The Third Pig

After finding my post about “lazy investing”, a reader of The Third Pig suggested following such an approach would eventually lead to financial ruin. The reader suggested to be a successful investor one had to be unnaturally gifted in analytic ability and/or spend countless hours researching and trading his portfolio. I cannot speculate on where this reader developed his point of view but what I can say is the evidence does not support him. Warren Buffett has often said that successful investing requires three things: a 5th grade understanding of mathmatics, a sound investment philosophy and the right temperament. Never does he say you have to be a genius or you have to stay up all hours a night trading your portfolio.

Legg Mason Capital Management performed a study in an attempt to find the common characteristics of mutual funds that beat the S&P 500 Index during the period of 1992 to 2002. What was found was a few common attributes of the outperformers which are strickingly similar to a lazy investing approach. Those funds were/are/have:

• Portfolio concentration: These portfolios have, on average 37% of assets in their top-10 holdings, versus 24% for the S&P 500 and a 28% median for all U.S. equity funds.
• Portfolio turnover: As a whole, this group of investors had about 30% turnover, which stands in stark contrast to turnover for all equity funds of 110%. They are truly, lazy investors (how we like to define it).
• Value Investment Style: Most if not all of the funds listed seek stocks with prices that are less than their value. These fund managers recognize that price and value are not the same, often diverge and then converge again. They take advantage of this consequence of investing in the stocks of companies.
• Off Wall Street: Only a small fraction of high-performing investors are located in the financial centers of New York or Boston. There location allows them to quiet the noise of Wall Street, dampening the temptation to trade frequently or with reckless abandon. They can take a more methodical and rational approach.

The chart below shows how some of those funds have fared against the S&P 500 in the 10 years ending September 30, 2009. As you can see, most of them beat the market and had positive returns in a period that experienced the worst economic times since the great depression. Oakmark Select in particular had a bad run as a result of owning a large piece of Washington Mutual during the subprime crisis (article) but it hardly mattered over the long term. The funds that didn't have been a little more volatile than the market and measured over different but similarly long periods, also outperformed the market. Although I cherry-picked the funds I follow most, the sample is representative of the group listed in the Legg Mason white paper.

Following this approach, our Core Model Portfolio Average has performed well over a similarly long period of nearly 7 years (ending 9/30/2009) returning an annualized 10.7% versus the S&P 500's 3.8%. Bottom line, it pays to be lazy when it comes to investing.

Disclosure: I and the clients of Brick Financial Management, LLC did not own shares in any of the the companies or funds mentioned in this post at the time of this writing. But positions may change at any time.

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Posted by Benjamin Taylor at 03:00 PM |
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Source: Flickr by timcullen

At the extremes, the bottoms of bear markets and the tops of bull markets, you will undoubtedly hear that buy and hold is dead. We find ourselves in the former market (we hope) thus that old refrain has returned. Over the last 10 year, the S&P 500 has seen a -2.5% annual yield (ending 4/30). Those who become disenchanted with the buy and hold strategy are folks generally uncomfortable with what feels like doing nothing. Alternatively they set to a course of frenetic trading at what seem to be opportune times. Unfortunately this approach leads to very little except frustrated investors.

The Journal of Finance published a white paper by two Cal Berkeley professors, Brad Barber and Terrence Odean which chronicled the folly of the active trading approach. Right from the abstract of the paper they write:

Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent. The average household earns an annual return of 16.4 percent, tilts its common stock investment toward high-beta, small, value stocks, and turns over 75 percent of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors.

So how does an investor beat the market?

Relax: The first thing to do is to simply take a chill pill. Most of what you need to beat the market comes down to your temperment. If you can keep a cool head while all the world is losing theirs you will have a tremendous advantage. Fear and panic cause investors to make bad decisions more often than not. So stay cool.

