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October 28, 2012

The SMALL TRADES JOURNAL contains articles written for do-it-yourself investors.  Please scroll down to read the latest postings.  Here are tips for navigating the articles:

  • The CONTENTS page provides links to topics in alphabetic order.
  • OR type a keyword into –SEARCH THIS BLOG– located on the side bar.
  • The GLOSSARY contains definitions of many investment terms.
  • The DISCLAIMER emphasizes that I am not a professional adviser/investor.

Here are links to lead postings:

Distinction: The focus of this blog is on accumulating wealth by actively investing in equities.  Strategies of leverage and derivatives-trading are not advised for individual investors and therefore seldom discussed.  On the important topic of savings withdrawal, I must refer you to free content provided by an excellent blog entitled investingforaliving.wordpress.com. That same blog also shines in its discussion of investing for cash distributions.  Although I enjoy reading good articles on retirement published by aaii.com, this blog avoids a focused discussion of planning for retirement.

Advocacy:  EVERY YOUNG PERSON SHOULD BEGIN TO INVEST FOR RETIREMENT WITHOUT PAYING AN INVESTMENT ADVISER.


Choosing an ETF

August 16, 2016

Investing in an exchange-traded fund (ETF) begins with screening many funds to identify a few candidates, then rating the candidates. My preferred open-source screeners are XTF.com and ETF.com, both of which have inclusion criteria for selecting desirable ETFs and exclusion criteria for rejecting undesirable ETFs.  Aim to find a reputable low-cost ETF that best matches the performance of its category.

Asset class

Assets are potential sources of income to investors.  Consequently, an asset class is a group of assets that earn income the same way.  The ETF portfolio holds assets consistent with the fund’s investment strategy, which is either to copy a market index by process of passive management or compete with a market index by process of active management. The index measures the performance of an asset market.

Competing ETFs are typically grouped in one of the following asset classes:

  1. EQUITY is a share of ownership claimed through the purchase of a company’s stock. Equity ETFs earn capital gains and dividends from stocks.
  2. REIT.  The real estate investment trust (REIT) is a company that owns and manages income-producing real estate. The REIT earns money from rent, mortgage interest, or other real estate investments. At least 90% of the REIT’s taxable income must be given to shareholders in the form of dividends. REIT ETFs earn capital gains and dividends from REITs.
  3. FIXED INCOME securities pay an expected amount of interest (e.g., bonds) or dividends (e.g., preferred stock).
  4. COMMODITIES are raw materials sold in markets for use in making finished products. Commodities are sold for cash or traded in futures contracts.
  5. CURRENCY is a system of money in the form of cash or notes. The currency market trades different currencies to profit from trading fees and differences in interest rates.

Inclusions

The following inclusion criteria direct the search for reputable candidate funds desired by most individual investors:

  1. Passively managed ETFs typically charge lower fees than actively managed ETFs and likely outperform actively managed funds over long time-periods.
  2. U.S. listed ETFs comply with SEC regulations, U.S. stock exchange rules, and the U.S. tax code.
  3. One of these Asset classes: Equity (stocks), REIT (real estate), or Fixed Income (bonds).

Refine your inclusion criteria by selecting reputable indices and desired market categories.

Exclusions

The following criteria should be excluded by all but the most adventurous investors!

  1. Exchange-traded notes (ETNs) are not ETFs.
  2. Closed-end funds (CEFs) are not ETFs.
  3. Leverage and inverse ETFs are very tricky investments.
  4. Actively managed ETFs charge higher fees in order to create porfolios that outperform or underperform a market index.
  5. These asset classes:
    Alternatives (imitation hedge funds)
    Asset Allocation (actively managed mix of assets)
    Multi-Asset/Hybrid (diversified asset classes)
    Volatility (exposure to volatile market)
    Commodities (potential tax burdens)
    Currency (potential tax burdens)

Reputable index

All ETFs compete on the basis of an Index they use to design an investment portfolio. Some Indices make better measurements of market performance than others. Beware that some Indices measure untested markets. Generally speaking, the best-in-class ETFs use reputable market indices. One way of choosing a reputable index is by selecting a long-standing, oft-quoted Index provider or Index name.

Index providers are companies that specialize in measuring market performance and selling the information to financial institutions. Table 1 provides a sample of reputable Index providers.

Table1

Category and Index names

Asset Classes have unique categories. Each category may be measured in a variety of indices listed in Tables 2-4.

table2

 

table3

 

table4

Rating the candidates

By now you should have several ETFs that could satisfy your investment goal. Verify that they belong to the same category, then assess their suitability based on the following critera:

  1. Net assets, Total assets, Assets Under Management (AUM), or Market cap AT LEAST $1 BILLION.
  2. Inception date AT LEAST 5 YEARS AGO
  3. Expense ratio BELOW 1%, LOWER IS BETTER AMONG COMPETITORS
  4. Legal structure PREFERABLY “OEIC” OR “UIT” (table 5)
  5. Number of holdings CONSISTENT WITH THE MARKET INDEX.
  6. Tracking error, LOWER IS BETTER AMONG COMPETITORS
  7. Premium (Discount), LOWER IS BETTER AMONG COMPETITORS

The finishing touch

It’s a good idea to review the Annual Report of your selected ETF.  Your potential tax burden is determined by the ETF’s legal structure, its portfolio turnover, and your tax accountant’s hourly fees.

table5

Copyright © 2016 Douglas R. Knight


Empower young investors with savings plans.

May 29, 2016

The purpose of this article is to help young people make long range savings plans.  It’s a three-step process: 1) Set the goal. 2) Adjust for inflation. 3) Make recurring payments. I begin by presenting a retirement savings plan and conclude with a generic process for making other savings plans.

Planning for retirement

QUESTION: How much money should I save to start retirement?

