Stake in Stocks Could Marginalize Security

Enticed by the 1990s bull stock market, Austin Dunn has tried to get rich fast by trading volatile technology and Internet stocks.

To build his $93,000 portfolio that includes such companies as Amazon.com, Yahoo and Microsoft, he has upped the ante by borrowing more than $20,000 on margin from his Charles Schwab brokerage accounts.

His wife, Katherine, is concerned because Austin, 49 and a part-owner of a machine tool repair firm, doesn’t have a penny in a qualified retirement plan. And in addition to retirement savings, the Alhambra couple want to help pay for college for their 10-year-old son, Matthew.

“Austin has a good job, but he’s not really looking toward the future, and that’s a major concern of mine,” said Katherine, 38, an executive assistant at Edison International.

For her part, Katherine diligently directs 19% of her income to her company’s 401(k) plan, in a diversified selection of stock funds. She now has $76,500 in that plan, along with $59,400 in an IRA, about one-third of that invested in Vanguard Wellesley Income, a hybrid fund that holds both bonds and stocks, and two-thirds in the Vanguard 500 Index fund, the largest of its kind, that invests to match the members of the Standard & Poor’s 500 index.

Meanwhile, Austin’s company doesn’t have a retirement savings program. And he hasn’t explored other tax-deferred savings options because he prefers investing for the short term. “I guess I want to make money fast,” he said. “Someone told me about the margin account, and it seemed like a good idea to use someone else’s money to make money.”

Although little damage has been done yet, Austin’s decision to play the stock market at high stakes could jeopardize his family’s long-term goals, said Maureen Tsu, a fee-only certified financial planner in San Juan Capistrano. The Dunns need to grow their assets, yet not put their retirement and Matthew’s college financing at too much risk, the planner said.

Furthermore, the planner notes the couple can take advantage of sure-fire strategies that defer or eliminate taxes on savings--strategies that are more likely to make the family richer than rapid trading.

The Dunns’ combined base salaries are about $95,000, but their total income can be as much as $150,000, depending on Austin’s bonus from his business as well as interest income and capital gains on stock trades. Katherine’s father, who draws $7,560 a year from Social Security, also lives with the family.

The couple’s current assets include $130,000 of equity in their home, the $93,000 portfolio in two taxable brokerage accounts, $24,300 in a custodial account for Matthew, about $140,000 in Katherine’s retirement funds, $24,800 in cash and $5,000 in U.S. savings bonds.

Katherine’s first concern is the $22,000 that Austin has borrowed on margin to buy more stocks in his brokerage account.

In a margin account, an investor’s securities or money market funds are used as collateral for loans to buy other securities. Investors pay interest on those loans, usually between 7.5% and 9% annually, which can be deducted from any taxable interest, dividends or short-term capital gains.

However, investors on margin cannot borrow more than 50% of the value of their portfolio to make a purchase, under Federal Reserve rules.

There are also rules that limit what stocks can be margined and how much money an investor can lose before stocks must be sold or an investor must provide more cash to back the loan. This is known as a “margin call” and usually happens when the investor’s margin borrowing exceeds 65% to 75% of the portfolio’s value.

Basically, buying stocks on margin means an investor’s returns are magnified if the stocks rise. But if the stocks fall, the losses are magnified as well.

Austin has actively bought and sold stocks based on tips from friends and financial publications. He estimates that he’s made at least $5,000 in the market in the last few years. “I know you win some and you lose some,” he said. “When you’re doing the margin, you just try to make a quick buck.”

His journey has been a nonstop roller-coaster ride. For instance, he bought 100 shares of Trimble Navigation at $18, then saw it rocket to $38 before it began tumbling. He sold it at $11.

Tsu said she doesn’t automatically steer clients away from margin investing. But in this case, the Dunns can’t afford to take major risks with their money because they first need to ensure their retirement. “You want to put your dollars in places that will meet your goals,” Tsu said.

Planners say buying on margin can be an acceptable risk when people have ample money and understand the strategy. It can also be handy when a wealthy investor needs some cash but doesn’t want to sell stocks and pay huge capital gains taxes.

For the right objectives, “there’s nothing intrinsically wrong with margin investing,” said Tim Kochis, a financial planner based in San Francisco. But few would suggest margin borrowing before a basic retirement plan is in place.

“It seems this is for people who, if they lose all their money tomorrow, they won’t cry over it,” Katherine said. “Unfortunately, that’s not our situation.’

Tsu encouraged Austin to try to pay off his margin loan by selling holdings at opportune times. She said he could keep some stable individual stocks, but sell the volatile ones.

“Your portfolio is very risky, with more than half of your money in tech stocks,” Tsu said. “And with the margin account, if the market goes down, you have to be ready to sell stocks or have cash available, which means you could be forced to sell stocks at a low.”

