Monday, May 31, 2010

Ignoring the Daily Market Report

You’ve heard the same dribble I have on the daily market report. The announcer breathlessly says something like, “The Dow surged higher today on news that same store sales increased one-tenth of one percent in the first quarter.”

Three weeks later the compiler of the statistic posts a correction and it turns out the minimal increase was in fact a decrease of one percent. No mention is made in the commentator’s daily report on the day of the change because the markets rose that day and the poor guy needs to find some reason “there were more buyers than sellers.”

Let’s tackle that one first. For every share someone wanted to buy, someone else wanted to sell. If at a given price more people would like to buy than sell, the price moves up until either potential buyers drop out (because it is now too expensive) or more sellers show up because of the higher price. This leads to the classic supply/demand curve:
As demand for the shares increases from Q1 to Q2, the price increases from P1 to P2, shifting the demand curve upwards from D1 to D2. Prices could also increase when supply decreases while demand remains constant. When stock prices fall it is either because demand decreased or supply increased.

The other thing to keep in mind is that 50% to 70% of the trading in stocks today is between two computers. Computers make decisions based on complicated algorithms designed by their masters. While it is possible the one-tenth of one percent same store sales increase is a component in an algorithm here or there, my guess is it’s not a big driver and certainly not the only one.

Assume the government releases the statistic at 9:00 am. By the time the markets open the algorithms have already reflected the new statistic, meaning the computer already knows whether it wants to buy or sell at the opening bell and at what price. What’s happening the rest of the day? At best the release of the statistic is like a stone tossed into a pond that generates a few ripples. After that, clear water. It certainly is not the driver of all purchases and sales.

At the end of the day the markets went up or went down. Unless the change has caused your portfolio to become unbalanced, do yourself a favor and ignore the market pundit.

~ Jim

Friday, May 28, 2010

Index Funds vs. Actively Managed Mutual Funds

Index Funds can’t do everything, but I am a fan of them and have 100% of my domestic stock portfolio in index funds and about 55% of my foreign stock portfolio in index funds. I do believe there are certain individuals who can do much better than index funds. If I knew for sure who they were, I’d give them my money.

My biggest problem with actively managed stock funds are the fees they charge. Some funds charge an upfront fee for taking your money. For example, if you buy less than $50,000 of Class A shares in Putnam mutual funds, they take 5.75% off the top. In order to match an index fund, the money manager must not only beat the index fund, the manager must make up this 5.75%. But hey, Aunt Matilda left you $250,000 and if you put it all in Putnam Class A shares, they’ll drop your upfront charge to only 2.50%. (A penny less and your charge is 3.5%. So much for the little guy getting a break.) [A quick note of self-disclosure: Some years ago, I worked for a subsidiary of Marsh McLennan, which at that time owned Putnam. Other than Marsh paying me a pension every month (and so I continue to wish them well) I have no relationship with either Marsh or Putnam.]

If you can choke down the upfront costs (or find managed funds without upfront charges) there are the ongoing fees, which are also higher than an index fund. Putnam’s Equity Income Fund (a semi-random example) charged 1.16% for a recent year for the Class A shares. For Class B and C shares where there is no initial sales charge (you could suffer a deferred sales charge if you sell the mutual fund shares too soon) the annual charge increased to 1.91%.

If you dumped the whole $250,000 in Vanguard’s Index 500 Admiral Fund your annual fee is .07%. Even if you didn’t have that much money, the maximum Vanguard would charge is .18%.

Putnam’s active manager must earn the annual difference in fees just to stay even.

Oh, but it’s even worse. The Vanguard fund must buy and sell from time to time. Their portfolio turnover for 2009 was 11.5%. Putnam’s reported turnover was over 100% for the Equity Index Fund. If the manager sells stocks at a net gain, you will have to pay capital gains tax. If they sell at a net loss you do not receive any immediate tax benefit. With over 100% turnover, you will be paying taxes much sooner than with lower turnover. The sooner you pay taxes the less money you have left to earn future investment returns.

You could say that the fund you’re thinking about has a great track record. Morningstar [] gives it five stars, meaning it did great in the past. Let’s do a little thought experiment about how you to could earn the coveted five stars.

This isn’t legal, so don’t try it at home! Start with 1,032 stock picking newsletters to go along with 1,032 new mutual funds. You make only one prediction in each newsletter. On half you say the market will go up more for the year than one-year treasuries will earn, and you should buy the market. The other half you say one-year treasuries will outperform the market. Each fund follows the advice of its newsletter. At the end of the year, 516 newsletters have 100% accuracy. The other 516 were wrong and you close those funds and newsletters down. (Merge the funds into the winners so you continue to handle the money.)

Next year do the same thing: 256 pick the stock market; 256 pick treasuries and at the end of the year you have 256 newsletters and funds that have correctly picked the market of two years in a row. Quietly merge the losers into the winners.