ANALYSIS: I know people save money for future expenses even though inflation increases those expenses. Thank goodness my current budget is designed to pay for emergencies and pay all debt before retirement. If I live within my means and save 25 times my annual salary, I could safely withdraw 4% of those savings in the first year of retirement and keep withdrawing that amount, adjusted for inflation, each year of retirement. Life would be good! [refs 1-3]

GOAL: Save $25 per dollar of annual salary, plus an adjustment for inflation. The goal has 2 parts: 1) The savings account should hold at least $25 for every $1 of gross annual salary. 2) Every saved dollar should be inflated to match the Economy’s inflation rate.

STRATEGY: Start to invest regularly at the beginning of my career.

  1. Starting at approximately age 25 and finishing at approximately age 75 will provide 50 years of opportunity to save for retirement.
  2. At an annual inflation rate of 3%, the average price of everything that costs $1 today will likely be $4.38 fifty years from now (check this estimate with a future value calculator).
  3. My real savings goal is $25 X $4.38, which rounds to $110 for per dollar of salary.  The planning table in Fig. 1 will help me select a regular deposit.

Fig. 1

Fig. 1

For instance, a stock index fund that’s expected to earn a 10% annual rate of return could accumulate $110 when 9 cents per year are deposited into the account for 50 years.

How does this apply to me?  Suppose I start earning $50,000 a year at age 23 and invest in a stock index fund that earns an 8% rate of return. Thanks to the help from my parents, I already have $1,000 to open an investment account. According to the 50-year plan in Fig. 1, I will choose to deposit 18 cents per year for every dollar of salary. That means my annual deposits will be $9,000 from the $50,000 salary. If things go right, my investment account will be worth $5,546,902 after 50 years. Really?!!?

  • The future value of $1,000 is $46,902 based on an annual return of 8% for 50 years {test this calculation with the future value calculator}.
  • The planning table in fig. 1 is designed to earn $110 by making regular deposits for every $1 of salary; $110 X $50,000 = $5,500,000.
  • $46,902+$5,500,00 = $5,546,902.  Happy retirement!

THEN WHAT? Plan on safely withdrawing 4% of your savings at the beginning of retirement in order to match your annual salary before retirement; 4% of $110 is $4.40. Next year withdraw the same amount plus extra cash to adjust for inflation. The adjustment factor is (1+I) for the annual rate of inflation. Assuming that I is a 3% rate of inflation, (1+0.03) X $4.40 = $4.53. Each succeeding year, withdraw the same amount as the previous year plus an adjustment for inflation. In the first 5 years of retirement your annual withdrawals will be $4.40, $4.53, $4.67, $4.81, and $4.95 per $1 of pre-retirement salary and you will have plenty of savings for the rest or retirement [refs 1,2].

Risk management

There’s no guarantee that your plan will work. What could go wrong and how do you avoid failure? Some likely risks are missed deposits, taxes, low rates of return, brief time, and market declines.

  1. Missed deposits- Deposits energize the process of compounding interest to accumulate savings [ref 4]. Avoid missing deposits by making automatic payments through an employer sponsored savings plan –e.g., 401(k), 403(b)– or through payroll deposits into an individual retirement account (IRA).
  2. Taxes- Tax-deferred savings plans reduce your taxes. Deposits into employer-sponsored retirement-savings plans and traditional IRAs are not taxed until withdrawals are made after retirement when the withdrawals are taxed as regular income. Deposits into a Roth IRA are taxed at the time of deposit, but never taxed again. If the traditional and Roth IRAs are not affordable for you, the U.S. Government offers an affordable Roth IRA called the MyRA. If you wish to invest in Treasuries and corporate bonds, beware that they ares taxed at a higher rate than the long term capital gains from stocks.  Use a tax-deferred account to invest in bonds [ref 5].
  3. Low rates of return- Stocks reputedly pay higher rates of return than bonds. Investing in individual stocks is a risky and time-consuming effort; joining an investment club may be helpful. Consider buying shares of index funds that invest in market sectors with the understanding that investing in market sectors is riskier than investing in broad markets.
  4. Brief time- Start investing while you’re young. Starting later will require larger payments.
  5. Market declines- Since 1929 the average stock market cycle was 40 months divided into 30 months of price inclines and 10 months of price declines [ref 6]. The net effect was an uptrend in prices over long time periods. Individual investors can protect their investment returns from market declines in two ways: 1) Continue investing during market declines when regular deposits will purchase more securities at lower prices. 2) Diversify by adding bonds to your stock portfolio. This is best done by making supplemental payments for bonds in tax-deferred accounts such as MyRA.

Generic savings plan

Any long range savings plan can be made in 3 steps:

1. Set a goal for how much money you want to save. Your goal becomes the accumulated amount calculated by the compounded interest calculator [Fig. 2].

2. Adjust for inflation by multiplying your goal by the factor (1+I). I is the decimal value of the annual inflation rate. If you choose last century’s average annual inflation rate of 3.2% [ref. 7], the factor is (1+0.032). If 3.2% seems too high, use your internet search engine to discover more recent inflation rates.

3. Determine recurring payments needed per $1 of annual salary.  Display them in a customized planning table similar to Fig. 1.  Here’s how:

  • The columns are values of N for the number of years. Choose at least 2 time periods for the sake of versatility.
  • The rows are values of R for an investment’s annual rate of return. Choose a practical range of stock and bond returns for the sake of versatility.
  • The cells display fractions of $1 for making the minimal recurring deposit (d). Determine the deposits by testing trial values of d in the compounded interest calculator (Fig. 2). For example, start with d = 10 cents at the highest rate of return (R) for the longest time period (N). 10 cents represents the idea of depositing 10% of every dollar in your annual salary [Hint: it’s practically impossible to deposit more than 50 cents per dollar of salary].
  • In Fig. 2, the value of PV can be $0 unless you already have an initial deposit.

Appendix: All-purpose Savings Calculator

Try fig. 2’s all-purpose savings calculator that’s in the open-source publication of PracticalMoneySkills.com [ref. 8].

Fig. 2

CompdInterestCalculator

Note: Fig. 2 can be validated by tests using the compound interest formula for annual additions discussed in ref 4.

