money and investing 101

Money and Investing 101

Eric Krock

Legal Disclaimer Eric Krock does not have any financial expertise, certifications, or qualifications. He does not guarantee the accuracy, currency, or completeness of this presentation or make any warranty, express or implied, or assume any legal liability or responsibility for the accuracy, completeness, or usefulness of any information or its suitability for any purpose whatsoever. This presentation is provided as-is for informational purposes only, is general in nature, is not intended to be a substitute for qualified financial, tax, or legal advice. Use is at your own risk. In no event shall Eric Krock be liable for any direct, indirect, special, punitive, incidental or consequential damage or any other damages whatsoever arising out of or in connection with the use or misuse of this presentation. For investment and retirement advice that's right for you, see a certified financial planner! For tax advice that’s right for you, see an accountant! For legal advice that’s right for you, see an attorney!

Disclaimers

•  I’m not a certified anything. •  All investments have risks. •  Past performance does not guarantee

future results. •  No investment strategy is optimal in all

situations. •  I am not responsible for your choices or

their consequences. You are.

Disclaimers

•  I’m not an accountant and can’t give you tax advice. Get an accountant for tax advice that’s right for you.

•  I’m not a financial or retirement advisor. •  This is for informational purposes only. •  It simply expresses some of my personal

beliefs about money management and investing.

What are your financial goals?

•  Pay down existing debt? •  Build up liquid assets? (cash, stocks) •  Cushion against job loss? •  Tithe? •  Cushion against disability/early death? •  Buy a home? •  Have children & put through college? •  Save for retirement?

The Problem: Uncertainty

•  Economy could tank and you could lose job for long time

•  Harder to get new jobs due to high unemployment

•  Stock market may drop •  Inflation may rise •  Home values may drop •  You could develop a short- or long-term health

problem (stroke, cancer …) that interrupts or reduces earning power

Real Problem: We Can’t Predict the Future

•  Can’t predict your personal future (heart attack? stroke? cancer? Alzheimer’s?)

•  Can’t predict the global future (debt crisis? inflation? low growth? bird flu epidemic?)

•  But you can try to prepare so you’re better able to handle various possible scenarios

•  Learn to invest and manage risk

Things We CAN Guarantee

•  Social Security and Medicare are running out of money. Current tax rates can’t pay for projected benefits.

•  Therefore they HAVE TO change. •  Taxes will go up and/or retirement age

will increase and/or eligibility will be narrowed and/or benefits will be cut.

Things We CAN Guarantee

•  Social Security alone provides for a low standard of living in retirement and no cushion for emergencies.

•  The older you get, the more likely you are to need medical care.

•  Lesson: Don’t rely on Social Security alone for your retirement income, and don’t rely on Medicare alone to cover retirement health care expenses.

Things We CAN Guarantee

•  U.S. can’t keep running deficits of $1.4 trillion per year indefinitely. (Debt as percentage of GDP is rising quickly.)

•  Therefore taxes will go up and/or spending will be cut.

Things We CAN Guarantee

•  Federal Reserve can’t lower interest rates below 0%.

•  Therefore if something else bad happens, they can’t stimulate the economy more this way than they are already. No more bullets on this front.

Things We CAN Guarantee: Current Fed Policies are Unsustainable

•  0% interest rate can’t last forever, so someday mortgage rates will go up. (Good time to borrow at fixed rate?)

•  “Quantitative Easing” can’t go on forever. (Good time to borrow at fixed rate?)

… yet the Economy Is STILL Weak!

•  GDP growth slowing •  Job creation slowing •  Unemployment ticking up •  Businesses sitting on cash, afraid to

invest or hire because of uncertainty about economic future & fiscal/tax policy

•  Consumers afraid to spend because of uncertainty about jobs and income

•  Huge backlog of foreclosed homes

Likely Things: When Stimulus Ends, Economy Will Get Weaker Still

•  Raising federal reserve interest rate will slow home construction & purchases

•  Ending quantitative easing will increase interest rates as well

•  Cutting deficit will cut some jobs and may reduce GDP growth in short term (but will help in longer term by stimulating real investment and economic activity)

Possible Thing: Home Values Could Drop Another 20% … or Not!

•  This could be a good time to buy a house due to foreclosures holding down prices and record-low interest rates.

•  But, if economy softens, home values may drop more in the short term.

•  Lessons: If you buy, do so for the long term. Be willing to stay for a long time. Have a big cash cushion so you aren’t forced to sell if you lose your job.

Likely Things

•  Health care costs will continue to rise as new, more-expensive treatments are invented.

