Links to resources mentioned during the video:

• Ann Arbor Board of Realtors
• FICO Score
• Fannie Mae Lookup
• Freddie Mac Lookup
• Federal Housing Administration (FHA)
• Home Affordable Refinance Program

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Please note that this blog post and video are for educational purposes only and should not be construed as advice specific to your situation. You should get advice from a legal, accounting, or investment professional before deciding what course of action is appropriate for you.

Before you pick, you should know how many of the envelopes in Hat Two contain $751 and how many contain $1,016. That way, you can calculate the probability of whether you will come out ahead of the sure $920 in Hat One.

In this case, Hat Two holds 66 envelopes containing $751 and 34 envelopes containing $1,016. Now which hat would you choose? It may be obvious, but let’s do the math:

Hat One: (100 x $920) / 100 = $920
Hat Two: (66 x $751) + (34 x $1,016) / 100 = $841.10

As you can see, you stand to make $841.10 from Hat Two based on probability and should pick the sure $920 from Hat One. Any rational person should pick from Hat One, yet most of us pick from Hat Two when it comes to investing.

Hat One represents an index fund, specifically the Vanguard 500 Index Fund during the years 1984-2009*. Hat Two represents the 136 actively-managed domestic equity funds that were around in 1976 when the Vanguard 500 Index Fund was born and had survived through 2009. The envelopes represent one year’s worth of the average annual compounded return for each group of funds. In the case of the Vanguard 500 Index Fund (Hat One), an investment of $10,000 would have yielded you $920 per year on average over the 25-year time frame.

For the actively-managed funds (Hat Two), two-thirds underperformed the Vanguard 500 Index Fund by an average of 1.69% over the time frame yielding a 7.51% average annual return or $751 per year. The remaining one-third of the actively-managed funds beat the Vanguard 500 Index Fund by 0.96%. That group averaged a 10.16% annual return or $1,016 per year on your $10,000 investment.

As shown above, randomly selecting an actively managed fund would have yielded you an 8.41% annual return versus 9.2% for the Vanguard 500 Index Fund. “But Rob”, you say, “I don’t randomly picks funds. My investment adviser selects them after doing lots of research”. Sorry to bust your bubble, folks, but no one can regularly select the winning one-third of actively-managed funds in advance, and the winners are usually not those that have outperformed in the past.

To make matters worse for the actively-managed funds, the results from this study do not include the actively-managed funds that closed or merged during the 25 years (the vast majority of which were under-performing). The results also do not account for sales loads (commissions). If loads were included, the Vanguard 500 Index would have beaten 88% of the actively-managed funds.

“Fair enough”, you say, “But this is one area of the market and one period of time. Don’t actively managed funds beat index funds in other asset classes like small-cap stocks or corporate bonds?”

Not according to Richard Ferri’s extensively researched book, The Power of Passive Investing. In fact, it shows that about one-third of actively-managed funds outperform their indexes across multiple asset classes and various time periods and that the amount you are compensated on average for randomly selecting a winning actively-managed fund is not enough to compensate you for the higher probability and lower return of selecting an under performing fund.

My advice is to stick to low-cost index funds whenever possible. Choose Hat One.

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*The study used in this post is from The Power of Passive Investing by Richard Ferri.

My wife wanted the kickstand back on her bike. I had taken it off years ago when we were competing in triathlons. No serious triathlete (which we weren’t) would have a kickstand on her bike.

I tried to put the kickstand back on myself. How hard could it be? There was only one screw and one nut and seemingly only one place it could go. Yet I couldn’t figure out how to get it back on in the few minutes I devoted to trying.

Since the bike needed a tuneup anyway, I took it to a bike shop. The repairman could not do the tuneup that day but said that he would be happy to install the kickstand for me. It was on and ready to go in about two minutes.

At first I was embarrassed that the kickstand was so easy to install and I hadn’t figured it out. But the more I thought about it, I realized that repairing bikes is what this guy does for a living. It’s his expertise. He has the tools, knowledge, and experience to work on bikes efficiently.