References

1. Jane Bryant Quinn. How to make your money last. The Indispensable Retirement Guide. 2106, Simon & Shuster, New York. 366 pages.

2. William P. Bengen. Determining withdrawal rates using historical data. Journal of Financial Planning, pages 171-180, October, 1994.

3. Craig L. Israelsen. The importance of diversification in retirement portfolios. AAII Journal, April, 2015. pages 7-10. American Association of Independent Investors.

4. Miranda Marquit. How does compound interest work for investments? ©️2016 empowering media inc. 2/18/2016.

5. Types of Retirement Plans. IRS.gov, 10/7/2015.

6. Paul A. Merriman. 22 things you should know about bear markets. Aug 24, 2015. MarketWatch.Inc, ©️2016.

7. Tim McMahon. Average annual inflation rates by decade. June 18, 2015.

8. Compound interest calculator. PracticalMoneySkills.com. ©️2010 Visa.

Copyright © 2016 Douglas R. Knight


Book review: The Index Card, by Helaine Olen and Harold Pollack

May 5, 2016

The Index Card. Why Personal Finance Doesn’t Have to Be Complicated. Helaine Olen and Harold Pollack. Penguin Random House, New York, 2016.

Genesis

The authors converged their experiences from  journalism (Helaine Olen) and academia (Harold Pollack) into the worthy effort of demystifying the world of personal finance for everyone’s benefit. Author Pollack began the process by devising an index card of rules for recovering from financial hardship and staying solvent. Author Olen’s experience with the Personal Finance Industry validated Pollack’s scheme. Together, they explain the index card to readers of this valuable book.

Rules from the Index Card

  1. Strive to save 10-20% of your income.
  2. Pay your credit card balance in full every month.
  3. Max out your 401(k) and other tax-advantaged savings accounts.
  4. Never buy or sell individual stocks.
  5. Buy inexpensive, well-diversified indexed mutual funds and exchange-traded funds.
  6. Make your financial advisor commit to the fiduciary standard.
  7. Buy a home when you are financially ready.
  8. Insurance- make sure you’re protected.
  9. Do what you can to support the social safety net.
  10. Remember the Index Card

Highlights

Rule #1. The household budget is essential for living comfortably. Be sure to save 10-20% of your income for future needs. The most important savings account is an emergency fund; every household should save 3 months of income in an accessible savings account to use for emergency expenses. —An emergency expense is both immediate and necessary; something bad has happened.—

Rule #2. Unpaid debt has top priority in your budget. Credit card debt is a preventable financial illness that must be corrected. Other forms of debt must also be managed within the framework of a budget.  Unfortunately, there may be unpreventable causes of overwhelming debt such as health care bills and other catestrophic events. Overwhelming debt may require seeking legal advice to file for bankruptcy; don’t feel ashamed.

Rule #3. The second most important savings account is your retirement fund and/or educational savings account. Start while you’re young to take advantage of the compound interest (a.k.a. compounding returns) from investments in either account. DON’T REJECT employer-sponsored retirement savings plans and DO participate in them to the full extent. You can also open personal retirement savings accounts. Facilitate your savings plan by making direct deposits into the retirement and educational savings accounts.

Rule #4. The media’s ‘toxic’ message is that playing stocks is easy and fun. But no matter how much research you do, buying stocks is still a matter of speculation. Stocks are a pay-to-play business where only the broker can always win. Forego the dream of a big win by investing in a small selection of index funds.

Rule #5. Index funds are designed to automatically match the performance of a selected stock- or bond market index. Index funds are true buy-and-hold investments. Most exchange-traded funds (ETFs) and a few mutual funds are index funds. They charge lower management fees than the actively managed mutual funds. Actively managed funds charge higher fees in order to pay for the research needed to outperform the stock or bond market. Few actively managed funds succeed in their effort to beat the market on a sustained basis. Annual management fees for index funds (~0.12%) are lower that for actively managed funds (~0.89%). The average household loses $155,000 in potential investment gains due to the unnecessary fees of actively managed mutual funds.

Rule #6. Most financial advisors are salespeople who chase a profit at your expense. They are not your friend. However, you still have to pay for good advice from a fiduciary advisor. A fiduciary advisor is responible for acting in your best interest, hopefully providing the best advice at lowest cost. The fiduciary advisor is usually a certified financial planner (CFP), registered investment advisor (RIA), fee-only advisor, or robo-advisor who is a proven fiduciary. It’s important to seek a fee-only advisor who is paid by you and only you. The advisor may charge a percentage of your assets under management, a flat fee, or an hourly fee.

Rule #7. Spend no more than 30% of your budget on housing. There are risks and advantages to either renting or buying a home. The authors discuss both.

Rule #8. Insurance is complicated but necessary. Don’t be exploited by salespeople. The 6 Golden Rules of Insurance are:

  1. buy term life insurance
  2. buy high-deductible property insurance
  3. buy a health care plan that pays your provider
  4. buy umbrella insurance that is twice your net worth
  5. avoid complicated annuities
  6. keep an emergency fund

Rule #9. We can’t protect ourselves from everything; sometimes we need a little help. The government is our insurance-backer of last resort. 96% of us have used government financial support to improve our financial situation. Isn’t it our fiduciary duty to Society to support the best government insurance programs?

Conclusions

I concur with the authors’ advice. The strength of their advice is supported by pages of references at the end of the book. Read and re-read their book.


Book Review: Blue Chip Kids, what every child and parent should know about money, investing, and the stock market.

April 24, 2016

Blue Chip Kids, what every child and parent should know about money, investing, and the stock market. David W. Bianchi. John Wiley & Sons, Hoboken, 2015. 234 pages.

Author David W. Bianchi wrote this book for young people who are interested in spending money. He wrapped the uses of money into 3 important topics: 1) All about money; 2) Ways of investing money; and, 3) Stock markets.  Gambling was excluded from the discussion.

