Lessons for the Long Term

Question of the week:Everything is so uncertain right now--the stock market is all over the place and I'm not convinced that the economy is back yet. What's the best way to respond to all this? --Collin

Dear Collin,

If you feel like you're on a roller coaster, it's because in a very real sense, you are. There have been few times in the history of the stock market when such a fantastic run-up (like the late 90s) has been followed so suddenly by such a sharp and protracted downturn (as we are now experiencing).

A bit of perspective can help a lot. We asked Armchair Millionaire community members for their views looking back over the last few years since the market dropped. Here's a bit of what we heard:

"If it were 1999 again, I would have diversified my portfolio. It would have made the last year or so an easier ride. Now I take a much closer look at the make up of my portfolio and realize that it is never to late to correct a mistake." --Bill Mac

"You can't beat the market. If it were 1999, I'd have looked more carefully at my holdings and gotten out of some things sooner. It's better to have your principal intact than trying to figure out what the very top of a stock (or fund) rise will be." --Hestarose

"Gold and real estate--five years ago these were not considered particularly good investments and I had to convince my broker that that was what I wanted. Call me old-fashioned, but at least I still have something more substantial than electrons." --Carrie

We can't help but compare that from this comment from the archives of the Armchair Millionaire, typical of those we heard during the late 90s:

"Internet funds and stocks are what you need to buy now. Even if you think it's a little late to get in, get in. It's only the beginning with a limitless future." --Tim

It's challenging to keep a sane, long-term perspective when you're in the midst of market volatility and rocky economic times. But keep in mind that some things are always in style, no matter what. My checklist has the rules that work-in good times and bad.

The Armchair Millionaire Checklist of Timeless Financial Lessons

• Pay off your high interest debt. Debt is savings in reverse. By paying off high interest debt (credit cards are the primary culprit), you'll sidestep paying plenty on interest that you can use for much better things-like saving and investing.

• Take care of what you have. Get on a first name basis with your insurance agent. Check your health, disability, car, homeowners and long-term care insurance to make sure you have adequate coverage. If you are older and have substantial savings, consult with an estate planning attorney. No matter what your situation is, keep an up-to-date will.

• Get yourself on track. If you fail to plan where you want to go financially, you probably won't get anywhere at all. Take the time to put your goals down on paper. Split them out into short-term (over the next year, mid-term (the next five to ten years) and long-term (over the really long haul, like the next 30 to 40 years). Be specific and define exactly what you'll need to do to achieve these goals.

• Don't panic. If the down market has you tempted to make radical changes in your long-term investments, take a deep breath and just hold back. The market has gone through these periods before, and has always come back.

• Keep investing. Dollar cost averaging will help you turn this lemon of a market into lemonade over the long run. If you haven't yet started to invest, don't wait for the market to go back up to begin.

THE BOTTOM LINE: There have been a lot of ups and downs lately, but you'll get through to better times by sticking to battle-tested strategies that have been proven to work over and over again.

The Mutual Funds We Love to Hate

Question of the week:I'm interested in an actively managed fund that has had decent returns recently and that I think will do well in the future. I know you advocate index funds, but I really want to take advantage of this opportunity. What do you think? --GT, Long Island

Dear GT,

I understand your temptation to chase performance, but I urge you to consider both sides of the coin when contemplating actively managed funds. To give you some perspective, we asked members of the Armchair Millionaire community for their opinions about actively managed funds. Here are some of the comments we heard:

"The law of averages and efficient market theories show that it is very difficult for an actively managed fund to beat an index fund over time. And when you add transaction costs, it's almost impossible." --Jamie

"Active fund managers charge higher fees and in turn, cannot even beat the index most of the time. I'll take the guarantee of keeping up with the index instead of paying fees to have a slim chance of beating it." --Pat L.

"In the end, three things determine your return: performance, taxes and fees. Index funds are totally comparable to actively managed funds on performance and kick butt on tax efficiency and fees. " --Polly T.

My guide describes what I see as of the major pitfalls of actively managed mutual funds.

The Armchair Millionaire Guide to the Drawbacks of Actively Managed Funds

• High expenses. Since fund management fees and expenses are subtracted from the fund's assets, you never really see what you're missing. This makes it easy to ignore the impact these fees have on your return, but it can be significant over time. While every mutual fund has expenses, actively managed funds on average have higher expenses than index funds-sometimes much higher. To find out exactly how expenses affect your return, check out the Security and Exchange Commission's fund cost calculator at www.sec.gov.

• Tax hits. Every year, funds have to distribute capital gains they have realized on stocks they have sold that are not offset by capital losses. If you receive a capital gain, you have to pay taxes on it-even if the fund has had a negative return that year. The SEC has said that more than 2.5 percent of the average stock fund's total return is lost each year to taxes--even more than the amount typically lost to fees. Because index funds have very little turnover of their holdings, they realize few or no capital gains that must be passed on to you.

• Style drift. In search of better investment opportunities, it's not uncommon for fund mangers to stray from the stated investment strategy of their fund. A value fund manager, for example, might start investing in growth stocks when they're hot. Likewise, a small-cap fund might buy some mid- or even large-cap stocks. This can make it nearly impossible for you to achieve the asset allocation you really want. Since index funds are pegged to an index, they won't stray from their original intention.

• Lack of disclosure. You have to know exactly what an actively managed fund owns on any given day. This means that you could easily own the same stock in several different funds, and not know it. It also makes it tough to confirm that the fund is still buying the kinds of stocks it did when you originally invested. Since index funds own the stocks of a particular index, you always know what you own.

