A Business That Punishes Its Largest Customers

Here's a Jeopardy question.

A financial service charges no fee if you have less than $100,000 with them. If your account has $100,000 or more, they charge you $100 a year account maintenance fee. If you create multiple accounts, each with less than $100,000, then you will pay no fee for all your accounts.

The answer: What is Legacy Treasury Direct?

"Legacy Treasury Direct is a program in which investors buy Treasury bills, Treasury notes, and Treasury Inflation-Protected Securities (TIPS) directly from the U.S. Treasury, without a broker.

Established in 1986, Legacy Treasury Direct allows customers to conduct transactions through the Web, over an automated phone system, or by mail.

... ...

If your account holds more than $100,000, we charge an annual fee of $100."

Most financial services reward their larger accounts with freebies or lower fees because larger accounts are less costly to maintain and more profitable to the business. Not U.S. Department of Treasury. They punish their larger customers with a fee other customers don't pay. If you break up your large account into several small ones, then you avoid the fee altogether. Don't you love how our government runs its business?

This question came up on Bob Brinker's Money Talk program on the radio two weekends ago. A woman caller said she got a notice from the Treasury Department about the fee being increased from $25 a year to $100 a year(!). She asked Brinker what to do. Bob Brinker totally blew the question. He said she would have to transfer the account to a broker and pay maintenance fees and commissions or buy CDs instead of Treasurys. Not true. There are several options for avoiding the fees and still investing in Treasurys if that's what the woman wants.

• Stay with Legacy Treasury Direct but break up the account into two or more smaller accounts, each with less than $100k.
• Migrate to the new TreasuryDirect, although she will lose the ability to conduct business by phone or by mail because the new TreasuryDirect is online only.
• Transfer the Treasury securities to Fidelity or Schwab, neither of which charges annual maintenance fees or commissions for purchasing Treasury securities online at auction or on the secondary market.

You can't trust what's being said on the radio or TV, even if the person sounds like an expert.

Mortgage Interest and Property Tax Deduction for Homeowners Who Don't Itemize

The New York Times reported that Senate Democrats and Republicans reached a tentative deal on the new housing bill. Among the various provisions is a federal income tax deduction for property tax paid by taxpayers who don't itemize deductions. Single taxpayers get a $500 deduction. Married taxpayers filing a joint return get $1,000. Presidential candidate senator Barack Obama also proposed a "universal mortgage credit" which gives a refundable tax credit to taxpayers who pay mortgage interest but don't itemize deductions.

The rationale behind these proposals is that the mortgage interest deduction and the property tax deduction benefit only the well-off. They say people who don't itemize their deductions don't get those deductions. From Obama's Tax Fairness Plan:

"Owning a home is the culmination of the American dream that so many Americans work so hard for. The tax code is supposed to encourage home ownership with a mortgage interest deduction, but it goes only to people who itemize their tax deductions. Like so much in our tax code, this tilts the scales toward the well-off. The current mortgage interest deduction excludes nearly two-thirds of Americans who do not itemize their taxes."

Is that so? On the surface, yes. If you don't itemize your deductions, you use the standard deduction, which in 2008 is $5,450 for single and $10,900 for married filing jointly. If you pay mortgage interest and/or property tax, but if they are not large enough, you still use the standard deduction. That's why by definition Americans who don't itemize their deductions don't show a mortgage interest deduction on their tax return.

However, to say that those Americans don't benefit from the mortgage interest deduction or the property tax deduction is a misunderstanding of how taxes and math work. The tax law says everybody is allowed to itemize their deductions. Everybody starts out listing their mortgage interest, property tax, state income tax, plus any other deductions they are allowed. Say for a married couple filing jointly, those deductions add up to $6,000, then the IRS tells them

"Guess what, you are lucky. We are going to let you deduct even more than what you've already got here. Would you like us to top off your deductions to $10,900?"

Now they can take up on the offer from the IRS or say "no thanks" and stick to their original list of deductions, which include their mortgage interest, property tax, state income tax, and everything else. In reality, when one has less in deductions than the standard deduction, nobody declines the sweet offer from the IRS because they get to deduct all the deductions they are allowed, plus a bonus deduction offered by the IRS.

Now tell me who's better off? The taxpayers who don't itemize their deductions but end up deducting even more than their deductions, or the taxpayers who itemize their deductions? The non-itemizers get to deduct everything they are allowed plus a bonus deduction they receive from the IRS. Itemizers don't receive such bonus. The non-itemizers are already better off than the itemizers. If we allow a new property tax deduction under the proposed housing legislation or a new "universal mortgage credit" under Obama's tax plan, the non-itemizers will deduct their mortgage interest and property tax twice, plus taking a bonus deduction from the IRS. Does that sound like fair to you?

I'm afraid our legislators and presidential candidates don't understand how taxes and math work because they don't do their own taxes. 

More On Missing The 10 Best Days

Blogger Nickel at fivecentnickel.com made some great comments to my post about missing the 10 best days in the stock market. I showed in my post that the probability of missing the best 10 days in 10 years is one in 2.8 billion billion billion. Nickel disagreed. Because the comments require a long response, I'm making a new post as opposed to burying it in the comments. First, the comments from Nickel:

"While you're correct that this overstates the problem in that people won't miss just the 10 best days of the market, you're forgetting that the biggest days often come in the earliest stages of a recovery.

