The Party Animal Saver

I recently got a call from an old friend of mine. We grew up in the same small farming town, attended the same secondary schools, and had the same friends growing up in that small town. Most, if not all of, the kids we had fun and games with still live in that same town. They never got out, and probably never wanted to.

My friend Steve and I both did. He joined the army and I went right to college. Steve saw the world and I learned about finance. We stayed in touch the entire time, and when his tour was finished he went to college on the GI Bill. It covered most of his expenses, and what it didn't cover he earned, working the midnight shift driving the campus bus. Steve initially studied English Literature, but in the eleventh hour switched his major to Engineering.

Steve's grandfather had been a coal miner in Pennsylvania. Talking to Steve, you can get a glimpse of that hardworking, solitary, risk-taking whim so often seen in men and women who put their lives at risk for the hope of a better future. I think it was that same impulse that drove him into the military, and ultimately, by the time he finished his tour of duty, to being the longest serving soldier on the DMZ between North and South Korea. He is an extremely intelligent, loyal, and hard working individual.

He also loves to party all night. He is completely disorganized: forgets to pay his bills, loses his wallet and keys constantly, spends every dime he brings home well before its time, and spills his coffee all over whatever electronic gadget he happens to have on his desk.

The occasion of his recent call was to tell me he had just been given the opportunity to move to Columbia to open the new South American branch of his engineering firm. He's been working at the firm since he graduated from college about 8 years ago, starting out as a grunt and steadily promoted to managing the Philadelphia office of his firm.

When he did start at the firm all those years ago, he had a conversation with an old army buddy who had attended the University of Virginia after completing his tour, and now worked on Wall Street. Steve's friend told him "Look Steve, you're basically an animal, and anything you bring home you are going to immediately devour. Do yourself a favor: max out whatever retirement plan options you have through your employer, and send $200 a paycheck to an account at ING Direct (who at the time was paying the highest yield). You won't miss it if you do it right from the start, and you won't know what you spent your take home pay on anyway." Steve's army buddy went through the process of helping him set up these two accounts, and since that day it has been on autopilot.

Steve hasn't withdrawn anything from his ING Direct account since he opened it, and I don't think he even looks at his 401k statements. To him, it's all money in the bank that he won't need for a long time, but when that time comes he should have plenty of it. I think when he started working the 401k max was $12,000, assuming he never raised it and a 9% rate of return, he probably has about $145,000 in his retirement account. Assuming an average rate of 4% on his savings account, at $200 a pay and 24 pays a year, he likely has about $40,000 in the account. Not bad for a guy who spends every dime he brings in the door! Even more impressive, at this rate, in another 8 years, he'll have about $430,000 in his retirement account and $108,000 in his savings account. Talk about a reason to party!

Steve is a good example of someone who is using the modern tools for wealth building that are available to everyone. These are tools that barely existed for the baby boomer generation, and did not exist for their parents. Unfortunately, too many people in our generation, the generation who will soon be the powerhouse of our economy, are uninformed and underutilizing these tools. As a result, they will be working long after the 'Steves' and 'me's' of the world have left working for new fun and games. Only this time it won’t be a small country-farming town, it’ll be on a South American beach!

The Roth IRA

The Roth Individual Retirement Account was created by an act of Congress. The Roth allows for post tax contributions that can be invested in a number of ways, the most common being mutual funds and stocks. Almost any financial institution provides Roth IRA accounts. Banks, brokerage houses, and insurance companies offer certificates of deposits, money markets accounts, mutual funds, and stocks. Considering the long term outlook of most Roth Investors (the funds cannot be accessed tax free until age 59.5), it probably doesn't make much sense for Roth account holders to invest their dollars into anything other than stocks and mutual funds that have a reasonable amount of risk and reward potential.

Contributions to a Roth are made post-tax, therefore, unlike a Regular IRA, contributions to a Roth are not deductible on your tax return. The advantage is that withdraws from a Roth, so long as they qualified, are completely tax-free. Qualified withdraws include those made after age 59.5, up to $10,000 for the purchase your first house, or if you become disabled. A Roth IRA effectively allows you to prepay a future tax liability at a tremendous discount. This is true for two reasons:

First, taxes in the future will very likely be higher than they are now. As the population ages, and there is a smaller percentage of people in the workforce, but a greater demand made on the government for services to support the aging, taxes will need to be increased to pay for this increased demand and lowered supply. Think of the welfare states of Western Europe. Their taxes are a much higher percentage of income. They offer more services, like free health care for all, have greater unemployment, and have a larger percentage of elderly and retired citizens.

