Friday, September 28, 2007

Equal weight ETFs

Yesterday I explored a new (to me) ETF called the Rydex S&P Equal Weight ETF (AMEX:RSP). The idea is that instead of representing the underlying companies proportionally to their market capitalization, each one is represented, well, equally.

Looking at RSP vs. SPY, the most famous S&P 500 ETF, there are a few things I immediately like. There is a bit less weight given to financial companies in RSP, which is good because at this point I don't really want to invest in them. SPY, on the other hand, has among its top 5 holdings both Bank of America and Citigroup. There's more weight given to sectors I like, such as consumer goods and services, industrials, and basic materials.

Consumer goods is a great sector to invest in right now given the downward spiral of our economy. We should be looking at recession-resistant companies. Consumer goods companies like Procter & Gamble sell essential products like soap and detergent that people buy regardless of how the economy is doing.

I like industrials and basic materials for a different reason -- globalization. Every day, some news comes out about GE's overseas deals. They're building locomotive factories in India, selling jet engines to Dubai, partnering with Japanese companies to build nuclear reactors, selling special furnaces to Chinese steel companies, and on and on. According to GE's Citizenship Report (silly term heh), more than half of their revenue will come from overseas this year. Large industrial companies in the US are in a great position to earn massive amounts of money overseas, especially with the falling dollar. And again with the falling dollar, basic materials companies will find it easier to compete with imports, as well as become more attractive overseas.

Aside from sector allocation, perhaps the best thing about RSP is that their reallocation strategy is more correct. Say a company has a great year and its market cap increases 50% (yay!). SPY will buy more of the company because now it represents a bigger piece of the S&P 500 pie. If the next year the stock goes down a bit, SPY will sell shares. Buy high, sell low -- doesn't sound like a winning strategy!

RSP, on the other hand, will behave better. If the stock goes up, RSP sells shares because it ignores market cap and looks at a fixed percentage. In other words, every company should represent 0.2% (1/500) of the total fund. If a company doubles, it will be above its allotted 0.2%, so they sell shares to bring it back down. Then if the company drops a bit, it will fall below 0.2% and they will buy shares. Buy low, sell high, just what we want to hear.

Thursday, September 27, 2007

A frugalish recipe

A few weeks ago, I bought some Pyrex containers so I could start cooking in bulk and freezing food. Another plus is I can take more complex foods to work, keep them in the refrigerator, and have a nice lunch. Before, I was pretty much limited to sandwiches and fruit.

Anyway, for lunch today I had leftover thin spaghetti, a dollop (or two) of olive oil, and some grated Parmesan cheese. Normally when I have spaghetti for dinner, I toss the extra noodles, but this lunch was so yummy I'll probably do it again. I think the total cost of this meal was less than $1, though it's hard to say because I don't remember how much the cheese had cost. It's truly amazing how much money you can save by bringing lunch, and specifically leftovers, from home. And it tastes so much better than a $5 sub or, even the McDonald's double cheeseburger.

Tuesday, September 11, 2007

My niece's first purchase

Today being Tuesday, Sharebuilder executed my (one-time) automatic savings plan in the new account I set up for my niece. The account now has 2.0738 shares of... wait for it... Pfizer! I know in previous posts I've gone on at length about why I didn't like Pfizer as a stock to own (if not as a company), but they've taken a real beating in the market lately and it looks good to me. The dividend yield is just about 5% and is set to increase regularly. Since I'm honestly planning not to sell these shares for 20 years (think of what the $19.95 real-time commission would do to the profits!), I feel like that gives Pfizer plenty of time to come up with a few great new drugs, raise the dividend significantly, and perhaps buy a few smaller drug companies to stimulate growth.

Speaking of the real-time commission, at some point these shares *will* have to be sold. Therefore my strategy is going to be to invest in just a few securities (some individual stocks and some ETFs) so that each position is big enough in 20 years that the commission won't seriously hurt it.

Since I just opened the account, I was able to participate in a free trial of Sharebuilder's standard pricing program, which means there was no commission on the purchase. However, after this month is up I'm going to have to come up with a strategy to minimize commissions. It will probably involve investing her birthday and Christmas presents together.

Another idea is to use this account for my other niece and nephew rather than opening separate accounts for them. Even though I'll miss out on potential promotions (like the $50 I got for opening this account), over the long run it'll save quite a lot in commissions. The downside is that transferring the shares to them will be more complicated. Well, I don't have to decide now!

A use for margin

Margin is a tool that lets an investor borrow money from his broker to buy stocks. Because you're using borrowed money, you're increasing the leverage of your non-borrowed money. For instance, if you invest $1000 and borrow $500, the total of $1500 is 1.5 times greater than your $1000 alone. That can be good if stocks go up, because you get 1.5 times the profit. Of course, if stocks go down, you lose 1.5 times as much. And in the worst case-, you can lose more money than you invested to begin with because you'll still owe the margin!

Investing with margin can be a dangerous game, much like speculating in real estate. Is there ever a wise time to use margin? Well since I opened a stock trading account for my niece, I've been thinking a lot about investing small sums of money ($50 or so). Let's say that the interest rate on your margin loan is 12% to make the math easyish (margin rates are usually lower).

So, if we're using Sharebuilder, commissions are $4, which means that every time you invest $50 you lose 4/50 = 8%. That's the equivalent of 8 months of margin interest (ignoring compounding), which should tell us there's some probably an equilibrium point around there. So let's look at the total cost of borrowing 8 months worth of investments on margin compared to simply investing each month.

