When I buy a car, I analyze what car I would like to buy.  I look at reliability, repair costs, overall costs, and style.  I use Consumer Reports to help me analyze this.  Then I go to the website(s) of the manufacturer in question, and copy the data on all of the used models on offer at the dealerships within 30 miles of me.  With price as the dependent variable, I then run a regression with model year as dummy independent variables, and total miles as an independent variable.  After I run my regression, I look at the cars with the biggest price deviations, the predicted price is a lot higher than actual.  I then look at the features of the underpriced cars, and choose one where there are good features with a discounted price.

I go to that dealer, review the car, test drive it, and if it passes my tests, I haggle over the price, and buy it.   In my experience, this cuts thousands off the price of the car.  What a great reason to have studied econometrics.

Getting help in investing is a tough decision.  Who is worth the money that you will pay?  Precious few.  In equities, I could probably come up with a dozen “long only” managers that have real skill, and are worth their fees with decent probability.  With hedge funds and private equity, the questions are harder, and would have a harder tme judging who has a sustainable competitive advantage.

With bond funds, the answer is simple.  Go to Vanguard.  Almost all bond managers earn roughly the same amount before fees. Over a long period of time, fees make up most of the difference in performance.  In general, low fees work with equities, but with more noise.  With index funds, the lower the fees the better, they are generic.

Now there are a few places where additional money might help.   Getting a good financial plan done can be worth the money.  For those that are wealthy, advice in limiting tax liabilities is usually worth it, though be careful when things get more complex than you can understand.  Also, insurance products can be useful, but don’t let someone sell you what is convenient for them.  Get advice from someone who won’t earn a commission, and then buy the products that you truly need.

Be careful, do your research, and buy what you want to buy.  Don’t buy what someone wants to sell you.

In some ways the biggest risk that we face is unemployment risk, because the biggest asset that most people have is the stream of wages that they will earn from their jobs.

Twenty years ago, as a young actuary who had just gotten his ASA, I made a promise to myself that I would build up my investment knowledge base, and spend one hour a day improving my skills.  Why did I decide to do this?  I realized that few actuaries were good with investments (then, on this side of the Atlantic), and that most of the risks that life insurance companies faced were driven by assets, not liabilities (still true for now).  That was different than what the actuarial syllabus would lead one to believe, but nonetheless true.  I only know of one life company that failed from bad liability pricing (calculation of premiums).  All the rest died from bad asset strategies.

That “one hour a day” (six days a week) made me invaluable to many of the companies that I served, and opened a lot of employment doors for me.  It also allowed me to make a jump out of the insurance world, at least for now.  In a knowledge based economy, continually improving your skills is a great way to advance your career, and limit downside when the inevitable bumps happen due to M&A, etc.

Now, to the average person entering the work force, it pays to look at the underlying economics of the industry to see how stable employment prospects will be.  No one is perfect in making these judgments, but there are often industries to avoid.  Examples: certain traditional media companies are being destroyed by the internet.  During the tech bubble, it was cool to work for tech companies, but how much future is there if they don’t make any money.  Wall Street is wonderful, but periodic layoffs can knock out a lot of people on the margins of the business.

Also, understanding the underlying economics of your industry instantly makes you more valuable to your employer, since many only understand the technical craft that they pursue.

Finally, cultivate friends.  Be competent, but be warm.  Help others in need when they are looking for work.  Be willing to lend a sympathetic ear to colleagues in their job troubles.  Network at industry functions.  Start a blog to demonstrate expertise.  (Okay, nix that one. 😉 )  Treat vendors with kindness and respect; learn their business if you can.  Join industry task forces to solve larger problems.

We can’t control our employment futures in entire, but we can influence how well we bounce when things don’t go right. To repeat, three ways to mitigate unemployment risk:

  • Continually improve your skills
  • Understand your industry
  • Build a network of friends in your industry

When I started this irregular series on personal finance, I didn’t think it would live this long. Maybe it’s appropriate then that this piece deals with longevity risk. After all, my prior piece dealt the the concept of the PRIER [Personal Required Investment Earnings Rate].

