The Amateur Financier

I know you’ve probably tried to put it out of your mind, but tax season is just about on us.  Yes, you don’t HAVE to file until April 15th, but why put it off until the last minute?  (Besides tradition, of course.)  Most of your tax documents should have been sent to you by January 31st, or more likely nowadays, are available online when you check your investments or savings.

Even though we’re just getting into the 2010 tax season, it’s not too early to get ready for 2011’s taxes.  In fact, now is probably the best time to begin your preparation for next year; changes you make now to the amount of withholding you ask your employer to take out of your paycheck will have a great effect on how much you owe next year.  But the question is, should you aim to make your refund as small as possible (thus getting more money with each pay check) or try for the largest refund possible (cutting down your take home pay throughout the year in order to do so)?

The amount of money you get back depends on you

The most common advice I’ve heard is try to minimize your potential refund.  It makes sense; after all, every dollar you get in your refund is a dollar that you (over)paid in taxes initially.  On the other hand, as Green Panda Treehouse and the Financial Samurai note, there are advantages to getting a sizable refund, as well.  Let’s look at both sides of this issue:

Small Refund Pros

-More Money Throughout the Year: The biggest advantage of aiming for a small refund (by putting as many allowances as possible on your W-4) is that you’ll get more money with each paycheck (as less will be withheld for taxes).  This means more for spending, more for investing, more for saving.  If you aren’t giving the money to the government, that means more for you in each paycheck.  Speaking of the government…

-No Interest-Free Loan to the Government: Whether you want to avoid giving the government more money than needed or just want to do your part to keep the national budget under control, minimizing how much you have taken by the government can be a goal in itself.  A small refund is proof that you succeeded in that goal.

-No Temptation to Treat the Refund like ‘Found Money’: Every year around this time, you start to see advertisements for companies offering sales, specials, and other inducements for people to spend their tax refunds.  You even hear about ‘refund anticipation’ loans where companies will offer to let you buy things with the money you’ll get from the government, before you even file your taxes.  This trend of treating a tax refund like money from heaven (rather than a refund of your own money to you) is one reason to consider increasing your allowances and minimizing your refund.

The Advantages of a Large Refund

-Lump Sums are Easier to Utilize: If you have financial goals you’re working to meet, a lump sum is easier to put to work for you.  If you want to build an emergency fund (always a good idea), it’s simple to take a $1200 refund and say, ‘Well, that’s a pretty decent bare bones fund’.  If you got that same $1200 throughout the year (in the form of slightly larger paychecks), you would need the discipline to put it away a little bit at a time, $25 or so every two weeks.  Many people just don’t have that discipline.

-Less Temptation to Spend Throughout the Year: Here’s a simple fact: if you don’t have money, you can’t spend it.  (Well, you can if you use credit cards and carry a balance, but none of my readers would do anything that foolish, right?)  If you are getting less money in each paycheck because you are paying more in taxes, there will be that much less available for you to spend, (hopefully) helping you to rein in your finances.  (This is also a major reason financial advisers will tell you to increase the amount you contribute to your 401(k); less money taken home means less temptation to go crazy with spending.)

-No Risk of Owing Taxes: Sometimes forgotten in the argument over whether to shoot for a small tax refund is the fact that you can overshoot and wind up owing the government money.  Much as getting a few thousand dollars can allow you to easily complete one or more of your financial goals, finding out that you owe the government hundreds or thousands of dollars can empty your emergency fund and possibly derail some of your plan.  If you ensure that you overpay throughout the year, you’ll never find yourself in that situation.

My Suggestion

This is a tough one; either option could be good, depending on how you utilize money.  The biggest question is, what would you do with a sizable refund?  If your answer is something financially responsible, like bulking up your emergency fund, investing it, or paying down credit card debt (hopefully not credit card debt you’ve accumulated since paying down your balance last year with a tax refund), then giving the government an ‘interest-free loan’ is not going to hurt you.  You’ll get the money back next year, anyway, and it probably won’t be bad to get used to living on a smaller paycheck in the meantime.

On the other hand, if you look at a tax refund check as an excuse for prolific spending for a short period of time, then taking steps to minimize the amount you’ll receive is probably the best course of action.   Assuming you have decent spending and savings habits (which is admittedly a big assumption), a slightly larger paycheck each week could prove less of a temptation than a single lump sum.  You should also shoot for a small refund (or even owing money) if you vehemently oppose giving the government any more money than you absolutely must AND you’re  willing and prepared to owe money when you file your taxes.

For myself, I’m reconsidering my previous belief that minimizing your refund is best, and I’m leaning a bit toward claiming fewer allowances on my W-4 when I am next hired.  Besides helping to discipline my monthly spending, I think I have enough discipline to put most of the refund money towards good financial goals (like rebuilding my emergency fund).  But you have to do what you think is right for your own personality.

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• Finished Our Taxes - All I Can Say Is My Wallet Is A Lot Lighter Now.
• Fair Tax:  The Pros and Cons
• Is Getting a Large Tax Refund Bad?

Welcome back fight fans, to the first grudge match in Great Debate history.  Yes, although we already fought this issue out a while back, it’s come up quite a bit in the media lately, and with 2010 being the year that anyone can convert their traditional account into a Roth without regard to the usual income limits, the arguments are only likely to increase in the future.  To help you decide which is the better choice, let’s look over the situations where each account really shines (as well as when we can’t tell):

Traditional Accounts Are Best If:

Tax Rates Drop in the Future: This should be pretty obvious; with traditional IRAs/401(k)s, you get a tax break now but pay taxes in the future.  If taxes come down between now and when you retire, you’ll have benefited by delaying long enough to see the tax rates decrease.

