The Amateur Financier

(Warning: The following blog entry discusses illegal actions and other unethical deeds.   I do not recommend doing anything described in the following entry; it’s simply a discussion of some of my moral views.  Your views may vary, and if so, please let me know what you think.)

One game I’ve always thought looked interesting was Scruples.  The point of the game is to discuss how you would react to a variety of ethical dilemmas.  One of the more interesting example questions listed on the official site asked how you would react to your spouse day trading, if doing so was profitable but caused your spouse to be stressed.  Ignoring the obvious objections many of my readers will raise to the whole idea of day trading, the underlying question is interesting: would you want your spouse to sacrifice his/her mental well being in return for money?

These sorts of moral questions got me thinking: what wouldn’t I do for money?  What is so beyond my ethical standards that no amount of money would convince me to do it?  It’s an interesting thought; you can gain a lot of insight into yourself and your ethics by considering what you will and won’t do for money.  So, what have I come up with?

Things I WILL NOT do for any amount of money:

• Murder: Killing someone in cold blood for money is the top of my list of things I will not do.  While I might conceivably kill in self defense or to protect my family, killing someone for money is definitely beyond my ability.  And not just because I’m a horrible thought; I can’t abide the thought of taking someone else’s life, particularly for money.
• Maiming: In the same vein, I can’t picture myself doing serious, permanent damage to anyone.  Torturing someone is (mostly) out.  I might be willing to cause someone pain under the right circumstances, if I felt that the good that could be done exceeded the harm.  There is one exception, of course…
• Harming a Child: I can’t hurt kids.  That, more than even these previous points, is a guiding principle in my life; until someone becomes a teenager, there’s no amount of money you can pay me to do any harm to them.

Things I Would Consider, In the Right Circumstances:

• Kidnapping: This one is pretty questionable; I’d only seriously consider kidnapping if I were doing something like reuniting a parent with her offspring.  Of course, the number of circumstances where this is actually the case is probably pretty small, and verifying the parent’s story would take time and effort on its own.
• Theft: This is easier; given a substantial reward and something to take from a rich enough target, I have no moral qualms with theft.  That said, I doubt my skills in this area would impress anyone.
• Blackmail: Here, I’m torn; if it’s something illegal, I would lean towards turning the blackmailed person in to the authorities.  If it’s simply immoral, I’d consider blackmailing someone.

That’s probably enough for now.  Of course, all this is off the cuff speculation; if I actually had the skills and techniques to do any of these things and faced the opportunity, my decisions would likely be much different.  That leads into a bit of catch-22: the only way I could get the skills would be to do these actions, but the only way I would do anything on these lists is if I were offered quite a bit of money from an outside source.  So, the chance of me becoming an expert cat burgular or superb blackmailer is rather slim.  (Hear that, FBI?  You’ve got nothing to worry about from me.)

That brings us to the $64,000 dollar question: what would you be willing to do for money?  What are you unwilling to do?  What circumstances would make you reconsider your opposition?  It’s an interesting question to ponder, and I’d like to hear what you think.

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Well, once again I’ve made the trek across the great state of Pennsylvania, this time for family reasons rather than work.  Yes, my godfather (the kindly, gift giving kind, not the running our family’s highly illegal crime syndicate kind) was born on August 1st, so I came back in order to more easily attend the party this Saturday.  It’s always good to help celebrate with your family, although these cross state trips are really starting to wear on me.

Still, it promises to be a fun time, and I do like my family for the most part.  Plus, it should be good practice for when I bring my fiancée out to visit; always good to get a refresher on the eccentricities of my family members before I subject her allow her to meet the crazies interesting people in my family.

Unfortunately, all the travel and time spent with my fiancée has left me with less time than usual for catching up on my blog reading.  Thank goodness for RSS Owl; otherwise I’d completely lose track of all the blogs I try to follow.  I’ve managed to catch some of the best posts each week using the feeds there.  Some of what I’ve found useful this past week includes:

What If There Was No Tomorrow? – Sometimes, you forget that on the other side of the computer screen, there are actual people who have lives outside of this computer screen.  It usually takes some big event to remind us that our fellow bloggers are mortal; earlier this week, Lazy Man of Lazy Man and Money had a near death experience.  He nearly choked to death and thus had an epiphany about his life and how quickly it can end (as people tend to do in these situations.  Thankfully, he seems alright, and will be imparting some of the lessons he learned soon.

Chart Early Retirement – A good post from Luke Grand, writer of the new blog Cash Out Life, which focuses on preparing for an early retirement.  In this post, he suggests plotting your expenses, earned income, and passive income over the course of several months.  That way, you can see whether you are earning more than you spend and gauge when your passive income will become high enough to exceed your expenses.  It’s a pretty good exercise, one that can help you see where you finances currently stand.

What to Bring to College-College Survival Skills – Studenomics takes a new twist on the list of things to bring to college, collecting a list of four different skill sets you’ll need to survive college life.  I agree with all of them (particularly cooking and cleaning, an area in which college students tend to skimp) and would add good study habits, as well.

