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The Biggest Risk

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If you've been around the financial planning business any length of time, you've likely run into the saying "The biggest risk is not taking one."

It is endemic to all financial instruments, indeed, all investments, that return is the reward for risk. It is axiomatic that the entity that takes risks gets the rewards.

Generic stock market returns are between ten and thirteen percent per year, depending upon who you ask and how you frame the question. Contrast this with the five or six percent that insurance companies will guarantee. You invest with them, and you get maybe five percent. They use your money, but they get the difference simply by accepting the risk. Sometimes they lose in the short term, but far more often they make out like bandits.

If you invest $100 per month at 5.5% from the time you are 25 until the time you are 65, the insurance company has guaranteed you about $174,000. If you annuitize that in a fixed annuity on a "Life with ten years certain" basis, you'd get somewhere between $1000 and $1100 per month if you're male. Ladies and gentlemen, that won't buy very much now, much less forty years from now with average inflation. Matter of fact, it's only about a 1.67 times overall return net of inflation.

$100 per month is a lot less than people should be investing for their own future, but it's indicative of the problem. Even if you contributed $1000 per month, which is more than most people can commit, between however many tax-deferred investments it takes, it's $1.74 Million, which goes to a payout of $10,000 or so per month if you annuitize at 65. Sounds like a lot of money today, right? But you're spending those dollars all in an environment where, at an average of 3.5 percent inflation between now and then, $10,000 per month is about the equivalent of $2500 per month now - and every year that passes in retirement, your money buys less.

Suppose, instead, you were to invest $500 per month - half what you had to come up with in the previous example - and invested it in the broader market, earning a 9 percent return, well below historical average market returns, and then in the final year you lost forty percent of your money due to a market crash? Think you'd be better off, or worse?

Slightly worse off, in raw numbers. $1.40 million ($2.34 million before the crash). For half the effort to save and despite a major investing disaster at the worst possible time. But then let's say you manage to retain your intestinal fortitude, and instead of annuitizing on a fixed basis, you simply withdraw the same $10,000 per month we had in the previous example, while leaving the rest invested and generally earning 9%. Your money keeps increasing, and if you live to age 95, you leave 2.23 million dollars to your heirs, a sum that, if not so great as it sounds, will still buy a decent house in most areas of the country seventy years from now under our assumptions.

Now let's say that you want to live the same lifestyle, equal to $2500 per month now, that you have at retirement, so your monthly withdrawals increase by 3.5 percent per year. You didn't even have this option in the fixed rate "guaranteed" examples. Your money lasts 19 years 3 months (plus a few thousand left over). Once again, for half the effort to save.

This is not wild risk taking. This is simply doing exactly what the insurance companies are doing, and assuming the investment risk yourself. Do not think for a minute that banks and insurance companies are insulated from failure if the market conditions go sour enough. They aren't getting the money to pay you from some kind of transdimensional vortex. If their investment results are bad enough so that they can't pay you, they won't. Government bailouts are also limited, and the government's guarantee programs are likely to undergo severe modification in the next forty years, as they deal with problems such as social security and medicare payouts that are much larger than what their pay ins will be. States, which generally stand behind insurance company guarantees, will not likely be in a stronger position than the federal government. Not to mention the kind of impact this sort of financial crisis will have upon government budgets.

Speaking of the banks, let us consider a hypothetical four percent CD, on a "taxed as you go" rather than tax deferred basis. Assume 28 percent federal tax rate, and 7 percent state and local. $1000 per month invested, every month for 40 years. How much does it turn into?

$842,800. As opposed to $1,044,600 just to break even with inflation at 3.5 percent per year and being able to buy the same stuff. I'd snark that you might as well bury it in a mattress, but in point of fact, that would only get you $480,000.

The point I'm trying to make here is that the so-called traditional "conservative" investments are anything but. If you aren't putting your money into investments where there is some market risk, then the only guarantee you have is the guarantee that it won't succeed, the guarantee that you will be living in poverty or forced to somehow keep working your whole life.

So in financial planning, the biggest risk is in not accepting some.

Caveat Emptor

Original here

This article was originally from April 2006 - anybody want to tell me I didn't call it? Of course, by that time it was like predicting a dropped anvil would fall but that was when the question was asked

From an email:

I've been enjoying your blog posts on mortgages. I've learned more from you about what to expect than I have from any other source, and I've gotten 10 mortgages in my life.

I was reading Larry William's website this week, and on there I saw one of his newsletters from last summer:

Larry Williams you may be familiar with, he's written many books on trading.

Anyways, the newsletter talks about buying 2nd mortgage notes as an investment. And that's something I haven't seen you write about.

With the softening of the housing market in many areas, and overextended borrowers, I suspect that the market for 2nd notes will be heating up over the next few months and years.

I'd appreciate hearing your views on the opportunities and pitfalls in this area.

Let us consider the efficiencies of the market. The Institutional lenders have economies of scale, underwriting guidelines, and a set checklist of procedures as to how to approve (or decline) loans. They have a system that makes them effective. They can do this because they have enough loans to make it cost-effective, and because of their experience, they know how to price their loans. From advertising to wholesaling to pricing to packaging and servicing, they are set up for efficient service. Lest people think I'm saying lenders are a better place to get loans than brokers, I am not. Quite the reverse is true. But the the vast majority of broker originated loans are with regulated institutional lenders.

What happens if you're not set up like that? The answer is you're either more highly priced than they are, or you're not as profitable. I've said more than once that without regulated institutional lenders, every loan would be a hard money loan. So in trying to originate loans, an individual is competing at a disadvantage. Where then, can they make a profit?

The answer is in the loans that the regulated lenders won't or can't touch. Now we need to ask ourselves why they can't or won't touch them. There are three common reasons. First is there is something wrong with the borrower. Second is that there's not enough equity. Third is that there is something wrong with the property.

Something wrong with the borrower has several subtypes. Credit Score too low, in bankruptcy, too many mortgage lates, no source of income to pay back the loan. Most of these can be gotten around in one degree or another unless they take place in combination with insufficient equity. Most single problems are surmountable by a good loan officer, providing you've got the equity required to convince the bank they won't lose their investment. You'll pay a higher rate or higher fees than you would without, but better that than no loan. It's when they take place in combination that problems arise which break the loan beyond the ability to rescue. And of course, if the property is not marketable in its current condition, no regulated lender will touch it.

What the first category reduces to is increased chance of default. The second category reduces to increased risk of losing money in case of default. The third category, something wrong with the property, reduces to you're going to get stuck fixing the property if they do default, which means sinking thousands to tens of thousands of dollars into it, above and beyond the amount of the trust deed. Furthermore, both the second and third categories are also at increased risk for default, even if the borrower has the wealth of Midas and the credit score to match.

So let's consider what happens when something goes wrong. The borrower doesn't make their payments, and it becomes a non-performing loan. You're not getting your money. If you need it every month, that's a problem. Do you know the proper procedure to foreclose without missing any i-dots or t-crossings? If you don't, your borrower can spin it out a long time. Actually, they can spin it out for a long time anyway. Well, that's what a loan servicer is for, but a loan servicer cuts into your margin, and they get their money every month regardless of whether or not you get paid. This means they're a monthly liability if the loan isn't performing. Furthermore, over half the time, some low-life attorney talks the people into filing bankruptcy to delay the inevitable. It's stupid, and it almost always ends up costing them still more money and making their final situation much worse, but they do it anyway - and now you have to start paying an attorney to have any hope of getting your money.

Suppose the property does go all the way to auction? You are second in line behind the holder of the first trust deed. They get every penny they are due before you get one penny. And if the first trust deed holder forecloses (or the government for property taxes), your trust deed is wiped out. The only way to defend against this is go to the auction with cash to defend your interest. And if the borrower isn't paying you, may I ask why you think they'll pay their property taxes or first trust deed? The answer is "they're probably not." They are going to lose the property anyway, so why make payments that don't prevent that?

