In doing some research into active management funds and passive (indexed) funds, which I will be writing more about later, a topic came up about how some studies overlook the effect of taxes on certain investment styles (e.g. buy and hold versus active management). Thus, let’s take a quick look at a simple analysis of how taxes can adversely affect the returns of a fund that has a lot of turnover in any one year.

To see this mathematically, let’s assume a 10 year holding period and a 10% annual return with a 20% tax rate (15% capital gains and 5% state tax):

Buy & Hold return

= (1 + 10% return) ^ (10 years) – 1 = 159% return

= 159 * (1 – 20% tax rate)

= 127% return after-tax

Annual Turnover

For simplicity, let’s assume a 100% turnover a year in stocks held at the end of each year. Many funds do not turnover this much; however, some turnover also causes greater short-term gains that are taxed at a higher tax rate than 15% capital gains which would lower the return.

Return with turnover = (1 + 10% * (1 – 20% tax rate)) ^ 10 years – 1

= (1.08 ^ 10 – 1) = 116% after-tax return

So you can see that a buy and hold strategy produces a significant return compared to an actively managed portfolio assuming that each has a comparable return (e.g., 10%) pre-tax. Yet, a reason that people select an actively managed account is due a belief (whether it is true or not is subject to debate) that a manager/broker can outperform the market. In this example, the average return for the active managed fund needs to be 10.7% return instead of 10% return to overcome the adverse tax effects. This may not be a large difference, yet when you add the additional fees paid for managers (1% to 2%), the differences start to add up.

Note, the effect of taxes may be more or less depending on the holding period, how often a portfolio is turned over (bought and sold), how turnover results in short-term capital gains (taxed at higher rates than capital gains) and the taxation by your state on investment gains/losses. There would be also taxes paid on an indexed fund due to some turnover (usually minimal to match index) and dividends. Thus, always review the funds perspective for turnover, short-term vs. long-term capital gains and expenses to determine which fund is right for you.

Many people relate having money with having power. Thus, for many, not having money makes them feel powerless. They feel that they are a victim to our economy because:

• They can not get ahead on minimum wage jobs

• They do not have the money to invest to secure their future

• They do not get the breaks that rich people get

• They are constantly looking over their backs for people who only want their money

Yet, power does not come from money. Power is an internal decision to have influence over you life instead of being influence by others (e.g., your boss, marketing ads, government, etc.).

How can people without money take control over their lives when they can only pay the bill collector that is knocking the loudest? Well there is a paradox to money. The less you have, the less power you feel. The more you have, the more power you feel. So, it sounds like a no win situation. As the saying goes, the rich get richer and the poor get poorer. Yet, the key word is “feel”. It is not about money, but how we feel about money. There may be things that you can not change. However, there are things that you can feel better about by taking some action.

For example, your can call your credit card company about lowering your interest rates. However, if you feel powerless, you will be less inclined to do this. It is the act of calling that you start to regain some of your lost power. However, real power is sustainable (like determination) that does not fade if the person says no. Many times, the first person on the line at a credit card company has the job to say no and only the supervisor can agree to change the interest rate. Sometimes the caller’s credit is so bad that the company can not justify lowering the rate at the given risk. Sometimes the supervisor knows who is reading from a script because someone told them to do it (yet not believing it will work) and knows who is determined (and powerful) to lower their rate anyway possible. Guess who gets the lower rate? Other times, a no is temporary until the caller can prove you are able to pay back the amount (e.g., for those with bad credit rating). So, take power back by taking responsibility. Ask what you can do to get a lower rate. It may be making double payments for 6 months. Get it in writing (with the agreed on plan and rate reduction) and do it.

A key is to feel more powerful by taking action. And, there is a trap because many take action against others (get angry or get revenge). If you feel angry, that is not true power. Anger is about someone hurting you. If you feel that you can be hurt, then you respond in anger to protect yourself. Yet, if you are powerful, you can protect yourself without anger. So instead of getting angry at the credit card company or your boss, get determined to make a change.

There are ways to be more determined in 2007 to control your money situation through action. Many times we fear of what may happen if we mess something up. Yet, many times no decision is worse than making the wrong decision. This is because if you make a decision and it is wrong you can always change your decision later. Yet, if you make no decision, then your 2007 will be just like your 2006.

