to beat it by so many 100s of basis points each and every year. As for diversification most mutual funds will hold anywhere from 50 to 500+ stocks and specialize in a certain industry, sector, or asset class (i.e. large cap stocks, or small cap stocks). The main objective in holding more stocks is to take away the specific risk of an individual company failing. Obviously if you hold only one stock the chances of you losing money is a coin-flip. There gets to be a point though when adding additional stocks doesn't really mitigate any additional risk, it is like the law of diminishing returns in economics. The more you add the less of a drastic result of diversification you receive. No matter how many companies you hold you will never be able to diversify away systematic or market risk - stock markets crash sometimes because of forces outside of individual company's control. See the graph below.

Now would I go so far as to say all mutual funds are bad? Of course not. I wouldn't advise an individual to hold stocks if he or she is just starting out in investing. Here is why:

• Investing seperately in 25 stocks requires a substantial amount of money
• Commissions per trade add up
• Studying individual stocks requires a lot of time and knowledge because there are so many moving parts to a company that you don't see or hear
• The volatility of individual stocks can be extreme

So what is my suggestion? No-Load Funds.

There are funds out there that don't have a front-load charge, or a back-end charge. Mutual Fund companies pay the salesman because he does the marketing for the company. Yet if you do a little bit of homework and research for yourself -- which you are doing right now -- why should you pay someone else?

95% of Mutual Funds are -- excuse my french -- complete horse-shit. But there are a few that have really good managers, which professionally pick and choose stocks for you, they have access to much more information than the average joe, they have a track record, and best of all you can find some that even keep their expenses lower than 1%

Please if you have any questions or comments leave them below, or contact me.