Simple Minded Investor

Traditional IRA and Roth IRA Contributions are Not Equivalent

2011-05-01T11:04:00.000-07:00

The Minneapolis Star-Tribune financial advice columnist, Chris Farrell has an article in the Sunday May 1, 2011 edition that epitomizes the results of over-simplified financial analysis. For some reason, most of the media's financial advisers seem intent on ignoring the complexity of comparing Roth and IRA contributions and the result is often poor advice. Let's take a look at the media's conventional wisdom and how it compares to reality.

Most media financial columnists will say that an IRA and a Roth contribution are equivalent assuming that your tax rate is the same on both ends. If you expect your taxes to be lower in retirement, then the IRA will give you a better return. If not, then the Roth is probably a better investment. On one level this is accurate.

If you put $100 into a Roth IRA and are in the 25% tax bracket, you will have spent $125 including the taxes. Lets assume your investments break even over the next ten years and then you withdraw the balance of the account. You will have $100.

If you put that $100 into a Traditional IRA. You will save $25 in taxes, but you will have to pay $25 in taxes when you take the $100 out if you are still in the 25% tax bracket.

Assuming you saved the $25 you would have paid in taxes, this is a wash and you end up in exactly the same spot with $100 to spend. (Whether your investments do better or worse than break even doesn't effect the comparison, they will have the same effect on either choice.)

Unfortunately the assumption that you will save the tax savings never seems to get dealt with. And if you don't save the money you would have paid in taxes, that investment in a traditional IRA is going to be worth 75% of the same investment in the Roth IRA.

Now what happens if, as in the article above, you decide to maximize your contributions to each? For the example in the article that amount is $6000 per year. If you save this amount in a Roth IRA you will have $6000 when you withdraw it. If you save it in a traditional IRA you will have $4500. Again, that assumes the 25% tax bracket. To have an equivalent amount in retirement, you need to put the $1500 you saved in taxes into a traditional savings account to be saved for your retirement along with your IRA contribution.

Essentially for someone in the 25% tax bracket, a quarter of their traditional IRA (or 401(K) and other tax-deferred accounts) belongs to Uncle Sam. When they withdraw their money, they are going to have give Uncle Sam his share by paying the taxes on both the principal and earnings for that 25%. With the Roth IRA, it is just like any other savings account, the money is all theirs and there are no taxes when money is withdrawn.

I suspect one reason this rarely gets discussed is that it makes explicit the fact that you aren't really "saving" anything on your immediate taxes by putting money into an IRA or 401(k). To get the same results as a $6000 contribution into a Roth IRA, you will need to save $1500 in addition to the $6000 contributed to traditional IRA. These tax deferred accounts are simply kicking the tax bill down the road. Its "tax-deferred", not "tax-free", and there are no "tax-savings".

There are still benefits to retirement accounts. There are real tax savings from earnings on the deferred taxes. But a $6000 contribution to a traditional IRA is not equivalent to the same contribution to a Roth IRA, no matter how often the media gurus tell you otherwise.

Taming the Risk of Markets

2011-04-17T17:13:00.001-07:00

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

A few years ago, in October 2008 right after the market "crash", I did a post on confusing volatility and risk. Yesterday an article on CNN Money in their "Ask the Expert" column made it clear that confusion about the risk of volatility extends to the media who provide advice on personal finances.

You can read the column for details. But the short version is that someone approaching retirement asked for advice on changing the balance between different assets in their retirement accounts to reduce its overall risk. Specifically they wanted to know "Should we rebalance all at once or slowly over time?"

The columnist response was all at once. His argument was "by transitioning to the new asset mix over time, you're really postponing (or perhaps more accurately, undermining) your decision to re-set the risk-reward balance in your portfolio."

This is just plain bad advice. The market can go up or down several percentage points in a day. The risk from that volatility exists only when you make a transaction. The risk is that you happen to sell when prices are temporarily at the bottom of a cycle or buy when they are temporarily at the top. The more money you move at once, the bigger the impact of luck (good or bad).

If you want to REDUCE your risk the dumbest thing you can do is to move a lot of money all at once. Whether you like it or not, you are timing the market. The only difference is that you are doing it with one random roll of the dice instead of some anticipation of the market direction. Averaging those moves over the course of the year won't eliminate the risk the market will be down or up over a longer cycle. But it will reduce the risk from day to day, week to week and month to month fluctuations. And given current market volataility, those risks are substantial.

Some people will argue that if the market goes back up again, you will have restored whatever losses you had. But that also misunderstands how volatility plays out. If you buy stock at a higher price, you get fewer shares. Regardless of what price you sell them at, you will get less for them in direct proportion to the higher price you paid.

I keep our personal finances in Quicken. I can follow the balance in our retirment accounts as the fluctuate from day-to-day. And occasionally I will joke to my wife that we made (or lost) some big sum of money. Since we have no intention of buying or selling, the reality is that those fluctuations are meaningless. And for accounts that we will not touch for another ten years, monthly and even annual changes don't mean much.

But once you go to buy or sell, those fluctuations can have a dramatic impact. Buy when the price is 5% higher than its average over the next twelve months and you have effectively lost 5% of the value. And that loss is permanent.

Put in different terms. If you gamble a large sum of money on the flip of a coin, there is a 50% chance you will lose it all. If you flip the coin twice, the chances of losing everything drop to 25%, if you flip three times they are 1 in 8 or 12.5% and flip once more and they are down to 6.25%. Of course your chances of winning every time also drop. But if your goal is to reduce risk, then the more times you flip, the less risk. Investments work the same way, the more times you gamble on market volatility the less likely you are to get badly burned.

I would note, I have not considered the cost of transactions here. If you are paying a fee every time you move money then you need to consider how much extra the over time strategy will cost.

The T-Party Movement and Running Government Like a Business

2010-10-18T08:00:00.000-07:00

There is a media narrative out there about the T-party that it is made up of people who are angry because they lost their jobs or fear losing their jobs. The actual demographics of T-party supporters don't really reflect this at all. Instead, the typical T-party adherent is male, moderately well to do and in his 40's. Of course, not all fit that demographic. But far from being "trailer trash" as some people imagine, the T-party folks have been relatively successful.

So why are they angry? Because they fear life is getting worse, rather than better. And they, as individuals, react psychologically to their fears by getting angry, as opposed to other extreme of going to bed and pulling the covers over their head. But to focus on the causes of their anger, which are mostly personal psychology, is to ignore the causes of their fear.

Of course, we can't expect politicians or the media to address those causes. Success in politics requires validating that fear and anger regardless of its source. And playing on people's emotions is what holds an audience for advertisers. Neither one has any real interest in deconstructing people's emotions and addressing their fears rationally.

