Financial Reference

It’s a wonder that in any serious pursuit, someone could be happy that they were behind. It’s even more perplexing when the pursuit is the alpha-dominated investment industry. But I think Jonathon Clements is on to something.

In an article written today, I’m a Loser and I Couldn’t Be Happier, Clements discloses that he has lost a “boatload” in recent weeks he “couldn’t be happier.” First, I have to “B.S.” — you would be happier with more money. Even the most passionate value investor can feel sick to his stomach after the recent turmoil. That being said, Clements is right.

As I wrote in a recent article, the time to buy is when you feel a sickness in your stomach, when all of the news reflects a depressed outlook, when people start asking you whether they should stop investing in stock market altogether. In short, the time to buy is when your stomach tells you run and your brain is starting to agree.

The reason it is such a good time to buy right now is that all of the rampant pessimism decreases the price of assets, especially in sectors connected to the bad news. As Clements states, “This sort of market turmoil scrambles valuations and creates opportunities.”

When the market is ruled by emotion and short-term thinking, as it is currently, opportunities are created to buy great businesses at low multiples. While it is true that in the short-run, many of these opportunities will continue to be volatile, money can be made by taking advantage of other investors short term thinking.

I can see how Clements has convinced himself he is happy. Intellectually, we should all be happy if we are able to purchase more with less. But, it’s hard to imagine that he is actually smiling underneath.

I have historically used credit cards extensively to finance a portion of my stock portfolio. But now, credit card companies are making it harder to arbitrage.

In the past, I would receive cash advance offers for 0% financing for at least a year, with usually a $50-$100 transaction fee. It was easy money to take that money, invest in a money market or stocks and lock in some attractive returns.

Lately, however, the offers haven’t been as kind. I’m not sure if they caught on to my money making machine or if interest rate increases or credit defaults have made the companies reign in their offers.

In any event, I would like to roll over some cheap financing but am finding most of the offers lacking. At least I should have the cash to pay off any debt coming due. But I am going to miss the free lunch.

I could have a blog just documenting the material errors I read in the financial press. My biggest victim would be “Money” Magazine. While they have many good articles that should help a lot of people manage their finances, they need to refresh their economics.

This month, they made a mistake any Econ 101 student could find. In an article entitled “Landlords in Waiting” (page 62 of the September edition for avid readers), they analyze involved in whether someone should rent or sell a house they own.

Depending on the assumptions used (i.e. the increase in value of the property and assumed net income per year), after two years the rental could be -$600 or $33,940. (Of course, these are only two outcomes, neither of which will occur, but the scenarios give you an idea of how important your assumptions are.)

The author claims that if you should rent if you think you are going to clear $33,940 but sell if you think you are going to lose.

The problem with this analysis is two-fold. First, the analysis doesn’t account for the paydown of principle on the mortgage. Second, and more importantly, there is no cost of capital for the equity portion of the investment.

People rarely forget about the explicit costs of the debt associated with an investment, but often forget about the cost of the equity. In fact, the article neglects to mention what the equity investment is.

Without this information, there is no way to know what the return on the investment or net present value of the investment actually is. The investment may be good or bad (which is found by comparing the expected return to the cost of capital), but we will never know.

During times of market turbulence, it is tempting to seek safety and comfort. This is often done in one of two ways: (1) through selling risky assets for safer assets (think selling stocks for treasuries) and (2) through rebalancing.

Selling risky assets and purchasing safer assets after a market drop is never a good idea. It is either an emotional reaction or the result of a need for liquidity. In either case, the reaction is the result of a portfolio that was too risky to begin with.

The second reaction is often the correct one. By rebalancing, investors can allocate more capital to segments that have recently declined more. The idea rebalancing increases diversification and can increase returns. It can increase returns because segments that have recently declined are more likely to be undervalued.

In today’s market, financial advisors are recommending investors allocate more capital to real estate, cyclical firms, and international firms due to recent underperformance. However, the recent underperformance comes on the heels of many years of spectacular performance. The recent underperformers are still overvalued.

While I encourage people to re-balance their portfolio periodically, the current recommendations are misplaced due to the fact that many of the securities recommended are still grossly overvalued.

