Consider Income When Considering Career

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In an earlier post, I referenced an article that discussed Bloomberg’s Shift: The Commission on Work, Workers, and Technology. That’s Bloomberg-as in Michael Bloomberg, the former mayor of New York City. I was shocked at the credit given to the capitalist economic system. From the report: “Today, the poorest Americans have higher living standards-and live healthier, longer lives-than the richest Americans in the 19th century.” It goes on to praise technological advances because increased productivity is the only real way to advance our quality of life. Unfortunately, advancement also means some workers are rendered obsolete. The point of the study was to address the state of workers in the near future (10-20 years). The commission had 100 members in 5 cities create 44 scenarios, which were whittled to 4 scenarios to analyze. More importantly, they surveyed workers about their jobs, satisfaction and expectations.

The conclusions and comments aren’t all that productive. The report seems to mostly provide the opportunity for the members to virtue signal (i.e., talk how much they care about workers). That said, some of the survey results are interesting:

1) There’s the disturbing part about unexpected expenses: 28% said they would have to worry about a $10 unexpected expense. That what my previous post was about.

2) The amazing result, to me, was the response to “What matters most to you about work?” While the report highlights the desire for stability (a top 3 response for every income bracket), a higher response was “Doing things I enjoy”… #1 for all income brackets except $50K-$75K, which had it at #2 (behind stability).

While everyone wants to do things they enjoy, they have to figure out how to get paid for it. Basic Personal Finance points out that work is called work because, for the most part, people don’t want to do it. Picking an occupation is about finding a good or service that you can provide that people are willing to pay for. It is important to consider future job prospects when you decide to invest in yourself through any kind of education or training. Studying a subject that you like but with little prospect of a job (either from no demand or abundance of supply) is not a good investment. Going into an industry on the verge of automation (e.g., truck driving) is also not a good investment.

Why Productivity Matters

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Bloomberg’s Shift: The Commission on Work, Workers, and Technology report tried to address the problems workers face with technological innovation. It did, however, praise technological advances because increased productivity is the only real way to advance our quality of life. Here’s why:

Consider the most basic model of a firm selling a single product in a competitive market. That means the firm can sell as much as it can produce at the market price, p. The firm’s inputs are labor, L, and capital, K. For simplicity, we’ll assume capital is fixed in the short-run. (It doesn’t affect the result.) The firm’s objective is to maximize profit, so it will produce efficiently. That means it will produce on its production function, f(L, K), a function that defines maximum output for given levels of inputs, L and K.

The firm’s objective is to maximize profit which equals revenue minus cost. Price times output (production function) is total revenue. Costs are wage (w) times labor and rental cost of capital (r) times capital. To keep the math simple, assume competitive input markets as well, so w and r are constant. The firm’s objective function is

MaxProfit

This is a simple, unconstrained optimization problem with a single decision variable, L. (The bar over K is to denote that capital is constant.) To solve the problem, take the derivative with respect to the single decision variable (L) and set it equal to zero:

dProfitdLabor

The result: pMPL = w, where MPL is the marginal product of labor (the derivative of the production function with respect to labor).

So, if we define our quality of life based on our income (wage), we want to increase w. That can only be done by increasing p or MPL. The former will raise wage, but not effectively increase real purchasing power because the increased wage will be offset by the higher price. Increasing MPL, however, will increase wage and allow workers to purchase more product (i.e., higher quality of life).

Note that this analysis also explains why you can’t simply mandate a higher wage. Product prices will rise to effectively negate the wage increase. The only real way to advance our quality of life (as mentioned in the Shift report) is to increase productivity.

 

Under 30? Time is on Your Side. Don’t Waste It.

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Nicholas Hopwood has an article in Investopedia (& Business Insider) that says your best asset is your income, not your home or savings. He makes a good point for millennials. (It doesn’t apply to those of us with fewer earning years ahead.)

A home ties up a lot of income and actually increases your expenses. Plus studies show the real return to real estate is negative. For savings, Hopwood is referring to 401(k) balances. There’s not much there for younger workers, but higher income allows you to make the best use of a 401(k) (to reach the $18K maximum contribution).

For young people, time is on your side because of the power of compounding. Anything you do to increase future earnings will be amplified by that extra time. Hopwood says your early income will be tied to your degree or technical expertise, a polite way of saying you should study something that will actually get you a job. Over time, he says attitude, personality and communication skills are most important to income growth.

Just make sure you save at least 10% of that income… and increase that percentage with each pay raise.

