AskDong

I’ve been very lucky in the last few years to have a great 401k plan at work with generous matching, and a great stock market to put my funds into. The market since the lows of 2002 have been on steady and uninterrupted climb up. I lost money 1999-2002, but since I was straight out college I didn’t have all that much money to lose. Sometimes timing is everything. I’ve been very fortunate to have had a great stock market to coincide with the ability to put more into my 401k. I’ve been able to max out my contribution the last few years. I thought it would be an interesting comparison to look at my 401k in comparison to S&P 500 Index, and a hypothetical account consisting of only contributions. I’ve normalized everything to value of $1 from when I started tracking in Sept. 2003.

What’s clear is that having a well performing 401K account is not just a function of having a great stock market, nor is just a function of making contributions. Both are equally important. However, at the early stages of savings, contributing is much more important than what the market does. In 10 years this chart should look very different. Hopefully it’ll look different in a good way and not just because everything point down instead.

September was one heck of a month for the Markets. Some of that performance is reflected in the value of my IRA. That said given my current bearish stance, I was not positioned to take full advantage of the rally. Personally, I think the current market rally is rather dumb. The market has gone up because economic prognoiscators are pointing down. The market has been delighted by the rate cut, and is expecting and asking the Fed for more. As a fundamentally driven investor, I think future earnings are more important than any rate cute (though rate cuts can help earnings). That said because of the weakness in the dollar, U.S. companies are looking cheap.  The U.S. Market as measured in Euro is not actually up all that much for the year.

I engaged in two transactions in September since the last update. I sold my shares of PALM, and sold another 10 shares of FXI which is a China Index ETF.  FXI has been far my top performer by far, and everytime I think it can rise no further it ends up going up another 30%.  Such is life.  I’m going to sit on my 10 shares, and potentially add to it if and when the China bubble deflates a bit.  As a result of my sales, I’m also sitting on bit more cash than I would like.  I will be looking to deploy that in the next few months.  I’m looking at European funds.  If current trends continue the dollar probably still has more to fall.

Now that Mary Ann has plan on tacking her credit card debt, she can start thinking about what she should be doing next. Personal finances is not about saving money, nor should it be about depriving one from the pleasures in life. If all someone does is save money i.e. Silas Marner, that person hasn’t done a very good job with regard to his or her finances.

Her priorities in terms of spending are as follows:

1. Travel
2. Going out to eat
3. Going out/Entertainment (drinks, concerts, etc.)
4. Groceries
5. Shopping

That priority list looks a lot like mine. The question now is given that those are her priorities, does she live by her priorities? I’m going to ask her to track her expenses for one month in a notebook (old school), or just to purchase everything on her debit card, which will list her expenses. At the end of the month she should categorize her expenses and see if the total spent each category matches us with her priorities.

Her assets are limited currently to her checking account at Bank of America. She primarily uses her debit card for spending. She doesn’t have an IRA or a 401(k) established. Given her situation her next priorities after or concurrent with paying debt should be:

• Establishing an Emergency Fund
• Establishing a Roth IRA
• Opening a 401(k)/403(b)

I’m not going to prioritize each of those, as some people want to maximize tax benefits, and others feel like they can’t live without the safety of a real emergency fund. Though, I would say if Mary Ann’s company matches, she should at least contribute to get the company match - no reason to throw money away. In any case, she should retain her account with Bank of America for the ATMs. In the Boston area, it’s not even funny how Bank of America ATMs dominate the competition. If she’s currently being charged any fees, she should open an online a My Access Checking account which has no fees, and no minimum balance. If she’s already avoiding fees by direct deposit, then she may not have to open a new account. There’s no reason ever to pay bank fees. Once Mary Ann has locked down her bank account, she can go ahead and enroll in the Keep the Change program if she hasn’t done so already. Bank of America will match the “Keep the Change” contributions in the first 9 months. Of course, they force the money into a lousy savings account that only pays .2% and has a minimum balance of $300. She can avoid the minimum balance and the monthly fee by transferring at least $25 a month from her checking account.

