The Economics of the Holidays

Most people are probably aware that more money is spent around Christmas time than any other time of the year. One estimate by Joel Waldfogel of the Wharton business school at the University of Pennsylvania concluded that $66 billion was spent by Americans on gifts in 2007. It is also estimated that 135 million Americans participated in Black Friday (the day after Thanksgiving and first day of the traditional Christmas shopping season) in 2007.

Considering the dollars spent and the enormous number of people involved, there are some significant economic lessons that can be learned. I love the holiday season, but like many things, I try to take a practical, analytical view at times and see what I can learn about human behavior.

1) Much of the holiday spending is unnecessary, or at least unappreciated. I don't recommend that everyone think selfishly, but Waldfogel also estimates that $12 billion of the $66 billion spent each year is inefficient spending, or money that the recipient wouldn't have spent on themselves. Gift giving is a wonderful tradition, but gift cards, cash or more educated purchasing can result in a more economically effective Christmas.

2) Consider giving to those who are truly needy instead of excessively giving to those who aren't needy at all. The percentage of GDP produced at Christmas time has actually decreased over time, so maybe we are improving our behavior a bit here.

3) Think about the long term value of Christmas gifts or decorations. Many products are designed for the "wow" factor, but are expensive or underutilized over a longer time period. Artificial vs. real Christmas trees and regular vs. LED Christmas lights have various costs and benefits that should be considered.

4) Certain gifts and traditions are not critical to a good Christmas. The most meaningful things are time together with family and friends and traditions that promote giving, peace and harmony amongst people.

Despite my tendency to focus on the economic side life, I love the positive, uneconomic parts of the holiday season. Like many significant events in life, Christmas provides an opportunity to think about the costs and benefits of various financial decisions and how they fit into a sensible long-term financial plan.

Tax Rates - Where are They Headed?

A pretty strong consensus exists that tax rates are going up. The massive deficit spending and entitlement programs of our government make this a near necessity. Different political parties will express different solutions to our current fiscal crisis, but rising taxes is included in many of these. Although most people don't like paying taxes or the prospect of increasing tax rates, awareness can help us plan and be prepared for these impending changes.

Personal Income Taxes - It is unlikely that personal income tax rates will change in 2009 or 2010. The Bush tax cuts will expire at the end of 2010 and the top tax rate at that point will revert back to 39.6% from a 35% rate today. A surtax for high-income individuals has been proposed in various health care proposals, but this should not take effect until 2011. A higher capital gains tax rate and other tax increases would likely also take effect then.

Estate Taxes - The current estate tax is set to expire at the end of 2009, with no estate tax being due in 2010. It is extremely doubtful that Congress would let this revenue source go away. Various proposals are being debated in Congress right now. The current estate tax rate of 45% and the current estate tax exemption amount of $3,500,000 per individual could change, but this should become clearer in the next several weeks.

Business Income Taxes - Business income tax rates have not changed much recently, but Congress has implemented various bonus depreciation deductions and additional loss carryback provisions to try to give businesses tax breaks in recent years. A more comprehensive business tax overhaul is possible in the next couple years, but these changes are unclear at this point.

Taxes are a significant part of all individuals and families' financial situation. Although the tax impact of various financial decisions should not be the primary consideration, awareness of current and future tax rates and deductions is an important part of any financial plan.

Is Growth Returning?

The third quarter GDP (Gross Domestic Product) report was released today and it showed an increase of 3.5 percent. This means that the total value of all goods and services produced in the United States from July to September grew 3.5 percent from the prior quarter. This quarter of growth follows four consecutive quarters of decreases and officially marks the end of the current recession.

Is this all good news? The answer can be "Yes" or "No," depending on how you interpret the news and who you are talking to. It is a good thing to see some growth in the American economy again. We all benefit from growth and progress in our economy and standard of living. One caveat though, is that the American GDP is still 10 percent below where it was at its peak in 2008. The unemployment rate also stands at 9.8 percent, which is the highest it has been since the early 1980s.