Stop trading: Transactions costs, the least of which is commission, eat away at returns. As damaging is the bid-ask spread as well as the capital gains taxes paid on any small gains made. According to Barber and Odean:

The investment experience of individual investors is remarkably similar to the investment experience of mutual funds. As do individual investors, the average mutual fund underperforms a simple market index. Mutual funds trade often and their trading hurts performance. But trading by individual investors is even more deleterious to performance because individuals execute small trades and face higher proportional commission costs than mutual funds.

Control your emotions and your ego: Consistently beating the market is difficult. For this very reason it pays to take your emotions and your ego out of it. Do you really think you will create some investment approach that is somehow smarter and more fantastical than the methods used by Warren Buffett or John Templeton? It's foolhardy to chase the latest fad in investing (or to think you'll create it) when the tried and true works like a charm.

Hold just a few positions: The investor would do well to select only the stocks of companies he understands well. By doing so he will reduce his portfolio's risk by steering clear of permanently weak companies and avoiding overpriced firms, not by excessive diversification. Increasing portfolio positions past 20 to 30 positions does very little to reduce volatility any further. Interestingly though, increasing positions past this point will continue to reduce returns. According to mutual fund manager Robert Hagstrom, concentrated portfolios of 15 securities are 13 times more likely to outperform the market than portfolios of 250 securities. In other words, excessive diversification fails to effectively reduce volatility risk yet greatly handicaps the investor’s ability of beating the market.

Buy at the right price: Even the greatest company will not make a good investment if it is overpriced. Determining the correct price for an investment is difficult as it requires many assumptions. But it is essential to a sound investment process. If bought at a price below the company's real value, all an investor really needs to do is wait until the price of the stock reflects the true value of the company. Eventually, it will.

If an investor follows these few steps, he can relax on the beach and let others worry about the ups and downs of their portfolios.

Disclosure: none

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Posted by Benjamin Taylor at 06:50 PM |
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Tisa Silver over at Bizzia noticed a post I did a while back regarding Robert Kiyosaki and his questionable math skills. She republished the article there and gave her own take on it as well. That article underscores why investors should always question, always investigate and always think for themselves.

Check out some of Tisa's other stuff as well here, here and here.

Below is an exerpt from the original post I wrote: 

---

Dear Robert Kiyosaki,

I've read a few of your books. I must say that when I first read Rich Dad, Poor Dad I loved the general premise of “become financially literate”. That made sense to me. But I must tell you, my feeling on all the subsequent books that have come out of the Rich Dad camp has been that the books (as well as your advice) have become more and more absurd. For instance, what's up with the figures in your book, Who Took My Money?. ...

... Throughout Who Took My Money?, you suggest that simply by heeding your advice, an investor can achieve returns of 180% per year. Forgetting, that we don't know how you came up with that figure, let's look at what an annualized return of 180% would mean.

Let's say a 25 year old has $20,000 to invest and is able to receive an annualized 180% return over his investment lifetime – about 50 years. At that rate of return, and at the end of that period that 75 year old would have a comfortable nestegg of…drum roll please…

$455,965,058,160,294,000,000,000,000!

This is not a misprint. That investor, by investing in single family homes, would be a SEPTILLIONAIRE 455 times over. Now, Rob, are you really telling me that I can be 455 quadrillion times richer than someone who is a mere billionaire? Seriously? If you are, I just have to say that that seems a little far fetched to me. Especially when you consider that, according to the Federal Reserve's 2001 Survey of Consumer Finances, there was only $44 trillion dollars of wealth in the U.S. that year. If we applied an extraordinary rate of growth of 5% to that $44 trillion, in 50 years total U.S. wealth would reach,

$502,905,811,102,164.

Now Rob, are you telling me that by following the investment program you lay out in your book, that in 50 years, with one $20,000 investment, I can be 907 billion times richer that the entire U.S. population? I have to say Rob, I'm not buying this. But I'm sure this letter is falling on deaf ears. However, if the New York Times Bestseller list is any indication, a lot of people are buying it.