I was interested in learning to coach my granddaughter on ways investing money. Bianchi exposed me to very low-, very high-, and mid-range risks of investment (I wouldn’t advise my granddaughter to invest at either end of the spectrum!). Here’s my synopsis:

All about Money. “Rule #1: live within your means”.

Chapter 1 has one of the best sections in the book which describes ways of earning money throughout life. Money is a “currency”. Don’t be surprised to learn that there are many different currencies with constantly changing values. Chapter 2 describes ways of paying for things.

The best ways of borrowing money are discussed in Chapters 9-11. If you want to avoid a penalty, repay your debt on time. Payments of interest on loans are called coupons. Coupons are a cost to the borrower that are paid to the lender. Some borrowers must pay simple interest and others pay compound interest. Lenders usually prefer payments of compound interest.

Borrowers are expected to show that they are reliable (“credit worthy”) people. For example, bankers will ask to read your financial statement before giving you a loan. Your financial statement is a document that lists the total value of assets (things that you own) and liabilities (money that you owe). The difference between total assets and total liabilities is your net worth.

Governments earn money by charging taxes and selling bonds. Everybody has to pay taxes. Failure to pay any of the many taxes described in chapter 12 may lead to a government audit and penalty. Chapter 13 reveals that the U.S. Government owes 17 trillion dollars to lenders from around the world! All of us face serious consequences if our government fails to pay its debts! Meanwhile, we can protect our personal financial reputations by avoiding default and bankruptcy. Better yet, don’t borrow money. Create a budget to “live within your means”.

Chapter 15 explains the challenge of retirement, which is to continue paying bills after you stop working for a living! After you graduate from school to begin a career in early life, start saving for retirement later in life at age 60-75 years. The author wisely advises to “give yourself the ability to retire if you want to”. Your retirement income will come from retirement savings, social security, pension plans, and annuities.

Investing

Investing is all about risk and return. Treasury bonds are considered no-risk investments that return about 3% annually. The investment choices that Bianchi offered to his readers were stocks (chapters 3,8), options (chapter 5), funds (chapter 6), bonds (chapter 7), and private companies (chapter 14).

A Stock is a certificate of ownership, also called a security. Brokers don’t issue the certificate, they send a confirmation that serves as evidence of ownership. The market value of the stock usually rises when its company earns profits.

Options are contracts that guarantee the trade of an asset at a fixed price for a limited period of time. The seller earns a fee for guaranteeing the trade. The buyer pays the fee in turn for the right to execute the trade before expiration. The buyer may benefit by 1) using the option as an insurance policy, 2) exercising the option at a favorable price, or 3) trading the option in the options market.

A Fund is a pool of money collected from many investors to invest in a group of assets. The advantages of the fund are that investors don’t spend considerable time doing research and don’t spend large sums of money for a diversified portfolio. Among the types of funds are

  1. Index funds, which copy a security index and charge low fees for the service.
  2. Mutual funds, which don’t copy a security index and do charge several fees for the service.
  3. Hedge funds, which invest in anything and charge very high fees. Hedge funds have strict rules of eligibility and charge “2 and 20” fees (2% annual management fee and 20% management ‘tax’ on investment returns).

A Bond shows that you lent money to the company on condition that it returns the money, with interest, at the maturity date.  The bond’s face value is the original price (printed on the face of the bond); it is the redeemable amount!  The yield is the bond’s annual rate of return; Yield = Interest / Price.

A Private Company does not trade its stock in a public stock exchange. Private company stocks are illiquid because they don’t have an open market. Venture Capital and Private Equity firms buy stocks in private companies. Venture Capital is money invested in start-up companies. Private Equity firms inject money into established private companies in exchange for the companies’ stocks.

Stock market

Advice: It’s difficult to predict the ‘top’ and ‘bottom’ of market prices. Do homework to buy quality stocks at a reasonable price.

Chapter 3 explains that the stock market is a place for orderly buying and selling of stocks (and other securities). There are many stock markets that vary according to listed stocks and total market capitalization (‘market cap’ is the total value of the company’s shares).  Chapter 8 describes how to make stock-buying decisions, how to participate in the stock market, and how the market behaves.  David W. Bianchi, if I misread your book, then I apologize for citing 2 nearly insignificant errors that were made about investing in stocks:

  1. Contrary to statement, there is no P/E ratio = 0.  Ratios of x/0 are undefined.  Financial websites don’t report the P/E as a number when company earnings are negative or 0.
  2. A share buyback doesn’t raise the price per share of stocks; only trading activity in the market can raise the price.   A share buyback raises the earnings per share (eps), which then may raise the share price.

I believe your book is well worth reading.


Book review: How to Make your Money Last. The Indispensable Retirement Guide. by Jane Bryant Quinn.

March 22, 2016

Jane Bryant Quinn, 2016, Simon & Shuster, New York. 366 pages.

Synopsis

This book should be read by everyone who needs to plan for retirement from the workforce.  Author Jane Bryant Quinn is an acclaimed financial journalist with excellent credentials. In this book, she draws from credible research to describe principles and checklists for retiring with a practical financial plan. She speaks from firsthand experience about reinventing life after leaving the workforce: “once again the future is a blank slate” that needs to be filled with activities for a meaningful life (chapter 1). Those activities need the support of a dependable income managed by a practical financial plan.

In her opinion, your default plan is to maximize social security benefits and gradually increase the market value of your retirement portfolio (a.k.a. retirement savings) while maintaining a monthly paycheck for the duration of retirement. The financial core of a good retirement plan is based on 3 principles (chapter 12):

  1. Estimating your budget gap in advance of retirement (chapter 2)
  2. Maintaining a cash reserve throughout retirement (chapter 9)
  3. Making safe withdrawals from your retirement portfolio (chapters 8, 9)

Quinn provides practical checklists for transforming various sources of retirement income to a homemade paycheck.  In addition to building a retirement portfolio by ‘bucket’ investing (chapter 9) are the supplemental sources of income from Social Security benefits (chapter 3), traditional pensions (chapter 5), simple annuities (chapter 6), and home equity payments (chapter 10).  She also provides practical checklists for securing retirement income with the help of spending rules (chapter 8). Quinn’s valuable checklists help manage the financial risks of inflation (chapters 2-4, 8), taxes (chapter 7), costs of healthcare (chapter 4), and spousal protection (chapters 3, 4, 6, 7, 10, 11).