Many corporations have shown earnings growth recently, but much of this is due to cost cutting as opposed to revenue growth. Much of the GDP growth was also due to consumers purchasing automobiles, many encouraged by the "Cash for Clunkers" program. Government spending in general has also been higher than normal recently.

An ideal situation is an economy experiencing fairly consistent, sustainable growth with low unemployment. The American economy has experienced this situation in the past and should again in the future, but much government intervention needs to be reduced and rolled back so the U.S. economy can stand on its own. American workers and consumers have the will and the desire to see our economy succeed. Our economy will move forward from a stronger base once a recessionary period is behind us. No one knows how the next few years will play out, but we are seeing more and more positive signs.

The Costs of Investing

Much has been said recently about a new sense of frugality in our economy. Down markets and higher levels of unemployment have a nasty way of forcing people to be more frugal. Whether this frugality continues is yet to be determined, but one thing is certain--consumers are more price conscious in today's environment.

So what is the price of investing? When I say price, I'm referring to the transactional or management cost of investments. The risk associated with stocks and bonds and the potential cost due to realized losses is another topic and a separate discussion. There can also be tax costs associated with investments which I won't address in this post.

The do-it-yourself investor will need to set up an online trading account and will typically pay a trading commission of $8-20 each time they buy or sell a stock. There might also be an annual maintenance fee. Mutual fund trades can have transaction fees, or might be "no-load," which means there isn't an initial cost to purchase the shares of the fund. Mutual funds also have ongoing management and trading costs, which can be quite significant. These costs are disclosed, but not easily obtainable or comparable for the individual investor. Mutual funds can also have front end (purchase) or back end (sales) charges.

The investor working with a professional financial advisor will typically pay on a transaction or ongoing management basis. Some advisors will also consult on an hourly basis. The transaction cost is often a commission or front end charge that is passed on to the advisor. Mutual fund management fees are also shared with advisors at times and surrender charges cost the investor for selling out of an investment before a specified period of time has passed. An ongoing management fee is typically charged based on the value of an investment portfolio.

The myriad of costs, fees, loads and commissions are often complex, confusing, and at times, unnecessary. They tend to enrich the advisor at the cost of the client or investor. Although any professional investment advisor needs to be compensated to make a living, I recommend three things to keep in mind with regard to investment costs.

1) Costs should be fully and completely disclosed. Financial advisors are more likely to hide their fees if they are unnecessary or unreasonable.

2) Costs should not be charged at multiple layers, if possible. Investing can be done in an efficient, institutional manner where costs aren't charged at many layers without any corresponding benefit.

3) The financial advisor's compensation should be fully aligned with the client's best interest. An advisor shouldn't be paid solely for a "sale" without any ongoing accountability for client success and service. Commission-based salespeople are motivated to convince you that their solution is the best because that is how they are paid.

Investing significant financial assets in an appropriate manner can be critical to a prosperous and flexible financial future, but careful attention should be given to the price of investing before moving forward with an approach.

Will America Still be No. 1?

The recent economic times have caused some to question whether America will continue to be the economic superpower it has been in the past. The World Economic Forum recently ranked the United States number two behind Switzerland amongst the world's most competitive economies. While I'm a strong believer in a free-market economy and the uniqueness of America rooted in the ideals of our founding fathers, no one can say how the American economy will compare to other world economies several generations into the future.

As an investor, what should you do to adjust to this potential new reality? It really comes back to one of the basic principles of investing - diversification. Any well-designed investment portfolio should take a world view and include more than just U.S. stocks and bonds. Developed and emerging international markets should also be considered. European and other developed economies, along with emerging markets like China and India, can diversify the risk of a portfolio while potentially increasing the return.

