Ask The Expert with Larry Swedroe, December 2007 Issue

This is the inaugural issue of the Ask The Expert column by Larry Swedroe. You can see Larry’s full biography and important disclaimer below. If you are interested in having your question answered by Larry, please send me an email via the contact page.

Now, let’s get to the questions and answers (please note that the emphases and links are mine).

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1. Is there a limit to how much you can contribute to a ROTH 401k? And is it wise to split your investment contributions between a traditional and a ROTH 401k?

From Erin @ Working For Financial Freedom

There is a limit which is set by the IRS every year for both Roth and Traditional IRA accounts. The current limit for those under 50 is $4000 and for those over 50 it is $5,000. This allows for what is called a catch up. What is important in making the decision between the two is mainly one thing: What is your current tax rate and what tax rate you expect to pay in when you withdraw the money. If the tax rate is higher now you should contribute to the Traditional IRA. If the tax rate is expected to be higher when you withdraw you should contribute to the Roth IRA.

There is another consideration, which is a bit complex. Most people do not understand that both Roth and Traditional IRAs allow you to invest tax free. Most people think that a traditional IRA allows you to invest tax deferred. But that is wrong. The right way to think about it is that with a traditional IRA the government owns a share of your investment. The percentage they own is the tax rate you will pay on withdrawal. They own that percentage plus any earnings on that percentage. You own the remainder. There is no tax on your withdrawal.

Consider two investors, John and Mary. Currently, both are in the 25 percent tax bracket. In addition, they both expect to be in that same 25 percent bracket when they retire. They also have the same income and spending needs. And they both invest on the same day in the same mutual fund. Each has just received a $1,000 bonus.

• John decides that he will invest his bonus in a Roth IRA. Given that he has to set aside 25 percent of his bonus to pay federal income taxes, John makes a $750 contribution to his Roth IRA. John invests that amount in a mutual fund that invests in equities. John’s investments increase in value by 33 1/3 percent. He now has $1,000. Assuming that there was no penalty for early withdrawal, he would be able to withdraw $1,000 and no taxes would be owed.
• Mary decides to use her bonus to contribute $1,000 to her traditional IRA. Despite being in the same situation as John, Mary can invest $250 more than John because she doesn’t have to pay the current income tax on the $1,000 invested. Mary now invests her $1,000 in the same mutual fund that John invested in. Thus, she earns the same 33 1/3 percent return. The result is that she ends up with $1,333. When she withdraws the funds from her traditional IRA (again assuming no penalty for early withdrawal) she will pay a tax of 25 percent. After paying taxes of $333, she ends up with exactly the same $1,000 that John did. Note that the tax of $333 is equal to the original tax that was deferred of $250 plus $83 dollars. The $83 presents the 33 1/3 percent gain on the $250. In other words, Mary was investing funds on behalf of the government. She actually owned only 75 percent of her IRA. The government owned the other 25 percent.

There is another consideration: The contribution to the Roth actually allows you to invest more of your assets in a tax free environment. Let’s assume your tax bracket is currently 25% and it is expected to be 25% on withdrawal. That would make the two investment vehicles identical, with one exception. If you invest in a Traditional IRA and you invest the maximum of $5,000, you will really have an investment of not $5,000 but $3,750 as the government owns 25% of the asset (which it will claim when you withdraw the funds–plus its share of any future earnings). If you invest in a Roth instead you get to invest the full $5,000 in a tax free environment, paying the taxes ($1,250) out of other funds.

Just to be clear: If you invest in the Roth you invested $5,000 and paid a tax of $1,250. That is a total of $6,250. Now let’s look at what happens to your $6,250 if you invest in the Traditional IRA: you invest $3,750, the government is investing with you $1,250 (total $5,000) and then you can invest the remaining $1,250 in a taxable account (you saved that amount in taxes because the $5,000 in contributions was not subject to current income taxes). That is the same total of $6,250. The difference is with the Roth you get to invest $5,000 in a tax free environment. With the Traditional IRA you get to invest just $3,750 in a tax free environment and then another $1,250 in a taxable account. The same $5,000 is invested but in the Roth case it is all free of taxes.

It is important to note that the issues related to the ability to maximize contributions also relates to a Roth 401(k). The difference is that the Roth 401(k) is not constrained by the same income limitations or contribution rules that constrain a Roth IRA. As we discussed, for 2007, individuals under the age of fifty are limited to contributing no more than $4,000 to a Roth IRA. Those fifty or above can contribute $5,000. Additionally, Roth IRA contributions are prohibited when taxpayers earn a Modified Adjusted Gross Income of more than $110,000. The limit is $160,000 for those that are married and file jointly.

