Fear No Finance

Book on Investing By a Dying Banker

2010-11-27T06:47:00.000-08:00

This blog has been dormant for a long time, but from time to time I'll post about topics that strike my interest.

There's an interesting article on a book being written by a man who used to be a banker on Wall Street and who is now dying of a brain tumor. I haven't read the book (not sure if it's available yet), but two things stuck out for me - first, if you hire someone to make investment recommendations or manage assets, make sure that they are fee-for-service (paid because they work for you) and not compensated for selling you something (on commission); and second, you can't beat the averages in the long run and indexed (passive) investing, diversified across and within asset classes, is the best way to achieve the best long-term return with the least volatility (ups and downs across the whole portfolio). These are principals of investing I've believed in, and followed, for a long time.

Records Retention

2010-03-30T12:23:00.000-07:00

CharlieHorse asked a good question about records and files retention - there was a recent very good article in the New York Times on exactly this subject - check it out.

43 Files, Plus a Few More

2010-03-23T07:13:00.001-07:00

This post really isn't about financial matters, at least not directly - it's about productivity - but being sufficiently organized that you can keep track of what you have to do is a big part of the battle and is essential for being organized financially.

A number of years ago, I happened to pick up and read a book on productivity - getting yourself organized so you can accomplish whatever it is that you want to get done - either in the workplace or at home - Getting Things Done: The Art of Stress-Free Productivity, by David Allen. I was already retired, and regret that I didn't encounter this book while I was still working - it would have made an enormous difference to me in the work world, although it's been immensely useful outside the formal work world as well.

Whenever I'm looking at a system like this, my key question isn't whether it's clever or cool, but is it easily maintainable and practical? It has to be something that can become a habit, a daily practice, that is easy and sustainable.

After reading it, I immediately implemented some of the key aspects of the book. One of the key points the book makes is that one of the things that keeps us distracted and unable to accomplish what we want is that we carry too many to-dos or potential to-dos and projects in our heads. He advises writing every single thing down and has a great system to accomplish this initially and easily maintain it thereafter. There are also very good sections on how to organize files and keep papers in a way that doesn't result in feeling overwhelmed or disorganized.

But for me the biggest, and simplest, innovation was the system of manila folders for dealing with time-related items. This consists of 31 folders, numbered 1 through 31, and 12 folders labeled with the months. I keep these in an upright file folder on the top of my desk. Each morning, I take out that day's folder and anything that is happening, or has to be done, on that day will be in it. (I also note appointments and happenings on a large calendar we keep in the kitchen.) As I near the end of the month, I take out whatever is in the next month's folder and add it to a calendar, put it in a daily file folder, or note it on a card to put in a to-do folder, as appropriate. I've been using this system for years, and it really works. Anything that is repeated each month on a regular date - paying horse board or giving the dog her heartworm pill, for example) has a card that lives in the appropriate day folder.

I also use several other folders that he recommends in the book, and some that are unique to me. I have a "Bills to Pay" folder for both my family and my father (I take care of all my father's financial matters), and as I open the mail, all bills, and checks to deposit, go in those folders, and then I pay the bills once a week. I have a "Contacts" file for all addresses, e-mails and telephone numbers I need - this file could do with some organization.

And one of my most important file folders is labeled "Waiting For" - this one contains anything where I've done something and I'm waiting for a response from someone else - you know how easy it is to lose track of these things and never follow up. This way, about once a week, I'll look through this folder so I know if there's anything else I need to do yet about an item.

Each major project can also have a "To Do" folder - he does not advocate using piles of papers as a physical to-do list, and this can also be reviewed on a regular basis. The really great thing about this whole system is that you don't have to remember anything. You can also have a separate file folder, if you travel for work or pleasure, for each trip, and that way when you get ready to go, all you have to do is just pick up the folder and go.

You get the idea - it's a great book and a very practical and helpful system, which I recommend highly.

Making Tax Time Easier

2010-03-11T07:56:00.001-08:00

I have a trick I've used for a number of years to make tax time easier. At the beginning of each year, I take a file folder and label it for the year - "Taxes 2009". I keep the folder in an place that's easy to reach. Then as things happen during the year - transactions or payments that might affect taxes, or receipts or other records that come in - I just throw them in the file. In January and February, as W-2s, 1099s or other year-end records come in, they go in the file. Then, when I sit down to organize my materials at tax time, everything is right there to hand. Sometimes I have to go back and consult my checkbook or credit card statements (those are saved in separate files), but otherwise, everything I need is in the tax file.

