Bert Whitehead, M.B.A., J.D. © 2010
Almost one of every four homeowners are faced with the sad reality that they owe more money on their home than they could sell it for. In the real estate world, that’s called ‘being underwater.’ This blog is a realistic review of your options, and discusses the biggest mistake people make when they are in this tight spot.
1. If you can still afford to live in your home and enjoy living where you do, stay there. If you are still working (or retired with the same income as when you bought the house and qualified for the mortgage) and living within your means – don’t worry about how much your home is worth because you don’t have to sell it. Your home is an inflation hedge, especially if you have a long-term fixed rate mortgage. In most areas of the country home values will eventually rise again. Keep in mind that one of the primary purposes of owning a home is the joy of living there.
2. If, however, you need to move, then you have to review your options. It may be that you have become unemployed, or your job requires relocation, or you want to downsize to cut expenses. Many people have adjustable rate mortgages that have been reset to a higher interest rate, so they cannot afford to live in their home. The obvious answer is that you can sell the house for what you can get, then sell other assets (perhaps some investments) and bring a check to the closing to cover the amount of the mortgage not covered by your sales proceeds. As we will discuss later, this is often the best option.
Regardless of what you may have heard, the following options (#3-#8) are successful only for homeowners who stop making payments. Banks are not likely to negotiate with you if they are still getting paid…and why would they?
3. There are 12 states* in the U.S. which provide that homeowners have no personal recourse for a mortgage taken out to purchase a principal residence. That means you can just walk away from the loan. The bank will foreclose and sell the home at auction, but they will not be able to sue you for any deficiency should the net sales proceeds not equal what you owe. Your credit score will drop by about 200 points, but this is a viable option. From a moral perspective, keep in mind that you paid a premium (built into your closing costs) when you bought the home to have this option. So it is not unlike collecting on an insurance policy.
In the past forgiven debt was taxable as income but currently this does not apply to cancellation of the unpaid portion of a mortgage used to buy the house. If there is a second mortgage, any unpaid amount may be taxable income.
4. In the 38 other states, if you walk away from your home the bank will foreclose and sell the home at auction. If the house doesn’t sell for enough to pay off the mortgage, they can sue you for the deficiency. With a judgment they can then put liens on other assets (like bank accounts or other real estate) and garnish your wages. So not only are you on the hook for the deficiency (plus the bank’s collection costs and attorney fees), but your credit score will likely crash about 300-400 points and you could have to pay income taxes on the unpaid portion of the mortgage.
5. A better option than foreclosure is to deal with the bank and work out an arrangement called a “deed in lieu of foreclosure.” When banks stop receiving payments, they will be open to talking about this approach. In these situations the bank agrees to have you just sign over the deed so they don’t have the expenses of foreclosure. With the bank’s agreement, you can qualify for non-taxable debt forgiveness. It will cut your credit score by 300-400 points initially, but you end up free of the debt. Again, the bank is not likely to agree to this if you are working or have other assets they can levy
6. In recent years there has been an effort by the government to pressure banks to provide “Loan Modifications” to homeowners who are unable to make their payments and who meet strict criteria. For most people, this is not a viable option. Loan modifications may include lowering the interest rate or extending the term to reduce monthly payments. However banks are not willing to reduce the principle owed. This is a time consuming process, and thousands of applicants have overwhelmed banks. It takes an inordinate amount of time to check applicants and banks don’t make any money beyond the $1,500 offered from the federal government (more red tape) if a loan is modified. Of the 4 million homes in foreclosure last year only 2% were approved for modification and 2 of every 3 modifications were in default again within 6 months.
7. Most homes selling now are ‘short sales.’ This requires the owner to find a buyer at a reduced price. If a bank accepts the low offer, the owner signs the house over to the bank and the buyer/investor buys the home from the bank and the bank releases the owner. Thus, there is no deficiency and the forgiveness of debt does not trigger a taxable event. It will knock about 250 points off your credit score. There are now some real estate agents who specialize in these transactions, although most avoid getting involved because of the paperwork, the time commitment, and very small commissions.
8. The final solution for most people who need to move from their home is to continue cutting the price until it sells, even though it means taking a check to the closing to pay off the mortgage. There are very few buyers in the market now, mortgages are difficult to get, and appraisals are very conservative. So even if you get a willing buyer at a reasonable price, often the appraisal will not be high enough to get a mortgage. As prices drop, this process reinforces itself.
You can sell your house if it is priced right but the ‘right price’ has nothing to do with what you paid for it, what you invested in it, what it was worth 3 years ago, or how much you owe on it. The ‘right price” is what someone in this market will pay for it.
To arrive at the ‘right price,’ recognize that pricing is a process, not an event. Start by listing your house somewhat below other comparable houses in your neighborhood. Keep in mind that current listings are overpriced – otherwise someone would have already bought them. Then ruthlessly cut the price on your house every 6-8 weeks by 5-10%, and keep cutting until you get an offer. Cutting the price will put you on the top of the pile and keeps your house from becoming a ‘stale listing.’
This makes good financial sense when you realize the tremendous carrying costs of a vacant house. Ignoring carrying costs is the biggest mistake people make when they face this scenario. Carrying costs generally run about 10% per year of the home’s value and include the house payment, taxes, insurance, repairs and upkeep, as well as opportunity costs for the equity (if you still have equity.) So if your home is worth $400,000, the carrying costs are about $40,000/yr. If you are determined to get your price, you might easily wait 2 years until the market bottoms out. Then you will have paid out $80,000 in carrying costs. Now it will have to appreciate 30%-40% per year for the next two years for you to pay 2 more years of carrying costs plus ‘catch-up’ appreciation for you to break even. To expect this spectacular market turnaround is naïve. You’re better off selling the home for $350,000 now, and in two years you will have avoided $80,000 in carrying costs.
Living in a home you can’t afford, or trying to rent it out, doesn’t change the math much either because the carrying costs don’t take into account the continuing drop in home values in most areas. In many areas there are huge inventories of unsold homes in foreclosure, and we are facing another tsunami of homes likely to go into default in the next year or two as all the of 5-year adjustable mortgages from 3-4 years ago are reset.
Keep in mind if you use any of the techniques in this article, under a new federal law you will not be able to obtain a new mortgage for 4-7 years. If you lost your job, or had a catastrophic illness, this disqualification period is shortened to 2 years.
Of course, each situation is different. It is advisable to get professional advice from someone whose compensation is not dependent on the outcome of your decision. The upside is that, if you are buying a home, you will very likely find a great bargain once this housing bust ends!
*AK, AZ, CA, CT, FL, ID, MN, NC, ND, TX, UT, WA – laws vary by state.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY., as well as the fact-checking of Terry Fraser (Mackinac Bank), and Trevor Smith (Incline Village Real Estate), and blog editing by Susan Stanley
Thursday, April 29, 2010
Thursday, April 8, 2010
What’s Next: Inflation or More Deflation?
Bert Whitehead, M.B.A., J.D.
Excessive government spending fueled by ‘printing more money’ or selling Treasury Bonds always raises the specter of runaway inflation. Inflation causes prices to rise rapidly, and is measured by the Consumer Price Index (CPI). Since the current downturn in 2008, the CPI has barely risen, and some measures of CPI actually indicate deflation (which is why retired folks didn’t get a CPI increase in their Social Security benefits this year).
Financial journalists, who write articles and commentary, as well as advertisements selling gold as an investment, often predict future inflation and point to reckless federal spending that erodes the future value of the dollar. Some suspect that government believes it can solve our economic issues by adding programs that will eventually pay for themselves (even though they never have in the past). These commentators may well be right. Inflation is created by too many dollars chasing too few goods. As the money supply increases on a vast scale many armchair economists are convinced that run-away inflation is inevitable.
