The Myth of Investment Bargains

By Robert Schmansky, CFP®
Franklin, MI
http://www.nfa1040.com/

Originally published 3/8/2010 at FPA's All Things Financial Planning Blog

We all know there are deals to be found in the shopping world. But do we ever consider the value we receive for the price we pay?

William Poundstone’s book, Priceless: The Myth of Fair Value (and How to Take Advantage of It) points out most of us are really suckers when it comes to shopping. (Poundstone has written more than dozen books, his first, published in 1983, was titled Big Secrets: The Uncensored Truth About All Sorts of Stuff You Are Never Supposed To Know.)

We overwhelmingly lack the information we believe we possess to be ‘price’ experts. The result, Poundstone argues, is we’re often taken advantage of, and prone to paying just about any price (and sometimes more today than we would have yesterday).

In this video, Poundstone gives another example of the ways price can be misleading by demonstrating how one can leverage psychology in their Internet sales to increase the price of a product on eBay.

In the investment world, it can be even more difficult to consider cost and value. And it’s understandable why that is when product prospectuses are longer (and more dull) than a textbook. Often, investors will rely only on hypothetical or recent returns equate to value, and costs — and by this I mean the total costs of a strategy — are never considered.

A few of my biggest concerns are with products that investors believe “guarantee” growth in “retirement income,” or products that shed sound, investment principles to employ strategies that you would like to have owned yesterday, but have no promises for tomorrow. (I wrote more about that topic in a blog post on what I call the “Barnyard Rules of Investing.”)

Total costs include more than just a percentage of your investment dollars paid in annual management fees (when annual management fees for a product go above 1.5%, alarm bells go off for me.)

Total cost of a product may include:

• Reduced growth or cash flow compared to traditional investment strategies;
• High back-end penalties for leaving. My personal rule of thumb is to be wary of any back-end charges;
• Fees that are low initially to attract dollars, only to rise when you are trapped in the product (the classic “bait-and-switch” tactic).

Whenever you review an investment proposal, consider your thoughts on the proposal before jumping in:

1. If you have the feeling that you are getting a real “deal”, or bargain — STOP! There are no “deals” in the investment world. Investing is not shopping.
2. If you sense that you are being pushed to make a decision today, or in the next week, stop and ask why. I hear stories from clients being told a product will no longer be offered over the next few months, so they need to invest now. Would you consider buying a car that is being discontinued? How about if your grocer told you a product is being recalled… buy now? Clearly you need to stop, and don’t walk, but run from this offer.
3. If you haven’t taken the time that’s necessary to analyze and compare the costs and benefits of an investment comprehensively by comparing it against low-cost strategies, stop and perform this exercise.
4. If you don’t have a clear understanding of how this product fits into your plan, stop and ask why you are not discussing how this product meets your future cash flow needs specifically. The product should be about a fit for your plan, not about exotic features that sound exciting.

If you don’t understand a product or strategy, don’t invest. It is sad to say, but most people who have been burned by products have not done their homework, and simply trust in an expert. They accept the sales pitch that they will receive “more” that is well worth paying hefty fees.

Clearly, it can be a tough job to compare products based on value. Because of that, I am a strong advocate of getting help explaining value by a second professional opinion before settling on a strategy. You would get a second opinion before major surgery, or even before buying a major household appliance. Your long-term financial security is far too important to squander on investments that drain, rather than provide, value.

Find qualified advisors for a second opinion with ACA's Find an Advisor tool.

Debit or Credit: How the Choice Can Affect Your Financial Security

By Troy Von Haefen, CFP®
Nashville, TN
http://www.vhfinancialmanagement.com/

We are all familiar with the point of sale transaction vernacular: will this be debit or credit. What’s the difference, and how does it impact you? Most folks really don’t understand the difference, but the difference can be vital.

