The reason I don’t write many book reviews is, the investment strategies that I follow and showcase are rather straightforward, and there’s little reason to ever reinvent this wheel. But Andrew Hallam is a fellow blogger (and on my personal blogroll), and I’ve read his articles for a while now, so I knew his book would be a very worthwhile read, and was waiting to get a copy and write a review. I had the opportunity to get a book before, but I waited, and therefore I just sat around and waited some more for Amazon to get more in stock. (They had been sold out due to the success of the book.)

So without further delay, here’s a review of Andrew Hallam’s Millionaire Teacher.

Overview

Andrew Hallam is an English teacher who became a self-made millionaire in his 30′s. He achieved this by taking his teacher’s salary, frugally saving it, and diligently investing it, year after year, in index equity funds, index bond funds, and some rational individual stock selections. He’s living proof that almost everyone in the developed world can become a millionaire because he led by example.

Andrew’s a smart guy, but he didn’t have to apply some genius stock-picking approach, or take on huge risk to get a huge reward. He merely maintained a balanced portfolio of stocks and bonds, and once in a while he adjusted it to keep it balanced. So for instance, if he had a 65% stock and 35% bond portfolio, and stock prices were rising, he was selling shares while everyone else was buying, and instead was buying bonds to maintain his portfolio balance. Inversely, when stock prices were falling, and everyone was selling stock to buy bonds, he was selling bonds to buy stock at low prices to rebalance his portfolio. It didn’t require market timing, fancy math, or any sort of intellectually rigorous activity; just simple portfolio maintenance and the responsibility to maintain it. It only took him minutes per year. In addition, as a fun side portfolio, he applied fundamental principles of rational individual stock selection. In a noble fashion, he beat the market with his individual selections, but humbly points out that over the long run, it’ll become statistically less and less likely for him to maintain that claim, and that people should index rather than try to beat the market. It’s a rather solid case of wisdom and diligence being a winning combination.

As a teacher, he has witnessed first hand how dismal the financial education is for most students. They learn how to work with quadratic equations, and learn the difference between eukaryotic and prokaryotic cells, but they don’t learn to manage their own money. Recalling my own education, I can literally say that not a single teacher taught me a single thing about investing, valuing a company, corporate structure, or stock indices, except for the simple chapter in a mathematics class regarding the power of compound interest. That was it. Andrew has sought to correct this by educating teachers, educating family members, giving talks, blogging, and now, writing a successful book.

The book is organized as a series of his “Nine Rules of Wealth”.

The Good

The book is excellent, as I expected.

-The organization of the book is well thought-out. He covers the basics, makes arguments, reinforces those arguments, but never becomes tiring or overly repetitive. This is in contrast to the famous book, The Millionaire Next Door, which contains a similar message, but after 50 pages of that book, the reader is like “OK I get it already! You don’t have to say the same thing ten times!” Andrew avoids that problem by providing enough reinforcement of his ideas without tiring them out.

-His set of arguments for index funds over actively managed funds is flawless. He really puts the nail in the coffin of actively managed funds. Not only does he make extremely effective arguments backed up by statistics, history, and reasoning, he even counters the expected counterarguments made by people who wish to sell you those funds anyway. His devastating arguments against the enormous self-serving financial services industry should be clear to any rational mind.

-His final section on individual stock selection uses intelligent principles, and covers a lot of the investment basics. In a few parts of the book, he covers topics of how corporations work, why shares go up in value, differences in company value, and more.

-He gives a definition of “wealthy” that I very much agree with. It’s very straightforward, and in my opinion it’s also accurate. Perhaps just as importantly, it’s reasonably attainable on a regular income with diligent saving/investing habits.

-Andrew is a Canadian teacher that currently lives and teaches in Singapore. So he’s sensitive to global differences, and takes an international approach. There’s a whole section devoted to international indexing. So it doesn’t matter what country you’re from; the truths in this book remain valid.

-The 184 page book is an elegant read. Remember, this isn’t a financial guru writing a book; it’s a self-made millionaire English teacher. It can be read in a weekend, is easily accessible to a multitude of different types of readers, and the nine rules break it up into easily read chunks. He artfully blends personal stories, humor, facts, and images to create a rather effortless reading experience.

-I found myself being unable to put the book down, and finished reading much earlier than I had planned. “Well, I’ll read one more of these rules for now…”, I kept telling myself, until I had read through all of them. It’s not because the book is overly short; it’s because it flows elegantly, and gives the information needed without providing any distracting extras. Andrew’s investment approach is simple, as any effective investment approach should be.

Any Downsides?

Any good review includes some constructive criticism. In this case, it’s not criticism of what he said, or of his arguments; it’s an observation of what he didn’t say, and what most people don’t say.

At one point, when Andrew is explaining how a corporation works (his reminder to readers that indexes are built on real companies, and are not just little lines on a graph that go up and down), he uses the following example: He discusses Willy Wonka starting a public company to raise more capital, talks about the shareholder relationship, talks about growth and dividends, and says that the board of directors is voted in by the shareholders.

All of this is true, and yet with index funds, that’s not what really happens in practice. With index funds, shareholders don’t vote for the board of directors. Instead, they own hundreds or thousands of companies, and can’t pay attention to what those boards are doing. Index investors give their right to vote to the owner of the fund. When Vanguard, for instance, votes on behalf of the millions of investors that gave up their right to vote by buying their index funds, Vanguard sets a very low bar for whether they will vote for a given board member, and they abstain from voting with regard to 94% of shareholder proposals that are related to corporate or social policy.

One can’t really blame Vanguard; they have fiduciary duty to their customers to promote good returns, and they can’t predict how millions of would-be shareholders would want to vote their shares. So they largely stay neutral and abstain from much of the process. I think pointing out the loss of shareholding voting that comes with index funds (as well as actively managed funds), would have been a fair addition in the book.

I believe responsible portfolio management includes treating shares as an owner would, and voting accordingly with regards to board member elections, management compensation, and review of shareholder proposals. It’s the one area where my investing philosophy seems to differ from the book.

Conclusion

Millionaire Teacher is an excellent, easy-to-read book. In my opinion, this should be on the reading list for every high school student in the world. In addition, I suggest that everyone who currently invests in actively managed funds should read this, since I couldn’t agree more that index funds in almost every case are far more rational to invest in than actively managed funds. I offered to let a co-worker of mine borrow my copy of the book after he started talking to me about his mutual funds. Andrew’s arguments are solid, the book is a delight to read, and after having seen him blog for a while now, he certainly is a genuine and honest person.

Click below to have a look at the book.

Disclosure: The book image link is an affiliate link to Amazon, and I only use affiliate links for products I highly recommend.

What a bummer!

That’s probably not the reaction that you’d expect, but it’s rather common among long-term investors. When stock market prices go up, the paper value of a portfolio increases, but finding solid investments for currently invested capital becomes more difficult. My brother, an executive at one of the largest US defense contractors and a husband and father to a wife and three kids, is joyed to see his indexed portfolio replenished, and I can’t really blame him, but I’m disappointed to see some values lessen! I’m glad to see people get to work; I’m not disappointed about economic improvement. It’s strictly the stock valuations that can be suboptimal.

