Should You Use The Brokerage Window In Your 401(k)?

July 27, 2018

Are you a hands-on investor seeking investments beyond your 401(k) plan’s core list of investment choices? If so, you may have an option available in your retirement plan at work that most retirement savers aren’t aware of – the self-directed brokerage account (SDBA). This “brokerage window” option available in some retirement plans gives participants the ability to invest in mutual funds, exchange-traded funds (ETFs) and in some cases individual stocks and bonds.

Who typically uses a self-directed brokerage account in a 401(k) plan?

According to Aon Hewitt, approximately 40% of employers offer self-directed brokerage account options, but participation rates remain low. Aon Hewitt found that only around 3 to 4 percent of retirement plan participants with access to SDBAs actually use this self-directed option.

The SDBA option has generally been more popular among retirement savers who have larger retirement plan balances or who work with an outside financial advisor. For example, Schwab recently reported that the average account balance of those using this option is just over $260,000. Compare this to Fidelity’s reported average balance of all 401(k) participants, which is just under $100,000.

What does a self-directed brokerage account offer?

The main benefit is that SDBAs give you more flexibility when it comes to the investment options available. Access to a wider range of investment choices than the default ones presented in your plan can be a refreshing alternative if you are generally unhappy with the investment options available in your plan.

For example, if your 401(k) plan does not include access to target date funds or asset allocation funds, you can use the SDBA to add this fund to your retirement portfolio. This can also be appealing if you are simply using the self-directed windows to gain access to asset classes not represented in your core investment lineup such as emerging market stocks, international small cap, and value or growth-oriented funds. SDBAs can even help you diversify with alternative asset classes such as real estate and commodities.

Beware of the paralysis of too many choices

But as behavioral finance studies on the paradox of choice have shown us, too many options can hinder participation rates in 401(k) plans. Choosing the right investments for your goals, risk tolerance, and time horizon also requires discipline. Most investors lack a written game plan or investment policy statement. As a result, many individual investors are prone to the “behavior gap” and underperform the actual funds they own due to mistakes related to emotional decision-making and market timing.  

Self-directed brokerage accounts are designed for advanced investors who know how to research and manage their investments. FINRA warns investors that the additional choices commonly associated with self-directed accounts require additional responsibilities. In order to follow a disciplined investment plan, you can start by focusing on things within your control such as asset allocation, contribution rates, minimizing costs, and asset location (i.e., pre-tax vs. Roth 401(k)).

Pay attention to the fees

Minimizing your overall investment costs is one thing you have some control over as an investor. That’s why it is just as important to understand all fees and expenses associated with a self-directed brokerage account as it is to know your core 401(k) plan expenses.

Some 401(k) plans charge an annual maintenance fee for using the mutual fund or brokerage window. It is also necessary to identify if there are any commissions and transaction costs associated with trades made through SDBA accounts. You can check your plan’s fee disclosure to better understand the actual costs related to your 401(k) plan.

Check mutual fund expenses

In some cases, you may also see an increase in mutual fund expenses when you go outside your core investment options. This is because most funds available in the SDBA are retail share classes which tend to be much more expensive than the institutional funds many large retirement plans provide access. On the other hand, if your 401(k) plan has expensive mutual funds, the self-directed brokerage account is a potential remedy.

How does its performance compare?

Finally, it is important to note that there is a reason self-directed brokerage accounts are underutilized. The average investor is often better served simplifying their investments as much as possible. That is why it is important to establish benchmarks to track your performance.

Self-directed brokerage accounts give you an opportunity to try to outperform or diversify your plan’s core options. But if you choose to take the self-direct route and find that your investment performance consistently lags the core investment portfolio, you may need to take a simpler approach to your retirement savings plan.

 

A version of this post was originally published on Forbes.

How To Evaluate Your Financial Advisor

July 24, 2018

There are a lot of advertisements and radio shows by financial advisory firms trying to convince you that their company is the best and the most trustworthy. I recently saw one that compared two advisors: theirs being a trustworthy, honest guy and the other a person who is only interested in charging you commissions and fees.

Ironically, the next day, I was solicited by the former company on LinkedIn and the job didn’t include anything about having the client’s best interest at heart – the only qualifications they were looking for were skills in asset gathering and sales.

I spent almost 18 years as a financial advisor and know a lot of planners that I would trust my mom’s financial future with. Financial planners offer a lot of value to their clients by providing expert advice and peace of mind. But how do you know how to determine the value of the services you are receiving? How do you know if your advisor is doing a good job?

Determining value

Like any service you pay for, you need to know what the total cost is. Some advisors prefer to talk in percentages instead of dollars, say a 1% fee on the assets they are managing for you. This might be a fair rate – 1% doesn’t seem like a lot – but it may not include all the costs involved.

Ask about money management costs and incidental fees, which can bring the total to 2% or higher. If you are transferring a $500,000 IRA account to this advisor, the total cost (at 2%) is $10,000 per year. You’ll want to know this and what you receive in return to determine if the cost is worth the service.

Remember, you’re a team

No one, I repeat no one, can or will have more interest in your financial success than YOU. Your advisor is just that, an advisor on your financial team. Your team can (and often should) include a tax consultant and attorney. You don’t have to know all the ins and outs of investing and tax laws, but you should know what and why you are planning and investing.

A good financial team also provides a system of checks and balances: as an advisor, I often had client’s tax preparers question their investments. This provided them confirmation that they were invested properly or opened up discussions to explain the reasons for certain investments.

What to look for and how to find it with your advisor

Here are some traits of a good planner and questions you might ask at your next check-in:

Trust and transparency

An honest and transparent planner will have no problem disclosing total costs information.

Question to ask: “Can you provide me with a total sum of fees, commissions, expenses and other costs I paid last year and what I can expect to pay this year?”

Red flag: If their answer is vague or they hesitate to answer, it could be a sign that you’re with the wrong advisor.

No conflicts of interest

It is not uncommon for some advisors or insurance agents to have incentives for promoting and selling certain products. That does not mean that these products are not appropriate, but you should know this and ask about alternatives if these products are suggested to you.

Questions to ask: “Do you have quotas? Do you have proprietary products you are required to sell or get paid more for selling? Do I own any of those? What are the alternatives?”

Red flag: If they are unwilling to explain alternatives or when they do, it seems that their product always comes out on top. It’s also a red flag if you only hear from your advisor toward the end of the month or to discuss a “new and exciting” product – that’s a strong indication they’re just trying to meet a quota rather than provide the best solution to you.

Competence (not just credentials)

There are so many credentials an advisor can obtain today (CFP®, AAMS, ChFC, CFA, etc.). While these show that the person has taken the time to study and pass the tests, they don’t necessarily show that they are good at providing you with personalized, expert advice. You are hiring an advisor to fill the gap of knowledge that you don’t have.

Question to ask: “What is your investment philosophy? How are my investments allocated according to this and my goals?”

Red flag: He/she is unable to explain their investment philosophy to you in terms you understand or doesn’t have one. Also watch out for defensive or uncertain behavior when you question the ‘why’ behind certain things – that can be a sign that he/she does not yet have adequate experience to deal with your situation.

Performance

Let’s face it, you are hiring an advisor because you expect them to get better results than you would on your own. One way an advisor can show value is by delivering “alpha” – the excess return of an investment relative to the return of a benchmark index. This outperformance is often a way to justify the fees being charged.

Question to ask: “How are WE going to measure the performance of my portfolio?”

Red flag: Any promises of consistent market outperformance – this is the goal, but no one can promise this. If your advisor ever uses the word “guarantee,” unless he or she is referring to an insurance product, that could be a sign of fraud. Finally, keep in mind that it’s unfair to compare the performance of your account to anything other than the benchmark that you and your advisor set. You actually SHOULD have different performance than someone who is significantly younger, older or in a different life situation than you.

All advisors should be investing according to your personal risk tolerance, so if you tell your advisor that you are uncomfortable with risk and yet you’re being pressured to allocate more toward riskier investments, that’s a red flag too. (as long as your performance expectations are also aligned with the level of risk you are willing to tolerate)

Candor

When I was a brand new advisor, I didn’t have the confidence or experience to tell my clients what they really needed to hear. I was afraid they would leave me. Everyone has to hear bad news once in a while, whether it’s a poor investment choice, market correction or a warning that you are spending too much money. A good advisor discloses underperformance and challenges you when you are getting off track in your planning.

Question to ask: “When I am going off track of my goals or my investments aren’t performing as planned, how are WE going to address it?”

Red flag: If your advisor does not return calls during turbulent markets or avoids discussing anything negative.

Services offered

Does your advisor offer other services besides money management? Holistic financial planning, which looks at all areas of your financial picture (and not just investments) can be a way that a good planner delivers value. On the other hand, if they are also performing a variety of disjointed services that you don’t need, they may be too distracted to provide you with the service you expect.

Question to ask: “What services besides money management do you offer to your clients? How often will we be reviewing my plan?”

Red flag: If you’re looking for someone who will be incorporating your goals, tax situation and other circumstances into their services, but he/she only wants to discuss investing and market performance, you may not be working with a holistic planner. On the other hand, if you’re strictly looking for investment advice, but your advisor is repeatedly pushing insurance or other products, that can be another red flag.

Many people start off working with their advisor due to the recommendation of a friend or family member, but it’s not unusual to outgrow each other. Your advisor may be perfectly great at what they do, but not great for you. By asking these questions, then following up to make sure that the answers fit with what YOU need, you can help to ensure you’re getting the most value for the fees you’re paying.