But confronting the sources of fear is probably the only way to pull out of a death spiral of fear feeding the anger and the anger just adding to the level of fear. The causes of people's fear are both rational and irrational. And they are not universal. So lets take a look at several of them.

One of the complaints you will here from the T-party folks is that they are paying taxes and "most Americans" aren't. This is based on the current talk show meme that most income tax is paid by the highest earners, while a large number of American families get off "scot-free", paying little or no taxes. It isn't really true, but that is a different issue. The T-party folks believe it because it fits their own experience.

Under our tax system, we pay income tax at different rates during different periods in our lives. Obviously most children pay no income tax. When we are teenagers, we may pay very little even if we have a job. Once we enter the workforce, we will start to pay a significant portion of our income in taxes, but our overall earnings are generally low. But the tax system is set up that once we start a family, there are numerous tax breaks that are income tested. People whose income is in the mid-range of household incomes, may find that with deductions they get for their children, there tax bill is again small or non-existent. Much like when they were teenagers.

Unfortunately(?), children leave home. When they do family expenses decline, but the tax man comes to take away a lot of that extra income. I think that may be why you see the T-party demographic being well-to-do 40-something male Republicans. These are folks who have moved from the "tax-privileged" category, that people who have families with children are in, into the tax-paying part of their lives. They had looked forward to the time when the kids were out of college and they would have a lot more money to spend on themselves. They found instead that Uncle Sam was going to take a much bigger share. So, while taxes in general haven't gone up, theirs have.

As we age, our income increases and the expense of maintaining a family disappears, our tax bill continues to increase. But once we retire, its likely the bill will fall again. Most people do not pay additional taxes on their Social Security benefits. So people totally dependent on social security and their savings for their expenses, may pay no taxes. Of course, that will be less true in the future when people have large amounts of tax-deferred savings that are taxable when used.

Of course, this process is nothing new. What feeds the fear now for those in the middle of that proccess, is that many of them have lost confidence in the future. They don't necessarily expect to be earning more in the future. They are under water on their mortgage, even if they can make the payments. The savings they thought guaranteed a comfortable retirement looks a lot less certain. In short, when it looks like hard times ahead, we all tend to hoard our resources. So as taxes take a bigger share of their income, it is coming at time when they are feeling very insecure about the future. They NEED that money.

You can see this fear of the future play out in the political debate. Concern about the federal deficit, the cost of paying for our retirement system, opposition to public investments and the demands to cut back assistance to the less fortunate all reflect a lack of belief in a prosperous, productive future. It is that fear of the future and feeling the need to hoard our resources for the coming lean times that is emotionally driving the current political/media discussions.

The problem is that acting on those fears makes that future all the more likely. Which brings us to "running government like a business".

I always wonder that when people use this cliche they seem to mean "run government like a small, unsuccessful business". They don't seem to include the most successful, large businesses that are perpetually in debt. Those businesses borrow money and invest it in production, confident that they will produce enough income to repay the debt and return an even larger profit than if they hadn't borrowed. They are always trying to reduce costs, but not at the expense of productivity.

Even small businesses faced with falling revenue or low profits have two choices. One is to cut costs even if it reduces productivity, the other is to invest to bring in new customers or increase productivity to serve current customers at lower costs. Its really the unsuccessful business, the one that is dying, that cuts its necessary expenses in order to maintain a profit. Successful businesses, large and small, go by the adage "you have to spend money to make money".

Of course, many small businesses are not successful or even run like a business. Instead, they are just a way for someone to make a living. As one local business owner said of a store that was for sale, "Its not really a going business, but someone might be able to buy it to create a job for themselves." For people who own and operate those businesses, cutting the advertising budget to pay for their kids college makes perfect sense. The success of the business is a secondary consideration. Its really just a way to have a job.

Those same choices exist with government. There are certainly good arguments that some of the money government spends is wasted. Government, like a business, should always be trying to identify and cut that waste. And other public costs, like retirement and other social service benefits are not going to bring a return in the future. Instead those are debts being paid to those who helped to build the vibrant country we inherited. But many of the folks who say they want to "run government like a business" also want to cut costs that are really investments for future success - education, infrastructure and effective business regulation. And that's because they have lost confidence in the country's future. They don't really believe those investments will bring a return that will repay them. They want to run the country like a failing small business that cuts advertising because it "can't afford it" only to have even fewer customers. They have given up on the American dream.

Rather than looking to the future, the T-party and its allies are fearful. Instead of building for the future, they are just trying to hang onto what they have until their lives run out. Of course that is not how America became the greatest country on earth, but it is how other country's have lost that status in the past.

I still believe in American exceptionalism. As a democratic country we can decide we are not going to go into decline and die. We can leave a better and stronger country for the next generation to build their prosperity on , just as our parents provided the basis for our own prosperity. I'm an optimist, the meme of the day is fear and anger, but this too shall pass.

"Courage... is mastery of fear – not absence of fear" - Mark Twain

Five Solutions to Social Security

2010-10-06T03:00:00.000-07:00

As I discussed in Friday's article, there is a concerted political campaign to "wean us off" social security, as one of the program's congressional opponents put it. Central to that campaign is the notion that the program is going "bankrupt" and future generations will not receive any benefits. While that argument has little merit, there is some reality to the underlying problemt. Lets look at the reality.

The real problem facing Social Security is demographic. That huge group of baby boomers born after World War II is approaching retirement. This means they are ready to leave the workforce and start collecting social security. That demographic bubble means more people will be receiving benefits and relatively fewer people will be paying for them.

This problem has been anticipated for a while. The solution hit on 25 years ago was to switch to having current workers pay more in social security taxes than the costs of paying benefits to current retirees. The extra money was put into the Social Security trust fund to be used when the demographics shifted and current workers were paying less than was needed for current benefits.

The extra money paid into the Social Security trust fund was "loaned", with interest, for other government expenses. This allowed the government to avoid borrowing that money elsewhere. One way to look at it is the Social Security trust fund bought government bonds rather than the government selling them to China. Another way to look at it is that the government used the money to pay for other programs. And still another way to look at it is that the government used social security taxes to keep other taxes low, including providing the currently debated temporary tax cuts.

Regardless of how you want to look at how the trust fund has been used, as of this year Social Security taxes will no longer cover current benefits. That means other taxes are now going to have to pay the difference. In essence its time to pay back the money taken from the trust fund.

This causes two problems. The first is that the government got used to having the excess social security taxes to spend. So it needs to replace that revenue by either borrowing more money elsewhere, raising taxes or cutting spending or some combination of those.

The other is that for about the next 30 years it will have to come up with additional funds to pay social security. Again the choices are borrowing money elsewhere, raising taxes or cutting spending. This is in addition to having to replace the revenue it no longer receives from excess social security taxes. Essentially its a double-whammy.