Janet Quinn’s Core principles

BUDGET GAP (chapter 2). The 3 important numbers in your retirement plan are its budget gap (chapter 2), cash reserve (chapter 9), and safe withdrawal (chapter 9). Calculate your budget gap before retirement. It is the difference between future income and expenses. The future gap can be minimized by staying in the workforce (to build a larger retirement portfolio) and spending less money.  Significant adjustments to financial assets and regular income may be necessary to support your desired level of spending later on. Estimate the future annual amount of money you can safely spend by using the following formula (chapter 2):

safe spending = (0.04*financial assets) + regular annual income – estimated taxes

CASH RESERVE (chapter 9). Create a cash reserve at the start of retirement. It will be an important source of money to pay for any budget gap that develops during 2 years of decline in the financial markets.

SAFE WITHDRAWAL (chapter 9). The “safemax” is a percentage of your retirement portfolio that you can safely withdraw in the first year of retirement (chapter 8;“safe’ means “as far as we can tell”). The amount withdrawn, plus an adjustment for inflation, practically dictates how much you can withdraw every year to ensure the 30-year longevity of your retirement portfolio.

Here’s the 4% rule (chapter 8): Withdraw 4% of your retirement portfolio at the start of the first year and safely store the money to pay bills throughout the year. At the start of the second year, withdraw the previous year’s amount adjusted for inflation. For example, assume your retirement portfolio holds a $50,000 investment in stocks and $50,000 investment in bonds for a total of $100,000. Even if you make no more contributions to the porfolio, the following annual withdrawals could be sustained for 30 years when adjusting the previous year’s withdrawal for a 3% rate of inflation and rebalancing the portfolio to maintain a mixture of 50% stocks and 50% bonds:

year 1- $100,000 * 0.04 = $4,000 withdrawal
year 2- $4,000 * 1.03 = $4,120 withdrawal
year 3- $4,120 * 1.03 = $4,244 withdrawal
legend- $100,000 is the portfolio’s initial value, 0.04 is the safemax, $4,000 is the first annual withdrawal, 1.03 is the inflation factor, and $4,120 is the second annual withdrawal.  there is no adjustment for taxes in this calculation.

NOTE: The amount withdrawn by the 4% rule is directly related to the initial market value of the retirement portfolio. For example in year 1, the amount safely withdrawn from a $200,000 portfolio would be $8,000, etc.

Protect yourself from the hidden risks of greedy salespeople as you get older and less interested in managing your accounts. Appoint a trustworthy person as your durable power of attorney and use a written investment plan.

Life-time income

Life-time incomes offset the risk of outliving your retirement portfolio. The reliable life-time incomes of retirement are Social Security, Pensions, and Annuities.

SOCIAL SECURITY (chapter 3). Social security benefits include a guaranteed income for life, protection against inflation, tax benefits, and protection of your spouse without the risk of market fluctuations and without paying investment fees. Beneficiaries can maximize their income by delaying the onset of benefits to age 70 instead of starting at age 62 (be sure to enroll in Medicare at age 65). A survivor’s benefit is based on the earnings-record of the deceased. The spousal benefit is automatically upgraded to a higher survivor benefit.

PENSIONS (chapter 5). Traditional pensions offer either a monthly lifetime payment or a lump sum payment that can be rolled over to an Individual Retirement Account (IRA). The rollover incurs an investment risk (investment risk is the possibility of incurring a loss from your choice of investment or the investment’s fluctuation in market value).  Government pensions (except municipal pensions) are reliable.  Most private pensions are protected by the Pension Benefit Guaranty Corporation (PBGC.gov). If you are ineligible for a pension, consider buying a lifetime annuity.

ANNUITIES (chapter 6). Annuities aren’t a do-it-yourself investment; they are a tool for managing the risk of outliving your portfolio. Find a good advisor who isn’t a salesperson and avoid buying variable annuities with living benefit guarantees. Simple annuities are purchased with a lump sum in return for monthly lifetime income.

  1. The Single Premium Immediate Annuity (SPIA) pays benefits until death unless purchased with payments “Certain”. The SPIA is not designed to create a legacy fund. Its advantage is the payment of benefits that exceed the interest of bonds and dividends of stocks. The insurance company’s rating should be at least AA- (Fitch, S&P), A (AM Best), or Aa3 (Moody’s). [The tax deferred variable annuity can be converted to an SPIA. Find the best available benefit-payments in ImmediateAnnuities.com and switch companies.]
  2. The Immediate Pay Variable Annuity pays monthly benefits that change with the market. The benefit is a percentage of the investment portfolio value. The assumed interest rate (air) is your selected rate of withdrawal from the investment portfolio. The investment risks are volatility and choice of investment portfolio.
  3. The Inflation Adjusted Immediate Annuity pays monthly benefits adjusted to last year’s inflation. There is no inflation or investment risk. The monthly benefits are lower at the beginning than later on. This annuity is more appropriate for younger people with a longer life expectancy.
  4. Fixed Increase Annuities pay monthly benefits that rise at a fixed rate of 1-5%.
  5. With a Deferred-income Annuity (“longevity insurance”) there is a time delay to the initial benefit followed by monthly payments for life. The reasons for owning this annuity are 1) protection from outliving retirement portfolio, and 2) providing your spouse with guaranteed income after death.
  6. Fixed-term Annuities start paying benefits immediately. This is desirable for people with illiquid investments such as delayed social security.
  7. The Charitable Gift Annuity gives a lump sum to charity that guarantees a fixed monthly income for life.

