Sunday, February 27, 2011

The Health Care Triangle

In engineering, there is a well-known concept called the Project Triangle.  In any engineering project, you can choose to optimize for quality ("good"), cost ("cheap"), or speed ("fast").  However, you can only choose two of these three goals:

1. If you want a high quality product on the cheap, the project is going to take a long time.
2. If you want a high quality product completed quickly, the project is going to cost a lot.
3. If you want a product completed quickly on the cheap, the project is going to be low quality.

It is physically impossible to build a project that is high quality, cheap, and completed fast.

This truth is often represented as a triangle, as seen in this picture:



Many PHB's forget that the Project Triangle is a law of nature.  They insist on asking for the impossible.  They ask for a project to get done better, faster, and cheaper all at the same time.  Usually when you ask for the impossible, you get what is known in the business as a CF.

Health care reform has its own version of the Project Triangle.  I like to call it the Health Care Triangle (original, I know!).  Good and Cheap are still at two of the corners; however, the third corner is Universal Coverage:

1. We can have cheap, high quality health care, but not everybody is going to be covered.
2. We can have cheap, universal health care, but it is not going to be high quality.
3. We can have high quality, universal health care, but it is not going to be cheap.

The health care debate should center on which two of the three elements of the Health Care Triangle we as a society want.  Do we want to give everybody high quality health care?  If so, we are going to pay more for it.  Do we want to limit the cost of health care but still cover everybody?  If so, we are going to receive lower quality care. 

Reasonable people certainly can have a difference of opinion about which of the three elements we want to sacrifice.  For some, cost containment should be the goal of health care reform.  For others, universal coverage for all is what health care regorm should strive for.  However, there are many politicians who think that we can have it all.  They think that they can deliver on the promise of cheap, high quality care for all.  Unfortunately, those politicians aren't completely at fault.  We the People share some of the blame.  Many politicians fear (and rightly so) that if they come clean and make health care reform about choosing something to give up that they will get voted out by an angry electorate.  Therefore, they distort the debate by insisting that we can have it all.

If we want real, sustainable health care reform (and goodness knows the system can't continue like it is) then we as a country need to grow up, grow a backbone, and "pick any two".  Otherwise, we are headed for a CF.

Wednesday, February 23, 2011

Why Financial Advisors Are Like Weight Watchers

Recently Free Money Finance had an article that was very anti-financial planner.  Specifically I am referring to this post regarding a financial advisor who, in the opinion of author, is charging too high a fee:

He's an investment advisor, so it was natural for me to ask him about what his firm does. Here's what he said (paraphrasing as I remember it):


"We educate investors about the stock market..."

Like that!

"...and let them know how index funds represent a better way to invest..."

Love that!

"...because they have lower fees..."

Oh yeah...

"...and offer superior returns over the long term."

Yes!!!

He and I were tracking 100% on the same path. I then asked about specifics -- what index funds he used, what the costs were, and how he got paid (I was thinking of potentially having him manage some of my money). It was then when I found out that he was using a proprietary set of funds (not his own but run by another company) and that the fees for both his services and the funds were "around 1%."

Uh-oh.

As you can see, the author believes that charging a 1% fee to invest in index funds is outrageous.  After all, you can go to Vanguard and find index funds which cost only 0.2% or less.  Why would you pay 1% for the same product?

The thing that the author is missing is that, yes you can construct a portfolio of index funds yourself, but some people need help.  They may need help deciding what types of index funds to use.  They may need help with their asset allocation.  However, the biggest service that a financial advisor provides isn't investment selection.  It is to give people the willpower to "stay the course" and stick to the plan.

As we have seen, the biggest mistake that people made during the recent financial crisis is bailing out at the market low which, of course, is the worst time to bail out.  A financial advisor helps people avoid this mistake in two ways:

1. Assessment of Risk Tolerance:  Simply put, a financial advisor will talk to his/her client and determine how much risk a person is willing to take and still be able to sleep at night.  This is an area where most people don't do a good job self-assessing.  When markets are booming, we are willing to take on more risk because things look so good.  Consider how many people sunk tons of money in risky real estate ventures during the mid-2000's because things looked so good.  Consider how many people sunk tons of money in risky dotcom start ups during the late 1990's because thingsd looked so good.  When things fell apart and people bailed, they realized that they couldn't stomach all that risk.  Sometimes you need a dispassionate third party to help assess how much risk you can really stomach.