This experience got me thinking about financial advice. It’s not rocket science, yet many advisers go out of their way to make you think it is. Most of the information you get from a good financial adviser, you could research yourself if you had the time and interest.

The difficulty is separating the sound financial advice from the noise. An objective and experienced financial adviser can efficiently guide you. We have the tools and knowledge, and we know where to look.

I realized something else during my short visit to the bike shop. The repairman never made me feel dumb for not knowing how to install the kickstand. I have had experiences when a professional or tradesperson has patronized me for not knowing about something that is his expertise. I have wanted to ask him to tell me the equation for the Capital Asset Pricing Model (something only geeky finance types would know) to get my point across, but I never do.

When I give financial advice, I remind myself that the reason that my clients come to see me is that they are not experts in personal finance. They are experts in their own fields. Something that is simple or matter-of-fact to me may be completely foreign to them. It’s my job and privilege to share with them the knowledge I’ve gained from years of study and practice. I help them put on their kickstands.

At first, I thought the book was about general debt reduction. Turns out that Debt-Free U is focused on paying for college without going into debt. (The U in the title stands for University.) The full title is Debt-Free U: How I paid for an outstanding college education without loans, scholarships, or mooching off my parents.

The author, Zac Bissonnette, challenges our society’s conventional view on the value of a name-brand college education and on the wisdom of taking out student loans to pay for college. He argues (with supporting data) that post-college success has more to do with the student’s work ethic than which college she attends.

For example, let’s say that your child is smart and diligent enough to get into both Stanford University and the University of Michigan where she qualifies for in-state tuition. Is it worth it for you and her to pay nearly $30,000 more per year* to go to Stanford? Not according to Mr. Bissonnette. (Although he might rethink that after a long winter in Ann Arbor.)

Debt-Free U efficiently covers a lot of ground and will help you think through:

• How much you can afford to pay for college (spoiler alert: not your “Expected Family Contribution” from the FAFSA),
• Which colleges provide the best value, and
• How to pay for college (spoiler alert: not loans).

If you have kids who are nearing college age, Debt-Free U is required reading. I also recommend it to parents of young children who are just getting started planning for college expenses. It may just change your view on how you will pay for college. It changed mine.

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* Peterson’s Undergraduate and Graduate Institution Databases

Happy 2011!  Below is a list of the essential numbers and phaseout ranges for this year.

• Maximum contribution to a Traditional or Roth IRA: $5,000 + $1,000 catch-up if age 50 or over (no change).
• Maximum contribution to a 401(k) or 403(b) plan: $16,500 + $5,500 catch-up if age 50 or over (no change).
• Income (modified adjusted gross income) phase out range for deductible Traditional IRA contribution, married filing jointly and covered by employer sponsored retirement plans: $90,000-$110,000.
• Income phase out range for deductible Traditional IRA contribution, married filing jointly and spouse covered by employer sponsored retirement plan: $169,000-$179,000.
• Phase out range for deductible Traditional IRA contribution, filing single and covered by employer sponsored retirement plan: $56,000-$66,000 (no change).
• Phase out range for deductible Traditional IRA contribution, filing single and not covered by employer sponsored retirement plan: no limit.
• Phase out range for Roth IRA contribution, married filing jointly: $169,000-$179,000.
• Phase out range for Roth IRA contribution, filing single: $107,000-$122,000.
• Social Security Cost of Living Adjustment: 0%.
• Annual gift tax exclusion amount: $13,000 (no change).
• Marginal income tax rates.
• Tax changes passed in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.
• Maximum deductible contribution to the Michigan Education Savings Program for Michigan residents: $5,000 single, $10,000 married (no change).

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Please note that this blog post is for educational purposes only and should not be construed as advice specific to your situation. You should get advice from a legal, accounting, or investment professional before deciding what course of action is appropriate for you.

