This weekend I will be attempting to switch this blog over from one hosting environment to another, something that will allow for more flexibility and features in the future. The look of the blog will change somewhat right away, and probably continue to morph over the next few weeks as I twiddle with things.
I mention this because the switch-over may cause a short term outage at some point today or tomorrow. Of course, if you are reading this, the blog is obviously currently up.
Saturday, February 28, 2009
The Wall Street Journal Guide to The End of Wall Street as We Know It by Dave Kansas, Part 1
Of the passel of hastily written books now on the shelves discussing the financial crisis and what to do about it, The Wall Street Journal Guide to the End of Wall Street as We Know It by Dave Kansas may have the best title. But like the other members of its micro-genre, it is not likely to become an enduring classic. Kansas is a web and newspaper reporter by trade and the entire book can be usefully thought of as an extended magazine article, what in an earlier age might have been called a pamphlet. It was written over a few weeks in the last months of 2008, was on shelves as a paperback by the end of January, and will probably outlive its usefulness by late summer. It will next be seen many years from now when unearthed by a graduate student doing research into the contemporaneous reaction to the Panic of ’08, or whatever it is that the current crisis winds up being called.
But as a long magazine article, the book has its merits. If you weren’t paying close attention to events in the financial world last year and now feel at a disadvantage at dinner parties, The End of Wall Street will help. Even relatively close readers of news accounts will find tidbits and pieces of the big puzzle they have missed. For example, the book points out that the average FICO scores of sub-prime borrowers actually improved as the housing bubble grew. While the sub-prime borrower of ten or fifteen years ago might have been sub-prime due to a bad credit history, by 2006 a sub-prime borrower typically had adequate credit but was buying more house than he could truly afford.
Kansas also provides a modicum of analysis and reflection, roughly what you would expect from a reporter given a book to fill but only a short time to do it. He deftly points out that the troika at the helm of the government’s handling of the crisis in the fall of 2008 was made of Fed Chairman Ben Bernacke, New York Fed President Tim Geithner and Treasury Secretary Henry Paulson. Kansas does not say it, but he clearly means the reader to notice that the new administration has merely contracted that troika into a duo.
And although he cannot resist blaming the Usual Suspects of crooks and overly clever bankers, Kansas does so with a light hand. The fiasco in mortgage bonds was propelled by the same forces that propel the economy in good times, avarice and optimism. As Kansas deadpans, “Creating new regulations that will eliminate greed is practically impossible.” Nor, he might have added, is it necessarily a good idea.
The fuse for the powder keg was lit in June 2006 when, according to the S&P Case-Shiller Indexes, house prices in the US peaked, having gone up 190% in ten years. It took some time to play out, but after years of aggressive lending and borrowing on the almost universally held theory that house prices never go down, the result was nearly pre-ordained. There are wrinkles that made it worse, such as the peculiar structure of the mortgage bond market, but as Kansas makes clear, these are complications to the core disease. A truly vast number of bad loans got written and, due to the nature of the beast, they all went south at the same time.
It is what happened next that made our current situation dire. As Kansas tells us, within living memory there have been several large-scale financial crises that failed to destroy Wall Street, and some of those failed even to cause a recession. The tech-telecom bubble burst at the start of this decade, vaporizing trillions in stock market wealth and littering Wall Street with worthless telecom debt. That came only a few years after the Asian Crisis and Russian Default Crisis culminated in the collapse of Long Term Capital Management, which caused dramatic late night meetings of the leaders of Wall Street, but not, apparently, any long term repercussions. And a few years before that, almost the entire S&L industry went up in flames.
Kansas calls these disasters Dog That Didn’t Bark moments, events that historians will realize hold significance for what did not happen rather than what did. Indeed, the fact that no really terrible damage was done only encouraged further risk taking. But in retrospect, the financial system was lucky to weather those storms as well as it did. The seawalls were just strong enough and the ad hoc and somewhat haphazard government rescue efforts were just adequate enough to see us through. When a slightly bigger hurricane made landfall it was revealed just how insufficient the financial system’s defenses had really been all along.
The levees were breached on Monday, September 15, 2008. That was the day Lehman Brothers failed, defaulting on its debt and turning what had been an atmosphere of fear and foreboding into one of panic. Investors reasoned that if the debt of a firm as significant as Lehman could become worthless then nothing was safe. All of a sudden everybody started hoarding cash, refusing to lend to anybody under any circumstances.
Lehman had been widely known to have been in serious trouble for some time, so a person might wonder why its failure could have come as such a shock to the system. As late as the Friday before, the credit default market was pricing the likelihood of a Lehman default in the following year at only 7%. This apparent incongruity can be explained by the fact that almost everybody on Wall Street believed that even though Lehman was probably insolvent, the government would never allow such a key player to default. Of course, that is exactly what happened.
[Stay tuned for part 2 of this review early next week.]
But as a long magazine article, the book has its merits. If you weren’t paying close attention to events in the financial world last year and now feel at a disadvantage at dinner parties, The End of Wall Street will help. Even relatively close readers of news accounts will find tidbits and pieces of the big puzzle they have missed. For example, the book points out that the average FICO scores of sub-prime borrowers actually improved as the housing bubble grew. While the sub-prime borrower of ten or fifteen years ago might have been sub-prime due to a bad credit history, by 2006 a sub-prime borrower typically had adequate credit but was buying more house than he could truly afford.
Kansas also provides a modicum of analysis and reflection, roughly what you would expect from a reporter given a book to fill but only a short time to do it. He deftly points out that the troika at the helm of the government’s handling of the crisis in the fall of 2008 was made of Fed Chairman Ben Bernacke, New York Fed President Tim Geithner and Treasury Secretary Henry Paulson. Kansas does not say it, but he clearly means the reader to notice that the new administration has merely contracted that troika into a duo.
And although he cannot resist blaming the Usual Suspects of crooks and overly clever bankers, Kansas does so with a light hand. The fiasco in mortgage bonds was propelled by the same forces that propel the economy in good times, avarice and optimism. As Kansas deadpans, “Creating new regulations that will eliminate greed is practically impossible.” Nor, he might have added, is it necessarily a good idea.
The fuse for the powder keg was lit in June 2006 when, according to the S&P Case-Shiller Indexes, house prices in the US peaked, having gone up 190% in ten years. It took some time to play out, but after years of aggressive lending and borrowing on the almost universally held theory that house prices never go down, the result was nearly pre-ordained. There are wrinkles that made it worse, such as the peculiar structure of the mortgage bond market, but as Kansas makes clear, these are complications to the core disease. A truly vast number of bad loans got written and, due to the nature of the beast, they all went south at the same time.
It is what happened next that made our current situation dire. As Kansas tells us, within living memory there have been several large-scale financial crises that failed to destroy Wall Street, and some of those failed even to cause a recession. The tech-telecom bubble burst at the start of this decade, vaporizing trillions in stock market wealth and littering Wall Street with worthless telecom debt. That came only a few years after the Asian Crisis and Russian Default Crisis culminated in the collapse of Long Term Capital Management, which caused dramatic late night meetings of the leaders of Wall Street, but not, apparently, any long term repercussions. And a few years before that, almost the entire S&L industry went up in flames.
Kansas calls these disasters Dog That Didn’t Bark moments, events that historians will realize hold significance for what did not happen rather than what did. Indeed, the fact that no really terrible damage was done only encouraged further risk taking. But in retrospect, the financial system was lucky to weather those storms as well as it did. The seawalls were just strong enough and the ad hoc and somewhat haphazard government rescue efforts were just adequate enough to see us through. When a slightly bigger hurricane made landfall it was revealed just how insufficient the financial system’s defenses had really been all along.
The levees were breached on Monday, September 15, 2008. That was the day Lehman Brothers failed, defaulting on its debt and turning what had been an atmosphere of fear and foreboding into one of panic. Investors reasoned that if the debt of a firm as significant as Lehman could become worthless then nothing was safe. All of a sudden everybody started hoarding cash, refusing to lend to anybody under any circumstances.
Lehman had been widely known to have been in serious trouble for some time, so a person might wonder why its failure could have come as such a shock to the system. As late as the Friday before, the credit default market was pricing the likelihood of a Lehman default in the following year at only 7%. This apparent incongruity can be explained by the fact that almost everybody on Wall Street believed that even though Lehman was probably insolvent, the government would never allow such a key player to default. Of course, that is exactly what happened.
[Stay tuned for part 2 of this review early next week.]
Friday, February 27, 2009
Frugal Friday Feb. 27
Another quiet week in the frugalosphere.
In a follow-up to last week, I must report that Almost Frugal gave into temptation and bought a new dishwasher after all. This in spite of the dozens of encouraging comments she got, cheering her on in her efforts to live dishwasher-free. It almost makes you wonder why she bothers blogging if she's going to lose her mind and spend money like a drunken sailor.
Speaking of blogging, today's Little People Wealth has helpful post about how you can get some free cheese. All you have to do is review the cheese on your high traffic cheese-related blog. Finally, a tip we can all use.
As true devotees of frugalism know, being frugal is not merely a way to get rich, it is a lifestyle. Frugal posts this week explored taking this further and transcending the Frugal Lifestyle (FL) and living what might be called the Substance Abuser Lifestyle, or SAL.
Money Saving Blog brings us a list of 20 things in your house you can sell. This post begins with the commonplace observation that "the first thing that I do when I suddenly realize that money is getting tight towards the end of the month is to look around my home to see if there is anything that I can sell." This is a good start, but I think that really living the SAL would mean looking around in other people's homes for things you can sell.
Bargaineering suggests Dumpster Diving. The post is short on details, but apparently in some garbage heaps there are more things you can sell.
The Greenest Dollar picked up the SAL pace with a post on living in shipping containers. It's an informative post, but the author lost my interest when she started discussing how much it costs to buy a container. Of course, a serious SAL practitioner would find one.
Not to worry. Tight Fisted Miser has an informative post, with a follow-up the next day, on what he calls "Extreme Frugal Housing Options." His first suggestion is to live in a van, which he thinks he would really enjoy, but concedes that his "GF" would not. (I'm not sure what GF stands for. In context, girlfriend seems unlikely. Goldfish? Grandfather?) If not a van, he suggests an RV, which again he worries that GF would not like. Also, they're hard to handle on the road and burn a lot of gas. But, then again, there's no room for a dishwasher.
In a follow-up to last week, I must report that Almost Frugal gave into temptation and bought a new dishwasher after all. This in spite of the dozens of encouraging comments she got, cheering her on in her efforts to live dishwasher-free. It almost makes you wonder why she bothers blogging if she's going to lose her mind and spend money like a drunken sailor.
Speaking of blogging, today's Little People Wealth has helpful post about how you can get some free cheese. All you have to do is review the cheese on your high traffic cheese-related blog. Finally, a tip we can all use.
As true devotees of frugalism know, being frugal is not merely a way to get rich, it is a lifestyle. Frugal posts this week explored taking this further and transcending the Frugal Lifestyle (FL) and living what might be called the Substance Abuser Lifestyle, or SAL.
Money Saving Blog brings us a list of 20 things in your house you can sell. This post begins with the commonplace observation that "the first thing that I do when I suddenly realize that money is getting tight towards the end of the month is to look around my home to see if there is anything that I can sell." This is a good start, but I think that really living the SAL would mean looking around in other people's homes for things you can sell.
Bargaineering suggests Dumpster Diving. The post is short on details, but apparently in some garbage heaps there are more things you can sell.
The Greenest Dollar picked up the SAL pace with a post on living in shipping containers. It's an informative post, but the author lost my interest when she started discussing how much it costs to buy a container. Of course, a serious SAL practitioner would find one.
Not to worry. Tight Fisted Miser has an informative post, with a follow-up the next day, on what he calls "Extreme Frugal Housing Options." His first suggestion is to live in a van, which he thinks he would really enjoy, but concedes that his "GF" would not. (I'm not sure what GF stands for. In context, girlfriend seems unlikely. Goldfish? Grandfather?) If not a van, he suggests an RV, which again he worries that GF would not like. Also, they're hard to handle on the road and burn a lot of gas. But, then again, there's no room for a dishwasher.
Thursday, February 26, 2009
Firm Grasp of the Obvious Week at WSJ
Yesterday Wall Street Journal columnist Brett Arends reported that from 1995 you would have been better off in a money market fund than the stock market. Apparently the meaning of the Dow hitting a twelve year low took a while to sink in. Arends also tells us that "Thanks to inflation, investors have lost ground simply if they haven't gained it."
Today Jason Zweig picks up the theme with a column entitled "After the Crash, Stocks May Face Long Road Back; History Suggests There's No Guarantee of Quick Rebound; Buy and Hold -- for Decades?" Zweig reveals the not at all shocking truth that just because the stock market went down a lot in the last year or two that does not mean it will necessarily go back up a lot in the next year or two.
He cites a soon to be released report from a professor of finance saying that the expected time that it will take the Dow to regain its 2007 high is nine years. That is, it has an equal likelihood of getting back to its peak after 2018 as before. Zweig says that this "shocked" him. Really? In round numbers the stock market is down 50% from the peak, so getting back up requires a gain of 100%. If you are a little pessimistic and assume an 8% average return from stocks, that will take 9 years. If you think 10% sounds right, then it will take about 7 1/2 years.
There is a powerful psychology of denial that affects many people, personal finance columnists at national newspapers included. The numbers on the 401(k) statement in early 2007 just seemed so real and substantial that it is hard to acknowledge that today's much lower numbers are just as real. People tend to expect a V pattern in stock prices, that a few really bad years are inevitably followed by a few really good years.
The stock market doesn't work that way. It can't. It's like a law of nature. The market cannot let itself be so easily predicted. Knowing what happened one year tells you (almost) nothing about what will happen the next. Since 1871 the stock market (as measured by the S&P 500) has had 38 down years. Excluding this year, the average return the year after losing money is +11.63%. The S&P has also gained more than 20% in a year 38 times. The average return in years following big gains is +12.27%.
There is obvious incredulity in the question "buy and hold -- for decades?" But the straightforward answer is "Yes, of course." Did you think that you could guarantee fat stock market returns if you were willing to stick it out for five or ten years? You can't, and that's something that all stock market investors, and all Wall Street Journal columnists, need to know.
Today Jason Zweig picks up the theme with a column entitled "After the Crash, Stocks May Face Long Road Back; History Suggests There's No Guarantee of Quick Rebound; Buy and Hold -- for Decades?" Zweig reveals the not at all shocking truth that just because the stock market went down a lot in the last year or two that does not mean it will necessarily go back up a lot in the next year or two.
He cites a soon to be released report from a professor of finance saying that the expected time that it will take the Dow to regain its 2007 high is nine years. That is, it has an equal likelihood of getting back to its peak after 2018 as before. Zweig says that this "shocked" him. Really? In round numbers the stock market is down 50% from the peak, so getting back up requires a gain of 100%. If you are a little pessimistic and assume an 8% average return from stocks, that will take 9 years. If you think 10% sounds right, then it will take about 7 1/2 years.
There is a powerful psychology of denial that affects many people, personal finance columnists at national newspapers included. The numbers on the 401(k) statement in early 2007 just seemed so real and substantial that it is hard to acknowledge that today's much lower numbers are just as real. People tend to expect a V pattern in stock prices, that a few really bad years are inevitably followed by a few really good years.
The stock market doesn't work that way. It can't. It's like a law of nature. The market cannot let itself be so easily predicted. Knowing what happened one year tells you (almost) nothing about what will happen the next. Since 1871 the stock market (as measured by the S&P 500) has had 38 down years. Excluding this year, the average return the year after losing money is +11.63%. The S&P has also gained more than 20% in a year 38 times. The average return in years following big gains is +12.27%.
There is obvious incredulity in the question "buy and hold -- for decades?" But the straightforward answer is "Yes, of course." Did you think that you could guarantee fat stock market returns if you were willing to stick it out for five or ten years? You can't, and that's something that all stock market investors, and all Wall Street Journal columnists, need to know.
Wednesday, February 25, 2009
Amex Paying Customers $300 to Go Away
There's much buzz in the blogosphere (e.g. here, here, and here) about the latest from American Express. They have offered certain of their customers $300 if they will close and pay off their credit card accounts by April 30. (Are there other businesses that will pay me not to do business with them? I could use the money.)