2. Courage to Stick to the Plan:  This recent article on Yahoo! Finance discusses how Baby Boomers are falling short in their retirement savings.  It gives several examples of people who lost a big chunk of their savings during the recent bust.  One common thread is that people saw their investments dropped, moved most of their savings out of stocks, and then missed out on the bull market of the past two years.  A good financial advisor should have been able to talk them off the ledge and encourage them to stick with their plan.  A good financial advisor would be able to use the perspective of history to inform their clients that markets go in cycles, and that even though things look bleak now, a dip in stocks is also an opportunity to get in on the ground floor of something good.  Historically, big dips are often followed by big gains, and those big gains are what grow your wealth. 

A good financial advisor is like Weight Watchers.  You can lose weight on your own.  The formula is not that difficult:  eat less, exercise more.  However, in practice it seems like applying this supposedly simple formula is not that simple.  Witness all of the people who have trouble with losing weight.  That is where Weight Watchers comes in.  Weight Watchers' system is basically this simple formula dressed up with some bells and whistles.  However, the secret sauce of Weight Watchers is the weigh-in.  On a weekly basis, participants attend a weigh-in meeting where they meet with a coach and other dieters, share tips, and generally get the psychological support and positive reinforcement to keep them on track.

Now some people don't need all of the extra support that Weight Watchers provides.  They are perfectly fine going it alone, and they are successful and keeping the weight off.  However, there are a large number of people who need this additional help to keep them on track and stop them from deviating from their plan.  Likewise some people don't need a financial advisor.  They can formulate their own investment plan and execute it successfully.  However, there are a lot of people who need the extra support that a good financial advisor provides.

Yes, that extra 1% in fees may seem excessive to the "go it alone" person.  However, if it prevents somebody from panic selling and missing out on a 100% gain, then it is 1% well spent.

Saturday, February 19, 2011

Stay the Course

Blogger Mark Miller at Reuters posted about a recent study from the investment firm T. Rowe Price which shows how different responses to the bear markets of past ten years affected the savings of retirees.  The results are quite interesting.

T. Rowe Price starts with a hypothetical person who retired on January 1, 2000 with $500,000 invested 55% in stocks and 45% in bonds (a typical asset allocation for somebody entering retirement).  They assumed that this person would follow a common strategy of withdrawing 4% a year with adjustments for inflation.  This person would withdraw $20,000 in the first year, and then increase his/her withdrawals each year based upon inflation.  As you know, between the beginning of 2000 and now, we endured two serious bear markets:  the dotcom bust of 2001-2 and the Great Recession of 2008-9.  T. Rowe Price ran a simulation of what would happen if this person reacted to the bear markets in different ways:

1. Do nothing.  Continue to invest in 55% stocks and withdraw money using the same strategy.

2. Keep the same asset allocation, but reduce withdrawals by 25% for the three years following each bear market.

3. Keep the same asset allocation, but don't adjust withdrawals for inflation for the three years following each bear market.

4. Switch to a "safer" 100% bond portfolio, and continue to withdraw money using the same strategy.

T. Rowe Price calculated the percentage change that this person would run out of money before the age of 95.  As you can imagine, reducing withdrawals increased the odds of not running out of money.  Strategy 2 had the best chance of success (84%), while Strategy 3 had the second best chance of success (69%).  Doing nothing (Strategy 1) had only a 29% chance of success.

The most interesting thing to me as that Strategy 4, the one where the person got out of the stock market altogether, had a 0% chance of success!  The funny thing is that I would suspect that getting out of the stock market the strategy that most people would actually follow!

The lessons here are:

1. Staying the course with stock market is extremely important, even for retirees.  Why?  Because over the long term, the growth that stock investing provides not only helps to build a nest egg for those saving for retirement, but it helps to prolong that nest egg for those in retirement.  You might think that as a retiree, you can't take on the risk that stock investing entails because your time horizons are so short.  However, with life expectancies what they are, many people can expect to spend 20 years or more in retirement.  Historically, over any 20 year period, the return of the S&P 500 stock index is positive.

2. Spending less is the best strategy for keeping your retirement savings from running out before you do!

Wednesday, February 16, 2011

Happy 100% Day!

