Recent financial news has been dominated by the initial public offering of Facebook.  Morgan Stanley underwrote the initial offering last week of 400 million shares at an initial price of $38 per share.  This served as one of the most publicized IPO’s in the history of the stock market.  At $38 per share, this created an implicit market capitalization of $104B for Facebook.

This level of valuation is approximately 107 times earnings.  For comparison, Apple’s P/E is approximately 13, and the S&P 500 index is valued at roughly 15 times earnings.  This means that earnings will need to grow dramatically in the near future in order for its current price to be supported by a valuation that regresses toward the market average.

Day 1 of Trading Tells the Whole Story

There were two notable events on the first day of trading that told the whole Facebook IPO story.  The first is that trading was delayed due to a technical glitch, and the second is that Morgan Stanley wrote a large amount of buy orders at $38 near the end of trading to avoid a net loss in price when the market closed.  What this ultimately met is that people who bought in on the first day made exactly zero money, and that feat was only accomplished by a major purchase commitment by the very company who underwrote the stock offering.

Facebook’s Future Business Model

Simple mathematics dictates that Facebook’s earnings must grow by a factor of 8.2 in order to reach a P/E ratio equal to that of Apple, which is roughly in line with the market average.  Thus, Facebook must find some way to generate MUCH higher profits than they do today if they want to avoid a wholesale collapse in their stock price.  Currently, the only path to earnings for Facebook is revenue from advertising.  Many major companies have commented that Facebook advertising is not highly effective, and GM has already announced that they will no longer advertise on Facebook.

The most valuable asset that Facebook has is a massive trove of user data.  It is not difficult to figure out that they will need to sell this data in some manner or form in order to raise earnings sufficiently for their stock price to be justified with a rational valuation ratio.  This means that the company will need to begin aggressively invading the privacy of its members relatively soon if they wish to have any hope of meeting their earnings expectations.

The Smart Money is Already Out

The most compelling story emerging from the first day of trading for Facebook is not who bought, but who sold.  Most of the people who sold shares were the early investors and insiders.  Many of the people and companies who sold a portion of their stake during the initial offering period are highly sophisticated, and frequently referred to as the “Smart Money” of Wall Street.  Thus, one must wonder if they are being intelligent when buying stock that some of the smartest firms in the world are selling as fast as they can.  Some of the key insider and “Smart Money” transactions are as follows:

• Accel Partners: 56 million shares (28% of total stake)
• DST Global: 53 million shares (40% of total stake)
• Goldman Sachs: 33 million shares (50% of total stake)
• Mark Zuckerberg: 32 million shares (6% of total stake)
• Tiger Global Management: 27 million shares (50% of total stake)
• Mail.ru Group: 23 million shares (40% of total stake)

These six sources account for over half of the 400 million shares that were initially sold to the public.  What this proclaims in large, loud, bright letters is that the smart money and insiders have already started to dump their stock in Facebook.  The IPO of Facebook singularly demonstrates everything that investors should be wary of … lots of hype, lack of fundamentals, and a high level of sales by insiders.  Ultimately, the people who are likely to be punished in this situation is the people who read Zuckerberg’s profile Time Magazine and figured that Facebook would be a great stock to own.  These are the people who will continue to be fleeced by the smart money and insiders for the foreseeable future.

And on the next day of trading, Facebook stock commenced a precipitous drop as more people who seek to unload their shares.  In the end, intelligent investors should focus on the things that matter such as fundamentals and sound business strategies.  Every time that somebody claims “This Time It’s Different” you can be almost totally certain that they are attempting to separate you from your money.  This case is no different, even if though is much more blatant.

 

It is one of life’s conundrums: If we hate paying taxes, then why do we consistently overpay them, collectively lending Uncle Sam some $300 billion year after year—interest free?

This year, as in previous ones, about 75% of individual taxpayers will receive federal income-tax refunds, with the average refund totaling around $3,000. From a purely economic standpoint, this makes no sense.

“All a tax refund is, is the government saying to you, ‘You’ve overpaid and here’s your change,’ ” explains Charles Enis, an accounting professor at Penn State University.

The rational thing to do, he says, is to pay just enough taxes throughout the year—via withholding and quarterly estimated payments—to avoid owing a penalty at tax time, and then pay any balance due when you file your return. (The minimum required payment is typically the lesser of 90% of the current year’s tax or 100% of the preceding year’s tax.) That way, you get an interest-free loan from Uncle Sam instead of Uncle Sam getting an interest-free loan from you.

But that is not what most of us do. Why not?

One possibility is that we are indeed acting rationally because, with interest rates so low, there’s not much opportunity cost to parking some money with the government for a while; it wouldn’t have earned any interest to speak of anyway. History shows, however, that we overpay our taxes in both high interest rate environments and low ones.

Another theory is that we find it too confusing or difficult to “zero out” our tax bills by, for example, decreasing the amount we have withheld from our paychecks. But at least one study has shown that even when taxpayers believe they could adjust their withholding relatively easily, they are still hesitant to do so.

