My “Lost” Purchase

Virtually all of us have been touched to some extent by the decline in stock prices and asset devaluations (houses). I recently was talking to someone and they mentioned this thought experiment:

What if you had spent all the money that was lost in the recent market declines instead of watching it fall in value?

I was walking through River North last weekend when my personal answer sat on the curb right in front of me – a brand new Nissan GTR, valet parked by a high-end restaurant and club. Sure it has a sticker price above $70,000, but it is about the fastest thing on the road and has a great control layout and is a Nissan, to boot (so it likely won’t end up being a rolling pile of junk after a few years).

 

Of course, this is now fantasy-land, since reality binds me to the GTR’s all-too-practical sibling, a 1999 Nissan Altima, nearing a decade in service but still reliable and practical for the almost no driving I do in the city.

Not that I am encouraging this type of thinking (spend it now because it is falling in value), because it is critical for everyone to keep a long term perspective and to plan for the future. These market losses are discouraging but this is life and we need to keep marching ahead and learn from our failures. It is likely that high government spending and large deficits will mean that relying on social security, always a bad plan, will become even less viable, since all the other spending will crowd out this benefit.

But it is a fun thought experiment, especially when it is sitting on the curb, right in front of you…

Cross posted at LITGM

Negative Net Worth

 

The Chicago Tribune business section has a series where readers write in with their financial issues and the columnists seek professional help and recommendations and publish the results. This column is titled “Law Degree on Her Side” and shows the plight of a woman under 30 who is a lawyer but is struggling under a mound of student debt and is considering bankruptcy.

BALANCE SHEET VS. INCOME STATEMENT

A big element in our economy’s struggle is the fact that the analysts and “experts” were focused on the income statement and not the balance sheet. An income statement view focuses on profits, or the difference between earnings (in her case, salaries) and expenses (rent, living expenses, etc…) and what remains each year. Companies often report earnings EBITA which stands for “Earnings Before Interest, Taxes and (depreciation) and Amortization”. In this model, you become a lawyer because you can make a lot of money (top line revenue) and use it to support the rest of your living expenses.

However, this “income statement” model ignores the debt needed to finance education and expenses related to education. This debt keeps piling up and is a negative item on your balance sheet, which is the long term debt that you owe others, along with the annual interest that you need to pay to service this debt. In an analogy to the stock market, it is the debt payments, along with the fact that companies can’t come up with the cash to pay off principal (or roll-over debt) that is causing the liquidation of companies like Circuit City, Linens & Things, Mervyns, and soon to be many others.

In this lawyer’s case, her balance sheet is “negative” meaning that she is insolvent or has a negative net worth. She has a tiny amount of assets (a bit of retirement savings, some cash on hand, and maybe equity in a car or something) which is all she can show to offset a mountain of debt.

I don’t have exact statistics but I would venture that most Americans have a negative net worth nowadays. By this I mean that the value of their debts exceeds the value of their assets. I also run a site called “trust funds for kids” and I often tell my nephews and nieces that even the relatively small amounts that we put aside ($10,000 or so), as long as they don’t accrue debt, will make them better off than most Americans who have worked their entire lives, since they will have a positive net worth. Obviously some of this is tongue-in-cheek since you need a steady stream of income to pay minimal living expenses but there is much fundamental truth in that analysis in that if you pile up debt you will never accrue enough assets to offset this debt. And if you have a negative net worth, you can never stop working (retire) unless you have a guaranteed string of income high enough to offset your living expenses, interest costs and principal repayments.

These debts cost money to finance, and this cost is in the interest rate. The woman in this article is drowning because $200k of debt will mean that interest payments of $14k ($200,000 * 7% or so) would be needed just to service the debt, without putting ANY sort of dent in the principal. Likely the principal is going to be due over a certain amount of years – let’s say 20 years – so she needs to pay $10,000 / year in principal plus $14,000 in interest (the interest will go down in future years as the principal is paid down) on the current balance. If her income is below certain thresholds (her income, at $75,000, is for now) then she can receive a tax deduction of $2500 based on the interest component (see IRS publication 970). Thus (using this relatively simplistic analysis) of her $75,000 / year salary, $24,000 (or almost 1/3) would go for debt principal and repayment (the tax deduction would likely offset this for about $1500 in cash, depending on her tax bracket).