"For example, looking over the past 25 years, three of the 10 biggest days came in the week and a half following Black Monday, and two more of them occur in close succession at the very tail end of the dot bomb debacle. Thus, these days are concentrated into periods when people are especially likely to have bailed on the market and not gotten back in.

"Consider the scenario in which sometimes gets smacked on Black Monday, jumps out of the market to lick their wounds, and then immediately misses gains of 9.3%, 5.3% and 4.9%. They've now locked in a huge loss that they had little chance of avoiding in the first place, and they also missed out on a huge recovery.

"Calculating the probability that people will randomly miss the ten best days is a *huge* oversimplification, and it casts doubt on your entire argument."

I want to thank Nickel for the comments and address the issue of best days coming right after the stock market bottom. Since he brought up Black Monday in 1987 and the dot com bubble, let's take a closer look.

Black Monday was October 19, 1987. The S&P 500 dropped a whopping 20.5% on a single day, from 282.70 to 224.84. Let's say a nervous investor sold the very next day on the open. The price was 225.06, close to the bottom made on the previous day. In the next 10 days, he would've missed 3 of the 10 best days in the next 20 years, which had returns of +5.33%, +9.10%, and +4.93% respectively. Does it mean this investor missed a total of (1 + 5.33%) * (1 + 9.10%) * (1 + 4.93%) - 1 = 20.6% of returns? No, after 3 best days passed, S&P 500 closed at 244.77 on 10/29/1987, up 8.8%, not 20.6%, from the 225.06 level he sold at. A little over a month later, on 12/3/1987, the market returned to 225.21, which was about the same level as the previous bottom. Now, having missed 3 of the 10 best days in the next 20 years, this investor didn't suffer any damage if he got back in a month and half later.

Date	S&P 500 Close
10/16/1987	282.70
10/19/1987	224.84 (sold here)
10/20/1987	236.83
10/21/1987	258.38
10/29/1987	244.77 (missed 8.8% of gains)
12/03/1987	225.21 (back to where it was)

Now, let's look at the same for the 2 best days in 2002. On 7/24/2002 and 7/29/2002, the S&P 500 had two best days, up 5.73% and 5.41% respectively. By then the bear market had gone on for over two years. If an investor was nervous, he would've sold way before then, perhaps in early 2001 when the S&P 500 dropped to 1,300 from 1,500 in the previous year, or in early 2002 when the S&P 500 dropped more than 20% in two years. For argument's sake, let's say our unlucky investor sold right before the best days, on 7/23/2002, at the close of 797.70. After two of the 10 best days in 25 years, the market closed on 7/29/2002 at 898.96, up by 12.7%. Was that a permanent loss of opportunity if the investor missed those two best days? Once again, no. 2 months and 10 days later, on 10/7/2002, the S&P 500 went back to 785.28, lower than the 797.70 price before the best days.

Date	S&P 500 Close
1/3/2000	1,455.22
1/2/2001	1,283.27 (down 12% from a year ago)
1/2/2002	1,154.67 (down 21% from two years ago)
7/23/2002	797.70 (sold here)
7/24/2002	843.43
7/29/2002	898.96 (missed 12.7% of gains)
10/7/2002	785.28 (lower than where it was)

Will the market always return to the previous low before the best days? I don't think anybody has an answer to that. The market is volatile and unpredictable. I continue to believe that (a) it's impossible to miss only the 10 best days; and (b) even if some best days were missed, the damage isn't nearly as bad as those meaningless stats imply.

Suppose calculating random odds is a *huge* oversimplification like Nickel said, and because the best days often come in the early recovery days, I'm off by a factor of a billion. That is huge, right? Say instead of one in 2.8 billion billion billion, the odds of missing the 10 best days in 10 years is actually only one in 2.8 billion billion. That is still 100 times less likely than winning 2 consecutive Powerball jackpots with the same set of numbers. If I write about what I would do if I won 2 consecutive Powerball jackpots with the same numbers, nobody will take me seriously because it's meaningless to talk about impossible events. Well the stats on missing the 10 best days in 10 years fall into the same camp. They are not worth the attention given to them.

Trust me, I don't advocate timing the market. I just think this missing the 10 best days in 10 years thing is over-hyped by at least a factor of a billion. My question to Nickel and all other readers, if it's not one in 2.8 billion billion billion, or one in 2.8 billion billion, what do you think the odds are for missing the 10 best days in 10 years and how do you prove it?

Out of the Market and Meaningless Stats

The stock market had a field day last Thursday (7/12/2007). The Dow rose 284 points, its biggest point gain in nearly five years. It reminded me of the stats about the risk of being out of the market. It goes like if you missed the best X days in Y years in the stock market, your return would've been cut in half or something like that. Let me tell you those stats are meaningless.

