Wise Money Decisions

A few years ago two elderly California ladies concocted a brutal and dastardly scheme to make $2.8 million.  Their plan involved life insurance fraud and homicide.  They implemented the scheme over a period of years in the belief that a statute of limitations would prevent the insurance companies from contesting the fraud. 

Since this is a family site I’m not going to dwell on the details of the scheme.  If you’d like to satisfy morbid curiosity you can read the article (link above). 

Now the 77-year-old woman is in for life without the possibility of parole.  Her 75-year-old co-conspirator faces 25 years to life.  Prosecutors are not seeking the death penalty because both women will have died of natural causes long before the legal system could impose the death penalty. 

A Better Way to Make $2.8 Million by Age 77

Fortunately there are better, legal ways to make $2.8 million by age 77.  Let me illustrate what I believe is the easiest for the greatest number of people.

When you are 27 years old you commit to putting $243 per month in a brokerage account.  You invest your money in a diversified portfolio of low-expense funds with low dividend yields to minimize current tax liabilities.  You achieve an annual before-tax return of 10%.  You invest relatively tax efficiently.

By age 77 you have a portfolio worth nearly $3.7 million.  You sell everything, pay federal and state income taxes at capital gains rates (I’m assuming today’s capital gains tax rates for someone in California), and you have $2.8 million left.

Hmmm…. $243 per month sounds easier than insurance fraud and murder.  It takes 50 years of commitment, but the commitment is not very burdensome (only $243 per month) and doesn’t take a lot of time once you get the hang of it (passive index investing).

Inflation Hurts You….

Of course $2.8 million will not be worth as much in 50 years.  At 3.5% annual inflation it will be worth only $500,000 in today’s dollars.  How much more do you need to invest each month to overcome the effects of inflation? 

The answer is rather sobering.  You would need to invest $1,360 per month to end up with $21 million before tax.  You would pay over $5 million in tax when you sell everything at age 77, leaving you $15.6 million.  After compensating for inflation, your $15.6 million is worth $2.8 million.

Yikes.  $1,360 per month is a lot harder than $243.

I’ve got three tricks up my sleeve to make things easier.  The first involves inflation.

Read the rest of this entry »

I love reading The Mole’s column on CNN Money.  Everybody’s got a gimmick, as they say, and his is an undercover financial planner giving his readers a behind-the-scenes look at the financial planning industry. 

His latest column describes a recent meeting of financial planners trying to figure out how to handle the recent market volatility.  The Mole writes:

I heard much discussion among planners about the “unusual behavior” of today’s market and what to do during “uncertain times.” In reality, what’s going on now is pretty common; the recent five-year run of steady gains was the unusual time.

Despite Standard & Poor’s recent report about a 70-year high in market volatility, my understanding is that the last five years of steady gains are more out of the norm than the recent market volatility. 

He continues:

From this meeting it was clear to me that some financial advisers chase performance just as much as individual investors do. They load you up on stocks or funds that are doing well and tell you to sell when the tables start to turn. Often these planners are simply following your emotionally driven pleas.

But a financial planner should rein in your emotions, not react to them, and help you stay the course in both up and down markets.

Well said.

Walter Updegrave Defends an Adviser

Walter Updegrave writes “Ask the Expert” at CNN Money.  A reader asked whether he should stick with an adviser that didn’t pull his money out in October 2007 before the market started dropping.  Updegrave responds:

First, let me say that it’s not at all clear to me that your adviser has done anything wrong. Frankly, I’m more suspicious when advisers are eager to dump existing investments and buy into new ones. After all, making more buy and sell recommendations is usually in the adviser’s financial interest, since more moves can generate more commissions, or at least make it appear that the adviser is on top of the situation.

So the fact that your adviser didn’t play yes-man to your urge to move into more conservative investments doesn’t automatically suggest to me that he’s incompetent or lazy. Quite the opposite. As long as you were going into 2008 with a reasonably diversified portfolio that made sense given your particular situation, then it seems reasonable to me that he would want to caution you against making any big moves.

Well said.  And he took some heat in his comments for saying it.

Don’t Use an Adviser that Churns Your Account

The following is a topic for another day but it’s worth a brief mention.   Updegrave mentions that some advisers make trades in their clients’ accounts to generate more commissions and earn more money.  It’s called “churning” and it’s a dishonest tactic that some advisers and brokers use to enrich themselves at the expense of their clients. 

If your adviser churns in your account, even once, it’s time to find a new adviser.  Preferably a fee-only adviser that doesn’t have any incentive to churn your account.

