Wednesday, October 31, 2007

Personal Finance Nightmares

In honor of Halloween, I thought I would share my top six personal finance nightmares. Some of these are far fetched, others a real possibility. All of them are very scary to me.

Here they are, in no particular order:

1. Disability - not being able to take care of myself, financially or otherwise, is one of my biggest nightmares. I am a very independently minded person, who deeply values his freedom and autonomy.

2. Persistent Joblessness - I have never really been unemployed, but I am very much aware of this possibility. I am a well educated, highly skilled and eminently employable individual, but bad things happen to good people. It's a fact. I have invested a great deal of time and money in my career and the thought of seeing that investment go down the drain is tough to confront. If I found myself in a state of long term joblessness, I would probably start my own business. However, I would like to do something like that on my own terms, rather than be forced to take such action.

3. Health Emergency - last year I got a small taste of what a health scare feels like. I felt unwell for several months, and despite a battery of tests, doctors could find nothing wrong with me. To my deep relief, the condition simply dissipated, gradually and slowly. Someone once told me that we are all one major health crisis away from bankruptcy, health coverage or no. I can believe him.

4. Major Natural Disaster - last week's California wild fires are one such example. A colleague of mine from San Diego was evacuated from her home due to the fires, and was allowed to return two days later only to discover very minor fire damage to a portion of her house. Unfortunately, her next door neighbors were not as lucky. Their house burned to the ground.

We live in earth-quake prone, fire prone, mud-slide prone California. The prospect of a natural disaster is something we have to live with, but that does not mean I am comfortable with the thought.

In fact, after writing these lines, I found out that Northern California was struck by a 5.6 magnitude earth quake tonight. Talk about a potential nightmare - a strong earthquake while I am on the other side of the continent and my wife is alone with the kids. Thankfully, all is well.

5. Complete Stock Market Meltdown - yes, it's unlikely, but a global 1929 style market crash could happen again. As someone who has a very considerable portion of his net worth invested in the markets, that would be one massively scary turn of events. What could trigger such a crash? Who knows? But it is possible that if we had a massive terrorist attack, such as nuclear terrorism, we could face a very different economic reality.

6. Homelessness - I have repeatedly spoken out against treating houses as an investment. I prefer to rent rather than buy, at least for now. However, homelessness is a very scary prospect for me. Can you imagine not being able to provide basic shelter for your family? Well, there are many homeless families out there. I believe that one of our greatest failures as a society, is our inability to eradicate homelessness and hunger in this country.

Those are my personal big, bad, six nightmares. I would love to hear about your own personal finance fears and concerns.

In an upcoming series of posts I will discuss personal finance crises, and ways to prepare for them and to mitigate their most adverse consequences. Let me know if there are any specific topics you would like me to cover.

Tuesday, October 30, 2007

She Makes More Than Me

I have noticed that some men have a problem with their wives making more money than they do. What a crazy notion that is. Some women feel bad about making less than their husbands or feel that their pay check may not be worth the effort. That's just as crazy. Here is the way I see it: marriage is a partnership. You share the responsibilities, the obligations and the rewards. If one of you does well, you both benefit. However, feelings are feelings and it's tough to ignore them, so here are some techniques you can use to make both parties feel better about the relationship and about their earning power:

1. Acknowledge the Facts - unless you have a magic wand you can wave around to change your respective earning power or fundamentally change the circumstances that brought you to where you are today, you are going to have to live with reality. One of you makes more than the other. Put that fact on the table and find a way to make peace with it.

2. Understand that Things Can Change - "for richer or for poorer" is not just an empty statement. Things in life change. Today you are making more than him, tomorrow something happens and the roles are reversed. God forbid, the higher earning partner could fall ill, lose their job or decide to accept a lesser paying job with more job satisfaction. The situation you are in now is not permanent. The important thing is to understand that your partner is a part of your financial foundation - a sort of diversifying asset, if you will. Isn't it a great thing to know that if things go badly for you, you can rely on someone close to carry you through?

When I was getting my MBA my wife was raking in the dough. This was at the height of the dot com bubble and her stock options were worth a nice chunk of change (no, we did not sell at the right time). She made much more money than I could generate from my measly teaching assistant gigs. She also contributed much more than I as I was going through law school. Now things have changed for us, and who knows, they could change again.

3. Trick Yourselves a Bit - who said trickery is a bad thing? The better earning partner can bear more of the deductions to allow the lower paid partner to bring home a bigger check. For example, the higher paid partner could ask for a higher withholding level, which would allow the lower paid partner to claim more deductions and increase their take home pay (as long as you end up withholding the correct amount - IRS penalties and interest suck). Similarly, the better paid partner could bear the costs of the family health care and any flexible spending accounts, again increasing the other partner's take home pay. If you decide to go this route, make sure that you are not opting for worse or more expensive medical coverage or for lesser benefits, just to make yourselves feel better.

4. Consider Your Full Contribution - I make more money than my wife these days, but she spends much more time with the kids and that's worth a bundle. It is frequently the case that the lower earning partner contributes more around the house or with other responsibilities. Make sure that you acknowledge this fact and give credit where credit is due. These additional responsibilites are just as important, if not more important, than money.

5. No Extra Credit - It is also important to acknowledge the fact that just because you bring in more cash than your partner, you are not entitled to more control and have no more rights to that money than does your partner. One of my colleagues at work once told me that he "gives his wife an allowance". This statement rattled and disgusted me. If you treat your partner as you would a child, and if you do not recognize the value that you each bring to the table just because one of you is currently making more money than the other, than I am afraid the future does not bode well for your relationship. Seriously, marriage is, first and foremost, about sharing.

6. Motivate Each Other - recognize that your financial futures are tied together, as are the rest of your lives. If one of you feels unhappy about your level of income, motivate each other. Help each other network, find a new job, get a raise, start a business, get an education - whatever it takes to improve your financial situation as a couple.

As a bottom line, I would like to leave you with the following thought: marriage is a partnership, not a contest. If one of you makes more, it only means that together as a family, you have more. It's a good thing.

Monday, October 29, 2007

Lowest Price Guarantee Scam

How many times have you heard the phrase: "we'll beat anyone's advertised price, or your mattress is free!"? One of the local mattress store chains here in Northern California routinely uses this pitch in their radio and TV ads. There is only one problem, and it's a big one: advertised mattress prices are never their true prices. Much like the sticker price on a car in the used car lot, the price advertised on a mattress is completely meaningless. It's a point from which you start your negotiations.

Lowest price guarantees in that context are a way to give consumers the feeling that they are getting the best price possible, without actually giving them any real value whatsoever. On the other side of the equation, there are some price guarantees which actually provide considerable value. Some electronics chain stores guarantee that if you find a lower price anywhere within 30 or 60 days from your date of purchase, they would pay you the difference. This guarantee is a good one in an industry in which price erosion is a constant fixture. There is nothing I hate more than buying the latest gadget only to find that the price dropped substantially a couple of weeks later.

Many chains will also refund your money if a certain product you purchased at their store later goes on sale. There is nothing sweeter than showing up at a store with nothing but a receipt, and walking out with the same receipt and some cash in your pocket.

When is a price guarantee a real one, and when is it a marketing scam? To find out, ask and answer the following two questions: 1. In purchasing the product, will you be required to haggle for a price in order to get the best deal? If so, the price guarantee is meaningless; 2. Is the product you are buying a commodity? If so, the guarantee is more likely to mean something.

At the end of the day, the price guarantee is a way for marketers to get you to buy immediately rather than wait for a price decline, and to prevent you from doing extensive comparison shopping. Marketers know that once people make a purchase, the vast majority of us go home to enjoy their new toy, and tend to forget about the price that they paid. The vast majority of us will never walk back into the store to claim a refund based on a price guarantee. Regardless of whether they are intended as such, most price guarantees end up being a scam from the consumer's perspective, a way to get us to buy something, without offering us any real value.