In a market with lower valuations, fresh capital can result in producing better returns, and reinvested dividends and company share repurchases result in better rates of return as well. Markets with higher valuations result in reinvested capital going to lower-return investments.

To illustrate this point, here’s an example. Company A has a P/E of 12, solid cash flow and a good balance sheet, pays out 75% of its EPS as regular growing dividends, and grows EPS by 6% per year. Company B is identical in every way, but has a P/E of 18. For simplicity, these valuations stay constant for 10 years, and dividends are pooled and reinvested once per year. I could have done this chart in multiple ways, such as making stock prices equal and having the two companies with different EPS (to reflect the differences in valuation), or I could have made EPS the same, and make the stock prices different. I choose the first approach so that we can start with the same amount of shares at the same price per share. This link shows a PDF of the charts and outcomes.

As can be seen, since both companies have the same payout ratio but company A is at a lower valuation (and therefore a larger dividend yield), investing in company A results in a larger initial amount of dividend income for the same invested value. In addition, over the next 10 years, since the valuation is lower and the yield is therefore higher, reinvesting the dividend purchases more shares, which grows the investment and the income at a quicker rate.

An investor in company A turned $12,000 into $39,403, which is an annualized return of 12.6% over this 10 year example. Meanwhile, an investor in company B turned $12,060 into $32,486, which is an annualized return of 10.4% over this 10 year example. The total dividend income growth rate matches the total return for each respective investment.

So, two identical companies had significantly different returns based simply on their valuation over that period. This is because dividends can buy more dividends when the valuation is lower (and this applies to share repurchases by the company as well). Of course, over any realistic time period, the valuation will rise and fall, but the point is, that at any given time, it’s preferable in the eyes of the long-term investor (net buyer) for the valuation to be low. Any time that’s spent with her dividend stocks at higher valuation, is money lost. Now, there are some times of course when a spike in valuation could be profitable, such as if a stock goes up to an overvalued state and the investor sells, looking for a better stock, or if the valuation increases just when a person retires and cashes out part of her stock portfolio. But for most long-term investors, especially net buyers that aren’t retiring any time soon, it’s low-valued markets that provide the better long-term returns.

Now, one could point out that valuations are directly linked to growth expectations. In other words, when the stock market changes, it’s because investors are increasing or decreasing their expectations. The example chart that I provided only remains true if fundamental growth is unchanged by the changing valuation; it assumes the differences in valuation of those two identical companies are strictly irrational rather than due to legitimate differences in expectation. But one can look at any long term graph of stock price and annual EPS for a given set of blue-chip stocks, and see irrationality in the stock price.

Buy low, look for good combinations of dividend growth and dividend yield, solid balance sheets, strong cash flows, economic moats, and hope it stays low for a while to let those shares accumulate.

I’m a shareholder of Abbott, and my 2011 analysis can be found here. It’s several months old, but it provides a solid overview of the company.

Split Facts

The company plans to split into two companies with a tax-free distribution. The sum of the dividends of the two companies is expected to equal the dividend of the combined company at the time of the split.

The first company, which will retain the Abbott name, will be a diversified medical products company with approximately $22 billion in annual sales. It will include the medical devices segment, diagnostics, nutritionals, and generic pharmaceuticals. Significantly more than half of the sales will be international, and the company will have strong emerging market exposure.

The second company, which is yet to be named, will be a researched-based pharmaceutical company with approximately $18 billion in sales. The business will invest in R&D to come up with new drugs. Abbott’s current blockbuster drug, Humira, will make up a considerable portion of the sales and will present much of the immediate growth, while other drugs will have to fill in for Humira’s success when it begins to go off patent in 5-6 years.

Advantages from Splitting

Splitting the company does offer some advantages.

-Smaller companies often have better growth opportunities. More opportunities are available to them that wouldn’t be large enough to matter for a larger company.

-Investors can invest in exactly what they want- diversified medical or pure pharma.

-The diversified medical company with the Abbott name should maintain very strong free cash flows since there will be no expenditure on leading edge pharmaceutical R&D. This should be good for dividends, and the risk overall may be reduced.

-The pharmaceutical company will be medium-sized. Although earnings will be more volatile than the diversified business over the long term, there is the opportunity for outsized returns if some of the pipeline drugs do well, and if Humira continues to grow as well as it has. Based on the medium size of the business, it’s not out of the question that this segment could be acquired by a larger rival, which would result in a premium for shareholders.

Why I don’t want to “Unlock Shareholder Value”

Apart from some downsides of the split, like the costs of duplicating operations and the cost of restructuring the debt, I believe a potential downside is what many are referring to as an upside.

One of the reasons given by investors for liking this spit is that it may unlock shareholder value. In other words, the combined stock valuation may increase due to the split. Segments can be more accurately valued for what they are, and many argue that Abbott is currently undervalued. Abbott’s flat stock price for more than a decade could see a boost.

As a long term investor, I’m not interested in an increased valuation, and in fact I’d rather it stay undervalued. An increased valuation may be beneficial to stock traders, but for long term dividend investors, it’s just an increase in paper value. Some of the best historical investments, such as Altria, were so great specifically because they remained undervalued. When a company trades for a low valuation, dividend payments can purchase a greater number of shares than if the valuation were higher, and this results in faster accumulation of dividend income and long-term total returns. On the other hand, increased paper valuation does noting for me if I were not intending to sell any time soon. It just lowers the dividend yield of fresh capital that I put into the company, and makes it so I can buy fewer shares and therefore smaller dividend payments.

Conclusion

While I can see some reasons for the split, as an intended long term shareholder, I’d rather hold the company as a unified whole. It’s too early to be sure, but my thoughts at this time is that I’ll likely keep my position in Abbott, and sell my position in the researched based pharmaceutical business. I’ll either reinvest that capital back into the Abbott half, or put it elsewhere. I’m not too interested in investing in pure pharma plays, and instead prefer diversified health care companies. This doesn’t necessarily mean I think the diversified medical company will have superior returns; it’s simply that I feel the diversified medical company more suitably fits my investor profile. I expect that the diversified company, Abbott, will continue to perform well, should stay at a reasonable valuation, and should have solid dividend growth prospects based on EPS growth and strong free cash flows.

There are several types of investments, however, that respond reasonably well to inflation. I don’t advocate market timing, or trying to tailor a portfolio to deal with very specific concerns, so here I present three investments that are useful in a variety of portfolios and that also respond well to inflation. It’s a fairly quick overview.

1) Stocks

Stocks, in general, are decent investments to hold over the long term during periods of substantial inflation. When prices are going up, it’s these businesses that are raising their prices. Periods of short-term major inflation can be bad for pretty much everything, including companies, but over the long-term, stocks hold up pretty well with regards to inflation. This applies to companies in general, but there are some specific types of companies that respond best to inflation.

-Companies with significant economic advantages, or moats, typically have good pricing power and can raise their prices accordingly.

-American companies that sell a significant portion of their products and services overseas in different currencies get “bonuses” when the US dollar falls. A company that has its expenses in a weakening currency, and revenues in strengthening currencies, reports growth that exceeds its “real” business growth due to positive currency effects.