There is a third problem beyond repaying the money saved for future social security benefits, which is that we didn't save enough. In 20-30 years the money saved will be gone and current taxes are projected to cover only 75% of the promised benefits.

So that's the problem. Here are the potential solutions:

Solution 1: Raise Social Security Taxes

The most obvious solution is to raise social security taxes. The current rate for social security taxes is about 6% for both employers and employees. Since that will pay 75% of benefits in 30 years, the tax rate will need to be raised to 8% in order to cover the benefits with current taxes. What that means is that if we raise the rate by one-tenth of one percent each year for the next 20 years there will be enough money coming into Social Security to pay all the promised benefits.

To put that in perspective, someone paying social security taxes on the maximum of $100,000 would see their social security taxes go up by $100 each year. Of course it adds up. After 20 years, they will be paying $2000 more each year, as will their employer.

Slowly increasing the rate prevents disrupting the economy. That extra $100 is unlikely to have much impact on either employment or spending decisions. It also means the trust fund will last longer, so the actual increase may not need to be even .1%. And, of course, the trust fund lasting longer means the rest of the federal budget doesn't have to pay it back as fast.

Solution 2: Raise the Cap on Wages Covered

Right now people do not pay social security taxes on wages over $100,000 (approximately). Wages over that amount also do not get counted in determining benefits. One of the reasons that not enough was saved in the trust fund is that as income disparities have grown, more and more wages have been exempt from having to pay social security taxes.

According to this analysis by the congressional research service , eliminating the cap would entirely solve the shortfall if individual benefits were not extended as a result. Even if benefits were extended to the people paying taxes on all their wages, removing the cap would almost eliminate the gap between the cost of benefits and tax receipts. This is because, as a group, the extra benefits high wage earners receive would not equal the taxes on their additional income.

Solution 3: Extend Payments to the Social Security Trust Fund

As mentioned above, by the time the trust fund is paid back, the annual repayments are projected to cover 25% of the cost of social security benefits. This means that 25% of the cost of benefits will be coming from the federal government's general fund, whether it is borrowed or tax revenue. To understand the impact of that on the federal budget, think of what happens to your family budget when your final house payment has been made. Suddenly a major annual expense is gone. The same thing will happen to the federal government.

There are a number of ways that new surplus could be spent. But one way to deal with social security deficit is simply to extend the existing payments to the Social Security Trust Fund in the form of loans against future revenue. Just as the general fund borrowed money when the social security trust fund had a surplus, the trust fund can borrow money from the general fund to meet its cash flow problem. At some point, as the baby boomers die off, the trust fund will begin to generate more revenue than benefits. At that point it can pay back the general fund.

Of course that assumes that the numbers work. We are already stretching our ability to predict the future when we assume there will be a shortfall in the future. Trying to project what is going to happen to the economy and demographics of the United States 50 years from now is almost pure speculation. So this solution would raise taxes or borrow to repay the trust fund to cover benefits as needed. The decision to extend those payments from the general fund would be made in 20 or 30 years, closer to the point at which the social security trust actually runs out of money.

The solutions above all look at how to preserve social security without cutting promised benefits. They are essentially revenue solutions. The other side of the coin is to reduce the cost of Social Security. There are two ways to accomplish that:

Solution 4: Reduce benefits for all Recipients

There are numerous ways too reduce benefits. One is to simply wait until the trust fund runs out and then cut benefits to to match current revenue. Current projections tell us that would be a 25% cut. Just as increasing taxes gradually would reduce the pain, so would reducing benefits gradually. If you reduce benefits by 1% each year from the currently projected benefits then in 25 years they will be equal to tax receipts. The current average social security payment for a couple is $22,000. To achieve a 1% reduction would would mean cutting retired recipients income by $220 each year and by $5500 over 25 years. That is in current dollars, the actual amounts will need to be adjusted for inflation.

Solution 5: Reduce the number of recipients

The obvious way to reduce the number of recipients is to raise the retirement age. There is a lot of logic to this. People live longer and many people are productive long past the traditional retirement age of 65. In fact, currently we require most people to retire later than 65 in order to get full benefits and delaying retirement even further results in still higher benefits.

Another suggestion is to "means test" social security, reducing or eliminating benefits for people whose income is over a certain level. One way to look at this is the flip side of raising the income limit for taxes.

Whatever the solution. What is clear is that social security is not in a crisis. There is plenty of time to consider options for making sure it remains a solid foundation for most people's retirement.

Social Security and Retirement

2010-10-01T06:36:00.000-07:00

The current media narrative is that "social security" is not reliable. It has gotten to the point that this urban myth has become an accepted part of unrelated discussions of retirement. Here is one on article on retirement planning that is an example. This repeated media driven mantra has lead many young people to adopt the attitude that, as one told me 15 years ago, "I don't expect to get any social security."

But in fact that is wrong. Even once the social security trust fund is gone in 30 years, continued revenue is expected to cover at least 75% of the projected benefits. And even that is based on projections that assume US workers wages will continue to represent a declining proportion of any increases in productivity. And reducing benefits to 75% of those promised is only one of many options, if in fact social security taxes don't cover all the promised benefits.

The reality is that for many people Social Security is the ONLY reliable leg of the stool. Personal savings are subject to the vagaries of investment decisions and the market. Most people do not have a pension and many don't even get any employer contributions to a 401k.

The real threat to social security benefits is political. There is a determined effort to gut social security and the people who oppose it have been very successful in portraying the system as insolvent.

The problem is not that social security is insolvent or ever going to be. Its that the money borrowed from the social security trust fund will have to be paid back, probably from income taxes or borrowing elsewhere. Just as surpluses have been used to reduce income taxes and the deficit over the past decade

The income tax is one of the few taxes that takes a bigger bite out of the wealthy than it does the middle class. And the wealthy are also the least dependent on Social Security for financial security in their retirement. Most of the nation's decision makers, opinion makers in the mainstream media and economists belong to the class of people that has more to lose from paying back the loans from social security than they have to gain from a secure retirement fund.

So, there is a lot of political pressure to avoid having to repay the loans from the Social Security Trust Fund. For the last 25 years, wage earners have been paying higher taxes on their income than necessary to support the benefits paid to current recipients. The reason for those extra payments was to cover the retirement needs of the baby boomer demographic bubble. In essence, we have been paying both retired workers benefits and fronting some of the cost of our own.

Most of this article above addresses that same audience. For many people their first career was about making money, making money and making money. "Fulfillment" was not part of the formula because, with their talents and training, they didn't have the option of a job that was both fulfilling and provided a living. They got their fulfillment from things they did that did not require an economic payback.

For those folks, a majority of Americans I think, retirement has always been about ending un-fulfilling work and having more time for the fulfilling parts of their life. And that really is about having enough money so that earning income is no longer the deciding factor in how time is spent.