Sunday, October 28, 2007

Vote for Shadox!

The new Carnival of Personal Finance is up and is hosted by the Millionaire Mommy Next Door.

Our gracious host has selected my post about the professional price that stay at home parents pay, as one of her top 10 carnival picks. She is also asking Carnival visitors to cast their vote for their favorite article. Well, here comes the shameless request for votes:

Visit the Carnival of Personal Finance and vote for Shadox!

A vote for Shadox is a vote for a better America; a vote for Shadox is a vote for the future of our kids; A vote for Shadox is a vote for campaign finance reform. It is essentially a vote to end world hunger and eradicate evil!

So, what are you waiting for?

Recommended Articles

This week's recommended articles post is a little (OK, a lot) late. The problem is that I have time enough for only one post per day, and this week there were some things that I really wanted to write about, for example the price new parents pay to stay at home with kids; the fact that having too many mutual funds can lead to less diversification; and the fact that government is way too involved in business sometimes. So, the recommendations got delayed a little bit - even though there were a ton of great articles out there this week.

This week I only participated in one Carnival, the Carnival of Personal Finance, hosted by The Dough Roller.

One of The Dough Roller's editor's picks for the Carnival was an article about how China could crush the Dollar on a whim. Why, yes, they could. Just like Russia could annihilate the U.S. with a nuclear strike, but that's not likely to happen either. The article completely misses the point. Every action China could take to harm the USD would immediately backfire and greatly damage the Chinese economy, since it too is highly dependent on the value of the Dollar. If China starts dumping large amounts of Dollars, the Dollar would indeed decline, and with it the value of China's own foreign exchange reserve. China's exports to the U.S. would become more expensive, and demand would decline, leading to a slow down in the Chinese economy. Stop with the xenophobia. The rise of China is a good thing for the world economy. Let's stop worrying about them and start worrying about us.

One of the most amusing articles in the carnival was published by A Penny Closer. Apparently, she recommended someone for a job who was the worst candidate ever to interview with a company. You gotta read this one to believe it. However, I think Melissa did everything right. Sometimes bad things just happen to good people.

In other news, Blue Print for Financial Prosperity, one of my favorite blogs, had a detailed discussion of a new tax reform proposal that Democrat Charlie Rangel is trying to push through Congress. Among other things the bill would eliminate AMT and would impose a 4% surcharge tax on families earning more than $200K. Well, this bill is about as likely to pass as George W. Bush is likely to get re-elected. However, there have been many calls recently for imposing additional taxes on families earning more than $200K per year. My problem with such proposals is that $200K means very different things in different parts of the country. If you live in rural Kansas, $200K will make you very wealthy (I recently met someone who was doing very well on $29K per year in that part of the country), but it will not get you far at all in Silicon Valley, where very ordinary houses cost close to a million Dollars.

Gen X Finance is running a poll asking his readers where they would put their money if they could only invest in one asset class. The scary result: 40% of responders said they would invest in international stocks. Is it a coincidence that this has also been the best performing asset class in recent years? Is there a little bit of performance chasing going around? Maybe more than a little.

Finally for this week, The Finance Professor (he is a real finance professor), had an article about whether finance professors practice what they preach when investing their own money. Turns out that they absolutely do. About two thirds of them invest.... passively, i.e. in Index Funds. Do you need more proof that index investing is the way to go??

That's it for this week. As I said, there were some really excellent articles this week.

Saturday, October 27, 2007

Asset Allocation - Oct 2007

It's been two months since my last asset allocation update, so here is a quick overview of our relative asset class weights as they currently stand:

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The biggest change in the past couple of months has been the share of our portfolio allocated to international stock. That share has climbed from 21.5% in August to 27.3% currently. That increase is due to both capital appreciation as well as to the fact that I have been slowly putting more money into our international funds.

To be honest, I am nervous about investing more money internationally, primarily because stock markets worldwide, but especially in emerging markets, have been on a tear in recent years. If there is one thing that history (and statistics) tells us is that things tend to regress to the mean, and if that is the case international stock markets are in for a little bit of a fall at some point.

I have decided to ignore my fears and to slowly increase our international position for two reasons: first, in the coming decades, I believe that the relative importance of the U.S. economy to the global one will decline, and that most opportunities for growth reside outside our small corner of the globe. Second, I am very concerned about the U.S. economy and the value of the Dollar - this is not a short term concern for me. I think that the Dollar is in for some long term declines, based on macro-economic trends. My goal is to insulate our portfolio from the effects of a declining USD to the best of my abilities.

I will say this: I clearly smell something is wrong with the global stock markets. Investing internationally has become a sort of a fad these days. AND if there is anything you truly want to avoid like the plague, it's investment trends. Nevertheless, I know that I am not chasing performance, and I will not try to outwit the market. I have a plan, the plan calls for 25% of the portfolio to be invested internationally, and this is what I am implementing.

The second portion of the plan I outlined last time was to increase our exposure to real-estate, especially now that the sector has taken a major hit. Well, even though I have slowly injected more money into our REIT Index fund, our total exposure to real-estate has only increased from 5.8% to 6% of the portfolio in the past two months. I will continue to slowly add to that position, until we reach my target exposure of 10%, but this will probably take another year, assuming no major market fluctuations.

Overall, things seem to be going according to plan. As I previously wrote, I will be introducing small, diversifying positions of commodities and global real estate into the portfolio at some point in the future. So far, I have not decided on the appropriate vehicles for such investments. I will keep you all posted.

Thursday, October 25, 2007

Think You're Diversified? Think Again.

Diversification is the mark of a good portfolio. Modern portfolio theory shows that for any given level of risk, the best performing portfolio is a diversified one. You can diversify your portfolio by buying a large number of individual stocks and bonds, but many of us choose a simpler method of diversification - we buy mutual funds.

A potential problem with that approach is that if you own more than a single mutual fund, you may be less diversified than you think. This is because it is possible that your funds are investing in overlapping sectors or even in the same individual stocks. Even though I invest our portfolio exclusively in highly diversified index funds, I recently decided to dig into our portfolio to determine whether we truly are diversified. I did so using e*Trade's recently launched portfolio analyzer tool.

The good news is that we do appear to be well diversified. However, even in our diversified portfolio there were some overlaps between funds. For example, Vanguard's Total Market Index (VTSMX), Vanguard's Growth Index (VIGRX) and the QQQQ ETF all contain a small percentage of Google stock. The result is that our portfolio contains double the amount of Google stock it would if we simply invested in the Total Market Index fund. The same is true for Apple, Cisco, Intel, GE, 3M and so forth. All in all, there is no real problem for our portfolio, since no stock accounts for more than 0.6% of our holdings. Still, you get the idea.

So how can you make sure that you don't over expose yourself to undiversified stock positions by investing in mutual funds? Here are a few rules of thumb:

1. Check Your Portfolio - using a tool such as e*Trade's portfolio analyzer made this process very simple for me, but you can achieve the same result by simply going through your fund prospectuses. If you find substantial overlaps, consider divesting of one or more of your funds.

2. Invest in Indexes - investing in Indexes should reduce the likelihood of dramatic overlaps, since index funds are, by nature, diversified and do not place sizable bets on specific stocks.

3. Avoid Sector Investing - if you concentrate your investments in a specific segment of the market, you are more likely to be investing in multiple funds that hold large, overlapping positions of a particular stock.