-Foreign companies that primarily operate outside of the US are buffered against US dollar inflation.

-I don’t include commodities as a separate category in this article, but companies that deal with commodities and basic assets are sometimes suited for inflation.

2) Real Estate

Real estate, either in the form of personal or investment property holdings, or Real Estate Investment Trusts (REITs), is typically a good portfolio addition for inflation. The primary reasons are appreciation and leverage.

-When a property is located in a good area, it will hopefully appreciate over the long term, at a rate that either equals or preferably exceeds inflation. But considering that properties are typically purchased using debt, this effect is amplified. For example, if you put 30% down on property, and take out a mortgage for the rest, you control the whole property despite only having partial equity. This means that your gains on your equity are amplified when the property as a whole increases in value (or the opposite when the property decreases in value).

-If debt is fixed-rate, such as with a fixed rate mortgage or with a REIT that offers fixed rate notes, inflation is good for those that owe this debt. Inflation can help reduce the debt compared to asset value, meaning that debt as a percentage of assets will decrease because the asset side is partially indexed to inflation and the liability side is not. Real estate is typically more comfortably leveraged than many other things, so the effect of inflation on their debt is more noticeable.

3) Treasury Inflation Protected Securities

Most diversified portfolios include a bond segment, but a key risk for bonds is inflation. Treasury Inflation Protected Securities (TIPS) are bonds issued by the treasury that change with expected inflation. It’s perhaps not a bad idea to have a portion of your bond holdings in TIPS to protect that aspect of your portfolio from inflation. Compared to regular bonds, however, TIPS are a risk during rare periods of deflation.

Other Notes

-Having a ton of money in cash is not optimal in a period of inflation, and there’s almost always some level of inflation. Parking assets in an account that offers a yield lower than inflation means you’re specifically agreeing to a negative return on value in exchange for perceived safety. And you’re getting taxed on this negative return. It’s important to have a robust liquid emergency/savings fund, but apart from that, putting too much of a portfolio into cash equivalents can concentrate inflation risk.

-Precious metals like gold, or other commodities, typically respond well to inflation, but I believe that cash-flow-generating assets are better in general. I think there’s a lot more priced into gold than just inflation; there’s also a tremendous amount of fear and uncertainty regarding the global economy.

Swensen is the chief investment officer of the Yale Endowment, which has outperformed other large institutions over a long period of time. He helped pioneer the “Yale Model” which has been copied by other institutions. His full list of qualifications can be found on his wikipedia article.

To a certain extent, his Yale model was criticized when it experienced its first year of major loss in 2009, a year of systematic failure, but all things considered, his rather defensive position buffered Yale’s portfolio against what could have been an even worse impact (as measured by standard indexes). It was criticized because an institution like Yale needs to draw from its endowment annually to pay expenses. Yale’s long-term performance has outperformed the S&P 500 over the 25 years that Swensen has led it (since 1985), and has done so with less volatility (Yale only had 3 years of endowment reduction out of the 25, and two of them were very mild).
1900-2000
2001-2005
2006-2010

So what’s his secret for long-term risk-adjusted success? Asset allocation and attention to liquidity.

For those that don’t want to watch the hour-long lecture (I’d propose that a free lecture by Yale’s chief investment officer is worth an hour, but perhaps I’m unusual), or for those that wish to watch it but want some background, I’ll provide a quick summary of what his technique is and what his main arguments are.

I’ve mentioned it a few times here on Dividend Monk, but I suppose I don’t mention it enough considering I focus on a specific niche rather than portfolio theory in general: asset allocation is the most important decision for a portfolio. Choosing where to invest your money and what your broad strategy is, is far more important than which specific investments you pick. Everyone has their preferred investment class (some prefer indexes, some prefer dividend stocks, some prefer other niches; I prefer both dividends and indexes), but what’s most important is how those investment types come together.

The main points from Swensen’s lecture are:
-Actively managed stock funds, in aggregate, underperform the market over the long term.
-Asset allocation is key, because it’s the closest thing to a “free lunch” around. With asset allocation, you can get better returns for the same level of total risk, or you can lower risk for the same level of portfolio returns. It’s an efficient way to maximize risk-adjusted returns, which modern portfolio theory assumes that any rational investor would want to do.
-There are some areas in which active management makes a difference, and it’s rather intuitive. The more efficient a market is, the less active management matters. In other words, the best bond traders are only slightly better than mediocre bond traders, but the best venture capitalists and leveraged buyout investors are significantly better than mediocre venture capitalists and leveraged buyout investors. The general progression of active management relevance is: bonds, stocks, real estate, buyouts, venture capital.
-Liquidity plays a big role in why some markets are more efficient than others. Less liquid investments, for the same level of risk, can often offer better returns. So, real estate and private equity, if invested in, can potentially provide outsize returns for a similar level of risk (assuming the fund is large enough to diversify even among these illiquid and large investments). If you want an example, look at a few of your favorite REITs, and imagine what your returns would be if you owned them personally at book value rather than paying a multiple of book value that the market has agreed is a good price to pay for what is on their part a passive and liquid real estate investment.

Obviously, some of this is more important for some managing an institution’s portfolio to know than for an individual investor to know. So what’s the takeaway for readers? The first takeaway is that, asset allocation really matters. The second is that, as an investor ascends in wealth, she may find it worthwhile to pursue some less liquid investments, including real estate and private equity (which to a certain degree are indeed accessible to individuals).

The third takeaway is, he also offers his portfolio advice for individual investors, which is not included in this lecture. The summary of his recommended asset allocation for a liquid individual portfolio is:

30% Domestic Equity
15% Foreign Equity
5% Emerging Markets
20% REITs
15% Bonds
15% TIPS

There are many similar portfolio allocations that will work approximately as well; the specifics are less important. There are ways to diversify effectively with only 3 asset classes rather than 6, and the various allocations could be either purely indexed (such as through Vanguard ETFs), or through individual stock selection. The benefits of this particular portfolio are that you get a ton of protection against inflation (REITs respond well to inflation, and TIPS (Treasury Inflation Protected Securities) are bonds that are indexed to inflation), and you get 70% of your portfolio allocated towards equity, which is typically the area that provides good returns.

The key to using a portfolio like this one is to realize the importance of rebalancing. The bond components aren’t necessarily a huge drag on returns; by rebalancing your portfolio with fresh capital or with annual selling/buying, you profit from both growth and volatility while being protected from some downside risk.

So, for those interested, here is his lecture, which I find to be worthwhile:

To summarize the article, Buffett argues that in this time of US deficits, debts, cuts, and unemployment, in addition to making spending cuts, the wealthy should pay higher taxes like they used to, and he defines wealthy as those making over $1 million, and especially those making over $10 million. To substantiate his point, he provides the information on how much he paid in taxes, and points out that he pays a lower percentage than anyone in his office, despite being the wealthiest by far. He claims he pays about 17% in taxes, while everyone else in his office pays between 33% and 41%.

