Saturday, October 9, 2010

2006 Financial Reference Archive

Archive for 2006


There are some well-established, uncontroversial ideas in personal finance that I don’t understand. Maybe I’m not smart enough, I’m not thinking about the ideas in the right way, or I stumbled across something.
The well-established, uncontroversial idea in my crosshairs is an application of diversification. Everyone is encouraged to spread their assets between many different classes including stocks, bonds, real estate, and commodities. The reason for this is two-fold: (1) it’s easier to cash out part of your portfolio and (2) it lowers risk.
While there is some truth to this, I doubt the extent of the benefit provided to investors and propose that most long-term investors would be better off reducing diversification across asset classes in their long-term investments and instead allocating extra to historically higher earning asset classes (i.e. equities).
First, diversification adds the benefit of not having to cash out the underpriced part of your portfolio. However, people often cash out, not the most undervalued asset, but the asset with the worst recent returns. Also, people are encouraged to put their bond/cash portion of their portfolio in their retirement accounts for tax reasons. To the extent someone does this, the benefit is reduced.
Second, diversifying lowers the return and standard deviation of the overall portfolio but, it is argued, the reduction in standard deviation provides a bigger benefit than the reduction in return. However, if you look at returns over any long period, stocks have outperformed bonds in any period, even periods including the Great Depression. While there is less volatility in the short run, if the historically good and bad case long-term scenarios for stocks both outperform those of bonds, why would long-term investors hold bonds? While the future may not play out exactly like the past, it is the best indication of the future we have.
Investors should look at the return and standard deviation of the asset over the intended holding period. If you let an investment ride, who cares how much an investment fluctuates in a year? It has no relevance. What matters are the probable ranges of your net worth many years out.

Long time, No Write

It’s hard to know where to start after such a long break from writing. Since I last wrote my wife has changed jobs, we bought a house (no, not the house we we talking about building in earlier blogs — more on that later), we bought a dog (from the local humane society), we went on vacation to Europe (my first time), I passed the third and final CFA exam, and I started an investment partnership. Needless to say, we have been very busy. It appears that things are finally settling down and I will again have time to blog.
In the meantime, there is a new link on the site, to While I would never support a site dedicated to a maniac screaming “booya” instead of doing real analysis, I love a site that compares a Harvard grad with a monkey. (Maybe it’s just my lesser, public school, upbringing.)

Diversification or Performance Chasing?

Recently, even after a large increase in international stock and commodity prices, a strange thing is happening: people are being encouraged to buy more. Even people who believe the sector is “fairly valued” (read “over-valued”) are buying more because of the diversification benefits of these investments.
It is usually the case when one asset class has a large run-up in price, the asset class should be re-examined and possibly partially sold. This is due to a couple factors. First, it might be sold because the asset class is more over-valued relative to other asset classes. Second, it might be partially sold to rebalance the portfolio.
But after the run-up in the prices of international stocks and commodities, Americans still don’t have enough invested in these assets, according to some analysts. While I agree with the basic sentiment — there are diversification benefits of investing in these asset classes — I believe that much of this diversification benefit is going to be overblown for the following two reasons.
First, international stocks and domestic stocks are becoming more correlated and are more correlated in times of panic. It makes sense that the correlation is increasing: (1) our economies are becoming more integrated in an increasingly globalized world and (2) domestic companies own significant foreign assets. Also, historically the time at which diversification is most useful — when markets are in crisis — have seen higher correlation (and hence lower benefits).
Second, I believe investors are buying these assets for the wrong reasons and so are more likely to sell than if they were buying for the diversification benefits. While investors and planners claim they are increasing their allocations due to the benefits of diversification, I believe the most important reasons for the increased allocation are recent performance and, possibly, a belief in a weak dollar and higher inflation. Investors have always had the opportunity to increase ther exposure to these assets but have only chosen to very recently.
Investors who buy for the diversification benefit are more likely to stick around, even when markets decrease. Investors who buy in order to increase returns are speculating and will be more likely to sell when these markets naturally fluctuate. While, overall, investors should increase their allocation to foreign assets, the motivation of the investor is more important than the actual allocation in determining performance.

The Role of Financial Advisors - Part II

The main role of financial advisors, as I see it, is to provide an unemotional reality check to investors. Most people have or can develop the knowledge necessary to manage their finances. It would take some time, but not much more than mowing the grass each week. The hardest part of managing your finances is to remain unemotional about your investments. A second, unemotional, opinion can help.
Planners can protect people from themselves. It is well documented that investors make sub-optimal decisions. They chase performance, sell after market declines, hold on to investments to try to break even, and use heurisics to analyze their portfolio; just to name a few problems. (For more see Psychology of Investing.) Planners can help investors be disciplined in their actions.
Planners can provide target asset allocations and rebalancing discipline; they can stop investors from trading too much, from trying to chase performance. They can also provide comfort by giving the investor financial projections.
Even for knowledgable investors, financial planners can provide value by providing piece of mind and by forcing investors to maintain discipline.

