Financial Literacy

A Roth IRA is the greatest location for your investment dollars compared to any other location:

•  Investments grow tax-free
• After a contribution has been made, after 5 years it can be withdrawn tax-free
• After age 59 ½, gains can be withdrawn tax-free
• Unlike a regular IRA, there is no mandatory withdrawal out of the account
• Heirs can make tax-free withdrawals, as long as they wait 5-years after the owner’s death
• Most importantly, when Congress talks about taxing retirement accounts, they do not include Roth IRAs because they have already been taxed once.

The primary use of this account is for retirement savings so it is best to begin contributing as soon as possible. Since the requirement is that contributions are limited to earned income, how can children get earned income? I know a Realtor who uses their toddler kids in advertisements so she pays them a modeling fee that is put into their Roth IRAs. All that is needed for earned income is a legitimate, arms-length transaction. If you don’t do this for them then they can begin to contribute when they earn money from a paper-route, baby-sitting, lawn-cutting, or other 10-14 year old activities to start their Roth IRA.

There are two limits for Roth IRAs: a contribution limit (today it is $5,500) and an income-limit (today it is $127,000.) However, there is a back-door to putting money into a Roth IRA to get around both of these limitations. Since 2010, you can contribute to a regular IRA and then convert that IRA to a Roth IRA. You can do this each year that you have earned income.

What has been mentioned are the basic rules for a Roth IRA but there are many specific rules that you’ll need to follow from either the IRS website or your tax advisor. Be aware that that taxes are your biggest drag on both your income and net worth and the Roth IRA is the best location for you to avoid these over your lifetime.

President Nixon started the U.S. petro-dollar in August 1971 when the U.S. defaulted on gold-backed currency and closed the federal gold window. The petro-dollar agreement was that the U.S. would be Saudi Arabia’s military protector and buy Saudi Arabian oil, in exchange, Saudi Arabia would trade all oil in U.S. dollars. This agreement props up the demand for U.S. dollars and defends Saudi Arabia from its enemies.

But the world has changed since 1971:

• President Obama has abandoned defending Saudi Arabia
• China has replaced the U.S. as Saudi Arabia’s largest oil buyer and investor
• Russia is the world’s largest oil exporter and they no longer price oil in U.S. dollars
• Russia now handles Iran’s oil trade, no longer in U.S. dollars
• U.S. oil fracking has reduced U.S. oil imports so there is less foreign trade in U.S. dollars
• Increasing Asian trade is being done directly between currencies, not through the U.S. dollar

Each of these elements is chipping away at the need, demand, and value of the U.S. dollar in world trade. The U.S. is still the world’s largest economy but it used to be that +95% of all world trade went through the U.S. dollar as the world’s reserve currency. Today, the U.S. dollar still dominates world trade and derivatives at 90%, but this ratio has been in a downtrend over the last couple years reaching all-time-lows. China’s economy has already surpassed the European Union’s economy and is predicted to become the world’s largest economy in 3-8 years by surpassing the U.S. So sooner or later, the U.S. dollar will be dropped as the world’s reserve currency for either the Chinese yuan or SDR’s (Special Depository Receipts by the World Bank; a basket of currencies). As this transition occurs, all the money printing, reckless spending, and the insolvent U.S. Federal Reserve balance sheet will no longer be ignored by investors and traders. If you have any cash, assets, or investments, do you have a plan on how to migrate these into stronger currencies if the U.S. dollar begins a notable decline?

As the U.S. Federal Reserve has kept interest rates low for over 6 years now, investors and retirees have searched far and wide to get a yield on their investments. One investment that many people get excited about are tax-free municipal bonds.

These are bonds issued by state, county, or city governments. There are a few types of municipal bonds: revenue bonds that are paid back from projects being financed, general obligation bonds backed by property taxes, housing bonds backed by mortgages, zero-coupon bonds that only pay at maturity, insured bonds in case the municipality defaults, variable or fixed-rate bonds, and others.