"Taxes 2010" is already made up and starting to accumulate materials!

On Saving

2010-03-07T12:27:00.000-08:00

Saving is a way of putting aside money you have now so that it will be available later. Saving is both a habit to be developed and a way of investing in the future. Even small children can learn how to save - every week when our children got their allowances, in addition to some money they were to use for immediate spending, and some money for charity, they put aside some money to accumulate for a later purchase they might want to make. They had the old-fashioned savings books, and every time a relative gave them money as a gift, at least some portion went into savings. When they had jobs, again a portion went into savings.

To save involves establishing a habit. If possible, saving should be made as automatic as it can - if you have a paycheck, have a portion directly deposited into a separate savings account (which might not be a traditional bank saving account). If you have access to an IRA at work, direct deposit the most you can afford into it. If you have money you receive directly, deposit a specific amount or percentage into savings. "Windfalls" - amounts of money that show up unexpectedly - are great candidates for savings as you weren't expecting to receive them.

But in order to know what to do with your savings, you need to have an idea of why you're saving - your goals. A basic purpose for savings is to smooth expenses - sometimes you know that there is a large expense looming - a capital purchase like an appliance, or moving expenses, or a wedding coming up, tuition, or even paying real estate taxes if you own a house - and your regular monthly income may not be able to absorb such a large expense, so you save for it over a period of months.

Another important purpose of saving is to establish an emergency fund in the event of loss of income. Everyone should have an emergency fund covering monthly expenses for a period of three to six months - it's a good idea to err on the long side.

Then there are intermediate-term savings goals - to pay for a vacation, to accumulate a down payment for a house purchase, to buy a car, to pay for all or part of a tuition expense in a year or two. There are also longer-term savings goals, such as to accumulate money for retirement.

Depending on how close or far the event is for which the money is saved, the money probably should be invested in different ways. Money that will be needed immediately, or in the short term, and the emergency fund, should be held in a safer place where the value is very unlikely to decline, such as an interest-bearing savings account, short-term bank CDs (banks should be FDIC-insured) or a lower-risk money market fund run by an established mutual fund company. The point is not to make much if any money on these "must-have" funds but to insure that they do not fluctuate in value.

Money needed for intermediate-term goals can take a bit more risk - longer-term CDs or U.S. treasuries, or a mutual fund that has a conservative bent but takes slightly more risk, say by including some amount of stocks. The goal here is to be prudent - big losses couldn't be made up in the intermediate term - but to also accrue a somewhat higher level of earnings than the safest investments.

Long-term money, or money that doesn't have to be used at any particular time, where you can avoid taking money out at a point where the value is down and where you'd like to earn a better return, can be invested in more diversified investments, including stocks, bonds and even other classes of investments. In some cases, there may be special tax-advantaged savings vehicles for tuition savings. Mutual funds aren't the most tax-efficient way to invest, but for the small or medium-sized investor, they can be an easy way to get one-stop shopping and get a balanced portfolio of investments. There are also "lifestyle" funds that hold various percentages of different types of investments depending on your age or circumstances. Obviously, however, if your retirement funds need to be available within a shorter period of time, at least a portion should count as short or intermediate-term savings.

So, in summary, establish the habit of savings, plan for sums you need in the future and divide the savings pot into separate categories for investment depending on when and if you need access to the funds.

Checking Statements and Shredding

2010-01-25T16:20:00.001-08:00

Something I'm a fanatic about is checking over credit card and bank statements to look for any errors. And I find them - two this month, one on the credit card statement and one on my bank statement.

With the credit card statement, I run my eye over all the charges to be sure they all look OK, and check with my husband if I don't recognize something. This month, I noticed that we were double charged at a bookstore - my husband confirmed that they had had an equipment problem while they were ringing up the charge, and it apparently went through twice. I called the credit card company, and they gave us a provisional credit, so I was able to pay the bill after deducting the extra charge. They said the credit would go through faster if we went to the store and got them to credit our account, which we did (we save all credit card receipts until the bill comes in, which made this easier; once the bill comes in, we shred the receipts). If we hadn't done that, the credit might have taken longer because the credit card company would have had to contact the merchant themselves, which they now don't have to do.

