Jonathan Clements's Blog, page 440

Nerd Gone Wild

IT’S LONG BEEN AN IDEA that’s captured my imagination: Get a child invested in the stock market at a young age and then leave compounding to work its magic. If stocks notch four percentage points a year more than inflation—which many would consider a conservative estimate—$10,000 invested at birth would be worth $230,500 at age 80. That sort of success would, I suspect, give a significant boost to parental popularity.

When my kids were born, I set out to turn this nerdy financial dream into reality. I was on a junior reporter’s salary, with a wife in graduate school, so it took a few years to get rolling. But eventually, I settled on a five-part plan to help Hannah, now age 28, and Henry, now 24.

What were the five parts? I would make sure Hannah and Henry graduated college debt-free, and give them $5,000 upon graduation, $20,000 for a house down payment, $25,000 for retirement and $5,000 toward a wedding or at age 30, whichever came first. I didn’t have this sort of money lying around, so it took many years of regular savings to hit these targets.

Earlier this year, I wrote about Hannah’s engagement—and mentioned my five financial commitments. That blog prompted a slew of emails. How, readers asked, did I go about doing all of this?

For the graduation and wedding money, I didn’t set up separate accounts. Instead, those sums sat in my money-market fund. Meanwhile, college costs were partly covered by money I had socked away first in custodial accounts and later 529 college savings plans, once those became available. Still, I probably paid three-quarters of college costs out of current income.

What about the $20,000 in house money? Hannah’s future down payment went into Vanguard Target Retirement 2010 Fund, while Henry got Vanguard Target Retirement 2015. The target funds kept things simple, offering a diversified portfolio in a single mutual fund. On top of that, I knew the funds would become less risky over time—an appealing attribute, because I wanted the money easing out of stocks as the day approached when the kids might purchase a home.

I bought both funds in custodial accounts. That wouldn’t be a smart move if you thought your children had a shot at receiving college financial aid, because custodial accounts weigh heavily against you in the aid formulas. But I was confident our family wouldn’t qualify. Hannah cashed in her target date fund in 2015, when she bought her house in Philadelphia. I provided additional help by writing a private mortgage for her.

What about the $25,000 in retirement money? That was trickier. To contribute to an individual retirement account, you need earned income. I’ve heard of parents who have funded Roth IRAs for their children, based on income that the kids earned from babysitting and mowing lawns.

Neither of my children earned much money until they were well into their teenage years, so I went hunting for a tax-deferred account that didn’t require earned income. Result: When Hannah was age nine and Henry was five, I opened a Vanguard Group variable annuity for each of them.

Variable annuities, of course, have horribly high investment expenses. But Vanguard’s offering is an exception, with an average all-in cost of 0.54% a year, versus a 2.27% industry average. The minimum investment for Vanguard’s variable annuity is $5,000. There’s a $25 annual account fee if the balance is below $25,000—which is why I settled on that as my target gift. The variable annuities were set up as custodial accounts, with me as custodian. Once Hannah and Henry turned 21, I transferred the accounts into their names.

Later, when they started earning money, I opened Roth IRAs for them. A Roth is obviously preferable—expenses should be lower and you get tax-free growth, versus the variable annuity’s tax-deferred growth. Still, for younger kids, a low-cost variable annuity strikes me as an intriguing option: They’ll enjoy tax deferral on a grand scale—and the tax penalty will discourage them from cashing in the account before age 59½. One additional feature I like: Vanguard’s variable annuity allows you to set up automatic rebalancing. That means Hannah and Henry’s accounts will likely stay on the course that I set many years ago—without any further involvement on my part.

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Too Trusting

AFTER SHARING MY BEST INVESTMENT in my previous post, it’s only fair that I follow up with my biggest blunder. I was 22 and working my first real job, as a high school English teacher in south Texas. Thanks to the job, I quickly kick-started my “adult” life: learning about health insurance, taxes and retirement savings.

