How are we going to pay for college? That’s the question families are increasingly asking themselves as they see education costs soar while their savings dwindle.

Just when college savings and other investments were starting to recoup some of the heavy losses of the past few years, markets took another tumble earlier this month. State budgets are still constrained, forcing many public schools to further raise tuition, reduce aid or cut grants altogether. Private universities are raising tuition as well, and in some cases, offering less aid. And deficit-reduction efforts could lead to cuts to federal programs such as the Pell grant.

All this makes it all the more urgent to get started on a plan. Here’s a three-year countdown on what you should be doing and when you should be doing it.

Three Years Out

Savings: While you’ve hopefully been setting money aside since your teen was a baby, this is the time to get your college savings on the fast track. “The greatest asset is time,” says Mark Kantrowitz, founder of financial-aid sites FinAid.org and Fastweb.com.

You can’t afford a lot of investment risk this close to the college years, but unfortunately interest rates on savings accounts and certificates of deposit are pretty paltry these days. And they’re likely to stay that way with the Federal Reserve indicating earlier this month that it will keep interest rates low through mid-2013.

So your best bet for boosting college savings is still a tax-advantaged plan, such as a 529 college-savings plan and Coverdell Education Savings Account. These accounts let you withdraw money tax-free to pay for qualified education expenses.

Many 529 plans took a hit during the recession and the recent market dives. So many states have added safer investments, such as CDs, to their plans. Investments and fees vary by plan. And annual contributions to a 529 plan exceeding $13,000 may be subject to a gift tax. You can compare all 529 plans at Savingforcollege.com.

If you have an underperforming or high-cost plan, you can roll over your money to another state’s plan once a year, but fees may apply. Some states offer tax breaks as well.

A Coverdell is like an individual retirement account, with your child serving as beneficiary. There are income limits for contributing to a Coverdell and you can put in a maximun $2,000 per child per year.

Financial Aid: It’s never too early to start thinking about how much financial assistance you can get — and from where.

Online tools, such as SimpleTuition.com’s TuitionCoach, can help you figure out where to put your money to qualify for the most aid, depending on the individual college and the methodology it uses for financial aid.

Janet Krochman, a certified public accountant in Costa Mesa, Calif., says you should start juggling money now so it won’t weigh as heavily in the calculation when you apply for aid. But speak to an accountant or financial adviser before making any moves. For instance, discuss whether to keep a child’s money in his or her name or transfer it to your name.

Start searching and applying for scholarships and grants. Fastweb.com has a free tool that matches your child with scholarships. You also should reach out to your child’s guidance counselor, your employer, and religious and service organizations about scholarship and grant options.

Two Years Out

Savings: Continue funding your 529 and other savings accounts, upping the amount if possible. This also is the time to start taking a serious look at potential schools — and estimating the cost of each.

Starting in October, schools that award federal financial aid are required to publish a net price calculator (most on their websites), which lets you enter basic financial information to get an estimate of the school’s bottom-line cost of attendance and how much need-based aid a student could get.

Financial Aid: If you’re planning to sell assets to help pay for college, and will have capital gains, some financial advisers say now is the time to do so. You don’t want to show a big capital gain on tax returns you’re going to submit to the school, Ms. Krochman says.

When planning campus visits, make an appointment with the financial-aid office to learn how the school determines financial need. Schools use the same formula for federal aid but some consider supplemental income and assets.

Loans: You still don’t know how much you’ll need to borrow, but you should start looking at your loan options — including federal loans for students or parents and private bank loans, which can have fixed or variable rates.

One Year Out

Savings: By this point, you should have the bulk of your money in less-risky investments, such as money-market funds, CDs and Treasurys, since you won’t have much time to recoup any losses. Mr. Kantrowitz says no more than 20% of college savings should be in at-risk investments when your child is this close to college.

Financial Aid: Your child will be applying to schools and filling out the Free Application for Federal Student Aid, or Fafsa. Be sure to submit all necessary paperwork. Delays could hurt your chances of getting money since some schools dole out aid on a first-come-first-served basis. If you haven’t already done so, apply for grants and scholarships.

Loans: Once you’ve figured out how much you’ll need to borrow, first look into federal loans, which typically have the lowest interest rates. There are the Perkins and subsidized Stafford loans for students and the federal PLUS loan for parents. Private bank loans should be your last option since they tend to have higher rates.

When it comes to borrowing, “a good rule of thumb,” Mr. Kantrowitz says, is that the “total debt at graduation should not exceed your child’s expected starting salary” upon graduation.

Write to Emily Glazer at emily.glazer@wsj.com

Article source: Wall Street Journal

 

Recent gyrations in the financial markets resulting from the recent downgrade of US government credit by Standard and Poors has been a roller coaster ride for investors.  Persistent decreases followed by a sharp increase, then a decrease, and another increase has investors wondering what to expect next.  The financial markets have become a roller coaster of volatility.  And this roller coaster is not only constrained to stocks.  The debt downgrade created a paradoxical result of stoking new fears for widespread default in the euro-zone, and actually channeled more capital toward US treasuries, which pushed down yields.

In addition to this, the housing market is still extremely soft, with very few buyers able to qualify for financing, and very few sellers able to price their property at the market rate, due to being under water on their loans.  In addition to this, there is still a persistent hangover of foreclosure inventory that is dragging on the resale of properties.  This has created a strange dichotomy in many markets where new construction or default/foreclosure properties are the only inventory that sells.  This creates another roller coaster for people attempting to move resale property since the intensity of competition results in lowball offers and excessive demands from buyers that would have been completely unheard of in the past.