One thing to watch for is very small - a dollar or two - charges to odd Internet sites - this can be a result of "pinging" - where someone looking to steal a credit card number generates huge numbers of randomly generated possible credit card numbers, sets up a fake Internet retail site and then tests the numbers by running tiny charges. If they generate enough numbers, they do hit some real ones. A "ping" is often a precursor to larger amounts being fraudulently charged - and many people let the pings go because the amounts are so small. We've been pinged in the past - our credit card had to be cancelled and a new card with a new number issued.

Errors on bank statements seem to be somewhat less common, but they do happen. I balance any checking account with more than a few transactions a month. This month, when I was balancing our account, I found that the same check had been paid twice - once as a normal check and once as an electronic check on a different date. I sent an e-mail to the bank to have this corrected, and will follow up if I don't hear back.

And I'm also a fanatic about shredding - anything that financial data on it that we're not keeping (records retention is another topic), or that could be used to establish a credit history - like utility bills, that has a Social Security number on it (I try very hard not to give these out, say at a doctor's office, and they're usually not required) or an unsolicited credit offer - I shred it. I actually own a shredder - they're not that expensive - and it gets a good bit of use.

We also never put mail out in our streetside mailbox for collection with the flag up - do you know what some people who work for the post office call the flag? - the "Steal Me" flag!

What Is Investment Risk, and What Does It Mean to You?

2010-01-19T10:33:00.000-08:00

No matter how much money you have, and no matter what investments you may have, everyone needs to have a basic understanding of investment risk. If you have any savings, or a home that you own, you need to understand investment risk.

Different types of assets have different levels of risk - I think most people understand that - but what does risk mean? In classic investment theory, risk is a measure of the distribution of likely returns. Unless you're into the math of statistics (which is in fact an interesting way of looking at things although it does have its limitations, which cause classic investment theory to have only a partial correspondence with real world events), just think of risk as the likelihood that an asset will go up and down in value, and by what range of ups and downs, over a certain period of time. So there's an element of probability, a range of possible amounts, and a time span to think about.

Classic investment theory presupposes that everyone is perfectly rational and has access to perfect information - and we all know that both of these assumptions are nonsense. Bubbles occur because people make decisions as groups, not as rational individuals, have only imperfect information, and tend to assume that whatever is happening now will continue into the future. But despite these defects, investment theory does have something to offer as a framework to start to think about risk.

One aspect of risk that many people tend to forget is that it is supposed to be related to return - that is, a higher risk asset is supposed to provide (over time - this is very important) a higher return. But there's another relationship between risk and return, and here's where people often get tripped up - the opposite of return is loss, and all assets pose a certain risk of loss that goes with the range of return - the higher the potential return the greater the possible loss - it's a range of outcomes. Any expected return for a type of asset is calculated over an often very long period of time, and within that time frame there are gains and losses, that taken together, produce the average (it's not actually a true average, mathematically, but that doesn't matter for this discussion) return expected from the asset. Therefore, if you plop yourself down on the timeline at any point, your return from the asset might bear little resemblance to the return you expected. This is what happened to people who bought into the real estate asset class in 2007 and then had to sell in 2009 - they certainly didn't make the normal expected investment return on real estate and in fact incurred huge losses.

This is why any sort of investment activity has to be one with long-term horizons, otherwise you have little chance of predicting what a likely return will be with any sense of confidence. That doesn't mean that you won't have assets that you want to be able to access immediately - your living expenses and upcoming items like taxes, tuition or other larger expenses, as well as emergency reserves, but that's a topic for another day. With investment assets which have a significant downside risk - say stocks as a class - I'm not talking about a specific stock for reasons that will become clear - it's important that the asset be able to be held through a period of negative returns since once it's sold at a loss the loss is "locked in".

This brings up the point that classic investment theory is about asset classes - the entire market of that type of asset - not any specific asset. In investment theory, the portion of the return of any asset that is attributable to its being part of a class of assets is called its "beta" - think of this as the return of the broad class of assets. The portion that is firm-specific - the risks that that particular issuer of stock faces - is called the "alpha". There are some implications of these separate components of return that relate to how an investment portfolio is constructed, say by an individual investor or an investment manager, in terms of the number of specific investments and the effect of fees on returns, but that's beyond today's discussion.

