Investing Archives - The Broke Professional

The Investing Book That Won My Heart

Reading books will make you a better investor.

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Life is a journey, but the beginning of that journey can have a profound effect on the rest.  Reading one book in particular completely changed the trajectory of my investing journey.

While you can learn to like new foods as an adult, most of our food preferences are formed when we are young.

Most sports fans, myself included, root for their hometown team.  I’m a born and raised New Yorker, so the Giants are my team.  If I was born anywhere else, I would most likely have rooted for that hometown team.  (Though never the Philadelphia Eagles.  NEVER.)

In the same way, while my views on investing have slightly evolved over time, my core investing philosophies came from a book I read years ago and immediately connected with.

That book is The Bogleheads Guide to Investing (hereafter referred to as The Guide).  I’ve read a few investment books before I read The Guide and they just didn’t connect with me.  I’ve read a bunch of investment books after I read The Guide and most of them were not as memorable.

The Guide was a life changing book for me because it presents an investing blueprint that made sense and was easy to implement.  The idea of technical analysis and digging through charts and graphs while following the comings and goings of companies doesn’t appeal to me.

(As a simple introduction, a Boglehead refers to a follower of the philosophy of John Bogle, the founder of The Vanguard Group.  This book as a comprehensive investing guide written by some big time Bogleheads.)

Here are the two reasons why this is my favorite investing book:

Investing Should Be Simple

If you want to make money off of the general public, keep them confused and helpless.  Electricians and plumbers want people to call them anytime they have a problem.  They can charge for materials and whatever they want for labor while we simply nod and hand over the check.

They DO NOT want you to go on YouTube and find out the solution to the problem on your own.  Contractors don’t want you to go online and get the materials you need at a cheaper price.  They will go out of business.

But the more you look up things on your own, the more knowledge you’ll gain and the simpler things will become.  You will also save a lot of money in the process.  And let’s face it, you don’t need to get a PhD in plumbing to become a good plumber.  You need to find solutions to various plumbing issues.  Doing this over time will make you an expert.

The investing industry is very similar.  Investment advisers and brokers have a (wait for it…) VESTED interest in keeping you confused.  They want you to think investing is a very complicated topic that requires decades of expertise to master.  That way, you will be forking over your hard earned money without question.

The Guide says otherwise.  It showed me that as long as you are aware of your financial goals and risk tolerance, knowing what to invest in becomes very simple.  The key is to stick to your plan despite the ups and downs along the way.

And there will be ups and downs.  That’s the nature of investing.  And this is where most investment companies will get you.  They will make you believe that only they know when the markets will go up or down and that’s why you need to keep paying them.

The simplicity of it all will shock you.  But it will also empower you to take control of your investments and focus your time and energy on everything else that matters in your life.

Investing Should Not Be Expensive

The aforementioned investment advisers and brokers who want to keep you confused and take your money?  They don’t come cheap.  Most financial advisers who manage your investments will take a cut of your assets every year, usually 1% or more.

Plus, they can potentially put you into investments that have high expense ratios while not offering you similar ones with lower expense ratios.  (An expense ratio is what you’re charged by the mutual fund company just to be invested in the fund.)  And advisers can receive a kickback from mutual fund companies for putting you in a certain investment.

This goes on top of the fee the adviser takes.  Not good.  The effect of high fees on your investment returns has been well documented.  Most mutual fund managers cannot beat the average market return in one year, let alone for decades.  So there is no way to justify high fees.

The worst part is that a lot of these fees are well hidden.  Most advisers and brokers just take the fee out of your returns rather than having you hand them over a physical check.  That way you don’t feel like you are paying anything.  It’s not illegal but it does seem slightly unethical.  So what’s an average investor to do?

The answer according to The Guide is to stick with mutual funds that have rock bottom fees and track the performance of the overall market you are looking to invest in.  In real terms, this means investing with index funds from Vanguard.  This will give you two major benefits:

1.  You will be paying very low fees

2.  Your investment portfolio will be very simple to manage

These two points will put you way ahead of the majority of investors.  Those investors are paying high fees and buy and sell at the whim of the market.  Investing with Vanguard index funds for the long term will allow you to fully take advantage of compound interest.

And you can do this all on your own without the help of an adviser.  Just sign up for an account with Vanguard and go from there.  No grubby hands trying to find their way into your wallet.

Conclusion

The Guide has taught me to focus exclusively on index funds from Vanguard, and that’s where the vast majority of my investments are.  The only exception is the 529 college plan for my son, which doesn’t contain any Vanguard funds.

Focusing on Vanguard index funds has provided a great return for my portfolio.  This can definitely be attributed to the recent near decade of growth for US stocks, which I’m primarily invested in.  But more importantly, The Guide has showed me that investing with in low cost index funds will give my money the best chance to grow over the long term because of low fees and simplicity.

If you can’t tell by now, I highly recommend this book.  It will set beginning investors on the right path while showing veteran investors that this is ultimately the best way to invest your money.  And it will turn you into a devoted Boglehead like me.

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Sweat the Big Things. Part 1: Housing

This may be a bit much for your family of 3

 

The first personal finance book I ever read was The Automatic Millionaire by David Bach.  It was a great intro to personal finance and I would recommend it to anyone looking for a great personal finance book.  One idea the author introduced is called the Latte Factor.

The Latte Factor is the idea that if you cut out your daily $5 latte and instead invested that money in stocks, you would have hundreds of thousands of dollars available to you at retirement.

And it’s true!  If you invest $25 per week into a stock portfolio with a 7% return, after 25 years you will have $72,947.  This doesn’t take inflation into account, but not bad for skipping your daily coffee fix.

The problem is, millions of people have read The Automatic Millionaire, but millions of people are still spending $5 (or more) on their daily coffees.  Lots of people actually enjoy their lattes so giving them up consistently for decades is just not gonna work.

