Insure For Your Future and Your Pocketbook

Get ready for the most boring blog post you will ever read... or is it?

That's right we are going to talk about insurance. Insurance may not seem like a sexy finance topic to go over, but it is one that could be costing you a lot of money if you are not careful.

When I first got my job offer out of school I was pretty much only worried about the salary. The first day at work I am given a packet of information on these things called "benefits". So here I am fresh out of school still trying to figure out how to read these things called "lease agreements" and pay for electricity and I am supposed to decide what types of insurances are best for my situation? Get out of here. So I did what any millennial would do and did a quick google search and just chose some stuff. Luckily I made some decent choices, but otherwise I could have been paying for a lot of stuff I didn't need. I don't want you to go through the same process so here I will layout what insurance is and what things to consider depending on your situation.

First, lets talk about what insurance really is.

  1. Insurance is a cost. We say that because you should not be looking to make money on insurance. This especially comes into play with life insurance.
  2. Insurance is only to transfer financial risk for events that you cannot cover with your current assets. For example, you probably can't cover a major surgery with cash, but you can probably afford (even if it sucks) to replace your phone if you drop it in a toilet one drunken night.
  3. Insurance is easy to sell to people because risk is scary, but you don't always need it.

Now that we have a better understanding for what insurance is we can talk more about the details. I will split this up into insurance you want and insurance that you don't want.

Insurance That You Want

  1. Health Insurance - If you are living in the US then I am sure you know are aware of the current situation. As of February 2017, you are required by law to have health insurance and if you don't you will have to pay a penalty on your taxes. The political debates on this subject are heated, but what we can be sure of is that you better have it. First, let's talk some health insurance basics. All health insurance plans have a couple basic features: they have monthly premiums that you/your employer (if applicable) pay, they generally have some type of deductible or limit at which you will have to pay out of pocket before receiving full benefits, and lastly they have some structure of who you can see and how the care can be given. There are generally three different types of health insurance plans I will list them here and let you know what type of situation they are best for:
    • Health Maintenance Organization (HMO) - The health maintenance organization plan is gaining in popularity. With this plan you will designate a primary care physician (PCP) who will coordinate all of your care. If you need to see a specialist then you need them to give you a referral to do so. Otherwise it will not be covered. This plan generally as low co-pays meaning you will pay very little out of pocket for general office visits. This is typically good for a person or family that goes to the doctor frequently either for an existing condition or otherwise.
    •  Preferred Provider Organization (PPO) - This is similar to the HMO except you do not have to choose a primary care physician. Instead there is already set up a network of specialist and other care givers that you can see as needed. The other thing to be aware of is that if you want to see a specialist that is outside of the network then you typically will have to pay out of pocket. Like the HMO you will receive services within the network at a steep discount, sometimes even more than the HMO. Like the HMO this is good for a person/family that makes frequent visits to doctors or specialists, but doesn't want to go through a PCP. Monthly premiums are similar to those of HMOs if not a little more.
    • High Deductible Health Plan (HDHP) - This one has the cheapest premiums of the three. Like the name says this is a plan that has a higher deductible than the other two and usually no discount for general visits. You have to pay 100% of health care costs until you reach your deductible. The great thing about the HDHP is that you will have access to the Health Savings Account (HSA). This account is the only account in the US that gets you TRIPLE tax savings: you contribute your money tax free, you can invest the money and any gains are not taxed, then when you take the money out it is not taxed. The only way to get access to this account is the have a qualified HDHP plan. You can contribute up to $2,500 per year into it and some employers even make contributions for you. The main stipulation on this account is that the money can only be used for qualified healthcare costs. This plan is great for people who are younger and healthier who don't plan on using their insurance very much. This allows you to save for your future while at the same time paying lower monthly premiums. This is the type that I currently have.
    Most people will get their health insurance through their employer. If you are unlucky enough to have to purchase on the market then you know the extreme cost that it is running right now. Here are a couple other options for relief.
    1. Consider changing plan types - Plan types can have drastically different costs. If you have the option, moving to a high deductible plan and supplementing with an Health Savings Account can be a great alternative to a higher priced PPO plan.
    2. Health Sharing Programs - Here is a good article on what they are and how they work.
  2. Car Insurance - Just like health insurance, a minimum amount of car insurance is required by law. Most of the time this is called "liability" insurance. Although insurance companies spend billions of dollars per year to convince you that you need a lot more coverage. The good news is that we can use this fierce competition to our advantage. Shopping around for insurance quotes is easier than ever and can be done almost exclusively online. Here is a great article on different ways to get car insurance. Remember that insurance is a cost, so we don't want to be paying to transfer financial risks that we can afford. Adjusting deductibles and coverages can save you hundreds of dollars per year without even switching providers. Here is more great information on sizing up your insurance coverage needs.
  3. Long Term Disability Insurance - It's never nice to think about a scenario where you could become permanently disabled and unable to work, but these events do happen. Depending on social security to take care of you if it were to happen is a recipe for disaster. This insurance is fairly inexpensive to purchase and can often be done through your employer. Here is great information on what to look for and where to buy.
  4. Term Life Insurance - This one really applies if you have dependents such as a children and/or a spouse that depends on your income to live in or if you have a large amount of cosigned debt. Notice how I specified TERM life insurance. You will see why down below. Term insurance is just like it sounds, it is life insurance over a certain period of time. Usually people will purchase 30-year term, but there are shorter periods as well. Here is a great broker for you to get some price quotes from.

Now we will move to some insurances that you definitely want to steer clear from.

Insurance That You Don't Want

  1. Whole Life Insurance - The premise of whole life insurance is that the policy lasts your entire life rather than just a term. The problem is that it is multiples higher than term insurance! They also will try to attach investments and other little gimmicks to it all in the name of separating you from your money while having to provide the least amount of value possible. Here is a good article that has some numbers on the subject. Overall, I never recommend anyone to purchase any variant of whole life insurance.
  2. Extended Warranties - One of the most popular of this variant is cell phone "insurance". Have you ever noticed that it seems like everything you purchase from an electronics store has the option to purchase an extended warranty? Have you ever wondered why that might be? It's mostly because they make a ton of profit from it! At the beginning I talked about insurance being to transfer financial risk for things you can't afford. This is a perfect example of paying a cost to transfer a financial risk that you can afford. Unless you happen to be an using your electronics while scuba diving then this is probably a waste of money for you. Here is a good article on extended warranties when it comes to cars. Here is one on cell phones.
  3. Cancer Insurance - Like any great gimmick there needs to be an imminent danger of death. Cancer insurance is touted to cover the costs of treatment. But there question is doesn't health insurance cover that? Well, it does. Sure there could be some coinsurance and deductible costs, but health insurance will cover most of it. Here is a great article on the details.

So now is a great time to take a look at your coverage and see if you have overlaps and where you can save some money. If you can find some savings you can roll that directly into your retirement and investing accounts! See you next time.

The Great Debate: Traditional Vs. Roth Vs. Taxable

Since the dawn of retirement accounts, people have been engaged in a great debate. The millennials want to ditch the retirement accounts because of "the oppression, bruh", the retirees complain that they didn't know what they were doing and picked the wrong account, and the legislaters fight off the intense allure of more tax income that they could squander if they could only get it from those pesky retirement accounts. Just think of all the sports stadiums and private jets they could buy!

In this article I want to go into the math of the debate and show you who wins (hint, hint: it depends). First let's define who the racers are.

Taxable

A taxable account is your run of the mill investment account that your could open up with any brokerage platform. It is subject to full taxation. For our purposes the taxable account is subject to both regular income taxes that you have to pay on your earned income and then a capital gains tax. 

Capital gains tax is currently 15% for growth in your investments that are held over a year. This could raise in the future, but for our purposes it will be constant.

Retirement: Roth

This is a retirement account. All retirements have one thing in common: you get some kind of tax benefit in return for restrictions on when you can access the money. A Roth account is the newest kind of retirement account and offers a unique benefit. With a Roth you contribute your money after you pay your income taxes, but it then grows tax free and is not taxed when you withdraw it at retirement age.

Retirement: Traditional

This type of account has been around a long time. Hence the name "traditional". With this retirement account you are able to contribute your money pre-tax which means you can technically contribute more money than if you were using Roth since you save on the taxes now. We will see this effect in the calculation. The catch here is that when you withdraw the money at retirement age you have to pay income taxes on the entire amount. 

Now that we have the accounts down let's talk about how the math works.

Retirement Vs. Taxable

What I want to do in my analysis here is to look at how each account grows over time in three different tax rate environments. There are many different political arguments out there for what tax rates may do over time. Some will say they will increase and some will say they decrease and some say they will stay the same. The fact of the matter is that we have no idea what is going to happen 30 years in the future with tax rates. For the purposes of this analysis I will look at all three cases.

Here are some assumptions I am using in the calculation:

  • The contribution amount that the person will use is $5500/year pre-tax (~$458/month). This is the current contribution level of an IRA. That means for taxable and roth the amount will be less after taxes.
  • Each person will start with $10,000 at the beginning of the investment period.
  • I will assume that the person contributes for 30 years and withdraw at the end of that time bearing all of the taxes.
  • I will assume an investment return of 10% per year across the board.
  • The beginning income tax rate will be 25%.
  • For the increasing tax rate environment the income tax rate at the end of the period will be 35%.
  • For the decreasing tax rate environment the income tax rate at the end of the period will be 15%.
  • For Roth and taxable the income tax rate switches at year 15.

Now lets take a look at the results!

Results

Above are the results of the calculations. Lets talk about a couple of conclusions.

Investing in a Roth account is often one of the most common pieces of advise that financial pundits will push. This is mostly because in all of the environments (increasing, decreasing, and constant tax rate) the results are relatively the same which means they are fairly reliable. If you are looking for a set it and forget it retirement then this could be a great option for you.

At the same time you can see that if tax rates are to decrease over time then the traditional will win out over the Roth. Although this is the only case that this is true in this calculation. At the same time for the constant tax rate environment the traditional and Roth are fairly consistent.

Lastly, we see that taxable accounts lose in all environments by over $100,000 compared to the Roth.

So what does this mean for you? Do you just go with Roth or risk it with traditional? First, lets talk about some caveats that I haven't considered.

Additional Considerations

In reality this questions is a bit more complicated than I have made it. The above calculation is to get major trends, but it is not personalized to your situation and goals. There are many things that would make you want to choose a certain account over others.

For example with traditional contributions when you get to retirement age there are many different ways you can change you tax liability. One simple way is modulating how much you withdraw. You can earn somewhere between $10,000-$12,000 without paying any taxes depending on how you file. So if you were to have some amount of money in other investments and only needed to draw a small amount then you could have no tax burden for quite a while. Similarly, depending on your current income and how much you want to put into your 401k you could potentially lower your tax burden almost completely by taking advantage of some deductions. This could be a big help to your current tax situation. Here is a great article on how some ordinary people have reduced their tax burden to nearly zero completely legally: https://www.personalcapital.com/blog/financial-planning-2/average-american-pay-no-taxes/.

Another thing is that if you are wanting to draw these funds out for early retirement (that is before the retirement age) there is a way to do this by strategically converting your pre-tax funds to Roth after you quit your job. I will write an article on this later, but for now you can check out this article which has a great explanation on it: http://jlcollinsnh.com/2013/12/05/stocks-part-xx-early-retirement-withdrawal-strategies-and-roth-conversion-ladders-from-a-mad-fientist/.

The point being that there are many complications that can make your situation different. You need to work with a professional to assess what strategy is best for you.

Let's end off with some conclusions.

Conclusions

Although the calculations are simplified we can learn some important things from them. First, we see that investing in a retirement account, either Roth or Traditional, will get you much farther than using taxable investments only even in a increasing tax rate environment. Taking advantage of retirement accounts can have a huge impact on your future financial life. 

Secondly, we can see that Roth contributions have the least sensitivity to future tax rate movements. For many this can give them some peace of mind and for general advice to give to someone off the street it is your best bet for success in the retirement game. 

Finally, as I had stated before, it is important to get help from a professional to figure out what is best for your situation. Whether you are thinking about retiring early or have a chance to significantly reduce your tax bill currently there are certain strategies that can get you there. It is important to consider those things. Although that will change significantly over your life.

I hope this article helps you out! Stay tuned for additional articles on retirement. 

Three Phases To Earning Financial Freedom

So far I hope you have enjoyed the financial series. We have talked about the number one reason why most people will never reach their goals. We moved through some of the most basic and fundamental building blocks of personal finance. Now we need to pull this all together into a step by step plan of action. 

The Goal

First we have to decide what the overarching goal is for our financial lives. Not having a goal for anything in life is an awesome way to use your resources very, very, very inefficiently. Whether the resource is time, money, or effort. We must have a simple goal which we can make sure we are moving towards. I believe the biggest financial goal for anyone in life is to become financially free. That means having your FU Money securely in place. Once you achieve this your options become theoretically unbounded. Having that base means that you only work when you want to, on what you want to, exactly how you want to do it. For most people that is only a pipe dream, but I am going to give you the step by step practical plan to get there.

Three Phases to Financial Freedom 

I divide this plan up into three basic phases:

  1. Foundation Building
  2. Asset Acquisition
  3. Compounding Wealth

I will go in depth into each of these and explain what the steps are and why they are important.

(Skip to the end if you just want to see the steps)

Foundation Building

We are only as solid as our foundation allows us to be. This is true in almost every regard whether it is physically building something (such as a building or house) or metaphorically within finance or even education. When going through engineering school most people become limited by there understanding of the foundations of math and science. Without those any progress into more advanced subjects is destabilized by the lack of solid foundation. In finance, the same is true. Without a solid foundation you leave yourself open for catastrophic events that can undo everything you have built. 

With regards to money, the foundation is built by achieving these three steps:

  1. Save $1000 to $2000 for a starter Emergency Fund

  2. Begin saving up to company match into your 401k (company match only!!)

  3. Pay off all Non-mortgage debt (credit cards, student loans, car loans, etc.)

  4. Save 3 to 6 months of expenses for your fully funded Emergency Fund

These four steps allow you to break the paycheck to paycheck cycle that most people are headed towards and puts you in the drivers seat of your financial life.

Emergency Fund

This is the bedrock by which you can build your foundation. It is essential to have a liquid (meaning not invested) savings of 3 to 6 months of expenses to guard yourself from the inevitable swings that life will throw at you. Whether it is an unexpected medical event or a job loss this will keep you from killing the golden goose that is laying your golden eggs, your investments. Not having an emergency fund is like not having medical or car insurance. Sure you might be fine for a while and nothing will happen. But in reality it is only a matter of time before you have to go see a doctor. No one lives their whole life without medical problems of some sort. Walking around without a way to cover yourself is just plain dumb.

Think of an Emergency Fund as insurance on your investments and overall financial health. It keeps you covered incase of the inevitable problems that will come your way.

Why Just The Company Match?

Working in a company that has a matching 401k plan is a blessing. The company has decided that it wants to help you along the way in investing for your future. Only a certain subset of companies offer such benefits so if you work for one you should consider yourself very fortunate. Usually the company will have a certain percentage that you will put in and they will match that amount. Although the matching type can vary widely between companies, it is important to take advantage of it. We want to pay off debt as quickly as possible as I describe in the next section but I know that it can be hard to pass up the free money you are being offered. So if you want to invest up to the company match in the 401k then that is fine. But ONLY THE COMPANY MATCH! Remember our first priority is to get rid of debt and get our emergency fund saved. For most people this should take a max of 24 months unless you have a very extreme situation (went 200k in student loan debt to make 30k per year as a teacher or something...). Not going hard on your retirement for 24 months while you clean up your debt is not going to make or break your nest egg. Eliminating debt will allow you to invest much more heavily in your retirement as you will read in the coming sections.

Elimination of Non-Mortgage Debt

If you have read through the rest of the financial series then you are well aware of how I feel about debt. So I will save you from another lecture and just say that if you still believe that you should get a car loan when you buy a car then you need to go back and reread the series. Instead I will focus on methods for eliminating it.

I wish that there was a silver bullet for this, but there simply isn't. Your debt problem is only going to go away with dedicated effort and resources and a little bit of sacrifice and perseverance. Nothing is going to change that fact. There are, however, certain strategies which make the paying off of debt much more efficient. There are two main strategies that I will talk about and then I will combine them into a strategy that I recommend.