There's another important concept related to risk, and that is correlation. Over long periods of time, certain types of assets tend to move up or down together, and others don't, and the degree of this relationship is called correlation. So, if a class of assets moves up and down perfectly with another class of assets, that is a perfect positive correlation. If a class of assets moves perfectly opposite to another class of assets - that is, if one goes up, the other goes down by the same amount, that's a perfect negative correlation. If you're an investor who's focussed on the long term, you don't want all your assets to move together - because what goes up sometimes comes down and then all your assets have moved down together. It's better to have assets that move differently, as that has a cushioning effect when things go sideways, although it does reduce your total upside in good periods. It's a technique to reduce the risk to the total portfolio. This is the reason that many investors hold both stocks and bonds, not just one or the other. There will be periods when most assets go down in value despite the historic correlations - the late 2008 period is one that we all know about, and there have been others. And there's increasing evidence that historic correlations may tell us less than we need to know in a world that's increasingly multinational and economically integrated. But the basic idea still has application.

Certain types of assets have specific risks, included in their risk/return profile. For example, assets have a range of liquidities - some are easy to sell and some don't have much of a market. It's possible to generalize about the asset classes - Treasury securities are easy to sell and real estate and private equity are illiquid (although some people were misled into thinking that real estate was liquid when it wasn't). Other things, like stocks and bonds, fall in between. One of the biggest causes of the current financial crisis was that some assets that appeared to be liquid all of a sudden weren't, causing big lock-ups in the financial system. Collateralized mortgage obligations - which were always investment "junk" (that's a technical term in my lingo) despite the approval of the ratings agencies - appeared to be liquid and then, poof, they weren't - it would have looked like a funny game of pass-the-hot-potato if the effects weren't so devastating. That wasn't any surprise to me - I'd seen the first CMOs when they came out and they never made any sense - but it sure seemed to be to those engaged in trying to sell them at the time. And an illiquid investment (in this case an illiquid investment based on an illiquid investment - real estate) is inherently much riskier than one with a liquid market.

And debt instruments - anything from CDs, to Treasuries, to any other sort of debt or bonds - carries two specific risks that are part of their overall risk profile - interest rate risk and reinvestment risk. Neither concept is difficult to understand - interest rate risk has to do with the fact that you're holding an asset that pays a specific rate of interest, say 3%. If economic conditions change, and new issuers of debt are having to pay 5% to get people to buy their debt, then the debt you hold that only pays 3% is now worth less, because the bond that pays 5% is now the more attractive asset. The reverse holds as well: if you hold a bond that pays 3% and new issuers would be able to borrow paying 2%, then your bond is worth more because it's a more attractive investment. That's why debt instruments you hold go down in value when interest rates rise, and go up in value when interest rates fall. (There's a lot more math that goes into the exact calculations, depending on such things as when principal and interest rate payments are made on your bond.) Reinvestment risk is the risk that when you sell your debt instrument paying 3%, the only similar debt instruments you can reinvest the money in are now paying 2%. That's all there is to it. There are some fine points related to these concepts, but they're beyond today's discussion.

Once you understand risk, you can better understand how to invest whatever assets you have. There's more to be said about this, but that's for latter. I hope this isn't too confusing to those who are reading it. Please let me know if there are things that are unclear or about which you have questions that future posts could address.

On Budgeting

2010-01-11T03:30:00.000-08:00

I pretty much learned to budget by trial and error - there are a lot of books out there, but because they're books, they tend to, in my opinion, ask for too much - too much detail, too much time. If budgeting isn't straightforward and relatively easy, it won't be sustainable and won't do much if any good. I think if you get lost in the details, you can lose sight of the objective - your objective - and having your objective more firmly in mind will help you design a budgeting process that works for you. Depending on your circumstance, it can be very simple, or sometimes something a bit more complicated is what you need and can work with - start simple, though - if you start out too complex you won't want to keep it going.

