So in December the Fed hiked rates 0.25%. Now you want to know how this should effect your investing strategy. The short answer is that it shouldn’t. If you do anything differently because of the rate hike, you are over-reacting. The Fed rate hike, however, might have some impact on you. Let’s really quickly go over what a rate hike is and what it does and doesn’t impact.
What is the Fed “hiking”
When the media reports that the Fed is hiking rates, they generally mean the Fed Funds Rate. This is the interest rate that banks charge each other to loan money overnight. In turn the overnight rate directly impacts the prime rate, which is the lowest rate at which money can be borrowed commercially. After all, why lend commercially if you could instead simply lend at the overnight rate. This has gone from 0% to 0.25%. In other words you get a quarter annually by lending $100 at the overnight rate, go nuts.
What this directly impacts
Since the prime rate is effected anything set based on the prime rate gets boosted by a tiny bit. This includes credit card interest rates and auto loan interest rate. Now, our goal as Thousandaire’s is to not pay credit card interest and auto loan interest. If you are paying these interest costs this hike is tiny anyway, costing about an extra $2.50 per thousand dollars of debt per year. In principle, this will probably also impact rates offered by short term CD’s and savings accounts. Again this isn’t much, and its starting to look like the Fed might not continue to raise rates [link article on fed rate raising slowdown]. If the rate raise makes you feel that you really need to pay off that credit card or that car, I think that’s great. If it stokes you to buy a three month CD, fantastic. You probably don’t need to worry about it though.
What this does not directly impact
Every day I drive to work I hear some radio commercial about how you need to refinance because the fed is raising rates. This is a load being shoveled by guys who sell mortgages. Mortgages are long term rates, the fed has a very difficult time controlling long term rates. There is some evidence that they were able to push down mortgage rates during QE and “operation twist”. The fed might be able to push up long term rates by selling mortgages and other long term instruments. If inflation expectations stay low and GDP growth stays low long term rates will probably stay low despite a couple small increases in short term rates. Additionally, given negative interest rates abroad, there is a lot of capital in Europe and Japan looking for somewhere safe to invest money. If rates stay negative internationally, I’d bet that mortgage interest rates will stay low. You’ll notice that rates have even dropped over the last month or so. Current 30 year mortgage rate is 3.88% as of February 3rd.
What not to do
In principle increases in the federal funds rate should reduce the value of stocks. The value of a particular stock is the value of all of the future cash flows of the companies discounted to the present at an appropriate interest rate. This means that increases in interest rates reduce the value of stocks in principle. Unfortunately, this is well known, and as soon as rates seem likely to go up the stock market accounts for that information. Even though “rising rates are bad for stocks” you do not sell your stock holdings. You can’t control interest rates. You can’t predict their behavior better than the market (even federal reserve economists have substantial trouble doing this). You can control transaction fees and taxes. Selling generates both. The goal of stock ownership is to treat your ownership interest as an interest in a business and simply sit on it for as long as possible.
I ran across a really common objection to fully funding your 401(k): Disregard a terribly common bit of advice about your 401(k). This is certainly one of the more well written version of this objection, but it’s not new. Boil the article down though and really it’s the common whine that if you put money into a 401(k) you won’t be able to get it back out (frankly, given the way most people manage their finances, that’s a big advantage). It straw-mans a bunch of personal finance theory, then assumes that consumption smoothness (spending the same amount of money every year) is necessarily more important than other goals, like control over your time.
The straw man
Schrager makes a key assumption at the beginning of the article. She claims that personal finance folk are prioritizing fully funding your 401(k) before any other personal finance goal, like saving up an emergency fund. She doesn’t link where she found this, and the links she does provide don’t seem to over-prioritize the 401(k) at all. This is all too common among critics of fully funding your 401(k), it’s important to make funding your 401(k) sound as scary as possible, what could be worse than going without an emergency fund to keep your 401(k) funded? I believe she saw someone with a list personal to them, somewhere that prioritized their 401(k), but writing a whole article about something that essentially no one thinks is a good idea sounds terrible.
