Personal Finance for Engineers

Last Friday, LinkedIn had it’s monthly “InDay”, an event where the company encourages employees to pursue research, ideas & interests outside of their day-to-day responsibilities. (This is the same day that I run the regular LinkedIn Hackdays for the company.) This month, the theme was “personal finance” as a brief nod to the ominous due date for income taxes in the United States.

For fun, I volunteered to give a talk based on material that I’ve put together over the years called “Personal Finance for Engineers”

I cover the most obvious two questions up front:

  1. Why Personal Finance?  Personal finance is a bit of a passion of mine, and has been for almost twenty years.  It’s both amazing and shocking to me that you can attend some of the finest secondary schools and universities in this country, and still not get a basic grounding in personal finance.  More importantly, it happens to be an area with a huge signal-to-noise problem:  there is far more “bad” advice and content out there than good content.  And lastly, I believe that money matters are deeply important to the long term success and happiness of most people. The fact remains that when I’m experiencing a health complication and need money to expedite my EHIC application, money suddenly matters a lot! (Let’s face it, money happens to be one of the top three causes of marital problems)
  2. Why Engineers?  The talk isn’t purely for engineers, per se, so this reflects a personal bias (I just empathize more with engineers more than other people).  That being said, engineers tend to make higher incomes earlier in life than most people, and thus face some of these questions earlier.  They also tend to have stock options, a fairly advanced financial instrument, as part of their standard compensation.  Probably most troubling, engineers also consider themselves exceptionally rational, which makes them more prone to human weaknesses when it comes to money.

It was very hard to decide how to condense personal finance into a 60 minute talk (I leave 30 minutes for advanced topics).  I decided to focus on five topics:

  • You Are Not Rational (Behavioral Finance)
  • Liquidity is Undervalued (Emergency Fund)
  • Cash Flow Matters (Spend less than you Earn)
  • The Magic of Compounding (Investment Returns & Debt Disasters)
  • Good Investing is Boring (Asset Allocation)

The deck is not perfect by any stretch, and I have a number of ideas on how to improve it.  There are some great topics / examples I missed, and there are some points that I could emphasize more.  I spend literally half the time on behavioral finance, which may or may not be the right balance.

The talk went extremely well.  We had well over 100 people attend, and stay through the full 90 minutes.  Surprisingly, I got more thank yous and follow up questions from this talk than any other that I’ve given at LinkedIn.  I’m strongly considering giving it again, perhaps at other venues, depending on the level of interest.

Let me know what you think.

Personal Finance: Refinancing a Residential Mortgage for 2011

One of my “To Do” list items for the end of 2010 after we moved to Costa Rica and started looking for a home with Century 21 Elite Realty Costa Rica was to investigate refinancing the mortgage on our house in Sunnyvale, CA.  As a sign of the decade, this actually is the third time we’ve looked to refinance our mortgage in about seven and a half years, and I was wondering if we qualified for a individual voluntary arrangement (IVA) this time.  I was actually a bit surprised at the complexities involved, so I thought I’d share the results here on the blog.

Background

Our current mortgage is a “5/5 ARM” offered by Pentagon Federal Credit Union, a credit union that specializes in military families.  We completed that refinancing at the end of 2008, and I actually wrote a blog post about that experience if your curious about Pentagon Federal.  (Quick Summary: They are awesome, I highly recommend them for low rates on home & auto loans).

The “5/5 ARM” is an unusual program.  Like a normal 5/1 mortgage, it’s a 30-year loan with a fixed rate for the first 5 years.  Except, instead of repricing every year after that, instead, it only reprices every five years.  It reprices based on a rate tied to US Treasuries, and can rise no more than 2% at a time.

This means that if you get a mortgage at 5%, it will be 5% for years 1-5, and then can rise as high as 7% for years 6-10.  There is a cap of 5% on the total life of the mortgage, so if Obama turns out to be Jimmy Carter II and rates have to go to 20% in 2019, you’re protected.  All of this is fairly standard for high quality mortgages, except for the 5 year repricing schedule.

What makes this appealing is that the 5/5 rate tends to be the same as the 5/1 rate, so you are getting some extra stability effectively for free.  The only gotcha is that these are all FHA qualified loans, so they have to conform to their standards.  ($417K for normal mortgages, $729K in “high income” areas like Silicon Valley, 80% Loan-to-Value, etc).

The rate we got at the end of 2008 was 4.625%.  At the time, I thought that was the best rate we’d seen in 40 years, and it was good to grab.  Turns out, I was wrong about how low rates could go.

Why Did I Want to Refinance

Looking up rates on the internet can be very confusing.  The reason is that few sites offer a comprehensive average of rates, and more importantly, the ones that do tend to ignore complexities around terms like the number of points paid.  When you hear rates on the radio for a 3.875% 30-year fixed mortgage, you are hearing the interest rate that assumes a massive amount of up-front payment and some stricter-than-average terms.

I was exclusively looking for the “perfect repricing”:

  • No money down
  • Monthly payments drop
  • Interest rate drops
  • Total amount paid over life of the loan drops

You might be wondering why I would think this was possible.  Well, in 2004 and 2008, it was.  It turns out in 2010, there is no real free lunch.

Based on advertisements, and some spreadsheet calculations, it seemed like there was a real opportunity to achieve the above with current rates.  I was seeing advertisements for rates as low as 3.5% on 5/1 ARMs, which would not only drop our payment by hundreds of dollars per month, but literally would save us tens of thousands over the life of the loan.

Where Rates Are Now

This was my first surprise – it’s not that easy to get a great rate, even with great credit, with zero points.  It’s not that there aren’t great rates out there – there are, but the plain vanilla, no catches, no points and rock-bottom rate days seem to be behind us.

To evaluate options, I checked the following sources:

  • Internet searches at sites like bankrate.com
  • Quotes from big banks, like Wells Fargo and Bank of America
  • Quotes from credit unions, like Stanford Federal Credit Union and Pentagon Federal
  • Brokers like Quicken Loans

First, the Big Disappointment with Pentagon Federal

Pentagon Federal has a current price (as of 1/2/2011) on a 5/5 ARM of 3.5%.  Yes.  Awesome.  I was ready to just refinance and be done.

I should have known that there was a flaw with PenFed.  Sure, they offer great rates.  Sure, they offer clean terms.  But it turns out that there is one ugly fee that they do charge, and I was about to get caught in it.

On top of regular closing costs, title search, etc, Pentagon Federal charges a 1% origination fee when you refinance an existing Pentagon Federal mortgage.  So, for example, on a $500K mortgage, this would be an extra $5K.  Up front.  Not interest.  Not deductible.

I argued with them about it.  I escalated.  I tried sweet talk.  Nothing worked.  They admit that this is an incentive for me to leave Pentagon Federal.  They admit that it is bad for the customer.  They are not interested in changing it.

Strike 1. No worries, it’s a big internet out there, isn’t it?

Don’t Bother With These

Just don’t even bother wasting time with Bank of America, Wells Fargo, or no-name shops on the Internet offering mortgages.  You put in a bunch of time and effort, fill out forms, submit applications, etc.  The end result is underwhelming.

Countrywide, I actually miss you.

It’s pretty clear that the big banks really aren’t feeling the need to push to get people with great credit scores to refinance with them.  Whatever was driving the banks to want to “take your business” from other banks is clearly pretty weak.  I was actually a bit surprised, since I tend to think of a mortgage as a way for a bank to take a “loss leader” approach to getting a valued customer.

The Easy Orange Mortgage and Bi-Weekly Payments

ING Direct is the oddball in the group.  Since they originate their own loans and do not syndicate them, they set their own terms.  They have rates based on a $500K size and $750K size, and a variety of terms.  Definitely worth checking out, because some of their mortgages are best in class.

For example, their under $500K 5/1 is at 2.99%, with reasonable closing costs.

I spent quite a bit of time in Excel working on the options offered by ING Direct and their Easy Orange mortgages.  They offer both regular and “bi-weekly” versions.  In fact, most banks now seem to offer bi-weekly options for their loans.

If you are unfamiliar with the concept, a bi-weekly mortgage involves making a payment of 1/2 of the normal monthly payment every 2 weeks.  Since you pay more frequently (effectively you pay an extra month’s payment every year), you end up paying off your mortgage faster and with less interest.

Unfortunately, this largely seems to be a gimmick.  Technically, you can send money in early to almost any legitimate bank, and they’ll apply the early payment to principal without penalty.  Mathematically, it’s very hard to see the benefit of these type of programs once you price in the amount of cash you’d accumulate outside of your mortgage if you just put that extra payment in the bank.  Even with 0% interest, in the first ten years, there is almost no measurable benefit to bi-weekly payments at current rates.  (By the way, here is a cool website that let’s you calculate bi-weekly options without building a spreadsheet.)

