Stocks, Drops and a Fear of Money

Obviously the news of the day (and perhaps moving forward, the weeks to come) is the broad-based sell-off of stocks throughout global financial markets on Tuesday. According to a large swath of the popular press, the consensus culprit appears to be the sudden unexplained drop in the Shanghai and Shenzhen stock market indices exacerbated by technical glitches from Dow Jones and the NYSE. And, just like that, presto, the economy becomes front page news with warnings of doomsday and gloom.

With no obvious sudden macroecomic shock (like 9/11), how does one explain this sudden fear and panic? If the market supposedly is "efficient" and all information is known and reflected in stock prices, why do these sudden gyrations happen if no big external event has happened? I don't have any definitive answers to these questions. If I did, the Honchos would be sitting on a beach somewhere sipping pina coladas. However, it does seem like herd mentality and chrematophobia have taken place. Yes, chrematophobia, or the fear of money. While a 3.5% one-day drop in the Dow is nothing to sniff at, as an isolated event, it's really no big deal. One has to go back to this day to really feel the hurt. If the 3.5% drop is a sign of things to come, an omen for the future, we're probably all in for a world of hurt. But for all the people who've been happily watching their stock returns increase for the past one, two, and more years, all also for no apparent reason other than vague notions of "increased profitability", it's probably good to see a drop here and there to chase out some of the weaker money from the markets.

Rollin' with Random Walk Investing

If you've taken a finance class in the past 10 years or have any interest in investment theory, you'e probably learned or heard about the efficient markets hypothesis. The efficient markets hypothesis essentially says that prices of assets in financial markets reflect all known information about those assets and are thus "efficient" or properly priced. Burton Malkiel's A Random Walk Down Wall Street is perhaps one of the most accessible and readable (i.e. you get to skip all the math and formulas and get right to the conclusions) books about this theory. The following is a copy/paste of UCLA law professor Steven Bainbridge's Amazon review/summary of Malkiel's Random Walk:

Two basic theories are expounded here. First, modern portfolio theory (MPT), which elucidates the relationship between risk and diversification. Because investors are risk averse, they must be paid for bearing risk, which is done through a higher expected rate of return. As such, we speak of a risk premium: the difference in the rate of return paid on a risky investment and the rate of return on a risk-free investment. In the real world, we measure the risk premium associated with a particular investment by subtracting the short-term Treasury bill interest rate from the risky investment's rate of return. The risk premium, however, will only reflect certain risks. MPT differentiates between two types of risk: unsystematic and systematic. Unsystematic risk might be regarded as firm-specific risk: The risk that the CEO will have a heart attack; the risk that the firm's workers will go out on strike; the risk that the plant will burn down. These are all firm-specific risks. Systematic risk might be regarded as market risk: risks that affect all firms to one degree or another: changes in market interest rates; election results; recessions; and so forth. MPT acknowledges that risk and return are related: investors will demand a higher rate of return from riskier investments. In other words, a corporation issuing junk bonds must pay a higher rate of return than a company issuing investment grade bonds. Yet, portfolio theory claims that issuers of securities need not compensate investors for unsystematic risk. In other words, investors will not demand a risk premium to reflect firm-specific risks. Why? There is a mathematical proof, which relates to variance and standard deviation, but Malkiel explains it in a way that is quite intuitive. Investors can eliminate unsystematic risk by diversifying their portfolio. Diversification eliminates unsystematic risk, because things tend to come out in the wash. One firm's plant burns down, but another hit oil. Thus, even though the actual rate of return earned on a particular investment is likely to diverge from the expected return, the actual return on a well-diversified portfolio is less likely to diverge from the expected return. Bottom line? If you hold a nondiversified portfolio (say all Internet stocks), you are bearing risks for which the market will not compensate you. You may do well for a while, but it will eventually catch up to you (as it has recently for tech stocks).