My wife and I have been exploring the idea of one of us going part time. With our second kid on the way and my investment business growing, it seemed like a good time. That is, until we reviewed our budget.

I took great pride in having a good understanding of our finances. I thought I knew how much we were saving every monthand what our balance sheet should look like months from now.

So, it came as a big surprise to me a couple days ago when I realized my estimates were completely wrong.

We figured this out after we put our financial transactions into Quicken. It was hard to imagine we spent so much for our cars ($200/mo. for gas and oil changes), energy ($150/mo.), and “household” ($300/mo.).

The biggest surprise was household. I didn’t even realize it was a category — we spent WAY too much at Target, IKEA and Costco.

As skeptical as I was that Quicken would help us manage our finances, it seems to already be making us think more about where we can cut back and save more. Currently, including the repayment of principal, we save about a quarter of our pre-tax salary. But, after reviewing the summaries on Quicken we should be able to find more fat to cut in our budget so we can get to our goal sooner.

Even if you think you have a good handle on your finances, and even if — like us — you are saving a reasonable amount of your salary, it may still benefit you to look at purchasing Quicken, Money, or some other financial software to help locate areas you could improve your spending.

Whenever I receive an email from a Schleppy organization, it promptly goes in the trash bin. It’s not that I’m worried about viruses from someone trying to sell me something, I just don’t want to encourage them to send me more.

It seems that every other day I get something from the Motley Fool, one of the Schleppiest, telling me that if I just subscribe to their newsletter I can get 50% returns or 43% annual dividends. While that sounds appealing, I’m much to skeptical to read any further.

However, my wife isn’t. Not that she will fall for such false claims; she is just curious enough to keep reading. Luckily for me, she has absorbed enough finance through my rants to figure out, relatively quickly, the error in the Motley Fool’s claims.

Their claim of 43% dividends went like this: buy a stock, wait a few years, and you will eventually earn a huge cash return on your initial investment. The idea is that the initial investment will not have a large dividend, but after years of growth in the price of the stock, the dividend will be huge compared to the initial investment.

The problem with this, my wife pointed out, is that the 43% is completely misleading. No one ever earns a 43% dividend return in any year. The right reference for the capital invested is not the original capital invested but the current price of the capital. This is the opportunity cost of the capital.

Before you get sucked into the many misleading claims in your inbox, there are two good options: (1) spend time figuring out the flaw in their reasoning, or my favorite (2) press delete.

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.

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.

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.

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.

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.

I usually agree with Jonathan Clements. (He writes the “Getting Going” article for the WSJ.) I also usually agree when someone has a disagreement with conventional wisdom. But parts of the article he wrote entitled “Five Bits of Conventional Wisdom to Ignore” were flawed to the point of being misleading. (See article, subscription required.)

First, he writes that homes are not the greatest investment of all time. While I agree with that statement, I disagree with much of the rest of his argument. He argues that there is no real cash flow from a home (and gives short shrift to implied rent). Also, he argues that you need to trade down to a cheaper home to realize your gains. These are both incorrect — he ignores the opportunity cost. If you did not own your home, you would have to pay rent. Rent that would theoretically have to compensate the owner for his investment and compensate for the agency costs incurred in a non-owner occupied property. By owing, you are forgoing rental payments for mortgage payments (and taxes, etc.) Also, you do not have to scale down your investment to realize your gains. The opportunity cost of owning is renting. To find your gains, compare the outcome of owning versus renting. It makes no difference how you invest the proceeds.

Second, he criticizes people for thinking they can make money in stock market. While I agree that most people end up trading too much by chasing trends and usually pay too much for “professional” advice, his math is seriously flawed. He argues that you should expect a 6% gross return from a portfolio of bonds and stocks; of this 2% goes to fees; then 25% goes to taxes, netting a 3% annual return. My experience is much different than this. The stock market has returned an average of 11% in the past — even if we assume a lesser return we should still see 8-9% long-term. Then you would have to choose the most expensive funds on the market (the average expense ratio is 1.25%). Then you would have to have either all short-term gains or a mix of short- and long-term gains and be in the highest tax bracket to hit 25%. The real expected return should be at least 5-6% for most of us, not 3%.