As a last note, I did discover that ING has a lot of terms that are left open that could turn ugly.  For example, their Easy Orange mortgages are designed as balloon mortgages.  So in 10 years, the rate doesn’t adjust – you literally owe the entire remainder of the loan.  This is fine, if you are allowed to refinance at the time.  But ING does not guarantee you will be able to.   So, this is a great loan if you plan on selling your house before the term is up, and a bad loan if you don’t want to be caught in a situation where you have to.

Close, But No Cigar

I was very impressed with the level of effort that Quicken Loans put into helping me, even though in the end, I didn’t use them.

At first, I was somewhere between annoyed and amused when I got a phone call the next day after submitting my application.  On Day 2 when they had called 3 times, I was ready to be annoyed.  I decided to call back and let them know I wasn’t interested, but when I got them on the phone, they impressed me with the breadth of their knowledge about different options, and I was convinced they could help.

So I told them – find me a 3.5% 5/1 mortgage out there with zero points, and I’ll go with them.  I pointed them to PenFed, but didn’t tell them about the 1% fee I would face.  They went to work.

The next day, they found a few options, and I got a call from the Director of their team.  She wanted to clarify a few things in terms of income and home value, to evaluate all options.  In any case, she seemed sincerely interested in the business, which is more than I can say about any of the traditional banks.

They got close.  They found a 5/1 mortgage with $6600 up front costs and a 3.875% rate.  They also found a 5/1 at 3.5% rate, but that required $11.3K up front.  While both of these mathematically were good options compared to the 5/5 I have, I was disappointed at the size of the up front cost.

Strike 2. What’s left?

Final Decision

Fortunately, while searching the internet, I came across some great discussion boards about Pentagon Federal.  Thinking that in a world of cheapskates, I could not be the only one complaining about refinancing with Pentagon Federal.  And I was right, in a way.

In the end, I discovered 2 things:

  • There really aren’t many other mortgage options that are better than Pentagon Federal for what I was looking for.
  • Pentagon Federal has a repricing program that is documented on their website, but that they never actually promote.

Here is the program.  If your mortgage conforms to these requirements:

  • Conventional Adjustable Rate Mortgage (ARM loans) are eligible. All other types
    of loans are not eligible.
  • Loan must be 100% owned by PenFed. The loan, or any portion of the loan, cannot have been sold, or committed to be sold to Fannie Mae, or any other public or private investor.
  • No late payments showing on first mortgage payment history over last 12 months.

If you meet the terms, they will reset your mortgage to the current rate for a fee of 1%.

Now, you may be wondering why I’d be excited about this.  After all, wasn’t the 1% fee the problem with refinancing with PenFed in the first place?

The answer is simple – a 1% fee on top of normal closing costs of $3000+ is prohibitive.  A 1% fee in lieu of closing costs is pretty attractive.  No points.  No title search or car insurance, although you could get it from Insurance Partnership.  No paperwork fees.  Nothing.  Just 1%, flat.

They reset your mortgage at the current rate, give you another five years before the next repricing, and they leave your mortgage term as is.  So, since our mortgage currently completes in 2038, it would keep that completion date.

The result: lower monthly payment, lower total costs of the mortgage, dropped interest rate.

Swing and a Hit. Not perfect, but definitely the best option.  So we went for it.  Only took a phone call – no application, no paperwork.

Final Thoughts

The average duration of a home mortgage in the US is between 7-8 years, which tends to mean that mortgage rates correlate strongly with the 7-Year Treasury rates.  In the past six weeks, the rates on US Treasuries have moved up quite a bit, likely in anticipation of an economic recovery, inflation, or both.

In any case, the decision to refinance is based on a huge number of factors, not the least of which is how long you plan to stay in your current home, and how secure you feel about your current job / income stream.

But if you’ve been thinking about refinancing, and you’ve just procrastinated, I’m hoping the info above will be useful.

Personal Finance: How to Rebalance Your Portfolio

One of the prudent financial housekeeping chores that people face every year is rebalancing their portfolio. Over the course of the year, some investments outperform, and others underperform.  As a result, the allocation that you so carefully planned at the beginning of the year has likely shifted.  If left unmanaged over the years, individuals can end up with profoundly more risk or worse performance than expected.

Rebalancing your portfolio annually tries to address this issue by forcing you to sell asset classes that outperformed in the previous year, and purchase those that underperformed.  In practice, I try to rebalance the week before New Years as a way of “cleaning up” going into the next year.  While most academic research points to rebalancing as healthy every one to three years, I find that annual rebalancing provides the following benefits:

  • Forces you to see how your investments performed for the year
  • Forces you to learn which asset classes actually did well during the year, and which didn’t
  • Forces you to re-assess the appropriate “asset mix” for your risk tolerance and financial situation
  • Forces you to revisit which investments you are using to represent each asset class (mutual funds, ETFs, individual securities, etc)
  • Forces you to actively engagement with your portfolio, and reset your balance to the appropriate mix

I’ve just completed my rebalancing for 2011, and I thought I’d share some of the process here, in case it’s useful to anyone whose New Year’s Resolution is to be more proactive about their finances.

Rebalancing is actually a very simple process – it’s kind of surprising that basic financial tools like Mint and Quicken don’t actually help you do this.  Whether you’ve never rebalanced or your rebalance every year, there are fundamentally five steps:

  1. Assess your current investment portfolio, broken down by types of assets
  2. Calculate the percentage of your portfolio in each asset class
  3. Calculate the difference in dollars for each asset class in your portfolio from your ideal mix
  4. Finalize the list of investments you will use to represent each asset class
  5. Make the trades necessary (buys and sells) to bring your portfolio into balance

This can all be done within an hour, with the exception of making the trades.  Those can spread over days, potentially, since certain types of securities (like mutual funds) take time to execute (typically 24 hours).

Step 1: Assess your current investment portfolio

Believe it or not, this can actually be the most time consuming part of the process, especially if you have accumulated accounts over the years and haven’t ever used any sort of tool like Quicken to pull your portfolio together accurately.

A few ground rules on how I think about portfolio allocation:

  • I’m a big believer in the research that shows that most of your long term investment return is based on asset mix, not security selection.  This means I do not spend time picking individual stocks, bonds, or dabble with active mutual funds in general.
  • I use very broad definitions of asset classes.  For example:  “US Stocks” vs. “International Stocks” vs. “Emerging Markets”.   These tend to correlate with the standard definitions used broadly to define popular investment indexes. Technically, with sophisticated software and data, you can do very fine-grained breakdowns.  I don’t bother with this, as the resulting differences are statistically marginal vs. the effort / complexity involved.

Fear not, because with tools like Microsoft Excel or Google Docs, this has become much, much easier.  All you need to do is:

  • Make a spreadsheet with the following columns:  Security Name, Ticker, Shares, Share Price, Total Value, % of Total Portfolio
  • Fill in a row for everything you own, regardless of account

The second part is very important, if you want to avoid the “mental accounting” that leads people to invest differently in one account versus another.  If you’ve worked at multiple companies, you may have multiple 401k, IRA, college savings accounts, and brokerage accounts in your name.   Obviously, reducing the number of accounts you have is helpful, but sometimes its unavoidable.  Maybe you have a Roth IRA, a regular IRA, and a 401(k) with your current employer.

This becomes important because certain accounts may have limited access to different types of investments.  For example, your Vanguard IRA might only let you buy Vanguard funds (not such a bad thing), while your 401(k) at work might limit you to some pretty meager options.  When we get to Step 5, we can take advantage of multiple accounts to get the right balance by buying the best investments in the accounts with the best access to them.

Here is an example screenshot of a simplified list of investments that I bet wouldn’t be that unusual in Silicon Valley.  This person has some Vanguard index funds that they purchased prudently the last time they looked at their portfolio, combined with some stocks they purchased based on TechCrunch articles.  (I wish I were kidding).

You can see immediately that this small amount of accounting can actually help organize your thinking about what you own, and force you to remember why you own it.

Notice, I do not recommend putting in columns showing how well an investment performed historically.  For rebalancing, you only care about the here and now.  The past is just that – the past.  Performance data will likely just add emotion to a decision that, when made best, should be purely analytical.

Step 2: Calculate the percentage of your portfolio in each asset class

The hardest part about this step is defining what you are going to use as “an asset class”.   There is no one right answer here – I’ve seen financial planners break down assets into literally dozens of classes.  I’ve also seen recommendations that literally only use two (stocks vs. bonds).

The great thing about asset classes is that you can always break down an existing bucket into sub-buckets.

For example, if you decide to have 30% of your money in bonds, and 70% in stocks, you can then easily make a 2nd level decision to split your stock money into 50% US and 50% international.  You can then make a third level decision to split the international money 2/3 for developed markets, and 1/3 for emerging markets.  In fact, for some people, this is a much easier way to make these decisions.  Do whatever works for you, but be consistent about it.