The Latte Factor essentially shows that cutting back on little things and then investing the difference can produce wealth.  And it certainly can.  But it’s not enough to change behavior since it takes decades to see any progress.  And even though $73,000 after 25 years is nothing to sneeze at, many people will need at least $1 million+ in retirement savings to have a similar standard of living as their working years.

That $73,000 suddenly doesn’t seem that impressive after decades of sacrifice.  So what’s the solution?

Focus on the Big Things

People would do better to focus on the big wins in life rather than focusing solely on little things like lattes.  This is especially true for professionals with high incomes but low net worths.  Saving $25 a week as a student would be huge.  Saving that much for a professional making six figures?  Doesn’t move the needle.  With higher incomes you need to set your saving sights a little higher.

There are three big things everyone should focus on:  Housing, transportation and taxes.  If you’re intelligent in these 3 areas and avoid the big mistakes, you will have more wealth than you can handle.

(This post will just focus on one of the big three:  Housing.  Stay tuned for upcoming posts on the other two)

Housing

Buying a home will be the biggest purchase most of us will ever make.  We will probably buy multiple homes during their lifetime, so getting this transaction right will set you up for financial success.

And getting it wrong will have you in a financial hole for your entire life.

There are three main factors that you need to focus on when buying a home:

1.  Credit Score:  Some people can buy a $500,000 house outright with cash. I plan to be one of those people but am not quite there.

Until that happens, me and most people in the country need to borrow money from a bank to buy that house. This type of loan is called a mortgage (which literally means “death pledge”)

Mortgage interest rates are pretty low nowadays, but to get the lowest of the low rates you need a great credit score.

Notice I said GREAT credit score and not just good. Having a great credit score can sometimes save you an entire point on your interest rate, which could result in tens of thousands of dollars of savings over the life of your death pledge.

If you don’t have a great credit score, read this and work on it.  Barring a history of bankruptcy or some major bills in collection, everyone should be able to increase their credit score year after year.

2. Down payment: Having a 20% down payment for your home purchase does three amazing things:

-Disqualifies you from having to pay Private Mortgage Insurance, which is usually about 1% of the purchase price of the home per year.

PMI, as it is known around the block, is what the lender will charge you in case you can’t come up with a traditional 20% down payment.  This goes straight to the lender’s bottom line and may or may not be tax deductible for you.  In any case, it’s a payment you can do without.

-Gives you instant equity in your home. This makes it pretty certain, though not a guarantee, you’ll make a good profit once you sell the house down the line. Not having enough equity will affect you during a housing downturn, like the one we had in 2008.

If you have little equity and your house loses 30% of its value, you are either stuck living there for a long time or have to go through a foreclosure or short sale to sell the house.

-Makes your monthly mortgage payment more affordable.  If you have a 20% down payment, it reduces the amount of mortgage you need and will give you some room to negotiate interest rates depending on your credit score.

If you stretch for a home by getting a low down payment loan, you are increasing your monthly payment which is holding you back from your other financial goals as well.  Plus, you’ll be paying the aforementioned PMI on top of everything.

Physician loans are a slight exception.  They allow you to get a home with a very low down payment without having to pay PMI.  On the flip side, they tend to charge slightly higher interest rates than traditional loans.

3.  Use numbers, not emotions, to buy a home:  Buying a home can be a highly emotional decision.  And that’s just how the home buying industry wants it.

There are many parties that end up making a lot of money from the sale of a home.  The bank that issues your mortgage makes interest off of you.  Your helpful and friendly agent also makes a nice percentage of the sale price.  Builders and contractors also make some nice money.  The only one not making money is you, the home buyer.

There is a whole industrial complex whose sole job is to make buying decision emotional for you.  That’s why they have certain types of lighting and music in stores.  The know emotional customers are overpaying customers, and that will keep the profits rolling in.

The best way to combat this is to work backwards by finding out what you can afford and looking for the best homes in that range.  This should be done before you look up homes or talk to an agent.  Model homes and home buying websites will try to make all their homes glamorous and “must haves”.  Starting your home search based on those false notions will lead you to pay more than you can afford.

A conservative rule of thumb I like is that your mortgage payment shouldn’t be more than 25% of your gross income.  So if you gross $5,000 a month, you shouldn’t be spending more than $1,250 on your mortgage.

And always remember to add 1% of the purchase price of your home as an annual maintenance cost.  Because maintaining a home will cost you, even if it’s a new home.  Many home buyers don’t account for this in their budget, and it can be a rude awakening that can slowly chip away at your checking account.

Your Home Will Make or Break You

As I said before, buying a home will probably be the largest transaction you will ever make.  This is one transaction that will make or break your finances.

By keeping a high credit score, having at least a 20% down payment and not buying a home beyond your means, you will save thousands upon thousands of dollars over the life of your loan.  Investing these type of savings can produce hundreds of thousands of dollars in retirement funds.

And that will buy you a lot of lattes.

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Take Full Advantage of Your Workplace Benefits

There are few things in life as potentially exciting and nerve wracking as getting that first job out of college.  After years of studying during college (and possibly grad school), building contacts throughout your field, polishing and re-polishing your resumes, going through rounds of interviews, you finally receive the job offer you want.

The salary is in line with what you’re looking for, you have a pretty decent commute and there is plenty of room for advancement.  Finding yourself in this “dream job” scenario is definitely a cause for celebration.

But once the party is over, it really pays to look at the COMPLETE picture of what your new position can offer you.  If you don’t, you risk potentially losing a lot of money and benefits.

Receiving a paycheck is the obvious benefit of working at a new job, but it is not the only benefit.  Every workplace is different, but there are many benefits that you could potentially be eligible for that go unused.

And no matter how nice upper management or HR seem, they will usually not go out of their way to tell you about all the benefits you’re missing.  Here are some of the benefits that many people leave on the table but really shouldn’t because it’s like throwing away free money.