4 Different Ways To Rebalance Your 401(k)

July 05, 2018

When the stock market starts going wild, it can cause you to second guess your investment choices in your 401(k). Perhaps all those aggressive funds that made you so happy these past few years are letting you down. You could ignore this roller coaster and focus on your financial life goals and maybe you should…or maybe you shouldn’t because that sick feeling in your stomach every time you look at your statement is trying to give you a message: you may need a portfolio rebalancing strategy.

What is rebalancing?

Everyone loves a mutual fund winner and dislikes a losing investment. It’s natural to want to keep funds that have increased in value and to sell out of funds that have fallen in value, but that can be a losing strategy. Rebalancing turns that natural tendency on its head. It means periodically selling a portion of the funds which have gone up, then buy more shares of your funds which have gone down to maintain your target mix of investments over time.

Rebalancing helps you buy low and sell high

Rebalancing back to a target mix of investments helps you keep the level of risk in your portfolio stable by taking some profits from those funds that are now taking up more space in your portfolio than originally intended – usually because they grew in value – and buying more of the funds that are now taking up less space than you intended, possibly because they fell in value.

Since stocks, bonds and other investments tend to move up and down at different times, implementing a regular rebalancing strategy with a diversified portfolio mix helps you “buy low and sell high” over the long haul. (In a tax-sheltered account like a 401(k), selling profitable shares to rebalance doesn’t have any tax consequences. However, keep in mind that rebalancing in a taxable investment account could generate short-term and long-term capital gains.)

Start by defining your target investment mix

Let’s say you were going to take a vacation in Europe. You’d plan your itinerary in advance, choosing which countries you’d like to visit, what sites you’d like to see, how you’ll get there, how much you plan to spend, etc. When you actually go on your trip, you may find that things change along the way that cause you to adjust your plans – a delayed flight, lost luggage, bad weather, etc. Then you have to adjust.

Investing is the same. First, you put together your itinerary, called your “asset allocation” strategy in investment jargon. Asset allocation is how you split up your savings between different types of investments such as stocks, bonds, real estate and commodities.

By diversifying your investments, you minimize the risk that they will all fall in value at the same time. For example, a 35-year-old who’s got 30 years to go until retirement and a moderate risk tolerance might target a mix of 60% to 70% in stocks and 30% to 40% in bonds.

How to create an asset allocation strategy

Don’t have an asset allocation strategy? Start by completing this risk tolerance assessment and following the guidelines for your risk profile. You can also use this calculator to develop a basic strategy and this worksheet to put together something more detailed.

Four ways to rebalance

Once you’ve begun your investing trip, you may find that there are unexpected detours along the way like a stock market downturn or interest rate cuts that cause a bond rally. Don’t let them throw you off your plan. Here are four ways to rebalance your investment mix to get back on track:

1. Rebalance according to the calendar

How it works: With calendar rebalancing, you pick a regular date where you will rebalance your investments to their target weights. Sell enough of what’s gone up to get back to the target weight and buy more of what’s gone down. You could do this monthly, quarterly, semi-annually or annually, but don’t forget to do it at regular intervals over a long period of time.

Many 401(k) plans have begun to offer automatic calendar rebalancing features at no additional cost, so research if your plan has one. You may also have access to “hands off” investment strategies like target date funds or asset allocation funds, where rebalancing is handled by the fund manager and you don’t have to worry about it.

An example: John is trying to maintain a constant mix of 65% stocks, 25 bonds and 10% real estate. He begins the year with a $10,000 balance, so he puts $6,500 in a stock fund, $2,500 in a bond fund and $1,000 in a real estate fund. He plans to rebalance his investment mix on the last business day of each quarter.

At the end of the first quarter, his balance is higher at $10,300 but the percentages have changed:

Stock fund $6,386 (62%)

Bond fund $2,678 (26%)

Real estate fund $1,236 (12%)

To rebalance his portfolio, John will sell $103 of his bond fund and $206 of his real estate fund and buy $309 of his stock fund. If he has enrolled in the automatic rebalancing feature in his 401(k) plan, it would happen automatically on the scheduled date.

2. Percentage of portfolio rebalancing

How it works: Not sure you want to rebalance that strictly? Percentage-of-portfolio rebalancing involves setting a tolerance band stated as a percentage of the portfolio’s value. When an investment falls below or rises above the tolerance band, it triggers rebalancing back to your target asset allocation for the entire portfolio.

An example: A 40% weighting in bonds with a +/- 5% tolerance band means that bonds could make up between 35% and 45% of the portfolio without rebalancing. If they rise to become 46% or fall to 34% of the portfolio, that triggers rebalancing of all the investments back to their target percentages.

It’s best to do some research when setting the tolerance band. Too narrow means normal market volatility will lead to excessive rebalancing and too wide makes it easy to take on extra risk. You’ll also need to check the percentage weights at regular periods to see if the need to rebalance is triggered. Percentage of portfolio rebalancing is a strategy that requires more frequent market monitoring, so it’s best for a more “hands on” investor.

3. Constant proportion portfolio insurance (CPPI)

How it works: Do you have an amount below which your portfolio must not fall? Consider a constant proportion portfolio insurance (CPPI) rebalancing strategy. Stock holdings are held to a constant proportion of the predetermined cushion – the difference between the total portfolio value and the floor value:

Target investment in stocks = target proportion × (current portfolio value – floor value).

CPPI rebalancing is expected to do well in bull markets, when the increasing cushion leads to purchasing more stocks. It could also be helpful in bear markets because when the cushion is zero, there are no holdings in stocks. In a volatile market with frequent reversals of short term trends, however, CPPI tends to underperform.

An example: Let’s say Susan has already saved $500,000 towards her goal of retiring in 5 years. Based on her conservative risk tolerance, it’s important to her to maintain at least a $450,000 value in her 401(k). She is comfortable putting 60 percent of her surplus over her floor value in stocks.

Target investment in stocks = 60% x ($500,000 – $450,000) = $30,000

At the end of year one, the total portfolio value is $510,000.

Year 2 Target investment in stocks = 60% x (510,000 – 450,000) = $36,000

Year 2 turns out to be a recession and horrible year for investors. Susan’s stock index fund has a 40% negative return and her bond funds lose 10 percent. Her total portfolio value is now $448,200.

Year 3 Target investment in stocks = 60% x ($448,200 – $450,000) = $0

4. Rebalance with future contributions

How it works: As an alternative to selling some investments which have increased in value and buying more of what has decreased, you could add more cash to your portfolio to buy more underweighted shares. For taxable accounts, this is a more tax-efficient strategy since you won’t incur capital gains by selling any shares.

In a tax-sheltered 401(k) plan, this would mean changing the investment mix of your future contributions so that you’re buying enough of the underweighted fund to get you back to your target percentage.

An example: Taylor began the year with a $100,000 portfolio and a target investment mix of 70% in stocks and 30% in bonds. At the end of the year, Taylor’s portfolio is worth $120,000: 78 percent in stocks and 22% in bonds. She plans to contribute $10,000 this year. In order to move towards her target 70/30 asset allocation, she would need to allocate all of her $10,000 contribution towards buying the bond fund.

The downside of trying to rebalance with new money in a 401(k) plan is that it may not be a perfect recalibration. Depending on the size of your balance, the amount you’re contributing may not be sufficient to fully rebalance. There’s also the risk that the markets could continue in the same direction.

Which rebalancing strategy is right for you?

What’s the best rebalancing strategy for your retirement journey? It depends on your risk tolerance, how “hands-on” or “hands off” you are with your investments, and whether you have perseverance to stick to it consistently over a long time period. Finally, don’t forget to check with your 401(k) provider as many have automatic rebalancing options available or offer fixed asset allocation funds where the rebalancing is done for you.

Learn more about rebalancing

Interested in learning more? New investors can try this free online course from Morningstar. More experienced investors may enjoy this Vanguard brief on best practices in rebalancing. The quantitatively-inclined can check out this article from the CFA Digest.

How To Create Your Own Investment Policy Statement (And Why It’s Important)

June 28, 2018

Are you confident that your investments are well positioned to help you reach your financial life goals? This can be a difficult question to answer if you do not have a written action plan already in place to help provide guidance for your investment decisions.

While the overall mood of investors has improved dramatically since the Great Recession, many investors still lack confidence that their asset allocation is appropriate for their age and risk tolerance. This is just as much a matter of lack of financial knowledge as it is a statement of fear and anxiety surrounding investing during uncertain times.

Putting a buffer in place for your emotions

The unfortunate reality is that we are not all rational beings when it comes to our financial decision making. Emotional decision making and our own innate biases lead to what is often referred to as the “behavior gap.” The behavior gap has been demonstrated through Dalbar’s Quantitative Analysis of Investor Behavior (QAIB) studies, which consistently show that average investors tend to earn below average returns.

The best way to avoid having your investments become a victim of your own emotions is to have an investment policy statment (“IPS”) in place, and to commit to referring to it any time you feel like straying from your plan. This can also help you to establish your plan in the first place.

What is an investment policy statement (IPS)?

An investment policy statement is a written document that defines how an investment portfolio should be managed. It typically includes details about investment objectives, potential investment strategies (active vs. passive management), risk tolerance, types of investment asset classes, selection criteria for investments, and monitoring and rebalancing procedures.

The main purpose is to make sure guiding policies and principles are in place during moments of uncertainty. This ultimately helps verify that decisions are consistent with your goals and desires.

Who needs an IPS?

Foundations, non-profits, pension plan advisors, and institutional investors generally have written investment guidelines. But according to an industry survey conducted by Russell Investments, 61 percent of financial advisors in the U.S. do not create a written investment policy statement for their clients.

The percentage of investors without a written plan who do not receive some type of professional guidance is likely much higher compared to those with financial advice. This is a concern because the burden for achieving important life goals such as retirement or funding a child’s education rests squarely on individuals.