BANKRUPTCY AND STUDENT DEBT

One very unfortunate difference between companies and this student is that companies can eliminate debt through bankruptcy (if they are cash flow positive on an EBITA base and can obtain interim financing), but the student debt can NEVER be discharged. I remember when I was studying for my CPA exam (20+ years ago, so maybe it isn’t an exact quote) that they had a section on bankruptcy and they mentioned that the discharge of student loans through bankruptcy was eliminated because

Doctors, who require mounds of debt to pay for medical school as well as finance living expenses while they are interns and only modestly paid, used to accept the diploma with one hand and declare bankruptcy with the other. Tiring of this tactic, the schools lobbied and changed the laws so that student loan could not be discharged through bankruptcy

Thus taking up student debt is serious indeed; unlike your house (which you can walk away from or short-sell to the bank) or auto, you can NEVER discharge this debt, and have to either pay it off or have this debt hanging over your head for the rest of your life (essentially meaning that you can’t accumulate any assets).

If you read the article, not only did the woman take on student debt, she also took a vacation and put it on her credit cards, which have a much higher interest rate (maybe 20% or so) and need to be paid off before she can make a serious dent in the student loans, unless she wants to declare bankruptcy. And even if she does declare bankruptcy, given her level of income, it is likely that the court will make her repay at least some of these obligations.

VALUE OF A DEGREE

When you incur tens of thousands of dollars in debt to get your degree (or $200,000, in this unfortunate case) you need to ensure that your degree will pay enough to not only support you going forward (and your family, if you intend to have one) but also to pay off the student loan debt and interest accrued on that debt.

In the case of this woman, she has a law degree. However, one item that wasn’t advice in this article is that she has to leverage this degree to make a lot more money. She needs to work for a firm with high billing rates and she needs to put in a lot of hours. Traditionally law firm employees had to bill 2,000 hours / year – note that this is BILLABLE work so everything that isn’t billable has to go into the rest of the week (or weekend) after you are done with a full days’ work, including what shred of a social life you’d like to have.

Given all the taxes and costs of living in Chicago (remember that the sales tax is over 10%, property taxes are high, and Federal and state tax rates are going up) if she increases her income to pay down debt effectively almost 50% of every dollar is going to be taken away from her between social security and taxes of all stripes. So she needs to increase her income by $50,000 to come up with the extra $25,000 which would allow her to pay down this debt sooner.

My uncle (now deceased) was a man who fought for the little guy. He was a lawyer with his own firm and he represented the poor and often did death penalty cases for the state (as a defender). He summed it up to me that

You can either represent poor innocent people or rich guilty people

I suggest that she find some major companies with problems and burn up a lot of billable hours helping them. Her $75,000 / year job will never pay enough.

RELATIVE RATES OF RETURN

The other more subtle point in this article and overall in finance is that the implied rate of return for investments has been decreasing. Anyone who hasn’t been fully invested in gold and treasuries has seen the value of their investments plummet, possibly by as much as 50%. Various articles come and go about how the DOW is now back to 1992 or prior – although this is kind of specious unless you were heavily invested all this time – sadly enough most people bought into the market much nearer its peak, so they took big losses on actual cash put into the market (and didn’t just lose gains from prior years).

If the markets are down 50%, it will likely take YEARS of sustained 15%+ growth, for instance, just to get back to where we were in 2007. Thus while those returns might be prominently featured in advertisements, essentially for the average investor those returns are needed just to get you back to zero, and then you need to make returns BEYOND this in order to increase your asset base.

Why does this matter? Because while the implied return on YOUR investments has declined (is frankly negative) and banks are paying about 1% in interest (BEFORE taxes), a loan at 7% is very pricey. In the old days when people put in 10% / year return in their model, they figured that a 7% loan was cheap money. Now with negative returns or puny returns in the risk-free market, 7% means that your loans are outpacing your gains and that your problems increase every day that you don’t pay off that loan. I won’t even go into the impact of a 20% credit card loan (plus the fact that consumer interest isn’t even deductible).

CONCLUSION:

ANY students who are considering taking out debt to finance their education NEEDS to understand the gravity of the situation:

1) these loans can NEVER be discharged through bankruptcy
2) the interest rate you are paying is likely higher than the return that you will make on your own assets
3) you need to earn enough money to pay off the principal and interest, as soon as possible
4) as you earn more money and try to pay off these loans, high taxes and cost of living eat up the value of each dollar earned so that you essentially have to earn $2 to get $1 to pay towards your obligations
5) you need to live as cheaply as possible and get this done as quickly as possible – in this case the woman worked as an unpaid intern which just let her interest accrue and she took expensive overseas vacations which caused her to add credit card debt
6) based on all of the above items, it likely isn’t worth accruing debt for a degree unless your degree is extremely marketable (law, medicine, finance, engineering) – that doesn’t mean that you can’t follow your passion, but it does mean that you need to pay-as-you-go or find a way to do it through scholarships or at your local community college
7) if you incur debt, you need to make money ASAP and forgo other social options, expenses and fun – else you will never escape the debt trap. You spent all this money for the degree, so now you have to leverage it to the hilt and make as much money as possible

Cross posted at Chicago Boyz

Covariance

One of the features of the stock market lately is that stocks tend to move in unison.  On a given day when the stock market goes up, it seems like almost every stock is buoyed in price.  On the other hand, if the market has a bad day, then everything seems to do down.

