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October 29, 2006

The Loser's Game

Warren Buffett, perhaps the greatest investor alive today, has an amusing way to describe his rules for investing:
Rule #1 — never lose money
Rule #2 — don’t forget rule #1

Although this may seem like an overly simple and conservative way to succeed, I hope to show you that these simple rules hold the key to successful investing for the vast majority of people: understand when you are playing a loser’s game and then play accordingly.

What do I mean by a loser’s game? Back in the 1960’s, an engineer from TRW did an exhaustive study of the game of tennis and found that it was not one game, but two: one game played by professionals and the other played by amateurs. Professionals, he found, won 80% of their points by making great shots. In other words, the winner of the game was determined by the winner’s actions. That’s a winner’s game. Amateurs, on the other hand, lost 80% of their points by making unforced errors—hitting the ball out of bounds or into the net, or double faulting. In other words, for amateurs, the winner of the game was determined by the loser’s actions. Hence the name, loser’s game.

Why is investing a loser’s game for the vast majority of people? Investing is a loser’s game because most people lose by making unforced errors. The record supports this claim. For example, over the last 19 years, the stock market as a whole has gone up around 12% per year. So, if you started with $1,000 19 years ago, you should have ended up with $8,500 from average performance. The average mutual fund investor, on the other hand, barely saw their money appreciate by 6% per year. Instead of ending up with $8,500, they ended up with around $3,000. Clearly, the average mutual fund investor lost. Perhaps you think professionals did better? Unfortunately, no. In fact, 80% of professional investors also failed to keep up with market averages. Now, why is that?

Most investors failed to keep up with the market because they were chasing performance. When you dig into the specific choices that mutual fund investors and professional money managers made, you find that they were continuously selling recent losers and buying recent winners. Unfortunately, the “losers” they were selling tended to do much better going forward than the supposed “winners” they were buying. Specifically, in 1999 they were selling Caterpillar and Fidelity Equity and Income and buying Webvan and Janus 20. What went wrong? They thought they were playing a winner’s game and were trying to hit great shots, but instead they were playing a loser’s game and causing their own unforced errors.

If investing is a loser’s game for most people, how do you win in a loser’s game? You win a loser’s game by not making mistakes. Let me use tennis as an example first to make my point. To win as an amateur in tennis, you need to first acknowledge that you are an amateur, and then you need to change your strategy. Instead of pursuing a strategy of making great shots, you need to become really good at keeping the ball in play. That way, you let your opponent have all the opportunities they need to make mistakes, thus handing you the win!

The same basic idea works for investing, too. First, you need to acknowledge whether you are in the top 20% of investors or the bottom 80%. If you are in the bottom 80%, you need to focus on not picking losers instead of trying to pick winners. You do this by buying index funds, or purchasing mutual funds or companies that have dependable, but unexciting, long term records that seem to be fool-proof. Stick with your choice over time instead of chasing performance and you’ll out-perform the vast majority of investors. Be honest with yourself about what you do and don’t know. If you don’t know anything about biotech, don’t buy it. If your uncle Harry gives you a stock tip and you don’t know what he’s talking about, don’t even think about acting on it.

Which brings me back to Warren Buffett’s rules for investing: Rule #1 – never lose money by acknowledging when you are playing a loser’s game and focus on not picking losers instead of trying to pick winners; Rule #2 – don’t forget Rule #1 by always being honest with yourself about what kind of game you are playing and by assuring yourself you can only win by sticking to your game.

Author: Michael Rivers, CFA, a Member of the Paladin Registry

October 18, 2006

Aging Population and the Affect on the Economy

For years, we have heard that aging baby boomers will place a tremendous strain on our economy after retiring. However, the problem is not limited to the United States, since the populations of Japan and Western Europe are also aging rapidly. With much of the world’s wealth held by people in the United States, Western Europe, and Japan, there will be a tremendous strain on savings worldwide due to the fact that retired people typically save less than younger people.

Over the next 20 years, the median age in Japan will increase from 43 to 50, while Italy’s median age will increase from 42 to 51. The United States does not look nearly as bad, with an increase from 37 to 38 (Source: World Population Prospects, 2005). However, our savings rate is already dismally low, even though the vast majority of baby boomers have not retired yet. For years, the United States has been relying on capital flows from Europe and Japan to finance our huge trade deficit. As savings rates decline in these countries, it will be more and more difficult for them to keep financing our trade deficit.

The Japanese have long been regarded as a nation of thrifty people, saving significant amounts of their income. Yet, their savings rate has declined from 25% in 1975 to less than 5% today and is projected to decrease to a mere 0.2% by 2024 (Source: How Aging Will Reduce Global Wealth, 2005).