He next argues that you should invest in sectors you believe to be overvalued. The reason for this is that we are overconfident in our ability to predict which sectors will perform well. For most people –people who don’t spend time in finance — this is good advice. However, for those of us who put in the effort, we can easily see that we should not invest in expensive markets. For example, I stayed out of tech during the late 90s. There were a few years I lagged the market, but in the end, I had the last laugh. Today, I am out of REIT and even though I missed some recent gains, I am optimistic I made the right choice. It’s not about hitting every market rise but being right in the long-run.

He next says that is doesn’t matter if you invest internationally or domestically, or in bonds or stocks. What matters is you don’t chase trends. For the most part, he is right. Sticking to your guns and not chasing fads is most important. However, it is important to have the right allocation for your risk needs.

Last, he makes the point that you should invest according to your risk tolerance and not your risk needs. This is wrong! A retiree should not invest in stocks if he can not afford the risk. If his portfolio decreases by 10-20% in one year, how will that affect his tolerance? The most risk tolerant person can become extremely risk averse if he is on the brink of disaster. Of course, if the retiree has the capital to afford to lose a large part of your portfolio, then it’s not an issue. But the portfolio should be structured to the risk needs of the retiree first and to the risk tolerance second.

I find it hard to continue to post new investment ideas every day. It’s difficult to even post two times a week with new ideas. It’s difficult because it isn’t very hard to be a reasonably good investor. Of course, you can put a lot of time and effort into investing to try to be better than average. But for most people, it is a much better idea to follow a few simple tenants.

The first five ideas come from WSJ columnist Jonathan Clements in today’s Getting Going column.

1) Saving is the most important factor in accumulating wealth. Despite the fact that we have a young son and are jealous of people with bigger homes, we still manage to save about 30% of our income so that we will have that bigger home some day. It’s not necessary to save 30% but making efforts to save as much as you can, as early as you can, will give you more safety and options later in life.

2) Time. The earlier you save, the more compounding and the less you will have to save later.

3) Diversification. Although many value investors — including myself — have derisively used the term “di-worse-ification,” the average investor would be much better off making less concentrated investments. For example, in this month’s Money magazine, a couple was profiled who had significant stakes in both of their employers and in Amazon.com. If either of their employers had a significant setback, they could be in big trouble.

4) Rebalancing. The most important part of an investment plan (i.e. a plan that defines how you are going to allocate your assets) is to make sure you follow through. If you follow the plan, emotion will play as little a role as possible and you will not get caught chasing hot sectors.

5) Indexing. In order to outperform the market you need some advantage. If you are not willing or able to do hours of research looking through annual reports (and looking at pictures and charts doesn’t count), there is no reason to believe you will have an advantage. As Warren Buffett said, if you “bring nothing to the party, [] why should [you] expect to take anything home.” For most investors, it is better to invest in index funds instead of trying to outperform the markets.

To this list I would like to add:

6) Use tax-deferred and tax-free accounts as much as possible.

7) Take free money whenever you can — maximize contributions to ESPPs and matched 401(k) contributions (if you have the option).

8) Maximize your exposure to stocks in your retirement accounts — especially if you have a long time to retirement. Over long periods of time the real return of stocks has been higher with less risk.

9) Minimize expenses. The biggest difference in long-run equity mutual fund performance is not the manager but expenses. Keep this in mind when looking at investments.

If you follow these simple rules, you can accumulate a large nest egg over your lifetime with little risk.

I’m sorry I haven’t posted lately. It was a rough week for me all around — I was sick, worked too much, and the market wasn’t too kind. It is the first time our portfolio had a very rough week. In the past, my portfolio has taken beatings, but this was completely different.

From past experiences, I know that these things happen from time to time. Net worth does not increase linearly (assuming you take some risk). And, since I take a lot of risk, our net worth jumps around quite a bit.

But I need to make some changes now that I’m married with child because my wife does not react to volitility in the same way, I have more responsibilities because of my son, and we do not have as much free cash flow to protect our portfolio.

I realize now that I can’t continue taking the risks I have taken in the past. It hurts, but I can’t continue to manage to my own risk tolerance and not take into account my new circumstances. After a conversation with my wife, we decided on a new investment plan involving lower leverage and more diversification.

The WSJ just came out with a Saturday edition that emphasizes personal finance. Their lead article made me want to revisit a blog I posted a few days ago.

