Sunday, July 27

Week 160 - Investment Strategies for Low Incomes

Situation: We all know that credit is a revolving door and that it’s difficult to use credit and still pay it off. Equity behaves in a similar manner. Some portion of equity will accumulate while some (hopefully less) gets distributed and used. Many households and businesses strive to become knee-deep in both credit and equity. But for households living below the poverty line these issues of credit and equity are beyond daily life. How to move the ball ahead? The heads of low income households have no choice but to become better-than-average money managers. Why? Because equity eventually has to exceed credit. 

What does “equity” mean? Equity is a resource that is fungible, meaning it can be turned into dollars. If you have title to a car, that title represents equity. If you “own” a home that you put 20% down on, and have paid off an additional 30% of the original cost through paying your mortgage, you have no equity and no liability, meaning you would likely “break even” upon selling the house, after allowing for transaction costs, taxes and inflation. Equity takes many forms, education being the most important. But all forms of equity have to end up with a positive dollar value after accounting for transaction costs, insurance, taxes and inflation. Otherwise, the household is pulled deeper into poverty through the spiral created by the use of credit and the payment of interest on borrowed monies. 

After education, the next most important equity-builder is a support network that will help you convert that new degree into a higher-paying job with full benefits. In other words, and this is important, friends and family represent equity through the job contacts they can provide. Also, learn to go online and maintain your “profile” at LinkedIn because that is the “go-to” site for employers looking to fill a vacancy in their workforce.

How else might a household living under the poverty line build equity? A home mortgage used to be the favorite route but most all of us have learned by now that houses gain value no faster than inflation, have volatile market values, and can entail expensive maintenance. Many other ways of producing equity have been tried. For instance, the lottery has been tried but it has average returns of only 37 cents per dollar invested. Gold bullion has been tried and it does indeed beat inflation, by 3.4%/yr since 1968 vs. 5.4%/yr for the S&P 500 Index. However, gold bullion beats inflation by only 1%/yr over longer time periods, undergoes sudden shifts in value, is expensive to store, has to be insured, provides no income, and profits from its sale are taxed at the highest rate. 

This means that we have to drill down deeper to find a reasonable way for you to build equity after landing a good job. Home ownership can build equity if you a) invest the lowest down payment needed to qualify for a “conforming” 30-year mortgage, and b) don’t sell the house until after the mortgage is paid off. A government agency will insure that conforming mortgage, and after 10 yrs the mortgage payment will mostly go toward equity. In the meantime, you won’t pay taxes on income that goes toward interest. While the value of the house will merely track inflation for those 30 yrs, you will have invested only a 5-20% down to end up with 100% ownership. Then you get to live the rest of your life rent-free. The equity in your home is called "rent-equivalent income" by government accountants. Much of that gain represents a “gift” from your Uncle Sam. This is because of banking and insurance subsidies paid out by the federal government to produce stability in those market sectors, as well as “tax expenditures” (the official term for allowing you to avoid paying taxes on income used to pay mortgage interest). You are rewarded for your perseverance in paying off your mortgage, while the government benefits from the stability and character you bring to the neighborhood. 

What other choices are there? Treasury Notes and Bonds were once thought of as a way to build equity but this is not the truth and never has been. They’re just seat belts in the car called “life.” Historically they have beaten inflation by 1-2%/yr. That may sound good on the surface but income tax must be paid on both interest and capital gains. The only subsidy that Uncle Sam awards is freedom from having to pay state or local taxes on interest. Transaction costs are zero if you buy at the government website, and Savings Bonds come with an IRA-like feature, namely, no taxes on accrued interest over the life of the bond. Inflation a protected Savings Bonds (ISBs) are an exceptional value, in that you slowly build equity if they're held for more than 5 yrs because transaction and inflation costs are zero; federal tax on accrued interest is paid upon redemption but that cost is typically covered by the basic interest rate.

Now we have 3 ways for a household living below the poverty line to build equity: 1) have a family member obtain enough additional education to land a better job, 2) start building a Rainy Day Fund with ISBs (see Week 119, Week 117 and Week 151), and 3) start paying down a 30-yr mortgage. You notice that we haven’t talked about stock purchases. But paying into an IRA that includes stocks is a smarter next move (after landing a better job and starting a Rainy Day Fund) than becoming a homeowner. 

We’ll start by looking at the lowest-cost and most conservative mutual fund available that places ⅔ in bonds and ⅓ in stocks, which would be the Vanguard Wellesley Income Fund (VWINX, Line 23 in the Table). It requires an initial purchase of $3,000 but you can start by duplicating it online. Assign ⅔ to ISBs and ⅓ to stocks purchased as a dividend reinvestment plan (DRIP), see Column K in the Table, with an up-front investment ranging from $10 to $500, and minimum amounts required for additional investments ranging from $10 to $100. For tax purposes, you can declare that any DRIP you own is part of an IRA. 

What’s not to like? Well, I’m sure you know that precious few stocks make suitable investments for a household trying to dig out of poverty, and those will require watching. We’ve come up with a list of 12, to help you get started (see Table): Wal-Mart Stores (WMT), McDonald’s (MCD), Johnson & Johnson (JNJ), General Mills (GIS), Chubb (CB), International Business Machines (IBM) and VF Corporation (VFC), plus 5 regulated electric utilities: Wisconsin Energy (WEC), Consolidated Edison (ED), NextEra Energy (NEE), Xcel Energy (XEL) and Southern Company (SO). Those are the 12 top companies on our list of 17 “hedge stocks” (see Week 150). 

This week’s Table shows those 12 stocks at the top. They’re likely to build equity at a rate of ~10%/yr (see Column C), which translates to ~6.5%/yr after deducting the 3.2%/yr rate of inflation that has prevailed for the past 101 years. The IRS taxes your dividends and capital gains at a reduced rate. However, DRIPs have an expense ratio (transaction costs divided by account value) of 1-2%/yr (vs. 0.25%/yr for VWINX and 0%/yr for Treasury Notes and Savings Bonds purchased at treasurydirect). NOTE: For this week’s Table only, red highlights denote underperformance relative to VWINX instead of VBINX. Why? Because higher risk factors (see Columns E, I, and J) make VBINX unsuitable as a benchmark (or savings goal) for families trying to dig out of poverty. Higher risk is also why such families should avoid investing in the lottery, gold coins, or a home mortgage. After taking on the expense of higher education (and building a Rainy Day Fund with ISBs), they need to start an IRA.

Bottom Line: Furthering one’s education is the best investment for anyone living below the poverty line. We think the next best move is to make online purchases of inflation-protected Savings Bonds at treasurydirect and DRIPs in selected stocks (declared for tax purposes as IRAs) at computershare. Both can be done by spending as little as $25 at a time, but starting a DRIP requires an initial investment of $10 to $500. Our preferred IRA option for such a family is to regularly invest in the Vanguard Wellesley Income Fund (VWINX), which requires an initial investment of $3000. 

Risk Rating: 3

Full Disclosure of current purchase plans relative to items in the Table: I dollar-average into DRIPs for WMT, JNJ, IBM, and NEE.

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