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Protecting Your Private Files

For somebody who makes a living online, I’m decidedly low-tech. I just got a scanner for the first time a couple weeks ago, and I’ve been scanning and shredding all my paper documents like tax returns, health insurance statements, and so on.

The downside of scanning such private documents and storing them on your hard drive is that they’re not safe. If your computer dies unexpectedly–or, worse, if somebody steals it–you’ve got a problem.

Fortunately, there’s an easy (and free) solution. (Hat tips go to personal finance blogger Nickel and the members of the Bogleheads forum for their help.)

Dropbox

Dropbox is a free service that allows you to store files online. I’ve been using it for quite a while now, and I’m very happy with it.

When you install Dropbox, it creates a folder on your computer that looks and works just like any other. That folder, however, is linked to your Dropbox account. When you save something in that folder, it automatically saves it online as well. And if you’ve linked other computers to your Dropbox account, it automatically updates the version of that file that’s saved on those other computers.

The problem with using Dropbox to store files with sensitive information is that there’s no option to password-protect the Dropbox folder on your computer. If somebody stole your computer, anything in that folder would be immediately accessible to the thief.

Enter Truecrypt

Truecrypt is a free encryption program. It allows you to create a “volume,” which is essentially an encrypted (password-protected) folder for storing files you’d rather keep private.

To the naked eye, your Truecrypt volume doesn’t even look like a folder. It just looks like a file with no file type (which you’ve ideally named something very unimportant-sounding) that gives a rather unhelpful error message when somebody tries to open it.

But when opened via Truecrypt (and using the appropriate password), the volume opens and works just like any other folder on your computer.

Truecrypt + Dropbox = Happy Storing

So, by creating a Truecrypt volume that holds all your sensitive files, then saving that volume in your Dropbox folder, you’ve backed up your important files online while at the same time keeping them safe from malicious users.

A few final notes:

  • Dropbox’s normally lightning-fast upload speed slows to a crawl on large transfers, so be prepared to wait patiently if your Truecrypt volume is a big one.
  • Dropbox isn’t necessarily the only solution. I’m sure there are other online storage services that would work equally well–perhaps even better.
  • Nor is Truecrypt the only solution. There are several high quality free encryption programs.
  • Truecrypt isn’t exactly intuitive to use. Fortunately, the online user manual has a super step-by-step walk through.
  • Be sure not to lose your Dropbox password or the password to your Truecrypt volume.

Your Personal Rate of Inflation

The Consumer Price Index (specifically, the Consumer Price Index for All Urban Consumers) is the most common measure for inflation. But when attempting to predict how your own spending will change throughout the course of retirement, there are two reasons that historical CPI figures might not be a perfect predictor:

  1. Future changes in CPI may not be similar to past changes in CPI, and
  2. Your rate of spending change doesn’t necessarily match that tracked by the CPI.

What Does the CPI Track?

The CPI measures a specific bundle of goods, as determined by a survey of several-thousand families regarding their spending habits. Per the Bureau of Labor Statistics’ website, the following categories are included in the calculation. (Note: The items provided in each group are just examples. They’re not the only goods measured in that group. For the full list, see page 11 of this pdf.)

  • Food and Beverages (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)
  • Housing (rent of primary residence, owners’ equivalent rent, fuel oil, bedroom furniture)
  • Apparel (men’s shirts and sweaters, women’s dresses, jewelry)
  • Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance)
  • Medical Care (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
  • Recreation (televisions, toys, pets and pet products, sports equipment, admissions)
  • Education and Communication (college tuition, postage, telephone services, computer software and accessories)
  • Other Goods and Services (tobacco and smoking products, haircuts and other personal services, funeral expenses).

Those may not be the goods that you spend money on. For example, as somebody who doesn’t own a car, doesn’t use any prescription drugs at the moment, doesn’t smoke, cuts his own hair, and has a rather unusual diet (vegetarian, gluten-free), the CPI isn’t exactly a perfect fit for my own spending habits.

Of course, you may look at my spending choices and think, “Wow, what a weirdo!” But that’s the point. We all spend money on different things.

Even if you do buy most of the goods/services tracked by the CPI, it’s entirely possible that your allocation between those goods/services is significantly different from the allocation used to calculate the index.

Consumption Changes vs. Price Changes

When attempting to determine how much income you need in retirement, it’s also important to remember that your consumption might change, not just the prices of the things you buy.

For example, the price of prescription drugs might increase by 5% per year, but if the rate at which you’re taking them is doubling every five years, then your own prescription drug spending will be growing faster than the rate of change that’s reported by the CPI.

Predicting Your Personal Rate of Inflation

My point here is not that the CPI is useless or that it’s way off base for everybody. Neither of those statements is true. But there is a chance that it won’t align very well with your own rate of spending change.

If you want the most precise answer possible as to how your spending will change over time, my suggestion would be to:

  1. Track your current spending (broken down by category),
  2. Do your best to estimate how your rate of consumption will change for each category, then
  3. Try to estimate how the prices for each category will change.