Above is a snapshot of the day’s results from Friday, February 6, 2009. You can see that every single stock in portfolio one and portfolio two increased in value during the day (portfolio three has a subset of the same stocks as portfolio two, so showing it was redundant for the point I was trying to make).

The covariance in the market is far more pronounced than it used to be in the past. This may be linked to the fact that the market is making more large percentage moves on a given day. Per Harper’s magazine February issue:

Number of times in 2008 that the S&P 500 closed up or down 5 percent in a single day: 17
Number of times between 1956 and 2007 it did this: 17

The fact that the stocks tend to move in unison makes selecting individual stocks more difficult. When you are selecting an individual stock, you are generally doing analysis on the performance prospects of that unique company. However, the fact that market moves are pushing all stocks in one direction or another (unfortunately, they have been mostly downward) no matter what the rationale for your stock may be, it is buried by the overall market moves.

Some items logically cause the entire market to move on a GIVEN day – for example, this day the market was up primarily due to the fact that the stimulus package appeared to be resolved. Other factors, like changes in interest rates, can make equities more or less valuable overall because they are often an alternative to debt instruments. As the interest rates rise, debt instruments become more attractive and stocks less attractive, all else being equal. Items like attacks on the US or foreign countries can also cause one-day (or longer) shocks to the market, or increase “systemic risk”.

In any case, covariance is definitely increasing, meaning that more and more of the return on an individual stock is due to what is happening across the entire market and less and less due to the story of a particular company. Nowadays company specific research should mainly focus on the downside risk – companies that have to refinance debt at unfavorable rates, for example, which could cause their value to go to “bagel-land” or zero.

One of My Favorite Investing Books in Context

I was reading a Wall Street Journal column by James Stewart recently. He has a column called “Common Sense” which outlines his approach to selecting stocks and investing.
His strategy involves buying when the stock market drops 10% and then selling when the stock market rises 25%. This type of investing (which looks at relative market levels) is a type of “technical analysis” as opposed to “fundamental analysis” which looks at the merit of individual stocks relative to financial metrics. To be fair, Mr. Stewart’s model is a mix of technical and fundamental analysis, but the “buy”and “sell” signals are pure technical analysis (in my opinion).
The headline of the article really caught my eye, however:

When bad times get worse, it’s best to stick to a system

That quote reminded me of a line from one of my favorite investing books titled “A Random Walk Down Wall Street” by Burton Malkiel. On p146 he discusses his opinions of technicians which rings eerily familiar:

I personally have never known a successful technician, but I have seen the wrecks of several unsuccessful ones. Curiously, however, the broke technician is never apologetic. If you commit the social blunder of asking him why he is broke, he will tell you quite ingenuously that he made the all-too-human error of not believing his own charts

In my mind, sticking to a system and not believing his own charts are one and the same.
As far as the book by Malkiel, I like to pick it off the shelf from time to time and read it again. The book is 30+ years old (it has been updated), but the main thesis is the same; a broad basket of stocks, best in an indexed fund, will typically beat active management when fees and taxes are considered. While this idea is pretty much accepted as common sense nowadays, when this theory first came out it was seriously attacked by the investment community, since it undercut their validity and high costs (relative to indexing, which can be done cheaply in a transparent manner).
I also like the book because the author acknowledges the thrill of individual stock-picking, and allows that some people are good at it, and that it can be “fun”. While he doesn’t recommend it for the whole portfolio, he notes the lure and that doing it with part of a portfolio or not “rent money” is also understandable. This to me sums up my plan in the funds I run for my nieces and nephews; I invest in individual stocks because the funds are relatively small and not needed immediately to pay for rent and food, and because investing in individual stocks allow for much greater interaction and teaching opportunities about the market relative to a simple index fund (or ETF).

I heartily recommend Malkiel’s book and am a bit worried about the normally staid and on-point Stewart… don’t ride that system to the end.