What is going on here? Amex is letting the accounting tail wag the business dog. They feel pressure to reduce their book of consumer debt. Investors are very worried about financial companies that are overly leveraged with too many (possibly bad) loans to consumers. Bribing some customers to beat it addresses this problem because it will reduce both the total that Amex is owed and the total that its customers could borrow. Amex may also be targeting customers with low credit scores or other characteristics of which investors are particularly leery.
Does this make good business sense? Not even close. Imagine separating credit card customers into two categories. Group A is made up of those willing and able to pay off their balance in 60 days in exchange for $300. Those in Group B are either uninterested or unable. Everything else being equal, with which group would you rather continue to do business? Amex has concocted a scheme that efficiently and expensively drops the customers it need not worry about and keeps the ones that might have trouble paying what they owe. Brilliant.
Does this mean that the people who run Amex are idiots? Not necessarily. They are probably acting rationally and making what are, from their point of view, sound economic decisions. Wall Street wants them to improve their balance sheet and will pay them to do this, in the form of a higher stock price and lower borrowing costs. From this, the managers of Amex can do the math and work out that paying some customers, even relatively good ones, to get lost is profitable. The fact that this ought not to be the case, that the markets should not be rewarding Amex for doing something that actually harms itself, does not enter into the calculation.
This scheme may not be the ideal implementation of the lose customers to improve balance sheet strategy, e.g. I have trouble believing that offering everybody the same $300 is optimal, but it's not a sign that the folks at Amex have lost their marbles. It is, however, a sign of the times. We currently live in a world where the appearance of improving a balance sheet outweighs the substance of shrinking a business.
What is going on here? Amex is letting the accounting tail wag the business dog. They feel pressure to reduce their book of consumer debt. Investors are very worried about financial companies that are overly leveraged with too many (possibly bad) loans to consumers. Bribing some customers to beat it addresses this problem because it will reduce both the total that Amex is owed and the total that its customers could borrow. Amex may also be targeting customers with low credit scores or other characteristics of which investors are particularly leery.
Does this make good business sense? Not even close. Imagine separating credit card customers into two categories. Group A is made up of those willing and able to pay off their balance in 60 days in exchange for $300. Those in Group B are either uninterested or unable. Everything else being equal, with which group would you rather continue to do business? Amex has concocted a scheme that efficiently and expensively drops the customers it need not worry about and keeps the ones that might have trouble paying what they owe. Brilliant.
Does this mean that the people who run Amex are idiots? Not necessarily. They are probably acting rationally and making what are, from their point of view, sound economic decisions. Wall Street wants them to improve their balance sheet and will pay them to do this, in the form of a higher stock price and lower borrowing costs. From this, the managers of Amex can do the math and work out that paying some customers, even relatively good ones, to get lost is profitable. The fact that this ought not to be the case, that the markets should not be rewarding Amex for doing something that actually harms itself, does not enter into the calculation.
This scheme may not be the ideal implementation of the lose customers to improve balance sheet strategy, e.g. I have trouble believing that offering everybody the same $300 is optimal, but it's not a sign that the folks at Amex have lost their marbles. It is, however, a sign of the times. We currently live in a world where the appearance of improving a balance sheet outweighs the substance of shrinking a business.
Tuesday, February 24, 2009
Carnival of Everything Money
My post on house prices appears in this weeks' Carnival of Everything Money hosted by The Penny Daily. Obviously, loyal readers of this blog have already read the house prices post and likely printed it out to stick on the door of their refrigerator. But the carnvial contains many other interesting items from other bloggers that even my most devoted fans might enjoy. Go on, give it a try.
Monday, February 23, 2009
More on ETF Fees
I've been meaning to do a follow up on the costs of ETFs vs. open-end index mutual funds. My post from February 5 on why ETFs should probably not be the mainstay of your investment diet has inspired interest (much to my surprise it continues to be one the most popular posts here) and a little bit of controversy.
To summarize what I said three weeks ago, the pecking order of low cost for investors is: open-end index mutual funds (best), ETFs, and then open-end active mutual funds (worst.) You will often see ETFs touted as being low cost, and relative to active funds this is certainly true, but the typical investor will do even better in an old-style index mutual fund.
For a change of pace, I thought I would gather some actual data to make my point. Yahoo Finance has a useful list of the largest ETFs. Let's look at the five biggest, which together account for about a third of all the money in ETFs.
One of the five, at number 3, is a special case, the streetTracks Gold Trust, which strictly speaking is not really an ETF at all. It represents simply the ownership of gold bullion, and Yahoo informs us that it is not registered as an investment company under the 1940 act, which means that it is not a mutual fund. Apparently as a side effect of this, Yahoo does not list an expense ratio for it, so it's not clear what the fees are. I am going to set this one aside, but I cannot resist remarking what a sign of the times it is that gold is in the top 5.
Numbers 1 and 5 are virtually identical S&P 500 ETFs, the giant SPDR Trust (SPY) and the Pepsi to its Coke, the iShares S&P 500 Index (IVV). Yahoo tells us that the expense ratio, i.e. annual fee charged by the manager, for these two is 0.08% and 0.09% respectively. Fidelity has a pretty big S&P 500 fund, the Spartan 500 (FSMKX) which charges 0.10% and, for investments over $100,000, the Spartan Advantage 500 (FSMAX) which charges 0.07%. Even a precision freak like me will concede that all these tiny numbers are practically the same.
Number 2 is the iShares MSCI EAFE Index (EFA) which charges 0.34% in fees. You can get the same thing from the Vanguard Developed Market Index (VDMIX) which charges only 0.22%.
And at number 4 we have the iShares Emerging Markets Index (EEM) which charges an impressive-in-a-bad-way 0.72%. Vanguard will charge you 0.37% for it's Emerging Stock Index Fund (VEIEX) or only 0.25% if you have more than $100,000 in the Admiral version (VEMAX). Note that both Vanguard funds have a 0.25% transaction fee to invest or sell.
So from this sample, based only on management fees, you might conclude that ETFs are mostly the same, or sometimes just a little worse than open-end index mutual funds. But with ETFs, you still have more costs to consider. ETFs trade like stocks, which means that you need to pay money to buy them and sell them. You will pay your broker a commission, you will pay the bid-ask spread, and you will pay both of these things twice, on your way in and your way out. These additional costs (shouldn't be) huge, but they do count and are more than enough to tip the balance in favor of old-school index mutual funds.
As I wrote in the previous post, ETFs do have their role. There are things you can do with them because they are stocks that you cannot do with an open-end fund, such as buy on margin and sell short. And there are some peculiar things that actually are cheaper as, or even available only as, ETFs. Gold might be an example, if only I could work out what that ETF charges. The Nasdaq Composite ETF (QQQQ) is another because there are so few open-end funds that bother tracking it. You might also just enjoy trading your ETFs more than investing in open-end funds. But if you want to know which will, in the long run, make you more money, the answer is open-end mutual funds, not ETFs.
To summarize what I said three weeks ago, the pecking order of low cost for investors is: open-end index mutual funds (best), ETFs, and then open-end active mutual funds (worst.) You will often see ETFs touted as being low cost, and relative to active funds this is certainly true, but the typical investor will do even better in an old-style index mutual fund.
For a change of pace, I thought I would gather some actual data to make my point. Yahoo Finance has a useful list of the largest ETFs. Let's look at the five biggest, which together account for about a third of all the money in ETFs.
One of the five, at number 3, is a special case, the streetTracks Gold Trust, which strictly speaking is not really an ETF at all. It represents simply the ownership of gold bullion, and Yahoo informs us that it is not registered as an investment company under the 1940 act, which means that it is not a mutual fund. Apparently as a side effect of this, Yahoo does not list an expense ratio for it, so it's not clear what the fees are. I am going to set this one aside, but I cannot resist remarking what a sign of the times it is that gold is in the top 5.
Numbers 1 and 5 are virtually identical S&P 500 ETFs, the giant SPDR Trust (SPY) and the Pepsi to its Coke, the iShares S&P 500 Index (IVV). Yahoo tells us that the expense ratio, i.e. annual fee charged by the manager, for these two is 0.08% and 0.09% respectively. Fidelity has a pretty big S&P 500 fund, the Spartan 500 (FSMKX) which charges 0.10% and, for investments over $100,000, the Spartan Advantage 500 (FSMAX) which charges 0.07%. Even a precision freak like me will concede that all these tiny numbers are practically the same.
Number 2 is the iShares MSCI EAFE Index (EFA) which charges 0.34% in fees. You can get the same thing from the Vanguard Developed Market Index (VDMIX) which charges only 0.22%.
And at number 4 we have the iShares Emerging Markets Index (EEM) which charges an impressive-in-a-bad-way 0.72%. Vanguard will charge you 0.37% for it's Emerging Stock Index Fund (VEIEX) or only 0.25% if you have more than $100,000 in the Admiral version (VEMAX). Note that both Vanguard funds have a 0.25% transaction fee to invest or sell.
So from this sample, based only on management fees, you might conclude that ETFs are mostly the same, or sometimes just a little worse than open-end index mutual funds. But with ETFs, you still have more costs to consider. ETFs trade like stocks, which means that you need to pay money to buy them and sell them. You will pay your broker a commission, you will pay the bid-ask spread, and you will pay both of these things twice, on your way in and your way out. These additional costs (shouldn't be) huge, but they do count and are more than enough to tip the balance in favor of old-school index mutual funds.
As I wrote in the previous post, ETFs do have their role. There are things you can do with them because they are stocks that you cannot do with an open-end fund, such as buy on margin and sell short. And there are some peculiar things that actually are cheaper as, or even available only as, ETFs. Gold might be an example, if only I could work out what that ETF charges. The Nasdaq Composite ETF (QQQQ) is another because there are so few open-end funds that bother tracking it. You might also just enjoy trading your ETFs more than investing in open-end funds. But if you want to know which will, in the long run, make you more money, the answer is open-end mutual funds, not ETFs.
Carnival of Personal Finance
My recent post on IRAs is in this week's Carnival of Personal Finance, hosted at Broke Grad Student. The host has included YouTube videos for much needed comic relief. Click and enjoy!
Saturday, February 21, 2009
IRAs: Roth and the Other Kind
Poke around the blogosphere and personal finance punditocracy and you will find lots of positive references to Roth IRAs and virtually no nice things said about its dull older brother, the traditional IRA. If you didn't know any better (and why would you?) you might assume that the younger and hipper Roth IRA was the way to go. After all, it is the cool new thing and the latest in retirement savings technology. Here's a rundown of the differences and why you are likely to want to go with the unhip kind after all.
IRAs come in two basic flavors. There is the traditional old-style IRA, in which you put pre-tax money, i.e. your contributions are tax deductible, and then later in life pay taxes on your withdrawals as if they were income. And there is the relatively newer type, a Roth IRA, in which contributions are post-tax, i.e. not deductible, but withdrawals are tax-free.
Which is for you? Obviously, you want the one that will wind up making you more money. To tee that up, consider the following.
Tom Traditional and Robbie Roth have identical incomes, and so pay identical tax rates, and they both have $3,000 a year of that income that they wish to put in an IRA. Obviously, each picks the type that matches their name, so Tom puts in the full $3,000 each year and Robbie puts in $2,250 after paying taxes of 25%. The years pass, and they make identical investment decisions until they retire on the same day. Tom's account is, of course, larger but he needs to pay 25% taxes on anything he takes out, while Robbie can withdraw tax free. Here's the big question: after Tom pays taxes on his withdrawals, who has more money to spend?
The answer, which seems to surprise a lot of people, is that they have exactly the same amount of money. Assuming the tax rate going into the Roth is the same as the one coming out of the traditional, the financial benefit of the accounts is exactly the same. Fire up Excel and run the numbers yourself if you don't believe me.
So why do the advocates of saving seem to universally prefer Roths? It's not about numbers, it's about conceptual appeal. Saving is about sacrificing now for a benefit in the far-off future. With a Roth, you pay taxes now so you can not pay taxes later, and that has a big attraction to the savings crowd.
Symbolism aside, there are good reasons to choose one type of IRA over the other. Primarily, which one is better depends on the tax rate you pay now and the one you will pay when you are retired. Tom and Robbie came out equal because they always paid 25%. If the tax rate had been 25% when working but only 15% during retirement, then Tom would have wound up ahead because he would avoid the 25% and only pay 15%. Conversely, if the rates were 25% while working and 35% when retired, then Robbie would be better off.
Occasionally you see the pro-Roth argument that given the fiscal problems the government has now and is likely to have in the future, tax rates will inevitably rise. That sounds perfectly reasonable, but it is worth reflecting that the same thing could have been said for the past 30 years and so far it's been wrong. Predictions of what Congress will do in future decades is hardly a sound basis for your retirement planning.
On the other hand, predictions of how much money you will be making in retirement, and so which tax bracket you will be in, are more practical. If you have a Roth, you are betting that your income, and your tax rate, will be higher in retirement than it is now. That's some bet. (You do understand that in retirement you won't have a job, don't you?) Furthermore, choosing a Roth over a traditional is doubling down the bet on your own future prosperity. If you wind up being a rich retiree, you'll be happy you have a Roth because you won't pay high taxes on the withdrawals. But if you wind up a poor oldster you'll wish you'd picked traditional, because you'd have more money, even after paying the (lower) income taxes on what you take out.
There are other factors to consider when choosing between the two types of IRA. (There's a nice rundown here and here.) But they are all secondary to the tax rate issue and some of them are pretty esoteric. In the big picture, what matters are tax rates now and when retired. And for many, if not most, people that means that an old-school traditional IRA is a better choice, even if it lacks hipness and the frugal appeal of paying more now for a benefit far in the future.
IRAs come in two basic flavors. There is the traditional old-style IRA, in which you put pre-tax money, i.e. your contributions are tax deductible, and then later in life pay taxes on your withdrawals as if they were income. And there is the relatively newer type, a Roth IRA, in which contributions are post-tax, i.e. not deductible, but withdrawals are tax-free.
Which is for you? Obviously, you want the one that will wind up making you more money. To tee that up, consider the following.
Tom Traditional and Robbie Roth have identical incomes, and so pay identical tax rates, and they both have $3,000 a year of that income that they wish to put in an IRA. Obviously, each picks the type that matches their name, so Tom puts in the full $3,000 each year and Robbie puts in $2,250 after paying taxes of 25%. The years pass, and they make identical investment decisions until they retire on the same day. Tom's account is, of course, larger but he needs to pay 25% taxes on anything he takes out, while Robbie can withdraw tax free. Here's the big question: after Tom pays taxes on his withdrawals, who has more money to spend?
The answer, which seems to surprise a lot of people, is that they have exactly the same amount of money. Assuming the tax rate going into the Roth is the same as the one coming out of the traditional, the financial benefit of the accounts is exactly the same. Fire up Excel and run the numbers yourself if you don't believe me.
So why do the advocates of saving seem to universally prefer Roths? It's not about numbers, it's about conceptual appeal. Saving is about sacrificing now for a benefit in the far-off future. With a Roth, you pay taxes now so you can not pay taxes later, and that has a big attraction to the savings crowd.
Symbolism aside, there are good reasons to choose one type of IRA over the other. Primarily, which one is better depends on the tax rate you pay now and the one you will pay when you are retired. Tom and Robbie came out equal because they always paid 25%. If the tax rate had been 25% when working but only 15% during retirement, then Tom would have wound up ahead because he would avoid the 25% and only pay 15%. Conversely, if the rates were 25% while working and 35% when retired, then Robbie would be better off.
Occasionally you see the pro-Roth argument that given the fiscal problems the government has now and is likely to have in the future, tax rates will inevitably rise. That sounds perfectly reasonable, but it is worth reflecting that the same thing could have been said for the past 30 years and so far it's been wrong. Predictions of what Congress will do in future decades is hardly a sound basis for your retirement planning.
On the other hand, predictions of how much money you will be making in retirement, and so which tax bracket you will be in, are more practical. If you have a Roth, you are betting that your income, and your tax rate, will be higher in retirement than it is now. That's some bet. (You do understand that in retirement you won't have a job, don't you?) Furthermore, choosing a Roth over a traditional is doubling down the bet on your own future prosperity. If you wind up being a rich retiree, you'll be happy you have a Roth because you won't pay high taxes on the withdrawals. But if you wind up a poor oldster you'll wish you'd picked traditional, because you'd have more money, even after paying the (lower) income taxes on what you take out.
