Wednesday, January 27, 2016

There Is No Financial Conspiracy

There is no shortage of conspiracy theories on the internet, but one I see time and time again is the popular “financial companies are out to get you” theme. Just look at some of these headlines:

I understand the thought behind them. First, they are definitely clickbait-y and are meant to drive people to websites. Everyone wants to hear secrets! And if you are in over your head in debt, it can certainly feel like everyone is conspiring against you. Add to this the whole Wall Street-caused housing market collapse which wiped out trillions of dollars in home equity across the nation and you can see how people might become angry and want to “stick it” to banks and credit card companies.

There Are No "Secrets"

But the reality is there are no secrets. There are no conspiracies by banks to keep you in debt. You’re in debt, in most cases, because you bought more than you could afford! It’s not the job of a credit card company to make sure you live within your means. That’s your job. With the exception of unforeseen things like medical emergencies and such, you are in debt because of the conscious choices you made. Take responsibility for that.

Look, banks and credit card companies are in business to make money. They provide a service that you use. They provide that service subject to certain terms -  namely they will lend you money at a certain interest rate with the expectation that you will pay it back on a certain schedule. If you miss a payment, you violated those terms and they will charge you penalties.  If you stopped paying your electricity bill, the power company would cut off your service. Why would you expect banks and credit card companies to be any different? If you don’t repay them the money they loaned to you, they will foreclose on your house or charge you penalty fees and raise your interest rates. Again, they are in business to make money. Yes, they hide sneaky charges and fees in the fine print and hope you won't see them, but they are disclosed to you. If you aren't going to take the time to read that fine print, don't apply for the product. You need to take some personal responsibility.

But here’s the thing.. all these “secrets” these websites claim companies don’t want you to hear about aren’t secret. Something like paying half your mortgage very two weeks to pay it off faster is no secret - it's math. Granted, it's calendar-based math, so it may seem tricky, but there's no great trick to it. Making a half payment every two weeks results in 26 half payments a year - or 13 full payments a year instead of the 12 you would make paying once a month. That extra payment each year can shave years off your mortgage.

Banks Don’t Care!

Banks don’t care if you make extra payments on your mortgage and pay it off in 23 years instead of 30. The bank still made money on that loan for 23 years! And with the low interest rate environment, most banks want those low interest rate mortgages paid off quicker so they can write new mortgages at higher interest rates when rates go up. They would rather lend money for 30 years at 7% interest than for 30 years at 3.5% interest. Trust me. I work for a credit union and this is simply a fact of the business. We actually have meetings about this. In fact, we would rather lend money on shorter term auto loans than long term mortgages right now because when interest rates do rise, we'll be able to re-lend our money at a higher interest rate quicker.

Furthermore, most banks don’t even hold your mortgage anyway. If the loan was backed by Fannie Mae or Freddie Mac, your bank almost certainly sold the mortgage to them soon after you signed the paperwork. The bank still services the loan – meaning they still send you the bills and you still make your check out and mail it to the bank. From your point of view, the bank still owns the mortgage, but the actual “company” who owns it is likely the government. The bank already got their money back when they sold the loan and now your payments get passed on to the government. That way, banks can turn around and lend their money out on a new loan to someone else. (They do make a small fee on servicing the loans they sell and they typically don't sell loans of people with high credit scores and a solid credit history - those less likely to default, in other words.)

Credit Card Companies Don’t Care Either!

Credit cards don’t care if you pay off your balance each month. Yes, they’d like you to carry a balance because you’ll end up paying them more money. If someone wanted to give me $100 a month extra, I wouldn’t turn them down either. But they’d rather you pay off your balance each month than carry a balance when you can’t afford to and possibly default on your debt. A default would cause them to lose money. Charging you interest is not the only way credit card companies make money. They also receive a merchant fee when you use their credit card. This fee is paid by the store that accepted your card. So even if you pay off your balance in full each month, you are still making them money every time you use their card. They aren’t going to be mad at you for that.

Can’t We All Just Get Along?

You and banks can have a mutually beneficial relationship. They will loan you money and you can repay it responsibly. They will give you perks for doing so – cash back deals, frequent flyer miles, whatever. Go ahead and pay off your mortgage early if you want to, but do it because it makes financial sense for you, not because you think it will somehow "hurt" the bank. There is no need to be adversarial with each other. Life is too short to be mad at people or companies all the time. You just need to uphold your part of the bargain. Be a responsible borrower.