One of the main ideas there is that you have to take enough risk so that you earn enough money to meet all of your goals. One of those goals would likely be having enough to live off of if you live to a ripe old age, like 100. 100 sounds old; after all, it serves our fascination with watching the odometer roll over. Old age mortality has been improving, though and the number of centenarians is growing rapidly. The same is true of those living into their 90s. Yet many people plan retirement as if they were only going to live to 85.

The destitute elderly definitely have it worse than those with resources. What if you could eliminate some of the risk of outliving your income? I have a product that could help you — the life-contingent immediate annuity. Life-contingent immediate annuities pay a stream of income for the life of the annuitant (or joint lives of two annuitants). They give an income that cannot be outlived. Today, a number of insurance companies do that one better, and offer inflation adjustments on the payments, with the trade-off being accepting a lower initial payment than the unadjusted annuity. The only remaining risk is insurance company solvency, but only buy from reputable firms. That said, remember that the state guarantee funds stand behind the companies, and the benefit payments they are least likely to cut off in an insolvency are death benefits, disability payments, and immediate annuity payments.

Immediate annuities are bought, not sold, unlike other life insurance products. Why? Because once they are bought, there are usually no ways to surrender the policy. You can only take payments over time. Agents don’t like selling immediate annuities, because they will never derive another commission from that money. They would rather sell a variable annuity with a living benefit rider, because it will be possible to roll the policy at a later date to a “better” policy (surrender charges are low), and earn another commission.

Though I am not crazy about variable annuities with living benefit riders, if you own one, be careful before you surrender it. You may have a valuable option to have the company pay a fixed amount for a long time that is worth more than your surrender value rolling into a new policy. In general, be careful in buying any deferred annuities, because the fees are stiff. Be most careful if the agent comes to you when the surrender charge is gone, and encourages you to “roll” to a new product. His interests are different than your interests. You are likely better off staying in your existing deferred annuity.

Are there any other solutions to longevity risk? There are a few. First, cultivate younger friends and family who will be advocates for you in your dotage. They are necessary for kind treatment on the part of the staff of any old age home that you might enter. Those that have no advocates don’t fare well. (For those who are really young, marry, and have more than two kids! Love them, and they will love you.) Second, have an investment policy that reflects the longer-term, realizing you might live longer than average for those that have attained your age. This means more risk assets (stocks) on average than what is commonly recommended, but I would temper this with two caveats:

1) Remember that the Baby Boomers are graying, and will need to liquidate assets to support their old age.

2) Sometimes the markets are overvalued, and it is time to preserve capital, not go for capital gains. Tweak you asset allocation to reflect asset valuations.

A long life is a blessing, and even more so when you have friends, family, good health, and peace with God. Plan now to live longer than you expect. Save more, invest wisely, and buy some longevity insurance.

PS — Don’t go “hog wild” with any single pecuniary strategy for your old age. This is another area where diversification pays, so don’t put all of your eggs in one basket.

PPS — Some of the larger insurers (Pru, Met, Hartford) allow you to buy future income streams should you be alive to receive them. They are an inexpensive way for younger people to put money away for retirement, though there are risks of early death, company insolvency and inflation.

Full disclosure: long HIG

Everybody has a series of longer-term goals that they want to achieve financially, whether it is putting the kids through college, buying a home, retirement, etc.  Those priorities compete with short run needs, which helps to determine how much gets spent versus saved.

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.  Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.  Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

I’m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.  There’s a reason for this, and I’ll get to that later.  Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.

Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.  (Today that would be higher than 9%.)  That means you are not likely to make your goals.   You can either:

  • Save more, or,
  • Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.

Those are hard choices, but most people don’t make those choices because they never sit down and run the numbers.  Now, I left out a common choice that is more commonly chosen: invest more aggressively.  This is more commonly done because it is “free.”  In order to get more return, one must take more risk, so take more risk and you will get more return, right?  Right?!