What this all comes down to is the fundamental truth that the future is intrinsically uncertain.  During the stock market bubble of the late 1990′s and the real estate bubble of the early 21st century, people came to expect continued rapid escalation of their investment assets.  The resultant collapse of these bubbles left many people in dire financial condition.  This problem was amplified even more so with the most recent bubble, due to the high number of people who had purchase property with high rates of leverage.  This meant that when the values compressed, the owner suddenly found themselves ‘upside down’ with more in debt than the market value of their property.

Now that we are in the middle of sorting out the mess from the real estate bubble, people are wondering what to do.  This problem is further complicated by the fact that our current economic difficulties are being addressed with many of the same policies that created the last bubble.  This has led many to speculate that a new bubble of some sort is in the process of forming.  With all of these swirling factors to consider, many investors are befuddled and confused.  Most people just want to earn a reasonable rate of return so that they can retire in relative comfort.  However, this task is proving to be much more difficult than financial planners make it out to be.

Opportunistic Investing

In a market environment that is highly volatile, the best results typically come from being opportunistic.  This means acquiring investment assets when confidence is low and buyers are distressed.  For stock market investors, this means finding companies that are fundamentally strong, and pay good dividends, then targeting them for purchase when market values dip.  In this way, investors purchase a stream of future dividend cash flows for a rock bottom price.  This strategy can also be employed for growth based companies as well, but it relies exclusively on future value appreciation, which is more volatile, but can also deliver greater total returns.

For property investors, market dips are the best time to acquire income producing real estate assets.  This is especially true since the high rates of default and foreclosure are driving many people who used to be homeowners into the renter pool.  Over time, this will become a boon for income property investors, as the overall increase in the renter population strengthens rents.  It means that investors must deal with the inevitable difficulties that accompany tenants and rental properties.  However, many investors are finding that the risk of tenants is preferable to the roller coaster volatility of financial markets.

Dynamic Course Adjustments

Another key characteristic of success in the current market environment is the ability to change course as the financial landscape evolves.  The strategies that worked best in the past may not be optimal in the future.  The investments that work the best now may not work the best in 20 years.  Astute investors must do more than “follow a system” … they must “create a strategy.”  The strategy should be what informs your decisions.  The strategy should be bigger than a single investment category, and it should encompass more than simply making money.

The purpose of a strategy starts with what you are attempting to achieve with all of your income producing activities.  It could be retirement, it could be a lifestyle, it could be paying for your children to attend college.  Whatever the goal is, it is very important to understand that part of your strategy first.  The second most important characteristic is your risk tolerance.  By and large, the more volatility and hassles you are willing to deal with, the higher rates of return you will be able to achieve.  However, these rates of return will not come in a smooth, even stream.  In order to achieve the “Big Kid” rates of return, you will need to move beyond packaged investments like mutual funds.

Once your end-state goal and risk tolerance has been defined, then it is time to decide what category of investment and specific opportunities are right for you.  The answer to this will most certainly be different for everybody.  Thus, it is less important to find the “best” opportunity, and far more critical to find the “right ” opportunity.  The way that you will be the most successful in business and in life is to pursue the opportunities that are right for your personality, temperance, and life situation.

 

The financial planning profession has a long history of demonstrating the power of compounded growth to clients who are looking to invest for the future.  Typically, a chart will be shown that shows the difference between investing $100 per month at 1%, 5%, 8%, and 10% rates of return for 20, 30, and 40 years.  As expected, the results are typically astounding.  The extended impact of compounding for a longer period of time at a higher rate of return creates a tremendous difference in the amount of compounded returns after a long period of time.  Thus, the fundamental assumption behind all contemporary financial planning models is to invest money into financial products that have historically produced a high rate of return so that you will be able to enjoy a happy and comfortable retirement from your compounded returns.

Unfortunately, there is one question that never seems to enter into the conversation.  This question is whether the historic rates of compounded growth for the stock market will continue into the future?  If the returns produced by the stock market in the past do not extend out into the future, there will be many hundreds of millions of people who have their entire financial lives decimated.  And the shock will be even more severe, as many people have not even considered that it could happen.  For many years, it has been assumed that the stock market can continue to grow faster than Gross Domestic Product (GDP) indefinitely.  However, that assumption may be faulty.

Currently, the ratio of total US Stock Market Capitalization compared against GDP stands at approximately 95%.  This means that the total value of all US stocks adds up to 95% of total US economic output for one year.  This ratio is consistent with the 10-year average from 2000 through 2010, but is higher than the 20-year or 30-year average for the stock market to GDP ratio.  This disconnect raises an interesting question.  How much longer can the stock market continue to grow faster than the economy?

It is important to consider that the overall stock market can only grow if new capital is invested.  Individual stocks will go up or down in value as people switch from holding one company to holding another, but there is only one thing that can propel the entire market upward, and that factor is additional investment.  However, that additional investment must come from economic activity.  What happens if the level of investment required to continue driving the stock market upward at historic rates is larger than the amount of economic growth?  The answer should not come as a surprise … if the money to invest isn’t being generated by the economy, it won’t be invested, and the stock market won’t grow at it’s historic rate of appreciation.

