Money Advice for Young People
By Stephen J. Butler Archives

A neighbor mentioned last week that his son, two years into the work force, needed a referral to a financial planner who could help the young man learn effective money management. I think a lot of parents are seeking similar help for sons and daughters who have just begun careers.

It's tough to find a good financial planner who can afford to spend time with someone who has no money. Young people, though, have a huge advantage: time. Acting on good advice today can really pay off over the next fifty years of their income-producing lives.

I am, of course, billed as a retirement planner, so why am I talking about kids? It should be obvious. Someday, late in our own retirement years, we'll want our children to have sufficient resources to provide us with adequate assisted-living services when we move into their spare bedroom.

If you're a young person with a thirst for financial knowledge, you should focus on mastering five questions: 1) How are you being taxed? 2) Why is buying a home or condominium such a good idea? 3) Why should you be depositing as much as possible into a tax-deferred retirement plan? 4) What simple investment advice should you apply to these deposits? 5) How can you be street smart with the money you spend?

First, you need to understand taxes. A surprising number of life's decisions hinge on a basic understanding of marginal tax brackets --- what you pay in taxes on the last few dollars of income. Yet, the average young person is clueless on the subject. Too often I hear, "Hey, I didn't pay any taxes, I got $400 back in April." That's on par with, "How can I be overdrawn? I still have some checks left."

The average single young worker in California makes enough so that the last few dollars of income are taxed at least 25%. People make the mistake of taking total taxes paid and dividing by total income to estimate their "tax bracket." It may be as low as 10 or 15%.

But most financial decisions bump taxable income up a little or down a little. We take a new job, or stay put for a $200 per month raise. A raise, by definition, is the last few dollars of our income. It will be taxed at the highest level of taxes we are charged.

A tax table that combines Federal and state income taxes with Social Security shows that a single person's adjusted gross earnings that fall between $26,000 and $36,000 per year are taxed at 42%. Any dollars over $36,000 are taxed at over 45%, and it just gets worse after that.

Young married couples experience the infamous marriage penalty. Married couples must combine their incomes for tax purposes, which means that a couple's combined adjusted gross income that falls above about $44,000 will be taxed at 42%. If a couple with one working spouse makes $44,000 and the other spouse decides to go to work, the additional income will be taxed at a staggering 45%.

Why do taxes work this way? The Federal Government seeks to collect an average of about 17% from all of us. However, on the first $20,000 or so, they collect very little because the rate is low and there are many exemptions. If they get next to nothing on the first $20,000, they need 34% or more on the remainder to reach an average 17%. That's why all the talk about a flat tax hammered on 17% as the magic number. Then, we have to add State income and social security taxes.

As I said, many decisions in life add or subtract to total taxable income. An informed decision needs to consider how much of that additional income will disappear in taxes. Or, conversely, how much of this tax-deductible (income reducing) expenditure or investment will be paid with money that would otherwise have disappeared in taxes.

When we contribute to 401(k)s or IRAs, we remove from taxable income the last few dollars that would have been taxed at the highest possible rate. When we pay house payments instead of rent payments, we reduce taxable income because mortgage interest and property taxes are tax deductible. Rent is not.

When we take a new job because it

What Makes Great Investors Tick?
By Stephen J. Butler Archives

When asked to describe Bill Gates for a recent New Yorker magazine article, Warren Buffet had a simple explanation for people like Gates: "They're wired in such a way that when they see business questions or problems or activities they tend to get the picture very quickly. They don't get tangled up in prejudices or biases they may have. They just tend to get the right answers. It's sort of like 'Why was Ted Williams a great hitter? It's about seventy-five percent DNA."

Yet another theory has it that Bill Gates, because of some mannerisms he displays, may be slightly autistic which gives him a powerful facility for digesting numbers. Anyone who recalls Dustin Hoffman in the movie "Rain Man" and his character's success in Las Vegas can understand why this theory may hold water.

For whatever reasons we want to choose, we can all agree that Bill Gates is a pretty smart guy, but sheer brain power doesn't necessarily translate into effective investment decisions. Ernest Hemingway once said, "Some intellectuals are the dumbest people I know."

After the stock markets of the last five years, it is hard to look dumb if we were in the market at all, but an old saying on Wall Street goes, "we can never confuse brains with a bull market."

When we stop to review our investment results, this is a time to pretend we're Bill Gates -- to break free of those Hobgoblins parading around in the left-hand side of our brains. Let's take a cold, factual look at 1999 and carefully process information that should bear some weight in our investment decision-making for 2000.

How badly do we feel about having endured a roller coast ride over the past two years? Whenever we have missed out on whatever stocks or funds rose substantially, it will definitely help us feel better if we look at funds or stocks that had spectacular results for a few early years of the 90's only to crater a few years later.

This year, of all recent years, it will be especially difficult for any of us susceptible to the "herding instinct" to resist diverting our assets into some of the recent better-performing funds. Probably most 401(k) plans have at least one fund that has dramatically outperformed the others. According to the great book "Why Smart People Make Big Money Mistakes," the warning signs of a major herding problem are as follows:

You make investment decisions frequently
You invest in "hot" stocks or other popular investments
You sell investments because they are out of favor, not because your opinion of them has changed.
You're likely to buy when stock prices are rising and sell when they are falling
You make spending and investment decisions based solely on the opinions of friends, colleagues and financial advisors.
Your spending decisions are heavily influenced by which products, restaurants, or vacation spots are "in."

It may be helpful to know that the odds are very good that we all suffer from a severe case of herding syndrome. Surveys of 401(k) participants ask the question, "What was the most important source of information influencing your choice of investment mix?" By far the most popular answer (for 80%) was "I asked my friends what they did." Give me a break. Or, as our mothers used to say, "Just because little Johnnie jumps off a cliff doesn't mean that you have to do it, too." These surveys of 401(k) participants illustrate one of the purest expressions of herding. Herding is the dark side of the force, and it explains Morningstar's statistic that the average mutual fund investor has earned only 3% per year over the past fifteen years while the average mutual fund has earned over 15%.

As we say to our therapists, "We don't want to go there." There's no reason for us to be led around by the herding instinct. Let's just rebalance our accounts, or leave them alone for another year, and let our basic mix, like a sensible pair of shoes, do its work. Rather than fretting over investment changes, we should try to save more money. If that's where we spend our energy, we'll wind up with a more comfortable retirement…and probably the last laugh.

BUYandHOLD does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular security, portfolio of securities, transaction or investment strategy. Any investment decisions you make will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. The securities mentioned above are being used for illustrative purposes only and should not be regarded as an offer to sell or as a solicitation of an offer to buy and past performance is no guarantee of future results.