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Roth Conversion Math

When deciding whether or not to convert a traditional IRA to a Roth IRA, many investors overlook the fact that the goal is not to minimize the amount of tax dollars paid. Rather, the goal is to maximize the ending value of the portfolio.

What Am I Talking About?

Let’s consider a simplified example. Imagine that an investor has a choice between paying a 25% tax on her portfolio right now or in three years. And let’s say that her portfolio earns the following annual returns over those three years: +8%, +17%, +20%.

  1. If she pays the tax right now, the math will look like this: Ending value = beginning value x 0.75 x 1.08 x 1.17 x 1.2.
  2. If she pays the tax at the end, the math will look like this: Ending value = beginning value x 1.08 x 1.17 x 1.2 x 0.75.

Note that, due to the commutative property of multiplication, the ending portfolio value is the same in either case–even though the investor will pay more tax if she selects option #2 (because her portfolio value will be higher at the time she pays the 25% tax).

The same analysis applies for Roth conversions: The amount of tax paid doesn’t matter. What we care about is the ending portfolio value.

Roth Conversion Scenarios

Admittedly, this is something of an oversimplification, but Roth conversions can be roughly broken down into three scenarios:

  1. You plan to pay the tax on the conversion out of the IRA (rather than with money from a taxable account), and you’re over age 59.5
  2. You plan to pay the tax on the conversion out of the IRA, and you’re under age 59.5, or
  3. You have enough money in taxable accounts to pay the tax without having to use money from the IRA.

Paying the Tax from the IRA

In the simplest scenario–the one in which you’re paying the tax on the conversion out of the IRA and in which you’re over age 59.5 (such that there’s no penalty for doing so)–things work out like this:

  • It’s a wash if you expect your tax bracket to stay the same. The commutative property of multiplication tells us that multiplying by, say, 0.75 now as opposed to multiplying by 0.75 later makes no difference.
  • It’s a good idea if you expect to be in a higher tax bracket later.
  • It’s a bad idea if you expect to be in a lower tax bracket later.

In the second scenario–in which you’re under age 59.5 and paying the tax out of the IRA–things become slightly more complicated. We have to account for the 10% early withdrawal penalty. For example, if you’re in the 25% tax bracket and you convert a $40,000 IRA and withdraw $10,000 to pay the tax, the 10% penalty will be charged on that $10,000.

End result: You need to expect a higher tax bracket in retirement in order for it just to be a break-even decision. (Specifically, your retirement tax bracket must be at least 1.1-times your current tax bracket for it to make sense.)

Paying the Tax from a Taxable Account

In the third scenario–in which you’re paying the tax out of taxable funds rather than out of the IRA–things get trickier. We have to make assumptions about the after-tax rate of return that will be earned (if you choose not to convert) on the money that would otherwise have been used to pay the tax.

That said, in this last scenario, things usually (though not always) work out like this:

  • If you expect your tax bracket to remain the same, there’s a benefit to converting. It’s essentially a way to use non-tax-advantaged money to increase the size of your tax-advantaged accounts.
  • If you expect your tax rate to increase, converting is a good idea.
  • If you expect your tax rate to decrease, converting is likely (though not necessarily) a bad idea.

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How Much Income Will You Need in Retirement?

Longtime Oblivious Investor reader Larry recently pointed me to an article from Kiplinger in which the author suggests that people save 10.6-times their annual salary before retiring.

Statements like that drive me crazy.

It makes no sense to make retirement savings suggestions in terms of years of income. Rather, we need to measure in terms of spending.

For example, consider two investors, both starting to approach retirement age:

  • Investor A has a $65,000 annual income, and he is saving $5,000 per year.
  • Investor B has a $65,000 annual income, and she is saving $15,000 per year.

In order to retire without a change in living standard, Investor A needs to fund $60,000 in annual spending, while Investor B only needs to fund $50,000. (We’re ignoring taxes for the moment.) In other words, Investor A will need 20% more money saved than Investor B, even though their incomes are the same.

The suggestion that the two investors should each save the same amount of money (10.6-times their annual income) either understates A’s need for savings, overstates B’s need for savings, or both.

The Best (More Time-Consuming) Approach

The best approach to projecting your retirement spending is to go through your last year of bank statements, credit card statements, and pay stubs, tallying up your current spending in each budget category (food, medical, housing, etc.). From there, you can do your best to estimate how each spending category will change as you move into (and through) retirement.

The Quick and Dirty Approach

I know from experience, however, that many people don’t want to take the time to do the above analysis. In that case, I’d suggest at least doing the following calculation:

  1. How much did you earn last year (net of taxes)?
  2. Subtract the amount you saved over the course of the year. (Not the change in your account values, just the amount you actually put into those accounts.)
  3. Subtract the amount of debt you paid off.
  4. Add the amount of new debt that you took on.

The total is how much money you spent over the last year. Again, from there, you should do your best to estimate how each category of spending will change as you move into (and through) retirement. (Naturally, this is somewhat less precise than it would be if you had the category-by-category spending totals provided by the more thorough method described above.)

Then, once you know how much you expect to spend each year in retirement, you can start the process of determining how much money you need saved for retirement.