Wednesday, January 20, 2016

Reminder: Time To Rebalance Your 401(k)

The start of a new year is a natural time to reflect on where you've been, where you want to go, and how you want to get there. It also is a good time to revisit things you don't pay much attention to - specifically your 401(k).

Once you start participating in a 401(k), it's easy to forget about it. It's one of those things that you set up once and then don't look at again. This can be a good thing. If you aren't constantly checking on it, you're not going to be bothered by the inevitable ups and downs that occur with any stock market investment. You won't be tempted to try to time the market, which almost guarantees a loss.

But once a year it pays to take a look at the asset allocation in your 401(k) and make sure it's still where you want it. Over the past year, some market segments and funds may have had a great run and now represent a larger portion of your portfolio than you want. For example, suppose you want 20% of your 401(k) money invested in mutual funds that invest in small cap companies. If small caps had a great year last year, those mutual funds may have gone up quite a bit in value and they now might comprise 25% or more of your portfolio. That's more exposure to small caps than you wanted, so you need to bring that back down to your 20% target.

Here's what my target allocation is and what my actual fund allocation is:

My target allocation

My actual allocation

As you can see, my actual allocation is not too far from my  target allocation - the largest difference is about 0.2%. This is because my company switched 401(k) providers in June and so I've only had this allocation for six months. Had I been in these funds for a full year, there would likely be a greater divergence.

The process of changing your actual allocation back to match your target allocation is called asset allocation rebalancing and almost every 401(k) company provides a tool that allows you to do this easily. Some even let you set up an automatic rebalancing schedule so you don't even have to do this once a year. That truly makes your 401(k) a set-and-forget option! I've got that option in my plan. Here's what it looks like:

Set the percentages to what you want

What Rebalancing Is

When you rebalance your portfolio, what you are doing in managing risk. You are selling some of your positions that have appreciated in value and buying more of those that have underperformed. This may seem counter-intuitive. Why would you sell stocks that are rallying and buy ones that are falling? Because the stock market is cyclical. Specific stocks or market segments will not always continue to rise. Likewise, those that are falling will not always continue to fall. By rebalancing your portfolio regularly, you can average out those cycles. Rebalancing helps ensure you sell high and buy low, always a winning strategy.

What Rebalancing Is Not

As you might have guessed, rebalancing can reduce your overall performance. When you sell your appreciated assets, you are missing out on any future appreciation that might happen. But not really. After all, you're not going to sell all your appreciated assets, just some of them. If the mutual fund or market sector continues to rise, you'll still get some of that gain, just not as much as if you didn't rebalance. Rather than think of the gains you might miss, think of it the other way around - think of the losses you may avoid. When the market sector drops (and it will at some point), you won't get hit with as much of that loss.

How Often Should You Rebalance?

Some people advocate rebalancing anytime your asset allocation deviates from your target allocation percentage by 5%. Some suggest doing it every quarter. Both those options seem rather frequent to me. There's no harm in doing it that often, but it involves paying more attention to your 401(k) than most people do. (Also note that, as you can see in the screenshot above, some funds might charge you a fee for excessive selling, so you probably don't want to do this too often.)  Since I'm posting this at the beginning of the year, you can probably guess what my recommendation is. Rebalancing once a year still provides the benefits of the process and yet is infrequent enough that you don't always have to worry about remembering to do it.

Remember, you are investing for the long term. You don't need to chase gains or beat the market. A boring, conservative investment strategy will make you a millionaire. You don't need to time the market. You just need to be in the market.

Wednesday, January 13, 2016

New Year? Time For A New Budget!

photo by Carol VanHookAh, January. Time to kick out that old year (and let's be honest, it was getting a little rusty and worn out) and bring in a shiny new one. It's a time for fresh starts, new goals, and more than a bit of optimism that this year, things will be better.

To help ensure things get better, at least financially, January is a good time to revisit your budget and make some tweaks.

Update your income figures

Most years, the tax withholding rates change slightly, so your take home pay may have changed. If you modified any of your job benefit options, such as changing insurance plans or changing the amount you contribute to a medical or dependent care FSA, those changes will affect your take home pay as well. Obviously any salary changes will be reflected too.

Revisit your budget assumptions

When you made your budget, you probably had to take a guess at some expenses that vary month to month. Things like grocery costs, auto-related expenses, and entertainment expenses can be hard to estimate if you aren't keeping track of them - and if you didn't have a budget before, you probably weren't. If you've been following a budget for a year now, you've likely been tracking your expenses with something like You've got a year of history that you can go back and check. Were your budget assumptions correct? Adjust as necessary.

