Financial Reference

The most controversial new tax law being debated in Congress is a new tax on carried interest. If you listen the media, the debate is about balancing the budget on the left versus “the war on wealth” on the right. What has been lacking in the coverage is facts and logic.

Carried interest is, in effect, profit sharing for the managers of hedge funds, venture capital firms, and other partnerships. These partnerships usually charge the non-managing partners a percentage of profits in addition to a fixed fee. The percentage of profits charged is called a carried interest.

Currently, the carried interest is taxed as a capital gain. The new law would tax it as income. People should not be asking whether this is a good revenue source or whether this is an attack on the rich. The question is whether the character of this gain is a capital gain or income.

The logical answer to this (and this is obviously not a self-interested conclusion as I run a hedge fund) is that this is income. Carried interest is a performance-based bonus earned by the managers of the partnership. Bonuses are taxed as income.

Capital gains are taxed at a reduced rate because the capital has already been earned as income and taxing capital gains at a high rate would, arguably, be over-taxing. Carried interest is not a return on capital already earned. There is, in fact, no capital. It’s awkward to argue that it is a capital gain when there is no capital at risk.

While I empathize with other hedge fund managers arguing against a “new” tax, the problem is that it is a loophole being closed rather than a new tax. The character of the gains is clearly income, rather than capital gain.

The past couple of weeks I have struggled to find things to write about. This is especially frustrating since according to Page 2 on ESPN.com, the definition of blogs are: “Essentially, lists of half-developed ideas, usually commenting on someone else’s actual work.”

I guess I need to further develop a thought…

At least I found solace from another financial writer. One that actually gets paid for his opinions…

“Problem is, in the financial markets, while there is much news, there isn’t much news that has long-term investment value. My preference: Take solid time-tested investment principles — and make them seem like news…The news angle can make my standard advice appear fresh and interesting. But don’t be fooled: If you think I am saying something new, either you are a new reader — or you aren’t paying nearly enough attention.”

There are only a few things to learn to effectively manage your finances — it simply does not change week-to-week or even month-to-month. Save, be consistent, and don’t be emotional.

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?

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 zillow.com 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 zillow.com 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 following is a comment to Merk Cuban’s recent post on blogmaverick.com

Mark,

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 berkshirehathaway.com.) 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.

Sorry for the very long delay in posting. Life got the better of me. Nothing serious, just busy.

During my “sabbatical,” I found some funny examples of personal finance gone bad.

The first example is from a show on HGTV called Dream House. (Here’s a link to the official site and a link to the more informative Rocky Mountain News coverage of the show.) The idea of the show is to show a couple’s adventure toward building their “dream house.” It’s a very simple concept but as you may imagine, the execution rarely goes as smoothly as the couple’s original plans. This season is no exception.

The couple inherited a nice plot of heavily-sloped land in Colorado. They started building before knowing how deep the bedrock was, naively assumed that everything would go as planned, and assumed they would only have a $300-350K mortgage. As happens all too often today, they stretched their budget to afford such a large mortgage.

Then the inevitable happened: the cost projections were flawed, the bedrock was too deep (so it would be more costly to build the foundation), and they got pregnant. They were faced with a house they couldn’t afford, temporarily reduced income (as she was the primary breadwinner), and a large increase in expenses.

What to do when faced with a project you can’t afford? Of course, take on more debt. They mortgaged the land and took out a $500K construction loan! By their own admission, they need his start-up (oh yeah, I forgot to mention, his income comes from a start-up) to take off to afford the new payments.

Good luck! I hope all the stress is worth it.

And the other story: a 39-yr old man bought a virtual space station for $100K. He financed it by taking out a second mortgage on his house. Wow! (On the positive side, a 30-something buying a virtual property is not living in his parent’s basement.)

When President Bush nominated now Chief Justice Roberts, I supported his decision. Not for the normal reason given in the media or by politicians — i.e. that they agree with the nominee’s politics — but because he has a lot of experience. For more see this blog.

The new nominee, Harriet Miers, does not have the experience necessary for such a position. Although she is described as a work-a-holic and is undoubtedly smart, she has never sat on another bench before. Her biggest claim to fame is that she is White House counsel under President Bush. Before that she held W’s hand in Texas.

Can we honestly say that she is the most qualified person for the job? To me, it doesn’t even pass the laugh test. This is obviously someone who has been very faithful to W and is being rewarded for her loyalty. In addition, she has not played a visible role and so there is little opportunity to critique her personal beliefs.

But this is exactly the problem — if judicial nominations are critiqued based on their political beliefs, we will be stuck with inexperienced, untested candidates. I have no doubt that she is intelligent and capable, but there are candidates who have proved they are great judges. Why not nominate a proven candidate?