The Role of Financial Advisors - Part I

I’m naturally skeptical that people need financial advisors; especially the ones who go by the monikers financial consultant or broker. There are two main reasons for my skepticism: (1) I often disagree with the advice they give and (2) I think most people are smart and disciplined enough to implement a simple financial plan.
Even assuming that the planner does not have perverse incentives (i.e. receiving legal kickbacks or encouraging trading and market timing), I often don’t agree with most planner’s financial advice. This is due to a number of reasons:
(1) Planners are more concerned with not screwing up than with helping their clients succeed over the long run. Even for very young investors, planners often recommend an allocation to bonds. The explanation for this in financial periodicals is that it smoothes volatility. But, for a young investor, assuming they don’t have to liquidate, all that matters is the long term. But the practical reality is that it’s much easier for a planner to show a series of slight gains than show a high volatility portfolio that outperforms in the long-run. Losses are psychologically hard to take and could cause the investor to do something rash like trade into less risky positions or, even worse, cost the planner a client.
(2) Planners still neglect to look at the client holistically. While planners are getting better at seeing the total financial picture, there is still some work to be done in this arena. For example, an investor can be very confident his planner will suggest he should keep 3-6 months of living expenses in cash in case of emergency. For most people, this makes no sense!
Let’s assume a typical modern investor with a large mortgage and some kind of other debt (a home equity line of credit (HELOC), credit card debt, margin debt, etc.). This investor would be much better off using the cash to pay down the other debt rather than having debt and cash. He would be better off because he would earn a higher return and not incur more risk. He would earn a higher return because the HELOC, credit cards, or margin debt all cost more than what you can earn investing in cash. There would be no more risk because the investor would still have the HELOC, credit cards, or margin capability in case of emergency. Many people balk at taking on debt during an emergency but it’s better than having debt in good AND bad times.
Even if our investor didn’t have any other debt besides his mortgage, it would still be better to pay off more of his mortgage and take a HELOC in case of emergencies. He could reduce his current payments and reduce his debt. While it is true that in the case of emergency the interest rate on his HELOC would be more than the interest rate on his mortgage, the probability of emergency is by definition small and the amount drawn down on the HELOC would hopefully not be the full amount. Some people critique this strategy by saying “what happens when your HELOC runs out?,” but what happens when your cash pile runs out? You are in the same place. If anything, you should be able to save more using this strategy so you should have more margin in times of emergency.
By ignoring alternatives to rote advice, planners can offer sub par advice for many investors. Looking at the client’s whole financial picture can offer better solutions.
(3) Some financial planners fail to listen to their client’s wishes. This is a small percentage of advisors but there is a recent, salient example. In the June 2006 edition of Money magazine, they covered the family who won last year’s Dream Home — a $2.5 million estate in Texas. After living in the huge house for a year, they realized the $36,000 they had left from the prize money wouldn’t cover the tax bill of $672,000. Now they are going to sell the house and move back into their smallish house around Chicago. But after living in such a huge house for a year they want to add on to their current house.
After hearing this, one of the financial planners suggests that if they only net $250,000 from the sale of the home after paying the tax bill, they should sell that house and move into an apartment. Can you imagine a family, especially a family that loves the idea of living in a big house going from a $2.5 million estate to an apartment? I can’t imagine they could imagine it either.
In addition, with $250,000 they could pay off their current mortgage and still have $115,000 left over to invest. So why would they need to sell both houses? My only thought is that this planner believed real estate prices are headed for a decline and wants them to “short” housing. The advice went against their obvious wishes and was speculative in nature.
While the normal mistakes planner’s make are not going to ruin you financially, they can delay your retirement. In the next part of this blog, I will talk about the second point: whether people are smart and disciplined enough to create and implement a plan. Obviously, it depends on the person and so there is some room for planners to add value. In addition, I will talk about other ways planners can add value.

When an Investor Creates Value

When we sell an investment, we feel the pain of a loss or the joy of a gain (offset in part by the tax bill). It is at this point that we know if our investment was “successful”, or so goes the common wisdom. We “lock in” our gains and either admit we failed or take pride in our obvious skill.
However, an investor doesn’t create value when he sells; he creates value when he buys. An investor creates value by buying investments whose current value is greater than the current market price. There are very few things the investor has control over but if, over time, he buys undervalued assets, he should be successful. One of the things he does not control is the future price.
So, by definition, if he does not control price, the success of the investment can not fully depend on the future price. It’s hard to think this way. Over time, someone who makes intelligent decisions should reap the rewards, but he will not be successful in every investment he makes. So, a long-term successful track record is indicative of success while individual picks are not. A successful long-term track record indicates that the investor probably has enough ability to put the odds in his favor and create value.

Jeff Opdyke

What is the difference between a writer like Jeff Opdyke or Jonathon Clements (for the WSJ) and other writers who choose to blog?
I think the biggest difference is: we still have day jobs. It’s easy to see this difference because they (at least Clements) has research, references, and interviews to back up his entries. Also Clements often writes more technically than bloggers.
Maybe the question is: what is the difference between Jeff Opdyke and a blogger. Honestly, I can’t figure it out. The only difference I can see is that he is employed as a writer, we are not. With his most recent titles: “You’ll play baseball and like it,” “Before ‘I do’…Don’t Do This,” and “How to Haggle for that Ride” it seems as if he’s just a blogger in corporate clothes. (By the way I didn’t stop that list because I got to an interesting story; I’m stopping because I have a day job and don’t have the time to continue.)
My wife and I used to religiously read the “Sunday Journal” but it soon became a waste of time because we ended up spending the whole time criticizing Opdyke’s empty entry.
Recently, the Journal ran an article criticizing blogs and posed the question whether blogs were a legitimate way to make money in the long run. I don’t know the answer to their question because it’s much too early to know the future of the blog. The question I do have is: what is the future of their own blogger?

