Eliminate the Capital Gains Tax (2008-02-25)

Eliminate the Capital Gains Tax

by David John Marotta

I've decided to run a mock campaign for president again as a forum to talk about public policy. Every four years I look for a candidate who understands economics, only to find politicians instead. My political bias, like many economists, leans toward freedom. The unintended consequences of much of our legislation result in great harm to the economy and to people's livelihood. If elected, I promise to do less harm.

Lots of polls are out there supposedly to help us choose a candidate. I hate them all. They inevitably ask a battery of two dozen questions dealing with issues I don't care about and only vague questions about the ones I do. As a result, these polls are as useful as recommending I vote for a candidate because we like the same flavor of ice cream.

From helping people from all walks of life with their family finances, I've discovered that the most successful people recognize that their financial future mostly depends on actions under their own control. The best way for people to achieve their financial goals is to moderate spending and stay on track with a savings plan.

The issues I consider of primary importance are those that interfere with everyday families becoming self-sufficient. Unfortunately, these are not the issues that voters seem most passionate about. But they should be. Issues such as the capital gains rate determine if we will be able to save toward retirement or not.

Saving and investing just a dollar a day over your working career produces $400,000 at retirement. Saving $2.50 a day produces $1 million at 11% after 45 years. Obviously, most families don't save at all. They are struggling because of the choices they make. Financial planners encounter this problem so often, it's been dubbed "the latte effect." People spend $2.50 a day on lattes rather than becoming millionaires.

Being a good citizen means first and most importantly to produce more than you consume. This will ensure you can take care of yourself. It will also mean you can be charitable and give to the truly needy. You, however, are not the truly needy. Odds are there are people getting by just fine earning half of what you bring home. Don't succumb to envying those who make more than you. At the same time, embrace the virtue of compassion for those who make less.

The previous few generations did not accrue much in savings, but they did have defined pension plans for their retirement. A pension paying $75,000 a year is equivalent to having a $1.7 million portfolio for your retirement. As we all know, however, the days of defined benefit plans are largely over. We need to grow our savings to more than $1 million simply to fund a modest retirement. The government can help us reach that goal by eliminating the capital gains tax.

Every economist worth his PhD agrees that the correct rate for the capital gains tax is zero, zip, nada. Some have even suggested the optimum tax rate for capital gains is negative! Unfortunately, all the 2008 presidential hopefuls (except for me) who would reduce or eliminate the capital gains tax have dropped out of the race.

Certain proposals regarding the capital gains tax are totally unrealistic. Some would like to impose ordinary income tax rates on capital gains; others want to raise the rate to 28%. Many people divide the nation between those who have an adjusted gross income over $75,000 and those who do not. All of the suggestions just described will dissuade Americans from saving and investing, the very activity we should be encouraging.

Under these rules, if your investment assets earn an 8% return, you will be unable to make any progress toward your goals. Five percent of your return will just keep up with inflation, and you will owe 2.24% for a 28% capital gains tax. You would only be left with a 0.76% real return after taxes and inflation. And at ordinary income tax rates, your return would be even more dismal. At these rates, everyone with taxable investments in the market would do better to pull their money out and buy municipal bonds and Treasuries.

Hopefully there isn't a chance these policies would be implemented, but I use a candidate's views on economic matters to judge his or her competence. I find this year's choices particularly discouraging.

We need an incentive to save and invest in order to create an economic environment that encourages the hard work and risk taking that pays everyone's salary. Investment is simply capital, and capital is simply deferred consumption. Why defer consumption if you are penalized for it?

Investment is what builds the factories, businesses and entrepreneurial endeavors that actually make money. Investment stimulates the economy, and as the economy grows, jobs are created and real wealth is produced.

The prospects for our Social Security system look bleak. There won't be enough money to support the number of retirees. Chances are only the worst off will receive anything significant from current funding. Now the political winds are blowing to make saving and investing for your own retirement much more difficult. It seems as though "fair" is being redefined as everyone being impoverished and reliant on the government.

Without incentives, we may as well all go have another latte.

from http://www.emarotta.com/article.php?ID=272

Learning to Live on Your Own, Part 2 (2008-02-18)

Learning to Live on Your Own, Part 2

(2008-02-18) by David John Marotta

Last week we discussed the many ways you can save money as you learn to live on your own. Our suggestions included sharing housing costs, buying a previously owned car with cash, preparing meals instead of eating out, and eliminating the frills from services that are deducted automatically each month from your checking account. Here we offer some sound advice on how to put that money you've saved to work for you.

