The Quiet Millionaire

The Quiet Millionaire: Part 7 - Give Me Investment Gains, Hold The Losses

Julie Rains — Sat, 26 Jan 2008 23:28:29 +0000

“Win by not losing” or rather win by minimizing losses during market downturns is the ticket to being an investment champion according to The Quiet Millionaire author and Certified Financial Planner Brett Wilder.

Here are the players in his investment strategy based on economic research that won The 1990 Alfred Nobel Memorial Prize in Economic Sciences (awarded to Harry Markowitz, Merton Miller, and William Sharpe):

Modern Portfolio Theory (MPT): “how wealth can be optimally invested in assets which differ in regard to their expected return and risk, and thereby also how risks can be reduced” developed by Harry Markowitz and the Capital Asset Pricing Model developed by William Sharpe. (Source: Nobel Prize website; see also Money Chimp's discussion of MPT)

Asset Classes: Bonds, Domestic Equities (Large Cap-Growth, Large Cap-Value, Mid-Cap, Small Cap), International Equities. Mr. Sharpe’s list of asset classes deviates slightly from Mr. Wilder’s list. For example, Mr. Sharpe has two asset classes for non-USA stocks (European Stocks and Japanese Stocks) whereas Mr. Wilder lists International Equities; Sharpe has Small Cap only but Mr. Wilder separates Small-Cap Growth from Small-Cap Value. (Learn about growth vs. value).

Reasonable Average Rate of Return (% annual growth desired) as defined by the individual investor.

Acceptable Volatility (see The Honest Dollar’s discussion of volatility) or how much you can stand to lose in portfolio value in any given year. Mr. Wilder recommends that risk tolerance of the individual investor be defined as a % of acceptable loss (e.g., would you go crazy if your investments declined 15% in one year?) rather than vague terms such as conservative, moderate, or aggressive.

Time Horizon or the years from now to when you will be using investments to fund a major purchase, college education of your children, retirement, or whatever you are saving for.

Portfolio Structure or Allocation Among Asset Classes is based on MPT and your investment profile (desired rate of return, risk tolerance, time horizon). A sample allocation from The Quiet Millionaire:
- Domestic Bonds 13%
- International Bonds 7%
- Domestic Equities Large Cap Growth 16%
- Domestic Equities Large Cap Value 16%
- Domestic Equities Mid-Cap Growth 4%
- Domestic Equities Mid-Cap Value 4%
- Domestic Equities Small-Cap Growth 6%
- Domestic Equities Small-Cap Value 6%
- International Equities 14%
- Specialty Sector Equities 14%
  Total 100%

Investments That Match Asset Allocations. Mr. Wilder recommends “low-cost mutual funds that are expected to perform better than their competitors categorized in the same asset class.” Choose between actively managed mutual funds (which are managed by a financial pro in hopes of outperforming the market index) or passive funds (index funds).

Performance Monitoring. Check your performance to see that you are on track with your investment goals but checking every day is not productive.

Portfolio Rebalancing. When growth occurs in an asset class, it becomes overweighted and not in line with your desired portfolio structure; so, periodically, you need to rebalance your portfolio. Mr. Wilder advises "Rebalancing should not be considered an automatic activity when the out-of-balance situation occurs because, strategically, it may be advantageous or prudent to delay or accelerate making shifts in certain asset classes."

In summary, from the book:

“The Modern Portfolio Approach to investing assures that more predictable performance results will occur during both the good and not so good investment environments. This is because a well-structured portfolio accesses multiple global economies for more investment diversification than can be accomplished with an unstructured portfolio consisting of too few asset classes and a limited number of individual holdings. The individual holdings within an undiversified portfolio typically have too high a degree of investment correlation, which means that all of the holdings go up or down in value at the same time.”

and from me (based on the book):

Investments increase in value over time.
If your time horizon is finite (and it is always finite, whether you are saving for a down payment on a house in 5 years or for retirement in 30 years), some of your investments will not reflect their true value at some point in time.
Certain asset classes will outperform other asset classes in a given time period.
Certain asset classes will under-perform other asset classes in a given time period.
You never know for sure which of these asset classes are going to perform better than average or lower than average.
If you spread out your investments in various asset classes, you will minimize (not eliminate) the fluctuations in your portfolio value while capturing market gains that occur over time.
When one asset class does well, it is likely that this performance will not continue indefinitely so it is best to rebalance your portfolio structure every once in a while.

Additional items of interest from Chapter 7:

Realize that media outlets promoting individual stocks, mutual funds, etc. are unregulated.
Understand that a negative investment environment can be positive, because you can buy stocks at relatively low prices especially if you continue automatic or regular contributions to your investments.

and from me:

Morningstar mutual fund ratings are based primarily on past performance and a risk factor so choose investments carefully and don't rely too heavily on one source of information.
The Vanguard 500 Index Fund is a Domestic Equities Large Cap fund (growth/value blend).