KMC at Advanced Personal Finance has graciously introduced me to his readers.  So let me offer a warm welcome to Advanced Personal Finance readers!  I hope you will find something worthwhile here.

And to my small but growing audience, you should check out Advanced Personal Finance.  It is one of my favorite personal finance blogs. 

To give you a sample, I recommend his recent post about the circumstances that led him to leave his job despite not having a new job lined up and his wife about to deliver their second child.  Spoiler alert: it has a happy ending. 

In the short time I’ve done this blog, the most widely read article by far is how my parents handled allowance.  When I mentioned it to the friend that gave me the idea for the article, he suggested royalties are in order. 

He can name his price as long as it’s based on a percentage of my site’s earnings.  Zero times anything is zero.

Back to allowance.  I came across a well-written article by Jennifer Allen at Scholastic that gave suggestions on how to handle allowance for different age groups.  It has some good ideas. 

When to Start 

She suggests starting at age 5 or 6, but that it depends on your child’s maturity.  Some kids might be able to handle it earlier and some later. 

I nearly made the mistake of starting my 2-year-old daughter on allowance tonight.  We were at her favorite restaurant Taco Bell.  She wanted candy from a candy machine.  She stuck her hand up as far as she could but couldn’t reach anything.   

I briefly thought about giving her a quarter and telling her it would be the only one.  It’s a rookie mistake I might have made a few months ago.  I’m smarter now.   There’s no way on God’s green earth she’d let it be the only quarter.

Yes, two years old is too early to start allowance.

Is it a Good Idea to Tie Allowance to Chores, Grades, Behavior?

The Scholastic article believes allowance should be a teaching tool rather than a disciplinary tool, and therefore recommends against tying allowance to chores, behavior, or grades.  The author believes kids should do chores by virtue of being a member of the family and not because there is a reward.

At this point I don’t have a strong opinion either way.  I can understand trying not to confuse kids by crosswiring a teaching tool with a disciplinary tool.  On the other hand my allowance was tied to chores and behavior and I lived to tell about it. 

How Much Allowance?

An expert cited in the article recommends a weekly allowance of 50 cents to a dollar for every year of age.  A 10-year old would get $5 to $10 per week.

It’s a lot more than I received, but maybe it’s the right amount these days. 

Somewhere in there is an opportunity to teach your kids some math.  For example, double your child’s allowance if she can successfully use the Rule of 72 to figure out her allowance in 1984 dollars.  No, don’t do that.

Other Suggestions

Another suggestion I found interesting:

“As your child grows, so should his responsibility for his own discretionary spending. Keep track of what you spend on him for a couple of weeks. Then, choose one or two nonessential items that you will cease paying for, such as after-school snacks, comic books, baseball cards, or iTunes downloads. ‘Explain that you’re no longer paying for those items, but instead will give her an allowance equal to the amount you’ve been spending.’ “

I think the idea has merit.  It would get your child to think about budgeting and priorities. 

By the way, do kids buy baseball cards these days?  I hope so, it means I’m not too late to get some value out of the four boxes in the corner of my closet.

Bailouts

Finally, the article suggests that you not bail out your child if she gets buyer’s remorse or runs out of money.  Seems right to me.  If they have buyer’s remorse, you could help them return the item or sell it on Craigslist. 

If allowance is meant to prepare them for real life, they should learn not to expect bailouts.  Just don’t tell them about the Savings and Loan scandals, Bear Stearns, or the mortgage crisis.  That would just give mixed messages.

Conclusion

It will be a few years before I have any experience with kids old enough for allowance.  Until then I’m not planning to form strong opinions about how to handle allowance.  But it’s one of those things that’s good to start thinking about before it sneaks up on you.

When I bike to work I pass two gas stations.  One was selling the lowest grade at $4.01 this morning.  It’s the first time I’ve seen the low grade above $4.  The other had low grade at $3.91.  Guess which one I frequent? 

It’s a trick question.  I don’t frequent either.  I go as infrequently as I can.  The weather’s nice and I’d rather bike to work.

A few days ago I pointed out that gasoline accounts for 70% of the average gas station’s revenues, but only 30% of its profit. 

Now I have additional data to offer.  According to the U.S. Energy Information Administration most stations receive only 7 to 10 cents per gallon sold.  That’s their revenue.  After expenses they’re left with a just a few cents of profit per gallon sold. 

Where Does the Rest of the Money Go?