(There are a lot of details in the foreclosure process. The stuff in the above paragraph should not be taken for anything more than a broad brush child's watercolor type painting of the process, as including those details would digress too far)

Now, suppose you're not originating the loan, you're just buying the right to receive payments, either on an individual loan or a package of loans, after the fact?

Well, can I ask you which loans you think the lenders are selling? If you answered "The ones in greatest danger of default" you get a star for the day! The lenders will either sell them off individually, if there are people inclined to buy, or actually repackage them thusly. The ones that are still performing, and still going according to the original guidelines will go to other regulated institutional lenders in mass packages, but those lenders won't take these, or if they will, it'll bring the price of the entire package down by more than it's worth. So they separate out the dogs before they sell the package. So unless you're buying them as part of the original loan package, this is what's happening. Now mind you, there are always those who want the non-performing loans because they know how to deal with them, but they know to only buy the ones with enough equity to cover the loans in case they need to foreclose. Those who specialize also know what these loans are really worth, and they don't pay full value - usually not even in the same ballpark.

So the aftermarket loans that are available tend to be in danger of default and without sufficient equity to cover if it goes to auction. If you're looking to lose your money, you've just found a very good way. You can also trivially spend thousands of extra dollars trying to defend your interests.

The equity issue is going to assume increased importance as prices in some overheated areas subside. If the loan was underwritten and approved on the basis of a $500,000 appraisal, but now similar properties are only selling for $420,000 and the loans total $450,000, it doesn't need a genius to understand you're not in the best of positions. Even if it sells at auction for as much as comparables are going for, you're still down at least $30,000 plus the expenses of the sale.

Now, with that said, second trust deeds can, if the equity is there, put you in the catbird seat. Suppose there's an IRS lien junior to you? Our office dealt with a $700,000 property with a $1.6 million lien against it - junior to the $28,000 second we bought. Nobody else could touch that property. The owner just wanted out - he wasn't getting any money regardless of what happened. He stopped making payments, and our clients had to step in with thousands of dollars to keep the holder of the first happy. There ended up being a fair amount of money made, although it took some serious cash for a while, because our clients had to make the payments on the first loan as well as everything else. This is not for the weak of wallet. If buying the Note had taken all of their ready money, they would have been SOL.

There are also all of the standard diversification of investment concerns. If ninety percent of your money is tied up in this deed, that's a pretty serious risk to your overall financial health. No matter how many precautions you take, some do go sour.

In short, while there is a lot of potential for gain, it's some serious work to evaluate the situation, and usually some serious work and serious cash to make it work for you when it is right.

UPDATE: something I'm running into a lot right now: Lenders that sell the note but retain servicing rights. So when the note goes south, and my client wants to buy into a distressed situation, the servicers are rejecting offers without checking with the actual investor, because they could get sued (for misrepresentation and bad underwriting) if they accept less than they loaned. On the other hand, if the property sits on the market (thereby costing the investors even more money), they don't get sued because, hey, the asking price is enough to cover the note. Now there is a legal deadline involved with lender owned properties, and nobody is going to offer enough to bail them out. But it's kind of like the old joke: "A lot can happen in a year. I may die. The King may die. And perhaps the horse will sing." Corporations don't die. Even if it were an individual investor, someone's going to inherit the right to payments. I do not think this horse will sing - it probably won't even whinny. In other words, nobody is going to offer enough to bail the lender out of their fix. Near as I can figure, those controlling the corporations holding servicing rights are evidently hoping that by that time, they will have moved on to other jobs and can't be held liable as individuals.

One more reason to be very careful investing in trust deeds

Caveat Emptor

Original here

The Nature of Estate Planning

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I've seen some fairly intelligent people completely fail to understand the value of estate planning, how easy it can be, and what it can accomplish.



To start with, there are some issues that happen when you die. The first is probate. This is a process whereby the state approves the distribution of your assets. Whether the state has any business putting their big nose into the process is not the discussion we're having here. The current fact is that they do, and this doesn't look likely to change. In the case of things like a home, where the family is living in it already, it's usually not too obnoxious as the state will typically allow the family to continue living in it, pending resolution of probate.



But liquid assets - the money you left - are tied up in the probate and cannot be accessed without court approval unless you titled the account correctly. This can be a major issue to a family that's just lost their major breadwinner - or either breadwinner in the case of a two income family. Unless you don't want your family to get it right away, titling accounts jointly in both your name and your spouse's as joint tenants with rights of survivorship is one way to deal with this. In the case of most accounts, there is the TOD, or Transfer on Death option of naming a beneficiary (or beneficiaries) for the account. The money then transfers upon your death to that person outside of probate. Estate and inheritance taxes are still potentially applicable, however.



The minimum charges for probate are about seven percent of the amount of estate under probate. If this includes your house and other major assets, it gets expensive quickly. A surcharge per year the probate is in effect is also usual. Probate sometimes doesn't get settled for several years - and some unusual ones have gone over twenty years, and with increasingly complicated family relationships, increasingly complicated probate becomes more likely. While probate is going on, your heirs will not have access to the money without court approval, and the court's priorities are not likely to be the same as your family's.



The number one tool for effective estate planning is not a will. That's an important component, especially if you have children and need to determine who their guardians will be, but for distribution of your assets, it falls woefully short. Everything disbursed by the will goes through probate, and estate and inheritance taxes as applicable. Wills can be and are challenged successfully every day, and the cost of the fight drains the estate even if the challenge is unsuccessful.



The most important tool for effective estate planning is the trust. There are varying kinds of trusts, so consult an attorney in your area. A trust is not a corporation, but if that helps you in your understanding, use it. A better way to think of it is as a robot that takes control upon your death and acts according to your instructions. When you create (or alter) the trust, you wind the robot, but (if written correctly) it acts like a string marionette during your life. You don't technically "own" the assets you transfer to the trust, the trust does - but you control the trust, and it dances upon your strings. Once the strings are cut by your death or incapacitation, the robot takes over and does what you told it to do in those circumstances. You might have told it to attach itself to someone else's strings, or you might have told it to disassemble itself, or both, as well as many other things. The important thing to remember about trusts is that they do not go through probate and they are (if written correctly) outside of estate tax as well. Remember, the "robot" owns this stuff, and the robot didn't die!. There may be a successful challenge to a trust on record somewhere, but I've never heard of one and (although not a lawyer) I can't see an angle for doing so. I do know of people who wanted to challenge them, and who appeared to have much better claims on the surface than the person who the trust had been instructed to deliver its assets to, who got their legal noses bloodied in a hurry. Ethical lawyers will generally tell potential clients seeking to challenge a trust "I'll look at it if you want, but if it's written correctly there's not a thing I can do except spend your money."



Next, life insurance. There are so many uses for Life Insurance in estate planning that it is hard to conceive of a good plan that doesn't use life insurance, and by that I don't mean term life insurance either, but one of the cash-value variety. Term life gets so expensive after age 60 that 97 percent of it gets cancelled before it pays benefits. For estate planning purposes, life insurance is useless if it doesn't stay in effect the entire rest of your life. Many people will tell you to buy term, but that's a particularly short-sighted, short-term solution that presumes your need for life insurance will vanish as soon as you've got some decent assets or your kids graduate college. Neither is likely to be the case for anybody middle class today.



This is most deeply rooted in straw-man arguments that claim term insurance is better by comparing it to whole life, ignoring the superior cash value life insurance types, and claim to have refuted the value of all cash value life insurance when they have only refuted whole life, and only within the set of parameters they have set. For older people (age seventy and up at time of plan) universal life is likely the way to go, while with younger people (definitely anyone under 50) it is difficult to come up with a scenario where Variable Universal Life does not outperform its term competitor in every way.



It appears that the difficulty of estate tax is likely to come soon, but there are issues. Even if a permanent repeal takes place, there is nothing to say it could not be re-imposed later. Second, it does nothing about state levied estate taxes. Third, some states have started re-exploring inheritance taxes as a consequence, which would be a disaster. Since estate tax is levied strictly on assets you own when you die (albeit with some recapture of stuff up to three years previously), it is avoidable to such an extent as to render it basically a volutarily paid tax on denial. All I can say is that the people paying it must have wanted to pay it, because there are legal ways not to owe the tax and all you have to do is plan ahead.



