Financial Time Perspective (2008-12-15)

by David John Marotta

I was back at Stanford University recently and heard famed psychologist Philip Zimbardo lecture on his latest book, "The Time Paradox." His work suggests that understanding your own time perspective may help you unlock the secrets of financial freedom. In other words, how we think determines who we are and what we do.

Zimbardo's book focuses on how we perceive the effects of time on every aspect of our lives and our decision making. His Time Perspective Inventory scores individuals in six different time perspectives. Each perspective comes with strengths and weaknesses, and some are better at handling modern life and wealth management.

Within Zimbardo's categories are two past, two present, and two future perspectives. Both the past and future perspectives are abstractions. In a very real sense, we only experience the present. The past is an abstraction of gratitude and regrets. Similarly, the future is an abstraction of possible fears and longings.

Although present thinking may have been critical in simpler times of survival, it isn't necessarily the best perspective today when wealth itself is also the abstractions of shares in a company or zeros in a bank account.

People who live in the future are by far the most successful. Western civilization rose and prospered because of our future-oriented culture. Unlike present hedonists who live in their bodies, Zimbardo writes, "Futures live in their minds, envisioning other selves, scenarios, rewards, and successes."

He explains that you can test for future thinking as early as age four by giving children one marshmallow and telling them if they wait until you get back to eat the marshmallow, you will give them another one. Interestingly, children who have learned to delay gratification at age four score an average of 250 points higher on their Scholastic Aptitude Test (SAT) 14 years later. It isn't that time orientation is determined by age four. In fact, Zimbardo argues we are all born as present hedonists, seeking pleasure and sustenance while avoiding pain and bitter tastes. But by age four it is already apparent that some children live in an environment that encourages a future orientation.

Futures make money. They earn more. They get more education. They get better jobs. But most importantly, they save more and spend less. They discuss finances with their children and model future-oriented choices every day for the next generation.

Much of the advice in this column could be summarized as acting in a prudent future-oriented way in your investments.

Present hedonists use their money for fun and exciting experiences. They are the most likely to pile up credit card debt or experience home foreclosure. Their journey from rags to riches, if it happens, is often a round-trip ticket. They consider savings a token expense and a low priority. Impatience may cause them to chase returns.

To present fatalists, money just doesn't matter. They don't designate their money for present or for future enjoyment but simply spend it because it's there. Thus their spending and investments are random, and they are unlikely to reach their long-term goals.

Past-oriented people are rare in the United States. They generally do not take risks, and they invest conservatively. Past-positives focus on their achievement of earning and saving and do not want to risk losing money. Past-negatives remember only investment downturns and don't want to be burned again. Neither the past nor the present-time perspectives prove to be as successful as the future perspectives at managing their wealth.

We can view our present market turmoil through each of these time grids. Past-positives are thankful for longer term gains over the last few decades, whereas past-negatives only measure their losses from the recent high watermark. Present hedonists use market losses as an excuse to enjoy rather than invest; present fatalists don't believe what they do matters because global forces are completely out of their control. Only future goal-oriented investors recognize that the stock market has gone on sale, and today is an even better day to invest in a balanced portfolio.

Zimbardo also points out that "smarter people have higher annual incomes but are no wealthier than average people are." Given that every 10 IQ points correlates to $4,250 a year more in annual income, smart people should be richer. Alas, they are not. Smart people make more, but they also spend more, sometimes a lot more. Zimbardo concludes with this simple moral: "To become wealthy you cannot spend more money than you make, and you must invest wisely." Sage advice.

Some researchers suggest that the present orientation of the poor is pathological. But Zimbardo is more optimistic. He believes we can learn to be sufficiently motivated and to change our attitudes and the behaviors associated with them.

Zimbardo offers the following five simple steps toward achieving financial freedom and using time to work for you: (1) The present is the best time to start investing. (2) Time in the market is more important than timing the market. (3) Know when your time will be up; those with a long time ahead of them can afford more risky investments. (4) You can't time the markets. (5) A hedonistic time perspective is an expensive habit few can afford.

I asked Professor Zimbardo what he thought was the ideal time perspective for Americans today. He replied, "It is vital to develop an optimal blend of several time zones, so that you are able to flexibly shift mentally from one to the other depending on the situation. When there is work to get done, call up your future focus--but not excessively so (that can lead to sacrificing family, friends, fun and sleep). When you complete a task, take a time-out to reward yourself, indulge the present hedonist in you (get a massage, manicure, hot tub, see a movie, read a good book, meet a friend at a coffeehouse) but only moderately so. And always make time to engage with your positive past, your family, your own identity over time, with your legacy and cultural foundation. The past gives you roots; the present hedonism supplies the energy to take chances, to improvise, to take risks; the future gives you wings to soar to new destinations, to imagine new visions. You can have it all if you work at creating this balanced time perspective."

Perhaps a future study could find the correlation between your Zimbardo Time Perspective Inventory Score, your credit score and the size of your investment portfolio. To see how you score, visit <a href="www.thetimeparadox.com" target=_blank>www.thetimeparadox.com</a>; take the test and score it.

from http://www.emarotta.com/article.php?ID=315

Owners of Second Homes: Beware of New Tax Laws (2008-12-08)

by David John Marotta

If you own two homes, sell the one you are living in and move into your second home as soon as possible. Tax changes taking effect on January 1 will make owning a second home much less attractive in 2009. As a result, the already depressed market for vacation homes will deflate even more.

Previously, any capital gains on your primary residence were excluded up to $250,000 for singles and $500,000 for couples. A primary residence was defined as any home you had lived in for two of the previous five years. The "prior rule" gave seniors moving to a new residence three years to make the move permanent. During that time they could still sell their original residence and take advantage of the exclusion.

It also allowed seniors who had a vacation home to move there and sell their primary residence. After two years their vacation home qualified as their primary residence. Young grandparents approaching retirement could buy a retirement home as a vacation destination while they were still working. After retirement they had time to sell their original home and in two years gain a full exclusion for their new residence.

With the new rule, primary residence is not something you can qualify for. Rather it is just a percentage of the time you live there.

The new law eliminates the capital gains exclusion, prorated on the amount of time a home was not your primary residence. After January 1, every day you aren't living in a home starts adding to the percentage of capital gains tax you will ultimately be obliged to pay.

Also, capital gains are no longer waived on a primary residence unless it has always been your primary residence. Starting in 2009, the percentage of time a home is not your primary residence will be the same number used to calculate the amount of capital gains that won't be waived. For example, if you own a house for ten years and have only lived in it for five, you will have to pay taxes on half of the capital gains when you sell it.

These are the same capital gains that President-elect Obama promised during his campaign to raise from 15% to 28% on the most productive citizens. Some states (e.g., California) tax capital gains at ordinary income tax rates, adding an additional 9.3%. So people who make significant contributions to society could easily be facing taxes of 37.3% on gains that are mostly inflation.

This isn't just a problem for the wealthy. You can be pushed into the top 1% of income tax payments simply by selling a house in California. Middle-class couples routinely get hit with unexpected taxes selling a home with capital gains well over the $500,000 exclusion. Because it is not a onetime exclusion, couples who have stayed in the same house for 40 years get socked with the tax, whereas couples who move every decade have multiple chances to realize smaller gains that are under the limits. People who move frequently shouldn't be rewarded with a tax break.

Here's another factor to consider: Home appreciation is mostly inflation. Taxing government-created inflation as so-called gains isn't fair. Even according to the official inflation numbers reported by the government, the equivalent of a million-dollar home today was a $179,154 home in 1970. Calling the $820,846 inflation a capital "gain" is ludicrous.

Class envy is equally mindless. Capital gains on real estate affect your finances even if you don't own a second home. The housing market isn't segmented into primary and secondary residences. What depresses the values on second houses depresses the value of all homes.

The second-house class is the very group that could have helped shore up today's slumping housing market. Speculators who would have bought real estate at the current depressed prices will find this option far less attractive in 2009. Instead the new law will encourage them to sell their current residence (taking the full deduction) and move into their second home. Then their second home will become their sole and primary residence, and they won't have to deal with future nonexempt capital gains taxes. Ask your financial advisor about the potential costs of continuing to own two homes. If you delay, you may be holding an unused vacation home until you die just to avoid this new tax burden. And as a result, your heirs will inherit the house with a step-up in cost basis.

Because of the law, thousands of additional homes will be added to the market, softening the demand for housing even further. It is as though a shortage of people are buying real estate and we've passed a one-per-customer tax incentive law. There is no reason to discourage what no one is willing to buy. The new legislation will probably push home values to new lows during 2009.

Why the law was changed is unclear. The old law was difficult to abuse. Those who were rapidly turning over real estate could not take advantage of the law. If someone tried to flip 25 homes, it would take 50 years. The new law doesn't make any sense, but if it did make sense, it probably would not be Congress.

The new law won't bring in much additional revenue either. But it will complicate record keeping and tax returns for anyone selling a home they have not lived in continuously. As a result of these disincentives, buying or selling vacation homes will become less desirable.

This legislation graphically illustrates the deadweight costs of taxation. Rarely is the concept so clear. The law will remove much of the value of vacation homes from the economy without collecting much additional tax revenue. All pain, no gain. It teaches us a sad lesson about the destructive power of taxation.

Vacation homes represent an expense that can easily be let go in challenging economic times. Many families own a vacation home during the season of children or young grandchildren. After that, the travails of maintenance and repairs outweigh their pleasure in the home. Management companies remove much of the headache but make the economics even more problematic.

In times of rising home values, the investment in a home at least kept up with inflation, but with the new laws the government will tax you on that inflation. As a result of these changes, consider simply renting a vacation home and letting someone else pay the capital gains tax.

from http://www.emarotta.com/article.php?ID=314

When Will the Markets Stop Dropping? (2008-12-01)

by David John Marotta

For the many investors glued to the news, the markets appear to be dropping uncontrollably and unstoppably. It doesn't appear rational, and they worry it could go to zero. From high to low, losses have halved account values. Waiting appears foolish, and selling seems cowardly. When will the markets stop dropping?