Sincerely,
Benjamin B. Taylor

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Posted by Benjamin Taylor at 11:25 AM |
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Two weeks ago I posted a video on YouTube declaring that I thought we were in the midst of a new bull market. I went on to say, in order to tell if we have entered a new bull market it is best to try and determine if we have seen a market bottom. November 20, 2008 was the day the S&P 500 reached 752. As of January 6, 2009 when the S&P 500 reached 934.7, it represented a 24% advance from the November 20th low. Technically, once an advance of 20% or more is underway that is a new bull market. But in an effort to be thorough, I went through five criteria I look at to determine if we were in fact in a new bull market.

Truthfully, I stole the criteria from Benjamin Graham’s The Intelligent Investor. In the book, Chapter 8, “The Investor and Market Fluctuations”, Graham explains how to recognize market tops. He gives five criteria. I simply turned those criteria on their head and replaced one with another I think is more relevant (at least to me). The criteria were:

1. A significantly low price in the market index.

From Oct. 9, 2007 through Nov. 20, 2008, the S&P 500 declined 52%, making it the third-worst bear market since the 1929-32 crash which saw a decline of 54%. The only other decline more significant than the ones just mentioned was 89% during the Great Depression. Additionally, the calendar year decline of 39% was only surpassed two other times in (1931 and 1937) in over 180 years. In other words the severity of the decline indicates that we are at a significantly low price.

2. A significantly low P/E on the market

At the 752 level, the S&P 500 was trading at a P/E ratio on trailing operating earnings per share of 11.5x. This is equal to the lowest operating P/E ratio in the 20 years that S&P has been tracking operating results and significantly lower than the average operating P/E ratio of 19.3x since 1988.

Another P/E measure is the Graham P/E (named for Benjamin Graham) which uses an inflation adjusted 10-year average for earnings. For the nine previous bear market bottoms the Graham P/E averaged 14.4x. At the 752 level in the S&P 500 the Graham P/E clocked in at 12.3x. This was lower than even markedly low P/Es.

3. High Stock market dividend yields versus relative to long-term bond yields

Dividends paid by Standard & Poor’s 500 Index companies in the 12 months prior to December of 2008 amounted to 3.5% of the benchmark’s closing value yesterday. In early December, the 10-year yield fell as low as 3.4%. Intuitively, stocks should yield more than bonds as they represent the more volatile investment. However since 1958, 10-year notes have yielded on average 3.7% more than stock dividends. The present condition, dividend yields higher than bond yields, serves as an indicator stocks are priced the lowest they have been relative to bonds in 50 years.

4. Low Level of margin accounts

Margin is commonly used in a speculative manner. When the market is rising, buying stocks with borrowed money can and does juice returns. But in a declining market, they can be a death certificate. Margin accounts declined 47% from July of 2007 to November of 2008.

5. High volatility in the market

The best measure of volatility we have today is the CBOE VIX. The VIX, is also called the fear index. When it is high it indicates there is a plethora of panic selling in the market driving prices down. Market prices and the level of the VIX move in opposite directions. Historically, a VIX above 20-25 meant there was a lot of selling. Since the high of October 2007 to date, the VIX has averaged almost 32 and even reached an intraday high approaching 90. Warren Buffett himself even indicated he had never sell panic like this in all his years of investing. Panic selling usually means market bottoms.

Although we have seen the market pull back from the 934 price it reached on January 6^th, it has not dipped below 800 since then. If history is any indicator, we are in the first few days of a new bull market.

 

Disclosure: I and the clients of Brick Financial Management, LLC are own shares of iShares S&P 500 Index ETF but positions can change at anytime.

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Posted by Benjamin Taylor at 07:35 PM |
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Over the last week or so I have been listing things to be thankful for in this market. So far I have covered three things. They are:

1. The Teachings of Benjamin Graham

2. Low P/E Ratios

3. The Inevitable Market Rebound

And now I am listing numbers 4 and 5:

4.     Black Eyed Peas, and
5.     Collard Greens

Seriously, do I really need to say more? There are few things in life that beat mom’s collard greens and pop’s black eyed peas thrown in with a little Jamaican corn bread. And with today's economy and the burden it is putting on the pocket book, a cheap meal is hard to come by. In fact, with Americans on food stamps reaching an all-time high, a cheap nutritious meal is just what the doctor ordered.