No, it turns out we may actually prefer getting tax refunds. Why? Because they pay emotional dividends.

For one thing, they free us from worry and uncertainty, according to Donna Bobek Schmitt of the University of Central Florida, who has studied the issue. It is never pleasant to have to write a check at tax time, but it is especially unpleasant if the bill is unexpected or unexpectedly large—and even more so if we don’t have the cash to pay it. So, to avoid any unpleasant surprises, we err on the side of caution and overpay throughout the year, engaging in a form of forced savings.

Apparently, we don’t trust ourselves to set aside money in advance to pay our taxes—with good reason. In a survey for Capital One Financial, only one-quarter of respondents who owe taxes this year had set aside cash specifically to cover the cost.

Then there is the rush we feel from getting a refund, an experience akin to putting on your spring jacket for the first time in a year and finding a $20 bill in the pocket. We frame it as income. A windfall. (Same goes for owing less tax than expected; we frame it as a gain.)

In fact, research by Mr. Enis shows taxpayers are so addicted to this adrenaline rush that those who discover during tax filing season that their refunds will be smaller than hoped (or their tax bills higher) are more likely to open traditional, tax-deductible IRAs or add to existing ones to goose their refunds (or lower their tax bills). Is it any wonder why most IRA contributions are made between Jan. 1 and April 15?

And what of taxpayers whose refunds end up being larger than expected? They are more likely to open savings accounts or certificates of deposit or to buy U.S. savings bonds, according to an ongoing study of low- to moderate-income taxpayers by J. Michael Collins and Nilton Porto at the University of Wisconsin.

No matter what their size, refunds clearly pay big dividends in the way of spending enjoyment. It seems we view money differently if it comes in a big chunk like a tax refund than if it is dribbled out in smaller amounts, as is the case when you decrease your withholding to give yourself more take-home pay each week.

According to Ms. Schmitt, we enjoy getting a tax refund more than having the extra money in our paychecks because we are more likely to spend the refund on a vacation or a new TV (Yay!) but more likely to use the extra money each week to pay bills (BOR-ing.).

What will you do with your tax refund this year? Email me your plans and I’ll share them, along with some suggestions, in my next column.

—
investingbasics.wsj@gmail.com

Article source: Wall Street Journal

 

Recent news about the advent of rapidly rising gas prices has brought the subject of energy into the forefront of public opinion.  Unfortunately, the majority of the discourse occurs over typical “political football” issues such as profits from oil companies and proposals for higher taxes.  Recently, the topic has shifted toward the topic of exporting domestically produced oil to other countries.  Naturally, this is being portrayed as unpatriotic greed on the part of the oil companies who are subverting the national interest of the United States for their own selfish interests. What this phenomenon really represents is a signal.  It is a signal to the United States that the “loose money” policies of permanently low interest rates and perpetual monetary expansion has consequences.  The government is clearly attempting to inflate values in the stock market and real estate sector by pumping money into the economy.  The problem is that this has the net effect of reducing the real value of dollars that are already in circulation.  It also has the effect of making products & services we sell to other companies less expensive, while making products & services they sell in the United States more expensive. One of the products made less expensive by a loose money / weak currency policy is oil.  When the US intentionally devalues its currency to support government spending programs and financial markets, it increases the relative purchasing power of other global currencies.  As the purchasing power of these other currencies increases, it allows them to purchase more energy than they otherwise would have bought.  This translates to increased incentives for oil companies to export their product instead of sell it domestically, unless the domestic price increases. Thus, the phenomenon we are seeing is not any kind of conspiracy or the result of evil intentions by corporate plutocrats.  It is nothing more or less than the predictable result of loose money policies.  It is certainly convenient for politicians to blame the usual suspects of “corporate greed” or “big oil” … however, the current situation is one that has been intentionally created.  It was not created to reward oil companies, it was created in an attempt to avoid a double-dip recession and conceal the sluggish growth of the US economy.

Canary in the Coal Mine

In years past, coal miners would take a canary down a mine shaft as a signaling mechanism.  If the canary died, it meant the air was becoming toxic and that they need to vacate the mine … quickly.  Similarly, these rapidly rising gas prices should be viewed as an indicator of what is going to happen as a result of continued easy money policies by the government.  It is an indicator of what the future holds for our economy.  Unfortunately, addressing the underlying problem that causes these higher prices carries with it separate problems.

A Rock and a Hard Place

The most certain remedy to the recent rash of price inflation is to begin tightening the money supply.  By raising interest rates and pulling-back money from circulation, it will increase the relative purchasing power of dollars.  This will make it (relatively) more profitable to sell oil in the United States than in other countries, so more supply will be attracted to the US.  This increase in supply will drive prices down to a new equilibrium.  The same effect will happen for food, which has also experienced a dramatic run-up in its price over the past few years.

