Michael James on Money

Half of Last Week’s Losses Erased

2008-10-14T00:01:00.000-04:00

If last week’s stock performance was a “meltdown,” then Monday saw an “explosion” that erased half of last week’s losses as measured by the S&P 500 index. With Canadian markets closed on Monday, it will be interesting to see how they react in today’s opening.

For some reason, the 11.6% recovery in the S&P 500 has not generated much excitement. Even if the rest of this week sees stocks prices fully recover from last week’s losses, it seems that many investors will still feel the stinging pain of loss.

We’re wired to feel losses more strongly than gains. Our instincts often do not serve us very well when it comes to making investment decisions. We’re prone to being overly confident during good times and overly fearful during bad times like we’ve had lately.

Do you really believe that our financial system and our way of life will crumble away? It’s time to tune out the hysterical ranting on pseudo-news channels and think for ourselves.

Thanksgiving in Canada

2008-10-13T00:01:00.000-04:00

Today is Thanksgiving Day in Canada, and the main thing I’m thankful for is that the stock markets in Canada are closed. Unfortunately, our American friends won’t be celebrating Thanksgiving for a few more weeks and their stock markets will be open today. So, we won’t get a complete break from the barrage of panicky reports about stock prices.

Maybe we would be better off if stock markets were only open one day per week. This might reduce panic and cause more investors to take a long-term view. In his 1993 letter to shareholders, Warren Buffett said “after we buy a stock ..., we would not be disturbed if markets closed for a year or two.”

I’m not as confident an investor as Buffett, but I understand the idea. I own my current set of investments because I believe they will do well in the long term. I’m not gambling on short-term moves.

Do You Have the Nerve to Rebalance Right Now?

2008-10-10T00:01:00.000-04:00

I’ve never been one to maintain a particular percentage balance between stocks and bonds like 70/30 or 60/40. However, many people do this on the theory that they are rebalancing buy selling something whose price is high to buy something whose price is low.

The advantage of this approach is that it’s a disciplined way to buy low and sell high. On the negative side, it has investors holding low-return bonds for the long-term. However, for investors who can’t stomach an all-stock portfolio, the fixed ratio approach isn’t a bad one.

Larry MacDonald wrote an interesting and amusing article titled the stock market hates you that does a good job of capturing our fears right now. We’re so nervous that many of us are abandoning our financial plans.

Recent price drops in the stock market has thrown the stock/bond balance of investors’ portfolios out of whack. The percentage in stocks has dropped and the percentage in bonds has risen. So, my question is do you have the nerve to rebalance right now?

Financial Side Effects of Election Promises

2008-10-09T00:01:00.000-04:00

Canadian Financial DIY gave us a great summary of the Canadian political party platforms. As usual, the NDP have the most entertaining promises. The Green Party are a close second with their promises to raise the GST and legalize marijuana.

Whenever I hear political promises, I tend to think about the side effects that will be caused. Charlie Munger, long-time business partner of Warren Buffett, illustrated the concept of second-order effects nicely in a speech at UCSB (pdf):

A truck trailer business had a plant in Texas whose workman’s comp costs were 30% of payroll. This means that for every ten people working at the plant, the equivalent of three more were at home getting paid because they were supposedly unable to work. Workman’s comp is important for legitimate health problems, but 30% is ridiculous. When legislators created the workman’s comp rules, did they project costs based on existing sick-day rates, or did they anticipate the secondary effects of soaring numbers of workers taking advantage of an easily-gamed workman’s comp system?

Credit Card Interest Rate Promise

The NDP promises to limit interest rates on credit cards to 5% over prime. With this policy, many people who currently have credit cards would no longer qualify for them or would only qualify for a drastically reduced spending limit. An interest rate 5% over prime roughly compensates the bank for a 5% chance that you won’t pay back the money you borrow. If the bank judges your odds of default to be above 5%, then you won’t get a credit card.

This may actually be a good thing; I’m no fan of the aggressive tactics used by banks to ensnare the unwary into debt. But, I wonder how many people with below-average credit scores agree with this policy not realizing that they would lose their own credit cards.

Promise to Forgive Doctors’ Student Loans

The NDP promises to forgive doctors’ student loans if they devote the first ten years of their practices to family medicine. I don’t have a strong opinion on whether this is a good idea or not, but I do have a strong opinion about assessing its cost. The wrong way to assess cost would be to use the average student loan size among currently graduating doctors.

Many doctors in training who would otherwise have paid their way without taking student loans would seek student loans under such a policy. People prefer free money to a loan. Without any change in the rules governing qualifying for loans, the average student loan size would increase.

Part of the reason why each party’s estimates of the costs of their promises tends to be too low is that they ignore secondary effects.

