Beating Broke

Spread Betting: How Does it Work?

March 12, 2012 By Shane Ede 5 Comments

I’ll be the first to admit, here and elsewhere, that I’m not an investing savvy person. I know just enough to get myself into trouble. One of the new terms that I’ve learned just recently is Spread Betting. Now, most anything that I’ve ever dealt with that involved the words spread and betting involved bookies, Super Bowls, and point spreads of more than a field goal. So, when I heard the term used in a financial sense, I had to go and do a little research to see what it was all about. And, like anything else, financially, that I research, I had to share it with you, the readers!

What is Spread Betting?

Spread betting, in a financial sense, is betting on the markets based on how you feel they will perform. If you think the markets will go up, you bet on them going up (go long). If you believe they will go down, you bet on them going down (go short). The betting itself is pretty simple. You simply place your bet (going up or down), and then wait to see where the markets go. After you’ve placed your bet, you can close it to claim your winnings.

How to Spread Bet.

This can probably be best described by example. Let’s assume that we’re going to make a bet on an index. It can be the NASDAQ, S&P, or whatever. We feel that it’s going to go up based on recent news. So, we decide to go long, and bet on the index to rise. We place a long bet. If the stock rises, so does our profit. The profit (or loss) is based on the spread. If the index starts at 100 (an example), and we go long, and it rises to 200, the spread would be 100. If we close the bet at 200, our bet is multiplied by the spread. If we had bet $1, we would have made $100.

Risks of Spread Betting.

As you can probably imagine, anything with the term betting in it’s name has a risky side to it. Much like our bet would be multiplied by the spread in the winning scenario above, so too would they be multiplied by the spread if we’re wrong. If we had been wrong, and the index had dropped by 100 points, we would have lost $100. To some degree, this can be mediated by using a stop order that will automatically close the bet should it drop (or rise, if we bet on a drop) past a certain point. While a stop order can minimize your loss, it doesn’t remove the risk entirely. There’s still potential for some pretty damaging losses should you be wrong often.

Is Spread Betting for you?

I’m not financial adviser, but if I were, I’d say that spread betting is something better left to those who know what they are doing. I’m not one of those people, and until you are, you probably should avoid it. On the other hand, if you’re a seasoned trader of the financial stock markets, and feel like you’ve got a good feel for what they are going to do on any given day, maybe it’s something you’ll want to try. I can’t say either way. What I can say, is that with anything that’s related to your finances, there’s no excuse for not knowing. If you don’t know what you’re getting into, you shouldn’t get into it. Do your research, learn the tactics and methods, and then give it a try.

photo credit: Perpetualtourist2000

Reader Question: IRAs, 401(k)s, and Dividends

March 7, 2012 By Shane Ede 11 Comments

Reader David left a comment with the following question in it:

Every other mutual fund I have ever owned has at one time or another paid out dividend distributions.This includes funds that I have held on my own, and some that were held in Traditional and Roth IRA’S. Not so with any funds I have had in two 401k plans over the years. Going all the way back in my annual statements I cannot find a single entry for dividend distributions. Do you have any ideas why this might be so and whether or not I would be better off making contributions to an IRA that go above and beyond the company match??

There are several ways that I’ll attempt to answer this. Keep in mind, I’m not a financial planner, or a financial adviser, so take what I say with a grain of salt. Perhaps a few of my adviser readers will have slightly better advice, we’ll see. I think there are really two questions there though (I won’t charge you extra.), so let’s break it down a bit.

Dividend Distributions in 401(k) and IRA accounts

Several things could be happening here, but here are the most likely scenarios. Because of the difference in how a 401(k) and an IRA are handled for taxes, (401(k) is pre-payroll tax while IRA is post-payroll tax) the tax that you would normally pay on a dividend distribution is deferred in a 401(k). What that means is that the dividend income in a 401(k) doesn’t have to be reported and is usually automatically reinvested. Depending on the 401(k) provider, dividend income might just be being shown as a capital gain on the fund since that’s what it becomes in this tax scenario. Another possibility (although somewhat unlikely) is that, like stocks, not all funds will pay a dividend. The only way to figure that out is to do some research into the individual funds that you own in your 401(k) and determine if they pay a dividend or not. I like finance.google.com for quick lookups, but the best place would be the website of the fund, or the prospectus for the fund.

Make Contributions to an IRA that go above and beyond the company match

I wanted to tackle this question separately. First, you should, absolutely, take advantage of your company match to it’s full extent. If your company will match x% up to y% of your income, you should contribute y% at a minimum. It’s free money, and I guarantee you the company looks at it as a part of your compensation package. You wouldn’t leave a paycheck un-cashed would you? Once you’ve met that amount, several things come into play. I think the biggest of these is your personal tax situation. A 401(k) acts as a deferred tax account. You don’t pay any taxes on your contributions, and then pay taxes (at your then tax rate), on the withdrawals. With a Roth IRA, you pay taxes on the contributions, but not on the withdrawals. Let’s say you make a lot of money now, and your tax rate is 35%. When you retire, you’re no longer making those fat stacks of cash, and your tax rate drops to 25% or less. You’ll now pay 10% less in taxes on those withdrawals. Keep in mind that those withdrawals will include any capital gains that the account has accrued over your working career. In the Roth IRA, you’ve already paid the taxes on contributions at 35%, and you don’t pay any taxes on the withdrawals. In this scenario (10% drop in tax rate), you’ll need to have managed gains of 10% above your contributions by the time you retire to realize any significant difference.