U.S. credit market debt is at an all-time high. It has grown from 250% of gross domestic product (GDP) a decade ago to more than 350% this year. Even 250% a decade ago set highs we hadn't seen since the Great Depression. The problem has not been the federal deficit, which has actually shrunk from 46% to only 37% of GDP. The primary problem has been borrowing, both by our financial institutions and by households. These two components (domestic financial debt and household debt) have both risen dramatically.

Domestic financial debt rose from 64% of GDP to 114% over the past decade. Financial institutions leveraged because it meant they were making more money. Borrowing money and putting that money to work translated to bigger profits in a rising economy.

Household debt was the second biggest increase. It rose from 66% of GDP to 100%. Savings rates dropped and spending rates soared.

If Adam put $100 in the bank, the bank only kept $10 and loaned the other $90 to Cain. Then Cain bought a plow from his brother Seth, who put $90 back in the bank. The bank kept $9 and promptly loaned the other $81 to Cain's son Enoch. Enoch paid his cousin Enosh, who put the money back in the bank. Feeling rich again, the bank loaned $73 to Irad, who paid Kenan for a pair of sandals. Kenan put the money back in the bank, which loaned $66 of it to Lamech.

The debt was fruitful and multiplied.

At this point the bank had $27 in cash reserves and $244 in outstanding loans. This situation was the United States a decade ago. Nobody wanted dollars while profit could still be made by keeping the money moving.

Lamech bought a couple of wedding rings from Jared, who put the money back in the bank. The bank loaned Jubal $59, who bought wood from Noah to make a lyre.

At this point the bank had $41 in reserves and $369 in outstanding loans. There appears to be $410 of wealth, and if there had been a stock market back then it would have been at an all-time high.

The number of dollars flying around is so high that people would rather have stuff than dollars. The line of Seth was preparing for a rainy day, but the line of Cain, so long as the velocity of money continues and no one tries to lower their debt or deleverage everything, will appear normal, perhaps even better than normal.

And then the rainy day came, and the bank asked everyone to pay them back.

A day of reckoning always comes when people use debt to leverage their investments. Only those who have assets will survive the deluge intact, and even the savers will not avoid getting wet. It is as if being debt free is your boarding pass for entering the ark. A little rain, and suddenly no one wants fancy jewelry and musical instruments. The only thing people want is cash to pay off their bank debt. Their very survival depends on it.

Highly leveraged financial institutions are going out of business, and the marginally leveraged ones are scrambling to pay down some of their debt in advance of the rising water. They are selling whatever they can to raise money. Individuals who enjoyed using their mortgages as ATM machines are now in danger of losing their homes. People used to be willing to pay $140 for a barrel of oil. Now they would prefer $60 cash instead.

To use a different analogy, it is as though your next-door neighbor got into credit card debt and is now trying to pay it off. On his front lawn he is having a yard sale. His couch is going for $10, his good china for $20 and his plasma TV for $25. And you think to yourself, "That's the exact same couch I just paid $200 for, and my neighbor is selling it for $10!" In fact, you are amazed that the entire contents of your house have dropped in value.

Diversification among household contents did not help because the financial institutions that are deleveraging also owned a nice diversified portfolio. Nothing is fundamentally wrong with couches, china and plasma TVs. The problem is that when a nation is deleveraging, everyone wants cash to pay off their debts. When you look down the block, it seems like every other house is having a yard sale.

Selling your assets in this market is a foolish move.

If you don't need to sell your couch, getting $10 for it is even more risky than holding on to it. If you sell your couch for $10 (fearing the going price for couches might drop to $9), at what price would you buy another couch again? If couch prices drop to $8, would you buy then? If couch prices rise to $12, would you buy then? Study after study suggests that by getting out, you risk having to buy the investment again later at a higher price.

The contrarian move is to look for an antique dining room table for $30. Buy it, store it in your basement for a few years and then sell it for a nice profit. Your neighbor desperately wants the $5. If you sell your couch for $5, you are investing in cash. You are betting that one of your neighbors is going to want $5 tomorrow even more than he wants $5 today. You are getting $5 today and offer that $5, hoping to get something even more valuable than a couch for it.

In other words, you are generating cash with the expectation that if the markets drop further you will put the money back into the markets and get some good china for it.

Many seasoned investors are fearful, which drives them to get the $5 one way or another and never buy household goods again. That is not a wise long-term plan. It is easy to get out of the markets, but it is difficult knowing when to get back in. Investor psychology tells us people won't get back in if the markets drop lower. They simply stay out until the markets show signs of recovering. And "recovering" means waiting to get back in until the markets have risen considerably higher than the point at which they got out.

Second-guessing the markets is especially difficult because they are a leading rather than a lagging indicator. They change direction long before the underlying fundamentals of the economy. Studies suggest that the markets start to go up 9 months to a year before the economy begins to recover. That means the markets may be bottoming out now in the expectation that the economy will recover in the third or fourth quarter of next year. As financier Warren Buffett recently wrote, "What is likely is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up."

With market volatility and deleveraging pushing the markets to irrational lows, the corresponding recovery could be an equally volatile snap-up in some sectors. Missing the upside could be costly.

As an investor, you should always have five to seven years of spending in relatively stable investments. The remainder of your portfolio should be able to weather the duration of even this tsunami. If you don't need to sell your couch to deleverage, sit on it. And if you are especially contrarian and courageous, buy your neighbor's antique dining room table.

from http://www.emarotta.com/article.php?ID=313

Dropping the Baton in Estate Titling (2008-11-24)

by David John Marotta

How you "title" the property you own is a lot more important than you might think. Failure to title your assets properly could undo the best will and trust planning that money can buy. And it could make a huge difference in how much estate tax your estate will pay and how much hassle your heirs will experience when you die.

Consider the case of Jonathan and Martha Kent. Jonathan spent his entire adult life building his business in Smallville to a value of $5 million. Then the Kents were in a car accident. Jonathan was killed instantly, and his wife Martha died four months later from her injuries. Their son Clark returned from Metropolis to handle their estate.

Let's look at the different ways the Kents could have titled their property and the effect of each one. We'll think of Jonathan's estate as a baton. The various ways of titling that ownership are alternative ways to hold the baton.

<b>Sole ownership</b>

If Jonathan was the sole owner of his small business, he was the only one holding the baton. When he died as sole owner, the baton fell to the ground. The required legal process called "probate" would determine the next holder of the baton. If he did not have a will, the laws of the state where he lived at the time of his death in effect would write his will for him, under its laws of intestate succession.

In Virginia, state law assumes you would leave a third of your estate to your current spouse and two thirds to children, if you have children from a former marriage. If you don't have any children from a former marriage, state law provides that your entire estate goes to your current spouse.

The probate process can take months, even years. The personal representative must gather together the decedent's assets, pay his debts and taxes, and distribute the estate as directed in the will (if there was one) or as the laws of the state dictate if there was not. In Virginia, probate fees of about 0.15% of the value of the estate, are paid to the clerk of the court, and the executor of the state could charge an additional 3% to 5% of its value. On the Kent estate, probate costs alone might be well over $150,000.

You don't want to drop a $5 million baton into probate.

Also, if Jonathan was driving and a lawsuit was brought about the accident, his entire estate could be subject to any subsequent legal action. During the probate process, it might be difficult to pay Martha's medical bills.

Fortunately, no estate taxes apply when a spouse inherits assets. But just as probate has finished transferring assets to Martha, she dies, dropping the baton again and requiring another probate process.

During this second probate, assets are passed to the children, and all of the assets over $2 million are subject to 45% estate taxes. So the taxes on a $5 million estate would be $1.35 million. Even though the business is worth $5 million, Clark and his brother don't have the money for the estate tax, and they are forced to sell rather than inherit the business. Clark must return to his dead end job as a reporter for a city newspaper.

<b>Joint tenancy with rights of survivorship (JTWROS)</b>

In a JTWROS arrangement, two or more people hold the baton, and each one has an equal share. One person can sell his or her share and pass their grip on the baton to someone else. They can also break off their piece of the baton and keep the piece. But if they die, their share is given to those still holding on. The last one holding the baton owns it outright.

JTWROS does not require probate, which would make the transition of ownership from Jonathan to Martha easy and straightforward. But it does not protect the estate from legal action. Nor does it help solve the estate tax problem for Clark.

Joint tenancy titling trumps a will. Even if you have been careful in your estate planning documents, if you are not equally purposeful and intentional in how you title your assets you can ruin your plan. Financial accounts that use POD (payable-on-death) or TOD (transfer-on-death) arrangements, if sloppily done, can also thwart all your best estate planning intentions.

<b>Tenancy by the entirety (TBE)</b>

Only persons married to each other can hold property jointly as tenants by the entirety. With TBE, each spouse holds the entire baton. They can't sell their share and pass the grip to someone else because they don't hold a piece of the baton separate from the other tenants' pieces. And they cannot break off a piece of the baton and keep it for themselves.

TBE can provide asset protection features unavailable in other forms of joint ownership. Suppose Jonathan's accident was due to his negligence. If he and Martha held the baton as TBE, Martha can inherit the entire baton at Jonathan's death, free of Jonathan's liabilities.

In our litigious culture, wealthy individuals often have a bull's-eye painted on their backs. Everyone should make asset protection a priority. You should probably have an excess liability insurance policy, often referred to as an umbrella. If you are married, your real estate should be held in TBE. Virginia law also allows married couples to title their investment assets (called personal property) as TBE. Generally speaking, creditors cannot seize assets held in TBE because doing so infringes on the other tenants' rights to the entire baton. TBE isn't perfect, but it does give some liability protection to married couples.

TBE, like JTWROS, trumps a will. It has to be integrated carefully with your estate planning documents to ensure that it will not thwart your plan to reduce your estate tax exposure.