The second pillar of Malkiel's analysis is the efficient capital markets theory (ECMH). The fundamental thesis of the ECMH is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never overpriced or underpriced: the current price will be an accurate reflection of the market's consensus as to the commodity's value. Of course, there is no real world condition like this, but the securities markets are widely believed to be close to this ideal. There are three forms of ECMH, each of which has relevance for investors: **Weak form: All information concerning historical prices is fully reflected in the current price. Price changes in securities are serially independent or random. What do I mean by "random"? Suppose the company makes a major oil find. Do I mean that we can't predict whether the stock will go up or down? No: obviously stock prices generally go up on good news and down on bad news. What randomness means is that investors can not profit by using past prices to predict future prices. If the Weak Form of the hypothesis is true, technical analysis (a/k/a charting)-the attempt to predict future prices by looking at the past history of stock prices-can not be a profitable trading strategy over time. And, indeed, empirical studies have demonstrated that securities prices do move randomly and, moreover, have shown that charting is not a long-term profitable trading strategy. ** Semi-Strong Form: Current prices incorporate not only all historical information but also all current public information. As such, investors can not expect to profit from studying available information because the market will have already incorporated the information accurately into the price. As Malkiel demonstrates, this version of the ECMH also has been well established by empirical studies. Implication: if you spend time and effort studying stocks and companies, you are wasting your time. If you pay somebody to do it for you, you are wasting your money. ** Strong Form holds that prices incorporate all information, publicly available or not. This version must be (and is) false, or insider trading would be profitable.

In the last section of RANDOM WALK, Malkiel distills all this theory into an eminently practical life-cycle guide to investing. As one may infer, it has two basic principles. First, diversification. Second, no one systematically earns positive abnormal returns from trading in securities; in other words, over time nobody outperforms the market. Mutual funds may outperform the market in 1 year, but they may falter in another. Once adjustment is made for risks, every reputable empirical study finds that mutual funds generally don't outperform the market over time. Malkiel's recommendation: put your money into no-load passively managed index mutual funds. You will see lots of anonymous reviews of RANDOM WALK claiming Malkiel is wrong. Odds are, most of those folks are have either been misled by the long bull market or, even more likely, are brokers or other market professionals who make a living selling active portfolio management. In sum, buy it, read it, believe it, and practice it.

So, basically, if you believe in Malkiel's analyses as I do, all you technical analysis guys out there looking at double tops, head and shoulders, wedge formations and what not are kidding yourselves. And, so are you fundamental value guys figuring out which P/E's are low. But, what about the Warren Buffets and Peter Lynchs of the world who have proven track records of consistently beating the market? There's no doubt that there are a certain number (a small number, by the way) who have had amazing performances over time - is it a matter of skill and abilities or are these individuals outliers, the guys who are several standard deviations above the mean in the distribution of the universe of investors? With the number of people out there playing the markets, probability theory predicts a certain number of Warren Buffets will make it out of the fray.

So, why do I embrace the Random Walk school of thought? One, because I think the theory is right, and two, it's expedient for me to do so (I understand the latter is not much of a justification). For starters, as smart and talented as I like to think I am (Mrs. Honcho's protestations notwithstanding), there are lots of much smarter folks out there working in finance and trading in the markets who are unable to consistently beat the market. And because I have limited time and resources to devote to research, the chances of me being one of the Warren Buffet multi-standard deviation outliers is about none to none. Sure, there's probably some genius holed up in an apartment in the likes of Brooklyn who has figured out a computer program to calculate and find temporary arbitrage opportunities in the market and make profits from that, but overall it's hard to see how markets aren't efficient. Do you really think Jim Cramer or Money Magazine is providing you information that isn't already known or readily accessible?

So what do the Honchos generally invest in? Index funds (including large, mid and small cap equities as well as exposure in foreign markets - e.g, SPY, QQQ, IWM, EEM) and retirement age-based fund of funds (e.g., VTIVX, VFIFX). Not only can you get a diversified holding of stocks and bonds through these holdings, investing in index funds and fund of funds takes away a lot of the thinking involved in picking individual stocks. This isn't to say that Mr. Honcho doesn't delve in the occasional small-cap stock here and there. Irrational you say? Absolutely. More thoughts on this as well as the first part of Malkiel's analysis (modern portfolio theory) at a later date.