The problem is that if interest rates are not constrained, and if money is removed from circulation, it will place significant downward pressure on both real estate prices and stock market values.  Increasing the cost of borrowing will also suppress business investment in new plants & equipment.  The unfortunate truth is that inflation has become the price we are paying for cheap money.  The irony of this observation is that the result of this policy, which is being pushed by the self-proclaimed champions of social justice is to disproportionately impoverish those at the bottom of the wealth and income ladder.

Since people who earn less income or are dependent on government subsidies tend to spend a higher percentage of their income on things such as food and energy, inflating the prices of these commodities to artificially reduce the costs for stock market investors and home buyers results in a net transfer of real wealth from those at the bottom to those at the middle and the top.

An even more concerning fact is that the current government entitlement liability has grown so large that long-term inflation is all but inevitable unless significant changes are made within the next few years.  Since entitlement programs are very popular with the people who receive the payments, it has become a matter of political suicide to propose any changes to these programs.  Unfortunately, the people who rely on these ‘safety net’ programs are the same ones who will be the most intensely impacted in the future when prices continually increase as the government prints money in an attempt to meet their financial obligations.

In the end, we must all decide what we will personally do to ensure that we are able to personally resist the coming inflationary wave.

 

Most parents worry about not having enough money in their 529 savings plans to pay for their kids’ college expenses. But sometimes you can end up with more cash in these accounts than you need—if, say, a child doesn’t go to college or attends a state school rather than a private university.

What then?

One option, of course, is to simply withdraw the cash. But if you do that, you will owe tax on the earnings, plus a penalty equal to 10% of the earnings portion of the withdrawal. Fortunately, there are plenty of other ways to use leftover 529 funds without incurring tax or penalties, says Matthew P. McCarthy, head of the education-savings group at Vanguard Group.

Alison Seiffer

After all, avoiding tax is a key benefit of state-sponsored 529 plans, which are named for the section of the federal tax code that created them in 1996. The money, typically invested in mutual funds, grows tax-free, and withdrawals to pay for qualified higher-education expenses generally aren’t subject to taxation.

Weighing the Options

If your intended beneficiary decides not to go to college, be aware that the money in a 529 plan can be used to pay for postsecondary vocational or technical training at schools eligible for financial-aid programs administered by the U.S. Department of Education. This includes schools that teach a variety of trades, such as automotive and aerospace maintenance, hairstyling and computer skills. A tool on the savingforcollege.com website, under “Tools calculators,” can tell you if a specific school is eligible.

If a child goes to college but graduates without wiping out a 529 account, you can always let the remaining money sit for possible graduate-school expenses.

You also can change the beneficiary of the account, so long as the new recipient is a family member. That might be a sibling or step-sibling of the original beneficiary, for example, or a first cousin. Alternatively, a parent who funded the account may want to take college courses on a part-time basis, or save the money for potential grandchildren. (In rare cases, there may be gift-tax or generation-skipping-tax consequences when you change beneficiaries.)

Say there is money left over in a 529 account because your child got a big scholarship that reduced his or her college costs. In that case, money withdrawn would be subject to tax on the earnings but the 10% penalty would be waived, as long as the withdrawal doesn’t exceed the amount of the scholarship. The penalty on withdrawals also would be waived if the beneficiary dies or becomes disabled.

Unless you need the money in a 529 account for something else, there is no rush to make a decision. In most plans, you can leave funds in the account to grow tax-free indefinitely, as long as there is a living beneficiary. The account owner can change beneficiaries at any time.

However, if the money is likely to stay in the plan for longer than originally expected, review how it is invested. The key is to think about your time horizon and your tolerance for risk. “It’s like any other investment,” says Ron Rogé, a financial planner in Bohemia, N.Y. “If you think you’ll need the money in under three years, look for something stable, like a short-term bond fund. If it’s longer term, look for growth.”

Know the Rules

Most of the more than $130 billion in 529 savings plans is invested in age-based portfolios, where the investment mix becomes more conservative as the beneficiary gets closer to college age. But most plans offer other options. Indiana’s College Choice 529 plan, for instance, includes a U.S. Equity Index Portfolio, an International Portfolio and a Short-Term Bond Index Portfolio, among other options. Alaska has a Total Market Equity Index Portfolio, composed of one stock fund that aims to parallel the performance of the entire U.S. stock market, and an Equity Portfolio, composed of several stock mutual funds.

“There are 3,000 investment options among all the plans,” says Joe Hurley, founder of savingforcollege.com. Almost all states have at least one plan, and an account owner usually can roll over assets from one plan to another—or change investment options—once every 12 months. Some plans charge a fee for rollovers.

Especially when investing for the long term, it is important to designate a successor owner for a 529 plan to ensure assets will be available to the beneficiary if the account owner dies. This can be done when the account is established, or later.

It pays to know the rules of the state plan in which you are invested. While two-thirds of states offer state income-tax deductions or credits for residents who invest in their plans, some, like New York, can move to recapture those benefits if the assets are moved to another state’s plan.

