I was riding home with child number seven after a basketball practice about four months ago — this is the child that if any of mine has the capability of taking over for me someday, this is the one. She said to me, “Dad, I always knew we were better off than most, but it finally sank home to me how much better off we are than most of the people we know.”

Me: “What do you mean?”

7: “I’ve been talking with my friends after basketball practice, after church, and other times, and I hear about what happens when their parents have a $500 surprise bill for a repair, and things like that.  They have to scrape for months to deal with the added expense, and they can’t do a lot of things that they do normally while they rebuild their finances.”

Me: “Okay, so what makes us different?”

7: “We just had three disasters hit us at the same time, and you just dealt with them for the long term without making a lot of noise about it.  Had that happened to any of my friends’ families, they would not know what to do, it would be impossible for them to do it without help.”

Me: “Actually there are a few of your friends whose families would likely survive what hit us easily, but yes, you’ve hit on something that I think is the most significant initial lesson on finance for the 75% of the population on the low end of incomes.  People need to start saving early, and build a buffer against disasters, etc.  If I were going to give a talk at most churches on personal finance, I would talk only about that, and almost nothing more.  Earn, budget, save, and be generous.  After that, we can talk about investing, but it is only relevant to a minority of the population with enough discipline to save early and often, initially aiming for 3-6 months of expenses.”

7: “When did you and Mom finally have that much saved?”

Me: “Going into our marriage back in 1986.  I had been a graduate student, and your mom a high school teacher in one of the poorest school districts in California, but we still both lived low on the hog, and saved money.  That gave us enough money that we were able to buy a small house at an opportunistic time six months after we married.  Within a year, we had rebuilt the buffer, and we haven’t been without it since.”


In personal finance, you have to develop good habits early, and learn that life isn’t about how much you spend.  I try to teach my kids that — Seven understands it, as does three or four of her siblings.  The other three or four don’t understand, despite my best efforts — some of it seems to be personality-driven, but I have seen one or two of them change and get better at money management.  We’ll see… they are still developing.

In finance, you have to focus on what you can control.  You have reasonable control over ordinary spending.  You have less control over what you earn, and almost no control over accidents and investment returns.  Thus the first bit of advice is to live below your means and save.  The second bit is to plan against catastrophes on a reasonable level.  Insurance can be useful to protect against some of the worst outcomes.  Just remember, insurance is an expense and not an investment.

Along with the above article cited, note these four basic articles and one book review on personal finance:

The last one is useful for learning to live less expensively, while still having most reasonable comforts that others have.

Now, what I have written about above has been noted in the financial media lately regarding a study done by JP Morgan on how many people don’t keep a buffer around, no matter how much they earn.  Here are two articles that talk about that study (one, two — good articles both, read them if you can).  Personally, I’m not surprised having worked with people who earned a lot and spent to the limit.  They lived far more opulent lives than I do, but decided they would save later.

If you want to save, start now.  Most good habits have to be started now, or they won’t get started.  Most good intentions don’t die from a frontal assault, but from the idea that you have plenty of time to change.  As a result — you don’t change.  And that is not just you, it is me in my life also.  Change must start now, or it does not start.

Two more articles worth a read:

These largely follow my point of view on personal finances.  Save, protect against bad risks, and take moderate risks to earn money both in work and in investing.  You can do it too, but remember, it is not a question of knowledge, it is a question of whether you have the will to do it or not.  I wish you the best in your efforts.

Now if you haven’t done it yet, go build the buffer.

When young couples come to me and say, “What should we do financially?”one of the first things I say to them is something like, “Build the buffer.”  You should have 3-6 months of expenses saved up.

I sometimes phrase it like this: use the stoplight rule.

  • Less than 3 months expenses in the savings fund? Red light. Defer all discretionary expenditures.
  • 3-6 months expenses in the savings fund? Yellow light. Some discretionary expenditures allowed, so long as you don’t dip back into the red light zone.
  • More than 6 months expenses in the savings fund? Green light. Discretionary expenditures allowed, so long as you don’t dip back into the red light zone.

For what it is worth, the same rule works well with congregational and other nonprofit budgets, for nonprofits without a significant endowment.  It balances mission needs, and donor giving.