Financial Voyeurism

It is extremely common for people to want to keep up with their neighbors, coworkers, and friends. From their income, to the house they live in, the vacations they take, and the cars they drive. More recently this need to keep up has extended to their net worth as well. While emphasizing net worth is far more productive than emphasizing material possessions, the recent trend is nontheless, disconcerting. In addition, the recent trend has not displaced the emphasis on income and material possessions; it has just added another pressure. And the information age has provided new ways of comparing ourselves to our cohort.
Instead of coveting the new lawnmower our neighbor bought, we can now compare our income, wealth, and possessions with those all over the nation (and world, should we desire). For example, the other day one of my wife’s coworkers wanted to know the address of the new home we are building. He was hoping to plug in the address into an online database, such as and find out how much we paid. While the information has always been public, it was not worth the time (or presumably the awkward confrontation later) to look up the records. Now, with easy access to information and a thirst for a better understanding of where we stand, we can compare ourselves to our neighbors, coworkers, and friends without their knowledge or permission.
For another example, many financial blogs are more than willing to share their net worth, including all assets and debts. Many also share their net income. I understand how it can be intriguing to view someone else’s financial condition; it’s a form of financial voyeurism. But I will not join this trend - I will not share our financial information over my blog for the following reasons:
(1) Besides our basic curiosity and a thirst for information, there is no financial knowledge imparted from knowing what someone else has accumulated. I can tell of all of the financial moves I have made that have been successful without giving numbers.
(2) It is private and I would rather keep the details to my family.
(3) It encourages people to think about their short-term wealth goals. If you track your net worth on a daily basis, you will be more likely to put more emphasis on the short-run. This could lead to trying to decrease daily fluctuations instead of building long-term value. Instead of investing, it could lead to trading more and an increase in “investing” in cash.
(4) I would feel less safe putting my financial information on the web.
I assume some financial bloggers report their financial information to encourage themselves to save. If they are being watched, they are more likely to perform. I, on the other hand, am cheap enough as it is. (I like the word “frugal” better, but those who know me best think “cheap” is more accurate.)
With so much more information at our fingertips, it is easy to get caught up in who is making what, who has what house, and who is worth how much. I will be the first to admit that I am just as curious as the next guy — I buy the Forbes list of Billionairs magazine each year, I watch shows about houses I could only dream about affording, and I want to go to to check out how much other people spent on their homes. But, I don’t gain any knowledge from satisfying this curiosity. So, I will not be adding any new information to this financial voyeurism and I will give my neighbors, friends, and coworkers their privacy, unless they choose to tell me their finances.

The Value of Time

I’ve struggled a lot lately with trying to decide what time is worth and how to spend it. I’ve looked at the MSN calculator and discovered (as depressing as it was) that with the time I put in outside of standard work hours, I made about $8/hour last year.
The additional time was a combination of overtime (unpaid, of course, since I’m an exempt employee) and the time spent trying to get my creditials so that I can keep my job. Now that I have a new job, I have very little overtime requirement (if any) but I still have to study – which works out to an additiona 15-20 hours a week, year round.
Eventually all the additional studying will pay off; I realize that. But for right now, it’s frustrating to have the very helpful calculator tell me that I could be making more working at Target. Of course, the calculator isn’t taking into account that there are future rewards built into the additional time I put in now, and that as soon as I stop studying, I’ll be putting in 1/3 less time on the average week.
Between Brian and I, we have roughly 5 jobs. We both work normal full time jobs, a partner and I have a wedding photography business, Brian teaches two nights a week at a community college (although this one is over in a couple of months) and then he manages money for a couple of his friends.
Which leaves just enough time in the day to play with our son for a couple of hours in th evening and get about 7 hours of sleep at night. We’re busy.
Not to say that there aren’t hours that are wasted – we still find plenty of time to get our money’s worth out of our netflix subscription. I still manage to lose a little money every week playing poker, and Brian still manages to keep up on most major sporting events.
In the end, we’re really just trying to reach our employment goals. We’d both love to be self-employed (separately – we’ve tried working together before). I’d love to find a job that I can mainly do from home. We’re trying to remember that though the we might not be making a lot on an hourly basis right now, we’re building a good foundation for later.

Why I Stay Out of Our Finances (for the most part)

Brian and I both have decent sized incomes and, before we merged our finances, I was really into using quicken (updated every other day or so) and paid my credit card bills weekly (a little complusive, I know). I was into it. I was all about being financially responsible. Other than a few (or not so few) dvds that I had the habit of buying, I saved the rest of my money and had just a little student loan (at 3.75%) when we decided to merge our income streams.
And now? I have no idea about any of it, and I’m okay with that. I couldn’t tell you when our bills are due or which credit cards we’ve used to finance things at 0% or which card we use to pay daycare. I stay out of it.
Why? It’s not because Brian makes more money, though he does.
I think that it stems from the fact that he had more of a plan for our financial future, while I just had some vague notion that I needed to save a lot and keep out of debt.
Brian, on the other hand, had a good idea of when he wanted to retire, what sort of funds needs to be available for that, and a better idea of what to do with the money in the meantime other than let it sit in a savings account.
This isn’t to say that we’ve agreed on everything. I didn’t even want to merge our finances at the beginning – nor have we ever really agreed on our level of risk tolerance, though I think we’ve made some big strides towards a happier middle ground.
I tend to be more emotional about money matters – to me, money means security.
Brian tends to have a more objective view of the whole financial situation.
So after many arguments about it, I’ve let go, for the most part. I still check in on our investment account and I love to watch my 401(k) grow. And the money that’s earmarked for our son is in my name, though Brian picked the funds for that as well.
I do, however, have some idea of where to find the financial information, if I wanted to. There are spreadsheets on his computer and a couple of drawers in the desk that have the majority of the papers. And every once in a while I ask for an update on where we’re at.
It works for us, for the most part. I’ve gotten over the fact that someone else can see every purchase I make, but that shouldn’t stop me from making them (within reason) and I think he’s gotten to the point where he doesn’t need to question every small purchase.
It works for us.

April Fools

A very long but good list of the top 100 April Fools Jokes. Nothing to do with finance, but even finance dorks have to have fun every once in a while.