THE BOTTOM LINE: When you take everything into account, I believe there's less to love about actively managed funds over index funds. By their nature, index funds are the lowest cost, most tax efficient, most reliable tools for building a long-term portfolio.

Borrowing from Yourself

Question of the week:Money is tight and I'm thinking about taking out a loan from my 401(k). Borrowing from myself--and paying the interest to myself--seems like a no-brainer. What do you think? --2LT

Dear 2LT,

You're not alone in considering this. According to Hewitt Associates, a major HR consulting firm, 94 percent of all 401(k) plans are set up to allow loans. And plenty of people take advantage of them-nearly one out of every five people with a 401(k) has a loan outstanding.

When we asked members of the Armchair Millionaire community about the wisdom of borrowing from a 401(k), we got mixed reviews:

"We did it at a good time when interest rates were very low, so we were actually making money when we paid ourselves back. However, the headache and frustration of knowing the money has to get back in there really wasn't worth it." --Bobbi T.

"No how, no way! Keep your mitts off your 401(k) unless in dire emergency. That's sacred money for old age!" --Betty

My opinion is that, in most cases, you should stay away from borrowing from your 401(k). While you're right that the interest payments you make go right back to yourself, it's important to consider the drawbacks:

• If you quit or are fired, you'll have to pay the loan back in full immediately--usually not a great situation when you've just left a job.
• You make your loan payments with after-tax money, but when you take distributions from your 401(k) upon retirement, you'll still owe tax on all that money. This means you'll end up paying taxes twice on the money used to pay back your loan.
• You miss out on the growth of your investment. Compounding returns are the magic ingredient for building your retirement fund, and you lose them when you take your money out for the loan. Depending on how much you borrow, you could end up with a significantly smaller nest egg.

I suggest you only borrow from your 401(k) if you absolutely must. For example, if you have an emergency on your hands and no other available funds. My guide provides the essentials of what you'll need to know.

The Armchair Millionaire Guide to Borrowing From Your 401(k)

• Interest. Rates are usually competitive with other kinds of loans-a point or two above the prime lending rate. Your principal and interest payments will be automatically deducted from your paycheck and put into your 401(k) account. The interest is not tax deductible.

• Loan amount. You can usually borrow up to $50,000 or one-half of your contributions and vested employer contributions, whichever is less.

• Repayment. You typically have to repay the loan within five years, although your plan might allow a longer term if you're using the money to buy a home.

• Defaulting. It's going to hurt if you fail to repay your loan. The unpaid balance will be treated like a distribution from your plan, meaning you'll have to pay income taxes on the amount and, in most cases, a ten percent early withdrawal penalty.

THE BOTTOM LINE: Borrowing from your 401(k) is not a brilliant financial move, but it could save your hide if you have no other alternatives. If you do borrow, know the rules, pay it back as soon as you can and, if possible, keep contributing to your plan.

Getting the Best Return on Your Holiday Spending

Question of the week:I'd really like to cut back on holiday spending this year, but I still want to get the biggest bang for my buck. Any gift-giving suggestions for people like me? --Gene N. Dear Gene, It seems that many people are in your position this year. In fact, according to the results of a Gallup poll released a couple of weeks ago, Americans are planning on spending less this year on average--$769 each--than they have in the past three years. When we did our own informal poll of the Armchair Millionaire community, we found that most people are either planning on cutting back or staying about the same. Here are a few of the comments we received: "We're spending about the same. My two children will get one, maybe two, well chosen toys from Santa. We are starting some great family traditions that center on each other instead of things." --Cecelia KC "I'm cutting back. Spending about the same on the kids, but for friends, getting together for dinner and to spend time instead of money on gifts we don't need." --Kris "We are definitely simplifying. Kids getting a little less, and grownups are getting more thoughtful, less expensive things. The idea is not so much to save money (though that helps), but to try to preserve the meaning of the holiday." --CP With a little thought, you can come up with gifts that will more than make up for their lower cost by paying dividends down the road. My checklist has a few ideas to get you started thinking about gifts that will make a little cash go a long way. The Armchair Millionaire Checklist of Financially Savvy Gifts Personal finance software. There is no better way to help someone ramp up their financial life than to give them personal finance software. These programs (Quicken and Microsoft's Money are the two most popular) will help with investment tracking, retirement and college planning, budgeting, debt reduction and more. A bit of stock. This is a great time to buy stock, and you don't have to commit a lot of money to do it. Netstockdirect.com and buyandhold.com will both help you buy just a few shares, and oneshare.com will sell you a single share along with a framed stock certificate. A new mutual fund account. Opening a mutual fund account is perfect for a child. Several mutual fund companies, including Stein Roe, Liberty Funds and USAA, offer kid-friendly funds. These have low initial minimums and come with educational materials to help children learn about investing. U.S. savings bonds. If you're thinking about giving cash, consider a savings bond instead. They're safe, liquid and offer a predictable return. I especially like I-bonds, which will keep growing ahead of inflation. You can buy savings bonds from most banks or directly from the U.S. Treasury at www.treasurydirect.gov. Initial consultation with a financial advisor. We all can use a little outside perspective on our investments. Ask trusted colleagues or friends for referrals for fee-based advisors, who will charge you a flat hourly fee for a consultation. THE BOTTOM LINE: The latest battery-powered gizmo will probably be forgotten by March. To make your holiday dollars stretch as far as possible, think about gifts that will still be giving returns next year, and for many years after that.