Saturday, January 29, 2011

Four Simple Steps for Choosing the Right College, Part Two

Last week, I outlined four simple commonsense steps that you can follow for choosing the right college:

1. Decide what your career and life goals are.
2. Decide what type of education you need to meet your goals.
3. Determine what your financial budget is.
4. Choose a college which meets your educational and financial requirements.

In the first installment, I discussed the first two steps in detail.  In this second installment, I will discuss the third step.

Determine Your Budget

While education is a noble pursuit, it is a pursuit that requires cold, hard cash.  Many people (particularly first generation students) enter college with the idea that they will go to the best college they can without any concern for what the price tag is.  They figure that they will find a way to pay for it later on.  Of course, we have seen that this is a recipe for disaster.  Racking up student loans without forethought about how you will pay them back is worse than taking on a mortgage you can't repay.  At least with a mortgage, you can always walk away and allow the bank to foreclose on you.  There are many dire consequences to not paying your student loans:

- You can lose your tax refunds.
- You can have the loan payments taking directly from your paycheck.
- You can lose your Federal benefits.
- You can be sued (note that there is no statute of limitations on collecting student loan debt).

Bankruptcy won't help you because student loans are non-discharegable.  That means that even after declaring bankruptcy, you will still have to pay the full amount of your student loans.  On top of all that, Tennessee suspended the nursing license of 42 nurses who defaulted on their student loans.  The moral of the story is that student loan debt is something to be taken very, very seriously.  Taking on more debt than you can handle can have serious consequences that will follow you for the rest of your life.

The remedy for indiscriminate student loan debt is to have a reasonable higher education budget:

YOUR COLLEGE BUDGET =
Money saved for college +
Money earned working during college +
Money borrowed through loans

The first two items are straightforward to calculate.  The last item requires some thought.  You have to determine how much you can borrow realistically.  Here is my humble suggestion:

The Federal Housing Administration has a set of debt guidelines for determining how much a person can borrow towards purchasing a house.  The guidelines are as follows:

1. Your monthly mortgage payments should be no more than 29% of your total monthly gross income.
2. The total monthly payments on your loans (mortgage, credit cards, student loans, etc) should be no more than 41% of your total monthly gross income.

That means that 12% of your income is for payments on things other than your mortgage.  My suggestion would be to assign half of that amount towards student loans (6% of your monthly gross income).  That leaves you a buffer for car payments and credit card payments. 

Now what you do is estimate what your monthly gross income is going to be in your chosen field, take 6% of this number, and this is what you can reasonably afford to pay every month towards student loans.  You can use a loan calculator (like this one) to determine how much of a loan you can afford to take.

Here is a quick example:

Let's say that you estimate that you can going to make $5,000 a month ($60K per year).  That means that you can afford to make a monthly payment of $300.  If the current Stafford loan rate is 6.8% for a 10 year loan, that $300 a month will get a loan amount of $26,087.  Therefore, you should budget for loans in the amount of $26,088.

To put it into a formula:

Total Maximum Loan Amount =
(Expected Monthly Gross Income) * 0.06 *
(10,000 / monthly payment for a $10,000 loan)

Here is the math for my example:

Total Maximum Loan Amount =
(5000) * (0.06) * (10000 / 115) =
$26,087

Now you might say that you won't have a mortgage so why not use the 29% that the FHA budgets for your mortgage payment for student loans?  Then you'll be able to borrow more.  While it is true that you may not have a mortgage, you will still need to pay rent.  This gives you the flexibility to budget for your rent without breaking the bank.  Of course, your mileage may vary, so feel free to adjust my guidelines to fit your needs.  My main message is that you need to consider what you are reasonably afford to pay back.  You can't just borrow, borrow, borrow.

In the final installment in this series, I will discuss the fourth step which is choosing a college.  Stay tuned!

Wednesday, January 26, 2011

Red Ink at U.S. Postal

The Wall Street Journal had an article regarding the current financial state of the U.S. Postal Service (better known as the "Post Office").  Here is how the article begins:

"The U.S. Postal Service plays two roles in America: an agency that keeps rural areas linked to the rest of the nation, and one that loses a lot of money."

The article goes on to say that the Post Office lost $8.5 billion in its fiscal year 2010.  Even though, technically, the Post Office is owned by the U.S. Government, it is an independent entity which is supposed to be financially self-sufficient.  However, it is allowed to borrow from the Federal Government, which it has done liberally over the past several years.  It owes the U.S. Government $12 billion, and it something is not done soon it will reach its statutory debt limit of $15 billion by the end of 2011.