To illustrate this point, both total stock market capitalization and GDP have been projected out at historic growth rates over the next 15 years, starting with actual data from 2010.  Over the last 30 years, the total stock market capitalization has grown at approximately 9% per year, while GDP has grown at approximately 5% per year.  When these assumptions are extended out to 2025, the infinite compounding fallacy becomes quite clear.  in order to maintain the historical rates of appreciation that are used in almost every financial planning model, the stock market will need to be $17.4 Trillion dollars larger than US Gross Domestic Product by the year 2025.

When one considers that this gap represents approximately 57% of Gross Domestic Product, it becomes increasingly evident that the total stock market capitalization simply cannot continue to grow at its past rates because there is not enough additional output being generated to fund the incremental investments that would be necessary to continue driving market values upward.  Thus, the answer to the question of what will happen to stock market capitalization is very apparent.  Unless the economy grows dramatically faster than it has in the past, there will be insufficient capital to propel the stock market values upward at previously experienced rates of appreciation.

Upon further analysis, the problem grows even more complicated.  Since the ratio of total stock market capitalization to GDP is currently equal to the 10-year average from 2000 through 2010, and is higher than both the 20 and 30 year averages.  This means that if the ratio between stock market capitalization and GDP regresses back to historical levels, the growth in stock market valuation will not only be constrained by GDP, but may actually grow slower than overall economic output.

Over time, it is not possible for the stock market to grow nearly twice as fast as the economy.  Eventually the capital required to drive further value growth equal to past rates of appreciation will not be available.  In this way, the fallacy of infinite compounding becomes strikingly apparent.  Financial planning models have been built on the assumption that one can passively generate a rate of return significantly higher than the growth rate of the overall economy.  Over time, this assumption will prove to be faulty, and spell ruin for the traditional models of investment planning.

So what can a person do?  It’s one thing to point out the problems with compounded appreciation assumptions built into financial planning models, but it’s another thing entirely to plot out a new course that overcomes these challenges.  The truth is that this course will be different for every person.  However, there are a few guiding principals that will make finding this course much easier.  These considerations are that cash is king, and leverage amplifies results.

Cash is King

This is the oldest and most hallowed of financial axioms.  Cash stands and the fundamental basis of investment value.  The ‘real’ value of an investment is the cumulative discounted value of all future cash flows it produces.  This can come in the form of dividends from a stock or rent revenue from an income property.  When evaluating an investment based on the cash it produces, the value is easy to see.  However, if the value of an investment depends solely on selling it to somebody else for a higher price in the future, it can result in tremendous volatility and risk … especially if the investment does not produce any cash flow.  Thus, the paradigm of the future for investors should be to seek cash flows.

Leverage Amplifies Results

Another fundamental consideration for astute investors is the power of leverage.  This can take the form of both financial leverage and organizational leverage.  In either case, the leverage will allow you to amplify the results produced by your efforts.  In the case of financial investments, borrowing at a low rate of interest and investing at a higher rate of return will allow you to amplify your returns much higher than could be earned with cash alone.  Similarly, leverage will amplify any losses that are incurred from your investments.  This is equally true with organizational leverage for business owners.  Amplifying your time through the efforts of others will allow you to generate better results if you are highly effective, or will create chaos if you are disorganized.

In the end, future investors will need to rely on their ability to create value.  The days of infinite compounding from perpetually escalating market values are reaching an end.  The people who survive and thrive in this environment will be the ones who focus on fundamentals and create value.  It is important to understand that every difficulty carries an opportunity, and that each person is responsible for capturing that opportunity to create the best future that they can.

 

People who are familiar with the popular board games of checkers and chess understand that there are vast differences between the two, even though they are played on the same board.  Checkers involves a simple, linear game where the objective is to capture all of the opposing players through simple jumps and reach the other side of the board so that a player can be “Kinged” and move both forward and backward on the playing board.  When the game shifts to chess, dynamics change drastically.  The game of chess involves different movements for different pieces.  There are also a handful of specialty moves.  Furthermore, victory is not one of simply eliminating all of the opposing pieces.  Winning a game of chess hinges exclusively on capturing the opponent’s “King” and does not require that you capture more pieces than the other player.

The complexity of strategy increases by many orders of magnitude when moving from checkers to chess.  Even though the playing board is the same, the games are completely and totally different.  Checkers is simple, linear, and easy to understand … similar to the financial advice that most people receive.  Frequently this advice is somewhere along the lines of go to college so that you can get a job, save 10% of your income in a stock account, and you will have a comfortable retirement with your stock account, pension, and social security.

On the other hand, we have the game of chess where strategies vary wildly based on individual game situations and super computers are placed into competition against master players to test the quality of their strategic thinking.  This more closely resembles the current financial world.  Real estate values have taken a beating, stocks have only experienced a partial recovery relative to pre-recession levels, the Government is running unheard of deficits, the Federal Reserve is printing new money out of thin air, pensions across the country are in danger of collapse and Social Security expenses are already exceeding FICA tax revenues.  This situation is clearly not financial checkers, it’s chess.

In order to prosper with the financial world becoming more complex and less predictable, it requires more sophisticated strategies.  The promises of social security and pensions were made by past generations of politicians without the slightest thought or care how they were going to be financed in the long run.  The long run has arrived, and the party is about to end.  It is likely that the government will result to monetary expansion (known to regular people as “inflation”) to satisfy their nominal obligations.  This will carry the unfortunate result of de-valuing the social security and pension payments they are making, de-valuing the savings of people who acted responsibly, de-valuing the equity of people who paid off their homes, and de-valuing the income paid to people who purchased bonds because of their “safety” relative to other investments.  In this situation, all of the people who have been trained to play financial checkers will be slaughtered by the financial buzz saw of runaway government and inflation.

