Low Interest Rates and Side Effects

I was recently at a bank as part of a non-profit (else I rarely step foot in a bank) when I was talking to the banker about setting up a new account and we started discussing the interest rates that each of the potential accounts would receive.  After a bit of discussion I said

At these rates, it doesn’t matter

Basically interest rates on savings accounts and non CD accounts are effectively zero unless you have an immense amount of money in that account.  For example, the Chase “savings” account offered .01% – which means that if you have $100,000 in the account all year long, you are going to make $100.  That is the definition of negligible.  Certainly you can shop around a little more and get a higher interest rate, but you aren’t going to get near 1% unless you buy some sort of vehicle with other conditions (i.e. locking up your money for a period of time).  The woman at the bank was apologetic but I knew that there was no reason for her to be – it wasn’t her fault that the nation had undergone a massive ZIRP experiment.

One side effect is that banks have now effectively become a vehicle for 1) making transactions 2) providing services.  They are no longer really a vehicle for making money (i.e. earning interest, especially compounded interest, that is meaningful over time).  Thus your money now is more of a way to avoid charges on those services (free checking, or avoiding low balance charges, or access to certain types of transactions without fees) than a means of making money.

The traditional function of banks is to take your deposits and turn around and “leverage” that money to make loans to others.  Since banks can count on not everyone to show up and demand their deposits back on the same day (unless there is a bank run), and they should be able to earn money on the difference between the cost of the money to them (they can borrow at the lowest rates) and what they charge loan customers, this should fund much of their profits.

The newspaper industry is dying because they provided journalism as a service but made their money selling advertising (effectively as a local monopoly for many years).  When businesses and individuals stopped buying advertising (hello, Craigslist), the “service” that they provide, journalism, had to pay the bills.  As a result this industry has gone into free fall since then.

Banks and many other financial institutions generally do a lot of services but make their money on the spread between what they pay you and what they pay for interest in terms of their cost of money.  Then they take that difference and it generally subsidizes everything else.  If that difference becomes negligible, then the financial institution has to make money in some other manner, or see their profits wither like the newspaper industry.

With interest rates so low and money washing into their doors, banks should be able to make up for everything on loans.  However, everyone is conservative about loaning money right now unless it is secured, and the home equity loan pipeline has mostly dried up since many houses have lost their equity buffer.  I don’t have direct experience with this but have heard that it is generally not easy getting a business loan, the type of loan that is riskiest unless it too is essentially secured in some other manner (property, receivables, etc…).

As a customer, if in the medium to longer term, if you assume that interest rates will stay very low, then you have options that you probably wouldn’t have considered otherwise.  For one – you may just want to consider taking a portion of your money out of the bank and just convert it into gold in your safety deposit box.  The biggest argument against gold historically is that it doesn’t produce a return – it just sits there, and has storage costs to boot.  While both items are true, a safe deposit box is cheap to rent each year (mine is about $100) but on top of it keeping your money in a financial institution has transaction costs, as well.  You can do the same thing by buying GLD the Gold ETF which may have other advantages with regards to transaction costs and sales taxes

Another alternative is to purchase foreign currency and put it in your safe deposit box.  This traditionally has been a terrible strategy because it earns nothing but in an era of almost zero returns on major currencies around the world the side effects of this strategy are lessening almost by the day.

Since the banks can only make so many loans that are basically secured and there hasn’t been a lot of impetus by them to move into more risky types of business loans, they are basically awash in cash.  In some circumstances, they have considered paying negative interest rates for large blocks of cash, and this has happened with short term debt instruments quoted in some markets, as well.

The last part of this is to strip the concept of “compound interest” out of your heads.  One of my blogs is for teaching kids about investing and if I was starting this years ago I would have made a big pitch for the advantages of investing your money for long periods of time and watching it grow with the “magic” of compounding interest.  It is hard to make this case with interest rates far below 1% unless you have large quantities or buy specific vehicles which take you near 1% and even that is a gigantic time frame to “double” your money.  If you assume 1% / year then it takes about 70 years (give or take) to double your money – better than the straight-line model of 100 years but in all cases virtually irrelevant for practical purposes (nice calculator here).