Unfortunately, it is hamstrung by one huge factor which needs to be addressed in order to make the Post Office profitable:

Universal Service Obligation:

The Post Office has a legal obligation to provide mail service everywhere at a uniform price.  Whether you are sending a letter down the street or across the country, a stamp costs the same.  Whether your letter is being delivered to an apartment in a high density urban area, or to a post office box in a remote area of Alaska that can only be reached by plane, a stamp costs the same.  Private carriers like UPS or FedEx are not burdened by this rule.  They are free to pick and choose to where they delivery.  They are free to charge more for rural areas, or for packages that go across the country.  Therefore, they can price their services in line with what it costs to perform the service.

This legal obligation was offset by a benefit that was supposed to make up for the additional cost:  a monopoly on mail service.  The Post Office is the only entity that is allowed to deliver letters.  UPS and FedEx are only allowed to deliver packages and urgent letters; they are forbidden by law to deliver non-time definite letters.

This monopoly on mail delivery is supposed to compensate the Post Office for having to deliver everywhere at the same low price.  In the past, this may have been true.  At one time, the mail was the only way to send messages to Aunt Betty in Scranton, and it was the only way to pay your telephone bill.  It was the only way that Sears could send you a catalog, and it was the only way that Ray's Car Wash could send you coupons.  However, as we know, all of those things can be handled more quickly and efficiently through electronic means.  The number of letters sent through the mail has dropped over the past decade, and it continues to drop.  A monopoly on mail service is like a monopoly on buggy whips after the advent of the automobile:  it is worthless.

My solution to this mess isn't to close post offices or eliminate Saturday service or raise rates in isolation.  My solution would be to free the Postal Service from the shackles of its Universal Service Obligation and give it the flexibility to compete in the 21st Century marketplace.  Then, the Post Office would be free to make the financial decisions necessary to keep itself in the black.  They would be able to price mail service according to the amount of work that it entails to send the letter from point A to point B.  They would be able to charge a premium for rural deliveries.  They would be able to close post offices that aren't profitable.  This would allow them to get their finances in order without becoming a burden on the taxpayers.

Now some may argue that this will restrict access to mail service to some who live in the far flung reaches of our country.  If the post office decides that a particular route is unprofitable and close it down, how will those people get their mail?  There is a simple solution to that, too.  In return for freeing the Post Office from its Universal Service Obligation, I would also eliminate its monopoly on mail delivery.  If the Post Office can't deliver to a particular location and there is demand for that service, a private entity can step in and provide that service.  Some enterprising entrepeneur might act as an intermediary.  They would have mail for a particular rural town delivered to a warehouse somewhere, and then the entrepeneur would then resort the mail and provide the last mile delivery of those letters.  The people in the town may have to pay a premium for this service, but they would their mail.  Plus, they would bear some of the cost for living in an out of the way place.

It is a noble goal that the Post Office should turn a profit like a private entity.  However, unless the Post Office has the flexibility to compete like a private entity, it will continue to run up debt at our expense.

Saturday, January 22, 2011

Four Simple Steps for Choosing the Right College, Part One

Yesterday, I discussed the value of a college education and whether it was worth the money.  On the one hand, there are statistics that show that college grads make more than high school grads.  As a general proposition, college does appear to have financial benefits.  On the other hand, there are stories of people for whom college was a poor financial decision.  These people are mired in debt up to their eyeballs.  Their plight doesn't mean necessarily that college is not worth the money.  Most of these stories boil down to two poor decisions:

1. Poor choice of major.
2. Poor choice of college.

When it comes to most decisions which could have 5 or 6 digit implications, most people take a very logical, measured approach, and rightly so.  If you choose the wrong deodorant, you might be out a couple bucks.  No harm, no foul.  However, if you purchase the wrong home, you could be looking at foreclosure, bankruptcy, and a poor credit score for years to come.  Somehow decisions about college often treated with the same care as purchasing a $2 deodorant.  Parents and students often make the decision based upon emotions rather than cold-hard facts.  Some people view college as a natural progression in life once a child turns 18.  It doesn't matter if you aren't sure if it will really help you with your career and life goals.  You are going to college.  It doesn't matter what you major in or what the cost is, you are going to college.  This type of thinking is what gets people into trouble.

In order to foster a more logical and fact-based approach to this large financial and life decision, I humbly offer my own strategy for choosing a college and major.  My hope is that these simple steps will allow some people to avoid making the poor decisions which could lead to a financial disaster.