Health Insurance

One of the biggest benefits of employment is affordable health insurance.  While healthcare premiums are usually cheaper for employees, you still have to choose the correct health plan based on your needs.

With the emergence of high deductible health plans (HDHP’s), this decision has become a little more difficult.  HDHP’s have lower premiums than traditional health plans, but they have higher deductibles to meet.  Which means you’ll have to pay more out of pocket before the insurance will start to cover anything.

This can be a good situation if you don’t usually spend money on healthcare throughout the year.  That’s because if you enroll in a HDHP, not only will you have much lower premiums than a traditional low deductible plan, you can also enroll in a Health Savings Account (HSA).

HSA’s allow you to set aside pre tax funds to pay for future healthcare expenses.  The best part is that the account is yours for life and can grow tax free.  A very effective tax savings tool.  Read more about them here.

But if you tend to spend a lot of money on healthcare, a HDHP may not be the answer for you.  Most companies will give you plenty of resources to make the right decision.  The employee still needs to do the work and choose the best plan for them.

Another aspect of health insurance that has caught on recently is the addition of “wellness incentives”.  These are discounts your company gives if you meet certain criteria regarding your health.

For example, my current company gives a discount on your health insurance premium if you are a non-smoker.  Getting a yearly physical with lab work will get you another discount as well.

This helps you by saving money and it helps the company because healthy employees means more productivity.  Many colleagues overlook these easy discounts.  It’s almost like free money since you just have to fill out some forms.

Retirement

With the overall demise of workplace pensions, most employers offer a 401k retirement plan.  This means that the employee is completely responsible for their own retirement.  If you do it wrong, you could end up with nothing in retirement.  If you do it right, you could be a multi millionaire.  No pressure!

A big advantage of 401k’s is that contributions are deducted before taxes, meaning you don’t pay any taxes on contributions the year you contribute but you will pay when you eventually withdraw the money.  The ideal scenario is to contribute as much as you can when have a high income with high taxes, and withdraw the money when your taxes are relatively low during retirement.

Another great perk is the 401k company match.  This is the amount your company will contribute into your account up to a certain percentage.  A common match offer is the company matching your contribution up to 3%.  Some generous companies will throw in some money even if you don’t contribute at all.  At least contribute enough to get the full match.  From there, you should look at your entire financial situation to see if paying off debt or contributing money elsewhere would be a good move.

Many employees don’t contribute to their 401k.  And it’s a darn shame.  According to the Bureau of Labor Statistics, only about 30% of employees who have access to a 401k contribute anything at all.  That’s going to produce a lot of poor people in retirement.  It’s a great “forced” savings plan that will save you on taxes today and provide you with money to live on down the line.  I can’t think of an easier way to pay yourself first.

As I mentioned before, 401k’s require participation on the employees part.  And they can be confusing for financial novices.  Here is a great guide to help get you started with understanding your 401k plan.

Health coverage and retirement accounts are two of the biggest benefits offered by employers.  It’s important to take full advantage of both of these offerings.  If you have any questions about how to fully optimize your plan, contact your HR department or shoot me an email.

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Inflation is Not a Big Deal. Here’s Why.

James can trade down to a slightly used BMW and save a ton on insurance and maintenance.

Imagine a reverse savings account.  You put money into it and it will slowly erode over time at a constant rate.  Let’s say that rate is 3%.  So every year the amount you have in the account will decrease by 3%.

So you deposit $100, then at the end of the year, you’re left with $97.  If you don’t add anymore money, the following year you would lose 3% more.  You would have to keep adding money just to keep your original $100 deposit.  Doesn’t sound like a good deal.

This is inflation.  It creates an increase in the price of goods over time which erodes the buying power of your money.  The most quoted inflation rate is around 3%, which is the Consumer Price Index (CPI) provided by the Bureau of Labor Statistics.

And many of us have seen this in our lives.  A gallon of milk in 2017 doesn’t cost the same as it did in 1997.  Same goes for a gallon of gas.  I’ve even written before that the only way to beat the inflation monster is to make more money and to do it FAST.

Making more money is a surefire way to beat inflation, but it’s actually a lot easier than that.  Many of you probably have a much lower personal rate of inflation than the 3% figure.

Here’s why the idea of inflation destroying our income and retirement while we stand by helplessly is just not true.

You Are Not an Average

According to the CDC, the average weight of a male in America is 195 pounds.  Besides that being a concerning statistic since that’s already considered overweight for most males, it also doesn’t tell you much about an individual male in America.

Sure, there are males in this country who are exactly 195 pounds, but many are below that weight and many are above.  The 195 pound number is the weight of a fictional “average” right down the middle American male, which most males are not.

And even if you are 195 pounds, there are other factors that make that number even more useless such as height and athleticism.  So that 195 pound number in a vacuum means almost nothing.

I look at inflation in the same way.  While the oft quoted rate of inflation is around 3%, not everyone is affected by that number in the same way.  Prices vary widely in different parts of the country.  Inflation could be at a rate of 5% in New York while it can be 1% in Iowa.  That 3% is a countrywide average.

Inflation also affects good and services in different ways.  Computers cost a lot more 20 years ago than they did now.  Milk costs more now than it did 20 years ago.  Cars cost more now but they last a lot longer than they did before.  That 3% assumes a constant inflation rate among all types of goods, which is just not true.

An average can serve as a good benchmark, but your personal situation can make the number utterly useless.  I never liked the idea of comparing average salaries or savings rates, as everybody’s situation is unique.

You Are Flexible

Now let’s say that you are indeed this average person, and your personal rate of inflation has been increasing at a steady rate of 3%.  It doesn’t mean it has to stay this way!

One of my favorite quotes of all time is from British philosopher Alan Watts:  “You’re under no obligation to be the same person you were 5 minutes ago.”  And this applies directly to the inflation argument.