I want estate tax gone, mind you, but if I have to choose between complete and permanent estate tax repeal, or say, indexing the Alternative Minimum Tax (AMT) to inflation and putting estate tax back to where it was pre-2000, I'll support the latter option unreservedly. So just because the sentiment is there for repeal doesn't mean it'll happen, or that it'll be permanent if it does. So I suggest planning for estate tax as if it's going to effect you, and some of the methods of estate planning can actually increase the size of your gross estate beyond what it would have been without planning.



Will. Trust(s). Life Insurance. A good plan will have all of these, as well as others (Durable Power of Attorney for Health Care, to name one). I'd say Caveat Emptor, except it's more a case of "Be careful what you wish for. You may get it."

Passive Asset Allocation

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A while ago I talked about Passive Asset Allocation as a way to beat market return as a strategy. So I'm going to write a bit about what it is, why it works, and how to do it.



Passive Asset Allocation is very simple at its heart. What you are doing is keeping the balance between asset classes that you have decided is best for your situation.



The way you do it is simple. The objective is to maintain a certain investment mix. You allocate your investment pool among the asset classes, and at strict intervals, rebalance to that allocation from whatever has happened over time. Typical period is once per year. You can do it either with individual stocks and bonds, or with mutual funds, variable sub-accounts, or even a mix. For most folks, bonds especially are going to require mutual funds or variable sub-accounts, as individual bonds tend to be high dollar values.



Here's an example, based upon an established portfolio of $100,000. Average market growth is 10%, but it's not evenly spread:



Large Cap growth $10000 @11%=$11100

Small cap growth $10000 @14%=$11400

Large cap value $10000 @14%=$11400

small cap value $10000 @20%=$12000

developing world $10000 @-5%= $9500

developed world $10000 @-2%= $9800

sector investment $10000 @24%=$12400

short bond $10000 @ 7%=$10700

intermediate bond $10000 @ 8%=$10800

long term bond $10000 @ 9%=$10900



The portfolio is now $110,000. Rebalancing (note that this is a taxable transaction unless it's tax sheltered) to the original percentage allocation, we get these returns the next year:



Large Cap growth $11000 @18%=$12980

Small cap growth $11000 @ 4%=$11440

Large cap value $11000 @25%=$13750

small cap value $11000 @ 6%=$11660

developing world $11000 @20%=$13200

industrial foreign $11000 @14%=$12540

sector investment $11000 @-12%=$9680

short bond $11000 @ 6%=$11660

intermediate bond $11000 @ 8%=$11880

long term bond $11000 @11%=$12210



Total is $121000. Seems like right on 10% compounded, right? But look what would have happened if you didn't rebalance:



Large Cap growth $11100 @18%=$13098

Small cap growth $11400 @ 4%=$11856

Large cap value $11400 @25%=$14250

small cap value $12000 @ 6%=$12720

developing world $9500 @20%=$11400

industrial foreign $9800 @14%=$11172

sector investment $12400 @-12%=$10912

short bond $10700 @ 6%=$11342

intermediate bond $10800 @ 8%=$11664

long term bond $10900 @11%=$12099



Total is $120,513. You've added $487 by moving money from where assets were relatively expensive, to where they were relatively cheap.



Let's do it on more year:



Large Cap growth $12100 @-5%=$11495

Small cap growth $12100 @14%=$13794

Large cap value $12100 @-9%=$11011

small cap value $12100 @12%=$13552

developing world $12100 @18%=$14278

industrial foreign $12100 @20%=$14520

sector investment $12100 @24%=$15004

short bond $12100 @ 8%=$13068

intermediate bond $12100 @ 9%=$13189

long term bond $12100 @ 9%=$13189



Total is $133,100. If you rebalanced once per year. If you didn't, here's what you end up with:



Large Cap growth $13098 @-5%=$12443.10

Small cap growth $11856 @14%=$13515.84

Large cap value $14250 @-9%=$12967.50

small cap value $12720 @12%=$14246.40

developing world $11400 @18%=$13452.00

industrial foreign $11172 @20%=$13406.40

sector investment $10912 @24%=$13530.88

short bond $11342 @ 8%=$12249.36

intermediate bond $11664 @ 9%=$12713.76

long term bond $12099 @ 9%=$13187.91



For a total of 131713.15, a difference of 1386.85 you lost in just two years.



This works even better in real world circumstances. Here, I used a larger number of asset classes than most folks use, forced them to be exactly equal, and then forced the yearly returns to average exactly 10% in order to isolate the effects of rebalancing versus not rebalancing from all other concerns. The real market is not so neat. Some years you'll be on top of the world because you gained 40 percent, some years you'll be picking up pennies on street corners because you lost twenty (and it's been better as well as worse than that within the last ten years).



The whole thing that makes this work is that you are moving money from where assets are relatively expensive to where they are relatively cheap at the moment. This is another real world example of the principle behind dollar cost averaging.



It would fall apart if one asset class outperformed all others, or underperformed all others, consistently over time. But this hasn't happened yet. Even in the asset classes that do outperform others over time, the consistency is not there. These classes are volatile. They will do very well one year or two, then do very poorly. When I see or hear people talking about "letting their winners run" over a multi-year period, particularly if they're talking mutual funds or the equivalent rather than a particular security, I know I shouldn't trouble myself about their advice. If an individual security was bought as part of an asset class, that's fine - as long as it still meets the definition of that asset class and you deal with it appropriately.



The one thing that kills this strategy is not sticking to it. "Google has doubled and is still going up!" (or Qualcomm, or Microsoft, or...). The idea is lock the gains in, buy where stuff is relatively cheap. The same asset classes do not do equally well from year to year. It is rare to find one year's superior asset class among the next year's superior performers. This can be hard with individual securities, so most folks who adopt this strategy use mutual funds or variable insurance instrument sub-accounts.



What can sabotage you is a fund company or variable sub-account who will not sit on their fund managers and make certain they adhere to stated asset class. When a Large cap value allocation has forty percent of its stocks in common with a small cap growth allocation, you've got a problem, no matter how wonderful that forty percent performs. It's likely buying apparent performance through demand, which only works short term. One mutual fund company got away with artificial inflation of this kind for about two and a half years back around the start of the decade before the market caught up with them. People are still holding their funds, though, confident that they'll recover because they were doing so well for a while...



Speaking of which, I left financial planning a couple of years ago, but my former clients who did this had amazingly resilient accounts when the market went bust in 2000-2002. Nobody went much below peak account values, and they were all ahead of previous high account balances by the beginning of 2003 (even discounting the effects of contributions). One's balance went from $44,000 to $86,000 over that period with about $10,000 in contributions. Why? Because they didn't let greed rule them.



And before I close, I do need to say that past results are not guarantees of future returns, and this is not a panacea. Consult a currently qualified professional. If an asset class is getting obviously overbalanced or under-represented, it may be time to deal with the situation even though it's only been six months, or one. If you're holding security X, and you keep getting tips on how hot it is, it's probably time to sell.



Caveat Emptor


what happen when 401K leave blank on beneficiary

Nothing unless you die, and it's not covered in your will or other documents. Then the state's intestate code takes effect. Each state has a law for how the estates of those who die intestate will be divvied up. These laws were typically made generations ago, and the societal assumptions that they make are no longer valid. Furthermore, by failing to name a beneficiary, you are passing up on the chance to avoid probate, the legal process by which your estate is gotten to your heirs. Everybody has a probate, and fees are levied on the basis of the value of the assets that are in probate. For many assets, such as bank accounts and investment accounts, avoiding probate is as easy as naming someone a beneficiary, and any accounts where you have names someone a beneficiary go to them immediately upon proof of your death, outside of probate.

This is important because your heirs do not have access to probated assets until probate is settled. This is a minimum of nine months, and in large complex cases can be a couple of decades. Probate fees are about seven percent per year, and until probate is settled, they might get to live in the house you left - but they can't sell the house if they need to move, or if, for instance, all of your assets are tied up in probate and they can't make the payments on the loan.

