Tuesday, December 21, 2010

The Talk: Children and Debt

Mutual fund giant Vanguard shared a link from DebtWatchdog.com entitled "How to Stop Your Children from Getting Into Debt". The article offers up six different ways in which parents can teach their children how to manage their money better. While I like many of the points that the article brings up, I think they're all predicated on a single issue: honesty.

By being honest with your children regarding money issues, there will be a deep mutual respect that will last a lifetime. After all, if your child does not know that you are a struggling financially, how can you expect to "give them the world" when "the world" requires lots of money these days? Indeed, the old adage is correct in that money isn't everything; unfortunately, in this day and age we're often of the perception that it is - and perception is everything. Remain honest with your children and talk with them about your financial mistakes. After all, if they don't recognize that bad financial decision making can lead to severely adverse consequences, then what will prevent them from making the same mistakes you did?

Thursday, December 16, 2010

Correlation Does Not Imply Causation

A key scientific principle is that correlation does not imply causation - basically, even though event A and B may be correlated, it's not necessarily true that one caused the other. This is very true in the investment world, in large part because financial markets are so complex and there are so many different variables at work. After all, with trillions of investment dollars sloshing around worldwide, it's highly unlikely that a singular event will be the absolute cause of something else happening. Even when venerable investment banks Bear Stearns and Lehman Brothers failed, many securities fell for reasons relating to their collapse or financial destruction elsewhere - it's simply impossible to tell.

I bring this up because I read an article on TheStreet.com this morning
which stated the following:

"The charts of the U.S. dollar index and the
SPDR S&P 500 ETF clearly show the inverse relationship they have. Right now it seems everything is directly connected with the dollar; it has been like that most of the year."

While the article doesn't explicitly imply that the two are correlated, the author seems to suggest that because certain indexes and financial products have a chart pattern inverse of the dollar, that the dollar's movements seem to affect them. While this may be the cause in some extreme instances, ultimately, the dollar is moving because of other variables - monetary and fiscal policy, economic indicators and geopolitical issues, among other things. To understand why a security is moving, you have to dig a little deeper; don't take a chart pattern at face value.

Wednesday, December 15, 2010

Final Tax Vote Up to House

The Senate has passed a 2-year extension of the Bush tax cuts which will now go in front of the House for a final vote. The good news is that it appears as if this bipartisan package will pass and every American will retain lower income, dividends and capital gains taxes which should help spur investment and economic growth. This is fantastic news, particularly for Gen Y investors who will be able to use the lower tax rates to their advantage and compound returns over a larger base. The next step for Congress heading into the 2012 elections should be making these tax cuts permanent.

Monday, December 13, 2010

Higher Risk Lending Returns

Some credit card issuing banks have begun to lend again to higher risk borrowers - but at a higher cost. The article notes "in contrast to the boom years, when banks “preapproved” seemingly everyone, lenders are choosing their prospects more carefully and setting stricter terms to guard against another wave of losses"

This is encouraging. After all, we simply don't know the circumstances surrounding many credit card defaults. It's one thing if a person got hammered by the recession - losing their job and subsequently any income stream - and failed to pay their credit card debts. It's entirely another situation if someone just stopped paying because they charged too much and got in over their head with debt. The person in the former situation may be a worthy borrower now, provided they have a job and a means to pay off their debts. The person in the latter situation requires a bit more scrutiny, so it's good to see that credit card companies have begun to wise up and analyze their credit risks more (as they should have been doing all along!)

I do draw solace from the fact that the article notes "For consumers, the resurgence of card offers, however cautious, provides an opportunity to repair damaged credit and regain the convenience of paying with plastic. But there is a catch: the new cards have higher interest rates and annual fees."

Hopefully, those higher interest rates and annual fees will act as a deterrent for those borrowers who had no plans of paying off their new credit cards and instead encourages only serious borrowers. If that's the case, more capital can flow safely through the economy and we will have avoided the mistakes that got us into the financial crisis in the first place.

Friday, December 10, 2010

Companies Cling to Cash - Should You?

The Wall Street Journal's Justin Lahart has a good article today pointing out that cash now accounts for 7.4% of corporate America's assets - the highest percentage since 1959. This is due mostly to the fact that companies are not finding profitable ventures to deploy their cash into, and instead are hunkering down with it given the slow economic recovery. Typically, companies with excess cash will either plow it back into the business by buying capital assets and growing their businesses, or pay out a higher dividend in order to offer a return to shareholders. In this environment however, the concern over the potential for a prolonged economic recovery has led more and more companies to pad their balance sheets with liquidity, and the most liquidity asset is cash.

Thus, if corporate America is hoarding cash, should you? Well, yes and no. The problem with hoarding cash in a low interest rate environment is that any return you earn on your cash in a savings account or a time deposit will likely be eroded by inflation. On the flip side, the liquidity that you will have as a result will give you peace of mind, particularly if the economic recovery takes longer than we would likely. I propose putting roughly 5-15% of your paycheck in an interest bearing money market account that offers checkwriting privileges. The most important thing about doing that is for you not to view it as an investment vehicle - it's not - and instead as untapped liquidity that's also earning something. After all, the liquidity is absolutely necessary, particularly in this environment. If things get worse, you'll have the extra cash available to help out and it won't appear as if you simply have "dead money" laying around.

Tuesday, December 7, 2010

Investors Cheer Tax Cut Deal News

Last night's news of a potential deal between President Obama and Republicans in Congress regarding an extension of President Bush's tax cut package helped fuel a market rally which has sent the S&P 500 and the Russell 2000 small-cap index to 2-year highs. This news is very encouraging and is something I have written about before - the need to keep tax rates low to spur economic growth, create jobs and allow more money to flow throughout the economy by keeping it in the hands of individuals.

Today's market rally is a key sign of the importance of low tax rates to the market as it creates an incentive for investment, particularly low capital gains and dividends tax rates. After all, the investment incentive begins to lessen when you have to pay out more of your investment earnings in taxes. By keeping tax rates low on income that corporations pay out (dividends) and the capital gains you make on selling an asset, investors will have more reasons to provide much needed capital to businesses going forward.