•  Medicare benefits for the elderly will be reduced (e.g. later eligibility age, higher copays and premiums, etc.)

•  Lesson: Don’t rely on Medicare alone to pay for retirement health expenses.

Risk of Future Shocks

•  European debt crisis flaring up again? •  China bubble bursting? •  Possible “Black Swan” problem:

emerging virus outbreak like SARS or bird flu?

Risk of Future Malaise

•  Slow growth in U.S. due to pain of resolving unsustainable tax, spending, and interest rate positions and impact of high debt if deficit not slashed ASAP

•  Slow growth in Europe due to debt problem, aging population, high taxes and unemployment

•  Slow growth in Japan due to 200% debt to GDP ratio, aging & shrinking population, energy shortage, cost of Fukushima cleanup

Bright Spots

•  High organic growth rates will probably continue in: –  India (rebound from decades of socialist

economic controls) –  emerging markets entering world economy

(Brazil, etc.) –  China (more socialist rebound, modulo

bubbles bursting along the way due to speculation, lack of transparency, and corruption)

Mistake #1: Spending > Income

•  You can spend more than you earn in the short run if you have savings or can take out loans

•  You cannot spend more than you earn in the long run

•  Always seek to spend less than you earn and invest the remainder

•  Corollaries: maximize your income; cut your expenses

Mistake #2: Needless Spending

•  Rolex watch •  Expensive car (new cars are a terrible

investment; guaranteed to lose half of value in two years; expensive cars lose you more money than cheap ones)

•  Expensive clothes, shoes, jewelry •  Usually reflects compensation for

unresolved psychological issues

Mistake #3: Gambling Addiction, Drinking Excessively, Using Drugs

•  Gambling addiction, alcoholism, and drug use are some of the most damaging mistakes you can make.

•  They lead to disastrous problems in other areas (lost job, divorce, lost home, DUI, arrest, prison, homelessness)

•  Get help NOW if you have these problems.

Mistake #4: Letting Health Slip

•  Would you smoke? Of course not. •  But not exercising is more harmful to

your health than smoking. •  Would you not exercise? 60% don’t. •  Exercise regularly. •  Start easy and work up. Vigorous

walking is good start. •  Keep Body Mass Index 25 or less. •  Belly fat is LETHAL.

Liquid & Illiquid Assets

•  Liquid & low risk: you can quickly and easily turn into cash when you need to –  checking & savings accounts, money

market, short-term CDs •  Liquid but volatile: stocks

–  what if market’s down and you have to sell? •  May be able to borrow from: permanent life

insurance cash value, current employer 401(k), home equity loan

•  Illiquid: home, real estate

Mistake: Ignoring Automatic Payments

•  Studies show that when people sign up for automatic payments (e.g. subscriptions), they stop noticing the expense.

•  Do you really want everything you’re paying for?

•  Lesson: Audit your automatic credit card payments and bank transfers.

How Large a “Rainy Day Fund?”

•  Old rule: have at least six months of income in liquid assets at all times

•  Eric’s new rule: have at least 12 months of income in liquid assets at all times

•  Unemployment more likely than in past •  Unemployment is longer than in past due

to high unemployment rate, low economic growth, low job creation

Debt Can Be a Tool If Used Wisely

•  Enable you to borrow a large amount of money when needed at one point in time and then pay it back over a long time

•  Examples: buy a house, student loans

Good Debt

•  Low interest rate •  Fixed interest rate; won’t go up if inflation

rises •  Pays for things that will increase your

earning power (education) or may increase in value (home)

•  Examples: federally guaranteed student loans; 30-year fixed home mortgage

Bad Debt

•  High interest rate •  Interest rate may go up in some

situations out of your control, e.g. if inflation goes up or your credit rating goes down

•  Examples: credit card debt, payday loans

Buying a Home

•  Tax benefits (deduct mortgage interest from taxes … for now, anyway …)

•  Capital gains if home values increase (lower tax rate than ordinary income)

•  Risks of no money down •  Problem of real estate volatility

Buying a Home (continued)

•  Home is a highly illiquid investment! •  Home is an investment that only makes

sense at certain points in your life (stability, stay in place, etc.).

•  Old rule of thumb: if you can afford to hold for five years, you won’t lose money

•  Eric’s new rule: 7-9 years? Not sure. •  If have to move, you can rent, but now

you’ve made yourself a landlord …

Investing in Stocks

•  Over the long term, equities (stocks) provide the best chance of growth and the best protection against inflation.

If the Market is Rational, Picking Stocks is Futile

•  “Efficient Market Theory:” everyone has perfect access to information and is rational maximizer, so current stock price incorporates all information about stock, so there’s a 50% chance stock will rise and 50% chance stock will drop.