There are other factors to consider when choosing between the two types of IRA. (There's a nice rundown here and here.) But they are all secondary to the tax rate issue and some of them are pretty esoteric. In the big picture, what matters are tax rates now and when retired. And for many, if not most, people that means that an old-school traditional IRA is a better choice, even if it lacks hipness and the frugal appeal of paying more now for a benefit far in the future.
Friday, February 20, 2009
Yet Another Excellent Carnival
The premier edition of The Carnival of Government & Money features my educational (and only slightly dated) post on how big the stimulus package really is. It's hosted at the brilliantly named blog Spilling Buckets. Government workers might not enjoy it, but everybody else will.
Frugal Friday Feb. 20
It's that time again! Here is this week's highlights from the Frugalosphere.
Lots of questions, sublime and mundane, were asked and mostly answered this week. Lazy Man and Money asked if wine tasting was a frugal hobby. Why, yes, it is. Wine drinking, on the other hand, could set you back a few dollars. Free Money Finance asked Should Christians Have Life Insurance? Again the answer is yes, provided you do not buy more than you need, which apparently raises thorny theological issues. (Possible follow-up posts: Should Muslims Drive Volvos? Should Jews Own a Tivo?)
Speaking of Frugal Dad, this week he has an insightful post on how to save money at sporting events. There are five tips, but they boil down to a) smuggling in your own food and drink, which is strictly forbidden at most venues or b) watching the game on TV at home.
Rounding out the week's frugal posts, and questions, our old friend Almost Frugal (Y'know, the one in the French Alps) asked on Wednesday Is a Broken Dishwasher an Emergency? It seems that her dishwasher gave up the ghost and instead of spending 400 Euros of her emergency fund, she plans to just do the dishes for her family by hand. At last count there were 31 comments on the post, nearly of all of which patted her on the back for her brilliant money saving decision. But none of them quantified her savings, which I, as a trained professional, am happy to do for you here.
Assuming that the 400 Euros earn 5% interest (a generous assumption, but this is the land of the 35 hour work week, so anything is possible) then the money she is not spending on a dishwasher is earning 20 Euros a year. And that works out to becoming richer by almost 5.5 Eurocents (or 7 of our US cents) every day! 7 cents just to do the dishes for a family of five? Where do I sign up?
I would post my calculations as comment #32, but due to context sensitive advertising, the blog post is accompanied by about a dozen ads for new dishwashers. That's like a brewer sponsoring an AA meeting, and I will have none of it.
Lots of questions, sublime and mundane, were asked and mostly answered this week. Lazy Man and Money asked if wine tasting was a frugal hobby. Why, yes, it is. Wine drinking, on the other hand, could set you back a few dollars. Free Money Finance asked Should Christians Have Life Insurance? Again the answer is yes, provided you do not buy more than you need, which apparently raises thorny theological issues. (Possible follow-up posts: Should Muslims Drive Volvos? Should Jews Own a Tivo?)
I am not sure how I missed it last week, but here is one last Valentine's Day tip from The Frugal Duchess. Instead of purchasing new cards every year, why not exchange old ones with your spouse? (Husbands note: according to the Duchess, an actual female, this is "romantic.") Ideally, a couple could swap the same two cards every February 14th for decades.
Ever the one to court controversy, Bargaineering makes the argument in favor of homemade laundry detergent. This is in response to Frugal Dad's heretical post in which he said that homemade detergent was "not for us" and asked "is it really worth the few dollars saved?" Bargaineering helpfully includes a recipe (washing soda, baking soda, borax, and, of all things, soap) for the adherents to the Frugal True Faith.
Speaking of Frugal Dad, this week he has an insightful post on how to save money at sporting events. There are five tips, but they boil down to a) smuggling in your own food and drink, which is strictly forbidden at most venues or b) watching the game on TV at home.
Rounding out the week's frugal posts, and questions, our old friend Almost Frugal (Y'know, the one in the French Alps) asked on Wednesday Is a Broken Dishwasher an Emergency? It seems that her dishwasher gave up the ghost and instead of spending 400 Euros of her emergency fund, she plans to just do the dishes for her family by hand. At last count there were 31 comments on the post, nearly of all of which patted her on the back for her brilliant money saving decision. But none of them quantified her savings, which I, as a trained professional, am happy to do for you here.
Assuming that the 400 Euros earn 5% interest (a generous assumption, but this is the land of the 35 hour work week, so anything is possible) then the money she is not spending on a dishwasher is earning 20 Euros a year. And that works out to becoming richer by almost 5.5 Eurocents (or 7 of our US cents) every day! 7 cents just to do the dishes for a family of five? Where do I sign up?
I would post my calculations as comment #32, but due to context sensitive advertising, the blog post is accompanied by about a dozen ads for new dishwashers. That's like a brewer sponsoring an AA meeting, and I will have none of it.
Thursday, February 19, 2009
House Prices: The Long View
There was an interesting post at Debit vs. Credit two days ago suggesting that now may not be the time to buy a house. The gist of the argument was that house prices still have a way to go before they return to normal. This was illustrated with a chart of median new home prices as a ratio to median income since 1963. That's not the most ideal set of data to use, for reasons that I will spare you.
The most useful measure of house prices are the S&P/Case-Shiller Home Price Indices. They only go back to 1987, but one of the co-inventors of the index, Robert Shiller, has chained together other useful house indexes to patch up a composite going back to 1890. (This is the third post that has mentioned Prof. Shiller in the past month. Just coincidence, I swear.)
I downloaded the data from his site, updated and cleaned up a few things, and produced the following chart, showing the inflation-adjusted sale price index for existing homes since 1890.
If you've never seen something like this before, you may be experiencing some shock and confusion. This is normal. Just keep breathing deeply. You thought house prices went up over time, didn't you? Well, they do, but mostly because of inflation. Recent experience excepted, house prices are generally flat over long periods of time once inflation is factored out.
A few other observations worth making:
1) The last index value in this chart (which is for November 2008) is 144.0, still 13% higher than the 1989 peak of 127.4. That does suggest that we have a little more to go, or at least did as of November. On the other hand, it's already down 40% from the 2005 peak of 202.5, so the worst may be behind us.
2) The recent run-up in house prices actually began in 1996. (From 1996 to 2005 real prices went up 86%.) It may not have gotten weird enough to be noticed in the media until the last years of the boom, but the index began hitting all-time highs as early as 2000. I mention this because it's currently fashionable to blame the low interest rates of 2003-04 for the housing bubble. They sure didn't help, but the worst you can say is that they were gasoline thrown on an already blazing fire.
3) As impressive as the 1996-2005 run up is, it is not entirely out of the ordinary. From 1942 to 1947, real house prices went up 60%, which is the best five year run in history. Further, prices pretty much stabilized after that and did not give back very much of the gain. This needs to be pointed out to those who say, in hindsight, that of course house prices had to fall after 2005, because the rapid gains made in years before were just unsustainable.
So is this a good time to buy a house? That depends. Do you need one to live in? There are many factors to consider, including interest rates, tax breaks and other incentives from the government, and local market conditions. (It is worth stating the possibly obvious that the chart above is a national average. Specifics of a particular area may differ both in the short and long run.)
But if you are looking at a house as a possibly shrewd investment, something you can buy cheap now and sell dear later on, you are likely to be disappointed. Even if the crisis were over today, and house prices returned to their pre-bubble habits, the normal state of things is that they don't go up very much.
The most useful measure of house prices are the S&P/Case-Shiller Home Price Indices. They only go back to 1987, but one of the co-inventors of the index, Robert Shiller, has chained together other useful house indexes to patch up a composite going back to 1890. (This is the third post that has mentioned Prof. Shiller in the past month. Just coincidence, I swear.)
I downloaded the data from his site, updated and cleaned up a few things, and produced the following chart, showing the inflation-adjusted sale price index for existing homes since 1890.
If you've never seen something like this before, you may be experiencing some shock and confusion. This is normal. Just keep breathing deeply. You thought house prices went up over time, didn't you? Well, they do, but mostly because of inflation. Recent experience excepted, house prices are generally flat over long periods of time once inflation is factored out.
A few other observations worth making:
1) The last index value in this chart (which is for November 2008) is 144.0, still 13% higher than the 1989 peak of 127.4. That does suggest that we have a little more to go, or at least did as of November. On the other hand, it's already down 40% from the 2005 peak of 202.5, so the worst may be behind us.
2) The recent run-up in house prices actually began in 1996. (From 1996 to 2005 real prices went up 86%.) It may not have gotten weird enough to be noticed in the media until the last years of the boom, but the index began hitting all-time highs as early as 2000. I mention this because it's currently fashionable to blame the low interest rates of 2003-04 for the housing bubble. They sure didn't help, but the worst you can say is that they were gasoline thrown on an already blazing fire.
3) As impressive as the 1996-2005 run up is, it is not entirely out of the ordinary. From 1942 to 1947, real house prices went up 60%, which is the best five year run in history. Further, prices pretty much stabilized after that and did not give back very much of the gain. This needs to be pointed out to those who say, in hindsight, that of course house prices had to fall after 2005, because the rapid gains made in years before were just unsustainable.
So is this a good time to buy a house? That depends. Do you need one to live in? There are many factors to consider, including interest rates, tax breaks and other incentives from the government, and local market conditions. (It is worth stating the possibly obvious that the chart above is a national average. Specifics of a particular area may differ both in the short and long run.)
But if you are looking at a house as a possibly shrewd investment, something you can buy cheap now and sell dear later on, you are likely to be disappointed. Even if the crisis were over today, and house prices returned to their pre-bubble habits, the normal state of things is that they don't go up very much.
Wednesday, February 18, 2009
Suze Orman's 2009 Action Plan, Part 2
[This is the second part of a two part review of Suze Orman's 2009 Action Plan. If you haven't already, you might want to read Part 1 first.]
In general, Suze Orman’s lack of candor can only be inferred from the advice she gives. For example, at several points in 2009 Action Plan she brings up the idea taking out loans from a 401(k) plan and using the proceeds to, for example, pay down other debt. (For the uninitiated, a loan from a 401(k) plan is just what it sounds like. You allocate some of your 401(k) account to a loan to yourself, which you pay back with interest.) In every case she is firm in her rejection of the idea, even to pay off credit card debt charging 32% interest (p. 59.)
On its face this advice is nuts. Taking out a loan from your 401(k) frivolously, to go on a cruise perhaps, is clearly a poor idea. But within the realm of debt a 401(k) loan is almost certainly the best deal going and using it to pay off a loan with a Tony Soprano interest rate is just about as clear a no-brainer as you can find in personal finance.
So why does Suze Orman wave you off this strategy? Is she nuts? She gives the feeble explanation that in these uncertain times the risk of losing your job, which might mean the loan would be due in 60 days, is too great. That would be a lot more convincing if she did not, in the two ”situations” that immediately follow, discuss withdrawing funds from your retirement accounts for living expenses if you become unemployed.
Reading between the lines, the real reason Orman thinks this is a bad idea becomes clear. She thinks that if you take out the loan and pay off the credit card it will only be a matter of time before you run up the credit card balance again, leaving you with both a large credit card debt and a loan from your 401(k) to pay off. She’s not nuts. She thinks you are. But she can’t say that. So she tells a little white lie and moves on.
Very similarly, she calls using a HELOC (Home Equity Line of Credit, or a second mortgage) to pay off credit card debt “a dangerous mistake. You are putting your house at risk.” (p. 30.) That’s a common bit of folk wisdom, but it’s wrong. Short of bankruptcy, you are going to have to pay back all the money you owe sooner or later, and it would be helpful if the debt had a lower interest rate in the meantime. If you do go bankrupt, you may or may not be able to keep your house (and if you do it will be without much equity) but whether the debt in question was a second mortgage or unsecured loan will not change the outcome. Again, Orman gives the advice she does because she assumes you have a serious willpower problem. If you refinance your credit card with cheaper debt you will only start spending even more and dig the hole deeper.
Do all of Orman’s millions of readers have that sort of psychological dysfunction? For all I know, they do. She certainly has a devoted following who apparently find her advice useful. Even so, I would be a lot happier if somewhere near the beginning of her books she said something like “this book isn’t for everybody” and explained the sort of self-destructive behaviors her work was meant to address. Like they say, the first step is admitting you have problem. But Suze Orman admits nothing. She is like the wife of the compulsive gambler who tells her husband she doesn’t want to visit Las Vegas because she doesn’t like the desert climate. While preaching the importance of honesty and being realistic about your finances, she gives advice that is, in fact, an elaborate and disguised work-around to compensate for her readers’ presumed shortcomings.
Suze Orman’s 2009 Action Plan ends with the platitude that you should “always choose to do what is right, not what is easy.” Sometimes what is right is hard and uncomfortable. It might be hard to hear that your favorite money guru occasionally gives bad advice or that you are acting irrationally, but if it is the truth, it needs to be said. Like the lady says “The lies need to stop.”
In general, Suze Orman’s lack of candor can only be inferred from the advice she gives. For example, at several points in 2009 Action Plan she brings up the idea taking out loans from a 401(k) plan and using the proceeds to, for example, pay down other debt. (For the uninitiated, a loan from a 401(k) plan is just what it sounds like. You allocate some of your 401(k) account to a loan to yourself, which you pay back with interest.) In every case she is firm in her rejection of the idea, even to pay off credit card debt charging 32% interest (p. 59.)
On its face this advice is nuts. Taking out a loan from your 401(k) frivolously, to go on a cruise perhaps, is clearly a poor idea. But within the realm of debt a 401(k) loan is almost certainly the best deal going and using it to pay off a loan with a Tony Soprano interest rate is just about as clear a no-brainer as you can find in personal finance.
So why does Suze Orman wave you off this strategy? Is she nuts? She gives the feeble explanation that in these uncertain times the risk of losing your job, which might mean the loan would be due in 60 days, is too great. That would be a lot more convincing if she did not, in the two ”situations” that immediately follow, discuss withdrawing funds from your retirement accounts for living expenses if you become unemployed.
Reading between the lines, the real reason Orman thinks this is a bad idea becomes clear. She thinks that if you take out the loan and pay off the credit card it will only be a matter of time before you run up the credit card balance again, leaving you with both a large credit card debt and a loan from your 401(k) to pay off. She’s not nuts. She thinks you are. But she can’t say that. So she tells a little white lie and moves on.
Very similarly, she calls using a HELOC (Home Equity Line of Credit, or a second mortgage) to pay off credit card debt “a dangerous mistake. You are putting your house at risk.” (p. 30.) That’s a common bit of folk wisdom, but it’s wrong. Short of bankruptcy, you are going to have to pay back all the money you owe sooner or later, and it would be helpful if the debt had a lower interest rate in the meantime. If you do go bankrupt, you may or may not be able to keep your house (and if you do it will be without much equity) but whether the debt in question was a second mortgage or unsecured loan will not change the outcome. Again, Orman gives the advice she does because she assumes you have a serious willpower problem. If you refinance your credit card with cheaper debt you will only start spending even more and dig the hole deeper.
Do all of Orman’s millions of readers have that sort of psychological dysfunction? For all I know, they do. She certainly has a devoted following who apparently find her advice useful. Even so, I would be a lot happier if somewhere near the beginning of her books she said something like “this book isn’t for everybody” and explained the sort of self-destructive behaviors her work was meant to address. Like they say, the first step is admitting you have problem. But Suze Orman admits nothing. She is like the wife of the compulsive gambler who tells her husband she doesn’t want to visit Las Vegas because she doesn’t like the desert climate. While preaching the importance of honesty and being realistic about your finances, she gives advice that is, in fact, an elaborate and disguised work-around to compensate for her readers’ presumed shortcomings.
Suze Orman’s 2009 Action Plan ends with the platitude that you should “always choose to do what is right, not what is easy.” Sometimes what is right is hard and uncomfortable. It might be hard to hear that your favorite money guru occasionally gives bad advice or that you are acting irrationally, but if it is the truth, it needs to be said. Like the lady says “The lies need to stop.”
Tuesday, February 17, 2009
Oh Those Wacky Rich People
For those of you who do not spend your waking hours prowling the blogs and newspapers (e.g. those of you with jobs) I thought I would summarize what I have learned lately.
1) The rich people who (used to) work on Wall Street are morons. Completely incompetent. All of them. "These people are idiots." says Claire McCaskill, and she's a senator, so she knows about groups of idiots.