<b>Revocable living trust</b>

With a revocable living trust, the trust owns the baton. Think of it as a glove. The trustee controls the glove, and usually you name yourself trustee during your lifetime. Your hand is in the glove and holds the baton. Because the trust is revocable, you can do anything you want while your hand is in the glove. You can pass the baton from your gloved hand to your ungloved hand, passing the baton between the trust and sole ownership.

So long as the glove is holding the baton when you die, the baton does not fall into probate. The trust still holds the asset in the same way the glove still holds the baton. On your death the trust becomes irrevocable. The trust documents specify the next trustee and the distribution of the assets. The next trustee slips his or her hand into the glove and immediately controls the assets.

Revocable living trusts are common estate planning instruments. They avoid probate and thus help families hold on to the baton. By themselves they don't limit estate taxes or creditor claims, but they can be effective estate planning tools. In Virginia and many other states, the assets in your revocable living trust at your death are still subject to the claims of your creditors.

<b>Bypass Trust</b>

A bypass trust is someone who will hold the baton in a trust after you die, for the benefit of your surviving spouse. A bypass trust may provide Martha Kent with income from the business while she is alive, but it passes ownership in the business to her sons after she dies.

Upon Jonathan's death, with proper planning he could have arranged to put as much as $2 million free of estate tax in a bypass trust for the benefit of his wife for her lifetime. Upon her death it will pass tax free to the children. Martha can leave an additional $2 million to her children tax free. With the wise use of a bypass trust upon the death of the first spouse to die, up to $4 million can pass to the children tax free, leaving only $450,000 worth of tax owed on the remaining million. With additional estate planning, the family can avoid even this tax.

Depending on the asset, the process for changing the title of your assets varies. To change the title on your house you must record a new deed. Changing the title on your car requires a trip to the Department of Motor Vehicles. If you want to change the title on your investments, you must send your custodian a letter. Drawing up legal trust documents to facilitate asset titling and transfer requires professional legal advice, which could be expensive. But the alternative is often even more costly.

Aside from the expense, estate planning remains a topic that few people want to contemplate. On the one hand, raising these issues with family members can make you feel like the prodigal son wishing his father was dead and he could enjoy his inheritance now. On the other, avoiding these issues can mean a lifetime of regret.

I'm very grateful that my father asked for an hour of family vacation each year to talk about estate planning issues and explain the plan. It may feel morbid the first time, but after a while, it seems loving and caring.

When people die without proper estate planning, the state distributes their assets in their own time. If someone involved is incapacitated, you may not be able to act on their behalf. Just because you are expected to take care of their affairs doesn't mean you will have the legal right.

Clip this article and send it to your parents as a way to begin the discussion. They will realize you want to know exactly what to do in an emergency. For your own estate, bring this column to your financial advisor and ask for a review of your titling and beneficiaries.

from http://www.emarotta.com/article.php?ID=311

Marotta Advisors join NAPFA Bus in Richmond, Virginia (2008-11-20)

by David John Marotta

Financial Organizations Are Taking Financial Education On The Road:

NAPFA Consumer Education Foundation, TD AMERITRADE and Kiplinger's Personal Finance magazine

join forces with local financial advisors to deliver financial education during national bus tour.

The national savings rate in the United States is currently at an all-time low, which means millions of American families are not in a position to plan for their long-term financial well-being.  This is a trend that must end.  To help educate people on the need to save and to promote the need for financial literacy, the National Association of Personal Financial Advisors (NAPFA) Consumer Education Foundation (NCEF), TD Ameritrade Institutional, and Kiplinger's Personal Finance magazine have teamed up with local members of NAPFA to bring this important message coast-to-coast.<img src="images/napfabus.jpg" align=right>

NAPFA members from across the state of Virginia met in Richmond on Thursday, November 20th, 2008, to conduct free advice events and symposiums to help consumers get their financial life back in order. The State coordinator for this event, Matt Illian, of Marotta Wealth Management of Richmond, and Bob Arms and Frank McCraw, of Marotta Wealth Management of Charlottesville, were on hand to answer financial questions for the attending public. David John Marotta, President of Marotta Wealth Management, was a guest speaker at the symposium, which addressed issues of concern for Virginians.

For the next year, Your Money Bus Tour will be going from border-to-border and coast-to-coast to deliver this important message.  Fee-Only financial advisors will be in cities across the country to conduct free advice events and symposiums where you can learn what you need to do to start saving and get your financial life in order.

Be sure to visit <a href="www.YourMoneyBus.com" target=_blank>www.YourMoneyBus.com</a> for information on the progress of the tour. Advisors also particiated in short video blogs including:<br>David John Marotta at <a href="http://www.youtube.com/watch?v=uo0TVi9sjgg" target=_blank>http://www.youtube.com/watch?v=uo0TVi9sjgg</a><br>and Matt Illian at <a href="http://www.youtube.com/watch?v=0EfO-UBADi4" target=_blank>http://www.youtube.com/watch?v=0EfO-UBADi4</a>

If you have questions about the NAPFA Consumer Education Foundation or would like a schedule of upcoming talks, please contact Marotta Wealth Management, Inc. of Charlottesville at (434) 244-0000, toll-free at (877) 244-1001, or by email at charlottesville@napfafoundation.org

You can also learn more about the NAPFA Foundation at:<a href="http://www.napfa.org/consumer/NAPFAConsumerEducationFoundation.asp" target=_blank> http://www.napfa.org/consumer/NAPFAConsumerEducationFoundation.asp</a>

from http://www.emarotta.com/article.php?ID=312

Keep Christmas Your Own Way (2008-11-17)

by David John Marotta

In Charles Dickens's "A Christmas Carol," Ebenezer Scrooge calls Christmas a "humbug" because of the foolish way people celebrate it. He asks his nephew, "What's Christmas time to you but a time for paying bills without money?"

Sadly, that sounds like Christmas for many American families binging on expensive gifts.

Every year, Americans seem determined to be more frugal than the year before because of the latest economic conditions. One year it is rising energy prices; another year it is rising interest rates. This year, of course, the drop in everyone's investments looms large. And so once again Americans will promise to cut back on presents, food and decorations and to fund their celebration from actual income instead of savings or credit cards.

But while the retailers worry, cut prices and may have an off year, the credit card companies are never concerned. One in every five families won't pay off their credit cards in January. They will pay exorbitant interest rates instead and begin the downward spiral into financial ruin. Many families, in fact, are still trying to pay off their credit card purchases from last Christmas.

We are a nation of consumers and debtors. Total U.S. credit market debt has reached an all-time high in 2008 at 350% of gross domestic product (GDP), up from 255% a decade ago. This increase over the past 10years is not due to the federal deficit. Only a paltry 37% of GDP is federal government debt, which is down from 46% a decade ago. The largest increase has been in financial institutions, whose debt rose from 64% to 114% of GDP. The second largest increase has been in household debt, which rose from 66% to 100% of GDP. Now the country is de-leveraging, and American families must do the same.

Christmas is an emotional time. Few families set a budget for spending, and consequently credit card debt spikes considerably. Our materialism urges us to show our love for friends and family members with big and expensive gifts. As a result, we often buy even more lavishly than the receiver would have wanted us to.

It's time to differentiate between the celebration of Christmas and the commercialization of Christmas. This year, give your family the gift of financial peace of mind. Celebrate the season simply.

Four decisions, if made together as a family, can help reduce the frenetic materialism of the season and bring back the holiday's warm fuzzy feelings: Cut back your gift list. Limit how much you spend. Decide to be charitable. Determine which activities bring you real joy.

We get into trouble when the number of people we buy for increases beyond our means. Make a list. Cull the list. Engage in a little honest financial talk among friends and family. Copy this article and highlight this section. They will understand that your retirement account is way down, finances are tight and you need to be saving more money to get back on track. Other family members may be equally relieved to cut back their own gift list.

For example, you might decide that only children 12 and younger among extended family members will get gifts. If that decision doesn't keep gift giving reasonable, ask each extended family member to draw the name of one child under 12 and buy a gift. These seem like sensible rules.

Limit how much you spend. All of your excess holiday spending should fit inside 1% of your annual take-home pay. So if your net income is $40,000, you have a $400 budget for Christmas. If you bring home $100,000, you can spend $1,000. If these amounts seem small, you are in good company. On average, people spend about $800 on gifts alone.

Try taking care of all of your friends with a single baking project. Cookies, homemade granola, Russian tea, or herb mixes are easy to make in quantity and always welcome during the holidays.

Family Christmas letters are a wonderful way to keep distant friends up to date on your life, but consider sending them via e-mail or posting them on a blog or website for free. It is better for the environment--and your budget.

For family members, consider buying gifts that are already part of your budget or that encourage your children to develop their inherent talents. My favorite Christmas gift idea comes from "The Homecoming," the first movie about the Waltons, in which the father buys John Boy paper and pencils. His gift, which affirms his son's choice of writing as a career, is the emotional climax of the story. Many parents' gifts at Christmas have changed the course of their children's lives or careers by inspiring them thoughtfully in one direction or exposing them to a new interest.

Decide to be charitable. We either choose to be the kind of people who take delight in giving generously or we are not generous. Jesus, whose birth we celebrate at Christmas, saw a poor widow putting two small coins worth only a fraction of a penny into the treasury. He called his disciples and said, "Truly I say to you, this poor widow put in more than all the others. They gave out of their wealth; but she gave out of her poverty."

Giving ungrudgingly can be an act of faith, a recollection of all we have been given. It is ultimately a declaration that we want to be generous people.

Finally, decide which activities bring you real joy. Dickens himself understood this. As his son explained, Christmas was "a great time, a really jovial time, and my father was always at his best, a splendid host, bright and jolly as a boy and throwing his heart and soul into everything that was going on. . . . And then the dance! There was no stopping him!"

Take a lesson from how the reformed Ebenezer Scrooge celebrates Christmas. He does six things, and only first two of them cost money.