A colleague introduced me to his brother, who worked as an investment advisor. We scheduled a meeting to talk about my retirement plan. He told me that I should supplement my mandatory contributions to the Teacher Retirement System of Texas with a retirement annuity. He assured me—quickly and authoritatively—that this money was guaranteed to grow over time, no matter what happened in the stock market. Furthermore, I could borrow against this money if I ever needed it. I asked a few basic questions, determined that he seemed trustworthy and had worked with other teachers, signed up and began contributing a portion of every paycheck.

A few months later, when I told my Dad about my smart move and showed him the annuity contract, he wasn’t as excited. He pointed out that the promised growth was far less than the stock market’s likely return over the next 30 years. He noted that the fees and early surrender charge on the annuity meant I had very little flexibility and would be earning even less than the promised amount. I felt ashamed by my decision and found myself arguing the advisor’s own points back to my Dad. After some debate, my Dad convinced me of his opinion and I had to admit I had made a bad investment.

I quickly pulled my money and paid the penalty. In the process, I learned three important lessons:

Don’t trust anyone who promises you that they can or will beat the market. If they can really do that, they would be rich and wouldn’t need your business.
Never immediately commit to a financial contract or decision. No one should make you feel pressured to sign right away. This is usually an indication that something is awry. Take your time and do your research. Usually, a simple Google search can help identify potential red flags and what questions to ask.
When making financial decisions, seek out people you trust, who have no conflicts of interest, to serve as your sounding board. Bounce ideas off them and listen closely, even if what they say is disappointing and doesn’t fit the narrative you’ve constructed. Your sounding board might be a financial advisor who won’t profit from your decision—or it could be a friend, colleague or parent who has some experience with the product or concept.

Zach Blattner’s previous blogs include Land Grab and Five Tips for a Better Trip. Zach is a former teacher and school leader who now teaches teachers across the Philly/Camden region as a faculty member at Relay GSE. He is a self-taught finance nerd who dispenses advice to his wife, friends, family and anyone else willing to listen.

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Site Seeing (Part I)

MAKING SMART PERSONAL FINANCE decisions involves lots of homework. Fortunately, there are plenty of great resources out there, both aspirational and practical, to help us figure out what to do. Here are my five favorite money blogs:

The Billfold is a personal finance site brought to us by The Awl, the trend-bucking culture blog favored by media industry types. On this idiosyncratic blog, you’ll find refreshingly human takes on everything from the unexpected costs of getting a divorce to receiving an inheritance.

The Simple Dollar is my blog of choice when getting up to speed on practical money issues, like picking a savings account or insurance company. If you could only have one resource to help with your overall financial planning, this would be it.

Money After Graduation is a millennial-centric personal finance blog run by Bridget Casey. The site is a perfect entry point for people in their 20s who want to start their journey toward building long-term wealth.

The Points Guy, Brian Kelly’s travel hacking blog, is my favorite resource for learning how to turn day-to-day credit card spending into tangible rewards. Thanks to advice from The Points Guy, I’ve booked eight flights this year using points and pocket money. Don’t apply for a new credit card without coming here first.

Finally, housing is probably the single most expensive spending bucket in all of our lives. I love following Curbed New York to keep up on the city’s real estate market, home design trends and new neighborhoods worth exploring. There’s a ton of motivational content, like celebrity housing listings, to keep you focused on your savings goals.

This is the first in a series of blogs devoted to the favorite websites of HumbleDollar’s writers.

Steven Aguiar’s previous blogs include Small Changes, Big Dollars and Going It Alone. Steve is the founder of  BlueWing,  a B2B digital marketing agency. He majored in Economics and Hispanic Studies at Brown, and is a big fan of compounding interest.

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This Week/May 21-27

ADD UP YOUR FIXED LIVING COSTS. Include mortgage or rent, car payments, property taxes, insurance premiums, utilities and other recurring monthly expenses. How long could you cover these costs if you lost your job? Are these expenses so high that you find it tough to save—and suffer constant financial stress? My advice: Keep fixed costs below 50% of pretax monthly income.