We Switch to a Non-Income Tax System: Similarly, if we as a country stop taxing income and start taxing something else, like spending, for example, traditional accounts again win out.  Switching over to spending based tax system (like the Fair Tax) would mean that your money avoided taxation on the way into your retirement account, and could be withdrawn without penalty and reinvested, only be taxed when it was spent.  A Roth account, on the other hand, is filled with money that’s been taxed at least once, and now faces substantial spending taxes, making it a double loser in this situation.

Sail Boats, those scream retirement, right?

(Side Note: in researching the above linked Fair Tax article, I called the Fair Tax organization and explicitly asked about what happens to Roth accounts under this system (since the benefits to traditional accounts were already listed on the Fair Tax website).  The answer I got was that, in short, Roth account holders were going to be hung out to dry if the Fair Tax is implemented.)

Tax Rates Stay the Same in the Future (Or Increase Slightly): This one is probably going to require a little bit of explanation, so hold on to your seats.  It has to do with the difference between marginal tax rates and overall tax rates.  The money you put into your traditional account comes off the top of your income pie, so to speak.  If you were still collecting that money, you would have to pay taxes equal to the highest tax bracket you are in (or a weighted average of the highest and next highest, if the contribution reduces your taxable income enough to move you from one tax bracket down to the next lower one).  So, with $50,000 in income, you’d be in the 25% tax bracket (as of 2010), and you would save 25% of $5000 ($1250) in tax expenses with a traditional account.

However, when you take money out of the account, you are going to be pulling out a much larger amount of money, spread across a wider range of tax brackets.  Because we have a progressive tax system, where your first dollar of income is taxed at a lower rate than you last dollar (aka, the dollars you were putting into your retirement account), your average tax rate is much less.  To pull out $50,000 as a taxpayer filing singly, you would have to pay $6393.75 on that income, or 14.2%, given the current tax brackets and standard deductions.  Same tax rates, much lower rate coming out than going in (as a result of which dollars you specifically added).  As a result, there’s also a bit of leeway at to how high tax rates can rise before it becomes a better deal to pay taxes now at your marginal rate, since taxes can go up a reasonable amount without pulling the average tax rate in retirement above the level of the highest marginal bracket during your working life.

Roth Accounts Are Best If:

Tax Rates Increase Dramatically in the Future: Just as tax decreases would be a boon to traditional accounts, tax increases benefit Roths.  Note the ‘dramatically’ qualification in this point, though; for many people in the middle income brackets (and even more in the upper income brackets), tax rates would have to rise substantially (ten to fifteen percentage points in every bracket, for example) for the taxes paid on withdrawals to be equal to your highest current income tax bracket.

Your Income Rises Substantially From Your Current Income: The lower your current income, and the more it rises in the future, the better a Roth looks.  If you end your career in a tax bracket several steps higher than your current one, there is a good chance that making investments in a Roth now will enable you to benefit from your lower tax bracket and save on taxes in the future.  This is one reason why Roths are particularly recommended for us young whippersnappers; our tax burden is likely to be much higher, even if tax rates stay the same.

We Just Can’t Tell If:

We Switch to a Flat Tax: If we go from a graduated tax system to a flat tax, how good it will be for each type of account depends on your current marginal bracket and the flat tax rate.  If the flat tax is higher than your top marginal rate, having a Roth will be better; if the flat tax is lower, then the traditional account is better.  (As a side note, if the flat tax is lower than your highest marginal tax rate but higher than the average rate you would pay under the current system, then the traditional account is still better, but you’ll be paying more than you would under the current tax system.)

Roth Accounts End Up Being Taxed: This entire discussion is predicated on the withdrawals from Roth accounts being tax free in the future.  If this is not the case, then the case for traditional accounts gets much stronger.  It’s not a slam dunk for traditional plans, though; if Roth withdrawals are taxed at a different, lower rate than ‘normal’ income, it’s possible (although harder) for Roth accounts to be the better deal.

Conclusions

You might notice a common thread for these points; they all depend on knowledge of the future which, unless you are a witch (and thus, weigh less than a duck), you can’t know for certain.  We can make educated guesses; given our large and increasing budget deficit and future obligations for Social Security and other programs, my assumption (one shared by many financial writers) is that taxes are only going to go up in the future, making Roths an attractive proposition.

What do I intend to do?  Basically, try to diversify my accounts; perhaps traditional accounts will save me more, perhaps Roth accounts will, it’s best to attempt to hold some money in both types of accounts, so that I can attempt to optimize my tax situation in the future.  Having money in a traditional account to withdraw until you fill the lower tax brackets, and money in a Roth for withdrawals beyond that point, allows you to lower your average tax rate without having to lower the money you have available.

How much to hold in each account?  That’s a tough one.  Before, I would have recommended mostly Roth accounts, but after reading some of the comments on Financial Samurai’s site and considering the effects of marginal tax rates, I’m leaning more towards traditional accounts.  (Going back to our $50,000 a year earner, to pay the same 25% as the marginal tax rate, he or she would need to pull $185,000 from a traditional account; even if tax rates go up substantially, you could still spend less on taxes with a traditional account.)  A mix of of two-thirds to three-quarters traditional accounts with the remainder as Roth accounts should provide plenty of tax savings now with a nice amount of tax-free income in the future to fill out my income needs without too much tax liability.