The Debt Snowball Method

This one is popularized by author and speaker Dave Ramsey. The method is simple. List your debts from smallest to largest (ignoring interest rates), pay minimum payments on all others and attack the smallest one with all extra money you have until it is gone. Then take all the money you were paying per month into that along with the minimum payment on that debt and apply it to the next smallest and so on. What this does is give you quick psychological wins. Debt reduction can be a grueling process that can take years depending on how much you have. Like anything else that takes sacrifice it can be very hard to stay the course over that long of time especially if progress is not immediately noticeable. Most people embark to pay off debt but get discouraged and give up and probably end up right back where they started. What the Debt Snowball Method does is allows you to get quick wins that give you a psychological boost to stay the course. It feels great to have a debt paid off and you get fired up about knocking out the rest of them. This usually motivates people to save even more money because they see that they can really get out of debt which is the real secret to the method.

As with anything there is always downsides. The biggest one here is usually noticed immediately by the math nerds. It was that little phrase "ignoring interest rates".

The High Interest First Method

If we look strictly at the numbers, the quickest way to get out of debt is to rank your debts from highest interest rate first to lowest and pay them off in that order. This minimizes the amount of interest you pay and allows that your money to have more weight in actually paying down the principle debt rather than interest. The problem here is that if you are unfortunate enough to have a large debt (such as a student loan) that is at 6 or 7 percent and a car loan or other that is less then you can feel like you get stuck because of the sheer size of the student loan. Also, this doesn't always promote the "fired up" effect that the snowball method does so you don't get the added benefit of motivation to save more money. What I want to do is attempt to get the best of both worlds

The Young Analytical Mind Debt Payoff Method

On one hand I really like the snowball method because I do believe that psychology plays a huge role in personal finance. A much larger role than numbers people like you and I are usually willing to admit. On the other hand I can see how we do need to minimize the amount of interest you pay especially if it is really large like with credit cards which can be as much as 29.9%! So here is the YAM Method for debt reduction:

  1. Split loans into two categories: Below 10% interest rate and above or equal to 10% interest rate
  2. With the below 10% category use the debt snowball method (list loans from smallest to larges)
  3. With the above and including 10% interest rates pay them off in order of highest interest first

What this does is minimizes the really high interest rates loans. For the most part these will be credit cards and other usually really bad debt that you need to get out from under of as quick as possible. After that you go into the debts that are lower in interest rates and the interest you will pay while paying them off will be negligible.

Asset Acquisition

Alright so we have our foundation built now. We have paid off ALL of our debt that is not a mortgage and we have a fully funded emergency fund. Having just recently achieved this I can say this is one of the best feelings. You now have the freedom to make many choices. At this point we can begin to make some larger purchases as long as they keep on the path to financial freedom. These may include cars, houses, nicer furniture, and heavier retirement savings. But remember, we must never lose sight of the goal which is to become financially free. One of the biggest factors in doing that is eliminating debt and expenses. We have done fantastic so far, but it's not over yet because elimination of debt does include a mortgage. So here are the next steps in our plan:

5.   Begin saving 15% of gross income into retirement

6.   Save a 20% or more down payment for a house (if necessary)

7.   Pay off house as quickly as possible

Luxury Purchases

This is the point where we can begin to make some luxury purchases. We have cleaned up our financial situation, have no debt other than maybe a mortgage, and have our fully funded emergency fund in place. There are a couple of rules to these.

First, unless you have a net worth of over 1 million dollars we don't want to have more than 50% of our gross annual income tied up in things that are consumed and depreciate over time. This includes anything with a motor and/or wheels (cars, boats, trailers, motorcycles, RVs, etc.), furniture, and other belongings. So that means if you make $60,000 per year and you are driving a $50,000 car then there is something wrong! That is just too much money going in the wrong direction. Second, you must pay for all of these purchases IN CASH. No financing whatsoever. There are no excuses or caveats to this rule. It is absolute. All purchases done with money you have saved. Now, does this mean you can never have anything nice? Absolutely not! We are going to have a lot of nice things if that is what we want. We just don't want those things to have us. Everything needs to be in balance so that you are still working towards your goal of becoming financially free.

Purchasing A Home

As you have learned in my previous article, buying a home is not the end all be all. Renting is a perfectly suitable option in many cases. Nevertheless there are plenty of reasons to want to own a home. I plan on buying one myself. If you are in a position where you want to buy a home here are some simple guidelines to make sure the home will be a blessing rather than a curse:

  1. Be completely debt free

  2. Have a fully funded emergency fund (3 to 6 months of expenses)

  3. Be ready to stay in the home for at least 5 years

  4. Have a down payment of 20% or more

  5. Make sure the mortgage payment is no more than 25% of your take home pay

  6. Only finance on a 15-year fixed rate mortgage

These rules will allow you to purchase with more confidence that you can afford the house. To demonstrate lets use an example. Let's say your bring home pay is about $4,000 per month. This would mean you could afford a mortgage payment of about $1,000 per month. This would include principle, interest, insurance, and taxes. That means you are looking at a maximum mortgage of roughly 100k. So that will tell you how much you need to save in order to get in the home you want.

Why a 15-year Mortgage Instead Of A 30-Year?

Most people who purchase a home will get a 30-year mortgage. So why would I recommend a 15-year? Well you would think that if you half the term of the loan then your payments would double, but this is not the case. Thanks to compound interest we actually only have to pay a couple hundred more dollars a month for the 15 year. Plus over time this can mean HUGE savings for you.

Let's take an example of a $150,000 house with a 20% down payment ($120k mortgage) and compare a 30-year vs a 15-year. First thing that is different is the interest rate. The interest rate on a 30-year is actually higher than the 15-year. At the time of writing the mortgage rate in Houston for a 30 year was 3.83% while the 15-year was 3.03%. This may not seem like much, but over time this can mean big savings. Using our example here is what we come up with:

30-Year

  • Interest Rate: 3.83%
  • Payment: $927
  • Total Amount Paid: $202,032

15-Year

  • Interest Rate: 3.03%
  • Payment: $1,218
  • Total Amount Paid: $149,477

So by switching to a 15-year you had to pay $291 extra per month, but you saved over $50,000 in interest! Not only that, you paid off your home a full 15 years sooner! So let's say you invested you mortgage payment of $1,218 per month at 10% for the next 15 years until the other person pays their home off. You would have an additional $510,825 dollars! Now that is well worth a couple extra dollars per month if you ask me.

You can see that the sooner your pay off your home the quicker you can start investing the difference and what a difference it makes. The math is pretty simple. The sooner you stop paying interest and start to earn interest the better off you will be.

Compounding Wealth

Let's take a look at our situation. You have no debt whatsoever, you have 3 to 6 month emergency fund, you have a nice nest egg started, and you have yourself a couple of nice things. Here is where the real fun begins. At this point the name of the game is compound interest. We have worked hard to eliminate paying interest. Now we can begin reaping the rewards of earning interest. At this point you have an unlimited amount of options to go after and it can seem intimidating. Many times I find people who try to get to this point before they are ready. Up until now your investing skill had little to no effect on your net worth. But now we have learn a little more about wealth building.

There are two main objectives here: maximize investment performance and minimize taxes while only taking on a reasonable amount of risk. Taxes become huge in this part as you can see a real effect of them on your performance. So first I recommend maxing out all tax-advantaged investment options. This includes Traditional and Roth IRAs, 401k, and HSA (health savings account). For most people this will be an IRA ($5,500/year) for both you and your spouse (if you are married) and $18,000 for both you and your spouse if you are married and they are available from work.

Next we need to look at investment performance. This is where people can get into a lot of trouble. For some insights on what I recommend take a look at these articles: The Calculation That Broke The Market, Humans Are Hardwired To Suck At Investing, The Simplest Investment Plan On Earth, What Driving In Houston Traffic Taught Me About Investing, and Tweaking The Simplest Investment Plan Ever. This should give you a base to move onto more about investing if desired, but keep in mind almost no one can consistently beat the market.

The goal here is to reach your FU Money. At that point you have reached true financial freedom and can now only work when YOU want to. Not when you have to. Fill out the form below to get a free spreadsheet to calculate what your FU Money is

FU Money Calculator

Name *
Name

Now let's summarize the plan:

Foundation Building

1.   Save $1000 to $2000 for a starter Emergency Fund

2.  Begin saving up to company match into your 401k (company match only!!)

3.  Pay off all Non-mortgage debt (credit cards, student loans, car loans, etc.)

4.  Save 3 to 6 months of expenses for your fully funded Emergency Fund

Asset Acquisition

5.   Begin saving 15% of gross income into retirement

6.   Save a 20% or more down payment for a house (if necessary)

7.   Pay off house as quickly as possible

Compounding Wealth

8.  Max Out Tax Advantaged Accounts

9.  Build FU Money

With this plan you have a step by step road map of where to go and always having a goal. Let me know in the comments below what you think and feel free to drop me an email if you have any questions at joshua.bird@younganalyticalmind.com.

 

What Driving in Houston Traffic Taught Me About Investing

If you live in a big city then traffic is simply a part of your life. Probably a part that is a little bigger than you would like. Driving in traffic brings out the truth in people. Sometimes too much of the truth if you feel the need to strip down and dance on top of a big rig. Want to get to know your new girlfriend or boyfriend? Ask them to drive you through a congested part of town during rush hour and see how they act. It's a lot cheaper and quicker than spending months with someone only to find out they are a sociopath. Although I hate traffic with a passion it has allowed me to make the odd yet perfectly fitting metaphor to investing.

The Road To Financial Freedom...Literally

Before you hop in your metaphoric investment vehicle you need to have a destination. Driving around aimlessly during rush hour traffic is probably not the wisest choice. You may end up where you don't want to be and will probably waste a lot of time and effort. Similarly with investing you need to have a goal or destination. This will give you guidance on what to do and gives you a place to run to. It allows you to design your investments for your specific needs. So let's say your goal is to get your F.U. Money.

When you set off on your destination, realize that in this metaphor there are no google maps. All you have is a compass and you know you want to go north. There is also intense fog out so you literally can't see hardly anything ahead of you. The only thing you can do is see the paths behind you. Oh and one last thing, as you drive along your destination get's farther and farther away from you. So the longer you take to get to the destination the farther you have to drive. Seems scary right? Investing is the same way. There is no google map that will optimize your route to financial freedom. You know that you need to invest and that you need to earn a certain return to reach your goals. How to get to that return is the hard part. There is no way to accurately and consistently predict the future. Also, inflation is constantly eating away at the purchasing power of your money. So not only do you need to earn a return that is high enough to simply outpace inflation, but you also need to earn a return above that to have the joy of compounding over time. For some people the thought of having to take the journey into this scary world of investing is petrifying to the point where they will simply choose to do nothing. They just stuff their money under a mattress and leave it thinking that it is "safe". All the while inflation eats it away effectively guaranteeing that they will lose value on their savings. So choosing to simply not go on the journey will definitely not get you anywhere...literally.

When you set off on your journey you have a couple of different modes of transportation. First you could take a train. I am not talking the maglev trains that go 300 mph. I'm talking some old school diesel train that goes about 40 because the tracks are not in the best shape. Sure the train will get you there, but it is probably going to take a while. There won't be much traffic and the train will move along at a constant speed. Also, the likelihood of the train having an accident or blowing up is pretty low so there is less risk. But realize that the train may barely go fast enough to beat the rate at which your destination is moving ahead of you. That means that effectively you could be just inching along and sometimes you might even be moving backwards. This would be like investing in bonds. Sure they are the safe bet and low risk, but the returns are not going to be great. You will likely barely outpace inflation. So after investing for 20 or 30 years you might not see enough money to truly live off of. But if you are extremely risk adverse then this may be the only place for you.

Next is your typical car. Having the car gives you almost unlimited options on different routes you can take. You can drive down highways or skim along the back roads. Also, cars can go faster than trains, but they have to travel on roads so that means traffic sometimes. This is like the stock market. In the stock market there are an unlimited amount of variables to consider. We know that over time the stock market gets better returns than the bond market, but this is at the cost of sometimes having to go through downturns.

Then there are the planes. Now these aren't the nice 747s we are used to. Oh no. These are small little planes flown by a pilot that you can't really decide if they are high, drunk, having a bad day, or any combination of the three. Similarly the parachutes on the plane look like they have been drug through a bear pit. It's really quite questionable whether the parachutes have been taken out of the bags and used to smuggle cocaine for your high pilot. Sure, the plane might get you there and it may be a ton faster than the car, but if something goes wrong there is not a lot options that you have. And if you crash then you are almost guaranteed to die. This is the commodities and derivatives market. The realm of questionable deals and illogical valuations. It was this sector (namely mortgage-backed securities) that was responsible for the crash of 2008 which was like a very large plane that crashed into a major freeway and set off a nuclear explosion and took out the trains as well so everyone was pretty damn screwed.

So there we have it: a system of trains that represent bonds, your typical car that represents stocks, and drunk pilots flying questionable airplanes as the derivatives market. Now that we know what the vehicles are we have to talk about the drivers.

For the rest of the post I will focus on the stock market (roads) since most people will not deal with derivatives and commodities and bonds are pretty straight forward.

It's Not About The Vehicles, It's About How They Are Driven

When you are driving through traffic you encounter all kinds of different people. Some you really want to pull out of the car and beat the crap out of them. Others you just want to smash into so that maybe they will move out of your way. But you typically do neither of those things and just grit though it. Now that our metaphor is set up it is time to make an observation.

Realize that there are almost an unlimited amount of possibilities. So many different routes and different things to look at. Not to mention that you can't see anything ahead of you and only things behind you. Trying to find the most optimum route to your destination is next to impossible. If you do happen to get it for a little bit then it was probably due to luck. Also, what was optimum in the past is probably not going to be the optimum in the future. Yet we know we need to do something. The best thing you can do is to layout a plan that you can stick with through thick and thin. By definition this means that some people may get ahead of you from time to time. But that is okay. The goal is to find the surest way to get to the destination in a reasonable amount of time. In investing the same is true. Trying to find the most optimum strategy that is going to get you the absolute best returns possible over the next 10 to 30 years is next to impossible. The best thing you can do is find a strategy you believe in and stick to it. Now let's talk about some different people we see on the road.

The Traders

First you have the Traders. We have all seen them. When you are on the highway they shoot from lane to lane trying to dodge cars. When you are on the side streets they do the same and race from red light to red light. From time to time they might get ahead and beat a light. But every time they zoom between lanes or beat that light they get a little more confident in their ability to drive. Little by little they start to increase the speed and cut it closer and closer to hitting another car. As their confidence goes up so does their propensity to take on more risky behavior. One day their luck may run out and they may smash into someone. Sure some can go the entire way to their destination and not get a scratch. But that might have just been due to luck rather than skill. These people might get news stories written about them and people might put a lot of faith in their abilities. They think they can "predict the road" or "see through the fog". People begin to believe they have god like abilities. More and more people see the traders making great times and think they can do it too. So with less experience and insight they buy themselves a fast car and start zooming around. But it only takes one bad accident to kill them or permanently disable them. The truth is all of these people may have been driving down a road that just had no traffic. In a wide open road it is fairly easy to make good times. All you have to do is drive fast and dodge a couple of cars. As time goes on the traders think that it will last forever. They will say things like "there is never any traffic on this road". It is hard to really argue with them. Maybe they start taking things off their cars to make them go fast. Some might even remove the brakes because who needs to stop on a road that has no traffic. Unbeknownst to the traders, a great wreck lies ahead. The entire freeway is shut down. But they just can't see it. Inevitably, the traders who have removed their brakes and aren't paying attention will immediately smash into the cars ahead of them. All the lane switching in the world couldn't save them from this crash. Many die and are never heard from again. Many more are permanently paralyzed and left stunned by what has happened.