The WSJ article (subscription req’d) “New Tools to Hedge Your Home” discusses a new and old way to hedge your home.

A problem with the old way, selling short an index of homebuilders, is that this is an imperfect hedge. In addition, the index of homebuilders has performed extremely well historically — often much better than the increase in home prices. It’s not a good long-term strategy to be short something that historically has performed extremely well.

There is a new way to hedge the value of your home through the use of derivatives. The first to market is HedgeStreet. Through their website you can speculate on the short-term direction of real estate prices in six markets. If the value of your home is correlated with the value of the real estate index in any of the six markets listed, you can hedge the short-term value of your home.

But I would advise against using derivatives to hedge the short-term value of your home. First, if you do not plan on selling your home soon, a lower price only means that your property taxes might go down. (The site currently does not allow for long-term hedging — the longest contract is for three months.)

Second, the markets are currently very illiquid and so hedging can be very difficult and expensive. As more contracts and market-makers enter the market, hopefully these problems will be fixed.

Third, derivatives are complicated instruments that can easily be misused.

Fourth, the hedges will probably be far from perfect for your circumstances.

The biggest problem I have with the products is that it reflects our current preoccupation with short-term changes in real estate values. Currently, real estate values are generally overvalued, but over the long-run values should increase from their current prices. I would not recommend investing more in real estate at this point, but there is no need to speculate in a negative NPV transaction that isn’t really hedging your real risk.

A sell-side analyst “works for a brokerage or firm that manages individual accounts and makes recommendations to the clients of the firm.” Investopedia. Every time a stock is upgraded or downgraded, one of these analysts are at work.

Their obligation is to the firm they work for, not to individual investors. Depending on the firm they work for, their objective could be to: increase trading, please a company by issuing a favorable recommendation, increase client satisfaction, or to avoid any number of other normal pressures a person faces at work.

During the internet bubble, some sell-side analysts developed quite a following. So much so that we still remember their names to this very day: Meeker, Blodget, Grubman to name a few.

After the internet bubble popped, these idolized analysts’ names were dragged through the mud. I’m not saying they didn’t do anything wrong, but a lot of them did what their job required of them. If they could explain away the irrational exuberance during the time, if they could convince themselves and the world that they knew the secret to the new economy, they could make a killing. And they did.

They made their clients happy by producing eye-popping returns (at least until the bubble popped); they made their companies happy by bringing in more assets and investment banking business; and they made themselves very wealthy. The good analysts knew the bubble couldn’t last but it was fun while it lasted.

At least in today’s more rational market, these abuses don’t happen. Analysts are there to tell you how they really feel about an investment. They are not there to make money for themselves or their firm. They have an undying to devotion to the well-being of the individual investor. Or so I thought…(Okay, I never really did.)

Sell-side analysts are, after all, trying to sell you something. In that spirit, most of the stocks a company covers are ranked as a “buy”. After all, who wants to buy a “hold” or a “sell?” In fact, Jefferies & Co. has 10 buys for every one sell; A.G. Edwards has 15 buys for every sell. (WSJ Online; Subscription Req’d.) It’s so bad that most investors recognize a “hold” for what it is — a “sell” with connections.

If you thought the game has changed, it hasn’t. Just the timing has — there is no crash so the losses aren’t as visible. If you decide to use the “expertise” of a broker’s firm, make sure you know what percent of the firm’s recommendations are “sells” and how their recommendations have performed over time compared to an index. Assuming that they aren’t playing games with the numbers, chances are that after fees their recommendations will have underperformed and you would be much better served in a boring, yet lucrative, index fund.

I don’t know if you’ve seen the new show on TLC called “Flip This House.” I haven’t, but I think I can figure out the premise: someone purchases a house, puts some elbow-grease into it, and tries to sell it for a profit — an amazingly common theme in this crazy time.

Every time I open a newspaper or magazine (or watch TV) I hear about how much people have made in real estate or how dumb they are for investing in real estate right now. For example, last month’s Money magazine featured condo flippers. Some people are buying condos that won’t be built for years with extreme leverage. This is crazier than being a tech speculator in the late 90s. At least the techies were not as leveraged, had a market to sell into when the crash came, and didn’t have to pay huge transaction fees.