4. Don't Double Up - realistically, you only need a single mutual fund to cover each major asset class. Theoretically, you could invest in a total market index fund (e.g. VTSMX), a total bond market index fund (e.g. VBMFX), a total international index fund (e.g. VGTSX), and a real estate index fund (e.g. VGSIX) and your portfolio would be very well diversified. There is no need to select more than one mutual fund that covers a specific segment. The fewer funds you have, the lesser the risk of these funds overlapping and creating an under diversified position.

There is one more complicating factor: most of us have multiple accounts with different financial institutions - brokerage account, IRA, 401K, 529 and so forth. Checking for overlapping stock positions across multiple accounts is somewhat harder, but it is a worthwhile exercise. Even if your positions are well diversified in a specific account, you may have some overlapping, undiversified positions in some of your other accounts. You'll only know if you check.

Wednesday, October 24, 2007

Weddings in Sonoma

My wife and I went away to Sonoma for a quick getaway, last weekend. For those readers who are not familiar with the name, Sonoma and Napa are Northern California's most famous wine producing regions.

Conspicuously, everywhere we went that weekend we ran into wedding parties. When I asked one of the servers at a winery about this unusual number of weddings, she told us that Napa county has regulations prohibiting wineries from holding wedding receptions, so many wedding parties are held in Sonoma instead. She also explained the regulations were put into place with strong backing of the hotel industry association, who wanted to prevent wineries from moving into the event business and competing with them.

Think about this for a second. What business is it of the government, local or otherwise, to tell private businesses what types of events they can or can't host? Why do we allow crooked politicians to sell us all down the river for a bunch of special interests and economic pressure groups? Why do we allow weak industries to insulate themselves from competition by essentially making that competition illegal?

My philosophy: if hotels are worried about losing wedding parties to local wineries they should make themselves more attractive to their customers. What an original thought.

Tuesday, October 23, 2007

Citibank Late Fee Update

A couple of days ago I wrote about how Citibank screwed us by "upgrading" our account and essentially making us miss our payment due date. To add insult to injury they charged us $89 in late fees and financing charges for their mistake.

Today my no nonsense fighter of a wife called Citibank and gave them a piece of her mind. Bottom line, charges reversed. Citigroup CEO should be arriving tomorrow at 5 PM to apologize in person and offer us his first born (no thanks, Chuck, we have three of our own).

Never acquiesce to unfair business practices.

Stay at Home Parents Pay a Professional Price

When our twin sons were born, my wife and I faced a decision. We needed to decide whether my wife would take a break from the corporate life to stay at home with the kids. Having me leave my job was never an option since my income is substantially higher and, quite frankly, I don't think that I could become a stay at home dad and remain sane.

At the time, my wife was working her old job, and her salary was barely enough to cover day care costs for the three boys. So seemingly, the financial decision should have been a simple one. After all, why work if your entire salary gets immediately signed over to Uncle Sam and a couple of day care centers. Right? Not so fast.

Here is the trick. Parents contemplating the stay at home option tend to make the financial portion of their decision based on their current financial situation. However, there are three additional financial factors that need to be considered:

1. Loss of Experience - as your career progresses and you gain more experience, your compensation increases. Say you are thinking of taking a five year break from work to stay with your kids until it's time for them to head to kindergarten. During that period you lose not only your current income, but also any pay increases you would have gained had you continued to work. You also lose five years of experience which are directly translatable into compensation and probably into a more senior position at work.

2. Loss of Skill - the term "use it or lose it" may be a cliche, but it's right on the money. If you stay out of the labor force, your skills degenerate. Let me give you a personal example: my readers know that I hold a law degree, but I haven't practiced law in 8 years (I like to think of myself as a reformed lawyer). At this point most intelligent people would not hire me as their lawyer, and with good reason. I am so rusty and out of shape that I couldn't even credibly play a lawyer on TV. The same is true for virtually any other skilled or professional position. Your degenerating skills mean a lot less pay down the road when you do decide to jump back in the water.

3. Rejoining the Labor Force is Tough - I am currently in the process of hiring another member for my team. I am reviewing dozens of resumes, some of them sent by people with some useful background and experience but with some unexplained gaps in their work history. Now, I am sure that many of these gaps can be easily explained away, the problem is that I review a very large number of resumes and only have time to interview a limited number of candidates. Do you think I am going to choose to interview someone with a stellar and steady career track? Or someone which has some clear holes in their resume but which could potentially be explained away? Don't get me wrong, I am not saying that people with work history gaps can't rejoin the labor force, only that it is not an easy matter, and many find themselves accepting lesser positions to get back into the game.

I am not arguing against stay at home parents. However, I am suggesting that most people underestimate the long term financial implications of the stay at home parent decision. For many people staying at home with the kids turns out to be a very smart and emotionally satisfying decision, however before making that decision, be aware of all of the career consequences associated with your plan.

For those making the decision to go back to work, I have a couple of pieces of advice:

1. Don't Feel Guilty - many families feel that they are doing a disservice to their kids by sending them off to daycare at the age of only a few months. I can attest from personal experience that children of working parents can grow up to be well adjusted and happy adults. My parents both worked since we were very young and my siblings and I have all remained pretty much jail free and advanced degrees are common in my family. My own five year old is as smart and well adjusted a boy as you can hope to meet (if I do say so myself). He is a very happy child, in spite of (or perhaps because of) having started at family daycare when he was 4 months old.

2. Work to Pay for Day Care - many couples with more than one kid feel that one of them is simply working to pay for day care. Getting your paycheck and seeing that your take-home pay is more or less equal to the daycare bill, can be emotionally difficult. To cope with this, my wife and I made some adjustments. For example, we put all the kids on my company's health insurance. Health premiums are deducted from my paycheck leaving a bigger paycheck for my wife to take home. We decided that we would fund our medical and child care flex accounts all from my salary, for the same reason. Similarly, you can decide to stop contributing to your 401K for a short time, if this helps you to feel better about your salary.

These changes were more or less cosmetic. I mean after all, does it really matter which pocket the money comes from? It turns out that it matters a great deal psychologically.

3. Finally, Do what Feels Right - regardless of anything I said, or of anything anyone else may say, make the decision that feels right for you. You will not hear this frequently from a personal finance blogger, but to hell with the money. Happiness and your family are the most important considerations. Make the decision that will make you happier in the long run.

Coincidentally, Trent, from The Simple Dollar is apparently considering this very issue right now. Check out this very interesting post about his greatest financial concerns.

Monday, October 22, 2007

If You Could Make an Extra $10K...

Let's say someone gave you an offer: you could work 10 extra hours a week and make and extra $10,000 a year. Would you do it? How about $15,000? Or $20,000? How much is your free time worth? Patrick of Cash, Money, Life and his wife had to answer just such a question.

I make a good living and I work pretty long hours. My remaining hours of free time are worth a lot to me. I would not give them up easily, but at a certain price, I probably would. Like every other resource, money has a declining utility curve: there is a certain minimum that is absolutely necessary, more is really nice, but beyond a certain amount money really becomes much less important.

For example, do you think that Warren Buffet, Bill Gates or Richard Branson would work an extra 10 hours a week for an extra million dollars in annual income? Well, maybe they would because they enjoy their work, but I am guessing that they wouldn't do it for the money.

I am not quite at the stage where I would be able to turn down a million dollars a year (or $50,000 for that matter), but if someone offered me a job that involved a mild increase in pay in exchange for a longer work week, I would probably say "no". That was not always the case. Earlier in my career, back when I was single and without kids, my career would have come first. My career is still very important to me, and I sacrifice a lot to keep it on track, however it is now far from being the most important thing in my life.

On the same topic, Moolanomy offers this story. I doubt if it's true, but it drives home the point.