A final thought: If there is no future beneficiary in sight, you may be able to mitigate the tax bite and the penalty by donating proceeds of the account to charity and taking a tax deduction—if you itemize deductions.

By GEORGETTE JASEN

Article source: Wall Street Journal

 

After getting laid off from an architecture firm in 2009, Margot Broom tapped her savings to open a yoga studio in New Haven, Conn., called Breathing Room.

But when she was forced to relocate the business two years later, Ms. Broom couldn’t afford to renovate the new space she had in mind—until she discovered crowdfunding, the practice of securing small amounts of money from multiple contributors online.

Using a crowdfunding service known as Peerbackers.com, Ms. Broom raised $10,000 from more than 100 contributors in just 45 days—with average contributions of $15 to $50. The 27-year-old is now using the money to turn an empty tattoo parlor into her business’s new home.

Ryan Snook

Need start-up capital—and fast? You may want to try crowdfunding, a money-raising strategy that’s become increasingly popular in recent years.

A number of web services, including Peerbackers, IndieGogo.com, Kickstarter.com and RocketHub.com, provide platforms for entrepreneurs to get funding from various contributors, often friends, relatives and members of their community. The funds don’t need to be paid back because they’re not loans. However, many entrepreneurs give their contributors some of the products or services their start-ups sell as a way to show appreciation.

To be sure, crowdfunding initiatives take effort and don’t always pay off. Entrepreneurs need to convey why they’re seeking financial support and hope contributions will come in during the timeframe allotted, which varies from service to service. Also, the crowdfunding sites typically take a small percentage of the funds that entrepreneurs raise.

In most cases, crowdfunding services require entrepreneurs to set a goal for contributions and will hold the pledges that come in until that goal is met. If the campaign falls short at the end date, some crowdfunding sites will return the funds to the donors or take a larger cut than if the entrepreneur’s goal had been met.

“You need to work hard because not all campaigns are guaranteed success,” says Slava Rubin, chief executive officer of IndieGogo.com. The San Francisco-based crowdfunding service releases funds regardless of whether a user’s goal is met, but the service takes 9% of the total from campaigns that come up short, compared with 4% for those that don’t.

Mr. Rubin’s advice for a fruitful crowdfunding effort: “Have a good pitch, be proactive and find an audience that cares.”

Ian Gaffney and Samantha Abrams launched a campaign on IndieGogo.com earlier this year for their start-up, Emmy’s Organics, a maker of allergy-free snack foods in Ithaca, N.Y. They asked for $15,000 so they could buy packaging materials that would allow them to ramp up production.

“We got to a point where we weren’t able to keep up with orders,” says Mr. Gaffney, 28.

Mr. Gaffney says he learned about crowdfunding from his musician brother who, along with several bandmates, had used the strategy to raise funds to cover the cost of recording an album. To bolster their plea for financial contributions, Mr. Gaffney says he and Ms. Abrams created a video and posted it to their campaign page on IndieGogo.

“We just talked about who we are and everything that we do and why we were doing this fund-raiser,” he says.

By the conclusion of the 30-day campaign, the entrepreneurs had surpassed their goal by $326. The average contribution was $100, though one person, who requested anonymity, pledged $5,000. “We were shocked by what some people were giving,” says Mr. Gaffney.

Among the contributors were some of his former colleagues from a marketing company that had laid him off in December 2008. The termination was what prompted him to start Emmy’s Organics with Ms. Abrams the following month, he says.

Mr. Gaffney says they thanked contributors by giving the group about $1,000 worth of products. The more money people pledged, the more free goodies they received.

Though the initiative went smoothly, the entrepreneurs don’t plan to participate in crowdfunding again—at least not anytime soon—because they say it would send the wrong message to their supporters. “If we asked for more money, that would be far-fetched,” says Mr. Gaffney. “We don’t think people would donate twice.”

In addition to being able to raise money via crowdfunding only so many times, entrepreneurs say another caveat is that some people find the tactic offensive. Others say would-be contributors aren’t always comfortable sending money through crowdfunding services.

Ms. Broom, the yoga entrepreneur, encountered the latter problem. “Some people were worried they’d get put on a mailing list,” she says.

But a few offered a simple solution without her even having to ask. “They said they would rather send me a check,” says Ms. Broom. “And some did.”

Article source: Wall Street Journal

 

A persistent situation has developed among the current political and economic climate that forebodes of large potential problems in the future.  This situation finds its source in a phenomenon that we refer to as “Evading the Obvious.”  The way this effect manifests itself is a stalwart refusal to recognize and adapt to the economic realities.  This issue is modestly problematic when constrained to people and absolutely catastrophic when employed by the political authorities.

The reason for this is because people are limited in the extent to which they can impact the overall marketplace.  However, political authorities can establish highly destructive rules and regulations that have the ability to cripple an otherwise vibrant economy.  Of the many pitfalls and problems that public officials can find themselves caught up in, there are three main principles that drive the most evasion of obvious economic truths.  These principles are that spending isn’t free, profits and losses are equally important, and that prices communicate knowledge.

