Analyzing Wealth

So I decided to take a look at my asset allocation this morning to see what a few months' changes have done to it. I went to Vanguard and found these basic numbers:

Value/Blend/Growth looks like 25.6/45.4/8.0 (with 21.0% in international)
Small/Mid/Large looks like 14.6/18.8/45.5 (again, 21.0% international)

To doublecheck, I went to morningstar's instant x-ray and entered all my funds and amounts. The result was this:

Value/Blend/Growth looks like 28.8/26.5/23.3 (with 21.4% in international)
Small/Mid/Large looks like 7.8/22.6/48.2 (again, 21.4% international)

Now, in my understanding, the concepts of value and growth and small/mid large are pretty concrete-- they depend on fundamental characteristics of each stock. So why such dramatic differences between M* and Vanguard?

My inclination is to think that Vanguard classifies a fund as value/blend/growth and small/mid/large, and then assigns every dollar in that fund into that classification. So a small cap value fund will go into the portfolio analyzer as 100% SCV, even though it may contain some portion of mid cap stocks or growth stocks. M* probably breaks it down to the stock level. That would explain why they differ.

But this is still disturbing to me, primarily because I arranged my entire portoflio to tilt toward small and value. According to M*, I failed at both. There is barely a value tilt (28.8/23.3) and my tilt toward small is instead a tilt toward mid. This aggravates me because I am specifically invested in funds that lean that way, and SURELY they do not stray so far from their title as M* sugests. I could not possibly have lost nearly HALF of my small cap stocks as M* suggests. Surely my small cap funds aren't just half small cap. And surely a small cap value fund isn't 40% value, 40% blend, and 20% growth, which is what M* is suggesting.

I'm thinking that my belief in how Vanguard analyzes your portfolio is correct, and thus it's not totally accurate. But I think there has to be something wrong with M*'s instant x-ray as well. There's no way that my growth content, which Vanguard reports as 8%, could really be 23.3%. I don't see how that is possible with my portfolio containing several index funds that specifically emphasize value and not one fund emphasizing growth.

Has anyone else noticed this? If you have a vanguard account with your outside account info typed in (which is nice, btw), look at their portfolio analysis tool and compare it to M*'s instant x-ray. Tell me if yours looks as wonky as mine.

Overall, the market was pretty flat this month. In late July I got hammered, and in August, despite the volatility, things were better. My market investments overall gained 0.23%. The bigger story for me (and my net worth) was debt reduction. I eliminated my auto loan this month . . . which led to a drop in my assets (lowest level since May) but a much bigger drop in my liabilities. My net worth is up 1.8% over my last report in August, and I'm back on track to meet my goal (though the market will need to help me a little more in the coming months). This is a new high for my bottom line after a dip last month, and I'm now up 24.2% since I started tracking in February. I think I still have a period of fast growth ahead of me, as new savings/investments will still be a decent chunk of my net worth. I won't post my goal graph this month, as I think it's getting a bit tedious . . . I've given you the pertinent information anyway.

As in previous updates, I checked in on my Net Investable Assets and Net Liquid Assets, both of which grew in relation to my net worth. NIA is now almost 51% of my net worth, and NLA is almost 8%. Both of those figures are new highs.

This month I have added a new figure to help track my progress: Earned Retirement Income (ERI). This concept was introduced to me by BrokNowRchLatr and he gives an explanation in this post. Essentially it measures what your current picture means in terms of retirement income. Instead of focusing on the dollar figure, I am tracking my ERI as a percentage of my goal. This month my ERI is 12.0%-- meaning I have enough saved to fund 12.0% of the retirement income that I feel I need. With my auto debt out of the picture, I expect my progress in ERI to speed up (it's only up from 9.8% in February).

I hope everyone has had a wonderful month and didn't worry too much about the markets. I apologize for the sporadic posting, but life gets in the way of blogging sometimes.

At some point there was going to be a crossover, where it made my emergency fund balance better if I took money out of it to pay my car off (since I drop 3 payments from its calculation). That point is coming up at my next paycheck. Between the payoff amount, my reserve balance, and my paycheck, I'll come out ahead by paying the car off at the first of the month. Basically, right now I'm $1150 below where I want to be in my emergency fund. To make the payoff and pay my additional monthly bills, I have to pull $1150 out of the fund. By making the payoff, I reduce the need in my emergency fund by about $1800.

The net result? I wind up about $500 down from where I want to be, an improvement from $1150 down before the payoff. With my usual car payment out of the way, my emergency fund will be at full strength by my next paycheck, and I'll have the title in hand. It's a win/win situation and I'm thrilled that I'll be seeing a significant bump in my true take-home pay so soon.

I'm glad I waited the extra month to do this, as this is really the time it finally makes sense. After this payoff my only debt will be my mortgage! What a good feeling. As I've discussed, I consider this car purchase to have been a financial mistake . . . one that I plan to not repeat if possible. Will I have a car loan again? That depends on the terms and interest rates at the time. I don't plan to have one anytime soon though, and that's a nice feeling.

I have two voices in my head that are fighting each other a bit right now, as they have been for months. With a downturn possible (and now happening) do I keep investing regularly or do I sit on cash for awhile and wait for an opportunity? Well, the keep-investing-regularly voice won. and maybe it should have. But it puts me in an awkward position now.

I want to buy more. We're going to hit the bottom soon, IMO, and I simply don't have a large enough cash reserve to really make the play I want to make. I've been putting it into the market each month. The downturn doesn't scare me, and most of the money I have in the market was put in at levels lower than this, but it would be nice to be able to substantially increase some positions while investors are irrationally pessimistic.

But the only way to do that is to raid my emergency fund, which I'm not going to do. I have a car to pay off, but I likely won't do that for a few more weeks. I won't really be comfortable putting a BIG chunk into the market until a few months after that, when my cash reserves will be stable and my cash flow will be larger. So of course the contrarian in me is saying "I told you so, you should have saved up and waited." But what is a young investor to do? In the long term this decision may not make a huge difference, but I wouldn't be an investor if I didn't fret over such things.

So now a new question. Do I continue to nickel and dime into my Roth, or do I wait this time? The market is down, down, down, but I really feel that it is going to get worse before it gets better. The contrarian in me is now confused. He wants to buy but he also wants to wait because they may be an even better time on the horizon. That would also allow me to build some cash, finish the car payments, and just generally get myself less cash-poor. But I hate to do that when stocks are on sale.

Decisions, decisions.

I'm a nonreligious person. Not that this matters much in the context of personal finance, but it does reveal a little about my personality, my desires, and the things I allow to drive my way of thinking.

Specifically, I loathe dogma. Not the movie Dogma, which is actually pretty funny, but dogma in general. "Because it is" or "because it always has been" or "because that's how it's supposed to be" are not valid reasons for doing anything. Period. Make each decision with an eye on history and common thought, but with the bulk of your decision coming from an informed logical thought process.

I began to think about this when I saw a question about a car purchase asked on a popular investing message board:

I'm going to buy a new Honda within a couple of weeks. I have the total money for the car sitting in a Vanguard money market. I can get 2.9% financing for 3 years or 4.9% financing for 5 years. Is there any reason why I shouldn't do the 3-year 2.9% financing. My after tax return from the money market account (about 3.5%) is greater than what money markets are returning. In addition, it's nice to have that extra money liquid for a few years.

The basic question: if a loan makes me come out ahead, should I use the loan offer or pay cash?

I was not the least bit surprised to see two suggestions in response, each stated and seconded at least once by the board regulars (paraphrased):

Your mistake is buying a new car. You'll do better financially if you buy a 1- or 2-year old car.
It's always better to pay cash when you have the option.

Now, does this advice strike you as sound, logical advice? Maybe it does, because both ideas have been crammed down our throats in the personal finance community. But in fact these responses come so readily because they are dogmatic. They are true because they are true.

The truth in the matter is that #1 is usually true but not always, and #2 is false even more frequently.

First let's talk about #1, because I have purchased a new Honda in recent years, and also because, well, I labeled it #1. Some vehicles hold their value far, far better than others, to the point where the first-year depreciation is not very dramatic. Specifically I'm talking about Hondas and Toyotas here, which have proven over time to be reliable vehicles that are inexpensive to maintain. Their residual value is so good, in fact, that shopping for used Hondas and Toyotas can be very, very frustrating. We feel, as consumers, that in addition to a year's wear and tear, we ought to get a price break on a used car because, well, it's not brand new. And in fact, we are completely right when we're talking about most cars. But these days, there is very little premium to be had when buying a used Honda or Toyota. If it's a "certified used" vehicle, in fact, sometimes the used car is more expensive than a new one because there's an extended warranty built in. This has happened over time due to market pressures, to the point that many shoppers have concluded that buying new may be the more sound decision. I know my new Pilot, which I bought under invoice, was cheaper than any used Pilot I had found with under 30,000 miles. So while it is good advice to pay attention to used cars and what they may offer financially, to say that you are always doing better by buying used is not a statement based in logic or fact, but instead is one based on dogma.