Cross posted at Life In the Great Midwest

Actively Managed Mutual Funds

In the “efficient markets” hypothesis, all available information is factored into the stock price, making attempts to “beat the market” by selecting your own stocks a fool’s errand. Index funds, which were originally stock mutual funds, such as those at Vanguard, not only attempt to mimic rather than beat the index, they also sport much lower expenses. Thus even if the performance was the same for an index as a stock picker, the index would win with costs as low as 0.2% / year as opposed to 1% – 2% / year for managed funds. One advantage that remained of a stock selection methodology over mutual funds was related to taxes – individual stocks were definitely more tax efficient if handled correctly; now index ETF’s have erased that lead.

Of course, theories don’t always work in the real world, as the recent financial meltdown attests, when AAA rated financial instruments took significant losses. In a similar vein, those in favor of active stock selection could always point to a few candidates to make their cases. One candidate was Bill Miller, head of the Legg Mason Value Trust, who beat the S&P 500 for 15 consecutive years.

 

While Bill Miller may have been the “poster boy” for those that point to active stock pickers, he was a reticent candidate. He even said that a lot of his “streak” was due to timing on the calendar and didn’t strut around like a world-beater. Thus I didn’t take much pleasure in the this article…

Bill Miller, whose Legg Mason Value Trust achieved the unlikely feat of beating the S&P 500-stock index for 15 consecutive years, has become the fund world’s punching bag. So far this year, the fund is down a devastating 56 percent on account of bad bets on stocks including AIG, Washington Mutual, and Freddie Mac. This horrific year (combined with lackluster results in 2006 and 2007) has banished Legg Mason’s crown jewel to the ranks of the worst-performing mutual funds not only for the year, but for all standard periods of measurement.

Actively managed funds did terribly in the current stock market environment, and index funds also fared poorly. The delta between the two is the “negative alpha” of active management (sorry, not everyone will get that, but I find it a bit funny) as well as the increased expenses of the actively managed fund over the index (it may be up to 6x bigger, as they say in the Vanguard adds, but unfortunately that is only a small percentage of the overall loss).

Due to the way that ETF’s are structured, there are basically no “actively managed” ETF’s. And ETF’s are more tax efficient than mutual funds. Thus when you pick an “actively managed” mutual fund, you are losing three times:

1) you probably are going to come in worse than your index performance
2) you will almost certainly pay higher fees
3) by selecting a mutual fund over an ETF, you are sacrificing tax efficiency

Bill Miller is among the last of the “index beaters”. The marketing departments for actively managed mutual funds are going to have to think hard to make this one shine…

Cross posted at LITGM

Larger Investment Topics

This blog is focused on practical advice for someone starting out in investing, setting up a smaller trust fund for a relative, or wanting to manage their own performance of a reasonably sized portfolio.

The author of this site also writes on larger topics, really ones that aren’t “actionable”.  Here are a couple that you might find interesting.

Here at Chicago Boyz I write about “Private Equity“, which mainly consists of 1) leverage buyout funds that take public companies private 2) venture capital funds that invest in early stage enterprises in hopes of taking them public for a big profit (those few that typically make it).  The general gist is that these types of financial professionals are supremely well-compensated for their efforts which haven’t warranted these big paychecks recently.

Here at Chicago Boyz I wrote about “Hedge Funds“, which also discusses their relatively vanilla strategies that seem to be easily replicable (note the pages and pages of hedge fund performance statistics in a recent issues of Barrons’) and also not worthy of the big 2% / 20% cuts.

I will try to focus this site on practical tips on a smaller scale that are actionable.

Re-Directing To This Site

For several years I have run a site at http://www.certificationhelp.net called “Trust Funds For Kids”.  Over time I have been moving from that web site to a word press blog run at this address http://www.certificationhelp.net/blog.

I re-directed the URL “Trustfundsforkids.com” to this site but as it turns out very few people got here through that URL; they got here because the text had been embedded in the search engines and they found it through search words.

Just today I changed the code at the Front Page site so that everyone who goes there, searching for something that was in a search engine, gets redirected to this blog, instead.

SO WELCOME!

I realize that many people are skeptical about what people write on the Internet and rightly so.  This blog is run by someone who has financial experience in setting up a trust fund, with selecting stocks, and other financial areas.  You don’t see any links to other dubious sites or get rich quick schemes.  Also no ads (maybe someday, but not now).  The only two links are to other sites that I also post at (recommended, by me at least) and likely I will add some other useful sites to the blogroll (the IRS, etc…).

I will be posting about various investing topics and how to set up a trust fund, select stocks, and related taxation issues.  Hope you enjoy the site and find it useful.