Save Money By Becoming An Organized Packer – Given how much I’ve had to carry from one side of Pennsylvania to the other in the past few weeks, any thoughts on how to be more efficient are welcome.  Luckily, on My Life ROI there are a fewer thoughts on how to make your travel a bit easier.  I’m especially fond of the reminder to Ziploc bag anything that might spill; after a bad situation with a left over milkshake on this last trip, I can definitely tell you it is no fun trying to clean up after a spill.

(Image taken from the Skate Ranch of Raleigh website)

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If you regularly add money to a 401(k), IRA, or bank account with the goal of withdrawing that money in the future, you need to able to calculate how much your money will be worth at the time of withdraw.  If you made a single, one time contribution, it’s easy enough to calculate the future value by using the appropriate future value calculations.  But what if you are adding money  to the account; how can you determine how much your money will be worth when it is time to withdraw?

If you wanted, you could take each contribution and use the future value calculation to determine how much it will be worth when it is your time to use the money.  However, that would be incredibly tricky to do, as well as requiring more time to do then we really want to expend (even setting up a spreadsheet could take hours).  Luckily, there are ways to simplify the math; one (relatively) simple equation that allows us to combine all the future value calculations into one:

AV = C * [({1+i}^n - 1)/i]

Where AV is accumulated value, C is the contributions, i is the interest rate, and n is the number of periods (usually years, if i is expressed as annual interest).  Crunch the numbers and you can determine how your contributions will add up over time.  Of course, even with this formula, there’s still a lot of number crunching that you might need to do in order to calculate the future value.  If you don’t want to go to all that trouble, I made up a shortcut table to make things easier on you:

This table shows the growth of annual contributions at fixed interest rates.  Take the number of years you want to stay invested, go down to the expected interest rate, and you’ll have the multiplier you need.  For a retirement in forty years and a 10% growth rate, for example, you have a growth factor of 442.6; if you invest $5000 a year, you’ll end up with $2.2 million when you retire.

Putting it all together

How can we use this equation to help plan our retirement goals?  Well, let’s consider someone who is thirty years old, makes $50,000 a year, and has no debt or retirement savings yet.  She decides that she wants to retire with $50,000 a year during retirement (adjusted for inflation) and hopes to retire in thirty years.  She wants to invest fairly agressively for twenty years (at about 10% return) and then dial back her risk for the ten years before retirement (so she’ll only earn 7% return).  She figures she can easily invest $5000 a year without decreasing her standard of living.  How can she determine if she’ll meet her goals?

First, if she uses a safe withdraw rate of 4% of her final portfolio, she should have twenty-five times her desired annual income in her nest egg when she retires, a total of $1.25 million.  Of course, given inflation, the actual amount needed will be much higher; we can use the future value calculation to determine how much money we’ll need in thirty years to be the equivalent of 1.25 million.  We can’t know for certain how much inflation we’ll experience during this time period, so we’ll choose a reasonable but high value (like 5%) to stay conservative:

Future Value = Present Value * (1 + inflation rate)^number of years = $1.25 million*(1+0.05)^30 = $5.4 million

So, we figure on a total of $5.4 million for our example woman to retire.  Quite an obstacle, but we have the power of compound interest on our side.  If look at our table, we see that the intersection of twenty years and 10% interest gives us a factor of 57.3.  With our given contributions of $5000, at the end of the first stage of her investment plan, she’ll have:

Accumulated Value = Contribution * Our Regular Contribution Factor = $5000 * 57.3 = $286,500

Not a bad start, but she needs more than that if she hopes to meet her goals.  For the second part of her retirement plan, she’ll need to calculate her added contributions separately from the money she’s already accumulated.  For the $286,500 she already has saved, the future value calculation at seven percent interest for ten years yields:

FV= PV*(1+i)^n = $286,500*(1+0.07)^10 = $563,600

And her new contributions, $5000 a year for ten years at 7% yield (for a factor of 13.8):

AV = C*Accumulation Factor (AF) = $5000*13.8 = $69,000

For a total of $632,600, well below the $5.4 million she needs to meet her goals.  Now, she could try to run the calculations again, changing some of the assumptions that she made the first time around, with the hopes that by shifting things around a bit, she can increase her nest egg and decrease how much she’ll need.  If she feels she can get by on only 80% of her salary, she can cut the amount she needs to $1 million in present value.  Further, if she assumes that inflation is only at the average rate (about 3%)between now and when she retires, the amount of her desired nest egg will decrease (although, if she is incorrect in her estimates, she can find herself short when retiring).  By delaying her retirement for ten years, she can give herself more time to build up her funds; she can also give her money more time to compound by investing aggressively for thirty years and conservatively for ten.  Finally, if she stretches her budget and invests $10,000 per year, she can increase the power of compounding that will work for her.