It’s probably not too surprising to see Financial Finesse’s research indicates that only 46% percent of investors are confident that their investments are allocated appropriately. In short, everyone needs an IPS.

Perhaps more important for a DIY investor

Perhaps the key is to avoid thinking that an IPS is just for professional investors or those who love paperwork. In fact, the IPS is just as important for the DIY investor as it is for those who are working with a trusted advisor. It is also a working document and not just another financial statement to file and forget.

How to create your own IPS

If you do not already have a written set of guidelines for your portfolio, you should go ahead and put your investment plans in writing. (Check out the Morningstar worksheet and statement templates if you are looking for a basic template to create your statement.)

Keep it simple

It’s important that you don’t get lost in the details because simple is okay as long as you have some general guidance in place. If you find this IPS discussion a bit too heavy for your personality, you can always complete a basic IPS by taking the note card approach to writing down your investment plan. In any case, here are some important questions that an investment policy statement will address by category:

Answer the following questions:

Investment Objectives

  • What are your financial goals?
  • What is your time horizon for funding this goal?
  • How much will you need to fund the goal each year?

Investment Philosophy

  • What is most important to you as an investor?
  • What is your comfort level for risk?
  • What are your allowable asset classes (stocks, bonds, etc)?
  • What is your target asset allocation mix?
  • How much of a loss are you comfortable with over various time frames (1 month, 1 year, 5 years)?
  • Do you have any special tax considerations?

Portfolio Monitoring and Review

  • How much do you intend to invest each month?
  • What is the expected rate of return for the portfolio?
  • Are there any upcoming withdrawal and deposit expectations?
  • What are the benchmarks for the portfolio (DJIA, S&P 500, Russell 2000, MSCI EAFE, etc.)?
  • How often will you review your investment plan?
  • Will you take advantage of automatic contribution rate escalator features in your 401(k)?
  • When will you re-balance your portfolio?

Keeping your IPS up-to-date

Next time you review your investment performance, take a few moments to review your investment policy statement. An IPS may not guarantee that we won’t succumb to the urge to make an impulsive investment decision during the next significant market downturn (or period of irrational exuberance). However, a policy-driven investment plan can help you stay focused on your big picture financial plans rather than simply react to emotions and current events.

The Red Flags To Watch For With Investment Fraud

May 15, 2018

The topic of investing can be a difficult one to navigate. One survey says 61% of Americans find the stock market scary or intimidating. To make things even more difficult, not every investment is what it is advertised to be — the last decade exposed us to high profile cases of investment fraud.

It’s understandable that seeing these cases can cause some trepidation for prospective investors. A key to harnessing the good parts of investing is to make sure you know what to avoid. 

What happened when I went to an ‘investment presentation’

In the mid-2000’s, my wife and I were invited to an investment presentation. There were not a lot of details but we were assured by our friends that the information we would receive would be “life-changing.” I assumed it was some type of pyramid style business presentation because they were very popular at the time. But I went along with it because dinner was promised afterwards and well… dinner sounded fun.  

Once the presentation started, the red flags were everywhere: no real investment materials were handed out, the people introducing the concept were selling outrageous returns with no risk, the emphasis was on success stories and not the actual methodology of the investment, etc. Questions from the audience about transparency were vehemently challenged. It turns out that I was in fact witnessing a sales pitch what would later prove to be a fraudulent investment. 

The red flags that told me this was possible fraud

Shhh…it’s a secret 

A reputable investment is not hidden under a rock. If someone is creating a sense that there is this secret opportunity that only they know about, you should be very cautious about proceeding. One tell-tale sign in the case I witnessed was the lack of printed information about the opportunity.

The lack of information hinders the prospective investor’s opportunity to research the investment. Publicly traded investments are required to make available documentation about the opportunity. Offering for smaller and non-publicly traded investments typically require documentation as well. If you can’t take something official away from the meeting then it is a big concern – it’s probably a scam.  

Selling a fairy tale

The most obvious red flag should always be the promise of exponential growth with no risk. I’m here to tell you that nothing earns significantly better interest than a savings account without some risk. That’s just the way it works. These folks were promising fantastic returns without any risk of loss.

Another red flag is when an unscrupulous salesperson states their track record is perfect. There is no such thing as the perfect investment that yields double digit returns with no risk. Investment returns are the function of increased risk, not lower risk.  If you are getting this sales pitch run the other way.  

Pushing back against transparency

One red flag that does not involve paperwork is the attitude of the person selling the investment. If there is push-back against questioning on the front end it is usually a bad sign. Even if the paperwork checks out and you understand the investment, but you get the impression that the sales person or advisor is not giving you the full story, there is a high likelihood that that impression will get worse as time progresses.

By investing in something, you become a partner in that endeavor and you should be treated as such. If you feel like your voice is being minimized, you may not necessarily be experiencing investment fraud, but you are being pushed out of the position of authority to make decision about your money and that’s still a red flag. If you feel like an investment product is the right one for you but you do not like how it is being sold, find another salesperson from whom to buy it. 

How to avoid being taken for a ride

Find out how it works

One of the great Buffett-isms (sayings of the billionaire investor Warren Buffett) is, “do not invest anything you do not understand.” It sounds simple enough, but people regularly break this rule with disreputable and even reputable investments. I have worked in the financial industry just under 20 years but have been in situations where someone couldn’t explain the investment to my satisfaction.

Asking the right questions

My most pressing questions are:

  • How does everyone get paid?

and

  • What are the risks?

If I cannot get clear answers to those questions, I will not touch the investment with a 10-foot pole. Generally, the more complex the investment the more likely you are to make a mistake by investing in it.  

If you feel like you may have already experienced investment fraud, FINRA offers a list of steps to take to recover from it. If you are not sure, solicit assistance from a trusted advisor, friend or family member to consider the situation.  

 

4 Money Hacks Millennials Can Use To Make The Most Of Their Assets

May 14, 2018

If you’re a Millennial, you’re probably familiar with various “life hacks” to make life easier. Why not do the same with your finances? Here are four hacks you can use to easily get more from various financial assets:

1) Use a Roth IRA for emergency savings

When you’re early in your career, you may not have had enough time to build up an emergency fund but may not want to forego the tax benefits of saving for retirement to do so. Enter a Roth IRA. With this account, you can do both at the same time.

Since you can access the sum of your contributions at any time and for any reason without tax or penalty, it can serve as part of your emergency fund. (If you use the “backdoor method” to get around the income limits, you’ll have to wait 5 years before you can withdraw the amount you convert penalty-free.) You may have to pay taxes and a 10% penalty on any earnings you withdraw before 5 years and age 59 ½, but the contributions come out first. Anything you don’t withdraw can grow to be tax-free for retirement. Giving up this tax opportunity and having to file a withdrawal form every time you take money out can also make you think twice before spending the money on an “emergency.”

If it’s part of your emergency fund, the Roth IRA should be invested in something safe like a CD or money market fund. That’s because you don’t want it to be down in value when you need it. Once you have enough emergency savings someplace else, you can invest the Roth IRA more aggressively for retirement.

2) Consider a Traditional IRA for grad school

If you don’t have a retirement plan at work or if you meet the income limits, you can deduct contributions to a traditional IRA. Otherwise, you can contribute pre-tax to a retirement plan at work and then roll the money into a traditional IRA once you leave the job. In either case, the IRA money is penalty-free for qualified education expenses. You’ll have to pay taxes on the withdrawals but you’ll likely be in a lower tax-bracket if you’re not working full-time anymore. Just be sure to keep any money you plan to use in the next 5 years very conservative like a money market fund or a stable value fund.

If you need the money for retirement or end up not needing it for education expenses, you can also convert the traditional IRA to a Roth IRA while you’re in school. You’ll have to pay taxes on the amount you convert, but again, you’re likely to be in a lower tax bracket. The amount you convert to a Roth IRA can be withdrawn penalty-free after five years and the earnings can be withdrawn tax and penalty-free after five years and age 59 ½.

3) Use a health savings account for retirement

HSAs have the most potential tax benefits since the contributions are pre-tax and the withdrawals are tax-free for qualified health care expenses. (These medical expenses don’t have to be in the same year you make a withdrawal so you can pay for health care expenses out-of-pocket to let the HSA continue growing tax-free and then later withdraw the money tax and penalty-free as long as you keep the receipts.) When you turn age 65, you can also use the money for anything without penalty so it’s part of your retirement savings (still tax-free for qualified medical expenses, including some Medicare and long term care insurance premiums). You have to be in an HSA-eligible high deductible plan to contribute, but these plans are most beneficial while you’re young and in relatively good health so your medical expenses are likely to be low.

4) Use a home for income

Known as “house hacking,” you can purchase a home or multi-family unit and have your roommates or tenants pay at least part of your mortgage. Putting extra rooms on sites like Airbnb and Homestay can yield even more income. (Just make sure you’re not violating any building rules or local laws.) Some people even manage to essentially get paid to live in their home if the rental income exceeds their expenses. You also benefit from any appreciation in the property and you can deduct depreciation on an investment property from your taxes.

This is a good strategy to use before you have a family, especially if you would be living with roommates anyway, but there are some downsides to be aware of. First, you need to have enough savings for a down payment and closing costs plus a good credit score and a low debt-to-income ratio to qualify for a low mortgage rate. You then have to play landlord, which means finding and vetting tenants, maintaining the property, and covering the mortgage during vacancies. Finally, you’re tied down in the sense that moving can mean having to sell the property or hire someone else to manage it.

Financial planning is about making your money work as hard for you as you do for it. Don’t just make it work harder though. Use these hacks to make it work smarter too.

 

This post was originally published on Forbes.