This exact scenario has played over and over many times in the investment world. In a market that is going up it is pretty easy to make money. Frequent trading can look very attractive. As they have success trading over a couple of years they really think they are able to outsmart the market. They little by little start to engage in risker behavior. They might start to use a little leverage (getting a faster car) or neglect to use stop losses or other hedging strategies (removing brakes). For a while these things work and they are able to make even more money. Then it all comes to an end. For one reason or another the market falls off a cliff. The people using lots of leverage can lose everything they own and more. Many people who have put all their savings into this can wipe out years and years of returns. Many do some much damage that it is almost impossible to return from. They ask themselves what went wrong and why they couldn't see it coming. The reality is that just about no one could. None of the "experts" in the world saw it coming which kinda makes you wonder how they became "experts". Need a case study? Look at the recent crash in oil prices. Since it's highs in summer 2014 oil has lost about 70% wiping out trillions of dollars. Yet no one saw it coming. Not the analysts or the oil companies or me who worked for an oil company during much of the crash. We were just producing as much as possible and weren't thinking about anything else. The truth is we must always protect the downside. Most of the time it is the most unsexy and boring thing in the world. It will mean that sometimes you have to miss out on some potential returns. People will laugh at you from their mountain of money. But you have to know deep within your bones why you are doing it. You are doing it because no one can see the crashes coming. Not you. Not your adviser. And for damn sure no freaking reporter on TV. You have to always be ready and have a plan for when the shit hits the fan and that plan shouldn't be "oh I am going to watch the market every day and sell when it gets to bad" because that is very subjective. What is too bad? What if you don't have internet access? What if you are too late?  Those people will end up like everyone else and blame the government for their shitty planning. Your plan for the crash has to be systematic. Your plan might be just to ride it out. Or maybe you use a stop loss of 15 or 25%. Or maybe you do something more complicated. Either way it needs to be something you can stick to no matter what.

The Indexers

Next we have the indexers. Now these guys are the chill ones of the bunch. The basic mentality is this: pick the biggest highway there is, put on some good tunes, and just go with the flow. No switching lanes. No racing around. Just chilling. The idea is that most of the time you will do pretty well. Sure sometimes the traders might get ahead, but then again they waste a lot of energy. Most of the time you will probably end up right next to them or worst case they might crash and burn while you are still out there moving. Sometimes you hit traffic, but you just stick it through believing that eventually it will clear up and you will be moving again. Best of all, your life is much more simpler. No stress of worrying about which lane to pick or which way is faster. You just pick a lane and drive. No fuss.

This is the path of the passive investor. You pick an index fund or multiple index funds and just ride it out for better or for worse. It's simple and easy to do and data has continuously proven that this strategy can outperform most people in the market. If fact, there is currently a million dollar bet going on with Warren Buffet and a hedge fund manager from Protege. The bet was that over a ten year period that a portfolio of hedge funds picked by Protege could not outperform the S&P 500 represented by the Vanguard 500 Index Fund Admiral Shares (VIFAX). We are now 8 years into the bet and one side has a stark lead. The S&P 500 has a total return of 65.67% while the hedge funds are at 21.87%. Still think they are worth their enormous fees? This is the pure essence of the argument. It is very hard to beat the market over the long term. If you don't then you wasted a lot of energy and time when you just could have bought the S&P 500 fund and be done with it. If you read about my Simplest Investment Plan Ever then you will see why.

The Fundamentalists

Finally we have the Fundamentalists. Now these guys are quite the group. Their method is simple: perform a deep analysis on the different roads and how many vehicles are driving on them in an attempt to identify the roads that are most likely to yield the fastest times. They will spend hours upon days gathering and analyzing the data. There are thousands of roads to choose from so this analysis is no small feat. They must be systematic and diligent in their analysis. They have to put their emotions aside and pick the roads which the data says are the best. Once they have their choices the work is usually not done. They continue to check the fundamentals and make sure that their choice is paying off. If the fundamentals start to turn then they move on to a different road. This means you will do a ton of work, but if you are good and can be disciplined enough then it can pay off with a much quicker route. Although it is not hard to derail from the fundamentals even for a little bit and undo everything you worked so hard on.

This is what we would call Value Investing. Value investors do a ton of analysis and research into stocks and other investments. They look at the underlying businesses and attempt to assess their intrinsic value. They then look to see what they are trading for. If they are trading at a discount to intrinsic value then they might buy. Once they are invested they continue to watch the fundamentals. If the stock begins trading at above intrinsic value then this might be a time to sell. Many people have made billions of dollars using this strategy. It has proven to be a strategy that works. The problem is it is one of the most difficult ones to implement. It usually involves always going against the sentiment of the market. Buying things that most people deem as bad investments. It means having to ride out large losses from time to time. It means having the intelligence, experience, and skill to be able to accurately place intrinsic values on complicated businesses. But in the end if you can do all of this then you stand to make a good gain.

How Do You Want To Drive

I hope you take a few things away from this analogy. First, that nothing in investing is a sure deal. There is always uncertainty and risk. You can never get away from it and if you try then you might end up getting scammed. The best thing to do is either accept it and face it or just do not get into the game at all. Second is that trading is really a losers game. Some make it, but the vast majority fail and whither away. You will just be spinning your wheels only to end up either underperforming a simple index fund or losing everything you put in. Lastly is that if you want to put in the extreme amount of time it takes to learn fundamental analysis then you can stand to outperform the market. But this takes a dedication and discipline that is extremely hard to achieve. You will need to think of investing like a sport and be willing the put in the time it takes. That may even mean you need to do it nearly full time. For most people this is not an option. Indexing is always a viable alternative. If you liked this and want to learn more about investing make sure to read through the Finance Series.

Can You Get A Mortgage Without A Credit Score?

image.jpg

Most of the biggest myths in the financial world revolve around the credit score and how it relates to your life. Almost anything you will read will tell you to maintain good credit so you can qualify for mortgages and car loans. The only problem is that building that credit involves going into debt and paying it off. There is a small subset of us who have actually researched this financial topic pretty heavily and who want to build solid wealth over time that understand this relationship. I will teach you to pay off your debt, build a solid emergency fund, and use your cash flow to purchase and grow solid assets over time with less risk. This means no car loans, no furniture loans, no student loans, and no credit cards. But this will lead you into a place that many people are perplexed about. If you pay off all of your consumer debt and do not use credit cards within 6 to 9 months your credit score will be “undefined”. Now most people will consider this moment one where they are in the best financial shape they have ever been in, but we have been taught to view the credit score as a measure of financial stability. So how can you be in the best shape yet have no credit score? It’s because the credit score really doesn’t measure financial stability. It really just measures how well you “play the game” the banks. To put it another way “The truth is that the best way to build a great credit score is not necessarily a great way to build wealth. There are plenty of people who are completely unprepared for retirement, living paycheck to paycheck with a negative net worth who have fantastic credit scores. A high credit score means that you tend to manage money in a way that makes you a good person to lend money to. That's very different from managing money in a way that will help you build wealth.” -DailyFinance

So since I do not use credit cards and am completely debt free I will be in a place with no credit score and I am quite happy about that. I view it as a sign that I am leaving “normal” behind. When I tell people this usually the first question that comes up is “well how are you going to buy a car?!” That one is fairly simple "…I’m just going to save up and buy it…” The next one is a little more complex, “How are you going to be able to get a mortgage without one?!?” This is not quite as quick of an answer. That is why I wanted to write this post about it.

How Mortgage Loans Work

Before I go into the specific details, I think it is important that we learn a little bit about how mortgage companies and mortgages work (If you are the impatient type that just wants the meat then you can skip to the next section without much disruption).

For many young professionals a mortgage is one of those things that you feel like you should know about, but when you really think about it you really don’t. At least that is how I was. The basics of a mortgage is very simple. It is where a bank will lend you money (combined with some of your own) to go purchase a home. This loan is called the “mortgage”. You will then pay this loan off over time with some interest so that the bank makes money. There are various terms to mortgages and various types. The mortgage that I recommend is a 15-year fixed rate mortgage. More on that later. A mortgage is what is called a “secured” loan. That is because if you fail to pay for the house and get foreclosed on, the bank will then repossess the house and can sell it to recoup its money it has tied up in it. Now banks typically don’t want to go this route because sometimes they don’t get all their money back. So it is very important that the banks correctly assess the risk of the borrower, which is yourself. To do this they undergo a process called underwriting.

Underwriting is where either a system or a person dives into your data and assesses your risk. This process is the meat of what a bank’s “competitive edge” is in the mortgage business. If you think about it what separates two major banks when it comes to mortgages? Maybe some market better than others. But more so it is their ability to correctly assess the risk of the borrower and assign the correct interest rate to make up for that risk. Therefore, bank’s take this process very seriously. Now humans have been shown to be pretty terrible at measuring risk in an objective manner. We are emotional creatures and emotions tend to lead to bad results when it comes to financial things. So what many banks have done is created an automated algorithm that uses specific information combined with statistical models to define the risk of each borrower and decide whether they are approved or not. This is where the credit score comes in. The credit score was designed for banks to be able to take that information and use it in their models. Unfortunately, like we stated above, if you don’t have much in the way of debt history then the system breaks down. So most people assume that in order for the bank to take the risk of loaning you money for a home that they have no gauge upon your risk then they will either deny you or charge you an ungodly interest rate. That logic isn’t necessarily wrong, but there is still one secret of the industry that most people don’t know about.

Manual Underwriting

Before the advent of computers and the credit score it was up to people to review your documents and assess your risk. Luckily there are still some banks around that can do these loans like Churchill Mortgage. What this means is you can still get a loan without a credit score at the same interest rate as a loan with a credit score. That being said, there are some things you need to be aware of. First, in order to qualify for a home loan you must first BE ABLE TO AFFORD ONE! All too often I see people saying “I think I am going to buy a house” and are paying 2% down with an adjustable rate mortgage. This is just trouble waiting to happen.

Here are some things you need to do to qualify for a no credit score loan. I will quote some of this directly off Churchill’s website:

1.       “Make sure you have 4 alternative credit trade lines, with one of them being a rent or lease payment. Contact the creditors and get a letter from each of them on their letterhead showing your name and account number, and stating your account has been ‘paid as agreed for the last 12 months.’ This is a good start, but further documentation could be required from the creditor.” So make sure you pay your rent on time. Another three alternative credit lines could be electric bill, cell phone bill, and car insurance. All three of those are things you are probably already paying anyways. Obviously the more and the longer, the better.

2.       Apply for a 15 year fixed rate mortgage with a 20% down payment. If you don’t have a 20% down payment then the mortgage company will have to get insurance on the loan itself called PMI. “It is not uncommon for the loan to be approved by the investor then turned down by the mortgage insurance company. That means the deal is dead - end of story. We have found the loan that has the best chance for approval is one that is on a 15 year fixed rate and the borrower has 20% down. This eliminates the need for the mortgage insurance, and presents a lower risk to the loan servicer.”

3.       Make sure your mortgage payment is no more than 25% of your take home pay with a solid work history. This will show the lender that you have more than enough fluff in your budget to make that mortgage payment even if hard times hit.

4.       Have a fully funded emergency fund of 3 to 6 months of expenses before you apply for the mortgage. This will show the lender that even if you were to lose a job you have enough liquid savings to cover you through those hard times.

5.       Lastly, “get preapproved long before you start looking for a home. You don't want to get your hopes up and get emotionally attached to the home of your dreams, only to wait 45 days and find out you cannot get approved.” Don’t wait until the last minute. Have your down payment and loan amount ready to go before you start looking. It will make sure you don’t make a rash decisions in the heat of the moment.

Downsides

Of course there are always some downsides. The biggest downside with having to do manual underwriting is the time. It takes much longer to get approved for a no credit score loan than when you are doing automatic underwriting. “No credit score loans require an underwriter to scour every piece of documentation in the file from your paystubs and W2s to the 24 pages of the appraisal to make sure the risks have all been identified. That takes time - about 3 times as long as a normal borrower file. Don't look for quick answers, because the quick answer is easy - no. We want to give that underwriter time to be familiar with all the aspects of your loan file so they can give the approval with confidence. This may even require additional documentation that doesn't seem to make sense to most of us. But let's remember the goal; give the underwriter what they need to feel comfortable with the risks on the loan to issue an approval. From the time the underwriter receives the file, I would give them at least 2 weeks to underwrite it. That probably takes a normal 30 day loan process up to about 45 days. Therefore, keep this in mind when writing a contract closing date.”

Another downside is that sometimes it is hard to find a bank that is still willing to do this. Churchill is an option and other smaller banks will probably do so as well.

Benefits

There are many benefits to going about your finances this way. First and foremost, it means you can escape the “normal” financial thought and focus on actually building wealth over time. One of my biggest problems with credit cards is that it takes people’s attention away from the fundamentals. Getting out of debt, spending less than you make, and finding good investments over time. Instead people are so worried about how to maximize credit card rewards that they forget about their retirement until they are in the late 30’s to early 40’s. Knowing that you don’t need a credit score to buy a home is a very freeing feeling. It means you can focus on managing your cash flow correctly and keeping everything in balance.

Next, having a solid down payment (20%) and a shorter loan life (15 year vs. 30) means you will be able to pay off your home in AT LEAST half the time of a normal loan and you will pay dramatically less interest. You can save hundreds of thousands of dollars just by making this one decision! The payments will be slightly higher than if you have a 30 year loan. But as long as you use the guideline of not having your mortgage payment more than 25% of your take home pay then you will be fine.

What Does This Mean

This means that in the end, the myth that you can't get a mortgage without a credit score is simply that - a myth. you can still get a mortgage without a credit score. It may take a little longer and you will have to make sure you are buying a house that you can afford, but you should have been doing that anyways. Remember, the credit score says nothing about your wealth or your financial standing. A high credit score only means you know how to payments.

The Best Credit Card Recommendation of 2016: Chop Up Your Cards and Burn Them

Oh if I had a dollar for every one of those "Best Credit Card of 2016" articles I have seen. Or rather if I had 25 cents for every click it got or 5% of all sign up fees that were paid from the article I wrote that was sponsored by said credit card companies to market their products... but of course that never happens. Reading these articles and their accompanying comments is like going to a redneck Walmart at 2AM. The people watching is real! I am truly in awe of the marketing geniuses these companies are and their extremely sophisticated use of psychology. I thought I would go ahead and take a shot at my own article. I am sure it will make some people very angry.

The Power Of Positive

Anyone who has had any contact with the outside world over the past month has surly heard of the recent Powerball frenzy. The record breaking 1.6 billion dollar jackpot had people from far and wide coming out of the woodworks to get in on the 1 in 292,000,000 chance of winning this sum of money. One lady even created a GoFundMe page after her inevitable loss to regain her savings along with an extra 100k. Ironically enough, this probably had a better chance of working than winning the powerball. The page had already received $800 in donations when it was shut down. For most people who played the Powerball it was simply something to do. A way to be a part of the conversation or join in with your coworkers on an office pool for which everyone pretty much knows they aren't going to win, but it makes for good lunch conversation. For others, there was a serious hope and prayer that they would win. But one question still remains: what makes people go so crazy over such absurdly small odds?

The answer falls back to some cognitive biases like I talked about in Humans Are Hardwired To Suck At Investing. Two of the main biases that are exploited with the lottery are Availability Bias and Present Bias. Availability bias is the tendency to judge probabilities on the basis of how easily examples come to mind. Present bias is the tendency to value immediate rewards over long term ones. You can easily remember a time you have heard of a lottery winner and can definitely easily see yourself winning. However, it is very hard for us to truly wrap our head around how small the odds of winning are. Winning the lottery is instant wealth over what saving money can do over the long term. Another example of this is the fairly recent Ebola freakout. How many people do you know that didn't die from Ebola? Chances are pretty much everyone you have ever met in your entire life. Yet people were going crazy over a astronomically few cases in the U.S. Why? Because the prevailing thought was that getting Ebola is assured death at a quick rate. It was so widely publicized that we all saw people that had it so we misjudged the probabilities to an irrational point.

So what does this have to do with credit cards?

Exploiting Our Biases

Credit cards, much like the lottery, are in the business of exploiting our biases. They use a number of tactics that are aimed at taking advantage of every bias they can to the point that we rarely notice. No tactic is stronger than the truly infamous credit card rewards.

In 1986, Discover was the first card to issue "cash back rewards". Today rewards credit cards can be found with virtually every company. It is truly engrained in the American culture so much so that the fact that I am writing this article will no doubt make a lot of people very angry. People love their rewards and there is an abundance of articles on the internet to support that. If you are getting angry then I ask you to take a look at this article: www.neurosciencemarketing.com/blog/articles/cognitive-biases-cro. It is from a website called Neuromarketing. Here is a quote talking about the cognitive biases: 

When you grasp just a few of these psychological nuggets, the advantage you possess is almost unfair.