Now, as to conversions, particularly this year, given the ability of everyone to convert.  If you are currently invested entirely or mainly in traditional accounts, it might be worthwhile to convert; just remember that the more you convert, the more taxable income you will have.  The more taxable income you have, the higher your marginal tax rate (and overall taxes), and the less likely that future tax rates will make the conversion worthwhile.  In short, don’t convert so much as to greatly boost your taxes now; you’ll be setting a high bar for tax rates to clear.  Better to keep your traditional accounts than to pay out the nose for the privilege of conversion.

The most important thing to do though, is to save now, and take advantage of either type of account if possible; it’s better to use a less ideal retirement plan than delaying things to try to figure out the perfect one for your situation.  You’ll definitely be better off, even if when you retire, the tax circumstances mean your (primary) type of account was not the ‘best’ one.  If you’re really, really worried about your retirement savings, there’s a simple and easy way to ensure your retirement is more secure: save more money, in any type of account.  The more you save, the better off you will be in the future.  Good luck, and happy retirement investing!

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Ah, one of the biggest Great Debates in the financial field, and perhaps the biggest argument when it comes to housing, period.  Which is more beneficial for your bottom line, buying a home outright or renting and investing the difference?  While the overwhelming majority of advisers maintain that buying is better, there are some staunch advocates of renting and investing.  The real story is more complex and nuanced than a simple, all-or-nothing answer.

A caveat before we begin; the entire debate about which method of putting a roof above your head is best assumes that buying a home is more expensive than renting (at least, in the early years), that our renter is putting most, if not all, of the difference in cost into investments, and that these investments will generate a substantial rate of return (high enough to beat house price increases, for example).  If any of these assumptions are wrong, there really is no debate: buying a house is a more profitable prospect.  If buying is less expensive than renting, if the renter blows the extra money on frivolities, or if our renter just socks the money away in a low yielding account, then buying becomes a much better deal than renting.

If we assume these caveats hold, though, things get much murkier.  The commonly held conclusion is that renting is less expensive in the early years of owning a home (because there are large upfront costs to buying, such as a down payment and closing costs on the house, as well as a fixed mortgage rate that is higher than rental costs to start), but after several years of living in the house (usually cited as 5-15), the fixed mortgage payments mean that living costs will be less than the rent paid out.  The common suggestion is that if you know with some certainty that you are going to stay somewhere for at least 5-10 years, buying will be a better deal for you.  But this ignores a number of factors that will influence how profitable each housing technique will be, including:

-Investment Returns: If you do in fact rent and invest the difference, how much your investments return will be a major determinant of whether renting is profitable for you.  If your investments do well, it can more than make up for the ever-increasing rent you’ll be paying; if they do poorly, you’ll be doubly hit, suffering from both rising rents and laggard investments.

-Housing Appreciation: If you buy, on the other hand, one of your major assets is going to be your house.  As it rises in value, you’ll be able to pocket more money if you sell it, making buying more profitable.  If prices shoot to the stratosphere (as they did in the early 2000’s), you’ll have huge potential profits when you sell; if prices lag (or even fall, as many have done in the past several years), buying will look like a much worse idea.

-Years to Collect Down Payment: Something often neglected in even the best discussions of renting vs. buying, how long it takes for our buyer to save up the down payment on the house can be a big factor in which is more profitable.  The longer it takes a would-be buyer to build up their down payment, and the more they have to cut down their investing in order to do so, the more attractive renting and investing start to become.  Especially now, when it’s gotten much harder to get a mortgage without a substantial down payment, the years needed to divert money from (potential) investments into down payment savings can give our renter/investor a substantial head start in building up his/her net worth.

(Dependent on investment returns and housing market conditions, of course; if our would-be buyer has enough saved up for a down payment in a year like 2008, when the stock market seemed to be disintegrating and house prices were falling, they’d be in a pretty good place to buy.  Such is the impact the broader markets (for stocks and homes) can have on the relative profit possibilities of each.)

-Inflation & Taxes: A major factor in determining which is the more profitable, and one that’s even more unpredictable than investment returns or appreciation, these broader conditions have all kinds of influence on which is better.  If taxes are raised on selling houses (or the substantial tax deduction currently available is dropped), renting will start to look better; if investment taxes are raised, buying becomes more attractive.  High inflation can make stocks decline in value while helping to drive appreciation, while low levels of inflation can keep appreciation low and help investments (and even this is a gross oversimplification of how inflation affects the housing and stock markets).

As a result of all these factors (most of which require making assumptions about future conditions), saying definitely which is better, renting or buying, is impossible without knowing more about the specific properties and market conditions.  Luckily, there are several good rent vs. buying calculators out there, which will help you to make your decision:

-MichaelBlueJay.com: Probably the best and most complete renting vs. buying calculator I’ve seen, covering everything I’ve mentioned above (except for the years to save up the down payment) as well as several other factors I didn’t get into (closing costs, maintenance on the property).  It generates a very thorough data table, as well as a simple explanation of when buying becomes less expensive than renting (if ever), as well as whether your investments as a renter will later generate more profits than buying.  It’s a bit complex, but every thing is explained, and it’s a good place to play around with the numbers to see what is the best for you in the long term.

-MotlyFool.com: While not as complete as MichaelBlueJay’s, it’s a pretty thorough calculator, which should enable you to determine which is the better deal.  (Just click on the ‘Am I Better Off Renting?’ link to open it up.)  It also have a few inputs that seem to be pretty unique to this calculator, including points and origination fees, although it’s easy enough to work around this lack in the other calculators.  Still, using it in conjunction with other calculators can lead to a better understanding of the best deal for you.