Two Bad Stock Market Days in a Row

2008-10-08T00:01:00.000-04:00

Lots of red ink has been flowing two days in a row now. According to Jason Zweig in his book Your Money and Your Brain, “after two repetitions of a stimulus ... the human brain automatically, unconsciously, and uncontrollably expects a third repetition.”

If Zweig is right, then we must all be anticipating the end of the world. Stocks will keep dropping every day until there is nothing left. Things really are different this time. The sky is falling.

All kidding aside, I do find myself looking for someone authoritative to explain that the world’s financial problems are now under control. I’m not sure who qualifies as sufficiently authoritative. President Bush does not. Warren Buffett might be good enough, but he’s too busy buying up businesses at fire-sale prices.

For now, the financial system is still in surgery, and we’re in the waiting room hoping to hear from the surgeon soon.

Bears are Smiling for Now

2008-10-07T00:01:00.000-04:00

Even after the US government settled on its $700 billion bailout plan, markets continue to drop on Monday. Investors who sold out of the market before this latest drop are congratulating themselves. Unfortunately for them, they still need to make another right guess to come out ahead.

Because I don’t believe we’re headed for anarchy, I expect recent stock market losses to reverse sometime in the future. It may not be for months or years, but I expect the sun to shine again. If I’m right about this, then any bears who sold before recent price drops will have to guess when to jump back into stocks. I suspect that most of them will buy back in at a higher price than their selling price.

A curious thing about human nature is that many of those investors who end up paying more than their selling price to buy back in will be happy with themselves anyway. Even though they have lost on their market-timing gamble, these investors will cheerfully tell others about how they got out of stocks before the big fall.

In the same way that most people claim to have above-average driving skills and have made money on their lottery ticket purchases, most market timers will claim to have made money. They aren’t necessarily lying, though. Many of the investors who lose money through market timing will actually believe that they are ahead.

The cold, hard facts about the futility of market timing are no match for human illusions. In the same way that someone has to win the lottery, some people will come out ahead by selling all their stocks and re-buying them at the right time. Maybe you could be one of these people, but probably not.

Extended Warranties are getting out of control

2008-10-06T00:01:00.000-04:00

We’re used to getting the hard sell for extended warranties on many of the things we buy. When I bought my latest television, I had to say no three times before the salesman finally gave up. It was the usual deal: the manufacturer warranty lasts for a while and I was offered a two-year extension for “only” $149. This magically dropped to $79 in less than 30 seconds.

None of this is very surprising, but I did get a surprise while buying a replacement battery after my car key finally died. At first I could unlock my car from 50 feet away. This distance began to shrink until final the battery in the key died completely.

This is actually my second car key battery replacement, and I confidently got out a tiny screwdriver to remove some tiny screws to get at the battery. The guy at the electronics store had no problem finding a replacement battery after I handed him the old one.

Store guy: “How long did your battery last?”

Me: “What? Oh. Uh, 2 or 3 years.”

Store guy: “That’ll be $5.67, and we can guarantee your battery for 3 years for a dollar fifty.”

Me: “Huh? I’m sure I won’t remember where or when I bought it.”

To his credit the store guy was slightly embarrassed at this point and muttered something about how the warranty didn’t really make much sense. I guess the training he got from his employer didn’t strip him of all common sense.

I’d be interested in hearing other people’s experiences with extended warranties:

Did the warranty offered make any sense to buy?
Did the salesperson hit you with an unpleasant hard sell?
When your item broke, were you able to collect on your extended warranty?

Lessons from the Great Depression

2008-10-03T00:01:00.000-04:00

Whenever times are turbulent, we are tempted to say that “things are different this time.” While there are aspects of the current financial crisis that are unique, they also have much in common with past recessions and the great depression.

In a moment of fear, we can begin to imagine that the current crisis won’t end and that we should all be buying bonds and gold in preparation for the breakdown of civilization. However, as the Canadian Capitalist explained with a 1932 Dean Witter quote, we should keep the faith in stocks. Our economy will either recover or there will be chaos. If there is chaos, then nothing will maintain its value. Even real estate will be worthless because titles will be insecure. The only sensible course of action is to plan for a recovery.

Another lesson from the great depression comes from the fact that the government of the time did not attempt a bailout of the type that US lawmakers are currently working on. It’s easy to argue against a bailout. Why should we use public money to help rich bankers?

As banks fail, the other institutions they owe money to will fail and there will be a cascading effect throughout the economy. As the Canadian Capitalist explained in Why Bailout Wall Street?, the first businesses to fail may be those most deserving of bankruptcy, but the pain will eventually spread to other businesses that had little or nothing to do with sub-prime mortgages.

