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February 09, 2011

In Defense of Frugal: Your Wealth Ratio

The Benz
source: topdeluxe

In this second installment of the “In Defense of Frugal” series or the IDF series I will tackle what I said was the first measure of wealth. In the first post, “Are You A Millionaire?”, I tried to illustrate how frugality lent itself to wealth getting. In other words I tried to show success in building wealth is in large part due to how efficient one is at converting earned dollars into wealth dollars. Further, I said someone who earns a modest income may be much better at income-to-wealth conversion than someone who makes a handsome income. In fact, as I mentioned in the previous post, folks of moderate income tend to become wealthier than high income earners over the long haul. Of course it doesn’t have to be that way. High income earners have an advantage in that they have more funds available to invest. But that’s on a “gross” level. They “net” less of their funds because the majority instead spend those funds on items of little or no lasting value.

The concept that moderate income earners may be better at income-to-wealth converting than high-income earners is hard for most of us to wrap our minds around. Considering the high-income earners are driving luxury autos, live in large homes and spend lavishly on clothing, entertainment and travel. Most of us think, if these folks can buy all that stuff, how are they not rich? Well, they aren’t rich because they buy all that stuff. It is true, you cannot have your cake and eat it too. They’ve traded their potential wealth (and independence) for trinkets. Here are the facts as culled together by Dr. Thomas Stanley and American Express Publishing /Harrison Group:


  • 87% of luxury motor vehicles are driven by non-millionaires. The most popular vehicles among high-income non-millionaires are Mercedes Benz and BMW. Most are leased. The most popular vehicle among millionaires is Toyota followed closely by Ford. Millionaires tend to purchase their cars.

  • 73% of homes valued at over $1,000,000 are occupied by non-millionaires. They are purchased with jumbo mortgages with very little equity in place. In fact, many are under water right now. Millionaires on the other hand live in much more modest homes. 90% of millionaires live in homes valued at less than $1,000,000 and 28% live in homes valued at less than $300,000. Millionaires understand buying a more expensive home is likely to decrease the odds of becoming financially independent.

  • Surveys conducted by Stanley and AmEx/Harrison showed similar results. Each survey focused on millionaires and high income earning non-millionaires on the subject of retailers frequented. Millionaires mentioned Target, Kohl’s, Costco and T.J. Maxx as most frequented. High income non-millionaires most cited stores were Banana Republic, Saks Fifth Ave, Neiman Marcus and Nordstrom.

I hear the boo birds chirping. Many of you reading this are probably saying, "What’s the point in having money if you can’t spend it on the finer things? Can’t I spend on the finer things and still get rich? After all, money is for spending, right?" I have to say I have a hard time arguing against this point. But over the years I’ve come to understand there is a time and a place for everything. Again, it is fine to spend. But not to the point that is sabotages your wealth building. This is where The Brick Wealth Ratio© comes in. It let's us know if our current lifestyle will allow us to become financially independent.

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November 05, 2010

Payday Challenge #3: Get Drunk For Cheap

Wine Shop by Paul Goyett
source: Paul Goyette

Most of us get a cash infusion into our bank account every other Friday and promptly do things with our money that are ill-advised. At least for those of us who’d like to be financially independent one day. But so many of us feel to do anything other than spend our money like it will self destruct in seconds if we don’t, makes us the 21st century version of Scrooge. Very few of us realize there is a vast difference between frugal and cheap. Frugal will eventually make you rich. Cheap will have the ghosts of Christmas Past, Present and Future visiting you in the middle of the night.

So few of us understand the power of thrift, saving and investing for the rainy (or even the sunny) day. Having “it” now is the only thing most of us know. Waiting for the proverbial “it” is simply boring and most of us are unwilling to be bored even if in the long (sometimes not so long) run we are far better off. The truth is getting wealthy is not boring. And the art of wealth getting has always been earn, conserve, invest, repeat. Heck, Benjamin Franklin wrote of the same formula in The Way to Wealth about 250 years ago in one issue of Poor Richard’s Almanac:

"If you would be wealthy, says (Poor Richard), think of saving as well as of getting: the Indies have not made Spain rich, because her outgoes are greater than her incomes. Away then with your expensive follies, and you will not have so much cause to complain of hard times, heavy taxes, and chargeable families; for, as Poor Dick says, 'Women and wine, game and deceit, Make the wealth small, and the wants great'."

What Benjamin Franklin, through Poor Richard, espoused was simply living frugally and investing the difference. Does living frugally equate to living like a pauper? Nothing could be further from the truth. Some of us just need a little education, need a little information, for us to understand we can enjoy ourselves without disturbing the “way to wealth” formula. We can actually have a little fun in the process. So a couple of weeks ago I starting posting a Payday Challenge on Twitter (link) with the goal of informing about saving and investing with the hope we might all be able to see the process of wealth getting can be fun along the way.