Reality #1: Spending Isn’t Free

Against the backdrop of huge deficits in both the US and Euro-Zone, this truism cannot possibly be expressed poignantly enough.  Every time that any person, business, or government spends money, that money must come from somewhere.  In the cases of people or businesses, the spending frequently comes from either savings or credit.  In the case of governments, it can also come from ‘monetary expansion’ or simply printing new money.  In all cases, it is not free.

The world is a place where resources are limited.  These resources are often represented in terms of money, but there is no scheme that can ever be devised to create new resources out of nothing.  When savings are spent, those savings are not available for spending on anything else.  When money is borrowed, it must be paid back … with interest.  When new money is created, it devalues the money already in circulation.  Any time that money is spent, it represents a choice to bear a certain cost in exchange for a certain outcome.

Thus, the fundamental question for people, businesses, and governments is one of whether their money/resources are being spent in the most effective way possible.  It is certainly true that the notion of effectiveness is inherently subjective.  However, it is also true that when people are spending their own money, they do so much more effectively than people spending other people’s money.

When investors borrow to build a new factory, they do so because the rate of return from the factory is expected to exceed the cost of interest on the loan.  When people spend their savings, they do so because they value what they are buying greater than having a certain amount of money available to spend on something else.  When the government borrows or prints money to spend on “stimulus” projects, the net result is to either create or destroy value.  Projects more valuable than the alternative uses create value, and projects less valuable than the alternatives destroy value.

When one considers that political decisions are made by people who must be re-elected at regular intervals, and who are spending other people’s money, it is not difficult to see how large sums of money are spent on value destroying projects that benefit a particular political constituency.  If we seek economic growth, then net spending needs to be concentrated in areas that will generate more value than the (full) cost of the resources.  It is not possible to create affluence through borrowing to spend on value destroying projects.

Reality #2: Profits and Losses are Equally Important

Another key concept that seems to have been lost over the past five years is the importance of losses in a free market.  Profits exist to encourage innovation and risk-taking, but the risk of loss must be present to encourage prudence, and to weed-out under-performing entities so that the capital can be deployed more profitably elsewhere.  Problems emerge when the government seeks to insulate certain businesses from the impact of losses.  When profits are guaranteed, and losses are bailed out, the result is highly inefficient entities that funnel benefits to their insiders.

The reason for this is because in a competitive market, businesses who take excessive risk or have incompetent management will eventually go bankrupt.  In this scenario, the assets of the business will be sold off at a discount to other entities who behaved more responsibly.  The profit and loss system systematically channels resources from under-performing entities to those who are more effective and more prudent.

The problem that many people see in this process is the ‘creative destruction’ aspect of economic growth that pushes some companies out of business while new enterprises emerge and grow.  In response to this churn of business fortunes, many companies seek protection of their business, while people seek projection of their jobs.  Unfortunately, all of this creates a barrier against the systematic re-allocation of resources toward their most effective use.

Reality #3: Prices Communicate Knowledge

The third, and least well understood of the fundamental realities is that prices communicate knowledge.  When prices for a particular product or service are high, it signals to entrepreneurs that there is an opportunity for profit.  This opportunity attracts new competitors, and this competition often places downward pressure on the prices.  Similarly, when prices are pressed down low by weak demand relative to the amount of supply in the market, it is a signal to the marketplace that there are too many entities in competition with one another.

The problem that many government’s run into regarding prices is their attempts to manipulate prices for political reasons.  Almost every politician in the world will complain about the high price of health care.  However, very few ask why health care costs are so expensive.  Much of the reason comes from the fact that most people access health care through insurance plans where they do not personally bear the costs of care.  This means that they have no incentive to economize, and often consume much more care then they would if they were directly responsible for the costs.

This phenomenon bears itself out over and over in nearly every corner of the economy.  Most of the people who are upset about prices fail to realize that the prices are communicating valuable information.  Instead, they accuse the business charging the prices of ‘greed’ when the business is really just a messenger of market realities.  High gasoline prices stem from a relative shortage of petroleum that drives up market prices.  These market prices are created by other people who are competing for the same petroleum.  The reason the prices rise is because exploration of petroleum has not kept pace with demand.  Thus, the problem is not one of rapacious oil companies, but regulations that constrain supply.  Nobody is able to maintain high prices for long when competing against somebody else who is willing to sell for less.

As we have seen, the phenomenon of “evading the obvious” has a distinctive impact on each individual’s personal, professional, and financial life.  The impact of these fallacious misunderstandings escalate as the scope of influence grows.  As each of us go throughout our own lives, we must stay aware of the fundamental realities so that we can learn to recognize opportunities and take intelligent action.  It is only through embracing the obvious and understanding the reality that we will be able to create a life of happiness and fulfillment for ourselves and the people we care about.

 

Planning IRA Withdrawals

When a retirement account is big and its owner gets older, the money flowing from it can turn into a tidal wave. So can the tax liabilities.