Today, the S&P 500 closed at 1336.72.  What makes that so special?  It is more than double of what the S&P 500 was at it lowest point during the height of the financial crisis.  On March 6, 2009, the S&P bottomed out at 666.79.  If you stayed the course and continued to keep your stock investments, you would have doubled your money from the low point.  However, if you decided to bail out of the market at the point (which people did in droves), you would have missed out on a phenomenal gain!

Thursday, February 10, 2011

We Are Our Own Worst Enemy

We have met the enemy, and he is us."
- Walt Kelly

CBS Marketwatch has an article which describes research which indicates that we are our own worst enemies when it comes to saving for retirement.  Research by Olivia Mitchell and Justine Hastings point to two factors why people make poor financial choices:

1. Lack of financial literacy.
2. Short term thinking.

Fortunately, the first factor is easy to rectify.  There are plenty of sources where you can better equip yourself for making smarter money choices.  With the advent of the Internet, one can get a real financial education at the click of a mouse, literally.  For those who have an "old school" disposition, I recommend several of the books listed on this site as good starting points on your educational journey.

The second factor is harder to overcome.  According to the article, it is possible that humans have "present state bias", which means that we have a hard time planning for the future and overcoming our short-term thinking.  Obviously, this is a large generalization.  There are some people who are excellent long-term planners, and some who live day to day without any consideration for what will happen tomorrow.  However, as a generalization, I think it holds true.

The recent economic crisis is a perfect example of lack of long term thinking.  The crisis was caused by institutions looking to maximize this quarter's profits and this year's bonus without much concern for how this thinking might affect them long term.  At its worst point, people bailed out of stocks in droves at the market low thinking that the previous year's returns would continue in perpetuity.  On the flip side, think of all the people who piled into real estate, looking to "flip that house" based on the belief that the housing prices would continue to rise and rise and rise.  At its heart, the crisis was a microcosm of the failure of we humans to plan for the distant future.

The saddest part is that slow and steady truly wins the race when it comes to saving for the future.  It is a fact that the earlier you start saving, the better off you are.  Small amounts saved over a long period will grow larger than a larger amount saved over a short period.  If we can just overcome our short term thinking, we would be much better off.

Saturday, February 5, 2011

Madoff, Social Security, and the Mets

In the wake of the Madoff Ponzi scheme coming to light, many people debated whether or not Social Security was also a Ponzi-like scam.  According to the Securities and Exchange Commission, a Ponzi scheme has the following characteristics:
  1. Payments to existing investors are paid out of the investments of new investors.
  2. New investors are lured by promises of above average returns.
  3. Because the scheme requires a constant inflow of money from new investors to pay existing ones, the scheme falls apart when new investors cannot be attracted.
Social Security certainly satisfies property #1.  Contrary to popular belief, the money that you contribute towards Social Security is not set aside in a separate account just for you.  That money is used to pay existing retirees.  By the time you retire, your Social Security payments will be funded by the contributions of those in the work force at that time.

However, Social Security does not satisfy the other characteristics of a Ponzi scheme.  With very few exceptions all new workers are required to contribute towards Social Security, so there will always be a steady inflow of new funds.

At least that is the theory.

Unfortunately, Social Security faces a Ponzi-like conundrum known as the Baby Boomers.  Over the next couple of decades, a large number of people will be collecting benefits, and there will not be enough workers to sustain these benefits.  Here is what the Social Security Administration says about this demographic problem:

"The number of retired workers is projected to grow rapidly starting in 2008, when the members of the post–World War II baby boom begin to reach early retirement age, and will double in less than 30 years. People are also living longer, and the birth rate is low. As a result, the ratio of workers paying Social Security taxes to people collecting benefits will fall from 3.3 to 1 in 2007 to 2.1 to 1 by 2034. The Trustees Report projects that in 2017, when the ratio will be 2.7, there will not be enough workers to pay scheduled benefits at current tax rates. The Trustees Report also projects that redemption of trust fund assets will be sufficient to allow for full payment of scheduled benefits until 2041."


It appears as if there may not be enough investors to sustain the benefits for the existing investors.  This is where a Ponzi scheme would collapse.  Obviously something must be done to make Social Security sustainable once again.  Unfortunately, most of the solutions that have been put forth put most of the burden on future retirees:  the farther in the future you are going to retire, the more of a financial cost you will pay for reforming Social Security.