Schrager argues that people with volatile incomes shouldn’t necessarily fully fund their 401(k), and she doesn’t fund her 401(k) beyond an employer provided match. I’m glad that we agree that a bunch of free money is still worth it. She further claims that you can go ahead and invest in stocks outside of a 401(k). She further goes on to throw the IRA into the mix as well. This is perplexing to me, simply because the Roth IRA makes a great emergency fund if you’re like Schrager and aren’t planning on investing in it anyway. (I should clarify, the Roth IRA makes a great emergency fund, but it’s an even better retirement fund. Since your tax sheltered space is limited, I’d strongly suggest contributing to a Roth and an emergency fund, but if you’re gonna be all I’m too good for retirement accounts about it please fund the Roth.) Basically her argument boils down to being scared of the penalty and trying to engage in consumption smoothing.
Basically the whole argument reads like someone who doesn’t really understand how 401(k)’s work or what the most common personal finance goal actually is. This is really strange for someone who specializes in pension economics. Honestly I wouldn’t bring it up if I wasn’t so sure she was misunderstanding key points about 401(k)’s and personal finance in general. Schrager, you really can have your cake and eat it too. If your goal is “consumption smoothing” you should note that investing in stocks is probably a bad idea. Stock returns are anything but smooth and it’s entirely possible that your income could be correlated with investment returns. Any money going into stocks might as well go into a 401(k), because you can take money out of a 401(k) if you lose your job (the cause, I assume, of the income volatility). Yes you do take a penalty, but you also have a substantially lower tax bill in years when your income is substantially lower. The other important use of the 401(k) is that it allows your total tax bill to hit important breakpoints in the tax code. If you have a pile of stocks (which you apparently do) you should note that you pay no taxes on dividends and capital gains if your after 401k contribution income is below ~$75,000 for those that are married filing jointly. This savings could easily be enough to justify paying the 10% penalty later. Furthermore, money in a 401(k) compounds without taxes. This is often overlooked, but can pay the penalty by itself. For the same tax bracket, you should keep in mind that the total effect of a 401(k) is mathematically equivalent to not taxing earnings on contributions. If you pay an additional 15% in taxes on earnings in stocks outside of your 401(k), then as soon as earnings are about as large as the initial investment you’re doing worse than paying the 10% penalty. This, based on historical stock data, would probably happen in as little as 10 years, so it’s not really fair to use the 59.5 number.
Lastly, most of the people I talk to in the personal finance community rate control over their time far ahead of spending the same amount every year. Any retirement contribution you make today is two similarly sized contributions you don’t have to make next decade. If you overshoot, then you just retire early. Alternatively, when the next job loss comes around you don’t have to panic that you aren’t going to be able to fund your retirement.
It’s that time of year again. Tax season! (I’m not sure why I find it so exciting, but it evidently has something to do with being the sort of person that would rather sit writing for a personal finance blog rather than watching TV, playing video games, or participating in underground Lucha Libre matches.) It seems like a good time to touch on the things that are a little different for our little community. If you’ve been following carefully you probably don’t just plug your W-2 into Turbo-Block and forget about it.
Does Contract Work Need To Be Reported to the IRS?
Sometimes this can be a little difficult. If you do contract work for a big organization they’ll generally send you a 1099 if you make over $600. If you make a really small amount of money say less than $100, some folks tell you not to worry about it. Those are terrible people. You owe the IRS that money. Some laws I don’t take seriously, I jaywalk from time to time. Some laws many people don’t take seriously, I don’t think I know anyone that had their first drink after 21. Don’t screw around with the IRS. I always pay every penny I owe on my taxes. When I order something on amazon I mail State of Colorado a check for 2.9% of the sale value.
Make Use Of The Saver’s Tax Credit
This is the dumbest tax credit I’m aware of. I mean you get a discount on your taxes if you’re rich enough to not be living paycheck to paycheck. Basically, it seems to be a bonus you get for using other tax shelters really well. I couldn’t be happier to take advantage of it. By my math you can use it to pay $0 in federal tax even if you already make $44,750 as an individual. It is completely and utterly ridiculous, you can basically double that figure if you’re married and filing jointly. Sure, you need to throw most everything into 401k’s, IRA’s and HSA’s, but it’s not like maxing those is a terrible idea on its own. See our article here.
Most Investment Expenses Can Be Deducted
One bit that new amateur investors often miss is that all investment expenses can be deducted against investment profits. Let me repeat that, all investment expenses can be deducted against investment profits. Your brokerage will handle the easy part. Your cost basis is an expense, your brokerage fee’s are an expense. Any decent brokerage will calculate these costs and report the difference (hopefully profit) to you. You need to add in any other costs you might have had. For example, a subscription to the Wall Street Journal, any investment books that you purchased, if you subscribe to an investment newsletter. All of these are deductions.