However, with the Roth 401(k), employees can decide to contribute funds on a post-tax basis, in addition to, or instead of, pre-tax deferrals under their traditional 401(k) plans. An employee under the age of fifty can defer (whether to a traditional 401(k), a Roth 401(k), or to both) up to $15,500 for tax year 2007. If they are over fifty, they may contribute an additional $5,000, or a total of $20,500. Note that employer contributions (employer match, profit sharing contribution, etc.) are always pre-tax; the Roth option is only available for employee contributions.

Since individuals should always try to maximize their contributions to tax-advantaged accounts, the Roth 401(k) is a valuable tool. Note the same issues apply to 403(b) accounts.

There is another advantage of a Roth IRA. While traditional IRAs require minimum withdrawals (RMDs), Roths do not. Roths do not have this requirement because the government has already collected its toll (taxes on the income have already been paid). The result is that if an individual believes that they will not need the RMD to pay for living expenses, the choice of the Roth could be better even if the tax rate was expected to be lower upon withdrawal than at the time of contribution. In addition, it is important to remember when estimating future tax rates to consider the impact of an RMD on the marginal tax rate.

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2. Other than by taking the self-denigrating stance: “I am not an above average investor”, how can a person justify support of modern portfolio theory when there is a Warren Buffett in this world?

From Zapp

That is perhaps the easiest question to deal with. First, with thousands or millions of investors we should expect some to outperform the market every year and some to do so for many years, randomly. The question is: Is there any more persistence of performance than would be randomly expected.

The evidence from hundreds of academic studies is there is not. Another answer to the question is that Warren Buffett is not the typical investor. He is not like a mutual fund manager. He often buys companies and then manages them. He provides them with economies of scale, lower cost of capital and the benefits of his managerial wisdom. And when he takes large positions in companies he often gets a board seat. So perhaps his great returns are more a result of his managerial skills than his investment skills, or some combination of both.

When I got this question a few years ago I went to do a simple check on the performance of Berkshire Hathaway for the prior ten year period and then compared it to the five major US asset classes of large, small, small value, large value and real estate. During that period BRK had underperformed all but the asset class of large stocks (as represented by the S&P 500) and had underperformed an equally weighted (20% each) portfolio of the five that was rebalanced annually by several percent.

So we know that Buffett had delivered great returns in the past but we don’t know that he will in the future. In fact, during that ten year period BRK underperformed. So now what would you forecast regarding the future?

The issue is this, we know that there will be some investor who produces “Buffett-like” returns in the future. The problem is we cannot identify them today. Unfortunately we can only buy tomorrow’s returns, not yesterday’s. And finally, what I tell investors is this: If you look in the mirror and you see Warren Buffett, go ahead and try to beat the market by picking stocks. But there is only one person who when he looks in the mirror sees Warren Buffett. The rest of us should simply accept market returns. If you do so you are virtually guaranteed, if you have
the discipline to stay the course, to outperform the vast majority of investors, both individual and institutional.

By the way, my second book, What Wall Street Doesn’t Want You to Know, contains a section called “Buffettology or Mythology” which addresses your question. Also my new book, Wise Investing Made Simple, contains the tale “When Even The Best Are Not Likely to Win the Game,” which indirectly addresses you question by looking at the results of large institutional investors who have access to the great money managers.

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3. I would like to hear your thought on borrowing money from my 401k to start a business. According to my employer, the current interest rate is 9.25% and there is a $45 fee to process the $5,000 loan. Over the next 36 months, I have to pay back $160.76 per month, or $5,787.36 for the life of the loan. I will be paying myself interest so the only cost is $45. What do you think?

From Malcolm

Short and simple: Never borrow money from a tax advantaged account unless there is no other resort — it is an emergency. You borrow money that is growing tax free and pay it back with after tax dollars.

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4. When deciding to purchase individual stocks, what process do you go through to determine if the stock is a good buy or not?

From Glblguy @ Gather Little By Little

One of my rules of prudent investing is that no one should own individual stocks. That has far more to do with speculating than investing. Instead own only mutual funds (or ETFs) that own all the stocks within a particular asset class (e.g., small caps, value stocks, emerging market stocks, etc.). Then build a globally diversified portfolio of a number of these funds-one that reflects your unique ability, willingness and need to take risk. My latest book Wise Investing Made Simple, provides a list of the recommend investments and also a model portfolio you can use. By the way, I don’t own any individual stocks and have not for a very long time.