The economic environment of the 1970’s is often offered as an example of government bungling that poisoned the financial markets. The 70’s remind us of wage and price controls, gas rationing, and oil prices increasing at the whim of the oil cartel. Yet these aren’t pertinent to today’s issues (so far). There are some parallels to the ‘guns and butter’ deficits (i.e. Vietnam and expansion of social services), distrust of government leaders, and the federal government artificially holding down interest rates. So while rampant inflation is a potential outcome, today’s economy doesn’t compare exactly with the 70’s. Inflation is not the only possibility.
Another possibility is the opposite of inflation, or deflation, which is characterized by too few dollars being available to purchase the goods and services being produced. If there is not sufficient ‘velocity’ in an economy to maintain ongoing economic growth, then prices, wages and employment can all decrease. I am more concerned about deflation than inflation in the future because deflation hits suddenly, whereas inflation typically increases gradually.
The Great Depression is the most common example of the deflation vortex. It was very difficult to obtain bank loans, so businesses had to scale back production and inventories. Lower sales created more layoffs, leaving even fewer people to buy goods and services. Deflation, once ignited, can become a voracious beast that sucks the life out of an economy.
Some economists believe the programs initiated by FDR pulled us out of the Great Depression. Others believe that the federal intervention created ‘make-work’ programs that made the situation worse. They note that we didn’t recover until we went into World War II. World wars are a horrible way to create full employment.
But what about today? As in the past the government is intent on increasing the money supply to help the economy move forward. Is deflation a possibility? I think so. There are at least three current phenomena, which can deflect the impact of increasing the money supply, and result in deflation rather than inflation.
The first is productivity, which measures G.D.P. This is the output of goods and services produced per worker. If productivity increases while the money supply is increasing, the impact of inflation can be nullified. Generally, recessions are initially accompanied by increased productivity as firms lay off the least efficient workers. This, of course, creates higher unemployment and puts downward pressure on prices. During the current ‘recession,’ productivity has steadily increased.
When the government creates ‘make-work’ jobs, which do not increase G.D.P., economic activity may be propped up temporarily. But this approach is not sustainable and could ignite inflation. If it were to continue, the economy would reach the point where virtually everyone worked for the government, as in Russia during the Cold War. But these daily lives without private incentive ultimately create economic collapse, sometimes expressed by the Russian saying: “We pretend to work and they pretend to pay us!”
The second factor is personal savings. If the personal savings rate increases in step with increases in the money supply, then less money is being spent. As monetary velocity drops, there are fewer buyers, and eventually fewer workers. Japan experienced this during the ‘Lost Decade’ of the 1990’s when they did not address the core problems with their banking system. As the Japanese government tried to “paper it over” by printing more money, people who increased their savings thwarted its efforts. It should be noted that the personal savings rate in the U.S. has increased from 0.5% at the beginning of this recession to 6.0% currently.
The third factor that comes into play is the global economy. Alan Greenspan, the former Chairman of the Federal Reserve, commented as he stepped down from office that he had been baffled by the low inflation in the 90’s despite large increases in the money supply. But by the end of his term he had identified that the expanding global economy enabled production to move to the least costly sites, which offset inflationary pressures.
Consider a ‘Perfect Storm’ of higher government spending and expansion of the money supply, offset by 1) higher productivity with high unemployment, 2) increased personal savings rates generated by widespread fear, and 3) protectionism exacerbated by a cycle of retaliatory tariffs strangling the global economy. This could create a much more destructive deflationary spiral than creeping inflation.
I am not forecasting this outcome for our economy. But it is a significant possibility that concerns me. That’s why we continue to structure our clients’ net worth using the guidelines of Functional Asset Allocation. This approach is designed to hedge against both inflationary and deflationary environments, as well as provide for long-term portfolio growth whenever we are fortunate enough to return to a period of prosperity.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Excessive government spending fueled by ‘printing more money’ or selling Treasury Bonds always raises the specter of runaway inflation. Inflation causes prices to rise rapidly, and is measured by the Consumer Price Index (CPI). Since the current downturn in 2008, the CPI has barely risen, and some measures of CPI actually indicate deflation (which is why retired folks didn’t get a CPI increase in their Social Security benefits this year).
Financial journalists, who write articles and commentary, as well as advertisements selling gold as an investment, often predict future inflation and point to reckless federal spending that erodes the future value of the dollar. Some suspect that government believes it can solve our economic issues by adding programs that will eventually pay for themselves (even though they never have in the past). These commentators may well be right. Inflation is created by too many dollars chasing too few goods. As the money supply increases on a vast scale many armchair economists are convinced that run-away inflation is inevitable.
The economic environment of the 1970’s is often offered as an example of government bungling that poisoned the financial markets. The 70’s remind us of wage and price controls, gas rationing, and oil prices increasing at the whim of the oil cartel. Yet these aren’t pertinent to today’s issues (so far). There are some parallels to the ‘guns and butter’ deficits (i.e. Vietnam and expansion of social services), distrust of government leaders, and the federal government artificially holding down interest rates. So while rampant inflation is a potential outcome, today’s economy doesn’t compare exactly with the 70’s. Inflation is not the only possibility.
Another possibility is the opposite of inflation, or deflation, which is characterized by too few dollars being available to purchase the goods and services being produced. If there is not sufficient ‘velocity’ in an economy to maintain ongoing economic growth, then prices, wages and employment can all decrease. I am more concerned about deflation than inflation in the future because deflation hits suddenly, whereas inflation typically increases gradually.
The Great Depression is the most common example of the deflation vortex. It was very difficult to obtain bank loans, so businesses had to scale back production and inventories. Lower sales created more layoffs, leaving even fewer people to buy goods and services. Deflation, once ignited, can become a voracious beast that sucks the life out of an economy.
Some economists believe the programs initiated by FDR pulled us out of the Great Depression. Others believe that the federal intervention created ‘make-work’ programs that made the situation worse. They note that we didn’t recover until we went into World War II. World wars are a horrible way to create full employment.
But what about today? As in the past the government is intent on increasing the money supply to help the economy move forward. Is deflation a possibility? I think so. There are at least three current phenomena, which can deflect the impact of increasing the money supply, and result in deflation rather than inflation.
The first is productivity, which measures G.D.P. This is the output of goods and services produced per worker. If productivity increases while the money supply is increasing, the impact of inflation can be nullified. Generally, recessions are initially accompanied by increased productivity as firms lay off the least efficient workers. This, of course, creates higher unemployment and puts downward pressure on prices. During the current ‘recession,’ productivity has steadily increased.
When the government creates ‘make-work’ jobs, which do not increase G.D.P., economic activity may be propped up temporarily. But this approach is not sustainable and could ignite inflation. If it were to continue, the economy would reach the point where virtually everyone worked for the government, as in Russia during the Cold War. But these daily lives without private incentive ultimately create economic collapse, sometimes expressed by the Russian saying: “We pretend to work and they pretend to pay us!”
The second factor is personal savings. If the personal savings rate increases in step with increases in the money supply, then less money is being spent. As monetary velocity drops, there are fewer buyers, and eventually fewer workers. Japan experienced this during the ‘Lost Decade’ of the 1990’s when they did not address the core problems with their banking system. As the Japanese government tried to “paper it over” by printing more money, people who increased their savings thwarted its efforts. It should be noted that the personal savings rate in the U.S. has increased from 0.5% at the beginning of this recession to 6.0% currently.
The third factor that comes into play is the global economy. Alan Greenspan, the former Chairman of the Federal Reserve, commented as he stepped down from office that he had been baffled by the low inflation in the 90’s despite large increases in the money supply. But by the end of his term he had identified that the expanding global economy enabled production to move to the least costly sites, which offset inflationary pressures.