• Budget

There are many myths about a budget:

“Budget Myth #1 – I do not have any money to do a budget”

“Budget Myth #2 – I Can Not Do a Budget Because I Do Not Know All My Expenses or Income in a Month ”

“Budget Myth #3 – Budget is a Restrictive Spending Plan

Yet, a budget is about regaining control over your finances. In one of my first classes, a participant was talking about how she could only pay the creditor that was knocking on her door first. By doing a budget, she became the one in charge of who got paid first. It was a shift in her mentality. By changing how she thought (out of control to in control), she found areas that she could cut back on to have more money to really have what she wanted more (peace of mind of not having creditors constantly calling her).

A budget is not going to be perfect. However, just spending a few hours on it may make you aware of an issue that you did not know about. Plus, it will make you more aware when you do make purchases. Some purchases may sound good in the moment of purchase yet feel terrible when the bill comes in. Having a budget sets up the criteria of what purchases will make you feel good both now and when the bill comes in because purchases are more thoughtful instead of spur of the moment purchases.

• Set up an Emergency Fund

One thing that many people over look is setting up an emergency fund. Many say that they do not have the money to put aside for this. Yet, in reality, you do not have the money not to. Once you fall behind, it is hard to get out of debt. Thus, it is sometimes better to feel a little pinch now than a bigger pinch later.

When I discuss budgets, I talk about analyzing your wants on what gives you the most peace, love and joy and using that as an indicator when deciding what goes in the budget. What many people do not understand is that having an emergency fund is want (and maybe even a necessity). Thus, when considering what wants should be in the budget, think about what would happen if you had a major medical expense or lost your job (or even if the job cut back your hours). An emergency fund usually gets pushed aside because the consequences are not right in front of people to consider. Yet, having an emergency fund in the time of need will give you more peace, love and joy than most of your other wants will.

Many people feel powerless when they lose their jobs or have a medical emergency because the event is something that happened to them. However, you can still be in control (have power over) your finances, by planning ahead and having an emergency fund.

• Contribute to 401(k) or Roth IRA

Stop fearing what you will have in retirement by taking action to put money aside for it. Can’t decide which plan to fund, read Power of 401(k)s and IRAs

• Invest

Some people do not invest because they feel that there are too many unknowns to consider like: which company to invest with, which stock to invest in, how to diversify, how to monitor the performance, etc. There can be a lot of decisions to investing. Yet, the basics for starting to invest are to (i) minimize the fees and (ii) diversity. The rest you can learn along the way and change companies or funds when you learn more.

To diversify, a mutual fund or an ETF (exchange traded fund) is usually the best for a small investor. The only thing to watch out for early on is to not put all your eggs into one sector like oil, technology, etc. because that sector is not well diversified on its own and can be hit hard like technology stocks where in the early 2000 to 2002. So, many suggest investing in the broad market like S&P 500, Russell 1000 (or 3000), international indexes, etc.

To minimize fees, the key is to do a quick research on the fees of the mutual fund or ETF that you invest in. For indexed funds (invested in the broad market), the fees should be less than .75% per year, in some cases fees can be less than .25%. For small investors, mutual funds may be best starting out because the fees to buy ETFs can be $10 to $20 per transaction. On $25 to $100 monthly investment, the fees as a percentage can be significant (10% to 80%). Thus, it is usually best to avoid any upfront fees or backend sales fees when initially investing especially if you may decide to change where you are invested as you learn more.

By taking a few steps and setting up and investment plan, even if it is as low as $25 a month, you are taking control of your future. And, as you start a plan, you may find out that investing is easier than you ever considered.

• Debt Reduction

I am not going to do a whole section on this because there are many things to consider. Yet, if you are in debt (in particular if you are in debt more than just having student loans or a single mortgage), then sit down and have a plan to get out of debt. Oprah had a good series on starting a debt diet plan.

For my two cents, if you are considering whether to use a credit counseling service or not, take the first step on creating your own debt reduction plan (with the exception if you are at the brink of bankruptcy where you need debt counseling immediately). The reason I say this is the more you are in control of your debt plan, the better results you will have. Many people go to a debt counselor and have a plan set up for them. However, a few years later, they are usually in the exact same situation again because they did not learn their lessons about managing their own money. Thus, just consider setting up a debt reduction plan on your own first. Once you have, you can always go to someone for their advice to make it better. Yet, by taking the first steps yourself, you are learning more about taking charge of your own finances than sitting back and letting someone else tell you what to do.