Making a location decision based on finances is exactly the kind of "money oriented" decision that the article decried earlier in the article. Rather than moving to save money, the question should by where do you want to live and how will you have enough money to do that. That may mean moving to a warmer climate and adopting a new set of friends and activities. But, just as likely, it means staying in your current community with established friendships and/or close to family.

The suggestion of moving somewhere for tax advantages is plainly silly. Even on a list of financial considerations, taxes ought to be close to the last item. On a list of what will provide a fulfilling retirement, it doesn't merit more than an asterisk.

The author is right in philosophy. Money is just a tool, not the focus, for having a rich life. But having said that, his specific suggestions head off in the opposite direction. If you want a fulfilling retirement, live a fulfilling life. Then make your retirement more of the same.

Understanding Property Taxes

2010-06-15T06:37:00.000-07:00

The AARP newsletter this month has a story about property taxes that seems to share many people's confusion about how the amount of property taxes they pay is determined. Once you understand the system, you realize there is no reason to expect your property tax bill to decline when property values decline or for it to increase when property values increase.

Many people think that local governments budget like they do. First you figure out how much money you have and then you decide how to spend it. But that isn't the case. In most jurisdictions, they start the process by deciding what to spend. Local elected officials decide what services they will provide and at what cost. This becomes the basis for making a levy of taxes against local property values.

The total local budget is divided by the total assessed value of taxable property. This establishes the tax rate. That rate is then applied to each property owner's value to determine their individual tax bill. What is important to understand from this is that the property owner's taxes are based on their share of the total assessed value for all taxable properties. When everyone's value goes up or down by the same percentage, property tax bills will not change. Its only when your assessed value changes more than your neighbors that it effects your tax bill.

This means that if an individual's property assessment is lowered, the taxes they save are transferred to other property owners. It also means that when new property is added to the tax roles, it will reduce everyone's property taxes. (Of course, that may be offset by an increase in the cost of services it requires.) And if an assessor undervalues one person's property or a class of properties, the result is higher taxes for everyone else.

It also means that in good times, when property values are increasing, the tax rate will go down even as your tax bill remains the same. And in bad times, like these, when property values are decreasing, your tax rate will go up, even as your tax bill remains the same. Which actually makes sense, since the value of real estate has little to do with the cost of government services or the ability of people to pay for them.

What it comes down to is this. The housing bubble didn't raise property taxes and its bursting isn't going to lower them. The cost of providing local services remains the same and so will your share of the bill. There isn't anyone else to pay for them.

Who is to blame for this mess?

2010-05-02T19:56:00.001-07:00

There seems to be a lot of discussion to who is to blame for the financial crisis. But an awful lot of the media coverage is highly misleading. Here is synopis:

1) The meltdown in the financial market had little to do with people getting mortgages they couldn't afford. The collapse of the mortgage backed CDO's was caused by the collapse in the value of the houses which provided the collateral. It turned the mortgages behind the "collateralized debt obligations" (CDO's) into mostly un-collateralized debts. The result was that they went from AAA rated bonds to junk.

2)So what caused the housing bubble and collapse? Many people blame the fed, but don't have the story right. The fed did play a role. By keeping interest rates on Treasury Bonds low, they provided a market for alternative bonds that would pay a greater return.

But the major cause of the housing bubble was the creativity of the investment banks. These are not the retail banks that make home mortgages no matter what their size, whether Grand Rapids State Bank or US Bank. To meet the demand for a high interest AAA rated investment, the investment banks figured out how to disguise risky real estate investments in complex securities that would meet the rating services criteria as the equivalent of government bonds.

They accomplished that by purchasing mortgages backed by real estate, instead of investing directly in the real estate. Then they pooled the mortgages and created several different "tranches" - tranch is a fancy word for slice. These are not slices as a pie, but rather layers in a cake. The top layer of lenders gets paid first, then the next layer etc. In theory this makes the risk for the top layer very low.

Think of tranches this way. If you have a mortgage and home equity loan, when you sell your house the mortgage holder gets all of what they are owed first, then the home equity lender gets paid and finally you get whatever is left. Bond tranches work the same way.

Unfortunately, as people went under water on their loans the value of the underlying real estate no longer even covered the AAA bonds. Even if people were still paying their mortgage, the bonds were no longer secured debt. They all dropped to junk status.

In the mean time, a there was a lot of money going into real estate. Mortgages became a valuable commodity. And the availability of cheap credit meant people could afford a much larger mortgage with the same monthly payment. To those of use borrowing it felt like we could afford a lot more house, but the reality was we were buying the same house at a much higher price. Of course for people who already owned a home that meant their house was worth a lot more.

The flood of cheap money provided by Goldman and the other investment banks new investment vehicles had launched the housing bubble. Of course "irrational exhuberance" played a role. Some people took advantage of the low interest rates and increased home equity to borrow against their home for other things. This was, misleadingly, called "taking money out" of your house. But, as people discovered when housing prices fell, they were really just borrowing more money. Others bought investment properties and treated them like ATM machines, borrowing against their value.

As the bubble grew, the loan originators became more and more creative in figuring out how to make mortgages appear affordable even as housing prices sky-rocketed. Nothing down, interest only loans, negative amortization loans, stated income loans - there is a long list of now infamous "toxic" loans. But these were the result of the demand created by Goldman and the other investment banks. Their creative investments did not really depend on the ability of people to repay the mortgages. Their ability to create bonds depended on mortgages backed by the value of the real estate. Whether people could afford the payments or not was of little importance. By the end of the bubble predatory lending became almost the norm.

Of course, like all bubbles, this one burst when they ran out of people who could pay increasingly higher prices even with creative loans. The market shifted from a sellers market to a buyers and prices started to drop. This is where the familiar media narrative picks up.

But the focus on the end game, misses the central reality. This was a classic pump and dump. Goldman (and others) figured out how to disguise risky real estate investments as safe AAA bonds. In the process they drove up housing prices and that made their real estate investments as bonds even more attractive. When the bubble reached its peak, they bailed out, transferring any of the risk they still owned and betting on their own products to fail.

4) This brings us to the next phase. Because not only were there enormous losses in the real estate market that hit every home owner. But the investment banks had created even more complex derivatives that leveraged the losses on housing. These were really pure gambles, sidebets on what people expected the bonds to do.

Chicken or Egg

2009-04-10T07:15:00.000-07:00

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.

Why Cost Averaging Really Does Work

2009-04-01T06:18:00.000-07:00

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.

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

2009-02-15T16:28:00.001-08:00

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.

You Try to Live on 500K in This Town

2009-02-09T21:05:00.000-08:00

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.

Is Now the time to Buy a House?

2009-01-31T09:09:00.000-08:00

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.

Is Lawrence Yun Really an Economist?

2009-01-06T09:36:00.000-08:00

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

----------
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.

