Money Management and the Economy

Friday, April 10, 2009

Chicken or Egg

You aren't smarter than the market. It really is that simple.


There have been a few articles recently on the financial meltdown with the same theme. That is that the housing bubble lead to the collapse of the financial markets. The reality is a little different. The financial markets, specifically the creation of derivatives based on real estate loans, created a housing bubble.

Beginning in the late 1990's trillions of dollars poured into the housing market, forcing prices well beyond what people could afford for housing. In most parts of the country, the median price of a home was no longer affordable to someone with a median income. Renting was far cheaper than owning. How did that happen? Where did the money come from.

The answer is that the Wall Street bankers had figured out a way to hedge most of the traditional risk of real estate. Instead of directly investing in real estate themselves, they loaned money to people who were buying a home. Then they took the resulting loans and bundled them into bonds that could be sold as low risk investments. Those "low risk" real estate investments, called Collateralized Debt Obligations (CDO's), produced far better returns than the government or AAA corporate bonds they were competing with. And they produced large profits for the Wall Street banks that created them.

The result was that money poured into the real estate market. As a result prices escalated and the terms of the loans got looser and looser in order to maintain the flow of investment opportunities. And that fed the bubble even more, as people who could not traditionally afford to buy a home entered the market. Thus the real estate bubble was a creation of the Wall Street bankers. Despite the recent collapse, businesses like Goldman Sachs made huge profits in the process and most of those profits were protected when the inevitable collapse came.

While much has been made of the problems created by "toxic assets", the truth is that when the bubble burst, most of the losses were to homeowners, not their lenders. It was the overpriced homes that were the really toxic assets, the bonds were considerably better investments. In effect, much of the risk of real estate investment had been transferred to people who bought a home to live in. Millions of those home owners now owe more than their house is worth.

If you look at the total losses in real estate in the last couple years, the losses to investment banks and lenders pale compared to the total losses to home owners. And all those losses can be traced back to the highly profitable business of taking real estate loans and bundling them into derivatives, shielding investors from the real risks of investing in real estate. And that is what created the financial crisis, not the housing bubble. It was just an unpleasant sid effect.

Wednesday, April 1, 2009

Why Cost Averaging Really Does Work

You aren't smarter than the market. It really is that simple.

There are a number of places on the internet and in the media where people have questioned the value of "cost averaging". Cost averaging is investing in regular amounts over time, rather than in one lump sum all at once. It has been standard investment advice, but now some critics are arguing that, since the market in the long run tends to go up, the earlier you invest the better. Cost averaging will reduce your return in the long run.

They are, of course right. On average, you will get a lower return. But cost-averaging is not done to maximize returns. Its used to minimize risk. It is a strategy to make sure you get an "average" return instead of hitting just one peak or one valley.

Think about it this way. Suppose someone offered to flip a coin and pay you $51,000 if it was heads, but you would have to pay them $50,000 if it comes up tails. Would you take that bet? On average, you would come out ahead. But only a gambler makes that kind of bet unless you can afford to lose the $50,000. On the other hand, if they offered to flip a coin 1000 times with the same odds, you might be tempted. The odds are still in your favor and you are unlikely to lose every time and cost you $50,000. Of course you are also unlikely to win every time and win $51,000 either. Instead you have a good chance of coming out ahead somewhere between those two exremes.

The market works the same way. If you want to maximize your return you, flip the coin once. If you want to minimize risk you spread your flips out. Most of us are trying to be investors, not gamblers. We want to make a reasonable return while preserving what we have. So lets look how this works in practice.

If you have $5000 to invest in your IRA and invest it on the first of the year you will do better, in the average year, than if you put $100 into your IRA over the course of the year. The problem is that not all years are average. More importantly, not all starting points are average. Some years the value of stocks will be higher to start the year than the average over the course of the year, other times it will be lower than average. In fact, in the current market, that is true from week to week as you can see in the example below.