So, it seems that the US government has little choice but to bail out Wall Street to try to contain the problem. I see two important questions to address in the aftermath of the bailout:

1. Why was there no effective government regulation to prevent this disaster?

2. Why are the boards of directors of public companies so completely unable to protect shareholders from CEOs who collect huge salaries and bonuses while driving their companies to ruin?

Returns Reported by Mutual Funds Don’t Tell the Whole Story

2008-10-02T00:01:00.001-04:00

You’d think that if a mutual fund reported a 3-year return of over 24% per year, most of its investors would be quite happy. After all, any money kept in the fund over those 3 years would nearly double. Looks can be deceiving. Reported returns aren’t enough information to tell how the investors have fared.

Suppose that ABC Explosive Growth Fund starts out with $10 million of investors’ money. To simplify our example, we’ll only allow money to enter or leave the fund at the start of each year. After one year, another $10 million of new investor money enters the fund. After another year, investors pour an additional $60 million into the fund.

After the end of the third year, suppose that ABC fund holds $80 million. Note that this exactly equals the total amount of money contributed to the fund ($10 million twice and then $60 million). So ABC generated zero net return over those 3 years. Does this mean that their reported 3-year return will be 0%?

Nope. In coming up with this 0% figure, we have calculated what is called the internal rate of return. But this isn’t how mutual funds calculate returns. To work out ABC’s reported 3-year return we need a little more information. Here is some more detail for our example:

Year 1: ABC grows $10 million into $15 million (50% return).

Start of year 2: Investors add $10 million. The fund now holds $25 million.

Year 2: ABC grows $25 million into $40 million (60% return).

Start of year 3: Investors add $60 million. The fund now holds $100 million.

Year 3: ABC has a bad year and loses $20 million (-20% return).

The average compound return of the 50%, 60%, and -20% one-year returns is a little over 24% per year. But, the other method told us that the return was zero. How could the two ways of working out the 3-year return be so different?

The answer comes down to what type of investor you have in mind. If you think of the investor who leaves his money in the fund for the whole 3 years, then you get the 24% figure. However, in our ABC example, very little of the money in the fund was invested this way. If you think of the actual average experience of investors in the fund, then you come up with the 0% return.

Essentially, the way that funds report their returns ignores the total assets of the fund. My example is extreme, but the internal rate of return method that takes into account the actual experience of investors usually gives lower returns than those reported by mutual funds. This is because funds tend to perform better while they are small. As funds get bigger, the managers often run out of good ideas for investing the new money. This isn’t true of all funds, but it does happen with many of them.

All of this begs the question of which method mutual funds should use for reporting their returns. There are advantages and disadvantages to both methods. My preference would be to require that both types of return be reported. This might be confusing, but potential investors would be right to be concerned if the two returns were significantly different.

Panicked Investors get Whipsawed

2008-10-01T00:01:00.000-04:00

After Monday’s big drop in stock prices over the failed vote on the financial bailout, Tuesday saw prices come most of the way back. Apparently, investors as a whole think that lawmakers will find some way to contain the financial problems. The net effect for diversified investors who sat tight through it all is minimal. Those who panicked and sold at the wrong time are facing real losses.

When stock prices fall quickly and then immediately reverse course, it’s called a whipsaw. The same name is used when stock prices rise quickly and suddenly reverse course. The effect is reminiscent of the action of a saw going back and forth cutting through wood.

Such whipsaws generate a lot of concern and discussion, but they really make little difference if you don’t do any trading. Unfortunately, many investors got caught up in the panic and sold their stock holdings near the low point of the whipsaw and plan to “wait until things calm down.”

Unfortunately, these investors have already missed Tuesday’s huge rebound. Prices may yet fall again, but another possibility is that they will continue to drift upward never to return to the levels at the bottom of the whipsaw.

Sadly, many pundits contribute to the panic. Even some who advise sticking to a plan and taking a long-term view are saying that shifting into safer investments is prudent right now. Somehow this sounds different from saying to sell stocks, but it means the same thing.

If you focus on the value of your holdings in say 5 years, stocks are safer to own now than they were at higher prices a year ago. However, the advice from pundits usually runs counter to this obvious fact. They advise caution when prices drop and express confidence when prices are high. This just feeds into our emotions that sometimes cause us to make poor choices in a panic.

I have no idea whether stock prices will rise or fall in the coming days, but as I explained in an earlier essay, nobody else knows what will happen to stock prices in the short term either. What I do know is that you can’t get whipsawed if you don’t sell in a panic.

Who will be protected by a Bailout?

2008-09-30T00:01:00.000-04:00

Reporters are running out of words to describe the drop in stock prices yesterday after the US House of Representatives voted down the $700 billion bailout of the financial system: crash, plunge, carnage, bloodbath. Supporters of the plan said that the bailout is necessary to prevent further financial collapse. Others fear that even $700 billion would not be enough.