But the really strange real estate conversation is: should you sell your home and rent? It belies the real change in philosophy towards housing: people are looking at their homes as an investment rather than a place to live. Yes, housing is overpriced, but people should not be selling their houses because they think they are overpriced because:

(1) The transaction costs can eat away at any difference between the price and true value of the home.
(2) Even if the housing market is overvalued, that does not mean that after you sell, the value of your house will decrease. Trying to time a market — even if it’s overvalued — is hard.
(3) There are other reasons to own a home rather than rent — like freedom, attachment, and pride of ownership.

Even though real estate is probably overpriced, you shouldn’t sell your house to rent. Instead of looking at a house as a sure road to riches, if you see it as a place to live, you’ll be much happier with your return.

I know long-term interest rates are going to increase. Heck, I knew this six months ago. It was going to happen — and happen soon. I would have put money on it (but luckily I didn’t).

I’m continually amazed by pundits and my ability to see the future so clearly, only to forget our predictions so easily. And those of us that do remember have ready excuses due to “unforeseen events.”

Each time I find a sure thing, I give myself a few days to think it over. Usually, I start finding problems with my idea. Most of us would be better off if we did this more often — much like shop-a-holics should put something on hold instead of making an immediate purchase. Buyers and sellers remorse is a big part of investing — and can cost you much more than a trip to the mall.

However, many people still try to time the market — moving money in and out of the market to try to get better returns. Of course, these timers inevitably end up hurting themselves in the end.

Money calculated the return investors actually earned investing in 700 mutual funds from 1998-2001 and compared that value to the returns of the funds over the same time period. The shareholders annual return was 1%, compared to 6% for the funds.

The difference is that shareholders were buying and selling at exactly the wrong moments. When the fund performed well, the investors gained confidence, and cash flowed in to the fund. When the fund performed poorly, the investors lost confidence, and cash flowed out. The investors were buying at the top and selling at the bottom.

The investors would have been much better off to buy and hold rather than to let their emotions control their investment strategy.

Before you decide to buy or sell, make sure you have good reasons and that your emotions aren’t guiding your decision. Don’t think that you can predict the future or get upset with yourself for your lack of foresight. (For example, it was obvious to me that the market was overvalued in the late 90s, and I should have cashed in, but if I would have given myself the leeway to bet against the NASDAQ, I would have been broke way before the bubble eventually popped.)

Maybe interest rates will stay flat for a while, maybe they won’t. But I’m smart enough to know that I don’t know what will happen; and smart enough that my investment strategy doesn’t totally depend on my forecast of the future.

A recent comment said that I don’t account for human nature in my strategies. I agree, I don’t. But I think there are good reasons for this. In investing and planning for our future, we have to try to beat the humanity right out of ourselves. Some examples of bad behaviors:

People have a tendency to spend, rather than save.

People have a tendency to buy into growth stories rather than boring, profitable companies.

People have a tendency to chase trends.

People have a tendency to buy after a run-up and not buy after a sell-off.

People have a tendency to put significance on insignificant events (e.g. recent stock performance).

The list could go on but my point is that we have to fight against our natural tendencies to the extent possible. Although the short-run is exciting (it’s fun to see our net worth go up and sad to see it go down), we should try to not react to short-term events and put more emphasis on the long-run. Easier said than done. I struggle with it every day.

The best thing you can do for yourself is to know what your weaknesses are: do you like to trade? Do you get caught up in manias? Do have trouble saving? Are you over/under-aggressive?

And create a plan — you can follow — to address these issues. Before you decide on an investment/savings plan, ask yourself whether you will be able to follow it.

The investment ideas I discuss are not for everyone — they have worked for me and may work for you — but that is up to you to decide.

Good and Bad Debt & Margin Debt
There is good debt and bad debt. Even the IRS agrees: mortgage, business, and student debt are deductible, while credit card, personal lines of credit, and margin debt are not. (An aside: there is an option to offset investment income against margin interest, but then the character of all your investment gains changes to income — i.e. long-term capital gains and dividends will lose their special tax status and be taxed at your marginal rate.) I suppose there are reasonable reasons to favor one type of debt over another — the government wants to encourage home ownership, entrepreneurship, and education but not speculation or excessive spending.