Sunday, October 21, 2007

While We are Holding You Hostage - Update

A couple of months ago I wrote a post about how American Express "held me hostage" when I called to activate my new credit card. Essentially, when you dial the number to activate your card, after you key-in your new account number you hear a recording saying "While we are activating your card, we would like to let you know about the latest in inane and useless products you have absolutely no need for, that will only cost you an arm and a leg..."

A consumer hearing this message is bound to think that there will be some additional action he may need to take following the drivel, or perhaps he will receive some confirmation message saying that the card was activated. The hapless consumer listens to the meaningless crap and is essentially held hostage for the length of this commercial.

Well, I got a new American Express card in the mail (the old one was a temporary card), and this time when I called to activate I refused to be held hostage. As soon as the mindless marketing pitch started I hung up.

Guess what? Card still works. "While we are activating your card", means nothing. Your card is activated as soon as you key in your account number. You can safely and happily hang up the phone.

Saturday, October 20, 2007

Yet Another Fight with Citibank

We missed our credit card payment again and Citibank socked us another $86 in late fees and financing charges. Once again, it's Citibank's fault and I am tired of it.

Citibank "upgraded" our card. Previously we had a Citibank Dividend Card and they "upgraded" us, without our request or action, to a Dividend World card. The new card has absolutely no advantages over the old one, as far as I can tell. When the "upgrade" was performed we got a new card in the mail, with a new card number.

What Citibank didn't do, is move our statement e-mail alert to the new card. So, here is a summary: Citibank decided we needed a new card, moved us without asking us to this new card, did not move our e-mail statement alert to the new card, and when we consequently missed our payment (because we did not get alerted to the new statement) charged us $86 in fees and penalties. Is that incentive enough for them to "upgrade" people's accounts?

Here is what we will do. We are going to call Citibank and get them to revoke that idiotic fee. If they refuse to do so, we will close not only the account in question but also the other account we have with them.

I will keep you posted on our discussions with the bastards. Can you tell that I have had enough of credit card company antics?

Friday, October 19, 2007

Recommended Articles

After a couple of days off, here are some of the articles I recommend this week from the Carnival of Personal Finance and the Festival of Frugality. The Carnival of Personal Finance this week had a Doctor Seuss theme. My god, it must have taken MBH forever to put that thing together. Multiple kudos!

Moolanomy offers a post about how inflation, taxes and the eroding value of the Dollar are impacting the real value of our investment. You can't do much about inflation, but you can do something about taxes and the value of the Dollar. Investing in tax efficient index funds, and holding onto your investments rather than trading will do a lot to reduce your tax bill. To protect yourself from the falling Dollar, diversify internationally.

The Online College Blog has a post about the best 25 online MBA programs. To which I must respond: are you kidding me? Why would anyone want to get an online MBA? An MBA is a degree which most people get to advance their professional career. It is not typically considered a program that people take for academic interest alone. If you are indeed planning on getting an MBA, let me teach you the first lesson for free: return on investment. Don't undertake a project that is bound to have a negative return. Very few employers give any weight or value at all to an online MBA degree. Now, if you are planning on using the knowledge you gain to start your own business, maybe that would be a different matter. But if you have your eyes set on corporate America? Save your money and your time. If you are serious about getting an MBA, take a look at this website.

Financial Reference complains that laws can distort incentives and wreak havoc on free markets. Boy, do I agree. In this day and age companies routinely and efficiently lobby into law incentives, programs and regulations that give them an unfair advantage over the competition. Such incentives include subsidies, outright restriction on competition, contract awards and so forth. If there is a problem with the free market it's that it is far less free than it needs to be. Unfortunately, the specific example given in the article is a really bad one: yes, if you are violating parking regulations (even by 10 minutes) you should get a ticket. If there is a rule on the books it needs to be enforced. That does not mean that the rule itself is appropriate.

Millionaire Mommy Next Door has a post after my own heart: she advocates renting as a way of building personal wealth. I agree. By spending $24,000 a year to rent our place in Silicon Valley rather than buying a house for about a cool million, we are able to let our diversified portfolio grow, without sinking the bulk of our assets into bricks.

The Financial Blogger has a post about how having a second child is not that expensive. Maybe in wonderland. It's true that the incremental cost of the second child is lower than that of the first. Yes, you can re-use the stroller, the crib, some clothes and so forth, but the truly big costs are still very much there: education, health care, housing and pretty much everything else. Numbers 2 & 3 came to us as a single package and had a big ol' bill attached to their tiny baby butts. Love them to pieces, but those little buggers are expensive.

An honorable mention this week goes to Cheap, Healthy, Good for their amazing post: 11 Things Dwight K. Schrute Has Taught Me About Food and Frugality. I laughed myself silly.

Tuesday, October 16, 2007

Got Passed Up for Promotion - Now What?

A few weeks ago I received an e-mail question from one of my readers. The reader felt that she was unjustly passed up for promotion, and was wondering what her next steps should be. Here is the full, unedited text of the e-mail:

"First of all, I just want to say that I really love your blog and the topics that you talk about, your posts are always very practical and applicable.From your blog I know that you are in management and I was wondering if you might be able to give me some insights on a situation at my company.

I am an engineer in my 20s at a company with recent layoffs. After the layoffs, all but one of the senior engineers within my group were laid off. This made me the person with the longest tenure at the company within my group. At this time, our direct manager also resigned from the company.

During goal setting discussions with management, I have been consistently told that I was the best engineer on the team. There are metrics to back this up. I also received a company award for outstanding performance from management. During the performance review we had around May, I also received the highest performance rating number. So it really surprised me when two individuals from my group were recently promoted to senior engineer over me. I have longer tenure at the company than they do, perform better on all levels, and actually know more about the company's processes etc. It is not even strange for these individuals to ask me questions on how to do things during the course of the job week. One is probably in the late 30s and the other is in the 20s.

I thought that promotion was the reward for performance but I'm starting to smell a rat to speak. My performance is documented and it definitely exceeds theirs, so could it be that I am being passed over based on my race, age or gender? Do you think that it would be reasonable for me to go to our group Vice President to inquire what was the criteria for these promotions and why was I not considered given my performance etc? Thanks for your time."

Interesting situation. I responded to the reader directly shortly after receiving her e-mail, but I think that my answer may be of general interest to my readers. Here is what I suggested:

"Thank you for the e-mail and for the kind words.

I understand from your e-mail that you are concerned that you may have been discriminated against. There is really no way for me to know whether this is the case, however, if your assessment of your performance and of the performance level, experience and skill sets of the engineers that were promoted is correct, it seems that you may have a reasonable basis for concern. I have a few of suggestions:

1. Understand the risks - generally speaking, if your company suspects that you may looking into possible grounds for discrimination based legal action, it will immediately re-trench and develop a story to cover itself from a legal perspective. This might go as far as creating documentation to show that you were not an appropriate candidate for promotion, or worse.

2. Understand the remedy you want - what do you expect to gain by bringing up your suspicions in discussions with the VP? Is there a possibility that you too will now be promoted to Senior Engineer? Or is the discussion purely academic? I would suggest figuring out what you are asking management to do, before you initiate any discussions. Ask yourself whether this is a realistic remedy to ask for. Is this something that the company can reasonably give you?

3. Look to the Future - getting passed up for promotion is tough. It really hurts your motivation and impacts your self image. Believe me, I know, I have been there. Having said this, it is rare that companies will reverse such promotion decisions after they have been made. In my experience, the way to address promotion issues is long before a decision is made. For example: when my boss moved to a new position two years ago, I walked into his boss' office and made it abundantly clear that I considered myself his obvious replacement. I was ready with all the relevant support for my statements, including my performance reviews but also a list of successful projects, a list of my accomplishments and so forth. It is not clear to me from your e-mail whether you were proactive about seeking the promotion, or whether you were assuming that it would happen based on the really good feedback you were getting from management. In any case, the aggressive, proactive approach often works best in these matters.