2) Until recently, the idiots who worked on Wall Street, who most Americans associated only with making great piles of money without apparently doing anything useful, were nevertheless loved and trusted by all. There was never any envy or animosity. All that has changed now. "America doesn't trust you anymore." said Rep. Mike Capuano (D - MA) to a panel of Wall Street CEOs. And members of congress know a thing or two about not being trusted by America.
3) The really rich people who (used to) run Wall Street are particularly clueless. For years, they paid thousands of somewhat less rich people more than a million dollars a year because it amused them. Sorta like how some babies like watching mobiles. Obviously (see #1) there was nothing special about these workers, so they could have paid them a lot less. Now that the government is in charge, these banks will be run to maximize profit, so they will no longer pay anybody more than $500K a year. That's not a bad salary for an idiot. Believe me, I know. It's not like these people could just walk out and spin money for another employer or start a hedge fund or something. They're idiots.
4) In these stressful times, comic relief is important for all of us, and what could be funnier than laughing at idiots? The New York Times has been making the most of this, with articles and opinion pieces that maximize the Wall Street idiot hilarity. Two weeks ago it was a side-splitting piece about how hard it is to live on $500K in NYC. Today we get one on what happens when the "Rituals of the Rich Meet the Realities of the Economy." It turns out that those idiots indulge in such obscure rites as having their so-called "suits" put through a process called "dry cleaning." Apparently, they still practice this behavior, but less often, much to the relief of the staff at Manhattan dry cleaners, who now have more time for reading and other hobbies.
5) Meanwhile, rich people outside Manhattan continue to reaffirm our faith in their judgement. A British bank, Barclays (not one cent of TARP money!) has introduced a Visa Black Card. For a modest $495 a year a person carrying this card will not only be able to buy all those things that a Visa card can buy, but will also get "24-Hour Concierge Service." And the card itself is made of a carbon graphite substance, meaning it's not mere plastic but really expensive plastic.
1) The rich people who (used to) work on Wall Street are morons. Completely incompetent. All of them. "These people are idiots." says Claire McCaskill, and she's a senator, so she knows about groups of idiots.
2) Until recently, the idiots who worked on Wall Street, who most Americans associated only with making great piles of money without apparently doing anything useful, were nevertheless loved and trusted by all. There was never any envy or animosity. All that has changed now. "America doesn't trust you anymore." said Rep. Mike Capuano (D - MA) to a panel of Wall Street CEOs. And members of congress know a thing or two about not being trusted by America.
3) The really rich people who (used to) run Wall Street are particularly clueless. For years, they paid thousands of somewhat less rich people more than a million dollars a year because it amused them. Sorta like how some babies like watching mobiles. Obviously (see #1) there was nothing special about these workers, so they could have paid them a lot less. Now that the government is in charge, these banks will be run to maximize profit, so they will no longer pay anybody more than $500K a year. That's not a bad salary for an idiot. Believe me, I know. It's not like these people could just walk out and spin money for another employer or start a hedge fund or something. They're idiots.
4) In these stressful times, comic relief is important for all of us, and what could be funnier than laughing at idiots? The New York Times has been making the most of this, with articles and opinion pieces that maximize the Wall Street idiot hilarity. Two weeks ago it was a side-splitting piece about how hard it is to live on $500K in NYC. Today we get one on what happens when the "Rituals of the Rich Meet the Realities of the Economy." It turns out that those idiots indulge in such obscure rites as having their so-called "suits" put through a process called "dry cleaning." Apparently, they still practice this behavior, but less often, much to the relief of the staff at Manhattan dry cleaners, who now have more time for reading and other hobbies.
5) Meanwhile, rich people outside Manhattan continue to reaffirm our faith in their judgement. A British bank, Barclays (not one cent of TARP money!) has introduced a Visa Black Card. For a modest $495 a year a person carrying this card will not only be able to buy all those things that a Visa card can buy, but will also get "24-Hour Concierge Service." And the card itself is made of a carbon graphite substance, meaning it's not mere plastic but really expensive plastic.
Monday, February 16, 2009
Suze Orman's 2009 Action Plan, Part 1
I have only respect and contempt for Suze Orman.
On the positive side, it would be hard not to admire Orman’s talent and achievements. She is undoubtedly the most effective and popular personal finance guru in America today. Suze Orman’s 2009 Action Plan is her seventh consecutive New York Times bestseller. She has won two Emmys. Last year Time named her one of the 100 most influential people in the world. To put that last achievement in perspective, consider that the Pope did not make the cut.
Alas, this highly tuned and powerful machine is used to bring her vast audience fairly mediocre and amateurish advice. At best, what Orman tells her readers and viewers is pedestrian and obvious. At other times it is dangerously specific, assuming unstated facts about the reader’s situation. And once in a while it is just plain wrong. But wasting her abilities with weak content is not the chief reason I have contempt for her. She also has a righteous new-age shtick about courage and honesty which is not only grating, it is hypocritical.
Suze Orman’s 2009 Action Plan is her reaction to the current economic crisis. (Of course, given its success, I would expect an Action Plan to appear annually every January from now on, crisis or no.) It is one of many quickie books on similar themes that have appeared in the last few months. Orman’s was finished on November 19, 2008 and on bookshelves as a paperback by mid-January 2009. As would be expected, it is not very long and lacks much in the way of a coherent organization. The great majority of the book is in the form of an extended FAQ, with “situations” that could have easily been phrased as readers’ questions followed by short answers or “actions.”
The slim volume does contain a few longish bits of advice and explanation. One of these is the second chapter of the book, entitled “A Brief History of How We Got Here.” It is not merely brief (11 pages) but shallow as well, what you might expect from a bright high school student asked to summarize the economic situation based on accounts taken from one of our nation’s lesser tabloids. Admittedly, Wall Street and the economy are not Suze Orman’s fields of expertise, but this section betrays a remarkable lack of knowledge about how indeed we got here.
For example, Orman explains that in reaction to the low interest rates of the middle of this decade, the “too-smart-for-their-own-good minds of the financial sector” “bundled the prime and sub-prime mortgages into one investment, called a Credit Default Obligation (CDO).” Actually, CDO stands for Collateralized Debt Obligation, prime and sub-prime mortgages are generally segregated (not that that helped) and CDOs became the standard method for structuring mortgage bonds twenty five years ago. How CDOs were invented is described entertainingly in Michael Lewis’ bestseller Liar’s Poker (1989) which until recently I had thought everybody involved in finance and over the age of 40 had read.
The Orman view on what went wrong in the global economy begins and ends with American house prices and mortgages. That is like blaming a warehouse fire on faulty wiring without mentioning that the building was full of fireworks and that the sprinkler system failed. But no matter. 2009 Action Plan is for consumers, so limiting the explanation of what went wrong to consumer-oriented factors is not the worst thing imaginable. Orman ends the chapter by summing up that “the mortgage crisis is the most vivid example of how dishonesty and greed leads to financial destruction” and exhorts her readers to become honest with themselves about their own finances.
That’s a sentiment with which it is certainly hard to disagree. Truth and candor is a recurring theme of Suze Orman’s, both in this book and elsewhere. It would be much more convincing if Orman was herself more honest about how her advice about houses has changed over the past few years.
2009 Action Plan tepidly endorses buying a house, saying that “over time a home can be one of the most satisfying investments you can make” (p. 147) and clarifies that your house “will, on average, rise in value at a pace that is only one percentage point above inflation.” (p. 154.) I have no objection to either of those points, but isn’t this the same Suze Orman who called home buying “one of the best known investments” (The Laws of Money, 2003 & 2004, p.131) just a few years ago? In 2009 Action Plan Orman is repeatedly strident about not taking out a loan from your 401(k) or tapping your IRA for any reason short of dire emergency, and yet in The Courage to Be Rich (1999 & 2002) she suggests doing both to raise money for a house down payment (p. 223.) In 2009 Action Plan Orman condemns adjustable rate mortgages and says that a 30 year fixed is a “requirement” for home buyers (p. 148.) In The Courage to Be Rich she discusses both flavors of mortgage favorably and lists reasons you might be better off with an ARM. (p. 254.)
There is no shame in having been much more enthusiastic about houses a few years ago. As far as I can tell, all personal finance writers urged their readers to buy houses in the Good Old Days, and Suze Orman was actually more cautionary than most. And circumstances have indeed changed in the meantime. But for a person who lectures continually about the importance of honesty and speaking the truth about money, would it be too much to expect a modest mea culpa? Wouldn’t her criticism of the “dishonesty” of those who borrowed too much to buy more house than they could afford be more persuasive if she conceded that the chorus of personal finance advisers, Suze Orman included, egged them on?
[Click to the second half of this review here.]
On the positive side, it would be hard not to admire Orman’s talent and achievements. She is undoubtedly the most effective and popular personal finance guru in America today. Suze Orman’s 2009 Action Plan is her seventh consecutive New York Times bestseller. She has won two Emmys. Last year Time named her one of the 100 most influential people in the world. To put that last achievement in perspective, consider that the Pope did not make the cut.
Alas, this highly tuned and powerful machine is used to bring her vast audience fairly mediocre and amateurish advice. At best, what Orman tells her readers and viewers is pedestrian and obvious. At other times it is dangerously specific, assuming unstated facts about the reader’s situation. And once in a while it is just plain wrong. But wasting her abilities with weak content is not the chief reason I have contempt for her. She also has a righteous new-age shtick about courage and honesty which is not only grating, it is hypocritical.
Suze Orman’s 2009 Action Plan is her reaction to the current economic crisis. (Of course, given its success, I would expect an Action Plan to appear annually every January from now on, crisis or no.) It is one of many quickie books on similar themes that have appeared in the last few months. Orman’s was finished on November 19, 2008 and on bookshelves as a paperback by mid-January 2009. As would be expected, it is not very long and lacks much in the way of a coherent organization. The great majority of the book is in the form of an extended FAQ, with “situations” that could have easily been phrased as readers’ questions followed by short answers or “actions.”
The slim volume does contain a few longish bits of advice and explanation. One of these is the second chapter of the book, entitled “A Brief History of How We Got Here.” It is not merely brief (11 pages) but shallow as well, what you might expect from a bright high school student asked to summarize the economic situation based on accounts taken from one of our nation’s lesser tabloids. Admittedly, Wall Street and the economy are not Suze Orman’s fields of expertise, but this section betrays a remarkable lack of knowledge about how indeed we got here.
For example, Orman explains that in reaction to the low interest rates of the middle of this decade, the “too-smart-for-their-own-good minds of the financial sector” “bundled the prime and sub-prime mortgages into one investment, called a Credit Default Obligation (CDO).” Actually, CDO stands for Collateralized Debt Obligation, prime and sub-prime mortgages are generally segregated (not that that helped) and CDOs became the standard method for structuring mortgage bonds twenty five years ago. How CDOs were invented is described entertainingly in Michael Lewis’ bestseller Liar’s Poker (1989) which until recently I had thought everybody involved in finance and over the age of 40 had read.
The Orman view on what went wrong in the global economy begins and ends with American house prices and mortgages. That is like blaming a warehouse fire on faulty wiring without mentioning that the building was full of fireworks and that the sprinkler system failed. But no matter. 2009 Action Plan is for consumers, so limiting the explanation of what went wrong to consumer-oriented factors is not the worst thing imaginable. Orman ends the chapter by summing up that “the mortgage crisis is the most vivid example of how dishonesty and greed leads to financial destruction” and exhorts her readers to become honest with themselves about their own finances.
That’s a sentiment with which it is certainly hard to disagree. Truth and candor is a recurring theme of Suze Orman’s, both in this book and elsewhere. It would be much more convincing if Orman was herself more honest about how her advice about houses has changed over the past few years.
2009 Action Plan tepidly endorses buying a house, saying that “over time a home can be one of the most satisfying investments you can make” (p. 147) and clarifies that your house “will, on average, rise in value at a pace that is only one percentage point above inflation.” (p. 154.) I have no objection to either of those points, but isn’t this the same Suze Orman who called home buying “one of the best known investments” (The Laws of Money, 2003 & 2004, p.131) just a few years ago? In 2009 Action Plan Orman is repeatedly strident about not taking out a loan from your 401(k) or tapping your IRA for any reason short of dire emergency, and yet in The Courage to Be Rich (1999 & 2002) she suggests doing both to raise money for a house down payment (p. 223.) In 2009 Action Plan Orman condemns adjustable rate mortgages and says that a 30 year fixed is a “requirement” for home buyers (p. 148.) In The Courage to Be Rich she discusses both flavors of mortgage favorably and lists reasons you might be better off with an ARM. (p. 254.)
There is no shame in having been much more enthusiastic about houses a few years ago. As far as I can tell, all personal finance writers urged their readers to buy houses in the Good Old Days, and Suze Orman was actually more cautionary than most. And circumstances have indeed changed in the meantime. But for a person who lectures continually about the importance of honesty and speaking the truth about money, would it be too much to expect a modest mea culpa? Wouldn’t her criticism of the “dishonesty” of those who borrowed too much to buy more house than they could afford be more persuasive if she conceded that the chorus of personal finance advisers, Suze Orman included, egged them on?
[Click to the second half of this review here.]
Saturday, February 14, 2009
What to Expect from the Stock Market
Just about all mainstream personal finance writers advise making stocks the centerpiece of your investment plan. Most will quote a reassuring average market return over a reassuringly long period and make the argument that for sober long-term investors such as yourself, stocks are the place to be. But few writers explain what that long term average return really means and what expectations you should draw from it.
The first thing to understand is that you cannot expect to actually get that average return in any given year. Get Rich Slowly has a guest post by Carl Richards that patiently makes this point with the use of an elaborate animated presentation. His data has an average return of 10% over eighty years and shows that only twice in that time did the actual market return for a year fall between 9% and 11%. I would hope that this is a nearly obvious point to all stock market investors, but I know better.
Moreover, I worry that by saying that the market has good years and bad ones, but that the long run average is high, people are led to believe that as long as they can stick it out through the ups and downs, after twenty years or so they will get the promised average return. This is not necessarily so. Those long run averages are not that much more predictable than individual years.
To illustrate, I will run some numbers of my own. Yale's Robert Shiller has a website with the S&P 500 index returns annually back to 1871 as well as some other useful stuff such as inflation rates. It turns out that, sure enough, the average return for the US stock market, as measured by the S&P 500, was 10.08% per year over the 138 years from 1871 to 2008 inclusive.
What do we know from this? We know that funds invested in the market on December 31, 1870 and held through December 31, 2008 would have made an average of 10.08% a year. We do not know what the average returns for the next 138 years will be. 10.08% is a pretty solid guess, and in fact is almost certainly the best guess we've got, but it's still just a guess. There is no "true" expected stock market return, even over long periods of time. Setting market return expectations is not science, just thoughtful estimation based on what has happened in the past.
To get a better feel for how volatile even long term averages can be, consider the 80 year period that Richards uses. The 80 year average return for the period ending in 2007 was 11.52%. But move it forward a year to end in 2008 and you get only 10.46%. That is a big difference considering those two periods are 98.75% identical.
And 80 years is a lot longer than the typical person will be invested in the stock market. For most, there is a critical twenty years or so from middle age to retirement when the nest egg does or doesn't grow. And the returns for twenty year periods are all over the place.
As it happens, the best twenty year period in the stock market since 1871 was recent enough that a lot of us remember it well. From 1979 to 1998 the market averaged 17.32% a year. One dollar invested at the end of 1978 grew to $24.41 by the end of 1998. At the opposite extreme, 1929-1948 averaged only 3.00% a year. The $1 invested at the end of 1928 became only $1.80 by the end of 1948.
There aren't a lot of people still around who remember the stock market in 1929-1948. But your parents or grandparents might be able to tell you about the period 1962-1981. The market went up an average of 6.57% per year, which doesn't sound so bad until you find out that inflation averaged 5.50% over the same period, leaving stock investors with an average real return of only 1.07%.
If you are like me, in your mid-forties and heading into the intense period of investing for retirement, the big question is will the period 2009-2028 be more like 1979-1998 or 1962-1981? Nobody knows.
There were 118 twenty year periods ending from 1890 to 2008. The average twenty year period had an average annual return of 9.22%, but a forth of those periods had returns worse than 7% and a fourth beat 11.5%. And you only get to do this once. Consider the difference in circumstances of a person born in 1933, who turned 45 in 1979 and enjoyed fat returns on his way to retirement in 1998 at 65, with somebody born in 1916 whose nest egg went nowhere in the twenty years before his retirement.
