Monday, June 27, 2011

Is College Worth the Money, Redux

I've already discussed at length my thoughts on whether or not college is worth the money.  I've even given some tips for choosing a college without going deeply into debt.  Today on Yahoo! Finance, there were a couple of articles on this subject with opposite views.  The first was this one containing the testimonies of four people who say that college was not worth the debt.  Four people describe, in their own words, why they feel that college was not worth the price.  Their stories are quite instructive, to say the least.

One of the testimonials stood out for me because the person obtained a degree in engineering.  We have all heard stories of people who accumulated massive amounts of college debt only to end up in minimum wage jobs.  However, a degree in engineering generally is viewed to be one of the bright spots when it comes to job prospects.  The demand for quality engineers is always high, and it is a career which not everybody can aspire due to the rigorous course of study.  However, the individual in the story ended up with $185,000 in debt after earning an engineer degree and, as he says, he is earning $15,000 less than he expected.  He hoped that he would be earning $70,000 - $80,000, so I assume that he is earning only $55,000 a year.  Of course, if he had done some research, he would have known that the average starting salary for an industrial engineer is around $58,000.  That means that is salary is right around the average.  Also, if he would have followed my formula for determining how much college debt you can afford, he would have known that he probably could have only afforded to take out a loan of around $25,000.  It goes to show that even if you are doing the right thing and obtaining a degree in a lucrative field such as engineering, you still need to do it in a financially prudent way.

The second article on Yahoo! Finance, which was a good counterpoint to the testimonials, was this one about how investing in a college degree, generally speaking, has a better return on investment than most other traditional investments.  The article cites well known research which shows that college graduates generally make more than those without a degree, and they are less likely to be unemployed.  On first blush, it seems like these two articles are at odds.  How can you say that, on the one hand, college is worth the investment, but on the other hand, hear stories about how people's lives were ruined by college debt?

Of course, neither article is wrong.  On aggregate, a college degree is a good investment.  However, as with all investments, many people still find a way to screw it up.  Think about stock investing.  Generally speaking, if you invest in stocks, you are going to make a return that exceeds inflation.  That doesn't mean, though, that these returns are automatic.  People routinely lose all of their money even in the most bullish of bull markets.  They put all of their money in loser stocks because they heard some talking head pump it up on TV.  They panic sell when the market hits bottom and re-buy only when the market has reached its high.  The same thing with college "investing".  People take on more debt than they can afford relative to their future career.  People make poor choices about what they study.  People think they need a degree when their future career doesn't require one.  In short, just because it is a good deal in aggregate doesn't mean that getting a degree is an automatic meal ticket.  You still need to use your head; otherwise, you'll end up in a future Yahoo! Finance story!

Sunday, June 26, 2011

The Freedom-Happiness Curve

As you know, the silly season (a.k.a the U.S. Presidential election season) has begun in earnest.  A few weeks ago, the first major debate of the season was held in New Hampshire.  As expected, the candidates were asked a variety of questions:  where they stood on health care reform, what they would do to boost the economy, would they have intervened in Libya, and so forth.  While these are important questions, they focus on how the candidates would handle specific issues, rather than what their overall philosophy is.  If I had the opportunity to ask each candidate one question, I would ask them, "how would you draw the Freedom-Happiness Curve?"

The Freedom-Happiness Curve is a device of my own invention, so it probably requires some explanation.  It is a graph which shows the aggregate happiness of a society versus the amount of freedom its citizens have.  Here is what a typical interpretation of the curve might look like:


The left side of the curve makes perfect sense.  In a society with little or no freedoms (think North Korea as an example), most people are going to be very unhappy.  In a "not-free" society, people are told what to do, what to think, who to worship, by the government.  Without the freedom to determine their own destiny, the population as a whole is generally not very happy with their situation.  They will even risk life and limb to escape to a more-free society.

As more freedoms are added, people generally become more happy.  They are allowed to make more choices for themselves and set their own course in their lives.  Thus, the curve rises as society becomes more free.

The right side of the curve might be counter-intuitive at first.  It shows that society's happiness actually declines after a certain point as people become gain freedoms.  Most people think of freedom as being a "more is better" type of proposition.  However, in practice, it is not.  Consider the extreme where people are allowed to do whatever they want whenever they want without any restrictions from the government whatsoever.  There is a word for this:  anarchy.  Anarchy is true and complete freedom, but most people are not happy under anarchy.  Without the rule of law, the person with the most guns and the most money might be happy.  However, everybody else is left to fend for themselves.  A modern example of an anarchy state is the failed state of Somalia.  Nobody would argue that Somalia is a happy place by any stretch of the imagination.  That is why the curve declines after a certain point.