Make Your Own Savings Plan

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We’re definitely in a period of “fake news.” Two stories on Yahoo make me think April Fool’s Day was postponed to May this year. The first story claims millennials save for financial freedom rather than to leave the workforce and retire. It cites a Merrill Edge study that claims the 18-34 age group is saving more money than any other age group. That’s hard to believe, given a Consumerist article two weeks ago that said nearly half of Americans are not able to cope with a $100 surprise expense. CNBC has run several stories on a March 2016 Economic Policy Institute report that shows median savings are pathetically low: only $480 for ages 32-37.

From the Merrill Edge study, “average income they say they’re saving per year”:

Millennials:   19%
Gen X:             14%
Boomers:        14%
Seniors:           12%

I started to question those numbers, but then realized it’s self-reported. (Re-read that quote above the numbers.) Digging through the article, it says millennials are more likely to spend money on travel, dining, and fitness than to put it into savings.

Sadly, the only thing in the article that rang true was this line: “they’re not thinking about retirement as a phase of life”

Curiously, another article about millennial savings by the same Yahoo author claims millennials are “more eager to pay their own way at younger ages than when baby boomers think they should.” That one claims a Bankrate survey. The funny thing is the conclusion: “The dream of financial independence and the reality of their current financial situation continues to be at odds for many millennials.” Don’t forget, this is the same author that just claimed millennials save more than other generations.

The take away (besides don’t print fake news): don’t make your decisions based on what other people are doing (or claim to be doing). Figure out what quality of life you want during retirement (i.e., how much you want to live on each year), and then figure out how much you need to start saving now to get there. My book helps you figure out how to do that. The important part is to start now. Compound interest isn’t something you get back later.

Don’t Let Your 15 Minutes of Fame Be as a Bad Example

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CNBC seems to be highlighting people’s financial mistakes . They started in January with a story about a woman spending $700 a month on Uber. This month, they have two stories: one about a guy with $100K in debt spending $1,100 a month on takeout (nearly 30% of his income!); the other is someone who wasted $41,000 at Amazon on over 1,400 items, none of which she can remember. That last one also links to a story about how consumers underestimate their online purchases.  OpenUp studied 1000 subjects in 2016 and found a big disparity between self-reported purchases and actual purchases (22 items vs 41 items). Fortunately, the personal articles go on to explain the mistakes and show how these people have turned their financial lives around.

It’s not hard to avoid the big financial holes these people dug for themselves. You can learn about financial discipline in Basic Personal Finance (or just about any consumer finance website… of course, my book is better). Don’t let your brief 15 minutes of fame be as a bad example for others to learn from your mistakes.

10-Year Forecasts are Fairy Tales

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The Wall Street Journal just had a great article on the pathetic job the Congressional Budget Office (CBO) has done with predicting costs and coverage from the Affordable Care Act. It’s about time someone points out the idiocy of these projections from Washington (not just the CBO). If you’ve had any statistics classes, you know the standard error for a prediction gets bigger the further away it is from your data. For a time-series model, the error as little as three periods into the future is so big that any predictions are practically meaningless.

I’ve never understood why we always get 10-year forecasts from every agency in Washington. I suspect the reason can be summed up by National Security Advisor Jeffrey Pelt in The Hunt for Red October: “I’m a politician, which means I’m a cheat and a liar, and when I’m not kissing babies I’m stealing their lollipops.” This raises the question: do lollipop makers take election years into account when forecasting future sales?

Anytime you see “10-year forecast,” you can replace that with “Once upon a time,” and you’ll be better prepared for what comes next.

Emergency Expenses Are Part of Financial Planning

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The Consumerist (a service of Consumer Reports) recently reported on a Bloomberg study on Work, Workers and Technology. The nugget they pulled is not related to any of those things; it deals with financial security, and the result is very bad. One thousand respondents were asked if they were prepared for unexpected expenses, and a majority said no. The results:

$1000 expense:  80% could not pay it
$100 expense:  48% could not pay it
$10 expense:  28% “would have to worry about being able to pay”

Most respondents said part of the problem is that their income varies from week to week. At the risk of sounding insensitive, that’s no excuse. One of the first things everyone should do when assessing their financial lives is develop an emergency expense fund (Rule of Thumb #6 in Basic Personal Finance). That goes along with building (and sticking to) a budget to ensure you can live within your means. As I’ve posted before: discipline, not income, prevents debt.

The silver lining is that 73% of respondents expect their kids to do better and make more money. Let’s hope they also do a better job of budgeting and saving that money.

