Robo-Advisors may be just what we need!

Should you really fear Robo-Advisors?

Reading financial news, you see many posts warning of robo-advisors, telling you how you really need a human advisor, how you can robo-proof your investment business, or how robo-advisors are merely a fad and will die off when everyone realizes how evil they are.

All these posts have it backwards. They are apologists for entrenched firms attempting to protect their turf when individuals need help.

Shift from pensions to 401(k) plans hurt individuals

Last century, many large employers provided pensions as a benefit. These were large portfolios that could hire good advisors and thus performed well. However, by the end of last century, retirement funds had shifted to 401(k) and similar plans, where individuals managed their own portfolios.

Institutional portfolios hire great managers so many are able to beat their various market indices. In contrast, individual investors historically achieve less than half the returns of their related indices.

Poor performance by individuals managing their own retirement funds is a key factor in the current crisis facing Boomers who are under-funded for retirement. (Note to Millennials: don’t just speak to your parents, do your own planning so this doesn’t happen to you!)

Why do individuals invest poorly?

Individual investors are seen as a contrary indicator:

  • If they are buying, then the market is near its peak and it is time to sell; and
  • If they are selling, the market has reached its bottom and it is time to buy.

Here is a case in point:

We saw the regret and pride response in action beginning in March 2000, the largest purchase of mutual funds in the history of the stock market. Fast forward to 2008, just before the “Great Recession” market downturn, and stock prices were falling, but investors refused to sell at a loss. As the market continued to fall, investors held off until they simply couldn’t take it any longer. Many sold their stock near the bottom and missed the following upswing that began March 2009. Forbes – Why average investors returns are so low.

To summarize, individual investors perform poorly due to these factors:

  1. Lack of access to good investment advice; and
  2. Investment psychology. For more on the psychological factors to which individuals fall prey, see Seven deadly sins of investing to avoid.

There is a third factor: High expenses in form of commissions and other fees.

Robo-advisors address all three factors. 

  • First, automating advice permits good advisors to offer services to small investors. Betterment with automated rebalancing and tax-loss harvesting is a good example.
  • Second, automation lowers costs, so fees charged can be reduced. Combine that with use of ETFs and you have dramatically reduced expenses.
  • Last, robo-advisors are immune to greed and fear so their performance will not suffer the way performance of individuals may. No robo-advisor would wait until the market hit bottom to sell, as in the case of 2008 summarized above.  

Bring on the Robos!

What is my conclusion? Not only are robo-advisors here to stay, they may be just what individual investors need so they can retire well!

7 things to do when starting a business to avoid nasty surprises

The only thing that hurts more than paying an income tax is not having to pay an income tax. Thomas Dewar

When you decide to start a business, taxes may be the last thing you think about. However, not realizing that you owe the self-employment tax as well as income taxes can lead to a nasty surprise when you file your taxes. This post is aimed at avoiding that costly surprise.

But, before we discuss the self-employment tax, there are other important steps to take when you become self-employed. Here are the 7 things to do after you start your own business to avoid nasty surprises:

Avoid nasty surprises – set up bookkeeping, form your entity, get licensed, buy insurance, and pay taxes

Bookkeeping – set up bookkeeping using software like QuickBooks (either online or on your laptop). You don’t want to be scrambling to find receipts at tax time or not be able to tell somebody if you are making money or not.

You can save time by downloading from your bank and credit card companies. If you set up things well, all income and every expense will be properly categorized for your profit and loss statement, or P&L. The P&L and balance sheet help you monitor your business to see how well you are doing and are essential for preparing your tax returns. The balance sheet will also come in handy if you need to apply for financing.

For all these steps, you may want to hire an accountant or speak to an attorney.

Entity – for many small businesses, being a sole proprietor is appropriate. You avoid paying corporate excise taxes and filing annual reports. However, if you have partners, you may want to form a partnership, corporation or LLC (details on choosing are beyond the scope of this post).

If your business involves risks that could lead to law suits, form a corporation or LLC to shelter your personal assets from liabilities of the business that insurance may not cover. Make sure that any actions you take for the business are in your capacity as an officer or manager – i.e., never sign personally.

Remember, you may want to consult with an attorney.

Get licenses, file annual reports and pay local taxes – certain businesses require a license to operate. Most entities are required to file annual reports. And, your city may impose taxes on the personal property in your business. Be sure to find out so you don’t owe penalties for failing to file and pay.