First, look carefully at your company's benefits plan. Disability insurance is probably the most neglected insurance. Consider signing up through a work plan. More employers are implementing health savings accounts, which allow you to pay for your medical expenses with pretax dollars. They are coupled with a high-deductible health insurance plan. If you are young and healthy, these provide you with disaster insurance as well as health-care insurance savings. If your employer has one, put the maximum away annually, and invest it if possible.

All the pundits say, "Save as much as you can," which is fine advice but not specific enough. You need to take a substantial chunk of change out of your discretionary money each month, some before it even makes it to your checking account and most of it after you deposit it. The amount, about half your take-home pay, may seem excessive at first, but remember, you are trying to grow rich, not live rich.

As your first priority, get the benefit from your company's 401(k), which usually amounts to contributing 5% of your salary while your employer matches with another 4%. This is the portion we mentioned that's deducted before you ever see a paycheck. If your employer has a health savings account, the money you contribute will also come out before your collect your paycheck.

After these deductions, you probably have the remainder of your paycheck deposited automatically into your checking account. You should then automate a transfer out of your checking account into an investment account to meet many of your long-term financial goals. Money in your investment account will appreciate. Always keep your goals in mind and stay on track.

For example, make a list of all the big-ticket items you will need to pay for over the next several years. You need to pay your car insurance. Transfer the appropriate monthly amount to your investment account. You should be saving for your next car. Transfer the appropriate monthly amount to your investment account. All of these significant purchases may comprise around 10% of your take-home pay.

You should be fully funding your Roth IRA while you are young and in a relatively low tax bracket. For 2008, to meet the $5,000 limit for your Roth IRA, you need to save $416 a month. Put this money into your investment account and then transfer it once a year to a Roth IRA account.

Save 5% of your take-home pay in a taxable account allocated for your retirement. This is after fully funding your 401(k) match and your Roth IRA. There are times in life when you will need taxable savings, and you should be saving and investing 5% of your take-home pay.

Save and invest 10% of your take-home pay for charitable giving. As your investments earn money for you, you will give appreciated assets to the charity and replace the same dollar amount from your take-home pay. Donating appreciated assets provides an additional 15% tax savings.

Finally, as a margin of safety, save and invest 10% of your take-home pay to help cover the cost of unknown unknowns. If your first response to this suggestion is to ask, "Like what?" the answer is "Exactly." Most people who run up credit card debit keep their regular spending within 100% of their take-home pay until some unexpected expense causes them to deficit spend. You can't anticipate unknown unknowns, so the best you can do is set aside some money to cover them when they arise

All of these expenses can easily comprise half of your take-home pay. Even if you've landed a good paying job straight out of school, don't spend over half of your take-home pay on daily expenses. Transfer half of your pay directly to an investment account and let it start growing. Cash in the bank is the best financial security. Cash doubling in an investment account is the best financial future. By the time you need money from your investment account for some of those long-range purchases, ideally it will have already started earning a nice return.

Saving and investing should be automatic. You won't miss what you don't see. Have half your take-home pay transferred out of your checking account and into an investment account each month.

Live simply. Avoid buying items you have to store, repair and maintain. Produce twice what you consume. Be generous. Avoid liabilities you have to pay each month. Invest in assets that pay you instead. Do these things and you will have a peace of mind that your contemporaries may never find.

from http://www.emarotta.com/article.php?ID=271

Learning to Live on Your Own, Part 1 (2008-02-11)

Learning to Live on Your Own, Part 1

(2008-02-11) by David John Marotta

If you're like most of today's college graduates, you may find yourself ill prepared for the real world of financial responsibility. You never saw how your parents lived when they were first married and struggling. Consequently, you may be basing your after-school expectations on an upper-middle-class lifestyle. Here is my financial advice for those of you learning to live on your own.

My own financial education began when I was very young. My parents shared openly with us about the cost of running the household. I learned our home mortgage was $12,500, or about half the value of the house, and the interest rate on the loan was 4.5%. I knew my father's annual salary ($7,500) and that a week's worth of groceries cost $20 for a family of five.

Although you have to count on spending about 6.58 times more than that today, the principles of proportional living I learned are still the same: You can look like you are rich or you can actually become rich by saving and investing. Wealth is what you save, not what you spend. So be rich. Live frugally, and learn to save and invest.

The people who are struggling financially buy things and clutter their homes with them. The middle class buy liabilities such as boats and vacation homes and must spend money every month to maintain them. The rich, in contrast, buy investments. An investment is anything that pays you money.