If you have already gone with a debt counselor, take the New Year as an opportunity to review their plan and see if you have any ideas on how to improve it. You may be able to call the credit card companies and see if they can lower your interest rates. Many remember the “No” that they heard about lowering their interest rates in the past and do not try again. Yet as your credit improves, you may find new opportunities

Over the last few weeks, I have heard a few people talking about starting their own business. Part of me wants to encourage them and part of me wants to discourage them. For me, the decision to start a business or not is all about the intent. When I hear that the intent is just to become rich, I start to cringe a bit. This is because when I question them about their intent, many times they believe that it is impossible to become rich while working for a company or they believe that companies are too greedy to share their wealth with their employees. For me, this is a sign that they should reconsider going out to work on their own because their focus is on what they do not want (e.g., being poor) and thus they become more susceptible to get rich quick schemes. We have all heard these pitches “Want to earn 6-figures while working at home?” and wonder why we are working so hard when others are making money so easily.

My feeling is that if there are no a sure fire way to make money without the potential risk of loss. If there was such an opportunity then everyone would do it and thus removing all possibility of making a significant profit. We have all heard in the past that real estate was a sure fire investment. Well ask someone this now who is holding property and can not sell it without a large discount in the asking price. Nothing really has a guarantee except FDIC insured savings accounts and a few other safe investments.

Yet, many people desperate to change their fortune believe that there is a magic business or stock picking software (sold to millions) that can beat the market even though the same advice is given to everyone. However, the law of efficient market says that when there is a large number of buyers and sellers with a low transaction fee, then the market will price the product so that the return will match the risk taken (larger expected return for higher risks). And, even if a business (like blogging or web design) sounds like a great opportunity for a business, there can become enough people doing it that will flood the market and eliminate any profit except for those who have a solid business plan or special niche. Thus, there is really no sure fire way to make a quick profit with no downside risks. Yet, people who desperately want to be rich (e.g., not poor) are suckered into these propositions because they focus on how to get rich while being blinded from seeing the risks.

As I said above, the purpose for going into business is the important indicator to someone’s success because when the focus is on being rich (e.g., not being poor), a person overlooks the risks of the business due to being desperate. In other words, when they want to make money, their gut is fooled when it comes across a snake oil salesman. If their purpose is on what they want to give to the world (a new product, your talent, etc.), they can better listen to advice that their gut provides may warn you of the risks involved. Plus doors just seem to open up when they are doing something for the right reasons.

For me, when I was looking to leave a prior job because I was disenfranchised, I could not seem to find anything even though I had a solid resume. When I became at peace with the job, I actually ran into someone (an ex-boss) at the local food court who offered me a great position (a part-time position for a great salary). Another time, when I invested into a start-up company in order to retire early, I lost my entire investment even though it had been evaluated and recommended by a man who I trusted. I even remember saying that if the investment failed, it would only be a part of a year’s salary (I did not listen to my gut warning me). Later, when I decide to go into business for myself to be more helpful in the daily life of people, strange coincidences started to turn up that brought me clients and opportunities that would have taken my a lifetime to do on my own. Being inspired by what you want to do will open doors while being inspired to run away from where you are (poor to become rich) will close doors. So my advice is to be at peace with where you are at, then you can attract what you want.

In addition, if there is something that you are trying to avoid, it is something that can come back to haunt you. If you are trying to avoid companies that are too greedy, you are denying others from having wealth and at the same time denying yourself the opportunity to have money. In running your own business, you may subconsciously sabotage yourself because if you make money (like “THEM”) then you are being greedy just like “THEM”. Or, you may be complaining about rising health care prices your company is charging you. Yet, it is even harder to find health care insurance on your own (especially with a pre-existing condition). The grass is not always greener on the other side. When I hear people say that you can not make money working for a company, I point out that Jack Welch and others who made a fortune working for a single company for most of their career. I also point them to the average income of a self-employed individual versus average income of someone who works for a company is not as big of a difference as they may think. For each self-made millionaire who started their own business, there are probably 5 to 10 failed businesses and other businesses struggling just to make ends meet. In reality, companies make large profits due to economy of scales (producing in large quantities), something a small business can not do.