My actual spending was remarkably close to my budgeted amounts. I was not over in any budget category and in a couple, I was significantly under my budget. For example, I had budgeted a monthly grocery expense of $1,000. Looking back over my 2015 costs, I actually averaged $800 per month. Likewise, I had budgeted $125 a month for gas for my car and I actually spent $62.  By adjusting these categories where I was significantly under budget, I've freed up another $400. I'm still being conservative and leaving some room in my figures, but not as much as I was.

Increase Savings

Hopefully, your comparison between what you budgeted and what you actually spent has made you realize you may have more room that you thought in your budget. If that's the case, increasing the amount you are putting away in savings is never a bad option

Identify New Goals

What are the goals you want to save for this year? A vacation? A bigger emergency fund? A home improvement project? Now's the time to start planning for those.

Identify Missed Areas

Did you have any big expense areas you forgot to include in your budget? Car repair, perhaps. Or clothing. Perhaps you want to add a line to your budget for gift expenses for all those birthdays and holidays throughout out the year. Now's the time to add those in.

Leave Some Wiggle Room

A budget that allocates every penny of income is worthless. You'll never be able to stick to it. Include a line in your budget for leftover funds, which will be the difference between your income and all your budget items. This is your "mad money" for each month. If you go over budget in one area or want to splurge a bit, this gives you an idea of how much you can afford without throwing your finances into chaos.

My Magical Budget Spreadsheet

Last year, when I got serious about budgeting, I made a very nice (in my opinion) spreadsheet for budgeting. I wrote about some of the neat features it has here. You can also download your own copy at that link. (I really like the goal planning section I made!)

So What Did I Change?

When I did my budget review, I added some line items that I left out of my budget last year (and I knew I left them out when I made it originally). I added a line for clothing. My daughter is growing like crazy and always seems to need new pants or shoes. I also added a line item for gifts. This isn't a big expense for me, except around Christmas, but I'd like to have funds set aside anyway. Other than adjusting my budget to more closely resemble my actual spending, that's about all the changes I needed to make.

What changes, if any, have you made to your budget for the new year?

Wednesday, January 6, 2016

Goal Update: End of December 2015 And A Stock Option Primer

At the end of each month, I post an update of my goals, including a brief discussion of any notable events that might have occurred during the month. The latest month's figures can always be found under the Featured menu in the menu bar at the top of the blog.

Last updated: End of December, 2015
Current value: $20,001
Change from last month: +$1,300
Percent of Goal:  18.40%

click to supersize

Note that the funds in this account are invested in stock, so there will be fluctuations in value that are outside my control. I never withdraw money from this account, so any dips are purely due to stock price changes.

Events Of Note Last Month:

Income this month from my online courses sales was $276.My account took a big jump in value thanks to Realty Income stock taking off. More on that below. I've also unlocked a new achievement this month:

I squeaked across the $20,000 threshold. It was December last year when I hit the $10,000 saved mark. Looking back at the last year, my contributions to this fund totaled $7,442. To put it another way, $2,558 this year came from investment gains - just over 25% of my increase this year. That shows the difference between just saving and investing money.

At $10,000 per year, I'm looking at another 8 years before I will reach my goal. However, as I accumulate more savings, my returns will start compounding and that time frame should come down.

As I mentioned last month, because I'm getting close to the point where I will be selling my shares of Realty Income and moving the money into a hard money loan, I started looking at a way I might be able to wring a bit more money out of the stock before selling it. One way to do that is with stock options. Specifically, by writing covered calls.

A Short Stock Option Primer

Calls and puts are types of stock options. A call gives the owner the right, but not the obligation, to buy a stock at a certain price. Similarly, a put gives the owner the right, but not the obligation, but sell a stock at a certain price.

Those definitions are written from the perspective of the option buyer. From the perspective of the option seller, it is reversed: selling a call gives the seller the obligation to sell the stock at the specified price (should the buyer of the call want to exercise, or use, the option). Selling a put gives the seller the obligation to buy the stock at the specified price (again, should the buyer of the put want to exercise the option).

(I'm going to stick to calls for the remainder of this discussion, as people tend to have an easier time comprehending those than they do with puts, for some reason.)