Can You Deduct Travel To An Annual Meeting of Stock You Own?
The only major expense associated with investing that you can’t deduct is cost of travelling to an annual meeting of a stock you own. This is unfortunate, but ultimately sensible on the part of the IRS. There are enough companies in the United States that it was pretty easy to simply find a place to go, find a company with an annual meeting close enough, and deduct your plane flight. Everything else related is fair game. Depreciation on your laptop can even be deducted as a 2% item if you use it for investment purposes. If you’re looking at any non-standard or large deductions in this area it’s a really good idea to ask a tax professional. I’m a scientist. That isn’t a defense when you get audited.
A Health Savings Account (HSA) is a tax sheltered account that allows you to buy healthcare with pre-tax dollars. They have to be glued to a high-deductible health plan. They’re really all the rage in personal finance circles. It’s easy to see why. Anything that transfers financial control over your life from business, government, or whomever to you usually gets a good review. In this case financial decision-making is transferred from insurance companies to you. Rather than pre-paying via insurance premiums for that doctor’s visit you seem to end up taking every year. Instead you pay for it out of your HSA. If you read our previous article, you know how great a deal this can be. There are a few questions you should *strongly* consider before making the swap however.
Is the “fully loaded” plan on offer from my employer a good deal?
This is really dependent on your employer, but your enthusiasm for a high deductible plan if you don’t end up seeing very significant premium savings should certainly wane. The point here is to save money, you don’t want to be assuming that you don’t need to spend money on healthcare in the future year. If you’re only saving $20 or $30 per month, unless you have a very special situation, you should likely consider giving the High Deductible plan a pass. Again, this all depends on your situation. Reading a blog online doesn’t absolve you from doing the math.
Am I prone to magical thinking?
A really great way to lose your mind is to sign up for a High Deductible Health plan (HDHP) and then when you have a new health related event say to yourself, “Of course this would happen now. With my luck now that I pay directly for my healthcare I’m having all sorts of health issues!” You should keep in mind that you, right now, are the oldest you have ever been. Likely situation is more bad health stuff will happen to you this year than last year. It isn’t the HDHP’s fault.
Do I take good care of myself?
Yes, anecdotally we all know that chain smoker that lived to 100. We all know a health-nut that dropped dead for no reason at 40. Maybe that’s your excuse to eat a non-stop smorgasboard of bad food. More power to you. The fundamental financial question is always, what is likely. You need to figure out if the fully loaded plans are losing money on you or making money off you on average. Take stock of your health, if climbing the stairs winds you, play with house money. If you’re the healthiest of your co-workers, it shouldn’t take a lot of math to figure that you want to be paying your own medical bills.
Another note on this subject is that you could be the healthiest fellow in the world, but if your idea of a hot Saturday night is base jumping in the dark, load up on all the health insurance they’ll sell you. Don’t just figure that your resting heart rate is 45 bpm so you’ll never see a doctor. Clinging to a rock wall 20 feet up counts as a lifestyle disease for our purposes.
There’s no judgement on any of these things. Just make sure that you’ve weighed the odds when buying your health insurance, not your hopes. With any luck all of our health and life insurance premiums will be wasted money.
Will I cut the “health” budget to the bone?
There are plenty of dumb ways to die that start with refusing to go to the doctor. My problem is that I tend not to notice when I spend money. That’s the personal finance problem I work on. Some people have the opposite issue. They see a $200 price tag on a doctor’s visit, they remember the last time they went, the doctor only told them to go home and drink soup, they figure the money was wasted. If you know that you aren’t going to see a doctor when you’re ill to save $200, a High Deductible plan probably isn’t a great idea. You don’t go to a primary care doctor to fix your illnesses, you go to the doctor so they can flag you if you have the dyin’ flu.
Do I take preventative medicine seriously?
One of the great things about the HDHP/HSA is that you get to capture the benefit of preventative medicine. When you get the flu vaccine and as a result, spend the winter not sick. You saved yourself a substantial amount of money there. Money that will now compound tax free in your HSA. If you regularly ignore doctor’s recommendations, turn that around or stick to your fully loaded plan. If you’re going to play Russian Roulette with your health might as well make your co-workers pay for it. If you think that vaccines cause autism, the HDHP is probably not for you. Also, you should probably take some time out of the day to meditate on how you got that crazy. Unfortunately this could also apply if you can’t use preventative medicine for legitimate reasons (like allergies). People who don’t use vaccines are putting you more and more at risk and you probably should give that risk to the insurance company rather than bearing it yourself.