I suppose I’ll get it out of the way and say I agree with him, but my main interest in this article is to analyze his claim, the claims of those who disagree with him, and to mostly stick to the facts about how this taxation works. This situation is relevant to dividend investing, because it is primarily about taxes on dividends.

Why Buffett’s Reported Tax Rate is So Low

The tax system in the US is complicated, just like most other countries. In theory, the more you make, the higher percentage you pay in taxes. In US history of the 1900s, the top tax rates were significantly higher than they were now, but a few presidents and Congresses, especially Reagan and Bush II, were responsible for reducing the top tax brackets significantly, for better or worse. In certain periods, dividends were taxed at the same rate as ordinary income, so people in the top tax brackets paid the top tax rate on their dividends. Under Bush II, the income tax brackets were mildly cut, and the dividend tax was substantially cut down from ordinary income tax to only 15% (or 0% for those in low tax brackets).

So, the most US citizens pay on qualified US dividends in taxes is 15% now. This was extended in 2010 until at least 2012, because President Obama and the Democrats made a deal with the Republicans in exchange for things they each wanted. I wrote an article before this occurred, about how tax changes may affect or not affect dividend investing, and a few months after that article, the tax cuts were extended, but the same article may be relevant as 2012 approaches.

So how does Buffett pay low taxes? It’s because most of his income that he fills out in taxes comes from dividend stocks, and dividends are taxed at only 15%. Most of Buffett’s wealth is in the form of tens of billions of dollars worth Berkshire Hathaway stock, which he doesn’t sell (but sometimes gives away). Since Berkshire pays no dividends, he receives no personal income from his Berkshire stock, so he pays no taxes on it. If he were to sell Berkshire stock, he would have to pay capital gains taxes, which are fairly low, but would amount to billions of dollars on his position. He gets a relatively small (at least for him) six figure salary for his job as Chairman and CEO, which gets taxed as ordinary income. In addition to his Berkshire stock and his CEO salary, Buffett owns a personal portfolio of dividend stocks that is worth somewhere around $2 billion. Many of these companies are the typical dividend blue chips, including ones you’ll find in my portfolio like JNJ and PG, and from this portfolio, he makes somewhere around $60 million in dividends.

So his total taxable “income” is these tens of millions in dividends, his small six figure salary, and possibly a few other sources here and there, but mainly those two things. He gives a portion of this income away and gets to deduct it from taxes, so a smaller majority of the income is left, and is taxable. So, for most of his income, he is taxed at 15%, and for a small portion, he is taxed at a higher rate (ordinary income taxes plus payroll taxes), and for some of the money he gives away, he is not taxed. The result is that on his tens of millions of dollars of taxable income, he pays around 17.4% in taxes, which according to him is lower than anyone in his office.

The Counter Arguments

Although I agree with him, Buffett’s article is misleading. He’s not paying 17%.

I’m sure he’s completely aware of why it’s misleading, and he tends to write very simply to get his point across. (He once wrote a very good article to educate the population on the US trade deficit, and to present his solution to the US trade deficit, and told the story in the form of inhabitants of two islands: Thriftville and Squanderville.) But that doesn’t change the fact that it’s inaccurate, and here’s why.

Buffett’s real income is not that $60 million in dividends. His real income is his portion of the operating profit of every company he partially owns, including Berkshire Hathaway and his personal stock portfolio, (plus that small six figure salary which I’m going to ignore from now on since it’s smaller than a rounding error for him). Owning shares in a company represents owning that portion of profits, and the operating income is the pre-tax profit (in general; there is also interest expense). The profit is then taxed, and is represented as net income, of which a portion is paid out in dividends, and those dividends are taxed again at 15%.

Therefore, Buffett’s total “real” income is in the billions rather than the millions, and most of the taxes he’s really paying, are being paid by the corporations at the corporate level, rather than being paid by himself. Still, those corporate taxes are really his taxes, and it’s important to view business income like this. Businesses make money for individuals, so it’s indirectly but accurately a part of an individual’s tax. Now, to mitigate this, one could argue that these corporate taxes are not just on the owners, but also on the customers since it affects pricing, so to be fair, let’s say that these percentages are the upper limit.

So to calculate his approximate real tax rate, he would have to:
-find the weighted average of the federal tax rate on the operating income of the companies he holds stock in
-find the weighted average payout ratio of dividends to operating income
-Calculate that a rough estimate of his tax rate is:
Tax Rate = (1.00)(% Federal Tax Rate on Operating Income) + (Operating Income Dividend Payout Ratio)(15%)
-A translation of this equation is that 100% of the operating income is taxed at whatever the rate is, and then a portion of this equal to the payout ratio is double-taxed at another 15%.
-Plus, if he ever sold his stake, we’d have to add capital gains tax on top of this.

I’ve seen some articles argue that his tax rate is 50%, since the number given for corporate tax rates is 35%, and dividends are taxed again at 15%. One such article is this one that was published on Forbes. It claims Buffett’s numbers are misleading, but these numbers are farther off. Buffett’s tax rate would only be 50% if corporations actually paid 35% in federal taxes (usually untrue), and if they paid out 100% of their operating income as dividends resulting in 100% double taxation (usually untrue). To take an example, Procter and Gamble’s effective tax rate is reported to be 27% by Morningstar, and only a portion of that is federal tax. Let’s say the federal tax rate is 20% for simplicity. Then, Procter and Gamble paid out approximately 35% of its operating income as dividends, which were taxed again at 15%. So, this rough estimate of the tax rate for an owner of Procter and Gamble is 1.00*20% + 0.35*15% = about 25%. Now, if we were accountants, we’d have to get into deferred taxes and other items such as foreign income that remains overseas, and the true tax rate is a bit gray.

To continue, Buffett is not paying any double tax on his Berkshire Hathaway stock, since Berkshire Hathaway does not pay dividends.

I’d estimate that his total real tax rate is somewhere between 20% and 30%, but it could be higher or lower depending on the precise federal corporate tax rates, precise payout ratios, and the gray answer to the philosophical economic question of which portion of corporate taxes are truly taxes on the owners, and which portion is a tax on the customers.

In addition, we could examine the reported 33% to 41% tax rate of his employees. Without details, we obviously can’t fact-check them, but I’d wager they are lower than these reported percentages. To get these figures, he’s taking into account income taxes and payroll taxes. But he’s focusing only on taxable income. These people likely have a lot of income that is not taxable, or is being taxed at a reduced and deferred rate, such as with an IRA, a 401(k), various government tax deductions and credits, and so forth.

Bringing it Together

Based on the arguments, the real situation is that he’s probably paying more than 17.4%, and his employees in his office are probably paying less than 33-41%. Still, I wouldn’t be surprised if he truly does pay a lower rate than some of them. The numbers seem to indicate that this is the case. Plus, his statement about wealthy fund managers holds true; they pay a very low tax rate. And, if Buffett wanted to legally minimize his taxes further, he could, by buying units of master limited partnerships (mostly deferred and somewhat reduced taxation), or by purchasing shares in companies that get huge government subsidies in the form of large tax breaks.

