October 2009

Roth Conversions and Socially Responsible Investing: Weekend Reading

Happy Friday, everybody. :)

This week I want to highlight a 3-part series from Allan Roth (author of How a Second Grader Beats Wall Street). Allan recently received an email from an insurance salesperson promising that he could give an 8% return with no downside risk. How did Allan respond?

“I gave Mr. Anderson a call this week and told him I was ready to plunk down $100,000 to buy my first annuity.  All he had to do was to convince me.”

How the story plays out is pretty entertaining, and it contains some worthwhile lessons. I’d suggest checking it out: “Insurance Investing and the Hundred Thousand Dollar Challenge” (Part 1, Part 2, Part 3).

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October 30, 2009 7 comments

Foreign Tax Credit

A solid understanding of the foreign tax credit can help minimize your investment-related taxes. What’s the foreign tax credit? The IRS explains it this way:

“You can claim a credit for foreign taxes that are imposed on you by a foreign country or US possession. Generally, only income, war profits and excess profits taxes qualify for the credit.”

In short, the idea of the credit is to eliminate double taxation on foreign income.

Example: You earn $500 in foreign dividend income over the course of the year and you pay $100 in foreign taxes on that income. You can claim a $100 credit for foreign taxes paid, thereby reducing your U.S. income tax obligation by $100.

Important note: Unless you meet three requirements, there is a limit to the credit you can take (please see IRS Publication 514 for details on the limit). The three requirements are as follows:

  • Your only foreign income is passive income (passive income being things like dividends, interest, and rents),
  • Your qualified foreign taxes for the tax year are not more than $300 ($600 if married filing jointly), and
  • All of your gross foreign income and the foreign taxes are reported to you on a payee statement such as a Form 1099-DIV or 1099-INT.

And now the fun part: How can you put this knowledge to use?

Look for qualifying mutual funds.

From IRS Publication 514:

“If you are a shareholder of a mutual fund or other regulated investment company (RIC), you may be able to claim the credit based on your share of foreign income taxes paid by the fund if it chooses to pass the credit on to its shareholders.”

The tricky part here is that “funds of funds” don’t qualify. Why? Because they don’t actually pay the foreign taxes themselves. (It’s the underlying funds that pay them.) So if you’re looking for an international stock fund to hold in a taxable account, you might as well find one that qualifies for the credit.

Example: Until 2008, Vanguard’s Total International Stock Index Fund was a fund of funds. As a result, many investors opted to use Vanguard’s FTSE All-World Ex-US Index Fund instead when investing in a taxable account, despite the fact that it has a slightly higher expense ratio and a very similar asset allocation. (As of today though, both funds are eligible for the credit.)

Use it to help determine your asset location.

Funds held in a retirement account–like an IRA or 401(k)–do not qualify for the credit even if they’re funds that would qualify were they held in a taxable account.

Does this mean that you should only buy international stock funds in taxable accounts rather than retirement accounts? No. Not at all. The benefit from tax-deferred or tax-free growth far outweighs this little credit.

If, however, you’re simply deciding which fund to hold in your retirement account (domestic stock fund vs. international stock fund) and which fund to hold in your taxable account, then it’s probably best to tax-shelter your domestic stock funds before tax-sheltering your international stock funds.

Claiming the Credit

Generally, you have to file Form 1116 to claim the foreign tax credit. If, however, you meet a few requirements (the same as the requirements listed above to avoid the limitation on the credit), you can simply enter your foreign taxes directly on Form 1040, line 47.

Fun how a little tax knowledge can save you significant money, isn’t it? :)

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October 29, 2009 0 comments

Are We Qualified to Invest on Our Own?

A recent Get Rich Slowly post asked whether one should stop investing for retirement in order to pay off debt. It’s an important question, and one that I’ve attempted to tackle before. But what I really want to talk about are the comments that were left on the GRS post.

They’re frightening. And I’m not saying this just to be snarky (though, admittedly, I do partake in a little snark from time to time).

Some people were attempting to mathematically justify paying down debt rather than taking advantage of a fully vested, 100% employer match. Now, if you gain a valuable psychological benefit from paying down debt, that’s fine. Go for it. But how somebody could argue that a 20% return is mathematically superior to a 100% return escapes me.

Other commenters argued that, if an investor is young, it’s better mathematically to invest for retirement, rather than to pay down debt–even if there’s no employer match to be gained, and even if the interest rate on the debt is higher than the rate of return from investing for retirement.

“The Horsepower to Do the Math”

This all reminded me of an article William Bernstein wrote a few months back, where he argues that most people just aren’t qualified to invest on their own. Bernstein estimates that less than 10% of the population has “the horsepower to do the math.” He elaborates,

“Fractions are a stretch for 90% of the population. The Discounted Dividend Model, or at least the Gordon Equation? Geometric versus arithmetic return? Standard deviation? Correlation, for God’s sake? Fuggedaboudit!”

I’m inclined to think that his estimate is overly pessimistic. (Is it really that hard to explain correlation?) And I’ve always thought investing mistakes aren’t caused by a lack of math skills so much as by a decision process that’s not based on math at all. (“I’ll just hold this stock until it gets back to where I bought it,” for example.)