The tax advantages of an HSA and HDHP are huge. I love mine. That doesn’t mean that it’s a great idea for everyone, and like every other major financial/health choice, you should weigh the money, your health, and your psychology carefully before you commit to it.
As we’re gearing up for election season it seems like a good time to remind everyone what unemployment statistics are and how they work. I’ve heard entirely too much uninformed discussion on the subject. First off, regardless of your party affiliation you should take a moment and realize that the economy is doing good right now. The economy is rarely doing this well, and in some sense, standard of living has never been so high in the history of the country. We should also note, the same thing happened during the Bush years. For some reason people only seem to want to believe progress is happening when their guy is in office. In general the history of the American economy has been an upwards march of awesome tempered by the occasional recession, with the large exception of the great depression.
It’s also important to remember that recessions are not a recurrence of a crappy standard of living, they’re a brief (half-year) long pause in an otherwise upward march. Usually recession means returning to a standard of living last seen a couple years prior. Some people do lose their jobs during recessions, and it is bad. Some people also lose their jobs during years when the economy is good as well. I recognize that average standard of living doesn’t mean that everyone is doing better, just that folks are doing better on average. It is important to recognize good things when they happen despite the fact that some bad things still happen.
Official unemployment rate
The unemployment rate (the headline number currently at ~5%) is computed by dividing the number of unemployed folks by the number of people in the labor force (this is the number of unemployed folks + the number of employed folks). The definition of unemployed, are people who want a job, are looking for a job, and don’t have a job. This doesn’t include people who have given up looking for a job (sometimes called the “discouraged”). It also doesn’t include folks who are stuck working part time when they’d rather be working full-time.
This number has had some criticism over the years. I’ve found a really easy method of guessing the political affiliation of these critics. It’s simply the opposite of whatever party holds the white house at the moment. There is a quite simple reason for this. After a recession, the economy recovers (shocker). During a recession, however, partisans spend a lot of time claiming that the opposing party’s policies will extend the recession indefinitely, cause a depression, or simply sink into the ocean. When these claims fail to materialize (double shocker), partisans have become so invested in the story that they were telling they have to save face somehow. Therefore, rather than acknowledging that a recovery has happened, they call it a “jobless recovery” (or “precursor to inevitable catastrophe”). Since they can’t acknowledge that unemployment has gone down, they simply claim that it isn’t a good measurement by nitpicking what goes into the data. Enter the U6 unemployment rate.
U6 unemployment rate
The U6 is simply a version of the unemployment rate that also includes “discouraged” workers (people willing to say they want a job, but unwilling to take any measurable actions to get one in the last month), “marginally attached” workers (people willing to say they want a job, but haven’t had one in a long time, they have also looked for work at some point in the last year), and underemployed workers (in this case, meaning workers who work part-time but want to work full time). Naturally, since this rate includes more people on the “unemployed” end of the ratio it is always larger. A common way to use it to deceive folks is the following:
Partisan A: Clearly this president is awesome, the unemployment rate is down to 5% from 10%!
Partisan B: Well, it isn’t a true recovery. The only reason the number has gone down is that the unemployed have gotten discouraged, or got just part-time jobs rather than good full-time jobs. The recovery isn’t real. You just can’t see it because you’re in the tank for your guy. You should look at the U6 unemployment rate, it includes these extra fellows and is 10%!
The implication is that the unemployment rate hasn’t changed. That, somehow, it went from 10% to 10%. Of course you can’t compare the headline number (which is lower) to the U6. But, it’s a good way to imply that no progress has been made. If someone says something like this to you, look up the trend of the U6 rate over the last few years to get a good idea of what is actually going on.
So what do I use?
Personally I think the headline number is most useful, but it probably depends on what you’re using it for. If you’re trying to prove that your party is better at managing the economy, I’d suggest doing something more useful, like digging a big hole in your backyard. When you’re done you can fill it up again. If you must, then the partisan answer to the question is U6 when it’s their fault, and the headline number when it’s our fault.