Response #2 is fraught with even more problems because there is a clear, quantitative message that the loan is a better financial decision. A simple read will tell you that the original poster's cash works harder for him in his money market fund than it would if he sunk it into the vehicle. Not only that, but using the cheap loan allows him to keep more cash on hand for the life of the loan, effectively extending his emergency fund and giving him a more liquid overall financial picture. For the life of the loan, he will have the option to pay it off if that becomes the more sound choice based on prevailing money market rates. But he will also have the option of maintaining the payments for as long as he finds it to be to his advantage. Refusing the loan and paying cash closes off this second option unnecessarily, and will make him more cash-poor in the short term and less wealthy in the long term. So why, why, why, do so many people seem to say "buy with cash regardless?" DOGMA! another infuriating example of a failure to think because one thinks the answer lies within their tried and true dogma.

I could give a hundred more examples of misleading dogma in the personal finance area alone, and the problem infests our entire way of being in all other areas as well. Challenge conventional wisdom, peer pressure, and your own beliefs. Only by doing this will you truly make the smartest decisions in your life. Reliance on dogma can lead to poor decision making and, more importantly, a more feeble mind due to inactivity.

One word for the market this month: UGLY. The US total market, as measured by Vanguard's Total Market ETF (VTI), dropped 4.6% in July. I had some domestic funds that fared better, and some that fared worse, but my international holdings helped soften the blow . . . a little. In total, my investments dropped 3.5% in July. This did offer a nice buying opportunity for my Roth IRA (bought Friday) and my employer retirement accounts (bought yesterday). However, those low purchases won't show much benefit until down the road a bit. For now, my net worth isn't looking so hot.

Since I started tracking in late February, this is my first period of negative change in Net Worth. I had quite a bit in new investments and debt reduction, but they were edged out by market losses. In total, my Net Worth dropped 0.3% from June 2 to July 1. It's not that bad in the context of the market, but you never like to be moving backward.

This month's setback means that progress toward my goal of 34.8% net worth growth this year falls back to about 22.3%. This is still ahead of the necessary pace, so if the market picks back up at all I am confident that I'll get there by next February.

My net investable assets (-0.4%) and net liquid assets (-0.6%) both fell this month, since they both have a higher correlation to the market than my net worth as a whole. Both were hurt significantly by market losses, and were not helped enough by new investments and debt reduction to offset the drop.

I'm not going to get down about this month's setback. I did my part, reducing debt, saving, and investing new funds, and it was simply a bad month in the market. This is going to happen from time to time and as long as I keep plodding ahead, I'll come out in good shape in the end. In a month where the market dips 4-5%, I consider only losing 0.3% in net worth a minor success.

I'm making a Roth IRA purchase today, and I'm not ashamed to admit that it's because the market took a dive today. I am not a believer in market timing, but if I can snatch an extra 2-3% simply by buying while prices are down . . . I'm going to do it.

Reading across the web, in forums and blogs, I've seen a lot of criticism of this practice, with the True Believers of the Efficient Market lecturing others that they should be watching prices to decide when to buy. I think that this is pretty crappy advice, and that it can cost people money in the long run. Here's a quick look at what happens to your money when you buy during a dip vs. the day before.

Suppose that I have $1000 to invest in VBR, Vanguard's Small Cap Value fund. Also suppose that from yesterday to the end of the year, VBR is destined to rise 2%. It looks like VBR is going to shed about 3% today, providing a discounted purchase price. What's the difference between buying yesterday and buying today?

Yesterday, VBR closed at $72.64, and the current price is $70.26, a drop of 3.28%. $1000 yesterday would have bought me 13.77 shares. At the current price, I can buy 14.23 shares. Under my assumption that VBR would grow 2% from yesterday to the end of the year, the year-end price will be $74.09.

If I bought yesterday, at the end of the year my 13.77 shares would be worth about $1,020.
If I bought today, at the end of the year my 14.23 shares would be worth about $1,054.

We're all frugal here in the PF blogging world. If I told you I could get you an extra $34 you'd be excited about it, right? So why are we made to feel guilty for buying on a down day in order to squeeze a little more out of the market?

Is this market-timing? Sure it is, in some ways. But we're not changing our allocations based on timing, we're not selling any stocks based on timing . . . we're merely making a decision on when to buy based on the status of the market.

Now, naturally, there is a problem with this. If you made all of your buying decisions based on this, you'd make some mistakes. Some months you're not going to see a 3%, 2%, or even 1% loss in the market on a given day. So waiting for that dip can cost you valuable gains, especially if you choose not to invest that month at all. There is no predicting this sort of thing, so counting on a down time in which to buy is a mistake.

However, buying doesn't have to be either/or. To some degree you can have your cake and eat it too. If you normally invest at the end/beginning of the month, but on the 26th the market drops 3% . . . go ahead and dive in early. Is it possible that prices will actually be lower a few days later? Sure, but often these dips regulate the market and it will rise in the following days. If you get to the end of the month and you haven't seen a dip in which to invest, just throw it in at the end of the month as you had previously planned. You're not keeping money out of the market unnecessarily, you're not pulling funds out . . . you're just taking advantage of an opportunity and investing a few days early.

I see no problem with this, and I think most people would agree. In the long run I think this strategy will make you more money than simply investing on the same day each month . . . but clearly others have a different opinion. What say you, readers?

So, I have been pretty adamant that I am not a subscriber to the idea of making financial decisions based on how they affect you psychologically. Specifically, I believe that you should make your financial decisions largely on the quantitative outcomes. If X will make you richer than Y, do X even if it means more short-term debt. So no Dave Ramsey debt snowballing-- high rates should come first, low rates second.

Consequently, I haven't been paying any extra on my 4.5% car loan (at least not in the last year). Instead I've been maintaining my emergency fund and all excess has gone into the market, primarily in retirement accounts, counting on higher long-term returns than the 4.5% I'd get from paying down the car loan.

Included in my emergency fund (which is designed to pay 3 months' expenses) are 3 car payments of $588 each. I've long known that my car will be paid off this December (5 more payments). But it just occurred to me this morning that the difference in my payoff amount (~$2800) and the amount this will lower my emergency fund needs (~$1800) is only about $1k. Meaning, if I paid my car loan off today, it would only cause about $1k shortfall in my emergency fund.

Bear with me. If the payoff amount and the emergency fund reduction evened out, it would be smart to pay off the loan, since I'm losing 4.5% on the car loan and gaining 5.3% (minus taxes, more like 4%) on my emergency fund at GMAC bank. So the question is . . . is the $1k discrepancy small enough that the "relief" of the debt payoff overcomes any risk of falling short in my emergency fund (as well as some small amount that could be geared toward the market over the next 5 months)?

In the end, this is a psychological vs. quantitative question. Quantitatively speaking, it would make sense to wait 2 more payments before paying it off. The small excess, about $500 this month and next, would go to the market under this plan. Under the psychologically-driven payoff, that $500 excess would instead go to replenish the emergency fund, which I raided to pay off the car.

So here's what it boils down to, in risk/reward:

With the optimal plan, I wait two months, netting a potential marginal gain of 2 months' worth of time in the market instead of in a fixed-rate savings account. The only risk involved is that the market over the 2 months will underperform the 4% yield on my savings account.

With the payoff plan, I pay it off now, gaining some peace of mind. I risk potential gains in the market, instead replenishing a raided emergency fund with a real return of about 4%.

I've been thinking that before November, there would be a dip in the market. A lot of "experts" share this belief. If that happens, paying off the car is financially wise in addition to being the good psychological choice. Of course, counting on that assumes much. It may climb 5% in the next few months. You never know, and I'd be missing out on some gains by doing the payoff. Quantitatively speaking, I'd be missing out on the gains of $1000 over 2 months. If it gains 5%, I'll be losing out on $50, sacrificing that money for some immediate peace of mind and the removal of my only consumer debt from my balance sheet.

Is it worth it? On the one hand, it's just $50 (and that's not guaranteed-- not even likely)-- a small price to pay for peace of mind. On the other, $50 here and there make a difference in the grand scheme. I make decisions based on lesser amounts every day.

Thoughts? Any input is welcome. I have a lean right now, but I can be swayed either direction.

Note: I am in no way endorsing binge drinking, under age drinking, drinking and driving, or drinking in general. This is a light-hearted post to compare the cost of various adult beverages. If you are offended by this article, you'll just have to get over it.

I like to drink. Not to excess very often, but I enjoy the relaxing effects of alcohol, safely and responsibly, with regularity. I can be a bit uptight and a little bit of alcohol can really help me relax. I am generally a beer drinker, but I do enjoy a glass of red wine from time to time. Far less often I'll partake in liquor-- it generally doesn't suit me. And by "generally doesn't suit me" I mean that

I generally start forgetting the events of the evening
I wonder the next day what ridiculous things I may have said, and the volume at which I said them
The liquor generally finds its way out of my body prematurely, via the oraface from whence I ingested it.

I find that wine and beer give me a more reliable and controllable buzz, and I get sick from them far less often.

Now, with that said, assuming all alcohol were the same, what would be the most frugal product for obtaining one's desired level of buzzedness? A good question, if you ask me. Being that I am writing a personal finance blog, a reader somewhere may like to have this information.