These marketers know these biases well and use them in every way they can. I think credit card companies are some of the best at it. Check out this one specifically on rewards programs.

The rewards programs on credit cards are taking advantage of some of the same types biases as the lottery. First and foremost, they take advantage of what is called the Framing Effect. This is the idea that people will behave differently depending on how a situation is presented. In a study by Nobel Prize winning scientist Daniel Kahneman and Amos Tversky in 1981, the scientists explored how people respond to the same situation whether it was framed in a positive light or a negative light. They told participants that there was a deadly disease that affected a total of 600 people and they were to choose between two treatments. In the positive framing example, Treatment A was said to be predicted to save 200 lives whereas Treatment B was predicted to have a 33% chance of saving everyone and a 66% chance of saving no one. In this frame, a full 72% of participants chose Treatment A. In the negative framing example Treatment A was said that they predicted 400 people would die whereas Treatment B had a 33% chance no one would die and a 66% chance everyone would die. In this case only 22% of participants chose Treatment A. Upon further inspection you can see that the outcome of Treatment A is the same in both cases. 200 people are saved and 400 people die. So why is the difference between the results so drastic? What they found is that when a situation is framed in a positive light people tend to avoid risk. When they say Treatment A will save 200 people then people will go for the 200 for sure saved rather than risk no one being saved even though the expected outcome is pretty much the same (1/3 x 600 = 200). Conversely when a situation is framed in a negative light people tend to seek risk. Rather than for sure killing 400 people they would rather take the chance for saving everyone.

In a different example, possibly a more applicable one, PhD students were sent an email to register for a paid seminar. In one case there was a penalty on the registration fee if they registered late. In the other case there was a discount for registering early. 93% of students registered early when the penalty fee was introduced whereas only 67% registered when the discount was introduced even when the amounts were exactly the same.

So what does this have to do with credit card rewards? Well let's talk about what these "rewards" actually are. If you spend $1000 on a 3% cash back card then you get $30 back. So that means you have effectively obtained $1000 worth of goods for $970. Instead of saying you get 3% cash back the credit card companies could also say you get a 3% discount. Mathematically, this would be the same thing. Yet why is it cash back? That is where the framing effect comes in. The "reward" is framed in a positive light. Who doesn't love a reward, right? It makes us feel good to have spent money and then receive that money back in our bank accounts. Over the month, it can add up so at the end of the month you get your reward and really feel like you got those credit card companies. If instead you simply got a discount people would not be going so crazy. This is not an accident, but rather a well researched and thought out tactic. 

Another bias that is being exploited, although much harder to do, is the Bandwagon Effect. This is exactly what is sounds like. If everyone is doing it then it must be okay. Having a credit card is like eating breakfast or brushing your teeth. We don't need to stop and think about it too much because everyone is doing it. Do a quick google search and you will find a million articles about how to maximize points. I want to point you towards two articles posted on the same website, Invetopedia, which does have some really great information. The first is your typical "Best Credit Cards of 2016" article. It includes link to go apply to the credit cards. They are no doubt getting either a commission on clicks or a commission when people sign up through their site. This is called Affiliate Marketing. In that article they are talking about "credit cards being a tool" and things like that. The next is an article on store branded credit cards. It brings up the point that the credit card rewards programs tends to lead people to overspend effectively canceling out any "rewards" they get. Overspend by 6% and you canceled out your 5% reward. Yet why do they not mention this in the other article on regular credit cards? They are both credit cards and both offer cash back rewards and therefore the tendency to overspend is the same or even more for regular credit cards because you can use them anywhere. Well if you are getting paid to advertise credit cards (which they definitely are) then you don't want to mention that. That would be bad "framing".

The Bottom Line With Credit Cards

The idea behind rewards programs are simple. Offer cash back rewards and people will tend to spend more; it is just the way they work. If you spend more, they make more in transaction fees. And if they are super lucky you will miss a payment and hold a balance and they can start smacking you with 15 to 20% interest. But I know what you are thinking. That is not you; you are responsible and would never overspend due to rewards. That is other people (by the way, there is a cognitive bias for this as well called illusory superiority bias).

Let me just give you one last reason to reconsider:

The entire finance series is about getting you in a position to become financially free. This can be achieved regardless of income. The fundamentals are pretty simple: protect against emergencies, save money by spending only on things you value, eliminate debt of all kinds, and use free cash flow to make wise investments for your furture. Can you tell me where credit cards fit into that? No where. Credit cards and their accompying rewards incentivize spending. They cause people to spend the majority of their time trying to maximize their rewards instead of optimizing their spending and finding ways to lower their fixed expenses. They promote debt as a tool. They push people to focus on building credit rather than building a net worth. And worst of all, they promote a dependency on the banking industry when it comes to making a purchase. You need a car? Come to our bank to get a loan. Need some furniture? No worry, we have interest free financing for 700 years. Need a house? We can most certainly give you a mortgage for a house far more than you can afford because it is an investment. All of these things make it harder to become financially free. You can go your whole life without using a credit card and do what I described above and build an amazing amount of wealth. That is why I have never had and never plan to have a credit card. Also, I never recommend anyone to get one.

The Darker Sides of The Credit Industry

Unfortunately, there is a darker side to credit cards. Almost everyone I have talked to about credit cards feels they are the exception. They use them as a tool and are in turn reaping the benefits from the credit card companies without paying them a dime. If you ignore the opportunity costs of what you would be doing if rewards weren't incentivizing you to spend then that might seem to be true. You spend money, they pay you money, you don't pay them interest. But one question has to be bothering you. Would the credit card companies do something that would cause them to continually lose money? Of course not. These are large institutions that make billions of dollars per year. So what is funding these programs? It is a combination of two things. First, there are transaction costs that are levied on the merchants and businesses that use their processing systems. These costs typically vary depending on the type of card you use. For credit cards it can average 3 to 4% of purchase price plus a flat fee of around 30 to 40 cents per transaction. Although, not all of this going directly to the credit card companies. So the rewards are partially funded by these fees. But these companies don't want to just break even, they want to make a lot of money. So where does the profit comes from? 

The real bang for the credit card company's buck is in interest and fees. You know, the fine print stuff that no one really reads. Because hey you are responsible, right? Just like no crack addict sets out to be addicted to crack, no one in credit card debt set out to be heavily in debt. It starts off as usual. Use it a little here and a little there. Get some rewards and feeling pretty great. Then all of the sudden something crazy sneaks up on them! Like ... Christmas! Who knew they moved it this year from August to December?! I have no doubt that many people are still suffering from their Christmas hangover on their credit card bill. Then one month they get a little behind. Car breaks down or dishwasher goes out. So they pull out the credit card just to make ends meet since they are probably in the nearly 30% of Americans that have no savings whatsoever. Little by little things rack up and soon they find themselves not being able to make ends meet. They pick up the slack with, you guessed it, more credit card debt. Its not surprising that 34% of Americans in 2014 were in credit card debt. The credit card companies need these people to survive. If they don't have people in revolving credit card debt then they don't survive. It is as simple as that. So think about this. In a way your cash back rewards are coming partially from the increase in the price of goods you bought since the merchants simply pass that transaction fee onto you as well as a middle to low income family that is struggling in a mountain of credit card debt. Sure the families got themselves into it. They overspent, they took the debt, and they need to clean it up. You didn't force them to do that and the credit card companies didn't either. But the companies sure as hell were willing to lend them money at 15 to 20% interest knowing the family can't afford it. They will for sure break federal laws attempting to collect on that debt. They will surely give a college student with no credit history, no job, and no income a shiny new line of credit knowing good and well that they will hold a balance and pay them interest. Just like the drug cartels should be partially responsible for the tragedy that drug addiction can bring on people's lives, the credit card companies cannot completely absolve themselves from blame. Lending to subprime borrowers is part of their business model. Paying federal fines for breaking the law is part of their business model. Putting middle and low income families in debt that they can never get out from under from is also part of their business model. 

My Recommendation

I know the vast majority of you will not stop using your rewards credit card simply because I wrote this article. That is okay. But here is an alternative to consider just for shits and giggles. 

Here is my best credit card recommendation for 2016: Chop up your credit cards and burn them. Forget they even exist. Use your debit card. Use a budgeting app like EveryDollar or Personal Capital to begin tracking and planning your spending every month. Look for expenses that you don't gain much value from. Put yourself on your own cash back plan. Set up an automatic transfer of 10% of your income to go to savings or paying down debt. I promise you that you will end up with more money and just the same amount of satisfaction at the end of the year then if you just used your 3% discount card (that is itching itself to charge you 15% in interest).  If people spent just half the time and energy they spend on trying to find the greatest credit card there is or trying to get that free flight and spent it looking for ways to save and making sure they are making sound investments then we wouldn't have such a problem.

I'll leave it with this. There a plenty of ways to build wealth out there. I can guarantee you no person who has built a substantial amount of wealth is going to say "man the best way to build wealth is to get you a Chase Sapphire card and start earning 3% cash back on restaurants and dildos". That is just not going to move the needle that much. I promise. Please leave me a hateful comment below or feel free to send me hate mail at joshua.bird@younganalyticalmind.com. :) 

The Anatomy of A Dollar

Inflation, deflation, quantitative easing, interest rates, the fed... for most people it is all just a mystery. Every day we hear things about the dollar, but it is not often that we take the time to learn about what it all means. Here I want to go into a simplified version of what all these terms mean and what they mean to the stock market and the American economy.

The Federal Reserve

I am sure you have heard of the Federal Reserve (or the Fed), but didn't know what exactly it is or what it does. The Federal Reserve is what we call a central bank. Now this central bank is technically separate from Congress and is intended to act on it's own devices when it comes to making decisions. Although the chairman and vice chairman are appointed by the President and confirmed by the Senate. The central bank acts as a bank for all the other banks... I know that was a bit confusing, but essentially it is a place where the banks that we use go to borrow money and perform other financial transactions. Since all the banks use the Fed then it in turn regulates how banks operate. Think of this regulation as terms on the loans it gives to the banks. For example, when taking a loan from the Fed the bank must keep a certain amount of this money in reserves as cash rather than lending it all out. Along with that it acts as the bank of the US government. So with a lot of arrows pointing to the Fed you can see how they can have a large effect on the global economy as a whole.

The Federal Reserve has two main mandates: keep unemployment low and keep the price of the dollar stable (low inflation). This is done by using one of their three levers: Regulating money supply (printing money, destroying money, buying treasury bonds and other assets), setting interest rates, and regulating how much banks need to have in reserves. Setting interest rates is a way they can regulate how much borrowing is done in the economy. In a bit we will talk more about some of the feds historic actions, but for now just know that they have a lot of swing when it comes to the banking industry.

Inflation Vs. Deflation And Why It matters

So what is this inflation and why do we work so hard to control it? Well first let's talk about what inflation and deflation is.

Inflation and deflation are two sides to the same coin. Inflation is generally the increase of prices on goods and services or you can think of it as that a dollar cannot buy as many products or goods as it used to. Conversely deflation is when prices of goods and services become cheaper over time. That is your dollars can now buy more products and services over time. Now at the surface we would think that things going down in price over time (deflation) would be a good thing and things going up in price over time would be a bad thing. Actually it is the exact opposite. Let's run through it.

Let's say you own a furniture store. Being a business owner you want customers to come buy your furniture sooner rather than later as this is more money in your pocket to either invest back into your business or do a number of other things. Now let's consider a period of inflation. In a period of inflation the costs of your furniture go up slightly (2-3%) per year. At a consumer level your customers are incentivized to buy furniture now rather than later because later on it will be more expensive. To expand this a little lets consider that your customers not only have the opportunity to buy your furniture, but they also have the ability to buy the exact same quality furniture from Europe. Since they live in the US and are paid in US dollar then they would theoretically have to convert their money to euros in order to buy this furniture. With inflation the value of the dollar is constantly eroded over time. If the dollar is less valuable relative to the euro then it is likely that you will opt to buy American rather than european as it is cheaper. That means that low levels of inflation is good for US businesses. Since we live in a capitalistic society, we are employed by  businesses which means if they do well we get better bonuses and better job security. This is good for the US economy. So even though our money sitting in our bank account is constantly being eroded over time, inflation is overall a good thing for the US economy, American industries, and American commodities.

Now let's consider the same situation but with deflation. With deflation the furniture that you sell is actually getting cheaper over time. Therefore consumers will be incentivized to buy later rather than sooner as the furniture is getting cheaper. This is bad news for you as you will begin to see a drop in sales. If this continues too much then you will have to start firing employees and closing down stores. Conversely, now that the dollar is getting stronger, things from Europe are starting to get cheaper relative to the dollar. This means people become more incentivized to buy foreign rather than American. Overall this causes a contraction in all businesses as our economy is dependent on consumer spending. So even though the value of money in our bank accounts is getting more valuable people are losing their jobs and are holding off on making purchases. This causes the US to drop into a recession. So you can see why the Fed exerts so much energy to keep us in a inflationary period.

The Fed and The Great Recession

So now we must ask the most important question of all: why should we care? This is often very complicated and difficult to understand as in this case, but we will walk through it.

Let's flash back to 2008. The real estate bubble bursts on dramatic proportions. Not only is the stock market tumbling but people are losing their homes and jobs and the investment banking industry is on the brink of complete failure. The economy is dropping into a deep recession and everyone is looking to the Fed, as usual, to pull us out of it. So the Fed begins to ratchet down interest rates over time until they eventually hit .25% in 2009, the lowest they have been in a very long time.

 

This means that banks can now borrow money from the government at near zero interest rates and then can in turn lend this out to consumers to buy houses and cars. This is one of the main ways that the Fed tries to stimulate the economy.

The other way is by essentially printing money. That brings us to how our currency system works.

With the emergence of the civilized world we moved away from a barter and trade system to a currency system. This means instead of saying "hey I need some milk and I have some grains so I will trade you grains for milk" we instead say "I need milk so I will sell some grains and buy milk". But who anoints this so called "currency" with value and how much value does it have? Historically it was governments who took this job and up until the 1970s this was usually done by backing the the currency with a precious metal such as gold or silver at a fixed rate. That is to say that every dollar there was in circulation there was a certain amount of gold sitting at a place like Fort Knox. In the 1970s the world left the gold standard and instead went to what we call a Fiat Currency System. That is to say that currencies are no longer backed by anything physical. Rather they are backed by the faith that the government will make good on their debts. With this came the establishment of the US dollar as the world reserve currency. This gave tremendous power to the Fed as they now are in control of the currency in which all other currencies are pinned to. So instead of the other central banks across the globe putting gold on their balance sheets to back the currency, they now put US dollars usually in the form of US treasury bonds on their balance sheet. Now the Fed essentially has the power to print US dollars out of thin air and use them to bolster the global economy. This is like going to Best Buy and buying a TV by taking out a piece of paper and writing "$1,000" on it. If it seems absurd then that is probably because it is. 

Starting after 2008 not only did the Fed and other global banks across the world cut interest rates to near zero percent but the Fed also began printing money. A LOT of it. About 3 trillion dollars or so of it. This is called Quantitative Easing or QE. But this "printing" is not exactly printing actual money (although they did do some of that). Rather it is buying assets with IOUs like I described above. They did this in the hopes that it would stimulate the US economy. Now you will see many articles written with authors who are cultivating the fear associated with the mystery of how the Fed works and will use this money printing fact to scare people into reading their site and usually buying gold or something like that. Don't let them fool you. The act of printing money alone is not telling the whole story.

Let's again consider an example. Let's use a company like Amazon who is selling gift cards. Now when Amazon sells a gift card they are essentially creating cash flow out of no where. They didn't actually sell you anything other than the opportunity to buy something from them at a later date. Now as long as Amazon continues to offer products to sell then they can sell all the gift cards they want. If for some reason Amazon suddenly begins to go out of business and doesn't have products to sell then that is when the amount of money used to purchase gift cards becomes a large problem. The same is true with the economy in a way. As long as there is products and services being sold in the US then the printing of money is not necessarily a problem. If for some reason things begin to become restricted and there is a lack of products to meet demand is when the money supply becomes an issue which is where the Feds ability to destroy money comes in.