Blips on a Screen

“The art of being wise is the art of knowing what to overlook” – William James
Even for long-term investors, it’s hard to ignore the short-turn fluctuations of the market. I do something I don’t recommend — I put the stocks we own on our “My Yahoo” home page. So every day(actually, every couple of minutes), my wife and I can see how our day was financially.
The short-term changes in stock market value is just noise. Noise that distracts from accumulating investment knowledge.
In the future, I’m going to try to keep price information as far away from myself as possible. I recommend you do the same.


I was driving home this evening and happened to pass a gas station that was overflowing with cars (mainly SUVs) to the point that I wondered if I should call Brian and see if there was gas shortage and that I too should join the masses and fill up my tank.
Being that I had our son in the car, I chose to drive pass the backup of mainly bright, shiney, new SUVs and head home, despite the fact that I was down to a ¼ tank.
I did happen to glance in my rear view mirror and check the price: $2.49. Up until that point I had been ignoring the gas prices figuring that I’d fill up tomorrow when the tank was much closer to empty.
Naturally, figuring that some gas crisis was on hand (which is the logical conclusion to jump to… for someone that tends to overreact to just about everything) I noticed that the next gas station was no where near as full. Actually, there weren’t any cars at the next station. Because… well, I can only assume that it’s because the next station had prices of $2.66.
I know. It’s more. It’s $0.17/gallon more. It’s 6.8% more.
I’m all for frugality when it’s justified. But spending five to ten minutes waiting to fill up the tank (and it would have taken that long at a station with six pump and at least 10 people waiting spilling out onto the business street) is a little absurd.

Expected Returns

How much should you expect any one of your investments to return? If you’re investing in highly-rated bonds and expect to hold the bonds to maturity, the answer is easy: you should get the yield to maturity minus a small amount for the small probability of default.
However, what if you are trying to forecast the returns of stock? The analysis becomes much more complicated and is often misunderstood — even by experienced market commentators. Even, Michael Sivy, in the April 2006 issue of Money magazine (p. 78), gets the analysis wrong. He claims that since certain stocks are projected to have earning growth above 10% per year for 5 years and currently pay dividends above 1%, investors should expect average returns above 11%.
The problem with this analysis is that it assumes the future outlook of the company is the same as the current outlook. There is an embedded assumption in Sivy’s analysis that the P/E multiple is not going to contract (or expand). If the outlook becomes less favorable for these companies (i.e. the projected growth rate drops below 10%), the P/E ratio will probably contract and reduce the actual returns.
(On a side note, 10% growth is an optimistic assumption. The market as a whole can only grow as fast as GDP. GDP growth has averaged 3-4%, so 10% growth is 3 times the growth of the market as a whole. While 10% doesn’t seem like a crazily optimistic assumption, be careful of overly-optimistic growth projections — they can throw your whole analysis off.)
The shortcut used by Sivy to arrive at a projected ruturn is often used by laypeople to justify overpaying for growth stocks. The calculation that should be used is to value the company using a discounted cash flow analysis (whether it’s discounted dividends, free cash flow, etc.) to arrive at a current value for the company and it’s shares. You can then calculate a value for the company at any date in the future using the same assumptions you used in your initial calculation.
Many investors use multi-stage models (in which the growth assumption decreases over time) to reflect (1) that the near-future is more certain than the distant future and (2) eventually growth companies lose their growth potential and increase their earnings at the rate of GDP. If you assume a multi-stage model, the P/E will contract over time and your returns will be lower than simply adding the growth rate to the dividend rate.
Don’t fall for lazy solution Sivy falls for; go through the calculations (or at the very least reduce P/E expectations and return expectations) to arrive at a better forecast of your return.

The House

We’re building a house. Actually, we’re building The House. This is the one that we plan on raising our son in and growing old in. We plan on staying there long enough to make planting trees a worthwhile endeavor and our son’s handprints will be put in the driveway.
We’re trying to plan for 20 years worth of contingencies. Which means that while we might not need an extra bedroom right now, where would we want it to be if the need arises. And while the basement won’t be finished right away, we’re planning on finishing it someday and everything needs to be in the right place for that to happen.
It’s not the most financially responsible thing that we’ve ever done. Talking to my mother about the way we’re taking out a bedroom to make a sitting room in the master bedroom, she said “you need to think about resale value” and I was able to say that I wasn’t planning on caring one bit about resale value. This will, hopefully, be it for us.
But there’s a slew of other financial considerations.
For our current place, we got a 3 year arm mortgage. It kept the payments down and we really weren’t planning on staying here any longer than that. Now we’re learning the ins and outs of construction loans and locking in rates and all the fun stuff that goes along with that. Unfortunately doesn’t handle construction loans so we’re left to the mercy of the salespeople at our local banks.
Then, of course, there’s the price. It’s well over what we were planning on spending when we started looking, although it’s still affordable. I have my days in which the massive amount of the mortgage overwhelms me a bit.
I think that the one thing that makes us pause every once in a while is that this is the first time we’ve ever had conspicuous consumption. It’s a pricy place. It looks like a pricy place. People will know that we have more than most people our age. And we’re not used to that.
We drive cars that are several years old. Our current place in nice, but cozy. I tend to wear name brand clothes, but I make no secret of the fact that my mother takes me shopping whenever I see her and foots the bill. I can count the number of toys we’ve bought our son on one hand (the grandparents are responsible for the massive pile of toys that take up half our living room). We don’t eat out all that often; I take my lunch to work. We don’t have any expensive hobbies – even when Brian plays golf it’s at a public course 99% of the time.
A few people know that we have substantial savings. My business partner realizes that Brian and I were able to fund our start up without blinking an eye.
So to think that everyone will know, is going to be a bit weird for us. But we’ll get used to it. And that’s not why we’re building it. We’re doing it because we want our son to have a place to grow up, and I want to finally unpack all the boxes because I will have found a place to call home and, as Brian said,
“What else are we saving all this money for?”
And because it’s going to be perfect. Absolutely perfect.