Here are my four simple steps to the college problem:

1. Decide what your career and life goals are.
2. Decide what type of education you need to meet your goals.
3. Determine what your financial budget is.
4. Choose a college which meets your educational and financial requirements.

This article will discuss the first two steps.

Career and Life Goals

There probably are thousands of people who are more qualified to give career advice than I am.  There are many books are written on this subject.  My take on the subject is simple.  Choosing a career boils down to identifying the intersection of three things:

1. What you like.
2. What you are good at.
3. What you can make money at.

The ideal career choice will satisfy all three criteria.  If your career choice only satisfies one or two out of the three, you should keep looking.  For instance, I love baseball, and baseball players make a nice living.  However, it was clear at a young age that I didn't have the "stuff" to make it to the major leagues.  Therefore, I never considered a career as a baseball player.  However, I also like math and science, and I happen to be very good at those subjects (that's probably why I like them!).  Fortunately, there are many lucrative fields which require an aptitude for math and science.  I ended up majoring in Engineering, which happens to be my day job (which is a good thing because blogger doesn't satisfy criteria #3).

Now, it may be asking a lot for some 18 year olds to have an idea of what they want to do when they grow up.  Heck, it is hard for some 28, 38, and 48 year olds to answer this question!  If that is the case, maybe it pays to defer college for a year or two.  Get a job.  Take some non-credit courses at a community college.  Backpack across Europe.  Join the military.  A little life experience outside of the cocoon of high school can help to mature a young man or woman and get them to focus on what they want to get out of life.  A nice side effect is that 20 or 21 year old freshman may be better equipped to deal with the rigors of college life.

Some parents view college as the default next step in a young person's life, so these suggestions might be blasphemy.  However, consider that college is an expensive way to figure out what you want to do with your life.  By the time you figure it out, you may discover that you need to start your studies over again which is going to cost you even more money.

If you insist on going to college at 18 without a clue, consider majoring in something like math.  Math is the foundation of many disciplines and careers (computers, economics/finance, engineering, meteorology, medicine), and the logical thinking that you will learn will serve you well in whatever your career path is.

Choosing an Education Path

Now that you have picked a career, you need to determine what type of education you will need to enter your chosen field of study.  As I talked about in my previous article on the value of college, there are two aspects to higher education:  the credential and the knowledge that you will acquire.  Most fields have both a credential you need to obtain and a body of knowledge you will need to learn.  Knowing what those are for your field of study will determine what your major should be and what school you should choose.

Of course, your field of choice may not require any college at all.  In that case, you can save the tuition money and skip the university.  There is no point in plunking down $50,000 a year for four years if your career goal is to become an automotive mechanic.  You are just wasting money.  By the way, mechanics have the potential to make as much as any college grad.  Everyone knows what a good mechanic is worth.

Stay tuned for part two where I will discuss the third and fourth steps for choosing the right college.

Friday, January 21, 2011

Is a College Degree Worth the Money?

The conventional wisdom is that a college degree is the minimum criteria for entry into the middle class.  However, what is generally considered to be a no-brainer is being challenged by various stories in the media about people who have accumulated crushing student loan debt.  Here is one example about a woman who accumulated almost $100,000 in debt while earning $22 an hour.  Here is another about a man who accumulated $150,000 in college debt but is unemployed.  There are countless other similar stories out there of people with mountains of student loan debt who are struggling with the payments.  After reading a couple of these stories, you have to wonder if the conventional wisdom is really true.  Is college really a worthwhile endeavor?

Certainly, there are plenty of studies which prove that a college education is a very valuable commodity.  Graduates of four-year institutions generally make more over their lifetimes than high school graduates.  With the decline of blue collar manufacturing jobs here in the U.S. that can provide a middle class lifestyle, this gulf will only get wider.  Most of these stories about crushing student loan debt should not be viewed as a indictment of a college education. 

A college education has two main sources of value:

1. The credential.
2. The education itself.

By credential, I mean the value in having the piece of paper (also known as a degree) in your hand when you are applying for a job.  There are many fields where a college degree is required for entry.  Can you imagine getting a job interview with Boeing for a position as a design engineer without an aerospace engineering degree?  Sure you can teach yourself all of the fluid mechanics, structural analysis, material science, and propulsion theory that you would need to be a successful engineer.  However, without a piece of paper from an accredited school which proves that you acquired that knowledge, your resume is going to end up in the circular file.

