Step3 Prophet

Thoughts on Rich Dad's Conspiracy of the Rich - Part 1

  A friend of mine lent me the book Rich Dad's Conspiracy of the Rich by Robert Kiyosaki. Kiyosaki is a very polarizing figure in the world of personal finance and wealth building, and I've read one of his other books before, so I thought this would be an interesting read. As a side note, I think Kiyosaki is crazy like a fox. His advice is very good, but at the same time carries a lot of risk that he doesn't adequately account for in the book that I first read.

 He starts the book by lamenting about the poor state of financial education in public schools and lists a bunch of basic finance terms that people may not fully understand, so I thought I would go over them for starters. These questions and terms are taken from page 6.

 The difference between a stock and a bond: Stocks represent an ownership stake in a company. Bonds represent debt obligations of a company or city. A bond is promise to pay back money that has been borrowed by the company/city, whereas a stock promises nothing unless you acquire enough stock to get control of the company.

 Why are preferred stocks labeled preferred? Preferred stock(or shares) are like a cross between a stock and bond. Preferred stock typically pays a set dividend, generating income like a bond, but also can trade like a regular stock share.

Why are mutual funds labelled mutual? They are mutual because a group of people pools their money to buy more stocks at lower cost than an individual could on their own. To get a diverse mix of stocks requires a lot of money and substantial costs, which mutual funds spread among all investors to lessen the impact on the individual.

The difference between a mutual fund, a hedge fund, and exchange traded fund (ETF) and a fund of funds. A mutual fund is explained above. A hedge fund is similar to a mutual fund, but it is a private investment and can therefore take more risks(and thereby get greater returns). Because it is riskier, hedgefunds typically require investors to be very wealthy already so a significant loss will not be as bad for the investors. An exchange traded fund is a mutual fund that trades during the day like a regular stock. ETF's are usually cheaper to own than a similar mutual fund, but have more transaction cost.  A fund of funds is made up of many mutual funds to give the investor one place to meet all their diversification needs. The most common examples are "lifetime" funds or "Target retirement" funds that change their assets overtime as people get to a specific retirement date.

How debt can be both "good" and "bad". Bad debt is debt that brings no return on your investment. All your unpaid credit card balances typically fall into this category, as well as car loans and personal loans. When you go to sell or trade in your car, it will be worth far less than what you paid for it if you bought it new. Good debt helps you increase you finacial returns. Houses are the most common example, or buying stock on margin (a loan from your broker). You could also borrow to start a business. By borrowing money you can afford something you wouldn't have been able to buy on your own, and which could be sold for a profit( or produce income). In my experiance Kiyosaki tends to downplay the risks involved with "good" debt.

The difference between capital gains and cashflow. Capital gains are the differnce in price between what you paid for something and what you sell it for. For example, a stock day trader hopes to make money by buying a stock a low price and selling at a higher price. Loosely speaking, cashflow is money that you earn from your investments or business. For example, if the stocks you own pay a dividends, you get a steady stream of income as long as you own them.

 

2010 Contributions to Roth IRA

Earlier this year I contemplated spacing out my Roth IRA contributions over the course of the year, looking for the lows and avoiding the highs. Sadly, the execution of that strategy did not go so well because this year has been a pretty steady climb for my preferred IRA investment, Vanguard's REIT index (VGSIX). I like it for my IRA because REIT's throw off a lot of dividends, and the IRA keeps those dividends tax free for now. Looking back now I would have been better off to just invest all my IRA money in January and collect the extra dividends and appreciation, but it's too late for that, so it's time to come up with another strategy. I've still got the bulk of my 2010 IRA contribution remaining, and since VGSIX has gone up so much this year, I'm going to diversify into something else (1 yr growth for VGSIX is 31%, whereas the S&P 500 index VFINX is only up 9%).

I've had my eye on some of Vanguard's Dividend funds. This wouldn't really be diversification actually, since I hold so much S&P 500 stock any way, but it would be a concentration of potentially higher quality stocks. Solid companies + Reinvestment of Dividends = high returns. Two fund that fit the bill are Vanguard Dividend Appreciation Index Fund (VDAIX) and Vanguard High Dividend Yield Index Fund (VHDYX). They both have high dividend yields, and expense ratios are the same as well. They are also both at a 52 week high right now, which make me reluctant to buy. Since everything is on a high right now, I'm going to hold off on my contribution a while longer. Thanks to IRA rules, I have almost 4 more months to decide.