For the Dunns’ long-term portfolio, Tsu recommended being 80% in stocks and 20% in fixed income investments. Of the equity portion alone, she suggested that more than two-thirds be in large-cap U.S. stocks, about 10% in small-cap U.S. stocks and the rest in international stocks.

Tsu prefers mutual funds over individual stocks because they offer more diversification and are less volatile. But for the Dunns or other clients who may want to be more aggressive, Tsu said they could keep 10% to 15% of their portfolio in individual stocks of large companies. For instance, Tsu said the Dunns might consider keeping shares of Microsoft, Pfizer, Disney, Best Buy and maybe a few shares of Yahoo.

To meet their long-term goals, the remainder of their money should go to mutual funds, Tsu said. She favors Janus funds, particularly Janus Worldwide (five-year average annual return: 21% ), Janus Mercury (five-year average annual return: 30.4%) and Janus Growth and Income (five-year average annual return: 27.2%). She feels the Janus funds have strong fund managers and respects their history of robust performance.

To pay for Matthew’s college expenses, the Dunns expect to tap his custodial account, invested in three individual stocks, Berkshire Hathaway, Disney and Merck. Tsu didn’t have a problem with the Dunns keeping these investments, but she suggested that any additional funds they decide to contribute to his education go into the flagship Janus Fund, a large-cap growth fund with a five-year average annual return of 25.13%.

In regards to Katherine’s IRA, Tsu suggested that she move about half of the sum in Vanguard Wellesley Income to Vanguard US Growth, a more aggressive large-cap fund. She suggested this move because Katherine is not likely to tap this money until retirement and can afford to have most of the IRA money in equities, which have historically performed better than bonds over long periods.

Along with shifting the Dunns into different investments, Tsu urged Austin to talk to his business partners about establishing a SIMPLE-IRA (or savings incentive matched plan for employees-individual retirement account). SIMPLE-IRA is a tax-deferred retirement savings plan for small businesses with 100 or fewer employees.

Austin said he and his partners haven’t considered establishing a retirement savings program because they thought it would be a hassle. But Tsu said the SIMPLE-IRA is easy and inexpensive to set up for the three partners and their one employee, compared with other kinds of retirement plans.

A SIMPLE-IRA allows employees to contribute up to $6,000 a year. Employers determine the percentage the company will match, which is limited to up to 3% of employee’s compensation. There are other kinds of small-business retirement plans, but Tsu thought the SIMPLE-IRA best because it is inexpensive and easy to set up.

Tsu said one advantage of establishing such a plan is that the company can write off its contributions as a business expense. Austin and his partners also would reduce their individual tax burdens, because the amount they contribute is tax-deferred and not included in the adjusted gross income of the current year.

Overall, the Dunns liked the idea of reducing their tax burden and increasing their retirement savings. But Austin said he wasn’t sure his partners would be convinced.

If the partners decide against setting up a company plan, Tsu urged Austin to contribute the maximum $2,000 a year to an IRA--a Roth IRA if they are eligible (joint income below $150,000) or a traditional IRA.

“It’s very important at your age to set aside money for retirement,” Tsu told Austin. “It’s a prudent way to utilize your money. The government has basically given us these tools, so you should try to take advantage.”

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Diane Seo is a regular contributor to The Times. To be considered for a published Money Make-Over, send your name, age, phone number, income, assets and financial goals to Money Make-Over, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053 or to money@latimes.com. You can save a step and print or download the questionnaire at https://www.latimes.com/HOME/BUSINESS/FINPLAN/make-over.htm.

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(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

This Week’s Make-Over

Investors: Katherine Dunn, 38, and Austin Dunn, 49

Gross annual income: Generally $125,000 to $150,000

Goals: Devise retirement savings plan for Austin; reduce tax burden; save for son’s college education.

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Current Portfolio

U.S. Savings Bonds and bank accounts: About $30,000

Real estate: About $130,000 equity in home

Investments: $93,000 in two regular taxable accounts (invested in individual stocks Inktomi, Microsoft, Pfizer, Yahoo, Amazon.com, Best Buy, Ciena, Walt Disney and Gulf Island Fabrication)

Retirement accounts: Katherine has about $59,400 in an IRA and $76,500 in a 401(k), both in equity mutual funds.

College savings: $24,300 in a custodial account for 10-year-old son, Matthew (invested in individual stocks, Disney, Merck and Berkshire Hathaway)

Other assets include Austin’s share of a machine-tool repair business.

Debt: $21,688 in margin account; $2,000 on credit cards

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Recommendations

Pay off margin loan.

Sell most volatile individual stocks and purchase diversified mutual funds.

Purchase $150,000 in additional term life insurance so that each spouse has $500,000 of coverage.

* Austin and his business partners should establish a retirement plan for their corporation. Austin should contribute as much as possible.

* Pay off credit card debt.

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Meet the Planner

Maureen Tsu is a fee-only certified financial planner at Professional Financial Advisors in San Juan Capistrano. She is a member of the board of governors on the Certified Financial Planner Board of Standards.