Friday, July 15, 2005

Rules of Dumb

I had a thought about financial "rules-of-thumb". Most don't work. Those that work at all, work in only some situations. What they should call them is financial "Rules-of-DUMB". I can think of a few right off the top of my head. Like:

1. Buy as much house as you can afford.

Now this one is just ridiculous although so many people follow it. Buying a "lot of house" will only serve to make you house rich and cash poor. And usually, what you can afford is determined by some mortgage broker. In my view, that's the last guy you should be listening to. That's like the sheep asking the wolf for advice on how not to get eaten. (No knock against mortgage brokers. I'm just pointing out a conflict of interest there.)

Most of us would be better off buying an easily affordable house. Not "mortgage broker" affordable, but The Millionaire Mind affordable. According to the book's author Thomas Stanley, an easily affordable house is one in which you can afford on HALF your present income for the next FIVE years without disrupting your lifestyle. If this can't be achieved, then consider that you have a house that is not easily affordable.

2. Diversify.

I'll paraphrase Warren Buffett by saying diversification is for the know-nothing investor. The know-something investor should concentrate. Our intent with diversification is to lower our volatility. But what we don't consider is we are also lowering our potential return. If we study our investments a little more and understand them, we'd be better served by concentrating on those investments that offer the highest probability of success. Concentrate to get rich then diversify to stay rich OR stay concentrated to get richer.

3. Save 6 months living expenses for emergencies in cash.

What emergencies are we talking about that would require 6 months worth of expenses? I mean seriously. This is just one of those rules that I think goes too far. If we are properly insured with health, life, disability, home/renter's, auto and the like, most emergencies are taken care of. Most of us, if we were to loose our jobs, will be able to collect unemployment. And if we were to find ourselves in that situation and unemployment doesn't cover our expenses, we certainly wouldn't need that much money in cash (money market fund, savings, under mattress, etc.)!

For most people, having more than say $5,000 in cash is a waste. The rest of your "emergency" funds should be diverted to higher earning liquid assets like stocks. But what if the stock market goes down you ask? Well all I can say is that the stock market is more likely to go UP! In fact, the market goes up about 75% of the time. So it's much more prudent to put your money (your emergency money too) in stocks, though the rule-of-dumb says otherwise.

The 2.5 Year Double

Mo' money, mo' money, mo' money! Yesterday marked the day that our Relative Value portfolio doubled. So your $1 became $2, or your $1,000 became $2,000, or your $10 million became $20 million! Feels good especially given that the feat was accomplished in about two and a half years. Our goal is usually to double our money in about six years. We beat our goal by about 3.5 years!!

Another nice little tidbit is that while the Relative Value portfolio has returned 104.9% since December 31, 2002, the Russell Midcap (using the iShares Russell Midcap Index ETF [symbol: IWR] as a proxy) return was 77.3%. So the portfolio has done extremely well over the last 2.5 years compared to its closest benchmark.

Now maybe doubling your money in 2.5 years doesn't seem like much, especially to those that that have dabbled in the real estate market in the last few years. Well, I'd say don't get too excited about those real estate returns. Although stellar, they still haven't exceed the returns of the stock market. Unlevered real estate (meaning leverage isn't considered but neither are mortgage costs in the return calculation), as measured by the the NCREIF Apartment Index has been approximately 38%-40% over this time frame.

Of course, this performance could have all been a fluke. It's too short a time frame to tell if our outperformance was luck or skill. Just as the underperformance of the Choice portfolio this year could be a fluke. But we're patient.

Wednesday, July 13, 2005

The Emotional Investor

One of the characteristics Warren Buffett looks for in managers of the companies he owns (read: The Warren Buffet Way by Rob Hagstrom) is rationality. In essence, he's looking for managers that will allocate corporate funds to areas that make the most economic sense. An emotional approach to capital allocation would undoubtedly lead to decisions that would decrease shareholder wealth.