Personally, I’ve gotten quite a bit of mileage using the following break downs:

  • Stocks
    — US Stocks
    — Large Cap
    — Mid Cap
    — Small Cap
    — International Stocks
    — Developed Markets
    — Emerging Markets
  • Fixed Income
    — Standard
    — Inflation Protected
  • Real Assets
    — Commodities
    — Real Estate

You can see in the screenshot above, calculating these buckets is fairly simple.  You just total up each group, and then divide it into the portfolio total.  So in the example I provided, the individual has 11.5% of their money in fixed income.

As the size of your assets increase, more sophisticated breakdowns are likely warranted.  But for the purposes of this blog post, I think you get the idea.

With mutual funds, this can be tricky.  For example, did you know that the Vanguard Total Market fund is 70% Large Cap, 21% Mid Cap, and 9% Small Cap?  (I got this data off etfdb.com).  In order to solve this problem, I actually create a separate column for each asset class.  I then put the percentage for each fund in each column, totaling to 100%.  I then multiply those percentages by the amount invested in each fund, giving me an actual dollar amount per asset class.

Step 3: Calculate the difference in dollars for each asset class in your portfolio from your ideal mix

This is the step where your self-assessment turns toward action.  How far are you off plan.

The hardest problem here is the implied problem: what is your ideal mix?

There are quite a few rules of thumb out there, and more than enough magazines and books out there to tell you what this should be.  Unfortunately, all of them are over-simplified, and none of them likely apply exactly to you.  At minimum, it’s a whole separate blog post to come up with this.  Fortunately, if you pick up the 2011 planning issue from Smart Money, Kiplinger’s, or Money magazine, you’ll probably end up OK.

But let’s say our individual in question is a 30-year old engineer who believes in the rule of thumb that they should take 120 minus their age, put that in stocks and the remainder in bonds.  Let’s say also that they’ve read that their stock investments should be split 50/50 between the US & International, with at least 10% of their overall portfolio in Emerging Markets.

That would leave our hypothetical engineer with the following breakdown:

  • 90% in Stocks
    — 45% US Stocks
    — 35% Developed Markets
    — 10% Emerging Markets
  • 10% in Bonds

Based on the numbers from the first screenshot, they would create an spreadsheet table like this:

This shows that our hypothetical engineer needs to rebalance by selling US Stocks, Emerging Markets, and Bonds.  The extra money will be re-allocated to international stocks in developed markets.

Step 4: Finalize the list of investments you will use to represent each asset class

Most people skip this step, but that’s a real missed opportunity.   Once you decide how much money to allocate to a given asset class, it’s worth a bit of thought about what is the best way to capture the returns of that asset class.  For example, is owning Google, Apple & Goldman Sachs the best way to capture the returns of US Stocks?  I’m not a professional financial planner, so you shouldn’t take my advice here.  But my guess is that you’ll be hard pressed to find a professional who believes that those three stocks represent a balanced portfolio.

We live in an unprecedented time.   Individuals with a few hundred dollars to invest can go to a company like E*Trade, open an account, and for $9.99 buy shares in an ETF that represents all publicly traded stocks in the US, for an annual expense of 7 basis points.  That’s 0.07%, or just $7 for every $10,000 invested.  That is an unbelievable financial triumph.  Previously, only multi-millionaires had access to that type of investment, and they paid a lot more for the privilege than 7 basis points.

Personally, I’m heavily biased towards using these low cost, index based ETF shares to represent most asset classes.  In fact, E*Trade let’s you mark any ETF for “free dividend reinvestment” under their DRIP functionality.  As a result, you get all the benefits of mutual funds with lower annual costs!  It takes some research to find the best ETFs, and in some cases, standard no-load mutual funds are a better option.  (Once again, I’m not a professional, so do your own research on what secrurities make sense for you.)

The biggest exception to this is with 401(k) plans, where you have limited choices on what types of investments you can make.  In these cases, I evaluate all of the funds in the 401(k), find those that are “best in class”, and purposely “unbalance” the 401(k) to invest in those.  I then make up for that lack of balance with my investments outside the 401(k).  For example, let’s say your current 401(k) has excellent international funds, but poor US funds.   you can skew your 401(k) to international funds, and make your US investments outside of the 401(k) where there are better options.

For our hypothetical engineer, let’s say that he’s decided to stick with Series I Savings Bonds for his fixed income, and uses the Vanguard ETFs to represent the different stock classes.

Step 5: Make the trades necessary (buys and sells) to bring your portfolio into balance

It seems like this part should be simple, but it can be surprising how many complications arise.  For example:

  • Sometimes the model says to sell $112 of something.  The trading costs alone make that likely prohibitive and unlikely to be worthwhile.
  • Share prices change every day, and your model leaves you short a few dollars here and there.
  • The model doesn’t take into account commissions for trading
  • Some funds have fees
  • Some transactions have tax consequences
  • Some investments can only be purchased in one account, not another
  • Some investments cannot be bought in a given account (like a 401k)

As a result, there is no advice that will apply to everyone.  Taxes alone make this the time when you may have to consult a professional.

In our hypothetical case, our engineer would:

  • Sell their stakes in Apple, Google, Goldman Sachs, and Teva
  • Decide to leave their Series I Bonds alone – not worth the trouble.  Take the extra money out of the developed markets stake.
  • Purchase / Sell shares in the Total Market, Ex-US, and Emerging Market ETFs to meet their new allocation goals

The following table shows how to use a spreadsheet to calculate the different trades (buys in Green, sales in Red):

Last Thoughts

I’ve been doing some version of the process above for at least fifteen years at this point, and it’s never failed to help me with my financial planning.  Of all the benefits described, annual rebalancing gives me the confidence to withstand the day-to-day gyrations of the markets, with the confidence that at the end of the year, I’ll get a shot to rebalance things.

There are a few “temptations” that I’ve noticed could lead someone astray:

  • Changing the “ideal asset mix” year-to-year based not on financial research, but based on what’s “hot” at the moment.  For example, if you find yourself saying that Gold should be 10% of your portfolio one year, and then the next year it’s “Farmland”, you’ve got some popular investing psychology drifting into your process.
  • You pick arbitrary “hot stocks” to represent asset classes.  This can lead to a double-whammy, you not only pick a bad stock, but you also miss out on key gains in your selected asset class.
  • Splitting hairs.  Don’t stress about small dollar amounts, or potentially, asset classes when your portfolio is small.  I remember investing the first $2500 I ever made from a summer job, and I got a little carried away with the breakdown.  In general, you can get pretty far with just the “Total Stock Market” and “Total Bond Market”.

This was a really long blog post, but hopefully it will prove useful to those who are interesting in balancing their portfolios, or just curious on how other people do it.  In either case, please comment or email if you find mistakes, or have additional questions.   Happy to turn the comment section here into a useful discussion.

The Incentives for Inflation Going Forward

In my last blog post, Lessons from the Masters of Deflation, I alluded to an upcoming article on why I expect heavy pressure towards inflation in the United States in the coming years.  I don’t think I’m at all unique in this projection – there are currently a huge number of economics and financial analysts that expect significant inflation in the coming years in the United States.  The rationale is almost universally the unprecedented expansion of the money supply by the Federal Reserve.  With over $2 Trillion on the balance sheet, and the acquisition of debt of questionable value, it’s easy to look at the incredible growth in M2 (a measure of money supply) and project out inflation once the economy recovers.

My rationale for significant inflation in the future is not actually based on these facts, although I don’t dispute them per say.  The rapid deleveraging of our economy argues for short term deflation.  The massive and hastily executed fiscal stimulus and monetary expansion argues for long term inflation.

I’m going to argue instead that you should just follow the incentives.  It is fairly obvious that a vast majority of Americans will benefit in the short term from a significant devaluation of the dollar.  If you believe that this country’s politics (and economics) tend to follow the majority opinion, then it seems like just a matter of time before we talk ourselves into policies that lead to inflation.

For the sake of argument, let’s assume that we could conjure up an instant 25% devaluation of the dollar. In this world, everything that costs $1 now will cost $1.25 tomorrow. Let’s look at some of the large groups of Americans that will benefit from this type of massive devaluation:

  • Homeowners.  A dominant majority of American households are homeowners, and almost all of them carry weighty mortgages.  More importantly, by some counts, almost 20% of those mortgages are underwater.  Inflation to the rescue!  In this world, every $400,000 house is now worth $500,000.  But of course, the mortgages themselves don’t grow, since they were written in the past.  Debtors love inflation, because they get to pay off old debts.
  • Federal Government. This is a two-fer.  First, most of our taxes aren’t indexed to inflation.  Want to keep that promise to tax only people making over $250K?  Devalue the dollar, and now more people will cross that threshold.  Capital Gains taxes?  Booyah, those aren’t indexed to inflation.  Now everyone whose stock just keeps pace with the devalution will owe taxes to boot!  Besides increasing revenue, the devaluation makes it easy to pay off bond holders of those trillions of dollars of debt, since they are all denominated in dollars.  With benefits like these, why stop at a 25% devaluation?  Let’s go for 100%!
  • Consumers in Debt. The average American has thousands of dollars in debt.  Assuming that wage inflation approximates price inflation, consumers can benefit from seeing increased nominal wages, and then paying off debts that were made before the devaluation.

