Tag: personal finance

Since I wrote the initial set of posts, quite a few people have asked me about good credit cards. So, I decided to write one about the same.

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(Since my previous posts, quite a few people asked me a basic plan which can be followed, here it is)

The items are ordered from first thing to be done to the last thing which can be done (assuming money is still left).

1. Emergency savings
   Put 6 months worth of expenses in a Series I-Bonds (sold by treasurydirect.gov) – they try to match inflation rates (but nothing more than that) and can be sold after holding them for at least a year. The idea behind this is to minimize downsides in case of a major market crash. Also, I-Bonds are not counted towards state taxes and a max of 10, 000$ can be purchased in a single year (per SSN).
   Another simpler approach is to put money in high yield savings account like Barclays Savings or American Express Savings, of course, there is no rate guarantee and rate do fluctuate (usually go down) over time.
2. Max out pre-tax 401K
   Assuming there is an employer match or if the person can convert it into Roth IRA.
   Otherwise, don’t do it.
3. Backdoor Roth IRA
   Invest 5, 500 $ in traditional IRA, hold that for a few weeks and then convert it into Roth IRA and let the money grow tax-free.
4. REITs and Preferred’s
   Investing in dividend paying (or “fixed income” as they are called) equities is not the optimal strategy for someone who is working full time but I think its psychologically beneficial to get regular dividends especially when market tanks down.
   An approach for that is to first figure out the amount of monthly dividend one wants to receive and then invest accordingly. For example, to get 100$ pre-tax a month in dividends from saying HSBC preferred shares (HCS) which has an 8% annual yield, the total investment has to be 15, 000 $.
   A caveat here, dividends coming from preferred are qualified and taxed at a lower rate while dividends from REITs are not, they are considered a regular income. The trick is to hold REIT in Roth IRA account where the income becomes tax-free.
5. Municipal Bonds
   (Disclaimer: I have not tried these)
   Municipal bonds are usually issued for long-term (30 years) and the dividends they pay are tax-free (no state or federal taxes) provided the person is resident of that state. Rich people love these especially because the dividends are tax-free and there is no risk (except for municipality filing bankruptcy) if they are held till maturity.
   If they are not held till maturity there is in interest rate risk where bonds can go down in value if the interest rate goes up. So, the current market value of the bond will go down and vice-versa.
   In the current scenario (2013), interest rates are low enough that they can only go up, so, investing in these does not make sense unless the person is planning to hold them till maturity.
6. Three-fund portfolio
   Rest of the money should go into a three fund portfolio (discussed earlier).

(Based on what I have seen financial savvy people doing and makes sense to me. Disclaimer: These are my opinions.)

1. Should a person contribute to pre-tax 401K?
   Only if the company has a matching policy, else wise, its money trapped till the person reaches retirement age.
2. Should a person contribute to post-tax 401K?
   Only if the company has a matching policy, else wise, its money trapped till the person reaches retirement age.
3. What about pre-tax 401K vs post-tax 401K?
   Post-tax  401K is better than pre-tax only if
   1. The person decides to immediately convert to Roth IRA (since in Roth earnings will be tax-free while in post-tax, they are tax-deferred, this depends on whether the employee permits it or not.
   2. If the employer does not permit Roth conversion but still the person is either on a really low tax rate for that year (eg. not working for a full year or had added dependents to the family etc.) or expects the future tax rates to be much higher.
4. What about traditional IRA?
   Same as pre-tax 401K, contributions are tax-deductible (if the income is below certain limits which are relatively low), earnings are tax-deferred either ways.
   The only case where this makes sense is to contribute and then immediately convert to Roth IRA where earnings will grow tax-free.  This technique is popular enough to acquire a name of its own “Backdoor Roth IRA“.
5. What about Indexed Universal Life Insurance?
   The solution of guaranteed no-money-loss in a single year sounds really promising but its stupid to be told that I have to pay interest to borrow my own money and will be charged a premium for someone else to make money off of the money, not to ignore the fact that this insurers itself can be at the brink of bankruptcy.
6. What about tax efficiency?
   Long-term stock gains and qualified dividends receive favorable tax treatment, that is, lower tax rates.
   Bonds, interest from bonds, short-term stocks, interest from bank accounts(yeah that pesky tenth of a penny) are treated as regular income, so, these things should be better held in either tax-deferred account or tax-free (retirement) accounts.
   International stocks should be held in taxable (normal) account since they are taxed by foreign countries and one can receive a foreign tax credit by holding them in a taxable account. All other stocks should be held first in taxable and then left over in tax-free and then tax-deferred account.
   Do note that stocks held in a taxable account will be taxed at a lower rate than in tax-deferred account where they are taxed as normal income upon retirement.
   More details on Bogleheads.
7. What about tax loss harvesting?
   Complicated topic, I will write a blog post some other day.
8. What would be a basic allocation?
   Go for Bogleheads three fund portfolio.
   Invest in three things
   1. Total US stock market (VTI or VTSAX)
   2. Total world stock market excluding US (VEU or VXUS or VFWIX)
   3. Total bond market (BND) ~ %age allocation should be almost the person’s age (conservative rule – reduce this %age to be more aggressive)
      Split between (1) and (2) should be roughly 80:20 or 70:30.
9. What about rebalancing?
   As the person invests more, s/he should put more money in a manner to ensure that the above allocation ratio is maintained.
10. Should the person go all in or slowly move money into the market (Dollar cost averaging)?
    Dollar cost averaging outperformsone-timee all-in in only 33% of cases (Vanguard study) but I think it makes one feel psychologically safer, IMHO, first timers should go for DCA.
11. What about exotic stuff like commodities, precious metals and rare earth metals?
    The only time people think about buying these is when everyone else is talking about them, these have already peaked in prices and its an even worse time to buy them – paraphrased from The only investment guide you will ever need.
    