Maybe it's just the engineer in me, but I love the way the IRS spells everything out on their website. IRS publication 590 covers IRA's, and it says:

You can make contributions to a Roth IRA for a year at any time during the year or by the due date of your return for that year (not including extensions).

 

You can make contributions for 2009 by the due date (not including extensions) for filing your 2009 tax return. This means that most people can make contributions for 2009 by April 15, 2010.

So I have until April 15, 2011 to make contribution for my 2010 IRA. I'll give the matter a little watching.

 

The Relationship between Money and Debt

I read an interesting post at Mymoneyblog.com (one of my regular reads) the other day entitled Where Does Money Really Come from? The author posted a flash video that I think everybody should watch(he didn't create it, he just found it). It outlines the fundamental concepts behind our modern banking system, and in some ways is quite scary. The animation is hokey but the lesson is vital. The last 15 minutes of the video get all conspiracy theory on you, so take what you will from it. 

I think he is spot on when he says exponential growth cannot be maintained infinitely in a world with finite resources. Eventually the world will have to find a sustainable equilibrium between people and resources. I just hope we won't bypass that equilibrium point too far before we realize it.

I think this video also explains some of the reasons behind inflation as well.

The video's author dosen't really account for all the money losses though. For example, right now banks are buying other banks( and their assets) for a fraction of what they are "worth". When business fail they take a chunk of money out of supply. When a companies stock price plummets, it takes a lot of peoples money with it. These factors mitigate the overall money supply and inflation rate.

His idea of a system where there is no interest, and where government taxes and money creation control the money supply,  seems to be trading one set of rules for a different set, with the net sum being zero.  The idea that if the government had no more interest payments to make, there would be more money for infrastructure is true under our current system, but would it be true under his proposed system? My instinct says no.

His views on interest are somewhat simplistic as well. Lending money at 0% interest is unsustainable because not all loans will be repaid. No one would lend money when the profit is zero but the losses are greater than zero. Furthermore, the interest to repay a loan does not need to increase the overall money supply. A person (or business) makes choices about how to spend their money. Some of it goes to food and shelter, and some of it may go to interest, or it may go toward a flat screen television instead.

The video's assertion that if there were no debt there would be no money under our current system is ridiculous. In that case the supply would reach equilibrium and interest rates would go to zero on money deposited in a bank, because there would be no major lending going on.

And finally, do bankers really want to own and control society? Hardly. They don't want to own everything, because owneing things is expensive. It's much easier to just deal with money. As for control, it depends on how much you let them control you. If you have no debt, then they have no leaverage. His assertion that banks would promote certain industries while suppressing others seems kind of strange too. I think greed will win out every time. If there is money to be made, the bankers will support.There is also the Federal Reserve to contend with.

Asset Allocation

Several weeks ago I did a post on my current financial state. Actually, it was more of a current paycheck allocation, but that can tell you a lot about your financial state. Today I'll examine my current investment allocation and determine if/when I want to change it.

 I started out when I got my first real bonus and decided to invest it for my future ( I was 20 at the time). I was pretty dumb about finance back then, but I did a little research and decided that Vanguard's S&P 500 was the way to go. Not a bad choice, but I should have opened up a Roth IRA instead of a regular account. I fixed that mistake a few years later, but some damage has been done. As my savings ( and income) has increased I've branched out into other areas. Currently all my investments are in high risk, high potential return investments. The bulk is in the S&P 500 index through various companies , with the rest being in other P2P loans, small cap stocks,  Emerging Markets, REITS(Real Estate Investment Trusts), and individual stocks. That sounds like impressive diversification, but really it's more my love of trying out new things than a plan.

So far I've avoided bonds and other guaranteed "safe" investments because I figured that I'm young and can handle the risk. If my portfolio were to drop 50% in value I wouldn't like it, but I'm not counting on using it until decades from now. As I've become more savvy about personal finance, I've realized that a certain amount of safe investments can serve as a gauge for my high risk investments. When used with an asset allocation plan, the periodic rebalancing can help you maintain the gains your portfolio achieves in good times, and be a "buy" indicator in rough market time.

I've had this demonstrated to me personally in the past year by my emerging market fund. I bought it in '06 for about $22 a share. Last year its value went up to $35 a share at one point ( I thought I was a financial genius!), but now it's back down to ~$23. Since I did monthly investments, it turns out that my average share cost is greater than the current share price. If I had had an asset allocation plan in place, I could have sold excess shares of the emerging market fund at a good price ( or better yet, bought less and invested in other areas instead).

