You Need a Financial House First

That person staring back at you in the mirror has a personal finance plan that is hard to argue with or ignore. Your reflection is probably suggesting to you what it suggested back at the turn of the calendar year: to save more, spend less and focus on getting your debt in line. Intimidated by what is obviously an imperfection in your financial life, you agree. Again. Something needs to be done.

Those mirror conversations are often forgotten as soon as you walk away from your own reflection. And with good reason. Only when you are looking directly at yourself do you see someone who has made these types of promises before. Once the two of you part ways, the reality of past decisions thwarts many of these well-intentioned pledges to do better. The question isn't what is better - that answer we know - it is more like how can you do better?

Improving your personal finances is much easier than you might imagine. So let's look at why your reflection is suggesting an overhaul in the first place. You can't avoid the idea that retirement or at least the time of retirement is closing in, often quickly. You can't dodge the fact that in order to retire at all, let alone comfortably, you need to set aside larger portions of your paycheck. No one has ever told anyone they are saving too much. Everyone, on the other hand will suggest that you and millions of others just like you, aren't saving enough.

In this scenario, they will tell you to max out your 401(k). To do this, the average American with the average paycheck in the average 401(k) can set aside $17,000. This number for this average person amounts to almost a third of their paycheck. And most will agree, this is an austerity measure that will not happen no matter how much the financial profession points out its wisdom. The over 50 crowd can toss another $5,500 into these accounts in order to play catch-up pushing the total contribution in this "maxed-out" situation to almost half of the average wage earners paycheck.

Knowing you are under-contributing often is the first roadblock in doing what you've told yourself you need to do. Resignation sets in and the next time you are in front of that reflection you quip: "I'll never retire" or "I'll just have to work longer". These will, without any argument help you achieve your retirement goals. But in suggesting that lengthening your work life is an adequate solution, you are subtracting from your retirement life. Think of it this way: If the speed limit is 55 mph and you drive 45, you will arrive at your destination; it will simply take longer as as you watch your fellow cohorts pass you, you will become discouraged and this will begin to weigh on the journey.

So forget the limits. Instead focus on the percentages: five percent (5%) of your paycheck contributed and producing a modest return will net you about 25% of the income you currently own, ten percent (10%) will get you about 50% of your current wage while fifteen percent (15%) will get you very close to 75% of what your current income is. Of course you will need to contribute and do so over a span of at least 20-years. But is much more do-able that the whole number that is the maximum contribution.

But even if that is do-able, as I suggest it is, something will have to give. A recent New York Life survey, done as they suggested, across the kitchen table, portrays the average American as someone who will try and manage their debt better. This is translated into spending less. Debt as we all know works against you in many different ways. More than simply spending what you don't have and exceeding what your paycheck brings, the cost of servicing that debt acts as a direct subtracting to that 15% and any return you might get in your plan.

So not only will you need to contribute more but at the same time, you will need to draw down that debt faster. What that reflection in the mirror is suggesting is often too austere for even the most parsimonious among us. Who looks at themselves in the mirror and says: "this year, I live on 30% less." While this might be excellent practice for the retirement you probably will experience, it is quickly dismissed.

Fourteen percent of those surveyed in the New York Life conversation with an agent revealed you will seek help. What you are doing is trading the reflection for a person who will tell you what you have told yourself. Of course this suggests that this financial professional has access to better tools to do what you have promised yourself to do. Ironically, they don't. For a fee, they will tell you what you already know.

Fear might be a motivator and many have taken to making these threats. But fear also brings a natural human reaction: to run in the opposite direction. Comparing where you are now with where you will be because you have done so little so far is a from of this fear. So is comparing you to your cohorts.

The simplest solution: 5, 10, 15. Contribute 5% to your retirement, 10% to your debts and 15% to your mortgage. A five percent contribution to your 401(k) will not impact your take home pay and will probably meet your companies matching contribution. A ten percent increase in payments to your debts will shave years and hundreds of dollars off of the interest you might pay. A fifteen percent payment towards the mortgage principal will reduce the length of your loan by as much as ten years. Doing this will have you arriving at the point of retirement with no debt and no mortgage.

Once the plan is in place and you have done this for five years, begin increasing the contribution by a single percentage point each year. This will be much easier to do as the debt you own is paid off and once the mortgage is satisfied, you will find your reflection congratulating you. This is far better than the criticism it once offered.