Using the right pick of investments, the MPT approach gives a structure to investing that yields gains, over time: “While investing may seem exciting when the investment environment is productive, it is when the going gets tough that uncertainty and fear set in, and it becomes more difficult to make smart decisions.” Being a champion doesn't mean never having a setback or loss but pressing forward with a winning game plan.

Note: I have received a copy of The Quiet Millionaire in exchange for a book review.

This article is from Julie Rains of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

The Quiet Millionaire: Part 6 - Are You Paying Too Much Tax?

Julie Rains — Sat, 29 Dec 2007 01:06:08 +0000

The Quiet Millionaire author and Certified Financial Planner Brett Wilder states that “Most ‘normal’ people think that the subject of taxes is an absolute bore and would much rather spend their free time thinking about more interesting, stimulating, and happier aspects of life.” Thankfully, I would be considered normal by this measure. Thinking about avoiding taxes, the focus of Chapter 6, however, is mildly exciting. I've selected some of Mr. Wilder's ideas and insight that I found particularly useful.

Plan tax reductions rather than just take tax deductions.
There is a difference between 1) gathering your tax information and preparing your taxes or having them prepared by a tax professional and 2) actively planning tax reductions, that is making financial decisions considering the immediate and long-term tax implications of your actions.

For example, if you are ready to capture capital gains on certain investments, then you might also sell shares on stocks that have lost value (and that you are planning on selling soon anyway). As a result, your gains and losses will be recognized in the same tax year and your overall taxes paid will be less than if you didn’t sell the losing investments.

If you are working with a CPA and/or tax professional, shouldn’t that person advise you on tax strategy? Mr. Wilder asserts (and I agree, based on my experience) that

“Even the most competent CPAs are too busy to do meaningful tax reduction planning for you during the height of the tax-filing season, so you need to constantly manage your tax situation as part of an ongoing comprehensive financial management program.”

So, consider:

Finding a financial advisor who keeps up with tax law and can recommend strategies based on your situation;
Meeting with your CPA during the off-season to discuss tax ideas;
Doing your own research and, if you are engaging a CPA, asking very specific questions regarding the feasibility, legality, and reasonableness of your tax reduction plans.

Mr. Wilder dispels two tax myths, beginning with

Myth #1 “Deferring taxes is always good”

Adhering to conventional wisdom will have you reduce your tax liability now. Here’s the upside: as a result of lower taxes, you can free up cash to pay off debt, reduce your need for borrowing, and/or invest savings to begin or add to your portfolio. Mark offers ideas on ways that you can reduce your taxes now if you’d like, such as paying your property tax bill before the end of the year.

But there may be reasons not to defer taxes (and as Mark notes may not be applicable to your situation). For example, if you graduated in May of this year and only have a half-year of earnings to report (June to December), you may not want to pay that property tax bill this year; next year those deductions might be more valuable because you may be in a higher tax bracket based on a full year of earnings (January to December).

Another reason not to defer taxes is that you may need to sell investments now to lock in profits. The sale will trigger capital gains tax but a possible decline in the value of the investments next year may be greater than the tax you’ll owe upon the sale this year.

Myth #2 “Taxes paid go down during retirement”
Retirement income and income tax planning may not be a high priority at this moment but it is useful to consider the possibility that you’ll need more money in retirement than you do now. The two big reasons you may need more are: 1) taxes will be higher and maintaining your standard of living will be costlier due to the impact of higher taxes and 2) things will cost more. Therefore, deferring as much income and income taxes as possible to the future may be damaging to your long-term financial well-being.

To address the unknown of taxes and income, Mr. Wilder offers this agrarian-based tax wisdom:

“…you may be better off not taking the tax reduction opportunity on the smaller amount being invested, the seed, instead of looking toward the gain of a bigger tax break on the larger amount coming out, the harvest.”

Funding Roth (retirement) and 529 (education) accounts are two great ways of paying taxes on the seed in order to avoid taxes on the harvest. There are no immediate tax advantages to funding either of these types of accounts. And if you are converting a tax-deferred account to a Roth, you’ll incur taxes now. However, if you’re a positive cash-flow maniac with a long-term view, you’ll love these benefits: 1) you won’t have to pay taxes on capital gains that occur when you trade investments and 2) you won’t have to pay taxes on withdrawals.