What will happen to the equity in that home that everybody told you to pay off?  What will happen to the value of your investment portfolio that everybody told you to judiciously save, and then invest in bonds to protect against market cycles?  What will happen to the value of your employers pension payments?  What will happen to the value of your Social Security payments, if you even receive them?  The answer to each of these questions is that your hard work and sacrifice will be rewarded by inflation that decimates the purchasing power of all your assets.

So how do we play financial chess?  How do we beat this game where responsible savers are punished so that politicians can spend money to purchase votes?  The answer is to own assets that increase in value with inflation and owe liabilities that are destroyed by inflation.

Assets that Increase in Value with Inflation

The first thing that most people think of when talking about inflation-favored assets is gold.  However, gold represents a fundamental enigma, since its value is purely speculative.  The only thing that gives it value is a willingness by somebody else to pay you for it.  It is not used for many industrious purposes outside of jewelry.  Some people have certainly profited from increases in gold prices, but the fundamentals do not justify making gold the basis of your financial future.

Another thing that many people think of is stocks.  It is certainly true that the stock market is a much greater hedge against inflation than bonds, but there is a deeper understanding that many stock market investors miss.  Aggregate stock market values move up and down based on the total amount of capital in the market.  Presumably, more money in circulation will result in more stock market investment.  However, there is a danger that higher prices will mean less capital available to inflate market values.  The flip-side of this danger is that many of the companies who will have their prices most impacted by inflation are the same ones who pay dividends.  Thus, it is most likely that a higher percentage of stock market returns in an inflationary environment will come from dividends instead of capital gains.

Another very important asset that increases with inflation is rents.  Not necessarily home prices, but rents.  The important difference is that home prices are based on credit availability.  During inflationary times, it is likely that high interest rates will decrease housing affordability.  However, that same decrease in affordability will increase rents by pushing more people into the renter pool.  Thus, people who invest in income properties are likely to have some very prosperous times ahead as their rents increase from the influx of people who need to find new housing.

Liabilities that Decrease in Value with Inflation

The key liability that decreases in value with inflation is fixed-rate debt.  The reason for this is because inflation frequently rolls through to wage incomes, dividends, and rent incomes.  Inflation also frequently pushes-up interest rates.  However, if you own a long-term loan at a low rate of interest, it means that you can pay back that capital at a low rate.  If your other forms of income flow from areas that increase with inflation, it will result in your loan becoming cheaper over time.  In the Creating Wealth Show, Jason Hartman refers to this as “Inflation Induced Debt Destruction.”

In this scenario, a paid-off loan can actually become problematic.  If tight credit suppresses the value of your house, and inflation destroys the value of your equity, it can place you in a tight financial situation.  People who use the power of the home mortgage to borrow at low rates of interest for a long time can frequently invest in assets such as income property that produce much higher rates of return than their interest payment and realize a significant profit.

The key to winning at financial chess and thriving in an iflationary environment is to create income streams that are pushed up by inflation, and finance those income streams with fixed-rate liabilities that are eroded by inflation.  The incentives of the financial world have been rigged against people who took what was once good advice and turned them into people who are waiting to be fleeced by a government that is hungry for money to feed its unmet promises.  It is a matter of mathematical certainty that the current trajectory of government entitlements and spending cannot continue.  The result will be large budget cuts, large amounts of inflation, or some combination of the two.  When these events finally unfold, it will be the people who have educated themselves and played financial chess that will come out ahead when the world of checkers finally implodes.

 

After I took a high-school job at the local Kentucky Fried Chicken, my grandfather decided to share the mysteries of the stock market by giving me two shares of its parent company, Heublein.

Though I was far more interested in the company’s extensive operations in vodka, tequila and various liqueurs than its net income, I got a good first taste of stock ownership—ultimately selling it at a tidy profit.

As we approach Father’s Day, it is worth underscoring the significant impact parents and grandparents have on our attitudes toward savings and investing, and the lifelong impressions they leave. Though each generation grows up with a different investing perspective, sometimes it is profitable to take a minute to reflect on how our fathers did it—or didn’t.

In studying relationships, Geng Li of the Federal Reserve Board found that parents and grown children can strongly influence each other’s investing activities, even if they no longer live in the same home. If parents begin to invest in stocks, their grown children are about 30% more likely to buy stocks over the next five years, he found.

The influence works two ways: Parents also are more likely to try stock ownership if their grown children are doing it

It doesn’t take much to leave a mark. In surveying 2,000 students at the University of Arizona, Prof. Joyce Serido has found that those students who are responsible with their money are likely to have parents who will talk with them about financial matters and who set high expectations for good financial decisions.

My family education came mostly from hearing personal experiences. My mother’s father, born in 1906, had vivid memories of co-workers who borrowed to buy stocks and then lost their savings to margin calls when the market continued to plunge in the early 1930s. That experience left him uneasy about stocks throughout his life. He owned some, but was much more heavily into bonds.

By contrast, my father, who came of age in the 1950s, was a buy-and-hold, blue-chip stock investor, with a deep faith in the resilience of the U.S. economy. Even during the market bottom in 2009, he insisted on staying with equities—and his portfolio recovered with the rebound.

