High Frequency Trading: Is The Small Investor Getting the Shaft?

60 MinutesLast Sunday 60 Minutes aired a segment about high frequency trading titled: “Is The Stock Market Rigged?”  Since its airing many of our clients have voiced concern over high frequency trading, so I have decided to share my thoughts.

To be honest, I knew very little about it prior to the 60 Minutes segment, but I did quite a bit of reading on the subject this week, and I now feel better prepared to weigh in on the conversation.  For those readers who don’t know what high frequency trading (or HFT) is, here is a little background.

Over the last few decades, technology has allowed the financial markets to make bigger and bigger buy and sell transactions faster and faster.  Trades that used to be done with handwritten orders and ticker tape can now be transacted by supercomputers in milliseconds rather than in minutes.  As it has become easier to fill large stock trades more rapidly, a cottage industry has sprouted up that exploits this new efficiency: the high frequency trader.  The high frequency trader sees your order to buy stock at a particular price, but before your order gets to the stock exchange (in less than a second), the high frequency trader buys the stock ahead of you and sells it to you at a slightly higher price.

Think of HFT like this:  suppose you want to buy your girlfriend a dozen roses, so you call the florist and ask what the price will be.  The florist quotes you $24.00. You tell the florist you live 15 miles away, but you will drive right down to buy the dozen roses.  Unbeknownst to you, a high frequency rose merchant eavesdropped on your phone call with the florist.  Knowing your intention to buy 12 roses at $2.00 apiece, he drove down to the florist shop from his office only 2 miles away and bought the roses in the store for $2.00 apiece.  Knowing you are on your way to buy roses, he is willing to sell them back to the florist for $2.01 apiece. When you get to the florist, the florist tells you that since you called earlier, the price of roses has risen to $2.02 (the florist added a penny per rose for his trouble).  Although you are perturbed because you are paying more than you were previously quoted, you pay $24.24 for the roses and you surprise your girlfriend.

In this scenario, the high frequency rose trader knew you were interested in buying roses, so he raced to the florist before you and bought the roses at the price you wanted to pay. He also took the risk you would buy them back at a penny or two higher when you arrived to get your flowers.  If you had balked at the price increase, the florist wouldn’t have bought them back at $2.01 apiece, and the high frequency rose trader would have been stuck with an order of roses he really didn’t want or need.

That is exactly how HFT works in the securities markets.  Electronic trade orders can’t move faster than the speed of light, and the stock exchanges are located at different locations around the world.  When an order is placed electronically, those HFT firms located between the buyers of stock and the stock exchange where the order will be filled, can buy the stock you ordered at the price you were willing to pay a millisecond sooner. The HFT then sells you the stock at a penny or so higher per share.

HFT sounds pretty rude at best, and downright dishonest at the least; but, is HFT really a bad deal for the individual investor?  I guess the best way to answer that question is to ask “compared to what?”

When it comes to buying and selling stocks, liquidity is extremely important.  A market with sporadic buyers and sellers is an illiquid and inefficient market indeed.  As distasteful as HFT looks on the surface, it appears to help ensure a large number of buyers and sellers in the market, thus shrinking price spreads and increasing the odds an investor can sell their stock in the future.

Secondly, HFT seems to be more of a burden on large institutional traders than on smaller individual investors (See Morningstar article: “About That Rigging Claim.”  From my floral analogy above, you can see that buying a dozen roses at $2.00 apiece and selling to you for a 12 cents profit doesn’t sound like a smart way to strike it rich on Wall Street; however, when you are buying 100 million roses (or shares) and immediately re-selling them for a $1 million profit, you can see where HFT can be enticing.  To date, there doesn’t appear to be widespread HFT front-running on small trades entered by individual investors.

Since the dawn of civilization, there have always been stories of markets being “rigged” against the little guy (see Proverbs 20:23).  The mission of the U.S. Securities and Exchange Commission (SEC) is:  “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  When I look back over my 20 year financial career, the markets are fairer, less costly, and more orderly and efficient today than they have ever been.