Continue this practice. After three years you have 128 newsletters and funds left. After four years you are down to 64. Five years: 32. Six years: 16 and those are starting to get some real attention from the media. Such a simple strategy, they say, but look at the results. Remarkable – a real skill! After seven years there are still eight left. By now your eight funds are superstars and money is flocking to them. After eight years there are still four; two after nine years and after the tenth year one remains.

Time to sell the one remaining fund to Putnam or one of their competitors and retire.

Okay. That particular thought experiment isn’t legal or even very practical, but the same thing is happening each year. Some investment managers guess right; others guess wrong. Those that guess wrong too often are fired. Keep guessing right and you get more money and attention and Morningstar stars.

With way more than 1,000 investment managers out there, after ten years and solely by random luck of the dice we would expect some managers to still have unblemished success. They are dubbed investment geniuses.

Does this mean I don’t think there are true investment geniuses? No, I believe there are. But I don’t know how to tell them from the ones who have been lucky, and neither do you. That, combined with the cost advantage of index funds, leads me to prefer index funds. So why don’t I have all my foreign stock investment in index funds?

In the US we have good transparency and efficiency in the markets. That’s not the same in all foreign markets. Because of that I think foreign investment managers can add value and are worth the costs. I choose managers with a wide diversification of stocks and I cross my fingers that they can avoid some real disasters along the way.

But I still hedge my bet (and that’s what it is) and invest roughly half my foreign stock holdings through index funds.

~ Jim

Wednesday, May 26, 2010

Risk in Buying Individual Stocks

I learned about stocks at my father’s knee. It’s hard to realize now when so many people have a stake in the stock markets that in the 1950s the percentage of households with direct or indirect stock ownership was much lower than it is today. With the advent of IRAs and 401(k) plans most working people indirectly own stocks. In 1950, individuals owned 91% of stocks; institutions (insurance companies, mutual funds, pension funds and the like) owned 9%. Now individuals own only about 30% of individual stocks with institutions owning the other 70%. As long as I have known my father, he has owned stocks – mostly individual stocks, although he does have mutual funds as well.

Let’s say you have some money to invest in stocks – we’ll say your great aunt Matilda dropped a quarter of a million bucks in your lap with the restriction that you had to invest it in stocks for the next ten years. She wants you to learn about equity investing and not so much about vacations in Aruba. After the ten years you are free to do with it as you wish.

There are two philosophies toward investing. We can summarize one as “don’t put all your eggs in one basket.” The other is “put your eggs in one basket and watch the basket very carefully.”

Every stock carries two kinds of risk: systematic risk and nonsystematic risk. Think of systematic risk as the rising tide that floats all boats (or the lowering tide that drops them all). As an individual, you can’t get rid of systematic risk, although you can hedge it to some extent. Lessening systematic risk is government’s responsibility – and as evidenced by the latest financial crisis they still do a miserable job.

Nonsystematic risks are the facts and circumstances unique to a particular company. For one company the CEO is a one-of-a-kind genius, and he lives to be a thriving ninety. For another the same type of genius dies the day after you buy the company’s stock. Or the company has an oil well disaster in the Gulf of Mexico. While an event such as an oil well disaster in the Gulf may affect the entire world economy (and therefore be a component of systematic risk), that risk is unique to companies who drill for oil. It is not a nonsystematic risk for everyone else.

Financial theory suggests you should be appropriately rewarded for taking systematic risk, but should not be rewarded for taking nonsystematic risk. Why? Because if you buy all the world’s stocks in the same proportion as their market value, you have essentially eliminated your nonsystematic risk. Therefore, to the extent it is possible to buy the world stock market, no one should be willing to pay you more to take on the risk of owning one particular company when you could own the world.

It doesn’t work quite like that. For example, you can't own a slice of privately held companies. Some foreign governments own corporations residing in their country, which leaves you and me out. There are, however, mutual funds that do a sufficiently good job purchasing a representative sample of the available securities around the world to essentially eliminate nonsystematic risk.

So why buy an individual stock rather than the world? Because you expect it to go up more than the world market. Why should that happen? Because you have a better understanding of the value of a company than the rest of the world (who through their purchases and sales have set the price for the stock.)

Now let me ask a question? How many hours a week do you spend researching individual stocks? And given that allocation of your time, how do you expect to outsmart people earning six and seven figure bonuses who work 60, 70, 80 or more hours a week doing this analysis?

Unless you know something the experts don’t because you have inside information (but not inside information that makes it illegal for you to buy the stock) you are placing a bet (not making an investment) that the stock market is wrong and you are right. I’m not a big fan of those odds.

Oh wait you don’t have to pick stocks by yourself. With your $250,000 a stock broker (slap my wrist, we call them financial advisors now) will be happy to make recommendations based on the work of their “proprietary” research staff. Stock brokers are salesmen – they may have initials after their names and talk a good spiel, but they only make money if you buy or sell something. They make more money when you frequently do both. And the research staff? Let me ask two questions: (1) If they’re so good, why are they not quadrillionaires? (2) When did they publish their findings and why hasn’t the rest of the market already followed their advice and bid the stock up to its fair value?