AARP has a poll running on its web site asking readers to vote on the single best way to sustain Social Security.  Here are the possible choices:
  1. Raise the retirement age.
  2. Eliminate the salary cap.
  3. Increase the payroll tax.
  4. Reduce benefits for future retirees.
  5. None of the above.
All of these choices are the standard solutions that have been proposed to save Social Security.  However, the younger you are, the more each of these solutions is going to cost you.  If you are 18 and just entering the workforce, either you will spend the next 50 years paying higher taxes (#2 and #3), or you will get fewer benefits (#1 and #4).  I rarely see any proposal which suggests cutting benefits to current retirees or raising taxes more for those who are closer to retirement.  Suggesting these things conjures up images of elderly people being forced to subsist on dog food or worse.  I certainly would never suggest that those senior citizens who need Social Security to survive should lose their benefits.  For those individuals, they should continue to get their full benefits, and we should consider increasing their benefits.  However, for those people for whom Social Security isn't a matter of life and death (i.e. retirees who are living on the golf course playing bridge all day), they certainly can afford to take on a little bit of the burden for saving Social Security.

I think the trustee for the Madoff victims has gotten this issue right.  Sports fans have probably heard that the owners of the New York Mets are being sued by the trustee in order to recover profits which they earned from the Madoff Ponzi scheme.  The trustee alleges that the owners of the Mets actually cashed out their investments, earning millions of dollars in the process.  Meanwhile those newer investors who did not cash out when the scheme fell apart lost everything. 

To me, it makes perfect sense that the owners of the Mets should share in the financial pain.  Why should they keep their profits just because they were lucky enough to be one of the older investors, while the newer investors take 100% of the hit?  The owners of the Mets should be required to return all of their profits back into the recovery pool, and then the trustee would distribute the monies to all of the aggrieved parties equatably. 

Likewise, why should most of the cost of fixing Social Security be paid by the newest workers?  All generations should share in the burden of making Social Security solvent.  It is only fair.

Thursday, February 3, 2011

Four Simple Steps for Choosing the Right College, Part Three

This is the conclusion of my series of articles on choosing the right college.  In Part One, I put forth four simple steps for picking a 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.

Part One contained a detailed exposition on the first two steps.  Part Two discussed in detail step three.  In this episode, I will discuss the fourth step.

Choosing a College

Now that you have a career goal, an idea of what type of education/degree you need, and a budget, you are ready to pick your school.  There are over 4,000 colleges in the United States, so you need to wittle the list down.  How do you do that?

Your choice of candidates is the intersection of the answers to the following questions:

1. Does the college meet my educational needs?
2. Does the college meet my non-educational requirements?

Note that price is not a consideration at this point.  Why?  Most schools publish a sticker price in their literature.  This is the price that you would pay if you don't receive any financial aid or scholarships.  However, many schools offer aid which will lower the actual cost that you will pay.  This means that many private colleges that may appear out of reach pricewise will end up being cheaper than a public college.  Consider that many private colleges have huge endowments which they use to defray the cost for even those families that are making six figures.  On the other hand, many public colleges are facing budget cuts as state governments look to balance their budgets.  The "conventional wisdom" that public schools are the path to an affordable education does not hold true.  Of course, the only way to know what type of financial aid you will get from a college is to apply.  Some colleges have cost estimators, but these may not be accurate as they are based off of broad assumptions.

Getting back to narrowing down your choices, the first thing to look at is whether or not the school offers the degree which you need for your chosen career.  Princeton University is a top school, but if you are interested in a career in nursing, you'll be out of luck there.  Why?  Because Princeton does not offer a nursing degree.  If you are interested in nursing, obviously a school that offers a nursing program is a requirement.  The first step is to identify what the top nursing schools are.  There are many sources for this sort of information.  U.S. News and World Report is famous for its rankings of schools, so that may be a good starting point.  However, a better way to gauge what schools offer the best programs is to talk to people who are in the field.  They can give you a good indication of which schools are considered to be quality schools.

There is a school of thought which says that where you go to school doesn't matter, and that you should just pick the closest or the cheapest school.  However, I disagree.

A quality school offers "name recognition":  If you are looking for a job in engineering and your resume has M.I.T. on it, you are more likely to get the job.  Why?  Because M.I.T. has a reputation as being one of the top engineering schools in the nation, if not the world.  Now some cynics may say that there are plenty of smart people who attend other schools with less name recognition who are just as qualified (if not more qualified).  However, I can tell you as somebody who is in the engineering field, if you have a degree from M.I.T., you are going to the front of the line.  Maybe it is not fair, but it is reality

A quality school offers a quality alumni network:  Again, this is another one which is not fair, but which is reality.  If you are an alumni of a particular school, you are going to be more likely to give a chance to somebody who went to the same school.

A quality school offers a quality education:  This is another one that may be controversial.  There are some who argue that your success depends upon the individual and not the school.  There is some truth to that, but you still need some structure to help direct your education.  Even Tiger Woods, arguably the greatest golfer in history, has a coach.  A quality school improves upon your education in two ways.  First, you have access to better professors, better facilities, and better educational opportunities.  A quality school will offer smaller classes for a more personalized education.  A quality school will offer closer contact to professors.  Rather than being taught by some graduate school, you will be taught by the person who may have literally wrote the book on the subject.  A quality school may have opportunity to access labs and facilities which will enhance your learning. 

The second way in which a quality school offers a better education is that you will be in class with a higher caliber of students.  On the one hand, being with better students means that you will be pushed to work that much harder in order to keep up.  For some that may be a disadvantage, but for many this may be the catalyst for success.  On the other hand, being with better students adds to the learning experience.  Sometimes you learn just as much from discussion groups and study groups with your peers than you do in the classroom.  After graduation, those relationships that you forged with the best of the best are going to enhance your professional network.

Now that you have narrowed down your list based upon education, you will also need to narrow it based upon other non-educational factors.  Do you want to live at home or on campus?  Some schools are commuter schools where students clear out at 5pm on Friday.  If you are planning to live on campus, a school like that may not be to your liking.  Do you want a city location or do you prefer a country environment?  If you like the hustle and bustle of the urban lifestyle, a school in the middle of nowhere is going to be torture.  The point here is that if you are spending four years and $100,000 for your education, you need to consider where you will be happiest.  Four years of misery are not going to be conducive to a good learning environment.

This is where school visits are important.  I am of the opinion that you should not apply to a school blindly.  It makes no sense to consider a school unless you have visited it.  What looks good on paper may not look as good in person.

Some might argue that you should suck it up and go wherever you get the best education.  This is very shortsighted in my opinion.  After all, there are over four thousand colleges in the United States.  With that much variety, it is possible to meet your education goals and be happy at the same time.  Why not have your cake and eat it too?

Now you should have a smaller list of schools to consider.  Now divide your list of schools into two categories.  One category are schools that are within your budget even if you get no financial aid.  The second category are those which would require some sort of grant or scholarship to attend.  Then within these two lists, further divide them into schools at which you are comfortable that you would be accepted, and schools which are a "stretch".  Now you should have four categories:

1. Financially safe, educationally safe.
2. Financially safe, educationally stretch.
3. Financially stretch, educationally safe.
4. Financially stretch, educationally stretch.

You should have at least one school in category 1 as this will be a school that you will be able to attend under any circumstance.  You should also have at least one school in categories 2 and 4, as you want to try and push yourself.

Now that you have your list, go ahead and apply.  Don't forget to apply for financial aid as this will be used by the school to determine what your actual cost will be.  There is no excuse not to apply for financial aid.  Many private schools will give aid to families making $100,000 or more.  If you don't apply, you are guaranteed to get zero, but if you do apply, you may get something.

Once you get your acceptances and your aid offers, you are in a position to choose.  The last step is to choose a school that is within your budget.  If you ignore your budget, you are setting yourself up for financial hardship.

Many careers require some sort of education beyond an undergraduate degree.  Make sure you take this into consideration when you are choosing your undergraduate college.  If you are going to scrimp, it is better to scrimp on the undergraduate side.  Your graduate degree is going to be the important one to your career.  You may also want to condense your undergraduate years by trying to graduate in three years, or by entering a program which combines a undergraduate and graduate degree.  Obviously, these paths require an extra measure of dedication, but for the smart student, they are a great way to save.

In closing, choosing a college is not something to be taken lightly.  A wrong choice can set up back financially for a long time.  However, if you remember my four simple steps, you should be well on your way to a prosperous and successful career!