An important goal of any good government should be to provide enough freedoms and yet enough restrictions to maximize a society's happiness.  Naturally, politicians disagree at what level of freedom would maximize happiness.  Politicians on the libertarian end of the spectrum ("that government is best which governs least") might argue that government should provide the bare minimum of services to maintain order and commerce and not seek to restrict freedoms any more that is necessary.  Therefore, they might draw the curve along these lines:


Note how, under this philosophy, the belief is that society's happiness is maximizes at a point where people have quite a lot of freedoms.  The curve still descends when there is too much freedom because even staunch libertarians believe that some amount of government control is necessary for basics like law & order, defense, roads, and the like.

On the other side of the spectrum are those who might view government's role as being more paternalistic, where government needs to step in to provide more than just the basics for people:  a baseline retirement, some form of health care for those in need, and even employment if necessary.  Franklin Roosevelt, with his New Deal during the 1930's, believed that the Government needed to take a role in sustaining the happiness of society even if it meant less freedoms (mandatory Social Security withholding, taxes to pay for job creations, increased regulatory scrutiny of companies, etc). 

Another example is the heightened security which we face as part of the War on Terror.  At the airports, we are restricted in what we can carry past the security checkpoints.  Being forced to buy water at exorbitant prices in the concourse might be necessary to prevent somebody from smuggling flammable liquid on board a plane; however, it is a restriction on our freedom.  Nevertheless, because the thought of exploding at 30,000 feet is not a very pleasant thing to ponder, this restriction on our freedom increases our overall happiness.

The curve of somebody who believed in this paternalistic philosophy of government might look something like this:


Note how this curve peaks out at a level that is closer to "less free" side.  This represents the belief that while basic freedoms need to be maintained, the government needs to provide restrictions on freedom in order to uplift the whole of society.

Asking politicians whether their world view is aligned to the libertarian curve or the paternalistic curve (or something in between) would go a long way in identifying the core philosophical beliefs of that candidate.  It would also help to predict how that person might react to some new issue which arises that the moderator did not have the foresight about which to ask.  The Freedom-Happiness Curve also can provide us with a tool to identify our own political beliefs.  How much freedom do you think we need in order to maximize society's happiness?  How much restriction on our freedom are we willing to endure?  There is no simple answer to these questions, but it is important that we start to ask our leaders and ourselves these questions.  That way we can have an intelligent dialogue on what we want our country to become.

Tuesday, June 21, 2011

Wall Street Layoffs Due To Pay Raises?!

The New York Times had an article yesterday talking about possible layoffs at Wall Street banks.  Of course, some of the same banks booked enormous profits in 2010 so one wonders if any of them have read the story of Joseph, but I digress.  In the article, the pay raises are singled out as the primary reason why layoffs are necessary.

The story goes something like this:

In the past, a significant percentage of ones income at a Wall Street firm was in the form of a bonus.  The idea was that if the company did well, the employees got an extra piece of the bigger pie and when the company didn't do well, the employees got less.  Not only did this provide an incentive to employees to perform, but it provided a safety net for banks as well.  When times got tough and profits were down (or non-existent), banks did not need to pay out big bonuses, and this automatically reduced their expenses.  Makes perfect sense.

However, in the wake of the financial crisis, many people pointed to these fat bonuses as one of the causes of the imposition of the banking sector.  One of the unintended consequences of this was that the bonus provided employees with an incentive to take excessive risks with other people's money.  After all, if you are getting a big bonus for selling lots of sub-prime loans, you are going to sell loans to anybody with a pulse without considering what it will do to your company's balance sheet.

One of the outcomes of the banking crisis was that banks were pressured to reduce the impact of bonuses on ones compensation.  Now that bonuses were being reigned in, banks compensated (no pun intended) by raising the base salary of employees.  After all, if you wanted to retain talent, you had to make sure that they remained well compensated.  Of course one has to wonder why you would want to retain the same "talent" that flushed your company down the toilet in the first place, but I digress again.