Southern folklore suggests, that a meal of black eyed peas and collard greens will bring with it good luck and financial prosperity. The peas represent coins and the greens represent folding money. Both foods are dependable sources of nutrients and antioxidants that protect your heart and maybe prevent cancer and both are great sources of folic acid.

So in the spirit of Thanksgiving and my hope we can all get a little more luck and wealth in our lives, I have decided to share a recipe from the Homesick Texan for black eyed peas:

http://homesicktexan.blogspot.com/2006/12/black-eyed-peas-for-new-years-day.html

And another for collard greens from Ms. Financial Savvy:

http://www.msfinancialsavvy.com/article.php?aId=141 

Good eats and Happy Thanksgiving!

Disclosure: I do not, nor do the clients of Brick Financial Management, LLC, own any securities mentioned in this article. But positions may change at any time.

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Posted by Benjamin Taylor at 01:25 PM |
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Target (TGT) reported earnings today and beat estimates by 5 cents per share. The second quarter (fiscal year 2009) earnings report show the company had made 82 cents per share which amounts to $634 million in profit for the quarter. This might have been better news had estimates not been lowered ahead of Target’s announcement. Given the turmoil in the economy, it is no wonder the company posted its fourth straight quarterly profit decline.

But long term investors in the company should take solace. Target is one of the best-managed and most profitable retailers in the world. It is competitive with Wal-Mart (WMT) on a price basis on most of the items both stores carry, but the typical Target customer earns over $20,000 more per year in income than does the Wal-Mart customer. Right now, in this tough economic environment, customers prefer Wal-Mart to Target based on the perception the latter store is more expensive. There is some buzz on Wall Street the company needs to let consumers know the retailer are just as “cheap” as the competition. However, based on findings regarding human behavior as it relates to consumerism, this would be one of the worst things Target could do. There is a peculiar human trait that wants to believe the more one spends, the more valuable the purchased item is, even if one only perceives he or she has spent more. People value items based on price instead of pricing items based on value. Thus Target has a competitive advantage over Wal-Mart in the minds of most consumers during better economic times.

To illustrate allow me to point to two studies which examine the role price plays in a person’s ultimate purchase satisfaction.  The first study was conducted by researchers at Stanford Business School and Cal Tech. In a blind taste test drinkers were given several glasses of wine priced from $5 to $90 per bottle. The results showed the drinkers preferred the most expensive wine. What the study participants were not told was the wine was exactly the same in each and every bottle.

The second study conducted by Dan Ariely, author of Predictably Irrational, measured people’s reaction to the prices of a pill they were given to mitigate their pain. The pain as it were was delivered via electric shocks administered by the conductors of the study. The result: although the pill was the same for all participants, 85% of the participants who were told their pill cost $2.50 felt less pain while only 61% of those who were told their pill was only 10 cents felt less pain. In the minds of the participant, the more expensive the pill, the more effective it was.

The “predictably irrational” behavior of people at it relates to their wallets has a couple of implications for Target. The company can use this information in two ways. The company could and should raise its prices above similar items found at Wal-Mart. In good economic times, all things being equal, consumers will prefer the perceived higher price alternative thus they will choose Target over Wal-Mart. Although in bad economic times, they may choose Wal-Mart. This actually has some merit as during the 5 year period ending April 2006, a period of economic expansion, Target’s stock clearly performed better than Wal-Mart’s (first chart). However, since then during an economic downturn, Wal-Mart has outperformed.

 

Since this is a counterintuitive approach it is not likely Target will go this route. Thus, if Target is going to continue be price competitive with Wal-Mart, it should market or continue to market itself as Targét (Tarjay) instead of just plain old Target. That way, it will continue to keep its higher earning customers and not lose them because they are not charging enough.

