Wednesday, March 20, 2013

Personal Finance

I had an interesting discussion last night on personal finance.  Kind of like Maslow’s Hierarchy of Needs, personal finance needs evolve based on where one is at.  At the most basic, income needs to cover shelter, food and clothing (usually in that order).  Once that is achieved, a safety net needs to be in place with ideally an emergency fund or at least credit available to cover any lapse in income.  Next, savings for short term expenditures like a car, house down payment or children’s education.  Long term expenditures are usually next and will include a secure retirement that does not depend on government assistance.  The highest level would include leaving some kind of estate or endowment after one is gone from this earth.  Very few of us get comfortably into level 4, so level 5 is pretty far out there.

Personal financial discipline is required for any state.  A person should have a budget that is preferably written down and tracked against regularly.  The best way to save money is to not spend it.  A rule of thumb for households is to save 10% of take home income.  My Father espoused saving over 25% of take home income.  Living frugally is the key to long term economic happiness.

Debt is expensive.  Payday loans will cost an individual upwards of 1000% interest.  Credit card balances can be 20% interest.  Student loan interest rates are 6.8%.  Car loans 6% interest.  Mortgage rates while low (and tax deductible) are still 3% interest.  Get out of debt.  No investment can absolutely guarantee you 3% return.

Once you are out of debt and have emergency cash on hand, congratulate yourself.  You are ahead of 75% of Americans.  Now the key is to not be stupid with investments.  Don’t invest in your friend’s frozen yogurt stand or real estate lots that you have never seen. If you want to own a home great, buy a home, but keep in mind maintenance costs, property taxes and the lack of liquidity.  The big dividend of a house is that you can live in it.  The balance of the article will address those individuals in level 3/4.

If you pursue financial assets there are three basic classes:  equities, bonds and commodities.  I excluded currencies as that is beyond my scope.  All assets provide return for risk.  Bonds are less risky and provide lower returns.  Stocks are more risky and provide higher returns.  Small companies are more risky than large companies.  Therefore large companies provide lower returns.

One can invest in stocks through index funds, mutual funds, individual stocks and derivatives (options).  Index funds are diversified and usually very low cost (less than 0.5%).  Mutual funds can be more expensive and you have a management fee to pick the right stocks (should be less than 2%).  Individual stocks can be the cheapest with the cost being the buy/sell transaction fee of less than $20 total.  Derivatives are tough and you really need to know what you are doing.

Investing internationally is tough and most often done through an index fund.  One can buy stock in individual companies, but currency fluctuations make this a challenging proposition.

One can invest in bonds through individual purchases of corporate, treasury and municipal bonds.  One could also invest in a bond fund.  Bond funds go up when interest rates go down.  Bond funds go down when interest rates go up.  With interest rates at historic lows, bond exposure is risky.  Corporate and municipal bonds are hard to buy and hard to sell if you don’t hold them to maturity.  Municipal bonds have the benefit that interest is not taxed.  Treasury bonds are easy to buy through, but must be held to maturity. 

Commodities are unique in that the prices are dictated by hedgers (farmers, airlines) and speculators.  The prices are driven by macroeconomic indicators.  For example worldwide economic growth will drive up oil prices.  The prices are also driven by shocks to supply or demand.  A military conflict disrupting oil prices will drive prices up.  It is difficult to invest in commodities.

Finally hedge funds have been in the news.  Hedge funds are for investors that have over $5 million in financial assets and are typically willing to put $500K to $1M with a hedge fund for investment.  Hedge funds use any number of strategies to beat the market returns and charge 2% of assets under management and 20% of returns for the privilege to invest with them.  This is a tall order and should only be considered by those with risk fortitude.  Not all hedge funds beat the market returns every year.

Once you have $100,000 in financial assets, it is probably time to have a financial advisor.  Ask for references, how they are compensated, and make sure you like them.  Finding a financial advisor is like finding a doctor or dentist.  They may all get the job done, but they are not all the same.

Somewhere in the mix, you need insurance and an accountant.  I never liked doing my own taxes and for less than $500/year my accountant provides financial advice through the year and does my taxes.  Medical emergencies and lawsuits are the biggest reasons families that are otherwise well off go bankrupt.  There is not much you can do about medical emergencies.  Have good health insurance and pray that you or a loved one is not stricken by illness.  You can do something about lawsuits.  Have auto insurance with limits in line with your assets.  Have homeowners insurance with limits in line with your assets.  Have professional liability insurance if appropriate.  If you have over $1M in assets, have an umbrella policy for anything not covered by auto and homeowners insurance.  Yes it is expensive, but it is worth it.  If you have dependents, you need life insurance.

Divorce is not cheap either.  Protect your assets with a pre-nuptial or post-nuptial agreement no matter how much you love your partner.  These can always be amended as circumstances change.  Very few people make good decisions during emotional times like during a divorce.

If you have significant assets, have a will.  I would not trust the state with very much.  A will, like a post-nup, can be amended and should be reviewed on a regular basis.

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