Sense a common theme here?  Debtors.  The United States is a nation of debtors.  Individual households are in debt.  State governments are in debt.  Homeowners are in debt.  The Federal Government is in debt.  Debtors, in the short term, love devaluation because it means they get to pay off old borrowing with inflated currency.  On average, we are in debt, which means, on average, we’re incented to devalue the dollar.

In fact, you could argue that Japan, a nation of savers, has been stuck in a deflationary spiral precisely because, as a nation of savers, they benefit on average from seeing their saved Yen go farther at the market.  Of course, the younger Japanese don’t see those benefits, but thanks to aging demographics, they are outnumbered by older generations who saved massive amounts of wealth.

Yes, I know I am grotesquely oversimplifying the ramifications for all parties involved once an inflationary spiral takes hold.  And believe, me, I do not believe that this is a good outcome for the country (or the world economy).

Of course, I am a saver, so I would be biased against inflation…

Lessons from the Masters of Deflation

You can’t open a decent newspaper these days without coming across an article warning of impending deflation.  (Yes, I know.  How many people still open a decent newspaper?) Deflation, the Bizarro twin of inflation, has been a major concern for the United States since the financial crisis unfolded in 2008, and fears of a Japan-style lost decade emerged.

We’re now two years into the unfolding drama, and fear of deflation has resurged in the past few months as the sovereign debt crisis in Europe has led to a spike in the value in the dollar, a potential for weakening global demand, and the threat of a double-dip recession.  While I personally don’t believe we’ll see an extended period of deflation given the current monetary & fiscal incentives in our country (a blog post on this topic is coming), I do think a few years of borderline deflation may still occur.

From today’s Wall Street Journal:

The old bogeyman of deflation has re-emerged as a worry for the U.S. economy. Here’s something else to fret about: After studying more than a decade of deflation in Japan, economists have slowly realized they have no idea how it works.

Every time you see a piece on deflation, you find references to Japan.  This is not unexpected – Japan is the second-largest economy in the world, and it wasn’t too long ago that many highly educated people thought that it would usurp the US role as the dominant western economy.  This is really the only large-scale modern example of deflation – to find another you have to revisit the 1930s, and too many elements of our system have changed for those analogies to be completely helpful.  In fact, I see some pieces stretch back into the 1890s at times.

Unfortunately, Japan has been a wreck of an example.  They pursued massive borrowing and Keynesian stimulus, running their national debt to over 200% of GDP.  In fact, the most notable thing that they’ve achieved is setting incredible new records for the potential debt a country can take on without completely imploding.  This is similar in some ways to new records being set for over-eating.  Impressive, scary, and not something that inspires you to try it yourself.

However, if you want to understand deflation, and more importantly how to handle deflation, you need to turn to the true masters of deflation.  That’s right, living in our midst, there are huge multi-billion dollar economies that have not only survived a deflationary environment for forty years, they’ve thrived in it.

I’m talking, of course, about the children of Moore’s Law: our high tech industry.  Moore’s Law (circa 1975), loosely put, predicts that the number of circuits that you’ll be able to put in a semiconductor for a fixed cost will double every two years.  This is the equivalent of saying that the price of a circuit will drop by 50% every two years.

That’s deflation of 22.47% per year.  Put that in your pipe and smoke it.

But the industry has thrived, and looking at the financial structure of high tech companies, you can learn a lot about the topsy-turvy logic of deflation and how individuals can cope.

  • Debt is Bad. For decades, high tech companies have resisted the traditional financial wisdom of adding leverage to their balance sheets.  Why?  Theoretically, leverage is one of the key ingredients in Return on Equity, a primary measure of financial performance.  The answer is, when it comes to deflation, debt can kill you.In an inflationary environment, being a lender is tough.  There is a risk that inflation will eat of the gains (or more) of the interest you are charging.  If I loan you $10,000 at 5%, and inflation jumps to 8%, I’m losing 3% on the deal.   $300/year lost purchasing power is tough, but imagine that being $3B on a $100B loan portfolio.  This is because as a lender, my return is the interest rate I charge MINUS the inflation.In a deflationary environment, roles are reversed.  As a lender, I’ll lend you money at 0%!  After all, if deflation increases the value of a dollar by 3%, then I effectively make 3% on a 0% loan.  My return as a lender is the interest rate PLUS the deflation.  But the borrower has the other end of the deal.  Not only do they have to pay the interest, but they have to pay it with higher value dollars in the future.  Ouch.

    Moral of the story: In a deflationary environment, you do not want to owe debt. This is why deflationary environments lead to massive deleveraging.   You do not want to be caught holding a check denominated in low value today dollars, and forced to pay it back with higher value tomorrow dollars.
  • Don’t Buy Today What You Can Buy Tomorrow. This is something that any avid purchaser of computer equipment knows.  You pay a lot for the privilege of buying computing power today.  I guarantee you, it will be cheaper 6 months from now.  Want a 2TB hard drive?  Just wait a few months for significant discounts.  Want that Mac Mini?  It will be cheaper (or faster) in a year.  Same item, same condition, same quality – lower value in the future.  That is what deflation looks like.In a deflationary environment, on average items will cost less in dollars in the future than they do today.  So if you don’t need it now, you should wait.  In fact, you are paid to wait.  Literally.  High tech companies know this – they don’t source components until they absolutely need them to put in boxes.  High tech consumers know this.  Want to buy a 42″ LCD TV?  Wait a year, I promise you that exact same model, brand new in the box, will be a lot cheaper.This may not seem weird to you, but think about it for a second.   It’s not normal.  In order to keep the box the same price, most consumer products companies literally shrunk what they are offering you, or raise the price.   In high tech, they regularly have to double what they give you every two years, just to keep the price the same!  This is also why high tech companies are desperate to unload inventory as soon as possible… within days.  When I was at Apple, we moved our days of inventory on the books from eight week to just under two days!  Dell at the time was at six days.  Just six days of inventory!  That’s how you handle deflation.

    Moral of the story:  If you don’t absolutely need it now, wait. In inflationary environments, we buy now to avoid paying a higher price in the future.  In deflationary environments, the later you buy, the cheaper it is.  So don’t buy it unless you need to use it, immediately.

  • Success Depends on Increasing Value through Innovation. We take this for granted now in the high tech industry, but let’s face it:  high tech is unique.  If the internal combustion engine followed Moore’s law, we wouldn’t be worried about oil usage right now because we’d all be getting over 1M miles to the gallon.What people don’t realize about Moore’s Law is that it isn’t some government regulation.  There is no one handing out 2x performance every two years that high tech companies can just cash in periodically.  Literally hundreds of thousands of brilliant people, across a range of disciplines, degree programs, and commercial ventures are constantly ahead of the curve, inventing the technologies that will deliver that incredible curve.It’s a trap, in a way.  The innovation that makes the deflationary environment a fact is also the path to surviving it.  If you miss the next step on the curve, you’ll find that your products quickly are only worth half as much, and your more innovative competitor will still be collecting full price.

    This is tough to handle at an individual level.  In an inflationary environment, everyone gets some form of raise to “adjust for inflation”.  In a deflationary environment, everyone should get a pay cut to “adjust for deflation”.  However, since employees, managers, unions and even governments hate to see this happen, you tend to see layoffs instead.   It’s a vicious productivity war.  If you want earn the same paycheck next year, and deflation is running at 3%, you have to be 3% more productive to make that math work for the business.   At the company level, you need to see companies that can deliver productivity gains every year at a rate above deflation, just to tread water.

    Moral of the story:  There is no coasting in a deflationary environment, no rising tide that lifts all boats. Inflation may be an illusion of more money, but it’s an illusion that people emotionally depend on.  Deflation forces people to come to terms with a basic economic fact – if you aren’t able to make more with the same cost next year, you’ll likely be worth less next year.

I’ve obviously oversimplified a fairly complicated macroeconomic situation in the comments above.  However, I’m hoping that the insights provided will be helpful to those of you who have trouble visualizing what deflation might look like, in practice.  If there is interest, I may put together another post on what types of investments perform best in a deflationary environment.

Accredited Investors: Fixing the Dumb Money Problem

We’re now days away from the potential passage of significant financial reform, and a particular issue in the bill caught my eye.  This excerpt is from Businessweek:

Currently, a person must have a net worth of $1 million or an annual income of $200,000 if single or $300,000 if married (and filing jointly) to be an accredited investor. The senator’s proposed bill doesn’t say what inflation adjustment will be used to convert these numbers, established in 1982, to today’s dollars. But if we use the Bureau of Labor Statistics inflation calculator to adjust these figures on the basis of the consumer price index, then the annual income requirements for accredited investor status would become $449,000 if the investor were single and $674,000 if the investor were married, while the net worth requirement would become $2.25 million.