Most people do not understand the naming of beneficiaries, and never give it a second thought. Many times this translates to the first spouse still being the beneficiary of a policy of life insurance, when you divorced without children fifteen years ago, and now your second spouse has two young children to bring up without you, and without your life insurance proceeds. Even if the first spouse is generous enough to disclaim the money, since you obviously did not name your second spouse as a beneficiary, the money now has to go through probate.

Contingent beneficiaries are also important. Primary beneficiaries sometimes predecease you, or perish in the same accident. One common (and often worthwhile) tactic is to name spouses as primary beneficiaries, children as contingent beneficiaries. Many accounts allow the naming of secondary contingent beneficiaries as well. One approach is to name them individually, another to name them as a class ("all natural and adopted children of John and Jane Smith"), and two ways of accounting for their as yet unknown numbers of people who may be born later, "per stirpes" which is by branch, and "per capita" which is by head.

Every time you have a major life event, such as marriage, divorce, birth of a child, or the death of someone who is one of your beneficiaries, you should make a habit of going through all of your accounts and making certain the beneficiary designations are up to date with the new developments. Of course, if you have trusts and the like, this is also an ongoing requirement for them, and trusts are even better for avoiding unnecessary estate complications.

Caveat Emptor

The Prerequisites of Investing

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It shouldn't surprise anyone that there are things you should do before you make your first investment. The SEC, NASD and all of the various other financial planning organizations all explicitly list three things that should be in place in most cases prior to making your first investment in anything.



The first of these is an operating reserve. This is a fund of ready cash outside of any investment account, that you can use for emergencies. The minimum is three months of your normal expenditures, but six months is better. People lose jobs, have accidents, have health problems, things come up - you get the idea. Unless your job is rock steady, your cash flow predictable, and you can live on less than fifty percent of your take home pay, you really want to have living expenses for six months saved up, and for some self employed situations where your cash flow is uneven (like say, financial planner or real estate), twelve months is better. Having this much cash on hand gives you a certain security, and you likely won't have to cash in your investment for some minor emergency.



The second of these is a life insurance policy. This isn't from any deep-seated desire to sell you a life insurance policy. Investment professionals have only been getting insurance licenses since about 1980, and this recommendation is far older than that. Almost everyone is going to need a life insurance policy at some point in their life, and it is cheaper and more effective to purchase while you are young. and especially before health problems are likely to develop. As I've found out, sometimes things happen to you that prevent you from obtaining life insurance (as in no company will issue you a policy, or will only do so on prohibitive terms), and if you want a family eventually, it is wise to take care of this now. Furthermore, certain life insurance policies are among the very best investments you can make, and more effective the sooner you start them. This is not to say that life insurance is for everyone. I have a client who's older, has no dependents and never will, has plenty of assets to cover final expenses, and those assets are titled so that they will pass immediately and correctly to his heirs. A life insurance policy would still be of benefit if he had certain goals, but he doesn't. So we've decided it's not for him.



The third of these is estate planning. This is actually in the requirements as a will, but there are other elements such as durable power of attorney for health care, living trusts, and so on. These do cost a certain amount of money, but it's money well spent. If something happens to you without doing this planning, every state in the US has a different law as to what happens to your assets, your minor children, your pets, etcetera. These are all cookie cutter approaches, and that cookie cutter was likely enacted a long time ago, to where the societal assumptions that the legislature made at that time are no longer valid for any large proportion of the population. The majority of your assets should not be transferred by a will, anyway - wills can be and are challenged successfully every day. Trusts are far better.



If the person you work with is any kind of financial planner, they should add two additional concerns to the list. They are disability income insurance and long term care insurance. The need for both goes away as you become more affluent. Remember, that insurance companies exist to make a profit and if you can afford the risk of losing what they insure, you shouldn't buy a policy. So if you've got a couple million somewhere, and if you never made another penny you would be comfortable, there is no need for disability insurance. The same applies to Long Term Care, albeit probably requiring more affluence. Average base per diem cost in California is $180, with another $60 or so in supplemental charges. So when you can afford $240 per day (between $85,000 and $90,000 per year) for a period of several years in addition to what ever else you may need for your family to live, you are not a good candidate for long term care insurance. On the other hand, long term care facility prices keep rising, and as medical capabilities for keeping you alive get better, you can expect to spend longer in such a facility.



(For all the money and research we throw at prolonging lives, you'd think we could spend more on making it a robust life, or allocate more of what we already spend towards that end. More and more, we are statistically tending towards living longer in an increasingly frail, helpless and joyless condition. As long as people are enjoying life, more power to them. When it becomes a miserable painful existence, as I have seen too much of, I just don't see the point. When I see what so many people put themselves or their loved ones through, I'm making certain I'll always have a "check out" option under my own control, and if I don't have control to exercise, my wife and I are agreed that neither one of us wants to hang around).



Thoughts on Abolishing Estate Tax

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I have never liked or favored the estate tax, and yet I am very much of two minds about actually abolishing it. I'm glad of the benefits to the individuals involved, and yet it is only one of the issues involved in planning for what happens to all of us eventually, and abolishing it removes the most obvious motivation for handling the rest.



The benefit of abolishing the estate tax is obvious: people don't get taxed, so their heirs get what they earned rather than the government. This is a good thing, and I favor it for that reason.



On the other hand, there were so many mechanisms varying from outright gifting to 529 accounts to life insurance to trusts, each of which except the first can be used to retain control and benefits of assets while avoiding estate tax liability, that estate tax is and always has been essentially voluntary. You have to just not plan in order to pay estate tax, and some of the mechanisms available actually increase your available estate over what would have been its original gross value otherwise. Since we know that death is something each of us is going to have to face, there can be no reason except stupidity for not undertaking to plan for it. Estate tax was a voluntarily paid tax on stupidity.



Furthermore, there are other estate and contingency planning options that people need to take care of, and fewer people are doing so as estate tax was one of the primary levers that moved people to do it. All of this planning is just as necessary as estate tax planning, and usually taken care of at the same time.



Here are just a few of the other issues:



Will: The will probably should not be used for financial purposes, but resolves other functions such as who gets custody of minor children. Please note that a will is not necessarily binding upon the states where your will is probated, and can be challenged. Many wills are challenged, a large portion of them successfully, and even if your estate wins the battle it will be diminished in the process.



Durable Power of Attorney for Health Care: if you can't make health care decisions, this tells who you delegate that power to. If there's a court case brought, it's going to be very short and abrupt. Case closed.



Trusts, revocable and irrevocable. I'm not certain it's possible to successfully challenge a well-constructed trust where the assets that are actually transferred to it are concerned. You didn't own them. The trust does, and the trust didn't die. The instructions live on, like a corporation. The named successor trustee also usually gets the ability to manage the trust's assets if you are alive but incapable. Assets in a trust can avoid not only estate tax, but probate as well. If you want to be certain of the disposition of what you leave, particularly in a speedy manner, this is probably the way to go. Many estates are not finished with probates for years, and until they are, your heirs don't get control of the assets. Nor are we certain that estate tax is going away forever. Probate is also expensive, time consuming, and lucrative for attorneys. Seven percent of probated assets seems to be about the minimum cost, and it can easily top thirty percent. I haven't investigated, but I suspect the trial lawyers would be solidly behind banishing estate tax for this reason.



Business operations: many small to medium sized businesses have no plan to keep them going in the event the owner-operator dies or becomes disabled. Certainly nobody else working there has the knowledge, the experience, and often the necessary licenses. If the business closes because the proprietor isn't there, it's worthless. If there's a plan of succession to keep it open and operating, however, you or your family can likely sell it as a going concern with consistent profit.



Retirement plans: If you have certain types of tax deferred retirement plans, they can be expensive to convert to assets in your heirs' possession, even without estate tax. Better to draw these down and keep other accounts available.



