Financial Reference

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 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.

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 savvysaver.blogspot.com. 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.

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.