Archives for February 2010

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7 Easy Ways to Get Filthy Rich Using Mutual Funds

1. Follow StockTwits for timely news on ETFs. Crowd-sourced information is an excellent way to get an edge on the market.

2. Don’t bother with index funds. They include way too many crappy stocks.

3. If you must use an index fund, make sure it’s enhanced.

4. Buy several mutual funds in each asset class. After three years, it will be clear which manager is the best, so you can sell the others.

5. Watch CNBC for daily info about where the market is headed. Jim Cramer used to run a hedge fun, you know. That means he knows his stuff.

6. Don’t worry about sales loads. If the manager has a proven track record, it’ll end up being worth it in the long run.

7. Bet heavily on emerging markets. Any chump can see that’s where the next decade’s growth will come from.

In case it isn’t immediately obvious, the above post is written in jest. The ideas are either a) terrible or b) backed up by decidedly faulty logic.

Using Probability to Set the Size of An Emergency Fund

Austin Frakt at The Incidental Economist recently wrote an intriguing post using Charles B. Hatcher’s work to rationally set the size of an emergency fund.

The basic idea of the post is that the ratio of the annual opportunity cost of forgoing a higher investment return to the cost of borrowing should an emergency occur can be interpreted as a probability, and this probability can be used to estimate the needed size of the emergency fund.

Or, in plain English: It’s rational to have an emergency fund if the cost of the emergency fund should no emergency occur is less than or equal to the cost of borrowing should the emergency occur.

Explained Mathematically…

M = the size of the emergency fund, r2 = rate of return of investments, r1 = the rate of return of the emergency fund, rb = the borrowing rate, p = the probability of an emergency occurring in a given year.

Using the above variables,

  • The cost of the emergency fund if no emergency occurs = (M)(r2 – r1)(1 – p)
  • The cost of borrowing if the emergency occurs = (M)(rb)(p)

So it’s rational to have an emergency fund if:

  • (M)(r2 – r1)(1 – p) <= (M)(rb)(p)

…which can be reworked in the following manner:

  1. (r2 – r1)- (p)(r2 – r1)<= (p)(rb)
  2. (r2 – r1) <= (rb)(p)+ (p)(r2 – r1)
  3. (r2 – r1) <= (p)(rb + (r2 – r1))
  4. (r2 – r1)/ (rb + (r2 – r1)) <= p

Since (r2 – r1)/ (rb + (r2 – r1)) <= (r2 – r1)/(rb) we can simplify the expression to

(r2 – r1)/(rb)<= p

Applied to Real Life

Following Mr. Frakt’s example and using the equation above, if the liquidity premium (i.e., the amount by which the rate of return on other investments exceeds the return on an emergency fund) is 2% and the interest rate for borrowing is 9%, then the probability of an emergency in a given year needs to be greater than 22% in order for it to be rational to have an emergency fund.

In other words, you’d have to believe you’re likely to have an emergency at least once in five years to justify the opportunity cost of the fund given today’s liquidity premium of 2% and borrowing rate of 9%.

Using the once-in-five-years probability, Mr. Frakt proposes that we can guess the necessary size of an emergency fund based on our experience. What kind of emergencies occur within a five-year period and how expensive are they? The catch is that if you already know from experience how much money is needed to cover emergencies occurring once every five years, I wouldn’t call these emergencies at all. They are periodic expected financial events that can be planned for via sinking funds.

The whole point of an emergency is that it’s an unexpected event, and it’s very difficult to assign probabilities to unexpected financial events. Sure, we know that over a very long time frame we’re bound to encounter an event we didn’t plan on, but we can’t really know the probability of such an event occurring this year, next year or in ten years.

It it, however, useful to consider the probability/frequency of emergencies in a general sense:

  • The higher the liquidity premium relative to the cost of borrowing, the more frequently emergencies would have to occur in order for it to make sense to pay the premium to keep liquid funds available, and
  • The lower the liquidity premium relative to the cost of borrowing, the less frequently emergencies would need to occur to justify the liquidity premium.

About the Author: Susan D. Tiner, financial organizer and consultant writes the blog Brain Dead Simple! Financial Organizing.

Can You Trust Personal Finance Bloggers?