Another thing to look at, is whether you are able to contribute to the limits. In 2012, the 401(k) contribution limit is 17,000. If you’re 50 or older, you can also make an additional “catch-up” contribution of $5,000, for a total of $22,000. There’s an additional overall limit of $50,000 for employee plus employer contributions. So, if you make the max contribution, your employer can only contribute the additional amount to $50,000. For the IRA, the maximum annual contribution is $5,000 (or $6,000 if you’re 50 or older). There are also some restrictions on how much of the contribution is tax deductible, and how much can be contributed based on income.

The simple suggestion here is that you should contribute to your 401(k) up to the % that the company will match to take full advantage of that added compensation. Once you’ve hit that %, contribute to an IRA up to the full amount you’re allowed. Once you’ve hit that contribution limit, invest any additional contributions into your 401(k). Obviously, it takes a bit of math to figure all of that out, since you won’t likely know whether you’ve hit the max on the IRA without some pre-planning. But, if you can manage to sock away the $5,000 (or $6,000 if you’re older than 50) into a savings, you can write one check at the beginning of the year as your current year contribution to your IRA, and then take whatever you’re comfortable with out of your paycheck for your 401(k). Using a tax refund as a boost to the IRA contribution can be helpful (if you get a refund).

That’s a very high level overview of the IRA vs. 401(k) question though, and you really should consult your accountant or a financial adviser on the subject. There are lots of factors that go into the the tax ramifications of both, and you really want to know as much as you can so that you can adjust your retirement planning accordingly.

I’m sure many of my personal finance friends who know more about the subject than I do will offer their wisdom in the comments, so be sure to check back and see what nuggets they have to offer. 😉

photo credit: urban_data

How Do You Define Affordability?

March 2, 2012 By Shane Ede 15 Comments

People use the term all the time when making purchases. “I can afford it, so why not?” they say as they sign the paper work for a new car, a new house, or swipe their credit cards for that fancy new television. But, can they really afford it? How do you define affordability?

Like many of you reading this, I’ve often defined affordability by whether I can make the payment or not. It was while reading The Millionaire Fastlane that I read a passage that made me rethink how I define affordability. The passage was this one:

Think about the last time you bought a pack of gum. Did you fret over the price? Did you ask, “Hmmm, can I afford this?” Probably not. You bought the gum and it’s done. The purchase had no impact on your lifestyle or your future choices. To a rich man who walks into a dealership and buys a six-figure Bentley without thought, the acts are the same.
Affordability is when you don’t have to think about it. If you have to think about “affordability,” you can’t afford it because affordability carries conditions and consequences. If you buy a boat and resort to mental gymnastics over affordability, YOU CAN’T AFFORD IT. Sure you can assuage affordability and make outlandish arguments, often starting with “I can afford this as long as…” […]
This self-talk is a warning that you can’t afford it. Affordability doesn’t come with strings attached. You can bluff yourself but you can’t bluff the consequences.
So how do you know if you can afford it? If you pay cash and your lifestyle doesn’t change regardless of future circumstances, you can afford it. In other words, if you buy a boat, pay cash, and are NOT affected by unexpected “bumps in the road,” you can afford it. Would you regret a gum purchase if you lost your job a week later? Or if your sales forecast was slashed by 50%? Nope, it wouldn’t make a difference. This is how affordability is measured against your level of wealth.
To overcome wealth impersonation, know what you can and can’t afford. There is nothing wrong with buying boats and Lamborghinis if you can truly afford them. There is a time and a place to indulge.

Reading that, and taking it to heart, it completely changes the perspective on what you can and cannot afford. I have no problem affording the pack of gum, but I certainly couldn’t afford a boat. In truth, I think it’s a bit of an extreme example, but one that we should probably strive for.

Think about some of the more recent purchases you’ve made and whether, using Demarco’s definition of affordability, you could really afford them or not. I know that, if I use that definition, I certainly couldn’t afford the new (to me) car we bought a year ago. The house we almost bought before I quit my job was absolutely out of our affordability range. On the other hand, the new Blu-Ray player we bought to replace our dead DVD player was affordable, and, with kids, somewhat necessary.

In a way, Demarco’s definition of affordability matches up quite well with the cash-only lifestyle that many try and live. If you can’t pay cash for it, you can’t afford it. It’s a personal goal of mine to someday be able to live my financial life in that way. I’d like nothing better to purchase our next car with cash. Or, our next house. Will it happen? Realistically? Probably not. But, it’s a goal, so we’re working towards it.

What about you? How do you define affordability? Does Demarco’s definition make sense to you?

photo credit: Tom Wolf | Photography