Although I disagree with his numbers, the basic concept holds fairly true. The poor pay little or nothing in taxes. The middle class and upper class pay a rather high rate of taxes, which comes in the form of income taxes and payroll taxes, and to some extent is mitigated with legal tax shelters (retirement plans), and tax credits and deductions. The rich can pay a huge variety in taxes depending on the source of their wealth, but it is likely lower than the upper middle class. Those who make money from work, get taxed pretty harshly. Those who make money with money, have far more options to reduce taxation. That’s the system he’s arguing against.

Buffet Interview

Recently, Buffett gave an interview where he talks about his opinion editorial. And for those who couldn’t care less about the politics of dividend taxation despite being dividend investors, he also talks about a lot of other topics, including his optimism on the US economy (and specifically why he is optimistic, and the two things stated by him that could potentially render his optimism incorrect). I highly recommend it:
Buffett Interview

Other Reading

Carnival of Personal Finance
I was included in a blog carnival.

5 Steps to Retire Early
Diviend Mantra wrote an article on how to retire early. And he’s not playing games; one can look at his income/expense statements to see that he’s walking the walk.

5 Things You Must Know Before You Invest
The Dividend Guy provides five warnings/encouragements.

Asset allocation is more important for your portfolio than individual selections. Dividend stocks are not a replacement for bonds, and shouldn’t usually be treated as such. A dividend portfolio with a reasonable allocation towards fixed income securities is important for long-term stability and growth.

Dividend stocks, although often less volatile than the market as a whole, still go up and down with economic fluctuations. This isn’t necessarily a problem for long-term investors, but if you want to fully take advantage of these fluctuations, fixed income securities are useful. Bond indices tend to move inversely in respect to stock indices, so when stocks are going down, bonds are often remaining steady or going mildly up. Interest rates tend to be higher during periods of economic strength, which keeps bond prices reduced. When interest rates fall (typically during a period of economic weakness), bond prices increase.

Think of fixed income securities as your “war chest” for recessions or flash crashes.

If you keep, say, a 70/30 allocation of stocks and bonds at all times, then you’ll be prepared for many market conditions. During periods of economic booms, when stock prices are rising fast and perhaps becoming overvalued, your stock percentage of your portfolio will increase to over 70%, and to keep the 70/30 allocation, you’ll either have to sell some stocks and buy some bonds, or preferably, keep the stock holdings you have and use your fresh capital that you regularly put in your portfolio to buy bonds. This is good, because when stock markets are highly valued and you have trouble finding good selections, you’ll instead be putting capital into bonds with solid interest rates.

Then, when a recession comes, and stock prices fall to attractive valuations, your percentage of stock holdings in the portfolio will decrease to under 70%, so you’ll naturally direct new capital towards buying stocks, and perhaps even sell some of your appreciated bonds to take advantage of the undervalued market depending on how big the stock drop was and how imbalanced your portfolio has become from your target asset allocation.

Keeping a consistent allocation of stocks and bonds naturally results in buying at fairly attractive prices, for both bonds and stocks. And note that none of this necessitates market timing. A 80/20 or 70/30 or 60/40 allocation of stocks to bonds can be maintained in all market conditions, so your buying habits are dependent on what your current allocation is rather than directly based on your market predictions.

Suppose I have a total portfolio with the following balance: 20% US Large Cap, 10% US Small Cap, 10% US REITs, 25% International Developed, 10% International Emerging, and 25% Bonds. As they go up and down relative to another, and you rebalance with fresh capital or with annual rebalancing, you harness that volatility by mechanically buying on dips or mechanically buying low and selling high. It can work whether it’s purely indexed or whether substantial portions consist of individual stock selections. Sometimes particular segments might move substantially apart from each other; for instance you could have an emerging market bubble and a US real estate slump, which means you’ll mechanically be selling your emerging market holdings when they are highly valued and buying lowly valued US REITs.

It’s important to pick portfolio segments that have low correlation. It’s useful to have both stable and volatile elements in a portfolio, such as stocks and bonds. Having a bunch of segments that all typically move in the same direction limits diversification. Spreading your assets among geographic locations, market sectors, and asset classes keeps your exposure to a catastrophic loss as low as possible and helps keep a lack of correlation between your portfolio segments. Some rather serious problems can bring down almost all asset classes, but careful selection (certain types of equities, certain types of bonds, real estate, infrastructure, perhaps commodities and cash, etc.) can reduce this possibility.

It’s often reasonable advice to gradually increase the percentage of bonds as you age, so that a large market drop that occurs right when you plan to retire won’t derail your plans, but this would depend on your individual situation and goals. For the most part I agree with the common advice; young people would do well to have a lot of equity exposure, since equities have historically offered the best returns, and those nearing retirement would do well to focus on capital preservation and moderate growth.

Although it can be tempting to think of assets that produce cash flows, such as dividends or interest, as being in the same group, dividend stocks are not a pure replacement for bonds in a portfolio. Maintaining diversification keeps your options open, your risks reduced, and improves the chances of attaining solid long-term returns.

This post showcases roughly what you need to do to attain a $150k stock/bond portfolio before you reach your 31st birthday, and to also have net worth stored away in retirement accounts and home equity. It’s a simplified and rough presentation, and only one of many ways to do it, but meant to be inspirational rather than thoroughly quantitative.

Prerequisites
Can everyone do this? Only if you strive towards certain goals. The core of the process presented here is dependent on graduating from a fairly high paying major and landing a job within a typical entry level salary range for that major. I base this on the salary that one might expect with engineering, science, software, or certain business degrees- perhaps $50-60k starting out. A major with a lower entry level salary could work out with these as well, if student debt is avoided.

This isn’t to say that students shouldn’t pursue other majors if that’s where their interests are, but it is to say that if one has the goal of building wealth, the facts show that certain majors will give you a much better jump start than others. But, even those who major in lower income fields, with enough frugality, can amass some substantial wealth. Lastly, this presentation doesn’t make allowance for unfortunate events, such as if you had to put a lot of income towards helping parents while still in your 20s, or suffering a major setback in your own personal life. There’s no doubt, building wealth does require a certain component of luck. Most of the results are based on smart effort, but negative circumstances can certainly get in the way.

This also happens to be tailored towards Americans, as that’s the job market and currency I’m most familiar with, but the basics apply in many places.

Tips
Attaining a six figure net worth before age 31 comes around requires a combination of substantial income and lifestyle frugality. Before I present the numbers, here are a few tips to maximize wealth accumulation potential without sacrificing much of anything else.

-Get a job in high school, and try to save some of the income. Have fun of course, since you’re only young once, but it’s best to realize early on that a happy person is typically capable of being happy regardless of the amount she or he consumes, and an unhappy person will typically remain fairly unhappy regardless of how much she or he consumes. Spend money on experiences that truly provide value.

-Work very hard in college to keep your grades higher than average. This will increase your job prospects when you graduate.

-Find a job while school is in session. Whether it’s working in the computer lab, or being a Resident Assistant, if you can find ways to avoid accumulating too much student debt, you’re going to improve your ability to build wealth. Join clubs and groups too, but spending a portion of your time on income generation can be helpful. Certain jobs, like being a resident assistant, can greatly reduce your student loan debt while simultaneously getting you connected with the college experience.

