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Submitted by: Christopher Currin
Many of us enter the New Year like Ebenezer Scrooge, haunted by the Ghost of Christmas Past. Even if you pay off the balances on your credit cards most of the time, your plastic may feel more like iron chains the first months of the year. Here are some ideas that can help you keep a clear perspective on personal debt and take decisive actions to keep high-interest revolving debt from wrecking your finances.
The first key to debt management is controlling your spending. Lots of advertising dollars are spent to persuade you otherwise, but this can be done. 1 don’t pretend it’s easy, but financial planning pioneer Bert Whitehead says that the number one cause of financial disaster for middle-income families is the habit of living beyond their means. To correct this bad habit you have to decide to pay yourself first-~in other words, establish a program of regular savings.
If you have a hard time believing you could live on less than what you spend now, try the following mental exercise. Think back to a time when you received a nice pay raise. Do you remember feeling especially affluent afterwards? How long did that feeling last? If you’re like most people, it wasn’t long before the sense of having “money to bum” was replaced by the old, familiar anxieties from your lower-income days. That’s because spending levels tend to drift upward along with increasing income almost imperceptibly. That’s the bad news. The good news is that the same thing happens in the other direction, too. Clients who take my advice about saving money report that the feeling of being pinched also goes away, as they gradually adjust their spending to a slightly less extravagant level.
The second key to keeping a clear perspective on the role of credit in your life is to understand the difference between good debt and bad debt. Generally, a debt is bad if what you are purchasing won’t last as long as it takes to repay the loan. An example might be a two-week vacation that sets you back two months’ pay and stays on your VISA card for a couple of years. Good debt, on the other hand, helps you gain control of valuable assets at favorable rates. A good example would be a low-interest, tax- deductible mortgage loan. Clients have benefited greatly from strategies we have developed to convert bad debt into good debt, as part of a comprehensive financial plan.
The first two keys detailed above are appropriate to most of the stages of your financial life cycle. The third key is only to be used on special occasions, but it can be very useful as well. From time to time, you may face a situation where you know in advance that your income will be going down sometime in the near future. Perhaps you are about to retire, or have just been laid off, or will be taking time off to care for a new baby. In these situations your tax bracket may be going down, too. That opens up opportunities for significant tax savings.
Here’s an example. A client expecting to retire midway through 2002 had gone through almost all of 2001 without contributing to their employer’s qualified retirement plan. I pointed out that -contributing the maximum amount to that plan would reduce their tax bill for the current year by about $3,200. They liked the prospect of the tax savings, but wondered how they could manage to forego most of their income for the last few months of the year. We conducted an online search of credit card offers, and found one with no interest for 9 months, plus 2% cash back.
They are using this card to pay for most ordinary expenses until they maximize their contributions to the qualified plan. Even if they pull the money out in January 2002, they will have saved over $1,600 in taxes by shifting the income into a year when their marginal tax rate will be 16% lower than it was in the previous year. A little planning has built them a plastic bridge to their golden years, where they will arrive with a nice bag full of free money.
Guest Column: By Stewart Farnell, PhD.
Rebalancing: A Long-Term Discipline
I’ve long been a believer in the annual rebalancing of investment assets. This involves setting percentage targets for each major asset class, and when the actual percentage of assets owned strays significantly from that target, coming back to that target. Rebalancing is accomplished by selling assets in those classes that exceed their target percentage (the classes that have performed well) and reinvesting the proceeds in those asset classes that are below their target percentage (the classes that haven’t performed as well). In doing this rebalancing, one typically is selling some assets at high prices and buying others at low prices, following the basic rule: “sell high and buy low”.
A recent article in the Journal of Financial Planning by Dr. Craig Israelsen of the University of Missouri confirms the wisdom of this approach. Dr. Israelsen conducted a retrospective study in which he constructed a hypothetical stock portfolio in 1970, rebalanced it annually, and compared the results to an identical stock portfolio that was not rebalanced.
Dr. lsraelsen’s portfolio was a simple one, consisting of one-third large cap domestic stocks, one-third small cap domestic stocks, and one-third international stocks. He assumed $1,000 was invested in 1970, $333 in each area. If each of these three investments was left untouched until the year 2000, the total portfolio was worth $42,961. If the portfolio was rebalanced annually, the total portfolio value grew to $49,496 by 2000, a 15% improvement over the non-rebalanced portfolio. What’s more, the rebalanced portfolio was less risky. The rebalanced portfolio had 18.5% less year-to-year return volatility than the non-rebalanced portfolio. The rebalanced portfolio produced a higher return with lower risk, just what we are looking for when it comes to investing.
To get these returns, however, one needed to stick with the rebalancing even when it was easy to be tempted to ignore rebalancing. There were periods of 5 or even 10 years when one asset class had a great run that allowed it to outpace everything else—just the kind of run that makes it hard to sell the top-performing asset class in order to buy more of the lesser-performing asset classes. In the 1990s, that asset class was large cap U.S. stocks. However, as people who piled all their money into large cap U.S. stocks can now relate, this great run came to an end, and these investors have had the sad experience of seeing their portfolios shrink substantially before their very eyes.
I have not done any studies of rebalancing similar to those of Dr. lsraelsen, but I do have some observations of my own. In recent months I’ve reviewed the financial positions of almost all my clients. All my clients rebalance annually. With few exceptions, my clients are better off than they were last year and the year before that, despite the downturn in the stock market. Diversification across asset classes other than stocks (interest earning and real estate, chiefly), along with rebalancing out of stocks when the stock market was riding hich, have provided real benefits to my clients. A well-diversified of mix of assets, rebalanced annually, works.
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