Our family investing didn’t always work out well. When my siblings and I were young adults and starting to ask lots of questions, our grandfather decided to educate us all at once. We all kicked in some savings to form what he named the Pappa Explosion Fund, our first taste of investing.

He compiled a small portfolio of regional common and preferred stocks and a corporate bond, and sent cheeky quarterly reports. The fund turned out to be aptly named—for the wrong reasons. An energy company ended up in bankruptcy, exploding our results and reinforcing his preference for bonds.

While my grandfather’s peers leaned toward bonds and my father’s toward stocks, my generation has largely ditched individual stock and bond holdings for mutual funds and exchange-traded funds, driven by an obsession with benchmarks. Today’s young adults will likely find their attitudes colored by the impact of the housing bust and the long economic slump, as well as their student debt burdens.

Despite the differences, there are ways for family members to share their experiences and values from generation to generation:

• Be a coach. My grandfather introduced me to investing in municipal bonds, which helped pay my children’s college bills during the recent market turmoil. My dad introduced me to mutual funds, though he rarely invested in them himself, preferring to pick his own stocks.

We may not have the answers for today’s economic and investment uncertainties. But we can use our experience to help our young-adult children sort through information and evaluate their choices, which may be just as beneficial.

• Keep preaching the basics. The best financial decisions my dad and granddad made were the least complex and required little understanding of Wall Street. They saved religiously. They lived within their means, even in the early years, when they didn’t have very much. They borrowed as little as they could get away with and paid it back as fast as they could. Those basics will still serve anyone well today.

• Keep investing in perspective. Regardless of your strategy, buying stocks, bonds or mutual funds isn’t a competition for market returns or a race with your neighbors. It’s about providing financial security for you and your family.

That is all my dad and granddad wanted—a nest egg big enough to allow them to maintain a comfortable lifestyle, give generously and not worry about running short, regardless of the curve balls life threw them.

My grandfather lived an active, independent life until the day before he died in 2002, just a few days short of his 96th birthday. He was one of those rare people your adviser warns about who make it to the far end of the investing horizon.

My dad’s hopes for senior years filled with golf and travel were displaced by a long fight with multiple sclerosis. But his savings allowed him to remain comfortably in his home and to still go to the office every day, until his death two months ago.

Did they beat the market? Who knows? To me, they left a greater legacy: lives well-invested and well-lived.

Write to Karen Blumenthal at karen.blumenthal@dowjones.com

Article source: Wall Street Journal

 

One of the most famous institutions in American cultural history during the 20th century is the Circus.  During the early portion of the 20th century, many Circuses moved from one small town to another, setting up a “Big Top” for their main show, and sponsoring side-shows, performance, and greasy food alongside carnival games in an area called the midway.  Traditionally, these carnival games were “difficult” (meaning that they were constructed so that you had an extremely low chance of winning) and required many attempts before the desired prizes were won.

When the Circus pulled into a new town, the local residents were frequently referred to as Rubes, which is a euphemism for an unsophisticated country bumpkin.  When these Rubes came to the midway, they frequently spent substantial sums of money buying food, playing rigged games, and paying to see side-shows or freaks of nature.  Another mainstay of the Circus midway was the announcer who would talk-up all of the shows and events to draw large crowds of people into the shows and attractions to spend their money.

There were some Circuses of a less than savory nature who would employ con-men that would cheat people at the midway games and pickpockets who would steal their wallet in the crowd.  Over time, these sketchy operations eventually collapsed, but the spirit of attracting people to the midway for the express purpose of separating them from their money remains.  Even among the carnival operations that remain today, the midway games are still extremely tilted against the player, and the prizes can be purchased at the store for much less than the cost of playing multiple games in an attempt to win.  Regardless, it is the excitement, lights, sounds, and smells of the midway that attract people to the games of chance that most people inwardly know are tilted against them.

An interesting parallel to the world of the circus is the realm of investments.  Many investment funds invest great amounts of fanfare and marketing behind their manager or fund family.  High budget advertising campaigns are created for the purpose of convincing you that the manager in charge of a particular investment fund or that the characteristics of a particular insurance product are going to provide everything you could every want.  In this environment, people who have not yet learned a tremendous amount about about investing are attracted like Rubes at the midway.  The excitement of a high-profile investment fund, the advertising campaigns and the colorful brochures all serve to attract new investors (Rubes).

Unfortunately, what the investors ultimately find out is that this game has been tilted in favor of the house as well.  The high-profile fund manager takes 2% of the asset base as a fee, but can’t consistently beat the market indexes.  Maybe he’ll do better than the market for a year or two, but then he does worse for a year or two.  When all of the fees are subtracted out, most of the investors would have been better off buying an index fund with low costs and no commissions.  The investors just got fleeced like Rubes at the midway.

This same phenomenon repeats itself over and over again with each new financial product that is rolled out for the investment Rubes.  The insurance product with an investment account may have some tax advantages vs. a regular brokerage account, but your cash is subject to fees and charges for the insurance part of your policy, and the associated expenses for each of the sub-accounts.  Some products even have a “guaranteed” rate of return from the insurance company that make the Rubes feel warm and cozy since they have a guarantee to fall back on.  However, that guarantee only holds water if the insurance company makes enough on its other investments to meet it’s capital reserve requirements.  Many people make the mistake of assuming that a guarantee from another party is guaranteed … it is nothing of the sort.  The guarantee of another person or company is only good if that company can make good on the promise when it becomes necessary.  What happens if the insurance company goes bankrupt before they can make good on your guarantee?