Thus some interesting side effects for me are

1) the lost “opportunity cost” of holding cash in gold is now negligible

2) the lost “opportunity cost” of physically holding non-US currencies is now negligible

3) the margin that financial institutions receive on interest is now very low and they will need to either expand into riskier non-secured loans (which they haven’t done) or start charging for services and transactions (or see their margins crumble)

4) with 3) above and interest rates near zero the real “value” of your money with the bank is in avoiding / minimizing transaction costs and being able to take advantage of better services 

5) the concept of “compounding interest” is basically dead on risk-less instruments, and for riskier instruments it is but one component of total return (probably the least essential component)

Cross posted at Chicago Boyz




Terrell Owens Illustrates “Income” vs. “Wealth”

Terrell Owens is a football celebrity who has earned millions over his 15 year career as a receiver.  He has made more than $30M in salaries over that time and also had endorsement opportunities due to his high profile.

In a recent video Terrell Owens describes his financial predicament due to the NFL lockout.  Here is a link to the video, where he apparently sheds a tear.

In the video, Terrell is calling his “financial advisor” who apparently hasn’t been returning his calls.  Terrell can’t see his statements, and is confused by his low credit score.

You can’t tell what is “made for TV” and what is reality, but even the least web-savvy person knows how to get to their account balances online.  And your credit score is easily found; you can get a credit report for free from each of the major agencies to check any blemishes and anytime you buy a car or apply for a major purchase you usually also have the opportunity to see your score (if you ask). This type of behavior is sad and reflects a very low level of financial literacy.

Then Terrell talks about his “predicament”.  With the NFL lockout he has “no income” and yet he has “mortgages to pay” on his real estate as well as child support payments.

Note that this is an individual who has earned over $30M in his lifetime, along with other endorsement and income opportunities that are available to a high profile public figure.  He has had many opportunities to receive and re-invest this money, which should be making him MORE money today.

He has had the opportunity to build a large net worth position, meaning cash in the bank or hard assets (land, equity in a house, or financial assets like stocks or bonds), but he obviously hasn’t done this, because the minute his “income” stream is done, he is unable to remain current on his bills.

Terrell’s position isn’t hard for the financially literate to understand, but it is lost on him and most professional athletes, who often end up broke or bankrupt after they stop playing the game.  This site, called “Celebrity Net Worth”, also completely misses the point.  I don’t know how they attempt to calculate net worth, but they appear to show lifetime earnings and current earnings instead and they assume that Terrell has maintained this money, not spent it.  Obviously it is ALL spent because he is unable even to make child support payments of $5000 / month, which would be a drop in the bucket if he had retained even one years’ salary after taxes in the bank.

It is possible that one of these portfolios (at trust funds for kids) would provide someone a higher NET WORTH than Terrell Owens, at $20,000.  That is a profoundly sad statement, since Terrell does not seem to be stupid and he has gotten knocked around plenty in 15 years of NFL football, and has NOTHING to show for it.

It isn’t what you make, it is what you save, which is a function of 1) not spending it on consumables 2) not paying for the bills of your hangers-on 3) not paying for your kids out of wedlock or for ex-wives 4) not paying “managers” large fees while remaining personally ignorant 5) not investing in businesses with your friends, especially if they have a limited or non-existent professional track record.  Terrell Owens probably fails all of these items.

And someone should re-name “celebrity net worth” something like “celebrity lifetime earnings”.  They are NOT one and the same, as Terrell illustrates.

The Importance of Saving and Thrift

Yesterday I had a chance to talk to my nieces and nephews who participate in this program and they were working summer jobs and other odd jobs to collect the money to invest so that they can receive their “match”. Remember in this model I put in $500 / year, then if they put in $500, I will match $500 more, to bring it up to $1500. After 10 years or so of this, plus some returns (hopefully), they can accumulate a sizable pool of money to either use for college or to start their lives post college (put money down on a house, or have it as a reserve fund).

Many times discussions about investing minimize the absolutely central fact that savings is about deferring consumption and the importance of thrift. You need to put aside money and question all of your spending, and when something adverse happens (you end up paying for something that breaks, or you end up paying a late fee on an account or interest on an open balance) you need to change the course of your activity so that it doesn’t happen again.

In America we don’t say it enough that it is HARD to accumulate any sort of nest egg or positive net worth. Many people’s paychecks are gone before they even receive them and it is so easy to add on debt for your car, your house, or to buy things on credit at a department store. The tax burden is high, and if you aren’t careful your entire lifetime of work will come and go and you will have precious little to show at the end, when you need to rely at least partially on your own savings to fund your retirement.