Which countries should be invested in and in what ratio? More emphasis should be put on developed economies because of a longer track record and stronger government regulation and controls. Emerging markets offer enticing potential returns, but they bring increased volatility and the added risk of unstable governments or unethical practices. Limited emerging market investments are appropriate for most investors. The world economic landscape is always changing, but these changes create opportunities to adjust a portfolio to capitalize on the new economic realities.

Finance - It's About More than Money

Finance types like me might view money as a practical, unemotional topic. It's all about what comes and what goes out in dollars and cents, right? My professional and life experiences have taught me that it is often a lot more than that.

I attended a presentation this morning at my local chapter of the Financial Planning Association. The speaker, a counselor and expert on the emotional sides of money confirmed the role emotions often play. She pointed out that Adam Smith, the famous economist who wrote "The Wealth of Nations" in 1776, first wrote about how our mental fallacies can influence economics in "The Theory of Moral Sentiments" in 1759.

Money is a representation of our efforts, our blessings, and our good fortune. It can be used to provide for the necessities of life or to acquire the luxuries of the world. What we do with that money is largely determined by our values, morals, habits and desire for instant versus long-term gratification. How a husband and wife feel about money is often illustrated when they make a significant financial decision together. These feelings are often rooted in much more than the item at hand. Children often model the behavior they see in their parents.

As an individual, I try to consider what is behind my financial decisions and consider all parties involved and the greater good, not just my own biases. As a financial professional I use my education and experience and the non-emotional role I play in significant financial decisions to help my clients. I care greatly about their financial successes, but I separate myself from the emotional decisions that may be holding them back from even greater practical success in their lives.

The Value of a Certified Financial Planner

A select group of professionals have attained the CFP® certification and are referred to as a CERTIFIED FINANCIAL PLANNER™. Other individuals may use the title "financial planner," but have not earned the official designation. What is a CERTIFIED FINANCIAL PLANNER™ and what should one expect from a financial plan?

CFP® certificants are individuals who have met the CFP Board's education, examination and experience requirements, have agreed to adhere to high ethical standards and complete biennial continuing education requirements. Although many other respected financial designations exist, the CFP® is considered by many to be the best example of a professional qualified to give comprehensive financial advice to individuals and families.

Most CFP® certificants will work with individuals to prepare a comprehensive financial plan. Like any goal in life, it is difficult to reach financial goals without a plan. This plan is unique to each individual, but it should cover the areas of saving for future goals, investing, taxes, risk assessment, insurance, and estate planning. Although these considerations are overwhelming to many people, a good CERTIFIED FINANCIAL PLANNER™should help reduce these burdens by boiling down significant financial decisions into manageable tasks. A good financial plan will involve an significant investment of time and money by the individual, but it will pay for itself many times over if it is properly implemented and updated over time.

Is it different this time?

The significant economic events of the past year have caused many to proclaim that traditional buy and hold investing is no longer valid. Supposed experts have also proclaimed that modern portfolio theory is dead. I've also read that the efficient market hypothesis no longer works. Have things changed in the U.S. or world economies so much that the tested, proven and researched tenets of modern investing no longer hold?

I would argue that things haven't changed and the modern ideas of investing are still correct. History has changed. Although history tends to repeat itself and what we've seen recently has happened before, many of us are seeing economic events occur that have not happened in our lifetimes. The reaction to these recent events by individuals and our government has been somewhat unprecedented, but that is a political discussion I don't want to get into at this point.

The efficient market hypothesis states that markets are efficient and asset prices reflect all known information or instantly change to reflect new information. The enormous amount of market volatility that we've seen recently has been due to the enormous amount of economic uncertainty. Once the uncertainty starts to recede, the market will react, as we've seen with some of the positive information being reported recently and the corresponding positive move in the markets.

The efficient market hypothesis is the best working model of how world markets function. The best way to invest in markets is to develop a diversified portfolio (Modern Portfolio Theory) with the appropriate amount of risk exposure. As opposed to markets "failing," much of recent economic history has been due to investors reassessing their level of risk and making appropriate adjustments. Despite the economic pain that has been inflicted on many, recent events have been an opportunity to really experience market risk and why the return premiums from holding equities (stocks and mutual funds) exist. Can we learn valuable lessons from this or are we bound to repeat these cycles again some time in the future?