There are good and bad debt — but the analysis is not as easy as saying one type of debt is “bad” and another is “good”. Mortgage debt is in not necessarily a good type of debt — many people take on too much debt and do not appreciate the risk of newer mortgage products. For example, Option ARMs — a mortgage with a teaser rate that allows people to buy more than they can afford — have a lot of built-in interest rate risk.

On the opposite end of the spectrum, credit card or margin debt is not necessarily bad debt. You can use either to leverage your investments. For example, some fixed rate credit cards are offered way below my current estimated cost of capital of roughly 6-8%. If I can borrow at a fixed rate below my cost of capital, I am adding long-term value.

With margin borrowing (or variable rate credit cards) you are also taking on interest rate risk and if interest rates increase, the value of your investment can decrease at the same time your borrowing costs increase. Still, especially with margin borrowing, you can significantly leverage your investments and increase value to your portfolio.

The most important problems people encounter when they use margin are: they over-leverage, they leverage the wrong investments, and they don’t manage their cash flows. The first, and most common, problem is that people leverage their portfolio to the hilt so that even a small an adverse price movement can mean liquidating part of your portfolio.

The normal person who uses margin is a risk-taker, the same sort of person who wants to invest in the next big thing. But, if you invest in more conservative run companies, with large dividend payments and low P/E ratios, you should not have as much price risk in your portfolio and will reduce your chance of a margin call.

It also helps your chances if you have positive cash flow to devote to your portfolio when the inevitable price declines come. If you are adding cash to your portfolio, there will have to be a much bigger decline in value before you need to liquidate.

I have learned most of these lessons the hard way. Now, I currently use a reasonable level of margin on more conservative investments and make sure that I have positive cash flow to devote to my portfolio when the value of my portfolio decreases. This does not guarantee that I will not have a margin call down the road, but it definitely decreases my chances while still increasing my returns.

Although most people’s goal is to become debt-free, debt can be a powerful way to increase your returns. As long as you are responsible in managing your risk, margin debt and other “bad” debt can be a good way to leverage yourself and create long-term value. However, if you are not responsible managing your risk, taking out any debt — even to purchase a home — can be disastrous.

(Disclaimer: I am not a tax advisor, so do not rely on statements contained herein — consult a tax advisor before filing. I try to be as accurate as possible but there are no guarantees.)

One of the first things most financial planners will tell you is that you need about 6 months of cash on hand for emergencies. But, if you have discipline, there is no need for you to keep cash on hand. In fact you would be better off not following their advice.

For example, my wife and I spend about $3-3.5K per month. In order to have 6 months of expenses on hand we would need to have $20K of cash on hand.

Let’s assume that we could earn 4% in a money market account (currently above the best rates at Bankrate.com) and an average of 8% in the stock market (below the historical average of 10%). In the first year we would accumulate an average of $800 more investing in the stock market than in a money market account.

Due to the magic of compounding the difference is much larger the longer the strategy is followed. For example, the annual difference in the 5th year would be $1241 and $2060 in the 10th year.

Even though the differences in percentage return seem small, over a long period of time, the effect on your net worth can be substantial. In 20 years, the initial $20K investment would be worth $44K if you were to invest it in a money market account versus approximately $93K if you were to invest it in the stock market.

However, if you know that you do not have the self-control to keep lines of credit available for emergencies, then you should not follow this strategy!

In the past, I have recommended this strategy to friends but they have decided to keep extra cash on hand. I think the thought of having cash is too comforting and the thought of debt too frightening for most to consider using this strategy. But this is a long term strategy that has been very rewarding for us and could be very rewarding for you.

Additionally, the same strategy has been advocated by Jonathan Clements, a columnist for the Wall Street Journal, in his book, 25 Myths You’ve Got to Avoid - If You Want to Manage Your Money Right:

So how will I pay for my emergency? If I put my mind to it, I figure I can get my hands on a fair amount of money fairly quickly by tapping credit cards, the equity in my home and the money in my company’s retirement-savings plan. I will borrow money to pay for the emergency and then pay off the debt either out of my paycheck or by selling stocks after the market recovers. Borrowing money is clearly costly. But over the long haul, the superior returns from stocks should more than compensate for any short-term borrowing costs.