4. Alternatives - if you genuinely feel that you were discriminated against, consider whether you would like to take legal action. If this is indeed the case, I also suggest you consider whether a company that discriminates against its employees is a good employer to work for in the long term. Whatever you decide, do not look back. The worst trap you can fall into is self pity or bitterness. Either of those would essentially derail your career.

Looking forward, my advice to you is this: go to your VP. Speak with him or her and be very candid about your disappointment at the fact that you were not chosen for promotion. Do not speak ill of your fellow employees that were promoted, simply make the positive case for yourself. Solicit constructive feedback from the VP, ask why management did not select you for the promotion, and what you can do to take your performance to the next level. Managers truly appreciate employees that solicit feedback and that are genuinely interested in getting better. Maybe you will find that management had some sort of valid reason for their decision, who knows? Keep an open mind.

Next, tell the VP that while you understand and respect the decision that was made you consider yourself a worthy candidate for promotion and expect to be on the short list next time. A clear declaration of intentions - without ultimatums - would serve your purpose best. From your e-mail, I am unable to tell how big your company is, but if it is large, you may also want see if you can find another suitable position within the company."

Can you suggest other ways to deal with the situation? Would you have answered the question in a different way? What would you have done under similar circumstances?

As you can tell, I am always happy to receive e-mail questions from my readers. Please keep them coming. If you would like your anonymity maintained when I answer your questions on this blog, or if you prefer to receive a private e-mail answer, I am glad to do either or both.

Monday, October 15, 2007

Carbon Tax - It's Time!

Today is Blog Action Day, and in honor of this concerted effort of thousands of bloggers worldwide, I am dedicating my post today to the environment. Like (almost) every post on Money and Such, I will be talking about the environment in the context of personal finance and the economy.

Regular readers of money and such know that I am a fervent supporter of free markets. Free markets have a lot to do with the environment. In fact, it can be argued that most of the environmental problems that we are facing today are actually economic problems. How so? If people had to pay for the full and true costs of their actions, they would make different economic decisions. Let me give you an example:

If a company is thinking about building a new coal power plant, they are taking into consideration the cost of building it, the cost of shipping coal to the plant, the cost of operating the plant, the cost financing the construction, and many other such costs. However, they are not taking into account the cost of the acid rain that they may be causing; they are not taking into account the impact their carbon emissions may be having on temperature, rainfall and weather patterns in other parts of the world, and so forth. Why not? Simply because they do not bear these costs.

It's not that these costs are not real. These costs are very real and have been repeatedly demonstrated to exist. The reason the company is not considering such important environmental implications is a trivial but critical one: someone else is paying for these specific costs. While the company will be earning the return from generating and selling the electricity from the polluting power plant, others will be paying for much of the harmful side effects. Costs paid by third parties are known as externalities, and should be eliminated.

If we want people to make the correct economic decisions, they must have complete and correct information on which to base their decisions, and in economics there is only one kind of information that counts: the price.

To get back to our example: the company that is planning a new coal power plant is not doing so because they have a particular sentimental attachment to coal. No siree. They are building a coal power plant because they sincerely believe that this is the best way for them to make money. That's a good thing. This is the way that the capitalist system works. If you want them to take a different approach, all you have to do is give them the right information about the true cost of their activities, and fortunately, this is very easy to do: charge them a fee which is equal to the costs that other people will bear as a result of the company's electric production operations.

If said company now has to pay an extra 10 cents per kilowatt to offset the cost of the harmful carbon emissions, the acid rain and the pollution to local streams and destruction of habitat, they may find that building a coal fired power plant is no longer economically justified. It may now makes more economic sense to invest in cleaner, less impactful forms of power generation, such as solar, wind and, yes, possibly even nuclear.

Don't get me wrong here. I am not talking about imposing penalties or excessive fees to give people an incentive to switch. All I am talking about is assessing a fee equal to the actual cost needed to offset any harmful effects from one's activities. I am talking about paying for the damage you actually do.

Taxing carbon emissions can be the first step towards ensuring that polluters pay for the true cost that their pollution imposes upon society. This a socially progressive and just tax that will impact pretty much everyone in society. If you drive a car, you will have to pay such a tax. If you use electricity from the grid (unless you are purchasing renewable power), you will have to pay this tax. If you purchase a gallon of milk at the store, you will have to pay this tax. This tax will be all around you, it will become a part of life. Guess what, pretty much everything we do in the modern economy generates carbon emissions. Once we all start paying for those emissions, and for the harmful effects that they cause, we will have a big, monetary incentive to reduce our carbon use.

Finally, I am not suggesting that we must immediately pay for the full cost of our carbon emissions. Such a sudden change will no doubt impose an unacceptably high cost on the world economy. However, we can start with this tax today and gradually phase it up to its full level over a 20 year period. This will allow people to adjust and phase out their use of harmful carbon and will allow industry plenty of time to adjust.

The market is a very powerful tool for innovation and societal good. If all true costs are reflected in the market prices we pay everyday, the magnitude of our environmental problems will decline dramatically. Environmental problems are not a failure of free markets, they are a symptom of markets that are operating without adequate information about the true price of commodities. Free markets, armed with complete information, are a powerful tool for solving the critical enviromental problems that humanity faces today. Hopefully someone in Washington is listening.

Blog Action Day

October 15th is Blog Action Day. Many of the blogs you read today will offer a post about the environment. I have decided to join this movement, because I feel strongly that big problems need to be addressed head-on, and the sooner the better.

I have written about the environment many times in the past. You can find a couple of examples here and here, but today is special. Today, Money and Such is just one of thousands of blogs all with a single theme: the environment.

Please support Blog Action Day by letting as many people as you can know about it. If you have your own blog, post about the environment today. If you don't, comment on someone else's blog. Write your representative. Let your local newspaper or television station know about this effort. Get involved.

Look for my post on the subject first thing in the morning (California time).

Saturday, October 13, 2007

The Stock Market is Not That Safe

A few days ago I had a lively discussion with Matthew of Crazy Money about whether it is a wise thing to hold a long term portfolio consisting entirely of stock investments. I argued for a well diversified portfolio comprised of weakly correlated asset classes. Matthew argued that since the stock market provides the highest long term expected returns, the best way to go is a 100% stock based portfolio. I wanted to revisit this issue and add a little more data.

Essentially, the core of Matthew's argument is that over the long term the stock market is safe. If you have 40 years to wait, the stock market will invariably go up. In last week's The Economist, I found an article called To Infinity and Beyond, which addresses this very issue. Let me offer a few choice quotes from the article:

"Among American financial commentators, it is almost universally accepted that shares always rise over the long run. And this perception does seem to be backed up by evidence; if you take any 20-year period, Wall Street has always delivered positive real returns. In addition, one ought to expect shares (which are risky) to deliver a higher return than risk-free assets such as government bonds.

Nevertheless, investors ought also to remember the world's second largest economy, Japan. Its most popular stockmarket average, the Nikkei 225, peaked at 38,915 on the last trading day of the 1980s; this week, nearly 18 years later, it was still only around 17,000, less than half its peak. Buying on the dips did not work either. By 1994, the Nikkei had fallen to 21,000—at which point a technical analyst, after poring over his charts, told this columnist that it had to be one of the great long-term buying opportunities."

And another quote:

Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School examined the record of 16 stockmarkets which were in continuous operation over the course of the 20th century. In itself, this selection showed survivorship bias by excluding the likes of Russia and China. The academics found that only three other countries could match the American record of having no 20-year periods with negative real returns.