-NYTimes.com: Possibly the easiest calculator to understand (due to the large graphic in the middle of the page), it provides a nice visual representation of when (if ever) buying will become more advantageous than renting.  Based on the data you enter (in the upper bar, the appreciation/rent increase sliders on the left, and the optional advanced setting entries), you can view a variety of options to see how it affects the graph.

My Conclusions

As mentioned above, it’s hard to say that renting or buying is always better, in all circumstances, because neither really is.  If you are only staying somewhere for short period of time (less than five years, especially, although it’s worth looking closely into your expenses for ten to fifteen years out), renting is almost always better; the transaction costs of buying and selling houses will definitely make it less expensive just to rent.  For longer periods, buying a house is usually better, although if you have the discipline to invest the difference between your rent and your potential mortgage/other buying costs in a reasonably high yielding investment, renting might be better.  But that’s if, repeat IF, you figure out the difference and diligently invest that difference; if you can’t do that (or know that you won’t), buying is probably the better choice for someone who isn’t planning on moving for a while.

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It’s been a while since I’ve done any Great Debates; for all the disagreement and squabbling about individual investments and the direction of the country that you hear, there’s a surprising amount of uniformity as to what constitutes sound investment advice. Invest early, invest often, don’t spend too much time and money trying to beat the market, just worry about keeping up with it; there, twenty-three words that sum up the greater bulk of good investment advice.

That said, the details do matter, and choosing the right investments is important, as well.  One issue you’ll need to resolve, even before sitting down to compare investments and choose the ones that meet your needs, is what investment vehicle to use.  There is a strong consensus among most financial advisers that the best way to invest is to choose well-diversified, easy to purchase investment vehicles that seek to match the performance of the broader market (or some defined segment of the market).

The two investment types best suited for such a plan include index mutual funds (or simply index funds) and exchange traded funds (ETFs).  They both have many of the same advantages, such as easy diversification, an index-following strategy, and low expenses.  But which is best for you and your particular purposes?  We’ll have to take a closer look at each type of investment to draw any conclusions.

Our Current Champion: Index Funds

Index funds are a type of mutual fund that doesn’t have its managers attempting to ‘beat the market’ by picking and choosing stocks (or other investments).  Instead, an index fund holds all (or a large representative sample) of the stocks in a particular stock index.  An S&P 500 index fund would hold all five hundred stocks from the index.  Each share of the index fund in turn represents a fractional share of all the stocks (or, as mentioned before, other investments) that are held, meaning that you would own a tiny, tiny piece of all the companies in which the index fund invests.  The advantages of index funds include:

-No trading costs: You can buy and sell shares of index funds without having to pay commissions or other fees on each purchase or sale.  (Although, if you are swapping the funds in a taxable account, you’ll have to pay taxes on any capital gains.)  As with all mutual funds, you can decide how much money you want to invest, and after the fund’s net asset value is calculated for the day, you’ll receive as many shares as you can purchase with your new contribution.

-Easy Automatic Investing: Most mutual fund companies allow you to set up investments for a particular amount that are enacted on the same date every month, allowing you to dollar cost average your way into a large fund position.  You might be able to do so through your brokerage (I know my preferred brokerage, Sharebuilder, makes automatic investing easy; I can’t speak for all brokerages though, whereas every mutual fund company worth its salt makes automatic investing simple).

Meet The Challenger: ETFs

ETFs are very similar to index funds, in that they are collections of stocks (or other… you probably get the picture by now) that are bought and sold as a single unit.  Unlike index funds or other types of mutual funds, though, ETFs are bought and sold on exchanges like the NYSE and NASDAQ, so they can be traded just like stocks.  This gives ETFs a few advantages over index and other mutual funds:

-Flexibility: Since you don’t have to wait until the end of the business day for the prices to update before you can buy and sell shares, ETFs give you many more options for when you can trade.  Furthermore, you can also do some of the more advanced techniques available to stock investors, such as shorting shares and buying on margin, for many more ways to use ETFs in your investments.

-Lower Expense Ratios: One of the advantages of index funds is that they are cheap; the expenses charged by the fund managers are usually under 0.50%, sometimes as low as 0.10%.  But the expenses of ETFs are even lower, frequently under 0.10% (at least for plain vanilla ETFs).  For example, the Vanguard Total Market Index fund has an expense ratio of 0.18%, while the Vanguard Total Market ETF has an expense ratio of 0.09%.  Same fund family, same underlying investments, but the ETF has half the expenses of the index fund.

-More Tax Efficient: Although index funds are known for being very tax efficient (there is much less buying and selling compared to actively managed funds, leading to fewer tax consequences), ETFs are even better.  Since they are created from a large number of stocks (or…you know) known as a creation unit and then sold, there are essentially no capital gains distributions, making them an improvement on index funds that have to pay out capital gains when they need to meet redemptions.

And the Winner Is…

Which should you choose for your investments?  Well, if you are an active trader, there’s really no option: ETFs are going to be your tool of choice.  That flexibility advantage is all you really need to know; attempting to jump in and out of mutual funds at the drop of a hat is a futile gesture, and the ability to perform more complex trades is vital to success as an active-trader.  (I would remind you that attempting to ‘beat the market’ is considered tough, if not impossible, by most commentators; just because ETFs are better for that purpose doesn’t mean you run out and become an active trader.)