Some other things you need to know abut options: One option covers a block of 100 shares, so a single call option gives the owner the right to buy 100 shares of stock. The buy or sell price of the underlying stock that the option is written for is called the strike price. Options are only good for a limited time and the day they expire is called the expiration date. Although one option covers 100 shares of stock, the option price is quoted on a single share basis, so the cost of an option is 100 times the quoted price.

The Terminology Of Buying And Selling Options

Selling a call or put is referred to as writing a call or put. You can write two types of options: covered or naked. Writing a covered call is selling a call where you own the underlying stock. Writing a naked call is a call where you do not own the underlying stock. For instance, if you write a call option for IBM and you own 100 shares of IBM, you have sold a covered call. This is because if the option buyer exercises the option, you must sell him or her 100 shares of IBM stock, which you already own. If you sold the call option and you did not own IBM stock, this would be a naked call. In that case, if the buyer of the option decides to exercise the option, you are required to buy 100 shares of IBM stock to sell to him. The problem is that IBM shares may now cost more than the strike price of your option, so you would lose money in this case.

Obviously, selling naked calls exposes you to unlimited losses. Suppose you sold an option to sell a stock for $10 per share in 30 days at an option price of $1 per share. By selling this option, you collected $100 up front. Fast forward 30 days and now that stock is trading for $75 per share. The option buyer comes to you and says "Here's $1000, give me my 100 shares of stock." Because you didn't actually own the stock, you have to go buy 100 shares at the current price of $75 and sell them to the option holder at $10, giving you a net loss of $64 a share (the difference between what you had to buy the shares for and what you had to sell them for, including the $1 per share you received for selling the option in the first place). Selling naked options is extremely risky.

Writing covered calls, on the other hand, is much more conservative. Let's look at the same situation, only this time, you own 100 shares of the stock. The option buyer comes to you and says "Here's $1000, give me my 100 shares of stock." You already own the stock, so there's no problem. You do have some "fictional" losses. You have to sell at $10 per share instead of the current market price of $75 per share, so you didn't make as much money as you could have. Hopefully, you bought these shares originally at less than $10 per share, so you still made some money.

If the option expiration date arrives and the stock is below the strike price, the option expires worthless. You, as the person who sold the call, gets to keep the money the option buyer paid you. The option buyer however, is out of luck. He or she loses the money paid for the option and gets no stock in return. Since no one can tell where a stock price is going in the future, buying options is pretty much legalized gambling. Selling options can be viewed the same way, however, it makes a bit more sense if you are in a situation like me, where I am planning on selling my stock anyway.

Got that?

It can be complicated. Let's walk through what I did:

On December 22, I wrote 3 covered calls for Realty Income stock at a strike price of $50 with an expiration date of Jan 15, 2016 at a price of $1.70. So I received 3 * 100 * $1.70 or $510 for this. The stock was trading at 51.18 at the time, so this is a bit of a premium over the current price ($51.70 per share versus $51.18 per share).

What happens now? I sit on my stock until January 15, 2016. On that day, if the stock price is below $50 at the close of trading, the options expire worthless. I get to keep that $510 and my stock. If the stock price is above $50, I will likely have to sell it at $50 per share. But keep in mind, I already collected $1.70 per share when I sold the option, so if the stock closes between $50 and $51.70, I've made more than I would have just selling the stock outright. If the stock closes over $51.70 per share, then I will have lost out on some potential profits because I will be forced to sell at a below market price. Overall, though, I will still have made a profit because I originally paid less than $50 each for my shares.

Why Bother?

Why did I do this? It's a complicated process and I've got the potential to miss out on some profits. Why wouldn't I just hold onto my shares and straight up sell them later? Because I don't believe the price of the stock will go much higher. (It's near a 52 week high and the Fed has started raising interest rates, which typically causes REIT stocks to drop in price.) In effect, I'm betting that, come January 15, the price will be below $50 per share. In that case, I'll have received an extra $510 for nothing. Its a way to squeeze a little extra cash out of the stock before I sell.

And if the stock ends up above $51.70 per share? Meh. No big deal. I was looking to sell anyway.

Another factor played into my decision to sell the covered calls: I want to move $20,000 into a hard money loan. Right now, my partner is getting 8% interest on loans. For $20,000 that works out to $133.33 per month. So the $510 premium I am receiving for three and a half weeks (Dec 22 to Jan 15), is more than I could earn from the loan, so this was the better investment.

I'll keep you posted on how this turns out. As of the time I am writing this, December 31, the stock closed at $51.63.