In the past, small investors had huge barriers of entry that made investing difficult.  There were odd lot differential fees which made small trades extremely expensive, but today, few brokerage firms charge odd lot penalties.  Until 2001, stock prices were quoted in eighths of a dollar which increased price spreads (and trader profits), but now stocks are priced down to the penny, reducing price spreads and trading costs for all investors.  30 years ago there were almost no discount brokerage firms available to the small investor, but today there are numerous low cost opportunities to fit the needs of practically any interested investor.

Is the stock market rigged, like the 60 Minutes segment implies?  Yeah; probably, but it has always been rigged.  Even though middlemen have been skimming profits on stock trades at the expense of investors since the invention of the stock market, that hasn’t stopped millions of long term investors from accumulating vast sums of wealth.  In my financial career spanning two decades, I have observed substantially more money has been lost by NOT investing than has ever been lost BY investing.  In spite of HFT, markets today are less expensive, more transparent, and less sleazy than ever.  With the airing of the 60 Minutes segment, I suspect HFT will percolate to the top of the SEC’s list of Wall Street shenanigans to investigate.  But, I hope any regulatory cures they implement are better than the alleged financial ills of HFT.

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Outstanding Customer Service in Cedar Park, Texas

urlLinda & I spent a few days recently in Cedar Park, Texas, a suburb of Austin, and our first impression was positive.  We took advantage of our Best Western Diamond Club status by lodging at the Best Western in Cedar Park.  When we moved into the room, the WiFi was horrible, making it virtually impossible for me to work.  The manager saw my frustration, and worked tirelessly to make things right; resetting the router multiple times, working with tech support, and giving me the number to tech support so I could work with them personally.  Ultimately, he moved us into a room with an Ethernet cable connection, but the new room’s WiFi was strong enough it really wasn’t necessary to use the cable.

While I was perturbed by the poor WiFi connection in the first room, I was very impressed by the manager’s attitude and efforts to make things right.  The poor WiFi connection wasn’t his fault, but he made it his responsibility to fix the problem, and he did.

DDpizzaOn Thursday for lunch, Linda said she wanted pizza.  There was a Double Dave’s Pizzaworks  just a couple hundred yards from our hotel so we decided to go there.  When we walked in, there was a young woman busing tables who stopped what she was doing and greeted us with a smile.  She then escorted us to the counter to take our order.  The Double Dave’s flyer in our hotel room said their Thursday  special was a 3-topping large pizza for $10.99, and we agreed to have that; however, out of the corner of my eye I could see they offered a lunch buffet; it looked pretty tasty, and on closer inspection we decided to opt for the buffet instead.

The young woman asked:  “What were the three toppings you were going to order?”  We asked her why she wanted to know because we already decided to have the buffet instead, and there was plenty of pizza in the buffet line. She replied: “I want to make the pizza you really want, and I will bring it out to your table.”  She then went in the back and made the pizza herself.

What great service!  We had already placed our order, and this young woman made the decision to go above and beyond what was necessary to make the sale.  We grabbed our salads and drinks and sat down, and when she brought out our pizza, I asked if she was the owner, and she said, “Yes, we own 3 restaurants.”  Her young husband came out and introduced himself and then busily started sweeping under a table earlier occupied by a toddler more interested in throwing food on the floor than eating her pizza.

This young couple didn’t look much older than their early 30s, but it was evident they worked hard to run and excellent enterprise and  put the desires of the customer above their own.  I am always impressed by outstanding service, and I told her so. She thanked me profusely, and said it was nice to hear because: “Sometimes being in business is really hard.”

I don’t know what Cedar Park is doing to promote such great customer service, but I hope it is infectious.