Other investors were far less lucky. Japanese, French, German and Spanish investors all suffered instances where they had to wait 50-60 years to earn a positive real return; in Italy and Belgium, the waiting period stretched to 70 years. It was no good following the famous advice to “put the shares in a drawer and forget about them”; the furniture would not have lasted that long"

I still have some QQQQ shares I bought in 2002 which are still about 20% below their nominal purchase value, they are much lower than that if you take inflation into account.

Now, don't get me wrong, most of our portfolio is invested in the stock market. However, I think that this article underscores the need to diversify beyond that asset class, and into assets that would not be impacted - and hopefully would even benefit from a decline in the stock market. Many would argue that the American stock market is unique and that it will not experience the kind of decades long bear market that other markets have seen internationally. They may be right, but is it wise to bet your financial well being on this assumption?

Friday, October 12, 2007

Fortune Cookie Finance

Yesterday a fortune cookie gave me financial advice. I went out to lunch with a customer at a Chinese restaurant. When the meal was done I claimed my fortune cookie and here is what it said:

Perhaps you’ve been focusing too much on saving

I also found out that my lucky numbers are 15, 10, 16, 28, 35 and 36. Hmmm.
I don’t know how I feel about getting financial advice from a baked good, but I think that good advice is something you want to use, no matter where you get it. Have I been focusing too much on saving? It’s possible. I am a personal finance blogger, after all, and if I were too focused on saving that probably would not come as a shock to many. But how can I tell if the criticism is true?

Let’s start by examining the facts. My wife and I save about 17% of our gross income. We don’t go crazy spending huge amounts of money, but I don’t feel like we are depriving ourselves of anything. If I have a burning desire to buy something, I buy it. OK, there is one big ticket item that I have consciously decided to not purchase and have had some second thoughts about, but overall I feel good about our consumption to saving ratio.

Could the sage cookie be referring to the fact that I spend too much time thinking about money? That’s a good question. I read a lot of personal finance blogs, financial books, and investing articles, but does that mean that I am obsessive about the subject and may be missing out on some bigger things? I don’t know, but I enjoy personal finance. It’s sort of a hobby of mine. I don’t think that my hobby is taking away from my enjoyment and focus on the big things in life.

Could the all-knowing cookie be referring to the fact that I have been hoarding my frequent flyer miles and not spending them on an awesome vacation in Maui? Maybe that’s it. A cookie can’t be wrong can it? I think its time for a big vacation purchased free of charge by massive spending of hard earned United frequent flyer miles. Now, if I could only find someone to take care of the kids for a week while the wife and I head towards the sunset.

Late Breaking Addition: Little Miss Money Bags left a comment saying that English Major got the very same fortune cookie. Fortune cookie companies everywhere have decided to branch out into financial services, apparently. Financial advisers beware!

Thursday, October 11, 2007

Price Gouging is a Good Thing

Last weekend we took the kids to San Francisco to see the Blue Angels perform as part of Fleet Week. The kids loved it, but that's not my story. The real story is the fact that many other folks had the same idea and the city was packed with would be spectators. So much so that parking was a nightmare. Parking lots that normally charge $10 now charged $40 and they too were quickly filled to capacity. Even if I were willing to pay that huge amount, finding a spot would not have been possible. Consequently, I dropped off the wife and kids close to Pier 39 and drove around for about an hour, until I found somewhere to abandon the car.

Let me get to the point here - and my point is not going to be a popular one. Do you know how after a natural disaster hits everyone starts complaining about price gouging, law suits start flying and everyone gets on their high horse? Well, so called "price gouging" is just a natural market reaction to a shortage in supply. The price mechanics are very similar to the ones we experienced last weekend in San Francisco. When demand for a previously abundant resource shoots up dramatically, and new supplies are not available, price spikes. In the case of our parking situation, parking spiked by 400%. That's a good thing.

Why are price spikes a good thing? They mean that the free market is operating correctly. The laws of supply and demand dictate that an increase in demand without an offsetting increase in supply leads to an increase in price. The alternative to allowing a price spike is to institute rationing. Both of these are acceptable systems in a crisis, but a price spike offers the added benefit of encouraging new supplies to come online. Price spikes also ensure that the people that end up getting a given resource, are the ones who value it the most, not the ones that happen to be standing first in line. Rationing is a surefire way to guarantee the development of a black market. Those individuals who received a ration for a price that is lower than the true economic value of the resource, will simply re-sell that resource for a higher price on the black market.

Rather than complain that vendors are price gouging, consumers and the government need to plan in advance to ensure an adequate supply of all necessary commodities, or to prepare adequate substitutes for those resources. In our case, I did not have to pay $40 for parking. I had several options: (i) not go; (ii) take the train instead of the car (which is what we should have done); (iii) substitute time for money by driving around until I finally found a spot. All three were valid options. Railing against price gouging was not one of them.

Wednesday, October 10, 2007

Recommended Articles

Here is my recommended articles post for the week. As always I try to choose the more original and novel articles out there.

Ask Mr. Credit Card hosted this week's Carnival of Personal Finance, which included my article "Advanced Portfolio Building". I also wrote two additional articles on the same topic this week. You can find them here and here.

Tezza from 4EvaYoung wrote an article titled Buying is for Suckers (she is referring to houses). I wouldn't go as far as the title of this post suggests, but you may remember that my article Rent is not Waste was selected editor's pick in last week's Carnival. I agree with practically all of the arguments Tezza is making. Tezza also adds a couple of excellent points, including the following: renters do not typically over-extend. Buyers of homes have a nasty tendency to buy more home than they need, thinking that they will either grow into it, or sell it for a profit. Talk about locking up valuable capital in bricks and mortar.

Free Money Finance has a post about strange and unusual job interview questions. I have had a couple of strange interview questions in my time. One interviewer put a batman action figure in front of me and asked me how I would market the masked crime fighter. In another interview, I was asked to suggest ways to prove that the light in the fridge does not stay on when the door is closed. In yet another interview I was actually asked to estimate the weight of a Boeing 747. Believe it or not, I actually heard of this question before, and had a good idea of how to approach the problem. People that are interviewing with me these days get some unusual questions that they can blog about. I tend to ask people to perform tasks that they would be faced with on their first day on the job. Just last week I asked several candidates to solve some Excel problems for me. The way I look at it, if I expect you to perform the task on your first day, I want to know you can do it, before I hire you. Am I crazy?

Chief Family Officer has a post about sending her boys to private school at a steep price. Her readers responded to the article with some fairly vile comments. I am amazed that she let some of those comments stay published. In any case, I can certainly understand the dilemma. My oldest started kindergarten this year and he is going to public school. The schools in our neighborhood are very highly rated, so I am very comfortable with that decision. However, I can certainly understand the desire to give your kids the best education possible. Education is the one investment that is better than any portfolio. In my humble opinion, that is.

Quest for Four Pillars has a post explaining how he decided how much life insurance coverage his family needs. My life insurance coverage is enough to replace my annual base salary 6.4 times. I am not sure whether this will be sufficient on its own should fate take me away from my family before my time. It's probably pretty close given that term life insurance payments are not taxed, and that the money can be invested as soon as it is paid. I may need to re-evaluate my coverage.

As always, I will add a couple of more recommendations later this week.

Tuesday, October 09, 2007

Advanced Portfolio Building III

Over the past week I have written a couple of posts on the topic of diversification and asset allocation. Today, I would like to discuss in a bit more detail a specific asset class that I am considering diversifying into: commodities.

For those readers who are not familiar with the concept of commodities, these are essentially the basic goods upon which the modern economy is built. They are typically divided into five categories: Energy, such as oil and natural gas; Industrial metals, such as copper and aluminium; Precious metals, such as gold, silver and platinum; Agricultural commodities, such as corn and wheat; and finally, livestock, such as live cattle.