So, do I discourage everyone from working on their own? No. I suggest that they find out what they really want to give to the world and start doing that today (even if it is at their current company). If they want to teach, then become a mentor to someone at work. If they want to make people happy, then make their co-workers happy. Then when the right opportunity comes, they will be inspired to do it. When an idea is truly inspired, things will fall in place with a little bit of effort that makes it an easy decision to go out on their own. Yet, if their only goal is to become rich, they may have a harder time succeeding (but not impossible) because their eyes are not open to salesmen with the magic snake oil elixir.

In reading a few blogs this week (some at Consumer Commentary, Free Money Finance and others), there has been a lot of discussion about the power of compound interest and about paying off college loans and mortgages early due to paying too much interest to the bank. It got me to think that a lot of articles are written covering one of three parts (i) interest paid to banks, (ii) compounded returns on investments and (iii) inflation; yet, only occasionally are all discussed together to see the interactions of each. Unless the numbers that are presented together; the results are incorrectly skewed in my mind. It can be a marketing magic trick that shows us only ½ the picture to influence us to use their services with inflated numbers. Other times it is done in pieces because it is difficult to show everything together (as you will see based on my attempt).

Let’s start easy. If you have $20,000 and invest it at different investment returns, it would grow over 20 years to approximately:

• At 3.5% - $40,000

• At 5.0% - $53,000

• At 8.0% - $93,000

• At 10.0% - $135,000

One would look at $135,000 and say “Wow, this is why I should be invested in the stock market.” Yet, before this goes too far, the first magic trick is showing numbers that have not been adjusted for inflation. For example, if you could buy something that is $20,000 today, it will cost $40,000 in 20 years assuming 3.5% inflation. In reality, the $40,000 return using 3.5% investment return is only worth $20,000 in today’s buying power. In addition, the $135,000 is only worth $68,000 in today’s dollars, still a significant increase but not as much of a “wow” as before.

In today’s buying power, the $20,000 investment would grow over 20 years to

• At 3.5% - $20,000

• At 5.0% - $27,000

• At 8.0% - $47,000

• At 10.0% - $68,000

That is some illusion of showing the power of compound interest and leaving out the point that a loaf of bread is going to cost $4 in 20 years instead of $2 today.

Now, let’s look the decision whether or not to prepay a mortgage (or other loan). First, the idea of prepaying a loan should be broken down into 2 parts:

• A decision to save the extra payment

• A decision where to invest (paying off mortgage or invest in CDs, bonds or stock)

If I have a $100,000 mortgage at 5% interest rate, I would have payments of $535. If I prepay the mortgage by paying $579.58 a month (44.58 more a month or $535 a year), I would payoff the loan in 25 years and 3 months. Yes, prepaying the mortgage would save $17,000 of interest. Yet, the $17,000 is only showing ½ the picture (which I will explain below) and the $17,000 in lost interest is equivalent to $9,000 in today’s dollars.

The other ½ of the picture is if you considered saving the extra payment and invested it in stocks, you may actually lose more money by deciding to pay off the mortgage instead of investing. If you had invested $44.58 a month (instead of paying off the mortgage), you would have after 25 years and 3 months the following (shown at various assumed post-tax returns and not adjusted yet for inflation):

3.5% - $22,000

5.0% - $27,000

8.5% - $47,000

10.0% - $61,000

If you saved at 5% rate, you would have earned enough to pay off the remaining mortgage of $27,000 at the same time that the prepayment plan would have paid it off. Thus, in my mind, prepaying a mortgage is like investing in bonds at your mortgage interest rate (ignoring taxes for now). So, the decision is in two parts:

• Whether to save an extra $44.58 a month – which would result in $22,000 using at 3.5% investment return rate (which is $9,000 in today’s dollars)

• Where to invest the money: either in money market at 3.5%, bonds at 5.0%, stocks at an estimated 8.5% to 10% return or by prepaying the mortgage

o Prepaying the mortgage will save an additional $5,000 which is the difference in 5% return and 3.5% return. In today’s dollars this is only worth $2,000 which is not very much compared to the $17,000 in interest saved

If you are a young investor (risk taker) and would invest a majority of your money in stocks (at an assumed 8.5% return), you could lose out on possibly $20,000 by prepaying the mortgage instead of investing ($20,000 = $47,000 assumed investment return - $27,000 remaining mortgage) and your mortgage would still have been paid off at the same time the prepayment plan would have been. So, by prepaying you may not being saving $17,000 of interest but losing potentially $20,000 or more depending on your actual investment return. Note, the $20,000 of potential return is equivalent to $8,000 is today’s buying power to compare apples and apples (because I do not want to appear like I am magically inflating numbers).

