Financial Frontlines ™

You current and ex-athletes were probably told by your coach that solid fundamentals make winning more likely.  Same holds true for your finances.  So let’s get back to the fundamentals!  Here are a couple high-priority financial game plans to use for your family.

Eliminate the debt.  But how?  Follow the table below.  Rank order your debts with the highest interest rates at the top.  Concentrate on the top debt.  Pay the minimum on the other debts.  Pay as much as possible, while being fiscally responsible with your household requirements, on the top debt.  When the top debt is eliminated, roll that payment down to the next debt by adding the top debt’s payment to the second debt’s minimum payment.  Continue as indicated in the table.  When you are debt free, stay that way.  Remain a cash-basis family.  Credit, when used, should be paid off, in full, the next month.  If you can’t pay the debt in full the next month, don’t charge it.  Save for the purchase until you can afford it.  Use lay-a-way!  If absolutely necessary, use your emergency savings for the unexpected emergency.

Have a simple financial game plan.  You must, repeat must, put yourself in the mind set of paying yourself first.  Then do it.  But how?  First, decide what percent of your paycheck you can afford to deposit into an emergency savings account…consistently…and not have to tap the account to pay bills or entertainment costs.  Then decide a percentage of your paycheck to contribute to your retirement account…consistently.  Live on the rest.  This forces you to live below your rmeans (provided you aren’t abusing your credit cards).  Increase the percentages after raises or promotions.  The emergency account should hold between 3 and 6 months worth of monthly expenses.  In an emergency, you’ll be able to pay bills for a while.  Or pay for that broken refrigerator or car.  Prefer a picture?  Need the picture to be larger?  Just click on it.  Here you go…

As the account value in the Living Expenses bucket grows, the extra spills down into the Emergency savings bucket.  And all extra amounts in each bucket spill down to the buckets below.  NOTE: the spill down from the 401k/TSP bucket to the IRA is not based on the value of the 401k/TSP.  It is based on the amount of the contribution.  If you are maxing out the amount of contribution and you have extra money that can be contributed to your retirement accounts, then put the extra in your IRAs.  IRAs are also used to hold your rolled over 401k/TSP monies after you leave the service or an employer.

Get back to fundamentals.  In a future article, we’ll talk about how to manage the retirement accounts.

The last few weeks are like nothing I’ve ever seen in financial markets.  I heard today, that in the last 13 or so sessions there has been only one day that the markets moved LESS than 1%!  Just today, the DOW is up over 500 and it was down 700 in the last session.  That is volatility like we’ve never seen before and of course the market is way off its high.  These are times that really challenge an investing strategy.  I’m sure the other authors on these pages would tell you to stay the course and stick with your long term plan…I don’t disagree with them.  But, you are or were a Military Officer and military officers don’t sit around while the there is a crisis going on.  They do something!  So, something you must do.  Here is what I believe that something to be.  Examine and correct the expenses you are paying for money management.  Boring?  Yup, but necessary.

Most of us ignore expenses when markets are up 10-15% per year.  Who cares if the manager takes a little extra?  But expenses become very noticeable when markets return to more earthly levels.  And, expenses can vary a great deal, up to 3-4%, besides that increases in expenses don’t always equal increases in performance.  So what is one to do?  I’ll talk to mutual funds, but the concepts are the same for stocks or managed portfolios.  Take a look at the mutual fund’s prospectus…the document you received and maybe skimmed when you bought the mutual fund.  In that document you’ll see what the fund charges as expenses.  These expenses pay salaries, research, and all the other expenses associated with running the mutual fund.  Compare this expense ratio (usually in the form of a percentage) with the fund type (Large Cap, International, etc) average.  There are several web sites that have that information.  Is your mutual fund above average?  Are you getting something for that extra expense?  If not, look for a lower expense mutual fund that has the same investment philosophy and similar portfolio.

So does this make a difference?  I think it does.  Let’s take an example.  Suppose you have identical funds with the only difference being that one fund charges 2% in expenses and the other fund charges 1%.  If the market returns 8% average over time you’ll receive 6% and 7% respectively each year.  What does that mean in dollars and cents?  If you invest $10,000; after 10 years you’ll have $1,763 more in the less expensive fund.  After 20 years the difference is $6,625 and after forty years the difference is a whopping $46,885.  1% makes a big difference.

What should you do with this information?  While the argument rages over whether managed funds outperform index funds over time, there is no argument that index funds have lower expense ratios…you might want to consider that and look at whether your managed funds have beaten the benchmarks over the years.  Another place to look is ETF’s some of which offer very low expense ratios.  However, a word of caution is in order in that ETF’s do have commissions when traded, so they are probably not a “cost cutter” for systematic investment.  But, they do offer advantages for long term holding strategies.  You just need to take a look at the math in the specific situation.

I know many if not most of you are itching to do “something” in this market.  I understand that feeling.  Just make sure the “something” you do is a move in the right direction.

Here we go again!

As of 10:40 AM today, the Dow Jones Industrial Average (DJIA) was off over 400 points, dropping through the psychologically important 10,000 point barrier and adding fuel to the “panic” fire.  At a kid’s birthday party this weekend, I overheard two parents talking and the gist of the conversation was they felt their stock market holdings in their respective 401(k) plans were going to go to ZERO…a complete loss…even though they were in well-diversified mutual funds.  Their solution?