Sadly, no.  Go back to Defined Benefit programs for a moment.  Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.  What have they earned?  On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion’s share coming from the less risky investment grade bonds.  The overshoot of the ’90s has been replaced by the undershoot of the 2000s.  Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.

While the ’80s and ’90s were roaring, DB plan sponsors made minimal contributions, and did not build up a buffer for the soggy 2000s.  Part of that was due to stupid tax law that the government put in because they didn’t want pension plans to shelter income from taxes for plan sponsors.  (As an aside, public plans did less than corporations, even though they did not face any tax consequences.)

But the same thing was true of individuals.  When the markets were good, they did not save.  Now when the markets are not good, the habit of not saving is entrenched, and now being older, saving might be more difficult because of kids in college, interest on a mortgage for a house larger than was needed, etc.

Now, absent additional saving, when investment earnings lag behind the PRIER, that makes the future PRIER rise, to try to make up for lost time.  Perhaps I need to apply the five stages of grieving here as well… trying to earn more to make up for lost time is a form of bargaining.  It rarely works, and sometimes blows up, leaving a person worse off than before.  Most aggressive asset allocation strategies only work over a long period of time, and only if a player is willing to buy-rebalance-hold, which only a few people are constitutionally capable of doing.  Most people get scared at the bottoms, and get euphoric near tops.  Few follow Buffett’s dictum, “Be greedy when others are fearful, and fearful when others are greedy.”  Personally, I expect the willingness to take investment risk over the next five years to rise, but over the next ten years, I don’t think it will be rewarded.

Now, as time progresses, and the Baby Boomers gray, unless the equity markets are returning the low teens in terms of returns, there will be a tendency for the average PRIER to rise, absent people realizing that they have to save more than planned, or reduce their goals.  This problem will be faced in the ’10s, bigtime.  The pensions crisis will be front page news, and I’m not talking about Social Security and Medicare, though those will be there also.  The demographics will be playing out.  After all, what drives the funding of retirement at a DB plan, but aging, where the promised expected payments get closer each day.

Well, same thing for individuals.  Every day that passes brings a slow weakening of our bodies and minds.  Dollars not saved today, or bad investment returns mean the PRIER rises, making the probability of attaining goals less achievable.

Now, is there nothing that can be done aside from increasing savings and reducing future plans?  In aggregate, no.  You will have to be someone special to beat the pack, because few do that.  Better you should take the simple solution, which is a humble one: save more, expect less.  For those that do have the talent, you will have to take the risks that few do, and be unconventional.  Note: for every four persons that think they can do this, at best one will succeed.  My own methods are always leaning against what is popular in the markets, and I think that I am one of those few, but it takes work and emotional discipline to do it.

Then again, I have done it, as far as my PRIER is concerned — it is below the rate on 10-year Treasuries.  Most of that is that my goals are modest, aside from putting my eight kids through college, and I am not planning on retiring.

With that, I leave to consider a post I wrote at RealMoney two years ago.  It’s kind of a classic, and Barry Ritholtz e-mailed me to say that he loved it.  Given what we are experiencing lately, it seems prescient.  Here it is:

David Merkel
Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples. In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

I have a filing system that I designed to help me save time.  I have a box in my bedroom that I toss papers that I might need into.  Any paper with sensitive personal data goes in there as well.  Once or twice a year, I go into that box and sort through the papers.  I sort the papers into various piles:

  • Insurance
  • Bank Statements
  • Brokerage
  • Taxes, last year
  • Taxes, this year
  • Not needed
  • Not needed, and shred, due to sensitive data (SSN, address, monetary data, identifying information)
  • Art that my children have given me
  • Articles that I wanted to keep a permanent copy of
  • Other, etc.