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Planning for Emergencies in Dual Working Families

Working ParentsMany of my clients are married professionals: doctors married to doctors, lawyers married to corporate executives, airline pilots married to dentists, etc.  In a bygone era, the husband was the primary breadwinner, and the wife focused her attention on children and household affairs; that era is quickly becoming an anachronism.  So what do you do when both spouses have equally important work responsibilities, and one of the children is sick, the car breaks down, or the repair man is coming by to fix the dryer?

The best way to deal with an unexpected emergency is to plan for it ahead of time.  Sick children are going to need to be brought home from school, and someone is going to have to let in the plumber when the pipes burst and the basement looks like an indoor swimming pool; therefore, decide BEFORE they happen who will be responsible for dealing with emergencies.

In the same way balanced families plan for financial emergencies, they should also plan for “time critical” emergencies.  A time critical emergency is an event both urgent and important enough that it pulls a person away from their primary professional responsibilities.  The school isn’t going to let your sick kid stay in class because you are closing a real estate deal, and the dead car isn’t going to drive itself to the mechanic because you have an important client meeting; therefore, couples where both work outside the home should create a “contingency” roster to plan for responding to unplanned emergencies.

040303-F-2828D-101When I was in the Marine Corps, my infantry unit was periodically tasked to be the “Air Contingency Battalion” (ACB).  Whenever our battalion was assigned as ACB, we went about our normal operational and training routine; however, in the event of a crisis, the ACB was expected to drop everything it was doing and be prepared to load on aircraft within 6 hours of notice and fly anywhere in the world to respond to a crisis.  While it was possible for us to train and operate close to home, we couldn’t be more than two hours away from the base and we certainly didn’t schedule operations that would prevent us from dropping everything we were doing to load aircraft in a moment’s notice.

In the same way, I encourage dual working parents to create a family contingency roster that pre-assigns one spouse responsible for responding to contingencies.  When an emergency pops up that requires immediate attention, the contingency roster helps prevent confusion or hard feelings about who will respond.

Couples should plan their professional schedules accordingly.  Emergencies are never convenient, and they always pop up at the worst possible time; however, when possible, you shouldn’t schedule contingency duty the same week you intend to be in court, and your spouse shouldn’t volunteer to have contingency duty the days she is traveling out of the country.  To the best of your ability, use grace and common sense to work with each other’s professional commitments to ensure the contingency roster is efficiently coordinated and duties are equally shared.

In a mini crisis, someone is going to be inconvenienced by having to leave a meeting, vacate a job site, or cancel an appointment with their biggest client. Ultimately, the purpose of the contingency roster is to ensure both working spouses share the responsibility of responding to emergencies equally.  Resolve schedule conflicts with your spouse ahead of time, and those assigned contingency duty should be responsible for resolving their own work related conflicts. The spouse who routinely expects the other working spouse to interrupt their professional duties to cover for them will eventually create bitterness and resentment in their marriage.

The contingency roster should be published monthly and discussed weekly to ensure it is understood and workable.  It need not be complicated, really nothing more than a color code or initial on a calendar (like Google Calendar) which both spouses have at their immediate access.

To be honest, having only one spouse working outside the home has been less complicated for Linda and me, and I often take for granted how fortunate we are that Linda is flexible enough to handle most of our mini crises, but for those couples who both enjoy their professional careers and expect their spouses to support them, the contingency roster seems to be a good solution.

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The myRA Will Add Unnecessary Complexity to Retirement Savings

140128225516-president-obama-state-of-the-union-inequality-economy-minimum-wage-00000127-620x348In President Obama’s state of the union address on 28 January, 2014, he introduced a new retirement plan called the” My Retirement Account” (myRA).  This new plan promises to provide investment opportunities for those workers who aren’t eligible to participate in an employer sponsored retirement plan.  It is true a majority of Americans unnecessarily retire without savings; however, creating yet another complicated tax advantaged savings vehicle will not increase the number of Americans adequately saving for retirement.