An adviser can help by planning well before things reach that stage.

One strategy is to spread withdrawals over many years, by beginning at age 59½, when early-withdrawal penalties no longer apply, rather than waiting until minimum distributions are required after 70½.

That’s what Kevin Sullivan, a financial planner in Winston Salem/High Point, N.C., recommended for a 57-year-old retired corporate executive who had $3.5 million of his $8 million of assets in an IRA. Spending down the IRA to $2 million by age 70 would reduce required minimum annual distributions from around $180,000 to $100,000. To keep his tax bill manageable in the meantime, some additional dollars needed before age 70 could come from selling securities, with capital gains taxed at lower rates than the ordinary income from the IRA.

The best time to start on such planning is before clients retire, says Maria Bruno, a senior investment strategist at Vanguard Group’s Investment Strategy Group.

Advisers who work with retirement savings say they also keep an eye out for people forgetting to take out money when required. Often these cases involve inherited plans, and the tax penalty is steep: In some cases, it is 50% of the amount that should have been withdrawn. Walter Pardo, a wealth adviser in Basking Ridge, N.J., is working with a family in which a young woman, now a 21-year-old college student, inherited an IRA upon her mother’s death in 2006 and didn’t start withdrawals as required.

Tying the Hands of Unreliable Heirs

Trusts are a common tool used to control a fortune for an heir who would fritter it away otherwise. But they involve some tricky decisions, professionals say.

Simple trusts can pay out enough income to keep a roof over someone’s head, while shielding a fortune so that it can grow. Or strings can be attached so that money is doled out based on behavior: The beneficiary must stay drug-free, for example, or get good grades in school.

Financial adviser Bo Blankenship, managing director of Greystone Financial Group, a MetLife Inc. agency in Roanoke, Va., believes the best approach is to get client, attorney and adviser together in a room to talk through the details. In one such meeting not long ago, a couple brought their 35-year-old son and heir, Mr. Blankenship recalls. The parents told the son he would not be able to tap his inheritance all at once, but would get an income. The son acknowledged his issues with money and accepted the arrangement.

Not every case works out so well. Parents sometimes set out to change behavior, rather than shaping a plan to a personality that may not budge. Incentive trusts, a tool that tends to go in and out of favor, can create resentment and also backfire. A requirement that a beneficiary stay in school, for example, might produce a perpetual graduate student.

Ms. Dale, a special writer for Dow Jones Newswires in New York, can be reached at arden.dale@dowjones.com.

Article source: Wall Street Journal

 

Stable is nice, but it isn’t perfect.

Investors in “stable-value funds,” which are bundles of bonds tied together with an insurance policy within a 401(k) retirement plan, have fared remarkably well in recent years. But rising fees, falling interest rates and reduced flexibility make the funds a bit trickier than some might realize.

While the stable-value category isn’t “hot,” it is definitely warm. According to the Aon Hewitt 401(k) Index, which tracks retirement plans with approximately $120 billion in assets, some $1.6 billion moved out of stock funds this year. Three-fourths of that went to stable-value funds.

These vehicles are attracting new money because of their safety. Whenever their market value falls below book value (typically $1 per share), the insurance enables anyone withdrawing money to receive the full book value plus interest.

Thus the funds protect against loss while providing steady income—appealing when the Dow Jones Industrial Average heaves up and down by hundreds of points a day.

Investors have known this for a long time. The funds, which have been around since the 1970s, hold more than $600 billion in assets, estimates Christopher Tobe of Stable Value Consultants in Louisville, Ky. Investors in 401(k) plans have more money in stable-value than in bond funds.

According to BrightScope, a firm that analyzes retirement accounts, nine plans with more than $1 billion have more than half their assets invested in stable-value funds. At DuPont, stable value makes up approximately 60% of its $8.2 billion in retirement-plan assets. Almost two-thirds of the participants in the plan are 55 or older and invest “with a conservative asset allocation stance,” says a spokeswoman.

Stable-value funds have proven their resilience. When Lehman Brothers failed during the financial crisis, its employees lost 1.7% in December 2008 on their stable-value fund. But the same fund still earned 2% for the full year. No other stable-value fund in a 401(k) fell below $1 or failed to deliver its promised yield, even as stock investors lost 37% in 2008.

There are a few concerns on the horizon, however.

First, costs are creeping up. “Wrap fees,” or the cost of the insurance, have gone from roughly 0.08% a few years ago to as much as 0.20%, says Gina Mitchell, head of the Stable Value Investment Association.

Those fees are rising even as yields are falling. The average “crediting rate,” or expected yield, ran at 2.99% in the third quarter, reckons the SVIA. That’s far higher than the 0.05% on the average money-market fund and exceeds the 2.4% yield on the Barclays Capital U.S. Aggregate bond index.

But the crediting rate has fallen by a quarter of a percentage point in the past year and is down from 4.05% three years ago—generating less income today, especially after inflation. Since the end of 2008, the yield on intermediate U.S. Treasurys has dropped to 0.82% from 1.25%.