The first two Payday Challenges on Twitter were:

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November 13, 2009

The Results of Lazy Investing

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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June 01, 2009

The Lazy Way To Beat The Market


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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March 09, 2009

10 Signs Your Financial Advisor Is Stealing Your Money (Part 2)

Bernard Madoff
Source: Reuters

Today Warren Buffet appeared on CNBC for 3 hours answering a multitude of questions from Becky Quick, Joe Kernen and a slew of emailers. One emailer from Cincinatti asked "How do we know that you are not another Bernie Madoff?" In response Buffett said:

"Well, that's a good question. I would say this. I--it is a problem with investment advisers. I mean, it--there are going to be a certain number of crooks in the world. And sometimes they're smooth-talking, and the best ones are the ones that kind of don't look like crooks... it is a problem who you put your trust in."

He then later agreed with Joe Kernen that an investor cannot rely totally on government regulation to catch these crooks. So what is an investor trying to protect herself to do?

I wrote a post (Part 1) back in September of last year with the intention of answering this question. This was before the Bernie Madoff or the R. Allen Stanford stories broke. In the post I promised 10 red flags which might alert an investor that his advisor is not on the up and up. I'm finally getting around to listing them. Today I'll do just a couple and get to the rest at a later date.

As a side note, The Wall Street Journal reports that the client list of Bernie Madoff became available to the public. The list contains well known and not so well known folks running the wealth spectrum. The one thing they all have in common is they are all considered sophisticated investors. The list should once and for all prove that "sophisticated" means little in the investment world and underscores my personal pet peeve with the restrictive accredited investor law. I digress.

1. Returns that (nearly) always go up:

If your advisor is reporting returns that always seem to go up, then you should regard his numbers with great skepticism. The markets are controlled by unpredictable human emotion and its movements simply can't be predicted. Madoff's firm produced returns of positive 1% to 2% in gains per month with only five negative months covering a period of 12 years. These types of returns are so improbable that an investor can almost stop here and safely speculate that they've encountered a ponzi scheme or at least an investment manager that is not telling the truth about his returns. But we'll go on.

2. Complex strategies that cannot be duplicated:

When and an advisor has to start using greek letters in formulas to explain his investment strategy, it's time to be concerned. Madoff used an investment strategy consisting of purchasing blue-chip stocks and then taking options contracts on them - a split-strike conversion or a collar. The strategy itself is not complicated. In fact, it's pretty plain vanilla. What was extraordinary are returns Madoff reportedly received with the strategy.

A few individuals attempted to perform due diligence but were unable to replicate the Madoff's past returns. Harry Markopolos was among those that tried. In an interview with 60 Minutes he said:

"As we know, markets go up and down, and his only went up. He had very few down months. Only four percent of the months were down months. And that would be equivalent to a baseball player in the major leagues batting .960 for a year. Clearly impossible. You would suspect cheating immediately... No one's that good."

The above represents a stark contrast to the investment approach employed by Mr. Buffett - value investing. Unlike the method employed by Mr. Madoff, it is niether complex nor does it produce returns that are always favorable. In fact, sometimes years go by without positive results. That's why it is so important to have a long term view as Buffett reiterated today in his interview with CNBC.

BECKY: Yeah. And on a serious note, there are people who look at the stock market and wonder how do they know the whole thing's not a Ponzi scheme?

BUFFETT: Well, the whole thing's not a Ponzi scheme.

BECKY: What--how do they know who to trust?

BUFFETT: We're talking about, you know--we're talking about American businesses that employ, just the ones on the stock market, tens and tens and tens of millions of people. They're real companies... in the 20th century, the Dow went from 66 to 11,000, you know, 400. And we had all kinds of problems during that period. Business works overall. It doesn't work every day or every week or every month, and sometimes it really gets gummed up. And then you need government invention sometimes to get the machines back working smoothly. But the machine works.

JOE: Warren...

BUFFETT: And equities, over time, are the way to do it.

Disclosure: none.

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February 20, 2009

Is There Still Room For Optimism?

Glass Half Full
Flickr by Mr. Keef

Last week I did a video saying that I thought we were still in a new bull market. This was a follow up to a video I did in January listing some of the indicators I follow as reasons I thought we were in the early stages of a bull market. I pointed out that even with all the bad news about the economy, and jobs, and bailouts, the S&P 500 remained above 800. I saw this as a positive sign.