If you are a buy and sell investor holding onto an investment for decades, on the hand, things get more complex.  As mentioned already, the expense ratios on ETFS are lower.  Going back to our Vanguard Total Market investments, the index fund will cost $18 a year on a $10,000 investment, while that same $10,000 would only ‘cost’ $9 with the ETF.  (This is an oversimplification of how expenses ratios work; the money is actually taken by very slightly lowering your investment gains or increasing your investment losses.  You’ll never get a bill or something similar asking you to fork out the expense ratio money, this is just to help you see the difference.)  It seems like the ETF is a no-brainer again, right?

Well, maybe; the other big expense for ETFs is the commission on buying and selling shares that will be charged by your brokerage.  If you happen to have a brokerage that charges absolutely nothing for your trades (such as Zecco.com, at least when certain conditions are met), then yes, ETFs will be the cheaper option.  Otherwise, the costs can quickly add up; buy some shares of the ETF once a month at a brokerage that charges $4 a trade, and by the end of the year, you’ll have spent $48 on top of the $9 from the expense ratio.  Suddenly, that $18 a year looks pretty good, doesn’t it?

If you’re looking to minimize your investment fees with ETFs, you’ll have to (a) limit the number of times you trade (to cut down on the trading costs, (b) invest larger amounts each time (so the smaller fees can counteract the trading costs) and (c) seek a brokerage with the lowest costs possible (a cheap brokerage, to say nothing of a free one, can make this calculation much more favorable to ETFs).  If you can do all of that, then ETFs will likely be your least expensive bet; if not, go with index funds.

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On the face of it, this match up shouldn’t be a Great Debate; it shouldn’t even be a minor scuffle.  After all, everyone knows that Index Funds are the one and only type of mutual fund in which you should consider investing.  And every adviser from David Bach to Suze Orman (to say nothing of plenty of accountants, financial planners, and other money experts) says that if you’re going to invest in the stock market, you should do the smart thing and own the whole market. Hundreds of experts can’t be wrong, right?

Well, now, let’s just hold on a minute; there are some contrary voices out there, who raise some good arguments in favor of actively managed funds.  So, let’s take a deep breath, and look at index funds compared to actively managed funds for a minute.  To be sure, there are several advantages to index funds that appear readily under closer examination:

1) Lower expenses: One of the key selling points for index funds are their low, low, incredibly low expense rates.  A good S&P 500 Index fund can have expenses of only 0.10% (or less) annually, while an actively managed fund in the same sector will have an expense ratio of several times that amount (typically something like 1%).  Assuming the performance of the index fund is equal to that of the active fund before expenses, the index fund will have a higher return and final value for each dollar of your invested money.

2) Less Trading: In addition to expenses ratios, you also have to worry about taxes with your funds.  Index funds trade out their contents much less frequently than active funds, thus creating fewer short terms gains within the fund.  As a result, there are fewer taxable events within index funds, and fewer tax obligations to be passed onto you.

3) More Certainty: Because index funds hold everything (or at least, a large, representative sample) within a particular index, there should never be any doubt as to exactly what your fund will be holding.  There’s no worry about style drift, closet indexing or holding the wrong stocks with an index fund; you’ll be holding a major portion of the stocks (or bonds, REITs, or other investments) within the fund’s index, and only the investments within that index.

4) Generally beat actively managed funds: Not exactly something most mutual fund managers brag about (at least, those ones who are part of actively managed funds), but most mutual funds don’t beat the appropriate comparison indexes.  At least 70% of  actively managed mutual funds have under performed the S&P 500 index (and that’s one of the more generous values cited).  You can dodge this risk with an index fund.

Obviously, index funds have quite a advantages in their corner.  But actively managed mutual funds have at least one trick up their sleeve:

Index funds cannot beat the associated index.

If you invest in an index fund, by definition, you’re not going to be able to do better than the associated index; the holdings of the index fund are designed to replicate the index, keeping you from doing any better.  In fact, in the real world, index funds can’t even perform as well as the indexes they track, because the expense ratio will always be subtracted from the fund’s performance, decreasing the fund’s performance compared to the index.  In theory at least, an actively managed and controlled mutual fund can do better than the market.  However, as point four in favor of index funds notes, the percentage that actually do so is fairly rare.

What should you do then?  Well, when considering actively managed funds consider them as somewhere in between stocks and index funds in turns of risk, and treat them in your portfolio accordingly.  To help you do that, consider the following rules:

-Limit the portion you put into actively managed funds - At least at first, until you have some experience researching and picking quality actively managed mutual funds, you should keep tight rein on the amount of your money you put into them.  Limit the actively managed mutual funds to a minimum in your account.  If you have 20% (or less) of your assets in actively managed fund(s) and the rest in a diverse group of index funds, you can essentially hedge your bet on the actively managed fund.  That way, if the actively managed fund(s) exceeds your expectations, you’ll still be a position to enjoy the profits; if it performs less well than you hope, you’ll be buoyed by the rest of your portfolio.

-Carefully watch your active funds – You have to treat active funds much more gingerly than index funds.  If you aren’t willing to closely monitor all you investments at least once a quarter (preferably, monthly or even weekly), you could find yourself losing a great deal of money there if your fund is unable to perform  Always be ready to close your account and move to another mutual fund, if the need arises; as with investing in individual stocks, you need to be

-Lastly, make sure your active funds fit your portfolio - You can’t worry so much about chasing returns or hunting down a good active fund that you forget to ensure that your funds fit your your portfolio’s needs.  Instead, determine your ideal asset allocation, figure out your  contributions, and buy mutual funds (active or indexed) that fit your need.  (And if you do opt for active funds, be aware that the most successful ones tend to be in areas where there are exploitable market inefficiencies; small cap, international and emerging markets rather than large cap US funds are good places to consider.)