This is exceptionally bad news, if it passes, on multiple fronts.  To explain why, let’s review some of the basics.

What is an accredited investor?

Investing in public securities, like stocks and bonds, is heavily regulated.  There is a long standing legal concept, dating back to the 1930s, that individual investors need to be protected from nefarious money raising capitalists.  However, a special exception was carved out for the rich, under the auspice that sufficiently wealthy investors have enough education and resources to protect their own interests.  Thus, for private companies that wish to raise capital from private investors outside these large regulated facilities, there is a concept of an “accredited investor”.

Accredited investor qualifications have changed over the years.  Currently, there are two ways to qualify as an individual:

  • You are single and make $200K/year, or you are married and make $300K/year as a household
  • You have over $1M in liquid assets

When do you need to be an accredited investor?

You need to be an accredited investor to invest money in angel investments, hedge funds, certain private partnerships, and other high risk / unregulated investments.  For example, if Mark Zuckerberg came to you in 2005 and offered to let you put $25,000 into thefacebook.com, you’d need to be an accredited investor to do so.   (BTW If you can go back in time and do this, I highly recommend it).

Who is this going to hurt?

This is really going to hurt two groups – entrepreneurs and individual investors.

Entrepreneurs are going to be hurt by the severe limitation of who they can potentially raise money from at the angel stage.  As the Business week article points out:

Updating Reynolds’ estimate of the share of the adult population who are accredited investors to the 2008 adult population as reported in the Statistical Abstract of the United States, there were 5 million to 7.2 million American adults who were accredited investors in 2008…

Adjusting the income and net worth requirements for accredited investing to those proposed in the Dodd bill would reduce the number of accredited informal investors to 121,000 to 174,000 people.

So if this passes, we are talking about a massive decline in the number of potential angel investors in a new business.  Potentially a 98% decline, if the numbers above are accurate.  Outside of web 2.0 companies in Silicon Valley, raising angel funding is not trivial as it is.  Reducing the pool of investors here is massively disadvantageous to most entrepreneurs.

Individuals are also hurt here – that same 98%.  These are people who make a lot of money – $200K/year individually or $300K/year if married.  Imagine yourself as the founder of a cool web company, which sells to Google for $10M.  Your cut is about $1M after taxes.  Your friend is starting a new company, and you want to make a $50K investment.  You can’t because… the government says you aren’t rich enough?  Really? (I guess you are rich enough for a top tax bracket, just not rich enough to make investment decisions.)

Why do they think this is a good idea?

The amounts to qualify as an accredited investor haven’t been changed in a very long time.  Originally, these amounts were incredibly large, but they were never indexed for inflation.  I don’t think anyone ever envisioned millions of Americans qualifying.

Given the recent scandals around hedge funds and related ponzi schemes, these changes are an attempt to “protect” the public from people who would trick them into investing into shady schemes and poor investments.  The assumption is the same as the original one in 1933 – that in order to be sophisticated about investments, you need to be rich.

Alternatively, you could argue that we just don’t care that much if “rich” people lose their money, but that normal people, even those earning $300K/year, need to be protected from charlatans and rogues who would trick them into unregulated investments.

A better solution: make accredited status earned by knowledge, not income or assets.

We are learning the wrong lessons from the recent financial crisis and scandals.  If anything, recent events have demonstrated that dumb money is bad in large amounts, whether it is aggregated from a bunch of small investors, or funded by large rich investors.

We know from clear evidence that lottery winners, professional athletes, movie stars, and other wealthy people can still be incredibly financially ignorant.  Just because a retiree has accumulated $2M over a lifetime does not mean that they have significant financial education, or that they understand how to evaluate a hedge fund for legitimacy.  We also know that there is significant danger in this money being lost, stolen, or even worse, leveraged and invested in ways that can exacerbate bubbles.

My thesis is as follows:

  • Just because someone has a high income and/or significant wealth, does not mean that they have significant financial education, or will appoint/hire people who have significant financial education.
  • Depriving entrepreneurs and individuals from the opportunity to fund new businesses is completely unfair, and likely counter-productive to goals of encouraging new business formation and entrepreneurship.

My proposal would be as follows:

  • We introduce a new form of license / test that gives you “accredited investor” status for a fixed number of years (3-5 years).
  • We do increase the accredited investor limits – in fact, we eliminate them over time.

Look, we force people to repeatedly take a test to prove that it’s safe for them to drive.  It’s not a big stretch to insist that people who believe they are capable of making unregulated investments have the proper education.

The advantages of this program are clear:

  • Meritocracy.  This allows for anyone with the will to research and learn the ability to become an accredited investor.
  • Education.  This allows the government to ensure that all accredited investors, regardless of wealth, are aware of relevant financial and legal issues around investments.  This would help prevent charlatans from taking advantage of people.  For example, the test could ensure people are aware of their rights, of recent financial returns, of warnings signs, and of recourse for reporting fraud.
  • Self-funding. The government could charge a fee to take this test to help fund the license and potential even some enforcement resources.  It could also charge a licensing fee for institutions that want to offer classes around the license.
  • Centralized verification.  This would ensure that every accredited investor is easily verifiable.

As always, very interested in thoughts and feedback from those familiar with the issue.

Update: Good news.  It looks like some amendments have made it through on the Senate bill that restore much of the status quo.  That means the primary damage will be avoided.  Maybe now there is an opportunity over the next four years to take a different approach to qualifying accredited investors.

Quicken 2007: How to Repair A Broken File

Only a long time Quicken user will empathize with the trauma of having your Quicken data file fail to open.  It happened to me this weekend, and after a couple days of experiments, I finally solved the problem.  I’m posting this here on the blog because my Google searches on the topic turned up *nothing*, and the Intuit boards were useless on this topic.

First, background:

  • I’m using Quicken 2007 for the Mac, updated with the R2 updater and the R3 Certificate updater.  This is the most recent version.
  • I’ve used Quicken since 1994 to keep track of my expenses and investments.  That’s right, this file has 15 years of meticulous data in it.
  • Quicken for the Mac users at some level are masochists.  Circa-2000, Intuit decided that the Mac market wasn’t worth supporting, and effectively ended support for the product.  As Steve Jobs brought the Mac back, Intuit brought back support… but very little enhancement to the product.  Quicken 2007 is largely the same as the Quicken 1999 product, except far more rickety and long in the tooth.

OK, so here’s the story:

  1. About 3-5 weeks ago, when downloading stock quotes, I got a very strange error.  It said something like “Unable to create INTC. Security already exists.”  (Of course it exists, I’ve been tracking INTC for more than 10 years…)
  2. About 2 weeks ago, I quit and relaunched Quicken for some reason (my machine tends to stay up for weeks at a time.)  On relaunch, all of my “manually entered” stock quotes were gone.  After a brief panic, I restored a file from Time Machine from a week prior, and all was forgotten.
  3. Periodically, I received that error when downloading stock quotes.
  4. On Friday, I restarted Quicken and got a spinning beach ball.  I thought it hung, so I force quit it, and restarted.  Spinning beach ball.
  5. No worries, right?  I have multiple backups.  I use Time Machine to get an older file.  I launch. Spinning beach ball.
  6. Uh oh. Mild panic.  I tweet.  No one tweets back.
  7. I go to the “Quicken Backup Folder”, which is created automatically in your Documents folder.  I select several of the backups, duplicate them, and try to launch them.
  8. Good news, the file from November 12 actually works, but all security prices are missing.
  9. Bad news, it’s missing two weeks of data!  A lot of manual re-entry of the last two weeks.  Not too bad though.
  10. On Saturday, I quit Quicken and relaunch as part of a reboot.  Spinning beach ball.
  11. Uh oh. Time Machine backups don’t work.  I tried five of them from the last three weeks.
  12. Double Uh Oh. The only file that seems to work is that one from November 12.  But it gives me an error “Unable to save security”.  It works, but is missing all security prices. But it’s missing the two weeks of transactions.
  13. A bit of panic here. I search Intuit boards.  No luck.  I post a question anyway, even though the community on the boards gives me no confidence of ability to help or desire to do so.
  14. I delete Quicken 2007 and all preference files, and try to reinstall + updaters.  No luck.
  15. Tweets return nothing, except strange semi-taunts like, “I hate Quicken too.”
  16. Finally, I realize I may have to create a new file, then export/import all the transactions to create a new clean file.  Creating the file works.  Trying to export QIF and reimport into the new file leaves totally bizarre numbers and transactions.  Seriously, has QIF export ever worked in the past two decades?  Will it ever work?
  17. Desperation.  I start seriously contemplating doing all my finances in Mint… except Mint doesn’t actually support managing accounts without online access that well.  I like Mint, but I use it differently than Quicken…
  18. Hail Mary. The Quicken file isn’t really a file, it’s a Mac OS Package.  It’s a fancy name for a directory of files that is tagged to act like a single file for the Finder.  Looking inside, I find a data file for “Quotes” and a directory for “Quotes Details”.  I delete both.
  19. Salvation.  I launch Quicken.  No beach ball.  Works beautifully.   All stock quotes are gone, but a quick click to download quotes fixes that.  I manually re-enter the few securities that don’t have ticker symbols.  Everything is wonderful again.