A Financial Tip from Ali G

Don't make financial decisions when you're high. Seriously.



Along those lines, a corollary: make contingency plans for how your financial matters are handled in case you become incapacitated. Most people know about wills, the legal documents which determine the legal disposition of the deceased's estate. There are a lot of do-it-yourself solutions both on the Internet and books, but there's no substitute for having a good attorney (not the emphasis on good), particularly if your personal and financial situation is anything more than straightforward. As we've been reminded this week via the tabloids and popular press regarding Anna Nicole Smith, estate law can be extremely complex.

What about for those situations where you're incapaciated but not deceased? A Power of Attorney is a legal document that can be drafted to grant someone of your choice the power to make financial decisions for you should you become incapacitated or incompetent.

Conspicuous Consumption: I-Banker Style

The most popular article from the online version of Friday's Wall Street Journal was "The Wealth Report" piece (paid log-in may be required) about a survey conducted on how 200 investment bankers who received bonuses of $2 million or more spent their recently-announced record bonuses. For most bankers and particularly even more so for senior bankers, the vast majority of compensation comes from their bonus, with just a small fraction coming in salary. So, what is a banker to do when he or she has slogged away for 364 days out of the year on just merely a salary (these "mere" salaries still dwarf salary and wages in almost any other industry or service field) and on that 365th day a windfall falls in their lap? According to the survey in the WSJ article, bankers did some of the following with their bonuses:

• 16.5% was put into savings or investments
• 16.1% was spent on real estate
• 11.9% was spent on art
  
• 11.2% was spent on jewelry or watches
• 4.2% was spent on charity
• 3.4% was spent on debt reduction (hey, even a banker has to keep up with the Joneses down the (Wall) Street - get it? Ok, that was corny)
• 2.8% was spent on luxury cars

No huge surprises here. What people choose to do with their money is very personal by nature, and the Honchos are completely neutral as to what others want to do with their coin. We'll leave the arguments over optimal saving vs. consumption arguments up to the eggheads in the ivory towers. Given that little caveat, we're not surprised that those with greater means to save more choose to spend (although, we should point out that the 16.5% put into savings is higher than the negative personal savings rate of Americans). The 16.1% (or $322k of a $2m bonus) on real estate is a little surprising in that we would have thought that number would be a little higher, particularly given the high cost of real estate in Manhattan. But, overall, just an interesting snapshot on what those top 1 percenters in the income world choose to do with their money.

Real Estate: Myths and Exaggerations II

Myth: Buying a home is a great investment.
Reality: Maybe

One of the most common reasons given for buying a home is that owning property is a great investment. The correlations don't lie - the average net worth of a homeowner in our country is much higher than the average net worth of a renter. But, is correlation equal to causation here? Should we put all of our money into real estate?

Let's compare real estate with another asset class - stocks. According the U.S. Census Bureau, in 1990, the median price of a home in the U.S. was $122,900. By 2006, the median price was $245,300, an impressive gain of $122,400 or 99.6%. Contrast that with the S&P 500, which on January of 1990 was at 329.08 and by June 1, 2006 was at 1285.71. That's a 291% gain. Or put it another way, invest that same $245, 300 in the S&P 500 in January 1990, and your investment would be worth $713,083. What if we go back further in time? Thirty-one years ago in 1976, the median price of a home in the U.S. was $44,200, the equivalent of a 455% gain by 2006. The S&P 500 was at 90.9 on January 1, 1976. That's a 1314% gain.

Some of you will say - hey, wait a minute. Most homeowners didn't pay for their homes outright - most people make a down payment and take out a mortgage. When housing prices increase, their return on investment is much higher because they're using the bank's money to fund the purchase of the home. If I put a $10,000 down payment on a $100,000 home and the price of my home appreciates to $150,000, I've made $50K just off a $10K investment. Those suckers who invested in stock had to spend $100K of his (because suckers are usually men) own money to buy the stock, and when the value of his holdings go to $150K, he's made the same $50K but had to put up $100K to get there! Perhaps, but how is this really different than buying stock on margin?