If the CPI has been showing an average rate of inflation of 3% for the country, there is not much you can do about that.  If your personal spending has been growing at a steady rate of 3% year after year, you can change that right now!  We’re not robots that need to keep spending money on the same things over and over.

There are lots of ways to do this.  We can cut out things we don’t need or just spend less on them.  We can buy less expensive versions of things we usually buy (skip Whole Foods and go to a normal store).  If you take a good look at your personal spending, you can definitely find ways to keep more of your money and reduce that inflation rate.

The fact that we can be flexible and adjust our spending to reduce our inflation rate turns traditional retirement planning on its head.  Most retirement plans and calculators automatically assume that your inflation rate will be 3%.  This can easily be changed so this means that most people can actually retire earlier than they thought.

We also may not need to save as much money as we originally thought.  This can make retirement planning seem a lot less scary and disheartening.  That being said, I’m usually pretty conservative when it comes to saving and investing.  So assuming an inflation rate of 3% is not the worst thing, because it will at least ensure that you will have enough money to reach your goals.

Conclusion

Don’t get me wrong, inflation is definitely real and it has very real effects on people’s lives.  But it’s not as big of a deal as its made out to be.  Capitalism wants people to keep consuming until the end of their days.  If you follow along, then your inflation rate will certainly be 3% or even more.

But it doesn’t have to be that way.  You can adjust your spending so you actually spend less of your money than you did in the past.  Humans are a lot more flexible than they think, and I believe everyone can find ways to make inflation a very minimal factor in their personal economy.

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4 Interest-ing Ways to Spend Your Tax Refund

My first and only job before joining the optical field was as a Starbucks barista.  It was hard work but I enjoyed it and learned a lot.  We had to manually and carefully load espresso into the machines back then.  No push button lattes!

My first year of income led to a nice refund at tax time.  I didn’t know anything about withholding rates.  Someone told me just put 1 on the W9 and you’re good to go.

And I got a bigger and bigger tax refund each year.  It was great!  I thought the government was so nice.

But after learning about the tax code, I realized I was just giving up my present income so the government could have some more money during the year.  I was giving them an interest free loan of a few thousand dollars every single year!

Now, I try to get my refund as close to zero as possible.  At the same time, I accordingly increase my savings and debt payoff contributions.  I’d rather have that money work for me throughout the year.

That being said, if you do receive a refund, you have to do something with the money.

Interesting Ways to Spend Your Refund

Here are 4 very interesting (and slightly questionable) ways to spend your tax refund:

1.  Buy an Apple Watch Space Black Stainless Steel Case with Space Black Link Bracelet.  Why spend hundreds of dollars on a run of the mill Apple Watch that tells the time and answers your phone?  Spend a thousand and now you can do the same with a space black link bracelet. ($1,099)

2.  Reserve the Tesla Model 3.  There is no car more coveted than the Tesla.  The Model 3 is a relatively affordable $35,000.  Put down the $1,000 reservation fee and figure out how to pay for it later when it arrives in 2018.

3.  Stay a few nights at a Trump Hotel.  Stay 3 nights at the Trump Hotel in Central Park.  Your friends will be so jealous.  It is the greatest, I mean absolutely the greatest most incredible hotel out there. ($1,500)

4.  Buy 50 shares of SNAP.  SNAP is the ticker symbol for Snap Inc. (very creative).  Snap is the parent company of Snapchat, which specializes in providing fun filters for our pictures.  It recently became a publicly traded company and is trading at $19.54 a share as of March 17, 2017.  Buy 50 shares and snap a picture of the confirmation email.  ($977)

While those are four pretty interesting ways to spend your tax refund, let me propose an alternative.  How about spend your tax refund on things that let interest work for you?  This will make your money go the extra mile.

Interest-ing Ways to Spend Your Refund

1.  Pay off your credit card debt.  The best thing to do when it comes to credit card debt is to avoid it.  The next best thing to do is to pay it off ASAP.  Credit cards charge extremely high interest rates.  The national average hovers around 15%, which is absurdly high.

This means that unless your investments are rocking and rolling and you’re getting a consistent 20%+ return year after year (which is nigh impossible), you need to get rid of that consumer debt FAST.  This will free up cash flow faster and save you a lot of money on interest payments.

2.  Increase your 401k contribution.  I like this suggestion.  I’m glad I thought of it.  The reason I like it is because it’s the most hands off and effective way to spend your refund.  If you already contribute to your 401k, just sign in to your account and increase your contribution percentage by a point or 2.  You will not miss the money trust me.

Once the tax refund hits your checking account, do nothing!  It’s as easy as that.  Your increased contribution rate will take that extra money throughout the year and get it invested.  You will save money on taxes and increase your retirement savings in one fell swoop.

3.  Fund a Roth IRA.  If you have maxed out your 401k, the next thing to focus on is your Roth IRA.  Combined with a pre tax 401k, the Roth IRA will allow you to withdraw money tax free, providing tax diversification for the future.  Because Donald Trump is the president so who knows what the future will bring?

The max contribution to a Roth IRA is $5,500 per year.  A tax refund of a thousand or so will get you almost 20% of the way there.  If you wish to max it out, you can set up automatic contributions for the rest of the year to get you there.

Another reason I like (love?) Roth IRA’s is that you can withdraw any contributions you’ve made to the account without penalty, as long as you’ve had the account for 5 years.  So it can serve as a quasi emergency fund if needed.

4.  Make an extra student loan or mortgage payment.  Depending on which of these debts has a higher interest rate, you can add rocket fuel to the payoff time with a nice lump sum payment.  Both of these debts can potentially give you some tax savings, so they’re not the WORST type of debt to have (see #1).

But debt is debt, and it should be paid off as soon as possible.  Just make sure to let your lender know that you want the payment to be applied to your principal amount ONLY.  Many lenders will pull a dirty trick of having it applied to interest first, which does nothing for you but everything for them.  Which is why it’s better to be debt free than continuing to do business with greedy banks!