Anyway, the crux of the matter is that now that banks seem to be hitting another bump in the road, bank profits are under pressure.  As with any company, banks look to cut expenses when revenue is down.  However, since bonuses have been replaced by a higher base salary, banks say that they cannot cut expenses automatically by lowering bonuses.  Instead, they say that the only way to cut employee expenses is to lay people off.  In economic parlance, they have replaced a variable cost (bonuses) with a fixed cost (salary).

As a student of microeconomics knows, there are two types of costs:  variable and fixed.  A variable cost is one that grows as you have more sales.  On the other hand, a fixed cost is one that stays the same regardless of your level of sales.  Consider a company that makes shoes.  As the company sells more shoes, it needs to buy more leather since the amount of leather it needs is proportional to the number of shoes it sells.  When shoe sales drop off, it doesn't need to buy as much leather, so its expenses automatically go down.  It is a variable cost.  On the other hand, if you make shoes, you need a factory building, and you might take out a mortgage to buy that factory.  Unfortunately, if shoe sales drops, you still need to pay the mortgage on your factory.  Just because sales go down doesn't mean that the bank will all of a sudden reduce your mortgage payment proportionally.  The mortgage is said to be a fixed cost because it doesn't vary with the level of sales.  Obviously, if you are a business owner, you'd rather have variable costs than fixed costs.

In the Wall Street situation, a bonus is a variable cost because it goes up and down based upon how well the company does.  That makes perfect sense.  However, is salary really a fixed cost like the article says it is?

Of course not.

The truth of the matter is that this sounds like an excuse more than anything else.  Who says that you have to consider a salary to be fixed?  There are many examples of companies which reduced employees' base pay in order to avoid layoffs.  If nothing else, the recession has shown that salaries, too, can be considered to be a variable cost that can be lowered in bad times.  I think the real story is that Wall Street wants to lay people off to save money (nothing wrong with that).  However, rather than coming out in saying "we need to pay people off because we have too many people", "we want to streamline operations", they are implying that they are laying people off because of the way the Government has meddled with their compensation policies.  This is an easier story to sell to the public, especially when you had such a good year in 2010.

The moral of the story is that maybe Wall Street needs to go back to college and retake microeconomics again.  Perhaps that is one of the reasons why they are having such a bad 2011?

Sunday, June 19, 2011

Everything I Know About Money I Learned From My Dad (and Andrew Tobias)

First of all, to all of the dads out in cyberspace, "HAPPY FATHERS' DAY!".

Anyone who has gone through the public school system in the United States knows that there is very little practical education regarding personal finance.  I certainly can understand why this is the case.  Schools are under pressure from the powers-that-be to satisfy the requirements of so many interest groups.  Schools have to make sure that children are instructed in so many random things as dictated by society (anti-bullying, condoms, the pledge of allegiance, nutrition, evolution v. creation, etc), while making sure they learn enough to pass the myriad of standardized tests, and still giving them the recess time that they need so they don't become obese.  The pressures on school systems to squeeze all of this into a six hour, 180 day school year is intense.  It is not surprising that personal finance falls through the cracks.

That is where dads come in (moms, too, but today is Fathers' Day so you moms will have to wait your turn).

My dad never sat me down for "the talk" (the personal finance talk, people - not the other one).  However, he set an example for me and my siblings when it came to money matters.  It was inevitable that we would learn from his wonderful example.

1. Don't skimp on education:

My father was very well educated.  He started off by earning a BS in Mathematics, followed by his MS in the same discipline.  Then, he went on to earn another MS in Meteorology (from M.I.T if I may brag).  Now many of you might wonder how he paid for all of his education.  He must have saddled himself with quite a few loans, right?  Wrong.  You see, my father was in the Air Force, so his education was paid for through his service to our country.  The second MS degree was paid for by M.I.T. as part of a graduate fellowship.  By the time he was done, he had zero loans.

Now some might say that he was fortunate to have these opportunities.  I strongly disagree.  His military service was during the Vietnam War when such service could be dangerous, if not deadly.  He paid for his degrees not with money, but by being willing to make the ultimate sacrifice, if it came to that.  In my mind, it was the least the U.S. Government could do.  Now not everyone qualifies for military service, so this avenue might not be available to all.  The point is that there are ways to get an education for those who are willing to work, whether it be through scholarships for superior achievement, or part time studies while working, or other means.