While saving for the future appears intuitive, it really is not when you factor in all the complicated options the government has created to incentivize citizens to save for their own futures.  While the following list is not exhaustive, it does give the reader some idea of how overwhelming it can be to choose the appropriate retirement savings account: 401(k), 403(b), SEP-IRA, SIMPLE IRA, Traditional IRA, Roth IRA, etc…

The rules for retirement planning are complex, and they are made even more so when politicians get involved.  When some (but not all) Americans take advantage of the incentives in the U.S. tax code to save, politicians often respond with legislation to contend with the corresponding wealth inequality they helped create.  To prevent “too much success” from saving, Congress imposes a variety of limits on how much a citizen can invest in different retirement plans based on participant incomes, participation in other plans, age, or how much participants earn from wages.  Over the years retirement plan possibilities have grown numerous, and for many Americans, the choices and complexities have become paralyzing.

The myRA attempts to use the concept of “new” to inspire individuals to save for their retirement because evidently, the “old” plans haven’t inspired enough low and middle income wage earners to save.  The Roth IRA, originally created by the Taxpayer Relief Act of 1997, is an ideal savings plan for low and middle income citizens, and it is offered by most banks, credit unions, brokerage firms, and insurance companies. Although Roth IRA’s are terrific, not enough Americans are taking advantage of them, and this is must be the inspiration for the myRA.

The myRA works a lot like the current Roth IRA.  It is funded with after-tax dollars, and the earnings grow tax free.  An investor can withdraw contributions out at any time without having to pay taxes or penalties, and after a person turns 59 ½, the earnings can be withdrawn tax free as well. The only difference I see between the myRA and the Roth IRA is the myRA will allow investors to invest in the “G” Fund, the government’s guaranteed cash option in the federal employees Thrift Savings Plan. The G Fund currently pays 2.2%, and although better than local bank savings rates, it still barely keeps up with inflation.  Investors in MyRA’s will be allowed to participate until they: (1) accumulate $15,000; or (2) after 30 years, whichever comes first.  At that time investors will be required to rollover their MyRA into a Roth IRA with some other private financial institution.

In theory, the myRA allows employees to invest contributions straight from their paychecks, just like a 401(k), 403(b), or SIMPLE IRA; however, many employers already allow their employees to direct deposit a portion of their paychecks into Roth IRA’s (many of my employer clients allow employees to do so).  Additionally, the myRA allows employees to make small initial investments of $25, and additional contributions as low as $5 per pay period; but, most banks and credit unions (and some mutual fund companies) already allow contributions this low as well.

I think we need the myRA like we need another Rambo movie; instead, we need LESS retirement complexity.  My proposal for getting increased retirement savings is for the government to simplify the current system by reducing the number of retirement savings accounts from several to two: (1) a traditional option funded with pre-tax dollars with earnings growing tax deferred; and (2) a Roth option funded with after-tax dollars with earnings growing tax free.

Under my proposal, a citizen who works for a company offering a 401(k), a 403(b) or a SIMPLE IRA would have his contributions deposited into either his traditional plan, his Roth plan, or both. Additionally, the citizen would also be able to make IRA contributions into either or both his two plans, subject to the contributions limits that already exist.

We live in an era where Americans change jobs multiple times throughout their working years. Rather than have two old 401(k) plans from  two different employers and a small SIMPLE IRA with a current job, my proposal would allow Americans to take their portable plans from one employer to the next, reducing the red tape necessary to rollover old plans into IRA’s or new employer plans. Although the funds being deposited into the two plans would be subject to current contribution rules for the type of plan the investor is eligible to fund, reducing the number of retirement accounts would greatly simplify the retirement savings process and increase the number of citizens capable of understanding them.

Because myRA’s offer limited investment options and capped growth but plenty of government bureaucracy, I don’t see much value in them.  We already have Roth IRA’s which are less bureaucratic and offer more options.  The complexity of the myRA outweighs its benefits, and like many well intended programs offered to help the poor and lower middle class, I predict the myRA will produce results that are the exact opposite of what were intended.