• Contribute to your state’s 529 Plan by the end of the year. Many states, such as Michigan, offer a state income tax deduction if you make contributions to the plan that the state sponsors.
• Convert your Traditional IRA to a Roth IRA by year end. The IRS created a special election for conversions made in 2010 that will allow you to spread the income from the conversion over 2011 and 2012. You can learn about Roth conversions at Vanguard and use its Roth IRA Conversion Calculator to decide if conversion is right for you.
• Lock-in capital gains and pay at current capital gains rates. Long-term capital gains rates are scheduled to increase in 2011 unless new laws are enacted. If you have unrealized capital gains in a taxable investment account, consider selling your long-term winners and pay at the 15% rate (or 0% if you are in the 10% or 15% ordinary income tax brackets). You can even sell and immediately re-buy the same security to reset its cost basis. The wash sale rule does not apply to gains. You can learn more about this strategy and whether it is in your best interest by reading this article at Fairmark.com.
• Avoid buying mutual funds in a taxable account late in the year. Mutual funds are required to distributed realized gains each year, and you should avoid paying taxes on distributions when you were not around to participate in the gain. Many fund companies report their expected distributions prior to year-end. Check for planned distributions before you buy or wait until the new year.
• Take Required Minimum Distributions (RMD) from your IRAs or employer-sponsored retirement plans if you have reached age 70 1/2. Failure to take a required withdrawal can result in a 50% penalty on the amount not withdrawn.
• Make annual exclusion gifts before year-end. You can give $13,000 in 2010 to an unlimited number of individuals free of gift tax. You cannot carry over unused exclusions from one year to the next.

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Please note that this blog post is for educational purposes only and should not be construed as advice specific to your situation. You should get advice from a legal, accounting, or investment professional before deciding what course of action is appropriate for you.

In my view, variable annuities are almost always a bad idea as a stand-alone investment. Most are exceedingly expensive, complicated, and illiquid. Occasionally, a low-cost variable annuity can be justified as an additional way to invest on a tax-deferred basis if an investor is already maximizing her other tax-deferred investment options. But this situation is a rare exception to the rule.

Yet I regularly work with new clients whose former advisers recommended they invest their IRAs in variable annuities even though an IRA is already a tax-deferred investment vehicle. In these cases, the investors are stuck (due to many years of high surrender charges) in high-fee products for no good reason and I’m left to help them make the best of a bad situation.

I was recently working with a colleague on a project for a new client, and he asked me why the client had bought a variable annuity in his IRA. I replied that he was asking the wrong question. Investors put their trust in financial advisors to steer them in the right direction. The appropriate question, I said, was why had the so-called advisor sold it to the client. Unfortunately, the answer to that question is all too clear to those of us in the industry – for the large commission.

But don’t take my word for it. The U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority have written investor alerts on the subject.

If your financial adviser recommends that you invest your IRA in a variable annuity, he almost certainly does not have your best interest in mind. It’s time to find a new adviser.

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Please note that this blog post is for educational purposes only and should not be construed as advice specific to your situation. You should get advice from a legal, accounting, or investment professional before deciding what course of action is appropriate for you. Please note that this blog post is for educational purposes only and should not be construed as advice specific to your situation. You should get advice from a legal, accounting, or investment professional before deciding what course of action is appropriate for you.

• Information about and photos of ATM skimmers: http://nyti.ms/d9jDdq
• New York Times writer Tara Siegel Bernard on social security jitters: http://nyti.ms/9t2aYu
• The Securities and Exchange Commission responds to investors questions about index funds and turnover rates: http://bit.ly/aLs0i5
• Mary Pilon of the Wall Street Journal on a pitfall of co-signing a private student loan: http://bit.ly/dDjxdP
• Insurance company complaint ratios for the State of Michigan: http://bit.ly/cRTmNH
• New York Times article by Stephanie Rosenbloom on spending habits and happiness: http://nyti.ms/afw0ZE
• University of Michigan lowers fees and broadens options for retirement plan participants: http://bit.ly/aeGNxf