There's a chart like this in a recent issue of Schwab's On Investing magazine (sorry, no online link):

It said the S&P 500 Index returned on average 8.4% a year between July 1, 1997 and June 30, 2006. Based on an average of 252 trading days a year, if someone missed the best 10 trading days in those 10 years, the return would've been only 3.4% a year. In dollars, 8.4% a year means $10,000 invested in 1997 would turn into $22,402 in June 2006, for a cumulative gain of 124%. If one missed the best 10 days, $10,000 in 1997 would only turn into $13,970 in 2006, or only a 40% cumulative gain. If someone missed the best 40 days, the return would've become -6.4%, which means $10,000 in 1997 would turn into $5,161, for a cumulative loss of 48%. Hmm ... 124% gain or 40% gain, perhaps even a 48% loss, night and day, huh? Unbelievable.

These striking stats are used as arguments against market timing because they illustrate the risk of being out the market. Market timing means investing in the market when the conditions are considered favorable and getting out of the market when the conditions are considered as unfavorable. There are various schemes of market timing. Some are based on seasonality, some on chart shapes, some on valuation metrics. It is argued that if someone is out of the market for even a short period of time, 10 days or 40 days in the example above, and if they happen to be out on the wrong days (best X days in Y years), the long term return would suffer, a lot.

Although I haven't double checked the statistics myself, I don't doubt their accuracy. The stats are technically true however this piece of information is meaningless. Why? Let's see what the stats really say. Being out of the market on the 10 best days in 10 years means that

1. Someone is out of the market for 10 and only 10 days out of 2,520 trading days in 10 years; AND
2. Those 10 days happen to be the best 10 days in 10 years.

If someone is going to be out of the market for 10 days, how likely is it that he/she will cherrypick 10 random days which in hindsight happen to be the best 10 days in 10 years? Very unlikely. How unlikely though? A math exercise will tell us.

The math formula for our calculation is called combination. We are calculating the number of ways you can choose 10 days from 2,520 trading days in 10 years. There is only one possible way those 10 days happen to be the 10 best days.

C(2520, 10) = 2520 * 2519 * 2518 * ... * 2511 / 10! = 2.796E+27

You will need a scientific calculator for this. The ! symbol means factorial. If you use Excel, enter this formula and you will get the same result.

=COMBIN(2520,10) = 2.796E+27

The symbol E here represents scientific E notation. That's 2.796 * 10²⁷, or 2,796 followed by 24 zeros. A billion is 10⁹. What we have here is that this unlucky market timer has one in 2.8 billion, billion, billion chance for missing the best 10 days in 10 years. In other words, IMPOSSIBLE. What about missing the best 40 days? Don't even go there.

What's the point of zeroing in on this impossible event? I don't know. Shock and awe, perhaps. Nobody should care what happens if the chance of it happening is one in 2.8 billion billion billion. If some other one in 2.8 billion billion billion event happens to me, I will be a million times richer than Bill Gates and Warren Buffett combined. The meaningless stats don't support effectively what they are supposed to prove. The really meaningful stats are those for the average or median impact to one's long term return if someone is out of the market for 10 random days, or 10 random consecutive days, not the 10 best days. I've never seen stats for those scenarios. Perhaps because they don't support what they are trying to tell you. My guess is that the average impact of being out of the market for 10 random days or 10 random consecutive days in 10 years is practically zero.

Does this mean it's OK to time the market then? No, just the cited evidence doesn't support the case. There are other valid reasons for not timing the market, but this 10 days out of 10 years thing isn't one of them. At least one shouldn't be too worried about being out of the market for a few days when they have a 401k rollover being moved from one place to another. Relax. It's not a big deal as some make it out to be.

Related Posts:

• Avoiding the Worst Days and Missing the Best Days
• More On Missing The 10 Best Days

$10,000 Lesson On Variable Universal Life (VUL)

Variable Universal Life insurance or in short VUL is sold by insurance agents as a smart investment to unsuspecting people. The pitch usually goes like this:

You invest in VUL. The money in the policy grows tax deferred. You get to choose what you invest in, stocks, bonds, international, you name it. It's like a super IRA, only way better. When you need money after you retire, you can first withdraw what you put in, then borrow from it, all tax free. When you die, your beneficiaries receive money tax free.

Sounds good? Tax deferred investing plus tax free income after retirement. Who wouldn't go for it? If you'd like to read the full pitch, here's an example: Variable Universal Life: Flexibility at Its Best by New York Life, whose slogan is "the company you keep." It's very enticing but you will see the real story at the end of this post.

VUL appeals to people who hate taxes (who doesn't?), especially to people who have higher income and therefore in higher tax brackets. After you hear about this wonderful clever way of avoiding taxes on your investment, you go "sign me up!" Uh oh, big mistake. Let's take a look at a real life example, from this thread on the Bogleheads forum.

Poster John and his wife each bought a VUL policy from a "friend" who works as a financial "advisor" at a "well known financial planning organization" (I'm guessing it's Ameriprise or formerly American Express Financial Advisors). After 9 months into their policies they put in about $5,000 each for a total of $10,000. Now they realize that their VUL policies have high fees and expenses, to the tune of $1,100 a year. But, if they get out before 5 years, they will lose ALL of the $10,000 they paid into the policies (?!?!) because the first $8,300 in each policy goes toward a "surrender charge" or better put, early termination fee like that on a cell phone contract. In other words, if John and his wife put $3,300 more into each policy, the policies will still suck it all in like a black hole with nothing coming out. They paid $10,000 into two policies but they only filled a little more than half way up the big hole that the VUL policies dug for them.