Unfortunately, in today’s world of ID theft and financial fraud the decision of debit versus credit matters. Many people feel that our banks will help to protect us in the case of a stolen card. While this true in most instances, it’s not guaranteed. Making the wrong choice between debit or credit may mean the difference between being protected or not.

Banks strive to protect their customers and indemnify (make whole after a loss) after a stolen card is wrongfully used. But some transactions may force the bank to refuse to pony up for your financial loss. If a check card customer uses the debit option, which requires the use of a personal pin, and the card and pin are stolen, the customer could be in trouble.

Using a check card as a credit card at the point of sell will require a signature and identification, at least in theory. Using the debit card option just requires a personal pin. If a thief steals a check card, or check card number, along with the personal pin (by looking over your shoulder or any other devious method), the bank may refuse to cover the wrongful charges. The bank’s stance is that the customer did not protect their personal pin; therefore, the bank can hang the responsibility of the wrongful charges on the customer. The personal pin is personal and should be protected!

The moral of the story; chose the credit option whenever possible. If you don’t have that choice and must use your debit option, be careful and protect your personal pin.

Roths Now Make the Tax Code Your Friend!

By Bert Whitehead, MBA, JD
Franklin, MI
http://www.bertwhitehead.com/

Here are some points to ponder and strategies to consider. Again, these can be complicated so you should expect to discuss whether these apply to you during the year when you do tax planning with your ACA advisor (i.e. a member of the Alliance of Cambridge Advisors).

#1: Got negative tax? A Roth conversion creates taxable income because of the IRA distribution that funds the Roth, so it certainly is advantageous to convert whatever amount you can if you have negative taxable income. It’s an opportunity to declare income and pay no income tax.

#2: Defer taxes…again! There is a quirk in the law for 2010 that lets you choose to either pay taxes on the 2010 conversion as 2010 income, or pay half the taxes of the 2010 conversion in 2011 and the other half in 2012. There is no interest or penalty to doing the latter, so it would generally be a good option.

#3: Automatic extension. If you are unsure whether your tax rate will be increased in 2011, you can convert to a Roth in 2010 and then file an automatic extension in 2011 so you don’t have to file until October 15, 2011. Then you may know whether your tax bracket has increased or not. If your bracket is being increased you can elect to pay taxes at the 2010 rate.

#4: How much to convert? If you aren’t sure how much to convert, keep in mind that you must make the 2010 conversion before 12/31/2010. However if you convert too much, you can elect to ‘recharacterize’ part or all of your conversion up until you file your 2010 return (i.e. until 10/15/2011) and put it back in your IRA without penalty. So you should always covert too much rather than too little!

#5: In-kind. When converting an IRA to a Roth, you can transfer your IRA investments ‘in kind’ to the Roth without having to sell them and buy them back. If you have a broker, make sure you let him or her know that you know that you don’t have to “sell” (pay a commission”) to convert.

#6: Outfoxing Mr. Market. If the investments drop after you convert them, you still must pay taxes on the value of the holding when converted. How do you preserve the value of the investments that you converted? For many clients, we are setting up 2 Roth IRA accounts: one for bonds and one for equities. We will transfer the full amount to be converted to each Roth IRA, using Stripped Treasuries to go into the bond Roth, and stocks or equity mutual funds into the stock Roth. Then in October of 2011, if stocks have dropped, we will recharacterize that account back to an IRA and do likewise with the bond account if stocks rise.

#7: Asset Location. To optimize ‘asset location,’ Roth investments should be in assets with the highest potential returns, such as small cap or international mutual funds. If using #6 above, and the stocks are recharacterized back to the regular IRA, they should be sold to buy back the bonds and the bonds in the remaining Roth account should be sold to buy back the stocks.

#8: Efficient cash flow. Long-term tax management and tax efficient cash-flow strategies are enabled through the use of Roths. Since there are no minimum required distributions for Roths, taxable distributions are reduced and Roth distributions can be used to maintain cash flow while keeping taxes low in retirement.