•  If you believe this, invest in low-overhead indexed diversified Exchange Traded Funds (ETFs) for the long term.

What If the Market’s Not Rational?

•  NASDAQ high technology bubble •  Real estate bubble •  Prices of B of A, Citibank, AIG, financial

services index, BP during oil spill …

NASDAQ 1971 - 2011

Source: Yahoo! Finance

U.S. Housing Prices

Source: jparsons.net

U.S. Housing Prices vs. Rents

Source: jparsons.net

Gold Price: 1975 - present

Source: kitco.com

Beijing Residential Real Estate Price Index: 2003 – 2010: Up 788% in 8 Years!

Source: http://www.businessinsider.com/chinese-land-prices-2010-7, citing Jing Wu, Joseph Gyouko and Yongheng Deng at NBER

Lessons About Bubbles

•  Before capital flowed freely, bubbles were limited to within a country or region, so their height & duration were limited.

•  Because capital now flows freely, bubbles can draw money in from worldwide, so they can ramp faster, go higher, and last longer (and crash faster).

Panics

Source: Yahoo! Finance

Citibank price September 2008 – September 2009

Panics

Source: Yahoo! Finance

BP price December 2009 – July 2011

Dollar Cost Averaging

•  Timing the market is difficult for anyone, especially amateurs.

•  If you invest the same amount every month, you’ll buy more stock when the market dips and less when it rises, automatically giving you an edge.

Eric’s Rules on Stock Picking

•  It’s hard to beat the market. 75% of professional mutual fund managers who try to do so fail! (with your money!)

•  Warren Buffett has historically beat the market. Is your name Warren Buffett?

•  Picking and tracking stocks takes time. Do you have the time & interest? If you’re too busy, don’t try.

Eric’s Rule: Don’t Gamble More Than You Can Afford to Lose

•  Picking stocks is gambling. •  Rule: If you pick stocks, only do with a

small portion of your portfolio that you can afford to lose.

•  Rule: Core of your portfolio should be diversified, indexed, low-overhead ETFs.

Classic Investing Mistakes

•  Holding losers too long •  Failing to diversify out of winners (Enron) •  Buying at the top of the market in

euphoria (Dow at 14,000) •  Selling at bottom of the market in panic

(Dow at 6600) •  Lesson: Buying and holding indexed

ETFs long-term via dollar-cost averaging reduces these problems.

Classic Investing Mistakes

•  Excessive concentration of your portfolio in a small number of stocks.

•  Eric’s Rule: If you want to turn a big fortune into a small one, just concentrate it in a small number of investments!

Start Saving Early

Source: https://personal.vanguard.com/us/insights/saving-investing/power-of-compounding

(assumes 7% return per year reinvested)

Source: http://www.sharebuilder401k.com/power-of-compounding.aspx

(assumes 8% return per year reinvested)

Automate Your Saving

•  Studies show that when you have money taken out of your paycheck automatically, you learn to live without it and don’t miss it.

•  Rule: Set up automatic deductions and learn to live below your means!

Max Out Your 401(k) or IRA Each Year If You Can Afford To

•  Reduces your current taxes (you pay no tax now on the money you put in Traditional 401(k) or IRA)

•  Dividends & capital gains compound tax free in the account over time

•  You only pay income tax when you withdraw at the end (Traditional 401(k) or IRA)

•  If you pass on to heirs, it is never taxed

Choose Funds With Low Fees

•  Fees that funds charge you are a pure loss. You can’t even add fees to the cost basis for the stock you bought, so they don’t reduce your capital gains!

•  If a fund charges you 2% in fees per year, it turns a 5% annual return into a 3% annual return.

Buy ETFs with Low Fees, Not Mutual Funds (at least for tax-exposed funds)

•  Mutual Funds: pay out capital gains distribution each year, which you must pay taxes on each year, reducing your ability to invest

•  ETFs: like a stock; you only pay taxes when you sell (defers taxes)

•  Vanguard specializes in low-overhead indexed ETFs

Tax Rules of Thumb

•  Never risk the wrath of the IRS. •  Legally deferring taxes is good. (IRA,

401(k), ETF instead of mutual fund) •  Legally deferring taxes until after your

death (when they may pass on tax-free to heirs in your estate) is better.

•  Legally avoiding taxes completely is best. (permanent life insurance & Roth IRA/401(k) compounding gains)

Two Types of Funds

•  “Actively Managed Funds:” people who think they’re smart, try to beat the market, fail 75% of the time, lose money on trading costs, and charge high fees that reduce your income even more

•  “Passively Managed Index Funds:” simply distribute your funds into an index like the S&P 500 and leave it there

Use Passively-Managed “Indexed” Funds, Not Actively-Managed Funds

•  75% of actively-managed mutual funds do worse than the stock market average (index) every year.