First, Ebenezer buys the Cratchits a prize turkey anonymously. He decides to treat his employee Bob Cratchit like family. Sharing a festive meal together promotes community. Today less than 20% of family meals are eaten together. Even if all you did during the holidays was to share a meal, it would make the season unique and special.

Expensive food does not make a meal a feast. In fact, it is eating out at fast-food places and precooked convenience foods that burden our budgets. The leisurely pace of homemade family meals costs a fraction of our typical eating on the run. Fold the napkins fancy, and use the good china.

Second, Ebenezer gives generously to the portly gentleman who was collecting for the poor. Ebenezer decides he wants to be charitable, and so he includes a great many back payments in his donation.

Third, Ebenezer is kind and gracious to everyone he meets. This attitude costs so little, but it sometimes seems as scarce as the latest sold-out fad toy. Ebenezer smiles. He is pleasant. He says, "Good morning, sir! A merry Christmas to you!" When he previously would have responded with a gruff word, he reacts now as a shock absorber with forgiveness and forbearance. These simple gestures cost us nothing but are all too uncommon.

As Ebenezer's nephew Fred describes Christmas in the opening scene of Dickens's famous story, it is "a kind, forgiving, charitable, pleasant time: the only time I know of, in the long calendar of the year, when men and women seem by one consent to open their shut-up hearts freely, and to think of people below them as if they really were fellow-passengers to the grave, and not another race of creatures bound on other journeys."

The fourth action of the reformed Scrooge is going to church. Worship is an act of celebration that helps us remember with gratitude all that God has provided. Our community provides scores of opportunities for free celebration during the holiday season.

Fifth, Ebenezer walks about the streets of London enjoying the sights. Sometimes a celebration can be simply taking time out of our busy lives to notice what is noble and beautiful all around us. Pausing and reflecting gives us time to refresh our bodies and renew our minds. It allows us to see beyond the ordinary and routine and appreciate life to its fullest.

Perhaps you don't feel that way. All the more reason to stop and reflect. Feelings often follow thoughts. Having an attitude of gratitude, being mindful of others in the present and looking confidently and eagerly toward the future encourages us to be people who live life with more satisfaction.

For his sixth and final new way to celebrate Christmas, Ebenezer goes to his nephew Fred's party for fun, games and music. Christmas provides the unique opportunity for the bonding that comes from joyful laughter.

After a musical interlude, the partygoers play "Forfeits" because "it is good to be children sometimes." The commands are usually silly requests intended to get everyone at the party laughing, such as "dance a jig," "tell how to make a pie without talking," "yawn until you make someone else yawn" or "try to stand on your head."

Next they play the games "Blindman's Buff," "How, When and Where" and then "Yes and No." None of these pleasures cost a cent, which is a lesson Scrooge as well as many of us have forgotten. Your best holiday delights need not even show up as a line item in your budget.

This year, take the hype out of the holiday. Feast merrily, give generously, show kindness, worship thankfully, live mindfully and laugh playfully. Cut back your gift list. Limit how much you spend. Simplify your Christmas, and set your family on the road to a lasting peace about finances.

from http://www.emarotta.com/article.php?ID=310

Give Generously During Hard Times (2008-11-10)

by David John Marotta

As a response to the recent market correction, you can enrich your life in three healthy ways: Cut back your spending, increase your savings, and give more generously to charities of your choice.

The first two recommendations are obvious. If your retirement account is down, reducing your spending and increasing your savings are the best ways to get it back on track. If you are still appreciating assets, this strategy will help you meet your retirement goals. And if you are retired, it will help you stay within your safe spending rates. Even trimming your expenditures by $100 a month during retirement can add an extra quarter of a million dollars to your estate over a 30-year retirement.

But just as critical during an economic downturn is increasing your charitable giving.

Charities are hit especially hard during rough economic times. They face reduced giving and often greater needs. They must find supporters who give more in order to offset those who give less.

Charity freely given is a virtue distinctly more valuable than any government program could be. For charity to be a virtue, it must be freely given. But government entitlement programs are funded from taxes. When you pay your taxes, it is no more virtuous if they are used to buy cruise missiles than to fund school lunch programs. The only virtue here is meeting your legal obligations.

Taxes are not freely given. They are coerced through the threat of imprisonment. Taxes are an obligation and a duty, not a virtue. Charitable begins only after you meet the financial obligation of paying your taxes.

The virtue of charity is an important one to understand and appreciate. True virtue and morality cannot be legislated. Government cannot make people virtuous; it can only make certain actions illegal. Coerced charity ceases to be charity. Politicians from both parties need to understand this principle.

Furthermore, only when you give of your resources is it true charity. Government has no resources of its own. It can only take the production of others and redistribute it, which certainly is not charity.

Those who seek to be charitable must first produce more than they consume to have something to share. As much as it may make you feel good to support laws that take from the productive and give to others, it is not charity on your part. Voting to spend tax dollars isn't charity. Only individuals who give from their own resources can be charitable. Voting for government entitlement programs is like being generous with your neighbor's credit card.

But doing good while doing well is an American tradition. We are a nation of generous people who generally don't want to pay taxes.

No matter what worthy organizations you support, you can donate up to 15% more if you give them appreciated stock instead of cash. For example, if you sell $1,000 worth of appreciated stock, you must pay the capital gains tax of 15%. If most of the stock's value is appreciation, the tax approaches $150, leaving only $850 for charitable giving.

This is the usual time of year to gift investments with gains to reduce your taxes. But that assumes you still have holdings with significant appreciation. Because of the market downturn, fewer people have appreciated stock, and nonprofit organizations as a result are feeling the pinch.

Fortunately another tax-savings opportunity is available for the charitably minded. The bailout plan includes one add-on that actually extended a good idea, at least for another year.

If you are age 70 1/2 or older and taking the required minimum distribution from your IRA account, you can give to charity directly from your IRA. Your gift will count as your required distribution. The gift will count as a distribution, but it won't be considered taxable income.

Normally you would be obliged to take the distribution, increase your adjusted gross income (AGI), and then gift to charity as a charitable deduction. The difference may not be obvious, but it's there. Many calculations in the tax code are tied to your AGI. Increase your AGI and you increase your phaseouts and other additional taxes. Take $5,000 out of your IRA and give it to charity, and you owe a significant additional tax on your generosity.

This provision in the bailout allows you to gift directly from your IRA. Although you won't get a deduction, it doesn't matter because it won't count as AGI in the first place. But here's the downside: This provision was only passed recently, and thus you can only use it on distributions you haven't taken yet. For many people, that might only mean their December distribution, but others take their entire distribution at the end of the year.

The details are complex, so contact your tax professional or financial planner to make sure you are complying with the IRS rules. And give purposefully what you have decided to give, not grudgingly or under compulsion, because God loves a cheerful giver.

If fear and worry about your own investments are eclipsing your charitable nature, there's help. The nonprofit <a href="http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm " target=_blank>National Association of Personal Financial Advisors (NAPFA) Consumer Education Foundation</a> is offering a free seminar this Wednesday, November 12, 2008, from 7 to 8:30 p.m. at the Northside Library, 200 Albemarle Square, Charlottesville. The topic is "Five Things to Do in These Financial Markets." Bring your questions and your concerns.

from http://www.emarotta.com/article.php?ID=309

The Assault on Free Markets (2008-11-03)

by David John Marotta

Free markets are under assault in America. We have seen much hyperbole and slander in these past two years of political polarization. But the idea of capitalism and free markets has received more negative campaigning and vicious attack than both candidates combined.

I prefer not to discuss the presidential candidates or the election tomorrow. Like many of you, I am sick of the campaign pomp and media horse race commentary that leaves those of us wanting a serious discussion of the issues quite frustrated. Rather, I want to talk about the specific proposal of increasing taxes on those households making over $250,000 ($200,000 for single people) and the claim that 95% of Americans will therefore not be affected.

Class politics and warfare are standard weapons of intellectual ideology but not a fruitful way of looking at American society. It is difficult to overcome the sneering and disdain for the productive class that both candidates have pounded into us. But such cynicism is unwarranted and a by-product of inexperience.

The charge is that to be "fair," the top 5% should be paying more, but we have no rational definition of that word. Politically, "fair" mobilizes and unifies support among voters. But if they stopped to ask, they would find they disagree on its meaning and implementation. In fact, the top 5% are paying considerably more than their fair share and should be given a tax cut.

As defined by adjusted gross income (AGI), the top 5% of taxpayers pay over 60% of the income tax collected by the federal government. That percentage, 53% in 2001, has increased every year. Concentrating the tax burden on the top 5% has also been the trend, rising from 35% in 1980. It isn't right to increase their taxes when they have already been laden with an additional 25% of the tax burden over the last 30 years. It isn't fair.

Despite these facts, this group has been so vilified as the idle rich that most Americans cannot sympathize. But the top 5% are not necessarily rich. And they certainly are not idle. Using income as a measurement of rich does not make sense. Imagine a small business owner who one year earns over $250,000 and leaves most of those assets in the business.

Using our class warfare definition, that small business owner is rich. But a quarter of a million dollars a year is not what it used to be. After adjusting for inflation, earning $250,000 today is equivalent to earning $44,336 in 1970.

Now imagine a couple in retirement with multimillions in a combination of investments and home equity. Using that same AGI yardstick, our retired couple could be below the poverty line. They may be wealthy, but they have no earned income. Why should the small business owner get socked with extra taxes and the retired couple enjoy a tax break?

Using the yardstick of annual income to talk about the rich and the poor as though they are fixed groups of people doesn't work either. Most people do not remain in the same income bracket over a single decade. Some fluctuate wildly. One year you could be below the poverty line because you are retired. The next year you could be in the top 1% simply by selling a second home in California.