So here is a snap shot of my current investment allocations:

S&P total	38.63%
P2P Loans	16.71%
Small Cap	12.57%
International	13.50%
REIT	10.32%
Individual Stocks	8.28%
Bonds	0.00%
SUM	100.00%

The table shows that I'm heavily weighed in large American companies and P2P loans. followed closely by Small Cap and International stocks. When you consider that my individual stocks are also large American companies, they make up about 46% of my portfolio. This isn't necessarily a bad thing, but I think my allocation should be heavier in other areas. I want a more exposure in the international and REIT areas, and while I think P2P loans are a lot of fun, I'm probably over exposed to them right now. I would also like to add a bond fund for several reasons. It is a way to mitigate risk while at the same time giving indications of how well my high risk investments are performing. The stocks should out pace the bond fund during the good years, and under perform it in bad years. By maintaining the allocation, I buy low and sell high. Also, it gives me a place to quickly reallocate if a stock fund goes wild.

I want to have the bulk of my portfolio in high risk, high return investments. To keep up with inflation and get ahead of the game there is really no other way. I'm happy with my current investments and have reasons for owning each of them. Most of my investments  are uncorrelated (except my individual stocks and the S&P 500) which means that when one is doing poorly, the other can help make up for it. Granted, the current economic downturn is based on real estate, so at the moment my REIT and the general market are correlated, but I don't expect that to last for more than 5-10 years.

My current ideal allocation would look something like this:

	Current	Goal
S&P total	38.63%	25.00%
Loans	16.71%	10.00%
Small Cap	12.57%	10.00%
International	13.50%	20.00%
REIT	10.32%	15.00%
Stocks	8.28%	10.00%
Bonds	0.00%	10.00%
SUM	100.00%	100.00%

Now, how do I get there? A quick reallocation now might be interesting, but I would incur a number of tax penalties that I would like to avoid. Instead I think I will just reallocate where I put new money. By adjusting how much of each investment class I buy, I can gradually shift the allocation while not incurring any tax penalties.

Wow, for the first time I have a plan. I'm pretty sure it's a good plan based on the hordes of financial magazines, books, and online articles I've read(the hordes really applies to the online articles part). In a future article I'll look at where this plan will take me in the next 10-15 years. This is just the staring point really. As the saying goes, a plan is just a place to start deviating from.

(Photo by Wendibular via Flickr)

Can I have an IRA?

I was talking about some random things with a friend of mine this weekend when the topic of IRA's came up. I asked him if he had one, and he told me that he didn't think he was eligible for one since he has a 401K at work. At the time I knew you can have both an IRA and a 401K  or other company sponsored retirement plan, and I was pretty sure(not 100% though) that he makes less than $100K. Therefore, I told him I was pretty sure he was wrong. A little research reveals that we we're both right.

From the IRS website:

Can an individual contribute to a traditional IRA if he or she has other retirement plans?

Yes, individuals can contribute to a traditional IRA whether or not they are covered by another retirement plan. However, they may not be able to deduct all of their contributions if they or their spouses are covered by an employer-sponsored retirement plan.

The details are in publication 590 (yeah baby!) To save you some time, here they are for 2008:

Your maximum tax deductible Traditional IRA contributions are $5000($6000 if 50 or older)

•     If you are single, your phase out begins at $53,000 (Yikes, that is smaller than I thought)
•     For married filing jointly the phase out occurs between $85,000-$105,000
•     Less than $10,000 for a married individual filing a separate return.

For Roth IRA's , its a different story.

•     If you are single you can contribute as long as your income is less than $101,000
•     If you are married and filing jointly, its $156,000.

And if you don't have an employer sponsored plan, then you can deduct the full amount no matter what your income is( if your spouse has a plan, then a $156,000 limit applies to joint filers)

Something I don't think many people realize is that you can contribute to a Traditional IRA even if you don't get the tax deduction benefit. You still get the benefit of tax deffered growth on your investments. Of course, if you exceed the Traditional IRA limits but not the Roth, then the Roth would be better for you than contributing nondeductible earnings to a Traditional IRA

If you exceed the income limits of a Roth IRA you can't contribute to one. If you over contribute, you will be subject to an excise tax of 6% unless you withdraw the extra amount before April 15.
(From wikipedia: An excise tax is a type of tax charged on goods produced within the country (as opposed to customs duties, charged on goods from outside the country).