Despite all the help from other posters on the forum, John's options are still limited because the policies are designed to trap them in good with high fees and various charges. John and his wife can:

1. Keep paying into the policies and get plucked by high fees (not good); or
2. Cancel the policies now and receive nothing back (not good); or
3. Stop paying premiums and let the policies wind down by themselves (not good)

None of the three options is good. The 3rd option is perhaps the least of all evils. Basically they will let what they already paid pay for the insurance and whatever is left over stays in some mediocre investment options with high fees. Every month more money is deducted from the investments part towards the insurance part and fees. After the 5-year surrender period is over, I doubt there will be anything left. Their policies may end even before 5 years because all the money will have been depleted by insurance charges and fees. That $10,000 is gone. They won't ever see it again. What an expensive lesson!

I feel really sorry for John and his wife. Having this done to them by a "friend" is even more sad. This VUL saga plays out over and over. It's almost always the same story. I personally know a small business owner who was sold a VUL policy by his "financial advisor" who is also an insurance agent. The "advisor" has nice sounding credentials like CLU and ChFC. The business owner was quite mad at the "advisor" after I pointed out the fees and expenses printed in black and white in the prospectus. Of course he didn't read the prospectus because he was busy running his business and he trusted that his so-called "advisor" would act in his best interest. The same "advisor" also sold him load funds, an expensive 401(k) plan for his business, limited partnerships that were impossible to get out of ... -- altogether the "advisor" cost him more than $200k.

Now let's get back to the wonderful VUL policies New York Life sells. Here's the 80-page prospectus (PDF, 476kB) of their NYLIAC Variable Universal Life 2000 product. Fees and expenses start on page 9.

• 4.5% - 6% charge up front for each deposit, like a load; plus
• $120 a year contract fees; plus
• 0.5% - 0.7% a year for M&E and admin charges; plus
• ~0.8% a year for expenses on investment options

Does it look like a good way of investing money? I like what poster ole meph said [1] on the Bogleheads forum:

"The only way you can benefit from this product is by dying fairly soon."

Oh wonderful. I'm sure the clients didn't want to pursue that route when they bought into the VUL policies.

[1] ole meph has been a veteran insurance agent and manager himself for over 40 years.

Commutative Law of Multiplication

Commutative Law of Multiplication is a fancy way of saying when you multiply two numbers, it doesn't matter which number you put down first and which number you put down second.

a * b = b * a

This basic law of arithmetic is taught in the second grade in elementary school. Yet it is very useful when you evaluate the relative merits between Traditional 401k, Roth IRA, and the new Roth 401k.

Blogger Trent writes the popular blog The Simple Dollar, which is one of the most successful personal finance blogs. Unfortunately Trent made the mistake of not recognizing the Commutative Law of Multiplication. In his post The New Roth 401(k) Versus The Traditional 401(k): Which Is The Better Route? he said Roth 401k is better even if the tax rate in the future is lower than the tax rate at present. His reasoning was

"Basically, by paying $2,800 a year now in extra taxes, Joe saves himself $14,000 a year in retirement."

Wrong. It matters not how much tax you pay at different times. What matters is how much money you have left after all the taxes are paid. Sadly when more than one commenters pointed out the problem with Trent's math, he still insisted that his math was correct. You would think a blogger writing about finance and investment should "get it," but I guess not.

In case someone out there is still confused, here's how the math works. Let t₀ be the marginal tax rate now, and t₁ be the marginal tax rate at retirement time. Suppose through successful investing, you are able to grow each dollar to $n when you are ready to retire. For each dollar you invest in a Traditional 401k, you will have $n before tax, and n * (1 - t₁) after tax. In a Roth IRA or Roth 401k, for each dollar before tax, you pay tax first and have (1 - t₀) dollars left after tax. Growing the money to the same degree, you will have (1 - t₀) * n when you are ready to retire. If the tax rate now (t₀) is the same as the tax rate at retirement time (t₁), we have

n * (1 - t₁) = (1 - t₀) * n

There, is the Commutative Law of Multiplication.

If the tax rate at retirement time is lower, t₁ < t₀, Traditional 401k will be better than Roth 401k because the value on the left hand side is larger than the value on the right hand side. The opposite is true if the tax rate at present is lower, t₀ < t₁.

Of course nobody knows what the future tax rates will be or whether they will be higher or lower than today's. In choosing between a Traditional 401k and a Roth 401k, you just have to take a guess or do a little of both. For me, my money is on the Traditional 401k. I think the Roth 401k is a device for the current government to maximize its current revenue at the cost of robbing revenues from the future government. When the future government needs money, it will find ways to raise revenue including taxing on Roth withdrawals either directly or indirectly. The laws on Roth IRA and Roth 401k only say withdrawals from them today are not taxed. They don't say withdrawals won't ever be taxed. Tax laws can be changed by the legislature in the future.