-Try to secure internships. Not only are they a great experience, they typically pay fairly well, and you should be able to save a few thousand dollars in a summer of working, if you are frugal.

-Consider building assets even if you have student loans. It’s important to keep student loans to a minimum, but it’s perhaps even riskier to not have any assets saved away. Rather than focusing on purely debt avoidance, or purely asset-building, I propose a moderate approach of trying to minimize student loans, but also putting some cash away into an emergency fund, and even a starter dividend portfolio, while still in college.

-After you graduate, consider attaining streams of income outside of your primary job if you’re only working 40-50 hours per week. If you find ways to bring in a few thousand extra dollars per year, it can help significantly. For instance, if you make $40k in net income and have $25k in expenses, and save and invest the difference, then although pulling in another $5k in net income only increases your net income by 12.5%, it increases your savings rate by 33% if you keep your expenses static. This is something major to realize- boosting income or reducing expenses moderately has a larger effect on net savings that one might immediately realize.

-Start off frugally pretty quickly. It may be tempting to splurge when you start getting paid higher than you’ve ever been paid before, but there are a lot of ways to save money. You may be able to get furniture for little or no cost from relatives that have extra. If you don’t have a significant other that you live with, you might consider having a roommate for a few years after graduation. By having a roommate, you cut rent in half, and a lot of expenses like power, heat, and internet connection, are divided among more people. Only pay for services you really want; dropping cable tv or land phone lines, isn’t too difficult these days. Try cooking a lot of your own food, and focus on cheaper and healthier meals (moderate or low meat, less junk food, high veggies, nuts, and beans, etc.) Either go carless, or select an inexpensive but reliable used car.

-There are some pretty inexpensive ways to have fun. Go camping, go to the beach, spend time with friends, play sports and exercise, get a quality used acoustic guitar to entertain, and develop hobbies that produce and create rather than consume. Being frugal or a minimalist, especially in your early years, doesn’t mean a lack of fun. Spend money on things that are truly important to you and that create value, but don’t spend money on things to impress, or things to distract, or things that society simply expects you to do that don’t necessarily make sense. Not only will you likely strengthen good character traits, you’ll set yourself up so that you can play with some of your money later when it’s more abundant if you want to.

-Use tax-advantaged accounts if possible. If you’re offered a matching 401(k) or similar at work, at least contribute enough to get full matching. Consider adding to an IRA as well. (Or the equivalent of these vehicles in other countries.)

Let’s Begin
So you’ve graduated college, and you’ve landed a job with reasonable pay. You may have some student debt, but hopefully you’ve kept it to a manageable sum, and you may already have a few grand or even over ten grand in liquid assets that you’ve built from high school through college. In addition, you may or may not have found a way to pull in another few thousand dollars per year. Plus, you have adopted a frugal lifestyle.

-This table assumes 8 years of investment growth at a 7% rate of return after taxes. The 7% rate of return is fairly conservative, and in reality, will be a lot more volatile than in this table, which is why I’ve kept it conservative. Some years may go up 50%, while other years may drop 50%. But by focusing on buying dividend growth companies at reasonable prices, and keeping your portfolio at a certain ratio of bonds/stocks (like 30/70), you can smooth out your volatility and hopefully get a 7% rate of return after taxes.

-It begins at the end of your 22nd year, where you start out without a dividend portfolio and without adding any that year (although as was previously mentioned, you may already have a few grand in liquid assets). During the 23rd year, only $12k is added to the stock/bond portfolio because depending on your initial asset position, starting a healthy emergency fund is wise, so it’s assumed that several grand goes to strengthening what you already have.

-It is assumed that in your late twenties, you purchase your first home with a 20% down payment (either a small condo for a single person or a frugal couple, or a modest home for a couple). If it wasn’t for this, I’d have increased the “fresh capital” column for years 25-28 to more than they are. Instead, it’s assumed that in these years, you’re building up for a down payment in addition to this.

-This post is about how to really have a $150,000 portfolio. Over the 8 year process, if 2.5% annual inflation is assumed, then you’ll need approximately $182,000 in future dollars to have $150,000 worth of today’s dollars. So, $182,000 is the real target, because we’re really going for $150,000 in today’s dollars.

At end of year 30, you have over $182k.

So, you’ve got $182k in the equity/bond account, and on top of this, you’ve got a sizable cash reserve and some home equity. Tens of thousands worth. Hopefully student debt is paid off. In addition, this table doesn’t expressly include 401(k) or IRA contributions (this article was intended as a taxable portfolio that you control completely), so you may and should have a sizable chunk in those other places too. For example, if you put a combined $5k-$7k away in your 401(k) after matching each year (meaning only $2.5k-$3.5k from you), and compound at 10% per year tax free or tax-advantaged, you’ll have $65,000 or so in your 401(k). It’s a similar story for your IRA.

Summing all of this together, it’s not out of the question to have over a quarter million dollars in net worth at age 30, even without a trust fund or college fully paid for by parents. To do it, you would do well to focus early on building wealth, get a job you like with decent pay, live frugally but fully, contribute to retirement plans, to your taxable account, and possibly towards home equity.

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It’s important as investors and US citizens to remain calm and look at the facts about this. I’ve seen a ton of incorrect information out there. An overreaction to the debt, especially from Congress (or the voters that elect Congress), would be more economically problematic than the debt itself. For value investors, a depressed Mr. Market may be coming to your door daily to offer you some good bargains.

History of the Contemporary US Debt

Although the US has almost always had debt, our contemporary debt situation began seriously accumulating in 1981, towards the beginning of Ronald Reagan’s term as president. Before that, both Republican and Democrat controlled legislative and executive branches had steadily decreased debt as a percentage of GDP from World War II. But after 1981, starting with Reagan’s significant decrease in the top marginal tax rate and sustained or increased spending, debt as a percentage of GDP began quickly increasing. Both Republican and Democrat controlled executive and legislative branches led to an accumulation of debt over these last 30 years, beginning with Reagan’s first term. An exception is that at the end of Democrat Bill Clinton’s term as president when Congress was controlled by Republicans, the US had a budget surplus and had managed to decrease debt as a percentage of GDP. More recently, the debt is due to tax cuts, two wars, and an unfunded portion of Medicare under President Bush, and recession-reduced tax revenues and stimulus spending under President Obama. US leaders and voters need to understand that if you cut taxes, you need to proportionally cut spending, or if you increase spending, you need to proportionately increase taxes, at least over the long term. Short term variances are ok, but we can’t have it all.
National Debt by Presidential Terms, and Congress Majority- Wikipedia

Facts about the Current US Debt

-The US currently has about $14.3 trillion in debt. A significant percentage of this is owned by the government itself (such as the Social Security fund), another significant percentage of this is owned by US citizens and companies, and increasingly, a percentage of this is owned internationally.
Federal Debt Basics- US Government Accountability Office

-The US has the most debt out of any country. But when it comes to debt as a percentage of GDP, which is a much more important metric, the US is far from the highest. Many other developed countries have higher debt as a percentage of GDP than the US, but still, ours is higher than it should be.
List of Countries by Debt- CIA World Factbook

-The US is nowhere close to financially defaulting. We would only default if lawmakers decided to default. It would be like being completely in a position to pay your bills, but deciding to pay them late and incur the penalties.