This is true of many, many other fields.  Want to be a nurse?  You'll need a nursing degree.  Want to be a CPA?  You'll need an accounting degree.  Want to go to law school or medical school?  You'll need a 4 year degree for those as well.  The bottom line is that there are many careers where a college degree is the credential which is going to get you a job.

The second source of value that I mentioned is the education itself.  What I mean is that in the course of proceeding through the course of study to get your degree, you will obtain knowledge that will benefit your career that you may not have been able to obtain if you didn't get the degree.  Going back to my aerospace engineering example, while you are obtaining your degree, you will be taking courses which will make you a better aerospace engineer.  That knowledge that you obtain will be valuable to a potential employer.  There may be some schools which are better able to impart this knowledge than others.  Therefore potential employers may be willing to pay more for people who went to a particular school.

Putting the credentialing aspect aside, one could argue that you could get the same education without attending college.  You could read the same books and do the same problem sets on your own without having to attend college and pay the tuition.  Heck, some schools will provide you with the same lectures, the same course material, and the same exams that a paying student would receive for free.  Why pay for an education that you can obtain on your own?

The difference is that in a classroom setting, you are given motivation to work and study, through the use of grades.  You can get feedback and interaction with the professors who are teaching the course to help you to assimilate the material.  You can benefit from the interaction with your fellow students through discussion groups, study groups, or motivation through competition with them.  These additional supporting structures are things that you can't get as easily through pure self-study.

In reading some of these student loan "sob stories", the problem isn't with the value of a college education.  The problem stems from two factors:

1. Poor college selection.
2. Poor major selection.

People view college as being some noble ivory tower pursuit which is worthy at any cost.  However, back in the real world, college has to be viewed from an economic standpoint.  One must consider how college will enhance one's job prospects.  If attending college is going to enhance your future earning potential, then the cost is worthwhile.  However, if you are going to pay $200,000 for a degree which will lead to a $22/hour job, then maybe you should reconsider your choice of college and major.

Now the idealists will throw out platitudes like "education is priceless" or "knowledge for knowledge's sake".  Well, if those idealists are willing to pay off the six figure student loans of people featured in the stories to which I linked, then I might willing to listen to their arguments.

Monday, January 17, 2011

MLK Day: The Economic Benefits of Eliminating Discrimination

"I have a dream that my four little children will one day live in a nation where they will not be judged by the color of their skin but by the content of their character."- Martin Luther King Jr.

As most of you know, today is the day when we commemorate the work of the great Martin Luther King Jr.  Dr. King was a visionary who pictured a world where people would be judged on their abilities, rather than the pigmentation of their skin.  Today this seems like an obvious concept, but in Dr. King's world, it wasn't quite so obvious.  It took men and women like Dr. King to bring the cost of discrimination into the public consciousness.  I think we can all agree that there is certainly a moral component to eliminating discrimation.  It is right for people to be judged on their merits.  However, what baffles me is that discrimination lasted for so long despite the fact that it goes against our own self-interest.  People who discriminate are only taking money out of their own wallets and pockebooks.  It is in a person's or company's best economic interest to be color blind.

Let's take the fictitious example of two companies:  Company A and Company B.  Both companies are in the business of making and selling widgets.  The only difference between the two companies is that Company A will only hire people whose first names start with a vowel.  People who's names start with consonants need not apply for any job opening at Company A.  In contrast, Company B will hire all comers.  Their mottos is, "It doesn't matter if you are an Andrew or a Steve; you are welcome to apply at Company B."

Which company is going to have the best employees?  Company B of course.  The consonant bigotry of its owners mean that even if Steve is more qualified than Andrew, Andrew is going to get the job at Company A.  Rather than hiring the best for the job, Company A must "settle" for second, third, and fourth best because they are hiring based upon a criteria which has nothing to do with job performance.  It would be one thing if people with vowel names were better at making widgets.  However, there is nothing to correlate widget-making with the fact that your parents happened to like the name Andrew.  Company B is going to make better widgets than Company A, and that is going to cost Company A real money.

If you think that this is a contrived example, consider the Washington Redskins football club.  From the initial inception, blacks were allowed to compete on professional football teams.  However black players eventually were purged from teams, and by 1933 there were none left on any teams' roster.  Many people attribute the elimination of blacks from the league to the owner of the Washington Redskins, George Preston Marshall.  Marshall was known to be one of the leagues biggest racists.  When the NFL finally began to re-integrate in 1946, Marshall refused to sign any black players. 