Related Post: The Case Against Roth 401(k)

Payday Loans, Anybody?

No, I'm not talking about borrowing a payday loan. We all know it's very expensive for the borrowers. If you treat the fee as an interest charge, the rate often reaches several hundred percent APR. You know, what's bad for the borrowers must be a good deal for the lenders, right? What about owning a piece of the action? Wouldn't it beat lending on Prosper ten times over?

Before you accuse me of being a cold blooded capitalist lack of morality or ethics, let me get this straight. Payday lending is a legit business regulated by the states. There are payday loan companies publicly traded on the stock market. Chances are you already own them through your mutual funds. For example a company called Advance America, Cash Advance Centers, Inc. (ticker symbol AEA) operates 2,900 payday loan centers in 36 states. The company is traded on the NYSE and it's worth more than $1 billion. Vanguard is a top institutional shareholder of that company.

Second, payday loan transactions are completely voluntary. The lenders provide a service which the customers use by their own choice. If there is a cheaper, better service, the customers will use that instead. If the customers don't seek out the best deals for themselves, it's not the vendor's fault, is it? The value of a product or service is in the eyes of the customers. I may not think a particular pair of shoes is worth $300, or a car is worth $40,000, but a lot of other people apparently disagree. The same goes for payday loans. The customers think the service is worth the price or else the lenders wouldn't be in business.

Are payday loan companies making a lot of money? Not necessarily. You see the mind boggling 600% APR on the revenue side but that 600% APR is on a very small sum for a very short term. Earning 600% APR is impressive but not if it's on $100 for one week. Then you are only talking about $3 and change. To really make money, you will have to pull in a lot of customers into your door. And you don't see the cost side of the equation. After the costs of doing business are taken out, the profit is nowhere close to what you'd imagine. Take again Advance America for example, according to Yahoo! Finance, its revenue in 2006 was $673 million. After expenses were taken out, the net income was only $70 million, for a profit margin of 10.4%. By comparison, the profit margin for banks is usually around 30%. I just picked a random bank First Midwest Bank (FMBI) in Illinois. On $345 million revenue in 2006, it made $117 million profit, for a profit margin of 34%. Now, who's making the big money?

The reason I wrote this post is not to defend the payday loan lenders. I think the society is better off without them. But then again the society is better off if people don't live barely paycheck to paycheck and don't need payday loans.

What I'm trying to show is that you have to look at any issue more closely and not jump to a conclusion based on what you read in the newspaper (or this blog, for that mater). The mass media pull on people's emotions. They create sensational headlines to attract eyeballs and ad dollars. If you read the mass media, you get the impression that payday lenders exploit their customers to the n-th degree (some do), and by logical extension, owners of payday lending companies are making obscene profits. Except they don't.

Be careful with what you read, and that includes what I write as well, because I may be wrong.

401(k) Committee Chasing Performance

I received an e-mail from my employer's HR department this week announcing some changes to our 401(k) plan. Here's what they said (emphasis added by me, fund names masked).

The 401(k) Committee decided to remove the ABC Fund from the Plan due to poor performance for several quarters. The committee closely monitors all funds in the plan for the best interest of our plan participants. ABC Fund will be replaced by XYZ Fund. XYZ Fund's 10-year performance is in the top 10% of its Morningstar category through 12/31/2006.

Wow, the 401(k) Committee is tough and impatient. ABC Fund's managers had several quarters of poor relative performance and they were fired by the committee! What happened to investing for the long term?

The committee replaced it with XYZ Fund, which had great performance in the last 10 years. Why didn't the committee choose the XYZ Fund 10 years ago? I'm sure when the committee chose ABC Fund, ABC also had great performance at that time. It didn't turn out well. Now the committee jumps over to XYZ. Who's to say it won't perform poorly for several quarters and get axed again?

This is called driving by the rear view mirror, or performance chasing. The 401(k) committee, with good intentions, picks funds that had good returns. What they really ought to do is picking funds that will have good returns, because what happened in the past does not benefit anybody who didn't invest in those funds. It's what happens in the future that counts. Of course the committee is going to say that they can't predict the future. Then why bother chasing past performance?

Picking Stocks Is a Waste of Time

The 2/26/2007 issue of the Wall Street Journal had a special section for stock score board. If you don't have access to WSJ Online, it's worth digging it out from a library. I'm highlighting something I noticed in that section which makes the point for the title of this post -- picking stocks is a waste of time.

When you invest in individual stocks, instead of mutual funds or exchange trade funds (ETFs), you can invest in the right stocks in the wrong time, or you can invest in the wrong stocks in the right time. Timing, or better put, luck, dominates any skills you think you may have.

Exhibit A. Chico's FAS (CHS) was one of the best performing stocks in the last 10 years. At the beginning of 1997, CHS traded at about $0.25 a share, split adjusted. At the end of 2006, it was worth over $21 a share. An average return of over 50% per year for 10 years. Fantastic stock! But, there's always a but, it was also one of worst stocks in the last 1-year period. At the beginning of 2006, CHS was worth $43 a share. By the end of 2006, it lost 1/2 of its value. Good stock in the wrong time. Since 2007 began, it went up 9%. S&P 500 was flat to slightly down during the same period. Will CHS continue its long term upward path, up 50% a year for 10 years, or will it continue its downward movement from last year, down 50% in one year? Or will it do something else? Whatever your answer is, are you sure?