CEO Comp

The following is a comment to Merk Cuban’s recent post on
An well understood point by experienced investors; sadly, not a well understood point by “mom and pop” investors.
In law school, we gave a presentation to our professor (a very experienced investor) about options and how they incent management to meet a target for their stock price. The incentive does not align the interests of management with long term investors. Management is incented to barely beat numbers they provide to analysts so they can get a “pop” in the stock price.
They are also incented to create volatility in the stock price (which increases the value of options) by playing games with their numbers. Experienced investors know that accounting is more art than science; management also knows this and uses this fact, legally and sometimes illegally, to their advantage. (Our professor had problems with our analysis, thinking that options were good, but I still stand by our analysis.)
The emphasis on diversification and long term investments (although both good things in the abstract) exacerbate the problem. Since each holding is only a small part of your portfolio, the agency problem becomes bigger.
Sadly, I don’t see an end to this problem. The only solution is more active management which brings its own greedy set of problems. (See, e.g. Warren Buffet’s latest letter to shareholders at As public markets become more public, the agency problem grows and management will continue to enrich itself at the expense of shareholders.
Experienced investors can only help themselves; they cannot help everyone else. I wish there was a better solution to this problem, but until investors are smart enough to solve this problem for themselves they will suffer the consequences of their mis- or non-information.
By the way, I loved your reality TV show. It was much better than any of the ones still running. In particular, the “you’re fired”, everyone selfish, B.S. show. Thanks for trying to inform people about what it takes to be successful.

Carnival of Personal Finance

It is my pleasure to host the Carnival of Personal Finance this week. We had a very large number of submissions. Below is my best effort to do all of them justice. The Dividend Guy will be hosting the Carnival next week.
Comparing Cash Back Credit Cards - If you are trying to compare different credit card cash back offers, Financial Revolution has a calculator that may help.
Taxes - RothCPA has some useful advice (and some scary pictures) on selecting a tax advisor.
Knowing the cost of items - MightyBargainHunter has useful advice about figuring out the true cost of an item. I would add that supermarkets and Costco usually have a cost per item/ounce/etc. in small type on the price tag — which makes comparisons easier.
Car Insurance - PFAdvice has an extremely helpful article if you are shopping for car insurance or would like to try to reduce your premiums. Another blog, retireat30, found a quirk in the pricing of car insurance.
Behavioral Finance - The Other Bloke’s Blog comments on evidence that we are not rational beings but in fact are being driven by the same pleasure centers that control our sex drive. Based just on my own experience, that can’t lead to good decisions! For more on how psychological factors can hinder the investment process see FinancialReference’s blog Psychology of Investing.
Sad But True - YoungAndBroke comments on a study that concluded, even among the educated, we are financially illiterate.
Delaying Saving - MyMoneyBlog has 25 reasons why you should delay saving for retirement. With everyone telling you to save all the time, it’s nice to have articles like this and books by Ben Stein.
Roth 401(k) - Consumerism Commentary talks about the difference between a traditional 401(k) and a Roth 401(k). The article, when combined with the comments, gives a good summary of the difference between the two types of 401(k)s
Inflation - Million Dollar Goal gives us some background information on inflation and how inflation effects your investments. This topic is extremely timely since after the markets took a nose dive last week because of inflation worries.
Purchasing a Home SearchlightCrusade gives us an insiders perspective on the process of purchasing a home.
Gambling - While we all know gambling and playing the lottery are not good ways to make money, Don’tMessWithTaxes argues they are still fun and worthwhile. My wife would agree. If you haven’t convinced yourself that lotterys are a bad deal, check out Frank the Atheist’s reason why he has no faith — in the lottery.
Saving for College - Financial Baby Steps wants us to know about a little-known provision in the nearly-signed deficit reduction bill that makes prepaid college plans more attractive.
Scams - ConservativeCat comments on one of the more recent penny stock scams, even divulging the identity of the perp.
Calculating Returns - NoBSFinance argues, and I couldn’t agree more, that excel should be used more for financial modeling. However, if you are still scared of starting in excel, ParanoidBrain created a web based model for calculating returns.
Income vs. Expenses - Nina at Sitting Pretty argues that income is more important than expenses when it comes to saving. I agree that we should also look at the income side of the equation and try to get more out of our investments, but many of us still have a lot of work to do on the expense side of the equation.
Small Business Insurance - InsureBlog interviews an insider about a new self-funded ERISA designed for small businesses.
Gas - Bargaineering argues that if your car is not made for higher octane gas, buying it is a waste of money.
Student Loans - BirdsAndBills argues that - due to changes in regulations - you should consolidate your student loans now.
Microsoft Money - If you are interested in purchasing financial software, check out Beyond-Earth’s thorough review of Microsoft Money Deluxe 2006.
Opening an HSBC account - FiveCentNickel writes about opening an HSBC direct online savings account.
Eating Out - JustAnotherMoneyBlog comments about sites to use when eating out.
Valentine’s Strategy - CFOBlog gives us some ideas for saving money during a commercialized holiday
Personal Beta - YouNeedABudget argues that you have a personal beta based on how your saving changes when your life changes. The less your saving changes, the better. I’m not sure the analogy works for me, but we can all agree that reducing the variation of saving is a good thing.
Simplifying Retirement Planning - SeattleSimplicity uses low cost Vanguard target retirement funds to simplify the process.
Future Social Security Benefits - If you are an optimist and think social security will be around to provide you with benefits, Mapgirl tells you how you can find out about your future benefits.
Economic Indicators - Financial Options gives us a listing of the economic indicators due to be released next week
Blingo - FrugalUnderground wants you to use a new search engine that gives out prizes.
ETFs - KirbyOnFinance recommends using ETFs to invest in specific sectors. While I agree ETFs are a great way to get market exposure, I don’t think the average investor should be using them (or any other vehicle) to speculate on specific sectors.
An MBA is a Good Deal - FreeMoneyFinance writes that getting an MBA was the best financial move he has made — especially since it was free.
Savings Strategy - ThatEdeGuy has an article on starting your savings — whether by reducing debt or increasing your assets.
Budgets - FinanDom comments on the purpose of budgets and how they can help us be prepared for whatever may come.
International Traffic - PaceSetterMortgage has 10% of his traffic from international hits.
Short-Term Returns - FatPitchFinancials talks about how he turned an investment of $195 into $293 in 2 months. He will, of course, sell you his expertise.
List - NCNBlog has a list of things to do to help get some order in your life in 30 minutes or less.