How do you know what’s best? Unless you are an income, investment, and tax prophet, you can’t see and know the future. So, Mr. Wilder allows that it is best to have funds in all types of accounts, which is certainly doable at least from a tax perspective. For example, it is possible to fund a 401(k) and a Roth IRA to lower your tax bill this year and future years. (Income restrictions apply).

Just for fun, I’ve got a few tax-savings ideas that may be applicable to your situation. These are inspired by The Quiet Millionaire and the IRS website:

Charitable contributions: If you are planning on using funds from investments to make a charitable contribution, transfer appreciated stock to the charity rather than sell the investment, pay capital gains tax, and donate the proceeds. This tip may be especially useful for someone who will be taking the standard deduction rather than itemizing deductions. The warning is that if that stock is going to be sold at a loss, you'll be better off claiming the loss on your taxes.
Volunteer expenses: Some, not all, expenses associated with volunteering are deductible. For example, you can deduct the cost of transportation to the volunteer site; you can’t deduct the value of your time or services.
Medical expenses: These expenses may include surgery, prescription medications, insurance premiums, dental work, modifications made to your home or car for medical reasons, eyeglasses, and tutoring for children with learning disabilities. The catch, according to the IRS, is the “you can deduct only the amount of your medical and dental expenses that is more than 7.5% of your adjusted gross income (Form 1040, line 38).”
Tax credits for child and dependent care, hybrid vehicles, and more: Mr. Wilder emphasizes that tax credits are superior to tax deductions; credits provide a dollar-for-dollar elimination whereas deductions reduce taxable income upon which tax rates are applied.

Avoid, don’t evade.

Cheating on taxes is illegal but it is a sin not to take allowable deductions, according to my personal income tax instructor at the community college. Wilder echoes these sentiments, saying that taxes “should be legitimately avoided, but not illegally evaded.”

”Ironically, if you earn a relatively high income and do too good a job of reducing your tax liability, the IRS can force you to pay a higher alternative minimum tax, or AMT.”

Again, Mr. Wilder recommends planning and projecting taxes to see if your tax avoidance strategies will lead you into “AMT territory."

All this careful planning might not be necessary if your income and the cost of living stayed constant throughout your lifetime, tax laws never changed, ordinary income and capital gains were taxed identically, and taxes were calculated on an unchanging, straight percentage of your income. Not only does income vary, tax laws change every year. Research, tax planning, and financial adjustments can reap payback now and later.

Note: I am not a tax professional so please check with your CPA before using these ideas. I received a copy of The Quiet Millionaire in exchange for a review of this book. This post is part of a series; see also:

This article is from Julie Rains of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

The Quiet Millionaire: Parts 4 & 5 - Building Your Net Worth

Julie Rains — Wed, 05 Dec 2007 22:18:37 +0000

In The Quiet Millionaire, author and Certified Financial Planner Brett Wilder shares common-sense advice on how to build net worth. His instructions on accumulating assets and borrowing intelligently will get you started on the path to financial independence, beginning with this wisdom:

“Your goal should be to make the value of what you own go up and the amount of what you owe go down.”

Here's his basic formula

Spend conservatively
Save/invest 25% of your income (you may need to start lower and build to this percentage!)
Limit downside risk of your real estate investments (primary residence and/or vacation homes)
Match your borrowing terms with the life of your purchases
Avoid high-interest credit cards

with specifics (based on Chapter 4: "Do You Own the Right Assets?" and Chapter 5: "Are You an Intelligent Borrower?"):

Personal Use Assets

How To Buy: plan purchases for personal use assets such as clothing, cookware, electronics, and furniture; realize that the value of most personal use assets are in their usage (antiques, collectibles and your residence being exceptions) so if you don’t use something, it has little value.
How To Pay: use current income or savings earmarked for purchases.
Warning: avoid paying with credit cards as the total cost of personal use assets may be double the original cost if you pay only the minimum monthly payment on the account balance.

Primary Residence

How to Buy: select a solidly constructed home (e.g., brick exterior and hardwood floors with predictable/quantifiable maintenance costs) in an established neighborhood with history of price appreciation in a desirable school district; watch and wait for a deal if possible.
How to Pay: commit up to 21% of your income to your mortgage payment (principal, interest, property taxes) rather than the 28% considered affordable; borrow with a 30-year fixed rate mortgage so that you can lock in a relatively low rate for a long period of time; don’t prepay your mortgage or elect to get a 15-year mortgage but use extra funds for investment.
Warning: avoid taking out a second mortgage and putting your house at risk for foreclosure.

Automobiles

How to Buy: buy from overstocked inventory at the end of the model year; or choose a used car among recent models with relatively low mileage.
How to Pay: make sure that your loan balance never exceeds the value of the car; make a down payment of 25% or more and limit the loan term to 36 months; use a home equity line to deduct interest fees; or take advantage of incentive programs that offer 0% or very low interest rates as long as your loan amount is not greater than the car value.
Warning: avoid a lease but if you do lease, make sure you understand the lease terms, lease a new car, and pay attention to mileage restrictions.