Before we additionally burden those who are the most productive, imagine what running your own business would be like. Assume our small company has $1 million in gross revenues. Five employees earn $65,000 each a year, and you, the owner of the company, earn $75,000. Owners are paid both a salary for their work and again as owners of the company if any profit remains at year-end. Any profit in a small business flows directly onto the personal income tax of the owner, increasing AGI.

As the owner, you pay the employer portion of FICA and Social Security (an additional $24,800) in addition to having your own deducted. You also pay the average 78% of each employee's family health care coverage, an additional $11,059 per employee. Your total personnel costs thus add up to about $500,000. Perhaps all of your other overhead can be contained to $300,000, leaving, in a good year, $200,000 of profit, or 20%, a bare minimum of profit for the size of the business.

Small businesses go under at an alarming rate. The primary reason is cash flow. Either a drop in revenues or an increase in expenses swamps an owner's ability to keep the business running. The best defense is a healthy profit margin. Because of the risk, venture capital expects a return of 20% to 40%.

With any expected return of less than 20%, you would be better off investing elsewhere. If you think the stock market has been volatile lately, consider what it is like to start and run a business. The stock market as a whole will never drop to zero, but the value of a small business--even one in which the owner has invested years of sweat equity--can go belly up quite easily.

Let's assume you run your company with only a 20% profit margin, which for safety's sake you leave in the business for growth and expansion. So after adding this profit to your salary of $75,000, your adjusted gross income is $275,000. If your spouse has any income, you are in deeper trouble. If he or she is a business owner too, you may be part of the top 1% who pay 40% of income taxes.

If you are lucky enough to have $200,000 in profits one year, you must pay about half of it in state and federal taxes. You can only keep $100,000 in the business. If the next year you have $200,000 in losses but insufficient funds to cover them, you must declare bankruptcy. Through the simple ups and downs of business profits, our progressive tax code socializes your profits but privatizes your failures. And by doing so, we make the success of your business much more difficult.

Given the downturn recently in several industries, ask yourself what you would do if you were running a small business and had employees counting on their paycheck to feed their families. Last year you made enough profit to cover this year's losses, but you lost half that profit to taxes. Uncle Sam isn't going to give those taxes back this year, perhaps some next year, but not this year.

In addition to raising the top marginal rate from 35% to 39.6%, part of the proposed tax increase raises the cap on Social Security taxes. About a third of those affected by raising the cap would be small business owners.

In two Wall Street Journal editorials, Michael Boskin found these proposals would raise the marginal tax rate from 44.6% to 62.4%. As a small business owner, currently you can only keep 55.4 cents on any additional dollar you earn. After these tax increases, you will only be able to keep 33.7 cents on the dollar.

Although only a small percentage of small businesses will get hit with these taxes, they represent the bulk of economic productivity and job growth. Two thirds of small business profits are earned in households making more than $250,000.

Edward Prescott, who won the 2004 Nobel Prize in economics, compared the highly taxed European countries and the United States and found that Europeans work a full 50% less than Americans. Incentives toward work actually succeed. And lest you think the difference in work is simply cultural, in the early 1970s before Reagan lowered the top marginal tax rate, it was Europeans who worked nearly 50% harder than Americans.

The most productive wage earners are among the hardest workers. A study by Steven Landsburg showed that leisure used to be evenly divided among the classes, but it isn't any longer. Although Americans as a whole have an extra four to eight hours of leisure per week, this extra leisure has been gained primarily by those in the lowest tax bracket. Today more than ever, it is the working rich and the idle poor.

Many believe it is acceptable to redistribute income but would consider it absurd to redistribute leisure. It turns out there really is little difference.

Additionally, it isn't a zero-sum game. Money taken from those earning over $250,000 isn't necessarily used productively. The most productive wage earners also are the most productive people that society can allow to spend the wealth they have earned.

Those with significant incomes save, which lowers interest rates. They start and invest in companies that create jobs and expand the economy. They hire others because their own time is more valuable to the economy working in their business. And they give their money to private charities. By comparison, the government is more wasteful in everything it does.

The government does not save; it deficit spends, sucking capital from investment. Government may employ people, but it doesn't create jobs that stimulate the economy. Unlike private enterprise, government can deficit spend indefinitely, creating a moral hazard. Government may spend money, but none of its spending frees it to produce more in the economy. And government entitlement programs offer none of the negative feedback that private charities provide. As a result, they are ripe with unintended negative consequences.

Only about 5% of people start and run businesses. Their work employs the other 95% of us.

Small businesses are most likely to be started by middle-aged white men. This demographic is also the least likely to be favoring taxes on those with reported earnings over $250,000. In a recent poll, 71% of small business owners said they could not name one way either U.S. presidential candidate would help their business.

Tax the most productive members of society and everyone will pay with lower wages, less benefits, smaller 401(k)s and higher prices. All this pain and suffering simply for the opportunity to increase government's wasteful spending. We can't tax our way to prosperity. What we need is a revival and respect for the entrepreneurial spirit--and more empathy for the productive class.

from http://www.emarotta.com/article.php?ID=308

Avoiding Another Lost Decade (2008-10-27)

by David John Marotta

Many investors are panicking. From its peak in March 2000, the major market indexes still show significant losses. Even looking back over the past 10 years provides little comfort. The news media is calling it "the lost decade."

The lament began with a front-page Wall Street Journal article in March of this year that noted the S&P 500 had only gained 1.3% over the past 10 years, factoring in inflation and dividends. Since then, the market has continued to lose ground, leaving investors depressed and discouraged about their investments.

Many proactive investors experienced an even larger drop when in their scramble to beat the markets, they sold what had just gone down to purchase what was just about to go down. Chasing returns often amplifies losses and volatility, so much so that many investors believe they are cursed with the reverse Midas touch: What they bought must go down.

As if to add to the misery, many buy-and-hold investors did not even receive the flat market return. They thought they were purchasing actively traded funds, but they were simply buying closet index funds with overly inflated expense ratios. Excessively loaded fees sapped value from their investments while the underlying strategy went nowhere.

I've said before that we do not recommend S&P 500 index funds. Because the S&P 500 is a capitalization-weighted index, it tends to buy more of a stock when it goes up and hold less of a stock when it becomes more reasonably priced.

If the S&P were a financial advisor it would say, "Let's buy mostly large-cap growth stocks in the industry that did well last year with a high price per earnings ratio." The result of this advice is a very aggressive and volatile portfolio that does better at the end of a bull market than at the beginning. And it performs very poorly at preserving capital during a bear market--exactly what has happened over the last decade.

If you are invested primarily in funds that mimic the S&P 500, a lost decade should be no surprise. If we use market history to run hundreds of Monte Carlo simulations on a portfolio invested in an S&P 500 index fund, projections indicate returns at or below zero about 6% to 7% of the time. This scenario is astonishingly accurate of trends in the past 100 years in which six ten-year periods showed no gains. These periods were the 10 years ending in 1914, 1921, 1932, 1938, 1974 and 1977.

If you were invested in the Vanguard 500 Index, your 10-year average return through the end of last month was 3.06%. Inflation during the past decade officially averaged 3.0%, although actual inflation was probably at least 5%. To make matters worse, your portfolio has dropped again this month. So if you were invested in an S&P 500 fund, your decade-long progress toward your retirement goals is at a standstill.

But if you were smart, you did not lose this past decade. If you were invested in a balanced portfolio, you experienced both higher returns and lower volatility.

Even a balanced portfolio of just six different common funds could have boosted your 10-year average return to 8.18%. And it would have lowered your volatility from a standard deviation of 14.4% to only 12.3%. That is a 5.12% better annual return with 2.1% less volatility.

The balanced portfolio I used as a comparison doesn't cherry-pick investments that have done the best recently. In fact, this portfolio underperformed the S&P 500 by 7.5% over the past quarter. Asset allocation means always having something to complain about.

My comparison portfolio allocates 20% to fixed income in the Vanguard Total Bond Index (VBMFX). Of the remainder, it allocates 31% to U.S. stocks with 21% in the Vanguard 500 Index (VFINX) and 10% in the Vanguard Small Cap Index (NAESX). Another 31% goes to foreign stocks with 21% in Vanguard Total International Stock (VGTSX) and 10% in the Vanguard Emerging Market Index (VEIEX). Finally, an 18% allocation is made to hard asset stocks in the T. Rowe Price New Era Fund (PRNEX).

The funds just described have been popular for over 10 years. They have not made their gains from active trading. And they have low expense ratios. These are not necessarily the best funds; they are simply typical funds in each of the asset classes.

Theory and practice agree that a balanced portfolio is a far superior way to meet your financial goals. In Monte Carlo simulations, balanced portfolios earn money over a decade, even the bottom 5% of random returns. The exact portfolio construction is less critical than including asset categories with a low correlation to the S&P 500. A well-balanced portfolio should result in good returns with lower volatility. Returns will still vary widely because the markets are inherently volatile, but the worst cases should be considerably better.

In conjunction with my recommendation of a diversified portfolio, the markets continue to provide object lessons and practical labs. Recently foreign stocks, emerging markets and hard asset stocks have all corrected more than U.S. stocks and are trading at valuations that make them an attractive way to diversify your portfolio. Holding on to an undiversified portfolio will, on average, keep on providing inferior returns with high volatility. Don't wait for an undiversified portfolio to recover. You can't afford to miss another decade.

from http://www.emarotta.com/article.php?ID=307

Part 2: Privatization Could Fix Social Security (2008-10-20)

by David John Marotta

Between 2037 and 2075, the Social Security program is projected to run deficits totaling $30 trillion. And annual shortfalls could be a problem as soon as 2017.

Privatizing the system could break the political deadlock between cutting future benefits and raising payroll taxes. We can have both our benefits and lower taxes if we finally admit that socializing retirement was a mistake and once again trust in the power of free markets.

For some people, the current volatility and decline in the stock market makes the best case against privatizing Social Security. Why would we want to inflict market shocks on every American's retirement? Isn't Social Security at least secure? Unfortunately, it is not.