Psychology of Investing

Investing would be easier if we weren’t always fighting against ourselves. We have natural tendencies that work against our own self-interest. We are not rational. We often make decisions based on emotion rather than based on a calculated cost-benefit analysis. (What follows is from The Psychology of Investing by John Nofsinger – required reading for the Level III CFA exam.)
First, we are overconfident in our abilities. For example, Garrison Keillor describes a fictitious place in Minnesota, Lake Wobegon, as a place where all the women are strong, all the men are good-looking, and all the children are above average. Additionally, when people describe their driving, they are invariably above average. Obviously, something has to give, not everyone can be above average. Not everyone can beat the markets, since everyone together is the market.
Overconfidence can lead to large investing mistakes. It can lead to large miscalculations in the amount of risk being taken. For example, the hedge fund Long Term Capital Management had the best and brightest designing it’s trading strategies (including two Nobel Laureates). But due to past successes, the partners developed an overconfidence that lead them to overleverage and pursue trades outside of their expertise. A couple warning signs that you are suffering from overconfidence is if you are trading too much or you are buying investments you don’t fully understand because you are either venturing into new territory or neglecting to do basic research.
Second, we tend to sell our “winners” too fast and hold our “losers” too long. The price at which a security is purchased should not affect the decision to sell. (The only exception is for tax purposes which is an incentive to sell losers and hold winners.) When you sell a loser, you admit to yourself that you failed, that you were wrong. When you sell a winner, you were right, and that feels good. Of course, the reason for buying or selling a security should be your estimate of the intrinsic value of the company and its shares.
Third, the past price movements of stocks affect the way we feel about stocks. If you bought a stock and made a lot of money, you are more likely to seek riskier investments since you are now playing with “house money.” So, if your investments in tech stocks went up the 90s you would be more likely to invest more of your money in risky tech ventures. If you recently lost money, you would be more likely to accept less risk. Often, the right move is the exact opposite: it’s better to be more aggressive after a market decline and less aggressive after a market advance.
Also, people want to at least break even. If you find yourself waiting to sell a stock because you want to break even, it is probably a good idea to sell. Or if you find yourself looking at past quotations or the original purchase price, try to keep that information out of your mind and redo an analysis of the company. What matters is not the return on any individual investment but the return on your whole portfolio. To that end you should track your long-term returns. That way, will be forced to face your real returns and won’t be fooled by the returns you remember. If your returns significantly trail the market over the long-run, it would be a good idea to either form a different investment strategy or, better yet, invest passively.
Fourth, we don’t account for things the right way. We create mental accounts for certain activities. For example, some people will maintain a large cash balance and credit card debt. It would be more economical to pay off the credit card debt and then use the credit cards in case of emergency. Another example is that people will not be averse to taking a large, risky mortgage but will never take out a margin loan or credit card loan – even if the margin loan or credit card loan is cheaper and less risky. The reason is we have a tendency to categorize and summarize rather than analyze.
Fifth, we are not able to look at a portfolio holistically. We are able to see the risk of individual investments but are not able to see how the individual investments fit into our portfolios. For example, equities are widely considered to be more risky than bonds. However, a portfolio of all bonds is probably riskier than a mix of stocks and bonds. This is because bonds and stocks often move in different directions. Instead of thinking of an individual security as risky or not, try to figure out how the risks associated with the investment fits into your overall portfolio.
Sixth, we often identify a good company as a good investment and a bad company as a bad investment. This is often not right. The real question is whether the value of the company is greater than the market value of the company. If the company is great, but everyone knows it is great, the price will reflect public knowledge and the shares may not be a good investment. For example, Google is a great company with great prospects but everyone already knows this and the stock is priced to reflect many years of uninterrupted growth. At its current price of $425.80, the stock is probably not undervalued. In fact, people often bid up the stock of great companies too much. This can be seen by noticing that stocks with low P/Es outperform high P/E stocks. Even though a company can be good, its stock is not necessarily good.
Seventh, we are much more likely to buy investments with which we are familiar. We are more likely to buy shares in local companies, especially our own company. We are also more likely to buy domestic rather than foreign companies. We do so because things that are familiar feel less risky. But concentrating our investments creates more risk. This is especially true when we invest in the stocks of the companies for which we work. Just ask anyone who worked for Enron, Global Crossing, Qwest, or any number of tech firms that shined and then fizzled. Buying stocks with which we are familiar gives us a warm, comfy feeling but can actually increase the risk we take.
When investing, we are our own biggest enemy. We are not built to make rational decisions but use mental shortcuts to arrive at decisions that are correct enough to serve us in the real world. But in the financial world our mental shortcuts can get us into serious trouble. We need to be aware of our psychological shortcomings so we can avoid making decisions based on psychological factors instead of real analysis.