Now that you are learning to live on your own, learn to live like the rich. The frugal millionaire enjoys both financial security and peace of mind. Living well within your means is a skill you may not have picked up from your parents or in school. Rather than learning from the so-called school of hard knocks, consider the following suggestions.

Rent is probably your biggest expense, but keep it well under 20% of your take-home pay. To lessen the impact, share your living quarters with roommates. If you learned nothing else in college, you at least found out how to share a room. Later on, when you get married and want your own place, you'll need the money you can save and invest now.

Whoever actually signs the rental agreement or lease and pledges to pay the rent on time each month deserves a better financial deal. That person should be able to charge his or her roommates more and also get first pick of the rooming options.

If you decide to live in a house or apartment and sublet, make sure to factor in the possibility that a roommate may leave without notice, owing you rent. Insist on a sublet agreement that requires the first and last month's rent to lessen the impact.

Your car ranks as your number-two expense. Again, keep total costs well under 18% of your take-home pay. With the salary at your first job after college, you probably can afford to make the payments on a trendy new car. Don't. Expensive cars increase both your insurance and your maintenance costs.

Be practical. Your car is a means of transportation, not a lifestyle. Buy a reliable car that has low maintenance costs. One that is at least a few years old will have already depreciated the most.

Only buy a car you can pay for with cash. Shun easy credit. The only decision that's worse than buying a depreciating asset is buying that depreciating asset on credit. Paying interest on an asset that's going down in value may buy you a ticket to the poorhouse. Instead, start saving some of your monthly salary immediately for your next car.

After rent and transportation comes buying food. The average family spends 10% of their take-home pay on food. If you don't eat out, you should spend about 6%. When your earnings increase substantially, perhaps you'll be able to justify saving food preparation time and eating out. But until then, the time you spend cooking is well worth it. The calories you purchase at restaurants are about 2.5 times as expensive as those you prepare at home.

For example, if you brown bag your lunch all week, you can easily save $5.40 a day. Saving $27 each week adds up to $1,458 per year. After factoring in the rising costs of eating out and investing your savings in the stock market where they will grow and multiply, the difference to your net worth is amazing. Investing $27 each week will produce $100,000 in 20 years and $1 million in 40 years. Bring your lunch from home starting at age 20, and you'll have an extra million dollars at age 60!

Eating at home isn't the only way to save money. To extend your savings to the grocery store, here are a few commonsense rules that will lead to uncommon cents savings.

For dinners, master a dozen easy-to-prepare meals. If you can read, you can cook. Keep staples on hand to make these meals. Consider a bread machine and a slow cooker as essential purchases.

Plan your meals when you are hungry, but shop right after you have eaten. Shopping on a full stomach will help you limit impulse purchases. Make a shopping list. Buy staples in bulk at super discount stores.

Avoid convenience packaging and expensive processed foods. Try buying the generic store brand. If you don't like it as well as the leading advertised brand, many stores will refund your money. Actually compare the prices. Most stores make the bulk of their profit from products placed at eye level.

You don't have any extra in your budget for monthly services. You have only about 6% more to spend, and the remainder you should be saving and investing. You may tend to ignore the services that are billed automatically each month, but they will be the most serious drain on your finances. So consider getting the least expensive package of features or doing without entirely. These electronic transfers include phone service options, cable or satellite TV, high-speed Internet, and health club dues.

Next week, in the second part of this series on learning how to live on your own, we discuss how best to manage the money you're saving by living frugally.

from http://www.emarotta.com/article.php?ID=270

For Now, Avoid Real Estate Investment Trusts (2008-02-04)

For Now, Avoid Real Estate Investment Trusts

(2008-02-04) by David John Marotta

I received my county real estate tax bill recently, and for the first time in several years, my property tax assessment went down by about 2.8%. The drop is very small, but the trend is significant. Commercial real estate investments fell sharply during 2007 and may underperform other investment choices during 2008.

Investors commonly purchase real estate through a real estate investment trust (REIT) that buys and manages properties. These are publicly priced and traded, and collections of REITs are available in mutual funds and exchange-traded funds.

Just over two years ago, we warned our readers that real estate prices might be peaking and ready to correct. We wrote, "A bubble is never known until after it has burst. What can be suggested is that the housing prices boom shows signs of weakness, and that they may correct or at least underperform for the next few years. Higher interest rates will slow housing growth in 2005, but the bubble, if it is a bubble, could pop as late as 2006 or 2007."