How My Wife Started A Successful Business & What It Took To Get There

May 04, 2018

Editor’s note: This post is part of our Personal Stories series, where our financial coaches share their own financial journey. We hope you enjoy getting to know us a little better and ultimately learn from our mistakes!

OK, so here’s the situation…

For several years my wife had been dropping hints that it was her dream to have her own business. She had a distinct vision for how she wanted to disrupt an industry and provide a unique service that she could not find anywhere else. I had always been mildly encouraging saying, “Sure if our income has progressed to this level and if we paid off all of our debt except for our home and if we got our savings to a certain level, then it will be worth a shot.” Suddenly without even realizing it, we hit those goals and my wife handed me a business plan.

“I got this”

Off we went into the wonderful world of starting a business. While we did a lot of things right, we have learned (and are still learning) some crucial lessons on this journey. For example, without realizing it, when I laid out those goals of paying off our debt and building savings, I was implementing a very crucial step to us being able to sustain a new business. To the extent that your business has overhead costs, the stronger you will need to be financially to stand behind that business. Here’s how we did it.

Counting the costs

When my wife handed me the business plan, I found she had made an itemized list of every expense she could find for the business and the time frame for each expense. She had taken hours to uncover the real-world cost of every piece of equipment, researched leasing costs, and estimated salaries for the first 3 years of the business. It allowed us to make realistic estimates for how much we would need to set aside and a time frame for profitability. Consider using the Small Business Adminstration’s template to lay out your costs.

Planning for error

My experience is no one has a perfect business plan. Even the most meticulous planning can be derailed by real life. That means making sure you have resources over and above what you have budgeted, in case things go sideways. In addition to your savings, assess your access to low interest loans. Banks generally will not lend to a start-up business, so having a good personal financial reputation is very helpful.

At the end of the day

These days my wife has a successful business that enables us to raise 3 children and live in the neighborhood we desire. Her work provides the flexibility to accommodate the fact that I occasionally travel for work, and being a business-owner allows her to choose how big she wants to go, depending on where we are in life.

If I could turn back time

One thing I’d say she’d do differently would have been to get a little more experience in her particular industry before launching her business. From the outside looking in, it can be easy to see that an industry needs a shakeup. For instance, Netflix wasn’t the first company to present an alternative to cable. On the other hand, it can be helpful to spend some time in that business to understand the reasons why companies do things a certain way.

In our circumstance, my wife always wondered why the level of personable service was so low in her chosen industry. If she had found a mentor or worked part time in the industry, she would have discovered that hiring and keeping employees was a challenge for everyone in the business. With a little real-world experience, we could have planned to manage this obstacle. Start networking in your desired industry to get an idea of those real-world obstacles. You can also find business mentors through the SBA here.

If I could tell you just one thing

It’s worth it to take the time and get your finances in order first before launching a business from scratch. There are success stories of people of who ran their business solely on their credit cards, but those are few and far between. There are far more stories of people who failed at a business using credit cards, and wound up back in the daily grind, saddled with high interest debt and nothing to show for it.

Your likelihood of a successful business goes up substantially if you have a firm financial foundation. Start where you are doing the things you can do. Go ahead and start itemizing the expenses, lay out your business plan, and try to get some of that on the job experience and mentoring. These are all things that cost you nothing but you can use that time to build the financial foundation to be ready when opportunity knocks.

7 Common Investing Mistakes

April 11, 2018

Investing can seem complicated and even intimidating to a lot of people, but I’d argue that’s it’s actually the easiest part of financial planning. All you really need to do is make sure you’re reasonably diversified (there is no “perfect” here), keep your costs low, and stick to your plan through thick and thin. No hours of reading the Wall Street Journal or watching CNBC are required.

Here are the most common big mistakes I see people making, along with the 3 steps to avoid all of them: 

1) Chasing past performance

Investments tend to go through cycles so buying whatever happens to be performing best will probably cause you to buy it closer to the top of a cycle then the bottom. If you sell it when it eventually under-performs, you’ll probably sell closer to the bottom. Repeat this enough times and you’re basically buying high and selling low, which is the opposite of what you want to do. 

Even if you’re buying a top mutual fund within a particular category (which eliminates the effects of market cycles), studies have found that these top performers don’t maintain their edge. In fact, they often do worse than average. You would have done better by flipping a coin.   

2) Trying to time the market

Instead of looking at the past through the rear view mirror, what about trying to invest based on what will happen in the future? This makes sense in theory, but in reality, the market is notoriously difficult to predict. You also have to be right not once, but twice. Even if you’re right about when to purchase an investment, how will you know when to get out of it? Professionals fail to consistently do this successfully, so do you really think you’ll be able to? 

3) Not being diversified

Another mistake I often see is people having too much money in a single stock. After all, while the stock market as a whole tends to go up over the long run, a single stock can go to zero and never come back. This is especially dangerous if it’s your employer’s stock since your income is already tied to that company.

A good rule of thumb is to never have more than 10-15% of your portfolio in any one company’s stock. If you have stock incentives or an employee stock purchase plan, consider selling the shares and diversifying as soon as you can to stay within that limit. 

4) “Diversifying” by randomly spreading money between all the funds in a retirement plan

The problem with this “diversification” is that you might not actually be properly diversified. For example, you can end up with 90% of your money in stocks if most of the funds available to you are stock funds. That might be fine if you’re an aggressive investor with a long time horizon but not if you are more conservative or have a shorter time frame to invest. 

5) Being too conservative for a long time horizon

Being too conservative can actually be risky, not in terms of market volatility but the real risk of not achieving your financial goals. That’s because more conservative investments tend to earn as much over long time periods. Even a small difference of return can have a huge impact.

For example, $10k earning 2% over 30 years would grow to $18k, while at an 8% return, it would be over $100k. That’s a “loss” of over $80k that could have gone towards your goals. 

6) Being too risky for a short time horizon

On the other hand, money that you need in the next 5 years should be invested very conservatively. That’s because investing it more aggressively puts you at risk of seeing the value of your investment decline and not recover in time. Don’t think it will decline in the next few years? Go back and visit mistake #2. 

7) Paying too much in fees

One way to avoid these problems is to pay someone else to invest for you, usually through a mutual fund. The problem is that the fees that fund managers charge typically outweigh any value they provide. A Morningstar study found that low fund fees were the most dependable predictor of future fund success.

This is why Warren Buffett has repeatedly recommended that people invest in low cost index funds that simply track the market. In fact, he recently won a $1 million bet by a landslide that a simple low cost index fund would beat any group of hedge funds over a 10 year period. 

3 simple steps to avoid these mistakes

  1. Make sure you’re properly diversified by taking a risk tolerance questionnaire and following the guidelines for your risk level, investing in a fully diversified fund like a target date fund, or using a robo-advisor that can design a portfolio for you. 
  2. Implement your plan using low cost funds like index funds. 
  3. Stick to your plan and rebalance about once a year to stay on track. 

That’s it. The more you fiddle with it, the more mistakes you’re likely to make. Now go enjoy the rest of your money. 

Should You Let A Robo-Advisor Pick Your Investments?

March 21, 2018

Technology has revolutionized everything from choosing a restaurant to getting directions or even a ride to that restaurant, but is it time for technology to get you to your investment destination as well? While this may sound like science fiction, the rise of “robo-advisors” over the last few years has made this into a plausible option.

These online automated investment services can provide investment advice or management for typically a lot less than a human advisor. But should you really entrust your nest egg to a computer and if so, which of the many options would make the most sense for you?

Pros of robo-advisors

  • It’s convenient. You don’t have to have a large amount to invest or go to a fancy office and talk to a pushy salesperson. Most robo-advisors have very low minimums and allow you to set up and fund the account from the comfort of your smartphone or at least, your computer.
  • You get a customized asset allocation. “Asset allocation” is a fancy term for dividing your money into various types of investments (called “asset classes”) like stocks, bonds, and cash. Rather than having to make this decision on your own, robo-advisors generally do this for you based on your responses to questions that are designed to determine your time frame and comfort with risk. All you need to do is then fund the account.
  • The costs are relatively low. You could get asset allocation advice from a human advisor, but that typically costs about 1% of your assets. They may also put you into funds with high fees. Robo-advisors generally charge a lot less and use low cost index funds.

Cons of robo-advisors

  • The “advice” is very limited. Robo-advisors generally only help you with your investments. You typically won’t get help with other financial planning issues like how much you should be saving, what type of accounts to invest in, and whether you have adequate insurance coverage and estate planning. The investment advice you do get may also not incorporate taxes or how your money is invested elsewhere.
  • There’s no “hand holding.” One of the most valuable services of an advisor is to talk you out of doing something stupid – whether that’s putting too much in an aggressive tech stock or bailing out when the market takes a downturn. To the extent that robo-advisors do this, they still lack the emotional connection and persuasive/motivational ability of a trusted human advisor.
  • There are generally still advisory fees. Even a small advisory fee can add up over time. You could do a lot of what robo-advisors do without paying their fees by simply investing in an asset allocation fund that matches your risk level or taking a risk tolerance questionnaire and following the asset allocation guidelines.

How to get started if a robo-advisor is what you need

  • Know what you’re looking for. If you’re investing in a taxable account, you might want to look for a robo-advisor that offers tax-efficient investing and/or tax loss harvesting. A few offer access to a human advisor by phone. Make sure you’re also comfortable with the program’s investment strategy.
  • Know your options. Your employer’s retirement plan may offer a robo-advisor program. Some are also offered by particular brokerage firms for their clients. You can find a good comparison of options here.
  • Know what you’re paying. Look at both the fees that the robo-advisor charges and the expenses of the funds it recommends. “Free” robo-advisors typically put you in their own bank accounts and mutual funds, which may be more expensive than another program’s fees.