So, just to capture some trouble-shooting for you, here is what I saw:

  • Launching Quicken with the corrupted file led to a spinning beach ball for over 30 minutes
  • When it did finally load, it gave me an error “Unable to open file”
  • There was a history of getting errors related to the downloaded stock quotes for securities

Solution was:

  • Make a duplicate of your Quicken file (always, always have a clean backup)
  • Right-click (or control-click) on the Quicken file.
  • Select “Show Package Contents…” from the Finder.
  • Double-Click on the “Contents Folder”
  • Select the “Quotes” file and the “Quotes Details” folder
  • Drag them to the trash, and empty trash
  • Relaunch Quicken with the file

Thus, I am still a Quicken user, at least for a little while longer.  Intuit, if you are reading, please get Quicken 2010 (which has been promised for two years) out the door.  And make sure the import from Quicken 2007 files is *flawless*.

The Best Hedge for Crisis: Gold, Dollar or Both?

I’ve been encouraged by a few friends to spend a bit more time writing blog posts about finance and economics in the real world, as opposed to Farmville.  (Hopefully the Zynga fans will allow me brief distraction with the real world.)

An article last week in the Wall Street Journal on investing in gold reminded me of a topic I had meant to cover this past summer:

What is the best hedge for a crisis?

The last two years have validated the fundamental premise of The Black Swan theory.  That premise is that, due to incomplete information and faulty statistical assumptions, the market generally underprices risk at the “tails” of the distribution.

In other words, while the outcomes of the market tend to look like a normal distribution, in reality, more “rare” events happen than would be predicted mathematically.

Given a potential fear of crisis, what is the best way to hedge?  What’s the best way to have some fundamental security in the face of these events?

For Nassim Taleb, the author, he has made his investment approach well known.  He keeps the vast majority of his money in cash, and periodically invests a small percentage in out-of-the-money puts on the market. In 2008, this made for extremely high returns (between 65% and 115%).

Unfortunately, this is such an extreme approach, it’s hard to recommend it as a general practice for anyone but the most stalwart intellectual and contrarian.

If you read any financial press, or listen to AM radio, you likely have heard a much more common refrain about a hedge against crists:  Gold.

Gold has historically been pitched as the ultimate hedge against inflation and crisis.  You can literally find websites that explain how to not only buy gold bullion, but how to effectively bury it in your yard in such a way that it won’t come up on satellite photos (in case the US Government chooses to confiscate it again, like FDR did in 1933.)  I’m not kidding.

Because fascination with gold goes back basically as long as recorded history, it’s rare to find new information on the topic.

This article in Seeking Alpha, however, caught my eye, as a rare piece that had something new to say about investing in Gold.

July 9: A Golden Hedge Against The Dreaded Dollar

This article highlights a well known point – that recently, when the market collapsed, gold actually collapsed with it.  In fact, if you look at the charts, in the past decade, gold and the market look like their moving together.  This makes it a terrible hedge, because good hedges are supposed to be decoupled.

In truth, GLD does appear to be a venerable contender for a portion of a well-diversified portfolio. Yet in a “black swan/perfect storm catastrophe” like the 3 month, systemic breakdown of 2008 (September through November), GLD dropped an astonishing -30%.  PowerShares DB U.S. Dollar Bullish (UUP) soared 20%.

What’s interesting, however, is that in these periods, a very surprising asset has done well: The US Dollar.  The author goes on to advocate for a split between the US Dollar Bullish ETF and Gold.

The article shows this chart, which tracks gold and the US dollar over the past two years:

The insight here is not that you should split your “crisis” holdings between Gold and the Dollar.  Most Americans are already heavily weighted in dollar holdings.   The insight is simply that gold actually doesn’t cover you in all crises, despite the protestations of the gold bugs.

Indeed, I would like to see this relationship going back over the past century, to see what possible approaches might make sense:

  • A balanced approach?
  • A reciprocal trade where you sell into strength of one, and buy the other?
  • Relationships between various mixes of gold & dollar to hedge a stock portfolio?

My guess is that a dollar-denominated fixed income allocation (Treasuries) would look similar to dollar bullish, and would fit a more traditional view of asset allocation.

Thoughts on the Obama IRA

Nice quick piece today in the Wall Street Journal about the proposed “Obama IRA”:

WSJ: Breaking Down the Obama IRA

It’s been a while since I’ve written a personal finance-related post, but this move towards fixing our retirement savings policies in the United States is the most promising since 2005.

Here are the basics of the Obama IRA, at least, based on current information:

  • Companies with 10+ employees will have to start offering payroll deduction service to contribute to a “Universal IRA” account.
  • Employees would be automatically enrolled at 3%
  • Employees can set the rates higher or lower
  • Employees would get a few specific options:  Series I Savings Bonds, Money Market, Stable Value.
  • At approximately $3000 – $5000, the amount would migrate to a Target Date Maturity Fund

That’s it on details.  There are a few things I like about this plan:

  • Broadly available. Most people would be covered under this plan.
  • Opt-out. The libertarian side of me loves the fact that people can choose their own contribution limits.  The behavioral economist in me loves the fact that the default state is set to opt-out, so that inaction leads to some savings for everyone.
  • Low cost. The structure of the plan ensures low cost options for both employers and employees.  Today, far too much hard earned money is literally wasted through hidden and exorbitant fees charges by retirement plans and mutual funds.
  • Simple investment options. Most people do not need a wide variety of options to provide a good, default retirement vehicle. This one keeps it simple.

Things that I don’t like:

  • 3% is too low. There is absolutely no possible way that a 3% contribution is going to help provide for retirement in a meaningful way, at any income level.  Most “opt-out” advocates currently recommend starting at 3%, but automatically increasing at a rate of 1% per year until they hit 10%.
  • Why tie this to employment at all? These plans should be available to anyone, particularly self-employed who don’t have the sophistication to set up more advanced vehicles.  In fact, imagine the option at tax-time to direct your refund towards your retirement account.
  • Create an open market for running these accounts. Define the “plain vanilla” investment types.  Cap the expense ratios that can be charged.  Allow any private firm to offer these plans.  USAA, Vanguard, etc will compete for this large pot of assets ($100B+ per year at current estimates).
  • Add an Immediate Annuity option at retirement. One of the biggest problems people have with 401k & IRA plans today is a lack of sophistication on how to turn a lump-sump into income that will last the rest of their lives.  It’s a version of the lottery-winner problem.  Offer a standard conversion for these accounts into a combination of a partial sum, an immediate annuity, and longevity income insurance to guarantee that you will have a certain amount of income until you die.  That’s what people really like about traditional pensions & social security.
  • Exempt these accounts from Social Security Means Testing. By means testing Social Security, we’ve already created a perverse incentive where incremental income in retirement can be taxed, at some levels, at more than 100%.  Give these accounts a boost by exempting income from these accounts from income tax calculations in retirement.  Otherwise, we’ll continue to penalize the ants who save for the winter vs. the grasshoppers who spend through their spring & summer months.

The plan isn’t perfect, and there is ample opportunity for the current Congress to complete mess it up.  But conceptually, the Obama IRA is starting to move in the right direction.  Ironically, it shares some of the goals of the privitization of Social Security – shift the nation towards providing for retirement through individual savings & investment rather than through transfer payments.

I’m working on a follow up post that outlines what I believe would be a better direction for retirement savings, since it’s clear that the previous concepts of pensions, social security, and the 401(k) all have significant weaknesses.

Timber Interview: Adam Nash

Of all the unexpected outcomes that have come out of my blogging experiment here on WordPress, one of the most surprising has been the amount of attention I received for a post on why I like investing in timber.

Why I love Timber as an Asset Class (November 10, 2006)

Since then, from time to time, the article has been referenced in investment blogs and journals.  For example, I am still getting hits to my blog based on the following article on Seeking Alpha:

Last year, I was flattered to see a quote of mine show up in Nuwire Investor:

What I didn’t realize at the time I wrote this blog post in January 2008 was that my entire interview was actually posted online.  That’s right. You can read the whole thing in all of its glory:

How embarrassing.  I remember doing this interview over the phone in March 2007 from a conference room from the Toys building at eBay.

Still, it’s a matter of public record now.  So enjoy, if you are curious.  I still do love timber as an asset class.

In Defense of Repricing Stock Options

This is actually news from last week, but Google announced that they are repricing their employee stock options.