But let’s take another look at the buffer, and why you might like to have it bigger.  Consumer finance charges really eat into the incomes of many people.  What if your buffer was so big that you could:

  1. Pay your insurance premiums in annual installments?
  2. Buy your next car without financing it?
  3. Pay off your credit card bills in full each month?
  4. Ask for a discount for cash when buying big ticket items?  (You’d be surprised.  I drove quite a deal with my orthodontist for my wife and eight kids. I’m the only one that hasn’t had braces.)
  5. End the escrow account on your mortgage?
  6. Pay tuition bills in full, rather than a payment plan?
  7. Take advantage of financial crises, and extend credit at tough times?  (I am still receiving 13% from a business associate that I lent money to in March of 2009, with warrants.)
  8. Retain cash in your corporation to reduce financing costs?
  9. Not worry about the minor disaster that recently hit?
  10. Raise your deductibles on your Auto, Home and Health insurance premiums to save money?
  11. Receive discounts on services that you want to receive, by getting a discount for buying years ahead?
  12. Fund your 401(k), IRA, HSA, whatever, to the fullest?
  13. And more…

Even when Fed policy is insane, the low rates do not apply to the masses, aside from GSE-supported lending.  In this environment, Fed policy starves liquidity in traditional lending to send it to the government, and related entities.

So, even though you can’t earn anything by saving, there is still the advantage of receiving a discount for full cash payment up front.  That doesn’t change, and because there are so many with bad finances, that discount is still valuable to businessmen who don’t want to deal with the costs of bad credit.

Now be wise.  When you use your liquidity to buy ahead, plan to replenish the buffer.  Don’t do everything at once; note the limitations of your liquidity, and act accordingly.

This is basic stuff, but I see many neglecting it.   Incidentally, the same rules apply to small businesses.  Being well-capitalized has advantages.  Take advantage of vendor finance discounts where you can.  Seek discounts for prompt cash payment wherever it makes sense.

I’m not saying be a miser and hoard cash.  I am saying there is a happy middle ground where you have enough cash to meet most contingencies and normal needs, and use the remainder to further long term goals and whatever you enjoy.

PS – I write this by the light of four candles as I continues to wait for power to be restored.  The candles illuminate my keyboard.  I will post this in the morning.

Photo Credit: Dr. Wendy Longo || This horizon is distant...

Photo Credit: Dr. Wendy Longo || This horizon is distant…

I ran across two interesting articles today:

Both articles are exercises in understanding the time horizon over which you invest.  If you are older, you may not have the time to recover from market shortfalls, so advice to buy dips may sound hollow when you are nearer to drawing on your assets.

Thus the idea that volatility, presumably negative, doesn’t hurt unless you sell.  Some people don’t have much choice in the matter.  They have retired, and they have a lump sum of money that they are managing for long-term income.  No more money is going in, money is only going out.  What can you do?

You have to plan before volatility strikes.  My equity only clients had 14% cash before the recent volatility hit.  Over the past week I opportunistically brought that down to 10% in names that I would like to own even if the “crisis” deepened.  That flexibility was built into my management.  (If the market recovers enough, I will rebuild the buffer.  Around 1300 on the S&P, I would put all cash to work, and move to the alternative portfolio management strategy where I sell the most marginal ideas one at a time to raise cash and reinvest into the best ideas.)

If an older investor would be hurt by a drawdown in the stock market, he needs to invest less in stocks now, even if that means having a lower income on average over the longer-term.  With a higher level of bonds in the portfolio, he could more than proportionately draw down on bonds during a crisis, which would rebalance his portfolio.  If and when the stock market recovered, for a time, he could draw on has stock positions more than proportionately then.  That also would rebalance the portfolio.

Again, plans like that need to be made in advance.  If you have no plans for defense, you will lose most wars.

One more note: often when we talk about time horizon, it sounds like we are talking about a single future point in time.  When the time for converting assets to cash is far distant, using a single point may be a decent approximation.  When the time for converting assets to cash is near, it must be viewed as a stream of payments, and whatever scenario testing, (quasi) Monte Carlo simulations, and sensitivity analyses are done must reflect that.

Many different scenarios may have the same average rate of return, but the ones with early losses and late gains are pure poison to the person trying to manage a lump sum in retirement.  The same would apply to an early spike in inflation rates followed by deflation.