What is usually left unstated in these discussions is what will happen if government doesn’t act. This part is usually left to our imaginations. In a more fearful moment, I tend to recall images I’ve seen of the homeless and hungry in the swirling dust of the great depression. Maybe others imagine burning buildings and widespread panic.

The truth is that supporters of a bailout probably get more mileage out of leaving the consequences unsaid. We imagine much worse outcomes than most commentators would predict.

I have little doubt that the US government will ultimately have to do something fairly costly to limit the damage, but it sickens me to think that public money may be used to protect the jobs of executives at financial institutions whose greed is largely responsible for the current mess.

If there was a plan designed to protect the economy, but not protect the businesses and individuals most responsible for the current crisis, this plan would likely get strong public support.

An Invitation to Become a Financial Consultant

2008-09-29T00:01:00.001-04:00

According to a sheet of paper stuffed in my mail slot, it’s “time to think about being paid what you’re worth.” Investors Group is taking on twelve new “consultants” in my area. This prompted me to poke around the Investors Group web site to look at their investment products. I didn’t much like what I saw.

Presumably, Investors Group (IG) consultants would sell IG mutual funds among other things. The fund selector on IG’s web site showed 84 funds designated as “aggressive growth,” which seems to mean stock funds. The dollar-weighted average management expense ratio (MER) was 2.65% per year!

This is staggeringly high. Most forecasters consider an estimate for the long-term compound return from stocks of 6% above inflation to be optimistic. IG stock funds take away nearly half of this return in MERs.

Actually, it’s worse than the 2.65% I calculated. This percentage is for the back-end loaded version of the funds, where you pay a percentage upon leaving the fund if you leave too soon. Typically, a back-end load starts at 5% or 6% and declines to zero over 5-7 years. The unloaded version of IG’s funds typically had an MER about 0.15% higher than the loaded versions.

What about Canadian money market funds? These are supposed to be ultra-safe funds that give very modest returns. They typically have low MERs. IG has three Canadian money market funds. The only no-load fund has a painfully high MER of 1.13%. The loaded funds have MERs of 0.66% and a whopping 1.27%!

This was enough for me. I have moments where I think it might be fun to be a financial advisor, but I certainly wouldn’t want to do it having to sell mutual funds with such painfully high expenses.

Why Pundits Can’t Predict Short-Term Stock Movements

2008-09-26T00:01:00.000-04:00

There is no shortage of pundits who offer predictions of what will happen to particular stocks or the stock market in general. You’ll find them on television, radio, and innumerable blogs. I’m open to the possibility that some investors can guess the long-term success of a particular business, but I simply don’t believe any short-term predictions that I hear.

Here is why: if these pundits actually get it right a significant fraction of the time, then they could make much more money investing based on their predictions instead of wasting their time as pundits. To prove this, I decided to run some Monte Carlo simulations.

Suppose that our pundit Peter predicts whether the S&P 500 will beat inflation each month, and he gets it right 80% of the time. So, 20% of the time when he picks stocks to win, he is wrong, and 20% of the time when he picks inflation to win, he is wrong. This may seem like only a mildly impressive record, but I’ll show how Peter can make himself fabulously wealthy.

Let’s say Peter decides to give up his life of wearing a bow tie on inane financial television shows and starts trading based on his insight. He starts by taking a $100,000 second mortgage on his home. (Fortunately, Peter bought well before the housing bubble began and has been conservative with his money until now.)

Each month, Peter will make his prediction and do one of two things:

1. If he thinks stocks will not beat inflation, he just keeps his money in cash for the month. In this case, we’ll assume that the interest he collects just keeps up with inflation.

2. If he likes stocks for the month, he leverages his money by a factor of 3 and buys an S&P 500 index fund. By “leverage” here, I mean that if he has $100,000, he borrows an additional two times this amount ($200,000), and invests the whole $300,000 in the index fund.

Before I can run the simulations to see what happens to Peter’s money, we need to factor in some assumptions about real-world stock performance and costs:

- The expected compound return of the S&P 500 will be 6% above inflation each year, with a 20% standard deviation.

- The cost of borrowing money is 5% above inflation.

- The cost of trading in and out of the index fund is 0.5% each time.

- Peter must pay 40% tax on his gains each year.

- Inflation is 4%. (This is only needed for the tax calculation. You have to pay tax on all gains, even the gains needed to keep pace with inflation.)

All of these costs are a huge burden for Peter to overcome with his market timing strategy. The simulations will tell us whether Peter’s 80% prediction rate can win out.

I piled all this data into my program and ran millions of possible futures for Peter’s money. After 20 years, there is a 90% chance that Peter will have between $1.6 million and a whopping $69 million! The median outcome was $10.3 million. These figures are in present day dollars taking into account inflation.