Consider a ‘Perfect Storm’ of higher government spending and expansion of the money supply, offset by 1) higher productivity with high unemployment, 2) increased personal savings rates generated by widespread fear, and 3) protectionism exacerbated by a cycle of retaliatory tariffs strangling the global economy. This could create a much more destructive deflationary spiral than creeping inflation.
I am not forecasting this outcome for our economy. But it is a significant possibility that concerns me. That’s why we continue to structure our clients’ net worth using the guidelines of Functional Asset Allocation. This approach is designed to hedge against both inflationary and deflationary environments, as well as provide for long-term portfolio growth whenever we are fortunate enough to return to a period of prosperity.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Tuesday, March 2, 2010
Roths Now Make the Tax Code Your Friend!
Bert Whitehead, M.B.A., J.D.©
Starting in 2010, the Tax Code opens up vast opportunities to increase Roth IRA participation for many taxpayers. As I will explain, you will need to consider at least 11 issues or possible strategies to make the most of this and determine the final formula that will reduce your long-term income tax bill and address other financial goals. But I caution you from the outset…Roth conversions are a hot topic with brokers and investment advisors who want to use this as an asset gathering gimmick or earn commissions from transactions. It is a complicated opportunity, and demonstrates how a comprehensive Financial Advisor who handles your taxes, investments, and estate planning is able to add value.
Here’s a review of some Roth IRA basics.
You probably know that if you work and your overall income is low enough, you can contribute to a Roth IRA as one of your annual IRA contribution choices. Your contribution is taxable (that is, you cannot deduct it on your tax return) when it is made. Age 70 ½ distributions are not required and, if taken, withdrawals in later years are totally free from income tax. Depending on your circumstances, this can be a huge advantage. A Roth IRA contribution of $5,000 can grow to $80,000 if invested at 7% over your working career, and you would save taxes on $75,000!
The only way to fund a Roth IRA other than an annual contribution based on earned income is to “convert” an existing IRA (or similar pre-tax retirement account) to a Roth IRA and pay tax on the current IRA distribution now rather than at age 70 ½. . In the past, your total adjusted gross income (AGI) had to be under $100,000 to avail yourself of this option. This is the big change this year.
Starting in 2010, you can convert any of your IRA’s to a Roth IRA no matter how high your income. While you do have to pay the income taxes now, remember that future withdrawals from your Roth IRA are tax-free! The reason why 2010 is a big year is two-fold; 1) there is special relief when paying the income taxes that result from any 2010 Roth conversion and 2) we are all facing the threat of rising income tax rates.
Here are some points to ponder and strategies to consider. Again, these can be complicated so you should expect to discuss whether these apply to you during the year when you do tax planning with your ACA advisor (i.e. a member of the Alliance of Cambridge Advisors).
#1: Got negative tax? A Roth conversion creates taxable income because of the IRA distribution that funds the Roth, so it certainly is advantageous to convert whatever amount you can if you have negative taxable income. It’s an opportunity to declare income and pay no income tax.
#2: Defer taxes…again! There is a quirk in the law for 2010 that lets you choose to either pay taxes on the 2010 conversion as 2010 income, or pay half the taxes of the 2010 conversion in 2011 and the other half in 2012. There is no interest or penalty to doing the latter, so it would generally be a good option.
#3: Automatic extension. If you are unsure whether your tax rate will be increased in 2011, you can convert to a Roth in 2010 and then file an automatic extension in 2011 so you don’t have to file until October 15, 2011. Then you may know whether your tax bracket has increased or not. If your bracket is being increased you can elect to pay taxes at the 2010 rate.
#4: How much to convert? If you aren’t sure how much to convert, keep in mind that you must make the 2010 conversion before 12/31/2010. However if you convert too much, you can elect to ‘recharacterize’ part or all of your conversion up until you file your 2010 return (i.e. until 10/15/2011) and put it back in your IRA without penalty. So you should always covert too much rather than too little!
#5: In-kind. When converting an IRA to a Roth, you can transfer your IRA investments ‘in kind’ to the Roth without having to sell them and buy them back. If you have a broker, make sure you let him or her know that you know that you don’t have to “sell” (pay a commission”) to convert.
#6: Outfoxing Mr. Market. If the investments drop after you convert them, you still must pay taxes on the value of the holding when converted. How do you preserve the value of the investments that you converted? For many clients, we are setting up 2 Roth IRA accounts: one for bonds and one for equities. We will transfer the full amount to be converted to each Roth IRA, using Stripped Treasuries to go into the bond Roth, and stocks or equity mutual funds into the stock Roth. Then in October of 2011, if stocks have dropped, we will recharacterize that account back to an IRA and do likewise with the bond account if stocks rise.
#7: Asset Location. To optimize ‘asset location,’ Roth investments should be in assets with the highest potential returns, such as small cap or international mutual funds. If using #6 above, and the stocks are recharacterized back to the regular IRA, they should be sold to buy back the bonds and the bonds in the remaining Roth account should be sold to buy back the stocks.
#8: Efficient cash flow. Long-term tax management and tax efficient cash-flow strategies are enabled through the use of Roths. Since there are no minimum required distributions for Roths, taxable distributions are reduced and Roth distributions can be used to maintain cash flow while keeping taxes low in retirement.
#9: Coordinate with charitable contributions using Donor Advised Funds. If you intend to include charities in your will, consider gifting stock now to your Donor Advised Fund in about the same amount that you are converting to your Roth. The tax deduction for the charitable contribution can then offset most of the additional amount of taxes due to the Roth conversion.
#10: The Next Generation. This is an unprecedented opportunity for intergenerational planning. The beneficiaries (spouse, children, etc.) of Roth accounts have the same advantages of taking tax-free withdrawals. If you don’t need the IRA money during your lifetime consider the benefits of not paying income taxes on many years of compounded investment growth.
#11: Reduce onerous estate taxes. Using assets to pay income taxes now reduces your estate for estate tax planning and provides a way you can pay the future income taxes for your children or grandchildren now. (note: as of the date of this blog there is no estate tax. Rules are in flux but it’s a good bet that they’ll return in the future.)
Although it may be obvious, note that Roth conversions also appeal to the federal government because they can tax your pre-tax IRA money now, rather than in 20 or 30 years! But that’s why it’s important to at least review the above points to see how the current legislation affects you. Since your ACA Advisor knows your comprehensive financial plan more intimately than anyone, there may be even more points and issues to discuss.
Be sure to look at these ways to make the Taxman your friend in 2010!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Starting in 2010, the Tax Code opens up vast opportunities to increase Roth IRA participation for many taxpayers. As I will explain, you will need to consider at least 11 issues or possible strategies to make the most of this and determine the final formula that will reduce your long-term income tax bill and address other financial goals. But I caution you from the outset…Roth conversions are a hot topic with brokers and investment advisors who want to use this as an asset gathering gimmick or earn commissions from transactions. It is a complicated opportunity, and demonstrates how a comprehensive Financial Advisor who handles your taxes, investments, and estate planning is able to add value.
Here’s a review of some Roth IRA basics.
You probably know that if you work and your overall income is low enough, you can contribute to a Roth IRA as one of your annual IRA contribution choices. Your contribution is taxable (that is, you cannot deduct it on your tax return) when it is made. Age 70 ½ distributions are not required and, if taken, withdrawals in later years are totally free from income tax. Depending on your circumstances, this can be a huge advantage. A Roth IRA contribution of $5,000 can grow to $80,000 if invested at 7% over your working career, and you would save taxes on $75,000!
The only way to fund a Roth IRA other than an annual contribution based on earned income is to “convert” an existing IRA (or similar pre-tax retirement account) to a Roth IRA and pay tax on the current IRA distribution now rather than at age 70 ½. . In the past, your total adjusted gross income (AGI) had to be under $100,000 to avail yourself of this option. This is the big change this year.