And, just like homeowners’ insurance, stable-value coverage doesn’t eliminate every risk. “There are protections written into the contracts that could get the [insurer] out of the obligation to provide a guarantee,” says Mitchell Shames of Harrison Fiduciary Group, a financial firm in Boston. For example, if a company initiates massive layoffs or an external manager violates investment guidelines, the insurance provider could decline to make employees whole on their stable-value funds.

While employers work hard to insulate their funds against those hazards, says Mr. Shames, the risk of losing coverage remains a possibility. On the other hand, he says, “you get compensated for that risk in terms of the added return” over short-term bond funds.

And while it’s never been easy to exchange from stable-value options into other funds, restrictions appear to be growing more common as insurers seek to cut costs, says Peter Schmit, a research manager at Towers Watson, the benefits-consulting firm. Under “equity wash rules,” you can’t transfer straight from a stable-value fund to a money-market fund but must park your money in a stock fund (or sometimes a bond fund) for at least 90 days.

That could crimp your style if interest rates rise steeply. At the typical stable-value fund, the income credited to investors changes only quarterly. So, if rates go up, your income will stand pat for as long as 90 days, even as the yields on money-market and short-term-bond funds rise with higher rates in the marketplace.

The lag in adjusting to rate changes can “work against you on the way up,” says Susan Graef, whose group manages $28 billion in stable-value assets at Vanguard Group.

With these caveats, stable-value funds remain a solid option for conservative investors. But your expectations for these funds shouldn’t be stable; you should be lowering them.

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intelligentinvestor@wsj.com; twitter.com/jasonzweigwsj

Article source: Wall Street Journal

 

How will 401(k) investors react to the latest blast of volatility in the markets?

If the recent past is any guide, they will retreat into the apparent safety of cash, Treasury bonds and “stable value” mutual funds.

They also will put money into their own company’s stock, which can be far riskier than leaving it in a typical stock mutual fund.

WSJ columnist Jason Zweig discusses the hottest new investment in 401 (k)s: company stock, due to workers’s belief that their own company is one of the safest options available during choppy economic times.

In August, when the Dow Jones Industrial Average went bucking up or down by at least 400 points on six out of the month’s 23 trading days, investors pulled out of every variety of stock fund, according to the Aon Hewitt 401(k) Index, which tracks the daily transfers of some 1.5 million participants in retirement plans nationwide.

That movement wasn’t a tidal wave; investors moved about 0.5% of their total assets, or $580 million. Half of that went into bonds, but fully 23% landed in company stock.

Likewise, in September, when stock indexes slumped by 6% or more, retirement investors put a startling 35% of the money they pulled out of diversified stock funds into the shares of their own company.

But while investing in your company’s stock might feel safer than betting on the stock market as a whole, that is usually an illusion. The return of the overall market tends to be driven by a few big winners—and, if your own company doesn’t end up among them, you will miss out.

Brian Wenzinger of Aronson Johnson Ortiz, a money manager in Philadelphia, estimates that only 13% of the companies that made up the broad-market Wilshire 5000 index generated higher returns over the past decade than the index itself.

What’s more, you already work at your company; do you want your salary and your retirement fund riding on the same risk?

Hewitt, says investors are making this seemingly safe but potentially much riskier choice out of confusion and uncertainty. “The No. 1 response we get in [investment] surveys of employees is, ‘I don’t know what the right thing is to do in these markets,’” she says. So investors are moving more of their money extra-close to home. “It’s just an emotional thing,” says Ms. Hess. “They feel connected to their own company’s stock, so it feels safe and secure to them.”

That appears to be true even among people who, above all, should know better: the employees of big banks and brokerage firms, many of whom earn their living by advising clients not to put too much money in the shares of the companies where they work.

“It’s a pretty concentrated problem,” says Shlomo Benartzi, a finance professor and expert on 401(k) plans at the University of California, Los Angeles. “A few companies have lots of company stock, and ironically, employees at some financial-services firms have huge exposure.”

At the median 401(k) plan offering company shares, 12% of assets are in the employer’s stock, according to the Plan Sponsor Council of America. That is down by nearly half from a decade ago, although it tends to remain higher at larger employers—including many major financial firms, where workers are deep into company stock, according to public documents.

At year-end 2010, employees at Franklin Resources, the mutual-fund manager, had 14% of their 401(k) assets in the company’s own stock; at TD Ameritrade Holding, the discount broker, 15% is in the firm’s own shares; at Bank of America, 16%; at J.P. Morgan Chase, 19%; at both Charles Schwab and Bank of New York Mellon, 22%; Morgan Stanley, 24%; Wells Fargo, 29%; U.S. Bancorp, 32%.

At many of these companies, spokesmen say, allocations are high because the firms match—or used to match—their employees’ contributions with company stock rather than cash. If your company matches your contributions in shares of its own stock instead of cash or a diversified fund, you are likely to leave the money there. Through sheer inertia, dollars tend to stick where they land, in what economists have christened the “flypaper effect.”