So, why would Peter bother being a pundit and give away his valuable insight? The answer is that he wouldn’t. I don’t pay attention to pundits who make short-term stock market predictions because I don’t believe they can get it right significantly more often than someone who tosses a coin.

The Perils of Short Selling

2008-09-25T00:01:00.000-04:00

In his article about the new ban on short selling 800 US financial stocks, Larry MacDonald discussed some of the pitfalls of short selling. This reminded me of one of the more interesting ways that short sellers can come out on the losing end.

Short selling is the practice of borrowing stock and selling it so that you effectively own a negative number of shares. Short sellers hope that the stock drops so that they can later buy the stock back at a lower price, pocket the difference, and return the borrowed shares. Until recently, this practice was perfectly legal. Now, short selling is banned on certain beleaguered financial stocks.

As Larry said, the biggest reason why short selling is a difficult game is that stocks tend to go up. When you pick a stock to short, you have to have far better insight into the stock’s future than other investors just to break even. Using short sales to make more money than you could have made by simply owning an index is very difficult. Some might say that it’s a fool’s game.

Even when you are right about a business being overvalued, you may not make money. Government interference to prop up stock prices or ban short selling are possibilities. Another possibility is the stock remaining overvalued for years until the business value finally catches up to the stock price.

One of the more interesting ways that overvalued businesses cheat short sellers occurred during the tech boom. Suppose that ABC stock trades for $100, but ABC’s business is really worth less than $1 per share. This would seem like a perfect situation for a short seller.

But, what happens if ABC makes an acquisition? Suppose that ABC doubles the number of outstanding shares to acquire another business that is fairly valued. Now the true value of ABC’s shares has jumped to about $50 each (that is $100 of value in the acquired business spread across twice as many ABC shares). In the mania of a bubble, this might cause ABC shares to jump to $300 each.

Now ABC repeats the process by finding another larger business to acquire that matches ABC’s new larger market capitalization. Again, ABC doubles its share count. The new business value is $50 from the first acquisition plus $300 from the new acquisition diluted across twice as many ABC shares. Now ABC shares have a fair value of (50+300)/2 = $175.

ABC has successfully used its overvalued stock to increase its real value by over two orders of magnitude. Imagine the poor short seller who sold ABC stock for $100 before the two acquisitions. He thought he had a sure thing because ABC was overvalued by a factor of more than 100. Now ABC stock is worth at least $175 per share, and the stock is likely to trade much higher than this because of the mania. Short selling is a difficult game.

The World’s Oil Reserves

2008-09-24T00:01:00.000-04:00

In his book, Twilight in the Desert, Matthew R. Simmons makes the case that Saudi Arabia’s oil production will soon peak as the most easily recovered oil is depleted. His extremely detailed analysis contrasts sharply with the Saudi assertion that they can satisfy world demand for another 50 years. Much of his technical information comes from Saudi technical papers that seem to contradict their public statements.

Simmons provides mountains of technical information that amounts to circumstantial evidence that oil supplies are dwindling. However, as he points out, it is up to the Saudis to prove their claims about how much oil is still in the ground and how quickly it can be supplied to the world.

Assessing the nature of oil fields and how much oil they contain is very difficult. As much as anything this could account for the seeming lack of reliable information about oil reserves.

Even if we knew how much oil is in the ground, it’s not clear how much of it can be recovered economically. And even if we could tell how much oil can be recovered, the Saudis and western oil companies seem to have an interest in projecting a message of stable oil supplies into the future. All this leaves little hope for the average person to know when oil supplies will begin to dry up.

The main way that this book has changed my thinking is that I no longer believe any reports of the size of oil fields. It’s not that I necessarily think that the report writer is lying; I just think that they likely don’t really know. In this sense, I put them in the same category as pundits who make short-term stock market predictions.

Obscene MERs

2008-09-23T00:01:00.000-04:00

Preet over at Where Does All My Money Go recently discussed the importance of paying attention to investment fees. In a lighter moment, he had some fun with a fund screener and listed funds with yearly MERs above 8%! To appreciate how ridiculously high this is, you need to see the effect over a long period of time.

As I have discussed before, MERs are paid every year, and investors have to be cautious about comparing them to one-time costs. After one year in a fund charging an 8% MER you would still have 92% of your money. The next year, though, the fund would take 8% of your remaining 92% leaving you with 84.64% of your money.

Over 25 years, an 8% MER would chew up 87.5% of your money. Suppose that your initial investment grows to $250,000 after 25 years. If you didn’t have to pay the 8% MER, you would have finished with $2 million!