Life Insurance: There are going to be expenses when you go. These vary from taking care of the body you leave behind to probate to keeping your business running if you have one. The people doing these things want cash. Life insurance is usually the cheapest way to pay them. Your family is also likely to need something to replace your income in many cases. Life insurance is about the only choice.



One hopes you begin to get the idea. Consult an attorney and financial professional in your area to find out how it works, but all of this needs to be taken care of, or your family will wish you had.



Caveat Emptor.





A while back, I got an e-mail asking me what my favorite books for investors and real estate folks were.



My response?







Unless you're going to practice professionally and undertake the study necessary to do a good job of it, personal financial advice books are largely a waste of money. The only reason I read them is to find out what the latest rationalizations are for avoiding professionals.



Every personal finance book I've ever read has an agenda of selling more (and future) books that conflicts with the ostensible purpose of making the reader as wealthy as possible. The one book in this category I've seen where this was outweighed by the good advice is Rich Dad, Poor Dad - which I suspect is already on your list. In fact, the best method of long term success is finding a good professional and making a long term individual plan, and the money you pay that professional is likely to be the best investment you'll ever make.



This is why the approach I take on my site is often weighted towards mathematical models, to debunk the nonsense and hype. My recommendations for reading would tend be in the way of college texts and similar things.



Any comprehensive logic text. Make valid arguments a habit. Spot bad links in an an argument.



A beginning psychology text is critical. Learn the importance of psychology in personal finance and get to the point where you always challenge your conclusions.



Double entry Accounting and tax texts. You cannot play the game well if you do not understand the system for keeping score.



One each freshman (college) calculus, physics, and chemistry books, that teach how to handle numbers and approaches that handle the entire system, with plusses, minuses, and second and third order effects. Learn that optimizing individual terms of an formula does not necessarily optimize the entire formula, and the more complex the system, the more likely this is to be true.



The NASD Series 6 and 7 license exam prep books. You have to be sponsored to take the tests, but anybody can read the books.



One of the California Principles of Life Insurance license exam prep books. I understand New York state may have an even better program.



Above all, believe it or not, various military works. Sun Tzu, Frederick the Great, and Von Clausewitz in particular. Sun Tzu is easy reading, but if you're not careful, you'll miss something critical. Frederick is fairly straightforward. Von Clausewitz can be heavy going

but teaches too much to be foregone.





For real estate investors, I would add a good real estate license prep course. For mortgage loans, well, the reason that's such a heavy area of concentration for this site is because there is nothing out there that I've found, and misapprehensions are legion.



There is no shortcut to competence or genius. Looking for shortcuts is a good way to waste your time, your money, and lose a substantial chunk of change when you could have made money instead. Nor is studying the market the only requisite for success. You won't often find people recommending you read a couple books and act as your own lawyer, and many of the best financial planners I know pay almost no attention to the day-to-day happenings of the market. Paying a professional puts somebody in your corner who should know better - and if they don't, if gives you someone that you can hold responsible, something that is not a feature of any of the self-help books that make a lot of people a very good living, but in my experience do more damage than good.



Caveat Emptor

In my experience, these are death to your credit rating. Why?



Because of how they work. The short story is they get your creditors to agree to accept some lesser number of dollars for your debts. The creditors, for their part, aren't happy about this. They often mark you as not having paid in full. But that's not the really painful thing.



Since you're not paying the service very much, what usually happens is that they sit on your money for as long as they can before passing it on to your creditors. Thirty, sixty, even ninety days, to earn all of the interest they can.



But your creditors want that payment every month on time. So of course they are marking you thirty days late, sixty days late, or even ninety days late. Every creditor, every account. Every single one that's late lowers you credit score. It's unusual for folks who go through this to have credit scores over 500, and the worst score I've ever actually seen was the result of a debt consolidation "service" promising to "help" them. To paraphrase Arthur Dent, these must be new definitions of those words "service" and "help" with which I was previously unacquainted.



(Unethical Chapter 13 bankruptcy trustees can do the same thing, which is one reason why Chapter 13 is usually worse on your credit than Chapter 7, a severe flaw in the bankruptcy reform law being that it forces folks to hurt themselves worse when they are already in a bad situation. I've seen people one day out of Chapter 7 with 650 scores, and 580 is pretty common. 650 would be possible A paper if you're full documentation and didn't have more than a couple late payments. 580 is eminently improvable to something that looks decent in a hurry. The score coming out of Chapter 13 is usually something under 500)



Furthermore, debt consolidation services don't do anything that you cannot do yourself. Call the company and tell them the situation. They will terminate any open line of credit and remove the privilege of new purchases from your account, but they'll do that as soon as contacted by debt consolidation services, anyway. Furthermore, if you're in a hole the first step to fixing the situation is to STOP DIGGING!



When you call, have a good idea how much you can really pay per month. If you need to do this with multiple creditors, keep in mind that whatever you've got to pay with is going to have to be parceled out amongst all of your creditors, and don't allow yourself to be talked into more than the proportional amount. If you run into a lot of problems with negotiation, go to a legal aid center. Bankruptcies are a large portion of what they deal with. Explain that you have tried to work out a payment plan but that creditors X and Y are not being reasonable. It may be that bankruptcy is the way to go, but that's between you and a lawyer to decide.



Furthermore, whatever you do, keep at least one or two accounts in good standing if you possibly can. Keep one or two credit lines outside the payment plan or bankruptcy, and pay the payments in full and on time every month. Once you come out of the payment plan or bankruptcy, you're going to wish you had. You see, percentage of trade lines you include is one thing that will help determine your credit score later. If you included everything, you've hit your credit report as hard as possible. If you don't have any credit lines, you have to have new ones to start building new credit, and every time you make an inquiry after bankruptcy, the hit is much harder on your score than an inquiry from someone who hasn't been bankrupt. Finally, if you don't have any post-situation record of payments, it's never going to get better. The poor schmoe who includes everything he owes is pretty much hosed for a long time. My understanding is that a credit line where you owe $75 counts for this every bit as heavily as one where you owe $75,000, but it would be wise to double check that as it may be incorrect.



Caveat Emptor

Probate Without Money

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legal information on going through probate without money


That was a search hit I got.

The problem with this question is that you can't go through probate without money. The deceased's creditors want cash. The probate court wants cash. Attorneys and anybody else your executor has to hire want cash. Federal Estate tax may be on the way out, but while it's still here, that final tax form and the cash are due nine months after death. State estate tax is still here in most states, nor is it likely to go away, and the state wants cash, not promissory notes.

Your estate is going to have to get this money from somewhere, and I'll enumerate the classical alternatives, assuming that the point is not moot. If you die owing more than you have, settling your estate becomes a matter of purely academic interest, because your heirs aren't getting anything substantial.

Most obvious is to pay for it with money on hand, already in the estate. If you could afford this, you wouldn't have been running that search.

Also obvious is to have the executor (or other heir) loan the money out of their own pocket. This sometimes happens in the case of someone who's inheriting a house or other major assets. Sometimes executors take out short term loans for this purpose, also. Be careful - one thing most state laws require is that when you pay a debt for an estate, you must get written proof that you paid it out of your own funds for the settlement of the debts of the estate. On the other hand, if you could do this you probably wouldn't be running this search.

The next option is sale of assets to pay the debts, taxes, and anything else. This happens disturbingly often, mostly as a result of people who persist in believing that they're going to live forever. The notable drawbacks of this are two. The minor one is that maybe your heirs didn't want to sell, and the major one is that they're not likely to get anything like full price in such a situation. When you have to sell, the ones with the cash drive fire sale-like bargains. Also, the executor has to have the court approve this, which costs money in and of itself.

The next option is to do nothing. If this is what your heirs opt for, the vast majority of the time the court will order any assets there may be sold in order to pay the existing creditors and new assessments caused by your death. Your heirs are likely to get even less money here than the previous paragraph, and the court itself certainly won't cost any less.