Keep this advice in mind, and you should be able to add active funds to your portfolio without sinking it.

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One of the most common pieces of investing advice given by financial professionals, right behind using tax-advantaged accounts and dollar-cost averaging, is to diversify your holdings.  The argument is pretty simple: by holding a variety of investments, and multiple investments of each kind, you can ensure that one bad stock/bond/REIT/whatever you are holding will not do huge damage to your portfolio.

Of course, as with virtually every piece of investment advice, there are dissenting voices.  One noted one is Robert Kiyosaki, the author of Rich Dad, Poor Dad, who refers to diversification as ‘de-worse-ification’.  His main argument is that attempts to diversify cause people to simply buy blindly and pray that their holdings rise, rather than properly investing.

What’s the truth?  As with most financial debates, there are pluses and minuses to diversification.  In an attempt to counteract some of the prevalent wisdom, let’s start with the minuses:

1) Blunts the Top Performers – One of the biggest flaws with diversification is that, by holding tens, hundreds, or even thousands of individual investments, you aren’t able to benefit from the full growth of the top performers.  If you have a single stock that doubles in price over the course of a year, you will have nearly doubled your money (after expenses); if that stock is one of a thousand held in a mutual fund, the growth of that stock will be averaged with the gains (and possible loses) of all the other stocks, greatly diminishing your returns.

2) Leads to Overconfidence – Another problem with diversification is that it can lead to thinking, ‘if I have enough different holdings, there’s no way my portfolio can decline.’  Unfortunately, if 2008 taught us nothing else, it’s that even being diversified can’t always protect you; sometimes, all the investments within an asset class decline, and occasionally many asset classes are hit simultaneously.  There are limits to what diversification can do to protect your assets.

3) It’s Boring – The last problem is purely psychological; while holding a diverse group of mutual funds makes for a good investment strategy, it’s not the most exciting topic to discuss over cocktails.  The negative effects can extend beyond simply making you less popular at parties; if you are not interested and involved with your investments, you might not give your portfolio the proper scrutiny it deserves, and could end up with a portfolio that is far from your desired allocation or investments that are completely inappropriate for you.

So, there are some drawbacks to diversification.  Still, there must be reasons why nine out of ten (or more) financial advisers recommend diversification.  So, what are they?

1) Blunts the Low Performers – The inverse of the first disadvantage of diversification, which smooths out your returns in general.  While it decreases what you could get with a proper investment in a high performing security, it will also increase your returns over the worst performing assets in the class.  It also prevents the worry and trouble caused by bankruptcies; if the company that goes bankrupt is only one of the hundreds you are holding, the damage to your portfolio is likely to be minimal.

2) Makes Investing Easier – Another big advantage of trying to invest diversely is that, thanks to products like mutual funds and ETFs, it’s easy to find diversified investments that meet your asset allocation.  Plus, it’s usually is less trouble to track the performance of a few broadly invested funds than to individually track dozens of stocks or bonds.

3) Tends to be Cheaper – Interestingly enough, thanks again to mutual funds and ETFs, it actually is cheaper (usually) to get a highly diversified investment than a more concentrated one.  The abundance of no-load mutual funds and low cost brokerages makes it inexpensive to acquire and hold many diversified investment, whereas the commissions of acquiring even a small portfolio of individual stocks will add up quickly.

Given these relative benefits, what’s the best way to approach diversification?  My advice remains the same as when I discussed how to build an investment pyramid.  First, start by creating a set of broadly diversified investments; that way, you should have a good base to build on.  Then, once you are diversely invested, you can consider putting a portion of your money into individual stocks (say twenty to thirty percent of your overall assets).  This approach allows you to gain the benefits available with individual stocks, while avoiding many of the associated problems.  You can have your cake, and eat it too!

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Welcome once again to the little corner of the blog where we discuss some of the greatest arguments in the personal finance world.  Today, we’ll discuss which is better when planning for your retirement, a traditional IRA or a Roth IRA.  (There are also traditional and Roth flavors of 401(k)s, as well, but since that choice will be made by your company and its human resources department, you’ll have less control over which variety you will have.)

The big difference between the two types of IRAs is when the the money you invest in them is taxed.  In traditional IRAs, the money you invest is taken from your taxable income, allowing you pay fewer taxes now, but the withdrawals when you retire are taxed at your regular tax rate.  Roth IRAs are funded with after-tax money and the withdrawals are tax-free.  The decision then becomes when you want to be taxed, now or when you retire.

Therefore, there’s a simple way to determine which type of IRA will be better for you: hop into your time machine, travel forward to the time you retire, and see what tax rates you will be paying.  If the rates are higher in the future than they are now, you’ll do best financially with a Roth; if the rates are lower (or if the Fair Tax has been enacted), than a traditional IRA is the way to go.  Then, come back to the present and open that style of IRA; easy as pie!

What’s that?  You don’t have a time machine?  That complicates matters a bit.  You can still choose the style of IRA you open based on what you think the future will hold for tax rates.  Personally, given the rising national debt and rather low current tax rates, I would imagine that tax rates are only going to rise in the future (although, again, the Fair Tax or other non-income taxes could drastically change the tax landscape), making Roth accounts more attractive.  Some other questions to ask yourself:

Will I need more or less money in retirement? – As a consequence of our graduated tax system, the less income you have, the lower taxes you pay as a percentage of your income.  Thus, since different IRAs allow you to be taxed at different times, you can attempt to determine how much money you will need to spend in retirement.  If you intend to cut down your spending when you retire, even just to the 70-80% of your final income that many experts say that you need, traditional IRAs should be beneficial; if you intend to maintain or increase your current level of spending, a Roth IRA will help you dodge the tax burden.