The time to plan is now for all contingencies, and please realize that this is an art and not a science, so if someone comes to you with glitzy simulation analyses, ask them to run the following scenarios: run every 30-year period back as far as the data goes.  If it doesn’t include the Great Depression, it is not realistic enough.  Run them forwards, backwards, upside-down forwards, and upside-down backwards.  (For the upside-down scenarios normalize the return levels to the right side up levels.)  The idea here is to use real volatility levels in the analyses, because reality is almost always more volatile than models using normal distributions.  History is meaner, much meaner than models, and will likely be meaner in the future… we just don’t know how it will be meaner.

You will then be surprised at how much caution the models will indicate, and hopefully those who can will save more, run safer asset allocations, and plan to withdraw less over time.  Reality is a lot more stingy than the models of most financial Dr. Feelgoods out there.

One more note: and I know how to model this, but most won’t — in the Great Depression, the returns after 1931 weren’t bad.  Trouble is, few were able to take advantage of them because they had already drawn down on their investments.  The many bankruptcies meant there was a smaller market available to invest in, so the dollar-weighted returns in the Great Depression were lower than the buy-and-hold returns.  They had to be lower, because many people could not hold their investments for the eventual recovery.  Part of that was margin loans, part of it was liquidating assets to help tide over unemployment.

It would be wonky, but simulation models would have to have an uptick in need for withdrawals at the very time that markets are low.  That’s not all that much different than some had to do in the recent financial crisis.  Now, who is willing to throw *that* into financial planning models?

The simple answer is to be more conservative.  Expect less from your investments, and maybe you will get positive surprises.  Better that than being negatively surprised when older, when flexibility is limited.

On the home front, I have been doing more basic financial counseling than usual, and I’ve had some say to me that it would be hard to build a buffer of 3-6 months of expenses.  If that is true of you, I would encourage you to build a smaller buffer of one month’s wages.  Why?

  • A change to good habits rarely happens immediately.  You gotta walk before you can run.
  • Psychological changes happen slowly, and there is a mental reward to achieving a smaller, interim goal.
  • The idea of living off of last month’s paycheck is a simple one.
  • Contra Aristotle, money is not sterile.  It tends to beget more money, once you pass a certain threshold.  Why?

There are discounts for upfront payment on large purchases, but the biggest reason is that once you get used to living on less than your full income, and living off of the buffer fund, there is a tendency for the buffer to grow.  You have begun to master a key concept:

Money has importance tomorrow that is more valuable than spending on purchases of trivial importance today.

I’m surprised at how money burns a hole in the pocket of so many people.  Spend down to the last dollar in the pocket and then some.  No wonder the credit card companies are so big and profitable.

I have another article coming up on this, but it is critical to basic financial management that you place importance on the ability to meet future needs with greater certainty.  Thus the need for the buffer, which implies saying “no” to low value and low priority spending.

It’s not a question of the intellect usually, but of the will.  When will you start making money your servant, rather than serving it?  Go build the buffer, even if it is small.  In time, with increased will power on your part, it will grow.


These articles appeared between August and October 2011:

Take Prudent Risk

One of the great secrets of investing is taking moderate risk.  High risk fails on average, because those swinging for homers make a lot of strikeouts.  Low risk fails because there is little reward.

De Minimus Laws, Redux

I catalog all of the de minimus laws for Registered Investment Advisers.  Only Texas and Arkansas require registration on the first client.  The rest require it on the sixth client.

How Would You Run a Rating Agency?

Points out the incompatible standards that rating agencies are encouraged to achieve.  It is a no-win situation.


There is no escape.  There will be a crisis.  Do you want a smaller crisis sooner, or a bigger crisis later?  The actions of our government say, “A bigger crisis later, much bigger and later if possible.”

The Rules, Part XXIV

Every excess eventually unwinds.  When an excess unwinds, the fall gets exacerbated by trend-followers blowing out of mutual and other pooled funds with lousy relative performance.

Leverage Isn’t Free

A critique of risk parity.  This is implicitly the same idea behind securitization, but it does not get the same criticism.

The Predictions of Michael Pettis

Few global macroeconomists are as perceptive as Michael Pettis.  I have learned a lot from him over the years.

The Folly of Large Acquisitions

I explain what most tends to improve the value of companies with respect to the use of free cash flow.