Starting in 2010, you can convert any of your IRA’s to a Roth IRA no matter how high your income. While you do have to pay the income taxes now, remember that future withdrawals from your Roth IRA are tax-free! The reason why 2010 is a big year is two-fold; 1) there is special relief when paying the income taxes that result from any 2010 Roth conversion and 2) we are all facing the threat of rising income tax rates.
Here are some points to ponder and strategies to consider. Again, these can be complicated so you should expect to discuss whether these apply to you during the year when you do tax planning with your ACA advisor (i.e. a member of the Alliance of Cambridge Advisors).
#1: Got negative tax? A Roth conversion creates taxable income because of the IRA distribution that funds the Roth, so it certainly is advantageous to convert whatever amount you can if you have negative taxable income. It’s an opportunity to declare income and pay no income tax.
#2: Defer taxes…again! There is a quirk in the law for 2010 that lets you choose to either pay taxes on the 2010 conversion as 2010 income, or pay half the taxes of the 2010 conversion in 2011 and the other half in 2012. There is no interest or penalty to doing the latter, so it would generally be a good option.
#3: Automatic extension. If you are unsure whether your tax rate will be increased in 2011, you can convert to a Roth in 2010 and then file an automatic extension in 2011 so you don’t have to file until October 15, 2011. Then you may know whether your tax bracket has increased or not. If your bracket is being increased you can elect to pay taxes at the 2010 rate.
#4: How much to convert? If you aren’t sure how much to convert, keep in mind that you must make the 2010 conversion before 12/31/2010. However if you convert too much, you can elect to ‘recharacterize’ part or all of your conversion up until you file your 2010 return (i.e. until 10/15/2011) and put it back in your IRA without penalty. So you should always covert too much rather than too little!
#5: In-kind. When converting an IRA to a Roth, you can transfer your IRA investments ‘in kind’ to the Roth without having to sell them and buy them back. If you have a broker, make sure you let him or her know that you know that you don’t have to “sell” (pay a commission”) to convert.
#6: Outfoxing Mr. Market. If the investments drop after you convert them, you still must pay taxes on the value of the holding when converted. How do you preserve the value of the investments that you converted? For many clients, we are setting up 2 Roth IRA accounts: one for bonds and one for equities. We will transfer the full amount to be converted to each Roth IRA, using Stripped Treasuries to go into the bond Roth, and stocks or equity mutual funds into the stock Roth. Then in October of 2011, if stocks have dropped, we will recharacterize that account back to an IRA and do likewise with the bond account if stocks rise.
#7: Asset Location. To optimize ‘asset location,’ Roth investments should be in assets with the highest potential returns, such as small cap or international mutual funds. If using #6 above, and the stocks are recharacterized back to the regular IRA, they should be sold to buy back the bonds and the bonds in the remaining Roth account should be sold to buy back the stocks.
#8: Efficient cash flow. Long-term tax management and tax efficient cash-flow strategies are enabled through the use of Roths. Since there are no minimum required distributions for Roths, taxable distributions are reduced and Roth distributions can be used to maintain cash flow while keeping taxes low in retirement.
#9: Coordinate with charitable contributions using Donor Advised Funds. If you intend to include charities in your will, consider gifting stock now to your Donor Advised Fund in about the same amount that you are converting to your Roth. The tax deduction for the charitable contribution can then offset most of the additional amount of taxes due to the Roth conversion.
#10: The Next Generation. This is an unprecedented opportunity for intergenerational planning. The beneficiaries (spouse, children, etc.) of Roth accounts have the same advantages of taking tax-free withdrawals. If you don’t need the IRA money during your lifetime consider the benefits of not paying income taxes on many years of compounded investment growth.
#11: Reduce onerous estate taxes. Using assets to pay income taxes now reduces your estate for estate tax planning and provides a way you can pay the future income taxes for your children or grandchildren now. (note: as of the date of this blog there is no estate tax. Rules are in flux but it’s a good bet that they’ll return in the future.)
Although it may be obvious, note that Roth conversions also appeal to the federal government because they can tax your pre-tax IRA money now, rather than in 20 or 30 years! But that’s why it’s important to at least review the above points to see how the current legislation affects you. Since your ACA Advisor knows your comprehensive financial plan more intimately than anyone, there may be even more points and issues to discuss.
Be sure to look at these ways to make the Taxman your friend in 2010!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Monday, February 1, 2010
How Do the Wealthy Get That Way?
Bert Whitehead, M.B.A., J.D.
Unless you are in the wealth category of Bill Gates and Warren Buffet, you probably realize that many people are richer than you are. So how did they get that way?
• Did they have the advantage of a large inheritance?
• Was it because they were self employed?
• Could they have married into a wealthy family?
• Were they “penny pinchers” for their whole life?
• Did they have high I.Q.’s?
None of these reasons fully explain the ‘millionaire’ phenomenon. I have read the popular books on this topic (The Millionaire Next Door, The Automatic Millionaire, Rich Dad, Poor Dad, etc.) I have also reviewed academic studies on this topic. But most of my insights come from working with clients for over 30 years, many of whom did become millionaires. These are my observations and conclusions:
1. Wealthy people are made, not born. 80% of millionaires are the first generation of their family to become wealthy. Interestingly, most of the very wealthy families leave a major portion of their estates to charity. Children, who inherit significant wealth, without achieving it on their own, seldom manage money well. As one wealthy man told me, “If money comes too easily, it isn’t properly respected.” A large inheritance can often undermine the character of the recipient because they don’t need to focus on adding value to the world. This often happens when parents continue to support adult children.
2. Self-employed people are more likely to become wealthy. Overall 20% of our population is self-employed, while 75% of millionaires are self-employed. This high percentage is largely attributable to self-employed professionals like attorneys and physicians. The others, who are entrepreneurs, are as likely to go bankrupt as they are to become wealthy. Those entrepreneurs, who do accumulate wealth, as well as the professionals, have other attributes.
3. Most millionaires became wealthy because they picked a spouse who helped them realize a dream. Seldom do people become millionaires totally by themselves. On the contrary, one of the significant obstacles to accumulating wealth is choosing partners poorly, especially spouses. I call divorce “the process of mutual impoverishment.”
4. Some wealthy people are very frugal, even to the point of being penny pinchers. Popular writers often glorify this trait as the path to riches, urging readers to forego lattes, drive old cars, and to never move to better neighborhoods. While living within one’s means is critical, as discussed below, developing a penurious character is a form of financial dysfunction. Misers never know ‘how much is enough’ and develop an obsession to save more money. In my opinion this trait is a barrier to good socialization and prevents people from enjoying the wealth they do accumulate.
5. The people that I have seen become wealthy are smart – but not necessarily the kind of “smart” measured by an I.Q. test. They have come to recognize and appreciate their unique gifts and advantages, and use their abilities to create value for others. When a high I.Q. is coupled with an expectation that one deserves special treatment, it is a hindrance to achieving wealth.
How much does it take to be wealthy? I think that financial wealth is measured by a balance sheet listing assets vs. liabilities, rather then an income statement because it demonstrates the resources that can be put to work to create more money. Statistically only 3.5% of the 115 million households in this country have net assets of over $1 million. 98% of those have a net worth between $1 million and $10 million. The 2% who are ‘super-rich’ are not addressed in this blog.
I have noted two attributes which apply to most millionaires. The first is that they value education, and are generally well educated themselves. As my mother often said, “Investment in education is the best investment that can be made, because it can never be taken away from you!” Education is the strongest predictor of future earning capacity.
A high income alone doesn’t make someone a millionaire. There are many athletes, movie stars, gamblers (including lottery winners), and highly paid executives who never are able to accumulate wealth. The reason is that they keep ratcheting up their standard of living to keep up with their income. So when their income drops, they don’t have the financial resources to provide the cash flow to maintain their life style.