John Batelle has fairly representative coverage on his blog.  His post cites coverage from Adam Lashinsky at Fortune (a personal favorite as a journalist) with a fairly typical dig on the issue.  Here’s the actual quote:

One last item of note. Google is offering employees the opportunity to exchange underwater stock options for newly priced options due to the stock price having been hammered. (The only catch in the exchange is that employees will have to wait an additional 12 months before selling re-priced options.) The stock price is  currently around $300, compared with $700 in late 2007. The number of shares eligible for exchange is about 3% of the shares outstanding, and the exchange will result in a charge to earnings of $460 million over a five-year period.

One must re-phrase this last bit in English: Google is transferring almost half a billion dollars in wealth from shareholders to employees, and for what ….? Motivation and retention, says Google. This a well known farce, as old as the Valley, which tells itself first that it offers generous stock options as a form of incentive and then, when share prices plummet, moves the ball so its employees, whose incentives apparently didn’t work (as if the stock price were under their control) can be re-incentivized. Retention? Would someone please tell me where the average Google employee is going to go right now?

To be clear, there have always been people who have a significant problem with employee stock option repricing, and with good reason.  Theoretically, options are supposed to align employee interests with shareholders.  In an ideal world, the employee wins if the shareholders win.   Repricing, therefore, breaks this model, because, after all, no one reprices the shares purchased by outside shareholders when the stock tanks.

Somewhere in the post-2000 bubble hangover, this criticism went from being a common argument to conventional wisdom.  Accounting standards were changed to require the expensing of employee stock options, and stock option repricing became largely verboten.

I rarely see anyone in the financial press explaining anymore why, in fact, there are very good arguments for stock option repricing.  So, I’m going to take a quick crack at it here.  Even if you disagree, it does a disservice to not reflect both sides of the argument fairly.

First, and foremost, it’s important to note that, while options are intended to help align employee interests with shareholders, stock options, in fact, do not do this in all situations.  The problem is the inflection point in the curve.

picture-11

This is a simple chart that shows the intrinsic value to an employee of a stock option with a strike price of 50 at different stock prices.  Notice the blue line, which is stock, actually reflects a 1:1 ratio of value.  If the stock is worth $10, the employee gets $10, etc.  For the stock option, however, there is a “break” in the line.  Below $50, the employee gets $0.  Above $50, the employee gets $1 for every $1 of stock price increase.

In general, employee stock options are granted at the strike price of the stock roughly on the date that they join.  So, the assumption is, this aligns the employee with gains after they join.  In theory, it’s even better than stock, because if the stock drops, they get no value for gains made before the date of their join.

This sounds good in theory, but we know that it has real problems, on both the upside and the downside.

On the upside, most stocks go up every year.  (Yes, I know.  In 2009, it’s hard to remember that.)  If the stock market itself goes up 7% every year, then an employee will see real returns on their stock options for just “matching the average”.  In fact, they can actually see real material gains over long periods even by underperforming their benchmark index.

However, since shareholders also enjoy that benefit, it tends to only get complaints when you see incredible gains by executives with huge option packages.   No one likes to see an outsized pay package for undersized performance.

On the downside, however, the problem is much more severe.  Let’s say our stock example from above drops to $25, a price that the company hasn’t been at for 3 years.  The good news is that shareholder alignment works, to a point, as advertised.  Not only are shareholder gains for the last 3 years wiped out, but so are the option grants for employees who joined in the last 3 years, and even any other employees who received grants in the past 3 years.

That part seems fine… at first.

Where does the company go from here?  Now we need to talk about the principle of sunk cost.  Sunk costs are costs that cannot be recovered, and therefore should be ignored when making future investment decisions.  (More rigorous explanation on Wikipedia).  For stocks, it’s important to remember the stock market does not care what you paid for a stock.  It has no memory.  The question for a shareholder (barring external effects like taxes, etc) is purely where you think the stock will go from here.

But now we see that the employee is no longer aligned with the shareholder!  From $25, most shareholders would love to see a gain of 20%, which would take the stock to $30.  But for employees, a $30 share price and a $25 share price mean the same thing:  $0.

Worse, if employees leave the company, and get a job at a new company, they will get option prices at today’s stock price.  In fact, if the employee quits the company, and then is rehired back, they would actually get their options priced at today’s stock price.

In a world of at-will employment, this is a big problem.  True, as Adam Lashinsky pokes at, most employees won’t be able to find a new job so fast.  But many of the good ones can.  And they will.  Because your competitor can actually come in with in a simple, fair market offer for the employee, and beat your implicit offer of zero.  Even if they don’t do it today, these problems tend to persist for long periods of time, and employees have long memories.  You may find that your best talent starts leaving, and then you get snowball effects because great talent is hyper-aware when other talent leaves.

So what is a company to do?

In a perfect world, the company would have a very tight and accurate evaluation of their best talent, and would target “retention compensation” proportionally to their people based on their value.  This would both minimize the risk of flight, and would also help “re-align incentives” for the gains going forward.

Unfortunately, the mechanics and accounting of repricing makes this fairly prohibitive.   As a result, it tends to be an all-or-nothing option.

The truth is, repricing stock options can be one of the best things to realign employee incentives going forward.  It resets the vesting period, basically treating employees like new employees.  The employees do not get to go back in time and recover their equity compensation for the past three years.  The new vesting period basically wipes out the history.  They literally no longer own the rights to the shares – they have to re-earn them.  In fact, if the employee quits the next day, they will take no stock with them, even if they worked for the company for three years.

As a result, stock option repricing actually re-aligns employees more closely with shareholders than nay-sayers give credit for.

Last thoughts

While I am explaining the reasons why repricing stock options makes sense, there is still the significant problem of “repeat abuse”.  If employees believe all options will be repriced for all drops, then you end up with a moral hazard, where you might actually want to drive down the price, get your options repriced, and then recover easy gains.  True, the market is fairly hostile to repricing due to the accounting charge, so it’s unlikely this would happen, but it’s still a real concern.

As a result, my recommendation would actually be that companies faced with this situation actually use the opportunity to not reprice stock options, but move to actual stock-based compensation.  Both have an accounting charge, but actual stock-based compensation serves three purposes:

  • The new stock grants can be better targeted to employees based on performance and value
  • The new stock grants have immediate value, serving as a kind of retention bonus
  • The new stock grants align the employee with shareholders going forward in both up and down markets

So while I do believe that repricing stock options gets a “bum wrap” in the financial media, I also believe that there may be potentially better compensation alternatives, particularly for public companies.

Bernie Madoff: YouTube Justice

I haven’t posted here to date on the Bernie Madoff scandal.  No sense writing a huge amount on the topic at this point – it’s been well covered elsewhere.  Let’s just summarize my feelings as:

  • We will never see an end to Ponzi schemes, because they work.
  • This exposes some of the flaws in the fund of fund approach to hedge funds.  Picking a manager is almost impossible, adding a level indirection truly is. (courtesy Dave Swensen)
  • The level of scandal for absconding with billions is historic.  The number of charity dollars, particularly from the Jewish community, is truly shocking, and likely deserves its own, new circle of hell (for those Dante fans).
  • There is no punishment that can fit this crime.  The impact will literally be felt by millions.
  • This failure will likely be used as a scapegoat and excuse to permanently damage the hedge fund industry in ways that may materially harm our markets for decades. (knee-jerk, political grandstanding regulation)
  • We still haven’t heard the worst of it.

Now, among friends, I’ve joked that while I’ve heard the expression “death by a thousand cuts”, this situation seems to be a good opportunity to actually test that theory out.  (yes, dark humor)

For my birthday, my brother actually forwarded me this Youtube video, and I couldn’t stop laughing.  So I’m posting it here, since it seems to have a shockingly low view count.

Enjoy.

The Benefits and Pitfalls of Inverse & Double/Triple ETFs

Caught this article on Seeking Alpha on Wednesday on the problems with using inverse ETFs.  It reminded me of a topic that I’ve debated quite a bit with Elliot Shmukler over the past two years, and have been meaning to write about here on the blog.

Since I haven’t commented much on personal finance topics lately, this seemed like an opportune time.  🙂

Quick set of definitions, if you aren’t familiar with the topic:

  • ETF:  Exchange Traded Fund.  These are funds that are similar to mutual funds, except that they are traded like stocks.  For the most part, they are index funds with extremely low expenses.  In the last five years, there has been an explosion of index-based ETF funds, ranging from the plain vanilla US Stock Market to indexes only for water companies.
  • Inverse ETF:  This is a fund that makes money based on the opposite direction of an index.  Example: An S&P 500 bear ETF, or inverse index, would attempt to give you a positive 20% return in the case that the S&P 500 dropped 20%.
  • Double/Triple ETFs:  A double (or triple) ETF attempts to give you double (or triple) the returns of a given index.  For example, a double oil fund would attempt to give you a 20% return in the case that oil rose in price 10%.