Now, there are a lot of reasons to prepay or not to prepay a mortgage. You can read more at:

Should I Have a Mortgage

Sometimes when people just look at interest that they are paying, they decide to prepay the mortgage after only seeing ½ of the total picture that does not even show results adjusted for inflation. So objects may appear larger than what they should and the illusion of seeing 1/2 the picture is an example of focusing our attention to one side of the room (savings) while the elephant (other investment options) is hiding on the other side. Thus before prepaying your mortgage sit down with a financial advisor to see the whole picture and get the numbers converted into today’s dollars so you are comparing apples and apples.

Some would say that prepaying a mortgage is a guaranteed return, which it is. For an older investor who wants to invest more conservatively due to his approaching retirement (e.g., invest more in bonds and less in stock), prepaying a mortgage may be a good option to look into with his financial advisor. Yet, for a young investor who is taking calculated risks due to a longer term investment horizon, it seems a little contradictory in my mind to say he would invest a majority of your money in stocks (which have a higher upside but no guaranteed return), yet prepay his mortgage for the guaranteed return. Of course, his overall risk analysis needs to be reviewed with his financial advisor because prepaying the mortgage is just one part of his investment plan. Yet, I am always a little cautions when someone tells me in one breath that a guaranteed return is always better (e.g., prepaying a mortgage) and then says that if I am younger investor with a long-term investment horizon that a large share of my investment should be in the stock market due to its potential higher returns.

For me, I am prepaying just little on my mortgage now for three reasons:

• I am getting a little older and have a large stock investment already, so I am looking to lower my overall investment risk (e.g., with bonds and prepaying my mortgage).

• I wanted my mortgage to be paid off by the time my son goes to college, so our income currently allocated to our mortgage can then be allocated to pay part of his college expense (with him paying the rest)

• My prepayment now less than the typical prepayment plan yet is going to increase over time so our home payments (including maintance and taxes) is consistently around 25% to 30% of our income

Note, the interest paid is not one of the reasons why I am prepaying my mortgage. My real decision is based on how much I want (need) to save and where to save it (e.g., equities, bonds, CDs or prepaying the mortgage).

Now, for the last point, I will attempt to discuss the effect of inflation on the interest charged on a loan. The premise is that for a low interest rate loan, a lot of the interest paid is due to inflation. For myself, I do not see this interest paid as lost money if it is due to inflation. It is just time value of money and does not constitute a loss of buying power. This may sound confusing because no one talks about it.

Let’s look at a scenario where a person has an outstanding loan of $10,000 due in 10 more years at 3.5% interest rate (3.5% being the assumed inflation rate):

• If he gets a windfall and invests it in CDs or mutual funds (safe investment) that provide a post-tax return equal to 3.5% (inflation) there is no loss of money if he pays if off now or later

Loan outstanding now – $10,000

Pay loan back – $14,000 in 10 years

Invest – $10,000

Investment grew to $14,000 after 10 years

Thus, his investment grew enough to pay back the loan and the decision to prepay the loan did not cost him anything. Now, many (if not all) will say that he is losing $4,000 in interest by not prepaying the loan back immediately. Yet, by saving the money in a secured investment, most if not all the costs of the low interest rate loan is eliminated. Plus, he has the money for an emergency if needed.  So the money lost by not prepaying the loan is $0 even though he is paying $4,000 of interest . Sounds confusing I know. After years of hearing interest is always bad, it is hard to see the distinction between interest due to inflation and interest costs due to risk and investment horizon.

Well, what happens if he spent the windfall instead of investing the money? From a buying power perspective, the buying power is still not affected.

If the person’s salary is $50,000, the $10,000 loan is 20% of his salary.