What can you do about this? In the most direct sense, nothing. Diversification will help some, but not by as much as you might like. Bad decades for the stock market tend to be bad decades for bonds and real estate too. The truth is that this is one of the many things in life that are beyond your control.
But you can take it into account when doing your financial planning. If the difference between 8% and 10% returns over the next twenty years is the difference between a comfortable retirement and hoping your kids can support you, you need to reconsider your plans. Expecting 10% a year from the stock market over the long run is reasonable, but counting on it is foolish.
The first thing to understand is that you cannot expect to actually get that average return in any given year. Get Rich Slowly has a guest post by Carl Richards that patiently makes this point with the use of an elaborate animated presentation. His data has an average return of 10% over eighty years and shows that only twice in that time did the actual market return for a year fall between 9% and 11%. I would hope that this is a nearly obvious point to all stock market investors, but I know better.
Moreover, I worry that by saying that the market has good years and bad ones, but that the long run average is high, people are led to believe that as long as they can stick it out through the ups and downs, after twenty years or so they will get the promised average return. This is not necessarily so. Those long run averages are not that much more predictable than individual years.
To illustrate, I will run some numbers of my own. Yale's Robert Shiller has a website with the S&P 500 index returns annually back to 1871 as well as some other useful stuff such as inflation rates. It turns out that, sure enough, the average return for the US stock market, as measured by the S&P 500, was 10.08% per year over the 138 years from 1871 to 2008 inclusive.
What do we know from this? We know that funds invested in the market on December 31, 1870 and held through December 31, 2008 would have made an average of 10.08% a year. We do not know what the average returns for the next 138 years will be. 10.08% is a pretty solid guess, and in fact is almost certainly the best guess we've got, but it's still just a guess. There is no "true" expected stock market return, even over long periods of time. Setting market return expectations is not science, just thoughtful estimation based on what has happened in the past.
To get a better feel for how volatile even long term averages can be, consider the 80 year period that Richards uses. The 80 year average return for the period ending in 2007 was 11.52%. But move it forward a year to end in 2008 and you get only 10.46%. That is a big difference considering those two periods are 98.75% identical.
And 80 years is a lot longer than the typical person will be invested in the stock market. For most, there is a critical twenty years or so from middle age to retirement when the nest egg does or doesn't grow. And the returns for twenty year periods are all over the place.
As it happens, the best twenty year period in the stock market since 1871 was recent enough that a lot of us remember it well. From 1979 to 1998 the market averaged 17.32% a year. One dollar invested at the end of 1978 grew to $24.41 by the end of 1998. At the opposite extreme, 1929-1948 averaged only 3.00% a year. The $1 invested at the end of 1928 became only $1.80 by the end of 1948.
There aren't a lot of people still around who remember the stock market in 1929-1948. But your parents or grandparents might be able to tell you about the period 1962-1981. The market went up an average of 6.57% per year, which doesn't sound so bad until you find out that inflation averaged 5.50% over the same period, leaving stock investors with an average real return of only 1.07%.
If you are like me, in your mid-forties and heading into the intense period of investing for retirement, the big question is will the period 2009-2028 be more like 1979-1998 or 1962-1981? Nobody knows.
There were 118 twenty year periods ending from 1890 to 2008. The average twenty year period had an average annual return of 9.22%, but a forth of those periods had returns worse than 7% and a fourth beat 11.5%. And you only get to do this once. Consider the difference in circumstances of a person born in 1933, who turned 45 in 1979 and enjoyed fat returns on his way to retirement in 1998 at 65, with somebody born in 1916 whose nest egg went nowhere in the twenty years before his retirement.
What can you do about this? In the most direct sense, nothing. Diversification will help some, but not by as much as you might like. Bad decades for the stock market tend to be bad decades for bonds and real estate too. The truth is that this is one of the many things in life that are beyond your control.
But you can take it into account when doing your financial planning. If the difference between 8% and 10% returns over the next twenty years is the difference between a comfortable retirement and hoping your kids can support you, you need to reconsider your plans. Expecting 10% a year from the stock market over the long run is reasonable, but counting on it is foolish.
Friday, February 13, 2009
Frugal Friday the 13th of February
It was a quiet week on the frugal front. It seems like every blog had the same Valentine's Day hints. The most common tip for saving money was to ignore the holiday entirely, but failing that, you could celebrate it late, when the candy goes on sale.
There was some mention of Lincoln on the occasion of his 200th birthday. There was no mention of Charles Darwin, a reasonably important figure in some places, who was also born on February 12, 1809. That Darwin doesn't rate in Frugal Nation isn't that surprising. According to The Economist, only 14% of Americans believe that humans evolved over millions of years. The scientifically minded can take heart in the fact that the trend is actually up. In 1982 only 9% believed in human evolution.
Of course, to the frugal, Lincoln is closely associated with that enduring symbol of saving really small amounts of money, the penny. Free Money Finance had an informative post of facts about the penny, including that 63% of Americans think we should keep using them. That's actually not that high, if you think about it, and shows that at least 37% of Americans are insufficiently frugal. Imagine how much worse it would be if it was widely understood that it costs 1.2 cents to make a penny. (It takes a special kind of government to mint coins at a loss.)
According to Coinstar, which supplied the penny facts to Free Money Finance, the average American household has $90 in coins lying around. Based on the handy converter on their home page, that's about half a gallon of change. What to do with this hoard of metal disks is of course a concern for the frugal. Dawn at Queercents suggests that you put it in a tin container rather than a glass one. Seeing the money will make you want to spend it. She also suggests other clever ways of hiding money from yourself, including inflating the values of the checks you write in your check register so that your balance is actually higher than you think it is. This has inspired me to convince myself that I belong to a high-end gym and to record imaginary large monthly checks for the membership fee. I think this will work as long as I don't notice that I am not losing weight.
Speaking of losing weight, Frugal Living Tips suggests saving on food bills by foraging for things to eat in the woods. Not only will you save money, you will lose weight because of the exercise you will get and because you will find so little to eat, especially in February.
And finally, Tip Hero has a post about saving what must surely be many small copper disks with Lincoln on them by making your own half and half for your coffee. The recipe given is one quart light cream to one quart milk. No word on what to do if you need less than half a gallon of the stuff, but you can use that glass bottle you used to store loose change in.
There was some mention of Lincoln on the occasion of his 200th birthday. There was no mention of Charles Darwin, a reasonably important figure in some places, who was also born on February 12, 1809. That Darwin doesn't rate in Frugal Nation isn't that surprising. According to The Economist, only 14% of Americans believe that humans evolved over millions of years. The scientifically minded can take heart in the fact that the trend is actually up. In 1982 only 9% believed in human evolution.
Of course, to the frugal, Lincoln is closely associated with that enduring symbol of saving really small amounts of money, the penny. Free Money Finance had an informative post of facts about the penny, including that 63% of Americans think we should keep using them. That's actually not that high, if you think about it, and shows that at least 37% of Americans are insufficiently frugal. Imagine how much worse it would be if it was widely understood that it costs 1.2 cents to make a penny. (It takes a special kind of government to mint coins at a loss.)
According to Coinstar, which supplied the penny facts to Free Money Finance, the average American household has $90 in coins lying around. Based on the handy converter on their home page, that's about half a gallon of change. What to do with this hoard of metal disks is of course a concern for the frugal. Dawn at Queercents suggests that you put it in a tin container rather than a glass one. Seeing the money will make you want to spend it. She also suggests other clever ways of hiding money from yourself, including inflating the values of the checks you write in your check register so that your balance is actually higher than you think it is. This has inspired me to convince myself that I belong to a high-end gym and to record imaginary large monthly checks for the membership fee. I think this will work as long as I don't notice that I am not losing weight.
Speaking of losing weight, Frugal Living Tips suggests saving on food bills by foraging for things to eat in the woods. Not only will you save money, you will lose weight because of the exercise you will get and because you will find so little to eat, especially in February.
And finally, Tip Hero has a post about saving what must surely be many small copper disks with Lincoln on them by making your own half and half for your coffee. The recipe given is one quart light cream to one quart milk. No word on what to do if you need less than half a gallon of the stuff, but you can use that glass bottle you used to store loose change in.
Thursday, February 12, 2009
Phil Town's Rule #1, Part #5
[This is the final part of a multi-part review of Phil Town's book Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! If you haven't already, you might want to read Part 1, Part 2, Part 3, and/or Part 4 first.]
Does anybody really believe that they can buy a book containing a sure-fire formula for riches? I do not mean conceding that it is remotely possible, I mean truly believing that Town’s book, or one of its thousands of competitors, will disclose a magic technique to the reader. I am sure that there are a few out there that are that gullible, but I don't buy the idea that Town’s large readership is made up entirely of such folk.
So maybe my efforts to demonstrate that Rule #1 does not work were a waste of time. If Town’s audience does not really expect his scheme to make them rich, then why bother showing that it will not? Moreover, if we accept that there are very few people out there who are both in the habit of reading books and naïve enough to think that reading a particular one will make them rich, how do these books become bestsellers?
For me, the most meaningful revelation from Rule #1 is just how impractical it is to carry out what Town advises. I expected that his formula for picking stocks would not work in the sense that the stocks picked would not do particularly well. I did not expect that it would not work in the sense that it would barely function, that it would be so hard to use it to pick stocks at all. And you might think that this kind of not working would be a big problem for the sales of the book. A scheme that is easy to operate but does not pick winning stocks at least has the virtue that it could take a year or two before the readers realize it is defective. A scheme that is more or less inoperable from the start would, you would think, be noticed right off and become a hindrance to climbing the bestseller lists.
The flaw in that logic is that it assumes that readers actually attempt to follow Town’s advice and discover it is defective. But just as the vast majority of Town’s readers does not, in the cold light of day, really think that his scheme will make them rich, the vast majority also does not bother to try to follow it. Why would they? They know deep down that it will not work, so why put in the considerable effort required to shatter the illusion that it might work? Which then begs the question, why buy the book at all?
Because Rule #1, like nearly all books (and seminars, for that matter) is, ultimately, primarily a form of entertainment.
Consider television cooking shows, a genre that dates back to the earliest days of the medium. Although nominally instructive, it is clear that almost all viewers will never cook the elaborate dish that the host prepares. They watch not to so they can follow the instructions, but because it is entertaining. If you are into food, watching a skilled chef prepare and discuss a dish is fun. You can, at least in the abstract, imagine yourself preparing and even eating it, and that is enjoyable for many. I know people who buy and read cookbooks on the same basis.
Or consider cowboy hats. Putting one on has no chance of turning you into a cowboy. But it helps with the fantasy of being one. (In reality, it is probably not a great job: long hours, low pay, lots of big dumb smelly animals, and no Internet access.)
The fantasy that goes with Rule #1, and other books like it, is that you will read them and become rich. That any modestly intelligent reader knows, at some level, that this is really unlikely, does not diminish their appeal. A person can read the book and imagine becoming rich just like the ordinary people in the inspirational stories included in the text. That some of the instructions are, in fact, impractical is unimportant. They only need to seem practical to somebody who will never attempt them. Just as the host of a cooking show can get away with using obscure ingredients or a tricky technique requiring years of practice, Town can get away with vague instructions that do not produce the desired result.
So in a narrow sense, I am willing to forgive these books for being as bad as they are. They fill an entertainment role for some, and, apparently, do it well. The problem is that personal finance is still an area that American adults need to master. After you are done watching the celebrity chef prepare Cajun crawfish stew, somebody still needs to cook dinner.
[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]
Does anybody really believe that they can buy a book containing a sure-fire formula for riches? I do not mean conceding that it is remotely possible, I mean truly believing that Town’s book, or one of its thousands of competitors, will disclose a magic technique to the reader. I am sure that there are a few out there that are that gullible, but I don't buy the idea that Town’s large readership is made up entirely of such folk.
So maybe my efforts to demonstrate that Rule #1 does not work were a waste of time. If Town’s audience does not really expect his scheme to make them rich, then why bother showing that it will not? Moreover, if we accept that there are very few people out there who are both in the habit of reading books and naïve enough to think that reading a particular one will make them rich, how do these books become bestsellers?
For me, the most meaningful revelation from Rule #1 is just how impractical it is to carry out what Town advises. I expected that his formula for picking stocks would not work in the sense that the stocks picked would not do particularly well. I did not expect that it would not work in the sense that it would barely function, that it would be so hard to use it to pick stocks at all. And you might think that this kind of not working would be a big problem for the sales of the book. A scheme that is easy to operate but does not pick winning stocks at least has the virtue that it could take a year or two before the readers realize it is defective. A scheme that is more or less inoperable from the start would, you would think, be noticed right off and become a hindrance to climbing the bestseller lists.
The flaw in that logic is that it assumes that readers actually attempt to follow Town’s advice and discover it is defective. But just as the vast majority of Town’s readers does not, in the cold light of day, really think that his scheme will make them rich, the vast majority also does not bother to try to follow it. Why would they? They know deep down that it will not work, so why put in the considerable effort required to shatter the illusion that it might work? Which then begs the question, why buy the book at all?
Because Rule #1, like nearly all books (and seminars, for that matter) is, ultimately, primarily a form of entertainment.
Consider television cooking shows, a genre that dates back to the earliest days of the medium. Although nominally instructive, it is clear that almost all viewers will never cook the elaborate dish that the host prepares. They watch not to so they can follow the instructions, but because it is entertaining. If you are into food, watching a skilled chef prepare and discuss a dish is fun. You can, at least in the abstract, imagine yourself preparing and even eating it, and that is enjoyable for many. I know people who buy and read cookbooks on the same basis.
Or consider cowboy hats. Putting one on has no chance of turning you into a cowboy. But it helps with the fantasy of being one. (In reality, it is probably not a great job: long hours, low pay, lots of big dumb smelly animals, and no Internet access.)
The fantasy that goes with Rule #1, and other books like it, is that you will read them and become rich. That any modestly intelligent reader knows, at some level, that this is really unlikely, does not diminish their appeal. A person can read the book and imagine becoming rich just like the ordinary people in the inspirational stories included in the text. That some of the instructions are, in fact, impractical is unimportant. They only need to seem practical to somebody who will never attempt them. Just as the host of a cooking show can get away with using obscure ingredients or a tricky technique requiring years of practice, Town can get away with vague instructions that do not produce the desired result.
So in a narrow sense, I am willing to forgive these books for being as bad as they are. They fill an entertainment role for some, and, apparently, do it well. The problem is that personal finance is still an area that American adults need to master. After you are done watching the celebrity chef prepare Cajun crawfish stew, somebody still needs to cook dinner.
[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]
Wednesday, February 11, 2009
Cops and Regulators
It's a story that is (appropriately) on the back burner in the media, but the slowly unwinding tale of The Greatest Ponzi Scheme Ever continues. In case you have (appropriately) been paying attention to other things, let me offer a quick recap.
Starting as long as twenty years ago, Bernie Madoff, a well known and successful figure on Wall Street, ran a Ponzi scheme. As with all such scams, he pretended to be putting his clients' money in a make-believe sure-fire investment. Those few who asked to cash out were given money he raised from other investors. By 2008, Madoff's imaginary investment empire was worth an imaginary $50 billion.
And he never got caught. Like funds of all kinds, last year he was hit by a wave of people wanting to cash out. Unlike other funds, the money he needed for the withdrawals did not exist. So before things got really really ugly, Bernie turned himself in. (Actually that's not quite right. He confessed to his sons that he had been running a Ponzi scheme and that he planned to turn himself in. They immediately dropped a dime on Ol' Dad. Wall Street is a really tough place.)
That's a pretty good plotline, but it gets better. If you are, like me, an investment professional in Boston, you have probably met a guy named Harry Markopolos. You might also remember that for several years in the middle of this decade Harry tried to make a living as a freelance financial fraud investigator, sort of a bounty hunter for the investment world. Well it turns out that one of his longest running investigations was Madoff's ponzi scheme. Markopolos figured out it was a scam as soon as he saw the returns Madoff claimed to be getting in 1999. He then spent the following nine years trying to convince the SEC to do something about it.
We do not yet know why the SEC did nothing. Further plot thickeners such as bribery or blackmail are certainly possible, but not likely. The mundane truth is that the SEC is just not that good at what most people think they do for a living. They are regulators and not cops. There is a difference.