How This Effects The Dollar and The Market

So in summary what has happened since 2008 is that the Fed has dropped it's interest rates to about as low as it can and has been "printing" a ton of money in an attempt to bolster the US economy after the great recession. Now you can't eat cake forever so at some point the Fed wants to let the market stand on it's own and prosper without holding it's hand. This past December we saw the first of this action. The Fed raised it's interest rates very slightly signaling that it will further do so in 2016. This is essentially a test as to whether the economy is back on it's feet yet. So far we have seen a strengthening of the dollar which is a very deflationary action. From my explanation above you see that this can be a bad thing for US based global businesses. Indeed that is what we are beginning to see. Corporate profits are beginning to sink and the euro is now worth .92 dollars at the time of writing this, the lowest it has been in quite some time. 

The billion dollar question is what will it do next? Will the Fed begin another quantitative easing program? Will the dollar keep strengthening? Will the market keep falling? The real answer is no one really knows. As of right now it is important for everyone to not make any rash decisions. There will be people screaming on both extremes for both hyperinflation and rapid deflation. Don't let them scare you. Hopefully this article gives you are better understanding of how it works so that you may be able to keep your wits about you when ignorant people begin following their fear.

Resources

http://www.investopedia.com/exam-guide/cfp/economics-time-value/cfp6.asp

http://www.investopedia.com/university/thefed/

http://www.heritage.org/research/reports/2014/08/quantitative-easing-the-feds-balance-sheet-and-central-bank-insolvency

Forget Everything You Know About Saving Money

In the last post we talked about setting up an automated financial system to make managing your money simple and removing the emotion. I told you that we needed to separate the act of budgeting from cutting costs. Budgeting is planning, cutting costs is cutting costs. They are not one in the same as people tend to imagine. Of the two, I would say budgeting is vastly more important. Cutting costs is something you usually have to do, but planning your financial life is the only way you can ever reach a financial goal. You have to be intentional.

What Most People Say About Cutting Costs

This is another area of finance that conventional wisdom generally proves to be mostly impractical and/or completely off. If you go read any book or listen to any "financial guru" they will tell you something like this: Cut discretionary spending, stop eating out, brew your own coffee, cook your own food, and clean your own home. These things no doubt save money and are effective ways to cut your spending, but what happens in reality? Very few people actually implement this into their lives. Why? Because no one really wants to hear that shit. It's all great in theory until you get fed up and just double down on the spending and abandon managing your money all together. I have seen it over and over again. It is like that friend you have that is always going on a different diet. They do well for a little bit and start to see results. Then they will slip and go off the diet and gain all the weight back and more. The fact of the matter is that most people will not save money through these means above until there is a crisis. So is there any other way to save money? Well I thought you would never ask... or I would never ask... whatever let's just keep going.

Spending Less And Getting More

I was always a little confused as to why no one ever wanted to talk about money. Everyone has to deal with it and it is no doubt a big portion of our adult lives just like relationships or fitness. But why is it so avoided? One of the reasons I think it is taboo is because people have been beaten down at one time or another about spending money on something. They are afraid of being judged for what they spend or don't spend based on other people's ideas of what is right.

Let me give you a personal example. As you may know, I am a skateboarder. As a skateboarder there are some items that are very important to me in regards to how I perform. The skateboard itself, of course, and the shoes I wear. Now most people wear shoes and have to buy them at some point and everyone is a little different (or a lot different) when it comes to what they value. I buy skate shoes based on the features that I feel work best for me when skating. If I am skating pretty heavily, I can tear through shoes in a month or two. Skate shoes are not really cheap either. I can usually pay around 70 to 90 bucks for a pair. People who don't skate would think I am crazy and that I was wasting a ton of money, but for me it was necessary if I wanted to skate.

The problem with blanket cost cutting advice is that everyone is different. What would seem like wasting money to one person is viewed as completely necessary for another. I see blogs all the time posting articles about how this is wasting money and that is wasting money. While some people will agree others will squawk about it. At the core everyone is different, so blanket cost cutting tips usually don't work.

Value Based Spending

What I want to tell you about is a simple, yet very different idea on spending and saving money. It is called Value Based Spending. It is just like it sounds. Instead of looking around and trying to cut discretionary spending and getting frustrated, focus on maximizing the value in which you get for every dollar you spend. Now what is value? Value is whatever it means to you! That is what makes this idea so great! There are no rules as to what is valuable and what is not. It is all defined by the individual person. Like my example above, I place a large value on finding good skate shoes. Skateboarding is one of my passions and it helps me relieve stress and makes me happy. If I were to buy skate shoes that were cheaper and lower quality I might not skate as well. So for me the extra money spent is well worth it when compared to the alternative. I'll give you another example. I don't personally follow sports a whole lot (yes, I know it is crazy and you can shoot me later) and most shows I watch on TV are offered on streaming services such as Hulu and Netflix. So the amount of money I was paying for cable was not bringing me much value. I would rather spend that money elsewhere such as buying skate shoes. So I was able to cut out cable and save a good $100 a month. For other people cable may be highly valued and well worth the money. So I can't say "cable is a waste of money" because everyone values different things. If I were to buy skate shoes every other month for $80 then looking at both of those actions together (saving $100 per month on cable and spending on average $40 per month on shoes) I saved $60 per month while getting more of what I wanted. That is how value based spending can save you money. Here are some characteristics of this train of thought that I think make it light-years ahead of most advice:

  1. It is personalized - Implementing this train of thought into your financial decisions is going to look different for everyone.
  2. It is much more practical - I am all about giving practical advice that you can implement immediately and this is about as practical as it gets.
  3. It further removes emotions and cognitive biases from your financial decisions - As with my previous post you can see that human emotions are generally bad news when it comes to money. We see people all the time getting caught up in the moment and then having buyers remorse. Taking a second to ask yourself "is this purchase really valuable to me?" can mean the difference between buyers remorse and purchase satisfaction.
  4. Everyone can use it - No matter who you are, you can begin today to buy based on value rather than based on emotion.

This is the most effective and consistent way I have found to save money. I try to make all my purchases based on value every day. Combining this with an automated saving and budgeting system and you can really make big strides.

Emotion and Value Based Spending

Now there is a bit of a hitch in this. Let's say you really like the idea of value based spending and realize that you value EVERYTHING. This could lead you to actually spend more. So there is another piece to this that is really going to boost you into saving money. We have to learn to separate value from wants. Wants are usually based on emotion. Value is based on long term and short term goals. Let's say you have a long term goal of saving for a house down payment. When you go to make a purchase you ask yourself this simple question, "is this purchase worth more to me than saving it for a house?" If the answer is yes then you make the purchase and if the answer is no then you don't. It is that simple. This means that you need to have short and long term savings goals that you value a lot.

I'll give you a personal example. At the time of writing this I currently am driving a 1995 Ford Ranger. I really like classic cars and currently am saving up to buy a classic 1970's Corvette. I am hoping to save around 20 to 25k to buy it. That is my current savings goal. So when I go to make a discretionary purchase I ask myself "is this purchase worth more to me than saving for the Vette?". There have been many times that I have got charged up about buying something and then this puts it back in perspective for me and I put it down. It's all about priorities. I believe that if you have goals that are meaningful to you then implementing this will no doubt help you save money towards that goal over time.

Fear The Revolving Door Of Business

Every time you walk into a mall or turn on your TV or drive down the road you are being bombarded by the marketing industry. Americans are the most marketed to culture in the history of human kind. Businesses fight tooth and nail to get you to spend your hard earned money on their products. These companies don't just sit in a room and brainstorm some ideas that just sound good. No, there are heavily scientific about it. They do discrete tests and scrutinize their results. They dig deep into human psychology to trigger your emotions because they know that we almost always buy on emotion, almost is the key word there. Don't get me wrong I am not one of those people that thinks all business is bad and that these companies are evil. I am actually in awe of their sophistication. But as a consumer advocate I feel compelled to at least bring some of this to light.

One of the key business strategies is product releases. Let's take phones for example. Why would Apple come out with a new iPhone every year? Does technology really advance that much? Do they really add a ton of new features? For the most part I think people would agree that year over year the phones don't change a whole lot. Yet year after year there is a new one released that outsells the previous one. How could this be? It is just human nature. We are attracted to the new and shiny. You can be cool if you whip out your new iPhone at the club. The same goes for cars. Every year the companies release a new edition of the car with not a whole lot of change. They make the real change every four to 5 years when they actually change the design of the car. Yet people will buy (or mostly lease) the new car year after year. Why? Because they want to pull up to the valet in their "brand new" car. Deep down most people buy it because they can say it is brand new. Every logical piece of information out there will tell you that new cars don't change that much year over year and that they depreciate heavily in value during the first 4 to 5 years that your own it. But logic on average does not trump the emotional high people get when they sit in a new car.

That is all fine and dandy, but here is the problem. Let's say you buy that new car and for a couple of months you really feel on top of the world. After a while the newness will wear off and you will start to see more and more of your car on the road. But no worries because it is still the new car on the road! But a year later the next year's version comes out. No longer are you driving a brand new car. The new car smell is gone and you don't get the same looks your used to get when you pull up at the valet. The message here is that chasing an emotional high from having new and shiny material things is a fallacy. Things fade over time. After an emotionally charged purchase you will always settle back down to what you logically value. It is totally fine to indulge in your hard earned money, but understand that these are short term. Having long term goals and using value based spending is a way to continue to get long term satisfaction our of your purchases.

How To Implement VBS

The implementation is pretty simple. Here are some discrete steps you can take to implement this into your life right now:

  1. Set some savings goals - The first step is to set yourself some financial goals. They can be short or long term goals. A short term goal might be a trip you want to take and a long term goal might be saving for a down payment on a house. Dream big and make sure your goals are important to you. This will be the catalyst that will kick this whole thing off.
  2. Look at your past spending habits - Take your budget and try to categorize your spending habits in order of what you value the most. Ask yourself "is this more valuable than the one above it" over and over again until you have a clear picture of what is important.
  3. Implement on daily purchases - Now that you have goals and have an idea of what is important to you, it will be easy to begin using this method on a daily basis. Like I have said above it is merely an act of asking yourself a question "is this purchase more valuable to me than X" or "Could I get more value out of this money somewhere else". It works is nearly all situations.
  4. Avoid emotionally charged purchases - We can all get caught up in the moment sometimes and buy something that we probably shouldn't. A few times here or there is okay, but doing it consistently can really have an affect on reaching your goals. First, if you feel you are getting too caught up then it is best to just walk away. I have a rule that before I make a purchase of $300 or over I always sleep on it. Sales people will tell you "this is the last one" or "this deal will only last today because someone will buy it". These are all tactics. A good nights sleep will really help you escape the emotion and if you still want it then you can buy it.

Summing it up

What I hope you all are seeing is that this idea of value based spending is really a way you can save money while getting more of what you really value. Most people say just cut discretionary spending and quit whining. This can work in crisis situations, but most of the time it does not. Value based spending allows you to buy things that you really care about and don't buy things that you don't really care about. Since most business marketing and sales are designed to make you buy on emotion if you begin to buy based on true value you will tend to save money as a whole. Be weary of the revolving door of business and the traps for making emotional purchases. Set some savings goals and begin to weigh each purchase up to those goals. Ask yourself "is this purchase worth more than saving for X" or "is this purchase the best use of my money". Over time you will find that most likely you will cut discretionary spending that doesn't bring value to your life and it will be different from person to person. You will learn to be content with what you have knowing that you are working towards something much bigger. Instead of just using will power to cut spending, you will be using your goals. Maybe buying shots for all of your friends at the bar isn't as important as the week long vacation to Italy that you have always dreamed of. Then again maybe it is.

I really hoped you enjoyed this article and found it useful. Make sure to share it with your friends! Do you currently use this idea? Do you have an example from your own life? Let me know in the comments and don't forget to subscribe to receive more great content!

Automated Financial Systems 101

I hope you have seen from the past articles that having a systematic approach investing is very important. The same is true for the rest of your financial life. Having an automated system removes the human emotion and psychology from the situation and keeps us from screwing our entire plan up. In this article I am going to tell you everything you need to know about  putting in place a fully automated financial system that automatically saves, pays off debt, and invests over time. I will be telling you about great apps that you can use to make all of this super easy and can all be done from your phone. Not more big excel sheets and hours of time. It will take you literally minutes to manage your finances every month. The backbone of any automated financial system is the budget. Whether you are a Fortune 500 company or anyone else off the street you have to manage and track your expenses to achieve your financial goals in an efficient fashion. Now most people have a really misplaced hatred with the budget so let's clear that up before we move on to setting up the system.


What Is Budgeting, Really

Most people think of a budget as something constricting. We have phrases like "ballin' on a budget" or people say things like "nope, can't have that it isn't in my budget". This leads some people to avoid the act all together. A budget is really just a plan of what you want to spend in a given time. It doesn't have to be constricting. It is simply being an adult and planning your expenses. John Maxwell describes a budget as telling your money what to do instead of wondering where it went. If you read anything into this paragraph it should be this: we need to separate the act of budgeting/planning our expenses from cost cutting. These are two separate acts that are based on different things. EVERYONE can plan their expenses. If you are a crackhead and you wanted to spend 70% of your income on crack then your budget could look like this:

  • Crack: 70%
  • Food: 10%
  • Cardboard Box to live in: 1%
  • Other: 29%

It doesn't have to be about cutting your expenses. Should this person spend 70% of their money on crack? No of course not. But for doing a budget it doesn't matter. It is just the plan. Cutting costs is optimizing this plan. If you don't have a plan to begin with then how are you really supposed to cut costs? You can't efficiently cut your costs, save money, and invest if you aren't doing a budget. It is just that simple. Think of all the fortune 500 companies out there. They all have INSANELY accurate budgets. They have a very good idea of what they are going to spend in a given year. Now these are money making machines. They don't spend time and money on things unless it has a real impact on the business in some way. So why do they spend so much time and money paying people to keep meticulous budgets on all expenses? Because they know that is the only way they can run their businesses well and help streamline what matters. Your personal finance is no different. It is the ONLY way you can truly get a grip on your finances and take advantage of the awesomeness that is investing and compound interest.


Automated Budget Basics

There are some fundamental characteristics of a budget that we must have:

  1. Must be unique to every month. None of this "let me set some goals and see if I hit them" type shit. That just doesn't work over time. Each month is different and you need your budget to reflect that.
  2. Must plan every dollar of income. That is the most effective way to plan your expenses. I will show you some apps to help you do this.
  3. Must automatically download transactions (Apps). This is one of my personal preferences. I make just about all my purchases using by debit card. Many budgeting apps require you to manually enter your transactions. While that is all great and very easy to do, I just simply don't keep up with it. It is mandatory for me that have my transactions download automatically. Some people like the manual, I just know I won't do it.

Next we talk about finance apps.

Financial Apps

With the dawn of the information age, budgeting has only gotten easier! There are some fantastic apps out there that you can use to not only budget, but also to track all of your accounts and net worth. I will show you some apps that we can use to make this whole budgeting thing super quick and painless.

I separate my apps into two separate categories: budgeting and net worth/investment tracking. So far I haven't found an app that does both effectively. Some will track your net worth and investing well and have a budgeting tool, but it just isn't that good. Some are great with budgeting and do decent in tracking your total financial picture, but just not very well.

Budgeting

EveryDollar Plus

This is the app I personally use for budgeting. Here are some pros and cons:

Pros

  • Very easy to categorize expenses on the go. Just drag and drop into the budget category from your iPhone.
  • Automatically syncs to your bank account and downloads transactions.
  • Has decent trends you can look at to track month over month spending.
  • Easily set up a budget using the previous month.
  • Easy to manage on the go with the added feature of editing and adding budget categories from your phone.
  • Encourages you to budget your income down to 0.

Cons

  • It does cost $99/year for the feature to connect to your bank account. I think it is money well spent as I hate manually tracking expenses.
  • Transactions are sometimes slow to load. Every once in a while I have to close the app and reopen it to get them to download.
  • It is only supported on the iOS (iPhone) platform. They say it will be available for android in 2016.