12. What about P2P lending?
    Income  from P2P lending is considered regular income and losses are not tax-deductible, therefore, from a financial perspective, it makes sense to invest only via Roth IRA. Apart from that, I believe its too much hassle in terms of time (see my previous post on Peer to Peer lending).

Books

1. One up on Wall Street by Peter Lynch – a good book on stock picking
2. A random walk down the wall street by Burton Malkiel – a good book on why not to pick stocks
3. The only investment guide you will ever need by Andrew Tobias – a hilarious summary of investing/saving and many other random money related topics
4. The retirement miracle – For people who believe in indexed universal life insurance plans (I don’t)
5. Where are customer’s yachts – hilarious read on wall street trader who profit on the expense of customers (won’t help in investing though).

Blogs

1. fairmark.com – There only guides are thorough and amazing but requires some effort to grasp (only recommended for advanced and the curious)
2. bogleheads – Interesting forum of people who believes in Jack Bogle’s philosophy of index investing (Jack Bogle is founder of Vanguard), definitely read three-fund portfolio
3.  Twenty Common Sense Investing rules
4. 401(k) Guide

Good portfolio checker sites

1. sigfig.com
2. personalcapital.com
3. futureadvisor.com
4. feex.com

A year back I decided to try peer to peer(P2P) lending (out of curiosity) will a small sum of money.
My net conclusion is that peer to peer lending is not a sensible form of investing.
My money is still stuck (and that’s not the only reason why I would recommend people to stay away from it).

How it works

A lender with say 1000$ will go to a site like lendingclub.com or prosper.com and will loan money directly to people in units of say, 25$ notes. The loan (with interest)  will be paid back in fixed period of time (36 or 60 months).

Reasons why I dislike P2P lending

1. Income counted as regular income
   The income counts as ordinary income and is treated at marginal income tax rates which is usually much higher rate then long terms capital gains and dividends. Not to ignore that if a person is living in high tax state like California, the state tax applies as well. So, the after tax rate of P2P lending is approx. 20% lower than equities.
   Note: This does not apply if you are using Roth IRA account for investment.
2. Tax inefficient
   The lender will get a fixed amount of money every month (except for defaulted loans) unlike capital gains, there is no way to keep it unrealized and timing it (Eg. postponing gains for a year). Even worse sometimes the creditors will pay back well in advance.
   Note: This does not apply if you are using Roth IRA account for investment.
3. Too much of work
   Unless the lender is ready to put in a minimum sum (~25, 000 $), the task cannot be automated.
   In my opinion, investing one’s savings in chunks of 25$ units is not the best investment of one’s time.
   Also, from time to time some creditors will pay back earlier forcing lender to spend time reinvesting that money.
4. No liquidity
   While equities and bonds can be sold at will (Eg. in case of a better opportunity or emergency), that’s not the case with P2P lending. The notes can be sold though (through trading platform provided by P2P sites), but only at a loss.
   
5. Money is not always invested
   While one can buy equities/bonds anytime in open market, P2P lending will not begin till the funding is finished. Eg. As a lender, you saw someone requesting a loan of 10, 000$ and decided to buy notes worth 1000$, but the rest of 9000$ did not arrive for next one week then the investing period won’t begin till then (even worse, all the loan requests have deadline and if requests is not 100% fulfilled then the loan will not be granted and you will get the money back after one week of lock-in and no gains). Therefore, the net annualized returns are misleading.

The bottom line is simple: If you want to try out P2P lending for fun then go ahead and try with small amount of money. Serious investors should probably stay away from it.