Bubbling Assets Are Not Good Investments

A recent column by Gail MarksJarvis in the Chicago Tribune warned that “Investors Should Be Wary of Bitcoin.” She warns that while Bitcoin has seen 358% gain this year, it’s probably approaching the peak of its asset bubble, and newer investors will get caught holding the hot potato when the bubble pops. They’ll be just like the losers from the 2008 housing crash, the 2000 tech bubble crash, and the Nikkei crash in the 1980s.

I’d like to add a separate warning that also applies to many other alternative investments, like gold or real estate. Often, the rationale for these investments is that they have “real” value or they’re more stable because they don’t rely on the financial system. Really? NOTHING has inherent value unless it can feed you, clothe you, or provide shelter for you. Everything else only has value because people agree on its value.

Take gold, for example. It’s a nice, non-corroding, malleable metal that’s also a good conductor of electricity. What good is it when the economy crashes and the zombie apocalypse starts? You’ll have hunks of metal. That won’t help you grow food or even buy food if there’s none available. It only has value if you find people willing to accept it in exchange for whatever they’re willing to sell.

One of the arguments people use for Bitcoin is that it’s independent of governments and central banks, so it’s more stable than fiat currencies and will survive the pending banking collapse from all the debt problems. Sorry, but nothing that grows at 300% per year is stable. Again, consider the worst case zombie-apocalypse scenario: if the “system” goes and there’s no power generation, what good is cryptocurrency when no one can use a computer to verify you have any?

If you’re really concerned about doomsday economic scenarios, build up a stockpile of food, water, and essential living supplies. If you’re looking for solid financial investments, jumping on an asset bubble is not a long-term strategy.

How’s Your Financial Wisdom?

After my last post on baby boomers failing their retirement planning, you might have some smug thoughts that you’re doing much better than them. Here’s a little test, thanks to The Atlantic:

  1. Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After five years, how much do you think you would have in the account if you left the money to grow? A) more than $102; B) exactly $102; C) less than $102; D) do not know; refuse to answer.
  2. Imagine that the interest rate on your savings account is 1 percent per year and inflation is 2 percent per year. After one year, would you be able to buy A) more than, B) exactly the same as, or C) less than today with the money in this account?; D) do not know; refuse to answer.
  3. Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.” A) true; B) false; C) do not know; refuse to answer.

The correct answers are 1-A; 2-C; and 3-B.

Based on a survey by economists Annamaria Lusardi and Olivia Mitchell, only 30 percent of Americans answered all three questions correctly. Their findings are published by American Economic Association (subscription required).

The Atlantic author warns that financial ignorance becomes more devastating in a modern economy. Fortunately, the study authors found that basic financial education can boost someone’s economic situation (by 82% of initial wealth for people with low levels of formal education and 56% for college graduates).

If you’re reading a personal finance blog (or read my book), you probably did pretty well on the test. Try to share your financial knowledge with someone you know who needs the help. They might not even know it. Start with the quiz.

Retirement Mistakes Before Retirement

Here’s an article from Yahoo! Finance that points out retirement mistakes many people make well before they get to retirement:

  1. Not starting early
  2. Not having a Roth IRA
  3. Raiding your retirement account
  4. Cashing out your 401(k)

The article quotes a lot from CPA and “retirement expert” Ed Slott. He points out that starting early and maximizing your Roth IRA every year (age 25 to 65) is basically all you need to do to have a million dollar nest egg. If you wait and start 5 years later, you’ll have $200K less in your nest egg.

Mistake #4 is a big one for people who switch jobs. If your next employer doesn’t have a 401(k) plan, or you prefer to manage the money yourself, you can open a 401(k) rollover account. Simply cashing out your 401(k) will incur a 10% penalty, plus a one-time bill for all the taxes owed. Worse, you’ll be giving up the benefit of future tax-deferred earnings.

If you’re unsure what this all means, check out Basic Personal Finance. You can read the first chapter, which lists the 10 rules of thumb for financial success, for free on Amazon. Chapter 6 shows an example of how tax-deferred investments outperform similar investments in taxable accounts.

Retirement Plan Math

A few days ago, I posted the two basic steps of retirement planning.

Step 1: Figure out what quality of life you want during retirement (i.e., how much you want to live on each year). This will determine the size of the nest egg you need to have ready when you retire.

Step 2: Figure out how much you need to start saving now to get there.

Of course, those makes sense to me, but my inner math teacher feels compelled to elaborate for those who need it (even if they won’t ask for it). The calculation for step 1 is a present value formula for an annuity payment. In this case, the payment (PMT) is the amount you want to draw from your portfolio each year in retirement. The present value (PV) is the amount of the portfolio when you retire. (That could be confusing because it’s a present value, but we’re talking about future money; we’ll deal with that later.) You have to specify a real return for the portfolio (r) and the number of years you want to draw this benefit (n). So, if you start with PV in your portfolio at retirement, you can draw PMT from the portfolio each year for n years until you run out of money. You can solve this with the following formula:


If you’re scared of math, you can solve it in Excel: =PV(rate, nper, -pmt). Because Excel looks at time-value-of-money equations as cash flows, enter your PMT value as a negative number. If you don’t, you’ll get the same absolute value, but PV will be negative… no big deal.

For Step 2, you set that present value to a future value (FV), because that’s what you want your portfolio to be in the future. Now use the future value annuity formula and solve for the payment (PMT), which is the amount you need to invest each year (at a real return, r, for n years) to reach that FV. The formula is:


Again, Excel makes it easy: =PMT(rate, nper, pv, -fv). In this case, add a present value (pv) if you already have some savings started.

Note that the second r and n are not the same as the previous formula. This time n is the number of years you have to save for retirement. The previous n was the number of years you plan to draw on your savings during retirement. Similarly, the r in the PMT formula is the real return you expect to earn while you save for retirement. The r in the PV formula is the real return you expect to earn during retirement (which will probably be lower, assuming safer investments).

This (and lots more financial math) is covered in Basic Personal Finance, but now you have the two most important formulas. You can complicate this by simulating returns to add some realism, or you can simply pad your numbers by using a smaller r in either or both formulas. You can also use a larger n and/or larger PMT in the first formula to pad your nest egg.

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.