This year I decided to basically add $100 each week to my IRA. The details are a bit more complicated than that, but I am simplifying here. So what do those investments look like:

Date Shares Security $Invested

1/6/2009 5.893 Vanguard Balanced Index Fund Investor Shares $100 
1/13/2009 6.127 Vanguard Balanced Index Fund Investor Shares $100 
1/20/2009 6.427 Vanguard Balanced Index Fund Investor Shares $100 
1/27/2009 6.250 Vanguard Balanced Index Fund Investor Shares $100 
2/3/2009 6.301 Vanguard Balanced Index Fund Investor Shares $100 
2/10/2009 6.329 Vanguard Balanced Index Fund Investor Shares $100 
2/17/2009 6.489 Vanguard Balanced Index Fund Investor Shares $100 
2/24/2009 6.588 Vanguard Balanced Index Fund Investor Shares $100 
3/3/2009 7.018 Vanguard Balanced Index Fund Investor Shares $100 
3/10/2009 6.887 Vanguard Balanced Index Fund Investor Shares $100 
3/17/2009 6.562 Vanguard Balanced Index Fund Investor Shares $100 
3/24/2009 6.394 Vanguard Balanced Index Fund Investor Shares $100 
3/31/2009 6.460 Vanguard Balanced Index Fund Investor Shares $100 

You will notice that the first shares I bought were also the most expensive. Had I invested to my IRA limit to start the year, I would likely end the year with many fewer shares than I will by my strategy of cost averaging. In January and February, I came out ahead with lower prices later in the month. In March, I would have been better off to purchase on March 3rd, when prices hit bottom for the year so far.

That is true, even if stock prices eventually recover to the level they were in January. The only way I will come out behind is if the average price I pay over the course of the year is higher than it would have been in January. Otherwise I will end the year with more shares of stock, regardless of their price at the end of the year. If 20 years from now, I sell the shares from these transactions, I am going to get 20% more money for the shares I purchased on March 3rd than I will for the shares I purchased on January 6th. That is a pretty significant difference.

I am looking only at share prices here. But there is another factor to consider in evaluating the overall return. That is any dividend payments I receive. Because my IRA is not getting dividends on shares I don't yet own.  Of course, the dividends in the future will also be higher since I own more stock. 

Which just clarifies when cost averaging makes sense. If you are buying investments where the primary return is from dividends and/or interest, you probably don't need a risk limiting strategy like cash averaging. But if you are buying securities whose price is volatile, cost averaging will reduce your risk and sometimes save you from paying a premium price that you will never recover.

Sunday, February 15, 2009

Now is a good time to roll over your IRA to Roth IRA

You aren't smarter than the market. It really is that simple.

One of the interesting aspects of the recent collapse in stock values is that it makes it a good time to consider rolling your traditional IRA over into a Roth IRA and paying the taxes on the lower valued stock before they go back up. Of course, that assumes they will go back up before you retire.

For people who don't pay attention to this sort of thing, the basic difference between a Roth IRA and a traditional IRA is how you pay taxes on them.

With the traditional IRA you put your money in an account for retirement and you don't have to pay any taxes on it. Or, looked at another way, you can deduct the contribution from your income taxes. You also don't have to pay taxes on any of the earnings from the investment while they accrue. But when you go to take money out of that account, you have to pay income taxes on the money you withdraw just as you would any other income you had earned. So, while you save money in the short run, you are fully taxed on both your investment and any earnings when you take the money out. And, with a traditional IRA, you are required to start taking the money out so you can't avoid paying taxes forever.

The Roth IRA works basically in reverse. You pay taxes on the money before you put it into the account. You don't have to pay any taxes on any earnings as they accrue. And you don't have to pay any more taxes on either the principal or the earnings when you withdraw them in retirement. There is also no required withdrawal, so they can go on generating tax free income the rest of your life.

Generally speaking, and the devil is in the details, you are better off with the Roth IRA if you expect your nominal tax rate to be as high or higher in retirement as it is now. Of course, none of us really know what our tax rate will be in retirement. That will be based on a bunch of factors, including decisions by people we elect in the future. For that reason, there are people who argue that you should have "tax diversity" with some money in Roth accounts and some in traditional IRA's (or 401K's which are similar to the traditional IRA in how they are taxed). But the general argument, that Roth is likely to be a better deal if the market goes up remains true.