•  So by choosing an indexed fund, you automatically get a fund in the top 25% of the performers.

•  You also reduce the risk of catastrophic losses due to asset concentration and bad management choices.

Use Passively-Managed “Indexed” Funds, Not Actively-Managed Funds

•  Passively-Managed funds don’t waste money on costs of active trading (so your gain is higher)

•  Passively-Managed funds can charge lower fees for their service (so your gain is higher)

Benefits of Diversification

•  Reduce concentration and risk of catastrophic loss (e.g. Enron shareholders)

•  Portfolios with domestic + international outperform domestic only.

•  Portfolios with 2/3 equities + 1/3 fixed income (bonds, etc.) outperform equities only.

Diversify

•  Asset Category (Stocks, Real Estate, Bonds)

•  Geography (U.S., Europe, Asia, Emerging Markets)

•  Asset Class (Small Cap, Mid Cap, Large Cap)

Assume Reasonable Rates of Return

•  Studies show that people overestimate the annual return their stocks will get (e.g. 10% per year)

•  Long-term historical average of U.S. stock market: 5-7% / year

Things I Don’t Know About

•  Pensions (I’ll never have one) •  Real Estate (so I own a home) •  Fixed Income Investing (so I have

permanent life insurance) •  Commodities (so I don’t invest in them)

Problems with Real Estate as an Investment

•  Property taxes and insurance every year •  What if you don’t get tenants? •  What if you do and they’re from hell? •  Requires active management and time if

you own and manage the property yourself.

•  Illiquid •  You must know what you’re doing

Eric’s Rules

•  Never invest with a friend. •  Avoid dual relationships. (family and

business, loaning to business partner) •  No “get rich quick.” •  No hiding money overseas from the

government. •  No speculative real estate investment. •  No commodities.

Eric’s Rules to Avoid Looking Like an Idiot

•  Warren Buffett: Never invest in something you don’t understand.

•  No oil and gas •  No hedge funds •  No real estate (except house; maybe

REITs someday …)

Eric’s Rules to Avoid Wasting Money

•  Avoid overpriced financial managers •  Avoid anything with high expenses •  Avoid anything with up-front fees (“front-

end load”)

Eric’s Rules to Avoid Catastrophic Losses

•  Never invest in anything that sounds too good to be true (“high returns, no risk!”)

•  Avoid complicated or exotic investments •  Never make an investment where you

can lose more money than you put in –  selling stocks short –  unlimited liability partnerships

Eric’s Rules to Avoid Catastrophic Losses (cont’d)

•  Never co-sign a loan with anyone for any reason. If they can’t get a loan themselves, there’s a good reason!!! –  Refer them to a financial advisor. –  Don’t be an enabler. –  Don’t make their problem your problem. –  Read Boundaries by Cloud & Townsend.

Eric’s Rules for Taxes

•  Have an independent CPA prepare your taxes for you. S/he will save you time, money, frustration, examinations, audits, and penalties.

•  Never risk the wrath of the IRS. –  Never do anything fancy! –  When in doubt, overestimate your tax

liability.

A Diversified Portfolio

•  Own home as real estate investment & for tax benefits

•  Traditional & Roth IRA •  ETFs for tax-exposed investing •  Stocks diversified by geography, asset class •  Money in the bank for short-term needs •  Permanent life insurance to cover risk of death,

diversify into bonds, tax benefit •  Disability and (maybe) long-term care insurance

for risk coverage

Don’t Be Overwhelmed

•  You can’t transform your financial situation overnight

•  You can’t completely guard against all risks

•  But you can make your situation a little better each month and year

•  Ten years later, you’ll be much better off •  Start changing things for the better now!

Action Items

•  Check your 401(k) & IRA investments •  Pay down credit card debt •  Optimize your investment allocation •  Get life insurance

Future Discussions

•  Retirement 101 •  Insurance 101 •  Real Estate 101 (guest speaker!) •  Company Stock 101

For Further Reading

•  The Black Swan by Nicholas Nassim Taleb

•  100 Questions Every First-Time Home Buyer Should Ask

•  Boundaries by Cloud & Townsend •  Subscribe to Wall Street Journal,

Fortune, and Forbes

For more information: http://www.vanguard.com/ http://www.nmfn.com/ Company names used for identifying purposes only. Neither Vanguard nor Northwestern Mutual nor Aflac nor any other company has seen or endorsed this presentation.