There is a wonderful series of studies on the results of stock trading by individuals by Professors Brad Barber and Terrance Odean. One of their studies found that the stocks individuals buy underperform after they buy them and outperform after they sell them. This is actually a commonsense outcome. The reason is relatively simple. Let me explain. For every buyer there must be a seller. Since the vast majority (about 80%) of the trading is done by institutional investors (who almost certainly know more than the individual investor) that it is likely that when an individual buys a stocks (because he thinks it will outperform the market) the likely seller is an institution (who thinks it will underperform or they would continue to hold it). And the institutional investor is more likely to be right. And the same is true when the individual sells (because he thinks the stock will underperform) and the buyer is likely to be an institutional investor (who thinks it will outperform). Again, only one can be right and it is likely to be the institution. A study buy Russ Wermers found that the stocks institutional investors (mutual funds) buy actually do outperform by about 70 basis points. Thus they are exploiting the individual investors lack of knowledge.

Taking this one step further, when an institutional investor trades the likely counterparty is another institution in most cases (about 80%). And only one of them can be right. It turns out that the evidence demonstrates that there are just not enough victims to exploits. The study by Wermers found that while the stocks the mutual funds bought did beat the market by about 70bp the funds underperformed proper benchmarks by about 1.6% per annum because they incurred an average of 2.3% in total costs (not just the fund’s operating expense ratio but all trading costs and the cost of sitting with cash). In other words, there were just not enough victims (individual investors like you) to exploit to overcome the burden of expenses.

You can find the studies by Barber and Odean on the Internet. Rational Investing in Irrational Times also discusses several of their studies.

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5. What’s the best way for someone who doesn’t know anything about investing to get started?

From Lynnae @ Being Frugal

One of the great sins is that our education system has failed the public. Unless you get an MBA in finance or go to an undergraduate business school it is likely that you have never taken any courses in investing. That is despite the fact that outside of your health and your family there is nothing more important than money. Not money itself, but what it buys you. Yet so many people begin investing without taking the time to learn anything about investing. It would be like taking a trip to a place you have never been without a road map or directions. No sane person would do that.

One of my favorite sayings is: If you think education is expensive, try ignorance. This is especially important because there are so many wolves out there (in the form of unscrupulous stock brokers, investment advisors and Wall Street firms waiting to sheer the unsuspecting sheep — who lack the knowledge to protect themselves. So the first thing I recommend you do is get educated. That means reading several good books on investing before you begin investing.

You might start with my latest book, Wise Investing Made Simple. It is a collection of 27 simple stories that uses analogies to help explain complex situations. The book also provides a check list of eleven items that you can use to help you identify a good financial advisor you can trust. Then you might read The Only Guide to a Winning Investment Strategy You’ll Ever Need and Rational Investing in Irrational Times. I have also written three other books that are designed to help investors understand how markets really work (not how Wall Street and the media want you to think they work) and how to put that knowledge to work for you. The advice is all based on what the academic research and the American Law Institute say is the prudent investment strategy. So it is not based on my opinions.

Other good authors you might read are John Bogle and William Bernstein. Unfortunately the vast majority of investment books are nothing more than what Jane Bryant Quinn called investment pornography.

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6. Should the decline in the dollar affect our current investing decisions, and if so, how?

From DR @ The Dough Roller

Simple answer is NO. And the reason is that would be making the mistake of confusing information with knowledge you can use to generate excess profits. Put simply, if you know something the odds are great that the market also knows it and thus has already incorporated that information into prices. Thus it is too late to act.

The time to act is when you are designing your investment plan, an asset allocation table. And that should include a large allocation to international stocks. That will provide the diversification benefit you are looking for, diversifying the economic and political risks of US stocks. I recommend that everyone should have at least 30% of their equities in international stocks, with as much as 50 percent, which is my own allocation.

Understanding the difference between information and knowledge (discussed in my book Rational Investing in Irrational Times and also in Wise Investing Made Simple) is one of the most important lessons investors can learn.

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About Larry Swedroe

Larry Swedroe is a principal and director of research at Buckingham Asset Management, LLC, an SEC Registered Investment Advisor firm in St. Louis, Missouri (www.bamservices.com). He is also principal of BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.

Before joining Buckingham in 1996, Larry served as senior vice president and regional treasurer at Citicorp and vice chairman of Prudential Home Mortgage. Larry is author of The Only Guide to a Winning Investment Strategy You’ll Ever Need (updated and re-released in 2005), as well as five other books. Most recently, he authored Wise Investing Made Simple (2007).

His Books

• The Only Guide to a Winning Investment Strategy You’ll Ever Need
• What Wall Street Doesn’t Want You to Know
• Rational Investing in Irrational Times
• The Successful Investor Today
• The Only Guide to a Winning Bond Strategy You’ll Ever Need
• Wise Investing Made Simple
• The Only Guide to Alternative Investments You’ll Ever Need

Disclaimer

• Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.
• Not all questions will be answered
• By submitting a question, you grant us the right to publish your question.
• The answer is given based on the information provided in your question. Please seek professional assistance for more personalized advice.

If you are interested in having your question answered by Larry, please send me an email via the contact page.