Confusing Volatility and Risk

2008-10-22T05:40:00.000-07:00

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

The recent stock market crash has reminded many people that there is risk associated with buying stock. But that is really the wrong lesson for people to learn at this point. What the crash has shown is that the stock market is volatile, it will go up and down. But how much risk that creates depends on your investment horizon. If you plan to hold on to your stock for another ten years, then the recent crash has few consequences. The price in the current uncertain market says very little about the price you will get ten years from now when you sell the stock.

In fact, the stock markets' hourly gyrations have very little import for most investors, regardless of their investment horizon. Volatility is relative. Monthly fluctuations have consequences for short term investors. The decline in market prices since July reminds us why we shouldn't own stock that we will need to sell in a couple months for our immediate living expenses. On the other hand, even the decline in prices over the past year has very little meaning if your investment horizon is 30 years out. But the ups and downs over the last decade do have consequences.

In fact, if you have been buying stock over the past 10-15 years, if you sell now the chances are pretty good that you will have lost money. And that is real "risk", not simply volatility. And that risk continues to exist. Its possible that the money you are "saving" by buying stock may not be there at all. The boom and bust of the dot com bubble followed by the boom and bust of the real estate bubble make it clear that projecting the likely real value of that stock portfolio ten years from now is uncertain at best. While the argument that the market will go up "in the long run" is probably still accurate, we should remember that adage "in the long run, we are all dead".

What is important is to recognize that the current market value of our stock portfolio is not the same as money in the bank. That current market value is an estimate of our stock's value. Its very accurate in telling you how much money you will get if you sell today. But it becomes less and less accurate the longer it will be before you sell. If you are planning to start selling stock in 30 years as you near retirement, then today's market price is pretty meaningless in determining how much money you will get for it. In fact, given market volatility, it is almost guaranteed that if you get a range of different prices if you sell over a period of time. And the recent market makes it clear those could be dramatically different prices.

So your financial management software adds your bank balances to yesterday's market value of your stock and gives you a very precise amount that you have "saved", right down to the penny. Then you plan for your retirement or other financial decisions based on that number. The recent market has reminded us is that precise number is really a very rough estimate. Just think of it this way, "I have this much saved - plus or minus 40%".

Its also important to understand that while money saved in the bank is not as volatile as the market. There is still risk associated with it. The risk that inflation will be higher than the interest paid on your savings and the money you have in retirement will buy less than it does today.

Volatility of the market creates greater risk the shorter your investment horizon. The risk of inflation is greater the longer your investment horizon. This is why as you get closer to actually needing money, it makes sense to sell stock and put the money in savings.

Inanities in a crisis

2008-09-25T09:18:00.000-07:00

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

The media is filled with plain silly inanities these days as everyone is focused on the crisis du jour on wall street. Here is one that grabbed my eye:

"The Depression itself was a dynamic sequence. It wouldn't have happened if the Fed hadn't insanely tightened credit in response to the stock market crash, rather than the correct policy of easing interest rates."

First, that monetary policy lead to the depression is a highly controversial explanation favored by money-supply ideologues. But the Fed did not have a policy of "tightened credit". They simply couldn't expand the money supply by printing dollars because, at the time, each dollar had to be backed by gold bars at Fort Knox.

Where the government did act to make the problem worse was cutting federal spending in response to reductions in tax revenue. Essentially the folks in charge ran government like a business, cutting expenses in response to reduced revenues, instead of using their almost unlimited borrowing power to stimulate the economy by keeping right on spending.

Finally, this ignores the central cause of the depression. People couldn't afford to buy the products they were producing. When the market crashed, as every speculative bubble will, businesses had enormous inventories of unsold goods. Think about what would happen today if every industry had the same oversupply that the housing market has. The housing market is in a depression now. That was the state of everything going into the great depression.

Of course blaming the great depression on low wages, cuts in government spending and market speculation are not messages that are very welcome in today's business environment. So we hear inanities about monetary policy that just coincidentally seem to justify the government stepping in to bail out the speculators when bubbles pop.

But that is just one example of what is turning into a propaganda fiesta with the media whacking pinata's and spewing out some businesses message. A recent NYT story described falling real estate prices and sales as "necessary" in order for the market to clear out the inventory of homes. Now you might ask how falling sales will help clear out the excess inventory. The answer is that it obviously doesn't. In fact, falling prices combined with falling sales indicates the opposite, the problem is getting worse and we are a long way from the bottom. Even with lower prices, the number of customers for homes continues to decline and the supply of homes available continues to grow. Of course that is not a good message if you are trying to get people to open their wallets and buy an overpriced house. Thus, whack! and the real estate industry's message comes flying out of the media's pinata.

Don't Buy a House Now

2008-08-10T20:32:00.000-07:00

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

There have been several articles lately that I suspect are part of a determined effort by the real estate industry to get people back into the housing market. The basic pitch is that higher interest rates will eat up any savings you get from waiting for lower prices. Even the New York Times has gotten in on this action.

The calculation always goes something like this. Say you have a house for 500,000 and you make a $100,000 down payment today with a $400,000 mortage at 6.5%. Now compare that to a year from now if housing prices fall by 10%, you would make a down payment of $90,000 and borrow only $360,000, but at a higher interest rate. If the interest rate is high enough, you will end up with higher payments and paying more total for the house than if you purchased it now.

There are two problems with that calculation. The first is that isn't really how people buy houses. People decide how much they can afford and then find the best house in their price range. So the actual comparison is if I can afford the payments on the $500,000 home today, what will I be able to get for that money a year from now. If you assume prices will fall 10%, then a house selling for $555,555 today will sell for $500,000 a year from now. Of course, whether you can afford it will depend on the interest rate - that was the point of the above exercise.

So what can you afford to borrow at different interest rates?
Your monthly payment at 6.5% on $400,000 loan is $2528:
at 7% you can borrow $380,000
at 7.5% you can borrow $361,000
at 7.8% you can borrow $350,000
at 7.97% you can borrow $345,000

So if you assume that you can get a 5% return on your $100,000 down payment, you will still be able to afford that house priced at $500,000 if it drops to $450,000 a year from now and interest rates don't go beyond 7.97%.

This brings us to the second problem with the calculation. Interest rates help determine the price of houses. If interest rates approach 8% a year from now, then housing prices are very likely going to drop a lot more than 10%. In fact, if you look at the example above as the typical buyer for a $500,000 home today, an increase to 8% interest, by itself, will force the price of that house down by more than 10%.

At this point, interest rates have not even been a significant factor in the plunge in housing prices. The housing bubble pushed prices well beyond their fundamental value when compared to the cost of renting and family income. And housing remains overpriced by those measures in most markets. If interest rates go up, that will only add to the market correction.