But getting out of real estate two years ago would have been a year early. It wasn't until 2007 that the Cohen & Steers Realty Majors Index turned negative, losing 18.03%. In fact, the three-year average is still positive, averaging 9.69%, and the five-year average is a whopping 19.79%. In the foreseeable future, however, we are very unlikely to see as much appreciation as the last five-year average.

Most real estate property sectors declined last year. Sectors with longer leases did the best. Health-care leases had a positive total return of 2.5%. The industrial sector of REITs was also positive. Apartments suffered one of the largest declines, down 25.4%. The office sector was also down 19.0%.

Since 2000, U.S. markets have experienced the ripple effects of the tech sector's correction. The latest waves were the slow decline of the housing market and the weakening of the commercial real estate market.

As a result of the 2001 recession, the Federal Reserve lowered interest rates to help stimulate the economy. These new rates created an unprecedented increase in lending activity in everything from refinancing for mortgage equity withdrawals to commercial real estate loans.

Lower interest rates also boosted available credit and the speed at which dollars were moving through our economy, in essence expanding our money supply. Lower interest rates for mortgages drove housing prices up. As interest rates hit historic lows, home buyers could now afford houses that previously were out of their price range. For example, in March 2000, a family with a 30-year fixed-rate mortgage at 8.4% could borrow $131,000 with a $1,000 monthly payment. By the time the interest rates had dropped to 5.4% in June 2003, that $1,000 monthly payment would service a $178,000 mortgage.

Housing prices soon skyrocketed in absolute dollars, but they were not rising as much in terms of monthly payments. Lower mortgage rates, along with a devaluation of the dollar and the resulting higher prices for all hard assets, explain the rise in housing prices over the past several years.

The rising real estate market boosted consumer spending in three ways. First, homeowners--because of rising home values--enjoyed a higher net worth and therefore spent more money. Second, low rates encouraged a huge turnover of houses, resulting in intensified levels of consumer spending as the new owners refurnished and remodeled homes and rentals. And finally, homeowners refinanced or set up equity lines of credit, turning their houses into virtual ATM machines.

As a result of Americans using their homes to finance bigger spending habits, their home equity began to dwindle. Many mortgages grew to exceed 80% of the home's value. Then the Federal Reserve started to raise rates.

Homeowners with adjustable-rate mortgages saw their monthly payments jump. Many found it impossible to stay in their homes. The rate of late payments and foreclosures increased, resulting in some of the lenders themselves declaring bankruptcy. Rising interest rates caused housing prices to fall.

Studies suggest that for every 1% drop in housing prices, the gross domestic product (GDP) could drop by 0.2%. Looking ahead, if falling home prices continue along with a slowing economy, the situation could result in a recession. Declining prices in housing would have a direct effect on company earnings and thus stock prices. If the real estate market does experience a downturn, the effects will continue to ripple through the economy.

More recently, Fed rate cuts have still kept mortgage rates near their low end. But if you haven't refinanced your home with a 30-year fixed rate, this is your last chance. As rates rise, home prices will continue to decline.

Short-term trends are difficult to predict accurately, but with foresight and a sound investment approach, you can still profit from some long-term trends. Diversifying your portfolio across noncorrelated asset classes is the best way to earn steady long-term returns while managing risk.

Investments in REITs are grouped in the hard asset stocks category, but C&S Realty's correlation with the GSSI Natural Resources Index is low at 0.23. Correlations change over time, but they haven't gone above 0.43 in the past three years.

Investing in REITs during normal markets makes a lot of sense, but we suggest you continue to steer clear of them for the coming year. The beta of REITs versus the S&P 500 is currently about 1.68, which means REITs are about 1.68 times more volatile than the movements in the S&P 500.

Perhaps 90% of wealth management is avoiding the financial products and mistakes that surround us and compete for our attention. Real estate may seem attractive with today's choppy U.S. markets, but we suggest you keep your money invested elsewhere until the Fed is done raising interest rates.

from http://www.emarotta.com/article.php?ID=269

Market Volatility Is Back (2008-01-28)

Market Volatility Is Back

(2008-01-28) by David John Marotta

Normal market volatility has returned, and with it investors are tempted once again to jump in and out of the markets.

Shifting a significant portion of your assets between different types of investments to try and maximize profits may seem like a smart investment strategy. But academics, for example Burton Malkiel, author of "A Random Walk Down Wall Street," believe timing the market is impossible. Active traders and get-rich-quick advocates disagree. They claim to have seen it work in practice.