Here’s the breakdown  for a $3.04 gallon of gas, according to the Energy Information Administration:

Crude Oil

More than two-thirds pays for the crude oil.  It’s the reason that gas prices go up when oil prices go up. 

Saudi Arabia can produce a $110 barrel of oil for as little as $1, while a U.S. company drilling in the Gulf of Mexico might spend as much as $70 to produce one barrel.

Taxes

The taxes vary depending where you live.  The average state adds 22 cents of gas tax, while the federal government tacks on another 18 cents. 

Guess which lucky residents of which lucky state get to pay the highest state tax?  Here’s a hint, it starts with ‘C’ and ends with ‘alifornia’.  According to the American Petroleum Institute, California adds 45.5 cents per gallon.  Yikes. 

If you’d like to see your state’s gasoline tax click here.

Ship and Sell

This includes the cost of moving the gas to gas stations via trucks or pipelines.

Refining

Refining is the process of turning crude oil into gasoline.  Refining companies have to buy crude oil at market prices.  Their bottom line is hurt by high oil prices.

Conclusion

When I buy a gallon of gas most of the money goes to the oil producers.  The U.S. oil companies do very well with high oil prices, but it’s the Saudi Arabias of the world that make a killing because of their rock bottom production costs. 

The corner gas station makes a few cents per gallon.  That’s less than 30 cents when I fill up the Accord. 

When I was a kid I filled up my lawn mower a few gallons at a time.  It must have barely been worth the wear and tear on the station’s pump - except it was worth it because I bought so many baseball cards at that station.

Today I read a Rich Greifner article at Motley Fool titled “Are We Headed for a Recession? Who Cares?“  Like many articles at Motley Fool these days, it’s mostly intended as a sales tool for its newsletter.  But there is some good information nonetheless.

It makes many of the same points I made in “Are We in a Recession? Does It Matter?“  The main idea is that you shouldn’t base investing decisions on whether we’re in an official recession:

“By the time it’s determined that the country is in a recession, odds are that the economy is already close to recovering. For example, the last trough in economic activity occurred in November 2001 — but the NBER didn’t make that determination until July 2003. By that time, the economy had been improving for over a year and a half!”

The stock market is a forward-looking indicator, while recessions are backward-looking.

Mr. Greifner needs only two sentences to sum up the main point of my post “Historical Behavior of the Stock Market During Recessions“:

“Wait, stocks can go up in a recession?
Since 1945, there have been 11 recessions lasting an average of 10 months each. But according to a recent article from Hulbert, during these recessions, the stock market actually rose seven times — and the average market return during all 11 recessions was 3%!”

In other words, the stock market does just fine during recessions. 

Conclusion

Historically, exiting the stock market during a recession is a bad idea.  It’s nice to see the Motley Fool back up my work (or vice versa!).

Several weeks ago Standard & Poor’s released a report that volatility in the S&P500 index was at a 70 year high.  The report states that the number of significant daily market moves, defined as days with a greater than 1 percent change in the index, has soared since summer 2007. 

The first half of 2007 saw only 12.9% significant daily market moves.  The second half of 2007 rose to 38.6%.  During the first few months of 2008 the percentage of days with significant market movement has risen to 51.9%.

It’s Great to be a Long-Term Investor

When I see reports of increased volatility it reinforces my reasons for being a long-term investor.  Short-term volatility is not a concern for people that hold diversified portfolios over long time periods. 

I plan to hold a diversified portfolio for the next 20 years, plus 10 more years after that.  And then maybe another 10 years after that.  The kind of short-term volatility described in the S&P report does not cause me any concern. 

I Like Volatility

Not only do I feel no concern over the S&P report, I actually like the report.  I love to see volatility!  Volatility helps me achieve a better return.  I have adopted an investing strategy that follows long-term upward trends, and it does better when there is volatility along the way. 

Also, higher volatility tends to push some investors away from stocks and toward safer investments, like CD’s or money market accounts.  As those investors flee stocks there are better returns for those of us that stick it out. 

If you’re academically inclined, you may find the following Wikipedia pages interesting:

Securities Market Line

Capital Asset Pricing Model

Modern Portfolio Theory.

Years ago I read that a gasoline station doesn’t make money by selling gasoline.  The gasoline draws people to the station, and some of those people buy tiny $3 bags of Cheetos to go with their gasoline.  The margin on the gasoline is tiny, but the margin on tiny bags of Cheetos is not tiny.

Writing a blog works the same way.  A blogger doesn’t make any money by posting content.  The content draws people in, and a few people click on ads.  At least that’s what I hear.