Why are savings so important to our economy? At first glance, it appears that savings hurt the economy. If consumers save rather than spend their income, current sales for stores, service establishments, and manufacturers will decline, putting a damper on jobs and income. However, this is only a short-term effect.

Over the long term, these savings are used to make investments, which finance modernized equipment, new construction of homes and factories, and research and development of new products. These investments, in turn, create more jobs and more income.

Savings in our country come from three sources: individuals, businesses, and the government. Personal savings as a percentage of disposable income have continued to hover at historically low levels, 0.9% in 2005 (Source: Bureau of Economic Analysis, 2006). The government is running large deficits that are expected to increase rather than decrease in the future. As the population ages, retirees will put even more strain on the federal government’s resources.

It is quickly becoming imperative for individuals to dramatically increase their savings and for the government to control the federal deficit. On an individual level, this should serve as a wake-up call to reassess how much we are saving.

October 15, 2006

Plastic Jungle Creates Gift Card Marketplace

ManagingMoney.com came across an innovative way to save a little money at major retailers when we discovered Plasticjungle.com. Plastic Jungle is a leader in the relatively new Gift Card Exchange Marketplace. Similar to EBay's auction process, Plastic Jungle allows their users to buy and sell gift cards, trade pre-owned gift cards, and sell gift cards immediately for "quick cash". Future plans include a feature in which you can donate unused amounts on gift cards to charity.

Now, we are the first to admit that trading gift cards is not going to make someone rich overnight, but nevertheless why not save a little money now and then when you shop. How many of us have unused gift cards in our wallets or purses, or gift cards with small amounts remaining that we never use?

Basically, the way it works is that the consumer goes to the site and registers online, regardless if they are buyers or sellers. Registration is necessary to provide a secure and honest environment so buyers and sellers can be comfortable doing transactions. Currently both buyers and sellers are required to have a PayPal account to facilitate the actual exchanging of funds. Plastic Jungle's Privacy Policy currently states that they do not sell name, demographics, or contact information to any third parties.

Buyers can purchase gift cards at ~90-95% of the cards' remaining value with Plastic Jungle keeping the difference. For example, a consumer could purchase a $100 Home Depot gift card for $90.

Sellers can sell whatever gift cards they have in the range of ~60-75% of the cards remaining value for a flat fee of $3.99 for each card listed regardless of value.

Surprisingly, a gift card exchange is fulfilling a major market inefficiency for retailers. As a consumer, the benefit and savings are obvious. However, for retailers, "gift card accounting" for unused cards has posed a major problem. When a company has unredeemed gift cards, the total is listed as a liability on the balance sheet and they are not able to show it as revenue until the card is redeemed. On top of that, state and federal authorities are phasing out expiration dates on cards meaning the retailer may be stuck with this accounting issue for years. Anything that causes the velocity, or use, of gift cards to pick up will be a benefit for retailers.

So, with Christmas right around the corner we suggest you re-visit those gift cards in your wallet and go to Plasticjungle.com. To find other ways to Save Money, be sure to visit the ManagingMoney.com Expenses Center. Here you will find online and in-store coupons, calling cards, ways to save on educational expenses, and much more. ManagingMoney.com will continue searching for more innovative ways to help you save money, so keep reading our blog.

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October 13, 2006

Securing Your Financial Identity

It is estimated that 4.25% of American adults are subject to identity theft every year (Source: Money, July 2005). Approximately half involve credit card fraud, where a thief steals a credit card number and charges items to it. While an inconvenience, this does not have a lasting impact on a person’s financial identity, and the person does not have to pay the fraudulent charges. The more significant worry, which occurs in 25% of identity thefts, is when another individual obtains sufficient information to borrow money or open accounts in your name. According to a Federal Trade Commission survey, victims spend an average of 60 hours and $1,200 to clear their names.

To help protect your identity, follow these tips:

Protect your Social Security number. This is the primary information needed to steal your identity, so only give it out in situations where it is absolutely required, such as on tax forms, employment records, and for banking, stock, and property transactions. Request a personal identification number for phone access to financial information. Don’t print your Social Security number on your checks.