Typically, I retain the year-end statements for mutual funds, and monthly statements for banks and brokerages.  The rest I shred.  Rather, my 9-year old shreds… she does a very good job, and does it happily. 🙂  Roughly half gets shredded, and one-quarter gets thrown away.  The rest gets filed.

I store the long term financial data in file folders until they get large, and I bind them into binders.  I retain tax data for personal reasons, though there is little reason to go beyond seven years.  About once every decade, I go through all of my files, and pitch stuff mercilessly, retaining only what is best.  I did that two years ago.  2016 is a long way away.

The idea here is to minimize my time spent filing, retain critical data, shred data that would be harmful in the hands of data felons, and make sure that I know where to find something that is truly needed.  So far this system has worked very well for me, and I have been using it for about 20 years.

Anyway, I went through this process yesterday, and now it is great to have things organized again.  2007 was a memorable year for me, and it was fascinating to consider all of the things that happened, including starting this blog.  (Yes, I found those papers as well.)

In this irregular series on personal finance, my next topic is protecting yourself against disaster.  Now there are a few main aspects to this:

  • Have adequate vehicle and dwelling coverages.
  • If you are worth suing, have an umbrella policy as well
  • Use insurance for big disasters only.  Don’t use the insurance company to pay small claims.
  • Adequate business coverages if you need them.
  • Buying insurance from a company that pays claims without too much argument.
  • Keep your credit rating good, it reduces all insurance premiums, because a credit rating is a measure of moral tendency; people who are careful with their money tend to be careful with everything else.
  • Avoid minor coverages; they aren’t worth it.

The first thing to note is that the lowest premium may not be the best option.  Companies that sell policies touting their low cost are typically selling minimal coverages, which may not be adequate to fund all claims in a real tragedy.  Other companies make it tough on claimants.  It can be worth it to review the complaint records per 1000 policyholders at your state insurance department website.  As the story goes, and I won’t name names, a wealthy guy got a policy from XYZ Insurance, and was bragging about the low premium to a friend.  The friend, who had a policy from Chubb, said, “You don’t have an insurance policy!  You only have the right to sue XYZ Insurance when you have a claim!”  (I like Chubb; no, they don’t insure me, and I don’t own shares…)

Make sure your dwelling protection is adequate to rebuild and replace possessions.  With inflation, and housing has had a big dose of that, policies can quickly become inadequate.  If the premium gets too high, better to raise the coverage and the deductible, leaving the premium even, than to leave the policy alone.

An umbrella policy can be a cheap add-on; I left GEICO because they would not underwrite an umbrella on me; too much risk from my writings on the internet (and I was on the board of a small college at the time).  It is definitely worth looking into if you want to protect yourself from liability.

If you are well enough off, with your own business, and you have a lot to protect, a good insurance broker can be an aid in all of this.  He is a professional who will proactively look for the risks you might be missing, and will find adequate companies to cover you at a reasonable price.

This would dovetail into another piece,  “Keep your credit rating good, it reduces all insurance premiums, because a credit rating is a measure of moral tendency; people who are careful with their money tend to be careful with everything else.”  This applies to personal coverages and small business coverages.  Insurers use this data to greatest extent they can, not to be unfair, but because it correlates so highly with low losses.

Finally, avoid little add-on coverages like warranties, and use your main coverages for large losses only.  Have money set aside for the vicissitudes of life.  A large deductible reduces your costs considerably, and signals to the insurance company that you regard yourself as a better class of risk than the average guy.  They will offer you better rates as a result.

I’m not a maniac on avoiding taxes.  Living through the 80s and 90s, I saw many cases where people bought financial products that made them less after-tax money than many fully-taxable products would have made them.  Limited partnerships, life insurance, annuities, etc… I never saw the value in focusing on what the government would not get.  I was more focused on what I would get after taxes.

