Advanced Personal Finance

This post appeared earlier this week on Money, Matter, and More Musings. Thanks to Golbguru for the opportunity to guest post at his blog.

When investors talk about diversification, they’re typically referring to diversification. But there’s another kind of diversification. It’s called tax diversification and you might be practicing it without knowing it.

Tax diversification is the idea that you should have investments subject to each of the various tax treatments. The idea applies not only to U.S. citizens, but those of other countries as well. There are three types of tax treatments for our purposes - tax-deferred, tax-free, and taxable.

The three account types

• Tax-deferred. Tax-deferred accounts are those that grow tax free until they are liquidated, at which time full taxes are due. Examples are the 401(k) and traditional(”deductible”) IRA. You invest pre-tax dollars. The full amount of money goes to work for you, compounding until withdrawn. At the time of liquidation, the entire amount withdrawn is taxed as ordinary income.

• Tax-free. Tax-free accounts use after-tax money to buy investments that then grow without ever being taxed again. Examples are the Roth 401(k) and Roth IRA and municipal bonds. In these types of account, you purchase the investment with after-tax income. The investment then grows over time. When liquidated, the total account balance is tax-free.

• Taxable. These accounts invest after-tax income. When the investment is liquidated, the earnings are taxed again. An example is a regular brokerage account.

How tax diversification works
In short, you use tax diversification when you split your investable dollars between the three types of accounts. Tax rates and treatments are moving targets. By using tax diversification, you’re hedging.

Why use it?
You simply cannot know what the tax brackets will look like at retirement (unless you’re within a year of retirement, I suppose). Using this technique, you’re spreading the risk of using any one type of account.

For example, if the bulk of your retirement investments are in a combination of traditional IRA and 401(k), at retirement all of that money is fully taxable. As of today, it’s taxed as ordinary income. If your tax bracket is lower in retirement, you made a shrewd move. If it is instead higher, you lost money by using only the tax-deferred accounts. So whether you think Roths are bad or good, it makes sense to have at least a portion of your retirement savings there.

I personally use this technique in my investments. Currently, I have 8% pre-tax going to my traditional 401(k) and 11% going to a Roth 401(k). We also have a taxable account we fund each month.

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I’ve seen a couple of different places where people have been sent letters by credit card issuers converting their dividend rewards cards to ‘Dividend World’ cards unless they opt out. Nickel over at fivecentnickel posted his story about it here.

For those of us who don’t have a card being converted, basically the story is that issuers are trying to sell people on a ‘new improved’ card. By most accounts, there’s not much advantage to the cardholder.

Why would an issuer make this conversion? Wait for it…

It generates more fees for the issuing bank.

I just saw the terms sheet that lays it all out. See, a friend’s wife is starting a business that will accept credit card transactions. So he’s going over all the paperwork to make that happen and was telling me about it. Seems there are three levels of transactions - qualified, mid-qualified, and non-qualified - each with escalating costs to the business owner. Most normal card-scanned purchases are qualified. Except World Mastercard and a handful of others.

When customers use a World Mastercard, it generates an additional 1.16% of the purchase amount in fees for the bank.  That’s in addition to the standard 1.67% plus $0.20 for a regular, qualified transaction.

Isn’t that surprising? Credit card companies trying to sneak in an extra fee?

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I’m willing to bet that 50% of readers of this blog are derivatives traders and don’t even know it. A derivative is a financial security that derives its value from the value of something else. That ’something else’ could be a stock, currency, interest rate, or anything else you can think of.

There’s a lot of debate about whether the modern use of derivatives is good or bad. On the one hand, they allow an entity to minimize its risk to a specific event. For example, a company might use an interest rate swap to better plan for the future. On the other hand, derivatives are lightly- or un-regulated, and often only the two parties involved are the only ones who know about the transaction. This can amplify events in the market and arguably increases systemic risk.