Spend Your Refund Wisely

You can certainly spend your refund on the things on the first list.  It would make for a nice story and talking point.  But with all material things, the glamour fades very quickly.  And you’re right back to where you started financially.

Spend your refund on the second list, however, and you will provide a nice boost towards financial freedom.  In the end, that is truly what we’re all looking for.  Once you reach there, you can spend all the nights you wish at Trump Tower.

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3 Things New Professionals Need to Know About Taxes

My note:  The following is a gracious guest post from Kathryn, who has an excellent blog called Making Your Money Matter.  If you want a complete financial lesson on any and every financial topic from an actual financial professional, head on over to her website.  Honestly, this is the type of information that I’ve seen only available in paid courses, but you can get everything on her site free and clear.

Without further ado, here is a fantastic post by Kathryn talking about some essential tax tips for professionals.

Kathryn Hanna is a CPA and specialized in business and personal taxes when she worked in public accounting.  She currently stays home with her 3 children and blogs at www.makingyourmoneymatter.com to help people improve their understanding of personal finance and thereby improve their lives.  She loves all things money and especially spreadsheets.

If the only sure things in life are death and taxes, I’m sure we can all concur that it’s more fun to talk about taxes than death.  The basic formula for taxes is really quite simple, it’s just the fact that there are so many exceptions and rules that make it incredibly complicated.  Fortunately, you don’t have to know all the rules, just the ones that you need for your own personal taxes!

There are 3 things that I believe will be most beneficial for every new (or even not so new!) professional to know related to taxes.  These are things that will help you reduce taxes and build as much wealth as possible.

1. TAXES MAY BE YOUR SINGLE LARGEST EXPENSE

Once you’ve gotten used to the huge chunk of money being taken out of your paycheck for taxes, you might just ignore taxes altogether (at least until April each year!).  However, FICA, federal and state taxes alone will likely be upwards of 15-20% of your pay.  I calculated my total taxes as a percentage of my income for 2016 and found that over 25% of my income goes toward various types of taxes.  This is my largest expense, exceeding my total housing expenses including utilities!  Likely, taxes just might be your largest expense as well!

While I acknowledge the importance of tax funds to keep our country running, I’m all about minimizing my taxes to not have to pay more than my legal share.  By learning more about how taxes impact various decisions, you can minimize your taxes and keep more of your money in your pocket.

The first step is to get a really good understanding of your current tax situation.  Go through your most recent tax return and make sure you understand, line by line, each and every income, deduction, credit, and tax calculation.  If you have any new financial situation come up, research and make sure you understand the tax consequences.

2.  ALL INCOME IS NOT CREATED EQUAL FOR TAX PURPOSES

As a new grad, you were probably super excited about having any sort of income.  A paycheck large enough to cover eating out instead of sitting at home with Ramen noodles or a tuna sandwich is life-changing.  Earning income is great!

However, that salary you are getting is the nearly the most expensive type of income there is.  First, you’ll be paying Social Security and Medicare taxes on it at a rate of 7.65%.  Then, you’ll need to pay federal income taxes on your salary likely in the range of at least 10-15% if you’re a single person just starting out.  Also, your state will want their cut of taxes, which will add another few percent (the tax rate is 4.25% in my home state of Michigan).  That’s a lot of your hard-earned money going to taxes.

The only income that is even more expensive to you than employment income is self-employment income due to having to pay twice the Social Security and Medicare taxes.  However, being self-employed can increase your income at much higher levels than working for someone else, so I’m definitely not discouraging it!

Most types of income are taxed at ordinary tax rates for federal and state purposes but are not subject to FICA taxes.  Examples of these types of income include:

  • interest income
  • short-term capital gains on investment assets held for less than a year
  • rental property income
  • retirement distributions (someday!)

There are also types of income that are not subject to FICA taxes and are also taxed at lower tax rates.  These types of income are actually taxed at a 0% rate for those in the 10-15% tax bracket (single filers up to $37,950 adjusted gross income for 2017).  Then they are taxed at only 15% for most people.  These types of income include:

  • qualified dividends
  • long-term capital gains on investment assets held for at least a year

There are even income streams that are not taxable at all for federal income tax purposes:

  • interest from municipal bonds (although this may be taxable in some states)
  • gifts, bequests, and inheritances

The moral of the story here is to increase your other income streams in addition to increasing your salary.  Taxes make a significant difference in the amount of your income that you actually keep, so increasing your portfolio income will help you get ahead in the long run.  In addition, saving money in retirement accounts will help you to defer your tax on that income for 30+ years or more.  It will make a huge difference in helping those funds grow more quickly for your future retirement.

3.  HOW TO CALCULATE YOUR MARGINAL TAX RATE

Another vital piece of knowledge is understanding your marginal tax rate.  Your marginal tax rate is the percentage of tax you will pay on your next dollar of earned income.  This is not to be confused with your effective tax rate, which is determined by dividing your total federal tax liability by your total income.

The main reason that there is often a large difference in the marginal versus effective tax rate is because the U.S. has a progressive tax system.  A progressive tax system is where the tax rates increase with higher income levels.  Those with high income are still taxed on the lower rates for the lower portion of their income.  This is shown in the tax rate brackets shown in the example below.

In addition, the difference in effective and marginal rates may also be due to a substantial amount of non-taxable income items or tax deductions and credits that decrease income.

An explanation of marginal and effective tax rates is best explained through a simple example.  Assume the following information for 2016:

  • Your annual salary is $55,000
  • You contribute $5,000 to a traditional 401(k) account
  • You have paid $1,000 in student loan interest
  • The standard deduction is $6,300
  • The personal exemption amount is $4,050

This quick tax summary shows your tax liability of $5,435 for 2016:

The effective rate you are paying on your taxes is only 9.9%, which is calculated as $5,435 in total tax divided by $55,000 gross income.