Unless the government reduces the complexity of investing for retirement, America is not going to see an increase in retirement saving any time soon.

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Backdoor Roth IRA Conversions: Read the Fine Print

Roth-IRA-401kI was recently chatting on Facebook with my cousin who is a successful financial advisor, and we were discussing the “backdoor” Roth IRA conversion.  The backdoor Roth IRA conversion is a strategy that allows some high income earners who participate in employer sponsored retirement plans to also make indirect contributions into a Roth IRA, in spite of IRS contributions limits.  The way the backdoor strategy works is you make a non-deductible contribution to a traditional IRA and then immediately convert it to a Roth IRA.  Sounds pretty easy right?  Unfortunately, there is a lot of IRS fine print that must be understood before trying this trick at home.

The backdoor Roth IRA conversion is a great strategy for transferring a non-deductible tax-deferred IRA contribution into a Roth IRA if (1) you have no other traditional IRA funds, or (2) the value of your other IRAs are less than or equal to the basis in your IRA accounts.  However, very few people own non-deductible IRAs exclusively.  Usually, investors will open a deductible IRA first, and then when their employer offers them a better retirement plan, they stop funding their deductible IRAs and begin participating in their employer’s plan.  Or, they will rollover a previous employer’s retirement plan into a deductible Traditional IRA when they change jobs.

Later on when the investor’s income is large enough to max out their contributions to their employer plan (as well as disqualify them for a deduction in their traditional IRAs), they pursue investing their supplementary funds into a non-deductible Traditional IRA.  The non-deductible Traditional IRA won’t help reduce a current year tax liability, but it will allow investors to defer the taxes on the growth of the non-deductible contributions.  Non-deductible IRAs are complex, requiring investors to file an 8606 Form with their taxes, as well as keep accurate records of which contributions were deductible and which were non-deductible.  From a tax perspective, funding a non-deductible IRA is easy; however, taking distributions in retirement and accurately paying the taxes on those distributions (some taxed, others not taxed) can be a real pain.

Because non-deductible Traditional IRAs are difficult and Roth IRAs are easy, there is a lot of incentive to replace non-deductible IRAs with Roth IRAs.  Initially, Congress disallowed high income earners from participating in Roth IRA conversions; however, in 2010 Roth IRA conversions were made available to everyone regardless of income.  As a result, financial planners saw an opportunity for high income earners to participate in Roth IRAs as well.  This is where the backdoor conversion came to fruition.

There are two flies in the ointment investors should consider before using the backdoor Roth IRA conversion.  Nothing that comes out of Congress is simple or even intuitive, and backdoor Roth IRA conversions are no exception.  If you don’t own any Traditional IRAs where you took a tax deduction, no problem.  However, if you own ANY Traditional IRAs where the values exceed the contributions you made to the IRAs, you will be subject to the IRA Aggregation Rule under IRC Section 408(d)(2).  This rule stipulates that when a Roth conversion occurs, the taxpayer must calculate the income tax consequences of a Roth conversion by aggregating together all of the taxpayer’s IRAs; therefore, if you own any other Traditional IRAs, they will complicate the tax consequences of the “contribute-then-convert” strategy.  For example:

Assume Steve contributes $5,500 to a non-deductible IRA with the intention of converting it to a Roth IRA.  However, Steve also has a $100,000 IRA funded from earlier pre-tax IRA contributions and two prior 401(k) rollovers.  When Steve converts his newly created $5,500 non-deductible IRA, he cannot simply convert at a tax cost of $0.  Instead, the IRA aggregation rule applies as follows: $5500 (all non-deductible IRA contributions/ ($100,000 (all IRA assets) + $5500 (newest non-deductible contribution ) = 5.213% or $286.73.  In other words, Steve will have to pay taxes on $5213.27, thus making the conversion about as enjoyable as chewing on tinfoil.