Mvelopes

I have just started trying this app out. Here are my observations so far:

Pros:

  • Easy to set everything up. It creates a budget from national averages and goes from there.
  • Automatically syncs to 4 bank accounts for FREE. They have a upgrade version for $95/year that has unlimted.
  • Easy to adjust everything from your phone.
  • Is supported on both Android and iOS devices.

Cons:

  • With the free version they have some ads that are around online and it pings you a lot to upgrade.
  • Does not have any trends to look at that I can find.
  • Is a bit confusing at first. I am sure once you learn how to navigate it will be fine, but it is just not intuitive.
  • Doesn't seem to easily track your month over month budget like EveryDollar does.
  • Seems to be a bit more cumbersome to move transactions rather than EveryDollar's drag and drop.

Summary:

If you have an iPhone I suggest the paid EveryDollar app. It is super easy to use and navigate. It has good trending and it is easy to go from month to month. I believe it is well worth the money. If you have an Android or are really against paying for EveryDollar then go with Mvelopes. It still works very well and I am sure once you get the hang of it there will be no problems.

Net Worth and Investment Tracking

Most of these apps are free. I will talk about two very powerful ones

Mint.com

Mint is the most popular financial app by far. It does have a budget feature, but I really don't like it. It is basically you setting goals and the software then automatically categorizes your expenses. Here are some observations from using the app for about 2 years before switching:

Pros:

  • It is free to use.
  • It has great trending tools to see the breakdown of how much you are spending on average every month.
  • It connects to most institutions and helps keep track of all of your accounts.

Cons:

  • It does have quite a good amount of ads all around the website and app. There is no doubt how they make money.
  • The software is supposed to automatically categorize you transactions into their respective categories, but it doesnt always do a great job. It is quite a chore to go in and make sure it is assigning everything correctly if you really want a good idea of what your spending is. If you use EveryDollar they have trends you can look at that you don't have to do any extra work to know they are correct.
  • It will track your investments, but doesn't have very much analysis around it.

Personal Capital

This is the app that I personally use. It has a great interface and has some great features that I haven't found on many other apps.

Pros:

  • It is also free to use.
  • It also has great trending tools to look at your spending.
  • It has a fantastic investment checkup tool that shows you what you are paying in fees. I haven't found this feature in any other free app.
  • Easily track net worth as you pay down debt and invest over time.
  • No ads whatsoever.

Cons:

  • Could do a little better with the trends.
  • Has a similar issue as with Mint above where it doesn't always categorize your expenses correctly.

Summary:

Both apps do a good job, in general, with tracking your net worth and investments. If you value the trending functions more that investment analysis then I would go with Mint. If you like the investment analysis more then I would go with Personal Capital. I have both Mint and Personal Capital and I almost always use Personal Capital. It just works better for me.


Creating Your Automated System

With budgeting, and most other financial things, automation is key. Having an automated system that requires minimal work month over month is the easiest and most effective way to reach your goals. I know this first hand. Before I found great budgeting apps like EveryDollar, I really struggled with budgeting. Some months I would do it and some months I wouldn't. I can tell you one thing, every month I didn't do a budget I always spent more and didn't get much for it. Also, you will find that you are much less stressed about your financial situation when you know the details and are managing them. So how do we create a automated system? Well I will show you step by step exactly how I manage my finances every month and how you can do the same. 

1) Set up your apps

First thing you need to do is get your apps set up to get the whole thing rolling. From the above list or from your own research find an app that works for you. Like I said, I personally use Personal Capital and EveryDollar Plus so that is what I will be talking about here. The basics will not change even if you are using different apps. Get your apps set up and get all of your accounts loaded in.

2) Determine your net worth

Once you get your apps loaded up, you need to make sure you gather your entire financial picture. Include all accounts and debt that you have. Your net worth is simply your cash (equity) minus your debts (liabilities). For many people this can be kind of scary at first, but realize that making this first step is the only way it is going to get any better. Financial problems don't just go away over time. They take work and you have to be intentional. Even if you don't have any debt right now it is good to have all your accounts in one place so you can quickly see where you are at.

3) Determine your fixed expenses and put them on AUTO-PAY

Now that we know where we are at we can set goals and start working towards them. First step in automating your life is making sure that all of your fixed expenses are paid on time automatically. Fixed expenses are things like rent/mortgage, utilities, debt payments (cars, etc.), and insurance. These are things that are usually paid all at once and happen at the same time each month. These are easy things to automate and make a huge difference. Most companies now offer automated bill pay through their own systems using a debit/credit card or a bank draft. I HIGHLY encourage you to set these up. Some things, however, still do not have this option. For these you can use the bill pay feature from whoever you bank with. I personally use Chase and use their bill pay feature to pay the minimums on my student loans (which are getting close to being paid off, I will post about that later). The way they work is pretty simple. First you will need to call whatever company you are trying to pay and ask them for a bank account number and zip code to set up auto-pay. Once you have that it is easy to set them up as a "payee" in your banks system. Then you can set up a reoccurring payment every month. Allow time for payments to process before their due date. For example if you have a bill that is due on the 15th of every month, set up the bill pay to go out on the 10th or 9th. That gives time for everything to go through so you don't have to pay late fees. Once you set everything up on autopay you will know that every month you don't have to worry about missing payments.

4) Set up the rest of your budget

Apart from your fixed expenses above, everything else can vary from month to month. This is where the budget and budgeting app comes in. If you set this up correctly this can be a simple and effective way to track where you are at any point during the month and plan for your goals. The hardest part of this is setting up the first budget. If you have never tracked your expenses before then it can be overwhelming to try to figure out how to start. Not to worry, that is where apps like Personal Capital and Mint come in. These apps, once you load your accounts, will automatically go in and categorize each transaction. Although it can take a little more work to check and make sure it does it correctly, it is an easy way to see what your spending habits are. I recommend you go back 3 months and find your average in each category. Once you do this, it is easy to set up your first budget. If you are using EveryDollar then you can go online and easily enter your income, your fixed expenses from above, and your 3 month averages. Here are a couple of very important things about setting up your first budget:

  • Make sure that ALL of your income is accounted and budgeted for. This is the most effective way to budget and forces your to plan your expenses. Trust me this is not as hard as it seems. If you find yourself where you have some money to save then just put the balance in savings. If you are spending more than you making then focus on simple ways to cut expenses so it can balance out.
  • Don't try to do too much cost cutting the first time you do your budget. For many people the first time they really look at the expenses it will be a bit shocking. I have no doubt you will find you are spending more than you thought on different things. A lot of times people will react and attempt to cut too deep the first budget and will bust it or get frustrated and give up. This is unfortunate. For the first time just focus on PLANNING not cost cutting. Once you get a grip on what you are spending and have your system in place it is easier to adjust.
  • Don't get discouraged if you bust your budget at the beginning. Many people who are new to budgeting often underestimate the time it takes to get used to managing your budget. They will go over the first month and get discouraged and just go back to doing whatever. I know because I have been there. Realize that is takes a solid 3 MONTHS to really get it down. Even for the most disciplined person. It's just the way it is.

Once you get your budget set up in whatever app your choose then start tracking your expenses. Hopefully you will see how easy it is to do.

5) Automate your saving and investing

This is HUGELY important. I would be willing to say that most people do not save consistently because they are relying on their own willpower to physically move money from checking to savings at the end of each month "if there is any left over". This is exactly opposite of what you should be doing. I know you have heard it 1000 times, but "paying yourself first" is the only way to do it. Having your savings automatically come out of your paycheck without you seeing it is the most underrated idea in all of personal finance. It is hard to really explain except for saying that in most cases if you don't see the money in your account you don't miss it. It is as simple as that. Once you have your budget set up from above you should know exactly how much you have to save and invest. It can be scary at first to not have this in your checking account "just in case", but trust me that idea is doing more harm than good. I personally have my savings account with Chase along with my checking. I automatically save each and every time I get paid. If I need to make a big purchase that month I can transfer over so it is not like the money is gone. It is just a different feeling when you don't see it in your checking account. Just like setting up bill pay it is insanely easy to set up automatic savings. Just have your account and routing numbers. Once you set it up it the bank will go through a verification process to make sure you are the account owner. At that point you will be able to set up your automatic transfer. It is similarly easy to set it up for an IRA, 401k, or any other investment account.

6) Plan for future purchases and goals

Once you have your automated system set up it is easy to see where you are going and how long to get there. Also, it gives you a clear path of what your money is doing at all times. You can now set realistic financial goals and know exactly what you have to do to reach them. Since it is all automated it won't take much work at all to keep everything on track and you can spend more time living your life! Whether it is a big trip you want to take or a down payment on your first home, it can all be within reach if you stick to your system.

Here is a diagram that explains how the system works:

As your income comes in you have already automated your saving and fixed expenses so those will just pay as they need to. From your checking account you can make all of your purchases and they will be tracked through the budget which is on one of your apps so it is very easy to manage.


Summary

Once you have your automated system set up you will see how much easier your financial life is. I have done it both manual and automated and I can tell you that automated is SO much more efficient and effective. I hope you find this guide easy to use and implement. What does your financial system look like? Let me know in the comments below. Next post we will talk about how to cut costs.

Tweaking The Simplest Investment Plan Ever

Last post we talked about the simplest investment plan on the planet: Buy the Vanguard Total Stock Market Index Fund (VTSAX) and continuously put money into it every month regardless of performance. That is it. That gives you a very easy way to buy a piece of the entire US stock market for very low fees. 

For some people, understandably, that sounds a little weird. If you go talk to anybody in the finance industry or any of your colleagues they will talk about all these different things they do and how they have certain percentages in different asset classes. This is called Asset Allocation. What I want to do in this article is give you some simple tweaks you can do to the simple investing plan above to make it a little more personalized for your goals.

Tweaks On The Funds

Above we chose the VTSAX for it's low fees and for the fact that it was designed to follow the US Stock market as a whole. We saw in the previous article that the long term rate of return for the total stock market (S&P 500) was around 7 to 10%.

This is a great return for only having to invest in one fund, but can we do some tweaks on this to get any better? The short answer is yes. Different sectors of the US stock market also have different returns and different levels of volatility. So let's look at some simple allocations that you can do just within the US stock market.

In general, the way it works is you can stand to get a greater average annual return if you invest in sectors with greater volatility. That is you can get a greater average return, but it will be a much bumpier ride. For example, small cap stock (stocks with market capitalizations of less than $2 billion) tend to have higher long term average returns than large cap (market caps greater than $10 billion) but they tend to be much more volatile. An easy tweak to make to our plan within the US stock market is to split it into different funds that index to different sectors. From the past post, I explained why I liked Vanguard for fund investing so I will list some good Vanguard funds here: the Vanguard Small Cap Index Admiral Shares (VSMAX) and the Vanguard Mid Cap Index Admiral Shares (VIMAX). Both of these follow the same idea as the VTSAX. They are both low fees (.09%) and both are index funds without the need of a money manager and their fees. A simple allocation would be 50% VTSAX, 25% VIMAX, and 25% VSMAX. You can also choose any other allocation that you feel is right for you. This would be a good time to consult a financial adviser to help with your personal situation.

Further Asset Allocation

If we take this a step further, we can diversify our investments in not only the class of stocks, but the class of asset. The idea around this is usually to lower the amount of volatility in your portfolio. This is used mostly in the retirement space. Let's say you are in your 50's and are looking to retire soon. Maybe they don't want to have too many bumps in their portfolio and want something a little more smooth (I will talk about the pitfalls of this train of thought later). They will then diversify into some more "stable" asset classes. There are four main asset classes: US stocks, bonds, real estate (REITs), and international stocks. The bonds are considered the "safest" asset class as they are mostly issued by AAA rated companies and the US treasury.  The likelihood of these two entities defaulting on their interest payments is fairly slim. Especially for the US government as all they need to do is print more money, but that is for a different time. Bonds, therefore, tend to have the lowest volatility and the lowest average return. What I want to do is show you some popular asset allocations along with their general returns. For reference, here is the results for a 100% stocks portfolio from 1926 to 2014:

  • Average Return: 10.2%
  • Best Year (1933): 54.2%
  • Worst Year (1931): -43.1%
  • Years With a Loss: 25 of 89

The Stock/Bond Split

This one is pretty simple. You have a certain percentage in stocks and the balance in bonds. This comes in flavors ranging from 60/40 to 80/20. Below are the numbers taken from Vanguard. Historical data is from 1926 to 2014:

60/40

  • Average Return: 8.8%
  • Best Year (1933): 36.7%
  • Worst Year (1931): -26.6%
  • Years With a Loss:  21 of 89

70/30

  • Average Return: 9.2%
  • Best Year (1933): 41.1%
  • Worst Year (1931): -30.7%
  • Years With a Loss: 22 of 89

80/20

  • Average Return: 9.6%
  • Best Year (1933): 45.4%
  • Worst Year (1931): -34.9%
  • Years With a Loss: 23 of 89

As you can see our previous thought holds true. The larger percentage of stocks in the portfolio the larger the average return, the larger the max/mins are, and the more years in loss thus more volatility.

The Bernstein Portfolio

Made popular by William Bernstein in his book The Intelligent Asset Allocator, Bernstein recommends a very simple breakdown for asset allocation: 25% US stocks, 25% Small Cap Stocks, 25% International Stocks, 25% bonds. In terms of Vanguard index funds this would be: 25% VTSAX, 25% VSMAX, 25% VTMGX, and 25% VBTLX. Here are the numbers below from Meb Faber's blog post. Historical returns are from 1973 to 2013 and are not indicative of the index funds I just mentioned specifically:

  • Average Return: 10.49%
  • Max Draw Down: -42.26%
  • Std Deviation: 12.65%
  • Percentage of Positive Months: 63.75%

So we see a slight improvement over the 80/20 above. Although this is over a different time period which did not include the great depression so I would wager that it would be damn close if you factor that in.

The Ivy Portfolio

To further give some more options we can look at what is called the Ivy Portfolio. This was a book written by Meb Faber which is who I am getting some of this data from. In this book he recommends 20% US Stock, 20% International Stock, 20% Bonds, 20% Commodities, and 20% Real Estate. Here is the performance of that portfolio again from 1973 to 2013:

  • Average Return: 9.92%
  • Max Draw Down: -46%
  • Std Deviation: 10.28%
  • Percentage of Positive Months: 67.08%

As you can see these results do not differ much from the above mixes. Next I will show you one on the other end of the complicated spectrum.

The Arnott Portfolio

This was written by Rob Arnott in this article on ETF.com. This represents one of the more complicated asset allocation models out there. Arnott splits his allocations into 10ths by putting 10% in each of the following asset classes:

  • US Stocks
  • Foreign Stocks
  • Emerging Market Bonds
  • TIPS
  • High Yield Bonds
  • US Govt Long Bonds
  • Unhedged Foreign Bonds
  • US Investment Grade Corporate Bonds
  • Commodities
  • REITs

The individual classes themselves are not too important if you don't know what some of them are. You can look them up if you are interested. Here is the performance:

  • Average Return: 10.13%
  • Max Draw Down: -32.5%
  • Std Deviation: 7.98%
  • Percentage of Positive Months: 69.79%

You can see that the average return is on par with the rest of the allocations. It does however offer a smaller standard deviation and a smaller max draw down so it might not be as volatile. Below is a summary table of the returns and the max draw down:

What Does It all Mean?

Here is the thing. People spend countless hours and entire careers on picking the perfect asset allocation. They worry about it all the time and you will see countless books and articles on it (as I am contributing to this number). In the end, all of these asset allocations performed pretty similar. Sure, some had a little higher return and some were a little more volatile but if you realize that the future is unpredictable and that just because something worked well in the past doesn't mean it will work well in the future then the certain asset allocation you choose is not very important. The important part is that you invest continuously over time no matter what. Whether you go with the simple plan of just VTSAX or a more insanely complicated allocation like the Arnott the most important factor will be that you stick to it. So the bottom line: don't worry yourself to death with what allocation to pick. Find something that makes you feel comfortable and just roll with it.

Cautions With Asset Allocation

It is not all gravy when it comes to asset allocation. There are a couple of things I want to caution you to think twice about.