Another things that people frequently overlook is the fact that every time somebody touches your money in a financial product, they take a cut, a percentage, a taste.  By the time your money has passed through multiple sets of hands, it will be exceedingly difficult for you to realize a rate of return that exceeds the market by a large enough margin to dissipate the costs.  The way that financial companies make their profits is by attracting money to “manage” for a percentage of the asset base.  The way that they attract capital to “manage” is by making loud, outlandish claims about their great skill and amazing ability.  Strangely, this is remarkably similar to the barker at the midway trying to fleece the Rubes.

One of the things that are very important for people to understand is the difference between financial products and direct investments.

Financial Products:

• Financial products are packaged together by a bank, brokerage, or other financial institution.  Typically, they involve multiple riders, proviso’s, or conditions that are all packaged into a single product.
• Each level of intermediary or “middleman” between you and the actual investments will take a percentage.
• The incentives are set such that manager succeed by attracting large amounts of capital.  This means that they will either produce average rates of return or must take very high risks to beat the market.
• If the returns end up being average, the high costs will push you behind simply purchasing the market portfolio.
• If high risks are taken to produce large returns, you will be unknowingly bearing a risk of substantial loss.
• Products frequently involve “guarantees” that are subject to change in the future … especially if there are financial problems.
• The financial companies who sell products to you will take your money and make direct investments into assets like bonds and real estate.

Direct Investments:

• As the name indicates, direct investments involve directly purchasing ownership in a company, property, or debt instrument.  There are no additional intermediaries between you and the investment.
• You must become educated about the investments available, the process of purchasing, and the management of these investments.
• As the owner of the investment, there will be nobody to take a cut from your returns.
• As the owner of the investment, there will be nobody to shield you from risk if problems arise.
• Direct investments can have rates of return that are much higher than market indexes, due to small fragmented opportunities that cannot be efficiently collateralized by a financial institution.

Ultimately, the question of direct investing or purchasing financial products comes down to one of personal comfort, preference, and willingness to do one’s own research and analysis.  There are some financial products such as Term Life Insurance or indexed mutual funds that offer minimal costs, and no additional layers of middlemen between you and the underlying investments.  There are also some financial products with exceedingly high fees, high levels of complexity, and a very confusing value proposition.  In the end, each person must make their own choices when it comes to investments.  However, in most circumstances it is quite safe to say that if you do not fully understand how a financial product or direct investment works, then it is probably not a good idea to place your money there.  It is almost always best to start with the products and investments that you understand, and then seek to expand that universe of understanding.

This is how you avoid being fleeced like a Rube at the midway.

 

When Avery Walker got her MBA from the University of Houston, she never dreamed that her passion in life would involve hard hats and backhoes. In the midst of a financial career, Walker took a hiatus to raise her children. Twenty years later she was ready to get back to work, but since leaving the financial world she had developed an independent streak. The prospect of punching the corporate clock no longer appealed to her.

Instead, she and her husband, Marty, who had recently retired from the financial sector, looked around for investment opportunities. They found Volvo Rents, a franchise that rents and sells heavy equipment to construction companies and other businesses. The only problem was, the rental market at home in Austin was saturated.

So they packed up and moved to College Station, Texas, to open their business. It proved to be the right choice: While most of the construction industry has been in the doldrums the last few years, in College Station–home to Texas AM University–work has been steady. Walker hit $1.1 million in revenues in 2008, her first year in business, and $4 million last year.

We’ve heard some of your equipment is pink. Why is that?
We painted a 65-foot boom pink and set it in front of the stadium for the AM women’s basketball charity game. It’s very striking, and we rent it out to anyone who needs a 65-foot boom, so it gets hauled to various job sites around town. Once a driver who was sent to pick it up said, “I don’t want to drive a truck with a pink boom on it.” But when he came back he said people were smiling and waving and honking. We also did a smaller truck to support the Special Olympics. Hopefully our next one will be red, white and blue to support the troops.

Was it difficult moving to set up a business?
No, we love the community we picked, and we’re glad we didn’t move into a larger area. Those areas are extremely competitive with other established rental companies. It’s also harder to become a member of the community. We have really found a niche between the local mom and pops and the big-box stores.

Why did you sour on corporate life?
In the corporate world, there are a lot of extraneous activities you have to participate in and a lot of other departments and goals you have to work with. You may not be able to head off in the direction you want. In my franchise, I can make decisions about what is best for my business and for me, whether that’s purchasing equipment or opening another store. One week I might put in 60 hours and there might be another where I take more time to deal with family issues. I definitely work more than I did in a corporate job, but I have more control over our financial decisions.

Any bumps along the way?
In the beginning, I bought some equipment that didn’t get used. Fortunately, Volvo worked with us to sell it and to do swaps to acquire more equipment.

Can you run a bulldozer yet?
I like using the smaller equipment, but I don’t think you want me out there operating it for you.

Article source: Entrepreneur.com

 

How can you prepare your child to make dollars and sense of a tumultuous economy? Start as early as possible.

Financial experts say it’s essential to get kids on the road to financial literacy at an early age. And schools, banks and other organizations are doling out new programs with that goal in mind.