Computing a return on Social Security as though it were an investment is difficult but not impossible. For example, my average annual return is about negative 7%. It is so poor for three reasons. First, average lifetime annual incomes above $60,000 produce miserable returns. Second, because I fall at the end of the baby boomers, my Social Security withholdings are at the current high rate of 12.4% rather than the lower rates that might have produced a better return. Finally, for those born my year (1960) or later, the age to receive full Social Security retirement benefits was raised from 65 to 67, further lowering returns.

A negative 7% return is huge. That's like investing $100 and 30 years later getting back $11, or investing $100 a year over 30 years and getting back $1,177 of your $3,000 investment. If recent shocks in the stock market seem difficult, imagine losing 60% of value over 30 years of investing!

Not everyone's return on Social Security will be as bad as mine. On average, Social Security provides a return of about 1.2%. If you don't work and therefore haven't paid into the system, your return is a complete gift.

As a comparison, the S&P 500 closed at a low on October 10, 2008, at 899.22. It closed exactly 30 years earlier on October 10, 1978, at 104.46. Even with the recent losses, investments in the S&P 500 have gone up 8.61 times, reflecting an average annualized return of 7.44%. Bond investments show a similar return with much less volatility. In fact, nearly any kind of investing has done better than the return within Social Security.

Proponents of the system view the redistribution of wealth from workers to retirees as positive. They believe we should pay whatever it takes to preserve the program in its current form. That the system destroys wealth and property rights is ignored because the system impoverishes the elderly more equally.

The proposal for privatizing Social Security is simple but elegant. Allow younger workers to deposit part of their Social Security taxes into a private account. If it produces a better retirement than Social Security, they can refuse Social Security and keep the private account. Otherwise they can take Social Security. Given my expected rates of return, putting just a tiny fraction of my withholding into a private account will do better than getting a negative rate of return in Social Security, even using the poor rate of return to where the market bottomed.

For more typical people who might receive the equivalent of a 1.2% return on their Social Security, they would get just as much benefit earning 7.44% on a third of the contributions. Thus 4.1% invested privately could do the job that 12.4% in Social Security can't seem to do without massive deficits. The proposals for privatization suggest allowing younger workers to invest 5% on their own. The other 7.4% would continue to be confiscated to pay aging early baby boomers the normal Social Security entitlement. A few years of deficit spending will be necessary before private accounts begin to relieve the deficit. But ultimately, private accounts will yield a greater benefit than Social Security ever provided. And when the baby boomers are off the Social Security dole, tax rates could be reduced to 5%.

Rather than relieving the problem, raising taxes exacerbates the inequities of Social Security and sends the average returns negative. Additionally, no matter where they are found, the higher taxes required to bail out Social Security would stifle economic growth. Most of the solutions that propose raising taxes result in top margin rate increases of over 15%. This level of curtailing freedom would kill economic growth and innovation.

Of course, cutting benefits is hardly a more attractive option.

Interestingly, either increasing taxes or reducing benefits sets the bar lower for private accounts to beat by any comparison. Privatization simply eliminates benefits for all the workers who can do better with 5% of their payroll taxes than the government does with the entire 12.4%.

Some people like the idea of using the growth engine of private accounts. But they suggest the government maintain control of the money. They would allow the government to invest retirement accounts directly in the private markets. So the government supposedly would protect citizens from their own ineptitude.

Others suggest that governmental involvement and oversight in the financial markets would bring a welcome measure of accountability to corporate America. They favor the so-called good intentions of politicians over the greedy motivations of the financial world.

Although tempting, this idea would be disastrous for freedom and for free markets. Even Alan Greenspan, former chair of the Federal Reserve, warned that governmental investing would "have very far reaching potential dangers for a free American economy and a free American society."

With private Social Security accounts, millions of workers would make independent investment decisions. But if the government took it on, the impact would be unified and rigid. And concentrating that power in a single government entity would magnify its effect. Having a Social Security trust buying and selling in the markets would be like turning on every electrical appliance in your house at the same time. The government retirement monopoly would short-circuit the free markets.

Overnight the government would have a controlling interest in virtually every major company in America. We should have learned from the scandal of political appointments to Fannie Mae and Freddie Mac that political power breeds political corruption.

The federal system would become swamped with feel-good laws requiring investments designed to stimulate the economy, create jobs or develop alternative energy sources. Federal advisors would shun investments that did not pass the litmus test of political correctness.

Some have suggested limiting the government's investments to passive index funds. But that leaves unanswered the question of which indexes will be used and in what percentages. Would all the investments be in U.S. stocks and bonds? If so, the resulting asset allocation would only use two of the six asset categories we recommend.

Ironically, the goals of collectivism are best achieved by respecting individual liberties. When well-intentioned bureaucrats force choices on workers, the incentive for innovation and risk vanishes. As a result, society hardens into a rigid structure that cannot easily align itself with changing market conditions.

Collectivism starts with the premise that the common people cannot be trusted to make their own choices. Once you have accepted that premise, you will take whatever you need and give whatever you want without regard for individuals who would have done otherwise.

Acting on behalf of a collective often justifies imposing our priorities on individuals. For example, if the few in charge believe that foreign investing costs American jobs, they will not allow us to invest overseas. Or if they believe that companies who develop alternative energy sources are a good investment, they will force us to invest in them.

We certainly know by now that not even smart people can force the markets to behave in a certain way. You might as well pass laws outlawing hurricanes.

These are some of the socialistic assumptions that caused the current Social Security system to fail. Privatized accounts could turn that around. It would be a shame to make the same mistake a second time and destroy the engine of capitalism in the process.

Privatization uses the strength of America's capitalist engine to solve the weakness of socialized retirement. Do your part by asking your senators and representative to support privatizing a portion of Social Security. And then assure your own retirement by saving 15% of your take-home pay regardless of what happens in Washington, D.C.

from http://www.emarotta.com/article.php?ID=306

The Seven Steps of Financial Preparedness (2008-10-06)

by David John Marotta

When a hurricane threatens, making a plan and gearing up for emergencies is imperative. Economic emergencies happen too, but it may be less obvious how to prepare. Here are seven steps you should take to weather any financial storm.

First, put $1,000 aside. It doesn't amount to a real emergency fund, but it will do until you get your finances in order. You can accumulate the $1,000 by allocating $10 a day for just over three months.

Most people go into debt because they live hand to mouth, spending 100% of their take-home pay. Then life happens: The car breaks down, the roof leaks or someone needs medical care. Without $1,000 in the bank, families spend the money anyway and go into debt. Having a mini-emergency fund can help you get out of debt and stay out of debt.

The second step to prepare for financial emergencies is to extricate yourself from credit card debt--forever. These first two steps are part of Dave Ramsey's financial peace course, offered in churches around the country. Ramsey suggests paying off your credit card by starting with the smallest balance in order to achieve small successes and then working to snowball your payments as you tackle the larger balances.

He also notes that the only way to get out of credit card debt is to adopt the intensity of a gazelle whose very life depends on outrunning the cheetah. If you are in debt, I highly recommend Ramsey's financial peace course. To be notified about the next course in your area, send your contact information to us at questions@emarotta.com.

These first two steps, having $1,000 and paying off debt, simply prevent you from facing a financial emergency by starting out wounded and bleeding. The third step is to improve your ability to handle fluctuating monthly expenses.

Set up a monthly budget so your day-to-day expenses are less than 65% of your take-home pay. No matter what your income, living off a smaller percentage of what you earn is the way to grow rich and be better prepared for financial emergencies. The difference between those growing rich and those remaining poor is not the salary they make. It is the salary they keep.

Relative to their income, the rich are frugal. They save and invest. They spend less than 65% of their take-home pay on day-to-day expenses. They save at least 10% in their retirement accounts and another 5% in taxable savings. They direct another 10% toward unknown big purchases. And they even live frugally enough to give another generous 10% to charities.

Setting aside 35% for unanticipated expenses is the minimum. When my wife and I first started our life together, we did not make very much. But we still lived off about half of our take-home pay. We were fresh out of college and did not have a very high lifestyle. After starting a family it becomes much more difficult, but not impossible, to save money. Remember that even if you don't earn very much, probably a family somewhere is living on half of what you make and doing just fine.

If you are well off, you can set your sights even higher. Think of learning to live frugally and still be content as part of the emotional training you need to weather a financial storm. That training starts with living within a budget even when financial conditions are good. Some productive families live off less than 15% of their take-home pay and still save, invest or donate generously with the other 85%.

Frugality is a skill needed to live a good life. It is a mindset best learned from parents, but even if yours were spendthrifts you can reeducate yourself and learn to view money differently. The poor buy things; their homes are cluttered with them. The middle class buys liabilities on which they have to make payments, such as second homes, luxury cars and boats. The rich buy investments that pay them money.

If you want to break your poor or middle-class mindset and learn how to be frugal, help is available. In addition to Ramsey's course, I recommend Dana Adams's blog "Frugal in Virginia" (<a href="http://www.frugalinvirginia.com" target=_blank>www.frugalinvirginia.com</a>), which describes where to find deals, both locally and on the Internet, that will stretch your family's budget. Not only will these suggestions save you money, but the mindset of frugality is contagious and will help you overcome any bad habits you may have learned growing up.

Once you've set your budget so money is left over after paying the bills each month, in step 4 you automate your cash flow to promote saving and investing.

Every month, have 10% transferred into your retirement account before you receive your paycheck. Then automate the transfer of 25% of your take-home pay into an investment account a day or two after your paycheck is deposited. Automating your savings makes savings a high priority and ensures that you pay yourself first. This investment account will grow over time, and you can use it to pay for big emergencies and charitable gifts.

Keep the balance in your checking account between two and three times your monthly expenses. If you are paid monthly, your bank account should cover two months of expenses the day before you are paid and three months the day after. You'll have both a generous cushion for your checking and money for unexpected repairs or big purchases. Whenever your checking account exceeds three months of take-home pay, consider moving some of it into a higher paying investment.