2. Hard work is rewarded:

In his career, hard work paid off for my father.  At a time when it was common for people to stay with one job over the entirety of their career, my dad jumped around from job to job quite a bit.  This wasn't because he was fired a lot; it was because he was always on the lookout for the next great opportunity.  Most of these opportunities came via people with whom he had worked previously.  When they had a need for somebody, my father often was the first person who received that call.  At the peak of his career, he was Directory of Engineering for a telecommunications company.  How did he get that job?  The President of the company was his former manager from one of his previous jobs.  He didn't need to send out a thousand resumes to get that position.  His former boss remembered what a great worker he was and offered him the job based upon that. 

3. Live Beneath Your Means:

My dad wasn't one to spend a lot.  Growing up, we only had one car (until my mom went back to work, but that is another story).  Interestingly, it didn't seem like much of an imposition.   For short trips, we walked.  For slightly longer trips (like to get to my piano lessons), I rode my bicycle.  For even longer trips, we took the bus which went through our town.  The funny thing is that, looking back, I really don't feel like I missed out on that much.  Having one car seemed "normal" to me, because I didn't know any better.  We were able to survive just fine.  Living beneath your means is easy, once you get used to it.

4. Stay out of debt:

My father was never a big credit card guy.  Every week, my parents would withdraw whatever spending money we needed from the bank and stick in an envelope.  They had to ration that money wisely because once it was gone, that was it until the next week.  I remember my parents wanted to buy a piano for the house because they had this idea that all of us kids ought to learn how to play (this goes back to don't skimp on education).  In this day and age, most people would put it on a credit card and pay it off.  However, my parents put aside some of their weekly budget money every week.  They only bought the piano once they had put enough aside.

My dad did the same thing with cars.  I don't think my parents ever bought a car on credit.  If they needed another car, they would buy whatever car fit their budget.  We never had a flashy car like some other families, but we owned all of them free and clear.  In fact, I think the only debt my parents ever had was their mortgage, and even that was paid off as quickly as possible.

5. Andrew Tobias:

When I was in college, I was starting to think about grown-up stuff like investing and the like.  I tried to educate myself, but it was overwhelming to say the least.  There were so many options:  stocks, bond, munis, CD's, etc.  How do I start? 

Since my dad seemed to know a little bit about this topic, I started asking his opinion on what stocks I should buy.  My dad wasn't one to lecture you about stuff.  His teaching style was more along the lines of "I'll point you in the right direction and you figure it out for yourself".  To that end, he didn't answer my question about stocks directly.  Instead he took a book off of his bookshelf, handed it to me, and suggested that I read it.  That book was The Only Investment Guide You'll Ever Need by Andrew Tobias.  He couldn't have pointed me in a better direction.  Tobias has a very simple philosophy which is mirrored in my father's:  be frugal, educate yourself, slow and steady investing, no-load mutual funds.  After a read it, my dad winked at me as if now I knew his "secret".

Thanks to my dad's gift of this book recommendation (he didn't actually give me the book - talk about frugal!), I felt like I knew enough to get myself started.  While I have read other investment books, I always find myself returning to the teachings of Tobias.

Now that I have children of my own, my challenge now is to set an example for the next generation about how to handle money.  Hopefully, I will be able to live up to the high standard set by my own dad.  Here's to you, dad!

Saturday, June 11, 2011

USAA: Five Things Worth the Splurge

United Services Automobile Association (USAA) generally is considered to be one of the top financial services companies when it comes to customer service.  Therefore, when they say something, I pay attention.  I might not agree, but I listen and consider what they have to say (disclaimer:  I have been a "member" of USAA for 18 years now, and I have nothing but good things to say about them).  In their most recent company magazine, they had an interesting article entitled Five Things Worth the Splurge.  I thought I'd pass along what they said was worth spending a little extra on, as well as my own personal thoughts.

1. Interior Paint:

According to the article, professional painters suggest using the highest-quality interior paint that you can afford.  Their reasoning is that the better paints are easier to apply, and they look better.  I can't really comment on this one other than to say that according to Consumer Reports' most recent interior paint comparison (March, 2011 issue), there doesn't seem to be a strong correlation between price and rating.  Of course, CR is just one data point, so who's to say if USAA is right or not.

2. Estate Planning:

The article says that while it is possible to create a will with a do-it-yourself kit for as little as $15, they point out that estate planning is complex.  Therefore it might pay to have a professional review your plan to make sure that nothing is missed.  I tend to agree with this advice.  My wife and I had our will, power of attorney, and living will drawn up by an estate planning attorney.  The attorney spent a lot of time with us asking us questions and pointing out possible scenarios which we should consider.  I believe that this was money well spent.  Perhaps if you are single without any dependents, a do-it-yourself will would suffice.  However, if you have children, you really need to consult with a professional to make sure that you cover all of your bases.

3. Mattress:

The article states that a quality bed is the key to quality sleep, and a better sleep can improve ones health.  This is probably one of those areas where your mileage may vary.  I know some people who could get a good night's sleep on a mattress made out of granite, so for them, a good mattress may only provide a marginal improvement to their sleep.  That being said, I generally agree with this.  A bed is one of those things which can last a long time (ours is from the last century) so an extra couple of hundred dollars spent will be amortized over the entire life of the mattress.  If a little extra money up front is going to give you years of more restful sleep, then it is worth it.

4. Kitchen Knives:

The article suggests that a good set of high-quality knives literally can last a lifetime.  Premium knives are forged from better steel and have crack resistant handles that allow them to last so long.  While you can get a set of knives for under $100, these knives do not have the staying power of a professional set.  A good set of knives will set you back at least $400 according to the article.  However, if they last a lifetime like they suggest, then it seems like a good investment.  Of course, I suppose this is another case where your mileage may vary.  If you cook a lot, then good knives make sense.  For my part, my wife and I are on our second set of knives.  The first set we got as a wedding gift and the second set was also a gift.  Neither set is what I would call professional.  However, since we've spent a total of zero dollars combined, we are ahead of the game!

5. Running Shoes:

According to the article, a good pair of running shoes will help to protect your feet, knees, and back.  While you can get a cheap pair for $50 or less, these will have inferior cushioning and support.  The article suggests that you visit a good running store and get fitted properly.  That way, you can make sure you can get shoes which are matched to your body type.  I totally agree with this one.  Running is an activity that puts so must stress and strain on your body.  A good pair of running shoes if your best defense against injury.  If you are going to run, paying $100 or more for shoes will save you from a lot of pain down the road.

Overall, I think USAA's list is a pretty decent one.  Of course, not all of these will apply to everybody, but it certainly provides food for thought.  Here are three more items that I think are worth splurging on:

1. Home Inspection:

As a home buyer, there are many hidden problems which you won't notice.  That is why you need an expert to point them out to you.  A good home inspector will do exactly that.  In addition, I've found that talking to the inspector while he is doing his work is a great education for any homeowner.

2. CF/LED Bulbs:

Compact Fluorescent and LED bulbs cost more than traditional incandescent light bulbs.  However, they not only last longer than the standard variety, they use less energy.  The first generation of CF bulbs took awhile to warm up, couldn't be used in dimmers, and looked funny.  However, the ones that are sold now have come a long way from those days.  This one is a no-brainer.

3. Regular Car Maintenance:

While there is some debate over whether or not cars need oil changes every 3,000 miles, it is indisputable that keeping up with a car's scheduled maintenance is a sure way to extend the life of your vehicle.  Even if you are one of those people who sells their car every three year, a well-maintained vehicle will have a higher resale value.

As a bonus, here are two things that are not worth spending extra on:

1. Books:

99% of the time, you read a book once and then it sits on the bookshelf for the rest of eternity.  This suggests that it doesn't pay to splurge on the hardcover edition.  Yes, hardcovers might last longer than paperbacks, but if you are only going to read the book once, who cares!  In addition, you often can get cheap used paperbacks, or even free books from the library (to borrow of course).

2. Dogs:

Why spend thousands of dollars buying a "pure bred" dog when you can get a great pet for free from a shelter or rescue group.  Not only do you save money, but you are providing a much needed home to somebody who needs it.  Besides, many of the dogs that end up for sale in your local pet store come from puppy mills.  In addition, many of the pure breds have a higher incidence of health issues than mutts due to genetics.  All in all, unless you are looking for a dog for the show circuit, you are much better off rescuing than buying.

Thursday, June 9, 2011

An Important Money Lesson From the Bible

Despite the title of this article, I am by no means a pious individual.  I am not an expert on the Bible by any stretch of the imagination.  My knowledge stems mainly from the Bible stories that I learned as a youth in religious school meaning that my level of familiarity with the Bible is probably weak at best.  However, there is one Bible story that has stuck with me throughout the years, and it is a story that has relevance to everybody, whether you are God-fearing or an atheist.

It is the story of Joseph.

For those who do not remember, Joseph was the son of Jacob, who is one of the three patriarchs of the Judaism.  Broadway fans probably are more familiar with him from the musical Joseph and the Amazing Technicolor Dreamcoat.  He was his father's favorite child (as illustrated by the fact that his dad gave him a famous "coat of many colors" which was immortalized in the aforementioned musical), this caused his eleven brothers to hate him.  His brothers hatched a plot to fake his death and sell him into slavery.  Eventually, Joseph ended up in Egypt.

While in Egypt, he ended up in prison.  However, one of Joseph's gifts was that he was an interpreter of dreams.  This gift, through a quirk of fate, ended up getting him out of jail.  You see, Pharaoh (the king of Egypt) had a very strange dream that nobody could interpret.  First, he dreamed of seven thin, gaunt cows devouring seven fat cows.  Next, he dreamed of seven shriveled stalks of grain devouring seven fat ones.  As it turns out, one of Joseph's former cellies was now the Pharaoh's cup bearer.  The cup bearer remembered his former mate was good at interpreting dreams and suggested to Pharaoh that he ask Joseph for his assistance.

Joseph interpreted the dreams to mean that Egypt would experience seven years of good harvests followed by seven years of famine.  Joseph went on to suggest that Pharaoh take some of the excess from the good years and put them away so that during the lean years, there still would be enough food.  Pharaoh was smart enough to follow this advise so that in the years of famine, Egypt was prepared.  Joseph was freed from prison and became Pharaoh's most trusted advisor.

The story continues with Joseph reuniting with his family, and so on and so forth.  However, that aspect of the story is not germane to the article.  The important lesson that I want to highlight is that you should save up in the good times so that you have something to draw upon in the bad times.  This lesson is an important one, but one that is often forgotten.

Consider your own personal financial situation.  When stocks were going up during the dotcom boom or home values were rising like there was no tomorrow, people just assumed that this would continue and they spent money accordingly.  They figured that times would always be sunny so there was no need to save for a rainy day.  However, when things collapsed and times were lean, they had nothing on which to fall back.  Unlike Pharaoh, they didn't take some of their windfall from the good times and put it aside for the bad times, and they paid the price.

Not to be outdone, companies did the same thing.  When the economy was good and companies were making profits on top of profits, many companies squandered that money on over expansion on the assumption that things would always be good.  However, when the economy collapsed, these companies could not support all of the fixed costs that they had racked up.  Many ended up going bankrupt.  However, some companies put aside some cash from the go-go times.  Those companies were able to pick up the assets of their former competitors for pennies on the dollar.  Those companies were able to buy prime storefronts on the cheap.  These companies are the one who were positioned for success when the economy turned around.

Of course, the biggest offender is our Government.  When the economy is going well, the Government is flush with cash.  Good times mean higher incomes for both people and companies and, of course, that means higher tax revenues.  Rather than setting aside that surplus for the inevitable downturn, our elected officials squander it on tax cuts, on pet projects, and on other discretionary spending.  Then when the economy tanks and tax revenue dries up, they have no surplus to draw upon to close the budget gap.  They either have to drastically cut services or they have to borrow and borrow some more.

The ironic thing is that this is exactly the opposite of what an economically savvy government should be doing.  During the good times people and corporations already are firing on all cylinders so there is no need for the Government to spend money either through direct spending or indirectly through tax cuts.  The economy already is well stimulated.  However, in bad times, the private sector stops spending.  Ideally, the Government would step in and fill the gap temporarily by spending the money that they put aside in the good times.  That way, the economy stays afloat until the private sector recovers.  However, as we know, Governments rarely are savvy (economically or otherwise).

Whether or not you are a religious person, the lesson of the story of Joseph is one that we can all stand to learn.  Although this story is thousand of years old, it is clear that all of us - individuals, corporations, governments - haven't learned it yet.

Tuesday, June 7, 2011

Rating Consumer Reports New Car Ratings

Consumer Reports is one of the most trusted names in new product reviews and testing.  They pride themselves on being fair, thorough, and independent.  As a non-profit organization that accepts no money, advertising, or freebies from companies, they can tell it like it is.  Millions of people rely upon their unbiased advice when it comes to making purchases, both major and minor.  Of course, there is no purchase as major as buying a car.

Consumer Reports' automobile reviews probably are their most popular.  They dedicate an entire issue of their magazine to new cars, and every other issues has several review of newly released models.  As the go-to source for many car buyers, their reviews are extremely influential.  Many people choose a vehicle based upon the CR's reviews.  A high score in their review potentially can lead to thousands of sales.  The question that I want to explore is how much stock should people put in these reviews.  In other words, I am here to review the reviewer.

On the plus side, CR has several things going for them right off the bat.  First, they have gone to great lengths to eliminate any conflicts of interest.  Their magazine doesn't accept any advertising from any third parties.  This means that they have no incentive to soften a review in order to keep a big advertiser happy.  They also buy all of their vehicles from dealerships just like you and me.  Because they don't free loaner cars from the manufacturers as gifts, they eliminate another source of conflict.  In addition, this ensures that they get actual cars that real life people are going to drive.  Many other magazines accept demo cars from the manufacturer which may be specially tuned to do well on a road test.

Second, their testing methodology is very consistent and very thorough.  They have their own testing facility where every reviewed car is put through its paces.  They subject each car to the same battery of tests so that they truly can compare the results.  Other car magazines vary their road tests from month to month, so it is not feasible to compare the results of one test to another.  Also, they testing is quite thorough.  They look at all of the aspects of a car that are of interest to most consumers, and they literally spend months behind the wheel of each test car.  That ensures that they are able to form a true opinion of how a car performs.  Other car magazines only might spend a day or two with each test car.  As many of us know, there is a big difference between how a car performs on a short test drive and in actual day-to-day usage.

All that being said, I have two bones to pick with their rating system.

1. They don't reveal their scoring methodology:

Fans of CR know that the magazine boils everything down to a numerical score.  The higher the score, the better the product according to CR.  However, they do not provide any quantitative information about how the score is derived.  Sure they mention, in broad terms, that they look at acceleration, handling, fuel economy, comfort, etc.  However, they don't reveal how these different elements factor into the score.  Do they give a maximum of 10 points for fuel economy or only 5?  Is acceleration weighted more than handling?  Why is this information good to know?  Because it gives the reader some clue as to what is important to CR.  This information is key to judging their ratings.

Cars (and all product for that matter) can be judged on a variety of criteria:  how fast does it go, how well does it handle, how comfortable are the seats, how safe is it, and so forth.CR says that they subject each vehicle to more than 50 different tests, but for every test, there are probably hundreds of other possible tests you could perform.  Different criteria might be important to different people.  If you have kids, you might value safety more than acceleration.  On the other hand, if you are young and single, you might not care about safety as much.  You might value handling more.

Every reviewer has their own weightings for all of the possible criteria on which you can judge a vehicle.  A good reviewer will tell you up front what they value so that way you know how to interpret their review.  If a reviewer primarily is looking at the performance aspects of a car, you aren't going to value their opinion if you are looking for a family vehicle.  A minivan shopper probably will trust the opinion of a review who is judging the vehicle based upon its utility and safety.

Likewise, they do not provide any guidance on how to compare scores to one another.  The Toyota Highlander has a score of 81 while the Honda Pilot's score is 74.  Both are at the high end of the Very Good range and both are recommended by CR, but the Toyota is seven points higher.  What does that mean exactly in real world terms?  Is seven points a significant gap or is the difference minor?  If a seven point difference means that the Highlander has an inch more headroom and slightly better acceleration, then it is probably a toss-up between the two and those seven points might not matter in the grand scheme of things.  On the other hand, if seven points means that the Highlander is vastly superior, then those points do matter.  However, we don't know because the scoring system is not published anywhere.

Why is this important?  Because there probably are a large segment of people who might look at the seven point difference and immediately eliminate the Pilot for consideration altogether.  After all, 81 is better than 74 and who wants to buy a car that is a 74 when you can get an 81?  However, if those seven points were gained because of minor things (or things that the buying might not even care about), then maybe the buyer is better off looking at the Pilot, too.  Maybe those seven points were earned because of the third row comfort, but the buyer doesn't care about the third row because he is going to be hauling cargo.  In that case, the gap between the two goes away.

2. The reliability rating is meaningless:

The other aspect of CR's review is the relative reliability of the car.  In order to gauge each car's reliability, they send out a survey to all of their subscribers asking them to report problems that they've experienced over the past year.  Based upon the results, they assign a reliability rating:  much worse than average, worse than average, average, better than average, much better than average.