If he waits 10 years to pay it off, his salary would normally increase to $70,000 (assuming 3.5% salary growth) and thus he would need to repay the loan $14,000 which is 20% of his salary ($14,000 / $70,000).

Thus, he did not lose any buying power at all due to his decision not to pay the loan of earlier. He could also pay the loan back 2% of his salary for 10 years as well. Thus, the money paid back on the loan is just from time value of money (inflation).

As you can see below, inflation affects everything over time (interest rates, investment returns and salary increases), thus to find the real costs (on an inflation adjusted basis) the inflation component should be removed from each to compare apples to apples:

Loan interest rate = Inflation + Risk + Investment Horizon (higher rate for longer loans)

Investment return = Inflation + Risk + Investment Horizon

Salary increase (in theory) = Inflation + Merit/Promotion + Productivity

Note, there should be a drive to pay back credit card loans, payday loans and other high interest rate loans as quickly as possible because they will rob you of overall buying power because they are charging an interest rate that dwarfs the long-term assumed inflation rate. Yet, low fixed interest rate loans do not rob you of as much buying power as interest charges suggest because most of the interest changed is for inflation which has minimum if an effect on your buying power. This is because your salary and investments are also increasing at a similar pace (over the long term).

One last example, let’s look at a student loan of $20,000 with 3.5% interest with his salary at $50,000. The person can pay the loan back now using 40% of his salary or pay it back over 10 years at 4% of his salary. From a buying power perspective, he is not losing anything (even though the interest paid is approximately $4,000). Yet, by amortizing the loan over 10 years, he makes it easier to payback the loan without killing himself in the first year.

To try to tie this all back together. If you have a loan that is repaid by at $115 per month for 20 years ($27,600 in total payments), the interest paid is at various loan interest rates is

• At 3.5% - $7,600

• At 5.0% - $10,100

• At 8.0% - $13,800

• At 10.0% - $15,600

From a buying power perspective, the loan at 3.5% has no effect on your buying power because it is the assumed long-term rate of inflation. Thus, lot of the interest paid on most standard loans low interest rate loans is due to time value of money (effect of inflation being $7,600). So if you have a mortgage at 5% or 6%, the marketing material for a biweekly mortgage plan can lead you to think that you are paying a lot of interest to scare you into their plan (for one-time fee of $300 with a small fee for each payment there after). Yet, the actual cost from a buying power perspective is less once inflation is accounted for.

So, my point is paying some interest is not that bad from a buying power perspective. Yet, this does not mean to load up with credit card and PayDay loans (at higher interest rates) or to have too much debt (as many are getting into trouble due to having to high of a debt burden).

In addition, when you look at numbers, see if the number can be converted to today’s buying power so you are comparing apples and apples. This way, you are not thinking that a $1 million today is equivalent to $1 million in 40 years when the average car will cost $100,000 (when the real value of $1 million is only $250,000).

And as always you should consult with a financial advisor to analysis your specific debt and risk situation.

There is always a debate whether an index fund is better than an active management mutual fund (or even a stock broker). For me, I am biased towards the low cost index funds and ETFs (exchange traded funds). Initially, I went with my parent’s stock broker. Yet, after a few years of disappointing returns, I finally took over the management of my stock portfolio myself and started to convert it slowly into index funds. Here is some of the math that I did to make my decision.

First, an index fund normally has a low expense fee ranging from 0.1% to 0.75% (lower for an S&P500 index fund and higher for an international index fund). While an active management fund can have a 1% to 2% or higher expense fee for their services. For my situation, the stock broker was going to charge me a 2% fee (a reduction from his normal 2.5% fee because he wanted my business). Thus, let’s assume on a $100,000 investment, a 0.5% expense fee on an index fund equates to a $500 cost per year versus $2,000 for a 2% fee for an active management fund/stock broker.

Thus, the manager in this scenario needs to earn 1.5% more than the market on a risk adjusted basis to break-even

Second, an active management fund usually has a higher turnover rate than an index fund. In order to get the higher return to justify his expenses, he (or she) needs to move in and out of the hot stocks of the week (or month). The issue with higher turnover is that for the return is taxed as ordinary income instead of capital gains if the stock is held for less than 1 year. Thus, even though their returns may be higher, so are taxes that you need to pay. For example, let’s assume a 3-year holding period with an 8% investment return and 28% tax rate & 15% capital gains rate:

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