Others of you will say - hey, what about all those people who made a killing off of real estate in California, Boston, Manhattan and DC - even better than stock market index returns? More power to anyone who can figure out which markets are hot and can time the market (or maybe they're just lucky that they picked the *right* place to live), but if you've really got those Nostradamus skills, why not use those prescient powers and pick some great stocks (and let me know your picks, please). Sure, you could have doubled, tripled, quadrupled or quintupled your money in your Bay Area condo over the past ten years, but you also could have put your money in Yahoo ten years ago and 20x your investment.

What I Want to Be When I Grow Up

For those of you looking for a change in careers, there's an article in the Business section of today's New York Times about a company named VocationVacations. For a fee of anywhere between $399 and $1999, VocationVacations will put together a personalized two to three day dream job experience allowing the customer to test-drive a potential career change or live out a long-desired experience.

I don't know about you, but when I was growing up, I had lots of different aspirations for what I wanted to do when I grew up. Topping the list was professional tennis player followed by professional football player and professional basketball player (why tennis? less chance of injury). Astronaut and mad scientist figured prominently in there somwhere too. Sadly, none of those worked out for me and none of those vocations/professions are available at VocationVacations. However, for those of you looking to make a change, there are some pretty neat ones, including:

• Brew Master
  
• Chocolatier
• Golf Pro (I assume this one takes some natural talent)
• Music Producer
• Restauranteur
  
• Sports Announcer
  
• Sword Maker
  
• Voice-over Artist
  

Real Estate: Myths and Exaggerations

Myth: Buying real estate will save you a lot of money on your income taxes.
Reality: Maybe

The interest that you pay on your mortgage and property taxes will save you money only to the extent that the interest, property taxes and your other itemized deductions exceeds the standard deduction you are eligible to take times your marginal income tax rate.

Example: Let's assume the Bush Cheney Average Joe family has a household income of $46,326 (median U.S. household income in 2005), putting them in the 15% marginal federal income tax bracket if they file married with a joint return. The Joes have their eye on a house like this 2500 sq. ft. beauty in Dallas listed on the market for $245,300 (median U.S. home price in 2006). The Joes put down a 20% down payment, leaving them with a $196,240 30-year mortgage and a total payment of $11,708.85 in interest in the first year of their mortgage. The Joes will pay another $4943.33 in property taxes. Assuming the Joes have no other deductions to itemize, their tax savings from buying this home is 15% x (11,708.85+4943.33-10,300) or $952.83. Not too shabby at all, but not exactly a bonanza either.

Some additional notes:

• If the Joes can itemize additional deductions, their tax savings will go up even higher. Of course, additional deductions also means a greater risk of running into AMT country.
• Another way the Joes can "save" more money on taxes is if they take out a bigger mortgage, allowing them to deduct the higher interest amounts. Of course, this begs the question of whether the Joes are actually saving any money if they are plowing their money into a bigger mortgage and, thus, bigger interest payments.
  
• As the Joes' mortgage amortizes over time, the interest component of the mortgage payments will decrease. Assuming (1) property taxes increase 1% a year to go along with Dallas home appreciation, (2) no other deductions are taken and (3) the standard deduction for those filing married with a joint return increases 3.8% per year (as it did from 2006 to 2007) , the tax savings of owning decreases by about one-half after just 5 years and becomes non-existant after an additional 5 years.
  

Unsolicited Credit Card Offers

Everybody gets a lot of unsolicited credit card offers in the mail. If you're like most normal people, you deal with the offers by either throwing them away or applying for the credit card.

As you can clearly see below, I am not a normal person. Mr. Honcho derives a very odd joy from taking the prepaid envelopes in these unsolicited credit card offers, stuffing them with other junk mail, and mailing the junk back to the credit card companies. Why do I do this? No doubt, it has something to do with my deep-seated mental imbalances. But, apart from the obvious, I like to think that my actions will cost these credit card-issuing banks something more than just a metaphysical impact to their bottom line. Because the postage for the envelopes are paid by the credit card companies and the cost of postage is determined by the weight of the envelope, I stuff the envelopes as full as possible. My masterpiece below:

Mrs. Honcho doesn't approve of this "waste of time." But, I am comforted by my discovery that I am not alone in this world.