Why does this matter? Because most people can roll investments they made in a traditional IRA over into a Roth IRA. But they have to come up with the money to pay the taxes. And, that money can't come out of the money being rolled over without paying early withdrawal penalties on it.

So assume, like me, you have $10,000 in a traditional IRA and a nominal tax rate of 25%. If you roll that $10,000 over into a Roth IRA now, next year you will owe an additional $2500 in income taxes. So does spending $2500 now pay off? Lets look at three scenarios:

1) Your investments have zero return:

IRA 10,000 - taxes paid upon withdrawal $2500.
Roth 10,000 - taxes paid now $2500.

This is essentially a wash, although the IRA has the "advantage" that you can pay those taxes out of the money as you take it out. I put quotes around "advantage" because this seeming advantage also means you have less money to spend in retirement. That extra $2500 you use to pay taxes on the Roth now can also be looked at as additional retirement savings.

2) Your investments return 10%: (this gets trickier)

IRA 10,000 + $1,000 earnings. Taxes due on withdrawal $2750.
You also would make another $250 with a 10% return from investing the $2500 saved by not paying rollover taxes. But those earnings are taxed - taxes on earnings $62.50
Net to spend in retirement: 10,937.50 after taxes.

Roth $10,000 + $1000 earnings (no taxes)
Net to spend in retirement: $11,000 after taxes.

Of course, 10% isn't a great total return for a long term investment. What happens if you leave the money there for 20 years and it doubles in value?

IRA 10,000 investment + $10,000 earnings. Taxes due on withdrawal $5000.
You also would make another $2500 with a 100% return from investing the $2500 saved by not paying rollover taxes. But those earnings are taxed - taxes on earnings $625.
Net: 19,375 after taxes.

Roth $10,000 + $10000 earnings -
Net: $20,000 after taxes.

But what if you don't invest the $2500 you saved on taxes? Then you have considerably less to spend in retirement:

Net IRA - $15,000 after taxes.

So, it pays to roll over if you are still paying the same tax rate on income when you retire. On the other hand, if your nominal tax rate drops to 15% at retirement, you may be better off waiting. But only if you invest the money you save on taxes. Otherwise you will still have less money when you retire if you leave your money in the IRA.

But what happens if your investments LOSE money? Then you are almost certainly better off leaving your money in the IRA. And that brings us to the reason many people think now is a good time to make the rollover. Because the value of most IRA accounts has dropped dramatically their value is at a low point and the taxes on the rollover will be lower. Some people also believe that today's low stock values will mean higher returns in the future and, as we saw above, the higher the total return on your investment the greater the tax advantages of the Roth IRA.

Monday, February 9, 2009

You Try to Live on 500K in This Town

You aren't smarter than the market. It really is that simple.

This article in the New York Times, You Try to Live on 500K in This Town , makes it easy to make fun of the perils of having to live on only the $500,000 Obama is suggesting be the limit for executives of failing banks who take federal dollars. But there is really something far more disturbing in the discussion as it takes place throughout the newspaper. It becomes apparent that there is the sense that even if you have lost trillion's of dollars of other people's money, you are still entitled to live an extravagant lifestyle.

Having left thousands of people losing their homes, jobs and feeding themselves at food banks, these people genuinely don't see why they would ever have to suffer the same fate. In 1929, wall street losers jumped out of windows. They understood that there was nothing to insulate them from their fate. Today's financiers have no such belief. And with good reason.

One of the reason the Obama administration is being cautious about limits on executive compensation is fear that the bank executives will simply refuse to have their banks participate if their personal compensation is too severely limited. And realistically, there is no one in the bank who has the ability to force them to participate, even if it is in their institution's best interest. In short, the banks are run for the benefit of their leadership.