However, your marginal tax rate is 25%.  Your next dollar of income will actually be taxed at a 25% rate, assuming it doesn’t give rise to additional deductions (for example, if you contribute this “extra” money to retirement accounts, it will not be taxed currently).  The marginal tax rate is determined by looking at the highest tax bracket, as determined by your taxable income.

Looking at the tax rate table below, you can see that with a taxable income of $38,650, this would put you in the $37,650-$91,150 bracket, which is taxed at a rate of 25%.

Looking at the tax table, you can also see that you can earn an additional $52,500 in income before increasing your marginal tax rate to 28% ($91,150 less $38,650).

Understanding your marginal tax rate will give you a realistic view of how much that raise or bonus is actually going to be on a cash basis for you.  It also will hopefully encourage you to contribute more to retirement accounts as your marginal tax rate goes up and those tax deductions become worth even more.

FINAL THOUGHTS

Understanding income taxes is key to building your wealth through the years.  Because of the progressive tax structure in the Unites States, it is even more important to understand your taxes as your income grows throughout the years and the value of your tax deductions increases.

Start now by looking at your current tax situation, making a plan to increase your passive income streams and determining your marginal tax rate.  Future you will thank you!

This information is meant for educational purposes and does not represent individual tax advice.  If you have questions about your personal tax situation, it is highly recommended to meet with a tax advisor or attorney.

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Investing Lessons Learned from Fantasy Football

 

football-stock

Fantasy football is one of the most polarizing things on Earth.  One on end you have people who are deeply embedded in the culture.  They have been playing in multiple leagues for years and have parties commemorating the start and end of the seasons.  It’s a way of life.

On the other end, you have those who think that those who participate in fantasy football are delusional and wish they were real athletes.  I’m somewhere in the middle, as I like playing but don’t do it with a lot of fanfare.  And I do wish I was a real athlete.

For those readers who are uninitiated in the ways of fantasy football, it is a game for football enthusiasts in which you select a team from the pool of current NFL players.  Based on how well the players do throughout the season, the team with the most points at the end of the season is the winner.  You have to keep track of player performance, injuries and other  league events to make sure you are fielding the best team possible.

This is usually played online nowadays and some league winners get cash prizes while others just get bragging rights.  It’s all in good fun, but there are some hurt egos along the way.

I bring this up because football season has just started, and I have noticed a bunch of similarities between fantasy football and investing.  In essence, they are very similar because you have to actively track how your players (investments) are performing and make adjustments along the way to win the league (reach your investment goals).

Here are some other startling similarities between fantasy football and investing:

Past Performance Does Not Predict Future Results

This is an SEC mandated statement that all mutual fund companies must put in their ads.  It’s a warning to investors that just because a company has done well in the past, it does not mean they will do well in the future.  If investors actually heeded this advice instead of listening to the latest stock tip, then we would have a lot more wealthy people in this country.

After looking at the top fantasy players from year to year, I realized fantasy football leagues should also mandate this statement.  Besides the many off the field issues that can affect a players performance (such as injuries, suspension, personal problems etc), even the top players in the league can have unpredictable results.

If a player has a tougher than normal schedule for the year or just a handful of poor performances, it can affect their results for the entire season.  Just picking the best performing players from the previous year is not a terrible strategy, but it probably won’t get you very far.  Many of those players may not do well this year and you will miss out on those players that have drastically improved their play.

Lesson Learned:  Don’t pick investments based on how they performed last year.  And don’t pick players thinking they will replicate their production from last year.  Look at the whole picture.

Everyone Has an Opinion

I enjoy watching Sportscenter and listening to NFL podcasts, so I hear lots of different views about who the best players are.  Everyone has an opinion on who they feel will be “dud” or “stud” in fantasy football.  And if you listen to more than one person, you will probably get more than one answer.

All sports writers and pontificators believe they “know” who will play great and who won’t.  But as history shows, no one really knows.  If they do get it right, it’s mainly because of the broken clock theory.  Even a clock that doesn’t work is right twice a day.

Sure, there are players like Tom Brady, Antonio Brown and my man Odell Beckham who will likely light up the scoreboard year after year.  But it’s extremely difficult to spot those players that come out of nowhere or to guess who will have a big drop off this season.

It’s difficult, but people will still try to guess.  And the same goes for investing.

Watch MSNBC or any other financial reality show for long enough and you will think the entire stock market is going through the roof.  Or that you should stockpile gold bars since the world is coming to an end.  Or that the latest election will produce disastrous results in the market.  Depends on what will drive ratings that day.

There will be so many passionate opinions that the average person won’t know what to think.  Mutual fund managers will urge you to sign up for their funds, but that may or may not be the right strategy for you.

Do your own research depending on your risk tolerance and investing timeline.  There is no one size fits all answer and that applies to fantasy football and investing.

Lesson Learned:  Tune out the noise.  Everyone thinks they found the winners but most of the time your guess is just as good as theirs.

Don’t Follow the Herd

Every fantasy league has “that guy” who is always wheeling and dealing.  His transaction history is super long and he’s always looking to trade away his players.  He loves being plugged into the latest news and is scouring the waiver wire to find the next big thing.

“That guy” usually doesn’t win the league.  More than likely the owner who picks solid and dependable players who perform consistently will win the league.  There is definitely a little luck involved to do well in fantasy football.  But picking solid players on great teams and staying the course is usually the way to go.

You will have the random backup wide receiver who has a great game and then is picked up that same hour.  He will be the “hot” player that everyone is clamoring after.  But then he might not do much the rest of the season.  All the while you’re consistent player will be racking up points riding the bench.

This lemming mentality plays itself out in the investing world as well.  As soon as some type of international incident happens, the knee jerk reaction is to sell sell sell!  So many people sell that the market takes a sharp dip, and this causes even more people to panic and sell.