8 months of interest = 8% * 50 + 7% * 50 + 6% * 50 + 5% * 50 + 4% * 50 + 3% * 50 + 2% * 50 + 1% * 50 = 0.36 * 50 = $18.

8 months of commissions = 8 * 4 = $32.

Total amount invested = 8 * 50 = $400

Overhead of margin = 18/400 = 4.5%

Overhead of commissions = 32/400 = 8%

As you can see, despite the huge interest rate, using margin has actually cut our overhead almost in half.

Of course, the other method is to save up 8 months of investments and invest all at once, giving an overhead of only 4/400 = 1%. Now you have to judge whether your investment will gain 3.5% over the next 8 months. Well most people who want to invest are optimistic that the future will always be higher (on average), otherwise they wouldn't be investing! So this actually seems like a fairly wise use of margin. It's something to think about if you are making frequent, small investments!

Thursday, September 6, 2007

Stocks for kids

My niece is turning three this month so I've been spending some time figuring out what to get her. I came up with three options: toys, activities, and stocks. She has plenty of toys already so when I looked through the aisles at some local toy stores, nothing jumped out at me. Does she need yet another doll? I decided not. Activities are a nice gift but she's already enrolled in gymnastics and my mom is getting her swimming lessons. That left me with stocks. I've been wanting to do that for a few years, to be honest, but now I'm finally doing some research into how it's done.

The thing is, what's the best way to give stocks to other people's kids? I guess for most people the easiest way is to give the parents the money and ask them invest it. I sort of tried that already with my other niece (both are my sister's daughters) but my sister said something pretty shocking: She told me she was going to take all the birthday money from everyone and put it towards a sandbox! Maybe that's not shocking, I don't know. I was shocked but my mom thought it was fine.

My sister's in-laws actually avoided the situation by announcing that they had opened a savings accounts for each child and deposited some money into them. At the time (this was before my sister's plan was revealed) I thought, wow isn't that kind of rude and mistrustful? Plus, how wise is it to save $X.00 a year in a SAVINGS ACCOUNT earning 2% interest or whatever, when the money won't be needed for perhaps 20 years?

Anyway, when my sister let slip her intentions for all the money, I realized the importance of being able to maintain some control over your gift. Not to be mean, but I want to give this gift to my niece and not my sister. I'm sad that she doesn't already have a nice little stock trading account with a few years' worth of investments.

So I began investigating what options I had.

The easiest thing is for parents to be involved, no question. Everything I read pretty much assumes that the parents are the ones setting up the account, whether it's an IRA, 529 account, or custodial account.

It turns out that for 3-year olds, IRAs are pretty much out of the question. Apparently the IRS doesn't consider allowances to qualify as earned income, and nobody would believe a 3-year old was a participant in a home business. Then I read that you can actually deposit unearned income in an IRA and pay a 6% penalty on it. Not bad, right? A 6% penalty in exchange for tax free growth! Well then I found out that the 6% penalty happens every year that the unearned income remains in the account, until it's all gone! So IRAs are definitely out.

Section 529 plans are almost an ideal solution to the issue. Anybody can open one and you don't even have to be related to the beneficiary. There are two reasons I don't like them, though. First of all, they're limited to paying for education-related expenses (college). What if she gets a full scholarship and doesn't need the money for college? Then you pay income tax on the withdrawal plus a 10% penalty. Well, paying for college is a really boring gift that is better left to her parents anyway. I'm thinking she can use it to buy a car, start investing, or travel around Europe!

Oh and the second reason is that they are awfully limited in their investment choices. The 529 plan for my state doesn't offer the ability to buy individual stocks. Instead, you have to choose from 12 mutual funds. That's not my style.

Coverdell ESAs (Education Savings Accounts) are similar to 529 plans except that (from what I can tell) only the parents can set one up (though anybody can contribute) and you can invest in stocks. Again, there's a penalty if the child uses the money for non-educational expenses, plus there's the whole thing about the parents having to set it up.

Custodial accounts are generally (always?) opened by a parent of the child. The bad thing about them is that anything you put into the account actually belongs to the child. When they turn 18, they can do whatever they want with it. To me, the ideal time for a gift like this is a year or two after college graduation. That way they have some life experience and some appreciation for money and savings.

Then I read three very interesting things. First, the gift tax exemption is something like $12000 a year, and if you're married you can use both exemptions for a total of $24000. Second, if you transfer shares of stock to someone as a gift, the characteristics such as basis cost and time held stay the same. Third, if you're in a low tax bracket (10% or 15%), the long-term capital gains tax is only 5%! Whoa! So basically, by keeping the stocks myself, I can give her up to $12000 in stock per year and if she sells immediately she only has to pay 5% capital gains tax. Good deal! Of course, I'll have two responsibilities in the meantime: pay taxes on dividends (which won't be huge) and make sure to buy-and-hold (no problem). Plus I have to make sure to give it all to her before she starts making lots of money.

So yesterday I opened up a new Sharebuilder account in my name and used a promotion code to get a $50 gift. Plus, I signed up for a free trial of their "standard pricing" program, which means I get 6 free trades. So I'm taking the promotion gift and the birthday gift and investing in a single stock. I'm thinking about doing the Christmas gift now too, to avoid commissions.

I'm plagued with doubts about whether I did the right thing, though. Is it mean to basically prevent my sister from using the cash as she sees fit? Do I have to get my niece a regular present as well, since a Sharebuilder account statement isn't very exciting? Have I overlooked any important tax consequences of this action?