The Rules, Part XXVI (Efficiency vs Stability)

T+1 will raise volatility.  Often increases in the technical efficiency of information or trading systems increase volatility, because people can act precipitously on information, all at the same time.

Missed Opportunities

The Federal Reserve was the primary architect of the debt bubble that we are now wrestling with.  It is the main reason that we need to eliminate the incompetent, overstaffed Fed.  (Lay off anyone that has a Ph. D.  there.  Dangerous idealists who have little contact with reality.)

On High Correlations

I explain why high asset correlations have to be bearish indicators.

How Do I Find a Job in Finance?

How Do I Find a Job in Finance? (Part 2)

I have helped many people get jobs in finance.  Most of my useful advice is in these two articles.

On Multiparty Transactions

My simple rule to average people when involved in complex transactions is this: be cynical.  No one is interested in your well-being, and most of the transactional terms are skewed against you.  To the extent that you can borrow less, and eliminate some of the parties that would be a part of the transaction, it is to your good that you do so.  The best situation is that you buy for cash, if you have it.

Debt Relief

The main thing holding back our world from recovery, is no one wants to take losses from bad debt, and so central banks extend a lot of credit, as if those pointy-headed intellectuals have any idea about how the economy really works.

Build the Buffer

There are advantage to having surplus cash around.  You can get discounts and minimize risks.

Financial Complexity, Part 1

Alas, there is no part two to this piece.  But this piece explains why financial markets are often not efficient.

The Retirement Bubble

We know we should save for retirement, but we don’t.  That applies to governments, corporations, and individuals.

We Eat Dollar-Weighted Returns

Explains how the average person did poorly investing with Bill Miller, while the few buy-and-hold investors did pretty well.

On Social Media, and How I Built my Blog, Part 1

On Social Media, and How I Built my Blog, Part 2

I divulge almost all of my tricks for building a good blog.

Improving Publishing in the Social Sciences

I adapt the concept of double-blind studies to the social sciences.  It would definitely improve the quality of the research.

Occupy Your Time Productively

I got a lot of hate mail over this, but my main point was that protesters should organize, and form a political party or something like it (think of a leftist version of the Tea Party).  The Occupy movement was lazy, and the results of their actions were minimal.

I sat down to talk with a young couple with three kids about personal finance.  This taxes me, because I’m not a financial planner.  I can remember most but not all of the rules on the taxation of various investments.

But this is the way that I handled it:

Do you have your risks covered?

  • Life insurance on the husband, because the wife stays at home with the kids.  Bright lady, highly employable, but she wants to raise the kids.  Not enough insurance for this family.
  • Disability insurance — covered by his employer.
  • Health insurance — ditto.
  • P&C insurance for cars and house — difficult to avoid, but wise to check.

Do you have a buffer built of 3-6 months of expenses?

Remember my stoplight rule:

  • Less than 3 months expenses in the savings fund? Red light. Defer all discretionary expenditures.
  • 3-6 months expenses in the savings fund? Yellow light. Some discretionary expenditures allowed, so long as you don’t dip back into the red light zone.
  • More than 6 months expenses in the savings fund? Green light. Discretionary expenditures allowed, so long as you don’t dip back into the red light zone.

When my friends asked me how to define a month of expenses, I said take half of your discretionary expenses over a year, add it to your non-discretionary expenses, and divide by 12.  In this case, it revealed that they weren’t tracking their income and expenses, and so I suggested getting Quicken.

They need to build the buffer.

After the buffer comes expenditures that improve life, or reduce long-term costs.  Use cash payment to get discounts.

After that, invest the excess.  50-50 stocks and bonds in index funds is an excellent start, with annual rebalancing. Or 25-25-25-25 cash-gold-stocks-bonds works really well across a wide number of economic environments.

The most important thing is to spend less than you earn, build the buffer, and then invest, or reduce debt, whichever is more promising.  How you invest is secondary.  The first priority is to be wise with your spending money, and then, save.  Especially in a low interest rate environment, the biggest benefit of saving is saving, and not what you earn.

One more note: there are two ways to make sure you spend less than you earn.  The first way is to budget strictly.  The second is to make sure your cash balance grows over every six months.  The latter has been my way.  It is more flexible, but it requires that people have limited desires, viewing spending as a necessary evil at best.

To give credit where credit is due, this post was triggered by an article at SmartMoney, 10 Things Credit Scores Won’t Say.