Finally, going back to the example above. If you plan to buy a house to live in for a few years, then the current fluctuations in price won't matter very much. But if you can wait a year and buy a house that is worth 10% more than the house you can buy today, you will be way ahead. Not only will you get more for it when you sell it, but you will have had the benefit of living in a nicer house for as long as you owned it.

Walking Away from Your Mortgage

2008-07-29T14:09:00.000-07:00

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

The BBC has a story about how home owners who find themselves under water, owning more on their house than it is worth, are simply walking away. In most states, they have no obligation beyond what the bank gets from foreclosure. The result is that people who can still afford the payment are making a business decision to simply let the bank take the loss.

Housing prices are continuing to fall. There are some predictions that the ultimate floor on prices may be less than 50% of a home's peak value during the bubble. That means even people who bought with hefty down payments may find themselves owing more than they own. In addition, the premium for owning your own home over the cost of renting went up with the bubble and still hasn't come down again. So in many places, most people who own could rent some place similar for less money.

So does walking away make sense? If you look at it as purely a financial decision, it probably does. You will take a hit to your credit record. But unless you plan to borrow again in the next five years that may not matter very much. You are probably better off investing the money you save from renting than continuing to make payments on a asset which is declining in value.

On the other hand. A house is a place to live, not an investment. So whether to bail out is more a life decision than a financial one. Do you like where you live? Can you find a place you like as well. Will your kids need to change schools? In other words, how much is your current house worth to you? If it was worth the payments when you bought it, then it is likely still worth that to you now. If you plan to live in your house until the mortgage is paid off, it probably doesn't matter very much what the current market value is.

But many people chose a house for its investment value as much as a place to live. They didn't buy the house because they wanted to retire there, they bought it with the expectation that they would sell it and move up in a few years. If you are one of those people, don't stay trapped. The sooner you bail out, the more money you will save and the quicker you will recover financially.

One thing from the BBC article I would like to highlight:

"This is becoming a tsunami of voluntary defaults," Professor Roubini says.

"The losses for the financial system from people walking away could be of the order of one trillion dollars when the entire capital of the US banking system is only $1.3 trillion.

"You could have most of the US banking system wiped out, so this is a total disaster."

That is a stark warning. But, in capitalist America, that is the way the system works. Better that they take the loss than that you do. When they loaned you the money secured by the house you were buying, the lenders understood that they were sharing the risk you took in buying that house.

Economics as Ideology

2008-06-26T07:42:00.000-07:00

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

This is a quote from a CNN Money online report on the debate over whether we are faced with inflation:

'president of the Federal Reserve Bank of Cleveland and a voting member this year of the Federal Open Market Committee, explained in a speech last month.

"As consumers spend more money for higher-priced petroleum and agricultural goods," she continued, "they eventually have less money to spend on other goods and services. Other relative prices must then fall."''

Well yes, prices are falllng "relative" to oil and food. But this is a clearly a statement of ideology rather than evidence based science. And it is clearly wrong. As people have less to spend, they buy less and producers produce less and lay off employees who now have less to spend, creating stagflation. From that same article:

"Automakers Ford (F, Fortune 500) and General Motors (GM, Fortune 500) have slashed their production schedules as well, as consumers stopped buying the fuel-guzzling sport utility vehicles that were once a huge source of profits for Detroit. The loss of high-paying pilot and autoworker jobs will only add to existing weak wage and job trends."

The only prices that seems to actually be falling as preciptiously as gas and food is the price of people's houses. But that is hardly a response to inflation. To the contrary, inflation may be what finally stops the bleeding in real estate by pushing up incomes to a level that makes the inflated price people paid for their homes a few years ago affordable.

This discussion, however, reveals the real role of economists, whether Marxist or Capitalist which is to express an ideological explanation for the privilege of their preferred group. For Marxist economists that is workers, for Capitalist economists it is managers. You can see it in the popular economic theory that inflation isn't a problem as long as employees can't demand higher wages to pay them. Essentially higher prices aren't a problem as long as the money goes into the money managers pockets. It becomes a problem when it encourages employees to demand a bigger share of the pie. But then who pays economists? Who funds economics departments? The answer is those who manage most of the resources. And they get paid to justify the privileges that group enjoys as the natural law of science, rather than a choice we make as a society.

Don't buy a house, Sell if you can

2008-04-14T05:14:00.000-07:00

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

Remember the adage, "buy low, sell high"? That applies to the real estate market too. This may be obvious to most people, but apparently not to the financial advice industry. Buying a house right now is a very high risk investment. In fact owning a home is a high risk investment, if you think your home is an investment.

Of course, most people don't own their home as an investment, they own a home to live in. But the cost of owning one's own home the last couple years has been very high in most markets. And unlike past situations where real estate prices fell, this one preceeded the onset of a broader economic slowdown rather than resulting from it. A weakening economy should push prices even lower in the short term.

Long term, the situation could be worse. The market fundamentals such as rents, household income and historic rates of appreciation all indicate the current market is still overpriced even with its low interest rates. If interest rates go back up to more normal levels, or when they go up, housing prices are going to take another hit. People buy houses based on how large a payment they can afford. That is what helped create the current housing mess. And when interest rates go up, the price of the house they can afford goes down.

It may well be a decade or more before housing prices get back to where they are now, muchless the peak of a couple years ago. And in real terms, when correcting for inflation, it may take much longer than that.

Inflation is actually one of the positive indicators for people who own a home or are thinking of buying one. Because as the cost of other goods and services go up, the relative cost of housing should go up as well. That changes the market fundamentals by creating higher family incomes and higher rents. On the other hand, inflation also drives up interest rates.

So buying a home is a risky investment. But worse, for most people it is a highly leveraged risky investment. While "no money down" is largely a thing of the past, we are a long way from requiring the traditional 20% down to get into a home. If you put 5% down on a house and it loses 10% in value the first year, you have lost your entire "investment" and now owe the bank more than you have in the house. Fortunately, unlike with securities, banks do not make margin calls and demand you invest more. While people have benefited from that leveraging in a boom market, they are going to suffer as prices continue to fall.

What this means is that if you have found your dream home and realistically intend to live in it for 30 years, then buying a house may make sense. Your housing costs are protected from inflation and you get the benefits of owning the home you live in. In fact, current low interest rates make buying attractive for someone planning to hold onto their house and pay off the mortgage over the next 30 years.

But if you don't know that you will be staying in the house you buy or are thinking about moving out of one you already own, look for a good rental situation instead. Finding a good landlord may be easier than finding a house worth the price. If you intend to use your house as your primary retirement savings you might want to consider selling it and getting that money invested in something more stable. Your money will be safer in the stock market. If you want to speculate, try pork bellies.

Stop Saving for Retirement

2008-03-26T09:20:00.001-07:00

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

No matter how often the financial services industry repeats the message, it is still a lie. Young people should not be saving for retirement. You have an entire life to live before worrying about what you will do when you have had bypass surgery and no longer have the energy to even go to the grocery store. While the financial services industry needs you, you don't need them.