Things get even sillier with the worst fund Preet listed: “Dynamic Power Hedge Fund-F” with an MER of 13.94%. I’m not sure what this name means, but it does a better job of distracting us from its high fees than something like “Stodgy Limp Noodle Fund-Z.” After 25 years in this fund, 97.6% of your money is gone. If the fund’s managers were to re-invest the MER they collect from you back into the fund for 25 years, for every dollar of your money left in the fund, the fund’s managers would have over $40.

Don’t let these high MERs desensitize you, though. Anything over 2% looks outrageous to me. Even a 1% MER takes away 22% of your money after 25 years.

I would like to see funds have to report their MER25, which is 25 years worth of expenses rather than just the one-year MER. When comparing a 2% MER actively-managed mutual fund to a 0.2% MER index fund, both percentages seem trivially low. But their MER25s are 40% and 4.9%. This gives a better picture of the damaging effect of fees.

Experiments in Assessing Risk

2008-09-22T00:01:00.000-04:00

Suppose you’re given a chance to bet on the toss of a coin. If it comes up heads you win $20, and if tails you lose $10. Would you take this bet? Given a chance to do it 100 times in a row would you do it? This experiment was actually performed in a coffee shop in Westwood, Los Angeles, as explained by Jason Zweig in his book, Your Money & Your Brain.

The average outcome is to win $5 every time you take this bet. But, if you do it only once, you could lose $10 instead of winning $20. What about doing it 100 times? The expected outcome is to win $500. The odds that you’ll actually lose money are less than 1 in 2000. The odds of losing $200 or more are less than one in a million. The odds of winning more than $200 are over 97%. This is an incredibly good bet.

Amazingly, two out of three people accepted the one-time bet, but only 43% said they would be willing to repeat the bet 100 times. What are the possible explanations for the 57% of people who turned this down?

1. People are spectacularly bad at assessing which risks are worth taking.

2. Some people believed it was a trick, and that the gamble wouldn’t be fair.

3. Some people have philosophical objections to gambling. (However, because almost everything in life involve some type of gamble, it must be difficult to draw the line on this one.)

4. A few of the subjects were compulsive gamblers, and they knew that if they accepted the bet, they’d go out and lose it all and more in a casino.

5. A few of the subjects were so wealthy that winning only $5 per coin toss was a waste of their time.

I suspect that the dominant explanations of the experiments’ results are reasons 1 and 2. It’s no wonder that so many people make poor investing choices given that they would turn down a near sure thing.

Understanding the Current Financial Mess

2008-09-19T00:01:00.001-04:00

I stumbled across an excellent radio program that puts a human face on all the players in the current mortgage crisis. To listen to the program, follow this link to This American Life and click on the “Full Episode” link under the picture of curled US dollar bills.

During the radio program we hear from borrowers who didn’t have to show any credit worthiness, a broker who aggressively sought out borrowers without caring whether they could pay back loans, and other players up the food chain packaging mortgages into investments for the $70 trillion world-wide fixed income market that hungered for higher returns than US treasuries.

Over the course of many steps, a half-million dollar loan to someone with low income was merged with other bad loans and transformed into an AAA-rated investment. This story is part stupidity and part greed. Unfortunately, both parts are extremely large.

It’s easy to listen to this radio program and get discouraged. Are we all just greedy idiots? On the other hand, we still have too much food to go around and far more clothing for sale than we could possibly wear out. Life is pretty good whether we’re greedy idiots or not. For most of us, unhappiness is driven by envy of our neighbours rather than actual need.

Life Insurance from my Alma Mater

2008-09-18T00:01:00.000-04:00

Yet another mailing from the university I attended years ago arrived. It’s life insurance this time. In a burst of optimism, I think, maybe this will be a good deal because my alma mater will have trimmed the rates down as low as possible. I’ll get the benefits of a low cost group plan, and maybe university grads have slightly lower mortality rates.

I decide to take a look. The first thing I see is a big picture of a smiling young woman. This is not a good sign. Advertisers know that men get looser with their money when they see smiling attractive women. I skip all the other mumbo jumbo and get right to the numbers. I’m a male non-smoker. I look up my age and desired coverage amount and find that the cost with the discount available to me is $67.50 per month.

Is this good? I’m not sure. I could hunt through some paper files, but Google is right here at my fingertips. It took less than a minute online to get 12 quotes from the major insurers in Canada ranging from $46.40 to $60.73 per month.

Hmm. That’s 10% to over 30% better than the quote from my former university. Maybe the fine print is different. No, they’re all 10-year renewable and convertible. What gives?

Obviously, I knew that the university was getting a slice of the insurance premiums. But, I’d hoped that they had negotiated a great deal and had split the difference with me. Instead, they’re trying to gouge me and split the proceeds with the insurance company.