Thoughts on a Flat Tax Proposal

A recent post from someone named 'popoman' on John Edwards' blog (note eerie resemblance to the Walmart website; second note: Barack Obama's website designed to look like MySpace?; third note: this is NOT John Edwards' plan or proposal):

Is there some reason we can't take [sic] tax the trillions of dollars hidden away from taxation (stock and bond property) of the Multi-Billion dollar companies and wealthy individuals? Why not take total wealth of all people and companies and tax them 30% per year and tax the people making less then $200,000 dollars a year 25%. No deductions for those above $200,000. Take the money and re-invest into society. Eliminate Poverty, Homelessness, Un-education, Sickness (mental and physical)!

A modern-day Robin Hood. Let's TAKE, er tax, from the rich and give to the poor. Why don't we take a look at this proposal a little more closely and see it means.

If you read this proposal literally, the plan would tax 30% of the total wealth of all individuals making more than $200k and 25% of the total wealth of everyone making less than $200k, and he would do this every single year. Or, to translate this into plain English: the greatest destruction of wealth in the history of the world. Consider:

• According to this Forbes article, the Congressional Research Service found that as of 2001, the median net worth of U.S. households where the head of household was between 55 and 64 was $181,500. Under a best-case scenario, let's assume one of these households retires with their $181,500 nest egg, collect $10,000 a year from Social Security and enjoy an 8% return on their entire net worth (highly unlikely unless each household's net worth is invested in the stock market) per year. Under the Edwards redistribution plan, each of these households would have approximately $91K left after 5 years, or roughly half of what they started out with. Oh wait, did we forget to mention that my calculations assumed ZERO spending by each of our households? Factor in food and other basic necessities, let alone vacations and Bingo trips to the casino, and you're talking about some very impoverished retirees.
  

• Moving to the other end of the spectrum, let's take Bill Gates and his 25 billion dollar net worth. There's no doubt that a 30% tax, or 7.5 billion dollars, would go a long way to helping fight poverty, homelessness, un-education and sickness. But, what happens when that money dries out? It's not exactly easy to create 288 billion dollar companies. And, do you really trust our fine politicians in Washington to spend this money wisely? Six B-2 stealth bombers and Bill's contribution is gone forever.
  

• And what about these companies who have to pay 30% of their total value each year? This would require every company to grow 42%! each year just to keep the status quo. Stock tip: if Edwards becomes President, it's time to short the US stock market.
  

But maybe we're reading the proposal all wrong here. Maybe popoman means a flat tax on incomes, not net worth. Putting aside the politics of a flat tax and whether it is morally or socially responsible, could someone please explain to me how such a flat tax on income would work? How would you define income? The Honchos know a whole lot of smart people, but we don't know too many who know what this stuffmeans. When we live in a country where our former President doesn't even know the definition of "is", how are we supposed to come to agreement on what is "income" or "compensation" or "benefit"?

Of course, the Honchos understand that this is all academic and serves no purpose other than to let Mr. Honcho rant a little bit. But, be forewarned - many a downfall of great societies have come from failed tax policy - see Qing Dynasty China.

An Oldie but a Goodie

In 2004, the PBS program Frontline ran an hour-long documentary entitled the "Secret History of the Credit Card" discussing the rise and proliferation of what is now the ubiquitous use of plastic in the United States. An excerpt from the introduction to the program:

The industry's most profitable customers, the ones being sought by creative marketing tactics, are the "revolvers:" the estimated 115 million Americans who carry monthly credit card debt.

Ed Yingling, incoming president of the American Bankers Association, tells FRONTLINE that revolvers are "the sweet spot" of the banking industry. This "sweet spot" continues to grow as the average credit card debt among American households has more than doubled over the past decade. Today, the average family owes roughly $8,000 on their credit cards. This debt has helped generate record profits for the credit card industry -- last year, more than $30 billion before taxes.