While reading the comments on one of J.D.’s recent posts, I got the distinct impression that many of his readers (and likely mine as well) aren’t yet familiar with the concept of affiliate links or how to spot them.

That’s unfortunate. It means that many savers/investors are being exposed to a significant conflict of interests of which they’re more or less unaware.

Here’s the skinny: Affiliate links are links that allow a blogger to receive a commission when somebody clicks the link and buys (or in the case of bank accounts, signs up for) the linked-to product or service. This is important for people to know because:

  • Some banks and brokerage firms offer affiliate programs, while others do not, and
  • The size of the commission varies considerably from bank to bank or from brokerage firm to brokerage firm.

End result: There’s a conflict of interests between us (the bloggers) and you (the readers). We benefit–in a short-term way at least–when we get you to sign up for the best-paying products and services. You benefit when you sign up for the best products and services.

Be Wary of Review Posts

This blog has roughly 900 subscribers at the moment. If I wrote a post reviewing Ally Bank’s money market account (which I really do use, and really do like), it’s likely that a person or two would sign up (at $40 commission each). What’s relevant here though is that the better I do at selling you an Ally money market account rather than just reviewing Ally’s money market, the more money I make.

Further, if the article ended up ranking near the top of Google search results for “Ally Bank money market” or “Ally Bank review,” the article could turn into an ongoing source of revenue for my business. (And again, the better job I do of selling Ally Bank, the greater the ongoing revenue I’d receive.)

To be clear: This isn’t to say that all review posts are crammed full of lies. I don’t believe that to be the case at all. But when you encounter a review post online, you should know that the blogger likely benefits if you buy the product or service being reviewed.

Common Affiliate Programs

In the personal finance realm, there are several affiliate programs. Some of the more popular ones include:

  • Brokerage firms: Betterment, Scottrade, Zecco, TradeKing, TradeMonster, ShareBuilder, OptionsHouse, optionsXpress, and E*Trade
  • Banks: Ally Bank, ING Direct, EverBank, WT Direct, and HSBC Direct
  • Credit cards: Too many to list!
  • Lending Club
  • Turbo Tax

This is not to say that the above companies are bad companies or that those of us who write about them are dishonest. But it’s no coincidence that you see so many more Lending Club and ING review posts than Bank of America review posts.

How to Spot an Affiliate Link

There are generally three ways to spot an affiliate link, and they all involve checking the url to which the link points. (This can be done by mousing over the link and looking in the bottom left of your browser window.) The things to look for are:

  1. An affiliate tag at the end of the url,
  2. A completely gibberish url, or
  3. An internal link to a redirect file (usually located in a “go” or “redirect” directory).

Example links with a tag at the end of the url:

Example link with gibberish url:

Example link pointing to a redirect file:

Any Questions?

From a business perspective, affiliate programs are here to stay. They’re profitable for both the linked-to businesses and for the bloggers promoting them. (About 8% of my own income is from affiliate programs.)

But it’s important that you understand how they work and how they can influence (whether consciously or not) the way in which bloggers describe a product/service.

Index Funds: Are They Really Passive Investing?

Index funds are–and probably will continue to be–the easiest way for an average Joe to invest. But contrary to popular belief, they’re not a “set and forget” type investment.

With index funds, you still have to:

Decide Which Index Funds to Use – Most people think of the Vanguard S&P 500 fund when they talk about index funds, but there are actually over 1,000 index funds we can invest in.

Worry About Asset Allocation – Perhaps more important than the right fund is to have the right mix of investments for your overall portfolio. Spending some time doing so is crucial, especially if possibly retiring someday is important to you.

Remember Rebalancing401(k)s are great in that they allow you to automatically rebalance your portfolio without intervention. Too bad none of the other accounts allow you to do that! Though it’s not hard, the process still takes time.

Consider Fees and Choices – Once you dig deeper, you will find that there are multiple funds tracking the exact same index, all with different fees and performance. While I highly recommend going with the most popular fund that has the lowest fees, it pays to know the differences of how they manage to mimic the performance of an index.

Where to Buy It – Vanguard has its own web portal, but you can generally buy most index funds with pretty much any brokerage account. Pick the one that you are comfortable with, and if at all possible, try to simplify your finances by having as few accounts as possible. Otherwise, more time keeping track!