The original discussion Elliot & I had was back in 2007, when we were comparing two hypothetical portfolios:

  • Portfolio 1:  100% invested in the S&P 500
  • Portfolio 2: 50% invested in cash, 50% invested in double S&P 500 ETF

At first blush, it might seem like Portfolio 2 is the winner.  After all, with Portfolio 2, it would seem that if the stock market were to drop more than 50%, Portfolio 2 would allow you to keep 50% in cash safe and sound.  If the stock market returns more than negative 50%, then the portfolio seems to offer exactly the same return as Portfolio 1.

The trick, however, is the nature of the double ETF itself.  Double ETFs are not perfect instruments – because they simulate returns using derivative contracts, they try to match their promised returns on a daily basis.  (I’m assuming here, by the way, that the simulation of returns is perfect.  In real life, these funds have an additional problem of tracking error due to the nature of the way they are implemented.)

So if on Day 1 the S&P 500 goes up 1%, the double ETF tries to return 2%.  I say “tries” because it’s rarely perfect.  If the next day the S&P 500 drops 2%, the double ETF should drop 4%.

Unfortunately, it turns out that the math for doubling daily returns does not necessarily lead to a long term result that matches the long term double of the index.

An easy example of where this breaks is to take a huge increase followed by a huge drop.

Let’s say you put $1000 into the S&P 500, and $1000 into the double S&P 500 ETF.

On Day 1, the index goes up 40%.  Great news!  Your $1000 in the S&P 500 is worth $1400.  Your $1000 in the double S&P 500 ETF is now $1800, expected, for a 80% gain.  Everything is as expected on Day 1.

On Day 2, the index goes down 40%.  Bummer.  Your $1400 in the S&P 500 is now $840.  Your $2000 in the double S&P 500 ETF is now $360.  Wow.  That’s bad news.

You can see the problem.  Technically, over two days, the S&P 500 dropped 16%.   But the double S&P 500 ETF dropped 64%.  Most people assume it would have dropped 32%, which is double the two-day return.  This is the issue with percentages – the product of a series of percentage changes will not equal the product of a series of 2x those same percentage changes.  (Covered in Calculus D at most schools, for those in a nostalgic mood).

If you are skeptical, you might be thinking: “Well, Adam just picked the extreme example.  Of course a one day 40% move wipes you out. Most stock market moves are small, so the error is small.”

Unfortunately, this isn’t the case either.  A long series of small moves can lead to large errors as well.

Let’s assume a stock market where every day is either up 2% or down 2%.  In this case, we’ll go up twice for every down.

Let’s say you put $1000 into the S&P 500, and $1000 into the double S&P 500 ETF.

After thirty days of +2%, +2%, -2% (10 times), here is what you are left with:

You’ll have $1214 in the S&P 500, for a 21.4% gain.  But you’ll have $1457 in the double S&P 500 ETF for a 45.7% gain.  In just thirty days, you’re off by 6.6% (in gains).  In this case, it’s a good thing, but obviously in a market like the one we’ve been having over the past six months, it can be a very bad thing.

In fact, over the long term, the errors can be fairly extreme, and whether they are to your benefit or not is based purely on the size and ordering of the volatile movements.  The only way to get ride of the errors is to have an absolutely equally distributed, linear progression of the market in one direction.  And let me be the first to say that we will never actually see that happen.

So, what’s the takeaway here?  Simple.

The errors in inverse and double/triple ETFs grow rapidly based on volatility.  In low volatility markets, they can be used for a short period with expected results.  Like options and other derivatives, however, their tracking errors make them poor choices for long term allocation or investment.

They do make interesting options for speculative bets in the short term, especially in situations where:

  • You want to keep liquidity (ie, cash available)
  • You want to limit your downside to 50%

But watch out for those error rates…

Refinancing? Try Pentagon Federal Credit Union (PFCU)

With rates plummeting these days, many people are choosing to refinance.  My family falls into that bucket, as we refinanced our home almost five years ago (2004) at the low, low rate of 4.5% for a 5/1 mortgage.  (In case you are curious, we ended up getting a 5/1 because while 30-year rates were also low, we felt it unlikely that we’d be staying in our current house more than 7 years.)  At the time, I remember looking at historical rates and saying:

When will we ever be able to refinance at 40-year lows again?

Silly me, the answer turned out to be about five years later, in late 2008.  Since our rates were about to float, and not trusting the bank to keep the rate reasonable, we decided to lock in rates for at least another five years.  In the process, we evaluated almost every web-based pricing agent, several internet deals, and one professional mortgage broker.

The winner: Pentagon Federal Credit Union

To get a mortgage, you must join the credit union.   You can do this for free if you or a family member served in the armed forces and has proof.  Otherwise, you can sign up to join the National Military Family Association for $20.  Yes, that’s right.  $20.

I’ve been extremely happy with the service.  In fact, when we originally engaged with them, the rates on a jumbo 5/5 mortgage (a unique mortgage they offer that resets every 5 years based on US Treasury rates) were at 5.375%.  They have dropped twice since then, and they allowed us to reset at their current price of 4.625%.

Yes, I know there is probably a better deal out there.  But I also know that most are worse.

In any case, they are worth checking out.  Their rates are updated daily.  Low closing costs.  They depend on Fannie Mae for securitization, so it’s really a good deal if you have a good credit score and fit within guidelines.  No points for loans under 70% LTV.  0.50 points for loans between 0.70% and 0.80% LTV.

If you find a better deal out there… don’t tell me.  I’m happy enough as is.  I may ask for you help again in 2014.

Or, at the rate we’re going, if rates plummet to 100 year lows in 2009, we might refinance again.

3% mortgages?  That’s the magic of deflation

Understanding Deflation: Bonds Paying 0%

There wsa a good article in today’s WSJ (requires subscription) describing the unique point we hit today in the bond market.  Some durations of US Treasury bonds are now actually paying negative interest, -0.01% in some cases.

Investors around the world are stuffing their money into a mattress — otherwise known as the U.S. Treasury-bond market.

Fund managers, corporate treasurers, hedge funds, banks and central banks want to show their constituents, or bosses, their portfolios are bulletproof as year end approaches. Even with all the government’s steps to shore up the credit markets, investors aren’t taking any risks. Instead, they are willing to pay a premium, rather than collect one, to ensure they have in 2009 what they have now.

That means that someone is paying $100.00 for the priviledge of  getting back $99.99 at the end of the term.

This may sound ridiculous, unless you think of it in plain English:

“I’m willing to pay the US Government one penny to keep my $100.00 safe and sound for this duration.”

In a world of fear and deflation, this statement starts to make sense.  Hell, you might even pay more than $0.01 for that security in some cases.

Deflation is a very weird financial state.  For most people, it’s completely counter-intuitive. It’s a world where cash today is worth less than cash tomorrow.  It’s a world where commodities (like gold, silver, oil, food) get cheaper over time nominally, not more expensive.  It’s a world where you don’t buy today, because tomorrow the same product will be cheaper.

In fact, the only large segment of the population at this point who likely have an instinctive feel for deflation are people tied to high technology, primarily hardware like hard drives and semiconductors.  They’ve spent 30 years dealing with the fact that their products will be cheaper tomorrow than today.  They’ve even created high return businesses in effectively a deflationary environment.

I’m not going to go into detail about all aspects of deflation in this post.  But I did think it was worth explaining why 0% bonds might make sense.

Think about the dangers for keeping cash:

  • Someone could steal it.  So you have to secure it.
  • It can get physically destroyed (fire, pets, small children)
  • You can invest it, but those investments may lose money (stocks, bonds, commodities, you-name-it)
  • You can put it in a bank, but they may go bankrupt.  (you are protected up to $250K, but you may not get it immediately)

When people are afraid, and liquidity is rushing out of the system, 0% guaranteed by the ultimate “too big to fail” institution in the world can sound pretty good.

Now, I doubt this makes sense for individuals with dollars measured in thousands.  With those numbers, you can get 3+% on a CD, guaranteed by the FDIC.  But for institutions with millions or billions, how do you protect your cash?  Seriously.  It’s not a trivial problem when you think about it.

And no, you can’t just “go to gold”.  Even gold drops in nominal value during deflation.

Mathematically, if a country is undergoing 5% deflation per year, that means that $1000 of gold will only cost $950 in a year.   From that point of view, 0% percent interest + 5% deflation = a 5% real return on your capital, adjusted for inflation.

Yes, it seems like a monetary phenomenon from Bizzaro’s home planet, a square world where people say “goodbye” when they come and “hello” when they go.

But that’s what we’re flirting with right now, as it seems like literally $20 Trillion in nominal value may have disappeared off the planet.

The silver lining, however, is that you can make money in a deflationary market, if you re-orient your thinking.  Sell your products quickly, for cash.  Money now is worth more than money later.  Prioritize products that buyers cannot postpone.  Inventory turnover is key.

Intel has made billions turning over products that drop in value 1% a week in some cases.  It can be done.