I guess my alma mater doesn’t love me as much as I’d hoped. Oh well, at least my wife, kids, and my neighbour’s dog still care about me.

20/20 Hindsight

2008-09-17T00:01:00.000-04:00

Most of us have heard the phrase 20/20 hindsight. It refers to the fact that we tend to view past events as inevitable even though we didn’t see them coming in advance. Another name for this is hindsight bias.

In his book, Your Money & Your Brain, Jason Zweig describes brain-scanning experiments that look for the biological basis for some of our human quirks. One of these quirks is hindsight bias.

When we learn something new, we have a tendency to begin to believe that we’ve known it all along. When we buy a stock that later rises, we tend to think that we knew the stock would go up. We come to think that we bought the stock confidently knowing it would go up when the truth was that we were probably very uncertain and almost made a different choice.

This tendency to believe that we were able to predict past events before they happened is very dangerous for investors. It makes us believe that the future is much more predictable than it really is.

Hindsight bias can even kick in on missed opportunities. Even if you just considered buying a stock, but didn’t buy it before it shot up can make you say “I knew it.” This feeling that you knew the stock would go up makes you more likely to throw money at the next stock that looks like it might rise.

The next time you think about some past event as having been inevitable, try to remember what you really thought before the event occurred. If you’re honest with yourself, you’ll likely remember that you really didn’t know what was going to happen.

Lehman Brothers and a Healthy Economy

2008-09-16T00:01:00.000-04:00

The banking crisis continues as Lehman Brothers files for bankruptcy. Most people seem to view banks failing as a sign that the financial crisis is deepening. You won’t be too surprised to learn that I see this differently.

The damage to the economy was done when financial institutions made poor choices chasing short-term profits at the expense of the long-term health of their businesses. Lending money to people who can’t pay it back has to cause problems eventually. That banks are failing now is a logical consequence of their actions rather than a sign that things are getting even worse.

To maintain a healthy economy, some businesses must fail. Everything would become stagnant if we were to prop up unprofitable businesses. Well-run businesses should see their market share increase as their poorly-run competitors fail.

This doesn’t mean that government intervention is always wrong. However, the important test of whether government should step in is whether it is in the public interest to do so. Having the government prop up a business just for the sake of that business is a mistake.

So, when you hear about a company failing, don’t automatically take it as a sign that the sky is falling and we’re doomed to a dark future. The remaining companies in the same industry are likely to be better run and more likely to succeed at offering products or services that make our lives better.

Life Annuities and Longevity Risk

2008-09-15T00:01:00.000-04:00

Unlike most investing products, life annuities actually solve a problem that do-it-yourself investors have difficulty handling on their own: longevity risk. By controlling my own investments with low-cost index ETFs, I can beat most professionally-managed mutual funds. However, when it comes to my retirement years, it will be hard to decide how much money it’s safe to spend because I don’t know how long I’ll live.

If you control your own investments, the only practical approach in your retirement years is to spend little enough that your money will last to the end of a very long life. Just because the odds are only, say, 50% that you’ll make it to age 80, that doesn’t mean that you can get away with saving only half a year’s worth of spending money for your eighty-first year. If you make it to age 80, you’ll need a whole year’s worth of money.

Life annuities are an insurance product designed to solve this problem. The insurance company takes a lump sum of money from you and pays you a monthly amount for the rest of your life, no matter how short or long your life turns out to be. This transfers the longevity risk from you to the insurance company. It also eliminates any inheritance.

The insurance company reduces risk by selling many life annuities. They can predict with reasonable certainty how many people will live to each age. So, if only half the people will make it to age 80, the insurance company will only have to pay half as much by then. The savings the insurance company expects over time allows them to increase the monthly payments everyone gets right from the first month.

So, with the longevity risk significantly reduced and with everything else being equal, a life annuity allows you to spend more each month than if you handled your own investments. Unfortunately, everything else isn’t equal. Insurance companies have to pay executive salaries and salespeople’s commissions somehow. These costs come out of the lump sum you hand over to the insurance company when you buy the life annuity.

Another factor is that the insurance company might not invest the money the same way that you would. If they are conservative and use mostly fixed-income investments, then you’re very likely to get less than if the money were invested in stocks.

Overall, I don’t have an answer to the question of whether a life annuity is better than investing on your own throughout retirement. But, I tried to come up with a way to have your cake and eat it too. By this I mean can we reduce longevity risk and cut out all the hefty fees and commissions?

One possibility is to pool retirement funds with other individuals to spread out longevity risk. Suppose that 50 people pool their money. At first withdrawals are split 20 ways, but as the participants die off, the withdrawals get split 19 ways, then 18 ways, and so on. The idea is that after you die, your share goes to the survivors.

