Archives for February 2014

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Automating Investing with an Unpredictable Income

A reader writes in, asking:

“For most of my adult life, I have made automatic contributions to my IRA or retirement plan at work. Pay yourself first as they say. But now I have a job with unpredictable income. Do you have suggestions for automating investing in such circumstances?”

Because my wife and I are both self-employed, we have an unpredictable income as well. The reality is that, if your income varies significantly from one period to the next, you cannot truly automate your investing — otherwise, at some point, you’ll end up investing more than you can really afford to invest. (Or, to avoid that, you’ll lowball the automatic investment amount, such that you’ll still need to make manual contributions in order to meet your goals, which largely defeats the purpose of automated investing.)

Because we cannot automate the contributions themselves, what has worked for us is to come as close as possible to having an automated process. Specifically:

  • Having a regular schedule for making retirement account contributions, and
  • Having a precisely-defined way to calculate how much we can invest, so that we’re not just making it up each month.

Have a Regular Schedule

It is helpful to have a specific day on which you will calculate and make your contribution each month. For us, it’s the day after the day on which we get paid by Amazon (Amazon being our largest source of income). By picking the day immediately after our largest source of income shows up, we come as close as possible to the “pay yourself first” idea — investing money before we get the chance to spend it.

Creating an automatic reminder email in Google Calendar (or other similar application) can be helpful to make sure you don’t forget.

Know How to Calculate Your Contribution

The other important part of the process is to know exactly how to calculate the amount you can invest. To do that, you first need to know exactly how much you want to leave uninvested (e.g., for an emergency fund plus regular operating expenses).

We have an Excel spreadsheet that we use to calculate our currently-available uninvested money. That is, it calculates the sum of our checking account balances and other safe, liquid sources of money, if applicable (e.g., savings accounts). Then it subtracts each of the following:

  • Credit card balances (we pay them off every month of course, but because the payoff dates don’t coincide with the date on which we calculate and make our retirement account contributions, there are balances that we need to account for at that time),
  • Current estimate of tax liability accrued year-to-date. Early in the year, for lack of any better information, I base the estimate on last year’s tax. For example, in February, the amount used in the calculation would be 2/12 of last year’s total tax figure. In March it will be 3/12 of that amount. In April, it will be 4/12 of that amount, minus the estimated tax payment we will have made by that point.
  • Any other significant expected liabilities that wouldn’t fall under normal monthly spending (e.g., a trip, if we’re currently planning one).

We then compare the total to the target amount to see how much we can invest. Then we make our retirement account contributions accordingly.

The Higher Your Income, The More Obliviously You Should Invest

Mike’s note: While I do not ordinarily publish guest articles, I recently invited Jim Dahle to write something for Oblivious Investor readers, and he was kind enough to oblige, with the following article.

A recent article by Tadas Viskanta, discussing a book entitled Scarcity: Why Having Too Little Means So Muchpromotes the idea that we all have limited psychological “bandwidth.” Much like your computer runs slower when you’re running a dozen programs in the background, so does your mind and life run more poorly when your bandwidth is heavily taxed.

One method of “freeing up bandwidth” is to put your investing plan on autopilot — to invest “obliviously,” as Mike frequently discusses on this blog. Doing so frees you from having to worry about picking stocks, watching active mutual fund managers for the inevitable downturn, evaluating “alternative” investments, and timing the market. As Michael LeBoeuf famously said, “Invest your time actively and your money passively.”

Aside from freeing up bandwidth, a simple investing plan also frees up a great deal of time. My life, for example, became abnormally busy recently. I normally work as an emergency physician full-time and also run an increasingly busy website/blog called The White Coat Investor, where I help doctors and other high income professionals get a “fair shake” on Wall Street. However, in addition to these two jobs, I recently wrote and self-published my first book, The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing.

Becoming busier was a very gradual process, but I finally realized I had simply run out of bandwidth. The final straw was when I took my laptop to work one night in the hopes that if the Emergency Room got really slow, perhaps I could deal with some of the 50 or 100 emails I had received that day. As those of you who have had the misfortune to visit an ER are probably well aware, it isn’t exactly a slow-paced job. When your life gets so busy that a job in an ER is the only place left from which you can steal some time in order to balance everything else out, you know you’re in trouble.

When you run out of bandwidth, something has got to give. You don’t want it to be your family or your career. Putting your investment portfolio on autopilot is not only likely to lead to higher long-term returns, but also frees up valuable bandwidth for you to use in the rest of your life, on things that really matter.

High-income professionals like doctors, lawyers, and business owners are even more likely to benefit from an oblivious investing plan than someone in a more typical career field, because their time can be used to generate money at a very high rate. It makes little sense to spend hours trying to eke out a little extra return on the portfolio when those hours could be better spent simply earning more money and increasing the amount contributed to the investment account — especially early in the career when the portfolio is small and the business is growing.

Some choose to hire an investment manager in order to free up this time and bandwidth. That is certainly a reasonable option, if you use a low-cost adviser who uses a smart investing strategy. But choosing a simple, low-cost investing strategy and putting it on autopilot will not only cost you less time and money, but counterintuitively, may also lead to better after-expense portfolio returns in the long run. The higher your income, the more obliviously you should invest. You can spend that time and bandwidth better elsewhere.