Bad Advice

In this month’s issue of Money, the cover (also on page 81 for readers) is a financial recommendation for a family who has a lot of equity in their house but few financial assets. Here is a summary of their financial condition:
1) They are both 46 and have a 5 year old son
2) Their home is worth $1 million
3) They have a $250,000 ARM (adjustable rate mortgage) that is about to be adjusted upward
4) They only have $100,000 in retirement accounts
5) They have $30,000 outstanding on a home equity line
6) They have $12,000 in credit card debt
7) Their income is variable but usually exceeds $120,000
8) They are only saving a few thousand dollars a year in one 401(k)
Looking at this problem, there are a few things that jump out at me. First, they have too much of their assets in their house. Second, they are probably not saving much – as evidenced by their credit card debt and home equity line. Third, they will need to refinance their ARM soon.
The financial planners consulted by the magazine came up with a controversial and risky plan to “save” the couple. They advise the couple to take out a new $500,000 ARM and invest the proceeds in a mix of stocks and bonds, after paying off the credit cards and home equity line. This will bring their total portfolio to about $300,000 but will increase their monthly payments substantially.
Their recommendation is crazy! It is obvious from the information given that they are currently spending more than their current income. Why else would their incur credit card debt and have a home equity line of credit? Taking on a larger mortgage is the last thing they need. It will surely lead to more credit card debt and a larger home equity line.
In addition, I see no sense in taking out debt to buy bonds that yield less than the interest rate on the debt incurred. They estimate the ARM will have a 6% interest rate, while the bond mutual funds they recommend are currently yielding 3.2% and 4.75%. I will gladly pay you $4 per year if you pay me $6. The advisors are blindly following an asset allocation strategy without realizing that they are in fact selling short bonds at 6% and going long bonds at 4%. In addition, the “short” bonds are risk-free to the investor, while the bonds they are buying have risk.
Lastly, the advisors claim that since the couple is behind on their saving, they need to take risk. Even assuming they are behind (which they may not be, discussed below), there is no sense to taking more risk. In fact, they cannot afford to take more risk. By definition, taking more risk means a higher probability of losing money. At this point they can’t afford to lose a lot of money. In addition, they probably won’t have the patience to lose much money so if their trade turns against them, they will likely sell at a loss.
The real solution would be to give the family the following options: (1) refinance to a fixed rate mortgage (preferably a 15 year mortgage) and set aside a few hundred dollars each month into their retirement funds OR (2) downsize to a smaller house and put the equity into a diversified portfolio of stocks. The second option is the better option financially but the harder option emotionally. It is hard to tell people the reality of their situation.
But, I have serious doubts that the couple can afford a $1 million home with the income and family responsibilities they have, especially considering their use of credit card debt and a home equity line of credit in the past.

Investments - Step 1

Investments are where we put our money to make more money. It sounds so simple, but the large number of investment options and opinions make this subject one of the most complicated areas in finance.
The complications involve a dizzying array of products: stocks, bonds, cash, commodities, mutual funds, and annuities to name a few. Within these classes, there are a ridiculously large number of individual options. And every time you open the paper or an investing magazine, there is a different advisor recommending a different individual product.
There are two right ways to deal with the complications. One is to put your investments on autopilot; the other is to actively manage your investments for maximum gain. Let me be completely clear: by actively manage I do not mean you should trade often; I mean you should learn enough about investments to get higher returns over the long run.
The first right way, putting your investments on autopilot, can be accomplished in a couple of ways. One way is to seek the services of a knowledgeable fee-only financial planner. This opens up a whole new hornet’s nest of issues which I will discuss later. Another way to put your investments on autopilot is to maintain a certain percentage of your investments in different asset class and rebalance when necessary.
The second way is to learn enough about investing to take advantage of inefficiencies in the market. For example, stocks return more than bonds, even after adjusting for the higher risk. This is commonly referred to as the equity risk premium. Another example is using consumer debt when the interest rate asked is below market value.
The first investment decision to make is what kind of investor you want to be. Do you want to put a lot of work into trying to beat the market or do you want to put only a little work into your investments and get close to market returns? Despite the popularity of the strategy, it usually is not a good strategy to try to beat the market using only a little effort. Usually that leads to trading too much and sub par returns.
After you decide what kind of investor you want to be, then you can move on to the next step of designing a portfolio to meet your individual needs.