Which Account to Buy It In – Finally, some index funds are more tax friendly than others. For example, REITs are particularly tax-inefficient, so it make sense to put them in tax-sheltered retirement accounts.

Essentially, most of the questions you need to answer for mutual funds apply to index funds too. You may mistakenly believe that index funds are a form of passive investing. But for completely carefree wealth building, you’d need to outsource your portfolio management to a competent financial advisor.

This is a guest post from MoneyNing, who writes about sensible personal finance tips every day. Check out his blog to learn the art of protecting your wealth.

Tips for DIY Investors

This is a guest post from Mr Credit Card of www.askmrcreditcard.com.

Most people I know who do their own investing–as opposed to sticking with index funds or ETFs–use technical analysis or simply do some basic research, assume some growth rate, and compare PE ratios. But investing is a lot more complicated than that. There are many more things that DIY investors should look out for.

Look at absolute P/Es.

I remember back in the late 90s when I was reading research reports on the internet by various brokerages. It was pretty interest reading at that time but even more hilarious when I look back. One of the recurring themes back then was how high PE ratios were. In fact, I read a report listing all existing and forward-looking PEs. The internet firms listed on NASDAQ had triple digit PEs and even folks like Cisco had 70 PE. But they all still justified buying Cisco because, compared to other stuff like Yahoo and AOL, Cisco looked cheap!!

Understand macroeconomics.

Most investors (whether professionals or individuals) focus on a successful strategy that has worked for them–whether it’s technical trading, credit arbitrage, convertible arbitrage, capital structure arbitrage, or options volatility trading. Very often, folks who are really skilled in these strategies can be successful for long periods of time. However, the occasional black swan event (like those in 2008), can result in a terrible loss of capital. I find that many folks who specialize in specific strategies do not dwell too much on macro economics–unfortunate given that many strategies are dependent upon the macroeconomic environment.

Understand the whole capital structure.

Many investors–especially amateur investors–only know about PE ratios and other equity-related things. But very often, the debt market (especially the credit default swaps market) is a better leading indicator about a company. Understanding bank debt is also important in understanding potential cash flow issues.

Learn how private equity investors value a company.

It is also vitally important to understand the backstop bid from private equity investors. Private equity investors rarely invest in 40 PE stocks. Most are essentially deep value investors. Understanding how they look at balance sheets is a great way of figuring out entry levels and takeover bids. This is also a good exercise in understanding balance sheets.

Understand breakup value.

Understanding breakup value is a great skill to have. If a company is liquidated today, how much will it fetch net of debt? Calculating this is vital because sometimes, the markets will misprice a security to below its breakup value. For example, a company may have a higher breakup value than what is on the balance sheet if its real estate holdings are valued at cost. But a retailer’s breakup value is probably overstated in the balance sheet because at liquidation, its inventory has to be sold at massive discounts.

Learn about the chapter 11 process.

Understanding the chapter 11 process and whether a company is at risk of filing for bankruptcy is a great skill to have. This is where (as I mentioned earlier), understanding the capital structure and its debt obligation is so important. If you understand the chapter 11 process, investing in distressed debt can be potentially very profitable. But even if you don’t, it will give you a heads up over folks who just read equity research.

Understand a company’s product.

Sometimes, I find that this is the best way to get a sense of where a company is heading. Given that I review credit cards, in hindsight, I could see which credit card issuers were doing smart things and which were not. For example, I could tell that Discover Credit Cards and American Express knew what they were doing–they did not offer the most generous rewards. For example, in the cash back credit cards area, Amex imposed a tier for their Blue Cash card, and so did Discover. Meanwhile, Chase was simply copying Citibank and copying their reward formula. When the good times ended, they had to embarrassingly reduce their cash rebates and pissed off many folks. Clearly, those products were not profitable. Amex also avoided getting into the ridiculous balance transfer game by not offering the silly 0%-for-15-months deals that essentially ruined Advanta credit cards.

Take Google as another example. As someone who has a website, I’m familiar with their Adwords and Adsense program, which form the bulk of their revenues. I am (and I’m sure many readers are) privy to what is going on in their program, whether it is the introduction of video ads, or whether keywords in certain sectors are getting more expensive. These can all be found on free tools Google offers. Yet, I wonder how many Wall Street analysts have a Google account aside from gmail!