In 1996, I got a call from a recruiter suggesting there was a real opportunity with the Philadelphia-based corporation Advanta.  They were looking for an actuary with investment knowledge that could help them in their joint venture with The Progressive to use credit scores in underwriting auto insurance.  Since I was local, and known to be a “nontraditional actuary” with some degree of talent, and my situation at Provident Mutual was deteriorating because of a management change, I accepted the interview.

Being a life actuary, I didn’t know much about P&C insurance, but my career had been one of growth.  I may not know everything there is to know about a given topic, but I learn rapidly, and bring allied knowledge to the table that others may not possess.  The interview was interesting.  If you are a life actuary, you don’t expect interviews like Advanta. Credit cards were reaching their apex, and some clever people were trying to figure out other ways to apply the data from individuals using credit cards.  I ended up being Advanta’s “second choice.”  Bad for them, good for me.  Two years later, I would join the St. Paul’s Investment department in Baltimore.

The key idea was that credit scores were highly predictive regarding personal insurance losses, particularly when combined with traditional underwriting metrics.  The idea was a surprise to me when I first ran into it, but it quickly made sense to me.  Let me explain.

Honoring agreements that you have entered into is an important indicator of your personality.  Those who do not repay are on average less moral than those that repay.  Those that are net creditors on average made efforts that net debtors did not.

Credit scores are important.  In a specific way, they measure your willingness to keep your word.  Anytime you enter into a debt contract, you make a promise to repay.  If you fulfill your promise to repay, you impress others as one of good moral character.  If you don’t repay, it is vice-versa, you appear to be of low moral character.  (Note: I am excluding those that got hoodwinked by lenders that defrauded borrowers in a variety of ways.  That said, if you can be hoodwinked, that says something else about you, and that may have an impact on your creditworthiness as well.)

Now, before I continue, these concepts work on average, and not always in particular.  I have helped some at the edge of society with gifts and loans.  In some cases there is a cascade of bad events that the most intelligent would have a hard time facing.  Being wise helps, but there are some situations that would tax the soul of anyone, and be difficult to claim that they were blameworthy; it’s just the way things happened.

That said, that concept of a “credit score” traveled rapidly to insurance, because moral character is highly correlated with how a person drives.  People who are sloppy with their debts tend to be sloppy with their driving.  As with everything in this post, this is only a general tendency.  It applies on average, it does not always apply.

Some US states were offended at P&C companies using credit scores, and so the companies moved to use “insurance scores,” which were little different from what they aimed to replace.  The insurance companies took the disaggregated data behind the credit scores, did a little more research, and discovered which variables were most predictive of insurance claims, in concert with their own data.

The same is true for many other uses of credit data.  Different parties want different aspects of the underlying data.  Whether it is employers, lessors, lenders, insurers, etc., in an impersonal world, where there are fewer shared ethical values than in the past, economic actors rely on semi-public data to get comfortable about who they are dealing with.

Two final notes:

1) It’s easier to go down than up with credit scores.  But that is similar to many things in life.  One big mistake can undo a hundred lesser things done well.

2) Those who pay off debts rapidly are rewarded with discounts, as many companies want to avoid bad debts.  You might remember my piece, Build the Buffer.  Be wise, and have enough cash around to get discounts over those that pay things monthly/quarterly.

I am happily debt-free aside from paying off the debts regularly on my few credit cards.  The simple truth is that living within your own means, and having enough of a buffer to deal with minor crises is the best place to be.


A friend of mine asked me the following:

I read an article or a comment from a blog that inked to your sight.  the statement was akin to this. ” The market is dead.  The lack of growth over ten years shows the deadness of the market.  If the market had kept pace with inflation over the last ten years it would be at 32,000 not the 11,000 we see today.”

I am not all that concerned that this is a true statement, nor am I convinced that their is any better long term investment then a good market strategy.  but I do not have the wisdom to know how to answer this sort of claim in my mind.