That doesn't mean you shouldn't be saving money. You should be saving for your wedding and honeymoon, to buy a house, to send your kids to college, to take that dream vacation or to buy a new IPOD. Of course, you can also just borrow money to do those things and pay it off later. For most young people that is more realistic and, frankly, a better idea. You are likely to earn more as you get older and it will be easier to pay off the debt you took on than to save the money now to buy stuff.

Of course, what you buy matters. A house is a pretty good investment. It gives you a place to stay and it will likely go up in value along with all the other houses keeping your housing costs affordable. By some measures your wedding is a good investment assuming it is a once-in-a-life experience. Your college education? A great investment that will more than pay for itself. The latest new Ipod? Well no, because you can almost guarantee you will "need" to buy a new one in six months if you want the latest technology. When you consider credit purchases, think about how long the item you buy might last. The longer it will last, the more sense it makes to buy it on credit. If you are using credit to afford groceries or takeout food, then you need to create a new household budget or find another job.

I have a vacuum cleaner I bought on credit almost 30 years ago that still cleans just fine. I have a cast iron skillet that I still use, bought on credit when I was out on my own for the first time. When I bought it, it was a week's food budget. Today I can spend enough on groceries for a single meal to buy a new one. And that is the fundamental point. As you get older, you will have more money and you will still be getting lasting benefits from the purchases you made on credit when you were younger. Even the money I spent wining and dining my wife is still paying off.

So yes, you will be much more comfortable at 70 if you start saving your money now for retirement. And if you measure your success by how much your estate will be worth, then go for it. But for most of us, money is a means to an end, not an end in itself. You are going to earn a lot of money over your lifetime - spend some of it now to make that lifetime more pleasant, interesting and valuable.

And if you really want a more comfortable retirement, brush your teeth and floss every day.

Your Social Security is more Secure than your Securities

2008-03-24T06:29:00.000-07:00

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

Allen Sloan over at Fortune Magazine is making the case that Social Security will run out of money in 10 years. His are the crocodile tears of the very people who have looted social security, using the excess social security taxes to provide themselves and their rich cronies with tax breaks. He makes clear his new-found concern for social security is really an excuse to further raid the treasury with his suggestion for a solution: "We can still buy time by investing current cash surpluses in non-Treasury assets." I.e. we should use social security taxes to buy some of his rich buddies' fancy financial products.

To understand how this really works you need to start with social security taxes. The original idea was that the taxes paid by current workers would pay the current benefits for people who were retired. In turn, the next generation of workers would pay the retirement of the next generation of retirees.

The critics like to describe this as a "ponzi " or pyramid scheme, but it isn't. It ought to be clear to anyone that once they retire they will be supported by the people still in the work force. The question is how those people will get paid. Whether its personal savings or social security that money will have to be taken out of the economy - which is another way of saying that those still producing will have to pay the bill. Far from a scheme, that is simply the way life works. People are born, join the work force, retire and die.

In the early 1990's there was a recognition that there was an element of a pyramid being created by the country's demographics. More people were entering the workforce than leaving it for retirement and the resources available to pay social security benefits was greater than would be sustainable when the baby boomers retired and those numbers reversed. The result was the "Social Security Trust Fund" where current workers paid more social security taxes than was necessary to pay current retiree benefits.

The extra money from Social Security taxes was put into treasury bills. The same treasury bills the government uses to borrow money from anyone else. Like the T-bills Mr. Sloan and his friends buy to avoid taxes and that, presumably, the government will have to pay him and his friends a higher return on to borrow the money they are currently borrowing from the Social Security trust fund.

The problem is not how the trust fund is invested. Its that many of the conservative critics don't want to have to pay off the loans the government took out to provide tax breaks to their rich friends. Social security taxes are incredibly regressive. They tax low income wage earners at a higher rate than those making over $100,000. Every year we pay more social security taxes than are needed to pay current retirees and the government borrows that money instead of raising the more progressive income tax. As that surplus is disappearing the government has two options, raise taxes or borrow more money from elsewhere.

Where Mr. Sloan is fundamentally wrong is suggesting the problem is ten years off. It is happening now. Each year the surplus available from social security taxes is declining and the government is having to borrow more from other sources, reduce spending or raise taxes. That process will continue into the foreseeable future. Putting social security trust funds into non-government securities will just speed it up. Of course, Mr. Sloan and his financial services friends will make a hefty profit from fast tracking the social security deficit.

But the larger problem is that the social security issue is an example of a much more fundamental shift. Over the next 50 years, fewer workers are going to have to produce the goods and services used by a large number of people who aren't in the work force. Social security is only one institution which is going to be effected by that reality, so is every business. Global markets may be able to absorb some of the production, but for the United States that will require continuing to transfer huge amounts of wealth overseas in the form of loans and/or capital.

And if you want to find a ponzi scheme look no further than the dot-com "bubble" or the real estate "bubble" or dozens of other unsustainable investments. The money "lost" in these bubbles was found by the people who got rich off them, just like any other pyramid scheme. But don't let anyone convince you to base your retirement on those investments whether its your 401-K or the social security trust fund.

The recession is coming! The recession is coming!

2008-02-18T18:51:00.000-08:00

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

So you think we are headed for a recession and the market is going in the tank. You aren't alone. There are plenty of other investors out there with the same idea. And your opinions are already reflected in the current market price of stocks. While you could turn out to be right, it is equally or more likely you are wrong. Guessing what will happen next in the stock market is not an investment strategy, its a gambling strategy. The only advantage it has over Vegas is that the investment analysts and financiers usually take a smaller amount off the top than the casinos do.

So what should you do? The answer depends on whether you are a buyer or a seller. And that has nothing to do with what you think the market is going to do. It is a question of where you are in the investment cycle. If you are adding to your investments then you are a buyer. If you are at a point where you are moving money out of the stock market, you are a seller.

While most people are buyers, there are circumstances where you might be seller. One is that, as you get closer to retirement or other use of your investments, you want to shift your investment mix from heavily in stock to a less risky mix with less stock and more bonds. There are two ways to do this. One is to add new money to your bond investments. The other is to sell some of your stock and put the proceeds into bonds. A second reason you might be selling is that your stock did better than your bonds the past year and you need to sell some stock and move it into bonds to rebalance to your targeted investment mix. The third reason would be that you are retired and are selling stock to pay living expenses or you need to cash out your investment for some other purpose.

If you are a buyer, the answer of what to do now is straight-forward. Buy stock. Use dollar cost-averaging to avoid getting caught spending all your money now when you might be able to buy more shares at a lower prices later in the year. By averaging out costs over the year you will protect yourself from buying high in what is a volatile market.