Being the resourceful soul that I am, I tracked down a website that can provide precisely that information: AlcoholShopper.com. This site provides the best bargains, in price per ounce of pure alcohol, throughout the US. It will even tell you which state this deal is in.

So, ounce for ounce, what is the best bang for your buck? Here are the tops in each category, in ascending order of price:

Milwaukee's Best Ice (beer) , keg, $0.34 per ounce of alcohol
Fairnoff (vodka), fifth, $0.38
Icebox Really Hard Ice Tea (pre-mixed drink), 1/2 gal, $0.47
Arrow Light (rum), 1L, $0.48
Taaken (gin), 1/2 gal, $0.49
Franzia (wine), 5L, $0.52
Carstairs White Seal (whisky), 1/2 gal, $0.53
Pancho Villa Rojo (liqeur), 1/2 gal, $0.59
McCormick Old Style (bourbon), 1L, $0.62
Gaetano Blackberry (brandy), 1L, $0.63
Everclear (grain alcohol), fifth, $0.64
Old Mr. Boston's Egg Nog (other), 1/2 gal, $0.67
Barristers (scotch), 1L, $0.69
Tribuno Sweet (vermouth), 1.5L, $0.74
Tortilla Silver (tequila), 1L, $0.74
Croizet (cognac), 200 mL, $1.31

So the most bang-for-your-buck comes from buying "The Beast" Ice in a keg, though this is easily the lowest alcohol-by-volume product in this list. In other words, it'll get you where you want to go, but be prepared to make a few bathroom stops along the way.

I am a little surprised at the result. First off, I thought Vodka would be far-and-away the cheapest, since you can get it cheap in large quantities and it is at least 40% alcohol in most cases. It was close, but The Beast beat its best price by a few pennies.

Also surprising is how far down the list grain alcohol is. After all, it's just super-pure vodka, essentially. It has no flavor of its own, so it should excel in a list like this-- where alcohol content is all that counts. But it seems to fail miserably. So next time you think it's a great idea to buy some Everclear to add some bang to a mixed beverage, forget it. Use vodka instead-- it's just over half the cost and will do exactly the same thing in your drinks.

What do you drink? How much does it cost? I drink cheap beers, generally (Miller Lite more than anything else-- according to this source it is 74 cents per ounce of alcohol in a keg). But I think I'd stop short of drinking something so nasty as The Beast, and especially something as ubernasty as The Beast Ice.

For what it's worth, the most expensive source of alcohol would be Mazzeti Grappa-chess Set, a brandy. $1,499.97 will buy you 50 mL-- a whopping $2,063 per ounce of alcohol, and nearly four times the cost of Courvoisier L'esprit cognac.

Today I was looking at my online account page for one of my credit cards, and thought, for curiosity, I'd click on the "request a limit increase" button to see what the options were. To my surprise, on the next page I was already approved for an increase that amounted to about 20% of the previous limit. I was then given the option of accepting the increase, canceling, or asking for more. I don't need a limit increase, so there's no point in the extra hassle of asking for more. So I accepted the increase and moved on.

As I was thinking about what just happened, it occurred to me . . . do people realize that they're better off with higher limits? Well, most people are. The exception is if you cannot control your spending to the point that a higher limit just means more spending . . . and in your case you don't need a credit card at all. But if you are like me and carry no balance (or even a small balance) from month to month, raising your credit card limits is a great thing to do. The reason? Your credit score, of course.

Specifically, how much credit lenders are willing to grant you (as well as how much of that credit you utilize) says a lot about your creditworthiness. If your lenders see you as a low enough risk to give you a large credit limit, that reflects positively on you as a borrower. Further, if you have a large cushion between your balance and your limit, it indicates that you can responsibly manage your credit.

For example, Bob and Joe have four credit cards each, and both have a total limit of $50,000. Jim also has four credit cards, but his total limit is just $12,000. Suppose both Joe and Jim carry a balance of $4,000 each month, while Bob carries no balance. Which man has the most attractive credit profile? The least attractive?

Bob: $50k limit, $0 balance
Joe: $50k limit, $4k balance
Jim: $12k limit, $4k balance

Clearly, Bob is the most attractive borrower. He has access to plenty of cash, but is financially stable enough that he doesn't need to access it at all.
Joe has access to plenty of cash, but unlike Bob he needs to tap into it to some degree. His utilization ratio is $4k/$50k, or 8%. Not bad, but not as good as Bob.
Jim hasn't been given the leeway by his lenders that Bob and Joe have, with only a $12k limit. Additionally, he needs to tap into it, like Joe does. But Jim's utilization ratio is $4k/$12k, or 33%. Of the credit available to him, Jim is using 1/3. To some degree, Jim looks like he "needs" money. As such, he is considered to be the borrower most at risk to become delinquent and ultimately default on his debt.

See, a portion of your score relates directly to these two characteristics-- how much you can borrow and how much you do borrow on revolving accounts. The less you borrow and the more cushion you have, the more financially attractive you are as a borrower . . . and the more likely a lender is going to want to do business with you. This can make the difference in a mortgage rate, terms, or points, saving you a substantial amount of money in the process.

It's unfortunate that Jim has to borrow $4k from his credit card companies . . . but his situation would certainly appear better, on paper at least, if he just had a higher limit. Sometimes credit card companies will grant you a higher limit to entice you to do more business, and sometimes you have to ask for it. Either way, as long as you don't use the extra credit, having your limit bumped up is a positive for your score. To make sure you're getting the most on paper for your responsible behavior in reality, see if you can get your credit limits bumped up. Your FICO score will thank you.

It was a rough month for my investments (I calculated these on July 2nd, so it has recovered some since). As the market dipped, so did I-- almost 1.5%. Still, my net worth chugged along, fueled primarily by new savings and investments. Debt reduction helped with a chunk of that as well. In total, my net worth climbed 1.5% over my June figure, the equivalent of 1.8% of my February benchmark. This is definitely a major slowdown from the hot growth that happened earlier in the year, but even at this pace I should reach my goal by February. It's nice to know that the market can struggle and my net worth can still simultaneously rise; although, this is a feature that is only possible because my net worth is relatively low compared to my savings level. At some point the earnings from current investments will hold much more power over my net worth than additional savings and investing, and a 1.5% loss will set my net worth back despite adding new money. I don't think I'll complain when my assets are that big, though.

Here is what my goal chart looks like with July added (and a June revision):

Looking good. Once nice thing about the market dip was that it waited until Monday to come back-- just in time for my retirement accounts to buy in at a discounted rate! I'm not into market-timing but I still like to see the market take a step back at the end of the month when I know more money is going into my accounts.

As I said above, the growth comes entirely from debt reduction and new investment, and was held back by market losses. I have a few more months of serious debt reduction before I'm out of all debt except my mortgage.

My net investable assets rose by about 2.5%, and my net liquid assets rose by about 12.4%. Both were hurt by market losses, but my liquid assets are so small that the loss was vastly outpaced by some new investment money. Since February, net investable assets are up 30.6%, and net liquid assets are up 134.4%. Debt reduction makes a huge difference for this measure.

In my neverending quest to find the best way to save for retirement, I've given some consideration to the 72(t) SEPP (substantially equal periodic payments) provision that applies to IRAs.

Basically it works like this. The 10% early withdrawal penalty can be waived, at any age, if you start taking substantially equal periodic payments designed to last the rest of your life. These SEPPs have guidelines set by the IRS, and you must be careful when you get one set up to assure that you don't get penalized for not following the guidelines.

Here's the cool part-- when you hit 59 1/2 or have been taking SEPPs for 5 years (whichever is LATER), you can stop taking SEPPs and withdraw the money at your discretion without penalty. So you can use SEPPs to help fund your early retirement, then when you hit 59 1/2 you can alter your plan to withdraw based on your needs instead of a formula. This enables you to fund both your standard retirement and any early retirement period entirely within the confines of an IRA-- giving you the tax benefits and still allowing you to take funds out before "retirement age."

How much are these SEPPs going to give you? Great American Financial Resources, Inc. has a nice calculator that will give you some idea of what one of these looks like. They also outline the rules, in layman's terms, for setting one up.

This changes the game a little bit. You now have a considerable number of options to fund early retirement: withdrawing Roth contributions, building up taxable assets and just paying capital gains taxes, or building an IRA and rolling your 401k assets into it, then setting up SEPPs. Depending on the size of your SEPPs, you may need to do more than one of these. Then when you hit 59 1/2, all these assets are fair game! Access them at your leisure, only paying applicable taxes and taking no fee hits.

My mind has been a roller coaster ride over all this research . . I've crunched way too many numbers and read way too many articles. But with the 72(t) SEPP option, I think the picture is becoming a little more clear. The best part is that conventional advice-- maxing your IRAs and 401ks-- remains applicable even if you plan to retire early. This is NICE, as it makes saving considerably less complicated.