• CHS vs. S&P 500, 1997-2006
• CHS vs S&P 500, 2006

Exhibit B. The problems faced by the U.S. automobile companies are well publicized: declining market shares, wrong products for the market, high cost structure, big losses, ... The price of General Motors (GM) stock at the end of 2006 was the same level it was in 1963, split adjusted. That's right, except for dividends, GM stock didn't go anywhere in more than 40 years. And the dividends aren't that much either. GM's current dividend yield is 3.3%. Who wants a stock that pays 3.3% dividend and doesn't go anywhere for 40 years? Aren't you better off in a savings account? Bad stock! But, there's that but again, GM stock went from $18.90 a share in the beginning of 2006 to $30.72 in the end of 2006, an increase of over 60%! Bad stock in the right time. Since 1/1/2007, it was up 2%, beating S&P 500. Do you buy, sell, or hold? Whatever your answer is, are you sure? Now it's Ford's turn. Its stock didn't go up much in 2006. Will Ford rally in 2007 like GM did in 2006?

• GM vs. S&P 500, 1963-2006
• GM vs. S&P 500, 2006
  

Those are the perils of stock picking. You think you are picking good stocks but they may deliver bad results despite your firm belief and research efforts. When your stock loses 1/2 of its value, it really tests your conviction. Do you bail or do you wait for a turnaround? Or you think you are avoiding bad stocks, but you may miss out on big gains from stocks you sold or didn't buy. Do you jump back in or wait on the sidelines and see it going up and up? Decisions, decisions.

I've been down that road. My results were poor, but not for lack of knowledge, discipline, or efforts. The market simply doesn't go where you think or want it to go. If you invested in individual stocks and the market went your way, you were lucky. Pure and simple. Don't ever think your results have anything to do with whatever you did. It could easily go the other way. Or as they say on Wall Street:

Never Confuse Brains with a Bull Market.

It's much easier to invest in broadly diversified total market index funds and save yourself the agony. Accept what the market delivers to you, good and bad. Focus your energy and efforts instead on something you can control -- advance your career, increase you income, reduce your expenses, save more, spend more time with your family, ... ... Picking stocks is a waste of time.

Does Your Auto Insurance Cover Engine Failures?

If your car's engine died, does your auto insurance cover the cost of replacing it? That's the question in this post on The Simple Dollar:

How The Simple Dollar Just Saved Someone $2,850 (And A Personal Finance Tip To Boot)

Trent, the blogger who wrote it, claimed that he was able to save someone $2,850 by pointing out that the "comprehensive" part of that person's auto insurance covered engine failures, not caused by a collision, but just during the normal course of driving. Baloney. I left comments for Trent but he doesn't want to admit he was wrong, saying "it varies from insurance policy to insurance policy." I'll assert that no auto insurance policy in the United States covers normal engine wear and tear. Manufacturer's warranty or extended warranty maybe, but not auto insurance. If you don't believe me, please check your policy or ask your insurance company/agent. If your policy covers engine wear and tear (I'm not holding my breath), I'd love to switch to that company.

Prosper.com Or Junk Bond Fund?

I saw on several blogs people are lending on Prosper.com as way of earning extra cash over money market, CDs, or savings accounts, for example here, here, here, and here. I must admit I'm not very familiar with Prosper.com but I think I understand the concept. It's often referred to as eBay for lending and borrowing. Borrowers list their loan requests. Lenders bid on them. As more people bid, instead of price for an eBay item going up, the interest rate for a Proper listing goes down. Lenders can lend a small amount ($20, $50, $100) and borrowers get their loan funded from multiple lenders. Borrowers make one payment to Prosper and Prosper distributes the payment to lenders after taking its cut. As an lender, you get a loan portfolio of many small loans to many borrowers. So there's a level of diversification that reduces the risk of lending to a deadbeat.

Is Prosper.com a good avenue for investing though? I'm asking this question from a lender's perspective because I think most people reading personal finance blogs will be lenders, not borrowers.

A sustainable marketplace must be beneficial to both buyers and sellers. eBay is a good example. Sellers have items they no longer need and sell them on eBay for a better price than what they can get elsewhere (garage sale?). Buyers want them and buy them at a lower price than what they can get elsewhere (retail and online stores). As long as the price for an item is between the alternatives for sellers and buyers, garage sale and retail respectively, everybody is happy. That's why millions of items are sold on eBay every day. Collectively, all items on eBay must sell at prices below retail. If they don't, people will just buy from retail stores.

What's being sold on Prosper.com is the borrower's creditworthiness and their likelihood of repaying the loan. It's a lot harder to evaluate and attach a price on than a physical item listed on eBay. The alternatives for sellers (borrowers) are borrowing from banks or credit cards. The alternatives for buyers (lenders) are money market funds, CDs, savings accounts, and perhaps even the stock market. So the price must fall between the alternatives. Borrowers must borrow at a lower rate than what they can get from banks, credit unions, or credit cards. Lenders must lend at a higher rate than what they can earn from money market funds and savings accounts. The risk of default and the amount of effort required must also be factored in somewhere there.