Nothing good can come from following the investing herd.  Nearly all hugely successful investors got their money by not following the herd at the right time.  As Warren Buffet (one of those hugely successful investors) says, “Be fearful when others are greedy and greedy when others are fearful.”

Lesson learned:  Don’t pick up a player just because everyone is talking about him.  And don’t invest in a stock just because it is the latest “hot” pick.  Do your research.  There’s a reason the herd doesn’t get great returns.

I love football and I love investing, so I’m probably going to find similarities between them.  But the similarities between fantasy football and investing are so clear.  Now someone should do a study comparing fantasy football performance with investment returns!

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Dancing is Not a Good Investment Strategy

If your investment strategy was a dancer

Investing is a patient man’s game.  This applies to almost any type of investing including real estate and stocks.  In general, if you’re investing for the long term (more than 10 years), the best strategy is to have a great plan and stick to it.

Unfortunately, many impatient men (and women) are investors.  This means many plans never make it past the first big market drop.  That’s usually when panic sets in and investors do something short sighted.

A 2015 study proves exactly this.  The study shows that we are our own worst enemy when it comes to investing.  And no other reason even comes close.

Let me set the stage by showing you the study results and what we can learn from them.

People are Not Good at Investing

I recently wrote why many investors are their own worst enemy when it comes to their investment performance.  While the subject of this post is similar, after reading the results of the aforementioned study I felt a separate post was needed.

The study was conducted in 2015, and at the time the S&P 500 Index had a 30-year annualized gain of 10.53%.  That means that every year for the last 30 years, the S&P gained an average of 10.53% per year.  Some years were way more and some years were way less (think 2008).  But on average, a nice 10% return every year.

What this means is that an investor who simply held an S&P 500 index fund for the last 30 years should have returned 10.53% minus fees.  Let us say this investor had some crazy fees which brought the return down to 8%.  Paying high fees is annoying, but 8% is still not a bad overall return.

According to the study, the average investor didn’t do this well.  In fact, they did a lot worse.  The study found that the average investor returned 1.65%!

1.65%!!!???  They might as well have put all that money into an online savings account and saved themselves the stress of investing.

This means that the average investor is probably not using index funds.  And if they are, they are using the wrong ones or are just going in and out of investments way too much.  I think the latter is the culprit for most investors.

Dancing In and Out of Investments

“Since the basic game is so favorable, Charlie and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of “experts,” or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.” -Warren Buffet in his 2012 letter to Berkshire Hathaway shareholders

(The basic game is investing and Charlie refers to Charlie Munger, Buffet’s partner at BH.)

As Mr Buffett explains in this quote, “dancing” in and out of investments is very risky.  I firmly believe this is why the average investor does not even come close to the returns of the S&P 500.

But why does going in and out of investments produce such poor returns?  Shouldn’t we always be looking to get out of our investments when things get bad and find some better places to put our money?

The answer is yes, we should be looking for better places to invest.  But the best place to invest is usually in an index fund that follows the overall market.  And it’s almost impossible to find another group of investments that does better than the overall market on a consistent basis.

And by dancing in and out of investments, most people are actually buying high and selling low.  We should always try to buy low and sell high!  People usually panic and sell investments when things get bad (sell low), and then they try to buy into investments that everybody is saying is “safe” (buy high).

A great example is the recent Brexit vote that will lead to the UK withdrawing from the European Union.  It was expected that the stock market would fall after the vote was yes, and it did just that.  The day after the vote was final, the S&P 500 dropped 66 points, which was about a 3% loss.  Not a huge drop, but pretty decent.

But if you turned on any form of financial news, you would think the Four Horsemen were arriving.  Predictions that the international markets will be in turmoil for years was the theme of the day.  The S&P actually did fall about 1% more the next day, which lead to more doom and gloom.

But about 10 days after the Brexit vote, the S&P 500 was right back to where it was before.  And as of now, 2 months after the vote, the S&P 500 is about 3% higher than it was pre-Brexit!

The Big Takeaway

What this all means is that if you were one of those investors who panicked and sold some stocks after Brexit and then bought more stocks when the market rebounded, you were dancing in and out of the market which means you were selling high and buying low.

And this is why the average investor averages returns a little over 1%.  As the study showed, just owning an S&P 500 index fund for the last 30 years and not doing anything with it would get you a 10% return.

The best course of action for investors who don’t want to make stock picking their full time job is to formulate an index fund strategy that is appropriate to your investing timeline.  Pick the funds.  Rebalance the funds every year so they don’t get too out of wack.  And then leave it alone.

You will be a better investor than the majority of America.

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Why Retirement Calculators are Dumb

I don't think Walter White needs 85% of his pre-retirement income.

I don’t think Walter White needs 85% of his pre-retirement income.

When I graduated from optometry school waaaaaaayyy back in 2009, I started to finally make some real honest to goodness money.  I figured I should learn more about this finance thing and proceeded to read almost every personal finance book at the library.

I started to follow awesome blogs like Ramit Sethi’s and Mr Money Mustache.  Being a personal finance novice, I eagerly soaked up whatever information I could.  This led me to be on both sides of the argument on many different issues.

Debt is evil!  But some debt is okay.  Increasing your income is the way to wealth!  But so is being frugal.  While some of my stances on different issues are pretty solid at this point, I’m always learning new things that affect one opinion or another.

But one thing I’ve never liked throughout my financial journey are retirement calculators.  You know, those websites where you input 5 different pieces of information and you’ll find out how much you’ll have during retirement.

I’m not sure why I’ve never liked them initially.  Maybe because retirement was so far away.  Or the fact that I thought I was done with calculators once I got out of school.  But after reading more and more on personal finance, I’ve realized that retirement calculators are downright dangerous.  That’s because they assume you will participate in lifestyle inflation!

Mo’ Money= Mo’ Problems?

I’ve talked about the dangers of lifestyle inflation a number of times on here.  Pretty much it’s when you start spending more once you start making more.  It is the killer of dreams and it’s what keeps most Americans in debt regardless what income class they are in.  Almost everyone would agree it is a bad thing.