At several big financial firms, the numbers have come down so far this year as the companies continue efforts to encourage workers to diversify.

Sometimes, however, the market forcibly reduces these exposures; with Morgan Stanley’s shares falling 48% this year, they probably make up less than 15% of 401(k) assets at the firm now. The bank’s employees have lost an estimated half-billion dollars on the stock so far in 2011.

If the latest market madness has you running for cover, find it in bonds or a blended “lifecycle” fund—not your company’s stock. And if your employer matches your contributions in its own shares, move them into more-diversified funds on a regular schedule whenever company stock exceeds 15% or so of your 401(k). Don’t let yourself get locked up too close to home.

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twitter.com/jasonzweigwsj

Write to Jason Zweig at intelligentinvestor@wsj.com

Article source: Wall Street Journal

 

Taking a loss is hard to take. But avoiding a loss can be much worse.

U.S. stocks have lost some $4 trillion since their peak in October 2007, but investors aren’t fleeing the market en masse. So far this year, according to investment-research firm Morningstar, investors have taken $14 billion more out of U.S. stock mutual funds and exchange-traded funds than they have added. That is less than 0.4% of the total assets of U.S. stock funds.

Can losing money feel good? Recent experiments show that reward circuits in the brains of investors who have losses will fire intensely whenever money-losing holdings have an uptick in price. Jason Zweig has details on The News Hub.

In other words, while some investors have taken their losses, most are grimly sitting on them.

That could be a mistake. Research published in 1998 by behavioral-finance professor Terrance Odean of the University of California, Berkeley, showed that individual investors are 50% more likely to sell a winning stock than a loser—even though, on average, the stocks these investors sell go on to outperform while those they hold onto underperform.

Why the reluctance to bail? Selling an underwater asset, says Mr. Odean, “isn’t primarily about economic loss, it’s about emotional loss.” Once you sell below your purchase price, he believes, you can no longer tell yourself, “I still made a good choice, and it’ll come back.”

Individual investors aren’t the only ones who can’t make peace with their losses, according to numerous academic studies. Mutual-fund managers who cling to losing stocks underperform, by roughly four percentage points annually, the managers who cut their losses.

Christophe Vorlet

While some investors have taken their losses, most are grimly sitting on them.

On average, professional futures traders and stock traders hurt their returns by clinging to their losers. Real-estate investment trusts hang onto properties that are losing money longer than they keep those that are in the black.

Unpublished research presented at the annual meeting of the Society for Neuroeconomics earlier this month sheds new light on this old problem. Neuroeconomics is an emerging field that combines the techniques of neuroscience with theories from psychology and economics to study financial behavior.

In one study, led by Gregory Berns of Emory University, people lay inside a brain scanner while deciding to hold or sell an investment; the price of the asset changed randomly up or down. The researchers focused on the ventral striatum, a region of the brain that has been shown to respond to rewards, particularly when they are unexpected.

When an asset was underwater and its price rose, activity in the ventral striatum of the typical person in the experiment was “blunted,” or insignificant, rather than robust. “Many of the participants told us they had hope for a rise,” says Andrew Brooks, a co-author of the study. Perhaps because these people got what they expected, an uptick in price “wasn’t surprising,” Mr. Brooks says, and therefore didn’t excite this part of the brain’s reward center.

That suggests that many investors who are losing money may automatically assume—rightly or wrongly—that their position is bound to recover.

Other research at the meeting pointed to a second flaw in how investors might think about losses. A study led by Camelia Kuhnen of Northwestern University found that people are much worse at estimating whether a bad investment will produce mild or severe losses than they are at predicting whether a winning investment will generate small or large gains. “Learning [about probabilities] is particularly faulty,” Prof. Kuhnen says, “when people are in a bad environment with losses left and right and they have their own money at stake.”

There are several steps that can help you dump your losers.

First, get a second opinion, from a financial adviser or an investor you respect, on your money-losing positions. Ask not whether you should sell the investments, but rather if they are worth buying at today’s price. If the answer is no, consider selling.

Measure how long you hold your losers and your winners. If you hang onto your money-losing positions much longer than your winners, then put yourself on a regular schedule of looking for losses to harvest. (You don’t have to wait until December.)

Taking a loss is easier when you think of it as a swap—in which you replace a loser with a new investment in a similar (but not identical) asset—rather than a sale. That makes taking action easier, since you aren’t forced to admit that your original judgment was a complete failure.

Finally, realize that a loser can change from a liability to an asset when you close it out at a loss, since you can use losses to offset up to $3,000 of ordinary income on your tax return.

“Think about the term ‘harvesting your losses,’” suggests Meir Statman, a finance professor at Santa Clara University. “That should put you in mind of strolling in an orchard picking ripe peaches rather than rotten losses.” Just be sure to check with your accountant to make sure the loss is worth taking.

Article source: Wall Street Journal