Most average investors, unfortunately, make the worst possible timing decisions because of their fear or pride. These feelings can dim the vision and distort the thinking of even seasoned investors, fooling them into concluding that their recent experience represents an inevitable trend.

On average, U.S. stocks provide a 10 to 12% return, so you may think you have found the answer by investing all your money in aggressive growth stocks. But since 1937, the S&P 500 has only had four years when the returns were between 10 and 12%. Usually they come in wildly over or under the average. So if you're counting on 10 to 12% returns, you'll find the ride extremely bumpy and the likelihood of meeting your projections nearly zero.

More commonly, returns over a four-year period are 18%, 18%, 18%, and then down 10%. In statistical terms, market returns form a bifurcated bell curve with two peaks, one well above 12% and another well below 10%.

None of the standard statistics you learned in college can explain this excessive volatility. Market corrections such as those that occurred in 1987 are so uncommon, they could never happen under the rules of standard deviation, and yet they do. Hence the bell curves of market returns are sometimes described as having lumpy tails, meaning that extreme events happen with some regularity.

Mathematicians challenge the assumption that market returns fit any sort of Gaussian bell curve. Benoit Mandelbrot formulated the math that describes the seemingly infinite variance found in the markets. Nassim Nicholas Taleb, in his bestselling book "The Black Swan," recently popularized these ideas. Taleb suggests you stay humble about your predictive powers and have the rare courage to say, "I don't know."

The primary application of volumes of mathematical analysis is to remember that the markets are inherently volatile and we just don't know what they will do next. The math suggests they are probably even more capricious than we have yet seen historically. Financial news organizations report that the markets are currently dropping, but all we know is they have been dropping. To say they are doing so now implies that their past downward momentum somehow influences their current movement, which is not the case.

The U.S. economy may face a serious recession and the markets may continue to fall. But the markets may just as likely be done dropping and will appreciate again soon. You can miss over half of the growth during a decade if you discount the top five days of each year. Those best days often come at the end of downward trends. By jumping in and out of the market, you risk missing the lion's share of a portfolio's growth. Therefore it is to your advantage to remain invested according to a diversified asset allocation.

Staying invested does not necessarily mean staying invested in your current asset allocation, however. Going forward, the best defense is always a well-diversified portfolio. If you did not have enough foreign stocks, you should sell U.S. stocks and buy foreign. If you did not have enough hard asset stocks, you should sell U.S. stocks and buy hard asset stocks. But if you've had a balanced portfolio and now your U.S. stocks are down and your bond portfolio is still up, you should sell bonds and buy U.S. stocks to rebalance your portfolio.

If you have set up an appropriately diversified asset allocation, then whenever you are unsure about what to do, simply rebalance your portfolio. This contrarian move will help you buy low and sell high and save you from chasing performance.

For example, imagine your portfolio has only stocks and bonds. If stocks have done well, applying a rebalancing strategy will help you sell some stocks when they are high and put money into bonds when they are low. If stocks have performed poorly, then rebalancing to sell some bonds and buy stocks will most likely be smart. Rebalancing will save you from trading too much to chase recent market performance, nearly always a poor idea.

Although implementing a dynamic asset allocation may allow you to boost returns, the average investor usually does not have the time or the expertise to analyze the numerous factors needed to construct this kind of model. In this situation, the help of a fee-only financial advisor can really make a difference. Visit the National Association of Personal Financial Advisors (www.napfa.org) to find a fee-only advisor in your area.

Lastly, if you think hiding money under your mattress, as it were, is a risk-free way to build wealth, think again. Cash has been one of the riskiest investments since 2002. Many investors try to stay safe by putting their money in a bank account or investing in CDs. But like any other investment, cash carries its own set of risks.

Cash is dangerous because the dollar can be devalued. When our currency decreases in value, we experience inflation and the purchasing power of our dollars is compromised. Having the same amount of dollars doesn't do you any good if your money won't buy as much as it did before.

Michael Joyce, former chairman of the National Association of Financial Advisors (NAPFA) and current president of the NAPFA Consumer Education Foundation, spoke in Charlottesville last weekend. He reminded the audience of the wisdom of this maxim: The person invested entirely in U.S. Treasury bills sleeps well tonight but eats poorly in 10 years. Treasury bills may be a safe and stable investment, but they won't help you with the goal of building real wealth.

from http://www.emarotta.com/article.php?ID=268