To illustrate this, let me change subjects abruptly to an excellent article in the Atlantic last November by Jeffery Goldberg. It is the account of his concerted multi-year effort to get himself placed on the TSA's notorious No Fly List. He failed, although he did manage to have a nail clipper and a can of shaving cream confiscated. On other occasions he boarded planes with items that ought to have raised some eyebrows, including lengths of rope, dustmasks, full sized Hezbollah flags, and of course, the traditional box-cutter. He also used badly forged boarding passes and at one point ripped up a stack of them in view of a TSA officer. (I thought the article was hysterically funny. Most of my friends swore they'd never fly again. Go figure.)
The TSA didn't stop Goldberg for the same reason that the SEC didn't stop Madoff. They are regulators. They employ large numbers of comparatively underpaid and undertalented people to make sure that most folks mostly keep within regulations most of the time. That can be a worthwhile government function (not in the case of the TSA) but it's completely different from finding the really bad guys and throwing them in jail.
If you point out an obvious wrongdoer to a cop he will arrest him and then, if necessary, work out exactly which crimes have been broken. Point out to a regulator a wrongdoer who is not obviously breaking any regulations, and the outcome will be paralysis. We don't know for sure yet, but I will bet real money that is what happened at the SEC. They stood around scratching their heads trying to figure out what SEC rules were being broken by Madoff, couldn't come up with any, added in the fact that there were no complaining victims, and decided to move on to other cases.
If you are confused (or outraged) that the SEC might not see any obvious violations to pursue with Madoff, you are not thinking like a regulator. Regulators work with very detailed and specific rules that they try to jam everybody and everything into. There is no such thing as "the spirit" of a regulation and no general remit for the regulator to fight evil beyond what is very specifically allowed or not. Madoff was not selling securities, as the law defines them. The SEC had a lot of rules about how Madoff could invest his clients' money in the public markets, but nobody has alleged that he broke any rules there. (Not surprising, given that he apparently didn't invest his clients' money at all.) Expecting the SEC to go after Madoff under the general principle that he might have been carrying out the greatest securities related fraud in history is like expecting the airport screener to take a closer look at the unlikely items in the carry-on of the guy in the al-Qaeda tee shirt. (Seriously. Goldberg wore one. Read the article.)
Markopolos had no direct contact with Madoff. (He still mispronounces his name. It's MADE-off, as in "Bernie made off with a whole lot of money.") Which raises the question, why didn't any of the thousands of other people who must have come across the same data in the course of their business come to the same conclusions as Markopolos did and alert the SEC? It's possible a few did, but it is clear that the vast majority of financial professionals did nothing. Again, because the SEC are regulators, not cops.
Innocent or guilty, dealing with regulators is a painful drag. As a wag once put it "the process is the penalty." Unless you are absolutely sure something is rotten you just don't finger your fellow man to a regulator. And even then probably not. You might call the cops if you thought that perhaps your neighbor was beating his wife, but it is almost inconceivable that you would call the IRS because you knew for a fact he was cheating on his taxes.
Obviously, what the Madoff scam needed was cops, not regulators. But there were lots of cops. This was, after all, plain old fraud in fancy packaging. The police in any of the hundreds of jurisdictions where Madoff's victims lived could have, in principle, investigated him. And of course there was the FBI. But if Markopolos had brought his story to any of these I am sure they would have all sent him back to the SEC. Wall Street fraud is their thing, isn't it? The final irony is that had Madoff claimed to be investing his clients' money in something other than regulated securities, Manhattan real estate for example, he almost certainly would have been stopped a long time ago.
Compared to the global economic crisis and our government's fumbling responses to it, the Madoff story is relatively minor, almost a comic relief. It would be unfortunate, but not all that unexpected, for the two stories to become intertwined in public memory, as popular imagination blames "accounting scandals" like Enron and Worldcom for the tech bubble bursting and blames fraudsters for the great S&L fiasco of the early 1990s. We already hear vague accusations that the root cause of our problems is a failure of regulators to properly regulate. As regards Madoff, the opposite is true. The regulator did everything we could have expected of it. It was our mistake for expecting anything more.
Starting as long as twenty years ago, Bernie Madoff, a well known and successful figure on Wall Street, ran a Ponzi scheme. As with all such scams, he pretended to be putting his clients' money in a make-believe sure-fire investment. Those few who asked to cash out were given money he raised from other investors. By 2008, Madoff's imaginary investment empire was worth an imaginary $50 billion.
And he never got caught. Like funds of all kinds, last year he was hit by a wave of people wanting to cash out. Unlike other funds, the money he needed for the withdrawals did not exist. So before things got really really ugly, Bernie turned himself in. (Actually that's not quite right. He confessed to his sons that he had been running a Ponzi scheme and that he planned to turn himself in. They immediately dropped a dime on Ol' Dad. Wall Street is a really tough place.)
That's a pretty good plotline, but it gets better. If you are, like me, an investment professional in Boston, you have probably met a guy named Harry Markopolos. You might also remember that for several years in the middle of this decade Harry tried to make a living as a freelance financial fraud investigator, sort of a bounty hunter for the investment world. Well it turns out that one of his longest running investigations was Madoff's ponzi scheme. Markopolos figured out it was a scam as soon as he saw the returns Madoff claimed to be getting in 1999. He then spent the following nine years trying to convince the SEC to do something about it.
We do not yet know why the SEC did nothing. Further plot thickeners such as bribery or blackmail are certainly possible, but not likely. The mundane truth is that the SEC is just not that good at what most people think they do for a living. They are regulators and not cops. There is a difference.
To illustrate this, let me change subjects abruptly to an excellent article in the Atlantic last November by Jeffery Goldberg. It is the account of his concerted multi-year effort to get himself placed on the TSA's notorious No Fly List. He failed, although he did manage to have a nail clipper and a can of shaving cream confiscated. On other occasions he boarded planes with items that ought to have raised some eyebrows, including lengths of rope, dustmasks, full sized Hezbollah flags, and of course, the traditional box-cutter. He also used badly forged boarding passes and at one point ripped up a stack of them in view of a TSA officer. (I thought the article was hysterically funny. Most of my friends swore they'd never fly again. Go figure.)
The TSA didn't stop Goldberg for the same reason that the SEC didn't stop Madoff. They are regulators. They employ large numbers of comparatively underpaid and undertalented people to make sure that most folks mostly keep within regulations most of the time. That can be a worthwhile government function (not in the case of the TSA) but it's completely different from finding the really bad guys and throwing them in jail.
If you point out an obvious wrongdoer to a cop he will arrest him and then, if necessary, work out exactly which crimes have been broken. Point out to a regulator a wrongdoer who is not obviously breaking any regulations, and the outcome will be paralysis. We don't know for sure yet, but I will bet real money that is what happened at the SEC. They stood around scratching their heads trying to figure out what SEC rules were being broken by Madoff, couldn't come up with any, added in the fact that there were no complaining victims, and decided to move on to other cases.
If you are confused (or outraged) that the SEC might not see any obvious violations to pursue with Madoff, you are not thinking like a regulator. Regulators work with very detailed and specific rules that they try to jam everybody and everything into. There is no such thing as "the spirit" of a regulation and no general remit for the regulator to fight evil beyond what is very specifically allowed or not. Madoff was not selling securities, as the law defines them. The SEC had a lot of rules about how Madoff could invest his clients' money in the public markets, but nobody has alleged that he broke any rules there. (Not surprising, given that he apparently didn't invest his clients' money at all.) Expecting the SEC to go after Madoff under the general principle that he might have been carrying out the greatest securities related fraud in history is like expecting the airport screener to take a closer look at the unlikely items in the carry-on of the guy in the al-Qaeda tee shirt. (Seriously. Goldberg wore one. Read the article.)
Markopolos had no direct contact with Madoff. (He still mispronounces his name. It's MADE-off, as in "Bernie made off with a whole lot of money.") Which raises the question, why didn't any of the thousands of other people who must have come across the same data in the course of their business come to the same conclusions as Markopolos did and alert the SEC? It's possible a few did, but it is clear that the vast majority of financial professionals did nothing. Again, because the SEC are regulators, not cops.
Innocent or guilty, dealing with regulators is a painful drag. As a wag once put it "the process is the penalty." Unless you are absolutely sure something is rotten you just don't finger your fellow man to a regulator. And even then probably not. You might call the cops if you thought that perhaps your neighbor was beating his wife, but it is almost inconceivable that you would call the IRS because you knew for a fact he was cheating on his taxes.
Obviously, what the Madoff scam needed was cops, not regulators. But there were lots of cops. This was, after all, plain old fraud in fancy packaging. The police in any of the hundreds of jurisdictions where Madoff's victims lived could have, in principle, investigated him. And of course there was the FBI. But if Markopolos had brought his story to any of these I am sure they would have all sent him back to the SEC. Wall Street fraud is their thing, isn't it? The final irony is that had Madoff claimed to be investing his clients' money in something other than regulated securities, Manhattan real estate for example, he almost certainly would have been stopped a long time ago.
Compared to the global economic crisis and our government's fumbling responses to it, the Madoff story is relatively minor, almost a comic relief. It would be unfortunate, but not all that unexpected, for the two stories to become intertwined in public memory, as popular imagination blames "accounting scandals" like Enron and Worldcom for the tech bubble bursting and blames fraudsters for the great S&L fiasco of the early 1990s. We already hear vague accusations that the root cause of our problems is a failure of regulators to properly regulate. As regards Madoff, the opposite is true. The regulator did everything we could have expected of it. It was our mistake for expecting anything more.
Tuesday, February 10, 2009
Phil Town's Rule #1, Part #4
[This is part 4 of a multi-part review of Phil Town's book Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! If you haven't already, you might want to read Part 1, Part 2 and/or Part 3 first.]
This is a strained analogy, but I think it works.
You are driving along on a quiet Saturday night. Phil Town pulls up alongside you in a big flashy car. He leans out the window and says “Hey, for $25 ($35 in Canada) I can take you to the coolest party ever.”
“Uh, I dunno…”
“It’s at this really gorgeous mansion on the beach. There’s an open bar, a huge gourmet buffet, and dozens of beautiful scantily-clad young people of both sexes who are tipsy and really open-minded, if you know what I mean. Also, the Rolling Stones said they would drop by later and play a few sets.”
Now you are pretty sure this is too good to be true, but there is that slim chance this smooth guy in the expensive car is telling the truth, and it is only $25. So why not? You hand over the money and Phil, assuring you the party is nearby, tells you to follow him. Which you do, weaving in and out of traffic at increasing speeds, making hairpin turns on mountain roads, running red lights, going the wrong way on one-way streets, and so on. Finally, Phil drives off the end of a pier, whereupon you discover that his car is actually amphibious. You stay on shore, watching him sail off into the sunset, calling back to you that the party is just a little farther.
So if by some miracle you have gotten through the main stock selection bits of Rule #1 with your sanity intact and a stock or two to buy, Town has just a little more work for you. We are almost there, you can hear him say.
On page 196 of Rule #1 Town introduces what he calls “the Tools” and what the rest of us investment types call technical indicators. Technical analysis is probably older than you think, possibly as old as the stock market, but at least as old as the familiar charts that show stock prices over time as squiggly lines. It is the developed pseudo-science of chart reading, based on the idea that stock prices follow a pattern that allows you to predict their near-term future. The name “technical” is old too, dating from a pre-computer era when the field seemed high-tech and nearly mystical.
Town is agonizingly ambiguous about the role that the Tools play in Rule #1 and vague about the specifics of how to use them, or even which exact tools to use. He instructs his readers to treat them as something they should follow without hesitation or reflection but also says “I’m not married to the specific set of Tools that I’m about to introduce to you.” He recounts how they have made him money, but seems to sell them to the reader primarily as confidence building accessories that will help a person pull the trigger and invest.
I am not going to conduct a backtest of the Tools. This because: 1) You are probably sick of backtests by now. 2) Town does not quite say that the Tools make money, in fact he is clear that as a stand-alone they do not, so finding that they do not work would not be a refutation of anything. And 3) Town is so unspecific about which tools to use, and how, that whatever results I got could be brushed aside by a true believer on the grounds that I did not do what Town really meant.
The three tools that Town recommends, but is not wedded to, are called MACD, Stochastics, and moving average. They are all, essentially, complex formulas that take only past prices of a stock as inputs and attempt to produce a “signal” that will predict if the stock is on its way up or down in the near future.
I have a lot of disdain for these sorts of tools. (Could you tell?) It is not that the underlying phenomena that they try to capture do not exist. They do. Stock prices really do exhibit some “momentum,” meaning that a stock that has been going up over the past three to six months is a little more likely to go up in the near future than one that has been flat. And over shorter periods, a few weeks for example, stock prices really do tend to revert, that is, stocks that have gone up or down a lot over a short period tend to give or get back some of the price movement right afterwards. These are small effects, but they are real and with enough data a person can prove it.
But these effects are not just small, they are simple. Calculations like MACD are not any more predictive than much less complex measures of price momentum. They have a lot of moving parts, in my opinion, just for the sake of having a lot of moving parts. It makes them seem so much more sophisticated and meaningful that way. In fact, these tools are no more subtle than looking a stock chart and saying “Golly, this has been going up all year. I think I’ll buy some.” or “Gosh, this has really been beaten up this week. I think I’ll buy some.”
Moreover, and here is where Town’s car is revealed to be a boat, these technical buy and sell indicators are by their nature short term. If you follow them you will inevitably be buying and selling every few weeks. Town gives the happy story of a couple who successfully used his system to make lots of money over two years in the stock of the Cheesecake Factory. They bought and sold the stock eleven times during that time. That is almost a trade in or out every month. Understanding, very late in the book, that this is what Town has in mind is probably a jarring surprise for many readers. In most of the book he stresses that he buys companies, not stocks, and that he would never buy a stock he was not willing to hold for ten years. Warren Buffet, an investor known particularly for his patience and long-term view, is cited as an inspiration throughout the book (he appears in the index 29 times) and the title is taken from something the great man said.
And yet, when you get down to it, Rule #1 is a form of investing that relies on a lot of short term trading. Look at any stock’s price chart and it is easy to imagine how profitable it could potentially be to trade in and out, buying on lows and selling on highs, provided, of course, you knew when those lows and highs were. The point is that that is true about any stock, not just that one in a thousand that passed the growth and value screens.
[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]
This is a strained analogy, but I think it works.
You are driving along on a quiet Saturday night. Phil Town pulls up alongside you in a big flashy car. He leans out the window and says “Hey, for $25 ($35 in Canada) I can take you to the coolest party ever.”
“Uh, I dunno…”
“It’s at this really gorgeous mansion on the beach. There’s an open bar, a huge gourmet buffet, and dozens of beautiful scantily-clad young people of both sexes who are tipsy and really open-minded, if you know what I mean. Also, the Rolling Stones said they would drop by later and play a few sets.”
Now you are pretty sure this is too good to be true, but there is that slim chance this smooth guy in the expensive car is telling the truth, and it is only $25. So why not? You hand over the money and Phil, assuring you the party is nearby, tells you to follow him. Which you do, weaving in and out of traffic at increasing speeds, making hairpin turns on mountain roads, running red lights, going the wrong way on one-way streets, and so on. Finally, Phil drives off the end of a pier, whereupon you discover that his car is actually amphibious. You stay on shore, watching him sail off into the sunset, calling back to you that the party is just a little farther.
So if by some miracle you have gotten through the main stock selection bits of Rule #1 with your sanity intact and a stock or two to buy, Town has just a little more work for you. We are almost there, you can hear him say.
On page 196 of Rule #1 Town introduces what he calls “the Tools” and what the rest of us investment types call technical indicators. Technical analysis is probably older than you think, possibly as old as the stock market, but at least as old as the familiar charts that show stock prices over time as squiggly lines. It is the developed pseudo-science of chart reading, based on the idea that stock prices follow a pattern that allows you to predict their near-term future. The name “technical” is old too, dating from a pre-computer era when the field seemed high-tech and nearly mystical.
Town is agonizingly ambiguous about the role that the Tools play in Rule #1 and vague about the specifics of how to use them, or even which exact tools to use. He instructs his readers to treat them as something they should follow without hesitation or reflection but also says “I’m not married to the specific set of Tools that I’m about to introduce to you.” He recounts how they have made him money, but seems to sell them to the reader primarily as confidence building accessories that will help a person pull the trigger and invest.