Back to the question of the day. Why do lenders on Prosper.com want to lend to borrowers at a rate below what banks and credit card companies are willing to lend? What advantages do individuals have over financial institutions? Do we have better information on the borrowers than the banks? Are we better than the banks in assessing and managing risks? Are we better equipped for dealing with defaults? Do we have lower cost of funding? If all lenders on Prosper.com pooled their money and formed a lending institution, what interest rate should the loan portfolio earn? Should it be lower than what other banks earn and why? I thought about these questions and I can't come up with any reasonable answers for "yes." I can see why lenders want to lend at a higher rate than savings account yield because Prosper loans are more risky. But I don't see why they want to lend below what other banks and credit cards do. If banks said a borrower's credit is worth 19% interest rate, why do we say it deserves a lower rate at 17%? Simply because we can't earn 17% elsewhere?

If Prosper.com lenders like higher credit risk, why not buy a junk bond fund? T. Rowe Price High-Yield Fund, with about 400 corporate junk bonds in it, had an average return of 9.62% per year in the last 5 years. Despite the "junk" label, those corporate bonds probably are less risky than lending to subprime borrowers on Prosper. Or how about becoming a part owner of a bank or a credit card company, i.e. buy their stock? That way you earn what the banks charge and have all the advantages the banks and credit card companies have. And you get to earn those late fees too. American Express (AXP) and Capital One (COF) come into my mind as a pure plays in this area. For diversification there are financial sector ETFs like IYF, XLF, IYG, VFH, etc. I don't necessarily recommend these investments because I've invested in a total market index fund. I'm already a part owner of those lending institutions so I haven't missed out on anything.

Prosper.com remains a puzzle to me. I don't have a good feeling for it because I don't see how it's better than the alternatives. More experienced lenders please chime in.

Book Review: Elliott Wave Principle

This is a review of the book Elliott Wave Principle: Key to Market Behavior by A. J. Frost and Robert R. Prechter, Jr. See my other book reviews on this list.

According to Wikipedia, Elliott Wave Principle is

a form of technical analysis that investors use to forecast trends in the financial markets and other collective activities.

In other words, it is a theory that uses the pattern of past prices to predict the future prices. R. N. Elliott asserted that the market prices form waves. They come in a 5-wave pattern followed by a 3-wave pattern that reverses the former. In the 5-wave pattern, waves 1, 3, 5 form the trend, while waves 2 and 4 correct it. In the 3-wave pattern that follows the previous 5-wave pattern, waves 1 and 3 reverse the previous trend, while wave 2 distracts. This book teaches you how to recognize the wave patterns and therefore predict where a stock or the market will go next based on where it currently is in the cycle.

Intuitively I can see where the theory came from. When you look at a stock chart, it does look like waves. It goes up, comes down a little, goes up again, comes down again, goes up again, on and on ... I think of myself as a person of average intelligence but I must admit that this book makes my head spin. There are supposed to be small waves contained within large waves which are contained in even larger waves. They also have something to do with Fibonacci series, Golden Spiral, 1:0.618, and square root of 5. It reminds me of the mumbo jumbo in Da Vinci Code.

Regardless whether the theory is right or wrong, this book certainly makes it very difficult to understand. I tried really hard wanting to understand how to use it so that I can see if it makes any sense, but I failed miserably. After reading it from cover to cover twice, I still can't figure out according to this theory where the current stock market is in the wave patterns. I think it's because the theory is intentionally vague. Wherever the market ends up going, it can be fit nicely into the theory.

Final verdict: 0 star, total waste of time, causes harm if you base your investment decisions on it, not worth the paper it was printed on.

More Risk, More Reward?

Perhaps inspired by home makeover reality shows, Trading Places, Extreme Home Makeover, etc., newspapers and magazines often run portfolio makeover articles. They typically feature a real family, tell us about their finances, their goals and their struggles. Then the newspaper or magazine brings in a financial planner who offers advice for them. I think people like them because it brings personal finance to the real world. When I was traveling for business last week, I read this article in USA Today (Jan. 8, 2007, page 6B):

Can they retire young and rich?

The article told a story about a young couple, Luke and Hannah Wickham, 30 and 28, saving aggressively toward a goal of retiring between 50 and 55 with $10 million. This couple did very well. They already accumulated $258,000 in stocks, mutual funds, bank account and private equity investments, their own home and 3 rental properties in Orlando, FL worth $529,000 net after mortgage obligation. That adds up to $787k in net worth. I don't know how many people in their late 20s can top that. Congratulations, Luke and Hannah!

How did they do it? They saved more than 20% of their income and invested aggressively in stocks, mutual funds and real estate. They plan to save $30,000 from their $137,000 income in 2007. That's a 22% savings rate. People wanting to learn from them should really take a lesson here -- you can't accumulate a high net worth without a disciplined habit for saving. Otherwise even luck can't help you.

What suggestions did the financial planner give them? Here's what the planner had to say:

Planner: They're off to a good start but need to be careful

The planner basically said luck was on their side in the last six years since they started saving and investing and it's time to lighten up and take less risk. The planner equated the real estate gains in Orlando to a "once-in-50-to-60-year occurrence."