Buy health and other insurance – in addition to liability insurance, you will want to obtain health insurance if you are no longer working for another employer. You may get favorable treatment for this expense on your income taxes. You can also purchase insurance to cover damage to equipment, loss of data, identity theft and so on.

File payroll taxes – if you hire people to work for you and pay them over $600 per quarter in any year, you need to report the compensation. If they are independent contractors, you file a form 1099 with the IRS. If they are employees, you file a W-2 with the Social Security Administration. You also provide these forms to your people for the income tax filings.

You may need to withhold and remit FICA and Medicare taxes. Also, your employees may request that you withhold and remit federal and state income taxes (unless you live in a state that does not impose income taxes). Failure to withhold and pay to the IRS and state can lead to serious penalties.

Pay your income tax – one big shock for many who start a business is how much they owe in taxes. When you received a paycheck, you probably did not focus much on the fact that your employer withholds federal and state income taxes and FICA and Medicare taxes. And, you never had a chance to spend what was withheld.

However, when you run your own business, you have full access to the pre-tax income, so you must diligently allocate funds ahead of time so that you don’t come up short at text time. To avoid owing interest on the taxes due, you make estimated tax payments each quarter to the IRS and state.

Pay the self-employment tax – when you were an employee, your employer withheld FICA and Medicare taxes from your paychecks. The employer also contributed FICA and Medicare taxes on your behalf

When you become self-employed, you are responsible for both the employee and employer amounts. This tax is based on your net self-employment income

A lot to remember, right?

Maybe, but knowing and planning is far better than trying to scrape together money in April to cover taxes you did not expect.

Good luck with your new business!

In future posts, we will examine partnering with others, assessing your profitability, rules on deducting expenses, and entry into the real estate market.

 

Before you take advice on your finances, ask this question

As I review posts for our sister website on financial literacy, this seemed to be a great post to repeat:

If you want financial advice, before listening to someone, ask yourself one simple question:

“If I’m not paying this adviser, who IS paying them?”

If you don’t know the answer, you may have a problem.

Think about it ….

“Simplify your finances? No; “Gain control, understand your finances?” Yes

After reading a recent article in Kiplinger’s Finance Magazine  on simplifying your finances, I wondered if your personal finances can really be made simple.  While many of us may hope so, I am not sure that “simple” is best.

However, gaining control of your finances and gaining a better understanding do make sense.

clutter-286975_1920 Okay, that does need to be simplified!

Here are some ways that help you gain control that may also “simplify” your life:

Cash management and Debt management

Set up automatic payments with vendors so they use your bank or credit card, or set up payments using your bank website.

  • If the payments are regular, and of similar amounts, you save time and can plan on the withdrawals.
  • However, if you change banks, sorting and resetting auto-pay at the new bank can be a major headache. Similarly, if you change credit cards, you need to update information with all vendors.

You can also automate tracking of your spending by using websites like Mint or Personalcapital.  Or, you can use Quicken or QuickBooks software from Intuit to track your bank and credit card accounts.  You can download from your bank and credit card websites into the program and then review to analyze your cash flow and spending.

Setting up direct deposit for payroll into your checking is great.  You can also split part so it goes to savings or even have some go to your investment accounts.  You will then need to follow up to invest the cash that accumulates, but having money set aside saves it from being spent, and adds to your investments

Investing

Kiplinger’s recommended consolidating retirement accounts to avoid low balance fees.  It also makes updating beneficiary designations easier.

While avoiding fees makes sense, am not sure that putting all investments into a single retirement account does.  You cannot do this if you have Roth and pre-tax accounts like a 401(k) plan, and you probably should not do it if you have contributory IRA and 401(k) accounts that are subject to different tax rules.

Kiplinger’s also recommended using one broker for your taxable accounts.  This makes more sense, in that you have a higher balance which should mean lower fees and more attention from the broker.  However, I prefer using exchange traded funds, or ETFs, and avoiding most broker fees, which means essentially no attention from a broker.

One article said that your investment plan should be to “sign up and forget it.”  While avoiding investment pitfalls like second-guessing yourself out of panic when a fund goes down is good, I do think you need to review and rebalance your investments once a year.

Another article recommended using an “all in one” fund for investing.  Now, this really troubles me.  If your sole goal is retirement, then an age-targeted fund could make sense.  But, if you are saving for goals with different time horizons, this is a bad idea.