I find that very few financial decisions we make for ourselves are rational. Just the opposite in fact. Almost all of our decisions, especially as they relate to our personal finances, have some emotional component. For example, I'm acquainted with a few single 30-somethings that have recently become homeowners. In every case (except for one), these individuals moved out of a small and inexpensive apartment into a much larger and expensive home. A couple were actually moving out of a rent free situation (they were living with mom). Along the line, each one of them has said to me in one way or another, that they thought they were making a good economic decision. In other words what they were saying is that they thought they were being rational and that they'd be making themselves wealthier by buying a home.

It makes me giggle a little that any of them would actually say that they'd be economically better off. I mean, how much better off can you be economically going from paying next to nothing (small apt/living with mom) to paying a substantial something (buying an expensive home in a historically inflated real estate market). These folks are clearly making emotional economic decisions although they'd like to think otherwise. In no way can a situation in which substantial money is spent be better than a situation in which no money is spent. The only explanation is that judgment was clouded by emotion.

But I'll give these individuals the benefit of the doubt as we all have heard time and time again that homeownership is a sure way to wealth. We've heard it so much that we'll even abide by it when the choice of homeownership is the much more expensive choice for us. We dread doing the wrong things with our money (at least some of us). Our emotions take over and suspend our rational thought. Without rational thought, we wind up making the wrong decisions.

Even in situations when we know better, emotions play a big part in our decisions. As some of you (I'm positive not all of you) may be aware paying down a low interest rate mortgage early is not the best financial decision one can make. One would be far better off putting those extra mortgage payments to work in the stock market (or your own business) where one would probably receive a much higher rate of return. But clearly, this is not simply a financial decision. Emotions play a huge part in personal finance and carrying a mortgage is no exception.

I have a friend and with his and his wife's combined incomes, they will be able to pay off his existing mortgage in a very short time. And they will probably go ahead and do just that. My friend also understands that he'll be better off financially if he never accelerated his payments. When I asked him why he planned on paying the mortgage off early knowing what he knows he simply stated, "Cause debt don't feel good."

"Debt don't feel good" is not rational. It's emotional. In Thomas Stanley's book The Millionaire Mind, he profiled several millionaires and their treatment of their homes and mortgages. It was clear that most millionaires are "less" emotional when approaching their own personal finances. Which is why according to Stanley most millionaires (not all) carry mortgages to full term. When millionaires approach a financial decision, they choose the alternative that puts the odds of being wealthier in their favor. This is why they save instead of spend, buy stocks more than bonds (or real estate for that matter), lead low consumption lifestyles instead of ostentatious spend-thrift lifestyles, run their own business instead of working for "the man". I think most millionaires exhibit some form of economic rationality. Paying down a mortgage early or buying an expensive house isn't economically rational. But like my friend says, debt just don't feel good and neither does living with your mama. And maybe that's more important but it won't help your wallet.

Tuesday, July 12, 2005

We're Not Afraid

I just came across and interesting website called We’re Not Afraid. It was a site started as an answer of sorts to the terrorist bombings in London. The site consists of photos from people from around the world proclaiming that they are unafraid of the terrorists. And how they’re going to live their lives as they have all along.

To be honest, when I first came across the site, I was a little offended. I guess I took the “We’re Not Afraid” stance as somewhat of a dis to those that actually died in the bombings. But after a minute of perusing the site, I realized that that’s not really the intent here. It’s an attempt to “castrate” the terrorists’ power (which is fear mongering). The pictures on the site of are people (animals, scenic views, babies) who are going on with the daily lives with smiles on their faces. I thought that’s pretty wild to fight terrorism with a smile. Crazy concept right?

On a related note, it’s interesting to see how very little news the bombings have gotten. Perhaps it’s because it’s on foreign soil, but you’d still think it would have gotten more coverage. But overall, folks seem to be relatively unaffected. Perhaps it’s because we expect this now. The financial markets barely made any movement on that day. In fact, the iShares MSCI United Kingdom ETF (symbol: EWU) has actually gone up 3.6% in the time since the bombing. Perhaps it’s an indication that the terrorists are losing their impact. At the very least it’s interesting.