#9: Coordinate with charitable contributions using Donor Advised Funds. If you intend to include charities in your will, consider gifting stock now to your Donor Advised Fund in about the same amount that you are converting to your Roth. The tax deduction for the charitable contribution can then offset most of the additional amount of taxes due to the Roth conversion.

#10: The Next Generation. This is an unprecedented opportunity for intergenerational planning. The beneficiaries (spouse, children, etc.) of Roth accounts have the same advantages of taking tax-free withdrawals. If you don’t need the IRA money during your lifetime consider the benefits of not paying income taxes on many years of compounded investment growth.

#11: Reduce onerous estate taxes. Using assets to pay income taxes now reduces your estate for estate tax planning and provides a way you can pay the future income taxes for your children or grandchildren now. (note: as of the date of this blog there is no estate tax. Rules are in flux but it’s a good bet that they’ll return in the future.)

Although it may be obvious, note that Roth conversions also appeal to the federal government because they can tax your pre-tax IRA money now, rather than in 20 or 30 years! But that’s why it’s important to at least review the above points to see how the current legislation affects you. Since your ACA Advisor knows your comprehensive financial plan more intimately than anyone, there may be even more points and issues to discuss.

Be sure to look at these ways to make the Taxman your friend in 2010!

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.

Credit Card Act of 2009

By Judy Stewart, CFP®, MBA, EA
Carlsbad, CA
http://www.stewartfinancial.com/

Recently, the most sweeping credit card reforms ever passed by Congress (The Credit CARD Act of 2009), began to take effect. On one side, consumer groups are excited that credit card companies are required to communicate more frequently and plainly about changes they make to your cards. Critics, however, say that these new regulations will make credit cards more expensive, in the long run, for everyone.
NPR’s “All Things Considered” outlines a few need-to-know-points for consumers:

Interest Rates: Card issuers cannot increase interest rates during the first year on new accounts. In most cases, retroactive rate increases are prohibited.

Payments and Billing: The issuer has to set the payment-due deadline on the same day each month.

Fees: Consumers cannot be charged extra fees for making payments online, by phone or by mail.

Disclosures: Issuers must notify cardholders of significant changes to their account terms at least 45 days before the changes take effect. If the consumer objects to the changes, he or she can close the account, or "opt out."

Young People: Consumers younger than 21 need an adult co-signer to open a credit card. In addition, the card issuers cannot entice students to sign up by offering free pizzas or other gifts within 1,000 feet of a college campus.

Also, have you ever tried paying your credit card over the phone, only to realize it will cost you 10 bucks to do so? That’s also out with these new credit regulations. (They always try to nickel and dime us, don’t they?)

What might be confusing to consumers is finding out what rules take place when. We found an interactive timeline at CreditCards.com that clearly outlines when legislation begins:

Creditcards.com Credit Bill Timeline

Who Wins When Your Financial Advisor Sells You a Product?

By John Scherer, CFP®
Middleton, WI
http://www.trinfin.com/

A column by syndicated financial journalist Humberto Cruz appeared in my local Sunday paper this week titled - at least in our paper - "Who wins when your financial advisor sells you a product?" (You can read the full text of the article on the Salt Lake Tribune website.) The dozen paragraphs are a must-read for anyone seeking advice from a financial professional.

The article uses a specific example from Edward Jones, but every other brokerage firm, bank investment arm and insurance company is the same in that its registered representatives are held to a suitability standard rather than a fiduciary one. This means that reps must be able to prove that their recommendations are suitable for a customer's situation. In contrast, registered investment advisors (RIAs) who are held to a fiduciary standard must make recommendations that are in their clients best interests.

As an example consider a person whose portfolio would benefit from having exposure to the large cap asset class. As long as a registered rep recommended a large cap fund he or she would be meeting the suitability standard, regardless of whether that fund cost the investor 0.25% or 2.25%. The registered investment advisor must recommend the large cap fund that was in the investor's best interests. This does not necessarily mean the lowest cost fund, but in most cases lower costs directly result in better investment options. But in the event that a more expensive fund makes the most sense, the RIA must be able to prove why that fund is in the investor's best interests.