Searching for an ETF

This weekend I was looking over my investment accounts at Zecco and thought now would be a good time to diversify into a Financial sector Exchange Traded Fund(ETF). My investment portfolio currently consists of several mutual funds, a few individual stocks, and only one ETF. My ETF is VHT, which is the health care sector fund from Vangaurd (VHT).

The first step is to decide what you want. I bought VHT more by accident that planning, because what I really wanted at the time was the Vanguard mutual fund that it tracks. When I first spotted the mutual fund, it had an initial minimum investment $20,000, which was almost my annual salary at the time. When I looked again a few years later it had become closed to new investors. So I bought the ETF instead. Now I take a look around at the beating the financial industry has taken, and I'm thinking that it is almost ripe to invest in. The failure and take over of IndyMac bank by the FDIC this weekend will probably have some repercussions on market in the next few weeks, but I don't think there is much more room to go down (famous last words in finance). The reason I wanted to buy the Vanguard health fund? Because baby boomers are getting old and need health care. So if you spot a trend you think you can make money on, there is probably an ETF out there to support you, whether it is the aging of America or the rise of nuclear power as an alternative to oil (NLR to name one). Or you could just go for the broad market (SPY)

Once you have an idea of what you want, you can go to a financial site and search for more specifics. I'm going to use Yahoo! Finance because I'm partial to them. Go to the Yahoo! Finance site, hover over investing, and select the ETFs option.

 Click on the View ETF's link to see all the ETFs. Select the category of funds you are looking for an them press the view button. Or if you are partial to a particular company, you can sort by family. There may be a lot to choose from. The way to narrow your selection down is by looking at critical factors.

 The same critical factors that apply to mutual funds and stocks apply to ETFs. For instance, the trading volume and net assets. A low trading volume and low net assets could hurt you when you want to sell your shares at a later date. Low volume (for example < 100,000 shares per day) or low net assets (for example < $250 Million) could mean that you will not find any buyers when you need to sell.

Another very critical factor is the expense ratio. Just like mutual funds, ETF's have expense ratios to cover the cost of managing the ETF. Typically these cost are lower than a similar mutual fund.

Lets take a closer look at one of the ETFs. I'll examine Ultra Finacials ProShares (UYG) in more detail. When you click on it you get the summary page, which has several bits of useful information. Last Trade tells you what you can expect to pay for the ETF currently. NAV is Net Asset Value(NAV), which is the value of all the underlying stocks that comprise the ETF. Notice the stock price is higher than the NAV. This means it would be cheaper to buy the stocks individually (not counting broker fees). That is not a good sign. Since ETFs are very easily traded, it means the stock value will most likely come down in line with the NAV. Net Assets of over 1 Billion mean there should be good liquidity in the fund( it is easily traded on the market). P/E is a statistic usually associated with an individual stock. It is the Price to Earning ratio, and it is a measure of how expensive the stock is. P/E ratios are typically between 10 and 20 for healthy companies. Lower than 10 means that the company is undervalued, or in some kind of financial trouble. For ETFs , the P/Es of the all the stocks in it are considered.  A P/E of 13 could be good, but other ETFs in the same sector have even lower P/E's right now, so that may not be a value after all.

 The profile tab also has some very good information. The Yield shows how much you can expect to get in terms of income from dividends or interest payed on the underlying stocks. While 3.8% is higher than the total market, it is not out of line for the financial sector. A higher yield means it would be better to put this ETF in a tax advantaged account like an IRA to avoid paying taxes on the yield. The fund summary tells you the funds overall strategy.

Fund Expense Ratio and Turnover are two very critical elements. An expense ratio of 0.95% means you pay 0.95% of your assets annually in fees to the fund. This cuts into your potential gains. That kind of expense ratio is normally seen by an actively managed mutual fund. For an ETF you should expect < 0.5%. Also, with a turnover ratio of 46% percent, there are a lot of active trades going on inside the ETF.  Active trades incur fees and taxes. In essence, the fund is all new every 2 years. You should look for a turnover ratio of 10-20% or less.

The holdings tab is also something to consider. For example, I already have a stake in Citigroup through individual share purchases, so a fund that holds a large percentage of Citigroup would not appeal to me.

Overall I would not buy UYG. There were two other funds I looked at that better meet my criteria. They are XLF from the people who brought you spiders, and VTI from Vanguard. Not surprisingly, Vanguard's ETF looks the best to the me, but XLF is almost the same. I'll be watching it closely over the next few weeks.

Buy low and sell high

This is my first real recession. I was an adult and mildly cognizant of the crazy times that happened in the investment world around the turn of the century, but I had no money and no stake in the game.