It’s all a bit morbid, but it could work out well if there aren’t any serious conflicts. Draining the money to pay lawyers over a squabble would be a problem. Another problem that might make an interesting movie is that each person would have a financial incentive to bump off the others.

Despite what many people seem to believe, individual investors with a little knowledge can usually get better returns than the professionals. Reducing longevity risk is one of the few significant ways that professionals handling big piles of money have an edge over the little guy.

The Dangers of Web-Based Trading

2008-09-12T00:01:00.000-04:00

One of the concerns I have about my investing future is my own emotions. One day I may become bold or fearful and make some rash decisions. The resulting trades would probably work out badly.

I consider my online trading account to be one of the things that increases my risk of doing something impulsive. Some people say that the solution is to work through a financial advisor who performs the trades for you. I have a much cheaper solution: I avoid logging in to my trading account unless it is necessary.

Many people choose to read stock quotes and other investing news through their online accounts. When you do this, making trades is always just a few clicks away. I do my day-to-day financial news gathering anywhere but through my trading account. This small extra barrier of trying to remember my password and figuring out how to make a trade gives me a little more protection against impulsiveness.

Usually, the people I mention this to think I’m a little crazy. Is anyone else concerned about their emotions getting out of control resulting in dumb trading? What methods do you use to stop yourself?

Million-Dollar Pennies

2008-09-11T00:01:00.000-04:00

A recent article at My Dollar Plan caught my eye: A Penny Saved is ... $6,977.03! This article points to the essay Every Penny Counts by Scott Bilker.

Bilker shows that if you increase payments on a long-term high interest debt by just a penny each month, big savings result. Starting with a $10,000 loan at 1.5% per month, the interest is $150 per month. The minimum you can pay and still have the loan paid off eventually is $150.01. But this will take about 54 years. Increasing the payment to $150.02 saves you $6977.03 over the life of the loan. Just a penny per month makes a big difference.

Now I understand the point these authors are making: small amounts can add up. Ignoring small amounts each day can seriously hurt your finances over the long run. I’ve made the same argument myself in Small Amounts Add Up, but Pennies Don’t. As you can guess from this article’s title, I argue that small amounts add up, but pennies are just too small to amount to anything important.

But, doesn’t Bilker’s example prove the opposite? No, because it is too contrived. It just shows that you should avoid high-interest loans.

Let’s take Bilker’s argument to the next level. Suppose that you have a department-store credit card that charges 2.4% per month. You build it up a $10,000 balance, and then pay the exact amount of the interest, $240, each month. Your balance should stay at $10,000 indefinitely.

But, you didn’t notice a short paragraph in the fine print. There is a one-penny service charge each month. At first your balance goes up by a penny each month, but interest begins to compound over time. After 60 years, you finally notice that something is wrong. How much do you owe at this point? Drum roll, please ... $10,868,192.14!

Of course, this whole example was silly. Bilker’s example was less silly, but silly nonetheless. It’s about time that we eliminate the penny. The pennies that we hand back and forth in cash transactions can never amount to much. We would be just fine if all cash transactions were rounded to the nearest nickel, or even quarter.

The Cost of a Free Dinner

2008-09-10T00:01:00.000-04:00

Let’s say you’re in a casino gambling and an employee walks up and says “I see you’re not having a good day. Here’s a voucher for you and your wife to have a free steak dinner. You can go right now. Enjoy.” This is a real possibility at Harrah’s casino in Las Vegas. This is a very kind gesture, but what is behind it?

Yale law professor and economist Ian Ayres answers this question in his book, Super Crunchers. The ability of computers to gather vast amounts of data about our actions and choices has given rise to decision-making based on data analysis, called super crunching by Ayres.

To see how super crunching works, let’s look at the case of Harrah’s casino. Like any business, Harrah’s would like to maximize profits. To use super crunching, Harrah’s began by collecting data about the gambling patterns of their “total rewards customers” who use swipeable electronic cards to identify themselves while gambling. Then Harrah’s used a method called regression on the data to see what factors lead to higher revenue per person over time.

There is no need to guess which factors are most important for profitability; the data analysis figures this out. Harrah’s determined that people tend to have a “pain point.” If they lose too much money in a weekend, then they don’t have fun and may not come back.

This pain point depends on income and other factors, and the regression analysis allows Harrah’s to guess each customer’s pain point from personal information collected when the customer card is created. When a customer approaches the predicted pain point, Harrah’s intervenes in some way, such as offering a free steak dinner. So, the free dinner is all about increasing the odds that you’ll come back and lose more money in the future.

So, what is your reaction to all this? Is Harrah’s making people’s lives better or worse? Some people have no problem with this sort of personal data collection, and others are horrified by the invasion of privacy.