All that said Target remains a great buy at this level, $49.72 as of this writing. Simply based on its earnings potential, it is worth at least $60 per share. Additionally, since selling half its credit card receivables to JPMorganChase for nearly $4 billion in March of this year, it is likely to redirect that money to share repurchases that will serve to further increase the value of the stock. For the quarter, Target has spent $4.9 billion of the $10 billion it plans to spend on share repurchases. And it has a real estate portfolio (it owns the land its stores are on) with a book value of $25 billion and worth at least $30 billion. That represents 75% of its market cap.

Buying in at these levels (not a recommendation; see disclosure) seems like a no brainer.

Disclosure: I and the clients of Brick Financial owned shares of Target (TGT) at the time of this writing however did not own shares of Wal-Mart (WMT).

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Posted by Benjamin Taylor at 07:02 PM |
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Every now and again we are presented with a choice to buy a new something or buy into a new idea. Often times these decisions are not the easiest to make. Do I buy the silver coupe or the red convertible? Sometimes the decisions are slightly easier. Do I accept the job working long hours for minimum wage or accept the million dollar inheritance from Uncle Ralph?

We at Brick Financial are often faced with the decision to add new positions to our clients’ portfolios. But our decision of whether to buy or not is often made easier by utilizing a simple technique. We simply compare the new position under consideration to what we already own. If we find after this comparison, that the new investment does not make our clients better off, we pass. This mental exercise saves of tons of time and effort. It eliminates 99% of the investments in the marketplace. Most just will not be up to snuff.

The beauty of this technique is that it can be applied to every day life. In managing your “life portfolio” you simply compare the new thing to what you already have in your possession. If you have children in a good school it might not be worth taking them out of the school they’re in unless the new school you’re considering produces Rhodes Scholars left and right. If you’re married, it’s probably not worth the headache and expense of divorce for a short-lived affair with the new office hottie. Well, maybe if it’s Angelina Jolie. Even then it’d be a close call.

The point is, your decisions become substantially easier to make if you are thinking about how they will improve your life. If it’s close, why bother. Your time is better spent relaxing with a Mai Tai than worrying about all the choices and decisions you need to make in life. Life is too short. Enjoy it.

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Posted by Benjamin Taylor at 03:41 PM |
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Value investors worry that they might be wrong. So they add a belt in addition to suspenders. Drawing on the point that prices are different than values, value investors insist on as large a favorable margin of difference between price and value as possible. Doing so produces a margin-of-safety against judgment of error.

Value investors invest only in the stock of companies known to be faithful stewards of investor capital. They seek proven track records of good judgment and fair treatment by management.

Few companies live up to the requirements of value investors when the philosophy is strictly applied. Thus few companies make it into the portfolios of value investors. It is far safer to make the error of omission than to make the error of inclusion.

Value investors view themselves as owners of a business, not simply owners of a stock. It requires a long-term view and means avoiding the rapid-fire buying and selling characteristic of the vast majority of investors.

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Posted by Benjamin Taylor at 10:47 AM |
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"Individuals who cannot master their emotions are ill-suited to profit from the investment process."

-Benjamin Graham

 

 

 

 

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Posted by Benjamin Taylor at 02:04 PM |
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"People would rather be promised a (presumably) winning lottery ticket next week than an opportunity to get rich slowly."

- Warren Buffett

 

 

 

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Posted by Benjamin Taylor at 08:22 AM |
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Value investors make hardheaded assessments of their competencies. If they doubt their skill in stock selection, they steer clear. Value investors know their limits, thickly drawing the boundaries of their circle of competence. They avoid investment prospects beyond those boundaries as well as anything even close to the boundaries.

Market gyrations, price-value discrepancies, and risks of overconfidence warrant exercising extraordinary caution in selecting an investment. In focusing on the business, value investors ascertain whether the business itself is substantially insulated from adversity. Value investors avoid business with permanent problems. The business itself must be fortified by a moat, a defensive barrier to ill effects such as arise from brand name ubiquity, staple products, market strength, and adequate research and development resources. Franchise value is exhibited by high, sustainable returns on equity and invested capital.

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Posted by Benjamin Taylor at 11:29 AM |
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A popular story passed on about Mahatma Gandhi goes something like this: A woman brought her son to see Gandhi because he was eating too much sugar. And despite her vigilance, the boy could not seem to give up eating sugar, even though it was bad for him. And so the woman asked Gandhi if he would speak with the boy about his problem. Gandhi replied, “No, but bring him back in a week.” And so in a week the woman returned and once again petitioned Gandhi to speak with her son about his rather bad habit of eating too much sugar. Gandhi welcomed the boy and had a discussion with him about giving up sugar. The boy seemed affected by Gandhi’s advice and the woman thanked him deeply. As she turned to leave she asked him one final question, “Why did you see him today and not last week?” And Gandhi replied, “Because last week I was eating sugar.”

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Posted by Benjamin Taylor at 02:14 PM |
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"You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."

- Benjamin Graham

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Posted by Benjamin Taylor at 01:54 PM |
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"Scared money don't make none."

 - Sean "P. Diddy" Combs

 

 

 

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Posted by Benjamin Taylor at 05:08 PM |
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"Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases."

-Warren Buffett

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Posted by Benjamin Taylor at 02:23 PM |
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"[Value investing] ideas seem so simple and commonplace. It seems like a waste of time to go to school and get a PhD in economics. It's a little like spending eight years in divinity school and having someone tell you the ten commandments are all that matter."

 - Warren E. Buffett

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Posted by Benjamin Taylor at 03:14 PM |
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"I conceive that the great part of the miseries of mankind are brought upon them by false estimates they have made of the value of things."

-Benjamin Franklin

 

 

 

 

 

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Posted by Benjamin Taylor at 06:22 PM |
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Seems I'm not alone in the my feeling on bottled water. An article in the New York Times points out that:

"Ounce for ounce, it costs more than gasoline...depending on the brand, it costs 250 to 10,000 times more than tap water. Globally, bottled water is now a $46 billion industry. Why has it become so popular? It cannot be the taste, since most people cannot tell the difference in a blind tasting. Much bottled water is, in any case, derived from municipal water supplies...Admittedly, both kinds of water suffer from occasional contamination problems, but tap water is more stringently monitored and tightly regulated than bottled water."

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Posted by Benjamin Taylor at 04:49 PM |
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So many of us drink bottled water. It's clean, it's refreshing, it tastes good. It's healthy for us. Right? Well, if we believe the bottled water companies then yes, all these things are true. But on some level, we drink bottled water because we are avoiding drinking tap water.

Tap water is cruddy, nasty, vile. We loathe it. Some of us won't even cook with it. And we do this to keep ourselves healthy right?

Funny how we're so influenced by marketing. A polar bear, or a snow capped mountain, or some Grizzly Adams look-alike standing by some river makes us think, "Dang, I'm thristy. Think I'll have some water in a bottle." But what those marketers don't tell us is that TAP water actually has less pollutants, has to meet more standards (governed by the EPA instead of the FDA as bottled water is), and when consumed in blind taste tests is often preferred.

Some of us are drinking tap water and don't even realize it. (We would if we took the time to read some of the bottles.) Some major bottlers have taken to bottling municipal water and selling it to us for $1.50 a pop. At my gym there is a bottled water dispenser, selling bottled municipal water, right next to the water fountain. I'd say for every person that uses the fountain, 10 buy the "same" water for that $1.50.

To be fair, I don't think its that we wouldn't choose to drink tap water if we had this information. And and don't blame the water companies for marketing the way they do. I just wish we'd question a little more. Let's not accept things for face value. Let's be aware of the difference between marketing and facts. I think if we did that, more of use would start using water fountains.

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Posted by Benjamin Taylor at 04:30 PM |
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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.

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Posted by Benjamin Taylor at 04:25 PM |
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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.

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Posted by Benjamin Taylor at 04:06 PM |
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"Money without brains is always dangerous."

- Napoleon Hill

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Posted by Benjamin Taylor at 02:07 PM |
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