For investors who are looking for investment management or advice but are unwilling or unable to hire a financial advisor, robo-advisors can offer a simple and relatively low cost solution. (Just be aware of their limitations.) At the very least, they will make human advisors work that much harder to earn the fees they charge.

 

Annuities 101

March 15, 2018

Have you ever heard a financial advisor describe the virtues of an annuity and found yourself thinking it sounds like a pretty good deal? Or maybe you are interested in an annuity because you like the idea of a guaranteed source of income when you retire? Perhaps, being the savvy investor you are, you’ve also read or heard that annuities are a rip-off and mostly benefit the agent that is selling them.

What to make of all this? As my colleague Erik outlines in this post, annuities aren’t all good or all bad. Let’s consider some common types of annuities, how they work, and the pros and cons of each. 

Immediate Income Annuity

Here’s how it works: You provide a lump sum of money to the insurance company, and in exchange, they promise to make regular payments to you right away. The amount of each payment you receive depends on your age, and the terms of the annuity (payments for your life only, your life and the life of someone else, or for a fixed period). 

Pros 

  1. Guaranteed income for the term of the annuity. 
  2. No account management or maintenance fees. 
  3. No maintenance or work once it is set up. 
  4. Reliable income which can simplify retirement planning. 
  5. You can add inflation protection to income payments (although that’s an additional cost).

Cons 

  1. Once you purchase an immediate income annuity, you lose access to your money (beyond your regular payments). The lump sum you deposited can no longer be used for emergencies (or anything else). 
  2. If you do not choose inflation protection, the purchasing power of your payment can be eroded. 
  3. If you pass away shortly after starting your payments, the remainder of the annuity goes to the insurance company unless you add a beneficiary, which requires you to purchase a death benefit and can be pricey.

Deferred Income Annuity

Here’s how it works: Like an immediate annuity, you provide funds to an insurance company in exchange for a stream of income payments. The difference is that a deferred income annuity does not require a single lump sum payment and you don’t start receiving payments until a later date. During the “accumulation phase,” when the policy is growing in value due to your payments and/or the interest rate paid by the annuity company, you can decide to make a single premium payment or a series of payments over time. Those funds then accrue interest, tax-free, until you choose to start receiving income payments. 

Pros 

  1. Interest accrues tax-deferred until funds are withdrawn. 
  2. Most deferred annuities guarantee against a loss of principal. 
  3. Guaranteed income payments for life (for you or your spouse) if you choose to annuitize. 
  4. Includes a death benefit component, so your beneficiary receives any remaining value if you pass away before the annuity ends. 

Cons 

  1. Be aware of the surrender period – a period at the beginning of the contract that prevents you from withdrawing funds without paying a surrender charge. You will also pay a penalty from the IRS if you pull funds prior to age 59 ½.
  2. Earnings are taxed as ordinary income. Principal is also taxed as ordinary income if you use pre-tax retirement money (like a traditional 401(k) or IRA). 
  3. Fees can really add up when you consider mortality and expense charges, administrative fees, charges for special features and riders, and high commissions for agents. 

Variable Annuity

Here’s how it works: Variable annuities share some common traits with fixed annuities like tax-deferred growth and various payout options. Unlike a fixed annuity, a variable annuity takes your premium money and invests it in sub-accounts that you determine based on your risk tolerance. As such, a variable annuity is a higher-risk alternative to a fixed annuity. One popular hybrid of a fixed and variable annuity is the equity indexed annuity (kudos to my colleague Cynthia for this great look at these). 

Pros 

  1. Allows you to participate in the market to maximize your return and the amount of your future income payments. 
  2. Tax-deferred growth and multiple payout options. 

Cons 

  1. You assume the investment risk – your annuity’s value is subject to loss based on sub-account performance or you may find your sub-accounts underperform if you invest too conservatively. 
  2. Limited access to money due to surrender period. 
  3. Fees, Fees, Fees! If you want to lessen the risk with a variable annuity, you can add additional riders to the contract to protect income. These can be costly, and are in addition to administrative fees, mortality expenses, and expenses associated with the investment sub-accounts you choose. Michael, a fellow planner here at Financial Finesse, covers these fees and the concern with them in this post.   

Other things to consider

  1. It’s usually a terrible idea to put all your money into an annuity. Diversify into other investments like stocks, bonds and cash to ensure you have flexibility to cover emergencies and other needs above your fixed income sources. 
  2. Make sure the insurance company is on strong financial footing. Check ratings at agencies like Moody’s, Fitch, A.M. Best and Standard and Poor’s to make sure the company you are doing business with can fulfill their promise when accepting your money. 

Tying it all together 

As you can see, annuities can be a great tool to help you increase the amount of fixed income you can bank on in retirement. This can make great sense if your other fixed income sources like Social Security and pension benefits don’t totally cover your fixed expenses.

But it is also clear that annuities, especially deferred and variable contracts, can become very expensive options to provide that income. If you are considering an annuity as part of your retirement plan, make sure you understand the benefits along with the costs and restrictions that come along with your investment. 

Should You Be A DIY Investor?

March 07, 2018

Should you choose your own investments or have someone else do it for you? It’s a choice that every investor has to make. Let’s take a look at the pros and cons of do-it-yourself investing: 

Pros 

  1. It can be cheaper. You avoid advisory fees and you can choose low cost funds or even avoid fund fees entirely by investing in individual stocks and bonds. This is important as minimizing fees is one of the surest paths to investment success. In fact, a study of various asset allocation strategies found that fees mattered more than which strategy you chose in determining your performance.   
  2. You have more control. Having someone else choose your investments can mean giving up some control. If you are very particular about your investment strategy or want to avoid investing in certain companies or industries for moral reasons, you may be reluctant to give up that control. 
  3. It can be fun. Many people prefer to manage their own investments because they actually enjoy it. This is especially true for more speculative and “hands-on” investments like individual stocks, direct real estate, and more recently, cryptocurrencies. 

Cons 

  1.  It can also be more expensive. Most of the costs of investing are relatively hidden and don’t show up on your statements or trade confirmations. Mutual fund expense ratios are generally buried in the fund prospectus and turnover costs aren’t reported at all but can have a significant impact on your returns. 
  2. You have more control. More control isn’t always a good thing. Some of the most common mistakes investors make include chasing past performance, not being properly diversified, holding on to losing investments too long in the hope that they recover, and paying more in taxes than you need to. At the very least, it can be helpful to have a second opinion. A Vanguard study found that a good financial advisor can save you about 3% a year (net of a 1% advisory fee) in helping you avoid bad decisions. 
  3. It can be time consuming and stressful. Even if you are good at managing your investments, you may not have the time or desire to manage them yourself. Your time may be better spent elsewhere. 

How to get started 

Let’s say you want to be a do-it-yourself investor. Where do you start? Here some tips: 

  1. Have a strategy. You don’t want to just pick whatever happens to be doing well at the time, your brother-in-law’s recommendation, or what “feels right.” Instead, you might want to start by taking a risk tolerance questionnaire like this one and follow the guidelines as to how much to invest in stocks vs bonds vs cash (known as your “asset allocation”). You can also check out these asset allocation models by the American Association of Individual Investors and these “lazy portfolios” put together by various investment experts. Once you’ve decided on a strategy, consider putting it in writing.  
  2. Keep your costs low. Remember that study that found that fees can be more important than your asset allocation strategy? To keep your costs low, consider Warren Buffett’s recommendation of investing in index funds, which tend to have very low fees and turnover costs. By using index funds, you also avoid having to choose an active fund manager, which can be a notoriously difficult choice to make as most underperform the market index (which is what index funds track) and those who outperformed in the past are no more likely to do so in the future. If you don’t have index funds available to you, look for funds with the lowest expense and turnover ratios in their category. 
  3. Consider individual securities. Another way to minimize costs is to avoid fund fees altogether and purchase individual stocks and bonds. (Just be careful of commissions and other trading costs.) To be diversified, make sure you have at least 20-30 different stocks from a variety of sectors and with no more than 10-15% in any one stock. You can use a free stock screener to help you find stocks that meet your criteria. If you don’t know what criteria to use, you probably shouldn’t be picking individual stocks. Don’t worry though. As we saw, most professional investors fail to beat the market so you probably won’t either and would likely be better off with simple index funds.   
  4. Don’t gamble with your retirement or college funds. Your retirement and college funds should be in a boring, diversified, low cost portfolio. If you insist on wanting to “play” the stock market or gamble on Bitcoin, consider doing so only with money you can afford to lose…or just take that money and go to Vegas. You’ll probably have more fun that way.       

Should You Invest More Aggressively To Retire Soon?

January 18, 2018

Are you getting close to retirement but feel like you’re behind on your retirement savings? Have you considered investing more aggressively to catch up? This is a question I’ve gotten a few times on our Financial Helpline (and is probably a sign that the market is getting closer to a peak).

Let’s take a look at the pros and cons

The main advantage is that a more aggressive portfolio is likely to perform better than a more conservative one over time. However, there’s also a risk of a significant market decline, especially when prices are as high as they are now relative to earnings. Earning a slightly higher return for a few years may not make much of a difference in your retirement readiness, but a big loss can mean having to delay retirement, withdraw less income, or face the risk of depleting your retirement savings. That’s why it’s generally recommended to be more conservative as you get closer to retirement.

The exception to the rule

However, there’s almost always an exception to every general rule. The biggest would be if you’re planning to retire early. If your aggressive investments perform well in the next few years, it can make that happen sooner. If they don’t, you can always retire a little later and probably with more assets in the long run. You can also split your investments into more moderate ones for retiring later and more aggressive ones for retiring earlier.