Treasury Floating Rate Notes

A few readers have asked about the new Floating Rate Notes (FRNs) that the Treasury began issuing last month and how they work.

In short, they’re Treasury bonds with a 2-year maturity and with an interest rate that adjusts over time (as opposed to most bonds, which have fixed interest rates). Specifically, the interest rate on Treasury Floating Rate Notes is calculated as:

  • The rate on the most recent issue of 13-week Treasury bills (which will change every week, since new bills are issued every week), plus
  • A spread that is determined (via auction) when the Floating Rate Note is issued (and which does not change over the life of the FRN).

For example, the first issue of FRNs has a spread of 0.045%. To this we add the rate on the most recent issue of 13-week Treasury bills (0.041%), to get a current interest rate of 0.086%.

As you can see, these new debt instruments have a very low yield. And there’s a reason for that: They’re very low-risk — less risky, even, than typical 2-year Treasury bonds.

Interest Rate Risk (i.e., Price Fluctuation)

With most bonds, the reason that their market value fluctuates over time is to make the bonds competitive (i.e., desirable to buy or sell) relative to new issues. For example, if you own a Treasury bond that you purchased in a period of lower interest rates, nobody would buy it from you unless you sold it at a discount (i.e., the value of the bond has gone down because rates have gone up). Conversely, if you have a bond that you purchased in a period of higher rates, the only way somebody could convince you to sell it would be to offer you a premium (i.e., the value of the bond has gone up because rates have gone down).

Floating Rate Notes, however, have an interest rate that adjusts along with market interest rates. As a result, their price does not need to fluctuate as much in order to keep them competitive with new issues. In other words, they will experience less price volatility than regular 2-year Treasury bonds. (And regular 2-year Treasury bonds already experience only a modest degree of price volatility due to their short duration.)

Inflation Risk

Treasury Floating Rate Notes are nominal bonds. That is, unlike TIPS or I-Bonds, they do not have a built-in inflation adjustment, so they are exposed to some inflation risk. That said, their exposure to inflation risk is about as low as you can get for nominal (i.e., non-inflation-adjusted) bonds.

When it comes to nominal bonds, owners of short-term bonds are less exposed to inflation risk than owners of long-term bonds. That’s because, in periods of significant inflation, interest rates will tend to increase. And the sooner your bonds mature, the sooner you’ll be able to reinvest your money at those higher rates.

FRNs are even safer than regular short-term bonds in this regard though, because in the event that inflation and interest rates spike upward, you don’t even have to wait for your FRN to mature take advantage of the higher rates. Instead, your Floating Rate Note’s interest rate will adjust every week when new 13-week Treasury Bills are issued.

In Summary

In summary, the new Treasury Floating Rate Notes are quite low-risk in terms of default risk, price volatility, and inflation risk. And they have the super-low yields that you would expect from such a low-risk investment.

Investing Blog Roundup: Celebrating the Bogleheads (Especially Taylor)

The neatest thing I read this week isn’t really a useful piece of information. It’s just plain neat.

The Bogleheads forum (named after Jack Bogle, the founder of Vanguard), is hands-down the best online community for investment-related discussions. One of the founding members of the community, Taylor Larimore (who, after more than a decade, is still one of the most active/helpful participants) recently celebrated his 90th birthdayAmong the many tributes shared on the forum was a poem written by Jack Bogle himself:

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Thanks for reading!

MyRA: Not “Like a Roth IRA.” It IS a Roth IRA

Based on reader emails, it appears that there’s still a lot of confusion about myRAs.

As far as I can tell, the primary source of this confusion is the fact that many media sources are reporting that myRAs are a new type of retirement account that is “similar to a Roth IRA.” At least from a tax perspective, this is not true. From a tax perspective, they’re not a new type of retirement account. Nor are they “similar to” a Roth IRA.

MyRAs are Roth IRAs.

Here it is in the Treasury’s own words:

“The [myRA] retirement savings account will be a Roth IRA account and have the same tax treatment and follow the rules of Roth IRAs.”

It’s hard to be more explicit than that. (For confirmation, see this Treasury fact sheet or this White House press release that also state that the accounts will be Roth IRAs.)

This distinction is important because it helps to answer many of the questions that people are asking about these accounts. For instance, for a given tax year, no, a single person cannot contribute $5,500 to a myRA and $5,500 to an IRA elsewhere.

So what’s newsworthy about the myRA?

There are some reasons why the TreasuryDirect “myRA” Roth IRA is newsworthy. Specifically:

  • These Roth IRAs will offer access to an investment option previously available only to federal employees — the Thrift Savings Plan G Fund (and this is in fact the only thing that you can own in these accounts),
  • Once a “myRA” Roth IRA reaches $15,000 or has been open for 30 years, you must roll it into an account elsewhere (e.g., a Roth IRA at your brokerage firm of choice), and
  • Employers will be able to make direct contributions to these Roth IRAs on behalf of employees.

But, from a tax perspective, these are just plain-old Roth IRAs.

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