Financial Intelligence – Personal Finances & Investing 101 Bob Y. Chan Outline fore talk #3 October 16, 2003 Synopsis of last talk Follow your “money trail” Is investing an art or a science? Markets can and do move up or down, crazily! Outline for Talk #3 Whom do you work for? On borrowing money On Taxes How smart are you vs. the market? Recap: Balancing the check book The money game is a cashflow game Want to manage your cash flow so you have “seeds” for investing Key is to track down what are your expenses Balancing the check book (cont.) Consolidate all income and expense items into 1 or 2 “principle cash flow points” Checking account Major savings account Keep investment monies in a separate account Allow you to look at income / expenses and also investment performance Balancing the check book (cont.) Actual money in and out of the account (s) is your monthly cash flow Evaluate investment performance of the other account Spend 15-30 minutes each month to work out your “money game score” Balancing the check book (cont.) The mortgage problem Mortgage is a liability, not an asset Your monthly payment (principal plus interest) is actual expense Your asset is the property, and rise and fall in the value will come out when you sell the property Borrowing money Balancing your check book does not mean you do not borrow In fact, learn to borrow is an important lesson in the money game What you get from borrowing Money to spend Financial restraint over loan period Credit history Borrowing money (cont.) The home mortgage Major problem is whether you buy the property Either a consumption or an investment decision Mortgage is the “by-product” of the buy decision Mortgage is a secured loan Lowest interest rate you can get Tax benefits Do not buy the house to get the cheaper loan! Have a schedule to pay off debts At some point of time, you need a “bridge” to finance your expense Once take on a debt, work out the size and time frame to repay debt The regular debt payment is an expense item within the debt-repaying time frame Who do you work for? Work for yourself, not for money Most people work for The boss The bank The government Do you future income flows too much to the bank and the government? Some facts and views on taxes Tax is a “necessary evil” in modern society Tax is a means of redistributing income Many forms of taxes, some “hidden” In reality, the middle income / poor pay a larger chunk of taxes Your actual income is after-tax There are ways to minimize taxes A brief picture of U.S. taxes Most comprehensive and complicated tax system Only “invented” in 20th century Direct and indirect taxes Like all other countries, the middle income and poor pay more taxes U.S. taxes – for individuals Federal tax State and local taxes Property tax Sales tax Taxes associated with investment U.S. taxes – for corporations Ordinary income (Profits) tax Capital gains tax Dividend tax Payroll tax Chinese taxes - a very very brief summary “second most” complicated tax system Based on input, throughput and output Most notably, value added tax (VAT) Hong Kong tax The most simple tax system Corporations based on output However, SAR government has serious financial problem! Temptation to introduce and / or increase tax Tax evasion and avoidance Tax evasion is to “hide” the truth to escape tax Illegal Don’t do it! Tax avoidance is to follow the tax code to minimize tax payment Legal Tax exemption vs. deduction Individual as a “tax subject” “salary man” vs. “business unit” Some professions allows choice of type Exemption vs. deduction (cont.) “salary man” – exemption Marital status and family members dependence Tax based on taxable income “business unit” Deduct expenses from income Tax based on after-deduction income Exemption vs. deduction (cont.) General rule is that “business related expenses” can be deducted However, tax code also allows for provision of “welfare” to directors and key executives Allowable expenses Housing “fair housing expenses” limits to 10% of income Might arrange housing allowance so taxable income is lower Traveling Tax code allows for trip expense for individuals Allowable expenses (cont.) mortgage interest (up to a limit) Education expenses Structure your taxable income Important note: Hong Kong has no tax on: Interest income Capital gains Dividend payment in some cases, may structure income so: Taxable income is minimized Build up asset base Realize investment income in the future Structure your income – an example Trading business Structure into corporate and individual level Part of income pay to individual Take on a loan and pay interest to offset income Use the loan to buy income generating assets (e.g., blue chip stock) Dispose asset some time in future to realize capital gain Estate tax and how to get around it You can’t escape “death and taxes” Build up a trust Purpose Trustee Manager Beneficiaries With proper arrangement, trusts don’t “die” and so need not pay estate tax Should you be your own boss? No simple answer -- only you know Key is how much risk can you take Most people work for their bosses, especially well educated people Stable income with smaller risk Most rich people own their businesses Most business fail There could be wide fluctuations in between How smart are you vs. the market Many smart people in financial markets, all hungry to try to “make a kill” There are also a lot of “fools” out there It only takes a few smart guys with the capital to reap most / all the profit Question: can I beat the market? How smart are you (cont.) Question: can you find a way to consistently make “large” profits? The salesman says “YES!” Many studies show that it is very difficult Probably most convincing study is that even professional money managers do not earn more than the “naïve” investor How smart are you (cont.) Key issue is called “market efficiency” If the market is very smart, all information is already reflected in the prices! Only the unpredictable shows up in price movements If some pattern shows up, someone will jump in and quickly grab the profit How smart are you (cont.) The way to “beat the market” is to be faster than most people People see things in different time horizons Prices might reflect a “consensus” that can change If you move ahead of the crowd, maybe you would do well How smart are you (cont.) Alternately, you can make more by taking more risk! Suppose in the long run, real estate goes up 10% per year If you buy in cash and hold, you get 10% a year If you can borrow 70% at 10% a year, you get a much higher return!