How I do it

For example, I’ve divided my retirement savings into “normal retirement” and “early retirement.” My normal retirement savings are moderately aggressively invested in my 401(k), HSA, and Roth IRA. I just need a modest rate of return in those accounts to reach my “normal” retirement goals.

Two timelines, two strategies

My early retirement investments are much more aggressively invested in my regular taxable accounts. If they do really well, I can retire earlier and don’t have to worry about early withdrawal penalties on that money. If they perform poorly, I can take the losses off of my taxes.

On the other hand, if I was approaching a normal retirement date and was just looking to catch up, I probably wouldn’t take that risk. Instead, I’d try to save more, reduce my retirement expenses, or consider other retirement income sources like an income annuity, a reverse mortgage, or even a part-time job or business. As always, it all depends on your situation.

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Can You Open A Roth IRA For Your Child?

January 10, 2018

The short answer is, yes, as long as your child has earned income, you can open a Roth IRA in their name and contribute up to the lower of either their total earned income or the annual limit ($5,500 for 2018). But there are some watch-outs to be aware of first.

Defining earned income

The key here is that the money you’re depositing into the Roth IRA is earned. That includes doing things like mowing the lawn, baby-sitting, cleaning the house (thinking back to when my parents paid me $12 to clean the whole house each week — holy inflation!), etc., you just have to be sure to document it. A part-time job where your kid receives a W-2 is a no-brainer — that’s 100% earned income.

What’s not earned income

Investment earnings, which are actually taxed differently, as well as gifts and allowance do not qualify as earned income and therefore cannot be counted toward the amount your child can contribute to a Roth IRA. In other words, you can’t just put $5,500 in a Roth IRA in your kid’s name, then say that they earned it by “being a good kid.” That’s a gift.

However, if they actually earned $5,500, even if they spent it on things like clothes and video games, you can still put that amount in their Roth IRA — the IRS only cares that the amount was actually earned by the account owner. Think of it like a match: you go get a job and learn some responsibility, and I’ll match those earnings in your Roth. A win-win!

Documenting earned income

If you’re using money your child earned doing tasks around the house rather than for a formal employer, one way to document it is to keep detailed records. You’ll want to document:

  • How much was earned
  • What was done to earn it
  • When it was earned

So for example, you could have a log that simply says: “1/1/2018, Baby-sitting for the neighbors on New Year’s Eve, $100.” You could file a tax return to really formalize the documentation, but it’s not required.

However, once your dependent child’s earned income exceeds the annual limit ($6,350 for 2017), they are required to file their own federal income tax return, regardless of the source of the income. There are reasons to file if their income was less, particularly if federal income taxes were withheld, so that they can have that money refunded. I always get a kick out of seeing my Social Security statement, which lists my first working year’s earnings as $136 from my first couple months working at McDonald’s!

Setting your child up for future financial independence

The bottom line is, one way to help your kid establish good savings habits from an early age is to open that Roth IRA as soon as he/she can legitimately earn money — in some families, that could be as early as 3 years old. You’ll have to open a custodial account until your kid is over age 18 (or 21, depending on your state), but most of the large investment companies allow these types of accounts. Keep in mind that because this is technically a retirement account, these savings wouldn’t even count again you when it comes to filing for college financial aid.

What better way to get your kids off on the right financial foot?

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Would You Consider This One Thing To Be A ‘Conservative Investment?’

December 22, 2017

As someone who has a moderately aggressive investment approach, I recently had a conversation with a friend who has a very aggressive investment approach (in my opinion) that made me rethink a piece of my investment philosophy.

Safe lifestyle, ‘risky’ investing style

Here’s his story: he & his wife, who are both 50, have put four kids through college (all four graduated with absolutely no student loans), will completely pay off their mortgage by age 55, and have amassed roughly $500,000 in the combination of their 401(k) plans & IRAs. They have no significant savings outside of retirement plans, but given the amount of spending they have done on the kids’ education, that is hardly a thing to worry about today.

They are hard workers and excellent savers. Their lifestyle entails very little in the way of risky behavior — they eat nutritiously, exercise regularly, do good deeds in the community, and live a fairly frugal lifestyle. We had never talked about money before, so I was surprised at what I learned — I guess I just assumed he’d be relatively averse to market risk with his investments as well.

All-in with stocks

When we started talking about how our retirement accounts are invested, he told me that he is invested 100% in the stock market and has no plans to “get more boring & conservative” over time. When I expressed surprise at his attitude toward completely excluding bonds and cash, even as he approaches retirement age, he said something that changed my perspective. In his opinion, Social Security fulfills the “conservative” bucket in his overall investment life.

Doing the math

According to his math, since he plans to work another 12 years (to get to age 62), between contributions to his retirement accounts and the growth of that money, he is expecting to have about $1 million saved at that point. If they retire at 62, he and his wife will receive roughly $2,800 per month in Social Security income ($1,500 for him, $1,300 for her).

Social security as an income-producing asset

Here’s the twist: since he considers Social Security income his “bond & cash” portion of his investment portfolio, he calculated its equivalent in income-producing bonds. He assumes that if you buy long term US Treasury Bonds, you should average a 4% – 5% rate of return over a long period of time. How much would you need in Treasuries to earn $2,800/month?

Using his return estimate, he would need to have between $672,000 and $840,000 invested in bonds producing 4 – 5% in order to generate a solid $2,800/month indefinitely. So, when looking at his $500,000 retirement accounts, he thinks he has way less than 100% invested in stocks. In his viewpoint, his current mix is 37% stocks, 63% bonds because of the $840,000 that would be required to generate that Social Security income (he used the biggest number available to exaggerate his point!).

Competing viewpoints

I thought he was an aggressive investor because of the way his accounts are invested and he thinks his portfolio is far too conservative. While I think he has a point, I don’t think it’s an appropriate way for most of America to start viewing their investment accounts — Social Security isn’t a given for most people under the age of 45, and he doesn’t factor in the fact that he can’t tap his SS payment early if he needs a lump sum for something like a new roof or hip replacement. But it is an interesting way to look at any type of guaranteed monthly income, since that is a relatively safe “investment.”

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In Search Of The ‘Perfect’ Investment

December 07, 2017

Do you know what the “perfect” investment would look like? According to a chart in this article of returns for a hypothetical “Mystery Fund” with “perfect returns,”  it would have consistent, safe, growth. It turns out that this mystery fund is actually Bernie Madoff’s supposed “returns” to make the point that “if it’s too good to be true, it generally is.”

No such thing

In the real world, there is no investment that offers safe, consistent, high returns like that. Instead, there’s a tradeoff between safety/consistency and long term returns. The “perfect investment” along that spectrum depends largely on your time horizon.

Short term versus long term = different focus, different results

For short term goals, the focus should be on return of principal rather than return on principal. That’s because earning a higher rate of return won’t make a significant difference over just a few years, but a big loss may mean having to delay or underfund your goal. For longer term goals, losses are much more likely to be dwarfed by your gains.

For example, if you earn just 2% in a savings account for 3 years, $10k would only grow to about $10,600. Earning a 10% rate of return (the long term average in the stock market) would give you about $13k – not bad. However, a 40% loss (like in 2008) would leave you with under $8k.

On the other hand, earning 10% over 30 years would mean having over $174k (versus just $18k at a 2% return) and a 40% loss would still leave you with over $100k. While that 40% loss would still sting (and perhaps much more since you’re losing more money), you’d still end up with much more than you would have had with the safe 2% return. The longer your time horizon, the less likely you are to lose your principal.

Of course, this assumes you’re invested in a diversified mix of stocks. An individual stock can go all the way to zero. For that to happen to the stock market as a whole, we’d have to be in something like a nuclear war, an alien invasion, or a zombie apocalypse, in which case your investments are the least of your worries.

Do you really think that’s perfect?

There’s one other thing to keep in mind. I’m not so sure that most investors would actually see the mystery fund in the article as the perfect investment. After all, it trailed the S&P 500 from the mid-1990s to the early 2000s and from around 2006 to 2008. How many investors would have the patience to stick with that long a period of underperformance?

Most of the rest of the time, it simply tracked the market with only a couple of brief periods of outperformance so I’m not sure how many people would have even invested in it in the first place without hearing Madoff’s sales pitch.

Underperformance doesn’t mean unsuccessful

If you define success as consistently beating the market, you’ll never be satisfied. (Even Warren Buffett, arguably the most successful investor in history, has had long periods of underperformance.) You’ll find yourself chasing past performance, buying what’s high and selling when it’s low, which is pretty much the opposite of what you want to try to do.

Instead, you want to pick an investment strategy that matches your time frame and personal comfort with risk. Then stick with it! When it comes to investing, the “perfect” can truly be the enemy of the good.

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Your Obsession With Being Perfect Could Cost You Six Figures

December 06, 2017

As a recovering perfectionist, I feel slightly hypocritical even writing about this — perhaps I should title the post “How I’d Be Wealthier If I’d Gotten Over Perfectionism Sooner,” but either way, I need to call out something I’ve noticed more and more in my conversations with peers and colleagues who are 40 and younger. There’s an obsession with perfect that is getting in the way of a lot of things (read Brene Brown’s Gifts of Imperfection if you really want to get into it), but when it comes to money, it’s costing real dollars.

Perfect as a goal

There’s nothing wrong with striving for greatness in life, and that desire to get things “right” serves us well throughout our school years in terms of getting good grades and therefore better college and eventual career opportunities. But once we get into the “real world,” there are benchmarks we use to measure certain areas of personal finance that can mislead people who put “doing it right” ahead of all other criteria.

When it comes to your financial outlook, getting it perfect in the short term could actually lead to missed opportunities in the long-term. The worst part is that you probably won’t even know if you got it “wrong” until it’s too late. Here’s what I mean.

What is “right?”

