Tuesday, November 27, 2007

The Backward Investor

Would you rather make 21% in a year on your investment or lose 18% in a year on your investments? Believe it or not there is a subset of investors who would rather lose 18% than gain 21% on their investments. Let me clarify. The Standard and Poors (S&P) 500 index went down 23.37% (excluding dividends) in 2002. In 2003, the S&P 500 gained 26.38%. There is a subset of investors who strive to "beat the S&P 500." This perverse group of people would be thrilled to have lost 18% of their money in 2002 because they would have beaten the S&P 500 by over 5%. (If you didn't invest in the stock market at all and ended up with a 0% return, you would have beaten the S&P 500 by 23% in 2002.) In either case, I didn't exactly see many people celebrating their investment portfolios at the time.

By contrast, These same folks would be bummed out to make only 21% on their investments in 2003 because they would have underperformed the S&P 500 by more than 5%. I don't know about you, but I would happy to make 21% in a year on my investments, and would feel ashamed to have lost 18% in my investments. The truth be told, I used to compare my stock performance against the S&P. I don't do that anymore, after I saw how ridiculous that comparison can be. This reminds me of the "keeping up with the Joneses" comparison in personal finance. My advice is not to constantly compare your portfolio performance with the S&P, Nasdaq, or your neighbors. Instead, strive to improve your own position year over year.


This article was originally published on September 23, 2006. It is being republished today.

Friday, November 2, 2007

Misc. 401(k) Plan Facts

I've come up with a short list of miscellaneous facts about 401(k) plans that are not so commonly known. As always, I'm not an expert, so you might want to contact a tax professional for clarification.

1) Company stock: when you take a distribution, you can take a distribution of stock shares, and pay ordinary income tax on your cost basis. You can hold these shares outside of the 401(k) until you sell your company stock shares. You will then pay taxes only at the lower capital gains rate on the amount gained.

2) 401(k) plans are qualified plans that afford you greater legal protections than a rollover IRA. Of course, this only comes into play only if you are sued later in life.

3) 401(k) plans have a fiduciary duty to invest your money. What this means is that the 401(k) administrators need to select appropriate investment choices for you. This is not the case with an IRA.

4) Contributions to 401(k) plans are indexed to inflation beginning in 2007. In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act that set forth a schedule for the increases in 401(k) contribution limits. Through 2006, this was $1000 per year. From 2007 onward, the contributions are indexed to inflation (known as a cost-of-living adjustment) rounded to $500 increments. The small increase for this year is because the inflation rate is low. For 2007, the current contribution limit is $15,500.

5) In-service distributions: You don't need to quit your job in order roll money from your 401(k) into an IRA. Companies don't advertise this fact, but in most cases you can request an "in-service distribution" and roll that into an IRA while you are still working there. You will need to read through the company 401(k) plan documents to find the details for your plan.