But I may be wrong. Thoughts?

October 28, 2009 8 comments

Vanguard Investors Outperform Fidelity Investors

Russell Kinnel, director of mutual fund research at Morningstar, recently compared investor returns at Vanguard to investor returns at Fidelity. His study is interesting because it looks at investor returns (aka “dollar-weighted returns“) rather than investment returns (aka “time-weighted returns”).

A brief example of dollar-weighted returns

If Mutual Fund ABC earned a 25% return in Year 1, then lost 20% in Year 2, its effective annual return over the two years would have been 0% (because it would be back exactly where it started).

If, however, the fund had doubled in size at the end of Year 1–due to investors chasing performance and buying the fund after a great year–its dollar-weighted return would be significantly below 0%, because the performance in Year 2 would be weighted twice as heavily in the calculation. In short, dollar-weighted returns measure how the investors performed rather than how the investments performed.

What did Morningstar’s research show?

The study showed that Vanguard investors earned greater returns than Fidelity investors over the last 10 years. But that doesn’t really mean a great deal to me. It could simply be the result of Vanguard’s larger funds being in more successful asset classes than Fidelity’s.

What does interest me, however, are the two following facts:

  • As usual, mutual fund investors underperformed their own investments across the board.
  • Vanguard’s investors underperformed their investments by a smaller margin than Fidelity’s investors.

Why do we underperform?

We underperform because we try to time the market, and we (usually) fail. We chase performance–both in terms of hot asset classes and in terms of hot funds–and it destroys our returns.

Why do Vanguard investors perform better?

My hypothesis is that it has to do with the core philosophies of the two companies. As a company whose success has been based on index funds, Vanguard’s core tenets are minimizing costs, diversifying, and buying and holding.

In contrast, Fidelity, at its core, is about active investment. Many of their own fund managers turn over their portfolios more than once per year. It wouldn’t be terribly surprising to learn that their investors do something similar.

Kinnel has a similar opinion:

“It’s possible that the performance gap also has something to do with each firm’s message to investors. Vanguard preaches long-term investing and goes so far as to warn investors away from hot-performing funds…Fidelity also preaches long-term investing, but it sometimes nudges people to invest based on short-term results.”

What can we learn here?

Surely, some people will look at this study and see it as evidence of an opportunity to outperform the market. They’ll draw the conclusion that we must learn to “be fearful when others are greedy and greedy when others are fearful,” as Warren Buffett would say.

To me, the lesson is slightly different. I see it as another piece of evidence that our predictive abilities are decidedly lacking. After all, nearly every single one of those people who underperformed sincerely believed that he was going to outperform.

“I am above average!” is the battle cry of underperformance.

October 27, 2009 2 comments

The Oblivious Investor is 1 Year Old

Today (10/26/09) is The Oblivious Investor’s first birthday. :)

A few statistics of interest:

  • 285 posts,
  • ~ 600 subscribers,
  • 1,359 comments,
  • Currently getting ~ 230 first-time visitors each day via search engines, and
  • 2 new books launched.

On growth and goals:

I’m happy with that level of growth. I can’t say whether or not it exceeded my expectations, because I didn’t have any. This being my first blog, I had no clue what to expect. Similarly, I don’t know what to expect by the end of year two. 1,000 subscribers? 2,000? 3,000? No idea really.

I’m comfortable with the fact that this blog will never be comparable to Get Rich Slowly or The Simple Dollar in terms of readership. It focuses on too narrow a niche for that to happen. That is, it only appeals to people with a serious interest in investing. And within that group, it only appeals to people who don’t mind the fact that I openly criticize activities such as stock picking, market timing, etc.

Giving thanks where due:

The blog has been an absolute blast to write so far. And with a growing group of people reading and participating in the discussion, it’s becoming more fun as time passes. So thanks to all of you for reading, and thanks to everyone who has participated in the discussion whether via comments, email, or replies on your own blogs.

Also, to everyone who has helped to share this blog (and its ideas) with others, whether by linking to it, tweeting about it, stumbling posts, voting for posts on Tipd, or good old-fashioned word of mouth: Thanks!

Similarly, I’m quite grateful to everybody who has helped with the two books, whether linking to them, reviewing them on Amazon, or, of course, buying them. :D

Where we go from here:

For my part, I’ll be continuing to write on a regular schedule, most likely on a range of similar topics. But a large part of where the blog goes from here is up to you. For example:

  • How quickly it spreads/grows is primarily a function of how many of you are compelled to share it with others.
  • In terms of topics, if you have something you’d like me to cover or questions you’d like me to address, please let me know.

Thanks again, everyone. I’m looking forward to year #2. :D

October 26, 2009 17 comments

The Problems with 401k Plans: Weekend Reading

A couple weeks ago, Time published an article entitled “Why It’s Time to Retire the 401(k).” When asked about it by my wife, I described it as “malarkey.” Five Cent Nickel and Bad Money Advice do a more thorough job of outlining the problems with the article’s argument:

My other favorites from this week:

Investing Articles

Other Personal Finance Articles

Blog Carnivals

Thanks to each of you for reading. Enjoy your weekends! :)

October 23, 2009 2 comments

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