Now that everything seems totally clear, I expect to read something in the next few weeks that confuses the issue further. But hey, early retirement wouldn't be nearly as fun as a goal if it were a stationary target. :-)

I was talking about my pappaw over the weekend, telling my girlfriend that he retired at 55. Of course, she asked, "what has he been doing for the last 30+ years?" I don't really know. He likes to garden, has rental property to take care of, and has been involved with the American Legion, but that's not nearly enough to fill so much time.

It got me thinking. I have this preposterous goal of retiring at the age of 45. I think it's doable, as in, I think I can have the money to pull it off. But what will I do with myself? That I don't know. If I plan to live it up-- travel, recreation, etc.-- then that will raise my required withdrawals considerably. If I don't plan to "live it up," I really don't know what I'll do with myself. I can't imagine finding enough hobbies to tide me over for 40 years, if I should live that long.

So I guess maybe I should figure in some pretty serious expenses-- a couple of long trips every year, perhaps . . . the cost of several rounds of golf per week . . . tickets to sporting events . . . the list would go on. I would be spending much more on recreation than I am now, but nothing on retirement savings, of course. In the end the two may cancel each other out, and my retirement expenses would be about the same as my expenses now. But you have to figure healthcare will be a major expense, and the cost isn't going down anytime soon.

So in my figuring, I should probably think about requiring withdrawals LARGER than my current income. I haven't run the numbers yet, but I've got to think it's going to set me back-- perhaps to the point where retirement at 45 is not realistically possible. This is okay, as it would solve my "what to do with myself" problem for the first 5 years or whatever it takes to make the numbers jive. And hell, retirement at 50 is still pretty damn sweet.

I'm rambling, but the point to take away from this is that when you assess your finanancial goals, you have to really put together a picture of what you want to do. Without a good understanding of that, your financial picture doesn't mean much.

The "latte factor" has been well documented in personal finance circles, but I thought I'd bring you another example of the effect . . . this time revolving around dinner beverages.

Suppose you are 25 and going out to eat, though expensive in itself, is something that you like to do and don't want to give up in order to be more frugal. Suppose also that you go out to eat once a week (we go out more frequently than this, unfortunately). How often do you order a soft drink, tea, or other beverage? For many people, this is just part of their meal. They get a Coke or a tea or some other favorite fountain drink. How much is this costing them?

Let's assume the drink is $2, which is on the low side for a sit-down restaurant. Ordering water instead will save you $2 per meal, once a week. Starting on your 25th birthday, you save this $2 every week, and at the end of the year, invest it in an index fund. Over the next 40 years, your money ($104 each year) grows at 10% annually. How much of a difference does this make to your retirement fund?

$46,029.

Wow! Opting for water instead of a soft drink can add more then $46,000 to your retirement fund.

Let's play with this a little more. Suppose you're a beer drinker, and at your weekly dinner you usually order 2 beers instead of a soft drink or water. Most places, a beer will cost you $3 or somewhere north of there. Let's assume $3, for a total of $6 per week. How much would the practice of ordering water instead add to your retirement fund at 65?

$138,089.

What if you like fancier beers @ $4 a pop?

$184,119.

What if you like to get a couple of glasses of wine instead-- nothing fancy, just a house wine-- at a rate of $6/glass?

$276,178.

More than a quarter of a million dollars for 2 glasses of cheap wine per week.

To me this illustrates 2 very important points. One is the power of compounding . . . you're putting in just $624 per year from your wine savings ($24,960 total), and when you hit 65 it's worth $276,178.

The second is how much of an impact your small spending/saving/investing decisions make. $2, $6, $8, or $12 may seem like very little compared to your salary or your portfolio value, but over time, I think we can all agree . . . $46k, $138k, $184, $276k . . . not small potatoes.

I'm guilty of straying from this pretty frequently . . . particularly for beer. But I try hard to avoid it, since beer in the store is SO MUCH CHEAPER than beer in a restaurant. I try to drink water with my meal, then go home and have a couple of beers at less than $1/bottle. Seeing the impact of decisions like this on my financial goals is a bit of an eye opener . . . one that you know is true, but when you see it in print, really smacks you in the face. Also keep this in mind-- if you like more expensive drinks or drink more of them, or if you go out to eat more than once per week, the magnitude of your decision is even greater.

So give it a shot. Start drinking water and earmark your savings for deposit in your Roth IRA. Your retirement will thank you!

In October, my girlfriend and I got our first puppy. We went down to a local animal shelter, where we were lucky enough to find an adorable little beagle/rat terrier mix, just 6 weeks old and less than 4 lbs. Three days later we took him home, and we've been so thrilled to have done it. He's about 8 months old now and is leveling off at around 23 lbs.

For most of his life, he's had a small area outside, essentially made with heavy chicken wire, where he could be let outside to do his business and play. The area was about 120 sq ft of patio and maybe 40 sq ft of grass . . . not nearly enough for a now full-grown pup! We would take him to the dog park and to play with his pals at their houses, but for the most part he just didn't have enough space.

After weeks of discussing and arguing about the cost (that was my angle) / benefit (that was her angle) of a new fence, we got an estimate for a wood fence-- about $4000. Neither of us was going to be happy spending $4k, especially in a house that we're in for the relatively short term.

In the end, we made the decision to go invisible-- specifically, we picked this kit up at Home Depot for $140. Four days and about 10 hours of burying the wire later, we had a functioning invisible fence, and we started training Bruno on it right away.

It's amazing! It is truly is remarkable how quickly he has learned his boundaries. He has gotten zapped 4-5 times, but now he's very careful around the boundary and listens for the beep-- and when he hears it, he immediately backs off. We've let him know that inside the boundary is a safe zone by playing with him consistently after he tests a boundary, and it seems to have paid off. He immediately turns and comes back, never giving a thought to continuing through the wire.

The cost difference is tremendous, and there are some additional benefits to invisible fencing as well. For one, we could snake the wire around a flowerbed in the back to make it off-limits, and it would have made no sense to do that with a real fence. Also, the back yard still has a very open feel, which we would have lost with a wood fence. When we eventually move, we can take the base and collar of the system with us, and we'd simply need to buy new wire ($30/500 ft) to install it at a new location.

So there you go. $140 vs. $4000, and we can take most of it with us. In the end, we are both happy, and Bruno is completely thrilled with his newfound freedom. Sometimes the best decisions are also the most cost efficient.

I've been doing some reading this morning and thought I'd highlight some posts that I enjoyed . . .

JLP of AllFinancialMatters shows why investing in the stock market should be a long-term strategy. Great post! What fascinated me is how lousy some of the periods involving the 1970s were . . . I knew none would be negative, but with inflation they got pretty damn close.
Jim at Blueprint for Financial Prosperity asks, is Zecco a scam? He seems to be leaning toward "no" as his next entry is about opening his Zecco account. :-) As for myself . . . I'm pretty skeptical. I don't trade much, so for now I'll play it safe and stick with Scottrade.
James of DINKs posts something I very much disagree with-- that smart people should not be using credit cards. I think what he is really arguing is that most people can't handle it, so most people shouldn't try. Those of us that are a little more responsible and savvy can use them to our advantage.
Teri at PFadvice warns us that we may be in a higher, not lower, tax bracket in retirement. This will certainly apply to some people . . . and it just raises the argument for the Roth IRA and 401k even higher. Take the lesser tax hit now and enjoy not paying them later!
Plonkee talks about randomness and insurance-- and why it's important to consider the consequences of a bad event, not just the probability. This is a great point! If my odds are 1 in 1000 of losing my job in the next year, that doesn't seem like a big deal. But 1 in 1000 type events do happen-- and if this one did, I better be prepared for the consequences. In some cases, this means buying insurance.
Kevin at HealthyWealthHappyWise makes a great post about frugal computing . . . save money by using Ubuntu linux. Actually, frugality is but one of several reasons to do this, as Kevin explains. I've used Ubuntu before and he is right . . . it's much easier to make this transition than with other linux distributions. Anyone can do it!

Great posts abound in the PF blog universe. Thanks for the good reading.

I have to say that I'm thrilled with how quickly I'm progressing toward my annual net worth goal. It was an aggressive goal and it looks like I may meet it early (though the market taking a bit of a dive right now is not going to help).

But there's a downside to this. Let me explain. I've been tracking my net worth for less than 4 months and it is up 20%. That's a fast pace, and it has been driven 2/3 by savings, new investments, and debt reduction-- so it's not like it's all about the market. Anyway, if you take that rate of growth back in time, just a couple of years ago I would have been near zero. That wouldn't be a big deal if I were at zero or if there was some reason for having a low net worth that changed only recently.

But there wasn't. When I finished grad school, I had no debt and a good job. My net worth was already positive. That was 4 years ago . . . what the hell did I do with my money for the first 3 1/2 years ? It sure wasn't growing much. If I can grow my net worth this quickly, it just casts a major shadow on my financial life for the first few years after I got out of school. It makes me wonder . . . what would my NW be if I was this diligent upon graduation? Double what it is now? Perhaps. THAT is a depressing thought.

It is also a stupid thought because there's not a damn thing I can do about it now. I made my mistakes and now I just have to do my best to move on and do better. It could be worse . . . much worse. Some people are 40 or 50 before they come to their senses about finances. Some people never do. I only wasted 3 1/2 years or so, and even doing that I didn't get myself into trouble (credit card debt, excessive spending). I just wasn't saving and investing like I should have been.