-Overall, America has more than $50 trillion in private household net worth, and $14.3 trillion in public debt, so the public debt to private equity ratio is below 30%. If we exclude debt owned by the government, US corporations, and US citizens, that number drops further. If this were a business, it would be a good figure. The problem is, the US government doesn’t really have that equity unless it taxes for it. The interest coverage ratio (federal income divided by interest expense) can be estimated to be between 10 and 20, depending on what time period I use. Currently, interest rates are low, but as they rise, the interest coverage ratio will shrink. Overall, an interest coverage ratio of above 10 would be very solid for a company. But we want interest as close to zero as possible for the federal government, because any positive interest means that a portion of our taxes, perhaps 5-10%, go to interest payments, which is deeply unsatisfying. Essentially, the US has a reasonable balance sheet as long as problems are fixed fairly quickly. If the trillion dollar deficits or even “only” multi-hundred-billion dollar deficits continue, a larger and larger chunk of our spending will be on interest until the situation becomes unsustainable.
US Household Net Worth-Reuters
US Revenue and Expenditure- Wikipedia

-The US Debt situation is fundamentally different than the European Debt situation. The US currently has a perfect AAA credit rating because a) the balance sheet is worsening but still fair, b) it can print its own money, c) it can raise taxes as lawmakers see fit. This is why US debt is basically a proxy for “risk free”. In a worst case scenario, the US can slowly inflate its way out of the current debt (but would still have to fix its deficit, which is largely indexed to inflation), which would of course have disadvantages. To avoid bad inflation or hyperinflation, there needs to be confidence in the integrity of the currency, so it’s better to balance the budget and let slow GDP growth shrink debt as a percentage of GDP, which would naturally include moderate inflation. Many European countries, on the other hand, have joined their currencies in to the common Euro. This means that if any country grows its debt too high, it doesn’t have full control of the situation, and needs other European countries for help. Both areas have their balance sheet issues, but they are fundamentally different.

What Will Happen if the Debt Ceiling is Reached with No Solution?

-Nobody can really be sure, because this is unprecedented and rather silly. The August 2nd date may not be the exact date the problem occurs. In reality, the US reached its debt ceiling a few months ago, but has been able to juggle its books to make a bit of room. This room is expected to run out sometime in early to mid August, and the conservative figure is August 2. The US is still bringing in revenue, but not enough to cover its obligations, so some things will go unpaid, whether it’s treasuries, social security, nonessential government options (government shutdown), armed forces, etc, until the debt ceiling is increased.

-If the US credit rating is downgraded, either because it defaults, or because it cuts services to pay the debt, or because it doesn’t extend the debt ceiling far enough, or because the budget remains grossly imbalanced, it will mean the US will have to pay a higher interest rate on its debt. This essentially means higher taxes or lower spending for citizens. Various private interest rates could increase as well. In addition, this would sadly mean that the bonds of four non-financial US corporations that currently are rated “AAA” (Johnson and Johnson, Microsoft, Exxon Mobil, and Automatic Data Processing), would be considered “less risky” than US treasuries. (Disclosure, I own JNJ and XOM stock.)

-Individuals, governments, or companies that rely on the integrity of US treasuries could be greatly affected. This is perhaps the most problematic, and least understood, area of this situation.

-There are already problems. The Federal Aviation Administration has already partially shut down without notice for nearly a week now. Congress wouldn’t agree on tiny details of the FAA reauthorization (they concern unions and a few subsidies to small airports; partisan issues), so all research, development, and construction of the FAA is currently shut down without notice. The House of Representatives slipped in some new things into the bill, which includes a union-weakening measure and an elimination of subsidies, and the Senate rejected it. 4000 federal engineers, scientists, programmers, and managers are out of work with no pay and with virtually no warning. In addition, thousands of private contractors that provide engineering services and work along with those federal employees, or that provide construction services on airports around the country, are immediately halted. There are over $2 billion of contracts affected, and there are literally empty construction sites on airports right now, and empty offices with expensive equipment sitting there. This wasn’t specifically due to the debt ceiling (instead it was due to irresponsible partisan politics), but it’s a smaller taste of what can happen. 4,000 federal workers and 70,000 contractors/construction workers are affected.
The Airport Jobs We Desperately Need: Congress’ Failure has Consequences
We Need an FAA Bill Exension
4,000 feds and 70,000 construction workers

How Do We Fix the US Debt Situation?

I’m certainly no wiz, and there are many potential paths to take, but there are some things worth considering.

-The debt problem cannot be fixed simply by refusing to increase the debt ceiling. Without raising the debt ceiling, the US would literally have to balance its budget over a matter of days or weeks, which would mean increasing taxes or decreasing spending by over a trillion dollars per year. The current debt represents our previous promises, not our future ones. Spending would have to align with the volatility of US revenue. This would mean either enormous and abrupt tax increases, or enormous and abrupt cuts to social security, medicare, defense, and various domestic spending.

-The debt problem, however, can be fixed over time. If the budget is balanced over the next few years, then debt as a percentage of GDP will decrease as the GDP increases. The largest spending areas right now are Social Security, Defense, Welfare, and Medicare and Medicaid.

-Social Security currently has a trust fund of over $2 trillion due to surpluses, at least on paper. Receipts have exceeded expenditure. The problem, however, is that when social security was started, the date of retirement was approximately the same as the average life expectancy. The number of people paying into the system was much larger than the number of people withdrawing. As people live longer (into their 80s rather than 60s), and as a large generation retires, the ratio of payers to withdraws will continue to decrease. To keep social security sustainable, there are numerous options. People can pay more into it, the income cap can be increased, cost of living increases can be reduced, and/or the retirement age can be increased. The other problem is that other areas of the government have “borrowed” from social security to pay for other unfunded things, so although social security is not entirely broken, it is rather broke.

-Welfare has spiked recently with the recession. It used to be in the ~$300 billion range but now it is in the ~$500 billion range. This can decrease if the economy improves. It can also be decreased by making it harder to receive benefits to try to keep out people who don’t really need them.

-The US spends around $700 billion per year on the armed forces. This is a huge chunk of our total spending, and a huge chunk of the total worldwide defense spending. The US has less than 5% of the world population, but spends somewhere around 40% of the total world’s annual military expenditure. In addition, defense spending as a percentage of GPD is larger than almost all large and developed countries.
Military Spending by Country- Global Security

-Corporate tax accounts for a fairly small percentage of US revenue, while individual taxes are a major component. We have a trade deficit, meaning we import more products than we export. This trade deficit mainly became a problem during President Clinton’s term (the timeline is rather correlated to the signing of the North American Free Trade Agreement), and continued under President Bush and President Obama. Corporations have benefited, because they can get cheaper labor and fewer restrictions on environmental damage elsewhere. But, if inflation-adjusted labor rates decrease domestically, that increases the divide between socio-economic classes and reduces the tax base. Government regulation and/or consumer decisions to spend more consciously, can potentially help address this issue.