To watch the entire program for FREE online and to learn about things like why all those unsolicited credit card offers seem to come from South Dakota, go to Frontline: The Secret History of the Credit Card.

For those of you who want the Cliff Note's version, below are selections from the 8 Things a Credit Card User Should Know on Frontline's website, along with some limited commentary from this honcho:

1. Even if you make your credit card payments on time, the credit card bank can raise your interest rate automatically if you're late on payments elsewhere -- such as on another credit card or on a phone, car, or house payment -- or simply because the bank feels you have taken on too much debt.
   


2. Your credit score -- known as a FICO score -- has become a vital statistic for many Americans and can be widely shared. It is used to determine how much you can borrow, how much you pay for life insurance, if you can rent a home, and ... it can be a factor in determining the interest rate you pay on a credit card.
   

Get free estimates of your FICO score here and here


3. There is no limit on the amount a credit card company can charge a cardholder for being even an hour late with a payment.
   


4. It's important to read the fine print on your credit card agreement.
   

Who are we kidding? Let's just say the Honchos know a lot of lawyers out there, and we can't think of a single one who is willing (certainly not one who's willing to do it for free) to sit down and read through a credit card membership agreement. And, if you do actually manage to sit down and read the fine print drafted by the credit card bank's army of lawyers, good luck trying to negotiate the fine print of your credit card agreement with your bank. We're talking about as close to a contract of adhesion as it gets.


5. Many Americans are inattentive about their credit card accounts.
   

You can add me to that list. Thank goodness Mrs. Honcho is the anal, er attentive, one in this household.


6. There is no federal limit on the interest rate a credit card company can charge.
   


7. Significant credit card debt can put you at a markedly higher risk of bankruptcy.
   

This deserves its own topic, but for the time being, you bookish ones should go here and then to your local public library. For you less bookish ones, try this one out.<

Rate Chasing - What's Your Cash Doing for You?

What is your bank paying you for the privilege of holding your money? Well, if you're living in New York City, Washington Mutual is paying you a whopping APY of 0.15% on a savings account. That's 15 cents for every 100 dollars of deposits.

What can you do to make your dollars work harder for you? Check out the best rates at Bankrate.com. Not comfortable with depositing your money with some bank called BankUnited in the financial powerhouse city of Miami Lakes, Florida, 5.35% notwithstanding? You can always go with one of the big boys like Citibank E-Savings (currently 4.75% APY), ING Direct (currently 4.5% APY), or HSBC Direct (introductory 6% APY for new deposits through April 30, 5.05% APY thereafter).

Think it's too much of a pain to open up a new bank account? Maybe, but consider that your $10,000 sitting in the Washington Mutual savings account at 0.15% APY will have netted you $460 less in interest than if that same $10,000 had been parked in the Citi E-Savings account. I don't know what Mrs. Honcho would do with an extra $460 in her pocket, but I'd have my eyes on one of these.

"There's No Such Thing As a Free Lunch"

We've all heard about those wonderful free vacations....where ALL YOU HAVE TO DO is sit through a daily 3 hour timeshare presentation with the good ol' friendly salesperson pressuring you to buy buy buy! But, believe it or not, there are a lot of free lunches out there requiring little or no effort just waiting for you to act. Ok, maybe on a metaphysical level, nothing is free because there's an opportunity cost to everything. But, with little more than a click of the mouse while you're watching those Everybody Loves Raymond re-runs, you can pick up some great swag:

• Fatwallet Free Stuff: Just off the tops of our heads, Fatwallet's Free Stuff forum has led us to all sorts of free swag including calendars, cigars, books and cookbooks, cat food, address labels, movie tickets, toothpaste, DVDs and subscriptions to over 10 magazines.


• Craigslist: One man's trash is another's treasure. If the city you live in has a Craigslist presence, check out the free stuff link. Free space heater any one?
  


• Freecycle: Similar to Craigslist except you have to give something away first before getting invited to the party.