You just might be trading derivatives without knowing you’re doing it. How? Common securities like Exchange Traded Funds (ETFs) are derivatives. They don’t actually own the stocks of the indexes they track. And there are mutual funds that exist solely to invest in derivatives. Rydex offers funds that match the performance of the dollar. There’s one for a strengthening dollar and one for a weakening dollar. Not only that, but these funds are actually leveraged so they match 200% of the dollar’s move up or down! [Alarm klaxon sounds]

The real point to remember with all this is that if you invest, for example, in ETFs, there is a certain, admittedly small, risk associated with them being derivatives.  This is particularly true for more thinly-traded ETFs.

Finally, whether you agree or disagree with this statement about derivatives, a word from Alan Greenspan,

“By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it - a process that has undoubtedly improved national productivity growth and standards of living.”

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The 102nd Carnival of Personal Finance is up at Money Smart Life. This week features a nice music theme to the carnival.

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Investing Mistakes I’ve Made and What I Learned From Them

I’ll admit it - like a lot of people, I sometimes got swept up in the hype of the late 90s stock bubble. I thought I knew what I was doing because I did some investing things right. Hey, I’d read books. My investments were up. I was a genius.

Except I wasn’t. I was a dumbass and I have the stories to prove it. Here, in no particular order are some investing mistakes I’ve made and what I learned from them.

I invested in a high-performing mutual…right when it stopped being high-performing.

I don’t remember the year but it was around ‘98 or ‘99. I used one of those super-duper mutual fund screeners to pick where I should invest my money. You know the ones. Highly technical. For skilled investors only. Free, too!

Then I pulled the classic bonehead novice investor move - I picked the one with the best returns and invested in it. I remember it like it was yesterday - Safeco Growth was the fund. I’d like to give you a graph of where I bought in (the top) and where the fund is today. But I can’t. The fund doesn’t exist any more. Hey kids, look! A classic example of survivorship bias!

What a jackass.

Lesson learned #1: Past performance has absolutely nothing to do with future performance. At all. Really.
Lesson learned #2: Don’t buy actively managed funds.

I bought a stock the day of its IPO.

Believe it or not, I did this twice - successfully. I don’t say that boastfully, but sheepishly - I’m not at all proud of it. Once again, I thought I was super-investor. I was going to get a piece of the IPO action! I operated on the ‘greater fool’ principle, intending to sell the stock in a few days or weeks when it inevitably skyrocketed. It was ‘Flip This House’ for stocks.

The two stocks were Net2Phone (no listing because the stock no longer exists) and Etek Dynamics (ditto). Net2Phone ended its IPO day with a market cap of $1.26B. It was later acquired by IDT for $26.1M in 2006 (yes, that’s several orders of magnitude lower). Etek was bought by another company for a ridiculous price about a year after it went public.

Even though I made money on both of these, I started to wake up to the fact that continuing to do what I was doing was stupid. Shortly thereafter…well, you know the rest.

Lesson learned #3: Don’t buy a stock on its IPO day with the intent to sell it shortly thereafter.
Lesson learned #4: Bubbles always pop. You don’t want to be there when they do.

I bought a stock based on a tip…from a complete stranger.

Same timeframe - mid-2000 or so. I’m in a training class for work when, during a break, the conversation turns to the stock market (as all conversations eventually did during this time). Someone in the class asked the instructor’s opinion about stocks in our sector. He named a name. I bought the stock.

Keep in mind, I don’t know this guy from Adam. And based on his say-so, I bought a stock. To my credit, I actually did look into the company and do some rudimentary research.

The stock cratered.

Lesson learned #5: Don’t take stock tips from strangers (or family members, or people on CNBC, or your barber).
Lesson learned #6: Twenty minutes of looking at a company’s website and one 10K doesn’t constitute ‘research.’

So there they are. Now that it’s all typed out, I feel even more stupid. But I wasn’t wiped out and I did in fact learn from the experiences. I guess that’s what it’s all about - learning from my mistakes and not repeating them.

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