Vacation Homes

How to Buy: choose a home in an established area to minimize risk of price depreciation and a desirable area near recreational and cultural activities; consider infrastructure (road access, availability of utilities such as electricity and water).
How To Pay: make sure your financial obligation for the vacation home doesn’t prevent you from funding for retirement, college, and other future needs; get a traditional mortgage.
Warning: realize that vacation rental income involves complex tax rules; avoid buying raw land as you will typically have little appreciation but ongoing costs associated with property taxes and mortgage interest.

Timeshares

How to Buy: buy timeshares on the secondary market (if you choose to buy).
How to Pay: pay cash preferably; use your home equity line for a short time only while you are waiting for forthcoming funds (e.g., tax refund).
Warning: avoid long-term borrowing for a timeshare.

More tips on building wealth

Limit holdings in liquid assets (even high yield savings accounts) as rates/returns typically do not exceed actual inflation rates, eroding your net worth over time; arrange a home equity line of credit to have access to cash.
Consider using Modern Portfolio Theory to structure your investment assets.
Determine your rate of return on rental properties to see if you are making an adequate rate of return.
Generate income and accumulate assets through business ownership and stock options.

Want to know your net worth and how it compares to others?

Calculate your net worth using The Quiet Millionaire's Financial Statement Planning Worksheet (PDF).
Check out All Financial Matters' chart showing median and average net worth by age group.

Though comparisons are interesting (and perhaps comforting depending on how much you've set aside), focus on building your net worth by accumulating appreciating assets and reducing debt.

Note: I received a copy of The Quiet Millionaire in exchange for a review and I have created a series of posts based on the book.

This article is from Julie Rains of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

The Quiet Millionaire: Part 1 – What is Important about Money to You?

Julie Rains — Thu, 18 Oct 2007 19:51:11 +0000

You’ve heard of The Millionaire Next Door (see Nora’s post on this book), now there’s The Quiet Millionaire. Whereas Next Door considers the mindset of the millionaire, Quiet offers practical advice on building and preserving wealth, beginning with an exploration of your life goals, reasons that money is important to you, and your possible motivations for desiring wealth. Its author is Brett Wilder, a Certified Financial Planner and President/CEO of Financial Management Group, Inc., a fee-only financial management and investment advisory firm. Through Wise Bread, I’ve been given a copy of the book so that I can give you an idea of what it has to offer.

Topics for most chapters are straightforward and cover issues such as borrowing intelligently, winning at investments, and making college affordable. In the first chapter, however, Mr. Wilder builds the platform for helping you make financial decisions and provides guidance on defining what is truly important; he proposes that

Money is the fuel for achieving your life goals and objectives.

He also suggests that each of us have a money personality and specific reasons that money is important, such as:

Security (you may fear being impoverished, which is motivating to save but may lead you to be too risk adverse)
Freedom (you have enough money to live the way you choose and work with enthusiasm)
Gaining Love (you feel that money helps you to attract persons who will love you)
Respect (you associate having money with being respected)
Power (you want to influence people with the power that money can bring)
Happiness (you enjoy the experiences and items that money can buy)
Self-worth (you equate self worth with net worth)
Accomplishment (you consider wealth a measure of success)
Entitlement (you feel deserving of money because you have endured years of struggling without money)
Helping others (you want to use your money to help others, possibly because you have been helped yourself)

Mr. Wilder recommends exercises to detect what drives you the most:

The objective is to discover what you really feel and truly believe is important about money to you in order to understand the reasons behind your earning, saving, and spending activities, which can be financially healthy or unhealthy and may require adjustments to be made.

I enjoyed the “building block” method, which might go like this:

Q. What is important about money to you?
A. Security. I like the security that money can bring.

Q. Why do you like security?
A. Because once I am secure, then I can focus on the things that are important.

Q. What are the things that are important to you?
A. Being able to pursue work that is meaningful, being able to spend time with my family, being able take part in activities that are rewarding to me.

Q. What about money allows you to do those things?
A. Enough money will give me freedom with my time.

It’s up to you to decide whether your reasons for wanting money are valid or not, and if you need to reshape your approach to money. (For further insight, read what Wise Bread writers and readers had to say in What Did Your Parents Teach You About Money?) While you’re pondering money motivations, I’ll be reading The Quiet Millionaire and sharing strategies (in future posts) for saving, investing, and protecting wealth so that you can realize your dreams.

This article is from Julie Rains of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: