Wednesday, April 27, 2011

Life Lessons From the NFL Draft

You may have noticed that, from time to time, I post something that is related to sports.  This is because, in addition to being a fan of personal finance, I am a sports fan.  Not only do I enjoy the action and excitement of rooting for my favorite teams, but there is a lot to learn about life from what happens on the field.  It never amazes me how sport imitates life and vice versa.

As any football fan knows, tomorrow night is the first round of the annual NFL Draft.  For those of you who aren't sports fan, the NFL Draft is an event where National Football League teams select new players from among college players who are leaving school.  Teams take turns selecting the players they want, with the worst team from the previous year (Carolina Panthers) getting the first pick and the Super Bowl champion team (Green Bay Packers) getting the last pick.  This continues for seven rounds.  Obviously, having the first pick gives you a huge advantage in that you can select the best college player to join your team.  A bad team can get better in a hurry if they select the right player.  On the other hand, bad teams have been known to squander this opportunity by selecting a player who ends up being a "bust".

Consider the fate of the Oakland Raiders.  In 2006, the Raiders were the worst team in the League with a record of two wins and 14 losses.  Because they were so bad, they were given the opportunity to pick first in the 2007 NFL Draft.  Oakland used their top pick on a quarterback by the name of JaMarcus Russell.  Russell was coming off a great final season as a college player.  He led LSU to a 10 win season and an appearance in the Sugar Bowl, one of college football's premiere postseason games.  In the Sugar Bowl, he led his team to a convincing win over Notre Dame and was the Most Valuable Player of the game.  During the player evaluation process preceding the Draft in 2007, teams fawned over him.  He was big man with good foot speed and an extremely strong arm.  In short, he had all of the physical attributes necessary to be a successful NFL quarterback.  The Raiders picked him with their #1 choice, and most football experts at the time said that the choice was a no-brainer.

However, his career did not go very well.  While he had all of the physical tools, he did not have much success in professional football.  To make a long story short, he ended up being "fired" by the Raiders, and now he is out of football.  By all accounts, his main problem was that he did not have a good work ethic.  When you are in college, you can get by on talent along.  However, in the NFL where everybody is talented, the difference between the best player and the worst player isn't necessarily talent but preparation.

Contrast Russell with a player like Tom Brady.  When Brady came out of college, he was not projected to be a star player in the NFL.  He was drafted in the sixth round of the NFL Draft.  For those who don't follow football, usually players drafted in the sixth round don't last in the league for very long.  Many don't even make the team's roster in the fall.  Brady obviously did not have the physical tools that Russell had when he came out of college.  However, he possessed one thing that Russell did not have:  the desire to work.  The fact that he was not considered to be an elite quarterback only made him want to work harder in order to prove the doubters wrong.  Obviously, Brady has had the last laugh as he has three Super Bowl championships to his name.

The moral of the story is that talent can only get you so far.  In fact, too much talent can be a liability.  In the case of JaMarcus Russell, his immense talent meant that he could coast through his high school and college football careers.  Because he could slide by on talent alone, he never developed the work ethic that is required to take his talent to the next level. 

On the other hand, hard work can overcome lack of talent.  Tom Brady certainly did not possess elite talent when he left college.  However, through hard work, he was able to compensate for this and now he is considered to be one of the best quarterbacks in the game today.

This morality play resonates with me personally.  As a boy, I discovered that I had a "talent" for academics.  Even at a young age, I observed that school lessons came much more easily to me than to most of my peers.  This pattern continued through high school.  While many of my peers had to study for hours to get B's, I could walk into class cold and get A's.  Because of my "talent", I did not develop a very strong work ethic when it came to school.  I could get by doing the minimum amount of work and still get straight A's.

Because of my "talent", I was fortunate enough to be accepted to an elite college.  While I will refrain from naming the college, it is one that would be immediately recognizable as being a top-tier institution.  My first semester in college was a wake-up call for me.  In high school I took advanced placement (AP) classes which had the top students in my town.  In college I was side-by-side with the top students from all around the country.  Needless to say, the academic bar had been raised by several order of magnitudes.  During my first semester, I struggled considerably.  I started off the semester with the same type of work effort that I gave in high school (i.e. not much of an effort).  Instead of being rewarded with A's because of my talent, I was rewarded with grades that were commensurate with my effort.  I remember actually getting an F on one of my early mathematics exams.  Up until then, I had considered math to be one of my strongest subjects, so getting an F on a test was a big slap in the face.

At that point, I was at a crossroads.  It was clear to me that talent alone was not going to cut it in college.  If I wanted to get by, I had to reinvent my work habits.  I had to open up the book rather than just showing up to class.  I had to go to study groups rather blowing them off.  In a nutshell, I had to discover how to work.

Fortunately, I was able to turn myself around.  My first year grades were nothing to write home about, but I was able to get by while I developing my work ethic.  While it wasn't my usual straight A's, they were good enough to make me start to believe that I could do this.  Each year that passed got better and better.  My grades steadily improved with year passing semester and my confidence grew.  I noticed that by combining my talent with my hard work, I was not only able to compete with my fellow students, but I could surpass them.  In my junior year, I won an award for the top third year student in my department.  In my senior year, I was inducted into the engineering honor society.  I concluded by undergraduate career by graduating with honors.  I could not have achieved these honors without the lessons I learned in my first year:  that talent can only carry you so far in life.  At a certain point, hard work trumps talent.

Whenever I am asked about an experience that changed my life, I always point to my first year of college.  Too bad JaMarcus Russell could not learn this lesson.  Otherwise, he might have become the elite quarterback rather than promise unfulfilled.

Saturday, April 23, 2011

Taking Stock of Stocks: Valuation, the Academic Way

In the first post in my series on stocks, I introduced the concept of a stock:  what it is, why a company would issue it, and why an investor would by it.  At the end of that article, I promised to talk about different ways to figure out what a stock's price should be.  Originally, I was going to put it all into one single post.  However, the concept of stock valuation is so important that I decided to split the discussion among multiple posts.  In this article, I will talk about how your friendly neighborhood economics professor might determine the value of a stock.  In other words, let's go back to school and talk about a stock's theoretical value.

[Note that the ideas contained in this article are based upon my old Finance textbook:  Principles of Finance by Robert W. Kolb.]

Dividend Valuation Model:
As with all investments, its value is based upon the cash that the investment generates, taking into account the time value of money.  For instance, if I ask you to buy a bond which will return you $105 a year from now and you want to earn 5% on your money, then you would pay me $100 for that bond.  One can apply the same principle to determining the price of a stock.  What are the cash flows that a stock generates? 


A dividend is the money that a company returns to its owners.  When you buy a stock, you do so because you hope that the company whose shares you are buying is going to make a profit, and as an owner, you are entitled to a share of those profits.  When a company makes a profit, it may choose to do two things with it.  It may hold on to those profits to help pay for acquisitions, expansion, or it might put them away for a "rainy day".  On the other hand, it may choose to return those profits to its owners in the form of a dividend.  If the Board of Directors decides to give back $1 million in profits to the owners, and there are one million shares of stock outstanding, each owner would get $1 for each share of stock he or she owns.

It stands to reason that the amount you would pay for a stock is based upon how much money that stock is going to generate for you.  This is the essence of what is known as the dividend valuation model.  The dividend valuation model tells you how much a stock is worth based upon the dividends that you expect to get from the stock. 

As with all investments, you hope to earn some interest on the money you invest.  Otherwise, you might as well stick your money in the bank instead.  Therefore, you expect some rate of return when you buy a stock.  Let's call that rate of return i.  A little later, we'll discuss how to determine the value of i.  Let's take a simple case of a company which plans to return a dividend of D one year from now, and then go out of business.  That means that you would pay the following for that stock:

Price = D / (1 + i)

If D is $105 and you want to earn 5% on your money, then you would pay $100 for that stock.

Of course, this is a somewhat unrealistic example.  Most companies (hope to) stay in business forever, and keep paying dividends forever.  Now what you pay for a company that pays a dividend D1 in year 1, D2 in year 2, D3 in year 3, and so forth?

Price = D1 / (1 + i) + D2 / (1 + i)^2 + D3 / (1 + i)^3 + ... + Dn / (1 + i)^n + ...


Price = Sum t = 1 to infinity (Dt / (1 + i)^t

Basically, we are summing up the value of all of the dividends discounted based upon what we would pay for that dividend today. 

Note that the denominator gets raised to the nth power in each period.  That is because we are assuming that i is an annual rate of return.  If you get a dividend in year 2, you would want to earn 5% each year, compounded yearly, or (1.05^2) - 1 or 10.25%.  Let's say that you are getting $100 in year 2.  You would pay 100 / 1.1025 or $90.70 for that dividend assuming you want to earn an annual rate of return of 5%.  Stated another way, you pay $90.70 now and you get $90.70 times 1.05 times 1.05 or $100 in year two.

Hidden Assumptions:

While this formula sounds very exacting, in practice it is very difficult to apply.  Why is that?  Because there are two big leaps of faith that you have to make.  First, this formula assumes that you know what a company's dividends are going to be now and in the future.  Of course, this is a near impossibility.  You cannot predict what a company's profits are going to look like years in the future.  If a company hits a rough patch, it may reduce or even suspend its dividends unexpectedly.  On the other hand, a company might do better than expected and pay a larger dividend than planned.  Therefore, any values of D that you would plug into this formula is speculation.

The second assumption you need to make is the value that you choose for i.  The rate of return you choose usually reflects the riskiness of the venture.  If you've read my first article on stocks, you know that stocks are riskier than bonds, because if the company loses money and goes bankrupt, you get nothing.  Therefore, as a rational investor, you would want to compensate yourself for that risk by demanding a higher rate of return.  For example, if you can earn 5% by buying a safe investment like a bank CD or a Government Bond, you would demand something higher than 5% when you buy a stock.  The riskier the stock, the high rate of return you would like to get in return. 

For a share of a company that is stable, profitable, and is likely to stay in business for awhile, you might demand a 7% return.  It is higher than the risk-free rate of return, but not that much higher.  On the other hand, for a startup company that doesn't have a track record of making money, you might demand 10%, 15%, or even more.  You do this because there is a strong possibility that you might lose your entire investment.  Therefore, if the investment does pan out, you want to be rewarded handsomely.

What About Non-Dividend Paying Stocks?:

Many stocks, particularly young companies that are still expanding, don't pay any dividend.  Based upon the dividend valuation model, the price of the stock should be zero because you are not getting any cash from your investment.  However, we all know that non-dividend paying stocks still have a positive value on the stock market.  How can that be?  That's because investors hope, at some point in the future, that company will be stable and mature enough to be able to return money to its investors.  For years Microsoft didn't pay any dividend and its stock kept going up and up and up.  However, it finally reached a point where it no longer needed that cash to fund its growth, and it started return profits to its shareholders.

What About the Money I Get From Selling My Stock?:

The other thing astute readers will note is that the formula doesn't include the sale of the stock.  For most investors, the biggest return on investment is when the they sell the stock.  However, the sale price is not reflected in the formula anywhere.  There is a reason for that.  The price that a future investor will pay for the stock is based upon the company's future dividends.

Let's say that you plan on selling the stock in year 2 after you get the year 2 dividend.  Here is what your cash flows will look like:

Price =  D1 / (1 + i) + D2 / (1 + i)^2 + Selling Price / (1 + i)^2

Note that the Sale Price is discounted by the rate of return, because you want to earn your rate of return on the cash flow you get from the sale of the stock.  Now what should the Selling Price of the stock be?  It should be the value of the future dividends from year 3 on:

Selling Price in Year 2 = D3 / (1 + i) + ... + Dn / (1 + i)^(n-2) + ...

If we substitute this value of the Selling Price in Year 2 into the previous formula we get:

Price = D1 / (1 + i) + D2 / (1 + i)^2 + D3 / (1 + i)^3 + ... + Dn / (1 + i)^n + ...

This is exactly the same formula we stated earlier.  In conclusion, you don't need to include the selling price cash flow in the equation, because your selling price is based upon the future dividends from that point on.

Is This Valuation Method Really Useful In Practice?:

Yes and no.

Let's look at the "no" side first.  On first blush the formula gives you the sense that the price of any stock can be calculated with precision.  This couldn't be further from the truth.  Nobody can know the exact composition of future dividends.  They may grow.  They may stay stable.  They may fall.  They may disappear altogether.  We may have some sense of what dividends are going to look like.  However, if we think we can predict them with certainty, we are setting ourselves up for some serious disappointment.

Therefore, what can we glean from this formula?  There are a couple of useful observations we can make.  First is that a stock investment should be treated like any other.  The price we pay for this investment should be based upon the amount of cash we expect the investment to generate.  Stocks are no different.  Investors are often blinded by hype when it comes to investing that they pour money into stocks which have no chance of making any money (ex:  dotcom bubble).  However, if these investors remembered that a stock is only worth what type of cash flow it will generate, there wouldn't be any bubbles.

Second is that a stock's price is dependent upon its dividends and the desired rate of return investments want.  Since dividends are in the numerator, we can say that the higher the dividend, the more we should pay for the stock.  This makes sense, since dividends represent profits.  The more profits a company makes, the more valuable it is to its owners.  On the other hand, since the rate of return is in the denominator, we can say that the higher the rate of return, the lower the price of the stock.  Again, this makes sense.  If a stock is risky, we would demand to earn more of a return on our investment.  In order to do this, we would pay a lower price for that stock.  Note how the stock price of small, risky companies often is quite low, hence the term "penny stocks".

In the next installment of this series, I will talk about the fundamental analyst's model, popularized by the late Benjamin Graham.

Monday, April 18, 2011

Happy Tax Day!!!

It's finally here:  Tax Day.  Thanks to an obscure District of Columbia holiday, U.S. taxpayers got an extra three days to file their taxes.  That means that here on the East Coast, you still have a little more than two hours left to get your return postmarked or electronically filed.  Apparently, many businesses are using Tax Day as an opportunity to offer deals and discounts on their products.  Here are a couple of deals to get your started.

Offering Tax Day deals is a great way to generate free publicity, as evidenced by the fact that I just included a link to some on my little blog.  A drop in the bucket, but I suppose if you multiply it by thousands of little blogs, you are talking some real numbers!

Saturday, April 16, 2011

Are Tax Rates Really Too High?

This Monday is the deadline to file your taxes.  As such, this is the time of year for people to complain about how taxes are too high, about how we shouldn't even think about raising taxes, and so forth.  However, if you look at the facts, our tax rates are quite low by historical standards.  Posted on the IRS website is a table of historical tax rates for the past 100 years (if you don't have Microsoft Excel, you can view the same information here).

As you can see, the highest tax rate in 2010 is 35%.  However, prior to the Reagan tax reforms, the highest rate often was above 50%.  In fact, there was a period of time when the highest rate was as high as 91%.  Obviously, this isn't a true measure of how much a person paid in taxes, because there were all sorts of tax shelters and other "tricks" that people used to keep their tax bill down.  Still, it is amazing to think that people are complaining about raising the highest tax rate from 35% when there was a long stretch of time when it was much, much higher.  With a 50% top tax rate, the sky didn't fall.  Somehow the United States still managed to maintain its superpower status.  I think we could handle an expiration to the Bush tax cuts as this would raise the top tax bracket to "only" 39.6%.

Friday, April 15, 2011

Four Lessons From the World's Oldest Man

Today, Walter Breuning, the world's oldest man, died at age 114.  I read this synopsis of his life, and I found it to be quite interesting.  It is amazing to think about all of the things that Mr. Breuning has experienced in his life, all of the changes in society that he has witnessed, and all of the wisdom that he has accumulated through his experiences.  Here are a couple of things that stuck out for me:

1. Work and retirement:  Mr. Breuning retired from his first career at age 67, but he continued to work in some capacity until age 99.  "One of the worst things a person can do is retire young," according to Mr. Breuning.  Work keeps your mind active and gives you a purpose.  He doesn't mention it, but it also helps to make your retirement savings last

2. Embracing change:  "Every change is good."  There is a false stereotype of a senior citizen who pines for the good old days (i.e. back in my day).  However, Mr. Breuning's philosophy is to embrace change and see its positives.  Although computers and technologies made many of the jobs his generation did obsolete, he views technology as an improvement which makes life "so much easier".  Fighting change is a fruitless battle, so it is better to accept it since it is going to happen whether you like it or not.  Accepting the inevitable is better for your mental health in the long run.

3. Appreciating what you have:  Mr. Breuning talks about how different life was when he was a boy.  A hot bath required fetching water, heating in on coal-burning stove.  Travelling meant getting on a horse, a train, or on your own two feet.  In contrast, today we can turn on a faucet and get instant hot water, and we can hop on a plane and get anywhere in the world within a single day.  Those of us who grew up with hot water heaters and air travel take them for granted.  When the hot water heater breaks or the flight is delayed, it feels like the end of the world.  We forget that for most of civilization, people lived without those luxuries.

4. The power of community:  Speaking of his friends at the retirement community where he lived, Mr. Breuning says, "Yeah, we're all one big family, I tell you that. We all talk to each other all the time. That's what keeps life going. You talk."  You can have all the money in the world, but what truly keeps us connected are the people around us:  friends, family, neighbors, co-workers.  They are our support system.  They are what help to bring sanity to our lives.

Walter Breuning lived a typical American life:  work, marriage, friends.  He wasn't exceptional in terms of his fame or his monetary wealth.  However, he is an example of the wisdom that exists all around us in everyday people.  Sometimes we all need to be reminded of this everyday wisdom from somebody who has truly seen it all.

Rest in Peace, Mr. Breuning.  After 114 years, you deserve it!

Tuesday, April 12, 2011

Four Modest Proposals For Cutting the Deficit

This Wednesday, President Obama plans to turn his attention towards cutting the Federal budget deficit.  While details are sparse, expect the usual partisan sniping about how we cannot raise taxes or how we cannot cut the "Big Three" (i.e. Society Security, Medicare/caid, defense).  Cutting the deficit is simple, in theory:  you either increase revenues or decrease spending.  Unfortunately, if you take tax increases and cuts to the Big Three off the table, there is a limit to what you can do.  Yes, you can cut so-called discretionary spending, but this is a tiny piece of a big budget pie.  The 2011 deficit is projected to be around $1.4 trillion, so the $38 billion that was cut from the budget in the latest deal doesn't close the gap very much.  If you really want to cut the deficit with the current political constraints, you will need to get creative.

That is where I come in.

The key component of the Money By The Numbers plan is to increase non-taxation revenue.  What is that, you ask?  That is money that the Government earns from sources other than taxes.  The Federal Government owns a lot of assets which are significantly under-utilized.  By thinking like a business, the Government can put its assets to better use, and get a better return on investment.

1. Naming Rights:

Sports franchises started doing this to great effect.  By allowing companies to buy the right to affix its name to stadiums, teams have created millions in extra revenue.  The woeful Mets were able to extract $400 million from Citigroup for the naming rights to their new stadium, and this deal was done at the height of the financial crisis.  It is insulting that taxpayers pay for these stadiums but don't get any of the revenue.  The Government ought to get into the act and name its own assets. 

Imagine what the Federal Government could get for the naming rights for national parks (the Home Depot Grand Canyon), aircraft carriers (the U.S.S. Coca-Cola), or even the White House (the White House presented by Glidden Paints)?  With all of these prime assets, the Government easily could raise billions of dollars.

2. Advertising:

Mount Rushmore, El Capitan, the Washington Monument.  What do these places have in common?  They attract millions of people each year.  Assuming each person has two eyes, that's a lot of eyeballs.  Imagine how much a company would pay to stick its logo on one of these iconic symbols?  We're talking Super Bowl type of exposure here!

3. Product Placement:

When the President signs a bill into law, he usually uses some non-descript pen.  When a Congressperson delivers a speech, she usually has a plain glass of water at her side.  When the defense department releases footage of a tank speeding through the desert, the tank has some generic markings.  I'm sure Bic pens, Poland Spring, and Lockheed Martin would pay handsomely to put their logos front and center so the American people can see them.

4. Sponsorships:

Budweiser:  the official adult beverage provider to the Inaugural Ball.

This is just a sample of the type of revenue-generating ideas that we need to consider if we aren't going to raise taxes or cut spending.  Sure, they may seem crass to some, but isn't crass more palatable than higher taxes?

Friday, April 8, 2011

One Big Reason Not To Telecommute

Personally, I don't telecommute, but I know a bunch of people who do.  They are always bragging about how they can take conference calls in their pajamas, file status reports while sitting outside on their deck, and design websites from the local Starbucks (free Wifi baby!!!!!!!).  My "day job" employer has not embraced telecommuting all that readily, much to the chagrin of most of the rank and file.  I used to be one of those people who brooded at the fact that my employer did not have a telecommuting policy.  However, the more that I thought about it, the more I thought that it was actually a good thing not to telecommute.  Here is my thought process...

One of the biggest criteria for deciding if a job is suitable for telecommuting is whether or not the job is not dependent upon being at a particular physical location.  Obviously a janitor is not a good candidate for telecommuting because he or she needs to be on-site to perform their duties (i.e. cleaning).  On the other hand, a computer programmer is an ideal candidate because programming does not depend upon being in a particular physical location.

Another trend in business is for companies to outsource jobs to far off lands - India being one of the big destinations for outsourced jobs.  Consider what makes a job suitable for outsourcing.  Probably the biggest criteria for deciding if a job is suitable for outsourcing is whether or not the job is depedent upon being at a particular physical location.  Astute readers will note that this is precisely the same criteria that makes a job suitable for telecommuting!!!

The question then is why would you want to advertise to the powers that be that your job does not depend upon you being in the office?  It seems to be that having a telecommuting position is like sticking a big sticker on your back that says "outsource me".

Of course, there are many other criteria whether a job is outsource-able, not just a lack of dependence on physical location.  However, it certainly is one of the main ones.  Why attract unwanted attention on yourself by working offsite?  After all, if somebody can do your job in their pajamas while sitting on the deck, that means that it is possible that somebody can your job sitting in an office park in Bangalore.

Thursday, April 7, 2011

Taking Stock of Stocks: Introduction

First, MBTN took on bonds.  Next, we conquered insurance.  Now, we plan to tackle a financial weapon which should be in everybody's arsenal:  stocks!  Stocks often are praised when they are going up in value, and maligned when they go down.  People who buy them can get filthy rich or dirt poor.  But what is a stock anyway?

Stock Fundamentals

A stock is an ownership share in a business - nothing more and nothing less.  When you own a share of stock, you are a part owner in whatever business that share represents.  When you own a share of Apple, you are a part owner of Apple.  When you own a share of Exxon, you are a part owner of Exxon.  Don't get too excited, though.  According to over 921,000,000 shares of Apple, so when you own one share, you own less than 0.0000001% of Apple!  That isn't a large ownership percentage, but I guess it is better than 0%.

When you own a business, you get two benefits:

1. You get to make all of the decisions.
2. You get to keep all of the profits.

When you own a share of stock, you get the same benefits.  However, you have to share those benefits with the thousands and thousands of other people who own that stock.  Obviously the more shares of stock you own, the more control you have over decisions, and the more profits you get to keep.

How do thousands of people share in the decision making?  Think of how hard it is for three friends to agree on where to go out to eat.  Imagine how difficult it is for thousands of people to make a decision about how to run a business!  Fortunately, there is a solution.  Every year, the shareholder vote for a people to represent their interests when it comes to running the company.  This group is known collectively as the Board of Directors.  The Board oversees the operations of the company and make sure that the owners' interests are taken into account.  Usually the Board won't handle the day-to-day operations of the company.  They will hire somebody to handle the management tasks, who is usually known as the Chief Executive Officer.

As far the profits go, the company splits some of the profits among all of the shareholders in the form of a dividend.  The size of the dividend depends upon how well the company is doing as well as the number of outstanding shares.  Normally, a company won't return all of the profits in the form of a dividend.  Most companies retain some of the profits so that they can use them for future expansion, acquisitions, or just for a "rainy day".  Some fast growing companies may not pay any dividends.  These companies retain all of the profits so that they can be used to continue to expand the company's business.  The Board of Directors are the ones who decide how much is retained and how much is returned to the shareholders.

Why Does a Company Issue Stock?

Consider a person who starts a business.  When they start their business, they might invest some of their own money to get the business off the ground.  However, the company may reach a point where it needs to raise more money in order to expand.  Perhaps a company needs to purchase a factory to manufacture its product.  Perhaps a company needs to hire more staff in order to increase their sales.  These things require a large investment of money which the founder may not have.  They need some mechanism the raise this money. 

Generally, there are two ways for a company to raise money:  get a loan or bring in partner.  For some companies, getting a loan may not be an option maybe because the interest rate is too high or nobody will lead you the money.  The other downside of a loan is that you have to pay it back at some future point in time.  Instead, a company may look to sell an ownership stake by selling stock.  The company gets some amount of money in return for giving up some ownership to an investor.  This means that the company now has to give up some of its profits and control to the new investor.  However, since this isn't a loan, the investment doesn't have to be paid back if the company goes under, since the investor now shares in the risk and the reward (more on that later).

Buying and Selling Stocks

Just like any business owner, you can decide to sell your ownership stake in a company by selling your stock.  Of course, there needs to be somebody ready, willing, and able to buy it.  Fortunately, a mechanism for buying and selling ownership shares of companies exists.  It is called the stock market.  A stock market is a place where buyers and sellers come together to buy and sell stocks.  The exact mechanisms of how the stock market works is beyond the scope of this article.  In a nutshell, the stock market publishes the price at which buyers are willing the pay for a share of stock, and for which sellers are willing to sell a share of stock.  The important thing is that, for most companies, it is quite easier to buy or sell shares of stock.  The buying and selling price fluctuates from day to day.  The price is based upon a variety of factors, including how people feel the company is doing and how people feel the overall economy is doing.

The Riskiness of Stocks

If you are an owner of a business, if the business takes off, you as the owner benefits from this financially.  The sky is the limit, as they say.  However, there is also a great deal of risk involved as well.  If for whatever reason your business tanks, there is a potential for you to lose all of the money which you invested.  This is he same for owners of stocks. 

When a company goes out of business, usually it will still have some assets:  property, inventory, patents, or other things of value.  However, first you have to use those assets to pay off all of the people to which you owe money.  If after you settle your debts there is something left over, then all of the shareholders split whatever crumbs remain.  In many cases, the value of the assets aren't enough to pay off a company's debts.  In that case, the company declares bankruptcy, a judge splits the assets among the creditors, and the shareholders get nothing!

The fact that creditors get first dibs on a company's assets is why bonds generally are less risky than stocks.  Remember that bonds are loans, so when you buy a bond, you are lending a company money.  When a company goes out of business, a bondholder gets their money before a stockholder, so a bondholder won't lose everything.  On the flip side, if the company does well, a bondholder is only entitled to get the bond's face value and coupon payments.  Therefore, there is less upside potential when you buy a company's bonds.


The main thing to remember is that when you own a stock, you own a piece of a company - a small piece but a piece nonetheless.  As a part owner, you have all of the rights and privileges that comes with being an owner:  a share of control and a share of the profits.

Next time, I will talk more about how a stock is "valued" by the market.  Stay tuned!

Monday, April 4, 2011

Money By The Numbers Is On Twitter

I know Twitter is so last decade, but Money By The Numbers is now on Twitter!  Follow along at @mbtn_blog (I think saying at @ is redundant but who cares!).  See you in the Twitter-sphere, Twitter-nest, or whatever you call it!

An Interesting But Flawed Tax Strategy

The Wall Street Journal has an article describing a scenario by which a person making $150,000 can pay no taxes legally and legitimately.  With the help of Gil Charney, principal tax researcher with H&R Block's Tax Institute, the WSJ's Brett Arends outlines one possible strategy for owing no taxes.  Not surprisingly, their strategy involves exploiting various tax deductions that are available to the self-employed.  However, is their scenario really feasible?  Let's take a look.

Before I pick apart their work, I first want to review exactly what a tax deduction and a tax credit are.  A tax deduction is money which is excluded from your taxable income.  If your income is, say, $50,000, and you have a tax deduction of $5,000, that means that $15,000 is deducted from your income for tax purposes.  Stated more simply, you only have to by taxes on $45,000.

A tax credit is money that is deducted right from your tax bill.  Let's say that in the above example, you owed $7,500 on the $45,000 of income you earned.  If you had a tax credit of $5,000, then instead of owing $7,500, you would only owe $2,500.  As you can see, a tax credit is more valuable than a tax deduction because your entire tax bill is reduced by the amount of the credit.

The Government doesn't give out a lot of tax deductions and tax credits for free.  Usually, you have to spend your money in a certain way.  The deduction or credit is an incentive which politicians give taxpayers in order to act in a way which they perceive as being beneficial to society (or to their chances of re-election).  For instance, in order to encourage people to buy homes, the Government allows homeowners to deduct the interest on their mortgage loans from their income.  The amount you pay in interest is deducted from your income from tax purposes.  However, you still have to write that check to the mortgage company, so you aren't getting the deduction for free.

Now that we have reviewed tax deductions and credits, let's get back to the article.  Mr. Charney of the Tax Institutes describes a scenario by which you can eliminate your tax bill.  However, doing so requires that you spend your money in a certain way.  Let's see how much money you have left over for everything else.  First, let's start with the deductions:

Item #DescriptionAmount DeductedAmount You Have To Spend To Get the Deduction
1Business Startup Costs$7,000.00 $7,000.00
2Business Expenses$10,000.00 $10,000.00
3Social Security, Medicare$9,500.00 $19,000.00
4Solo 401k$43,100.00 $43,100.00
5IRA (Self and Spouse)$10,000.00 $10,000.00
6State and Local Taxes$10,000.00 $10,000.00
7Mortgage Interest$10,000.00 $12,500.00
8Health Insurance Premiums$10,000.00 $10,000.00
9Health Savings Account$6,150.00 $6,150.00
10Student Loan Interest$2,500.00 $7,500.00
11College Tuition$4,000.00 $4,000.00
12Personal Exemptions$10,950.00 $-
TOTAL$133,200.00 $139,250.00

According to my calculations, in order to get $133,200 of deductions, you will need to spend $139,250.  Some explanation of my assumptions are in order:

Item #3:  Social Security, Medicare.  When you are self-employed, you still have to contribute towards Social Security and Medicare, just like you would have to do if you were an employee.  However, you only get to deduct half of your payments.  In other words, $19,000 in payments only earns you a $9,500 deduction.

Item #7:  Mortgage Interest.  I am assuming that only 80% of your mortgage payment is interest.  The other 20% is principal.  Unfortunately, principal isn't deductible but you still have to pay it if you have a conventional mortgage.  Nowadays, there are very few banks that will give you a interest-only mortgage.

Item #10:  Student Loan Interest.  Just like with a mortgage, only a fraction of your student loan payments will consist of interest.  Because a student loan usually is shorter than a mortgage, I am assuming that only 25% of your payment is going to be interest.

Item #11:  College Tuition.  For this item, I gave Mr. Charney the benefit of the doubt and assumed that your child's total tuition is only $4,000.  Therefore, you only have to spend $4,000 to get a $4,000 deduction.  However, in practice, you'll probably have to spend a lot more than $4,000 a year on tuition.

Based upon my calculations, these deductions will reduce your taxable income to a hair under $17,000.  However, if you pursue this strategy, you will have only $10,750 left over for other spending.

Of course, we aren't quite done yet.  The article states that with a taxable income of $16,800, you will owe Uncle Sam about $1,700 in taxes.  Now you could just pay the bill and then you'd be left with a mere $9,050 for the rest of your expenses.  However, the article attempts to reduce your tax bill to $0 through a couple of tax credits:  the home energy efficiency tax credit and the adult-education tax credit.

The home energy tax credit allows you to get a credit for 30% of qualified energy-saving costs up to $1,500.  In order to get the full tax credit of $1,500, you will have to spend $5,000.  That leaves you with $5,750 for other spending.

Next is the adult-education tax credit.  This allows you to get a credit for 20% of qualified educational expenses up to $2,000.  If you spend $1,000 on this training, you will get a credit of $200 which brings your tax bill to $0 as promised.  However, now you have only $3,750 left for other spending.

The article concludes with caveat that this is just an illustration ("Few will be quite so fortunate.")  However, based on the numbers, this strategy is doomed to fail.  Yes, your health care, mortgage, education, and retirement are all full paid for.  However, with only $312.50 a month for food, transportation, clothes, home repair expenses and the like, you will be in big trouble.

All that being said, this article is still very thought provoking.  There are two lessons to be taken.  First is that the Government provides all sorts of incentives to direct our spending in a variety of different ways, with a variety of different side effects.  Certainly, there are opportunities to game the system in order to reduce your tax burden.  The second lesson is that it really isn't worth it to reduce your taxes by a dollar if you have to spend more than a dollar to get that reduction.  Sometimes it is cheaper in the long run to pay the piper!

Friday, April 1, 2011

Should You Count Your Home As a Retirement Asset?

Recently, I received in the mail a letter from Consumer Reports touting their Money Advisor newsletter.  This is their "mini-magazine" that is dedicated solely to articles and advice on money matters written in Consumer Reports' trademark no-nonsense style.  On the envelope were a number of "key questions to ask yourself now":

1. True or False:  If you retire with $400,000 in savings, you can safely withdraw up to $24,000 a year and avoid running out of money.

2. True of False:  You should never count your house as a retirement asset.

3. True or False:  38% of Americans who run out of money cite health care costs as the #1 cause.

The envelope proclaims that the answers are inside (cheap tactic of theirs to get you to read the contents).  However, you only have to keep reading to get the answers for yourself (cheaper tactic of mine to get you to keep reading this article)...