Marshall steadfastly refused to sign any black players despite the fact that his fellow owners all did.  By limiting himself to white players only, he was making his team less competitve than their rivals.  From 1946 until the time they finally signed two black players in 1962 (under pressure from the U.S. Government) they were not very good:  zero playoff appearances and only three winning seasons.  In their final season before integration, they went 1-12-1.  It is clear that Marshall's policy of not signing black players doomed his franchise to years of irrelevance. 

As a footnote, Bobby Mitchell, one of the first two black players the Redskins signed in 1962, went on to have a Hall of Fame career.  Maybe Marshall's franchise would have had a more successful run if he had put aside his bigotry in favor of his own economic self-interest.  I guess it goes to show how irrational, and frankly, how stupid bigots are.

Sunday, January 16, 2011

How Do You Know When It's Time To Say "Goodbye"?

Yahoo! Finance has an article on their site entitled 5 Bad Financial Decisions and How to Recover which makes for an interesting read.  There was one point in particular that piqued my interest regarding hanging on to an investment for too long:

"Just like a boxer needs to learn how to take a punch, investors must eventually learn to take a loss. Not every investment will be a winner. It takes emotional discipline to recognize the mistake and cut your losses."

The article goes on to suggest that, rather than holding onto a loser investment, one should sell the investment and take advantage of the tax benefits of a capital loss.  For those who aren't aware, if you sell a stock or other investment for a profit, you must pay capital gains taxes on your profit.  Likewise, if you sell an investment for a loss, you can use the loss to offset any capital gains you had during the year.  For instance, if you sold stock A for a gain of $1000 and sold stock B for a loss of $1000, your net capital gains is $0.  Thus, you would not pay any capital gains tax.  In addition, if your loss exceeds your gain by less than $3000, you can deduct the loss from your income.  If sold stock C for a loss of $1000 and your taxable income is $50,000, you only have to pay taxes on $49,000 of your income.  If your capital loss is greater than $3000, you can carry over the loss into future years.

[As always, consult your tax advisor for more information on how a capital loss might impact your specific tax situation.]

Getting back to the subject at hand, the advice that the article gives is sound except for one fact:

How do you know if something is a loser investment?

One of the other "bad financial decisions" the article highlights is letting short term thinking ruin your long term financial plan:

"There are active management strategies, in which a preset event triggers a decision to buy or sell. And then there is random flailing. That would be the strategy in which investors randomly sell positions after losing money and then buy back in after the market recovers."

The only problem, according to the article, is that by the time things are better, you might have missed out on the market recovery.


Obviously, the two pieces of advice (selling loser investments for the tax write-off and holding onto loser investments until things recover) are in conflict.  How does one know whether it is better to sell or wait out the storm? 

On one hand, you have Circuit City.  Circuit City went into a downward spiral due to poor management decisions throughout the 2000's, resulting in the company going out of business in 2009.  Today, Circuit City stock essentially is worthless, and there is pretty much no chance that the stock will ever be worth more than zero.  Therefore, this would be a situation where "selling" for the tax writeoff makes sense (actually you would just take the write off since nobody is going to buy a worthless stock).

On the other hand, you have something like an S&P 500 index fund.  Back in March 2009, when everyone thought the sky was falling, the S&P 500 had been beaten down by the financial crisis.  However, as we all know, it has bounced back quite well from those dark days.  Therefore, this would have been a situation where staying the course made the most sense.

The only problem is that most people have trouble distinguishing between the two situations.  If you remember the first quarter of 2009, people were panic selling their stocks in droves.  There were financial "experts" who were predicting further drops in the stock market, and they recommended getting out while the getting was good.  Of course, those who sold based upon emotion and took their tax writeoffs ended up missing out on quite a nice bull market.  You would have been much better off staying the course.

Yes, if you have an investment which you know is a loser, by all means sell it for the tax writeoff.  Just make absolutely sure you know how to distinguish the true losers from the short term drops. 

Wednesday, January 12, 2011

Is It Better To Have STRONG dollar or a weak dollar?

If you go out and ask random people man-on-the-street style whether we are better off with a strong dollar or a weak dollar, I would wager said dollar that most people would answer "strong".  After all, a strong dollar conjures up images of muscular George Washington with a Rambo-style headband beating the stuffing out of a weakling euro, thus proving the superiority of the American financial system.  Besides, isn't it better to be strong rather than weak?

What does a strong dollar mean anyway?