If you do find yourself unemployed the important thing to remember is that you need to be taking active steps to find work. Looking for work isn’t something you do by virtue of being unemployed. It is an activity you have to literally undertake. You have to make actual phone calls, and go to actual establishments of employment. Online simply doesn’t cut it. Until you find your next job I recommend taking a look at some alternatives you might not of considered. Even making a little money helps, and it helps keep you focused. If you’ve been reading personal finance blogs like this one, you hopefully have an emergency fund or some liquidity that you can tap in the meantime. Most importantly, don’t spend your time arguing about unemployment statistics online.
Real Estate, in my view, is probably a worse investment than the stock market. The transaction fees are massive, the amount of work required is onerous, the amount of leverage required makes me nervous, appropriate diversification is hard for Thousandaires. I don’t like any of these things. There are surely benefits, for example the lack of diversification and amount of leverage allowed can make you rich very fast if you’re good or lucky. The main benefit of real estate, in my view, is behavioral. I suspect that if an investor treated his stock investments, they’d no longer consider stock investing riskier than real estate and they’d make a great deal more money. (No, I don’t mean that you should get an 80% loan on one stock and hold it for thirty years, don’t be an idiot.) How could you treat your stock investing more like real estate investing? What are the behavioral advantages?
Huge transaction fees
This means that you don’t jump in and out of real-estate. You buy some land or building and sit on it for years. In the stock market the average holding period of a stock is 5 days. Sure, some of this is downweighted by computerized trading, but you shouldn’t be trying to make money from a stock purchase after a month.
Long Buying Process
Buying a house takes about a month. During this period you have a long due diligence process. You inspect the property to make sure you’re getting what you’re supposed to be getting. You appraise the property to make sure its worth what you intend to pay for it and you spend weeks doing this.
Rare Price Quotations
People get the impression that housing prices are really stable, simply because they only see the actual market value of their house twice, when they buy it and years later when they sell it. If someone told you the exact value of your house every second of every day I suspect the illusion that house prices were stable would be utterly shattered. Imagine this story if you will, your friend comes to you having very recently bought a house. He says, “After only a month of owning my home the price has dropped $4,000! A similar home in my neighborhood just sold for $4,000 less than I paid for mine. This is a big investment for me, I couldn’t afford to lose that $4,000, and I certainly can’t afford to lose any more money! I better sell my house today before I lose any more money.” Clearly your friend has lost his mind, and you would know that you need to talk him out of doing anything drastic, sure maybe house values in his area will keep falling and he’ll lose all his money and hate you forever, but you still know the “right” thing to do in his situation. For some reason when it comes to stocks, all that clear thinking goes out the window.
Treat Your Stocks Like Real Estate
If you bring the behavioral advantages real estate has over to the stock market, I’d bet that you’ll make more money with less work and stress. The rules here are: never sell (because you pretend your transaction fees are huge), do careful research (a month on any stock before you decide to buy), and never look at the price (which doesn’t matter until you sell, which should be never). If you do that, and mix those advantages with the advantages from stocks: simple diversification, very little work required to upkeep a stock (no one from Coke will call you at 3 AM expecting you to solve some problem with the business), and tax advantages (Much easier to own in tax shelters like IRAs + dividends and capital gains have a top tax rate of 15% rather than ~40% for rental income).
Real Enemy: Sloppy Thinking
Real estate can make you rich, plenty of people have also gone bankrupt in real estate because of the leverage present. Lack of diversification sometimes causes a problem. For example, your rental property can get flooded, most flood insurance policies don’t cover garden level units. One bad tenant can wreck your investment. You can mitigate these risks, but ultimately having the majority of your net worth tied to one investment seems like a recipe for a lot of variance (here variance means wild riches or financial catastrophe). My biggest gripe with real-estate is my interaction with folks on the subject. The numbers they estimate for income are inevitably rosy and important costs are often left out, the benefit of stock in a business is that someone has already done all the accounting for you to figure out if the business is profitable.
The other bit that drives me nuts is when discussing the risks the possibility that the price of the real-estate might fall, or that rents might fall is often treated as totally impossible. Looking at the last five years of price/rent appreciation and drawing a line through it is completely insufficient. Prices include all known information generally. People wouldn’t be selling if they thought that they were getting a bunch of appreciation in the near future. The best response I’ve ever found to this sort of sloppy thinking is a lecture given by Robert Shiller entitled Irrational Exuberance – As Relevant As Ever:
If had I mic to drop…