It troubles me when I think about it, but I'm going to try to just forget about it. Spilled milk and all that. Most of us have to do this from time to time; make a mistake, learn from it, and then just forget about it. Letting it linger is not going to do any of us any good.

So, on to better (and hopefully much, much bigger) things. But I thought I'd share because we've all kicked ourselves (perhaps a little too much) over mistakes that just ought to be dead and buried.

I've been giving early retirement a lot of thought lately. Specifically, I've been trying to figure out which investment accounts can be best used for this purpose. Should I throw money into a taxable account, paying only capital gains taxes when I need to sell some for income? Should I put it in a Roth IRA so that I can withdraw contributions tax- and penalty-free before I am 59 1/2? Should I put it in a 401k and take the 10% penalty when I need to withdraw some?

One thing, to me, is obvious. The Roth IRA is the best solution. It beats the taxable account hands down, essentially eliminating the capital gains tax as long as you only withdraw contributions. It also beats the 401k (on which you would pay ordinary income taxes plus 10%) in most situations. But there's a problem here; you can only shelter so much money in a Roth IRA each year. Currently it's $4k, soon to increase to $5k. If you plan on retiring very early, say at the age of 45, it's unlikely that you could have built the Roth IRA up enough to support you until "retirement age."

The Roth 401k is a solution to that problem. The limits on the Roth 401k are just like the traditional 401k-- in the neighborhood of $15k per year and set to increase in the future. Contributions are also after-tax, meaning you can contribute more overall than in a traditional 401k (considering the front-end nature of the Roth taxes). Withdrawal rules are similar to the 401k, so you have a 10% early withdrawal penalty as well as mandatory withdrawals at age 70 1/2. But just as you can rollover a 401k into a traditional IRA, you can rollover a Roth 401k into a Roth IRA . . . and in the process you can circumvent these withdrawal restrictions. As long as you wait 5 years to withdraw funds, you can withdraw contributions from the rolled-over Roth 401k tax- and penalty-free. In essence, the Roth 401k allows you to increase your contribution limits on your Roth IRA, from a paltry $4k per year to a hefty $19k per year, getting you much, much closer to being able to support a long early retirement. You simply have to do a timely rollover when you leave your job.

This is a phenomenal tool, and one that most companies to date are not offering access to. Fortunately mine is-- and I am about to change my deferrals to take advantage of it. As long as the government keeps its promise and does not tax Roth withdrawals, the Roth 401k will be the ideal tool for preparing to retire early.

It seems, every week, there are a lot of PF bloggers talking about renting vs. owning, and it's a subject I love to comment on. This morning I read Real Estate Isn't a Gimme on Money Musings, a post referencing a David Crook article on Yahoo! finance.

It all got me thinking about my house, how much has gone into it, and how much I'd get out of it if I sold right now. I decided then to make a spreadsheet, add up all my payments, maintenance costs, small improvement projects (that I wouldn't have done in an apartment), and my startup costs (closing costs and down payment) to see what kind of returns I've seen in my two years in the place. Here is a breakdown of what was included:

closing costs (less than 1% of loan value)
down payment (11% of home price)
monthly payments (20 year 5/1 ARM with initial 5.o% rate, plus taxes and insurance)
maintenance costs (only those that would not have been incurred in a rental)
improvement costs (landscaping, new hardware, painting, etc.)
Sale proceeds, assuming market value and a 6% realtor fee (which we won't be paying when we actually sell, but included for illustrative purposes)

The end result? We broke even, spending $100 more than we gained in the 2 years we have lived there. That may not sound good, but it is . . . and here's why. We lived in the house for those two years. That means we had no rent to pay. Between rent and renter's insurance, we had been paying about $820 per month to rent before we bought the house. (As an aside, this apartment was 500 sq ft smaller than our house and had no garage . . . so our living situation improved as well.)

When I factored in the monthly rental savings (assuming no increase in rent-- which is doubtful), I get a considerably different bottom line-- an internal rate of return of more than 44% annually. Forty-four percent. Now THAT is a return on investment.

The usual caveats apply-- your mileage may vary, your market may differ, etc. In fact, I'm certain that such a gain would not have been possible in larger markets because of the considerable cost difference between renting and owning. But in a market where they are relatively close, like mine, your returns from buying a home over renting can be tremendous. Ours certainly have been.

Okay, so I'm on the 1st of the month now. I'll try to keep it here from now on, but it will certainly test my patience.

It was a good month (well, 3 weeks) overall. Net Worth is up 2.66% over last month, bringing me up to a 20.4% gain over February. I'm about 58% of the way toward my goal for the year. See the chart below.

Of the growth, about 32% comes from debt reduction, 20% from investment gains, and 48% from new savings/investments. I expect debt reduction to continue to be a big factor until my car loan goes away (either from downsizing my vehicle or paying it off). That will be December, at the latest. At that point debt reduction should be a smaller share of my growth each month and new savings and investments should take off.

As promised, I also calculated Net Investable Assets (5.01% gain) and Net Liquid Assets (14.19% gain). Both represent an increased share of my Net Worth, which I consider a very good thing. My equity in my home is going to keep rising but I want the more liquid assets to fuel most of the growth.

Things are going pretty well, at least partly do to the continuing rise of the stock market. But I'm young, so if we eventually have that pullback that everyone is calling for, it will be an opportunity to buy up cheaper shares. I've got plenty of time for it to catch back up.

I was exchanging emails with a former coworker yesterday, and we have had mutual frustration with my employer. Not that this is rare; I think everyone gets frustrated with their employer at times. Overworked, underpaid, underappreciated, office politics-- something bothers everyone.

But you know, I really don't like my job. It's not just about my employer either, though that certainly factors in. I just don't really like what I do. I never come to work looking forward to it, and often my motivation wanes. Am I miserable? No. I don't dread work every day . . . it doesn't keep me from sleeping, and I don't get terribly stressed out about it. But it is certainly not something that makes me happy. I'm good at it and it pays the bills . . . but for me it's just a means to an end.

Is that bad? Yeah, probably. But how bad is it? How important is job satisfaction to your overall ability to enjoy life? I've wanted, for a long time, to find a job/career that could satisfy me both financially and personally, but it simply isn't happening. Not now, anyway. So I've dealt with it by tossing my energy into other areas of my life that do give me joy: Yardwork and landscaping, and working with my hands in general. My finances and investing. Sports (I'm a big college basketball and football fan). My girlfriend and our puppy. Beer and wine. I devote most of my free time to these endeavors, and it keeps me sane.

In fact, I'd say I'm a pretty happy person, despite the misfortune of being on a career path that does nothing for me except provide a paycheck and some benefits. I am constantly looking for a way to improve that part of my life, but you know-- I can live with it, for as long as I must. At times I haven't felt this way. I've let myself get too worked up about my career, and felt that a career change was a pressing problem that I needed to address. But when I think about things rationally, I realize that things at work aren't so bad, and that the rest of my life is good enough not to fret.

I know that some people feel very strongly about doing what you love and loving what you do. But how important is that, really? If you can pull away from work and at the end of the day do other things that make you happy, doesn't that go a long way toward happiness? For me it does. I won't give up on my goal of self-employment or obtaining a dream job (like being a statistician for a certain athletics program, for example), but in the meantime . . . I'm doing fine.

Ah yes. All fund companies have something to offer you that nobody else has-- funds that will beat the market! Or so they will tell you. You can beat the market with managed mutual funds-- sometimes. To do this, you either need to be lucky or know something that most people don't-- a fund manager or company that consistently outpaces the market indexes.

Some managers are better than others, but nobody consistently beats the market. You have to pick and choose the right funds from the right people, hoping to maximize your chances. But your odds are still not great. When googling on the subject I ran across the following curiosity, courtesy of Vanguard:

So on average, here's how badly the managed funds lose to the market indices (for the 10-year period ending Dec. 2004):

LCV: 0.86%
LCB: 1.82%
LCG: 2.43%
MCV: 3.54%
MCB: 3.04%
MCG: 5.00%
SCV: 1.05%
SCB: 1.10%
SCG: 1.29%

The managed funds fared best in the small cap blend arena, where they still lose 53% of the time (and by an average of 1.1%). Managers do especially poorly with mid cap stocks.

Why? Well, two reasons. One is that fund managers, in general, do not pick winning stocks very well. The second is fees. Huge, enormous fees. Some managed funds do well enough to beat the market, but fees erode the difference (plus some) and the fund is a loser in the end.

Personally my investments are blended between managed and index, but this is not by choice. I would go entirely with index funds if my options allowed it. The managed funds I do have are at least rated well by morningstar and have relatively low fees.

Let this tidbit sink in for a moment. Fund managers are educated, trained, and experienced in stock picking. And according to this chart, it seems they lose to index funds some 3/4 of the time or more. What does that say about building your own portfolio out of individual stock picks? To me it says, "you'd better get lucky." You may win big, but you also may lose-- and the odds are stacked severely against you.