-Medicare and Medicaid currently are causing part of the deficit. It’s the same fundamental problem as social security- an aging population. Worse yet, the life expectancy is lower than many other highly developed countries, and the infant morality rate is higher than many other highly developed countries, and yet we pay more per capita, and as a percentage of GDP on healthcare, than most all other countries. There is a ton of improvement potential here.
Health Care Spending by Country
Infant Morality Rate- CIA World Factbook
Life Expectancy- CIA World Factbook

-The US has maintained rather consistent taxation as a percentage of its GDP over contemporary history, but has significantly lower taxation than other developed countries. Taxation has become less progressive, as the top marginal rate has significantly decreased, and dividend and partnership taxation has decreased. This how someone like Warren Buffett can pay a lower tax percentage than his secretary. Nonetheless, the upper middle and upper classes have most of the tax burden, mainly because they have most of the wealth. When discussing taxation, it’s important to compare the situation to the past, and to compare it internationally, to see what’s working and what is not. The United States currently attempts to provide services to its citizens that roughly correspond to the low end of other developed countries (social security, medicare, disability, high standards for medicine and food, but no universal health care, and rather low subsidy for higher education), yet taxes at levels that correspond to the upper end of developing countries. There needs to be a decision- either tax and provide the services of a developed nation, or tax and provide services at the high end of a developing nation. We can’t provide the services of one, and pay for it with the taxes of another.
15 Charts about Wealth and Inequality in America- Business Insider
Worldwide Tax as Percentage of GDP- World Bank
Tax Revenues Fall in OECD Countries

-Discretionary domestic spending is actually a fairly small part of the US budget, and so is foreign aid. These areas can be looked at and streamlined.

Summary

There are a variety of ways to fix the deficit, and it will require compromise, moderation, and reason. As previously mentioned, if the budget can be balanced, then debt as a percentage of GDP will decrease over time. I do not think the government will default, and in the off chance that it does, it would be due to leadership failure rather than due to necessity.

As for dealing with the current situation, the same answer pretty much always applies. Make sure you are diversified in terms of number of companies, number of sectors, and asset class (stocks, bonds, etc). Look for opportunities to buy on weakness; companies that may lose value if the markets react poorly to US silliness, but that you believe are good long term investments. Remain focus and fact-driven, and allow any potential market irrationality to help you rather than hurt you over the long term. Portfolio values may temporarily fall, but remember, for net buyers of stock, markets with low value are better than overvalued markets. As always, buy quality companies at reasonable prices.

There are some mixed signals on the economy. One one hand, jobless claims were reduced. But, if the research, development, management, and construction of the FAA federal employees and contractors remains shut down, and if other government agencies have to shut down, this will undo itself. In addition, Emerson Electric warned about a slowing economy in the US and Europe. Being a cyclical business, Emerson tends to have a pretty strong understanding of economic conditions. Emerson reported that orders are still growing, but that they “moderated”, and the stock price fell 7%. (Disclosure, long EMR). Housing is still not showing strong signs of improvement.

I’m interested in reader opinions- what do you think of the deficit, the debt, the current debt ceiling debate, the partial FAA shut down, the investing opportunities, and the current state of the world economy?

Other Weekend Reading

Dividend Stocks 101: The Essential Guide
If you’re new to the site, check out this key resource.

Carnival of Personal Finance 319
I was included in a blog carnival this week.

Master Limited Partnerships: The Perfect Dividend Stocks
The Dividend Growth Investor presents some dividend ideas.

Ensure your Dividends with Insurance Stocks
Dividend Mantra presents some insurance companies.

Should you Fear US Treasury Bonds?
Andrew Hallam presents some facts about America’s situation, from a non-American perspective.

Managing a dividend portfolio is a fairly low maintenance activity. The purpose is to have low portfolio turnover to avoid trying to time the market, to avoid unnecessary trading fees, and to avoid unnecessary taxation, while all the while building a larger portfolio and increasing levels of passive dividend income.

But buy-and-hold doesn’t mean set-and-forget. It’s important to routinely review your investments, make note of any changes, and to invest accordingly. Taking time to determine which investments you’re interested in adding more capital to, and which investments are deviating from your investment thesis or not meeting your expectations (of fundamental performance, not stock performance), or becoming overvalued, allows you to streamline and enhance your portfolio and returns.

I spend more time on investing than I would estimate that the average dividend growth investor does (or should), since it’s a hobby of mine, and I write about it. Maintenance for my own portfolio is fairly low, however.

Regularly, give the portfolio a quick check to look for news and updates. Stock price changes matter little for long-term investors, but a large stock price swing either way is an indication of a piece of news that might be worth reading. Google Finance is a good tool for this, because you can scan your portfolio prices and top portfolio news stories on one page, and if you have an email account there, it can all be checked quickly within one log-in. How often one does this is up to the investor (and likely dependent on whether the investor is a hobbyist or if they only invest for the sake of the outcome), but there’s no reason to get too crazy about checking stocks.

Occasionally, give the portfolio a more thorough check by looking through valid news on your investments, and possibly checking various useful sources of opinion (I enjoy Seeking Alpha and Morningstar, in particular, as well as fellow dividend blogs). If possible, add fresh capital to the portfolio on a regular basis, and keep a “watch list” or a “buy list” so that you have stock ideas ready for purchase rather than making up your mind on the spot when fresh capital comes in.

Annually, give each investment a thorough re-analysis. I do this throughout the year, so that once per year, I have analyzed my entire portfolio again to ensure that my companies are still in line with my investing thesis. In addition, I vote in annual shareholder proxies for my holdings, and I particular advocate doing this because healthy capitalism depends on prudent corporate governance. One of my reasons for starting this blog was to hopefully make my time more useful by spreading my discovered facts and opinions with others, to help stabilize my commitment towards thorough stock analysis, and to be part of a community where I can continue to find good ideas. This is a reason why I typically recommend a fewer number of portfolio holdings than some other individual dividend investors might- having a moderate amount of positions makes portfolio maintenance more reasonable, makes voting less time consuming, and allows investors to have a more thorough understanding of their businesses.

Knowing when to sell a stock can be difficult. I keep my portfolio turnover especially low, but still reduce or eliminate a position from time to time. Sometimes my risk preferences change, or a smaller holding is overvalued and I have a significantly better opportunity in mind, or more rarely, a company deviates from my original investment thesis. A little bit of rebalancing to take money from high-performing richly-valued stocks and allocating the capital towards stocks you are currently more favorable toward can be a good idea, but only if the expected rate of return of the new investment is considerable compared to the sold asset, even after fees and taxes are taken into account.

For a more in-depth article on selling stock, see my previous article on the subject: 3 Reasons To Sell a Dividend Stock. When it comes to pruning a portfolio, the saying of “less is more” typically holds true, but failing to prune at all is not optimal.

How much time you decide to spend on investment is up to you, and mainly should depend on your goals and your level of interest. These are my suggestions and experiences. Fortunately for individual investors, dividend growth investing is among the lowest maintenance of all investing strategies, next to pure indexing.