The final option, and likely the best one, is to do what folks who plan ahead do, and have a policy of life insurance in effect. This is one of the reasons why Variable Life, and particularly Variable Universal Life Insurance, beats term life insurance like a red-headed stepchild when you consider the lifelong implications. The proceeds are all leveraged, tax free money, coming to pay your estate's bills as soon as your executor sends the insurance company your notice of death. Unfortunately, at the time your heirs are running that search, it's too late for this option. Like most really wonderful financial windfalls, you've got to plan ahead to make this work for your heirs.

Caveat Emptor.




From an email:





I've been enjoying your blog posts on mortgages. I've learned more from you about what to expect than I have from any other source, and I've gotten 10 mortgages in my life.



I was reading Larry William's website this week, and on there I saw one of his newsletters from last summer:

http://www.ireallytrade.com/

http://www.ireallytrade.com/freestuff.htm

the May 2005 Right Stock.



Larry Williams you may be familiar with, he's written many books on trading.



Anyways, the newsletter talks about buying 2nd mortgage notes as an investment. And that's something I haven't seen you write about.



With the softening of the housing market in many areas, and overextended borrowers, I suspect that the market for 2nd notes will be heating up over the next few months and years.



I'd appreciate hearing your views on the opportunities and pitfalls in this area.





Let us consider the efficiencies of the market. The Institutional lenders have economies of scale, underwriting guidelines, and a set checklist of procedures as to how to approve (or decline) loans. They have a system that makes them effective. They can do this because they have enough loans to make it cost-effective, and because of their experience, they know how to price their loans. From advertising to wholesaling to pricing to packaging and servicing, they are set up for efficient service. Lest people think I'm saying lenders are a better place to get loans than brokers, I am not. Quite the reverse is true. But the the vast majority of broker originated loans are with regulated institutional lenders.



What happens if you're not set up like that? The answer is you're either more highly priced than they are, or you're not as profitable. I've said more than once that without regulated institutional lenders, every loan would be a hard money loan. So in trying to originate loans, an individual is competing at a disadvantage. Where then, can they make a profit?



The answer is in the loans that the regulated lenders won't or can't touch. Now we need to ask ourselves why they can't or won't touch them. There are three common reasons. First is there is something wrong with the borrower. Second is that there's not enough equity. Third is that there is something wrong with the property.



Something wrong with the borrower has several subtypes. Credit Score too low, in bankruptcy, too many mortgage lates, no source of income to pay back the loan. Most of these can be gotten around in one degree or another unless they take place in combination with insufficient equity. Most single problems are surmountable by a good loan officer, providing you've got the equity required to convince the bank they won't lose their investment. You'll pay a higher rate or higher fees than you would without, but better that than no loan. It's when they take place in combination that problems arise which break the loan beyond the ability to rescue. And of course, if the property is not marketable in its current condition, no regulated lender will touch it.



What the first category reduces to is increased chance of default. The second category reduces to increased risk of losing money in case of default. The third category, something wrong with the property, reduces to you're going to get stuck fixing the property if they do default, which means sinking thousands to tens of thousands of dollars into it, above and beyond the amount of the trust deed. Furthermore, both the second and third categories are also at increased risk for default, even if the borrower has the wealth of Midas and the credit score to match.



So let's consider what happens when something goes wrong. The borrower doesn't make their payments, and it becomes a non-performing loan. You're not getting your money. If you need it every month, that's a problem. Do you know the proper procedure to foreclose without missing any i-dots or t-crossings? If you don't, your borrower can spin it out a long time. Well, that's what a servicer is for, but a servicer cuts into your margin, and they get their money every month regardless of whether or not you get paid. This means they're a monthly liability if the loan isn't performing. Furthermore, over half the time, some low-life attorney talks the people into filing bankruptcy to delay the inevitable. It's stupid, and it almost always ends up costing them still more money and making their final situation much worse, but they do it anyway - and now you have to start paying an attorney to have any hope of getting your money.



Suppose the property does go all the way to auction? You are second in line behind the holder of the first trust deed. They get every penny they are due before you get one penny. And if the first trust deed holder forecloses (or the government for property taxes), your trust deed is wiped out. The only way to defent against this is go to the auction with cash to defend your interest. And if the borrower isn't paying you, may I ask why you think they'll pay their property taxes or first trust deed? The answer is "they're probably not." They are going to lose the property anyway, so why make payments that don't prevent that?



(There are a lot of details in the foreclosure process. The stuff in the above paragraph should not be taken for anything more than a broad brush child's watercolor type painting of the process, as including those details would digress too far)



Now, suppose you're not originating the loan, you're just buying the right to receive payments, either on an individual loan or a package of loans, after the fact?



Well, can I ask you which loans you think the lenders are selling? If you answered "The ones in greatest danger of default" you get a star for the day! The lenders will either sell them off individually, if there are people inclined to buy, or actually repackage them thusly. The ones that are still performing, and still going according to the original guidelines will go to other regulated institutional lenders in mass packages, but those lenders won't take these, or if they will, it'll bring the price of the entire package down by more than it's worth. So they seperate out the dogs before they sell the package. So unless you're buying them as part of the original loan package, this is what's happening. Now mind you, there are always those who want the non-performing loans because they know how to deal with them, but they know to only buy the ones with enough equity to cover the loans in case they need to foreclose. Those who specialize also know what these loans are really worth, and they don't pay full value - usually not even close.



So the aftermarket loans that are available tend to be in danger of default and without sufficient equity to cover if it goes to auction. If you're looking to lose your money, you've just found a very good way. You can also spend thousands of extra dollars trivially trying to defend your interests.



The equity issue is going to assume increased importance as prices in some overheated areas subside. If the loan was underwritten and approved on the basis of a $500,000 appraisal, but now similar properties are only selling for $420,000 and the loans total $450,000, it doesn't need a genius to understand you're not in the best of positions. Even if it sells at auction for as much as comparables are going for, you're still down at least $30,000 plus the expenses of the sale.



Now, with that said, second trust deeds can, if the equity is there, put you in the catbird seat. Suppose there's an IRS lien junior to you? Our office dealt with a $700,000 property with a $1.6 million lien against it - junior to the $28,000 second we bought. Nobody else could touch that property. The owner just wanted out - he wasn't getting any money regardless of what happened. He stopped making payments, and we had to step in with thousands of dollars to keep the holder of the first happy. There ended up being a fair amount of money made, although it took some serious cash for a while, because we had to make the payments on the first loan as well as everything else. This is not for the weak of wallet. If buying the Note had taken all of our ready money, we would have been SOL.



There are also all of the standard diversification of investment concerns. If ninety percent of your money is tied up in this deed, that's a pretty serious risk to your overall financial health. No matter how many precautions you take, some do go sour.



In short, while there is a lot of potential for gain, it's some serious work to evaluate the situation, and usually some serious work and serious cash to make it work for you when it is right.



Caveat Emptor.





UPDATE: something I'm running into a lot right now: Lenders that sell the note but retain servicing rights. So when the note goes south, and my client wants to buy into a distressed situation, the servicers are rejecting offers without checking with the actual investor, because they could get sued (for misrepresentation and bad underwriting) if they accept less than they loaned. On the other hand, if the property sits on the market (thereby costing the investors even more money), they don't get sued because, hey, the asking price is enough to cover the note. Now there is a legal deadline involved with lender owned properties, and nobody is going to offer enough to bail them out. But it's kind of like the old joke: "A lot can happen in a year. I may die. The King may die. And perhaps the horse will sing." Corporations don't die. Even if it were an individual investor, someone's going to inherit the right to payments. I do not think this horse will sing - it probably won't even whinny. In other words, nobody is going to offer enough to bail the lender out of their fix. Near as I can figure, those controlling the corporations holding servicing rights are evidently hoping that by that time, they will have moved on to other jobs and can't be held liable as individuals.



One more reason to be very careful investing in trust deeds.

Passive Asset Allocation

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A while ago I talked about Passive Asset Allocation as a way to beat market return as a strategy. So I'm going to write a bit about what it is, why it works, and how to do it.



Passive Asset Allocation is very simple at its heart. What you are doing is keeping the balance between asset classes that you have decided is best for your situation.