Watch this eight minute video to hear Eugene Fama, the father of the efficient market hypothesis, share his views.

Cash for Clunkers

Considering my personal interest in automobiles and the recent headlines, I decided to write a bit today about the "Cash for Clunkers" government program. This program was set up to encourage people to trade in older, less-efficient cars and replace them with new, more efficient cars. This trade was encouraged by making $3,500 or $4,500 government rebates available to automobile dealers. The auto industry has been suffering lately because of the overall economic situation so this program was set up to encourage additional new car demand, which has been sorely lacking in the last several months.

The overall idea of the program sounds nice, but there are several unintended consequences and costs that seem to be ignored or set aside. Some of these are also political considerations, but I will try to present an objective analysis.

1) Should we (as taxpayers) be using $1,000,000,000 (soon to be $3,000,000,000) to subsidize and encourage automobile purchases for a very small subset of our citizenry? Are the resulting economic effects great enough to consider this investment?

2) Should the government decide for us or narrow our choices when it comes to purchasing an automobile? I am a strong believer in efficiency and economy in all areas of our lives, but we sacrifice more and more of our personal liberties as we grant our government control over more and more of our decisions. A market economy, with the painful, yet necessary and beneficial ups and downs will take care of these decisions naturally, but often on a differently timetable than those in government might like.

3) What about the independent auto repair shops that have been servicing these clunkers? These are small businesses in America that also contribute to the economy. Once again, I am a forward thinker that embraces progress, but removing so many older cars so quickly is an abrupt end to a part of many mechanics' livelihood.

4) Should the government play such a role in influencing consumer behavior? Should we encourage people to continue spending when overspending caused many of the problems we're seeing in the economy right now? I know of several people who have sped up or delayed auto purchase decisions because of this program.

5) What is the best future for the U.S. transportation industry? Should the government be making these decisions or should the private industry respond to what consumers want? The government can help to influence some of the decisions of the uneducated masses, but when does this become a threat to our personal liberties?

The recent changes in the U.S. and world economy have brought significant amounts of government involvement in economic decisions. Although some of this has been beneficial, many of these decisions are made more effectively on a local or family level. I am relieved to see some positive signs in the economy of late, but I am also wary of unintended consequences that our "helpful" elected officials might be bringing upon us.

Do You Need a Fiduciary?

In order to answer this question, one must first know what a fiduciary is. A simple definition is someone who puts your interests first, or someone who is working for you. Considering the importance of financial affairs in our lives, I would assume that almost anyone would want to know that his or her financial advisor was held to a fiduciary standard.

Although the perception amongst the American public is that financial advisors are working with their clients' interest in mind, this is often not the case. Brokers are not held to the fiduciary standard. Instead, they are supposed to follow a suitability standard. This standard only requires that a client is presented a suitable investment product, versus considering the clients' needs first, as a fiduciary would. As a result, investors are often paying too much for a "suitable" investment, when a lower cost alternative might be available.

The recent financial turmoil has brought this inequity to light for many more Americans. Earlier today, the House Financial Services Committee held a hearing titled, “Industry Perspectives on the Obama Administration’s Financial Regulatory Reform Proposals.” The Financial Planning Coalition, made up of like-minded financial advisors who put their clients' interests first, testified in favor of a proposal that would require all financial intermediaries who offer broad-based financial advice to be subjected to the high standards of a fiduciary. Although regulation should be carefully implemented in order to prevent too much government intervention in our economy, this new standard would be a benefit to many Americans and their financial well-being. I encourage you to contact your U.S. government representative to express your feeling if you agree.

Is Real Estate Investing a Good Idea?