Check your credit report annually. As of September 1, 2005, all consumers are entitled to one free credit report per year. You can request it at annualcreditreport.com or by calling 877-322-8228. After that, you can get a report from one of the three major rating agencies, Equifax, Experian, and TransUnion, every four months. Review your credit reports carefully for errors. It is not uncommon to find information on people with similar names or other family members in your credit file. If you find errors, report them immediately in writing. The credit bureau must then investigate the items and resolve those that can not be verified. If the matter is not resolved to your satisfaction, you can submit a “statement of dispute” explaining your position, which must be included in your report. To obtain your credit report from all three rating agencies go to ManagingMoney.com Loans & Credit Center.

Carefully share information online. Make sure you are dealing with a reputable company before giving personal information. Also review the site’s privacy policy, which should tell you how the information will be used and whether the site sells this information to third parties. Leave information blank, especially Social Security numbers, if you are uncomfortable providing the information. Provide sensitive information only from secure web pages. Looking at the web address will let you know if the page is secure — a secure connection will begin with https:// rather than http://.

Shred financial information when discarding. When discarding old tax returns, bank statements, brokerage statements, or any information with account numbers or identifying information, make sure to shred them.

Remove yourself from mailing lists. Preapproved credit card offers are an easy way for thieves to get credit cards quickly. Credit bureaus often sell lists to companies making these offers. You can call the credit agencies and request that your name be removed from these lists.

October 11, 2006

Stock Allocation

Your asset allocation mix represents your personal decisions about how much of your portfolio to allocate to various investment categories, such as stocks, bonds, and cash. How much you allocate to each category depends on your financial objectives and personal circumstances. However, it is a percentage that is likely to change over time. As your needs for safety of principal and a steady income stream become more important, the percentage of stocks you own is likely to decrease. Some factors to consider when deciding how much to allocate to stocks include:

Your risk tolerance. The advantage of including both stocks and bonds in your portfolio is that when one category is declining, the other category will hopefully offset this decline. For instance, in 2002, the Standard & Poor’s 500 (S&P 500) returned -22.1%, while long-term government bonds returned 17.8%, and intermediate-term bonds returned 12.9%.* One way to assess the percentage of stocks to include in your portfolio is to look at how holding varying percentages of stocks and bonds would have impacted your average return.

Your time horizon. The longer your time horizon for investing, the more risk you can typically tolerate in your portfolio, since you have more time to overcome any significant downturns. Certainly, individuals with short time horizons, perhaps five years or less, should be very cautious about how much to allocate to stocks. But as your time horizon lengthens, you can theoretically add a higher stock mix to your asset allocation. However, in all situations, make sure you’re comfortable with the percentage allocated to each category.

Your return needs. Your need to emphasize income or growth is likely to change over your life. When you are trying to accumulate significant assets for a goal far in the future, you may want to allocate more of your mix to stocks. However, when your needs for a predictable income stream become more important, such as when retirement approaches, you may want to allocate more to bonds.

Once you decide how much to allocate to stocks, you need to ensure that you diversify within the stock category. Consider large-capitalization stocks, small-capitalization stocks, value stocks, growth stocks, and international stocks. Each type of stock has different risks and return potential.

* Source: Stocks, Bonds, Bill, and Inflation 2006 Yearbook, Ibbotson Associates. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.

October 6, 2006

The Basics of Charitable Remainder Trusts

A charitable remainder trust (CRT) is an irrevocable trust set up to benefit a charitable organization. The trust’s term is one lifetime, several lifetimes, or a period not to exceed 20 years. Basically, you irrevocably gift an asset to the CRT, usually an asset with a low tax basis that has appreciated significantly. During the trust’s term, you receive a certain amount of income and/or capital annually (called the retained interest). At the trust’s termination, the charitable organization receives the remaining assets (called the remainder interest). CRTs offers a number of benefits.

• Since the trust is a tax-exempt organization, the CRT can sell the asset and reinvest the proceeds without paying capital gains taxes. Selling the asset yourself would result in a significant capital gains tax bill.

• You get a current income tax deduction equal to the value of the remainder interest that will eventually go to the charity. That value is based on your life expectancy, the payout percentage, and an interest rate designated by the Internal Revenue Service. Higher tax deductions result as you get older, the interest rate increases, and the payout percentage decreases. This deduction is subject to limitations on charitable contributions, but any excess deduction can be carried forward five years.

• The asset is removed from your estate when it is transferred to the CRT, so it will not be subject to estate taxes after your death.

• You receive an income stream for life or for a designated period.

• You make a substantial gift to a charity you select.

There are two basic types of Charitable Remainder Trusts:

• A Charitable Remainder Annuity Trust (CRAT) pays the donor a fixed annual amount based on the trust’s initial value.

• A Charitable Remainder Unitrust (CRUT) pays the donor a percentage of the assets’ value, which is calculated every year.