The way you do it is simple. The objective is to maintain a certain investment mix. You allocate your investment pool among the asset classes, and at strict intervals, rebalance to that allocation from whatever has happened over time. Typical period is once per year. You can do it either with individual stocks and bonds, or with mutual funds, variable subaccounts, or even a mix. For most folks, bonds especially are going to require mutual funds or variable subaccounts, as individual bonds tend to be high dollar values.



Here's an example, based upon an established portfolio of $100,000. Average market growth is 10%, but it's not evenly spread:



Large Cap growth $10000 @11%=$11100

Small cap growth $10000 @14%=$11400

Large cap value $10000 @14%=$11400

small cap value $10000 @20%=$12000

developing world $10000 @-5%= $9500

developed world $10000 @-2%= $9800

sector investment $10000 @24%=$12400

short bond $10000 @ 7%=$10700

intermediate bond $10000 @ 8%=$10800

long term bond $10000 @ 9%=$10900



The portfolio is now $110,000. Rebalancing (note that this is a taxable transaction unless it's tax sheltered) to the original percentage allocation, we get these returns the next year:



Large Cap growth $11000 @18%=$12980

Small cap growth $11000 @ 4%=$11440

Large cap value $11000 @25%=$13750

small cap value $11000 @ 6%=$11660

developing world $11000 @20%=$13200

industrial foreign $11000 @14%=$12540

sector investment $11000 @-12%=$9680

short bond $11000 @ 6%=$11660

intermediate bond $11000 @ 8%=$11880

long term bond $11000 @11%=$12210



Total is $121000. Seems like right on 10% compounded, right? But look what would have happened if you didn't rebalance:



Large Cap growth $11100 @18%=$13098

Small cap growth $11400 @ 4%=$11856

Large cap value $11400 @25%=$14250

small cap value $12000 @ 6%=$12720

developing world $9500 @20%=$11400

industrial foreign $9800 @14%=$11172

sector investment $12400 @-12%=$10912

short bond $10700 @ 6%=$11342

intermediate bond $10800 @ 8%=$11664

long term bond $10900 @11%=$12099



Total is $120,513. You've added $487 by moving money from where assets were relatively expensive, to where they were relatively cheap.



Let's do it on more year:



Large Cap growth $12100 @-5%=$11495

Small cap growth $12100 @14%=$13794

Large cap value $12100 @-9%=$11011

small cap value $12100 @12%=$13552

developing world $12100 @18%=$14278

industrial foreign $12100 @20%=$14520

sector investment $12100 @24%=$15004

short bond $12100 @ 8%=$13068

intermediate bond $12100 @ 9%=$13189

long term bond $12100 @ 9%=$13189



Total is $133,100. If you rebalanced once per year. If you didn't, here's what you end up with:



Large Cap growth $13098 @-5%=$12443.10

Small cap growth $11856 @14%=$13515.84

Large cap value $14250 @-9%=$12967.50

small cap value $12720 @12%=$14246.40

developing world $11400 @18%=$13452.00

industrial foreign $11172 @20%=$13406.40

sector investment $10912 @24%=$13530.88

short bond $11342 @ 8%=$12249.36

intermediate bond $11664 @ 9%=$12713.76

long term bond $12099 @ 9%=$13187.91



For a total of 131713.15, a difference of 1386.85 you lost in just two years.



This works even better in real world circumstances. Here, I used a larger number of asset classes than most folks use, forced them to be exactly equal, and then forced the yearly returns to average exactly 10% in order to isolate the effects of rebalancing versus not rebalancing from all other concerns. The real market is not so neat. Some years you'll be on top of the world because you gained 40 percent, some years you'll be picking up pennies on street corners because you lost twenty (and it's been better as well as worse than that within the last ten years).



The whole thing that makes this work is that you are moving money from where assets are relatively expensive to where they are relatively cheap at the moment. This is another real world example of the principle behind dollar cost averaging.



It would fall apart if one asset class outperformed all others, or underperformed all others, consistently over time. But this hasn't happened yet. Even in the asset classes that do outperform others over time, the consistency is not there. These classes are volatile. They will do very well one year or two, then do very poorly. When I see or hear people talking about "letting their winners run" over a multi-year period, particularly if they're talking mutual funds or the equivalent rather than a particular security, I know I shouldn't trouble myself about their advice. If an individual security was bought as part of an asset class, that's fine - as long as it still meets the definition of that asset class and you deal with it appropriately.



The one thing that kills this strategy is not sticking to it. "Google has doubled and is still going up!" (or Qualcomm, or Microsoft, or...). The idea is lock the gains in, buy where stuff is realtively cheap. The same asset classes do not do equally well from year to year. It is rare to find one year's superior asset class among the next year's superior performers. This can be hard with individual securities, so most folks who adopt this strategy use mutual funds or variable insurance instrument subaccounts.



What can sabotage you is a fund company or variable subaccount who will not sit on their fund managers and make certain they adhere to stated asset class. When a Large cap value allocation has forty percent of its stocks in common with a small cap growth allocation, you've got a problem, no matter how wonderful that forty percent performs. It's likely buying apparent performance through demand, which only works short term. One mutual fund company got away with artificial inflation of this kind for about two and a half years back around the start of the decade before the market caught up with them. People are still holding their funds, though, confident that they'll recover because they were doing so well for a while...



Speaking of which, I left financial planning a couple of years ago, but my former clients who did this had amazingly resilient accounts when the market went bust in 2000-2002. Nobody went much below peak account values, and they were all ahead of previous high account balances by the beginning of 2003 (even discounting the effects of contributions). One's balance went from $44,000 to $86,000 over that period with about $10,000 in contributions. Why? Because they didn't let greed rule them.



And before I close, I do need to say that past results are not guarantees of future returns, and this is not a panacea. Consult a currently qualified professional. If an asset class is getting obviously overbalanced or under-represented, it may be time to deal with the situation even though it's only been six months, or one. If you're holding security X, and you keep getting tips on how hot it is, it's probably time to sell.



Caveat Emptor.

How Do You Think About Money?

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I am profoundly lucky in that I read "I Will Fear No Evil" in high school. Not an assignment, I just like to read, and Robert A. Heinlein has always been one of my favorite authors.



A very few pages into the book, he has one of his characters toss off two famtastically good pieces of advice in quick succession, viewed from the point of view of thirty years later and multiple licenses in financial planning. He has one character, a lawyer no less, deal effectively and beyond challenge with two financial problems in quick succession. The first had to do with a very ill old gentleman with a will of longstanding effect, who doesn't want the existing provisions upset, as often happens to people who die with a new will. This extremely wealthy man has decided he wants to leave his secretary a million dollars.



The solution? A single-pay policy of life insurance. Problem solved. But once he's out of the room, the secretary protests, saying she'd just waste the money, or even get in trouble with it. She wants it given to charity.



Solution? Write it so she got an income off of it every week - essentially turn the lump sum into an income generating asset, with the additional advantage of a donation to charity when she shuffles off the mortal coil. She tells the lawyer she would never have thought of that solution.



His answer? "That's because most people think of money as something to pay the rent. They don't think of money in terms of what it can do."



Okay, I always was a math geek, but this concept was something I understood immediately, and it made a huge difference in the way I thought about money forever afterwards. Money wasn't just something to buy stuff with. Money could do things. Money could make more money. Money was potential, potential that got bigger all on its own if you only let it.



Now from a much later viewpoint, I see the flaws in Mr. Heinlein's plan. If you don't want your estate plan messed with, a living trust beats a will on every point. Furthermore, the interest rate imputed in the return of the life insurance proceeds was only a simple compounding at less than four percent - I can almost certainly do that much above inflation if I invest reasonably. Nonetheless, Mr. Heinlein grasped some very powerful concepts very well, and he was able to show the application to a teenager of no particular qualification. This is better than the vast majority of supposedly more sophisticated writers of serious "litracha" can usually do, and he did in almost in passing - no preaching, no grandstanding, just one heck of an effective example, twice in the space of a hundred words or so that were completely aside of the main plot.