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Welcome to all the readers who’ve come from Advanced Personal Finance Carnival of Personal Finace #116, but without further adieu we move on the topic of the day: The performance of my IRA.

Another month and another update on my IRA. My IRA accounts saw some recovery in August, not enough to get me back to where I was at the end of July. However, I’ll take what I can get. My cash/money market holdings are still around 20% reflecting my current ambivalence with the state of the market. Given what I think are some very real risks to the economy, the market is not cheap enough to buy in general and I haven’t had enough time in the last few months to research particular companies that I want to buy into. I expect my cash to sit as cash until at least early November.

Above I’ve also highlighted a few interesting non-transactions. Sun Microsoft systems changed their symbol from SUNW to JAVA in order to better reflect the direction of business (according to them). In addition the calls I had sold on PALM expired, and I’ve reflected that by highlighting it in light yellow.

How much you need is subjective question. The two truest answers are:

1. You need more than you think.
2. You need much less than you think

For some people it’s all about the minimum that you need to get by – hence needing less than you think. That’s the ultimate truth. We really don’t need all the things that we think we need. However, most people end up “needing” more than they think. As much as many of us try to be frugal, for most people there is inevitable lifestyle creep. Sometimes, it’s unavoidable like children (while children themselves may be avoidable, the additional cost of providing for them isn’t). For others, it’s just the inevitable spending increases that go along with income increases.

Nobody knows what’s going to happen in the future, but we should know where we are now. I think it’s always good to have a simple estimate of what one would actually need to retire tomorrow if you had to. I use the most basic of models - a present value estimate assuming a life expectancy, estimated annual expenditure, expected inflation, and expected investment growth rate. My number: 1.823 million and some change

How do I come up with this number? For those who aren’t familiar with present value, present value is simply the dollars needed now to have X dollars in Y years. For example let’s say I needed 20,000 in 3 years for down payment, I wouldn’t actually need 20,000 today. I would only need $17,276 right now assuming I could get a return of 5% annually (and not have to pay taxes on the interest). As of today, I shouldn’t have much of a problem getting a 3 year CD that pays around 5%. I would m$17,276 into a CD, and have the $20,000 in three years as needed.

Present value calculations reflect the fact that a dollar today is inherently worth more than a dollar tomorrow. Calculating what I need for retirement is not much different from calculating what I would need for a down payment. Instead of a single payment that I would need in three years, in retirement I would effectively need a payment every year to match what my expected expenses should be.

The one thing to note in the calculation above is what I actually use for the “rate”. Typically the rate is the discount rate or interest rate. If I weren’t making an adjustment for inflation I would’ve used 9%, the expected investments growth rate. However since I’m trying to take inflation into account, I need to adjust it.

i = inflation, r = growth rate

That adjusted rate = (1 + r)/(1 + i) - 1 = 5.83%

At first thought which was my first thought, the adjusted rate might be just be r - i. It’s not however for the same reason something that’s marked up 50% and then discounted 50% doesn’t return to the original price. If something that costs a dollar is marked up by 50%, it’s $1.50 and then subsequently discounted 50% it become .75 cents. Like discounts and markups, the effects of inflation and growth are multiplicative, not additive.

So back to my 1.8 million number. For myself I’ve assumed life expectancy of another 70 years, inflation of 3%, investment growth of 8.5%, and expenses of $100,000. The adjusted rate = (1+8.5%)/(1+3%) - 1= 5.34%. In Excel the formula is simply PV(5.34%, 70, 100000). Voila, 1.823 Million (actually negative 1.823 Million since the convention is to express the value as how much you would need put into (-) an investment)

If planning for retirement were truly this simple, everyone would know exactly how much to save. The biggest problem with using any simple model like this is the absolute certainty that is built into the model. Do I really know what inflation will be? Or how my investments will grow? For example if the first year my investment only grows 3%, but I spend the full 100,000, my whole plan would be derailed even if everything else continued as planned. I would’ve spent money that would never get a chance to grow. All the caveats aside, a simple model such this still does serve as good basic benchmark, and everyone needs a basic benchmark.