Kids going into college now also face an immense burden in the form of college loans, which cannot be discharged by bankruptcy, and can stay with you for decades. I think that as people accumulate debt during college for legitimate purposes (tuition) then they just figure that they are in debt anyways and pile in on the living expenses, vacations, and other minor expenses which pile up over the time that they are in college. Since the number seems large, what is the harm in adding a few more dollars to the pile? In addition, I don’t think that all of them consider ways to reduce this debt by 1) completing school faster 2) taking courses in the summer in local community colleges and living at home 3) doing all they can to minimize living expenses, including no vacations from work, living as cheaply as possible without getting robbed, and avoiding having a car.

In order to make money you need to HAVE money, money that you have saved up after day to day expenses and isn’t already spent by debt and living expenses. You can only HAVE money if you save diligently, question expenses continuously, and minimize debt.

Even once you have money and are investing it, it is far from a “sure thing”. Some of my portfolios (particularly #3) have started up during terrible times in the stock market, and haven’t grown like #1 which came during a still bad but not as difficult period. This is another important lesson to learn; that investing takes patience and guts and doesn’t always turn out like you planned. This is “real money”, not money like you see on TV or in a video game, and it is painful when investments don’t pan out and you lose money, but you also can’t just put it all in a bank account and watch it sit there and essentially earn nothing.

These are real life lessons and if I can do anything to help them along during the course of this trust fund effort then I feel that I am helping, even if just a bit. And through this web site I am trying to help anyone else who would want to do the same thing and directly or indirectly impart these same lessons.

Antoine Walker An Example of Net Worth vs. Earnings

One of the prime concepts behind this site is the difference between “net worth” and “earnings”.  Net worth is what you have, left over, after all of your liabilities (mortgage, car payment, student loans, and other debts) are paid off.  For most people, unfortunately, their net worth is very near zero.

Antoine Walker, the former Celtic who resides in Chicago, is a prime example of someone who earned a large amount of money during his lifetime and yet has a negative net worth.  He recently declared bankruptcy, as summarized in this article:

After a 13-year career and over $110 million in salary, Antoine Walker has filed for bankruptcy after being hit with a $2.3 million foreclosure lawsuit on a mansion that he bought for his mother in Tinley Park, a small city south of Chicago. Walker, of Wiggle (or Shimmy) fame, just has too much debt.  “Off the court, there were the cars, the jewelry, the houses, the suits, the gambling. He liked to move in an outsized entourage; his mother estimates that, during his playing days, he was supporting 70 friends and family members in one way or another. And speaking of his mother, he built her a mansion in the Chicago suburbs, complete with an indoor pool, 10 bathrooms, and a full-size basketball court.  And then this: “Walker turned the pavement surrounding his home into a virtual luxury car lot – two Bentleys, two Mercedes, a Range Rover, a Cadillac Escalade, a bright red Hummer. Often, the vehicles were tricked out with custom paint jobs, rims, and sound systems at considerable added expense. He also collected top-line watches – Rolexes and diamond-encrusted Cartiers.”

There you can see where the EARNINGS go – onto cars, watches, supporting non-working friends, and also clothes.

One part of the article I disagree with because it is poorly worded:

Mr. Walker owns four properties: a $2.34-million home in Miami; two South Side apartment buildings each worth $190,000, and the Tinley Park home, valued at $1.4 million, according to the bankruptcy filing.

Mr. Walker, as they refer to him, owns NOTHING.  He possesses some assets, but cannot make the payments to keep up with his liabilities, so net, he has no assets.

Mr. Walker, 33, lists liabilities of $12.74 million vs. assets of $4.28 million in the bankruptcy filing. Mr. Walker’s 2006 NBA championship ring, valued at $6,000, is listed among his assets, according to the Chapter 7 filing May 18 in U.S. Bankruptcy Court in Southern Florida.

This is a very sad story but one to learn from; no matter how high your earnings, if you keep spending enough money and taking on more debt, you will inevitably end up on the wrong side of the ledger.