The dollar is said to be strong if you can exchange a dollar for larger amount of a foreign currency.  The dollar is said to be weak if you can exchange a dollar for a smaller amount of a foreign currency.  To illustrate the point, here is a graph which shows how many euros for which a dollar could be exchanged over the past five years (courtesy of Yahoo! Finance):

Looking at the graph, you can see that at the beginning of 2006, you could trade a dollar for about 0.84 euros.  However, fast forward to mid-2008, you could only trade a dollar for about 0.64 euros.  One could say that in 2006, the dollar was strong in comparison to the euro.  However, in 2008, the dollar was weak. That is because every dollar could be exchanged for fewer euros in 2008 than you could in 2006.

Now that brings us back to the question at hand:  is it better to be able to trade a dollar for more euros or less?

Well it depends on your point of view.

If you are an American student backpacking across Europe, you would prefer a stronger dollar.  If you left home with $1000 in your pocket in 2006, you would be able to exchange that for 840 euros.  However, if you started your journey in 2008, you would only be able to trade your money for 640 euros.  Obviously, 840 euros is going to last longer than 640 euros.

On the other hand, if you are the owner of a bed and breakfast in the U.S., you would prefer a weaker dollar.  When the dollar is weak, a room at your inn is going to appear cheaper to a European tourist who comes to the U.S. with a pocket full of euros.  In 2006, 1000 euros is going to translate into about $1190.  However, in 2008, that same 1000 euros is going to be worth about $1560.  Because Europeans are going to be able to exchange their money for more dollars, they might be enticed to cross the pond for a vacation, rather than staying closer to home.

The same is true for imports and exports.  When the dollar is weak, it benefits U.S. companies which want to export their goods abroad.  When the company sells its products in Europe, consumers pay for those products in euros.  The company must then exchange these euros for dollars in order to pay its workers, suppliers, and shareholders.  If the dollar is weak, those euros will be exchanged for more dollars, thus benefiting net exporters.

On the other hand, when the dollar is strong, it benefits companies which import goods from abroad.  When a company buys a product from Europe, it must trade its dollars for euros in order to make the purchase.  If the dollar is strong, the company can trade its dollars for more euros, thus the price of the foreign goods is that much cheaper to the American firm.

Which is better then:  strong or weak?  A strong dollar means that the cost of goods from abroad are cheaper.  Since the U.S. is a net importer, that sounds pretty darn good.  All of those imports are cheaper when the dollar is strong.  On the other hand, a weak dollar benefits U.S. companies.  Because imports are relatively more expensive, domestic firms are better able to compete.  Likewise, a weak dollar means that U.S. exports are more lucrative.  Both of these things could mean more jobs of American workers.

As you can see, there isn't a right answer.

The interesting thing is that the U.S. has been accusing China of keeping the value of its currency artificially low.  The U.S. believes that if China were to raise its official exchange rate (thus making the dollar weaker relative to the Chinese yuan), it would make it easier for U.S. companies to sell their products in China, and it might stem the tide of cheap Chinese imports into the U.S.  This is a case where the U.S. Government believes that weakness is strength.

The bottom line is that you shouldn't assume that stronger is better when it comes to the dollar.

Monday, January 10, 2011

Maybe You Can Predict the Stock Market After All

If you are an avid reader of this site, you know how I feel about attempts to predict the movements of the stock market.  Any known information about the movement of a particular stock already will be taken into account in the price of the stock.  However, this week's Economist provides a counterpoint to this view.  In the article Why Newton Was Wrong, the Economist discusses research which shows the effect of momentum on the stock market.

Momentum is a complicated word for a simple concept:  stocks that have gone up in the recent past will continue to go up.  The Economist describes research which shows that on average the price of the top performing stocks of the previous year will outperform the rest of the market over the next year.  This trend is observable not only in the U.S. stock market, but in stock markets from around the world.  This trend has also existed since at least the beginning of the 20th Century, so it's been around for some time.

The article points out that this defies conventional logic.  As I have pointed out, if a trend is observable, people will take advantage of the trend which effectively destroys this pattern from appearing in the future.  However, it seems as if the momentum trend defies this logic.  One must search beyond logic for an explanation of why this pattern persists.