I'm a big fan of the Net Worth metric. I think it paints a nice picture of what position you are in financially, and gives you an easy way to set goals. But it has flaws, says Nickel. He suggests a similar measure with a different name and one major difference: Net Investable Assets. In a comment, FMF of FreeMoneyFinance goes a step further with Net Liquid Assets. I'd like to take a look at all three metrics because they each have something to offer.

Net Worth. The classic measure of wealth. All of your assets (cash, investments, property, etc.) minus all of your liabilities (loans, revolving debt, etc.). This is a great measurement because it paints the whole picture-- how much MONEY do I have? If I sold it all and moved to South Dakota, how much would I be taking with me?

Net Investable Assets (NIA). Nickel dislikes that the net worth calculation involves the primary residence and personal possessions:

The main reason for my aversion to net worth calculations is that I’m most interested in charting a course to financial independence and, in my view, financial independence doesn’t involve selling our house or getting rid of our cars. True financial independence involves amassing enough wealth that you’re able to live of your investment income with no additional input.

In his view, NIA provides a good measure of this. You simply tally up your assets and liabilities, as before, but eliminate your residence and personal property (side note-- I'm not sure what Nickel would say about an auto loan. Even if I don't count the value of the auto, I think I still ought to count the loan as a liability).

Net Liquid Assets (NLA). FMF says:

I track and record my net worth every month. In addition, I also track and record my liquid assets (the ones I can get my hands on easily and without penalty) which excludes my home and retirement investments.

I think it's wise to continue to leave personal property out of this equation as well. This becomes a measure of how much money I have that I can readily get my hands on without having to start selling my stuff or tap into retirement funds. Another good measure.

Let me just say that I like all three of these very much. They're all similar measures but the purpose of each is considerably different. I have added NIA and NLA to my tracking spreadsheet and think they'll be very informative.

This all leads to a question for me. What percentage of your net worth should be in NIA? In NLA? It's a tough question, and depends largely on your goals. If you have no plans to retire early, NLA can merely be whatever amount makes you comfortable in case of an emergency, since you don't need the liquidity otherwise. But if you plan to retire early (as I do), you'll need assets you can get to without penalty. As for NIA . . . well, that's tough. For a renter this is not a MAJOR issue, as your net worth and your NIA aren't terribly different. For a homeowner, perhaps the percentage is not so important as long as you have goals set with NIA, not just net worth, in mind.

As for me, here's how the numbers break down: 48.7% of my net worth can be classified as NIA, and 5.7% of my net worth can be classified as NLA. So personal property and my residence comprise just over half of my net worth. I knew this already, and getting that under 50% has been a minor goal for me.

The shocker is the NLA. 5.7% of net worth? Just 12% of NIA? That seems really lousy and I'm not comfortable with that number, and if I'm to retire early, it will have to grow rapidly. What this amounts to is cash savings + taxable investments - non-mortgage debt.

When I read other blogs, some people have negative net worth. I always felt good because mine was significantly positive. Well . . . my NLA hasn't been positive until recently. It was probably negative last summer, as I had a car loan with a much larger balance and no brokerage account. If people took a hard look at this, some people with great net worth may not look as rosy, and some with negative net worth might look far worse off (credit card debt would be nasty for NLA).

There is a bright side though, for me and everyone else. NLA can grow rapidly. Probably much more rapidly than net worth or NIA, if you are committed to it. Why? Because all debt repayment will go straight to to this bottom line, and as a %, the growth can be tremendous-- especially early on.

Take me for example. My net worth has grown 17.3% since February. My NLA has grown 83%. Why? Well, two reasons. One, it started small. Damn near zero. Two, debt repayment on my car loan and eye surgery is contained in my NLA, and these account for nearly $800 each month. That's a far larger percentage of NLA than it is of net worth. In the coming months I expect it to continue a rapid ascent. I'll know that my NLA is in better shape when it starts to slow down a little-- this will mean that my debts are gone and my NLA isn't so tiny anymore!

I'll be thinking, in the coming weeks, months, and years, about what percentage of my Net Investable Assets needs to be liquid. There is an answer out there and I just have to do some math to get a good estimate. It's clear to me that this is the weak area of my financial situation. I have to thank Nickel and FMF for their comments on the topic. Without them, it may not have jumped out at me as it has.

I've danced around it a bit, partly because I knew I had more changes to make, but I think it's time to go ahead and post my allocation. Silicon Valley Blogger over at The Digerati Life has put up a second post highlighting some bloggers' asset allocations, so I figure this is a good time to share mine as well. I've struggled with this a lot, and am only 90% settled on this as a long-term allocation strategy. Specifically I am still deciding how much I want invested in the international markets.

Keep in mind, this does not include my emergency cash reserve (about 3 months' expenses)-- this is my retirement/investment portfolio. I got these images as screen captures from Vanguard, where I keep up with all of my accounts.

So as you can see, I'm 99.9% in stocks (all in mutual funds with an overall expense ratio of 0.72%) with the 0.1% being unused cash in my brokerage account. My domestic stocks are tilted towards value with an increased position in small cap stocks to help maximize long-term growth.

The value tilt isn't a trend thing. While it's important to have some balance, as growth stocks have outperformed value before, value, over the long haul, has had better returns with less volatility along the way. I will probably keep a significant value tilt in my portfolio unless something makes it less reasonable to do so.

As I said before, I'm considering increasing my position in foreign stocks (perhaps to 30%), but I'll probably do so gradually with increased contributions in my retirement accounts. I briefly had some 10% in bonds, but my research last week convinced me that now was not a good time for me to put my money there; not even a small percentage. So for awhile I will be invested nearly 100% in stocks, ready to ride the peaks and valleys to (hopefully) high returns down the road.

Conventional wisdom says everyone needs some bonds. If you don't need them for income, you need them for a diversifier, to balance out those bad years in the stock market. Right?

Wrong.

At least when your investment horizon is at least 10 years it is wrong. I recently came across a spreadsheet with total annual returns for most of the major segments of the financial marketplace, dating back to 1972 . . . it also has a handy tool that calculates what your return would be with a certain asset allocation. I added functionality to see what return would be by 10 year periods, since I am not interested in short-term behavior as a long-term investor.

When looking at the total US stock market and the total US bond market, care take a guess in how many 10-year periods bonds beat stocks? Once. Out of 26 10-year periods, bonds beat stocks once, from 1973-1982, by a score of 8.32% to 7.44%.

In only one period out of 26 did holding bonds enhance your returns over the returns of the total stock market. Not what I would have expected, but then I had never held all the numbers before.

Is there a better option to limit the chance of a "bad" decade in the market? Yes, there is. Let's start with Large Cap Value stocks. In the short term they are clearly more volatile than bonds. But when smoothed out over 10 years, they are never beaten by bonds. Ever. Not once in 26 periods. The worst period for large cap value stocks was from 1993-2002, where it saw 9.27% gains. That was the worst period. Read that again . . . let it sink in. The average return for bonds since 1972 is 8.06%. The worst 10-year period for large cap value stocks is 9.27%.

Hello.

And Large Cap Value isn't alone. Mid Cap Blend (10.64%) and Small Cap Value (10.92%) also outperformed the average bond return in their worst 10 year period. I didn't have info on mid cap value, but I would be willing to bet that it did too.

So it's clear here that there are better investments when it comes to minimizing long-term risk-- and they return much, much better. But what of the possible return enhancements of diversifying with bonds? Is it possible that in some years, their higher returns over stocks will actually improve the overall return? Assuming you aren't psychic and can't time the market, you'll have to keep some bonds all the time if you hope to accomplish this.

So I took this question and some handy common portfolios to try it out. Here are the portfolios:

Swenson: 30% US market, 20% REIT, 20% international, 30% bond. The total return of this portfolio over 35 years is 11.56%. The worst period was 8.35% and the best was 16.78%. What happens when we replace the bonds with

Large Cap Value stocks? Total return of 13.00%, worst period of 8.83%, best of 18.55%.
Mid Cap blend? 13.89%, 9.48%, 19.05%
Small Cap Value? 13.55%, 9.44%, 21.18%

CoffeeHouse: 10% large cap value, 10% large cap balanced, 10% small cap balanced, 10% small cap value, 10% reit, 10% international, 40% bonds. Returns of 11.68%, 8.63%, 17.04%. Replace bonds with:

LCV? 13.61%, 9.29%, 21.02%
MCB? 13.71%, 10.13%, 21.73%
SCV? 14.26%, 10.01%, 24.56%

My portfolio: 35% large cap blend, 15% mid cap blend, 10% small cap blend, 30% international, 10% bonds. Returns of 12.26%, 8.14%, 18.89%. Replace bonds with:

LCV? 12.70%, 8.24%, 19.46%
MCB? 12.73%, 8.48%, 19.40%
SCV? 12.91%, 8.50%, 19.46%

Hm. So in all 3 of those portfolios, replacing bonds with one of the other 3 asset classes raised returns EVERY time. Overall, in the best times, and in the worst times. So much for the diversification benefits of bonds.