This doesn’t only apply to high income people; many low income people stay poor because they live beyond their means. I find that the easiest way to tell whether a new client is living within their means is to examine their credit card statements. If someone consistently carries a balance on their credit cards, they are living beyond their means.
Thus the second attribute of the wealthy is their ability to live within their means. This translates into a life-long habit of always saving at least 10% of their income. Even those who aren’t fortunate enough to have a good education can become financially independent if they consistently live within their means and save 10% of what they make starting at an early age.
It’s that simple: to help your children become wealthy, make sure they get as good an education as possible, and teach them to save a dime of every dollar that they earn starting with their first allowance!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Unless you are in the wealth category of Bill Gates and Warren Buffet, you probably realize that many people are richer than you are. So how did they get that way?
• Did they have the advantage of a large inheritance?
• Was it because they were self employed?
• Could they have married into a wealthy family?
• Were they “penny pinchers” for their whole life?
• Did they have high I.Q.’s?
None of these reasons fully explain the ‘millionaire’ phenomenon. I have read the popular books on this topic (The Millionaire Next Door, The Automatic Millionaire, Rich Dad, Poor Dad, etc.) I have also reviewed academic studies on this topic. But most of my insights come from working with clients for over 30 years, many of whom did become millionaires. These are my observations and conclusions:
1. Wealthy people are made, not born. 80% of millionaires are the first generation of their family to become wealthy. Interestingly, most of the very wealthy families leave a major portion of their estates to charity. Children, who inherit significant wealth, without achieving it on their own, seldom manage money well. As one wealthy man told me, “If money comes too easily, it isn’t properly respected.” A large inheritance can often undermine the character of the recipient because they don’t need to focus on adding value to the world. This often happens when parents continue to support adult children.
2. Self-employed people are more likely to become wealthy. Overall 20% of our population is self-employed, while 75% of millionaires are self-employed. This high percentage is largely attributable to self-employed professionals like attorneys and physicians. The others, who are entrepreneurs, are as likely to go bankrupt as they are to become wealthy. Those entrepreneurs, who do accumulate wealth, as well as the professionals, have other attributes.
3. Most millionaires became wealthy because they picked a spouse who helped them realize a dream. Seldom do people become millionaires totally by themselves. On the contrary, one of the significant obstacles to accumulating wealth is choosing partners poorly, especially spouses. I call divorce “the process of mutual impoverishment.”
4. Some wealthy people are very frugal, even to the point of being penny pinchers. Popular writers often glorify this trait as the path to riches, urging readers to forego lattes, drive old cars, and to never move to better neighborhoods. While living within one’s means is critical, as discussed below, developing a penurious character is a form of financial dysfunction. Misers never know ‘how much is enough’ and develop an obsession to save more money. In my opinion this trait is a barrier to good socialization and prevents people from enjoying the wealth they do accumulate.
5. The people that I have seen become wealthy are smart – but not necessarily the kind of “smart” measured by an I.Q. test. They have come to recognize and appreciate their unique gifts and advantages, and use their abilities to create value for others. When a high I.Q. is coupled with an expectation that one deserves special treatment, it is a hindrance to achieving wealth.
How much does it take to be wealthy? I think that financial wealth is measured by a balance sheet listing assets vs. liabilities, rather then an income statement because it demonstrates the resources that can be put to work to create more money. Statistically only 3.5% of the 115 million households in this country have net assets of over $1 million. 98% of those have a net worth between $1 million and $10 million. The 2% who are ‘super-rich’ are not addressed in this blog.
I have noted two attributes which apply to most millionaires. The first is that they value education, and are generally well educated themselves. As my mother often said, “Investment in education is the best investment that can be made, because it can never be taken away from you!” Education is the strongest predictor of future earning capacity.
A high income alone doesn’t make someone a millionaire. There are many athletes, movie stars, gamblers (including lottery winners), and highly paid executives who never are able to accumulate wealth. The reason is that they keep ratcheting up their standard of living to keep up with their income. So when their income drops, they don’t have the financial resources to provide the cash flow to maintain their life style.
This doesn’t only apply to high income people; many low income people stay poor because they live beyond their means. I find that the easiest way to tell whether a new client is living within their means is to examine their credit card statements. If someone consistently carries a balance on their credit cards, they are living beyond their means.
Thus the second attribute of the wealthy is their ability to live within their means. This translates into a life-long habit of always saving at least 10% of their income. Even those who aren’t fortunate enough to have a good education can become financially independent if they consistently live within their means and save 10% of what they make starting at an early age.
It’s that simple: to help your children become wealthy, make sure they get as good an education as possible, and teach them to save a dime of every dollar that they earn starting with their first allowance!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Friday, January 8, 2010
Lessons from the ‘Lost Decade’
Bert Whitehead M.B.A., J.D.
The ‘Dow’ and the ‘S&P’ are the most common indexes of U.S. large company stock valuations. At the end of 2009 they closed lower than their opening values at the beginning of 2000. As a result, many economists have dubbed the ‘aughts’ (2000-2009) the ‘Lost Decade.’ They claim that there were no investment gains in the large cap stock market for these past 10 years.
Active money managers will point to the performance of these indexes to crow about the futility of ‘buy and hold’ investing. These managers insist that they are able to add value to an investment portfolio by buying low and selling high, instead of just holding onto stocks. This observation is, of course, tainted with self-interest.
Many ordinary people have sworn off stock market investing because they lost so much money during this period. And with current short term interest rates so close to zero, they are tempted to simply invest in junk bonds or municipal bonds, ignoring that these may be today’s outsized risks.
The truth is that the loss of 8.7% in the Dow during the ‘Lost Decade’ is mostly attributable to the selection of the “starting line.” The beginning of 2000 was near the peak of the ‘dot-com’ bull market. If you start the chart just two months later at the end of Feb. 2000, “voila!” … the market shows a gain! Start the chart two years later in Feb. 2002 and there is a 30+% gain by the end of 2009.
The S&P index outperforms 85% of money managers in the large cap arena over most any 20-year period. The reason? Money managers keep cash in their portfolios, whereas indexes are by definition fully invested. Therefore, managers tend to underperform less in bear markets, and underperform more bullish markets.
If there are any lessons to be learned during the ‘Lost Decade’ it is not about the investing prowess of the active money managers but rather: 1) the advantage of dollar-cost averaging (DCA), especially in down markets; and 2) the necessity of having a diversified portfolio.
DCA is a strategy by which you invest new money on a regular basis, usually monthly, instead of investing all your cash at once. It protects you from investing at the WRONG TIME because you are investing all the time. Most people use their 401Ks or other retirement accounts for their primary investing activity, so they use DCA by default. Investing a fixed sum each month helps you buy more shares of a stock when the price drops. Investing $1,000 per month (plus dividends) over the past ten years would have resulted in a small gain (3.2%) rather than a loss.
Diversifying your holdings beyond large cap stocks protects you from investing in the WRONG TYPE of investment. You shouldn’t invest in any one thing but, rather, in everything. For example, during the past 10 years, small cap and foreign stocks on average appreciated over 30% including reinvestment of dividends. The Vanguard REIT (Real Estate Index) was up over 50%. 20-year Treasury bonds had an average yield of over 5% increasing over 60% during the period.
Dollar Cost Averaging and Diversification are the two primary strategies you can use to avoid investment mistakes. But having said that, the average annual return of a well-balanced portfolio from 2000-2009 (6-7%) fell short of returns for similar prior periods. We usually use assumptions of 7-8% returns for conservatively balanced portfolios over the long term.