You need an emergency fund in case you are unemployed. The first three months of the fund are safe in your checking account. Now invest an additional three months in vehicles you could easily sell within 90 days. Your emergency fund investments should not be in a retirement account, but they do not need to be in a money market account. Many people use no-load, no-transaction-fee mutual funds. They should also be stable enough to guarantee three months' worth of expenses. Therefore if your emergency reserve funds are large enough, you can diversify them fully into investments that fluctuate more but pay a higher rate of return.

Step 5 is creating an asset allocation for your investments that's diversified for safety while being invested for appreciation. Diversification works, and it's never more obvious than in times of market turmoil.

Without diversification, portfolios can have a zero return over a decade. After being well diversified, the likelihood of no return over a decade drops significantly. Your asset allocation should be a guideline in times of trouble. Whenever you are worried or glad about what is happening in the markets, rebalance your portfolio back to your target asset allocation.

Rebalancing means buying stocks after they have gone down and selling stocks after they have gone up. This contrarian move is always wise. When stocks are hitting new highs, rebalance. When stocks are making new lows, rebalance. Studies suggest that the simple act of rebalancing annually earns about a percentage and a half more.

The sixth step toward emergency preparedness is using your taxable investment account properly. You are putting in 25% of your take-home pay each month: 5% is taxable savings and should start to accumulate real wealth, and 10% is for charitable gifting. Each month you buy investments, some will grow in value and become highly appreciated. Each year, find the investments that have appreciated the most, and use these for your charitable contributions.

Done properly, this method of annual charitable gifting plants the seeds for gifts that may not be realized until ten years later. Thus your charity can survive for ten years after you have stopped contributing on the front end.

The last 10% is for unknown large purchases. If your first response to this suggestion is to ask, "Like what?" the answer is "Exactly." Most people who run up credit card debit keep their regular spending within 100% of their take-home pay until some unexpected expense causes them to deficit spend. You can't anticipate unknown unknowns, so the best you can do is set aside some money to cover them when they arise.

Having the discipline to budget for small financial emergencies will help you be prepared when you encounter larger financial crises. When some unknown spending need strikes, take the money to cover the expense from your growing emergency fund. Then, determine if you have been budgeting for this level of unknown expenses adequately.

You should be able to budget for car repairs, medical bills and house repairs. If the expense truly swamps what you have been saving, you may need to increase the amount to better anticipate the level of emergencies.

The seventh and final step is mobilizing during an actual emergency.

In a real financial emergency you should have two to three months of spending in your checking account and another three months in your taxable savings. You should have a pile of money for large unknown purchases (that 10% of your pay) and another pile of taxable savings (that 5% of your pay you have never touched). Finally, you should have been planting seeds toward future charitable gifting that will last through the next decade.

Usually emergencies don't happen. So the money you have socked away makes more money. Keep an emergency fund for several years and it should double in value, giving you an additional emergency fund. Whether you need it or not, being prepared for a financial emergency means peace of mind, knowing that your lifestyle is sufficiently frugal so you won't be in trouble.

from http://www.emarotta.com/article.php?ID=304

Our Financial Crisis: The Result of Centralized Planning (2008-09-29)

by David John Marotta

Assigning blame for recent events in the financial markets is today's most pressing political issue. Unintended cause and effect are both complex and subtle, but recognizing the culprits is important if we want to avoid giving them additional power and responsibility.

Two different opinions are circulating to explain the fundamental cause of our failed financial markets. One claims that unfettered capitalism and greed caused excessive risk taking, which harms society. This argument maintains that without constraints capitalism produces grand profits during market increases, but the losses are socialized by government bailouts in times of trouble.

The other opinion holds that regulation and centralized planning have caused financial instability and failing institutions. If this is the root cause, then many of the proposed solutions will only make matters worse.

The pending election politicizes the issue and impedes clear thinking. But clear thinking is paramount. One of these two opinions is closer to the truth, and economic public policy must be based on truth, not emotion. The forensic evidence points to centralized planning. Let's look at whose fingerprints were left behind.

The failed institutions were among the most highly regulated industries in the country. If the subprime meltdown was the result of greedy capitalists, you would have to assume they were awfully inept to have lost so much money. The markets are smarter than that. Only feel-good legislation could be so naive.

Bill Clinton's presidential website still boasts of creating the highest homeownership rate on record. In 1994, Clinton hoped to increase homeownership to 67.5% by 2000. He sponsored the revised Community Reinvestment Act (CRA) regulations, which required banks to increase mortgage lending to low- and moderate-income families. These changes also allowed the securitization of CRA loans for subprime mortgages.

The revised act resulted in a raft of community organizers who could now prevent banks from merging, expanding their branches or creating new branches simply by protesting to any of four different regulatory agencies. Using regulation as a weapon, community organizers could now bully and blackmail private businesses. Legislation that encourages such thuggery produces anything but free markets.

These community groups described the regulatory pressure forcing banks to increase their underwriting of low-income loans as positive and encouraging. Bruce Marks of the Neighborhood Assistance Corporation of America boasted to the New York Times that he had netted $3.8 billion in loan commitments in the city of Boston alone.

Banks were scored on their results rather than the fairness of their process. Those that scored poorly were punished. Most banks complied. As a whole the industry increased its lending to low-income families by 80%, more than twice any other group. Advertisements said that CRA loans were available with "100 percent financing . . . no credit scores . . . undocumented income . . . even if you don't report it on your tax returns." Mere participation in a credit counseling program qualified as proof that the applicant was capable of managing the debt.

The government-sponsored entities Fannie Mae (the Federal National Mortgage Corporation) and Freddie Mac (the Federal Home Loan Mortgage Corporation) were involved as well. Because of their government backing, their bonds have the highest possible credit rating (A1). Only their guarantee was considered as secure as federally issued bonds. This implied backing allowed them to sell their loans at a lower yield than any private firm could muster.

Although Fannie and Freddie were officially created to encourage the development of private markets, they thwarted every attempt to take their influence away. They are powerfully connected, and following their lobbying efforts and campaign contributions leads directly to the politicians responsible for encouraging and continuing regulatory interference.

These agencies became places where former government officials went to enrich themselves and wait for new federal appointments. Their chief executives had contract clauses providing severance benefits when they left for a government post. While homeowners took cash out of their homes, politicians treated themselves by using Fannie and Freddie as political ATMs.

As a result, Fannie and Freddie became two of the largest corporations in the world, with about 80% of conventional home loans. Their monopoly on the housing market is anything but a free market.

Because they are government sponsored, these two entities were expected to engage in public policy as well. They were enthusiastic supporters of the CRA. They even singled out Countrywide as one of the lenders with "the most flexible underwriting criteria permitted."

Countrywide's low-income loans grew from a $1 billion commitment in 1992 to $80 billion by 1999 and $600 billion by early 2003. It was one of the first companies brought down by the current pressures and sold to Bank of America.

Fannie and Freddie were encouraged by their federal overseers. The Office of Federal Housing Enterprise Oversight (OFHEO) was charged in 1992 with keeping tabs on their financial safety and soundness, and the U.S. Department of Housing and Urban Development (HUD) was supposed to manage their housing mission.

The dangers of Fannie and Freddie failure were widely known and discussed publicly before the establishment of OFHEO and HUD's oversight. The regulatory oversight was specifically implemented to avoid complacency and ensure that their social mission would not jeopardize their financial soundness. Oversight obviously did not work.

HUD's mandate was implemented by requiring a certain percentage of the mortgages purchased by Fannie and Freddie to support low-income families. HUD's purchase quotas of low-income loans rose sharply over the past 15 years. Given their implied guarantee against failure, this increase was not perceived as reckless for Fannie Mae bondholders, but it has proven disastrous for nearly everyone else involved.

It isn't as though oversight failed because the issues were not known. In 1991, Carl Horowitz of the Heritage Foundation warned about H.R. 2900, the bill to create OFHEO and HUD oversight. And a 1999 New York Times story stated, "In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's."

The plethora of federal entities that regulated and oversaw all of the failed firms gave us a false sense of security. In retrospect, the cause and effect seems obvious, but none of the agencies already involved took the steps they could have. Believing government bureaucrats are wiser than the free markets is a socialist utopian delusion.

As recently as 2003 the Bush administration was pushing Congress to overhaul Fannie and Freddie and require stricter lending practices. Barney Frank, chairman of the House Financial Services Committee, who is supposed to provide oversight, said, "These two entities--Fannie Mae and Freddie Mac--are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing." So much for congressional oversight.

The government itself created the conditions of greed and lack of negative feedback. Free markets use negative feedback instead of regulations and legal constraints. But when the federal government legislatively removes the negative feedback, which is the natural consequence of poor decisions, it makes such decisions more likely and causes more harm than good.

Planning for competition works wonders. Planning substituted for competition wreaks destruction.

Given that socialistic impulses got us into this mess, it isn't likely that further socialization will help matters in the long run.

Now the government is loaning AIG $85 billion, but at what cost? Virtually nationalizing the country's largest insurance company was not the only possible solution. Providing AIG with a loan to allow the company time to sell assets would have been much less intrusive. Instead, the government provided additional bond security at the expense of shareholders' value.

None of this intervention would be the free market solution, and it is all rife for political manipulation. Only by getting government out of the private markets can we reduce corruption.

Popular opinion overwhelmingly supports free markets. According to a Rasmussen survey, only 7% of voters think the federal government should use taxpayer funds to keep a large financial institution solvent. Sixty-five percent favor letting the company file for bankruptcy. And 49% said they worried the federal government would do too much to purportedly solve the financial crisis.

Any kind of bailouts and interventions encourage excessive risk taking in the future. When people gamble with others' money, they take bigger risks. We should be skeptical that financial institutions that made bad investments can somehow infect well-run banks. In fact, letting poorly managed banks go under is good for those still standing. Financial institutions have needed a pending consolidation, and allowing such failures should make the remaining financial services industry more profitable going forward.