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Not So Dumb

IT’S ONE OF WALL STREET’S more galling rituals: its regular dismissal of everyday investors as stupid. They’re the “dumb money” you should watch so you know what not to buy—the sheep that the “smart money” regularly fleeces.

This narrative was bolstered by early behavioral finance research, which detailed our many mental mistakes: In our overconfidence, we trade too much and make large investment bets. We’re overly influenced by recent returns. We assume our investments perform better than they really do. We hang onto losing investments, because we hate selling at a loss and admitting we made a mistake. We discount the future at too high a rate. We latch onto evidence that confirms our beliefs, while ignoring information that might force us to revise our position.

The archetype of the dumb small investor was always a little suspect—and it’s become ever harder to sustain, as evidence mounts that professional investors also regularly underperform the market averages and also make their own fair share of behavioral mistakes.

Moreover, this focus on smart and dumb money ignores an alternative explanation: Even if investors aren’t rational as judged by classical economics, their behavior can make sense if we consider what they’re aiming to achieve with their money.

That’s the intriguing argument advanced by finance professor Meir Statman in his fascinating new book, Finance for Normal People. His book represents what he calls “second generation” behavioral finance. In the first generation, it was all about identifying behavioral oddities and dismissing them as mistakes. In the second generation, those mistakes are being reappraised—and viewed as more sensible when we consider investors’ wants.

As Statman explains, our purchases—including the investments we purchase—offer three benefits: utilitarian (what it does for me), expressive (what it says about me) and emotional (how it makes me feel). Hedge fund performance has been disappointing—the utilitarian benefits are often far less than promised—and yet folks are still anxious to buy, because owning a hedge fund makes them feel special and gives them bragging rights at the country club. They get mediocre returns, but maybe they’re still getting their money’s worth.

That doesn’t mean we never make errors. Investors—professional and amateur—are subject to a host of cognitive and emotional mistakes. Those mistakes can occur when we make decisions based on intuition alone, when it would have been wiser to hit the pause button and call on the reflective, slower-moving part of our brain.

For instance, rapidly trading stocks is unlikely to deliver market-beating returns, but folks find it thrilling and it gives them the occasional winner that they can boast about. So is this a sensible way to address our wants? Obviously not, if we’re betting our entire portfolio on the foolish assumption that we can predict market movements and outsmart other investors. We’re likely falling victim to a host of cognitive and emotional errors. But if we create a “fun money” account with a sliver of our savings, knowing we’ll have lots of fun but probably not much financial success, then it seems more sensible.

In its early days, classical economics would dismiss behavioral finance as just a collection of “interesting stories.” But today, behavioral finance is much more than that. Statman takes the notion of wants, coupled with potential errors, and offers up theories of how portfolios are constructed, how stocks are priced, why markets can’t be beaten and how folks think about spending and saving over their lifetime. The theories may need fine-tuning—but they seem right, because they take fuller account of the messy way humans behave.

Finance for Normal People is geared toward an academic audience, but it has much to offer everyday investors. Statman has an engaging writing style, mixing theory with real-life examples. My advice: Put the book on your bedside table and occasionally dip into one of the chapters. It’ll help you figure out what wants you have—and help you avoid costly cognitive and emotional errors.

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Shaking the Dice

WHEN THE WORLD SEEMS A LITTLE CRAZY, we strive for greater control over our lives, including our financial lives. But the greater control we feel is often an illusion and the steps we take can badly hurt our finances. Want to learn more? Check out my latest article for Creative Planning.

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Land Grab

WHEN WE MAKE INVESTMENT mistakes, often bad advice is to blame. Someone recommends a stock or annuity or no-risk rental property, and we’re so tantalized by the upside that we completely miss the pitfalls. Sound familiar? As a counterpoint to this common trope, I wanted to share my best investment—one I never would have made if I hadn’t listened to those around me.