The variable annuity is a pure investment that risks poor performance in the market. Its insurance company offers a guaranteed living-benefit rider (LBR) that provides a minimum lifetime income regardless of the investment’s performance. Taxes on the accumulating returns are deferred until withdrawal, then taxed as regular income (unless “qualified” in a Roth). The tax is proportional to the ratio of investment return to invested capital.  The goal of a variable annuity is to allow growth of your investment above the guaranteed minimum. Success depends on a 90% allocation of stocks in the investment, yet most insurance companies limit the stock fund to 65% stocks. Why? The insurance company is protecting itself by using fixed income from the portfolio to pay the LBR instead of the company’s own money. Living benefits are first taken from the investment portfolio while you continue to pay the annual fee! This seems unfair, so try to exercise your right to withdraw from the investment every year up to a fixed percentage amount. Even if you draw down to $0, the company will continue to pay your benefit. Spouses are usually not covered by a variable annuity. Rather, the death benefit is an insurance payout that doesn’t replace the annuity’s investment return a survivor might lose. If you bought a variable annuity, it’s too late to extend to your spouse. But you can switch to a better annuity in a tax-free exchange or buy more insurance. Variable annuities often charge excessive management fees of 3-5%.  For a second opinion, consult the Marco Consulting Group at Annuity Review (AnnuityReview.com). They will analyze 2 variable annuities for a fee of nearly $300.

HOME EQUITY (chapter 10). The equity of your home is a ‘piggy bank’ that can be used for income or passed to your heirs. There are several ways of squeezing income from your home equity:

  1. take a Reverse Mortgage to create a 20-30 year spending plan
  2. borrow to pay a large bill
  3. eliminate a traditional mortgage.
  4. refinance your traditional mortgage
  5. take a boarder after first checking on possible restrictions imposed by homeowners associations, zoning laws, etc.
  6. sell the house and lease it from the new owner (i.e., Sale/Leaseback). Consult a lawyer before selling the house.

The reverse mortgage is a loan against the equity of your home in which the lender makes tax-free payments to you because they are loans. You pay all maintenance costs. Don’t repay the loan while living in the house; proceeds of the sale will repay the loan. You keep the excess proceeds, but otherwise are not responsible for a loss on the sale.

The Home Equity Conversion Mortgage (HCEM) is issued by private lenders and insured by the FHA. The HCEM offers 3 types of payments:

  1. lump sum at the beginning
  2. monthly payments
  3. borrowings from the principal

At your death and before selling the house, your heirs will have the option of buying or selling the house before foreclosure. Seek more information and advice from Jack Guttentag on his website, MtgProfessor.org.

Portfolio management

SPENDING RULES FOR THE HOMEMADE PAYCHECK (chapters 8, 9). The basic rules are to make buy-and-hold investments in your portfolio, withdraw funds using the 4% rule, and rebalance the portfolio after you make an annual withdrawal. Based on Quinn’s research up to the year 2016, the 4% safemax may be modified in one of several ways:

  • 4.5% if your stock allocation is 45-65%
  • 5.5% if you reduce the withdrawal in declining markets
  • 3% to ensure surviving the next 30 years
  • adjustments to the Shiller PE Ratio
    • 4% if P/E10 >20
    • 5% if P/E10 = 12-20
    • 5.5% if P/E10 <12
  • 6% is too high and your portfolio may only last 15 years. Instead, borrow on your house through a reverse mortgage.

The amount of annual income withdrawn from your retirement portfolio is determined by your safemax rate of withdrawal (discussed above in the core principles). Be consistent in withdrawing from your portfolio except when the market is depressed. Then withdraw from your cash reserve to pay bills. When the market starts to recover, tap the investments to restore the cash reserve and resume withdrawing at the safemax.

Skip an annual withdrawal when you don’t need it. If the required minimum withdrawal from tax-deferred accounts exceeds your planned annual withdrawal, reinvest the excess amount. Here are 2 ways to preserve capital:

  1. Withdraw from investments that have increased in value, otherwise from investments with the lowest potential return.
  2. Withdraw from taxable accounts before tax-deferred accounts. Within the taxable accounts, withdraw a blend of gains and losses to minimize taxes.

PORTFOLIO INVESTMENTS (chapters 8, 9). Bucket investing is done by putting money into different funds (‘buckets’), each having a specific purpose. First, create a cash reserve (‘cash bucket’) that will pay bills for 2 years when added to pension checks. 90% of the remaining retirement portfolio is allocated to investments and 10% to a discretionary bucket. Allocate 40-65% of the investments to stocks and the remainder to bonds [the author discussed additional guidelines for adjusting your allocation of stocks and bonds according to age (chapter 8)]. The discretionary bucket is used for big, extra items (e.g., new car).

Your allocation of bonds and stocks depends on your capacity for risk, not your tolerance for risk. The capacity for risk depends on how well you are funded and able to pay bills with pension funds. If your risk capacity is low, don’t risk too much on incurring a loss in the stock market. Do you need to risk a stock investment? Not if all your expenses, including health, are covered for life. People older than 80 tend to fall into this category. Younger people with at least a 10 year horizon have more time to survive market fluctuations. The S&P500 Total Return index has never declined over 15 years. Otherwise, you need to invest in stocks if all expenses are not covered for life. The reasons for investing in stocks are to hedge inflation (low allocation of 20-30%) or create a legacy fund for heirs (high allocation of 40-80%).

There are several important advantages to investing in index funds instead of individual stocks and short-term bonds.

  • index funds are easier to rebalance each year
  • you will earn the return of the whole market
  • you will own a portfolio of diversified investments
  • index funds are easily converted to cash
  • short term bond prices aren’t as volatile as long term bond prices

What if you don’t want to rebalance the retirement portfolio?