To quote Cruz "In plain English: When brokers recommend a product, you can't be sure it's because it's best for you or best for them."

What Can the NFL Draft Teach Us about Personal Finance

By Robert Schmansky, CFP®
Franklin, MI
http://www.nfa1040.com/
Originally published 3/17/10 at Filife.com

Though it's still more than a month away, the National Football League draft is the nonstop talk of sports radio.

Given my hometown team's position at the number two pick in this year's draft, speculation is at an all time high. Will they pick the best athlete overall, or the one in a position they most need? Will their first choice be available, or will he already have been taken by another team? There may also be strategizing and offers to trade down to a lower pick.

There are several parallels to personal finance in these speculative times that we can learn from the draft.

Expect the Unexpected
Many things happen before draft time. Even the best laid draft plans are often thwarted by the moves of another team that you have no control over. These are factors we often spend all of our time focused on, despite the lack of control.

Likewise, you might think you know where the economy is headed. You might think the stock you've had your eye on (be it your own company or another) is headed higher. But don't get stuck counting on it! Despite your reasoning, the chances are good things won't turn out as planned. For that reason, come up with plans for multiple scenarios. In investment terms, this is diversification not only into different products, but diversification over asset classes in preparation for multiple economic scenarios.

Build Around Fundamentals, Not Flash
Flashy players are often the fan favorites, but make sure you have plenty of players that are solid in their fundamentals before taking too many prima donnas.

Often, the biggest need for a team isn't the player with the most interceptions but doesn't like to tackle. It's having players at all positions who can do the job. If you are lacking in a certain part of your portfolio, don't just take the best performer, you should diversify in all areas with solid performers.

Just the same, many investors place their hopes in flashy investments to make enough to fund their retirement. Whether it is a gimmicky product you wish you held last year, or the latest asset fad, a plan without solid fundamentals will not go the distance through retirement.

And the Expert Opinion Is…
The expert sports radio hosts in my town are always right, even when they end up being wrong.

But there are always plenty of equally 'right' experts who hold opposite opinions. The same is true of investment and economic experts:

• The dollar is dead. The dollar is strong against other currencies.
• The U.S. economy will stumble. Or it won't.
• Inflation is coming. Or maybe it's deflation.

When the draft experts are predicting a team's picks, they are in as much disagreement as the economists' thoughts on the direction of the economy.

Don't get stuck on what one expert has to say. When the situation doesn't go their way, to their minds they are always either right for the time being, proven right by time, or their memories become a bit fuzzy. Economists are best at explaining why things happened after they happen. When it comes to what they thought was going to happen, they usually have a little less to say.

The same is true of draft experts. They too will tell you about that one scenario from the past in which they were right. They won't tell you about the 99 percent of their other predictions which didn't fare so well. It is human nature not to remember those times when we got it wrong. It's also true with economists predicting markets (and investors' stock returns).

Economist and historian Murray N. Rothbard said the value of the economist to the average businessman is limited to explaining generally truths of the economy; not in predicting its short-term movements. The same could be said for sports experts.

Take what you hear from economic, investment and sports experts with a grain of salt. Chances are good many have an educated forecast, but actual results will be something entirely different, for better or worse.

The Benefits of a Mortgage

By Troy Von Haefen, CFP®
Nashville, TN
http://www.vhfinancialmanagement.com/

The recent downturn in the economy has spurred financial scrutiny in personal spending and savings. Most families have taken a closer look at their income versus expenses as well as savings versus debt to see how they can weather the financial storm. Anytime an examination of personal finances arises, the question of paying off the home mortgage seems to pop up. While the theory of debt elimination is good, understanding how a home mortgage can impact a personal financial plan is needed. To better understand the pros and cons of mortgage reduction we must take a closer look at debt.