Why diversify into commodities? The main reason is that, as explained in my previous post, commodities move independently of equity prices, or in more technical terms: the correlation between these two asset classes is close to zero.

While doing my research into the feasibility of commodity investing, I came across this informative article in the Journal of Financial Planning. One of the main points I wanted to research was the expected return of the commodity asset class. According to the article the average annual return of the Goldman Sachs Commodity Index (GSCI) between 1970 and 2006 was 11.5%. That is pretty impressive. Just as importantly, the commodity index seems to generate the highest returns in times of unexpected inflationary pressures. This means that while the rest of your asset classes may be suffering the twin scourges of inflation and high interest rates (which the Fed uses to combat inflation), investments in commodities tend to perform at their highest levels. For a more complete picture of the historical performance of this asset class, take a look at a chart of Dow Jones AIG Commodity Index (DJAIG).

The article offers a quantitative analysis of the diversification benefits offered by commodities. I will save you the suspense. According to the article a portfolio weight of 24% in commodities between 1970 and 2006 resulted in a a higher return compared to a portfolio of 60% stocks and 40% bonds; while simultaneoulsy reducing the volatility of the portfolio by 13.5%. That certainly gives me some food for thought.

Once again, it seems that the main issue is finding a good vehicle for investing in the commodities market. The article mentions two ETFs, GSG and DBC as funds worth considering, but both of these funds seem relatively new and don't offer enough of a track record for my taste.

I will do some more thinking on this topic. I am not quite ready to jump into that particular pool.

Monday, October 08, 2007

Seven Random Things

I got blog-meme tagged by Plonkee to join in the "seven random things about me" discussion. Well, here are seven things about me that you really did not have a burning need to know:

1. I have been on all continents, except one. The exception being Antarctica. One day...

2. I am a huge chocolate fiend. Before you say anything, Hershey's is not real chocolate. In fact, I don't think that there is such a thing as real American chocolate. Yes, I am also a chocolate snob.

3. I have no middle name.

4. I have three boys. The oldest is five.

5. I have a law degree, but after three years of practicing corporate law in a firm, I dumped that career and got an MBA. That was one of the best decisions I have made.

6. I love to watch sci-fi movies (and shows), pick them apart and complain about how stupid they are. Do you know how in the movie Armageddon in the final scenes they show the asteroid blowing up and then they show people around the world looking up at the sky an cheering? Yeah, right. The people in India, England and the U.S. see the same place in the sky at the same time. You know what I mean? It's just awesome to complain about fake science in movies.

7. I drink way too many cans of Diet Coke every day. It used to be regular Coke, but a couple of years ago I started watching my sugar intake.

I always seem to be at the tail-end of the blog memes, but let me try to tag Money Ning, Gen X Finance and The Div Guy. See if any of them has anything to say on the subject.

Sunday, October 07, 2007

Advanced Portfolio Building II

A couple of days ago I wrote a detailed post I called Advanced Portfolio Building. As of now, that article received only a single comment, but I think that comment merits a detailed discussion and I will do so in this post. Let's begin by reviewing the full text of the comment, left by Matthew from Crazy Money:

"There are two methods for reducing volatility in a portfolio: building a basket of assets with weakly or anti-correlated betas, or increasing your time horizon. No discussion of risk and reward is complete without including the impact of time on both quantities.Given a sufficiently long window, there is no reason to invest in anything but 100% equities. Diversifying beyond this asset class would only create a drag on your final return and increase transaction costs.

I agree with some of the points Matthew is making in his well thought-out comment, but I strongly disagree with others. Clearly, Matthew is right that the longer your time horizon the more aggressive your portfolio can be. This is a basic truth of investing.

However, let's make a distinction between risk and expected return. Risk is traditionally measured by the volatility of the asset class in question. Volatility is the relative change in price over time. The concept of risk is strongly related to but is very different from the concept of expected return. Expected return is the amount of money you would receive, on average, over a certain period of time, by investing in that asset class. Let me give an example that will clarify the difference between those two concepts:

The S&P 500 for example has historically averaged a return of approximately 7.3% per year since its inception (not including dividends). If you believe that the S&P will continue to behave as it previously did, your expected return is about 7.3% per year (plus dividends). However, the S&P very rarely yields exactly 7.3%. The return fluctuates. Some years the S&P returns double digit gains, other years investors lose an arm, a leg and one buttock. The S&P (as well as all other equity) is a relatively volatile and hence risky asset class.

Given the option between a volatile asset and a stable asset, both of which are expected to return the same amount, a rational investor chooses the more stable asset. Why accept uncertainty and risk if in the end you expect to make the same amount of money? Think of it this way: if you were able to get 7.3% on a CD, every year, for the foreseeable future, would you invest in the S&P which on average would yield the same return, but could have some seriously down years included in the mix? Of course you wouldn't.

With the concepts of expected return and volatility safely locked in out heads, let's go back to Matthew's comment. Matthew is saying: "There are two methods for reducing volatility in a portfolio: building a basket of assets with weakly or anti-correlated betas, or increasing your time horizon". That statement is not correct. By increasing your time horizon you are more likely to achieve the expected average return on the asset class in which you are investing (7.3% in the example we used above), but you are doing NOTHING about volatility.

Let me explain: in any given year the stock market may tank or soar, but if you stay in the market for a large number of years, your chances of achieving your expected return are high. Compare it to a game of heads or tails. If you flip a coin twice, you wouldn't be surprised if it came up heads (or tails) twice. However, if you repeated that coin flip 1,000 times you would expect (and the laws of probability are on your side) that the number of heads and tails will be pretty close to each other. You would be really surprised if you threw heads 900 times and tails only 100 times - although that too COULD happen. This is because the expected outcome of the game is that 50% of the time you will flip a head, and 50% tails will appear. However, the long term expected outcome has absolutely no bearing on the next flip of the coin.

Matthew is confusing volatility with expected return. By expanding your time horizon you are likely to achieve the expected return, over the life of your investment, but that does not reduce the risk that your portfolio will tank in any given year.

Enter diversification: going back to the coin flipping game. Diversification is akin to playing heads or tails with several coins simultaneously. Each coin represents a different asset class in your portfolio. The chances of flipping all tails when using, say, 10 coins simultaneously is vanishingly small. Diversification reduces the volatility of your portfolio, and in many cases it can do so without reducing your expected return. Matthew's statement that "Diversifying beyond this asset class [equity - Shadox] would only create a drag on your final return and increase transaction costs", is simply not accurate. More about this specific point in a future post.

In the meantime, I will let this excellent example from The Sun's Financial Diary, speak for the merits of diversification. I suspect that if diversification beyond equities was not a worthwhile undertaking, a sophisticated investment team such as Yale's endowment managers wouldn't bother with it... 'nuff said.

Thursday, October 04, 2007

Advanced Portfolio Building

Warning: the information in this post is about how to achieve more effective diversification in your portfolio. It may actually be useful, but it might not be an easy read.

Diversification is a very useful trick. It allows you to maximize your return for a given level of risk, or to minimize your exposure to risk at any target level of return. Diversification works because different assets do not always move in lock-step, such that a decline in the price of one asset is often offset by an increase in the price of another asset.

Diversification becomes more effective as the correlation between your different asset classes declines. In other words, if you want to increase your level of diversification, your portfolio needs to include asset classes that have a more tenuous link with each other, or better yet, assets that are negatively correlated. For those readers who are less statistically inclined, if two assets are negatively correlated they tend to move in opposite directions.