“We would never send our kids to school and not teach them how to read, not teach them the ABCs,” says Lori Mackey, founder of Prosperity 4 Kids, a financial-literacy website for kids. “So we have to build that foundation.”

You don’t have to wait for money lessons at school, however. Kids can get some Finance 101 thrown in with soccer and swimming this summer.

Junior Achievement, a nonprofit that educates students about the economy, runs a nationwide BizTown summer camp where kids work with teachers and volunteers to create a simulated economy. Kids ages 10 to 14 work pretend jobs, such as bank teller, product developer or CEO; pay rent for their space; make bank deposits; and balance a personal checkbook. The camp costs $225 to $269 per week. (Go to www.ja.org/Programs/programs.shtml.)

Junior Achievement has gotten into the classroom as well, with free, year-round programs at various elementary schools across the country. Lessons include in-school visits from local entrepreneurs and field trips to Junior Achievement centers where kids learn financial lessons such as opening a bank account.

Last summer, ING Direct started a summer camp for kids that teaches earning, spending and saving lessons to about 1,500 students in the Wilmington, Del., area. The free, one-week programs are taught by volunteers from the bank. The program is expected to return next month.

The bank also has partnered with the Books for Kids Foundation, which promotes literacy among children, to roll out five preschool financial-education literacy centers in Wilmington, Del., San Francisco and three other cities by 2012. The centers will include libraries with finance-related books geared toward kids ages three to five. (Go to booksforkids.org/libraries.)

Girls will soon be able to earn a merit badge for their financial savviness. In September, the Girl Scouts of the U.S.A. will roll out 13 types of “Personal Finance” badges for girls ages five to 18. To earn one, girls will have to complete five activities based on age. For instance, a five-year-old must recognize different coins while a 13-year-old must create a budget, says Suzanne Harper, the Girl Scouts’ director of program resources.

“Even at the Daisy level [ages 5 and 6], they can start to understand that money doesn’t grow on trees,” Ms. Harper says.

Boy Scouts already can earn a “Personal Management” badge by completing activities such as stock research and shopping comparisons.

Parents also can find a host of new financial books, games and websites catering to younger kids. Ms. Mackey has written activity books in partnership with ING for first- to eighth-graders that include finance word searches and puzzles. (Download the activity books at ING’s site for kids, orangekids.com.)

And don’t let your kid’s penchant for borrowing the smartphone to play games go to waste. There are apps for younger kids that focus on budgeting and saving. For instance, the Kids Money app for the iPhone teaches about saving for long-term purchases, like a new toy. Android smartphone users can try Kids Shopping Calc, which teaches budgeting by shopping in a virtual store with a set amount of money.

By EMILY GLAZER

Article source: Wall Street Journal

 

Questions and Answers

Q: I have a question on beneficiaries and trusts. I have numerous IRAs, money-market accounts, savings accounts, etc., and they all have beneficiaries named. However, I want to put a revocable trust together for members of the family, and I don’t know if I have to contact each financial institution and remove those names as beneficiaries and reference the trust. Or would the trust “trump” the beneficiaries named for those various accounts?

Michael D. Brown

Scottsdale, Ariz.

A: Before you get to the “how,” make sure you are clear on the “why” of setting up a revocable trust—often called a “living” trust because it functions in your lifetime. These trusts can be “a phenomenal tool” to ease management of your assets in case of disability or illness, says Martin Shenkman, a lawyer in Paramus, N.J. They also can be useful to minimize or avoid probate at your death. But, he says, living trusts are often “oversold” for probate avoidance to people who have relatively few assets that would be subject to probate.

Upon your death, for example, individual retirement accounts and other accounts for which you have named beneficiaries, along with jointly owned accounts, pass outside of your will and the probate process.

In implementing a living trust, meanwhile, the key is for the trust to be named the owner of various assets, not the beneficiary. Advisers gripe that many individuals set up living trusts but fail to retitle assets. Indeed, Mr. Shenkman says: “It’s almost every time that people don’t follow through.” He notes also that there are tax reasons not to transfer ownership of certain assets, including IRAs, to a trust.

***

Q: I have a 529 plan for my grandchild. I read an article that said 529 funds held by grandparents weigh against financial aid more than if the plan was held by my granddaughter’s parents. I recently began to transfer these funds when my Vanguard representative recommended that the funds stay with me, saying 529 funds held by me weigh less in the financial-aid calculation than they would if held by my granddaughter’s parents. So the question is: Should the 529 funds be held by me or my son?

Richard W. Johnston

Stuart, Fla.

A: When grandparents fund a 529 college-savings plan for a child who might qualify for financial aid, there is no single answer as to the most advantageous ownership. “The best outcome for one family’s situation will not necessarily be the best outcome for another family’s,” says Joseph Hurley, founder of savingforcollege.com.

There are two issues: the treatment of 529 assets and of 529 withdrawals. The assets in a grandparent-owned 529 aren’t counted as family assets under the federal financial-aid formula; in contrast, a student’s parents are expected to pony up 5.64% of their assets, which include parent-owned 529s.

But when grandparents tap a 529 to help pay college bills, those dollars count as student income—with as much as half going into the aid calculation for the following year, Mr. Hurley explains. (Withdrawals from a parent-owned 529 aren’t counted as income.)

One strategy that works for some families is for the grandparent to retain ownership of the account and then to pay for the student’s final year of college, since he or she won’t need to file another aid application, says Matt McCarthy, head of Vanguard Group’s 529-plan business. By keeping ownership, you also retain the right to use the 529 money for yourself if you need it or to direct it to another beneficiary.