Do you want to lock in your tax rate? – One of the biggest advantages of a Roth is that you know what tax rate you are paying now (or at least, should be able to figure it out), and therefore know exactly what you are paying in taxes.  As we’ve already discussed, though, tax rates in the future are a big unknown.  If you prefer to pay your current tax rate and not have to worry about tax increases in the future, a Roth provides you with that opportunity.  On the other hand, if you are currently in a high tax bracket, taking a tax break now for your traditional IRA may make the most sense.

(If your taxable income is high enough, you may not even have the option of using a Roth.  For single filers, you can put in the  maximum ($5000)  if you earn less than $105,000 in 2009, with partial contributions allowed up to an income of $120,000; married couples filing jointly can donate up the max if they earn less than $166,000, and partial donations up to $176,000.  A complete matrix comparing income limits and other factors affecting traditional versus Roth IRAs and 401(k)s can be found here.)

Am I diversified? – Diversification isn’t just about holding a variety of investments, it also involves ensuring that your portfolio is prepared for whatever the tax rates do in the future.  If you have a traditional 401(k) at your work place, having a Roth IRA to help in case of rising taxes is a good way to diversify.  Similarly, if you are one of the lucky ones who has a Roth 401(k), having a traditional IRA can help to lower you current tax burden and help to minimize the taxes you will pay overall.

These questions, as well as your thoughts about how taxes will change in the future, will help you to decide which type of IRA will be best for you.  As is frequently the case, there is no easy answer to which type of account is better that applies to everyone equally, but hopefully, asking yourself questions about your tax rate, future spending, and the types of other accounts you hold will help you to make some good decisions.  Happy retirement planning!

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Here’s another persistent and oft-debated question: when you manage to control your expenses and actually have money left over at the end of the month, what do you do with it?  Do you pay down any debt that you happen to hold, or do you put the money away into an emergency fund?  As with most serious debates, both sides raise some good and interesting points.

For many people, paying down debt makes the most financial sense.  If you have credit card debt with an interest rate of 25% (sadly, a standard rate for many card issuers), then for every one hundred dollars you put towards paying down the debt will save you twenty-five dollars a year.  Even if you were able to find a completely safe account that yields 5% a year (which isn’t too likely, given the current state of most savings account yields), you’d still be losing twenty dollars per year for every hundred dollars you keep in your emergency fund.  There’s also the psychological factor to consider.  Being able to look in the mirror and say, ‘Yes, I’m debt free’, or at least, ‘I’m free of high interest credit card debt’ is a wonderful feeling.

As always with these great debates, the other side makes a strong case, as well.  Having an emergency fund has its own psychological benefits: if you find yourself facing a large, sudden expense (in other words, an emergency), being able to pay for it out-of-pocket without adding onto your debt.  Furthermore, there are some emergencies where you are unable to use credit cards, and having the necessary funds available for such cases will be a huge morale salve.  (For example, my fiance has a little dog named Toby, and his vet doesn’t accept credit cards.  If we don’t have cash on hand to pay for Toby’s treatment, Toby will end up suffering.)

So, what’s someone who faces both a sizable amount of debt and no emergency fund supposed to do?  The best option is to split the difference; work to build an emergency fund and pay down your debt at the same time.  A short list of actions to take:

1) Build up a small emergency fund.  Not a full emergency fund, which would cover six to twelve months of expenses, but enough that you can cover the more common ‘emergencies’ that arise in life; things like car maintenance, doctor’s trips, or fixing a leaky toilet.  We’re not trying to prepare for a financial disaster at this point, but simply to smooth out our monthly spending.  One month worth of expenses, put into a high yielding, online savings account (SmartyPig would be ideal for an emergency fund) should suffice in most cases; but if you have reason to believe you could end up needing more in the near future (if there’s someone in your household with health issues, for example), then by all means, build a larger emergency fund.

2) Start paying down the highest interest debt.  Ideally, you should make the minimum payments to all your debts, and devote any extra money (now that you’ve got a small emergency fund cushion) to the debt with the highest interest rate.  Once you have paid off that debt, you can put all that money into paying off the next highest interest rate debt, and the process will continue from there.

3) Increase the size of your emergency fund.  Once you have the highest interest rate debt out of the way (any debt with an annual interest rate of more than 8%, let’s say), you should start increasing your emergency fund with some of the money you are paying each month.  The last thing you want is to add more high interest debt now that you have eliminated your previous debt.  You can start splitting the money you had been putting into debt repayment between paying off the rest of your debts and building up your emergency fund.  How much you put towards each goal will depend on how comfortable you feel with your emergency fund and how much you want to be completely debt free.

4) Decide on your next course of action.  By this point, you have paid down your highest interest debt, are only paying low interest rates on your other debt (if you have any debt remaining at all, that is), and have built up a sizable emergency fund.  Where you go from here depends on your goals and current situation.  You could start investing for the future, agressively pay down the rest of your debt, or start saving for a specific purchase.  Each choice is equally valid, and any one of them could be a good option for you, depending on your goals and other factors.

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One of the greatest challenges facing many people is debt repayment.  This isn’t surprising, given the proliferation of credit cards and other forms of lending that have been fairly common over the last decade.  One of the few good points of the recent economic contraction is that the credit crunch has forced everyone to rethink the debt culture in which we have been living.