The article talks about some of the explanations for this anomaly.  One possible explanation is a "bandwagon effect".  People see that a stock is going up so they feel the need to "jump on the bandwagon" lest they feel like they are missing out.  As a consequence of this, the stock price continues on its rising trend.  A perfect example of this is the dotcom bubble.  Back in the late 1990's, people heard about how others were becoming overnight millionaires from all of these tech company IPO's.  They didn't want to be left out of the excitement so people started throwing money at anything with a dot com in its name in the hopes of getting rich, too.  That lead to a period of euphoria where the price of tech stocks went through the roof.

This illustrates that as logical as people like me try to make investing out to be, humans are creatures of emotion.  As such, we get caught up in an irrational exuberance which can defy logic.  The role of emotion and psychology in markets is something which cannot be denied, as markets are made up of people, not automatons.

Of course, in the case of the dotcom bubble, it reached a point where logic finally did take over.  Cooler heads realized that the tech sector is completely overvalued, and the whole house of cards collapsed.  This illustrates another point that the Economist article makes:  momentum is a short term phenomenon.  At some point, rationality prevails as people realize that momentum can't last forever.  This often leads to a "whipsaw" effect where stock prices suddenly drop and return to a more logical level.  The trick for momentum investors is to figure out when the bandwagon is about the crash so they can jump off. 

Of course, predicting when your luck is going to run out is a tough business.  Human nature is such that we always want to hold out for just one more day in hopes that we'll be able to wring that last dollar from the stock.  Las Vegas was built on the backs of people who thought that their winning streak would keep going so they stayed behind for "just one more" roll of the dice.  It's tough to walk away from the table when you are ahead.  That's why we get burned over and over again by the whipsaw effect.

The moral of the story is that maybe there is a momentum effect that a savvy investor can exploit.  However, don't get too greedy because it may not last for long.

Friday, January 7, 2011

The BEST Piece of 401(k) Advice I've Read in a Long Time

If you search for articles which give 401(k) tips, you usually will get the standard pearls of wisdom:
  • Contribute at least enough to get the company match
  • Pick funds with low expenses
  • Invest for the long term
  • Periodically rebalance
  • Don't be tempted with withdraw the money
All of these pieces of advice are wise, but pretty much every advice article on 401(k) contains them.  It is rare that I come across 401(k) advice that is original.

Today is one of those days.

The website TheStreet.com has an article entitled Financial Advice That Can Do Serious Damage.  Author Joe Mont quotes financial planner Robert J. DiQuollo who gives the following warning about how it is possible to miss out on one's full company match by having too high a deferral percentage:

Even if you have an above-average salary, is a bigger deferral rate necessarily better?

Choosing how much to contribute isn't always so simple.

"If you contribute too little to your 401(k), you may not get the full employer match," says Robert J. DiQuollo, president of Brinton Eaton, a New Jersey financial planning firm. "On the other hand, if you contribute too much, too fast, you can shortchange yourself."

DiQuollo uses the example of an executive making $20,000 a month who contributes 20% to a 401(k), with a 5% company match. He or she will reach the IRS' annual contribution limit of $16,500 in May and can't contribute for the rest of the year.

In this example, the executive gets a match of only $4,500 at a company that frontloads contributions. If the executive chose a 7% contribution rate instead, the $16,500 limit wouldn't be reached until December and would get the full company match of $12,000 -- or $7,500 more.

Honestly, this is something that has never crossed my mind, but it makes perfect sense.  If you max out your 401(k) contributions prior to your last paycheck, you are short changing yourself.  This concept doesn't just apply to highly compensated executives.  This is something that applies to anybody who is contributing the maximum of $16,500 to their 401(k) and gets a company match.  Anybody who intends to max out their contributions should make sure that they at least are contributing enough to get the full match in each and every paycheck. 

Of course, if you are not getting your company's full match, you are leaving free money on the table.  Most advice articles think in terms of making sure you contribute at least enough to get the full match.  Never have I come across an article which points out that you may be missing out on the full match by contributing too much too early in the year.

Serious kudos to Mr. Mont and Mr. DiQuollo!!!

Wednesday, January 5, 2011

U.S. Government Losing Money on Real Estate?

If it wasn't bad enough that the U.S. national debt is increasing day by day, it seems as if the Government is losing money on the White House.  According to news reports, it is estimated that the White House has lost nearly 25% of its market value since the peak of the housing boom.  In 2007, the White House was worth $332 million.  Today it is worth a paltry $252 million.

Personally, I don't put much stock in these estimates.  When appraising the value of a typical home, real estate experts look at sales of comparable properties in order to determine a home's value.  In the case of the White House, there aren't too many comparable properties.  I mean, how many 55,000 square foot, 132 room, 35 bathroom six story homes on 18 acres are there in downtown D.C?  How many of those are equipped with a bowling alley, movie theater, tennis court, swimming pool, and putting green?  If you find one, let me know!