  • invest in a target-date fund
  • use a rebalancing program
  • pay a low-cost online advisor (e.g., betterment.com )
  • hire a good fee-only financial advisor and avoid paying high fees. consult FINRA.org for help finding a reputable financial advisor.
  • seek advice from a no-load mutual fund company

Risk management

TAXES (chapter 7). The main categories of tax-deferred retirement savings accounts are employer-sponsored plans and personal IRAs. The typical employer-sponsored plan allows investments in mutual funds. After leaving an employer you can keep the plan, merge it into that of a new employer, or convert it to a rollover IRA. Personal IRA’s expand your investment choices, some of which require a trustee to make the transactions (e.g., precious metal trust, real estate trust). Be aware of the costs of converting a traditional IRA to a Roth IRA. At the time of conversion you must pay regular income tax on the investment returns. You may also incur a higher medicare premium and pay possible tax on unearned income. To minimize taxes when you withdraw funds to pay bills, withdraw from the taxable portion of your portfolio first, the traditional IRA second, and the Roth IRA last.

If you inherit an IRA from your spouse, your choices are these:

  • ask the trustee to name you as owner
  • rollover to a new IRA owned by you
  • rollover to an IRA already owned by you
  • create an inherited IRA if you are younger that 59 1/2 years.

If you inherit an IRA from someone else, your choices are these:

  • take your full inheritance now and lose the tax shelter
  • retitle it as an inherited IRA to keep the tax shelter

HEALTH INSURANCE (chapter 4).  The Affordable Care Act guarantees your eligibility for health insurance irrespective of your state of health. There are 3 general healthcare plans: HMO (Health Maintenance Organization), POS (Point of Service), and PPO (Preferred Providers Organization).  In each plan, your cost share is capped by the annual maximum out-of-pocket payment.

The government’s Medicare program is comprised of part A for hospitalization, part B for outpatient services, part C for extra benefits plus prescriptions, and part D for prescriptions. You pay premiums for parts B-D, but not for part A. There are cost-sharing charges for services in parts A-D. Medigap is a private healthcare insurance designed to supplement Medicare and used to replace Part C of Medicare. Don’t miss the enrollment dates or else pay a higher premium!

LONG TERM CARE (chapter 4). If you become incapacitated and require long term healthcare outside the hospital, your costs may exceed $85,000 per year. Consider purchasing long term care insurance, but don’t spend more than 5% of your retirement income on insurance premiums for long term care. Group policies are cheaper. Minimize your premiums by choosing a 3-year benefit period (instead of 5 years), avoid paying for inflation adjustments later in life, insure 50-75% of your expected cost, and extend the waiting period to 6 months. The alternatives to long term care insurance are:

  1. join a continuing care retirement community that offers a nursing home benefit.
  2. self insure by selling your home
  3. use Medicaid as a safety net.

LIFE INSURANCE (chapter 11). Don’t buy any if you are a single retiree without dependents. You’re better off investing the saved-premiums. Consider owning life insurance if you have dependents and want to leave a legacy fund or charitable gift. Chapter 11 describes how to extract more value from a life insurance policy.

SHELTER (chapter 10). Younger retirees like living in an active community and older retirees like their “independent living” in a more secure location. The choices for independent living are to remodel your existing home as needed to compensate for a handicap (e.g., wheelchair) or change homes. For example, move to an active adult community (consult 55Places.com; ensure that you will continue to receive healthcare).

Retirees seek “assisted living’ when they need help with the basic functions of living.  The choices for assisted living are to receive in-home healthcare or move into an assisted living facility (consult ALFA.org for choices).

Downsize to make life easier!


Income statements can surprise investors

March 15, 2016

[updates: 3/18/2016, 3/28/16 addition of the ‘customer-derived profit’ concept of EBIT]

No other report of profit exerts greater influence on the Stock Market than that of a company’s net income. Why? Stock analysts make predictions of future net income that influence the decisions of investors.  Eventual announcements of actual net income may be very pleasing or disappointing news to investors who then generate a surge of trading in the market place.

The company’s only sources of income are customers, investments, and investors.  For an established company, customers are the preferred source of profit!  Operating income (a.k.a. EBIT) is the profit earned from customers.  The adjustment of EBIT by extra items yields net income.  Net income (a.k.a. Earnings, EPS) represents the profit that a company can share with its stock holders. Market regulators require companies to reveal the operating income and net income in quarterly and annual income statements.

Income statements are designed to reveal how business operations generate net income. The purpose of this article is to describe the income statement of companies outside the banking and insurance industries. Hopefully this article will help you perform a fundamental analysis of most companies listed in the stock market.

Structure

The Income Statement is one of 3 financial statements that companies report to investors on a quarterly and annual basis. Accountants prepare the statement by consolidating all of the company’s non-cash transactions into a standardized ledger that measures the business operations used to earn a profit. Chart 1 shows the main elements of an income statement:

incomestatement

Chart 1

Total Revenues are also called the top line of the income statement. They measure the net sales of all products. Operating expenses are used to acquire, sell, and distribute the products. Extra items are additional transactions that don’t generate sales, but increase or reduce the profit from sales. Net income is also called the bottom line of the company. Net income is the profit that a company can share with its stock holders.

Relevant information

In my opinion, the “LINE ITEM” column in Table 1 lists the income statement’s most relevant information for individual investors. The “$” column shows the relevant measurement in units of U.S. dollars. The “% OF SALES” and “PROFIT MARGIN” columns display convenient ways of analyzing the income statement. At the time of this writing, I collected the “$” and “% OF SALES” data from a company’s ‘financials’ tab in morningstar.com. I simply toggled the statement’s ‘view’ command to switch from $ to %.

mainitems

Table 1.

“Revenue” (a.k.a. Total revenues, Sales) is the total value of all products shipped to customers during the reporting period. The revenue is usually recorded at the time of delivery before any cash payment is made by the customer. “Gross profit” is the remaining revenue after deducting all costs of production from the Sales. “Operating income” is the remaining revenue after deducting all other expenses of operating the business from the gross profit. “Income before taxes” is the remaining revenue after adjusting the operating income available to pay taxes. Net income is the company’s earnings after the revenue is reduced by all operating expenses and extra items.