I’m having flashbacks to 2000 today. Back in 2000, Time Warner merged with AOL to create a media behemoth. The goal was to unlock synergies between delivery and content. Obviously, that didn’t turn out as management had hoped. (On a side note, the new Time Warner re-believes that AOL is the key to their future.)

Today, Yahoo announced a plan to enter the content world by hiring eight new financial columnists. With, I’m sure, more to come. I hope, for their sake, they are only trying to differentiate themselves by providing a little exclusive content, rather than trying to revamp their business model. We shall see.

On the positive side, I’ll take any free financial content I can get.

I just realized that I have been posting for a while and have never introduced myself. Even though I am only 26, I have been investing for about 10 years. I started by using my parent’s financial planner to help me pick two active mutual funds.. She recommended I pick funds with high Morningstar ratings. It was more than I knew at the time so I followed her advice.

Later, I found out she had a cushy relationship with the fund family she pushed the hardest. I doubt there was anything illegal going on and the fund family has a decent lineup of funds but she did have a conflict she did not disclose to me. Ever since then I have been a skeptic about investment advice and have been learning how to manage money on my own.

Since that time I have spent way too much time talking to other investors, reading books, 10Ks, and 10Qs — doing anything I can to gain an advantage — and more importantly, doing anything I can to make sure I don’t screw up. Despite all of my efforts to the contrary, I have done a lot of dumb things.

The two biggest mistakes I’ve made are that I have been overconfident and overly aggressive. During college and especially during law school, I played a high stakes financial game and didn’t appreciate the risks I was taking. I took out as much student, credit card, and margin debt as I reasonably could (I never paid more than 10% on the debt) and invested the proceeds in undervalued stocks. Even though I was eventually proved correct in my valuations, for a while my positions went the wrong way. I didn’t have any extra capital to support my positions in the short-run and was forced to periodically liquidate part of my portfolio.

Eventually I was proved to be very correct in my analysis and was rewarded for taking the risk. But it was still a mistake to lever myself to the point at which I could not support my portfolio. Had I had extra cash flow from a job, more lines of credit, or less leverage I could have survived any liquidation and not had to sell any of the undervalued shares on the open market.

Since then I have always left extra margin in my investment account and had lines of credit available for emergency. Over time, I will scale back my leverage to decrease my risk and increase my cash flow. It will allow me to have more flexibility and more toys as I grow older.

Unlike a lot of blogs, I don’t reveal my personal balance sheet or income statement. All I can say is that my wife and I are well-off and should have the freedom to retire early even after paying for our child’s education.

The Important (Non-Financial) Part of My Life

I got married in June and have a 10-month old boy. (I know, the math doesn’t work…) My wife and I both work in the actuarial field — so I usually avoid talking about insurance in my blog even though it is a very important part of the financial picture.

My background is as varied as my interests — I have degrees in math, economics, and psychology; and I have an unused law degree. I also manage accounts for a couple of friends and have had very good results managing their accounts and my own.

Every once in a while, I think about something other than finance — this is one of those moments. Even less often, I think about politics. But the recent news surrounding the coming John Roberts confirmation hearings is aggravating.

First, let me start with a little background about me: I have never voted for a Republican Presidential candidate — but most of that is because of W. (I am only 26 and so two of my votes would be better described as settling for the person I disliked the least.) But I can’t believe the politics being played right now by the Democrats before the confirmation hearings of Roberts.

Despite disagreeing with almost everything Roberts believes in, he is a good candidate. A person is not unfit for the judiciary because we disagree with him. Yet, politicians and the media have been attacking Roberts because he argued the “wrong” side of cases.

He argued for overturning Roe v. Wade when it was his job to do so. By the way, it is a lawyer’s job to argue for his client to the best of his ability. (I still remember a little about law from my days in law school — I have a law degree but am not a practicing lawyer.)

Democrats: let’s face the facts. Roberts has beliefs that are the exact opposite of ours. Roe v. Wade may be overturned, states may get more rights, religion may become a part of our government — and I hate to think about these things happening (at least 2 of the 3) — but Roberts is a good candidate. He has the intelligence, experience, and morality necessary to perform the duties of the Chief Justice of the Supreme Court. Although I fear the ramifications of a Chief Justice Roberts, there is no good reason to stop his confirmation.

A collection of my favorite stories of the week:

Thou shalt not pay too much for oil: nothing like a right-wing religious zealot suggesting murder is the cure for high oil prices. Link

A great blog by a UCLA professor of the Vioxx trial and the jury system in general. Link.

This needs no introduction. Link

Have a great weekend!