Her new desired nest egg:

FV = PV*(1+i)^n = $1 million * (1 + 0.035)^40 = $3.26 million

How her contributions grow over the first thirty years (on our table, thirty years and 10% returns lead to a factor of 164.5):

AV = C*AF = $10,000 * 164.5 = $1.65 million

For the last ten years, this amount of money will grow as follows:

FV = PV*(1+i)^n = $1.65 million*(1+0.07)^10 = $3.25 million

Along with her continued contributions (ten years at seven percent interest gives a factor of 13.8):

AV = C*factor = $10,000*13.8 = $138,000

For a grand total of $3.39 million, more than she estimates she needs (which somewhat makes up for the less strict numbers she used in her initial calculations).  This example shows not only how to run these calculations, but also how a few changes can shift the amount of money you expect to have at retirement significantly.

So, now that you know how to calculate the future value of your regular contributions, how many of you still feel your retirement plans are on track to meet your needs?

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(Tuesday is one of my favorite days of the week, or at least it has become so, because each Tuesday I get to write another Investing 101 post.  As we cover more and more possible investments, I’m starting to get a bit more esoteric with the chosen investment options.  Here, we’re going to look at municipal bonds, commonly known as munis.)

Q: What are munis?

A: Munis, or municipal bonds, are bonds issued by cities or states.  As with any bond, it’s a promise that the invested money will be returned along with an agreed upon interest payment.  Like Treasuries issued by the federal government, munis are a way for cities, counties and states to fund current expenditures by taking on debt and paying it back in the future.

Q: Why invest in munis as opposed to Treasuries, then?

A: Munis have one feature that makes them very attractive, particularly to high income investors: many are federal tax free.  In order to encourage investors to buy munis and help fund state and local projects and programs, the federal government has exempted some munis from federal taxation; all the profit you make from muni interest payments can not be touched by the IRS.  Furthermore, many states exempt munis issued within the state from the state income taxes as well, meaning that the interest from your muni could be free from state taxes as well.

Q: Wow, that’s great; but what’s the catch?

A: The ‘catch’ is that munis have lower yields than corresponding corporate bonds.  Thus, you might be better off financially by taking a higher yield corporate bond and using the profits to pay the needed taxes rather than going with the muni.  In general, if you are in a high tax bracket, muni bonds will be the best option for you; if you are in a low tax bracket, then taxable bonds will be better.

Q: That’s sort of vague; are there any firmer rules I could follow?

A: There’s a simple calculation you can use to make a decision between munis and taxable bonds into an apples-to-apples comparison.  If you take the yield of a municipal bond and divide by 1 minus your tax bracket (in decimal form), you’ll come up with number that you can compare directly to a taxable bond yield in order to choose the best investment for you.  For example, if you are in the 25% tax bracket and can invest in a municipal bond that yields 4%, the calculation would look like this:

(Muni Yield)/(1-Tax Bracket) = 4%/(1-0.25) = 4%/0.75 = 5.33%

Assuming you can find a corporate bond with a yield at or above 5.33%, that would be the smarter investment (assuming both the corporate bond and muni have the same rating and default risk, of course).  If not, the tax exempt nature of the muni will more than compensate for the lower yield, allowing you to come out ahead financially.  (All this assumes that you are investing in a taxable account; if you are investing in a tax-deferred or after tax account (such as a retirement or educational savings account), then the tax advantage of munis disappears and you can just compare the offered interest rates.  Of course, for straight interest rates, corporate bonds usually come out ahead.)

Q: Is there an easier way to invest in munis?

A: Just like with any type of bond, there are mutual funds that invest in purely in municipal bonds.  If you want the tax advantages offered by munis without the hassle of purchasing individual bonds (as well as diversification without having to buy dozens of different bonds), a muni bond fund could be the answer.  Of course, the unlike individual bonds, the yields on muni funds aren’t fixed, which could make it harder to determine whether the muni fund is a better value for your investment dollar.

If you do opt for a muni fund, you can find both general muni funds as well as state specific muni funds.  If you are looking at a mutual fund company such as Vanguard, you can find these funds by looking for the ‘tax-exempt’ title in the fund name or category.  You can find their long-term muni fund or if you are a fellow Pennsylvania resident, you could opt for the Pennsylvania muni fund and save even more in taxes, for example.

Q: Finally, how should I invest in munis or muni funds?

A: Basically, if you are looking to add some bond exposure to your taxable holdings, you can consider using munis for your bond allocation (assuming your tax bracket is high enough to make the lower but tax free return for munis to be worthwhile).  This is one way to manage your taxes and limit how much you will owe.  (Again, if you are investing in a tax advantaged account, munis will do you no good; a tax-free investment in a tax free account serves no purpose).  As with any bond investments, you want to increase your exposure as you get older, stabilizing your portfolio.  How much to hold at each age will depend on your risk tolerance as well as your plans for the future.

That’s about it for municipal bond investments; hopefully, you now have a better idea of just how ‘munis’ can fit into your investment goals and future plans.

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