There are several line items of net income listed in every income statement.

  • “Net income available to common shareholders” represents the residual net income after payments of dividends to the company’s preferred shareholders.
  • “Diluted Earnings per share” (EPS) is the portion of “net income income available to common shareholders” divided by diluted shares. Diluted shares are all outstanding shares (“basic shares”) plus the potential gain of shares from convertible securities.

Fundamental analysis of profitability

Profit margins are percentages of Revenue that represent intermediate and final profits. The profit margins in Table 1 measure the impact of production, operating expenses, and extra items on the company’s sales. Here are the units of measurement:

  • Gross margin = 100 * Gross profit / Revenue = 41.3% = 43.1 cents of every sales dollar.
  • Operating margin = 100 * Operating income / Revenue = 22.4 % = 22.4 cents of every sales dollar.
  • Net margin = 100 * Net income / Revenue = 14.2% = 14.2 cents of every sales dollar.

In table 1, the gross margin reveals that after paying all costs of production, the company is left with 43.1 cents from every dollar of revenue to pay for the remaining operating expenses. Costs of production include all expenses of manufacturing goods and providing services. The manufacturing process requires equipment, labor, and basic materials to build an inventory of finished goods. The provision of services requires labor and equipment. A company can be more profitable by reducing its costs of production.

The operating margin (Table 1) represents a residual revenue of 22.4 cents per sales dollar after paying all costs of production plus the costs of maintaining the business and selling the product. Think of the operating margin as customer-derived profit.  A company can earn more profit from its customers by cutting some of its operating expenses.

Net income is the remaining profit after paying operating expenses and adjusting for extra items such as government taxes. In table 1, the net margin is 14.2 cents for every dollar of revenue. The company could be more profitable by cutting some of its expenses or earning extra income. The net income is available to reward share holders in a variety of ways that eventually translate into capital gains and possibly dividends. For example, the earnings per share (a derivative of the net income) enables thousands of stock market participants to place a value on each share of ownership in the company. An increase in market value would allow stockholders to sell their shares for a capital gain.

Fundamental analysis of the competition

The business performance of 2 or more companies in the same industry can be compared by assessing their profit margins. Table 2 provides an hypothetical example of how 2 competitors manage their business revenue. For every sales dollar, company A is less profitable than company B as revealed by A’s lower profit margins. Why is B more profitable? Its 66% gross margin reflects a lower cost of production that ultimately generates a higher net margin of 24%. Game over!

Table 2.

Table 2.

Notice that company A is more efficient at maintaining its business and selling its product. Company A’s 19 percentage-point difference between 41% and 22% is less than company B’s 33 percentage-point difference between 66% and 33%. For every dollar of sales, Company A was better at squeezing some profit from its customers with lower maintenance and sales costs. Also notice that the impact of extra items (e.g. potential taxes) was nearly the same for both companies; 8 percentage-point versus 9 percentage-point differences between the operating and net margins.

Conclusions

Income statements report a set of measurements that investors can use to analyze a company’s business operations and its ability to earn a profit. The company’s operating income (‘EBIT’) and net income (‘EPS’) are the key elements of an income statement.  Operating income is used to calculate the operating margin, which measures how much profit the company earns out of every sales dollar from its customers.  The net income  depends on total revenue and efficient management.  For every dollar of revenue, the company that operates more efficiently has a better chance of earning a net income as measured in separate ways by the net margin and EPS.  The company’s earnings per share (EPS) represent the profit that the company can share with its stock holders. There are several ways to increase the EPS: boost sales, trim costs, retrieve shares, and seek extra income.

Copyright © 2016 Douglas R. Knight


Websites for retirement-planning

February 19, 2016

[updates: 3/4/2016, 3/18/2016]

Resources

http://DOL.GOV/EBSA/PDF/RETIREMENTTOOLKIT.PDF , federal programs and retirement calculators
http://SOCIALSECURITY.GOV , benefits & ‘retirement estimator’
http://MEDICARE.GOV health insurance for retirees
http://WISERWOMEN.ORG Women’s Institute for a Secure Retirement
http://HHS.GOV/AGING , health- and legal information
http://USA.GOV/BENEFITS-GRANTS-LOANS , federal benefits
http://AGING.OHIO.GOV , quality of life
http://economiccheckup.org , to plan retirement, reduce debt, find work, and cut spending.

Money management (‘financial planning’)

http://DOL.GOV , search for “Taking the mystery out of retirement planning” and download this excellent pamphlet of useful advice.
http://MYRA.GOV , A safe, affordable Roth savings account for wage earners.
http://WESTERVILLELIBRARY.ORG , search for “Investments 101”

Portfolio management

http://apps.finra.org/Calcs/1/RMD , find link to “required minimum distribution”
http://BANKRATE.COM , click on “RETIREMENT” tab, then on “Retirement Calculators” subtab, then on “Asset allocation calculator”
http://53.COM, click on “Financial calculators”, then click on the “Retirement Planning” tab, then click on the “Retirement Income Calculator” to estimate your longevity of savings; click on the “Retirement Account Calculator” to compare retirement savings accounts.

Risk management

http://IRS.GOV , search “identity protection”, about Identity theft
http://FINRA.ORG (securities help line for seniors, 844-574-3577), Check the credentials of a broker or financial advisor; about Investor protection; http://apps.finra.org/meters/1/riskmeter.aspx to assess your risk for Financial fraud
http://NELF.ORG , about Elder Law
http://ELDER.FINDLAW.COM  , about Elder Law
http://LONGTERMCARE.GOV , about LTC health insurance
http://PBGC.GOV ,  to assess pensions
http://immediateannuities.com , to shop for simple annuities
http://annuityreview.com , obtain a second opinion about variable annuities

Low income assistance nationwide and in Ohio

http://benefitscheckup.org
http://OHIOHERETOHELP.COM
http://OHIOBENEFITS.ORG


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