Interestingly, the return of a conservatively balanced portfolio achieved the 7-8% long-term return if you start the chart 15 years ago…there’s that starting line issue again.
All of this is small comfort if you bought a home five years ago. Depending on location the value of your home may have dropped over 50%. This is made even worse if your 401Ks have decreased in value despite your contributions over the past ten years. If you lost your job on top of these other setbacks, the last ten years have been ruinous.
No matter what your level of loss, beware the temptation to offset your losses by timing the stock market. It only aggravates your misfortune. Studies repeatedly show that, on average, individual investors who buy and sell stocks in their portfolio underperform the market by a wide margin of 5-7%. They constantly fall prey to trying to select the best time to invest and the best type of investment. It’s far better to avoid this situation by not capitulating to your fears when the market drops, only then having to face buying in a greedy frenzy when the market rises quickly.
The final lesson of the Lost Decade is that it’s merely a story line for writers and editors who need to sell their publications with “new ideas” and “what to buy now!” insights. The Lost Decade is merely the last decade. Select a different time to measure and you come up with different results and story lines.
Unfortunately, the most boring story of all, that consistent investing during good times and bad, is also the most successful for those willing to stick to it. The only problem with it is that it just doesn’t sell this month’s magazine!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
The ‘Dow’ and the ‘S&P’ are the most common indexes of U.S. large company stock valuations. At the end of 2009 they closed lower than their opening values at the beginning of 2000. As a result, many economists have dubbed the ‘aughts’ (2000-2009) the ‘Lost Decade.’ They claim that there were no investment gains in the large cap stock market for these past 10 years.
Active money managers will point to the performance of these indexes to crow about the futility of ‘buy and hold’ investing. These managers insist that they are able to add value to an investment portfolio by buying low and selling high, instead of just holding onto stocks. This observation is, of course, tainted with self-interest.
Many ordinary people have sworn off stock market investing because they lost so much money during this period. And with current short term interest rates so close to zero, they are tempted to simply invest in junk bonds or municipal bonds, ignoring that these may be today’s outsized risks.
The truth is that the loss of 8.7% in the Dow during the ‘Lost Decade’ is mostly attributable to the selection of the “starting line.” The beginning of 2000 was near the peak of the ‘dot-com’ bull market. If you start the chart just two months later at the end of Feb. 2000, “voila!” … the market shows a gain! Start the chart two years later in Feb. 2002 and there is a 30+% gain by the end of 2009.
The S&P index outperforms 85% of money managers in the large cap arena over most any 20-year period. The reason? Money managers keep cash in their portfolios, whereas indexes are by definition fully invested. Therefore, managers tend to underperform less in bear markets, and underperform more bullish markets.
If there are any lessons to be learned during the ‘Lost Decade’ it is not about the investing prowess of the active money managers but rather: 1) the advantage of dollar-cost averaging (DCA), especially in down markets; and 2) the necessity of having a diversified portfolio.
DCA is a strategy by which you invest new money on a regular basis, usually monthly, instead of investing all your cash at once. It protects you from investing at the WRONG TIME because you are investing all the time. Most people use their 401Ks or other retirement accounts for their primary investing activity, so they use DCA by default. Investing a fixed sum each month helps you buy more shares of a stock when the price drops. Investing $1,000 per month (plus dividends) over the past ten years would have resulted in a small gain (3.2%) rather than a loss.
Diversifying your holdings beyond large cap stocks protects you from investing in the WRONG TYPE of investment. You shouldn’t invest in any one thing but, rather, in everything. For example, during the past 10 years, small cap and foreign stocks on average appreciated over 30% including reinvestment of dividends. The Vanguard REIT (Real Estate Index) was up over 50%. 20-year Treasury bonds had an average yield of over 5% increasing over 60% during the period.
Dollar Cost Averaging and Diversification are the two primary strategies you can use to avoid investment mistakes. But having said that, the average annual return of a well-balanced portfolio from 2000-2009 (6-7%) fell short of returns for similar prior periods. We usually use assumptions of 7-8% returns for conservatively balanced portfolios over the long term.
Interestingly, the return of a conservatively balanced portfolio achieved the 7-8% long-term return if you start the chart 15 years ago…there’s that starting line issue again.
All of this is small comfort if you bought a home five years ago. Depending on location the value of your home may have dropped over 50%. This is made even worse if your 401Ks have decreased in value despite your contributions over the past ten years. If you lost your job on top of these other setbacks, the last ten years have been ruinous.
No matter what your level of loss, beware the temptation to offset your losses by timing the stock market. It only aggravates your misfortune. Studies repeatedly show that, on average, individual investors who buy and sell stocks in their portfolio underperform the market by a wide margin of 5-7%. They constantly fall prey to trying to select the best time to invest and the best type of investment. It’s far better to avoid this situation by not capitulating to your fears when the market drops, only then having to face buying in a greedy frenzy when the market rises quickly.
The final lesson of the Lost Decade is that it’s merely a story line for writers and editors who need to sell their publications with “new ideas” and “what to buy now!” insights. The Lost Decade is merely the last decade. Select a different time to measure and you come up with different results and story lines.
Unfortunately, the most boring story of all, that consistent investing during good times and bad, is also the most successful for those willing to stick to it. The only problem with it is that it just doesn’t sell this month’s magazine!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Tuesday, December 8, 2009
How to Spot a Bubble
Bert Whitehead, M.B.A., J.D.
If you are younger than 40, you will likely be telling your kids and grandkids about the ‘Great Recession’ of 2007-2009. Our recent experience is likely to impact your investment decisions for the rest of your life. So what advice will you give the next couple of generations?
I’d suggest you start with: “Beware of Bubbles!” Hindsight is a huge advantage in recognizing dangerous financial bubbles. We are all familiar with the stock market crash which kicked off the ‘Great Depression.’ If you are over 40, you probably remember your elders caution to ‘Stay out of the Stock Market!’ That was the wrong lesson; the real lesson is to be wary of leverage. The stock market then was a huge bubble, aggravated by the ability of even small investors to leverage stock purchases on margin requiring an investment of only 5%.
Surely over-leveraged investments, spurred by easy credit is a hallmark of bubbles. In the 1970’s however, bond investors lost their shirts and inflation ravaged the stock market. It’s not so clear that leverage aggravated that recession as much as excessive government spending, high oil prices, and built-in cost-of-living increases which contributed to spiraling inflation. But when the fed raised interest rates, the reduced leverage eventually sucked the air out of the economy and resulted in new federal reorganization of the banking system. The S&L collapse soon followed.
The ‘Dot.Com’ bubble in the 90’s was fueled by an astounding amount of capital chasing new ideas. Tech stocks soared to incredible heights and seemed to be invulnerable to fundamental requirements. They had no P/E ratio because they could sell stocks without a revenue, much less profit. Those entrepreneurs failed miserably at being able to leverage the capital effectively.
In our current situation, there’s no question that easy money accessed by low mortgage rates and virtually no vetting of borrowers artificially inflated housing prices, and the financial industry tanked taking down the rest of the economy. It’s by no means certain that the government spending intended to create employment will solve the problem, and there is a real danger that excessive government debt will create worse problems down the road.
Looking at our present worldwide condition, there are at least three possible bubbles on the horizon: China, Gold, and most recently the financial disruption in Dubai and other closely allied emirates in the U.A.E.
The red flags in all three situations are all related to the same phenomenon: unsustainable rapid increase in expansion.
China, and many other emerging nations, have experienced a growth in production capability which carries the danger eventually of excess capacity. Hundreds of millions of Chinese moved to the cities for employment. Now they are without jobs because there simply isn’t enough worldwide demand to keep the factories operating. In the process China basically subsidized exports by keeping its currency, the Yuan, pegged artificially low to the dollar.