I'm almost convinced that I need to get rid of my bonds and get into something better. I'll do some more reading first. If my investment window were less than 10 years, I would reevaluate bonds over that short timeframe. As it is, my investment horizon is at the very least 20 years away. From the looks of it, I'm only going to lose money by keeping anything in bonds.

JLP at AllFinancialMatters has a disagreement with some arguments on the virtues of paying off a mortgage early. I agree with JLP, and it comes down to some (somewhat) basic calculations. Let's take a quick detour here by talking about real estate as an investment. First of all, my opinion is that real estate is a phenomenal investment. The reason can be summed up in one word: leverage. Leverage, in terms of real estate, refers to the relatively small investments you make each month in order to get the returns on a much larger sum of money. This leverage comes in two basic varieties.

You own your home. You get phenomenal leverage here because the "investment" turns out to merely be a tradeoff. It's what it costs you to buy a home vs. what it costs you to rent. Housing expenses will always be there, whether you rent or buy. So the real "cost" of homeownership is how much more it costs you to buy than rent. If renting costs you $800 a month and owning a $150,000 home costs you $1100 in mortgage payments, taxes, maintenance, insurance, etc., then your investment cost for the real estate property is $300 per month. Historically, real estate appreciation is in the neighborhood of 5%. But do you earn 5% on your $300 monthly investment? NO! You earn it on the value of the house-- $150k. A quick calculation says that 5% of $150k is $7500. So after one year, you've invested $3600 into the house, and the value has gone up $7500-- not to mention the small gains in equity from paying down the principal. You don't have to be a math whiz to know what a phenomenal return that is.
You own rental property. The reasoning here is identical. You pay so much per month in costs, but you get some (or all, or more) back in rental income. So again you pay a small amount (at worst) each month to get appreciation on a much larger amount. Interest rates are higher on rental properties, but rental income usually makes up for much of this difference. Again you get a phenomenal return.

In both cases you are putting in a small amount to obtain growth on a much larger amount. Leverage. In all but the worst housing markets you can get good financial gains using leverage in real estate.

How does all this relate to the argument over paying down a mortgage? The bottom line is that every time you throw extra funds at the mortgage, you are reducing the leverage you have on the property. Think about it this way: if you buy a house outright (no mortgage), you have absolutely no leverage. How long will it take you to see good returns on the investment? Well, unless appreciation is well above average, you never will. You'll merely see a 5% ROI. There is a sliding scale between paying in full and paying only the minimum payment, and the earlier you pay off the mortgage, the closer you are to paying in full. In other words, your returns go down as you try to pile up the equity. It has less to do with the difference in rates between the mortgage and the stock market (though this does matter if you divert additional mortgage payments into the market) and more to do with the reduction in leverage.

Let me give you a quick example. Take the $150,000 house mentioned above, at a rate of 6%. The payment is approximately $900, so assume an extra $200/month for other associated costs. The costs above renting (assume $800) are $300/month. You are paying an extra $300/month over renting to gain this investment. Assuming 5% appreciation per year, at the end of 10 years your equity is almost $118,000 (on $36000 total investment over time). According to Excel's XIRR function, that's an annual return of 22.5% on your money. Not bad!

Suppose instead that you pay an extra $100 toward the principal each month over the same 10 years. Then your equity would be about $134,200. Sounds better, right? But wait-- you paid an extra $100 each month ($48,000 total). What is your annual return now? About 19.6% per year overall. Still phenomenal, of course. How does it compare to investing in the market? When the extra $100 is conservatively invested in the market (assume 8%) instead, your overall rate drops only to 19.8%. With more aggressive investments (12% return) your overall rate climbs back up to 20.3%. If you invest that $100 in another real estate property (say, a rental) your returns are likely to be even greater (again through the power of leverage).

How many investors would shrug off a couple of percentage points? Not many. But that's exactly what you do when you sacrifice leverage for more equity. Paying off a mortgage 5 or 10 years early sounds great for your peace of mind, but it's lousy for your bottom line . . . many higher yield alternatives will make you richer in the end.

I try to catch up on all the blogs first thing Monday morning when I can. My Money Blog reveals some misinformation (or at least misleading use of information) in Suprising Truths (and Half Truths) About Credit Card Debt. I've heard several times that when looking at more robust measures, credit card debt is not nearly the epidemic that the media makes it out to be, and it's nice to see that confirmed with some hard data. I haven't ever carried a balance, so I'm in that 29% category. It's nice to know that less than half the country carries credit card debt at all-- and I bet a small fraction (maybe 15% overall) are in what I would consider "problem" credit card debt. Great info!

The other strikes me differently. S. Shugars wrote a post at PFadvice claiming that the money-saving result of kicking the smoking habit is a myth. I think this is probably a good point for a lot of people, but not everyone. I'm familiar with the phenomenon of eating, drinking, or some other vice taking the place of the smoking, but I don't think this is by any means universal. I live with a counterexample. My girlfriend quit smoking almost 5 years ago, and to my knowledge she has picked up no nasty or expensive habits to replace it. She was ready to quit and be rid of cigarettes, and once she had done it, she simply became a non-smoker. Perhaps that is the key-- you have to be emotionally and psychologically ready to kick the habit, not just the nicotine. Those are the two components of a smoking addiction and they're both difficult, from what I understand. It's hard to quit unless you can do both, and if you can't, you may develop these other habits that continue to make your life expensive and less healthy.

Think about dividing your expenses in this manner:

1) Necessities. Housing, food, gas, clothes, etc.

2) Personal and financial betterment. Taking a class, reading a book, remodeling a bathroom to increase home value, etc.

3) Recreation/leisure/personal pleasure. Everything else, pretty much. Movies, vacations, concerts, whatever.

Note that there is some overlap for some items. for example-- food and clothes are a necessity but when you go out to eat, buy fancy shoes, etc. you are not making that purchase purely out of necessity. It is also for personal pleasure. Beer is probably my biggest overlapping expense.

Now that we have our definitions down, how much is it okay to spend as a percentage of your income? I haven't ever taken the time to break down how much I spend in this area, and if I did I can guarantee that I wouldn't like the result-- and I am a pretty frugal spender for the most part. But why should I get upset about it? Spending in this area is okay to a certain degree. I'm convinced of this. But where is the threshold?

We are probably not taking a vacation this year, for two reasons.

1) I don't have much disposable income since I am paying off a car and a surgery by December.
2) We'd rather save up some money and take a better vacation next year. If we could spend $1500 this year and $1500 next year and take two small driving trips to relatively uninteresting places . . . or we could spend $3000 next year and fly somewhere we can't get to on the road, we'd prefer the latter.

At least those are the two reasons we agree on. I have a third reason . . . I don't want to spend the money! More and more lately, I have gotten obsessed with my bottom line, and my better half doesn't think I spend enough money/energy on fun in the present. We had a bit of a spat last night on this issue after a conversation about my vehicle downsizing effort. She's fine with a vehicle swap but she doesn't want me to go too cheap or too old because she thinks it's just unnecessary and I'll enjoy the car less. She's probably right, and I'd probably get the urge to change cars again sooner than I need to because of it.

We have different opinions on spending, clearly, and we both tug each other toward the middle. I think this is ultimately a good thing-- she'll be better off in 5 years for saving more, and I'll be better off in the present for not being quite as much of a tightass!

But I digress. How much should we be spending in this 3rd category? In the coming days I may subject this question to some detailed analysis and estimate what fraction of my income goes toward this. I'd like some opinions from readers and other bloggers, though, as I know my opinion is skewed in the "less is better" direction.

I currently drive a Honda Pilot. It's a good value, as SUVs go, and I got a decent deal on it when I bought it new in the Fall of 2005. But the financial revolution I have been going through has revealed something to me . . . I don't need an SUV. I didn't then, though I made lots of arguments to myself that justified getting one. I bought the SUV out of desire, not need. In many ways I am ashamed of myself for this, as I always try to be sensible with my money. I thought I was being sensible . . . I couldn't find a used Pilot or Toyota Highlander for less than I was getting this one new. My mistake was thinking I needed one of the two.

Driving this car has hurt me financially. There are no two ways about it. I get about 17.5 MPG city, and maybe 20 highway. Depreciation has not been that terrible, since it is a Honda, but the extra cost of getting an SUV automatically increased the deprecation over other vehicles I could have purchased. Between this and fuel costs, I'd say it was a mistake of several thousand dollars.

That's a mistake I'm going to try to (partially) correct by ditching it for a more sensible vehicle. Gas just keeps getting more expensive, and I'm not far from paying $60 for a fillup. I'm sorry, but that's just not going to cut it for me. I can't stand that kind of expense. So I'm starting to look around at used compact cars . . . Civics, Corollas, Sentras, and any of a number of hatchbacks. If I buy used, I will come out ahead on the deal. My vehicle is worth about $19k and I don't plan to spend more than $15k on a compact car. I still owe some, but it's less than $4k. If I did the deal right now, the swap, after taxes and such, would be even or better, and from here on out I'd be getting some money back in better mileage and depreciation.

Anybody else going through these same deliberations? Fuel costs are just out of hand. It made little sense for me to buy big when I did, and it makes even less sense to keep paying for that mistake.