First is the widely accepted thought process that as you get older you want to make your investments more conservative. On the surface this looks okay, but I think people tend to underestimate how much they will really need/want in retirement. Let's say you follow the general advice and go mostly into bonds as you near your fifties. You could see your returns drop to 6 or 7 percent. This may not be bad, but realize that life expediencies are getting longer and longer. It is not uncommon for people to live into their 70's and 80's. Missing out on 20 years of stock returns can mean the difference between in-home care or a medicare nursing home. If you are young like I am then by the time we are eligible for retirement the life expectancy is likely to be even better with advances in medicine. The point is that just because something is a little bumpy doesn't mean you should just abandon it when you are ready to retire. Investing doesn't stop when you retire. Personally, I don't plan on going more conservative over time although I may use other techniques to lower volatility that I will write about in the future.

Next I want to caution you on Target Funds or other investments that automatically alter your investments over time. I very strongly believe that you should ALWAYS have control over your investment choices and you should always personally understand why you are investing in what you are. Financial advisers can "advise" you on what to do, but ultimately it is you that pulls the trigger. The problem with them is two fold. First you need to take responsibility for your financial life. There will come a time when you will see a large draw down and lots of fear in the markets. If you understand why you chose what you did for investments then you are less likely to run when it gets tough. Second is there are some not so nice people in the financial markets. Time and time again you hear stories of people promising great things, taking your money, and then never to be heard from again. Don't be this person. Take responsibility and manage your own investments. It takes a few hours EACH YEAR if that when using these passive strategies.

Hope this helps you! Let me know if you have in questions in the comments section or feel free to email me at joshua.bird@younganalyticalmind.com.

Simplest Investment Plan On The Planet

So far we have talked about a lot of ideas that I think are really important to your financial life. Now one thing I believe is that learning the "theory" so to speak is incredible important, but the real value comes when you can turn it into a practical and actionable solution. That is what I intend to do here. This post will be some theory, but it will mostly be about setting up a solid investment plan that you can implement immediately and do better than the 85 to 95% of people who lose money in the market

First, you need to define what kind of investor you are.

Passive Vs. Enterprising Investor

This is an idea I am taking from Benjamin Graham's book "The Intelligent Investor". This is truly a must read for anyone who even wants to begin to go down the road of investment analysis. Ben splits investors into two groups. The first is the Passive Investor. The Passive Investor is one who really doesn't want to mess with their investments every day. They just want to put it in there and let it grow over time and focus on whatever it is they do in life. Now generally people have two thoughts about passive investing. It is either "OMG, that is exactly what I am looking for please tell me more!" or "Wow, how non intellectual is that. I am a math wiz and I can for sure do better on my own." If you are having some version of the second thought then you are probably what he classified as an Enterprising Investor. This is a person that is in love with the analysis. They want to run the spreadsheets every day and will consider annual reports as light spring reading. Deciding which type of investor you are is the first step in setting up a investment plan. So, are you a Passive Investor or an Enterprising Investor? Decide this now and write it down somewhere. Internalize it.

Expectations Of Each Type Of Investor

Now that you have decided what type of investor you are, we need to establish some parameters around what some realistic expectations are. 

Passive Investing

For passive investing the expectations are fairly easy to line out. Your goal is to pretty much match the market. Now what do I mean by "the market". The market is typically defined by the index called the S&P 500. It is a list of the 500 largest stocks on the New York Stock Exchange at any time based on the size of the company also known as the market capitalization. Your goal as a passive investor is to match the return this index, or another index that matches you portfolio mix, with a very low amount of fees and little work. A good number to use as an average return you can achieve over long periods of time is around 7 to 10% depending on the source you look at. Realize this is with little work. The set it and forget it type.

Enterprising Investor

Now you guys are a much bigger beast. Once we decide we want to get into the weeds there are an endless amount of "strategies" out there. The vast majority of them are bullshit. There are also some good ones. Think of being an enterprising investor as playing the most complicated game of chess ever imaginable with essentially an endless amount of variables. In this vast sea there is no one silver bullet. If anyone claims they have it then you need to run. Here are a couple of warnings I have for you. First, your return is not likely to be THAT much larger than that in passive investing. Some of the best investors on the planet have achieved a rate of return of around 20% to 30%.  Which is no doubt amazing, but you are not these people. I would say IF you are a successful enterprising investor (and that is the biggest if ever imaginable) you could stand to see average returns of 12 to 15%. These are the best of the best. Moreover you have a good chance of averaging a negative return which can be very devastating (See this post on market cycles). There are ways to lower this risk, but you must first understand that it is very possible to lose money (See this post on why humans suck at investing). The second thing is that good investing can take A LOT of time and a lot of money saved in order to have a diversified portfolio. You will essentially need to learn more about the businesses you invest in than you know about yourself. If you do it very well, you can stand to see that 12 to 15% return. If you just do well and not very well then you will probably match the passive investor's return with A LOT of time wasted. If you do average then you will lose money. So the question is "is the time you spend worth it to you". Your time is very valuable. I would say if you just love to analyze businesses and run calculations and look at financial ratios regardless of the money then it is probably for you. If you are doing it just for the money then it might not be. Your time might be better spent somewhere else.

Okay, so now you know what type of investor you are and you have some realistic expectations of what can come of each of them. Now we get to the meat. The rest of this post will be aimed at the passive investor, but you enterprising peeps should definitely take some notes.

The Simplest Investment Plan On The Planet

For the Passive Investors, this can be your playbook. This can be the one thing you can put your money into and leave it and stand to make a good return with little work. Are you ready? Here it is: buy the Vanguard Total Stock Market Index Fund (VTSAX) and invest in it continuously every month regardless of performance over time. Literally that is it. Now I can't just tell you this and not explain why. So let's dive in.

Why Vanguard?

First lets talk about why I like Vanguard (I am in no way affiliated with Vanguard other than I invest in their funds). One of the things I think is VERY important to think about when purchasing or paying attention to anything is to understand how that entity is paid and therefore what they are incentivized to do. Let's take this blog for example. At the time of this writing I currently have no products to sell. Therefore my goal is really to help as many people as I can. Since I have no ties to any other business I am effectively "selling" information for free. If I were to knowingly give people bad information, over time my reputation would be ruined and I would have less people follow and read my material. So I am incentivized to give you all the very best material and information I can find and bring as much value as I can to your lives. This is a good thing for you as my "customers" as I am incentivized to give you the best I can. So let's look at Vanguard. What is Vanguard incentivized to do for us? One of the main reasons I like Vanguard is that it has a very unique structure that sets it apart from any other competitor out there. The picture below explains it all.

This is taken directly from their website here

The typical fund management company is owned by third parties, either public or private stockholders, not by the funds it serves. These fund management companies have to charge fund investors fees that are high enough to generate profits for the companies' owners. In contrast, the Vanguard funds own the management company known as Vanguard—a unique arrangement that eliminates conflicting loyalties. Under its agreement with the funds, Vanguard must operate "at-cost"—it can charge the funds only enough to cover its cost of operations. No wonder Vanguard's average fund expense ratio in 2014 was 0.18%, less than one-fifth that of the 1.02% industry average. That means Vanguard fund investors keep more of any returns their funds earn.

Therefore Vanguard is incentivized to act in your interest rather than in the interest of the private or public shareholders as most publicly traded investment banks are. Try to look up what the stock price is for Vanguard as a company? You won't find it. In order to invest in Vanguard you simply buy its funds. It's investors and clients are one in the same. This unique structure is what is so brilliant about the creator of Vanguard, Jack Bogle. This is not to say that there is something wrong with a company like Fidelity. It's just that they may not be incentivized to do what is in the best interest for you. Like I said before, I am not an affiliate of Vanguard. I make no money off you investing in their funds personally. I do, however, personally have my retirement in Vanguard funds. 

Why This Fund?

Next let's talk about why I chose this fund. The VTSAX is an index fund that is designed to match the US stock market as a whole. So let's break that down. First why would I choose an index fund? That is fairly easy. When you look at the expense ratio on this fund it is .05%. The industry average for this category of fund is around 1%. That means every year, regardless of performance, the mutual fund will take 1% of your invested money to cover the cost of operations (and to cover the profit for it's company shareholders as we learned above). With this fund you pay .05%. So on $10,000 invested you pay... $5. For the cost of one Starbucks pumpkin spice latte per year you can own a piece of the entire US stock market. That is what I call a bargain.

The next, and probably more important question is, why the US total stock market? What you are effectively doing is betting that the US economy will prevail over the long term as it has done for the past 100 years or so. Let's look at some charts (these awesome charts are courtesy of FinanceAndInvestments.Blogspot.com):

What these are showing is the the annualized returns of the S&P 500 since 1926. I think the most practical information is the column to the far right. That is the 25 year annualized return from the year you are looking at back. Let's look at 2014. If in 1989 you were to invest in the S&P 500 through the 2000 and 2008 financial busts which are some of the worst in history, you would have averaged 9.62%. That is a damn good return for just setting something and forgetting it. Now if you look at the column on the left you can see that it was by no means a smooth ride. You must have the gaul to invest continuously no matter what. Also notice that in NO 25 year period did the market as a whole lose money. It is not until you get to the 10 year column that you start to see small losses. This is really good news for those long term investors and further proves that if you take a long term approach to investing you stand to gain.

Looking at all these returns we can say that we have a pretty good chance that the US economy will grow in the future. Also the stock market is what we call "self cleansing". Every year poorly run companies are thrown to the wayside as they go bankrupt and they are replaced by the new, up and coming companies that will create value for their customers. In order to lose money in the long term the US economy would need to take a deep nosedive for many, many years. My argument is that since the global economy is so dependent on the US economy that if this were to happen then your investment return would be the least of your worries. We would be under threat of a nuclear war or mass rebellion or many other bad things. So taking the long term bet on the whole US economy is a pretty good option for those looking for a low cost and simple investment over time.

Why Investing Continuously Over Time

Lastly, why do I say invest continuously over time no matter what the performance? This leads to something called Dollar Cost Averaging. So how does it work? Let's use an example. Let's say you have $1,000 every month that you can invest in general investment X. Currently the price of X is $10. For $1000 you can by 100 shares of investment X. Right after you put your $1000 in the price of X goes up by 10% to $11/share. You now have $1,100 and you are pretty happy! Now let's say the next month right before you put your money in the price drops by 30% to $7.70/share. You now have $770 in your account. A huge drop by any measure. Most people would see this as a scary situation and think "eh I will hold off for a bit and wait until the price comes back". So they hold off for a bit and the price comes back to $10 per share the next month and then they buy $2000 worth. Now they have 300 shares of X in their account and managed to avoid a loss and break even. Now let's say you took a different route. Let's say you didn't care about the price drop, you just have your $1000 per month on auto pilot and it just goes in. At a share price of $7.70 per share. That means your $1000 would have bought you about 130 shares. Now when the price comes back to $10/share you put in your other $1000 and now you are holding a total of 330 shares so you would have about $3300 in your account. A total gain of $300 over the other person who waited! Here is a summary chart:

So while they broke even during this time you actually MADE 10% and didn't have to do any work at all. This is known as Dollar Cost Averaging. What it does is effectively makes you buy more shares when the prices are low and buy less shares when the prices are high. This is buying low and selling high which is what you want to do as an investor! Obviously this is just an example where I have picked numbers. But this is the exact effect we saw in 2008. Those who invested continuously during the crash and out ended up making a great return after a couple years while those who simply waited it out didn't make anything or lost money.

Summary

So let's summarize what the take aways are. First, you need to decide what type of investor you are: passive or enterprising. Next I lay out the simplest investment plan every: buy the Vanguard Total Stock Market Index Fund (VTSAX) and invest in it continuously every month over time regardless of performance. I chose Vanguard because their unique structure that aligns your financial interests with theirs. I chose the index fund for it's ridiculously low expense ratio of .05% per year. I chose the overall US stock market because of it's past performance and overall importance to the total global economy; and I reccomend you invest continuously over time regardless of performance to take advantage of the dollar cost averaging effect. This can be done either inside of a retirement account such as a ROTH IRA or outside in taxable accounts. If you are doing it outside of your retirement then the minimum to invest is $10,000.

In later posts I will go into some things you can do to get some Asset Allocation going. I will also be going into more advanced investing techniques for you Enterprising Investors. Subscribe below to stay tuned and leave your feedback in the comments!

Resources

Pete the Planner - http://blog.petetheplanner.com/what-rate-of-return-should-you-expect-on-your-investments/#sthash.rETeZcuK.dpbs

About Vanguard - https://about.vanguard.com/what-sets-vanguard-apart/why-ownership-matters/

Jim Collins Blog - http://jlcollinsnh.com/2012/05/09/stocks-part-v-keeping-it-simple-considerations-and-tools/

 

You Need F-U Money

Let's talk about what we have learned so far. In The Calculation That Broke The Market we learned about how the credit cycle can cause most investors to buy high and sell low. We also discussed how we can short circuit the credit cycle by being contrarian and running our lives cash heavy to take advantage of the swings in credit. In Humans Are Hardwired To Suck At Investing we discussed cognitive biases that drive us to make horrible financial decisions. Everyone falls prey to them at one time or another. These two ideas are the foundation on which we can begin to design a system to optimize our finances. Now we will give ourselves a direction.

If you haven't read Stephen Covey's "7 Habits Of Highly Effective People" I suggest you buy it immediately. It is an all time classic. In the book Covey boils down years of research on highly successful people into 7 habits. The second one is "begin with the end in mind". For many young people this is easier said than done. The question "but what if I don't know where I want to end?" usually arises. I am not going to act like I have it figured out, but here is my two cents on it: having an end in mind, even if you aren't entirely sure if it is the correct one, is better than aimlessly going through life. Start off with a direction and move towards it. You may veer off in a slightly different direction over time than you thought, but it is unlikely that the direction you pick is the completely wrong one.

With investing, the same is true. The hallmark of a successful investor is one that has an end in mind and has a good grasp on what reality should look like. They plan their investments around a realistic idea that can be achieved over time. The recipe is simple and has been around for decades. It is often that people try to derive a different way and nevertheless fail miserably. I believe having the wrong expectation of investing gets many young people into more trouble than they can handle.

The Simple Formula

Investing comes down to this simple formula:

Future Value = Present Value * (1 + Interest Rate)^number of years invested

Many people will recognize this as the compound interest formula. Anyone with a knowledge of investing will know this formula by heart and could write it in their sleep. Yet most look at it as simply a tool to calculate something. In reality it is much more than that.

We will start from the left. First we have Future Value which is the end in which we are looking for. But in order to get a future value we first must have a Present Value. Investing is not some sort of magical, money printing scheme that will make you filthy rich overnight. It is a process that first requires you to already HAVE some money to begin with. Of course there is leverage, but we discussed that in a previous article. If we discount leverage then that means we must first be able to SAVE money in order to be able to participate in investing in the first place. Next we have what most people focus on which is Interest Rate. Next we have Number Of Years. Now since most people focus on the interest rate you would think that it has the most effect on the outcome, but it doesn't. I can't just say that though without looking at the numbers. Lets say we invest $1000 for 10 years at 10% per year. That would be $2593.74. Now what I did was vary each of the input individually by +/- 25% and graphed the differences. Here is the chart.

You can see that the number of years investing has the greatest impact on the outcome even if it isn't by much. 

What we can take away from this is that investing comes down to how much you put in, how long you keep it there, and how much you can earn. 

The Billionaire Path

Now that we understand a little more about the math of compound interest we can start to break down what a realistic goal of it is. Many people have a warped expectation of what investing can bring. We all hear different stories of a great investor who went into the market with $10,000 and came out with $10 million in 10 years. Let's look at the math of that. In order to do that you would need to average a 99.5% rate of return every year for 10 years. That sort of return is next to impossible for just two years in a row much less 10 years. So the question becomes is how did the Warren Buffets and Ray Dalios of the world get their billions? The answer is they were businessman. One of the only practical ways people can amass that much money in a lifetime is by owning and running highly profitable businesses. Warren Buffet owns a holdings company and Ray Dalio runs a very successful hedge fund. People like Mark Zuckerberg and Bill Gates are all very successful businessman. It is very rare that people will generate vast sums of money in a relatively short period of time solely by making great investment decisions. 

Many people go into the market thinking they can strike it rich off of their skill and wit. These people almost always end up blowing up at some point in their career and lose everything. Investing simply isn't the vehicle that will get you to that point. You need to create a successful business.