I am not going to conduct a backtest of the Tools. This because: 1) You are probably sick of backtests by now. 2) Town does not quite say that the Tools make money, in fact he is clear that as a stand-alone they do not, so finding that they do not work would not be a refutation of anything. And 3) Town is so unspecific about which tools to use, and how, that whatever results I got could be brushed aside by a true believer on the grounds that I did not do what Town really meant.
The three tools that Town recommends, but is not wedded to, are called MACD, Stochastics, and moving average. They are all, essentially, complex formulas that take only past prices of a stock as inputs and attempt to produce a “signal” that will predict if the stock is on its way up or down in the near future.
I have a lot of disdain for these sorts of tools. (Could you tell?) It is not that the underlying phenomena that they try to capture do not exist. They do. Stock prices really do exhibit some “momentum,” meaning that a stock that has been going up over the past three to six months is a little more likely to go up in the near future than one that has been flat. And over shorter periods, a few weeks for example, stock prices really do tend to revert, that is, stocks that have gone up or down a lot over a short period tend to give or get back some of the price movement right afterwards. These are small effects, but they are real and with enough data a person can prove it.
But these effects are not just small, they are simple. Calculations like MACD are not any more predictive than much less complex measures of price momentum. They have a lot of moving parts, in my opinion, just for the sake of having a lot of moving parts. It makes them seem so much more sophisticated and meaningful that way. In fact, these tools are no more subtle than looking a stock chart and saying “Golly, this has been going up all year. I think I’ll buy some.” or “Gosh, this has really been beaten up this week. I think I’ll buy some.”
Moreover, and here is where Town’s car is revealed to be a boat, these technical buy and sell indicators are by their nature short term. If you follow them you will inevitably be buying and selling every few weeks. Town gives the happy story of a couple who successfully used his system to make lots of money over two years in the stock of the Cheesecake Factory. They bought and sold the stock eleven times during that time. That is almost a trade in or out every month. Understanding, very late in the book, that this is what Town has in mind is probably a jarring surprise for many readers. In most of the book he stresses that he buys companies, not stocks, and that he would never buy a stock he was not willing to hold for ten years. Warren Buffet, an investor known particularly for his patience and long-term view, is cited as an inspiration throughout the book (he appears in the index 29 times) and the title is taken from something the great man said.
And yet, when you get down to it, Rule #1 is a form of investing that relies on a lot of short term trading. Look at any stock’s price chart and it is easy to imagine how profitable it could potentially be to trade in and out, buying on lows and selling on highs, provided, of course, you knew when those lows and highs were. The point is that that is true about any stock, not just that one in a thousand that passed the growth and value screens.
[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]
Two Carnivals to Read
Posts from this blog appear today in two carnivals, the Carnival of Everything Money hosted by The Penny Daily and the Personal Finance News carnival at Peak Personal Finance.
Click, read, and enjoy!
Click, read, and enjoy!
Monday, February 9, 2009
Lotteries and Money Advice
Two posts this morning mention lotteries. Jabulani Leffall at WiseBread starts with a great quote “That buck that bought the bottle coulda’ struck the Lotto.” and proceeds with an excellent riff on the snake-oil-salesman aspect of personal finance gurus. Mighty Bargain Hunter then asks "Did Powerball tickets beat the S&P last year?" They didn't, or at least didn't on average. Your mileage may vary.
Apparently, a decent slice of Americans believe that winning the lottery is their most likely route to even modest wealth. According to the survey cited by MBH, 21% of them think that winning the lottery is the most practical way they have to accumulate several hundred thousand dollars. To be fair, 55% thought saving over time was the best course. And we don't know how likely members of the 21% thought winning the lottery was, only that they thought it was their best shot.
People buy lottery tickets and become rich every day. A non-crazy and only modestly stupid person might reasonably conclude that buying a lottery ticket is a good way to become rich. Given ticket sales, the number of possibly sane but at least modestly stupid people must be very large.
I do not know of any personal finance experts who advise buying lottery tickets. Much as they specialize in repeating back what their audience already believes (or wants to believe) this would be a bit much. But the experts often make the same illogical jump as the modestly stupid person. There exist people who got rich by doing X, so doing X is a good way to become rich.
The fallacy is exploded by the great pile of worthless lottery tickets. Doing X may have made a few rich, but it also may have made many poor. If I wasn't so horribly cynical, I might be surprised at how many people fall for this. The money guru points to the rich people who started their own business or bought real estate with no money down and the audience nods its head and agrees that yes, this is the way to wealth.
It is said that lotteries are a special tax on those who can't do math. I agree, although I would change "can't" to "won't." Much of the personal finance establishment is built on fees charged to those who can't or won't think logically. Even the august Millionaire Next Door spent three years on the bestseller lists and moved close to three million copies without, apparently, anybody noticing that its premise was fundamentally flawed. Just because a characteristic is shared by millionaires it does not follow that adopting that characteristic is likely to make you a millionaire.
Apparently, a decent slice of Americans believe that winning the lottery is their most likely route to even modest wealth. According to the survey cited by MBH, 21% of them think that winning the lottery is the most practical way they have to accumulate several hundred thousand dollars. To be fair, 55% thought saving over time was the best course. And we don't know how likely members of the 21% thought winning the lottery was, only that they thought it was their best shot.
People buy lottery tickets and become rich every day. A non-crazy and only modestly stupid person might reasonably conclude that buying a lottery ticket is a good way to become rich. Given ticket sales, the number of possibly sane but at least modestly stupid people must be very large.
I do not know of any personal finance experts who advise buying lottery tickets. Much as they specialize in repeating back what their audience already believes (or wants to believe) this would be a bit much. But the experts often make the same illogical jump as the modestly stupid person. There exist people who got rich by doing X, so doing X is a good way to become rich.
The fallacy is exploded by the great pile of worthless lottery tickets. Doing X may have made a few rich, but it also may have made many poor. If I wasn't so horribly cynical, I might be surprised at how many people fall for this. The money guru points to the rich people who started their own business or bought real estate with no money down and the audience nods its head and agrees that yes, this is the way to wealth.
It is said that lotteries are a special tax on those who can't do math. I agree, although I would change "can't" to "won't." Much of the personal finance establishment is built on fees charged to those who can't or won't think logically. Even the august Millionaire Next Door spent three years on the bestseller lists and moved close to three million copies without, apparently, anybody noticing that its premise was fundamentally flawed. Just because a characteristic is shared by millionaires it does not follow that adopting that characteristic is likely to make you a millionaire.
Saturday, February 7, 2009
Phil Town's Rule #1, Part #3
[This is part 3 of a multi-part review of Phil Town's book Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! If you haven't already, you might want to read Part 1 and/or Part 2 first.]
Last time I walked through the third of Town's Four Ms. Today it's the turn of the fourth, Margin of Safety. As a concept and phrase, margin of safety has a long and august history. Benjamin Graham, Warren Buffet’s mentor and the founding father of modern value investing, coined it in the 1930s. The idea is that if you buy a stock at enough of a discount it is hard for things to go wrong. To be specific, if you buy it for less than liquidation value, the value of the company’s tangible assets less its debts, then the worst case scenario is that the company will go out of business, auction off what it owns, and make you whole. That is quite a safety net.
Graham was writing and investing in the Great Depression and its aftermath. Even by today’s measures, the bargains available in the stock market in the 1930s and 1940s were inexplicable. Stocks that sold for less than book value were common. So when Graham talked about margin of safety he was making a pretty convincing “what’s the worst that could happen?” argument. Buy something for half of what it is really worth, and even assuming things go badly, you have a big cushion to fall back on.
Things have changed a lot since the concept of margin of safety was born. Looking for stocks you can buy for less than liquidation value is not a viable strategy. When Town talks about a margin of safety he is not suggesting that there is a liquidation value safety net, he is just making the argument that if a stock is cheap enough the cards are stacked in your favor. That is not a terrible way to invest, but it is not about safety. What he is saying is that you should buy cheap stocks because they tend to go up. Which is true. The trick is deciding which stocks are the really cheap ones.
There are lots of ways to do this, ranging from the exquisitely complex to the brutally simple. Entire books have been written on the topic. Town’s methodology is definitely on the simple side, although still more bother than it is worth.
The most annoying part of his valuation method is that he calls the value that gets calculated for the stock not the “true value” or “fair value” but “sticker price.” What could be more jarringly inappropriate? A sticker price is what a car manufacturer puts on the sheet of paper glued to the window of a new car in the forlorn hope that somebody, somewhere, will pay that much for it. Why not just call it the “unrealistic goal price?”
In a nutshell, Town instructs the reader to value a stock as follows. 1) Project earnings per share ten years from now. 2) Project a price/earnings ratio for ten years from now. 3) Use the future earnings and future price/earnings ratio to back out a price for the stock in ten years. 4) Discount that back into today’s dollars.
I will not repeat Town's specific instructions for coming up with earnings projections, future P/E ratios, and the like. Suffice it to say that all are somewhat questionable, often obscure, and easily expressed as computer code I can use to test it.
Backtesting this value portion of Rule #1 is actually easier than the growth part. With fewer numbers as inputs, it runs faster and lets more stocks pass. But passing stocks are still pretty rare. Only 45 of the 1000 met the cutoff on December 31, 2007. That's more than passed the growth test, but it's still fewer than 1 in 20. (Again, running this without computer automation would be at best torturous.) And how did the passing stocks do? Not so great. The 45 lost an average of 47.19% during 2008, against an average loss of merely 37.01% for the other 955.
For the nine years 2000-2008, Town's Margin of Safety screen selected an average of 51 stocks at the start of each year and on average they lost 0.27% over the next 12 months. The stocks that did not make the cut rose an average of 3.00%. That's really pretty dismal. Any worse and I might suggest that shorting these names was a reasonable strategy.
Of course, Margin of Safety is not meant as a stand-alone. Town would have you invest in stocks that pass both the growth (Moat) and value (Margin of Safety) screens. So how many stocks passed both screens as of 12/31/07? Just one: Cognizant Technology. It lost 46.78% last year.
Overall, of the nine years of the sample, four (2000, 2002, 2004, and 2007) had no stocks at all that passed the two screens. The other five years had a grand total of 11 names that qualified. As it happens, some of those picks did pretty well. Others did poorly, but the average annual return was 14.77%, a little more than 10% better than the unselected members of the 1000 did in the same years.
And so what? This is hardly an actionable plan for putting your money to work in the stock market, given that there is nothing at all to buy half the time. And finding these needles in a haystack is not really practical without specialized software. Nor is this, with such a tiny sample, evidence that Rule #1 works after all. And Town is not done yet. There are still more parts to this “simple strategy for successful investing in only 15 minutes a week.” Stay tuned.
[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]
Last time I walked through the third of Town's Four Ms. Today it's the turn of the fourth, Margin of Safety. As a concept and phrase, margin of safety has a long and august history. Benjamin Graham, Warren Buffet’s mentor and the founding father of modern value investing, coined it in the 1930s. The idea is that if you buy a stock at enough of a discount it is hard for things to go wrong. To be specific, if you buy it for less than liquidation value, the value of the company’s tangible assets less its debts, then the worst case scenario is that the company will go out of business, auction off what it owns, and make you whole. That is quite a safety net.
Graham was writing and investing in the Great Depression and its aftermath. Even by today’s measures, the bargains available in the stock market in the 1930s and 1940s were inexplicable. Stocks that sold for less than book value were common. So when Graham talked about margin of safety he was making a pretty convincing “what’s the worst that could happen?” argument. Buy something for half of what it is really worth, and even assuming things go badly, you have a big cushion to fall back on.
Things have changed a lot since the concept of margin of safety was born. Looking for stocks you can buy for less than liquidation value is not a viable strategy. When Town talks about a margin of safety he is not suggesting that there is a liquidation value safety net, he is just making the argument that if a stock is cheap enough the cards are stacked in your favor. That is not a terrible way to invest, but it is not about safety. What he is saying is that you should buy cheap stocks because they tend to go up. Which is true. The trick is deciding which stocks are the really cheap ones.
There are lots of ways to do this, ranging from the exquisitely complex to the brutally simple. Entire books have been written on the topic. Town’s methodology is definitely on the simple side, although still more bother than it is worth.
The most annoying part of his valuation method is that he calls the value that gets calculated for the stock not the “true value” or “fair value” but “sticker price.” What could be more jarringly inappropriate? A sticker price is what a car manufacturer puts on the sheet of paper glued to the window of a new car in the forlorn hope that somebody, somewhere, will pay that much for it. Why not just call it the “unrealistic goal price?”
In a nutshell, Town instructs the reader to value a stock as follows. 1) Project earnings per share ten years from now. 2) Project a price/earnings ratio for ten years from now. 3) Use the future earnings and future price/earnings ratio to back out a price for the stock in ten years. 4) Discount that back into today’s dollars.
I will not repeat Town's specific instructions for coming up with earnings projections, future P/E ratios, and the like. Suffice it to say that all are somewhat questionable, often obscure, and easily expressed as computer code I can use to test it.
Backtesting this value portion of Rule #1 is actually easier than the growth part. With fewer numbers as inputs, it runs faster and lets more stocks pass. But passing stocks are still pretty rare. Only 45 of the 1000 met the cutoff on December 31, 2007. That's more than passed the growth test, but it's still fewer than 1 in 20. (Again, running this without computer automation would be at best torturous.) And how did the passing stocks do? Not so great. The 45 lost an average of 47.19% during 2008, against an average loss of merely 37.01% for the other 955.
For the nine years 2000-2008, Town's Margin of Safety screen selected an average of 51 stocks at the start of each year and on average they lost 0.27% over the next 12 months. The stocks that did not make the cut rose an average of 3.00%. That's really pretty dismal. Any worse and I might suggest that shorting these names was a reasonable strategy.
Of course, Margin of Safety is not meant as a stand-alone. Town would have you invest in stocks that pass both the growth (Moat) and value (Margin of Safety) screens. So how many stocks passed both screens as of 12/31/07? Just one: Cognizant Technology. It lost 46.78% last year.
Overall, of the nine years of the sample, four (2000, 2002, 2004, and 2007) had no stocks at all that passed the two screens. The other five years had a grand total of 11 names that qualified. As it happens, some of those picks did pretty well. Others did poorly, but the average annual return was 14.77%, a little more than 10% better than the unselected members of the 1000 did in the same years.
And so what? This is hardly an actionable plan for putting your money to work in the stock market, given that there is nothing at all to buy half the time. And finding these needles in a haystack is not really practical without specialized software. Nor is this, with such a tiny sample, evidence that Rule #1 works after all. And Town is not done yet. There are still more parts to this “simple strategy for successful investing in only 15 minutes a week.” Stay tuned.
[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]
Bonus Outrage Resolution Understood at WSJ
Today's Wall Street Journal carries a column by Jason Zweig in which he reveals that the action that the President announced on Wednesday to address the Wall Street Bonus Outrage will have no practical impact. Apparently it takes three days for people who work at the Wall Street Journal to understand what is immediately obvious to those that work on Wall Street. To be fair, it takes almost a day for unemployed hacks like me to get around to posting on a topic.
Friday, February 6, 2009
Frugal Friday 2/6
It's Friday again, so here's the weekly roundup of frugal hints from around the blogosphere. Just to make it clear, these are selected with the intent of finding ideas you haven't seen before. Lots of sites tell you not to go grocery shopping hungry. It is the useful blog that gives tips on making a meal of free samples in the store.
We start with a cautionary tale. As all citizens of Frugal Nation know, Denny's gave away free Grand Slam breakfasts this past Tuesday. And as some may have noticed, they failed to specify one to a customer. A reporter with the Chicago Tribune attempted the obvious act of frugality, consuming 5 Grand Slams before 9AM. The results were not as joyful as you might have expected.
I don't know if that feast of free cholesterol inspired self-reflection, but there were quite a few posts this week wondering if this frugality thing might not be bad for society. For example, Almost Frugal, which as you may know is written by an American living in the French Alps, had a post entitled The Ethics of Frugality which mused that buying the cheapest item available might be sending American jobs to China.