First, figure out what your objectives are - do you have the feeling that your overall spending, or some category of spending, is out of control? Do you want to reduce or eliminate debt? Do you want to save for some specific purpose - to buy something, save for retirement or education, or for a vacation or home improvement? Do you want to be able to make a contribution to a charity on a regular or annual basis? If you know what your objective is, it will clarify your thinking. Your objectives may change over time, and your budget can be adjusted for that.

Second, in order to budget effectively, it's essential that you know what reality is, good, bad or ugly. I think many people start the process backwards - they (perhaps with a tone of "bad dog") say to themselves "I'm only going to spend $blank on clothes per month" before they even have a good idea of what they're spending now. When I was first budgeting, I fell into this trap - there were a lot of hypothetical numbers that had no relationship to what I was actually spending, so of course it didn't work and was soon abandoned.

To do this second stage effectively, you have to take a period of time - say several months - and record absolutely every penny you spend, whether cash, checking, credit charge or automatic payment from a bank account. And I mean every penny - the objective is to capture a snapshot of reality. Cash spending can easily become a black hole down which a lot of money vanishes if you don't capture it. A tiny notebook you can carry with you everywhere works well for this - all you need to write down is the date, amount and rough category - "food", "gas", etc. Make it an automatic habit. I strongly recommend that you not try to change anything about your spending during the data collection phase - otherwise the budget you create from the data may turn out to be unsustainable. The judgments about what you should spend come later. Also collect a list of "lumpy" items that may come up only once or a few times a year - real estate taxes, insurance payments, car registrations, homeowners association dues, the vacation trip you take every year, and don't forget tax payments if your taxes aren't completely covered by withholding - you'll have a list of your own. List those and put them aside.

During the period of time you're collecting your data, think hard about what purpose you want your budget to serve - what is it supposed to help you to do? Don't think about what purpose a budget "should" serve - your objective is your own and your budget is just a tool.

At the end of the second stage - set yourself a specific time limit - sit down with your data. Allocate a couple of hours for this. You can use a spreadsheet program for this, but paper, pencil and calculator work fine too. Run your eye over your data set and write down possible lists of spending categories - this will be different for each person, although many will be common to many people. You can group the possible categories in different ways - some people group by essential (you'll starve, freeze or be homeless if you don't pay these bills) and less essential, some people group by topic - auto, clothing, food, etc. Only you know what categories work for you, and what breakdown in categories is needed. For example, if you're a commuter and have a car you like and which is young and healthy, you might lump together all car-related items, like gas, tolls and maintenance, but if you have an older car and are deciding whether it's time to trade, you might want to separately break out maintenance so you can decide whether you're spending more or less than you would for a replacement car. I tend to keep the various categories simple - for example, utilities might be a category within housing, but I wouldn't bother to break out every little item - gas, electric, etc. (Cable or internet should go in entertainment.)

Once you have your categories roughed out, put in your data by month. For lumpy items, like taxes, there are two ways to fold them in - either annualize them (divide them by 12 and include them as a monthly expense), or expand your horizon to a year (you don't have to do a year of data collection - just copy an average of a couple of months over the whole year) and put the lumps in their proper months. (I prefer the lumps-in-proper-months method because it makes it easier to plan for them, otherwise they're easy to forget until they hit you in the face.)

Third, take a hard look at the data - what does it tell you about how and what you spend? The process is not about telling yourself what a bad person you are for spending $blank on whatever it is, it's about understanding exactly what you're doing now, in an objective and non-judgmental fashion. Start by looking at the largest categories first, as they have the most effect. Also focus on the "hot spots" - areas where you are concerned about what you're spending. Is your money going where it should be to help you move towards your objectives?

Fourth, construct a rough budget that you think will help you move towards meeting your objectives, by category, taking into account the lumps that may occur in certain months. Most importantly remember that this is your budget - if certain things are really important to you, you may be spending more on them than another person would, and that may be OK - or it may not - only you can answer that question. Then continue the data collection process and compare the actual to the budget, and either adjust the budget or adjust the spending. Do this on a monthly basis at first, although you may be able to move to quarterly at some point. Don't have a budget that bears no relationship to your actual spending as you go forward - if you're too "ideal" with your budget it'll do you no good. And, if you keep your objectives firmly in mind, sometimes budgeting, simple and mechanical as it seems, can lead you to make life changes - you could look at the numbers and conclude that a significant change in how or what you spend is needed to allow you to meet your objectives.