Before I officially closed on my house in Philadelphia, my parents drove by, so they could see it. My Dad’s first words were, “You should buy that vacant lot next door.” I quickly assured my Dad that the corner lot, filled with trash, wasn’t for sale. In the coming weeks, he kept asking me about it and I eventually checked the public record to appease him. I learned that the lot was owned by a company, it didn’t appear delinquent and it was zoned for building. This convinced me that buying it wasn’t an option, and I thought that put the matter to rest.

Eighteen months later, my friend Theo was visiting. We were standing on my back deck, looking at the trash and weeds in the lot. Theo was in his second year of law school and had just learned about Adverse Possession, a rarely used legal procedure sometimes known as “Squatter’s Rights,” whereby an individual can claim ownership of land if he has “continuous, hostile, open and notorious” possession for a set period of time—21 years in Pennsylvania. Usually, this law is invoked when contesting small property boundaries—think of a stone fence separating two homes—or in rural areas with large swaths of untouched property. Theo suggested I might be able to use Adverse Possession law to claim ownership of the lot. This struck me as unlikely.

Theo and my Dad continued pestering me about the lot, leading me to do some initial research into the company on record. I tried calling, but could find no number listed. I sent mail to the address on file with the city and it was returned to me. Eventually, through online research, I learned that the company had once produced envelopes and owned various lots in the neighborhood. They had gone out of business in the 1970s and this plot of land was the only piece that remained in the company’s name.

As I shared my findings with Theo, he grew convinced that I had a case. He connected me with a law professor, who told me the first action I needed to take was to fence the land off, securing my claim to “hostile and open” possession. I installed a cheap chain link fence and contacted a law firm that specialized in real estate.

From there, I worked with a lawyer for over a year, investing about $10,000 in legal fees, as we built a viable but challenging case. I was required to use various means and methods to contact the owner, including running newspapers ads and visiting their address of record. In the end, the outcome hinged on whether or not the company appeared in court. If they appeared and contested my claim, I would likely lose. If no one showed up, I’d win. On the day of the hearing, I waited anxiously to hear back from my lawyer. The outcome: The company did not appear and the court granted a default judgment, where I won free and clear title of the land.

Over the last four years, I’ve used my lot as a parking space, garden and extended patio for my small row home. Now, as I transition out of Philly and my neighborhood continues to gentrify, developers are making offers that are nine to 10 times what I paid in legal fees to obtain the land. How can I show my gratitude to Theo and my Dad? As a first step, I figure I’ll send them the link to this blog.

Zach Blattner’s previous blogs include Five Tips for a Better Trip and Zeroing In. Zach is a former teacher and school leader who now teaches teachers across the Philly/Camden region as a faculty member at Relay GSE. He is a self-taught finance nerd who dispenses advice to his wife, friends, family and anyone else willing to listen.

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Footing the Bill

IN MY HOMETOWN OF BOSTON, there’s an old joke about our dismal winter weather. “February,” they say, “is the longest month of the year.” I don’t disagree and so, each year at Presidents’ Day, my family tries to get away for a warm weather vacation.

On these trips, we often stay at the same hotel and, because of that, we have noticed certain patterns. Among them: Most years, there is the same large corporate gathering. Truth be told, it’s hard to miss. There are five-star dinners under a tent by the beach. There are groups huddled with cigars by the pool. In short, it appears that no expense has been spared. Not surprisingly, it turns out that this group is a high-level delegation from a well-known Wall Street firm.

Knowing the hotel bill for my family’s single room, I can only imagine the total cost for this corporate gathering. The opulence, repeated year after year, is an image I can’t shake. It doesn’t take much analysis to figure out how they afford this luxury. Some of it is underwritten directly by individual investors, when they buy mutual funds or trade stocks. And a lot of it is earned from institutions, such as pension funds, which hold individual retirees’ savings. Ultimately, then, this Wall Street firm’s monstrous bill is paid largely by mom and pop investors.

This strikes me as a problem, for three reasons. First, data has shown that fees have the most predictable impact on investment returns, so unnecessarily high fees directly affect people’s ability to meet their financial goals. Index funds have brought down the cost of investing, but financial advisors’ fees remain stubbornly high.