Second, the money you invest now in a Roth IRA will grow and you will experience compound returns, so if you're 30 years old and make a $5,000 contribution in 2008 that you have already paid taxes on, when you withdraw that money at age 60, that same $5,000 is now worth $66,338 (30 years at average 9% return per year). Further, even at a 25% tax rate (and believe me the tax rates in 30 years will be higher, not the same and definitely not lower than they are now) that $66,338 is effective worth the same amount as earned taxable income of $88,459. But you paid taxes on $5,000! And at a lower rate!

Beginning in 2008, Congress has allowed contributions of up to $5,000 for taxpayer’s age 49 and younger, and $6,000 for taxpayers age 50 and older. After 2008, contribution limits will be indexed with inflation and raised at $500 intervals. There was a lot of talk for years in the financial services industry that the Roth was too good to be true, and that Congress would eventually be forced to close this opportunity to taxpayers. That has not happened yet, but most Americans do not take advantage of this powerful tool. As both the Roth IRA and the Roth 401k gain in popularity and the pool of taxable income continues to shrink, it's anybodies guess what the future holds.

These are the Times

I don't like to provide commentary on current market conditions. We all know the aggregate success of stock markets over long periods of time, and that is what I am most concerned about since my time horizon is in excess of ten years. Apart from a few months in 2002 when I believed oriental rugs where a better investment then equities, I have always had and continue to have a great amount of faith in the ability of equity markets to provide positive returns.

I am using this current opportunity to sell shares of Duke Energy and their spin off Spectra Energy. I will invest the proceeds in the Dodge and Cox Stock fund, whose price has been effected to a greater degree by the current market meltdown than the two previously mentioned companies. I have been divesting my portfolio of individual stocks for the past year, and am moving toward a portfolio of almost exclusively index funds.

Although I am relieved that the credit exuberances of recent times have finally caught up with the markets, it is always a disappointment to see your net worth travel south without seeing a new sport car in your driveway. When weeks or months like this do occur, I tend to hunker down, sort of get in front of the TV with potatoes chips and wait it out. I don’t like to make changes, and just stick to the plans I made in happier times. I also think markets like these help produce greater returns down the road, after the sharp contraction, the rapid expansion, but I don’t bet on these theories and don't suggest anyone else does either. It just gives me something to dream about during the dark nights.

A theory I am interested in learning more about is the "sell in May and go away." That is, the divesting of equities in very early summer, and the repurchase of them after Labor Day. I am not an advocator of market timing, and don’t think that if it can be done I am the one to do it, but I would like to hear any comments about this strategy anyone may have.

Spreading Wealth Like a Virus

Researchers have proved that weight gain is actually contagious, and spreads from friends and family members to unsuspecting friends and family members. The study, which took place over thirty years, found the strongest correlation between the weight gain of friends. In fact, the study found that if a close friend gains weight, it actually increases our chances of gaining weight by 171%. Therefore, the study concluded, obesity can spread like a virus, from person to person, close friend to close friend.

This immediately brought into my mind the following question: if obesity can spread from person to person, does that mean that wealth can spread from person to person? Can wealth spread like a virus? Can the habits of wealthy friends rub off on less wealthy friends? Can the Rich teach the Not Rich how to build wealth?

I then examined what I will call my core group of close friends, that is, friends whom I have remained close with and in very regular contact with (meeting with socially at least once a week) for 5 years or longer. What I found was that we all have very similar balance sheets: we all happen to have a little more financial success than average, and enjoy approximately the same standard of living. (As a side not, I’d estimate that each of the two sexes fall within a 20-pound weight range at most.)

So this raises the question: If I were to make wealthier friends, would I become wealthier? Would I learn habits and about options that would lead me to greater wealth? I suspect the answer is yes. Does this mean that I am going to go out tomorrow and make all new friends and drop all of my good old friends? Of course not, but I do have friends whom I don't see as regularly, that for whatever reason I have not brought into my core group of close friends, that are much more successful than me and whom I could benefit from knowing. They may even teach me some things that could make me richer.

It turns out my father was right, "be careful who you choose as friends, you will become what they are." It just never occurred to me to use this as an advantage.