Back to gasoline.  All these years I’ve marveled at the gasoline business model:

• Sell a popular low-margin product to draw in crowds;
• Make high margin products easily available;
• Hope that some people buy the high margin products.

When I stop at a gas station I fill up my tank and I leave.  Unless I’m traveling a long distance I never go in to buy something.  Even worse for the gas station, I always use my American Express Blue Cash or my Discover Gas Card, both of which pay 5% cash back on gasoline.  The gas station gets charged a higher fee for rewards cards than other credit cards. 

Since I use a rewards card and don’t buy Cheetos, I always figured gas stations might actually lose money when I buy their gas.  That would make me a gas station’s worst nightmare. 

I’m Not Their Worst Nightmare After All

A few days ago I learned that “gasoline accounts for 70 percent of a typical station’s revenues, but only 30 percent of its profits.”

It surprised me for two reasons:

• If gasoline is 70 percent of revenues, then the other 30 percent is Cheetos and other junk food.  Check my math, but if the average price of a fill up is $50, then the average motorist is buying $21 of Cheetos per stop. 
• 30 percent of profits on gasoline is a lot more than I had thought.  For years I thought it was basically zero.  If the gas stations are making 30 percent or their profits on gasoline, then their margin on gasoline is much higher than I thought, which means they’re not losing money when I use my rewards card, which means I’m not their worst nightmare. 

I never felt guilt when I thought gas stations were losing money on me.  But it’s nice to know the gas station can make a small profit even if I don’t buy Cheetos.

There are several good reasons to use credit cards.  They save you money, they build your credit history, and they’re convenient. 

Recently I became aware of one more reason to use credit cards.  ATA Airlines announced last week that they are discontinuing operations.  For customers that purchased tickets using a credit card, their homepage says:

“ATA customers who purchased tickets using a credit card should contact their credit card company or travel agency directly for information about how to obtain a refund for unused tickets.”

If contacting the travel agent or credit card company fails, a customer would also have the option of initiating a credit card chargeback.

Tougher Road to Hoe if You Bought a Ticket with Cash or Check

On the other hand, customers that purchased tickets using cash or check may only seek a refund by become a bankruptcy creditor:

“ATA currently is unable to provide refunds to customers who purchased tickets directly from ATA with cash or a check. These customers may be able to obtain a full or partial refund for their unused tickets by submitting a claim in ATA’s Chapter 11 proceedings.  Information about submitting a claim will be available at the following website: http://www.bmcgroup.com/ataairlines.”

Conclusion

Let me think.  Would I rather call my credit card company?  Or would I rather figure out how to submit a claim to bankrupcty court, become a bankruptcy creditor, wait through the long bankruptcy process, and hope there’s enough money left for me after the senior debt gets paid?  That’s a tough one.

Unless you have a dysfunctional relationship with credit, you ought to use credit cards.

It has been widely reported that David Sneath, who had worked in a Ford Motor Company warehouse for 34 years, won a $136 million Mega Millions jackpot on April Fool’s Day - his 60^th birthday. 

According to Wikipedia, Mega Millions pays out in either 26 annual payments or one lump sum.  If a winner chooses the lump sum, the payment is much less than the reported amount of the jackpot.

If Sneath had chosen 26 annual payments, the annual payment would be $5,230,769.  He did not choose the 26 annual payments.  He chose a lump sum payment of $84.3 million.

Is that a wise money decision?  Depends.  We can analyze the numbers to see if it’s an optimal decision financially, but there are also some individual factors (such as his tax situation) and intangible factors (such as his desire to give four of his co-workers a million bucks) that may drive the decision.  Since we can’t analyze the intangible factors, all we can do is look at the numbers.

The Numbers

To analyze whether the lump sum payment is the right choice, I calculated the rate of return he would need to recognize in order to turn $84.3 million into a stream of 26 equal annual payments of $5,230,769.  It’s a very simple calculation if you have a spreadsheet or a financial calculator. 

The answer is 3.924%.  In other words, if he can invest his money at a rate of return greater than 3.924%, then he made the right decision to take a lump sum payment.  His rate of return must take into account taxes of course.

Two Pieces of Unsolicited Advice for Sneath

First, be aware of the gift tax consequences of giving $1 million each to your co-workers.  You will likely owe gift tax upon making gifts of that magnitude. 

And finally, don’t be a dufus like Richard Hatch and neglect to pay your taxes.  It’s too late to blend in.  The IRS isn’t going to forget about you.