Save and Conquer

Our work pays $200 every year per employee to be used toward a health club membership. The nice thing about this stipend is that it does not need to be used for a health club. It may be used to pay for anything that promotes health. This year, my wife bought a new bicycle. Her old bike was a beater that she rode during college many years ago. The total cost was $379. With $200 paid by our company, the cost to us was only $179. That is a sweet price for a new Specialized Crossroads Sport bicycle.

Our company also annually pays up to $2000 tuition and fees for advanced learning that is applicable to our field. Seminar costs are typically paid up front. University costs are reimbursed after receiving a satisfactory grade.

You may be leaving free money on the table if you don’t read your company’s HR plan to see if you qualify for any of these types of additional benefits.

I can understand emergencies causing a short term monetary loss for people, but what is it that causes a majority of Americans to spend more than they earn? The average savings rate is at its lowest levels since the Great Depression. According to the Bureau of Economic Analysis, which is part of the U.S. Commerce Department, the personal saving rate was 0.2 percent in the fourth quarter of 2007. Their January 2008 report goes on to say, “Saving from current income may be near zero or negative when outlays are financed by borrowing (including borrowing financed through credit cards or home equity loans), by selling investments or other assets, or by using savings from previous periods.”

Why are people spending more than they make? Is it bad bookkeeping? Is it trying to keep up with the Joneses? Is it that the American marketing machine is too good?

The most likely reason for negative savings is that people thought they could continue to use the rising value of their assets, rather than work and save, to pay for the things they wanted. The last two economic bubbles, internet and then housing, were the main contributers. People forgot that the economy is cyclic. Rapid asset growth is always followed by a drop back to the mean. The average annual growth in realty value over the last century is somewhere around 3-4%. From 2002 to 2005, the growth rate of realty was around 15% and over 35% in some areas. This now has to go negative to get back to the mean of 4%. People who took equity out of their houses with second mortgages and HELOCs are now in debt for more than their houses are worth. They typically spent the money on expensive home remodels or cars or vacations. If they spent it on the house in the form of a remodel, they may get a large portion back as long as they can afford to stay in the house long enough. If they spent it on vacations, that money is gone.

Unfortunately, now that the bubble has burst, the people who took on too much debt and are now negative savers are affecting everyone else. While they were spending, they drove the economy. Silly elected officials, who typically are not good money managers, made spending estimates based on the strength of the economy. Now that the spending has dried up, the Federal Government is using everyone’s tax dollars to try to buoy the economy. Smaller governments, such as state and city, are having to cut back on various programs.

Kristin at the Financial Engineer has written a series on behavioral finance. It is definitely worth a read.

Debt is not a bad thing when it is used within limits that are affordable. It can be used to fuel growth if the proceeds are used to start a business or to purchase appreciating assets. Unaffordable debt, or negative savings, invariably lead to the circumstances we are in now.

I have been lurking on the Vanguard Diehards’ (also known as Bogleheads) message board for some time. Their premise is that you can’t beat the market, so index funds with the lowest expenses are the only way to go. I agree with low expense index investing, but I am not sure that you can’t beat the market. Paying attention to current market conditions can help you stay out of troubled sectors as well as preserve capital.

Sometimes being contrarian can work in your favor. That is, buy when everyone is saying “sell” and sell when everyone is shouting “buy.” Currently, though, some contrarians are saying that since everyone is scared of the financials, now is a great time to buy. Contrarians should not ignore good judgement, however. You have to weigh future earnings against the current price to see if a fallen investment has value. In the case of financials, the majority of bad loans have still to be realized. This is going to further drop earnings. I will not buy financials until many many more bad loans have been counted.

I think John Bogle has a lot of great things to say about retirement savings and financial companies. But as with any sort of investing, it pays to do your homework. Don’t just blindly invest in anything you don’t understand.

I still have not bought any of the ETFs in the HMETF. I may not buy equal weightings of them when I do. With the billions of defaults still to be realized in financials. it would not be smart to purchase much of IYG now. S&P makes the following recommendations for the 10 sectors of the S&P500. (Remember that the HMETF condenses technology and telecommunications into one ETF: XLK.)

I will probably use equal weightings for all sectors other than the financials. I will hold the portion that I would allocate to buy that sector in cash for at least another three months. After hearing Ben Bernanke this past week, I expect the market will climb in expectation of further rate cuts. However, even though many people are thinking the financials may be good buys at the current low prices, I am skeptical.