If you are a seller, you actually have an apparently more complicated decision to make. But because we simple minded investors don't like complicated answers, there is a simple one. Or rather two simple ones.

If you want to change to a less risky investment mix because you are getting closer to retirement, or other use of the money, you should do it over time. Just as you cost average purchases, you should cost average sales. That means figuring out how much you will need to sell to achieve your new investment mix. Then divide that amount into 12 equal installments. Then sell stock worth that much on a monthly schedule. By cost-averaging you will guarantee that you aren't selling all that stock at rock-bottom prices. You will sell at roughly the average price for the year.

Correction: On reflection, this is not correct. In fact cost averaging your stock sales means that you will sell more shares when the price is down and fewer shares when the price is up to generate the same amount of money. This will actually result in your getting less than the average price for your shares. You should decide how many shares you will need to sell. Then divide the shares into equal installments. Whatever disparities the different selling prices create will get fixed when you do your annual rebalance.

If, on the other hand, you are selling in order to rebalance your investment mix, you should continue to do this all at once on an annual basis. The point of rebalancing is to sell high. You are selling because the class of assets you are selling did better than the other classes of assets in your portfolio. Think about it as taking your profits (or cutting your losses if all your assets went down).

The one thing you should not do is change your investment mix because you are nervous about where you think the market will go. Managing risk based on your expectations about the market is the same as any other attempt to time the market in stock. Its likely that you will end up with that more conservative investment mix just about the time the market decides to take off. You will have sold low and now be faced with buying high to restore the mix you initially had. Your investment mix should be based on your long term goals, not your current nervousness. You are not smarter than the market. So don't try to be.

Media Investment Advice

2008-02-05T07:05:00.000-08:00

CNN's Walter Upgreave today made clear why taking investment advice from the media is a bad idea. In his column today he takes a contrary view of "dollar cost averaging". The dead giveaway is this line:

"But while dollar-cost averaging has risen to the level of accepted truth in many circles, it isn’t the magic bullet it’s made out to be. Indeed, some of the claims are simply an illusion."

Put another way, his job is to provide something interesting for us to read and repeating conventional wisdom won't get you many readers. But there is a reason why dollar cost averaging is conventional wisdom and Upgreave is doing a huge disservice by encouraging people to ignore it. Sometimes conventional wisdom is wrong, but, if you really understand the role of investment mix or dollar cost averaging in risk management, you realize that Upgreave's argument has no merit. Here is the nut of his argument:

"Over the course of the year, you would have actually been investing much more conservatively than you intended when you chose a 60-40 mix. The reason is that you’re holding on to so much cash, you’re virtually guaranteeing you won’t be at your 60-40 target mix for most of the year. By moving your money a little at a time, you’re actually undermining your investing strategy."

There are several reasons this is flat out wrong. The first, is that by investing all your money in a lump sum you are increasing your risk well beyond what you intended by a 60-40 investment mix. This is because you are taking on the risk of daily/weekly/monthly fluctuations in the market compared to a similar investment dollar-cost averaged. In essence, he is encouraging you to make a short term investment in the stock market.

One way to look at this is to take your lump sum and divide into four installments. That is what you do with dollar cost averaging. The next question is what should you do with the money in the mean time until you need it? Upgreave is, in essence, suggesting you invest it in stock and bonds using the same 60-40 mix that you had settled on for your long term investment strategy. But the 60-40 mix that is appropriate for money you will not need for at least 10 years, is not appropriate for money you will spend on stock three month from now.

To get an idea of how this works take a couple scenarios this year:

Lets assume you got a tax refund of $1200 on June 1st, 2007 and invested it in Vanguard's Balanced Index fund which gives you that 60-40 mix. The fund's shares were at 22.54 that day so you would have purchased 53.24 shares. Three months later, on September 4th that same $1200 would have bought 54.15 shares. By December 4th is would buy 53.98 shares.

At the end of 2007 those 53.24 shares were worth $1172. The 54.15 shares were worth $1192. and the 53.98 shares were worth $1188. By February 4th, 2008 that $1200 would buy 56 shares. Those same shares would have cost $1262 in June.

Having saved your money in a conservative cash account, you would be buying low. Having spent all your money in June - you would still own just 53.24 shares.

But why stop now? What happens when shares have reached $40 per share? That investment from June is worth 2121, if the investment was made in September it is worth 2166. The December investment is worth 2159. The February investment is worth 2240. If you invested the money in four installments, you made $50 more than you would have if you had invested int all in May and those net losses will continue to grow right along with the price of your shares.

Of course, the opposite could have happened. The market might have gone up. On average, that is more likely to happen. But if you don't cost average, you aren't playing the averages. You are timing the market whether deliberately or not. You may happen to get lucky and buy when the market is low. If you are very unlucky, and buy when the market is high. But avoiding that kind of high risk, is exactly the reason for having a relatively conservative 60-40 mix of stocks and bonds to begin with.

There is no doubt that leaving your money in cash is more conservative than investing it in the market. Bonds are more conservative than stocks. That is a the reason why investment horizon is important in determining your mix of cash, stocks and bonds. In the long run, stocks, on average, will give you the best returns. But, as the saying goes, in the long run we are all dead.

You are NOT smarter than the market

2008-01-24T10:27:00.000-08:00

You are not smarter than the market. Accepting this basic fact is the first step toward successful investing. That is counterintuitive to some people. There are lots of people out there who want to "beat the market". They hire financial advisers who claim that they will help them accomplish this allusive goal. There are also people out there who want to win the lottery, they buy lottery tickets. In both cases, you hear a lot about the "winners". What you don't hear is that there are a lot more losers and the odds are you will be one of them.

Now, financial advisers will argue that what they do is not really gambling because they can control the outcome. They claim that by being "smarter" they give you a leg up on the typical investor. That isn't really true because the market price of stocks in not set by the "typical investor". Prices are set by the collective wisdom of market professionals, many of whom manage billions of dollars each. Your financial adviser is one of them, albeit not likely one of the billion dollar managers. And, on average, they collectively lose money for their clients.

We know that they lose money for their clients because for every stock sold, there is a buyer and a transaction cost. So while the financial advisers will have made money, that money came out of some poor dumb investor's pocket. Don't be the that dumb investor. Take a deep breath and admit you aren't smarter than the market.

The positive side of this is you don't need to be smarter than the market. Because the market,in general, is pretty smart and you will make money if you can just match it rather than beat it. So your goal as an investor is to match the market, not beat it.

Of course, people go to Vegas because they like to gamble. They want to win, but many of them accept losing as part of the excitement. Just don't gamble with your house payment, the kids college tuition or your retirement funds. If you have extra money and want to play in the stock market, go for it.

But you won't find much help or wisdom here for doing that. Except to understand is you win, it proves you were lucky, not that you were smart.