So What Can We Expect Then?

So if we can't amass huge fortunes and live in castles with investing then why even bother? Well the truth is investing is how we can create that builds on itself over long periods of time and eventually can amass huge fortunes. Christopher Columbus sailed over to the New World in 1492. Let's say Chris took one penny and placed it in an investment that paid 6% interest per year. And let’s say he instructed someone to take his interest payments every year and place it into a piggy bank from 1492 to 2014.  At the end of 522 years he would have a total of… 31 cents. Now let’s say instead he left that interest in that account and let it compound over that same 522 years. At the end he would have $162,054,713,810.29! Yes that is 162 BILLION dollars all from just one penny!

So investing is not about going into the market and making millions of dollars in a couple of years. It is about slow, steady growth of your savings over time. It is about continually saving and investing so that eventually you can become financially free.

The Math of Financial Freedom

So what is a realistic expectation? I believe a realistic goal for investing is to get what Jim Collins calls F#@k You Money. FU money is the amount of money you need invested to be able to cover your living expenses solely off of the interest that the money earns. Essentially that you can walk up to your boss and say "F#@k you!" and walk out and only work when you want to. Some people call this financial freedom, but I like my version better.

So the question is how do we get there? Let me show you how this works mathematically. Let's say your monthly expenses are $3000 per month. A good rule of thumb to use for draw rate on your FU money is about 4% per year. So you would need to have $900,000 invested. Now if you were able to save $1000 per month and able to earn 10% on your investment it would take about 22 years to save up. 

Now you might think that is too long and you want to get your FU money earlier. So here are a couple of points about this calculation. First, if you can lower your monthly expenses then you can decrease the amount of FU money you need. Second, if you can save more money per month then you can reach your amount sooner. Let's take the above example. You have a total of $4000 coming in every month, $3000 for expenses and $1000 saved. Now let's say you can lower your expenses by $500 per month and save that. Now you only need $2500 per month and can save $1500 per month. Your FU Money is now $750k and it will take you about 16 years. Now how could we save $500 of ongoing expenses per month? Well most people's car payment is about $500 per month. Here again we see that by eliminating fixed expenses, such as recurring debt payments on things, we can increase our savings and decrease our time it takes to get our FU money. I think you will find this graph very interesting: 

What this shows is how long it will take for you to get your FU money based on the percentage of income in which you save and invest. It assumes a 4% draw rate and an 8% investment return. The moral of the story is the more you save and invest the less time it will take for your to be able to walk out of your job.

If you are wanting to run the numbers for your own situation, fill out your email below and I will send you a FREE spreadsheet that is set up for you to tinker with. I know you numbers people can't resist a spreadsheet...

F#@k You Money Calculator

Name *
Name

Summing It All Up

So how do we put this all together. First, we need to make sure we have a realistic goal in mind when it comes to our investing. We know that the major components of our plan is how much we can save, how long we can save it, and how much we can earn on it. We also saw that investing alone is not going to make you insanely wealthy overnight. In fact, investing is a life long process and honestly it is usually very boring. We saw that a realistic investing goal is to become financially free and have our FU money. That is having enough money that we can cover our monthly expenses without a need to work for a paycheck. Our money works for us. We saw that the math of the FU money favors less fixed expenses and more monthly savings. Simply put the more you save and invest the less time it takes to get that FU money.

Now that we understand that our end goal is to be financially free we can begin to set up our system. In the next posts we will start to dive into that. Stay tuned!

Humans Are Hardwired To Suck At Investing

When I started to learn about finance I had the same thought. I could do engineering and learn all of the complicated math and science then why can't I figure out this investing stuff? It's just numbers and I know how to handle numbers. But when I started to really dive in I started to really understand that investing and finance is not just about numbers. It's about so much more. To demonstrate this I want to show you some interesting numbers (who would have thought).

You may have heard that most people lose money in the market. In fact, the vast majority of people lose money in the market. Depending on the source in which you look at, you will read that 90 to 95% of investors lose money in the market. There are many engineers and numbers people that are a part of this cohort. These are staggering numbers when most people first hear them! Many people in the investment industry set out to learn why this is. I think the principles in the post account for the vast majority of that statistic. Before we dive in I want to talk a little more about the difference between STEM and investing.

The Market Is Not Physics

As an engineer it is my job to use math and science as tools to create and design things for our benefit. This is because we have something which we can build a foundation from. The laws of nature never change. Whether we like it or not. Whether we are having a bad day. Whether it is "hard" to understand. Nature doesn't care. There are laws that you cannot break. Once we understand these laws we are able to design systems to use them to our advantage.

With the stock market these laws do not exist. There is no foundation in which we can build our complex formulas off of. There are a lot of numbers, but their foundation is ever changing. There is an entire field of investing called technical analysis that is about using very complicated math to try to guess what the market will do next. I can't say that I have done a whole lot of research on technical analysis, but I feel that the majority of it is finding shapes in the clouds.

Many engineers go into the market looking to capitalize on their analytical skills and make loads of money. Unfortunately many times they tend to neglect the emotional side of investing and end up losing loads of money. This is where we enter the world of behavioral investing...

Enter The World of Behavioral Investing

When this statistic first started to come out there were a lot of numbers oriented people scratching their heads. "But we optimized the trading algorithm how could this be?" Well this is where Daniel Kahneman enters the picture. In 1979 he published his paper "Prospect Theory: An Analysis of Decision Under Risk" which he evetually won the 2002 Nobel Prize In Economics for. This is the point in which the world of finance and psychology truly meshed into behavioral finance. Since then psychologists have made huge strides in understanding how we interact with our money when it comes to investing. Being a well rounded investor can not be accomplished without a real understanding of their work and the implications it has on our portfolios. One by one we will go through some common principles of behavioral finance. Knowing and respecting these ideas is the first step in limiting their effect on our investments. So without further ado let's dive in.

Overconfidence

This is more formally known at the illusory superiority bias. This one is fairly easy to demonstrate. Next time you are at a party ask everyone if they think they are an above average driver. Well, maybe that isn't good party conversation. Anyways you will generally find that the majority of people will say they are an above average driver. This study in 1981 found that 90% of Americans ranked themselves in the top 50% for driving skill. Now statistically this isn't possible within the same sample set. This same bias can be seen in many different areas. In one study done at the University of Nebraska they surveyed their faculty and found that 68% of faculty ranked themselves in the top 25% for teaching skill and 90% ranked themselves as above average. Do you think you will easily be able to help those professors teach better? Yeah probably not.

Another place that I personally see this is with financial literacy among people in their 20's and 30's. In a recent study released by NFCC (National Foundation of Credit Counseling) found that 92% of Americans are somewhat or very confident in their most recent big financial decision. Although 70% said that they are worried about their finances. This is a classic example of this bias. 

When it comes to investing this manifests itself in how we feel about our portfolio choices. We all feel that we are the ones that can beat the market and that we have it figured out. Another way that this manifests itself is in the frequency of trading. It is very well known that trading quickly rarely leads to higher returns. But making constant moves in the market makes us feel in control of our future. Unfortunately the market is an unforgiving place. This is only scratching the surface.

Loss Aversion

Another very strong concept in behavioral finance is loss aversion. This was the hallmark that Kahneman found and is formally know as "prospect theory" named after his 1979 paper mentioned above. Simply stated it is the idea that we feel more pain when taking a loss than when taking an equally sized gain. This leads us to do things which are irrational in order to avoid feeling the pain of loss. According to some studies it was shown that losses are twice as powerful as gains of the same amount. This manifests itself in investing when some people tend to sell their winning stocks a bit early to "take some profits" and others tend to hold their losers longer than they should in the hopes they will bounce back.

A simple way to avoid holding losers too long is to ask yourself this question "if I had the same amount of money in cash that I have invested in X would I buy it?" If the answer is yes then you hold. If the answer is no then you sell. All too often I see people holding things with such regret because they don't want to take the loss. Most of the time it only deepens the pain.

Sunk Cost Fallacy

This one is more of a manifestation of loss aversion. It is the idea that we are largely unable to ignore sunk costs when it comes to our analysis of a situation. Let's say for example you purchase a cruise that is non-refundable and you are unable to transfer the tickets. Before going on the cruise you learn that the cruise liner is notorious for having horrible food and all around not good experiences. Most people would choose to go on the cruise anyways because you had spent money on the tickets and booked vacation time and so on. If instead you had won the cruise by chance then most people would probably just skip it. This, however, is illogical. The money you have spent on the cruise is sunk cost meaning you can never get it back. Since you have no way of getting it back, it should not enter in your decision of whether you go on the cruise or not. It should be solely based on your interest. Therefore there should be no difference in the decision outcome between the case where you bought the tickets and the case where you won the tickets. Nevertheless, you see this all the time.

With investing you see this with people holding onto losing positions longer than it is logical to do so. Let's say you buy a stock and the next month it tanks due to underlying business issues. Most people will stick it out in the hopes of breaking even rather than taking the loss and putting that capital to better use elsewhere. Using the same mindset I explained above with loss aversion will help guard against this. If you wouldn't re-buy the stock at the current price then you shouldn't be holding it.

Gambler's Fallacy

When I was in community college I worked at a store in the mall that sold scratch off lottery tickets among a bunch of other things. Almost every day there was a guy that would come in and spend on average $80 on lotto tickets. He had all of these theories about which ones would be winners. He would ask me which ones were on a new roll or if there had been any big winners we knew of recently on a certain roll. Almost always he would lose money. This is a classic example of Gambler's Fallacy. It is the idea that the probability of an event is dependent upon the probability of another event. In my example, every time you buy a scratch off ticket your probability of winning is exactly the same no matter the circumstances. You see the same mentality with slot machines. Many people will post up on one machine for hours at a time believing that every pull is getting them one step closer to the jackpot. The reality is that every pull has the exact same probability of winning the jackpot as the one before due to it's programming.

This manifests itself in investing with the tendency for people to base their buy/sell decisions on an event that is not related to the situation. Have you ever heard someone hold a losing stock because "a company that big just CAN'T go bankrupt". Ever heard of Enron? The fact is ANYTHING can happen when it comes to the market. Look at the recent deal with Volkswagen's "clean diesel" scandal. A company that large wouldn't engage in outright fraud, right? Think again. To guard against this it is important to make sure all your decisions are based upon thorough analysis rather than whims or rumors.

The next four are really the Mac Daddy's of cognitive biases. 

Overreaction and Availability Bias

If you are a reader in the world of economics, you have no doubt heard about the heated debate of whether markets are "efficient" or not. Basically the efficient market hypothesis states that all the information about a stock is currently factored into the stock price and everything is completely rational. Therefore, bubbles cannot exist under this theory. But in reality bubbles appear and bust with great impact. In 1985 Richard Thaler published a paper called "Does The Market Overreact?" You have to remember, at that point in time the efficient market hypothesis was VERY widely accepted as truth so what they were proposing was essentially heresy on the financial gods. What they did was look at 3 years of past stock market data and compare what they called the "winners portfolio" which was the 35 highest performing stocks and the "losers portfolio" which was the 35 worst performing stocks. He then looked at the following 3 years and compared how the portfolios did compared to a representative index. In almost all cases the losers portfolio consistently outperformed the market while the winners portfolio consistently under performed the market. But how could this be?

What they were showing is how the market will overreact to the most recent information. Let's say a company happen to post good quarterly earnings compared to estimates. Most likely the stock will shoot up. Over the long term the investors will realize that the increase might not have been warranted and slowly it will tick back down. Conversely if a company were to post poor earnings the stock would lose. Over time the investors would realize that the loss was not warranted and it will tick back up. This is why we see that the losers portfolio consistently beat out the winners. This was also one of the first times we had hard proof that being a contrarian investor (that is doing essentially the opposite of the crowd) really pays off.

The availability bias accentuates the overreaction theory. This is the idea that we tend to put heavy weight on the most recent information and not as much on past information. This is why the market tends to overreact to short term news and rumors. This makes the short term variation in the stock market very erratic while the long term trends are much more calm.

To avoid availability bias it is important to keep everything in perspective. Following stock tips and short term news is a very easy thing to do and will make you seem like you know what is going on. In reality, it is usually bad for your investments.  Learning to take a long term approach to your investing is one of the hallmarks of the pros. The pros are there to profit from the amateur's short term fluctuations. It is the only way to consistently grow your wealth over time.

Confirmation and Hindsight Bias

I could ascribe almost all political/religious/any other heated debates to these two biases. Although I don't really get into those subjects here on this site. Confirmation bias is the tendency for people to look and weight information that supports their previously held beliefs while ignoring or discrediting the information that does not.

I think the best place to see confirmation bias is in the political field as I mentioned. There are so many news outlets that produce very one sided content and people grab a hold of this. When an event happens, they turn on the favorite news channel to hear about what opinions they should have while claiming the people who hold contrasting beliefs are "just idiots". I believe social media intensifies this as it is so easy for information to spread quickly. 

In investing this is particularly apparent in how people justify buying or selling stocks. If you bought because you had a strong positive feeling toward a stock then you will tend to seek out news which confirms your thoughts.

Hindsight bias is the belief that an event (after it has already happened) was entirely predictable. This is better known as "20/20 hindsight". You can hear it all the time with people saying things like "oh I saw that happening from a mile away" or saying that "they totally knew" the real estate bubble or oil crash or take you pick was going to happen. The fact of the matter is that it wasn't predictable or it wouldn't have been a shock. And if it was predictable then the people saying that should have just put their money where their mouth was and lock in a position to profit from it. The biggest danger from this is people can sometimes form thoughts that are far too oversimplified. If they then enact this strategy it could cause great loss in their portfolio.

These are quite tricky to overcome. The best way to guard against confirmation bias is to purposefully seek out contradicting information on any given event and to honestly analyze both side for their merits. Somewhere in between generally lies the answer/truth. For hindsight bias the best thing is to understand that people were operating on the best information they had at the time. Although this may not be entirely true it will help curve the tendency to be overconfident in your own abilities to predict the future.

How Do We Put This Together

First thing we need to do is understand that we have programmed tendencies that truly make us horrible investors and especially horrific in the short term. You need to realize that you too fall victim to these and there is no way to completely overcome them using only self control. If you think you have never been victim to any of these then you are a liar and you need to reread the overconfidence section. 

Realize that these biases are not mutually exclusive. I would say they are almost always found as a mixture of many. I think of a witches cauldron (maybe because it is close to Halloween) with a nice brew of different combinations that make up almost all of our decisions. Take some overconfidence and mix it with a hefty dose of confirmation bias and hindsight bias and you have a nasty brew that will cloud even the most disciplined investor's thoughts. Take a little sunk cost fallacy with a little gamblers fallacy and you have a brew to make anyone hold their losing stocks for years.

These are just the internal factors within your portfolio. Think about this in the context of the credit cycle. Think of if on top of all these biases you have debt that you took out to invest and you lost a job and so on. It only heightens the effect of these. Even with the greatest self discipline, when you are facing some truly scary situations you will default to human nature. That is why it is so important to know how our tendencies can affect us.

On a more positive note, understanding these and learning to have a deep respect for them is the first step in helping guard against them. Understand that making money with investing does not come down to how good you are with numbers or how fast you can solve complicated differential equations. It comes down to who can learn to master their emotional tendencies. Be weary of what everyone else is doing. Turn off your TVs and news channels. If you can learn to consistently be contrarian to the norm then it is likely you can reap the rewards over the long run.

In The Weeks To Come

In the next posts we will begin to break down how we can create our system to optimize our long term finances. Like process safety (getting to my chemE roots) first we try to design out what we can and then we will attempt to mitigate the rest. This along with the post on short circuiting the credit cycle are laying the foundation of principles which we can begin to build from. Make sure to subscribe to the email list below and like the page on Facebook to follow along!

Resources

Jim Collins Blog: http://jlcollinsnh.com/2012/04/25/stocks-part-iii-most-people-lose-money-in-the-market/

Investopedia: http://www.investopedia.com/university/behavioral_finance/

MorningStar: http://news.morningstar.com/classroom2/course.asp?docId=145104&page=1&CN=COM

Huge Database of Papers: http://www.behaviouralfinance.net/

The Little Book of Behavioral Investing By James Montier