What many investors look for in municipal bonds is for them to be double or triple-tax free. Triple-tax free refers to the interest being untaxed on your city, state, and federal tax returns. (Double tax-free refers to those that do not pay city income tax.) Be aware that some municipal bonds are taxable, for example sports stadiums are not free from federal taxes. When you find a bond that is tax-free for you, the next step is to determine its taxable equivalent yield. This refers to calculating how much it would yield if it were taxed – so you can compare it to other taxable bonds to determine if it is a good investment choice for you. For example, if you find a municipal bond paying 4% how do you compare that to a corporate bond paying 4%? By using this formula to calculate the tax-equivalent yield:

Tax Equivalent Yield = Tax Free Yield / (1 – (Your Tax Bracket))

So, if you were in the 30% tax bracket, then your tax-equivalent yield is: .04 / (1 – .30) or .0571 which is (5.71%). So now you can compare taxable bond yields with municipal tax-free bond yields. If you are considering taxable bonds but they are yielding less than 5.71%, then this municipal bond is offering you a better yield, on an after-tax basis.

Please do not purchase a municipal bond or fund without doing some further homework:

1. Is this bond double or triple tax-free for you? Municipal bonds are state specific.
2. Review if the bond may be called from you before you want it to mature. This may also be called a Sinking Fund where a portion of the debt must be periodically paid off.
3. Find the credit rating of the bond issuing entity to find if their credit rating is adequate or has a negative future outlook.
4. Determine if the bond is exempt from alternative minimum tax (AMT). Some bonds, such as sports stadiums, will be taxed by AMT even though you do not pay state income tax on the income.
5. If the bond is insured, then you must also check the credit rating and future outlook for that insurer to make certain the insurance isn’t worthless.
6. Finally, the maturity date of the bond must correspond to when you need to spend the money, otherwise, you are taking on interest-rate risk for which you are not being compensated.

A co-worker read an article Monday about 3D printing and bought shares of one of the industry leaders. Then he called me to ask what I thought about that stock. I replied, “I’d sell it immediately. It is trading at 2-times what it is worth and trending down, I’m afraid the big run-up was 2 years ago.”

It is fine with me if he wants to speculate with a small and affordable amount of risk capital. But having traded for a long time, I see the phases that new stock traders go through over and over. I went through these myself and most traders do as well.

Beginner Stage: buy a stock in the news that you hope might go up but instead you ride it a long-way down for a loss. Financial results are overall losses in spite of a couple lucky winners.

Novice Stage: buy stocks but continually get scared out of your trades so you never ride them up, leaving you with many tiny losses and tiny gains. Financial results are just treading water after a lot of work.

Intermediate Stage: your computer screen has two dozen conflicting indicators and chart patterns, but your stock trades have a price target and a stop-loss exit. Financial results are slightly profitable overall but very erratic.

Advanced Stage: you use very few indicators, scale out of positions, thoughtful position sizing, diversify your types of trades, and have a positive expectancy. Financial results are profitable and relatively consistent.

If some of these vocabulary terms are new to you, then you may want to get acquainted with them before you make more stock trades.

Many people discover that they really don’t enjoy the process of stock trading. At this point they either become a dividend investor, buy-and-hold index investor, or outsource the work to investment newsletters or financial advisors.  Outsourcing to others can be fine but first you must get an audited track record. Whether it is a newsletter or advisor, most of them lose money for clients. Therefore, you must locate and perform some type of due diligence before you put a single penny of your hard-won money to risk on their ideas.

One measure for evaluating stock investing is to determine whether the stock market is relatively high or relatively low. Are stocks getting cheap or expensive? With reference points like this you can more accurately make decisions about purchasing, selling, or rebalancing.

In late 1997, I wrote that the stock market was horrifically over-priced and you should be very careful with your stock portfolio. The stock market bubble then continued to inflate for 2 more years until its peak in 2000. During those run-up years, internet companies with minimal sales and no hope of earnings were going public and then skyrocketing in price. At the market peak back in 2000, the Russell 2000 Index, a stock index for smaller-capitalized companies, was trading at 39-times earnings. (Let me explain what this means: if you purchased this stock index you are paying $39 for $1 of earnings. Just to break-even on your purchase it would take 39 years – does that sound cheap or expensive to you?)

Over the last 25 years, the average price-earnings ratio for the Russell 2000 is under 30. For a comparison, the large companies of the S&P 500 Index have an average price-earnings ratio of around 18 times earnings. Some investors would never consider buying a stock with a price-earnings ratio over 12.