Since last week, the economic news has gotten worse. There have been renewed talks about nationalization of our banking system. [Psst. We’ve basically already nationalized the banks.] In response, the Dow reached a new 6-year low, penetrating the bottom it reached this past November. The S&P 500 broke through the 800 price barrier and threatens to challenge the low of 752 it reached last year. As of this moment (9:55 a.m.) the S&P 500 is trading at 769.

So was I wrong about this being a new bull market? Technically, no if the market holds where it is. Unless the S&P 500 falls below 752 (the November 20, 2008 price), this will still (technically) be considered a bull market. Recall I pointed out in the in first video that only once has the market declined 20% or more, rebounded 20% then, broke through the previous low. Could that happen now? Well we’re very close. It’s definitely possible.

Does any of this matter? Not really. The overall point I was trying to make in the videos and the past few posts on the topic is that stocks are cheap. They remain cheap. As I pointed out in the last video, we don’t know what the market or the economy will do in the next or any six month period. But it is highly probably the stock market will generate very good returns over the next five to ten years. And an investment in stocks now makes a lot of sense at these valuations. I’m still optimistic.

Next week I will be doing another video highlighting why I’m still optimistic about the market using some specific company examples. Stay tuned.

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February 14, 2009

Are We Still In A New Bull Market?

View video on The Third Pig or YouTube

Last month I posted and videoed about whether or not we were in a bull market based on five market indicators. I said that one way to tell if we’re in the beginning of a bull market is to try to ascertain whether or not we had seen a bottom. I concluded that we had seen a bottom in the market (November 20th, 752 level in the S&P 500) and that we’re in a new bull market trend. Today I’d like to look at another three:

1. Worst GDP decline in 25 years

On January 30, 2009, the BEA reported that GDP shrank 3.8% in the 4th quarter of 2008 (chart below). This was the worst showing in 25 years. The last time the economy shrank this severely was the 1st quarter of 1982. What did the market do the day these figures came out? It declined 2.2%, falling from 845.1 to 825.9. Not much of a move considering the news.

2. Job losses skyrocketing and unemployment trending toward double digits

February 5, 2009, the Labor Department reported 598,000 were lost bringing the total since the beginning of 2008 to 3.6 million. The unemployment rate went up to 7.6% making it the highest it’s been in decades. What did the market do that day? It went up 2.7% from 845.9 to 868.8.

3. Market price to GDP ratio

Back in 2001, in a Fortune magazine article Warren Buffett presented a chart comparing the total market value of U.S. based business as a percentage of GNP. An update of that chart is presented below. In the article Buffett said, “If the percentage relationship falls to the 70% to 80% area, buying stocks is likely to work very well for you." Currently this ratio sits below 75%.

I compared the market value of U.S. equities using the Wilshire 5000 index which comprises all stocks traded on the major exchanges in the U.S. I then compared it to GDP, a decent proxy for GNP. At the November 20th low, the percentage relationship between the two figures was 64% (Wilshire 5000 = 7.4 trillion and GDP = 11.7 trillion) and by the end of December remained below 80%.

Even if the market breaks through the 800 level, which who knows, it might, I am still on the side of this being 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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January 28, 2009

Are We In A New Bull Market?

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 6th, 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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January 10, 2009

American Eagle and Abercrombie: Inventory Foretells Margin Squeeze


Source: Flickr by k-ideas

This holiday shopping season has been dismal for retailers. Retail sales slipped dramatically year-over-year. Luxury sales were most hard hit clocking in at a 35% drop in sales year-over-year while women’s apparel saw a 23% decline. Most retailers resorted to large discounting of their products to move merchandise. One retailer however decided to go against the retail herd and refused to discount any of their merchandise sacrificing sales in the interim.

Video

Abercrombie and Fitch (ANF) considers itself a premium brand in the teen apparel space. The company believes discounting will hurt the brand. According to Chairman and Chief Executive Michael Jeffries in an earnings call with analysts, "promotions are a short-term solution with dreadful long-term effects." Abercrombie’s main competitor in the space, American Eagle Outfitters (AEO), on the other hand has aggressively discounted its products in an effort to move inventory.

I believe Jeffries has a point. In a post the last summer, I suggested Target (TGT) should raise their prices in an effort to match the perception that Target more expensive than competitor Walmart (WMT). Human psychology has us place a higher value on items that are higher priced. Jeffries is aware of this psychology thus believes discounting will erode consumers’ perception they company's tees and jeans are of higher value than their competitors. Even though any casual observer can see Abercrombie’s and American Eagle’s clothing is of the exact same quality.