Melville's Mutual Fund Advice

There is a passage in Moby Dick where Ishmael reflects on the sight from the masthead. He could have been speaking to the world of investing in mutual funds as much as he was discussing the meditative sights below his perch. Melville writes that from that vantage “you stand, a hundred feet above the silent decks, as if the masts were gigantic stilts, while beneath you and between your legs, as it were, swim the hugest monsters of the sea… The tranced ship indolently rolls; the drowsy trade winds blow; everything resolves you into langour.” And from our desks we watch our investments swim below us, our mutual funds existing in a world of murky depth, and our distance providing perspective on how well they are doing and giving us, at the same time, no perspective at all.

Melville writes a cautionary tale with a well-known outcome. And as we enter the fourth quarter of what is turning out to be one of the more volatile years for investors, where advice on what to do has mostly proved wrong (move to cash, they said to avoid, as Melville writes “the universal cannibalism of the sea”) and to coin a nautical term “stay the course” has proved profitable. We set sail and hope for the best and yet are wary at every change in the investment weather while we worry about what swims beneath the surface.

Such events leave us wanting to gain some control over where we are and what we determined as the course we’ve set. No one enters the ocean of investment choices without wondering if the plot we have set in motion will be the right one. One of the monsters of the deep however may breach the surface of your calm sea and take back the adventure. This will happen if you are not careful. But even care may not help.

It is often recommended that you watch over your investments, periodically rebalancing and adjusting your portfolio to follow the course you may have set. You can, as many do in the final months of the year, increase our contributions to your 401(k)s and IRAs to grab the tax advantage. But that act might not turn out as expected; particularly when the funds you invest in may also be considering a chart change as well.

You can’t invest without considering the tax consequences. You invest, often in a pre-tax way to capitalize on the advantage your plan offers. And when you invest otherwise, you sell what you own to grab the gains you have made and if you are tax-savvy, sell the losers in order to offset those profits. But what if you have no losers? What if the year was good enough to book the profits? What if you are a mutual fund manager and those profits need to be sold despite your best efforts, to satisfy the redemption of less confident investors who may have heard the siren song of another investment opportunity?

Several things you need to consider in the coming months as you contemplate what to do with the investments you own. When Melville wrote: “We cannot live only for ourselves. A thousand fibers connect us with our fellow men; and among those fibers, as sympathetic threads, our actions run as causes, and they come back to us as effects” he was not writing about mutual fund investors and the thousand fibers that this sort of investment connects us to others like us.  Yet mutual fund investors simply can’t and in many instances, won’t consider the group as a whole when making investment decisions – and they shouldn’t. But what you do and how the fund manager reacts matters.

The fourth quarter as I mentioned is often the time when you consider changing your investment balance. And this consideration is often recommended. But the fourth quarter may very well be the worst time to do what would seem to be the right thing to do. The tax implications of selling shares in one fund and buying those of another may give you the very thing you don’t want: capital gains without the capital gain.

Investors looking to purchase shares in another fund might find the fund manager has the same motive: rebalancing. had you been in that fund for the whole year or longer, the capital gains is welcome. Enter the fund in the weeks prior to this event, and you get all of the taxable downside and none of the profit.

It isn’t s if this comes without a warning. A fund’s website will often estimate these distributions and your research (you do research right?) should give you reason to hesitate. What is often less clear, is the fund manager’s reason when it is due to redemptions. Redemptions in mutual funds trigger a series of events. The exiting shareholder must be paid and to pay them, something must be sold. When the redemptions are small, the event is almost unnoticeable. When the exits are packed however, the selling impacts the remaining investors. If it was good year, then gains are sold.

According to Christine Benz, Morningstar’s director of personal finance “The strong market rebound since early 2009 means that many funds now have more gains than losses on their books: In fact, fully half of the equity mutual funds in our database have positive potential capital gains exposure, meaning that they have gains on their books that they haven’t yet paid out to shareholders, and more than 200 stock funds have potential capital gains exposure of more than 50%.”

While a domestic mutual fund may have large profits that may or may not be realized before years end, some emerging markets and International funds will need to satisfy exiting shareholders in greater numbers than in years past. Many of the funds concentrated in areas like China, Brazil or even Latin America are on the small side. The smaller the fund, the greater the impact of an investor exodus. With Europe hanging in the balance, many small and mid-cap funds may find their ship sailing in choppier waters than the previous three quarters.

Of course, if you need to rebalance, do so. But do so with a word of caution. If you can wait, that would be wise and even prudent. But do your homework well in advance of any sudden changes. While you can’t time markets, you can time these distributions. And failing to do so could cost you dearly. As Melville points out: “Ignorance is the parent of fear…”