Today, the S&P 500 Index is still trading at a reasonable 17.2 times earnings, however, the Russell 2000 Index is trading at a lofty 49-times earnings. This is far higher than it was during the dot-com bubble in 2000 before it crashed. Sure, the Russell 2000 Index could still move up another 2 years, but it indicates that you should be very careful with buying or holding small-cap stocks at this high level. The risk or downside is very large and the potential gain or upside keeps getting smaller.

In 2008, the U.S. Federal Reserve lowered interest rates to zero to prevent the financial system from locking-up and causing an economic depression. This was a helpful temporary measure for a few months. But then the Federal Reserve continued their zero-interest policy for over 5 years. This chronic price distortion to the economy has had several predictable effects:

• Savers were punished as they earn little to nothing on their money. This transfers wealth from people like retirees that should not be taking risks with their money.
• Businesses and banks were rewarded with cheap money to take on all kinds of low-paying investments, even lending money back to the government for a guaranteed profit.
• Governments were rewarded with cheap money to borrow – keeping deficits artificially low.
• The stock market boomed as profits increased, not from operations, but from lower interest rates for their loans.

Keeping interest rates at zero for so long creates a transfer of wealth from these distortions. This was confirmed recently in the Wall Street Journal, the surge in stock prices and home values has boosted affluent household wealth to a record in 2013. Although keeping interest rates low was supposed to stimulate economic activity, overall consumer spending is still down because of huge swaths of unemployed, rising healthcare costs, and consumer debts are still being paid off from pre-2008.

Keeping interest rates artificially low will end in one of two scenarios. First, interest rates will rise on their own (investors fearing inflation or lack of confidence in U.S. debt repayment), or the U.S. Federal Reserve will begin raising them on their own. Either way, the low-interest party will end and you need to be prepared when the next wealth transfer will begin.

A few suggestions for you to consider include: refinance loans now while rates are still low, be ready to sell some of your stock funds as the stock market begins to decline, avoid bonds because they will be falling in value as interest rates rise, look for floating rate investments to take advantage of rising interest rates, and put some money in investments indexed to inflation.

There have been hundreds of concepts of money over the last 5,000 years. Since the internet was popularized around 1993, there have been many failed digital currencies (look up Flooz that was promoted by Hollywood celebrities). New crypto currencies were supposed to be Gold 2.0 by solving all the problems related to failed digital currencies: limited supply (they must be mathematically mined), they are transparent (through the blockchain), and are peer-to-peer with no intermediary.

One cryto-currency shot up in value in 2013: Bitcoin. It rose from a value of $150 to $1,100 in a single month before it fell back in price. This popularity started an explosion in competing cryto-currencies, crypto-exchanges, and other digital products and services around them. Retailers jumped into accepting Bitcoins and everyday economists and financial advisers are asked, “What do you think of Bitcoin?”

Let’s review some key risks and benefits:

1. There is no intrinsic value underlying crypto-currencies – a specific mathematical number has no worth. So unlike gold or silver, cryptos require “faith and belief” in their value, just like the paper currencies of dollars, pesos, euros, and yen.

2. The blockchain of transparency has not prevented theft by hackers and there is no recourse to get your stolen “money” back (because there are Bitcoin money launderers just like cash launderers of illegal transactions).

3. There is personal benefit of temporarily using crypto-currencies to bypass currency controls and societal benefit to having a currency out of the hands of politicians that have a 100% track record of destroying it.

Right now, crypto-currencies are a new industry in flux. Many new cryptos are “pump & dump” currencies to defraud buyers while others are improvements upon deficiencies in older cryptos. Many cryptos are being hoarded because buyers are hoping that they will rise in value – they are being created and held for speculation, not for transactions. This indicates that cryptos are not yet money, but a gamble on a volatile price. Many cryptographers argue over which direction the industry should move to become more acceptable. Since this industry is quickly changing, it may be unrecognizable a year from now. If you want to get involved with these you’ll have to learn a new language around hash-rates, blockchains, mining methodologies, e-wallets, payment-gateways, the changing laws and regulations, along with possible user acceptance of cryptos.

However, it is my recommendation that current crypto-currencies are not yet a vehicle for money, a trusted store of value.