 

All CFPs Come From Lake Wobegon

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It’s amazing how two people can read the same article and come to completely opposite conclusions. A couple days ago, I mentioned a study by Arizona State professor Hendrick Bessembinder that likened individual stocks to lottery tickets. The study itself looked at all stocks from 1926 and concluded (among other things) that 58% of individual stocks failed to outperform 1-month Treasury bills over their lifetimes. That last part is key. Any stock can have a good day, good month, or good year. Bessembinder pointed out that over half of them do not perform well over their lifetimes (years). Enter your typical financial advisor. For a fee, they’ll reallocate your portfolio every year (or month!) using their super-secret formula to ensure you only have the winner stocks, and you can beat the market average (but only with the advisor’s help). The catch is, you have to beat the average by more than the advisor’s fee PLUS the added trade costs PLUS the additional capital gains taxes you’ll pay.

Bessembinder’s final conclusion was that your typical investor is better served by index funds. As an economist who understands the efficient market hypothesis and many other studies that have the same conclusions, I simply added Bessembinder’s study as another data point supporting index funds. Lauren Rudd read it and decided to channel his inner Lake Wobegon CFP… don’t you know, they all earn above average returns! Rudd claimed some secret unpublished method to construct “portfolios capable of outperforming the S&P 500 index over a 3, 5 and 10-year timeframe.” Anyone can do that with historical data. If, on Feb 5th, Dan Quinn had today’s knowledge of Bill Belichick’s play calls from Feb 5th, the Lombardi Trophy would be in Atlanta.

The saying goes “past performance is not indicative of future performance.” Market returns are essentially random, and anyone who says otherwise is trying to sell you something.

When financial planners face an uncertain future, rather than using known historical returns, their performance rarely lives up to the bluster. Academic studies consistently show the majority of brokers and financial planners underperform the market in the long run. Just last month, the Wall Street Journal reported on academic research showing that 82% of all U.S. stock mutual funds have trailed their respective benchmarks over the last 15 years.

Rudd also claimed that other advisers recommend closed-ended (ETF) index funds. That’s a total straw man argument. Brokers might recommend ETFs (good commissions and/or fees), but everything I’ve read (including my own book) says to use open-ended, low cost (<0.25%) index funds. This will provide higher after-tax and after-expense returns to the majority of investors.

 

The Future of Trading is Scary

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My last post discussed Robinhood’s targeting of millennial investors, suggesting Robinhood was the real winner of the Snap, Inc. IPO. It may be hard to see how they “won,” given that Robinhood allows free trades. What they did was build a customer base by targeting a generation that expects everything to be free.

But how does Robinhood expect to survive as a “sub-discount” broker with free trades? Investopedia has some ideas: (1) low costs (no physical locations or PR campaigns), (2) interest earned from customers’ unused cash deposits, and (3) venture capital. That last one is the real reason Robinhood exists: $16M in venture capital. Future income streams will come from margin trading with a 3.5% fee, phone-assisted trades for $10, and a subscription service for pre- and after-hours trading.

If this is the future of trading, I fear for young investors. Free trades are bad enough because they practically encourage day trading, which is essentially the same as gambling. Trading on margin takes a dangerous thing like day trading and takes it nuclear (pronounce it nuke-you-lar for added emphasis). One of the top rules of gambling is to not do it with money you can’t afford to lose. With margin trading, people are gambling with money they don’t even have. This type of rampant speculation causes asset bubbles and subsequent crashes (see the 1929 Black Tuesday crash or the 2008 real estate crash).

Chapter 7 of Basic Personal Finance clearly explains why most investors would be better off automatically depositing a monthly amount into low-cost index mutual funds, which allow them to diversify and get higher after-tax and after-expense returns.

Young Investors = Easy Prey for Brokers

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Years of investment advice boils down to (1) diversify your portfolio and (2) the easiest, cheapest way to do so is with low-cost, index mutual funds. Given this reality, where are brokers going to find new suckers clients? Enter Millennials. An article by Jefferson Graham in USA Today says the Snap, Inc. (i.e., Snapchat app) IPO on 3/2/17 was very popular with investors under 30. As with many IPOs, initial hype led to a strong opening (up 59% in two days). Once people realized Snap, Inc. hasn’t actually monetized Snapchat, several brokers released sell recommendations, and the stock plummeted.

The real winner was Robinhood, a trading app whose users average 30 years of age (median is 26). The company saw a surge in new accounts, and 43% of all its trades on 3/2/17 were for Snap, Inc.

Chapter 7 in my book, Basic Personal Finance, is the longest chapter in the book because we wanted to clearly lay out the case for our recommendation to use low-cost index mutual funds. This is the best after-tax and after-expenses investment for the majority of people. Picking individual stocks is essentially gambling and the brokerage fees will eat away at any gains you might get.