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Q: In your March 21 column, Jon Demos asked about the impact of the Social Security family maximum on individuals who have children under age 18 when they reach age 62. My brother-in-law will be in this situation in a few years. He, like Mr. Demos, plans to continue working for a number of years. When I looked at the Social Security rules, I saw another strategy, “claim and suspend.” My brother-in-law would file a claim but suspend payment. By making the claim, his children would be eligible for the dependent benefit. But his eventual benefit wouldn’t be reduced by early claiming. Is this a viable strategy?

Hanns Kuttner

Bethesda, Md.

A: As noted in the last Ask Next, the minor child of a person receiving Social Security retirement benefits may qualify for a payment of up to half of what the parent would collect at his or her full retirement age. But the total benefits based on one person’s record are limited to 150% to 180% of the worker’s benefit. And until the worker reaches full retirement age, income from continuing employment can reduce or eliminate those payments to the worker and the children.

The claim-and-suspend approach you suggest wouldn’t work for a worker turning 62: You can suspend your retirement benefit only when you reach full retirement age, which is 66 for people born between 1943 and 1954.

But this could be a smart strategy for people who still have minor children when they reach full retirement age, says Carolyn McClanahan, founder of financial-planning firm Life Planning Partners, Inc. in Jacksonville, Fla. The children could collect their benefits; meanwhile, the parent, by not collecting, would get “delayed retirement credits” to boost his or her eventual benefit by about 8% for each year of delay, to age 70.

The claim-and-suspend strategy is more commonly used to start a spousal benefit for a worker’s wife or husband while the worker waits until age 70 to file. “It is underutilized for spouses. People don’t even think about it for benefiting children,” says Dr. McClanahan, who practiced medicine before becoming a financial planner.

By KAREN DAMATO

Article source: Wall Street Journal

 

The current world is one where information abounds.  The flow of information moves so fast and increases so quickly that many have led themselves to believe that this extreme amount of information means that we have greater mastery over chance and uncertainty.  However, the financial collapse of 2008 demonstrated quite aptly that there is a prolific difference between “Know What” and “Know How” when it comes to situations of volatility or uncertainty.

For those who have not been living in a cave for the last few years, volatility and uncertainty are an inextricable part of life that cannot be controlled with mathematic algorithms.  This is where ‘know what’ has become woefully inept.  By attempting to force reality into mathematical models, the purveyors of self-proclaimed intelligence place the entire world at the mercy of their algorithms.  The pseudo-intellectual class has attempted to make itself “master of the universe” by publishing highly detailed forecasts built on nothing more than subjective assumptions that have been rolled into a quantitative model.  The problem compounds even more when people demand that public policy be based on the output of these models.

This phenomenon results in a form of “Scientism” that emerges from a combination of mathematical techniques that are used as a justification for pushing subjective views or beliefs.  The method for holding up these forecasts that border on religion are to use the ‘credentials’ of people who form the predictions as a method of insulating them from criticism.  The implicit belief of “Know What” or “Scientism” religion is that only the elite possess the necessary intelligence for creating forecasts.

In contrast to this view, we have an emphasis on “Know How” or the viewpoint that nobody possesses the necessary knowledge to accurately predict the future.  In this worldview, future trends represent the emergence of many people making independent decisions, and success is less about knowing what will happen and more about knowing how to make astute decisions.

The net effect of recent focus on “Know What” and econometric forecasts has been a de-facto regression toward medieval religion where the edicts of leaders are to be obeyed without any thought or question.  In the current environment, just like the middle ages this phenomenon creates a tremendous opening for graft and corruption by those who construct the edicts that are handed down to the ‘little people’ who are expected to obey.

The challenge that most people face in the face of this conflict between “Know What” and “Know How” is that the promises of comfortable retirement made by the “Know What” apostles are quickly becoming revealed as vacuous and empty.  The pension funds, trust accounts, and other means that politicians have used to purchase votes with public funds are not sufficiently capitalized to support the promises made to future retirees.

Ultimately, the only financial security available to regular people is to “Know What” is necessary for building a portfolio that is completely owned by them and free from the prying fingers of politicians, union bosses, and corporate executives.  This stands contrary to the “Know What” religion, since it involves a departure from dependence on the pseudo-intellectual elite for people’s wellbeing.  The unfortunate reality is that political power comes from influence, and dependence on the government places a tremendous amount of influence in the hands of those who run the government.

When going throughout your life, resist the temptations from hucksters and shysters who claim to have a ‘secret’ to financial success that they will reveal only if you purchase their $6,000 system.  These people are simply peddling false hope to people who are desperate for a way to improve their financial situation.  Similarly, resist temptations to believe people who try to tell you that a particular pension fund will completely take care of your retirement needs, and that no other investment is necessary.  These people are also playing on a desire to believe in financial security.  In both cases, false hope is being sold to exercise influence over large groups of people.

Actively seek knowledge about the principles of success that will help you “Know How” to achieve your goals.  Much of this information is available for a very low cost through your library, the internet, or other methods of distribution.  The rub is that very few people will actively market the principles of success.  Most people marketing information are trying to sell a ‘system’ that is based on some form of ill-conceived prediction model.  In the end, your best alternative for creating a strong financial future is to build it yourself by practicing the principles of success.