Generally, I would not have a problem with Abercrombie’s approach. But, if the company is going to successfully execute the no discount policy, they must do a better job with inventory management. Abercrombie seems to have flooded stores with merchandise consumers seem, for the moment at least, unwilling to buy. On the other hand, American Eagle has scaled back on inventory growth anticipating a tough holiday season. Sales and inventory growth for the most recent quarter from the same quarter a year ago are as follows:

Abercrombie’s, as opposed to American Eagle’s, aggressive approach in inventory management is bound to cut into the company's margins. For the most recent quarter Abercrombie has gross margins of 66% and has averaged the same over the last five years. American Eagle on the other hand has gross margins for the most recent quarter of 41%, down from its five year average of 46%.

Operating margins are another story. While Abercrombie sports some very high gross margins, their operating margins are very close to American Eagle’s. In fact Abercrombie’s cavalier attitude regarding inventory management, among other things, has chipped away at its operating margins. Abercrombie’s average operating margins for the past five years were 19% but were only 11% in its most recent quarter. Meanwhile American Eagle’s operating margins for the past five years average 18% but were 13% in the most recent quarter.

Although both companies will see their margins shrink due to anemic consumer market, I would bet you will see American Eagle’s operating margins continue the trend of outpacing the margins of Abercrombie’s in the very near future. Although both stocks are down substantially over the last year, I would expect American Eagle to rebound while I am not too optimistic about Abercrombie right now.

Disclosure: I and the clients of Brick Financial Management, LLC owned share of American Eagle Outfitters and Target at the time of this writing. But positions can change at any time.

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December 12, 2008

The Auto Bailout and Mental Accounting

Source: Flickr by Cobalt at www.flickr.com/photos/cobalt/1422157740/
Source: Flickr by Cobalt

Last night the $14 billion bailout for the auto industry failed in the Senate primarily because the United Auto Workers union refused to accept a pay cut for its members. This likely spells big trouble for the Big 3 as collectively they are asking for funds in excess of $30 billion. General Motors (GM) alone, which employs a quarter of one million workers, needs $8 billion over the next two months to stay afloat according to its CEO Rick Wagoner.

Supporters of the bailout are now looking to the White House and the Treasury to step in. To date the Bush administration has resisted dipping into the remaining balance of the $700 billion TARP earmarked for the banking industry to help the Big 3. The Bush administration’s position in this regard is well understood. It wants to reserve the remaining TARP funds for the banking industry “just in case”. But there is also no denying reluctance to use the TARP funds to assist the auto industry is really grand scale mental accounting.

Mental accounting, as studied by Richard H. Thaler, is the way we attribute a monetary value or utility to an economic transaction, situation or expectation. It tends to separate those values in different accounts according to their origins and purposes. Mental accounting can also be seen as the failure to see the entire financial picture and how one decision affects another. To understand this concept on a personal level it is best to consider a couple of examples.

  • A divorced mother holds a grudge against her ex-husband and father to her children on whom she depends for child support. In an effort to exact revenge against the ex, the mother makes crank calls to the father’s place of employment causing him to loose his job. This in effect decreases the mother’s income in the form of child support. The mother failed to connect that her income was dependent upon his. In her mind they were separate.
  • A consultant on a temporary project wants a file cabinet to store just a few papers. The local office supply store has small, medium and large size cabinets which cost $200, $250 and $300 respectively. Being analytically minded the consultant buys the largest cabinet as he calculated it would allow him to get the most space per cubic inch for his money. However, he failed to consider he had only enough files to fill half of the smallest cabinet. In essence, he wasted $100 dollars. When something sells for below the mental price we have assigned it, the deal takes precedence over the actual utility of the item.

Whether the government uses the TARP money, some other funds or does nothing at all, we as Americans will collectively “pay” for the automakers woes. Perhaps it will be in funds going directly to the companies. Or perhaps it will be in increasing the welfare and unemployment rolls. It may come in increasing bankruptcies and foreclosures among former workers of the industry. At this point, we, Americans, the government, cannot avoid expending these dollars either directly or indirectly.

In the interest of full disclosure, I wrote an earlier post suggesting giving money to the automakers amounted to a very bad investment decision. I stick by that position. In 2007, GM lost $38 billion in 2007 and Ford (F) lost $2.7 billion. However, in no way was I suggesting nothing be done. As an investor, I am against the bailout. As an American, I can see the government giving the Big 3 the billions they are asking for – I will just close my eyes and hold my nose when and if they do.

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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About Brick Financial Management, LLC

Blogged by Brick Financial

160 Maplewood Ave, P.O. Box 263
Maplewood, NJ 07040
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Brick Financial Management, LLC specializes in providing investment management services to individuals, families, organizations and institutions. We implement highly focused stock, bond, and balanced portfolios using an investment approach commonly referred to as value investing. Disclosure

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