According to answers.com, optimization is “the procedure or procedures used to make a system or design as effective or functional as possible.” There are several ways to optimize your investment allocation.

One way is to lower your tax liability on investment earnings. The way to do that is to use tax-sheltered accounts, such as an IRA or 401k to invest in things that have lots of distributions. A classic example is a REIT fund. Even in today’s bad housing market, REITs may be decent investments with high dividend yield on commercial properties. However, since REITs do not qualify for the 15% dividend tax rate, you would have to pay tax at your nominal income tax rate for any REIT dividends each year. The key to smart investing is to hold them in a tax-sheltered account where you won’t pay taxes until you withdraw your money. (You may not have to pay any taxes if they are held in a Roth.)

Another way to optimize your allocation is to invest based on your time frame. If you do not need your money for more than 10-15 years put the majority into diversified stock holdings, such as the HMETF, and re-balance once a year. As you get closer to retirement, you need to move a larger percentage to lower-risk holdings, such as inflation-protected bonds and stocks that pay a high yield. There are many web sites that give stock-bond allocations based on time to retirement. AARP has a good discussion of this on their web site. In fact, they have a wealth of investing information here.

The final way to optimize is to trade less. Even though I talk about different strategies and various allocations on this site, I do not trade often. The best way to trade is to mechanically re-balance your holdings once a year. There are times when you might go against this rule, such as the capital preservation move to half cash that I did in late December. But typically, you should have diversified holdings that you rarely trade.

I am still leery of buying into this market with the current job loss and credit worries looming over it, but I have just run some numbers further comparing the HMETF to the S&P500 (SPY) index ETF. The following table compares the annual returns from 2001 through 2007.

Annual comparison of SPY and HMETF starting with $10,000 at the beginning of 2001:

While the SPY returned a paltry 3.2% annually compounded increase over those eight years, the HMETF returned a 10.3% annual increase. Not bad, considering it includes the 2001 recession.

Granted, this is not a very long sample. Most of the ETFs in the HMETF were started in the 1990’s so I may be able to extend the comparison a bit further.

I have been using Taxactonline.com for several years now to prepare our federal and state income taxes. I am not affiliated with them in any way, but I wholeheartedly recommend their service. There are several other online tax preparation sites that I have heard good things about as well.

Taxact’s interface is very similar to Turbotax. You can go through a question-and-answer session about your income and expenses and your tax forms are automatically filled in. You can access tax forms directly, as well.

There are some complaints on consumeraffairs.com about them, but the complaints all have to do with being charged for e-filing, rather than getting free tax preparation. The only free e-filing service I have found is on the IRS web site. You can only use this service if your adjusted gross income is less than $57,000.

You can get free printouts of your federal tax forms that you can then send in by mail from most of the online preparation sites, but you will have to pay for e-filing as well as for state form preparation and e-filing.

Some people prefer using software on their computer, such as Turbotax, for their tax preparation. I have found that to be a more expensive option than preparing taxes online. The IRS web site has links to quite a few “approved” online tax sites.

If you can use the “EZ” forms, I would advise you to skip the online preparation and just go to the Post Office to get both Fed and State forms for free.

As I previously wrote, the market has been very volatile this past month. It fell more than 10% until the Fed cut the funds rate by 1.25% within a little more than a week. This was an unprecedented total cut. And it sure surprised me.

I expected that when the Fed discovered they had cut too far when they dropped both the funds rate and the discount rate each by 0.75% on Jan 22, that they would not continue with their expected cut of an additional 0.50% on Jan 30th. But lo and behold, they did cut again. This may lead to dire problems such as those experienced by Japan in the 1990’s, as outlined by Jim Jubak, but who am I to go against the Fed.

If the market looks as promising next week (and that’s a big “if” based on the recently released January job-loss reports), I will buy back in with around two thirds of my available cash. I plan to buy ETFs that make up the Homemade ETF (HMETF). This consists of equal value purchases of basic materials (XLB), consumer goods (XLP), consumer services (XLY), financials (IYG), health care (XLV), industrials (DIA), oil and gas (XLE), technology and telecommunications (XLK), and utilities (XLU).

This HMETF gives great diversity and has been shown to outperform the SP500 in each of the past 7 years. This Homemade Mutual Fund has had the following percent greater annual returns compared to SPY: 2001 (+18%); 2002 (+12%;) 2003 (+1%); 2004 (+6%); 2005 (+4%) ; 2006 (+0.3%); 2007 (+4%).

I normally don’t like to move so quickly in and out of the market, but like the saying goes, “Don’t fight the Fed.”