A few great personal finance blog posts from the last couple of days:

Trent at The Simple Dollar talks about the all-important tradeoff between money and job satisfaction.
The Sun's Financial Diary offers up the top 5 reasons he started a personal finance blog. I'm right there on #1-4 . . . it'll be awhile before I can even sniff #5.
One of the writers over at Personal Finance Advice gets paid to have sex. Until I read this post I didn't realize that I , too, get paid to have sex, although I'm not making nearly enough money in this particular business venture. :-\
Mighty Bargain Hunter lists the top 5 ways to kill your retirement dreams. What a great list! There have been some fantastic contributions to the ProBlogger Group Writing Project.
English Major talks about her Financial Foe: lack of planning. Some would say I have a planning problem too-- I overplan. I get grumpy when people want to change things up.

I'm going to try to do this once a week-- if for no other reason than for the other bloggers to know that I appreciate what they contribute to the blogosphere and my knowledge/sanity/life. Thanks folks!

So I'm impatient! I keep telling myself to wait a full month before updating my net worth, but it's fun to update, so I haven't been able to wait that long. I figure when I back up all the way to the 1st, I'll try hard to stick with the 1st from then on as a measuring point. Anyway, since April 17th (3 1/2 weeks) my net worth has climbed 3.45%. Since I began tracking in February, it has grown 17.3%, nearly halfway to my 2007 goal of 34.8%. Here is a chart of my progress so far:

The strong US market fueled 31% of this month's growth, debt reduction another 36%, and the remaining 33% came from new savings and investment contributions. Pretty good balance! If the market stays strong, it looks I will achieve my net worth goal by the end of the calendar year, which would be nice. Many people are expecting a pullback at some point . . . that could keep me from achieving my goal at all. But that is beyong my control, and if the market dips, that just means I will buy more shares and get faster growth later. It's nice to have a long investment horizon.

After giving the matter a lot of thought, I made some changes in my accounts that "fix" my allocation problem without forcing me to go all-small or all-big in the accounts. I also discovered that there is a really good bond fund (Calvert Income: CINCX) available in my 401k, so I used that to get my allocation in bonds to near 10%.

I'm going to get on my horse and make several short posts today . . . I have a lot on my mind. Stay tuned.

The last couple of weeks I have been giving asset allocation a lot of thought. Everyone has their own ideas about this topic, and I'm still trying to lock down what I want my target to be. I'm currently thinking 20% international, 10% bond, 35% large cap domestic, 20% mid cap domestic, and 15% small cap domestic. That would get me a lot of exposure to the high risk/reward smaller companies but still diversify me across large caps and bonds. As young as I am I need to be willing to put money into high long-term return vehicles.

That's all well and good, but how does one go about achieving their target asset allocation? I'm a big believer in the efficiency of the market and thus a big believer in index funds. Low cost, good returns, simple to manage. But I'm pretty young, and my employer-related benefits (401k and alternative 401a pension) make up some 60% of my portfolio. That would be okay if my fund options in those vehicles included index fund choices and especially if there were small- and mid-cap options. Those choices are slim, though. I have one S&P 500 index in the 401k, and then small- and mid-cap index funds from ING in the 401a. Beyond that there aren't index funds to speak of, so currently I have considerable assets in managed funds.

The bottom line is, I can get large-cap exposure in the 401k and small- and mid-cap exposure in the 401a, but ONLY if I devote all of my funds that way in the respective plans. I know I should be looking at my overall portfolio allocation, but for some reason having all my eggs in one basket within a plan makes me nervous. What to do? Well, for now I have a Roth IRA with Vanguard and a Rollover IRA with Fidelity, and both afford me many more low-cost options, but those are a much smaller percentage of my total portfolio, so their influence isn't great. I guess if I truly want to achieve my target allocation, I'm going to have to move nearly all my 401k assets to large cap and nearly all my 401a assets to small- and mid-cap. Do my nerves regarding this seem irrational? Maybe those of you with more experience can advise.

This has been a hot topic around the blogosphere lately. The most recent entry I read is from Consumerism Commentary: Renting Makes You Richer. He quotes the argument from an MSN article throughout, so these are not necessarily his feelings. The problem with so many of these articles is that the assumption (or argument) is often made that there is a right way to do things. With the housing market there is most definitely not one answer. It is very dependent on local conditions.

For example, where I live, homes are generally cheap and there is not much difference between a mortgage payment and a rent payment on the same property (in fact, the rent payment is usually more). It's also a market that has not declined at all because it never really got overpriced-- $100/sq ft is about average here now, and it only fluctuates a little from area to area. My house has in fact appreciated considerably since I moved in 2 years ago . . . almost 18 percent, using a conservative estimate of the current value.

So, what do things look like if you live in a market like mine? First of all, rent payments save you virtually nothing and often cost you more per month than owning (including taxes and insurance). For my house I think I can state with confidence that rent would be more than my mortgage and escrow payments. But let's assume it's equal. Then renting saves you no money over buying, so there are no additional monies to invest. The only savings from renting would come in maintenance costs. For my house, that has mainly been yardwork and improvements we've made inside and out. I estimate that among painting, mowing, and landscaping, we've probably spent $2,000 in two years. I can't think of any other significant maintenance costs that I wouldn't have if I were to rent. So there's your monetary difference: $2000 over 2 years.

What do I get for that $2k? About $6k in equity from mortgage payments and more than $20k in appreciation, for a net of $24k. If you can find me another investment that would have earned me 1100% in 2 years, I will jump on it. I know what you're thinking-- 18% appreciation in two years is not ordinary. And I agree. So assume that it tracked inflation instead, appreciating 6.1% in those two years. Then my appreciation is only $8k instead of $20k, and my total return is only $12k instead of $24k. So we're talking a mere 500% return on my $2k. Yawn.

That's ignoring the tax benefits of owning the home, which most people get. To be fair, it's also ignoring my down payment. The argument still works, since I could have put down much less than I did without incurring considerable fees (no PMI at my credit union). Suppose I include the down payment in my house investment "costs." Then my extra expense is $15k instead of $2k. But you have to add that $13k to my equity as well-- so my return is $37k. That's a return of 150%. And again, even if you suppose this happened in an average real estate market returning only inflation-- 6.1% over 2 years-- I've spent $15k to earn $25k. That's a return of 67%. It would have taken some really good stock picking to get that in 2 years, and we all know the risks involved in stock picking.

Alright, alright, what's the bottom line? The bottom line is that in my market, renting would have been inferior to owning even with average appreciation. With actual appreciation my returns have been tremendous, and could not have been matched by renting and investing. Not even close. In a market where rent was much lower than a mortgage payment (as in Flexo's example), I can easily see the argument for renting. But it ain't so here.

Starbucks, why must you tempt me?

Some mornings I just wake up and need a chai latte from Starbucks.A Chai and a blueberry muffin make a terrific breakfast. Too bad it's more than six bucks to get this breakfast at Starbucks, and nobody else makes a chai like they do. So this morning, like most mornings, I resisted the urge. I came to work, sans chai, and now I'll just think about it longingly as I sip my bad coffee instead. I don't want to deprive myself of everything good just because it's more expensive than I'd like, but if I can stop myself, say, 5 out of 6 times, I'll save quite a bit of money. And when it comes to the chai and muffin at Starbucks, 5 times means more than 30 bucks-- or almost two shares of Vanguard's Small Cap Value Index Fund (VISVX).

If only I could be Roger Clemens

Clemens just signed with the Yankees to play another season at the age of 45. He'll start pitching in the Yankees' farm system in about 2 weeks. His pay for a partial season? A mere $18.5 million. Let's not forget that Clemens is a starting pitcher as well-- so not only will he just play for the yankees for 1/2 to 2/3 of the season, but he'll only pitch 1 in every 6 games for them when he does join the team. If you do the math, depending on the assumptions, he'll make somewhere in the $50k and $100k range per batter he faces. Not bad for a couple of minutes of work.

Do you do your own yardwork?

I do. My girlfriend and I mowed the lawn and planted some annuals yesterday. I can't stand the thought of paying somebody $25/hr or more to mow my lawn. It seems that more and more people are hiring lawncare services to at least mow-- and often to seed, fertilize, etc. as well. The lawncare companies make money hand over fist from this. Put your gloves and an old t-shirt on and do it yourself, America. Your savings will thank you.

Gen X and Gen Y woefully undersave for retirement

Big surprise, right? JLP over at AllFinancialMatters talks about this a little in his post Young People All But Ignore Planning for Retirement. English Major also has some words about the same article in The Kids Are Alright. I have to agree with English Major's points on the subject-- few people under 26 can afford to max out their 401k even if they want to. There's no way I could do it right now. With no mortgage and no car loan? Yes. But that's not exactly realistic.

However, JLP brings up some really important points. First, the table he cites is troubling not in the % who max out their 401k, but in the % who participate at all. Less than 1/3 of those under 26 and less than 2/3 of those under 42 participate in their company's 401k. Second, he brings up the need for personal finance education in our schools. If people, on average, knew a little more about finance, would we have the big rash of foreclosures and the huge credit card debts that we see? I'd like to think not.

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