Good Debt Versus Bad Debt
Some financial pundits argue that all debt is evil and there is no such thing as good debt. I take exception to this thought and find it somewhat short-sided. Some debt is bad, and I call this bad debt consumer debt, which includes personal loans, auto loans and revolving debt (credit cards). Consumer debt usually carriers a high interest rate and offers no tax benefits. The debt that I classify as good debt is mortgage debt and student loans. Both mortgage debt and student loans have tax advantages. While not all taxpayers can take advantage of the student loan interest deduction, I find an investment in one's education and future certainly justifiable.

Understanding Mortgage Debt
A mortgage is a debt secured by a personal residence, and that residence is an appreciating property (at least over the long term). Since a home will increase in value over time, mortgage companies allow long term debt against this property. A 30-year mortgage is the most common example.

The IRS gives homeowners a break by allowing a mortgage interest deduction for interest paid on a home mortgage. Obviously, there are rules and restrictions, but the majority of homeowners have allowable mortgage interest. This deductible mortgage interest effectively reduces the taxpayer's true mortgage expense. For example, a taxpayer in the 25% tax bracket with a 5.5% 30 year fixed mortgage will effectively hold an after-tax interest rate of roughly 4.4% (this number will vary based on the calculation and year of the loan).

There is another benefit to holding long-term mortgage debt that most people do not realize. A long-term fixed-rate mortgage provides a nice inflationary hedge. Sound confusing? Here's an easy way to understand this concept. A homeowner will pay tomorrow's mortgage payment in today's dollars. Simply put, the mortgage payment 10, 20 or 25 years in the future will remain the same (barring escrow payments). The home increases in value, but the mortgage payment does not.

Why Have a Mortgage?
Besides tax deductibility and the inflationary protection, a properly valued home and properly sized mortgage can create balance. Buying the right size home and carrying the right size mortgage is a vital piece of a balanced financial puzzle. If a homeowner pays off a mortgage and draws down cash to do so, a liability can be created. A rich house and cash poor homeowner who owns their home outright is not balanced.

Retaining cash and leveraging that cash can be quite powerful as well. I often see prospective clients that don't fully max out their retirement plans or IRAs but are paying extra money every month towards mortgage reduction. This move does not grow wealth. Imagine the scenario where a couple is paying an extra $500 a month to their mortgage. If that couple is not maxing out IRAs or 401ks, they could put the $500 a month towards their retirement. If they are in the 25% tax bracket, the $6,000 contribution for the year would reduce their tax bill at least $1500, and this is not factoring state taxes. That's a 25% return on investments before the money is invested. Once the money is invested it will grow and should outpace the after-tax effective mortgage rate in the long run. That's leverage!

A Few Things to Remember
Once additional money is paid towards a mortgage, it is gone. The only way to get that money back is to refinance, open a home equity line of credit or sell your home. All three of these have fees and costs involved. While a home is somewhat marketable, it is not an asset that can be sold quickly and efficiently. Any money put towards principle reduction will be tied up and difficult to utilize.

Personal financial planning is similar to Newton's Third Law: "For every action there is an equal and opposite reaction." Every financial action taken in one specific area will affect another. This is why the topic of mortgage reduction or elimination should only be discussed from a comprehensive viewpoint. The above examples illustrate how a mortgage can impact, either positively or negatively, many other financial areas, such as taxes, cash flow and even retirement.

Even though there are many positive attributes to having the right size mortgage, there must be parameters. Taking the stance that mortgage debt is a plus does not one give free rein to overspend! The decision of homeownership should be carefully considered in the context of the whole financial picture.

While we tighten our financial belts and march forward through the economic downturn, it is wise to fully understand all financial decisions and how those decisions can impact our financial wellness. The mortgage reduction question is one that requires careful consideration. For all the reasons discussed above, a rush to reduce a mortgage balance could be the wrong choice. A comprehensive understanding of a home mortgage is essential before any steps are taken to either increase or reduce mortgage debt.