But not retirement calculators.  I was fiddling around with my company’s 401k retirement calculator, and at my current contribution rate (maxing it out!) it said I’m on track to have a great retirement by age 60.  Great news.

Then I started playing around with some numbers.  What if I changed my contribution rate?  What if my salary changed?  I found that if I doubled my salary and kept the same contribution rate, my retirement was in danger.  What in the hell?  If I make double the money I will be worse off during retirement?

In what universe does that make sense?  In the sick universe of retirement calculators, that’s where!

The problem lies in a ridiculous “rule of thumb” that keeps popping up:

“You will need 70-85% of your pre-retirement income during retirement.”

This is not an official rule (hence rule of thumb), but it is adopted by most calculators.  The retirement calculator on CNN.com says this:  “We then assume you can live comfortably off of 85% of your pre-retirement income. So if you earn $100,000 the year you retire, we estimate you will need $85,000 during the first year of retirement.”

According to the same calculator if you work hard and end up making $200,000 per year, saving $85,000 for retirement will magically not cut it anymore.  That’s because they assume the extra money you make will be going towards new expenses and not towards things that can actually produce more wealth.

This assumption shows a lot about the mentality in this country as well as the retirement industry.  While it’s good to be conservative and assume you will need more money during retirement, assuming that your expenses during retirement will increase in step with your pre-retirement income makes no sense.

Conclusion

Maybe this is not a big deal.  Maybe I just got offended because a calculator told me my retirement was in danger since I’m making more money than I was before.  It does make sense to be conservative when it comes to retirement.

But what doesn’t make sense is that this rule of thumb is like gospel throughout the retirement industry.  What financial advisors and retirement specialists should be saying is that when you make more income, don’t increase your expenses!

There are so many financially positive ways you can apply your extra income.  You can pay off debt, increase your emergency fund, invest it into equities or real estate or use it to help out a family member or charity.

The idea that you will need more money during retirement just because you are making more before retirement is preposterous.  Studies show most retirees become naturally conservative compared to their working years.  And it’s also important to remember that during retirement you won’t be saving for retirement anymore!  So a huge expense is already gone.

Lifestyle inflation is what keeps most middle and upper class people in the paycheck to paycheck cycle.  It’s a type of hedonistic adaptation that is dangerous because it can keep you from fulfilling your dreams and spending time with the people that matter.  Don’t let a retirement calculator tell you otherwise!

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I Would Love to do Peer to Peer Lending but…

check-cashing

Our state is too good for P2P lending, but not too good for establishments like this.

Update:  As of February 2016, Lending Club is now open to Maryland residents!  Click here for the details.    I will be doing some heavy research into this before I take the plunge, so look for an update on my journey into P2P lending.  Edit:  Still no Prosper though 🙁  

I’ve been hearing a lot about Peer to Peer Lending (also known as P2P lending).  It’s one of those topics I just kind of glossed over since I had more “pressing” things to learn about like student loans, investing and trying to freelance.  Before last week I had a rough idea of how it worked.  Many people were reportedly getting great returns, but it seemed like a lot more work than I would have liked.  It seemed complex and then some bloggers reported that they were still getting good returns, but not as high as before.  I didn’t think it was worth my time.

But last week I heard an interview on the Stacking Benjamins podcast (which is a great podcast by the way).  The interview was with Simon Cunningham, who runs a website called Lendingmemo.  His interview pretty put P2P lending in a much clearer light for me and I was itching to learn more.  I went over to LendingMemo and got some great information.  Here are what I believe to be the pros of P2P lending:

  • You’re loaning capital to actual people, and not a big corporation.  The vast majority of borrowers on P2P sites are looking for help paying off credit card debt.  I could definitely get behind that.
  • It’s relatively low risk.  The two big P2P sites are Lending Club and Prosper, and they each have their own algorithms they use to determine the risk that a borrower will default on their loan.  According to LendingMemo, the default rate for Lending Club is around 5%, which was a lot lower than I expected.  Higher risk borrowers give investors the potential for higher returns, while low risk borrowers give less a return but a good chance that you will get a return at all.  It’s like a balancing act between risk and reward, which is what investing generally is.
  • Returns are solid.  According to Lending Club, historical returns of their lowest risk loans range from 4.91%-8.38%.  That’s a very good return for what seems like a low risk investment.  And it certainly beats the pants off of an online savings account or CD.  While past returns don’t reflect future performance, it’s good to keep them in mind.
  • It seems like fun.  My preferred method of long term investing, making regular contributions to index funds, is pretty boring.  The only thing I may have to do is rebalance, which takes just a few minutes.  Otherwise, it’s set it and forget it.  With P2P lending there are a few more decisions you have to make, and while they do have an automatic contribution system to make things super easy, you still have to check on your loans from time to time.  This seems like it would be be a fun mental exercise.

I say it SEEMS like fun, because I will not be able to see if it is really fun.  Here’s the notice I received when I tried to sign up for an account at Lending Club:

lending club deniedYes, because I live in the state of Maryland, I can’t participate in direct P2P lending as a borrower or as an investor.  As a medical professional, I’m used to the zany differences from one state to another, but this was just a little annoying.  Some states allow you to use Lending Club only.  Some states allow Prosper only.  There are only 3 states that don’t allow any type of P2P activity (Kansas, Ohio and Maryland), and I happen to live in one of them.  This would firmly fall into the category of a first world problem, but it’s still a problem.  (Here is an interactive map that diagrams all the craziness between states).

So what is an aspiring P2P’er from Maryland to do?  My plan is to do some more research on P2P lending until I know it front to back.  In the meantime I’m still working on getting rid of a 6% student loan, so paying that off would be a pretty good use of my money.  And then I’ll just wait until the curmudgeons in charge of Maryland join the P2P bandwagon.

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