I suppose the good thing is that the mortgage on the White House was paid off long ago...

WSJ: Slow and Steady Saving Still Pays

Last week, I made the case that if you invested continuously in the stock market during the "lost decade" of the 2000's, you would have made money.  It seems as if the Wall Street Journal has come to the same conclusion.  The scenario outlines in the WSJ article is slightly different, but the basic conclusion is the same:

"For younger retirement investors, the long-run part of the equation is what matters. Despite the stomach-churning ups and downs of the stock market during the past decade, an investor who started with $300 in an account 11 years ago, and who has nearly $52,000 socked away today, is much further down the path toward a comfortable retirement."

Monday, January 3, 2011

Diversify, Diversify, Diversify!

There is an old adage in real estate that the three most important things are "location, location, location".  For investing a similar admonition might go something like this:

Diversify, diversify, diversify.

Diversification is defined as owning a wide variety of different investments on the theory that a slump in one investment will be offset by gains in the other investments.  Obviously if you knew with certainty which stock or which investment is going to be the big winner, you would just buy that one particular stock or investment.  However, unless you have a crystal ball, you aren't going to be able to predict which investment is going to go through the roof.  Therefore, the next best thing is to hedge your bets and invest a fraction of your money in a little bit of everything. 

Here is a real life example of diversification in action...

Remember the crazy gas prices back in 2008?  During the summer of that year, gas prices peaked out at over $4 a gallon which pinched the wallets and pocketbooks of many Americans.  The average consumers weren't the only ones affected by this.  Companies big and small were also affected.  Companies which purchase and consume lots of fuel did worse than average; however, those companies that either supplied oil or other alternative energy did well.  Here is a sampling of some companys' stocks leading up to that summer (I also included the S&P 500 for comparison):



CompanyTicker SymbolIndustryPrice on 1/2/2008*Price on 7/1/2008% Change
S&P 5001467.971284.91-12.5%
Exxon MobilXOMOil94.1588.35-6.2%
ReneSolaSOLSolar Power12.2215.7629.0%
American AirlinesAMRAirline13.704.85-64.6%
FedExFDXShipping88.5776.37-13.8%
FordFAutos6.734.71-30.0%
* - ReneSola's price is from 2/1/2008 since it did not go public until January.

Exxon's stock price dropped by only 6.2%.  At first this may be somewhat counterintuitive since you would expect that Exxon would make a killing from high oil prices.  Note that the entire market went down by over 12% during this time due to the beginning of the recession and the financial crisis, so a loss of only 6.2% still beat the overall market.

ReneSola's stock price went up by 29% during this time.  The business case for alternative energy such as solar was bolstered by high gas prices.

American Airlines's stock price plunged during this time.  Airlines are major buyers of petroleum-based fuels for their airplanes, and because of the competitive nature of airline business, they are unable to pass along these additional costs to the flying public.

FedEx's stock price also dropped, but not quite as much as American Airlines.  Because there aren't as many shipping alternatives, they can pass along some of the higher cost of fuel to their customers.

Ford's stock price dropped by 30% during this time.  Ford and the other domestic auto markets were caught with their pants down because they had invested very little in the types of fuel efficient vehicles that consumers were demanding at the time.

As you can see, the shock of high gas prices affected each of these companies in different ways.  If you had invested in ReneSola, you would have been lucky that gas prices skyrocketed.  If you had invested in American Airlines, on the other hand, you'd be cursing the high gas prices.  However, when you were looking for investments back in January of 2008, you would have no idea that gas prices would go so high.  The only defense against a situation like this is to invest in everything:  large company stocks, small company stocks, US stocks, international stocks. 

Of course, you shouldn't invest in stocks alone.  When stocks were dropping in the last half of 2008, the bond market was booming.  If you held 100% stocks, you would have gotten crushed by the market.  However, if you had some money invested in bonds, your financial blow would have been cushioned.

The bottom line is that by diversifying your money, you are protecting yourself from unforeseen events which may batter an individual stock.  How do you diversify?  The most cost effective way is by investing in a good low cost index mutual fund from one of the big investment companies.  These allow you to "buy" the market with a very small minimum investment.  How do you determine how much to invest in each asset category?  Do I put 50% in stocks?  Higher?  Lower?  That question will have to wait for another day, unfortunately.