With so much debt, there are plenty of debt repayment plans.  Three big plans are widely publicized and touted, including the high interest plan, Dave Ramsey’s plan, and David Bach’s plan.  There are advantages and disadvantages to each.  Here’s a quick summary, for those of you who haven’t encountered these plans:

1) High Interest Plan – The rationale behind this plan is simple: pay down the debts with the highest interest rates first, while making only the minimum payments on all the other debts.  Then, when highest interest rate debt is gone, the money used to pay it down will be put towards the next highest debt, and the next highest, and the next highest, until all the debts have been extinguished.

Pros: This is the quickest plan; paying off the highest interest rate debt first results in the debts being discharged as quickly as possible.

Cons: Depending on how much money is at the highest interest rate, this method may take the longest to result in the complete elimination of the first debt.  If that’s the case, it might be somewhat disheartening to someone attempting to eliminate the debt.

2) The Dave Ramsey (Debt Snowball) Method: Dave Ramsey recommends starting with the smallest debt and concentrating on paying that down first, while making the minimum payments on the other debts.  Then, when the smallest debt is gone, you can add those payments towards eliminating the next smallestdebt and so on, until all the debts are gone.

Pros: This method will lead to eliminating the first debt as fast as possible, which can be a huge ego boost.

Cons: Unless the smallest debt also has the highest interest rate, you’ll be paying more in interest, and taking a longer period of time, to eliminate all your debts.

3) The David Bach (DOLP) Method: David Bach presents a third method of paying down debts, called Dead On Last Payment (or DOLP).  Essentially, you divide the amount of money you owe on a particular debt by the minimum payment, giving a DOLP score; if you owe $1000 to Visa with a minimum payment of $25, that would have a DOLP score of 40.  You then arrange the debts from lowest DOLP score to highest, and pay them off in that order.

Pros: You’ll pay off the first debt faster than with the High Interest plan (though, perhaps not as fast as the Debt Snowball method).

Cons: If the lowest DOLP score isn’t the debt with the highest interest rate, you’ll end up paying more than the High Interest plan.

My view: As you con probably tell by looking through the pros and cons, the only advantage I can see for either Dave Ramsey’s or David Bach’s plan is that it gives you your first taste of completely eliminating a debt quicker.  The financially optimal plan (in that it will save you the most money on debt repayment) is the High Interest Plan, and that’s the best option for most people.

If you need the psychological boost that comes from paying off a debt quickly, you could consider one of the other two plans.  Better yet, find a fairly small debt, and devote part of your debt repayment money to knocking that off, while the rest goes to making the minimum payments and paying down the highest interest debt.  You’ll get a quick psychological boost by knocking out the small debt, while still chipping away at the highest interest debt.

No matter what method you choose, though, know that you will be in far better shape than the millions of people who aren’t paying down their debt at all.

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Ladies and Gentlemen, financial fight enthusiasts of all ages, welcome to tonight’s event. We are moments away from our main event, a bout that will go down in history and settle one of the great debates in finance once and for all, the argument over whether buying individual bonds or bond mutual funds is the best way to get some bond exposure.

As you are well aware, this grudge match has gotten especially dirty, since both the fighters fill the bond part of your asset allocation. This means they’re government or corporate debt, and pay out higher interest rates than most stocks. They also tend to be more stable in price than stocks; they don’t drop as far in value, but they also don’t rise as fast. Finally, there’s more protection if the company or government goes bankrupt than you have with stocks. But that’s where the similarities end.

Wait, wait, the fighters are entering the ring. They’re circling each other, eyeing each other up. And individuals bonds make the first move, pummeling bond funds with all their advantages:

Fixed Interest Rates: The biggest advantage of individual bonds is that the interest rates they offer stay the same for the life of the bond. (Unless it’s called or the company defaults; although those are fairly rare events, especially with high quality bonds.) If you lock in a high interest rate for a long-term bond, you can enjoy high dividend payments for years, decades even.

Return of principal: When the bond’s term is up, you’re guaranteed to get back your principal. The amount for which you can sell the bonds before they reach maturity can vary, but the underlying principal will be returned at maturity (again, barring defaults). With bond funds, the amount of principal will move up and down as the share prices change.

Oh, bond funds have been taking a beating! But wait, here they come, bringing out all the pluses that come with funds:

Easy Diversification: The biggest advantage of bond funds is the ability to own hundreds, if not thousands of bonds with one investment. The natural diversification of funds lowers the cost to add bonds to your portfolio, as well as decrease the risk should any of the bonds in the fund default.

It’s one heck of a struggle out there! And here come the ref, making a ruling on the mat. And it’s a tie! Depending on the situation it seems that either individual bonds or funds could be a good choice for the fixed income portion of your portfolio.

There are a few caveats, though; the higher the risk of default, the more advantageous it is to opt for bond mutual funds. If you decide to dabble in junk bonds, for example, you’ll end up much better financially by using a high-yield bond fund. The large number of bonds held by the fund will insulate you from much of the risk of default, allowing you to profit from the higher yield of these bonds without gambling on your portfolio.

On the other end of the risk spectrum, if you’re looking to invest in Treasuries (US government bonds), you would do best by buying directly from the Treasury. There’s essentially no default risk, the bonds are never called, and you can avoid the fees that mutual funds charge by buying Treasuries yourself.

For high grade corporate bonds, which have a moderate amount of risk, you could go either way. If you have the money to create a diverse portfolio and like the characteristics of individual bonds, go ahead with the bonds; if not, bond mutual funds will do fine.

Oh, ladies and gentlemen, that was certainly a thrilling debate. I think we’ve all gained a little more knowledge about bonds and bond funds.

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