The Other Question also comes from a blog that linked to your site:  http://pragcap.com/the-importance-of-understanding-macro

“Whitney Tilson’s latest monthly letter provides us with some insightful lessons for the current market environment.  Regular readers will know that I believe there is no such thing as a one size fits all investment strategy or a holy grail approach.  Instead, investors must understand the macro environment and apply the correct strategy to fit that particular environment.  That micro approach could involve buy and hold, trading, value investing, etc.  But the likelihood of success using one strategy in all environments is unlikely. The current turmoil and unusual asset class correlation is making for a very difficult environment for value investors.  Tilson explains (thanks to Zero Hedge):”

Later on he states the following: “Value investing might not be dead (it’s certainly not dead for those who have the ability to implement it in the actual way that Warren Buffett implements it – no, not the “buy and hold” myth that Wall Street has sold to everyone), but we can be almost certain that it’s more important than ever to understand the macro.  If there’s one great lesson to learn from the recent turmoil that should be it….”

Is the above author stating the difficulty of being a value investor, or is this a man trying to validate his own lack of plan or strategy in a difficult market?  Besides a difficult month for some value investors what is their augment against it.  Would your “bloodless” strategy of quarterly trading be the answer their the accusation of the “buy and hold myth.”

With respect to the tripling of the index level due to inflation, that seems really high to me, akin to a 10% inflation rate.  I think that government inflation statistics are biased low, but by 1-2%/year not 6-8%/year.

On value investing, I rely on Ben Graham’s dictum that the stock market is a voting machine in the short run, and a weighing machine in the long run.  Periods of high correlation where the voting machine dominates eventually go away, and when they go away the weighing machine comes back and patient holders of cheap quality stocks get rewarded.

Value investing has gone through far deeper periods of underperformance such as the one in the late ’90s where many famous value investors got fired, just before the paradigm was about to shift, and value outpace growth by more than the underperformance.

“Buy and hold” is always lionized in a bull market, and castigated in a bear market.  That’s normal.  I grew up in the ’70s watching Wall Street Week with Louis Rukeyser, and at that time, traders were dominant in a static market.  That was not true in the ’80s and ’90s.

My quarterly trading strategy strikes a balance between too-frequent trading that most mutual fund managers do, and the never trade strategies that those who misunderstand value investing do.  Most investors trade at the wrong times, giving up on a stock merely due to bad performance, or buying because it is fashionable.  But if the business is fundamentally sound, it can be held through periods of weakness, and even add to the position.

That’s what I do, and it has worked well for me.  May it work so well for my clients.

I lead a finance class for church.  I think we have talked of it before.  I do not deal much with investing. Mostly I work with cleaning up the personal finances of the families.  Paying down debt, increasing savings, Setting and living below your income, budget, basic investing, using your tax shelters, and avoiding risky investments.

I have a family who some years ago purchased $8000 worth of Microsoft stock.  This has over the course of their holdings dropped between $8-10 a share.  Their financial situation requires cash, cash they do not have.  They need to pay off debts, and their current income gives them very little wiggle room to pay extra on debts.  They asked me what to do with the Microsoft stock, that is now down about $1500 from when they purchased it.  Microsoft stock has remained at a price of $23-29 a share for over a year now.  with the average being somewhere around $24-27 My thoughts have been: That the stock has corrected for the time being and

$25 is probably the true value.  IF $6500  would make a big diffrence in you budget, let you pay down alot of debt and free up some extra cash in your budget to pay off other debts, then sell the stock now.  $1500 is a cheap price to pay for a not so wise investment decision, if it can be use to improve your overall financial standing.  I told him he might ask his broker to sell as soon as it hits $26.

I have however read that Microsoft is a company that has put up good sales and profits in the past few years and that their stock price might be well undervalued.  should I encourage him to hold or sell.  Not asking you to predict the future, simply wanting to get counsel on the advise I have given.

If you think this is good advice let me know.  He is able to get by without the funds immediately, but it will be best if he sell them and use them eventually.

Microsoft is a test for value investors.  What do you do with a company that is cheap on a price-to-earnings basis, but tends to waste free cash flow on foolish acquisitions, investments, and stock buybacks?  My view is that you reject Microsoft; there are better things to buy.

But what of the decision of Microsoft versus cash?  Look, one of the first principles of investing is never invest what you can’t afford to lose.  If you might need the money to spend in the near term, don’t invest it in stocks.

Reconsider my article, Build the Buffer.  Until someone can meet all cash needs easily, including small disasters, he should not be investing in stocks.

With that, I would say that he should sell the stock to the degree that he needs liquidity.  Ability to pay cash in advance is worth far more than equity market returns.