I started investing in August of 2002. For those of you keeping score, this is when the market did it's last reversal, going from the long slide down after the tech crash to the housing boom of the last five years. This was not due to my talent at reading the market, but dumb luck that I happened to run into some money at that particular time and wanted to start saving for my future. I bought $3000 worth of Vanguard's S&P 500 index, which is the minimum buy in, for about $78 a share. Since then every stock purchase has cost me more than the last one. Actually, since I dollar cost average, each monthly purchase has got me less for the money. I should have bought an IRA then but I really didn't know much about investing. Live and learn.

Since October of 2007, the market has lost about 20%. Even after such a huge loss, I'm only now getting close to my cost basis for most of my mutual funds. [Cost basis is essentially the average price per share]. It looks bad on paper, but when you think about what this really means, things look much brighter indeed. I'm buying the same dollar amount of several mutual funds (I've diversified to 3 different funds in 2 accounts) that I was this time last year, but I'm getting them for 2006 prices. If you're like me and have a long way to retirement, then this is probably the best thing that could happen. If this recent down turn means you will be suffering a lower quality of life in the near future, that means you need to diversify into safer investments.

Buy low and sell high. Sounds simple right? It's the number one rule of investing, and probably the most violated rule as well. It continues to astound me that at things get worse in the market, more people want to sell out of their stocks! The only sane reason is that you need the money right away. If you do not need the money to live off of, then you are selling at a loss. You may be kicking yourself for not selling prior to this point, because looking back in time that is the obvious decision, but when you are looking at things real time is is not so simple. If you sell out now you will most likely miss the turn around as well.

The market will drop until prudent investors think the discounts are too great to pass up, and them will shoot screaming upwards as the large professional money managers jump back in, passing the individual by. The only way to take advantage of the up turn is to remain in stocks and keep investing. For some reason people don't kick themselves nearly as hard when they miss the big up swings as the down swings.

Types of Investment Strategies

I've been investing for almost 6 years now, but until recently I didn't really understand what some of the basic investment strategies people use to pick stock and mutual funds where. This is important to know for stocks because it explains some of the fluctuations in stock prices when parameters change, and for mutual funds because many funds invest along these lines.

The Morningstar style box sums up the major two styles. Here is the style box for the Vanguard S&P 500 index fund. Looking at the where the shaded box is, we can see that it is a large blend fund, but what does that really mean? Blend means that the stocks in it are a mix of Value and Growth stocks. Large means the companies have a large market capitalization. First I'll look at value and growth.

A Value stock is one that is considered to be cheap relative to it's potential value. Basically it is a stock that the stock market has undervalued and can be bought at a discount. So how do you value a stock? The most basic method is to takes a companies earnings and divide it by the number of shares a company has. This is the Earnings Per Share(EPS) ratio. It is compared to the stock price by dividing the stock price by EPS. This gives you the price to earnings (P/E) multiple. Generally this is between 10 and 20. For example, Starbucks reports a net income of $613 Million dollars. It has 730 million shares outstanding. EPS is 613/730 = 0.84 Starbucks is trading at about $16 per share right now, so 16/0.84  gives a multiple of 19. That indicates that it might not be a good value right now. All this number crunching doesn't really mean anything, this is just a way that some investors look for value.

Growth is another way to look at how a company will do. A growth investor looks for companies that are expanding rapidly. That's economic expansion, not necessarily physical. Companies that grow rapidly are likely to have a matching growth in stock price. This "growth" is all speculative or based on past trends, so a stock that is considered a growth stock might not do anything at all in the future. Financial analyst make predictions of company growth with limited success. In contrast to value, a growth investor probably doesn't care what the P/E multiple is because the stock will grow regardless. Incidentally, right before the fall of tech stocks in 2000, many "hot" companies had P/E multiples close to 90.

Another category on mutual fund is Income or dividend. These funds look for dividend paying stocks or invest in bonds for a fixed return. Dividend reinvestment is one of the major factors in the high return of stocks over time. These can provide a passive income for a person without selling any extra stock. Since you pay taxes on this form of return, it is good to have an income fund in a tax advantaged account.

Market capitalization is the a companies stock price multiplied by its shares outstanding. It's not a hard value since share prices change daily. A company is considered small cap if less than 2 billion, Mid 2-10 billion, and large if greater than 10 billion dollars. Market cap is a measure of a companies stability. Larger companies are more likely to be more stable and therefore are less risky.