This enabled them to keep prices of exports low, so US purchasing essentially provided the capital for Chinese expansion in their private sector. The anomaly is that that the US has begun using Chinese lending power to fuel its public sector. This is ripe to start unraveling with unforeseen consequences, but the fallout will surely hurt investors who have rushed in to make a quick buck in China.
Gold is now at record highs. Since 2000 the price of gold has jumped from $252 to $1,100 per oz. and has been touted as the best antidote for inflation which has increased about 18% during that period. But it hasn’t fared so well in the past: the price of gold dropped the beginning of the 1980’s through the 1990’s (from $934 to $252 per ounce) while inflation surged 50%. Since there hasn’t been an increase in demand for production, the recent price increase is likely due to speculation. Gold ETF’s became available, which buy actual gold to hold for investors. So instead of having to buy gold, have it shipped, and then store it, speculators can buy and sell positions in one day’s trading. Bubbles that are created by speculative demand are very likely to collapse, even faster than their rise.
Recent news that Dubai is defaulting on $80 billion in debt has spooked the worldwide markets and undermined the assurance that Oil Sheiks would step in to back any debt. The massive construction in Dubai, which dwarfed the construction bubble in Las Vegas, was based on a conviction that ‘if you build it, they will come.’ Well it turns out that they’re not coming. There is no financial underpinning for a new city built in a desert without any existing industry or commercial basis.
What China, Gold, and Dubai have in common is that they experienced such spectacular growth that financial realities were increasingly ignored. A naïveté around basic economics inexplicably overtake even seasoned investors, then speculators start rushing to cash in the new hot investment, and finally the small investors pile on. Bubbles are built on an irrational belief that ‘this time it’s different’ and the balloon will never burst.
We have learned a valuable lesson, and bubbles will continue to form regardless of government regulation and our supposed increased financial sophistication. Our experience should be passed on. So be sure to lecture your children and grandchildren to “Beware of Bubbles!”
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
If you are younger than 40, you will likely be telling your kids and grandkids about the ‘Great Recession’ of 2007-2009. Our recent experience is likely to impact your investment decisions for the rest of your life. So what advice will you give the next couple of generations?
I’d suggest you start with: “Beware of Bubbles!” Hindsight is a huge advantage in recognizing dangerous financial bubbles. We are all familiar with the stock market crash which kicked off the ‘Great Depression.’ If you are over 40, you probably remember your elders caution to ‘Stay out of the Stock Market!’ That was the wrong lesson; the real lesson is to be wary of leverage. The stock market then was a huge bubble, aggravated by the ability of even small investors to leverage stock purchases on margin requiring an investment of only 5%.
Surely over-leveraged investments, spurred by easy credit is a hallmark of bubbles. In the 1970’s however, bond investors lost their shirts and inflation ravaged the stock market. It’s not so clear that leverage aggravated that recession as much as excessive government spending, high oil prices, and built-in cost-of-living increases which contributed to spiraling inflation. But when the fed raised interest rates, the reduced leverage eventually sucked the air out of the economy and resulted in new federal reorganization of the banking system. The S&L collapse soon followed.
The ‘Dot.Com’ bubble in the 90’s was fueled by an astounding amount of capital chasing new ideas. Tech stocks soared to incredible heights and seemed to be invulnerable to fundamental requirements. They had no P/E ratio because they could sell stocks without a revenue, much less profit. Those entrepreneurs failed miserably at being able to leverage the capital effectively.
In our current situation, there’s no question that easy money accessed by low mortgage rates and virtually no vetting of borrowers artificially inflated housing prices, and the financial industry tanked taking down the rest of the economy. It’s by no means certain that the government spending intended to create employment will solve the problem, and there is a real danger that excessive government debt will create worse problems down the road.
Looking at our present worldwide condition, there are at least three possible bubbles on the horizon: China, Gold, and most recently the financial disruption in Dubai and other closely allied emirates in the U.A.E.
The red flags in all three situations are all related to the same phenomenon: unsustainable rapid increase in expansion.
China, and many other emerging nations, have experienced a growth in production capability which carries the danger eventually of excess capacity. Hundreds of millions of Chinese moved to the cities for employment. Now they are without jobs because there simply isn’t enough worldwide demand to keep the factories operating. In the process China basically subsidized exports by keeping its currency, the Yuan, pegged artificially low to the dollar.
This enabled them to keep prices of exports low, so US purchasing essentially provided the capital for Chinese expansion in their private sector. The anomaly is that that the US has begun using Chinese lending power to fuel its public sector. This is ripe to start unraveling with unforeseen consequences, but the fallout will surely hurt investors who have rushed in to make a quick buck in China.
Gold is now at record highs. Since 2000 the price of gold has jumped from $252 to $1,100 per oz. and has been touted as the best antidote for inflation which has increased about 18% during that period. But it hasn’t fared so well in the past: the price of gold dropped the beginning of the 1980’s through the 1990’s (from $934 to $252 per ounce) while inflation surged 50%. Since there hasn’t been an increase in demand for production, the recent price increase is likely due to speculation. Gold ETF’s became available, which buy actual gold to hold for investors. So instead of having to buy gold, have it shipped, and then store it, speculators can buy and sell positions in one day’s trading. Bubbles that are created by speculative demand are very likely to collapse, even faster than their rise.
Recent news that Dubai is defaulting on $80 billion in debt has spooked the worldwide markets and undermined the assurance that Oil Sheiks would step in to back any debt. The massive construction in Dubai, which dwarfed the construction bubble in Las Vegas, was based on a conviction that ‘if you build it, they will come.’ Well it turns out that they’re not coming. There is no financial underpinning for a new city built in a desert without any existing industry or commercial basis.
What China, Gold, and Dubai have in common is that they experienced such spectacular growth that financial realities were increasingly ignored. A naïveté around basic economics inexplicably overtake even seasoned investors, then speculators start rushing to cash in the new hot investment, and finally the small investors pile on. Bubbles are built on an irrational belief that ‘this time it’s different’ and the balloon will never burst.
We have learned a valuable lesson, and bubbles will continue to form regardless of government regulation and our supposed increased financial sophistication. Our experience should be passed on. So be sure to lecture your children and grandchildren to “Beware of Bubbles!”
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Thursday, November 19, 2009
What Deflation Looks Like
Bert Whitehead, M.B.A., J.D.
For years we have been told about the evils of inflation. But now we are witnessing deflation, which most people have never experienced since 1950. What does deflation mean for you today? How is the economy affected? How bad can it get?
Inflation is an economic phenomenon that has been described as too many dollars chasing too few goods. Deflation occurs when the opposite happens -- too few dollars are being used to buy the available goods.
For most of this decade credit has been abundant and too much money was lent, especially to people without a strong financial foundation. It was easy to buy houses, cars, take trips, etc. As borrowers defaulted en masse on mortgages, student loans, car loans, etc., the banks and other lending institutions curtailed lending to consumers and to businesses. This resulted in an alarming drop in sales of cars, houses, etc. Retail sales across the board have shrunk as people became very frugal.
The downturn is compounded by a significant increase in the average family savings rate from about 1% of household income a few years ago to 6%+ now. The stock market dropped to the lowest level in 50 years, which caused working people to be alarmed about their retirement prospects. Seeing your house drop in value along with your 401-k is gut wrenching. So people are improving their “balance sheets” by paying off debt and increasing their savings at a feverish pitch.
These developments are good in many ways because we are weaning ourselves off the spending binge that lasted until about 2007. The downside is that companies have trouble making a profit because they have to cut their prices so much to sell their goods and services. This impacts suppliers. New orders for their products drops. To survive, all businesses are cutting staff. Then unemployment rises, there are even fewer purchasers, and people refrain from buying things because they either don’t have the money or they expect prices to drop further. This cycle creates a vicious vortex which sucks the wind out of our economy and causes deflation.
