Financial Reference

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.

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.