Sell.

Even though they are in their mid-40s and have years to go before retirement.  Perhaps a bit of historical perspective is in order.

Last week’s drop of 777 points on September 29, 2008 was big…from a raw point level.  It dropped the DJIA down to 10,365 points.  However, as a percentage drop of about 6.9 percent, it didn’t even break the top 10 (not that you would have known that if you listened to the nightly news shows).  Compare that to the infamous “Black Monday” drop on October 19, 1987, when the DJIA dropped 508 points or a staggering 22.6 percent!

A drop comparable to the October 1987 drop would have sent the DJIA down a whopping 2,545 points or all the way down to 8,597 points.

Now, that doesn’t mean the things aren’t serious in the market today and that we shouldn’t be concerned…but even with today’s interday drop…the DJIA is still nearly 6 times higher today, 21 years later, than it was after the 1987 crash.  So where will your money be in 21 years?

If you pull your long-term money out and move it to cash, you do two things: (1) You guarantee yourself a 25% loss and (2) at 3 percent a year, it will take 24 years to double your money in cash.

Something to think about…

I have been out of the office with pneumonia this week and I have had time to listen, read, and watch plenty of news on this credit crisis issue.  As I put together the pieces of the puzzle, I’m struck by how worthless credit has become in society and how misguided, no spoiled, we as citizens have become when it comes to credit.

We all knew it.  We talked about it around the kitchen table with our friends and family.  You talked about how easy it was to get credit and some company was throwing credit at you.  You might as well use it to buy that new furniture or electronics gear or that extra house.  How many people tried to become little Donald Trumps?  So we kept using credit to purchase what we wanted.  The problem is that we were living in a box of free credit and we lost relativity and reality of things outside the box like the real financial world.

In today’s situation credit in and of itself is worthless.  It has no value.  It’s an empty promise without proof of assets backing it up.  Someone finally noticed and called us on the fact the emperor has no clothes.

Now that credit is getting tight we are offended that we can’t get credit.  There are countless stories of people and businesses in the papers crying because they can’t get the credit they have become accustomed to keep their lives and businesses going.  Truth is that you can still get credit.  It’s just that the credit rules are going back to what they used to be; something of value.

What we are seeing now is called reverting to the norm.  Happy days are over and it is time to get back to reality.  Credit has to have assets backing it up to be worth something.  Credit is not owed to us as if it is some kind of right.  It’s not a right, it’s a privilege and nothing is owed to us so it’s time to buck up.

When I was a teenager, it was a big deal to start your credit record and that meant you applied for a Sears or Montgomery Wards or gas company credit card.  These companies weren’t giving credit away back then.  It was not a sure thing.  You had to supply proof that you were good for the credit—a good credit risk so to speak.  It was a big deal to find out you were approved and then you were careful not to abuse the power.  With power comes responsibility.  Then credit was backed up by proven assets and the ability to pay.  Credit had substance, value.

Now what do we have?  We have credit card companies pushing credit cards to kids with no assets.  I know.  My girls received credit card apps in the mail when they were in high school and college when they had no assets.  Shame on those companies.  You deserve your default rates.  And for you people who accepted the offers, hope things worked out and if not, oh well.  People have to be smart enough to know their financial situations and whether they can afford the responsibility to have a card—or credit in general.

You would think we should know better since we’ve been down this road before.  A big reason for the Great Depression was people buying stocks on margin (credit) with no assets (collateral) backing up the margin.  Back then you could purchase a substantial amount of stocks with no assets backing up your credit line.  The values of stocks were based on worthless credit.  The bubble had to burst when people figured out the stock market value was based on nothing.  Now we have rules for minimizing the amount of margin and the required collateral a person must have before buying investments.  But here we are again only this time it is houses instead of stocks.

The housing market and financial world realized mortgages are based on nothing—worthless credit.  The housing market was ballooning as more and more people bought houses with no collateral.  Now why would a company risk their own financial security and future by making mortgage loans to people who can’t afford to pay the loan?  That type of business transaction makes no sense and in fact would be financial suicide.  Well to do that type of business you would have to know someone else would take the risk off you.  Take a look at a New York Times article of 30 Sep 1999 by Steven A. Holmes.  Just pull up the New York Times and search under September 30, 1999.  The article will pop up in the search.  It seems our government decided responsible tax payers would be willing to bare the load for people who couldn’t afford homes to buy a home.  I guess someone decided home ownership should be a right.  Wonder what the motivation for something like this decision would be?

Right now, I’m not feeling much sympathy for companies or people.  Maybe it’s my illness talking.  Bailout?  I think not.  Let the market get the worthless credit out of its system and get back to the norm.  In the 1930s it was a stock market based on worthless credit.  In the 2000s it’s the houses based on worthless credit.  How long will it be before the credit card companies follow suit?  If financial companies called in all your debts right now, how much of your credit is based on thin air?  I have to think there are loads of senior citizens out there with a little smile on their faces thinking “I told you so.”