Almost Time For Stock Picking Season

As a brief overview again of how my trust funds work:

  1. I set up individual trust funds for my nieces and nephews when they are around 11-12
  2. Every year I contribute $500 / each, they contribute $500 each, and then I match $500 more, for a total of $1500 / year
  3. I select 6 stocks a year and each niece or nephew selects 2 of them from that list (for about $750 / each)
  4. We make the stock purchase around September of each year; this gives them the summertime to earn enough money doing work or odd jobs to get the $500 for the additional match
  5. I watch the funds and if certain events occur and I think it is time to buy or sell a particular stock I will let them know and we can discuss and then I execute the trade.  When this money is reinvested then sometimes we purchase more than 2 stocks at a time or we increase the purchase amount of each above $750

From a portfolio perspective, once you get to 10 or so stocks (assuming that they aren’t in the same industry) you have a reasonably diversified portfolio.  Portfolio One (the longest term portfolio, at about 9 years) is at that state; the other portfolios may swing significantly in value based upon the performance of a single stock.

So it is now time for me to begin researching the stocks that I want to consider for my list of 6 stocks.  Dan, our newest contributor here, asked in semi-jest if I just threw a dart at the dartboard.  We are a little bit more sophisticated than that, although we realize that selecting individual stocks is a difficult business and not recommended fora large portion of your total portfolio.

Here is a mix of the principles that I use and what I look for in a stock:

  1. Value not Momentum – given that these are long term investments and I don’t want to terrify the kids with wide, gyrating swings I tend to look more at value type stocks and not chase faddish or momentum stocks
  2. Stocks I understand – I don’t expect them to fully understand everything (or I’d be forced to just let them pick from consumer products, which is a bad plan) but I want a stock that I understand.  Sometimes when I understand an industry (like the financial industry) it is strongly tied to me NOT recommending stocks from that industry.  I do try to explain every stock to them, what it does, and why it is on the list, because I want them to inspire to investing in this manner as they gain more experience over the years
  3. Seek international diversification – through ADR’s there are a large number of individual foreign stocks that can be purchased and I try to have half or so (all else being equal) of the stocks on the list as non US stocks
  4. Try to have a mix of large and smaller market cap stocks – there is nothing on the list that is typically less than $1B or so in market value but I want to have a mix of large and small stocks, especially since smaller stocks generally have more room to “run” than a behemoth
  5. Dividends are preferred – I don’t want a stock whose entire value is dependent upon a dividend stream but I think that paying some sort of reasonably large, regular dividend is associated with better management and dividends do make up a significant percentage of the return in the long term.  On the other hand, high dividend paying stocks are likely to be hit hard should the tax laws on dividends be significantly impacted

Since Dan has joined and he is a pretty sophisticated guy (and I have some other friends whom ultimately I will try to twist their arms to join, too) I will put up some of the stock ideas I have in an earlier, less-final manner and see what I get in terms of comments and suggested alternatives.

I generally keep up to date on companies through the Wall Street Journal, Barrons (although I don’t subscribe to the paper version anymore because it got expensive), Investors’ Business Daily (which I periodically pick up, although their stock selections are usually too small and fast-moving for my purposes), Financial Times, and then the large general business magazines like Forbes, Fortune and Business Week.

The Psychology of Gifting


While I called out Gail Marks Jarvis of the Chicago Tribune for her article on our assumed rate of return, she provided what seems to be solid advice on the topic of giving in an article titled “Financial Cord Can Trip Up Adult Children“.

While this article is focused on parents giving money to adult children, the concepts still resonate with those setting up a trust fund for a minor (such as this site). She quotes from Brad Klontz, author of “Mind Over Money”.

Financial handouts are rarely helpful in the long run… money for nothing typically results in more of the same – nothing.

That is very well said, direct, and to the point. If you give someone something for no activity on their part, why should they try to help themselves?

While everyone has their own situation to consider, in my experience the “matching” concept has been very effective. Matching requires the recipient to take action in order to receive the gift, so you are rewarding action, not inactivity. Since the money came from their sweat and toil (it takes a lot of work to earn $500 when you are a kid, mowing lawns, working for minimum wage, or babysitting) they really take this process seriously, and feel that they have a stake in the outcome.

In order for matching to be successful, you have to be consistent in your expectations and give notice. The kids need to earn the money, and they need to know when it is due. For my nieces and nephews the end of summer is a good time because it is right before school starts and gives them a chance to earn money when they are on break. You also can’t reward when there isn’t any achievement on their side (we did put in an additional amount at our discretion upon graduating from school or college).

Handouts can also “lead to resentment on the part of the givers, who may feel that they are being taken advantage of”.

I learned from a good friend of mine who told their experience of giving when the recipient just wanted more, more and more and in the end they are hardly even on speaking terms. I listened to this advice in constructing my matching program.