That doesn’t mean there aren’t clever strategies to avoid taxes, particularly if you are rich.  For the rich, taxes can be more of a negotiation.  How much work will the IRS have to go through in order to drag incremental dollars out of me?  (The same logic applies to corporations… I have seen it in action.)  Perhaps Leona Helmsley had a point, even if she overstated it, “Only the little people pay taxes.”  Maybe it should be, “Only the little people pay sticker price on taxes.”

Now, as for me, I have a Health Savings Account, a Rabbi Trust, IRAs for me and my wife, and a Rollover IRA from all of the jobs I have worked at.  It’s not as if I don’t try to manage my tax position.  But I don’t let it drive my investment decisions on its own.  I own my house free and clear.  I enjoy the benefits of flexibility in my finances; I have not used 529 plans, for example.  Where the investment fits my overall goals and objective, then I will consider how it affects my tax position.  In general, the higher dividend stocks go into my Rollover IRA, the lower dividend stocks into my taxable account.  I also gift appreciated stock through my taxable account to charity.

At present, I don’t own any munis.  That’s something I’ll have to revisit.

Now, here are two things to be careful about.  If IRAs grow too big there can be additional taxes on them.  I’m not too clear on the rules, perhaps readers can more fully flesh that out.  The other is that taxes are likely to be higher in the future, so avoiding taxes today may lead to more taxes tomorrow.  Also, I would question whether our government will honor the concept of a Roth IRA.  Social Security benefits were not supposed to be taxed, but today they are mostly taxed.  The same might happen to Roth IRAs at some point in time.   Congress giveth, and Congress taketh away.

My closing point here would be to not overcommit to any single tax strategy.  Congress changes the rules so often, that it is difficult to make long term decisions.  Stay flexible, and avoid taxes where it does not compromise your flexibility.

I was shopping this evening, and as I went to check out, the two checkers were discussing with a third party their financial woes.  One was making her payments after a workout, and would be free of her debts in a year.  The other had declared bankruptcy, and it would be eight years (or so) before things would normalize for her.  As for the one making payments, her parents had gone through bankruptcy two years ago.

I talked with them for a little while, and both had reverted to lifestyles where debt was not even an option.  Well, good for them, in the short run.  They are learning discipline (the hard way).

I’m not an ogre on debt.  It can be useful, but you have to be careful with it.  I have been debt-free for the past five years, and have enjoyed the freedom that it has brought me.  I take enough risk as it is, why should I magnify it through leverage?  Borrow for a home?  Fine in the right environment.  My advice would differ in 1998 vs. 2005.  Borrow to finance consumption?  No.  Never right.

I feel the same way about companies that I own.  I prefer companies that are less levered, and companies that borrow on a nonrecourse basis.  When we borrow, we are making a statement about the future — that we can presume that it will be good, hey, even better than today.  That’s a tough statement to make.  Avoid debt if you can, and save your debt capacity for times when assets have been crunched, like early 2003.

PS — One more note: because of the AMT the advantage of borrowing money to buy homes is diminishing, because the AMT erases mortgage interest deduction.

I should have started out with this question when I began this irregular series, but somehow it slipped my mind. When I talked with my Mom this evening, it came back to me. People come and ask me for investment/financial advice. My first question is:

How much are you willing to learn, and how much work do you want to do?

Depending on the answer, I have several different solutions that I offer my friends. For those that want to do nothing, I tell them to hire a financial planner, and give them a few bits of advice on how to evaluate the planner. For those that want to do a little, I give them a list of things to consider, how to pursue those, and what a reasonable asset allocation would be at Vanguard. For those that want to make it a hobby, I tell them what they need to read and learn in order to choose their own investments, and plan their own financial future.

My advice varies. Most don’t want to do much, and really, they don’t have the temperament for it. For them, finding good advisors and good mutual funds is a must. For the minority, education is where it is at. That is a big part of what my blog is about: learning about the markets. Those who read me know that I have a wide set of interests in investing and related topics. You won’t get personal tailored advice from me, but you will learn a lot about how the markets work.

Once I learned the “first question” my life got easier advising my friends.