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  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

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Emerging Market Risks

A few days ago, I received what I thought was a great question from a reader:

“Why are emerging market funds said to be risky? It seems to me that with countries like China or India, it’s a low risk bet that their economies will grow. It hardly seems like there’s any more uncertainty over there than there is right here at home in the U.S.”

Growth is Already Priced-In

As we discussed on Monday, every company’s stock price already includes the market’s estimate for that company’s future growth in earnings. And, therefore, the same thing is true for any particular group of stocks (such as the stocks that make up an index representing the Chinese stock market)–expected growth is already priced in.

So the risk is not that the companies in the index will not grow. The risk is that they will grow more slowly than expected.

Emerging Market Risks

And when attempting to guess the growth rate for a company in an emerging market, there are a handful of factors that cause significant uncertainty.

Accounting risk: In the U.S. and other developed markets, accounting standards are very well defined. Each transaction is recorded in a prescribed way (or one of a few ways), and financial statements are presented according to a very specific set of rules.

In contrast, in many emerging markets, accounting standards are not as thorough–the result being additional uncertainty as to the quality of information contained in a company’s financial statements. Naturally, this makes it even more difficult than usual to predict a company’s rate of growth.

Political risk: In emerging market economies, the governments themselves can often be less stable. If a country’s government is overthrown or one dictator is replaced with another, it’s nearly impossible to predict the fate of any particular company in that country. For example:

  • Will that company’s industry be popular with the new government, thereby receiving government support such as subsidies?
  • Or will that industry be unpopular, thereby incurring new taxes and fees?
  • Or will the new government nationalize the industry, thereby forcing out private owners completely?

Lack of regulation: Our regulatory system is imperfect, no doubt about it. But we have it good compared to countries in which bribes and corruption are an everyday part of the regulatory environment. Just like the accounting risk mentioned above, lack of regulation makes it more difficult to place trust in a company’s financial statements, thereby making it more difficult to accurately predict growth.

Currency risk: As with any international investment, there’s the risk that, even if it performs well, your dollar-denominated returns will be reduced as a result of that country’s currency decreasing in value relative to the U.S. dollar.

Historical Volatility

To the extent that risk can be represented as the volatility of returns, emerging markets stocks have definitely shown higher risk than U.S. stocks. (For example, Morningstar’s “risk” page shows significantly higher volatility of returns for Vanguard’s Emerging Markets Index Fund than for their Total Stock Market Index Fund.)

Should You Invest in Emerging Markets?

Despite the above warnings as to the high-risk nature of emerging markets, I don’t think it’s a bad idea to allocate a portion of your portfolio to them. Approximately 10% of my own portfolio is in emerging markets (via Vanguard’s Total International Stock Index Fund).

I just think that it’s important to know what you’re getting yourself into. 🙂

Stocks or Mutual Funds: Which Should I Buy?

Ask a beginner-level investor what investing is about, and you’re likely to get an answer to the effect of, “Buying stocks of companies that are likely to grow quickly.”

That’s understandable, since it’s the lesson one might gather from much of the mainstream financial media. But that description is way off base for two reasons:

  1. It’s important to own investments other than stocks (most importantly: bonds), and
  2. There are very few circumstances in which it makes sense for an individual investor to own individual stocks rather than mutual funds.

The reason it’s (usually) such a bad idea to own individual stocks is that it results in more risk without (in most cases) the expectation of higher returns.

Why Are Individual Stocks Riskier?

This is the easy question. The more of your portfolio you have invested in any one company, the more risk you’re exposed to. Nothing hard to understand about that.

By investing in a broadly-diversified mutual fund (for instance, Vanguard’s Total Stock Market Index Fund, which includes over 3,000 different companies), your portfolio will be exposed to far less company-specific risk than if you own just a handful of individual stocks.

Why Is it Hard to Pick Above-Average Stocks?

This is the question many investors struggle with. Many people are unaware of the fact that there’s more to picking winning stocks than simply finding companies that will experience above-average growth.

At any given moment, a company’s stock price already includes the market’s best estimate of the company’s future growth. So a stock’s performance isn’t a function of how quickly the company grows. It’s a function of how the company’s growth compares to its expected level of growth.

In other words, picking an above-average stock does not mean finding a company that’s going to grow quickly. It means finding a company that will grow more quickly than the market expects it to.

And that’s no small task. The market is made up of millions of individual investors as well as a small army of highly-intelligent, specifically-trained professionals whose sole job is to estimate such growth figures. It’s silly for most individual investors to think that we can reliably outsmart such a massive collection of data and intelligence.

When Might It Make Sense to Own Individual Stocks?

Despite all of the above, there are a few scenarios in which an investor would want to own individual stocks. For example:

  • Your company’s retirement plan gives you shares of company stock, and you’re not yet allowed to sell it (or you’re holding it to take advantage of the Net Unrealized Appreciation rules), or
  • You’re looking to do something other than maximize your returns for a given level of risk. For example, you derive an entertainment benefit from picking stocks or a self-actualization benefit from buying the stocks of companies that do things you morally approve of.

But for most investors, there’s no reason to own any individual stocks whatsoever. Doing so just increases the risk in your portfolio without increasing your expected return.

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