Amounts paid out by the CRT must be greater than 5% and less than 50% of the property’s initial value. Also, the present value of the charity’s remainder interest must be at least 10% of the property’s value. The IRS will disqualify a CRT with more than a 5% probability that the trust funds will be completely used before the trust’s termination date. Thus, carefully assess all factors before setting up a CRT.

Keep in mind that the gifted asset is removed from your estate and will not be available to your heirs after your death. Thus, many individuals purchase life insurance to replace the value of the gifted assets. If the insurance policy is properly structured, your heirs can receive the proceeds both income- and estate-tax free.

October 4, 2006

Tax Planning Strategies

While many strategies can help you reduce your income tax bill, those strategies basically fall into three main techniques: reduce or eliminate taxes; postpone the payment of taxes until sometime in the future; and shift the tax burden to another individual.

1. Reduce or eliminate taxes.

With this technique, the objective is to receive income in a nontaxable form or to find additional income tax deductions, exemptions, or credits. Some strategies that accomplish this objective include:

Become familiar with all types of income tax deductions, exemptions, and credits. There are a wide variety available and you should be aware of any that may apply to you.

Consider municipal bonds, whose interest income is generally not subject to federal, and sometimes state and local, income taxes. This strategy typically becomes more attractive as your marginal tax rate increases. Before purchase, however, compare the municipal bond’s rate of return to your after-tax rate of return on other investments.

Investigate investments that generate capital gains or dividend income. Capital gains on investments held over one year and qualified dividend income are subject to the 15% capital gains tax rate (5% for individuals in the 10% or 15% tax bracket), compared to the top ordinary income tax rate of 35%. Also, you can typically decide when to sell the investment, giving you some control over the recognition of gains and losses for tax purposes.

Utilize losses to offset capital gains. Losses on investments can be used to offset capital gains, reducing your total tax bill. Excess losses may be used to offset up to $3,000 of ordinary income, and the unused portion can be carried forward until utilized.

Sign up for fringe benefits offered by your employer. Many benefits are offered on a tax-free basis, so you should take advantage of all that you can.

Consider donating appreciated stock held over one year to charitable organizations. You can deduct the stock’s fair market value without paying the capital gains tax on the sale.

2. Postpone the payment of taxes until sometime in the future.

By postponing the payment of taxes, your investment grows on a tax-deferred basis, allowing earnings to compound on the entire balance, including the portion that will eventually be paid in taxes. A secondary benefit is that you may be in a lower tax bracket when the taxes are paid. Some strategies to consider include:

Contribute to retirement accounts, including employer plans and individual retirement accounts (IRAs). For 2006, you can contribute $15,000 to a 401(k) plan plus a $5,000 catch-up contribution if you are age 50 or older and $4,000 to an IRA plus a $1,000 catch-up contribution if you are age 50 or older. Most provide a tax-advantaged way to save for retirement.

Designate which shares of stock you are selling. If you are selling a portion of a stock’s shares and have different bases for those shares, designate which shares you are selling.

Consider selling certain capital assets on the installment basis. You can use this method to sell certain capital assets, particularly real estate, which will typically allow you to recognize the gain as the installments are collected. You may also want to consider a like-kind, or section 1031, exchange, which allows you to defer any tax liability.

3. Shift the tax burden to another individual.

The objective of this technique is to transfer assets to other individuals so any income on those assets becomes taxable to them. Before implementing these strategies, realize that you must typically give up control of the asset. Some strategies to consider include:

Make annual gifts, up to $12,000 in 2006 or $24,000 if you split the gift with your spouse, to any individual tax free. You can make gifts to any number of individuals. If you make gifts to minor children, be aware of the tax laws regarding investment income for minor children. If your child is under age 18, he/she is subject to the “kiddie tax” — in 2006, the first $850 of investment income is tax free, the second $850 is taxed at the child’s marginal tax rate, and any remaining investment income is taxed at the parents’ marginal tax rate. Thus, you may want to use tax-free or tax-deferred investments for a portion of the child’s assets. If the child is age 18 or older, all investment income is taxed at his/her marginal tax rate.

Consider using your $1,000,000 lifetime gift tax exclusion during your life. This allows you to shift a much higher amount to heirs than you can with your annual tax-free gifts.

Gift property that has the potential to appreciate in value, but hasn’t already done so. The tax basis of a lifetime gift remains your original basis plus any gift tax paid. Thus, if you gift an asset with a low basis, your heirs could owe significant capital gains taxes when the asset is sold.

These are just a few of the many tax strategies that can help you reduce your tax burden.

 

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