Second, employees who save through their company’s 401(k) plan have no control over the menu of funds available. If the only funds on offer are the high-fee sort, employees are stuck overpaying.

Third, most investment fees are structured as a percentage of a client’s assets. This is a problem because it means that these fees rise quietly over time, as financial markets climb and investors add to their accounts.

Earlier this year, when I decided to start my own investment firm, I made it my goal to serve individual investors, those who I feel are being treated the worst by Wall Street, and to focus on holding down the cost of both my services and the investments I recommend. This was an easy decision. By whittling away unnecessary expenses, I am able to pass significant savings on to my clients.

Early in my career, an industry veteran summed things up: “This is the most overcompensated profession in the history of the universe.” I couldn’t have said it better. My hope is that in the future, when I am an industry veteran advising young people, I will speak of the industry’s high fees—and the lavish getaways that they paid for—as an historical anomaly that’s long gone.

Adam M. Grossman’s previous blogs were Trust Issues, Contain Yourself and Take It Slow. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers.

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This Week/May 14-20

ELIMINATE DUPLICATION. Many folks have multiple bank and brokerage accounts, multiple funds that invest in the same market sector and even multiple advisors. This can make sense if, say, the goal is to increase FDIC insurance. But often it reflects a naïve notion of diversification—that more accounts somehow mean greater safety. My advice: Simplify—for your sake and the sake of your heirs.

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Odds Against

IF YOU WANT TO BEAT the market, you need to pick stocks that perform well enough to overcome the investment costs you incur. That task is made harder not only by the market’s efficiency, but also by another hurdle: skewness.

What’s that? The most a stock can lose is 100% of its value, but the possible gain is far greater than 100% and potentially infinite (though no stock has got there yet). In any given year, the market’s highest-flying stocks—which might double or triple in value—skew the market averages upward, so most stocks end up lagging behind the averages.

Investors have long been aware of this phenomenon, but a recent academic paper took the notion—and added a huge exclamation mark. Hendrik Bessembinder, a finance professor at Arizona State University, looked at U.S. stock performance over the 90 years through December 2015. Here’s what he found:

Over their lifetime, 58% of stocks underperformed one-month Treasury bills and a majority lost money. For purposes of the study, lifetime was measured from 1926 or whenever a stock was listed through to 2015 or whenever a company was delisted.
The 25,782 stocks that existed during these nine decades managed to create some $32 trillion of value for shareholders, over and above what they could have earned in T-bills. But the top 86 stocks accounted for half that wealth.
The largest wealth creator was ExxonMobil, at $940 billion. Other major contributors were Apple, General Electric, Microsoft, IBM, Altria Group, General Motors, Johnson & Johnson, Wal-Mart Stores and Procter & Gamble. Most of these stocks performed well. But their large contribution to wealth creation also reflected both their size and corporate longevity.
Over the 90 years, the U.S. stock market’s entire gain, over and above T-bills, can be attributed to less than 4% of stocks. The other 96% collectively matched T-bills.
Smaller-company stocks were especially likely to lose money—not a huge surprise. More surprising: Higher returns were clocked by companies with little or no debt. (This latter insight reflects performance since 1962—the period for which data on leverage was available.)
The typical stock was around for only seven of the 90 years. In fact, of the 25,782 stocks, just 36 were in existence for the full nine decades.

Skewness is a powerful argument for broad diversification, especially through total market index funds. That way, you don’t run the risk of badly trailing the market. But instead of appreciating that powerful argument, many investors are drawn to the sizzling sideshow.

What sideshow? While skewness means most stocks and most active managers will end up with market-lagging results, that still leaves a modest number of winners—and their triumph can be spectacular. The danger: Inspired by those big winners, many investors will stray from more diversified strategies, and try their hand at picking hot stocks and star managers. Most, of course, will pay dearly for their greed—thanks to skewness.

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