Although our portfolio is well diversified by most measures, I noticed that during much of the market turmoil we experienced in July, most of our asset classes moved in the same direction: down. Domestic and international stocks, bonds and real estate all seemed to face the same price pressures. This prompted me to do some research, and led me to discover this phenomenal article, in the July issue of the Journal of Financial Planning. The article offers detailed correlation matrices between 17 different asset classes.

According to the article, the asset classes that exhibit the lowest average correlation with the S&P 500 are: U.S. Bonds (0.23); Global Bonds (-0.03); Cash (0.02); Natural Resources (0.01); and Long - Short investments (-0.01). Let me interpret these results for you: on average, if the S&P moves up by 1% on a given day, the average cash position will tend to move 0.02% in the same direction, while a diversified global bond position would tend to move 0.03% in the opposite direction.

Bonds truly are an excellent way to diversify a stock position. Global bonds are an even better way to achieve this goal. How many of us have global bonds in our portfolio? Not very many.

How do real estate (as measured by REITs) and International stocks fare in the diversification department? Good, but not great. International stocks have an average correlation of 0.55 with the S&P, while REITs have an average correlation of 0.52. In addition, at certain times these asset classes exhibit a substantially higher correlation with the U.S. equity market. So, while these asset classes offer substantial diversification, this benefit sometimes diminishes to a large extent.

Without boring you with the details of the statistical analysis offered in the article, you should note that the correlation values provided above are averages and that the correlations of some asset classes vary dramatically over the years. However, the article mentions natural resources, long-short, U.S. bonds, global bonds and cash as the five asset classes that consistently offer the best diversification benefits with an equity position. It is also interesting to note that the same asset classes also have a weak correlation with each other.

I highly recommend taking the time to read the full article for yourself.

More about this article and its take aways in the coming days.

Wednesday, October 03, 2007

Personal Finance: Intentions & Reality

A couple of days ago I ran across this interesting article. The article outlines the often huge distance between intentions and actions as far as personal finance is concerned. Here is a summary of one section that I thought was especially informative:

Attendees at a retirement planning seminar all claimed that they would be joining their company's 401K plan. In reality, only 14% of un-enrolled seminar participants actually joined the plan. For comparison it should be noted that only 7% of those that did not attend the seminar joined the same plan. This information could lead you to the conclusion that the seminar helped motivate people to take action, however, it could also be argued that there is selection bias at work: i.e. people that chose to attend the seminar did so because they were more serious about taking action regarding their retirement planning. This means that the seminar itself may not have influenced people's actions at all, rather it simply provided a gathering venue for those more serious about retirement planning.

The article also shows that a large majority of people who were already enrolled in their 401K but needed to take certain actions, such as increasing their contribution rate also failed to follow up on their intentions after the seminar.

Here is what I take from this article: people procrastinate. It is in our very nature. We mean well, but our intentions do not always translate into action. Take me for example. I have been meaning to take my car in for an oil change for the past three weeks, but somehow I just can't seem to get it done. I have many good excuses: work has been crazy; my brother is in town for a visit; I have to pick up the kids and so forth. All excellent reasons. Still, no oil change.

What does that mean for people who care about personal finance? A couple of things: first, recognize your tendency to procrastinate, and combat it by building a plan and attaching schedules and goals to it. You want to do something? When are you going to do it? Second, don't develop personal finance plans that require too much activity or that rely on perfect timing. Those would be the most susceptible to procrastination damage.

What does this mean for public policy planners? If you think people are going to plan for their own retirement or make provisions for their long term economic well-being, there is a very strong chance that a majority of the population, while very well intentioned, will never actually get around to doing so. In fact, Congress and regulators are trying to use people's procrastination and laziness as tools to promote healthy retirement savings. One of the ways to achieve this is automatic enrollment of people in their 401K plans. Congress ok'd auto-enrollment in the Pension Protection Act of 2006. Hopefully procrastination now becomes a tool for good, as people who otherwise would never have saved now don't actually get around to opting-out of their retirement plans.

I hope you enjoyed this post. I was actually planning to write it last week, but never got around to it...

Tuesday, October 02, 2007

Recommended Articles

Once again it is time for my Tuesday morning article recommendations:

This week's Carnival of Personal Finance is hosted by My Retirement Blog, an excellent blog that I read regularly. Our kind host did me the honor of selecting my article Rent is Not Waste as the top Editor's Pick for this weeks Carnival. Good deal.

This week's carnival included a whole bunch of articles that I read and appreciated last week here are some of my favorites:

Money, Matter and More Musings posted an article about the fact that signing the back of your credit cards is a useless security feature. Absolutely. Two of my cards are unsigned, and very few times does a sales clerk even check to see if there is a signature on the back. Even when they do check, and see that the card is unsigned, very rarely do they ask for an ID. Checking is sort of an automatic, meaningless gesture for them. The one exception to this rule: Best Buy. I always get asked to show my ID at Best Buy, and I am glad to do so.

Advanced Personal Finance has a good post about how to deal with a lousy 401K plan. The advice is all good, but he leaves out one critical piece of advice: lobby your company to change the plan. Companies are generally interested in offering a good 401K plan to their employees. The problem is that in many cases the person running the plan is someone from HR that has little or no understanding in personal finance or investment strategy. If you offer your insights or formally file your complaints regarding the plan, there is a good chance that your suggestions will at least be considered. Be aware that companies are always worried about the possibility of being sued by employees unhappy about the company's 401K plan. Each 401K plan is managed by at least one trustee who has a fiduciary responsibility to run the plan for the benefit of its participants. That’s a very big incentive to listen to employees.

For those thinking about asset allocation, the Finance Buff offers some useful advice about how to build a portfolio while limiting complexity to a level you are comfortable with. Generally speaking this is sound advice, but I have some posts coming up about other asset classes that are not adequately addressed by the proposed strategy. Stay tuned. It's going to be interesting.

Chief Family Officer has a post about how much you should stash away in your flexible medical spending accounts. Personally, I check our medical spending each year, using Quicken and follow that amount. However, I find it bizarre that the government (or employers) makes individuals guess their medical spending in advance, and penalizes them for guessing incorrectly by taking any remaining funds they haven't spent. Talk about promoting waste and creating unnecessary complexity.

Also, check out the Festival of Under 30 Finances hosted by How to Make a Million Dollars.

The Festival of Frugality this week was hosted by My Two Dollars. This week I also participated in the Carnival of Financial Planning.

Monday, October 01, 2007

Recession in the Cards?

The polls are closed and the votes are in: 56% of readers who responded to my latest poll voted that the economy will not be going into recession. However a large minority of 44% thinks that something is about to hit the fan.

Regardless of your own personal opinion, I think this survey shows that people that care about personal finance, and hence read personal finance blogs, are not feeling too confident about the state of the economy right now. The problem is that the economy is sort of a self fulfilling prophecy: if people feel that the economy is doing well and that they are on sound financial footing, they spend more, which actually boosts economic activity. On the flip side, if people feel that the economy is at risk for a recession, they may preemptively cut their spending to prepare for the bad times, thereby reducing economic activity and tipping the economy over the edge and into recession. If a large segment of the population think the economy is about to go into recession, chances for a recession increase.

One more interesting point about this poll. I ran this poll for the past two weeks, and have been following the way the votes were going from day one. Two weeks ago, the early votes that came in were pretty pessimistic, with most voters expecting a recession. When the Fed cut interest rates, there appeared to be a burst of optimism with positive votes quickly overtaking the nay sayers. In the past couple of days, a little bit of pessimism has returned to the vote. Of course, this survey is nowhere near scientific and no sane person can draw any conclusions from it, however I found the correlation between the votes and the Fed rate cut to be intriguing. It is either a co-incidence or an example of the type of change in investor psychology that the Fed wanted to create.