Debt – beyond good and evil

Most people think debt is bad. But this is not necessarily true. While it is true that debt is often abused and misunderstood, debt can be a positive. By understanding the benefits and drawbacks of debt, you can use it to your advantage and, more importantly, avoid the pitfalls of debt.
The real question is not whether or not debt is bad but rather what debt is good and bad. To decide whether it is a good idea to borrow, there are three things to consider: (1) the interest rate, (2) whether the debt is tax-deductible, and (3) whether you will have the cash flow to pay back the loan as it comes due.
If the cost of the debt is lower than your cost of capital, it makes sense to borrow. Even though this is the right measure to use, most people borrow on a need basis. If they need cash, they will borrow; if not, they will remain debt free. But, just like any corporation, the right capital structure usually involves having some debt. By using debt in a positive way you can reduce your cost of capital and increase returns.
Just like most economic theories, minimizing your cost of capital sounds easy but putting the theory into practice is ridiculously hard. First, what is your cost of capital? Second, even if the interest rate on the debt is below your cost of capital, would your cost of capital be reduced by taking on the debt? (It may not be reduced because more debt sometimes means more risk which would increase your cost of equity and cost of capital.)
Luckily, we don’t need to know our exact cost of capital. We know that our cost of capital must be at least as large as what we can earn in a money market or short-term CD after tax. (I assume money markets and CDs are risk free.) If we are able to borrow at less than what we could earn in a money market after tax, we have an arbitrage situation. (That is, borrow as much as you can at the low rate and earn a higher rate in the money market. Also, there would be no extra risk because you could pay off the debt at any time with the money market.)
For example, I currently use credit cards to finance a portion of our portfolio. The cards carry an average interest rate of 2.04%. This is easily less than my after tax cost of capital. Additionally, I can easily make more than that investing in equities. As long as we are able to manage our cash flows, we should end up ahead. (For a less risky version of this same type of transaction, see The author used 0% credit cards to finance investments in a money market.)
The same type of analysis should be applied to any decision to take on debt. Of course, the analysis can be more complicated. Or the analysis can be frustrated by the “need” to have something. But, if you are disciplined enough to stay away from high cost debt and are able to use low cost debt to leverage your investments, you will be able to increase your returns for very little risk.

Mutual Fund Expenses

I had my first confusing experience with mutual funds in high school. I have always been frugal (though everyone else calls me cheap) and so by my senior year in high school, I already had a decent savings. My parent’s financial advisor led me through the process of selecting the funds. She gave me a list of single page Morningstar reports and recommend I select 2-3 funds with 4-5 stars.
I had no clue what I was doing. Is there any other relevant data? Why did some funds have much larger returns than others, even though they were all 4-5 stars. I guess I could choose the right fund like my wife chooses bottles of wine — based on the name and packaging. But I didn’t even have a pretty package to judge; I only had a name, major holdings, return information, expense information, portfolio turnover, and number of stars.
I soon realized that one of the most common investments is also one of the most confusing. I worked hard and passed on a lot of fun purchases to have the money to invest. But, at that point in my life, I had no choice but to make an uneducated decision and risk everything. Everything turned out okay but over time I learned enough to make better investment decisions every year. Hopefully, you will be able to make better decisions in the future as well.
It many seem, at first glance, that the most important consideration is past return. If management performed well in the past they should perform well in the future. Right? Wrong. Good past performance is not indicative of good future performance.
But low expenses are very predictable. And low expenses are predictive of performance. However, this is often one of the most confusing areas of analysis. There are three important numbers to know related to expenses: the total expense ratio, the load, and the turnover. The total expense ratio is the most important piece. It is composed of management fees, distribution fees, and other expenses. This is expressed as a percentage of assets and can run anywhere from 0.1% to over 2%. The difference seems small but through compounding can cost the investor a lot of money. For example, a fund I previously owned (when I didn’t know better) is Davis New York Venture C (NYVCX). The fund has an expense ratio of 1.68% of which 1% goes toward selling the fund (12b-1 fees). Why should I get lower returns so they can get more assets under management.
The load is the cost of buying or selling the fund. A front-end load is the cost of buying the fund while a back-end load is the cost of selling the fund. It’s yet another way to give your money to the fund company.
The most hidden fees are in the turnover ratio. They cost you in both transaction fees and in taxes. And there is no reason to incur such huge turnover. If a manager has new ideas every few months, his ideas can’t be too good. And this is born out by the data: as turnover increases, performance decreases. (See SmartMoney Feb. 06, p. 42).
So, instead of looking at past performance, look at expenses. That is find a fund with low annual expenses, no load, and low turnover. And maybe next time you won’t struggle through selecting a mutual fund. Just look at the relevant data (expenses) and don’t chase the noise (past returns).


My wife set up this blog/website for me. I would like to think it was because she loves me. Not that she doesn’t love me, but more and more I think she did it so I could annoy someone else with my financial rants. I’m sure it was much less work — not to mention less annoying and stressful.
Currently, I am in the beginning stages of starting an investment partnership. (Legally, it would be formed as a hedge fund but would have little hedging, leverage, or trading and much lower fees.) It is easier to think of it as an investment partnership or, if you will, a mutual fund that uses some leverage and is not diversified.
Knowing this, my wife found me the perfect article: How to Build Your Own Hedge Fund. My first clue that this might not be helpful was that it was written for BusinessWeek. I have nothing against reading BusinessWeek — you’ll learn a little more than watching a Bowl Game on mute (what I’m currently doing).
I soon realized that the article was not about building your own hedge fund but about hedging your annual bets by using long and short mutual funds. And if you would have used the best performing long and short mutual funds you could have hedged your bets (annually) and performed very well over the last five years.
The salespitch goes like this: by going long and short you are taking out the effect of the market. Sounds like a good thing. No more wild swings year to year. Own stocks but have a risk profile closer to bonds or t-bills! It’s a great sales pitch. An increasingly popular sales pitch. See, for example, my local paper’s (Milwaukee Journal Sentinal) treatment of this new product.
The problem with the product is that it takes an investor’s best friend out and replaces it with his worst. Over time, the best results come from having a positive exposure to the stock market. The market has returned 10-11% annually although many bears fear the best days are behind us and we will only see 6-8% returns. Even at only 6-8%, that’s a tough tide to bet against. The product takes out the positive effect of the market.
In addition, the product gives the investor more exposure to a stock-picker. A stock-picker who works for a mutual fund. In the past, mutual funds have underperformed the market! The investor is substituting the source of most gains with a source of losses.
The investor would be much better off buying index funds and exchange traded funds (etf) and letting the market take you on a more wild but more lucrative ride.
And now I feel better — I got in my two cents and my wife doesn’t have to pretend to listen to me.

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