Of course, you might also wonder to what extent some of the people in the finance industry who populate the new administration are concerned about their own future salaries. After all, the last thing you want to do is initiate a deflation in executive salaries. It will come back to bite your own compensation in a few years when you go to cash in on your Washington experience.

Perhaps Nader was right - there really is no difference between the Democrats and the Republicans. America now has an aristocracy that moves easily between Washington and New York depending on who is in power, but always preserving their own class privileges.

Saturday, January 31, 2009

Is Now the time to Buy a House?

You aren't smarter than the market. It really is that simple.

The real estate industry is putting on a full court press for the notion that real estate is now a bargain. But the reality is that housing prices still have a long way to fall before they reach historic norms. And there are plenty of reasons to wonder even once they hit those norms, whether that will be the bottom of the market. The bad economy, huge amounts of other consumer debt, the tightening of credit and the hangover from the binge of new houses built at the height of the bubble would all argue that the immediate future is likely to see prices stay well below those historic norms for several years even once the current price bubble has fully deflated.

So if you are renting and thinking about buying, you are probably better off waiting until at least 2010 and probably 2011. Buy now and it may be 5 years or longer before your house gets back to the current price you paid for it.

On the other hand, if you already own a home and are unwilling to move into a rental, you are going to be on the hook as values fall regardless of what house you own. And one thing that real estate has going for it right now is very low interest rates. If you already own a home, those interest rates make moving up in the market both possible and attractive. The new home will fall in value, but probably not much more than your existing house.

If you are buying a house to live in, not as an investment, then there is a real opportunity right now. You will need good credit, a stable job and equity in your existing home to take advantage of that opportunity, but you can probably take on a bigger mortgage on a nicer house with the same payments as your existing mortgage. So if you want another bedroom, a larger yard or a lakeside location now may be the time to get a house that gives you those improvements.

Of course the worm in that apple is that you have to find a buyer for your existing home. With the smart new money sitting on the sidelines, that means finding someone in the same situation as you who sees your home as a step up. And has good credit, a stable job and equity in their existing home. With housing prices and the economy in freefall, those buyers are going to be increasingly hard to find. Which is another reason why housing prices are not likely to stop falling any time soon.

Tuesday, January 6, 2009

Is Lawrence Yun Really an Economist?

You aren't smarter than the market. It really is that simple.

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Update:

Here is an article about Yun's predecessor essentially admitting his job was "spin".
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Is Lawrence Yun, the Chief Economist for the National Association of Realtors, really an economist? No, I don't mean does he have a degree and training in economics. I assume that he does. The question is what services of an economist does the National Association of Realtors provide.

In case you haven't noticed Yun before, it seems every time there is an article about the housing market in the New York Times, Associated Press and other media, Yun appears with his usually rosy prognosis of the future of real estate. That is not surprising, given who he works for, but it is not really the job of an economist. Its the role of a PR flak who is delivering the message that suits his employers. I suspect the job title of "economist" is also a part of that message. Afterall, identifying himself as a "spokesperson" for the Realtors would alert people to the self-serving nature of the opinion he is providing.

Unfortunately, this is the nature of much of the economic information we get from the mainstream media. Economists are generally employed by institutions with an interest in certain economic behavior. Even those in the academic world work in departments whose success depends on contributions and grants from institutions with an interest in their work. Its not that economists or economic departments conciously slant their analysis to serve particular outcomes, but that those whose natural bias supports the wealthy are the ones that are successful.

In addition, like Mr. Yun, the people who seek out reporters tend to be the ones that have seeking out reporters as part of their job description. When you look at real estate, the average person who is facing foreclosure does not have many "economists" working for them. On the other hand there are literally thousands of people with economics and business degrees working for the other players in the mortgage meltdown. This is why Bear Stearns is a national problem requitring immediate intervention, but the thousands of people losing their homes is just the workings of the market place. This is why regulators step in immediately to help Bear Stearns with almost unanimous approval from economists, while congress will dither for months over finding the right political solution to the problems created by foreclosures for both individuals and communities.