To get around the aggregation rule, some investors choose to roll their existing IRAs with pre-tax contributions into their employer plans.  By not having a Traditional IRA with pre-tax contributions, there is nothing to aggregate, thus the annual backdoor Roth IRA conversions are much simpler; however, not all 401(k)s offer investments as robust and diverse as a self-directed traditional IRA; therefore, investors will need to determine if losing their options and flexibility by rolling their Traditional IRAs into their employer’s plan will be offset by the advantages of funding their Roth IRAs annually.

Another consideration is the “Step Transaction Doctrine,” which permits the IRS to disallow strategies such as the backdoor Roth IRA conversion if they can prove the only economic value you received from opening a non-deductible Traditional IRA before converting to a Roth was to avoid the prohibition of funding a Roth IRA directly.  The problem with the step transaction doctrine is the IRS applies the rule arbitrarily on an individual basis.  That means some people might get away with it, and others might get hammered.  There is no way for certain to know if they will use the Step Transaction Doctrine to slap you with a 6% excess contribution penalty sometime in the future after you have been converting for decades and your Roth IRA has grown hefty.  Therefore, backdoor at your own peril.

While the backdoor Roth conversion strategy might be a good opportunity, I recommend meeting with your financial planner and tax advisor first to discuss how the aggregation rule and the step transaction doctrine might affect you.  With long-term capital gains and dividends currently taxed at 15% for most investors (high income earners will pay more) many clients may prefer investing in a taxable account or real estate with their supplementary investment dollars rather than go through the hassle of a backdoor conversion of non-deductible Traditional IRAs.

Teach Your Children Well

kid counting pennies_425425x283One of the fascinating experiences of growing older is watching other people’s children become adults.  For the last 20 years, I have observed children in my community grow up in a consumer culture, and how different choices made by different children in similar situations have had a profound impact on their future financial outcomes.  Here are 3 things I have witnessed:

1) The wealth of a child’s parents has proven to have little impact on a child’s future ability to manage money.  I have seen children raised in humble surroundings grow up to be remarkable financial stewards, and I have seen children of the wealthy develop into spendthrifts.  There is zero correlation between a parent’s balance sheet and their children’s future ability to manage their own finances.

2) Parents who pay 100% of their children’s college tuition don’t help them become better future money managers (and children who go to college on full scholarships don’t manage money much better).  College is often the first place a young adult learns to make choices about necessities (i.e., rent, food, utilities).  Many parents of means feel it is reasonable  to pay their children’s college expenses, expecting their children will have more time and energy to focus their attention on academics; however, I haven’t seen any evidence that children who don’t earn money during college get better grades.  Upon graduation, those students who worked through college and paid for at least some of their expenses, have demonstrated better money management skills and more lucrative work prospects than those who  completed college without part-time work.

3) Parents who intentionally teach their children about money management before middle school tend to produce better future money managers.  Bar none, intentional financial instruction by both parents has produced the greatest number of children who grow up to be good financial stewards.  It is critical that age-appropriate basic financial principles be taught at a young age before the children are old enough to get their money cues from the culture.  Many parents require their children to tithe, save, and invest, before spending.  For others, shopping becomes a learning opportunity to drive home important money principles.  Many of my clients who have raised financially savvy adults asked me years ago to partner with them in teaching their children about saving, investing, and goal setting.  By saving money starting in high school, these children have built a relationship with a financial professional whose money values are similar to their parents.

There are a couple of caveats to my observations.  Even though parents may teach all their children the same sound money principles, not every child will heed them.  Some strong-willed children will reject sage advice, much to their parents’ disappointment.  Secondly, if one parent is good with finances and another a free spirit with the family’s money, the children will tend to follow the example of the less disciplined parent.  Parental unity on money management is critical for ensuring children don’t get mixed messages.

We all want our children to be happy adults.  By teaching them while they are young age appropriate skills and values of good stewardship, we can ensure they are equipped to survive in a consumer culture.

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