Learn how accounting is done.

If balance sheets were all there is to investments, everyone would be like Warren Buffet. But there is more to the number than meets the eye. It’s worthwhile to study accounting matters like FASB option rules and how revenue is recorded. For example, Auto makers used to push sales to dealers and record it as revenue (they might still do that). But that is really not a true measure of end consumer demand.

Learn how to calculate cost of goods sold and calculate depreciation expense among other things. Studying these rules will give you a better understanding of the company you are researching. Learning basic accounting is so important for understanding a balance sheet.

Remember that nothing lasts forever.

The last point I want to make is that nothing lasts forever. I’ve heard countless times how Microsoft is a stock to leave to your grandchildren! If you look at the S&P 500 list in 1950 and compare it to the current one, you will realize that most of the companies in the index decades ago are no longer in the index today. So don’t get fixated on any investments. Even Warren Buffet’s newspaper investments have seen their economic model and viability change because of the internet.

Mike’s note: As regular readers of this blog know, I’m firmly in the “don’t bother picking stocks” camp. That said, I find that it’s worthwhile to consider opposing viewpoints. (If nothing else, it makes for more interesting discussion!) I look forward to hearing your thoughts in the comments.

Is Private Education a Good Investment?

This is a guest post from Michael, a contributing editor of Dough Roller, a personal finance and investing blog, and Credit Card Offers IQ, a credit card review site.

The debate between private and public education will most likely go on forever. Whether your child comes out of private or public school better prepared for the rest of his/her life will never really be known. In order to find out, you would need to have the same child experience both, which simply isn’t possible.

Public schools provide statistics on how the diversity and larger class sizes teach students to be patient with (and tolerant of) others. Private schools show that smaller class sizes allow teachers to be more interactive with students, that they have better-kept facilities, and that they can fit more material into a school day when they follow their own curriculum rather than the state’s.

I don’t doubt that both schools have their advantages, but is paying for a private school education truly worth the money?

According to a census taken at the end of the school year in 2009, the average private education tuition was $17,441 per year. If you decide to send your child to private school for grades 1-12, you will be spending a total of $209,292 on your child’s pre-college education. If you choose to send them to public school, you spend nada.  Is spending over $200,000 a wise investment for your family and–more importantly–for the child you are spending it on?

My answer is “no, not even close.”

Granted, there are going to be situations where the public schools located in your area are poor or downright unsafe and sending your child to a private school is an excellent decision. But for many parents, I can think of better ways to invest in your family’s future.

If you invested $17,441 a year into a high yield savings account paying 2%, when your child graduates from high school, you will have a total of $240,000 available to pay for college, cars, or anything else you think would help your children out. And if you have a financial advisor you trust, you can probably do much better than that.

Why do I feel this way? It comes down to return on investment.

  • Does the $200K ensure that your son or daughter will be better educated? No.
  • Does the $200K ensure that your son or daughter will be approved for a top end University? No.

Statistics show that a proportionate number of private and public school students are accepted into quality universities and that private students standardized test scores are only slightly higher than that of public schools. I would argue that private schools show better standardized test scores on average because the living conditions for privately schooled children are better than those of publicly schooled children.

So if there is no guarantee of a better education–or a better shot at college–then what do you get out of your purchase?

  • More Control – Parents have little control over a school board’s curriculum in a public school because it comes from the local or state government. Private schools are funded by parents and not by taxes, so parents have a little more control in what they can change (or try to change)
  • Better Facilities – There’s no doubt that a private school will have better-kept facilities, more resources and offer more opportunities for students to expand their minds. Whether or not students are receptive to these options is dependent on the student of course.
  • Peace of Mind – Just as my mother doesn’t mind spending $90 each year to have her taxes done by a professional, rather than doing them herself, private educations can put a parent’s worries at ease, because they are better maintained and overall safer than public schools.

From personal experience, I can tell you that my public school education taught me a lot about life that I most certainly would not have learned had I been enrolled in private school. Students that work hard and take education seriously can do so in either setting, and who’s to say that private school will actually be the better option?

Whatever decision you choose, make sure you are doing it for the right reasons and everything will work out A-OK.

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