The big danger is that this downward spiral can worsen over time. As more people lose their jobs they can’t buy goods and services, sales continue to drop, and employers lay off more people, etc. Economists call this a drop in ‘velocity of money’ and, if it continues, it could cause a severe depression. At that point, it is very difficult to regain economic momentum. The Great Depression of the 1930’s only ended when we went to war in 1941. War increases employment, and creates a strong demand for armaments (which keep getting blown up and have to be replaced).
Deflation also causes the value of our dollar to drop against other currencies. For American workers, this means that the price of imports and the cost of travel abroad increases. For non-U.S. residents this situation is a bonanza: for example, Europeans can not only buy more dollars with each Euro, but those dollars will buy more U.S. goods, and travel to the U.S. is a real bargain. As foreigners buy more U.S. goods and services and travel here to spend their money our balance of trade is favored.
Swings in economic activity are often self-correcting. As prices drop during deflation, the value of the dollar for U.S. residents actually increases and we can buy more for less money. For example, the price of real estate has plummeted in many areas, the negotiated price of cars has dropped, and most retail stores, restaurants, etc. are offering enticing specials.
The U.S. is not the only country facing this situation: the whole world is experiencing deflation. But a free market economy like ours is affected sooner because a higher degree of our spending is non-governmental compared to many other mature economies. To address the danger of deflation, the U.S. government had to inject money into the economy using stimulus spending. Most countries have a stronger social ‘safety-net’ like unemployment benefits and free health care. They have decided that, for now, additional government spending in the form of a stimulus is not necessary.
Most of the U.S. stimulus money, however, is being spent on government jobs that do not create additional employment. The ‘TARP’ money earmarked to shore up our banking system isn’t being lent out by banks to create economic activity, as was expected, but is rather being used by the banks to repair their own balance sheets and recapitalize. So the ‘law of unintended consequences’ has kicked in to further complicate the situation.
Investors are faced with very low interest rates on their savings. Series I Savings Bonds, which accrue interest on an inflation-adjusted basis, are now paying zero interest due to deflation. As you well know, it’s all but impossible to find bank savings accounts or money market accounts that even pay 1%!
What can you do to combat deflation? The best hedge is U.S. Treasury bonds, which have a fixed interest rate over the life of the bond and are non-callable (i.e. cannot be paid off earlier than the original maturity date). Including them in your portfolio preserves your purchasing power when equities in your portfolio decline.
Although infrequent, deflation has its particular perils and it is important that you build protection into your portfolio to shield you from its devastating effects. It is actually more important to protect a portfolio against deflation with fixed rate Treasuries than to try to sidestep inflation by filling a bond portfolio with TIP’s (inflation adjusted Treasuries) that leave no defense against deflation.
We are a resilient nation, and we will survive this economic cycle. Indeed there are simple, sensible approaches you can take to ready yourself for all economic environments - deflation, inflation, or prosperity. The key is to build and maintain a balanced approach that positions you for any economic scenario. You’ll be able to stop trying to predict what might happen because you’ll know that you are prepared to face whatever does happen. Isn’t that one of the best “returns” your portfolio could ever provide?
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
For years we have been told about the evils of inflation. But now we are witnessing deflation, which most people have never experienced since 1950. What does deflation mean for you today? How is the economy affected? How bad can it get?
Inflation is an economic phenomenon that has been described as too many dollars chasing too few goods. Deflation occurs when the opposite happens -- too few dollars are being used to buy the available goods.
For most of this decade credit has been abundant and too much money was lent, especially to people without a strong financial foundation. It was easy to buy houses, cars, take trips, etc. As borrowers defaulted en masse on mortgages, student loans, car loans, etc., the banks and other lending institutions curtailed lending to consumers and to businesses. This resulted in an alarming drop in sales of cars, houses, etc. Retail sales across the board have shrunk as people became very frugal.
The downturn is compounded by a significant increase in the average family savings rate from about 1% of household income a few years ago to 6%+ now. The stock market dropped to the lowest level in 50 years, which caused working people to be alarmed about their retirement prospects. Seeing your house drop in value along with your 401-k is gut wrenching. So people are improving their “balance sheets” by paying off debt and increasing their savings at a feverish pitch.
These developments are good in many ways because we are weaning ourselves off the spending binge that lasted until about 2007. The downside is that companies have trouble making a profit because they have to cut their prices so much to sell their goods and services. This impacts suppliers. New orders for their products drops. To survive, all businesses are cutting staff. Then unemployment rises, there are even fewer purchasers, and people refrain from buying things because they either don’t have the money or they expect prices to drop further. This cycle creates a vicious vortex which sucks the wind out of our economy and causes deflation.
The big danger is that this downward spiral can worsen over time. As more people lose their jobs they can’t buy goods and services, sales continue to drop, and employers lay off more people, etc. Economists call this a drop in ‘velocity of money’ and, if it continues, it could cause a severe depression. At that point, it is very difficult to regain economic momentum. The Great Depression of the 1930’s only ended when we went to war in 1941. War increases employment, and creates a strong demand for armaments (which keep getting blown up and have to be replaced).
Deflation also causes the value of our dollar to drop against other currencies. For American workers, this means that the price of imports and the cost of travel abroad increases. For non-U.S. residents this situation is a bonanza: for example, Europeans can not only buy more dollars with each Euro, but those dollars will buy more U.S. goods, and travel to the U.S. is a real bargain. As foreigners buy more U.S. goods and services and travel here to spend their money our balance of trade is favored.
Swings in economic activity are often self-correcting. As prices drop during deflation, the value of the dollar for U.S. residents actually increases and we can buy more for less money. For example, the price of real estate has plummeted in many areas, the negotiated price of cars has dropped, and most retail stores, restaurants, etc. are offering enticing specials.
The U.S. is not the only country facing this situation: the whole world is experiencing deflation. But a free market economy like ours is affected sooner because a higher degree of our spending is non-governmental compared to many other mature economies. To address the danger of deflation, the U.S. government had to inject money into the economy using stimulus spending. Most countries have a stronger social ‘safety-net’ like unemployment benefits and free health care. They have decided that, for now, additional government spending in the form of a stimulus is not necessary.
Most of the U.S. stimulus money, however, is being spent on government jobs that do not create additional employment. The ‘TARP’ money earmarked to shore up our banking system isn’t being lent out by banks to create economic activity, as was expected, but is rather being used by the banks to repair their own balance sheets and recapitalize. So the ‘law of unintended consequences’ has kicked in to further complicate the situation.
Investors are faced with very low interest rates on their savings. Series I Savings Bonds, which accrue interest on an inflation-adjusted basis, are now paying zero interest due to deflation. As you well know, it’s all but impossible to find bank savings accounts or money market accounts that even pay 1%!
What can you do to combat deflation? The best hedge is U.S. Treasury bonds, which have a fixed interest rate over the life of the bond and are non-callable (i.e. cannot be paid off earlier than the original maturity date). Including them in your portfolio preserves your purchasing power when equities in your portfolio decline.
Although infrequent, deflation has its particular perils and it is important that you build protection into your portfolio to shield you from its devastating effects. It is actually more important to protect a portfolio against deflation with fixed rate Treasuries than to try to sidestep inflation by filling a bond portfolio with TIP’s (inflation adjusted Treasuries) that leave no defense against deflation.
We are a resilient nation, and we will survive this economic cycle. Indeed there are simple, sensible approaches you can take to ready yourself for all economic environments - deflation, inflation, or prosperity. The key is to build and maintain a balanced approach that positions you for any economic scenario. You’ll be able to stop trying to predict what might happen because you’ll know that you are prepared to face whatever does happen. Isn’t that one of the best “returns” your portfolio could ever provide?
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
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