These days, I still love reading fiction where the writers show they really understand economics and finance. They're hard to find. I happened to be volunteering as an event coordinator at a con a couple years ago, and ended up assigned to a reading with an author who made a mistake so elementary it showed that he had done no research because it impacted a benefit that literally everyone gets - he just didn't know about it. It really was critical to the plot, and if he had made one phone call when writing the story, any professional he called would have corrected the error. I very tactfully (for me, anyway) informed him of this gap, and I recently ran across the story in print. He hadn't fixed the error. I'm not planning on buying any more of his stuff. Another highly hyped novel said that the author understood economics and finance. What the author understood was that illegal drugs were a highly profitable trade if there's no real possibility of getting caught. Well, duh. He blew it, otherwise, not even considering the constraints of the problem he had set up. Despite the fact that I really enjoyed most of his writing, I may not buy the sequel just because what he missed was so painfully obvious to me that it really destroyed the rest of the story. As long time friends have heard me say many times, "I'm willing to suspend disbelief, but not hang it by the neck until dead!" This stuff is more constant than even the laws of physics, unless you postulate that you're dealing with a non-human psychology, and even then they're still there. Don't even get me started on the stuff supposedly written for everyday, mundane situations.



Still, some do get it right. S.M. Stirling in his Island In the Sea of Time stories, and to a lesser extent in Conquistador. Poul Anderson must have gone back through merchant records in the early Age of Sail, or known someone who did, for some of his Polesotechnic League stories, because he more than once cites some of the same sort of brutally coldblooded logic that was present then. Many of his other stories bear this same kind of mark. I was pleasantly surprised about a year ago by a side plot in a stand-alone novel from Michael P. Kube-McDowell - although he always seems to do solid research.



Got some suggestions? I'd love to hear about more such authors, who manage to teach, or at least stay in touch with economic realities while they entertain. Those authors who do a good job of this perform a real public service, while those who ignore it so that they can tell their story unencumbered by mere facts often earn their work a ceremonial throwing - twice across the room.



Caveat Emptor.


what happen when 401K leave blank on beneficiary

Nothing unless you die, and it's not covered in your will or other documents. Then the state's intestate code takes effect. Each state has a law for how the estates of those who die intestate will be divvied up. These laws were typically made generations ago, and the societal assumptions that they make are no longer valid. Furthermore, by failing to name a beneficiary, you are passing up on the chance to avoid probate, the legal process by which your estate is gotten to your heirs. Everybody has a probate, and fees are levied on the basis of the value of the assets that are in probate. For many assets, such as bank accounts and investment accounts, avoiding probate is as easy as naming someone a beneficiary, and any accounts where you have names someone a beneficiary go to them immediately upon proof of your death, outside of probate.

This is important because your heirs do not have access to those assets until probate is settled. This is a minimum of nine months, and in large complex cases can be a couple of decades. Probate fees are about seven percent per year, and until probate is settled, they might get to live in the house you left - but they can't sell the house if they need to move, or if, for instance, all of your assets are tied up in probate and they can't make the payments on the loan.

Most people do not understand the naming of beneficiaries, and never give it a second thought. Many times this translates to the first spouse still being the beneficiary of a policy of life insurance, when you divorced without children fifteen years ago, and now your second spouse has two young children to bring up without you, and without your life insurance proceeds. Even if the first spouse is generous enough to disclaim the money, since you obviously did not name your second spouse as a beneficiary, the money now has to go through probate.

Contingent beneficiaries are also important. Primary beneficiaries sometimes predecease you, or perish in the same accident. One common (and often worthwhile) tactic is to name spouses as primary beneficiaries, children as contingent beneficiaries. Many accounts allow the naming of secondary contingent beneficiaries as well. One approach is to name them individually, another to name them as a class ("all natural and adopted children of John and Jane Smith"), and two ways of accounting for their as yet unknown numbers of people who may be born later, "per stirpes" which is by branch, and "per capita" which is by head.

Every time you have a major life event, such as marriage, divorce, birth of a child, or the death of someone who is one of your beneficiaries, you should make a habit of going through all of your accounts and making certain the beneficiary designations are up to date with the new developments. Of course, if you have trusts and the like, this is also an ongoing requirement for them, and trusts are even better for avoiding unnecessary estate complications.

Caveat Emptor

The Biggest Risk

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If you've been around the financial planning business any length of time, you've likely run into the saying "The biggest risk is not taking one."



It is endemic to all financial instruments, indeed, all investments, that return is the reward for risk. It is axiomatic that the entity that takes risks gets the rewards.



Generic stock market returns are between ten and thirteen percent per year, depending upon who you ask and how you frame the question. Contrast this with the five or six percent that insurance companies will guarantee. You invest, you get five to six percent guaranteed. They use your money, they get the difference.



If you invest $100 per month at 5.5% from the time you are 25 until the time you are 65, the insurance company has guaranteed you about $174,000. If you annuitize that in a fixed annuity on a "Life with ten years certain" basis, you'd get somewhere between $1000 and $1100 per month if you're male. Ladies and gentlemen, that won't buy very much now, much less forty years from now with average inflation. Matter of fact, it's only about a 1.67 times overall return net of inflation.



Now $100 per month is a lot less than people should be investing for their own future, but it's indicative of the problem. Even if you contributed $1000 per month, which is more than most people can commit, between however many tax-deferred investments it takes, it's $1.74 Million, which goes to a payout of $10,000 or so per month if you annuitize at 65. Sounds like a lot of money today, right? But you're spending those dollars all in an environment where, at 3.5 percent inflation, $10,000 per month is about the equivalent of our $2500 per month now - and every year that passes in retirement, your money buys less.



Suppose, instead, you were to invest $500 per month - half what you had to come up with in the previous example - and invested it in the broader market, earning a 9 percent return, well below historical average market returns, and then in the final year you lost forty percent of your money due to a market crash? Think you'd be better off, or worse?



Slightly worse off, in raw numbers. $1.40 million ($2.34 million before the crash). For half the effort to save. This despite a major investing disaster at the worst possible time. But then let's say you manage to retain your intestinal fortitude, and instead of annuitizing on a fixed basis, you simply withdraw the same $10,000 per month we had in the previous example, while leaving it invested and generally earning 9%. Your money keeps increasing, and if you live to age 95, you leave 2.23 million dollars to your heirs, a sum that, if not so great as it sounds, will still buy a decent house in most areas of the country sixty years from now under our assumptions.



Now let's say that you want to live the same lifestyle, equal to $2500 per month now, that you have at retirement, so your monthly withdrawals increase by 3.5 percent per year. You didn't even have this option in the fixed rate examples. Your money lasts 19 years 3 months (plus a few thousand left over). Once again, for half the effort to save.



This is not wild risk taking. This is simply doing exactly what the insurance companies are doing, and assuming the investment risk yourself. Do not think for a minute that banks and insurance companies are insulated from failure if the market conditions go sour enough. They aren't getting the money to pay you from some kind of transdimensional vortex. If their investment results are bad enough so that they can't pay you, they won't. Government bailouts are also limited, and the government's guarantee programs are likely to undergo severe modification in the next forty years, as they deal with problems such as social security and medicare payouts that are much larger than what their pay ins will be. States, which generally stand behind insurance company guarantees, will not likely be in a stronger position than the federal government. Not to mention the kind of impact this sort of financial crisis will have upon government budgets.



Speaking of the banks, let us consider a hypothetical four percent CD, on a "taxed as you go" rather than tax deferred basis. Assume 28 percent federal tax rate, and 7 percent state and local. $1000 per month invested, every month for 40 years. How much does it turn into?



$842,800. As opposed to $1,044,600 just to break even with inflation at 3.5 percent per year and being able to buy the same stuff. I'd snark that you might as well bury it in a mattress, but in point of fact, that would only get you $480,000.



The point I'm trying to make here is that the so-called traditional "conservative" investments are anything but. If you aren't putting your money into investments where there is some market risk, then the only guarantee you have is the guarantee that it won't succeed, the guarantee that you will be living in poverty.



So in financial planning, the biggest risk is in not accepting some.



Caveat Emptor.

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