If you use an age-targeted fund, do your homework on the funds.  For example, if the fund plans to suddenly shift to bonds when you retire, that will not serve you well because you are likely to have several decades for which you will need the growth from stocks.

Protecting your information

Having a master password for access to all your other passwords reminds me of the joke about the student who repeatedly distilled his notes down, first to an outline, then to note cards, and finally to one word.  How did he do on the day of the exam?  He forgot the word.

Nonetheless, having passwords is clearly important so having a way to manage them is as well.  Check out this recent review of apps for managing your passwords PC Magazine Best Password Managers for 2015.  You can manage the passwords yourself by creating a document that you save as a PDF and then encrypt.  But don’t forget the password you used for the PDF!

Store files in one place

We did a post on using cloud storage when you do not need originals.  Here is another site to check out:  Shoeboxed

Credit cards

In addition to downloading transactions as noted above, you can track your credit score and credit history by using sites like Credit Karma

Estate planning

For insurance purposes, and for your estate plan, having a record of possessions, you can list all your property using sites like Know your stuff home inventory.

Conclusion?

There are ways to gain better understanding of your finances that also make your finances simpler.  But setting simplification as your primary goal risks distorting your finances – too simple may be a bad result.

P.S. Our sister website, www.wokemoney.com, encourages you to gain a better understanding of your finances so you can handle your own planning.  Let me know what you think.

Young people, don’t let this happen to you. Plan for retirement now!

Young people, a.k.a. “Millennials,” have the time horizon that should allow them to save well, and thus avoid the need to save much more in later years. Otherwise, they will end up like those now nearing retirement that Theresa Ghilarducci describes in her 2012 article on retirement:

Seventy-five percent of Americans nearing retirement age in 2010 had less than $30,000 in their retirement accounts. The specter of downward mobility in retirement is a looming reality for both middle- and higher-income workers. Almost half of middle-class workers, 49 percent, will be poor or near poor in retirement, living on a food budget of about $5 a day. See Our Ridiculous Approach to Retirement.

Acting now is crucial, but what do you do?

Step 1 – As a Millennial, accept that you need to start saving now and commit to acting. For encouragement, remember that:

The 35-year-old would need to boost her contribution rate to 9 percent to achieve the same result as the 25-year-old starter who was saving 6 percent. (from Retirment Saving for Young People) See You can Ignore Most Financial Planning Rules.

Step 2 – Identify how much you need to save by using a retirement calculator. There are many calculators you can use – see what we listed in The results from retirement calculations on different websites vary. Why?

Step 3 – Follow this hierarchy for how to set up accounts for your savings:

Start with your employer plan, 401(k), 403(b) or if you are self-employed, SEP-IRA. The contributions you make to a 401(k) or 403(b) are made from payroll deductions, so you never get a chance to spend this money. The deductions reduce your taxable income now, so the government is effectively helping you to save. Also, the amounts invested grow “tax sheltered,” meaning that you pay no tax on any interest, dividends and capital gains. However, when you retire and withdraw from the plan, you are taxed on that amount as regular income.

If you save more, use a Roth IRA next. Set up an auto debit from your checking to fund your Roth IRA, so contributing works like payroll deductions. The amount contributed to a Roth IRA is not deductible, but amounts withdrawn at retirement are not subject to income tax. The amounts invested grow tax sheltered.

Finally, if you still need to save more, set up a “taxable account,” meaning an account with no tax sheltering benefit. You can use auto-debit to add to this account.

Note: for the Roth IRA, you must qualify and have earned income from which to make contributions to the account. Also note that, for any of these tax sheltered plans, withdrawing funds before age 59½ may subject you to a 10% penalty in addition to income taxes, so do not fund any plan when you expect to need withdraw the money before retirement.

Step 4 – Invest. And when you invest, stick to the plan you set in place (this cannot be over-emphasized). The time to retirement is decades away so you can afford to take risks, some of which will take many years to pay off. If you panic and sell, you only lock in a loss; but if you weather the ups and downs, you will be far ahead. (see Don’t Let This Happen to You, Plan for Retirement Now)

Creating an asset allocation, where you diversify among stocks, bonds, real estate and cash. Include large cap, mid-cap and small-cap stocks, as well as international stocks. You man also include invest in real estate investment trusts (“REITs”) and hard assets. You can use exchange traded funds (“ETFs”). The low fees of ETFs leave more invested to grow, compared to high fee and load funds.

If you on-going advice, you may want to check out alternatives such as LearnVest and the new Future Advisor website.