The biggest issue here is that “right” is a moving target when it comes to things like investing, your credit score and even building a cash nest egg (also known as the emergency fund).

Investing

When it comes to investing, getting it “right” doesn’t actually mean you never experience a loss of value in your portfolio. If you make it through your entire career without once seeing your 401(k) balance drop, you actually got it wrong because it means you invested too conservatively and missed out on the greater growth that comes with greater risk.

It may feel better because you never had that pain of “loss,” but you’ll never actually know what you lost out on in missed opportunity. In fact, investing too conservatively over a 30 year career could literally cost you a half million or more.

When it comes to investing, there is no perfect, but generally speaking, the longer your time horizon, the more chance that taking risk will pay off. When the market drops, think of it as a buying opportunity — the cheaper you buy into your 401(k) and other investments, the better the long-term outcome. Even investing on the worst day in the market (aka going all-in the day the market peaks before an extended down period) leads to a better outcome than not investing at all — don’t wait.

Credit score

I like that people want to have a great credit score and it’s kind of cute how some of my more competitive colleagues compare scores all the time, but trying to get it perfect may actually hurt you in the long run. For example, I’ve talked with people who are hesitant to explore refinancing their debt or even apply for a mortgage because they were afraid of the “ding” from applying. What’s the point of having a great credit score if you’re not going to use it? Anything over 750 is enough, heck even 720 will be good enough to offer you great credit options. Obsess less about your score and more about these things.

Nest egg

When you’re first starting out, getting some cash in place to handle the things that come up in life like job losses, cat surgeries and car engines needing replacing (all true stories in my life) is super important. A great guideline to shoot for is 3 — 6 months of expenses, but as life goes on and hopefully cash flow becomes a little more … flow-y, it’s important to reassess that balance.

We can get to a point where we’re so used to putting cash in a savings account that we may be missing out on other opportunities for that money, whether it’s using it to increase HSA contributions, invest in something else or even pay down your mortgage faster. There is no perfect number that applies to everyone, actually. The amount you need in your nest egg depends on several things:

  • job security (the more secure your job or in-demand your skills are, the less likely you’ll face prolonged unemployment)
  • family situation (the more mouths you have the feed, the more you need)
  • housing situation (the person who could get out of a month-to-month lease and move in with mom and dad in an instant needs less than someone who owns an historic old home in a transitional neighborhood that might take several months to sell)
  • other sources of cash available (not that you want to use these things, but they can be a part of your emergency plan as time goes by)

If you find yourself the sole breadwinner with a spouse and 4 kids at home, you probably need up to a year’s worth of salary set aside, while a DINK couple (dual income, no kids) could get by with 3 months as long as they would be able to trim back on spending quite easily upon a job loss or accident.

Getting this one wrong on either side could cost you — have too little saved (perhaps because you were focused on spending money on making your house look perfect first?) and you could find yourself in serious debt or losing your home should something come up. Having too much in cash could cost you investing opportunities (see above). It’s best to re-evaluate how much you need at least every 5 years or so, and definitely when you have a big life event such as the birth of a child, significant increase in income, new home purchase or change in marital status.

Where you should try to get it perfect:

Avoiding high interest debt (or debt at all) — Interest, whether it’s tax deductible or not, is money wasted. The less you can spend on it, the easier it will be to achieve financial independence, which I view as having choices in life.

Minimizing taxes — I don’t mean spending money on mortgage interest to get a deduction, but making sure you’re taking full advantage of all tax savings opportunities. Some examples:

Choosing your life partner — You won’t find a perfect human and you can’t be perfect (sorry!), but you can find someone who’s perfect for you and that makes a huge difference in your long-term finances. My CEO Liz wrote about this in her book What Your Financial Advisor Isn’t Telling You and it’s true — who you marry could be your best or worst financial decision ever.

 

 

Does The Billboard Top 10 Mean The Market Is Heading For A Crash?

November 24, 2017

In my 20 years or so as a financial planner, I’ve heard some pretty wacky theories about things and events that allegedly have an influence on the stock market. They all have interesting and catchy names too like the “Santa Claus Rally,” the “January Effect,” or the “Super Bowl Indicator.” According to market folklore, each of these seemingly unrelated conditions or outcomes is supposed to determine the future direction of the U.S. stock market.

For example, according to the Super Bowl Indicator, a win by the American Football Conference (AFC) team is supposed to bode negatively for the stock market in the coming year, whereas a win by the National Football Conference (NFC) team is supposed to foretell a rising stock market for the next twelve months or so.

Balderdash! Correlation does not indicate causation. Everyone knows that, right? Entertaining as those correlations might be, there isn’t much (okay nothing) in the way of practical scientific support to back them up.

Can Billboard predict the next market crash?

However, some new research suggests yet another seemingly unrelated indicator that may actually have a hint of scientific support behind it. According to recent research conducted by Dr. Philip Maymin, then assistant professor of finance and risk engineering at NYU’s Polytechnic Institute, the public’s choice regarding popular music may indeed be closely tied to forecasted movement within the U.S. stock market.

Based upon Dr. Maymin’s findings, people tend to prefer softer, calmer musical beats when they anticipate a more volatile stock market in the coming months and faster, livelier music in anticipation of calmer markets. He based these findings on observations of variance in standard deviation of returns for the S&P 500 index in comparison to average annual beat variance in songs tracked by the Billboard Top 100.

Market timing – investing with two left feet

If making your investment decisions based upon who wins the Super Bowl or whether the song in your head sounds more like “Despacito” or a Mariah Carey tune comes across as a rather silly way to manage your money, you are probably right. Imagine trying to dance at a club or wedding where the DJ changes songs every few seconds. Investment choices based on changing market conditions can feel the same way.

Nevertheless, investors of all stripes frequently do engage in attempts to time the market based upon their thoughts, feelings, fears, hopes, dreams, etc. regarding a whole host of events, including election outcomes, the weather, how long the market has been up or down, chitchat among coworkers, and more.

Humans, it seems, are just not wired to handle uncertainty very well, and investment markets are the definition of uncertainty as they can be down one day and up the next. Much has been and continues to be written regarding human psychology and the uncertainty of investment markets.

Even market trend timing guru Paul Merriman applies mechanical market trend timing strategies to only half of his own investment portfolio, and he is adamant that timing in general is not suitable for the majority of individual investors. As Mr. Merriman and I tend to agree based upon our collective experience, most investors lack the psychological fortitude, discipline, and stamina to stick to a timing strategy during periods of short-term financial losses that will inevitably happen.

Why? The simple fact is we hate to lose money, and when we see values drop, we feel obligated to do something, even when the best course of action is often to do nothing. As a result, market timing doesn’t work and often serves to do nothing more than make a bad decision even worse.

Stick with the same old song

As with dieting, exercising, and balancing your checkbook, there are no reliable shortcuts to success with disciplined long-term investing. Diversify your investments appropriately across stocks, bonds, and cash. Buy and hold even when it feels wrong and continue to invest regardless of whether the market is up or down that day. Be mindful of fees and commissions.

It’s not sexy and it doesn’t make for riveting conversation in the lunch room or around the water cooler, but a consistent, disciplined approach to your investments will ultimately leave you humming a much happier tune.

This post was originally published on Forbes.

Investing 101: Understanding Your 401k Options

November 13, 2017

If you’re like a lot of people, even if you have gotten help choosing the investments in your 401k, you may not really understand how those investments work or what they are made up of. I felt that way for a long time.

Like fish in moving water

I still remember choosing investments for my first retirement plan, a 403b. I really had absolutely no idea what I was doing — even after studying for and taking various securities exams, I was still a little bit fuzzy on some things.

To me it was like looking at a fish swimming under moving water. You can kind of see it, but only in the most general terms. The variations in the color of its scales, or features of its fins are distorted so much that even though you know it’s a fish, you can’t tell much more than that. Likewise, you may know you’ve got an investment in your 401k, but, beyond that, who knows what’s in that thing!

Understanding some basic terms

To help de-mystify some of the terminology, I’d like to break down some different terms that you might come across. Here’s a basic idea of how it works:

Mutual Funds

A mutual fund is basket of investments in stocks and/or bonds that are chosen to meet a certain goal. Some mutual funds are professionally managed (often called “actively managed”) by a fund manager who buys and sells investments as she/he sees fit to earn the highest returns within certain parameters. The name of the fund will oftentimes tell you what is in it.

For example, a large cap mutual fund will hold stock in large companies. It may own stock in a few companies or in hundreds of companies. The fund manager gets to choose which stocks or bonds to buy in a mutual fund.

Index Funds

Index funds are a subset of mutual funds that are what we often call “passively managed” and the word “index” will usually be in the name of the fund. An index fund will typically be invested in all of the funds of a certain index, such as the S&P 500, Dow Jones, Russell 2000, etc. Indexes are made up of all of the available stocks or bonds that fall into a certain category. The most notable difference between index funds and actively managed funds is cost — index funds typically have much lower fees.

For example, the Russell 2000 Index tracks the stock of 2,000 small companies in the United States. Therefore, a Russell 2000 Index Fund would likely own stock in most of the 2000 companies represented in that index.

The idea behind investing in an index is that it provides very broad diversification within a certain category at a lower cost. This means that if something really bad or really good happens to one of the companies represented in the Russell 2000 index, it isn’t very likely to affect the overall index very much. If one of the companies goes bankrupt, you have the other 1999 companies to counteract that effect.

ETFs

ETF stands for Exchange Traded Fund and they are kind of like an index mutual fund in make up — the difference is how they are traded on the active market. With mutual funds (including index funds), when you request to buy or sell a fund, the trade is executed at the end of the trading day (4pm ET on days the market is open) so that is the price you get. ETFs, on the other hand, trade the moment you request a buy or sell transaction, so are often preferred by more active investors.