Fifth, make adjustments as needed. You may discover that certain categories don't work and need to be changed. You may find that your spending in a particular category is very stable and you might combine it with a different category. Over time, your objectives may change and your budget may change with it. And keep it going, and talk to your whole family about what you're doing - you need buy-in from all the adults to make it work and I firmly believe that children are interested in learning about this stuff and the more the adults in their lives involve them in understanding financial matters, the better.

What is Debt For?

2010-01-05T09:32:00.001-08:00

Much of the credit/housing crisis was due to excessive debt - particularly excessive debt by homeowners. There is also the issue of consumer debt - particularly credit card debt, which still lurks in the economy. Easy credit fueled the economic growth of the decades leading up 2008. Easy credit involved two participants - the borrower and the lender - both assuming the party would never end and that asset values and incomes would continue to increase.

What is debt good for, and what risks and opportunities does it present?

Debt (also called leverage) fundamentally increases risk - this means that if an asset financed with debt increases in value, debt will increase the return, and if an asset decreases in value, debt will result in greater losses (unless the debt is non-recourse, which means that the creditor can only recover from the specific asset and not the borrower's other assets). So debt is an amplifier - the highs are higher and the lows are lower.

Many of us have used debt - to buy a house or a car, or to purchase other items we deemed necessary to our lifestyle. Debt is often used by consumers, and also governments, to allow a spending rate they would not otherwise be able to afford based on their income. This type of debt is essentially a buy now, pay later kind of deal - but the question is pay with what? If your spending rate exceeds your income, you must anticipate that your income will increase in the future to pay off the principal borrowed plus interest - and remember that consumer debt carries the highest interest rates and fees of almost any type of debt - it's expensive money.

Many people who borrowed money to buy houses during the housing price bubble borrowed using exotic (before then) mortgages based on interest-only payments with huge balloon payments due later unless the property could be sold to pay off the debt, or even structures where the principal actually increased over the term of the loan. And there were also adjustable rate mortgages with artificially low introductory rates that then later ratcheted up to much higher rates. The responsibility for this mess is due to lenders who pushed these products on buyers, but also on buyers who eagerly snapped up these (apparently) attractive mortgages without thinking things through or understanding what they had agreed to. It's easy to say that the documents are hard to understand - they are - but one of my basic financial principles is if you don't understand something, don't sign it unless and until you do.

In my opinion, debt should not be used for:

Purchases of assets like new cars that rapidly depreciate. Cars are a necessity for many people for work, but using debt to buy one is an expensive way to go.

Purchases of items that will be consumed - including consumer goods and other personal expenditures that are not creating or enhancing the value of an asset. Yes, this means that lifestyles should relate to one's actual and not one's anticipated (greater) future income. Consumer credit card debt, as noted above, is also extremely expensive in terms of interest and fees - so effectively you end up paying a lot more for those items you bought using your credit card than it looked.

Debt can prudently be used to:

Finance a productive asset. If you've got a small (or big) business, and you want to buy a productive asset that will earn money for you going forward, or will enhance your ability to earn money - in an amount permitting the payment of the debt and interest with the asset producing a return in excess of the payments. A piece of productive equipment used by a business may meet these requirements.

Finance the purchase of an investment asset, where the amount of debt and structure of the debt is prudent - that means a large enough down payment to absorb likely losses - and where there is a substantial probability of a return on the investment that will exceed the debt payments. Here's the cause of the mortgage/housing crisis in a nutshell - everyone - lenders and borrowers alike - assumed that housing prices couldn't decline, and people were encourage to think of their houses as investments that could be relied on to finance consumption as housing prices rose. When the party stopped, it was a case of who's holding the bag. Many lenders had little risk in the transaction, and had no incentive to require prudent terms, and many borrowers were deluded into thinking they had made a prudent investment. In my opinion - and I expect many economists and policymakers might disagree - a house isn't an investment asset - it's a place to live and you're effectively paying rent if you borrow.

The effect of these rules would be substantially less borrowing and less consumer spending - people would only spend what they earned and would only borrow in specific cases and prudently, and our economy seems to be grounded on consumer spending. More on that later!