Real estate is something that will always be there. It is the ground we live on or the structure we work and live in. For this reason, it is something of value. The population of the earth isn't decreasing and the prime places to live and work aren't increasing. This seems like an obvious formula for success as an investment. Many people have made fortunes investing in real estate, but the average investor doesn't always have this experience. Why is this and what has recent history taught us about investing in real estate?

Many Americans are homeowners and, as a result, they became aware of the significant increases in home prices of recent years. This seemed to be a ride that many people were taking to easy prosperity. No one wanted to be left behind so more and more people jumped on for the ride. Like any speculative bubble, the residential real estate market has come crashing down and many novice investors have suffered with the crash. Many people are now avoiding real estate of any form and regretting their decision to invest in this market. Is this the best thing to do?

Your home is often your most valuable asset. Not only does it provide a place to live, but it allows for tax breaks and a forced savings plan (through paying down a mortgage and building equity over time). As a result, buying a home within ones means is not a bad decision. The idea of your home as the primary means to build wealth does not always make sense, though. Over the past twenty years (which included the housing bubble) home prices have averaged gains of just 3.6% a year. Stocks, on the other hand, have averaged gains of 8.4% per year (including the recent downtown in the stock market).

I'm not saying there isn't a place for real estate in a diversified investment portfolio. There are professional real estate managers and ways to invest in commercial real estate in a prudent, diversified manner. My experience and history have taught me that a home should be primarily a home and investing in real estate beyond that should be done carefully, prudently and with a long-term, diversified approach, just like the rest of the investment portfolio.

Tax Consequences of Investing

The tax code is complex and constantly changing, but the tax consequences of building and maintaining a diversified investment portfolio are fairly straightforward. I will provide an overview of taxes and investments in this post and then delve into more details regarding specific investments at another time.

The federal tax system classifies taxable income in two ways. Income is considered ordinary income or capital gain income. The capital gain classification is then broken down into short-term or long-term capital gains. Ordinary income is taxed on a sliding scale in a progressive manner. This means that the higher your income, the higher percentage you typically pay in tax. Short-term capital gain income is taxed at your ordinary income tax rate. Long-term capital gain income is typically taxed at a flat 15% income tax rate.

Investment assets (stocks, bonds, mutual funds, CDs, etc.) are taxed in two ways. The first is the income that these assets produce on an ongoing basis. This income is taxed as ordinary income, except when it is qualified income and it is taxed at a 15% rate. The gain or loss realized from selling these investments, after holding them for a short-term (one year or less) period or long-term (greater than one year) period, is taxed at the capital gain tax rate described above.

As this basic introduction to investment taxability illustrates, the tax code is complex and convoluted. Despite being a Certified Public Accountant (CPA), I wish that Congress would enact a simple, straightforward tax system, as opposed to playing political games with our money. In the meantime, we are required to spend a lot of time learning how our tax system works or having professionals do this work for us.

Finances & Children

Being a father of four children, I'm becoming more experienced in this topic. My wife and I were also raised in large families and have discussed the various financial lessons we did or didn't learn as we were growing up. As my children get older, I want to make sure I'm doing what I can to pass on some sensible financial management skills, even if none of my children follow in my footsteps professionally.

The most critical thing a parent can do is to set an example of sound financial management. Even though we are all unique and born with different personalities, we tend to model some of the parental behavior we saw as children. Although I understand financial principles and could "justify" certain financial decisions, I try to consider the message I'm sending to my children. I can already sense the natural approaches my children might take to money by the way they manage their piggy banks, but I will never regret the positive influence I may have on their future financial decisions.

Example aside, what are some other things we can do as parents to teach our children sound money management skills? I suggest giving them financial responsibility at a relatively young age. This can be done by providing an allowance with expectations or helping them participate in entrepreneurial activities. Handing children money with no expectations doesn't encourage much learning, but adding some responsibility to meet obligations can encourage simple prioritizing or budgeting at a young age. Many children also like to participate in childhood businesses like lemonade stands, recycling, yard care, or babysitting. These activities teach important business skills at a young age before the decisions become more critical and life altering. These skills can also be taught through games like Monopoly or computer games like Lemonade or Zoo Tycoon. I try to make learning these skills fun for my children at this age so they are prepared for the time when money isn't always so much fun anymore.