ETFs are typically also made up of stocks or bonds that fall into a certain category and are not actively managed — they are passively managed (like index funds). For example, there could also be a Russell 2000 ETF, and as long as a stock is part of the Russell 2000, it will be purchased and held as part of that ETF.

You are unlikely to have direct access to ETFs within your 401k or 403b account, but the funds that are available may use ETFs instead of individual stocks to achieve their investing objective.

Target Date Fund

A lot of plans are using these — sometimes they’re called “Target Retirement” or something similar, but the dead giveaway that they’re a Target Date fund is when there is a year in the title of the fund. The “target date” they are referring to is your retirement date (or the year closest to when you plan to start making withdrawals from your account).

Target Date funds are mutual funds (sometimes even called “fund of funds”) that are typically professionally managed to meet certain criteria so that the fund will be appropriate for someone with a specific time frame left before they will need to start withdrawing the money from their account. So, the closer you get to the targeted date, the more conservative the fund will become.

The idea here is that YOU don’t have to worry about selecting investments, the fund manager does all of that for you. But what is IN the account? A Target Date Fund will hold a variety of investments, usually other mutual funds or ETFs.

Target Date funds are basically a “set it and forget it” option for people who want to be hands-off but know that they are still giving their savings access to growth that’s appropriate for their timeline.

Stocks

Mutual funds are made up of a variety of different stocks (or bonds, if it’s a bond fund). Owning a share of stock simply means that you own a tiny percentage of a company.

Bonds

We’ve talked a lot about stocks but not so much about bonds. If you own a bond of a certain company, municipality or the federal government, it means that entity owes you money. They have borrowed from you and must pay you back with interest. Because they are an obligation versus just part ownership in a company that could go gangbusters or go bust, bonds are considered more conservative investments because you’re more likely to get your money back with interest and hopefully some growth. Bonds can also be held in a mutual fund or ETF.

 

So, there you have it: Target date funds hold mutual funds and ETFs, and mutual funds and ETFs hold stocks and bonds. Which essentially means that you may be invested in a target date fund or mutual funds and ETFs, but either way, somewhere under all of the layers, you are probably invested in individual stocks and bonds.

 

Even Jay-Z Has Investing Regrets — Why That’s Not Always A Bad Thing

November 09, 2017

“I could have bought a place in Dumbo before it was Dumbo for like 2 million. That same building today is worth 25 million. Guess how I’m feelin’?” — The Story of O.J., by Jay Z

Have you ever heard someone rave about their investment successes? They tell you how they got in that stock when it was worth nothing or how they sold out of the market just before the bottom fell out. It is easy to point to your successes in life, but I think failures teach the best lessons. Here Jay-Z gives us a glimpse of some of that pain. He speaks of an opportunity to buy a property in Brooklyn and passing on it. Now that property is worth more than 10 times what he would have paid for it.

Financial mistakes can be good for you

I am a strong believer that the lessons learned from financial mistakes are the best. You can be told a million times that it is a good idea to have a diversified portfolio but nothing gets your attention like going through a downturn with the wrong mix.

It definitely doesn’t feel good to lose like that, but if you can bear to examine those mistakes you will walk away with information that will put on the right side of opportunity the next time. Here is how to mine those investment mistakes to take away those gems of wisdom for future reference.

Making the most of money mishaps

Perform an autopsy on the mistake. Instead of kicking yourself over missing out on an opportunity or beating yourself up over buying something that did not perform, take a moment to think about what led you into that decision in the first place.

  • Was I being narrow minded or stubborn?
  • Were my priorities in a wrong place?
  • Did I not take the time to implement some basic rules into my investment decision?

My big investing lesson

When I look back on my own investment history, one big lesson I learned is that you cannot take advantage of an opportunity if you do not have the resources. I started in the financial planning business at end of the dot com boom. Coming out that recession I had a decent grasp on some of the brands that would thrive over the next decade because of my age.

What I didn’t have at the time was the savings to make truly meaningful moves on those opportunities. I was not in a financial crisis, but I was not prepared to sink capital into my own convictions. Because of that I missed on several great investment opportunities.

My lesson there was clear. I had to have my financial house together in order to take advantage of great opportunities when they come up.

Learning from others’ mistakes

While making your own mistakes is the most likely way to keep you from repeating them, there’s still value in examining what others, like Jay-Z, have to say about their own financial regrets. If you have a friend, a family member, or just someone you admire, ask them what lessons they have learned from their investment failures. I find the wisest people are the most gracious when sharing about this topic. They want others to know that success is not an easy road.

Warren Buffett, considered one of the greatest investors ever, essentially publishes his investment failures in his annual shareholder meeting. There are articles and podcasts dedicated to just that.

So now the secret is out: if you have made an investment mistake you are in very good company (assuming you consider Jay-Z and Warren Buffett to be good company!). The key is taking the lesson — your long term success is based on what you will do with your learnings.

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How I Learned To Lend Money To Family & Like It

October 13, 2017

In traditional financial planning circles, lending money to family is considered taboo. However, I must admit, I’ve bent the family finance rules a few times. Please don’t judge. After making some big mistakes (that you don’t have to make because you are wisely reading this blog), it’s actually worked out well for everyone. Here’s what happened.

Lending to family the first time: 3 big mistakes

A close relative of mine who had been living with me in the Rocky Mountains found a job opportunity in Las Vegas that was exactly what she needed to get her foot in the door. All she needed was a reliable car to get there and then to use while living there. Since she had no money, I agreed to sell her one of mine at less than market (because she is family) and we agreed she would make payments to me once she got settled.

Saying good-bye to my Trooper

So, that’s how my perfectly maintained, excellent condition 1992 Isuzu Trooper was soon never to be seen again. Long conclusion short – things hadn’t gone according to plan and my family member didn’t want me to know that the job hadn’t panned out the way she’d hoped. She had sold that awesome SUV for an absurdly low price to raise cash, keep her place, and continue her job search. She couldn’t bear to tell me and kept hoping she’d get a job and be able to start paying me back without my noticing too soon.

When I finally did find out, I felt soooo foolish. Every older person I knew had warned me never to lend to family or friends. I learned some valuable lessons:

Mistake #1 – Not assigning market value. The market is the market when it comes to anything, and if you end up with an asset for whatever reason, you want to make sure you’re not devaluing for no good reason. (even if it is family)

Lesson: Assign a realistic value to things.

Mistake #2 – Not formalizing the agreement. There’s a stereotype about rural folks whether they be from the mountains or the plains: Your handshake is as good as your word. While I’ll admit the stereotype is completely true (it’s still dangerous to go back on a handshake deal), you may be surprised to know that even where it’s recognized as official, it’s just a place holder until something formal is put in place. Without something in writing, the terms of any loan can get fuzzy and someone or everyone gets hurt.

Lesson: Put it in writing. As my father always said, “When you trust each other, neither of you has any problem putting it in writing.” When it comes to family, the formal agreement is arguably even more important than in traditional business. The repercussions are very long, after all.

Agree to sign a Promissory Note with your borrower (you can get a template online for free) and set up a payment schedule in the document. You can always make changes, but this ensures you are both on the same page with expectations (and should the deal go bad, you may even have a tax write-off).

Mistake #3 – Not insisting on insurance of some kind and letting her keep the title (presumably for automobile registration). If the family member doesn’t have the money for the transaction, how do you think they’re going to be able to pay you back if something goes wrong?

Lesson: Keep collateral. I should have held onto the title of the vehicle until my family member paid me back, and I certainly should have obtained a copy of the insurance policy to make sure my collateral could be replaced if something bad happened.

Lending to “family” the second time: a success story

My good friend, David, had been a great employee of mine in corporate America, and I supported him with advice and motivation when he chose to leave and figure out his true career path in music. David was in his late 20’s. He was single, owned a nice little condo, a cool jeep, and an adorable cat.

The time came when he needed to buy a new vehicle and clear his debts in order to keep pursuing his career in music (which was actually going well). It made sense for him to sell his condo — he could rent for less than his mortgage and the debt was limiting his credit. In the meantime, he needed some cash to tide him over — $30k to be exact.

Putting the deal together

He came to me with a formal proposal (in writing), basically saying that if I could lend him the $30k he needed to buy a new vehicle and clear all his other debts right now, then when the condo sold he would reimburse me, with interest. It was big chunk of change, but it all went according to plan because we solved all of the mistakes and he and I became partners in his condo sale.

Assigning value — David and I worked together to sell his condo. We were realistic about the market value and I knew that if the sale didn’t happen and I didn’t get my $30k cash back, the value was still there.

Putting it in writing — We signed a Promissory Note and I recorded a lien on the property at the county in case anything went wrong.

Keeping collateral — What if the condo sale hadn’t gone according to plan? If I had been a banking institution I would have pursued David for the remainder, foreclosed on the property, taken him to collections or court, you know the drill.

Since he is a friend (and adopted family), I instead had to be prepared to walk away with my losses and the condo as collateral. Since I’ve been a landlord since I was 22, I knew I could use the condo either as a sale or a rental to offset the worst-case scenario; and David and I could still look each other in the eye and smile at family gatherings.

The result

I broke even on the deal, and David went on to become my business partner for 12 successful years, and remains my closest, surrogate brother. I’ve since been able to assist family with other needs, including helping my brother open and sell a successful restaurant in Madrid, an experience that we all profited from.

Thanks in part to the things I’ve done right in family and friends lending, I’ve been able to revel in their successes more, and even have a part of ownership in a number of businesses and properties that I never would have considered on my own. The successes are great stories at family gatherings, and with the right pieces in place, the failures are a laugh and a bonding moment.

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