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

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

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

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

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

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

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.

More Evidence for Index Funds

There are always individual actively-managed mutual funds that bring outstanding returns, but it is rare for these funds to actually outperform passively-managed funds in the long run. According to the Wall Street Journal, 82% of all U.S. stock mutual funds have trailed their respective benchmarks over the last 15 years. Do you think you can pick the 1-in-5 winner? And then, do you think you can switch to the next hot fund before your current hot fund loses its heat?

For those interested in a more complicated answer (i.e., some mix of index and actively-managed funds), another Wall Street Journal article gives some options. However, Danial Solin warns that half of actively-managed funds disappear before then reach 10 years. As for the “winner” funds, he says “There’s no evidence of persistence of performance beyond what you would expect from random chance.”

After accounting to taxes and fees, actively-managed funds are even worse when compared to a passively-managed the index fund. The safe bet is to pick an index fund. Chapter 7 of Basic Personal Finance discusses the topic in more detail.

Hot Stocks Or Hot Potatoes

An article by Jeff Sommer in the New York Times points out the potential rewards of picking individual stocks, but also warns about the riskiness: “Over the long run, while the total stock market has prospered, most individual stocks have not.” He summarizes a study by Arizona State University professor Hendrik Bessembinder, which likened individual stocks to lottery tickets: a small chance of winning with a large chance of making nothing. The study showed that since 1926, over half (58%) of stocks failed to outperform 1-month Treasury bills over their lifetimes (i.e., less than 1% return). All net market returns from 1926 to 2015 were provided by just 4% of stocks.

From the article: “Professor Bessembinder said that he, personally, favors low-cost index mutual fund investing.” Add another data point for the recommendation found in my book Basic Personal Finance.

Privatizing Social Security, Part III

The Expense of Transition Will Prevent Privatization

The previous posts already showed how privatizing Social Security would result in better returns for beneficiaries and how most opponents to privatization simply make emotional arguments in opposition to privatization. The real reason the system will not get privatized is the same reason the system will eventually collapse: it’s a Ponzi scheme. If that term is too inflammatory, call it a pay-as-you-go system.

John Goodman (not the actor) provides a list of reasons why most democratic voting countries have pay-as-you-go social security systems rather than privatized systems. The main reason is that such a system allows politicians to “appear to meet the need without really paying for it.” Next, the system generates revenues that exceed required payouts in the early years, allowing politicians to raid the “trust fund” to transfer money to their constituents (i.e., buy votes). The system cannot be dismantled because of the “ratchet effect.” That is, as the beneficiary base expands, it becomes too costly to transition them into another system.

As many people have pointed out, the Social Security system will eventually collapse because the number of beneficiaries continues to increase while the number of  contributors per beneficiary is decreasing. The promised benefits impose a huge unfunded liability to the government. Transitioning to a privatized system would be better for future beneficiaries but removes the funding of current beneficiaries. In short, privatizing Social Security would force the government to acknowledge the unfunded liabilities, and the deficit (and debt) would explode. No politician wants to take the blame for that.

Privatizing Social Security, Part II

Comparing Returns

Usually, any opposition to Social Security privatization will use some kind of emotional argument about the risks of stock investing versus the absolute certainty of the safety net embodied by Social Security. They never seem to produce numbers to back up the claims, unless they cite specific days when the stock market performed especially poorly (i.e., any market crash day). You can just as easily pick days when the government performs poorly (e.g., missed someone’s paycheck). That one event doesn’t reflect on all future Social Security payments for all beneficiaries. Let’s try to put some numbers to the argument to compare Social Security to the stock market.

The real return on social security “contributions” was determined by the Social Security Administration by running simulations for beneficiaries born between 1920 and 2004. The return for an individual is difficult to determine because it is based on lifetime earnings and the length of time drawing benefits. That said, the highest return was earned by single-earning couples born in the 1920s: 6.52%. Everyone else will get less. Younger workers have paid higher payroll taxes, so their returns will be lower. Single beneficiaries will earn less because they don’t receive Social Security’s generous spousal benefits. For example, a middle-income single-earning couple born in 1943 will get a 4.59% return, while a single earner with similar income will only earn a 2.49% return. Of course, the returns improve the longer the beneficiaries live, but the simulations show you have to live beyond 85 years old to guarantee a positive return (only half of the people who die between 75 and 84 earn a positive return).

How does that compare to the stock market? The minimum 45-year after-tax average annual return for the S&P 500 index since 1927 is 4.4% (1963-2008). The average is 6.4%, and the standard deviation is 1.1% (based on return data from Aswath Damodaran and inflation data from the Minneapolis Fed, as credited in my book, Basic Personal Finance). So you’re earning a positive return the moment you start saving. Unlike Social Security, this return is not dependent on marital status or longevity, and the proceeds can be passed on (increasing returns to future generations). Under Social Security, if you are single and have no dependent children under 18, your contributions produce zero benefits if you pass away. If you put your money in the stock market, that money could be bequeathed to anyone you specify.

Bonus: It turns out that minimum return of 4.4% is the magic return to ensure ANYBODY saving 12.4% of their income for 45 years could earn his or her salary for 31 years after retirement. Ask anyone drawing Social Security benefits how those checks compare to their salaries when they worked. According to the National Academy of Social Insurance, those benefits will be between 26% and 53% of career-average wages. (The higher number is for lower income earners.)

This is significant because whenever retirement advisors suggest people save at least 10% of their income, detractors say something like, “Easy for you to say. The poor can’t afford to save 10%.” Well, if they were allowed to save their Social Security contributions, that’s 12.4% (including the employer portion).

Let’s look at a worst-case scenario of an individual who makes minimum wage for their entire 45-year working career. We’ll use $7.25/hr with a 40-hour work week and 50 weeks per year. That’s only $14,500 a year. If this person’s 12.4% Social Security tax were invested at 4.4% for 45 years, the retirement account balance would be $242,836. That doesn’t sound like a lot of money, but if the account continued to grow at 4.4%, this individual could live on that money for 31 years and draw $14,500 in each year, the equivalent of the minimum wage salary. (The cool thing is that this works for any annual salary.)

That’s just using basic time-value of money calculations with average returns. A more thorough analysis would simulate real returns to capture the variabilities which could hurt (or benefit) the portfolio. Maybe someone with one of those many university research grants could do that. It would be nice of the proponents and detractors of privatizing Social Security would actually do SOME analysis rather than just regurgitating the tired talking points.