Investing is a Way of Life

I have been thinking about purchasing a new car recently and this whole process has reminded me how many of life's decisions are better made when they are looked at as an investment. This also includes non-financial decisions, since just about all decisions we make involve a time, energy or emotional commitment. Some people might think I'm a little over-the-top to think this way, but this view on life can pay for itself many times over, just as a good financial investment can.

My current automobile has proven to be a worse investment than I would like to admit. This might have something to do with the fact that I suppressed a few of my governing principles when I made the initial purchase. I have since become a bit wiser and committed to not make the same mistake again. I am considering the total cost of ownership with the potential new purchase, including value, reliability, warranties, resale value, practicality and so forth. This is how any major purchase or decision should be viewed. Hindsight is 20/20, so we will never make all our decisions perfectly, but investing time up front and considering the total cost of ownership of an investment approach or financial advisor relationship is crucial.

In regards to the auto purchasing, there are many great values available right now, along with tax incentives. If you happen to be in the market for a new car (remember total cost of ownership) I have a link here on my blog to TRUECAR, a great new site that helps you discover what people are "really" paying for their cars. Cars are a neglected side interest that I have, so maybe I will blog more about the auto industry in another post later on.

Long-Term Thinking

Many trusted, well-grounded professionals in various fields will agree that true success rarely comes without discipline and a long-term perspective. Due to the amazing advances in technology and the pace of change in the world today, one might think that success can easily be achieved overnight. This does happen on occasion, but it is more the exception than the rule.

There are also great risks in approaching things with a short-term perspective. One need not look any further than Wall Street and the recent meltdown to see what happens to companies, financial markets and entire economies in this case, when too much emphasis is put on growth or profits in the short-term. The changes in the U.S. real estate market are also an example of how emphasis on short-term profits from "flipping" homes has wreaked havoc on many Americans, well beyond the guilty profiteers.

A recent analysis I did on the returns of a well-diversified portfolio showed that the typical average returns of various investment assets have not held up in more recent history. On the other hand, these returns do occur when the investment time horizon is extended to a generation or longer. This analysis, along with personal experience throughout my lifetime, confirms that achieving exceptional returns from the implementation of proven investing principles is a disciplined, long-term process.

What is Investing?

The dictionary states that investing is "to put (money) to use, by purchase or expenditure, in something offering potential profitable returns, as interest, income, or appreciation in value." Somewhat similarly, I like to define investing as an investor supplying capital to an investment market with an expectation of a future return. The expected return is dependent upon the market that is invested in and the risk commensurate with that market.

Many investment "managers" or "professionals" use the term investing to disguise purchasing of a product, gambling, or other types of irrational speculation. They claim to know better than the aggregate knowledge of publicly traded markets or have access to pricing "mistakes" that few others are aware of. Achieving investment returns greater than the market are only possible when taking on above market risk. This increased risk often becomes inappropriate to the point that investing has morphed into speculating or betting. The majority of the investors I know do not have the means or desire to take these type of risks with their savings or future retirement assets. As I continue to share my thoughts on investing, I will expand on ways to actually implement these ideas.

Life is a Risky Proposition

All parts of life involve risk. We all take risks with our travels, our relationships, our health, our purchase decisions and our investments, among others. Recent history has proven to be an especially risky time in the world of finance and investing. Despite these risks, we all turn to our inherent values or attitudes and move forward in life. My personal experience, education, struggles, training and common sense has taught me a bit about how to quantify these risks and deal with them in a sensible way. I have decided to begin publishing this blog in order to share some of my "sage" ideas and advice in the world of investments, financial planning, taxes and various other practicalities.