Fannie Mae and Freddie Mac should be dissolved, and a more stable diversified collection of private companies should replace them. Any time power is consolidated in the hands of a single government entity with centralized decision making, the resulting structure has a great propensity for harm.

Such concentrated power is infinitely heightened. It can be used monopolistically and has no competitive negative feedback. With multiple private entities, there is naturally less power to be abused or mistaken. There is no way a diversified collection of private companies could have failed so spectacularly.

It requires a savvy voter to understand the root causes of these financial troubles during a time of political blame shifting. But even the average citizen should be skeptical that bigger government and additional regulation will somehow put more money in middle-class pockets. That we are largely left without politicians who endorse these views is most unfortunate.

from http://www.emarotta.com/article.php?ID=303

Eastern Europe and Turkey: BRIC Wannabes (2008-09-22)

by David John Marotta

In 2003, the Goldman Sachs Global Economics Department predicted that the economic and geopolitical influence of Brazil, Russia, India and China (the BRIC countries) would become increasingly visible in the developed world and even dominate it by 2050.

BRIC nations have surpassed expectations. The original Goldman Sachs analysis projected the four economies would comprise over 10% of the global output by the end of the decade. A year and a half early, they comprise nearly 13%.

Goldman Sachs published an update on the BRIC nations this year, forecasting that although growth is slowing, they will still contribute almost half of all global growth in 2008 and 2009.

It is easy to be lulled into thinking you can simply buy and hold investments in BRIC countries. But emerging markets have faced serious crises every several years. A better strategy is to buy and rebalance, trimming positions as they appreciate and reinvesting as they correct. With the drop in emerging markets this year, 2008 is now an opportunity to reinvest.

These countries have averaged a total return on investment in their stock markets that is now down to 27.49% over the past five years because they have dropped sharply over the past year, falling 24.48%.

The BRIC acronym made four emerging market countries sound like more attractive investment opportunities than the other two dozen. Nobody likes being excluded from the cool crowd. Other countries have been clamoring to add their initials into the mix ever since.

BRICET is the term used to add Eastern Europe and Turkey to the in-crowd. Since the fall of the Soviet Union, Eastern European countries have been struggling out of the darkness of communist rule into the light of free markets.

Eastern Europe has become a fuzzy term that may include a different set of countries depending on who is using the label.

The S&P/Citigroup BMI European Emerging Markets Capped Index includes companies from the Czech Republic, Hungary, Poland, Russia and Turkey. This index, constituted to include the most developed countries of Eastern Europe, is heavily weighted toward Russian companies as a result. Selecting these countries produces an index that is more developed than the typical Eastern European country.

The least developed countries are sometimes not even classified as emerging. Instead they are labeled "frontier markets," a step below emerging. These countries include Albania, Belarus, Bosnia, Bulgaria, Croatia, Estonia, Herzegovina, Latvia, Lithuania, Montenegro, Republic of Macedonia, Romania, Serbia and Ukraine. Many of them are listed in the MSCI Frontier Markets Index.

Although a few of the countries just named, such as Ukraine and Croatia, have very little freedom, others are entering the global scene on the side of free markets. A dozen countries in Eastern Europe have implemented a flat tax on either personal or corporate income. Most of them have a higher percentage of freedom than even Brazil, the best of the BRIC countries, according to the Heritage Foundation's Freedom Index.

In addition to a flat tax, many Eastern European countries are taking advantage of their proximity to Western Europe. Several Eastern European countries have joined the European Union (EU) and benefited from the single economic market representing 31% of the world's total economic output. The lack of trade barriers and a common stable currency encourages growth. To join the EU, a country must have a stable democracy that respects human rights; the rule of law, including EU law; and a functioning market economy capable of competing within the EU.

These requirements have the effect of pushing countries politically toward free markets, which helps them overcome the socialist or centralized planning legacy of communism. In addition to economic alliances with the West, some have also been invited and joined NATO. Turkey also enjoys significant freedom having been a part of NATO since 1952.

All of these economic freedoms and the accompanying social stability have produced good investment returns for Eastern Europe over the past five years, averaging 20.51%. The MSCI Turkey Index averaged 25.20% over the past five years. The BRIC index has earned 27.49% annualized.

But all emerging market countries have a high correlation. Little benefit is gained by diversifying among BRIC, Eastern Europe and Turkey. Currently the BRIC index is down 38.86% year to date. Eastern Europe is down 39.16%, and Turkey is down 31.30%.

Emerging and frontier markets are suitable for a portion of your portfolio, but only a portion. You must take care to limit the percentage of your assets invested in categories that are highly correlated and therefore all move in sync with one another. Diversification means finding asset classes that are not positively correlated to reduce the chances that everything in your portfolio goes down together.

Determining the correlation between your investments is one of the most important steps you can take toward building a defensive investment strategy. Tools are readily available online. Or to find a fee-only advisor in your area, visit the National Association of Personal Financial Advisors at <a href="http://www.napfa.org" target=_blank>www.napfa.org</a>.

from http://www.emarotta.com/article.php?ID=302

BRIC Countries: China (2008-09-15)

by David John Marotta

In mid-September, the Chinese observe the Moon Festival. Timed to the moon's fullest and brightest phase, the festival celebrates the abundance of the summer's harvest. In recent years the Chinese economy has been waxing toward ascendance. It passed Japan in November 2007 and began to rival the brightness of America.

One in every five people in the world lives in communist China. Unlike other BRIC countries, the Chinese lack representative government, the rule of law administered by independent judges, basic human rights, freedom of the media, independent universities and the right of workers to move freely. Even the constitution makes clear that the government has no limits or accountability to the Chinese people.

China began its experiment of mixing explosive free-market economics with totalitarian control and repression in 1978 when Deng Xiaoping took power.

After having been purged once by Mao and a second time by the Gang of Four, Deng did not deify Mao. Rather he declared the leader to be "seven parts good, three parts bad." Understanding that Chinese Marxism needed to be reinterpreted to allow market forces, Deng argued that "socialism does not mean shared poverty." His most famous quote clarifies his utilitarian nature: "I don't care if it's a white cat or a black cat. It's a good cat so long as it catches mice."

Deng abandoned centralized planning and protected the unrestricted flow of goods throughout the country. The resulting competition between provinces led to significant growth in China's standard of living. Unlike Gorbachev, who tried to institute his own reforms in the top-down approach of perestroika, Deng simply allowed freedom at the bottom. Then he sanctioned and took credit for whatever reforms worked.

Much of China's innovation has been an investment in infrastructure. The country is spending about 12% of its gross domestic product (GDP) on infrastructure, which accounts for 43% of emerging market investments. Greater investment in infrastructure reduces the cost of moving goods and allows freer trade within the country. Estimates suggest that a 1% increase in a country's infrastructure boosts its GDP by 1%.

So the resulting economic growth in China has been explosive. But containing an explosion is difficult if not impossible.

Free markets thrive when a country guarantees property rights and the rule of law. China possesses neither of these. All land is state owned and can only be leased. The state also owns the banks, either directly or indirectly. A majority of judges are retired military officers and directed by the party. As a result, enforcement of contracts is impossible. Party officials are effectively police, prosecutor, judge and jury for any case of importance.

Currently China is ranked 52.8% free, "mostly unfree," in the Heritage Foundation's Index of Economic Freedom. Although it ranks 126 out of 157 countries, China does place highest among the communist countries, beating Vietnam, Laos, Cuba and North Korea.

Freeing selective market forces produces impressive economic gains until bottlenecks in the existing monuments to centralized power hinder progress. Without a free press and working court system, the resulting internal totalitarian monopoly of economics can't be called capitalism. As a result, most of China's growth stems from its participation in free-trade agreements.

Thanks to China's growth, it will pass the U.S. economy in the near future. But because of its huge population, its average citizens will still be economically poor by American standards. And they will be politically destitute.

The Communist Party in China worries most about religious movements, which pose the greatest threat to the party's supremacy. In 1999, about 10,000 members of the Falun Gong spiritual movement surrounded the Chinese Communist Party headquarters in Beijing. They silently meditated to protest their rejection as an accepted spiritual movement. As a result, China severely repressed Falun Gong's leaders and practitioners.

Religious groups are obligated to register in China. Their leaders must be trained and approved by the government. Sermons and teachings are monitored to ensure they do not confront government decree. Thus spiritual movements such as the Falun Gong and unregistered house church movements provide the biggest challenge to the party's supremacy and power.

Movement toward democracy, freedom and the rule of law is not inevitable. Since the brutal crackdown on pro-democracy demonstrations in Tiananmen Square in 1989, government leaders have used force to remind the population of their control. China has its own gulag where labor camps reeducate, terrorize and torture. According to Amnesty International, human rights violations are pervasive in China where nearly half a million people currently endure punitive detention without charge or trial.

Although movement toward freedom is not inevitable, the yearning for freedom is universal.

China exemplifies how the free flow of information allows a developing nation to leverage other countries' knowledge and double its per capita GDP in a decade or less. And yet China fears this freedom. It is nearly impossible to stop the flow of information, but the government continues to try. Dubbed the "Great Firewall of China," over 60 sets of broad regulations restrict Internet content.

The returns on investments in China have been impressive, averaging 23.8% over the past five years. Despite these returns, we don't recommend selecting China for specific emphasis. It is a component of the Emerging Market Index, which should be a small part of your portfolio. Think twice before investing in China because investments there won't always go up. In fact, over the past year China's return has been down 26.1%.

But you don't need to invest directly in China to benefit from a growing Chinese appetite for goods and services. Several countries in the Far East both engage in significant trade with China and also offer exceptionally open markets. Among economically free countries in the region, Hong Kong at 42.6% reports the highest percentage of its exports with China. Australia is also significant at 8.4% of its exports. Even "mostly free" Taiwan (14.9%) or Japan (12.2%) would be preferable to direct investments in China.

from http://www.emarotta.com/article.php?ID=301