However, what do these scores really mean?  According to CR, here is what they mean:

<1%:  Much better than average
1% - 2%:  Better than average
2% - 3%:  Average
>3%:  Worse or much worse than average

They don't reveal what the cutoff is between worse and much worse.  However, in the best case, a worse than average car has a failure rate of 4%.  That may sound "high", especially compared with the better than average categories.  However, if we flip that around and show the success rate (% of cars without a failure), here what it looks like:

>99%: Much better than average

98% - 99%: Better than average
97% - 98%: Average
<97%: Worse or much worse than average

If a model of car has no problems 96% of the time, it would end up in the worse than average category, and it would not get recommended by CR.  However, from a practical standpoint, there isn't much difference in reliability between the 96% of the worse than average vehicle and the 98% of the better than average vehicle.

Of course, that assumes that the scores are even accurate.  CR says that they only publish reliability ratings for vehicles that received at least 100 response.  That really isn't enough to get a statistically significant sampling.  Let's say that you have a particular model that has 500,000 vehicles on the road.  Of those 500,000 vehicles only 1% had a problem.  That would put the car in the better than average category which would earn it a recommendation from CR.  However, CR isn't basing their results on looking at all 500,000 vehicles on the road; they are basing on the 100 owners who returned the survey.  If you take a random sample of 100 owners out of 500,000 vehicles, there is a good chance that more than 1% of that 100 vehicle sample are going to have a problem.  There is even a good chance that more than 3% of those 100 randomly selected vehicles are going to have a problem.  CR would put that vehicle into the worse than average category based upon 100 vehicles when in truth, that vehicle should be in the much better than average category.  After all, it only takes 3 problems out of the 100 sampled to give the car a negative rating - not very statistically sound.

There are other problems with the reliability rating.  They rely upon the owner judgement in determining what is a problem and what isn't.  Unlike their road testing, there is no consistency.  Also, each person drives a car differently.  Is it fair to report something as a problem when it was caused by "user error"?  I could keep on going, but you get the point.

The bottom line is that no reviewing system is perfect, even Consumer Reports.  While they certainly are a useful data point, you should not treat it (or any reviewers' opinion) as gospel.

Wednesday, June 1, 2011

A Man's Got to Know His Limitations

I've said it before and I'll say it again:  99.9% of investors ought to forgo active stock picking in favor of index funds.  Unfortunately, most people try to pick stocks, time the market, or otherwise try to beat the odds in a game that is stacked against the little guy.  It seems as if yet another expert agrees that it pays to be passive.  In the Atlantic, Cal Tech finance professor Bradford Cornell writes quite convincingly that the little guy/gal can actually beat the big boys/girls in the investment game - but only if they invest passively.

His argument goes something like this:

1. The returns of those who invest in a passive index fund will mimic the returns of the overall market.  Let's call that amount X.

2. The returns of those who invest actively (market timing, stock picking, etc) will also mimic the returns of the overall market in aggregate.  In other words, the combined investment return of all active investors will also be X.  After all active and passive investors ARE the market.

3. However, where passive investors come out ahead is that their expenses are lower than those of active investors.  An index fund just has to buy and hold a basket of stocks that represents the entire stock market.  There aren't a lot of transactions involved, so commissions are low.  In addition, you don't need a spend time and money on research, computer programs, etc.  On the other hand, the expenses of the active investor are higher.  They are paying more in commissions because they are buying and selling more often.  They are paying more for fancy computer programs, newsletters, premium website content, etc.  Finally, they are paying more in terms of time spent researching their moves.

Some readers might reason that even though active investors will earn the same return in aggregate as passive investors, some active investors will do better and some will do worse.  This is a foolish thought.  It is human nature to think that you are better than everyone else; however, you aren't.  The people who are going to exceed market returns are those professionals who have access to research you don't have, who have access to supercomputers which you don't have, who have network connections that allow them to trade faster than you do.  In short, they have all the advantages that you, the little guy, don't have.  By the time you hear about some piece of news on CNBC, the big fish already have acted on it.  You are way too late.

However, if you stick to the relatively boring domain of passive index funds, you'll end up beating the aggregate returns of all active investors.  The article concludes with a quote from Dirty Harry which is appropriate:

"A man's got to know his limitations."