As this is the first week of February, lists of money saving hints for Valentine's Day were everywhere. They mostly just repeat the same old stuff about handmade cards and single roses instead of a dozen. But Sound Money Matters had a list that cut to the quick by starting with the suggestion that you just skip the holiday entirely. Failing that, push it back a week when restaurants are much less crowded and gifts have been seriously marked down. And SavingAdvice.com has an original list of Valentine’s Day Tips for Gals. Obviously, what most guys want from their gals costs no money at all, but the post does come up with a few alternatives, including allowing your man to teach you how to change the oil on your car.
If you are a frugal user of candles, presumably because you want to save money on both lighting and heating, you will appreciate Little People Wealth's tip: store your candles in the freezer. They will burn more slowly.
Speaking of heating, Zen Personal Finance had a series of three posts with a total of 13 ways to save money on your heating bills. The first twelve are pretty obvious, but the last one in the last post suggests saving money on heating by not eating out, because your stove will create heat when you cook. Further, the blog points out that "If your thermostat is near the kitchen, you will save money." How true. Sadly, my thermostat is not near my kitchen. But I have remedied this by putting an electric space heater right under it.
The best frugal post of the week comes from Gather Little by Little, which provides a list of 25 uses for dryer sheets, none of which involves a clothes dryer. This, of course, is particularly important for the truly frugal, who save money by hanging laundry on a line to dry. Inevitably, this results in a growing stock of unused dryer sheets, which can really clutter up a storage closet. These 25 uses will have you putting a dent in that backlog in no time. For example, did you know that to reduce odor you can "Scrub incoming dogs or cats (especially wet ones) with a dryer sheet before they come back into your home." All wet cats love being rubbed down with scented foam sheets.
We start with a cautionary tale. As all citizens of Frugal Nation know, Denny's gave away free Grand Slam breakfasts this past Tuesday. And as some may have noticed, they failed to specify one to a customer. A reporter with the Chicago Tribune attempted the obvious act of frugality, consuming 5 Grand Slams before 9AM. The results were not as joyful as you might have expected.
I don't know if that feast of free cholesterol inspired self-reflection, but there were quite a few posts this week wondering if this frugality thing might not be bad for society. For example, Almost Frugal, which as you may know is written by an American living in the French Alps, had a post entitled The Ethics of Frugality which mused that buying the cheapest item available might be sending American jobs to China.
As this is the first week of February, lists of money saving hints for Valentine's Day were everywhere. They mostly just repeat the same old stuff about handmade cards and single roses instead of a dozen. But Sound Money Matters had a list that cut to the quick by starting with the suggestion that you just skip the holiday entirely. Failing that, push it back a week when restaurants are much less crowded and gifts have been seriously marked down. And SavingAdvice.com has an original list of Valentine’s Day Tips for Gals. Obviously, what most guys want from their gals costs no money at all, but the post does come up with a few alternatives, including allowing your man to teach you how to change the oil on your car.
If you are a frugal user of candles, presumably because you want to save money on both lighting and heating, you will appreciate Little People Wealth's tip: store your candles in the freezer. They will burn more slowly.
Speaking of heating, Zen Personal Finance had a series of three posts with a total of 13 ways to save money on your heating bills. The first twelve are pretty obvious, but the last one in the last post suggests saving money on heating by not eating out, because your stove will create heat when you cook. Further, the blog points out that "If your thermostat is near the kitchen, you will save money." How true. Sadly, my thermostat is not near my kitchen. But I have remedied this by putting an electric space heater right under it.
The best frugal post of the week comes from Gather Little by Little, which provides a list of 25 uses for dryer sheets, none of which involves a clothes dryer. This, of course, is particularly important for the truly frugal, who save money by hanging laundry on a line to dry. Inevitably, this results in a growing stock of unused dryer sheets, which can really clutter up a storage closet. These 25 uses will have you putting a dent in that backlog in no time. For example, did you know that to reduce odor you can "Scrub incoming dogs or cats (especially wet ones) with a dryer sheet before they come back into your home." All wet cats love being rubbed down with scented foam sheets.
Thursday, February 5, 2009
ETFs and Other Mutual Funds
Million Dollar Journey today asks Can You Invest Solely in ETFs? The answer given is, basically, yes. And that is true. You could also live for a week eating only pickles. At least I'm pretty sure.
This is probably as good a time as any to give a quick rundown of the differences between open-end mutual funds and ETFs.
What is usually meant when somebody says "mutual fund" is an open-end mutual fund. Like with all funds, what you own when you own shares in an open-end fund is a proportionate share of a large portfolio of assets run by a management company.
With an open-end fund, you can buy or sell shares only once a day, at a price calculated based on the closing prices of everything in the portfolio. When you buy/sell shares, you are trading with the fund itself. If you buy, your money goes in the fund and new shares are issued to you. If you sell, your shares are cancelled and cash comes out of the fund.
Most open-end funds are "active" meaning that the management company is actively deciding on a day to day basis what to have in the portfolio. A sizable minority are "passive" or "index" funds that simply hold the members of a published index, such as the S&P 500.
ETFs, or Exchange Traded Funds, are similar in that you own shares of a portfolio, but these trade all day long on the stock exchange like a stock. When you buy or sell shares of ETFs, you are trading with another investor who is selling or buying.
For reasons I will spare you, ETFs are always passively managed portfolios.
In both types of fund the management company that runs it gets paid in the form of annual fees, sometimes referred to as "expenses." (I'm not sure if an "expense" sounds smaller than a "fee", but it sure does sound more unavoidable.) How much the management company charges varies a lot from fund to fund, but as a general rule, active open-end funds charge the most, followed by ETFs, followed by passive open-ended funds. Additionally, to buy or sell an ETF you would pay a commission to a stock broker.
So if ETFs are, essentially, index funds with higher fees than otherwise identical open-end index funds, why would you invest in them? The short answer is that most people reading this shouldn't. The long one is that there are a few situations in which it makes sense. Since ETFs trade like stocks you can short them, buy them on margin, and trade them at a moment's notice. There are also some rather exotic types of assets available as ETFs but not as open-ended funds. But if you are a typical investor looking to hold a vanilla index for more than a week or two, ETFs will only cost you more money.
This is probably as good a time as any to give a quick rundown of the differences between open-end mutual funds and ETFs.
What is usually meant when somebody says "mutual fund" is an open-end mutual fund. Like with all funds, what you own when you own shares in an open-end fund is a proportionate share of a large portfolio of assets run by a management company.
With an open-end fund, you can buy or sell shares only once a day, at a price calculated based on the closing prices of everything in the portfolio. When you buy/sell shares, you are trading with the fund itself. If you buy, your money goes in the fund and new shares are issued to you. If you sell, your shares are cancelled and cash comes out of the fund.
Most open-end funds are "active" meaning that the management company is actively deciding on a day to day basis what to have in the portfolio. A sizable minority are "passive" or "index" funds that simply hold the members of a published index, such as the S&P 500.
ETFs, or Exchange Traded Funds, are similar in that you own shares of a portfolio, but these trade all day long on the stock exchange like a stock. When you buy or sell shares of ETFs, you are trading with another investor who is selling or buying.
For reasons I will spare you, ETFs are always passively managed portfolios.
In both types of fund the management company that runs it gets paid in the form of annual fees, sometimes referred to as "expenses." (I'm not sure if an "expense" sounds smaller than a "fee", but it sure does sound more unavoidable.) How much the management company charges varies a lot from fund to fund, but as a general rule, active open-end funds charge the most, followed by ETFs, followed by passive open-ended funds. Additionally, to buy or sell an ETF you would pay a commission to a stock broker.
So if ETFs are, essentially, index funds with higher fees than otherwise identical open-end index funds, why would you invest in them? The short answer is that most people reading this shouldn't. The long one is that there are a few situations in which it makes sense. Since ETFs trade like stocks you can short them, buy them on margin, and trade them at a moment's notice. There are also some rather exotic types of assets available as ETFs but not as open-ended funds. But if you are a typical investor looking to hold a vanilla index for more than a week or two, ETFs will only cost you more money.
Bonus Outrage Resolved
If you read my post two days ago on the Wall Street Bonus Outrage you can imagine my relief at the President's press conference yesterday.
You see, from all this hysteria about excessive Wall Street compensation, partially whipped up by Mr. Obama himself, I was really worried that the President might do something rash, such as, for example, restrict Wall Street compensation.
The new rules will not apply to firms that already have received government aid, will only apply in the future to the recipients of some kinds of help, will only restrict the compensation of a very small number of top executives (who collectively didn't make much of a dent in the $18.4B that got everybody bent out of shape) and only requires that these few be paid in stock instead of cash, which is fairly typical anyway.
Whew. That was close. Turns out the President isn't ignorant of how Wall Street works and isn't a closet bomb-throwing socialist. He's just a cynical politician willing to kick people when they are down to score political points. Thank god for that.
You see, from all this hysteria about excessive Wall Street compensation, partially whipped up by Mr. Obama himself, I was really worried that the President might do something rash, such as, for example, restrict Wall Street compensation.
The new rules will not apply to firms that already have received government aid, will only apply in the future to the recipients of some kinds of help, will only restrict the compensation of a very small number of top executives (who collectively didn't make much of a dent in the $18.4B that got everybody bent out of shape) and only requires that these few be paid in stock instead of cash, which is fairly typical anyway.
Whew. That was close. Turns out the President isn't ignorant of how Wall Street works and isn't a closet bomb-throwing socialist. He's just a cynical politician willing to kick people when they are down to score political points. Thank god for that.
Wednesday, February 4, 2009
Phil Town's Rule #1, Part #2
[This is the second installment of a review of Rule #1, by Phil Town. If you haven't already, you might want to read part 1 first.]
Rule#1 starts with a bang. From page 1:
The First Amendment is a wondrous thing. You can say anything you want in a book (or a blog) and the worst thing that will happen to you is that people will think you are a jerk or an idiot. On the other hand, if Phil Town had started a mutual fund and put this paragraph at the start of his sales brochure, government regulators would have shut him down right away. (Although as a hedge fund he might have gotten away with it for a while. This is almost exactly what Bernie Madoff claimed to be delivering to his clients.)
As I wrote in part #1, there are lots of books that promise a formula for getting rich picking stocks. What makes Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! attractive as a victim of my scrutiny is that most of Town's "simple strategy" is very specific. So specific, in fact, that I can program a computer to carry it out. I can go back in time and work out what stocks his system would have picked and track their performance. This is what is known in the investment biz as a backtest. It's the first thing that would pop into the head of a pro being pitched on a system for picking stocks. It is pretty clear that Town's mind is uncluttered by such concepts.
Town summarizes the core of his system, not all that gracefully, as four Ms: Meaning, Management, Moat, and Margin of Safety. Meaning and Management are squishy subjective things. And squishy subjective things annoy me. By Meaning, Town signifies both that you should understand the business of the company involved and that it should resonate with you in a vaguely moral way. And by Management he means that you should make sure that it has good management. I can't teach my computer to simulate these two, so they get a free pass.
Moat turns out to be a set of ratios Town calls the Big Five. Four are growth rates: growth in sales, earnings, free cash flow, and book value. And the fifth, ROIC, is strongly associated with growth. (ROIC, according to Town, stands for Return On Investment Capital. Actual investment professionals believe it stands for Return On Invested Capital.)
Town says you should calculate each of the numbers three times, for one, five, and ten year time periods. Then, if a stock has a score of at least 10% on each of these fifteen numbers it is attractive enough to be further considered for purchase. I can only assume that his intent is that his reader should do this by hand, one stock at a time, which would eat up the weekly 15 minute time allotment pretty fast. But with access to the right tools, I can do 1000 stocks relatively easily.
Which is exactly what I did. I took the 1000 largest stocks in the US as of December 31, 2007 and found those that pass the Rule #1 Moat test. There are exactly 20 of them. Which means that only 1 in 50 stocks pass this screen, and there are more screens to come. Imagine what it would be like to use this system without automation, testing one stock at a time. And 12/31/07 is pretty typical. I tested the eight previous years and found, on average, 16 stocks that cleared the screen out of possible 1000.
Of course, the point is to find stocks that will go up, and on this score the screen is marginally better than throwing darts. The 20 stocks that cleared the hurdle at the end of 2007 lost an average of 34.67% in 2008. That's actually not that bad, as the other 980 stocks gave up 37.53% on average. Including the other eight years of this decade the stocks that met the criteria to pass the Moat test returned an average of 4.29%, against 2.82% for the others. That ain't terrible, but consider:
1) So few stocks clear the screen that one or two lucky picks can make the whole thing look good. In 2000 the screen only picked 5 names, but two of them, Paychex, up 83% for the year, and Concord EFS, up 71%, did very well. Kick out those two and the average return for the screened stocks for the whole nine years drops to 0.14%.
2) 4.29% is nothing like the 15% returns promised.
3) So few stocks clear this screen, and remember this is only part of the Simple Strategy, that a person has to wonder if this is really a practical methodology for an ordinary investor.
Next up, I will continue with Rule #1's value screen, the Margin of Safety.
[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]
Rule#1 starts with a bang. From page 1:
This book is a simple guide to returns of 15 percent or more in the stock market, with almost no risk. In fact, Rule #1 investing is practically immune to the ups and downs of the stock market – and by the end of the book I’ll have proved it to you.
The First Amendment is a wondrous thing. You can say anything you want in a book (or a blog) and the worst thing that will happen to you is that people will think you are a jerk or an idiot. On the other hand, if Phil Town had started a mutual fund and put this paragraph at the start of his sales brochure, government regulators would have shut him down right away. (Although as a hedge fund he might have gotten away with it for a while. This is almost exactly what Bernie Madoff claimed to be delivering to his clients.)
As I wrote in part #1, there are lots of books that promise a formula for getting rich picking stocks. What makes Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! attractive as a victim of my scrutiny is that most of Town's "simple strategy" is very specific. So specific, in fact, that I can program a computer to carry it out. I can go back in time and work out what stocks his system would have picked and track their performance. This is what is known in the investment biz as a backtest. It's the first thing that would pop into the head of a pro being pitched on a system for picking stocks. It is pretty clear that Town's mind is uncluttered by such concepts.
Town summarizes the core of his system, not all that gracefully, as four Ms: Meaning, Management, Moat, and Margin of Safety. Meaning and Management are squishy subjective things. And squishy subjective things annoy me. By Meaning, Town signifies both that you should understand the business of the company involved and that it should resonate with you in a vaguely moral way. And by Management he means that you should make sure that it has good management. I can't teach my computer to simulate these two, so they get a free pass.
Moat turns out to be a set of ratios Town calls the Big Five. Four are growth rates: growth in sales, earnings, free cash flow, and book value. And the fifth, ROIC, is strongly associated with growth. (ROIC, according to Town, stands for Return On Investment Capital. Actual investment professionals believe it stands for Return On Invested Capital.)
Town says you should calculate each of the numbers three times, for one, five, and ten year time periods. Then, if a stock has a score of at least 10% on each of these fifteen numbers it is attractive enough to be further considered for purchase. I can only assume that his intent is that his reader should do this by hand, one stock at a time, which would eat up the weekly 15 minute time allotment pretty fast. But with access to the right tools, I can do 1000 stocks relatively easily.
Which is exactly what I did. I took the 1000 largest stocks in the US as of December 31, 2007 and found those that pass the Rule #1 Moat test. There are exactly 20 of them. Which means that only 1 in 50 stocks pass this screen, and there are more screens to come. Imagine what it would be like to use this system without automation, testing one stock at a time. And 12/31/07 is pretty typical. I tested the eight previous years and found, on average, 16 stocks that cleared the screen out of possible 1000.
Of course, the point is to find stocks that will go up, and on this score the screen is marginally better than throwing darts. The 20 stocks that cleared the hurdle at the end of 2007 lost an average of 34.67% in 2008. That's actually not that bad, as the other 980 stocks gave up 37.53% on average. Including the other eight years of this decade the stocks that met the criteria to pass the Moat test returned an average of 4.29%, against 2.82% for the others. That ain't terrible, but consider:
1) So few stocks clear the screen that one or two lucky picks can make the whole thing look good. In 2000 the screen only picked 5 names, but two of them, Paychex, up 83% for the year, and Concord EFS, up 71%, did very well. Kick out those two and the average return for the screened stocks for the whole nine years drops to 0.14%.
2) 4.29% is nothing like the 15% returns promised.
3) So few stocks clear this screen, and remember this is only part of the Simple Strategy, that a person has to wonder if this is really a practical methodology for an ordinary investor.
Next up, I will continue with Rule #1's value screen, the Margin of Safety.
[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]
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