The kicker is really at the end of the story.

The Wickhams say they aren't surprised by Fitzgerald's suggestions, and they agree with many of them. They plan to adjust the asset mix in their portfolio and open a money market account.

But despite the planner's recommendations to reduce investment risk, the Wickhams don't plan to stay away from real estate or individual stocks.

"We're not going to go that route," Luke Wickham says. "More risk, more reward, in my opinion."

Ding! Really? While one has to assume some risk to realize the reward, more risk doesn't necessarily mean more reward because some risks are not compensated. Risks that can be diversified away are called non-systemic risks. Non-systemic risks are not rewarded. When you have been lucky, you can't count on being lucky all the time. Moreover, with the assets the Wickhams already accumulated (with the help of being in the right real estate market at the right time), it's not necessary to take on more risks. If you have good chance of hitting $10 million, shooting for $100 million and ending up with $1 million is just not worth it. The planner gave the Wickhams very good advice. I hope they don't brush them aside.

Elsewhere in the blogsphere about the same article:

• Boston Gal's take
• Lazy Man and Money's comments about 10% compounding growth
  

Investing a Small Amount

Jonathan Clements is my favorite columnist. He writes a column Getting Going on Wall Street Journal every Wednesday and Sunday. I always seek out his column online every week and see what he has to say. A week ago he wrote about investing a small amount. Here's the link:

Start Small, Think Big: How to Launch Your Financial Life With Just a Few Bucks

Although I usually like with what Jonathan writes, I disagree with his suggestions in that column. Here's what he suggested for investing a small amount (less than $3,000).

1. Buy ETFs through one of the low-cost Internet stock-purchasing services, like ShareBuilder or FOLIOfn.

To get a diversified portfolio, Jonathan suggested buying three ETFs, VTI, EFA and AGG. ETFs are the wrong products for investing a small sum. For each ETF purchase, the investor must pay a commission. Although $4 per trade sounds low, it adds up quickly. When a small portfolio grows larger and meets the minimum for a mutual fund, and if you want to move into a mutual fund, you will have to sell the ETFs and pay another set of commissions.

If you only have a small amount to invest, that probably means you haven't maxed out your 401k/403b or Roth IRA yet. You are much better off contributing to those accounts. Setting up an IRA with ShareBuilder or FOLIOfn will cost more money than having an IRA at a mutual fund company.

2. Buy stocks through a company's dividend-reinvestment plan, or DRIP.

Again, individual stocks are the wrong products for investing a small amount. It's very difficult to build a diversified portfolio in individual stocks with a small amount of money. Small fees here and there will eat up a good portion of the small investment. It's almost impossible to use DRIPs for an IRA.

3. Buy life cycle funds at T. Rowe Price or AARP.

This last suggestion from Jonathan Clements is better than the previous two. AARP Funds allow you to open an account with $100 and add to your account with $25. IRA fee is a reasonable $10 per year. 0.5% expense ratio on its funds is not the lowest but low enough. If a few hundred dollars is all you have to invest, AARP Aggressive Fund is a fine choice. But if you have at least $1,000, you are better off investing in Vanguard STAR Fund, because AARP Funds become more expensive than Vanguard Funds as your account grows larger and because AARP Funds' low expense ratio is subsidized by a fee waiver which may go away after November 2007. Vanguard STAR Fund is a winner of the TFB Award for Best Mutual Fund for Investing Less Than $3,000. If you have less than $1,000, you will have to decide whether it's worth it starting with AARP Funds and moving to Vanguard after you accumulate more in your account.

Is Inflation Dead?

Bob Brinker, host of a nationally syndicated radio program Money Talk, opened his show a few weeks ago by observing that the year over year inflation rate as of October 2006 is only 1.31% as measured by the Consumer Price Index. He went on to say that the Federal Reserve was mistaken about worrying about inflation and that they went too far in raising the short-term interest rate. I don't know if the Fed's concern about inflation is right or not, but I'd like to give them the benefit of the doubt rather than believing a radio show host. The low inflation number in October is a special case. It appears low when compared to a high number last fall due to Hurricane Katrina. You only have to go back a few more months to see that the 1.31% number is not a good indication that inflation is dead. Using the Consumer Price Index data from U.S. Department of Labor, here are the annualized inflation rate over the last X months as of October 2006:

• 12 months: 1.31%
• 13 months: 1.39%
• 14 months: 2.35%
• 15 months: 2.61%
• 16 months: 2.80%
• 17 months: 2.67%
• 18 months: 2.45%
• 19 months: 2.76%
• 20 months: 3.10%
• 21 months: 3.29%
• 22 months: 3.25%
• 23 months: 2.91%
• 24 months: 2.82%
• 25 months: 2.96%
• 26 months: 2.95%
• 27 months: 2.86%
• 28 months: 2.69%
• 29 months: 2.73%
• 30 months: 2.87%

So you see for the most part the inflation rate is a little under 3%. The 1.31% number over the last 12 months is certainly not the norm. Inflation is still here with us, every day.