The chart below shows the results of a 1987 study on diversification. To diversify away a large portion of the nonsystematic risk, experts suggest you need to have at about 30 stocks in your portfolio, and you need to make sure to spread them around the various market segments. It takes a lot of time and a lot of smarts to do this well. Oh, and you need a lot of money to buy thirty different stocks.

I don’t have the smarts or the time to try to get rid of nonsystematic risk through individual securities. Nor do I think a financial advisor is the way to go. I let mutual funds do the work for me.

On Friday we’ll look at index versus actively managed mutual funds.

~ Jim

Monday, May 24, 2010

Buy Low, Sell High

Well sure, everyone wants to buy low and sell high. The question is how to know what’s high and what’s low. If you are expecting an answer to that question, you will be disappointed, but I do have a technique that has worked well for me over the years.

I rebalance my portfolio whenever it needs it. Each month I develop a balance sheet and I check to see how far out of whack my actual investment allocation is relative to my “ideal.” If there is a large enough difference, I sell whatever I have too much of and buy whatever I need more of.

How do imbalances occur? Either an asset class has risen more than others (not a bad problem to have), or has fallen more than others. Sometimes one asset class rises while another falls. However it happens, when a significant imbalance occurs, I rebalance by selling the one that has made relatively more money (which is selling high, more or less) and buying the laggard (buying low.)

I try to keep as much of my balancing in my tax-deferred accounts to avoid immediate capital gains taxes. I also hold down fees and expenses by utilizing mutual funds (mostly index funds) rather than individual stocks. On Wednesday I’ll explain my preference for mutual funds over individual stocks.

~ Jim

Friday, May 21, 2010

Personal Budgets, Part 2

Some people I know are paralyzed by not knowing how to go about constructing a budget. You have two large groups of items: money coming in (Income) and money going out (Expenses). Here’s the process that has worked for me.

First, I remind myself that any budget is an estimate, not a perfect prognosticator. Something will happen that I don’t anticipate. Medical expenses are always a variable. Some years I will only have my insurance payments; other years I need additional care. I try to estimate what I expect them to be on average.

I develop only as many categories as I am interested in understanding. Now, I’m a numbers guy, so I like more detail than most people and so have more categories. I suggest starting with a smaller number and increasing them if a category becomes too much of a catchall that it hides necessary information.

For Income, one broad category may be sufficient. However, if your income is variable, you may find it beneficial to track base pay, overtime, bonus and commissions (or whatever forms your compensation takes) separately. If investments are a major source of income, it may deserve its own category.

What Expense categories do I suggest? In alphabetical order:


You may want to split several of the categories. For example, if you eat out more than once in a blue moon, it probably makes sense to split Food between eating out and eating in. If you are interested in tracking the various components of housing you can have subcategories for utilities, mortgage or rent, insurance, repairs, etc.

If Miscellaneous is too big a percentage, find some subcategories that make sense for your spending.

Notice I listed Savings as an Expense. Savings isn’t a balancing item. Savings should reflect money you invest toward retirement or your children’s education. This includes 401(k) contributions, mutual funds you buy, stocks, bonds, CDs, etc. If you have the money sitting in a checking account that isn’t investing, it’s deferred spending. You haven’t committed to saving that money!

Put down your estimates for each category. If the Expenses add up to more than 100% of Income, you will need to adjust your expenses. Work on this until it feels right. Remember to reflect year specific events, like your daughter’s braces, or the special family reunion you’ve planned.

The best way to keep track of your expenses is to use a software package. There are lots of choices, I happen to use Quicken. My one suggestion is to get the inexpensive version, which will have all you need for budgets. If you decide later on to use the software to keep track of your investments, or make a will or toast your blueberry muffin, you can upgrade later.

Collect your receipts and add them to your software database as often as you can, but no less than once a week. It won’t take much time and they won’t build up to a huge task if you do it frequently.

Many people have trouble remembering what they spend cash on. Two approaches that work are to carry a pocket notebook to record your cash purchases (and then transfer them to you software) or use a debit card, so if you forget to record something your monthly statement from the bank captures them for you.

That should get you started.

~ Jim

Wednesday, May 19, 2010

Personal Budgets, Part 1

I’m a budgeter. My partner, Jan, is not. Her approach is to allow herself a certain amount of money a month and to spend no more. If an emergency car repair happens then something else has to be deferred a month. That approach would drive me crazy because I would never know exactly where I was going, only where I had been.

We aren’t the extremes – Jan at least knows how much money she has to spend and stays within her limits. My budgets have enough detail to suit my needs, but a CPA wouldn’t be impressed.

Budgeting should be a tool, not a shackle. It should provide guidance, not lock you into an immutable set of decisions. I worked hard to earn my money and it makes sense to me to make sure I don’t fritter it away through inattention.

If you think a budget makes some sense, but you’re not sure how to go about doing it, I’ll give you some suggestions on Friday.

If you are like Jan and think budgets are constraining and you believe you already know where you spend your money, I’d like to suggest you do this experiment for two months. Keep track of everything you spend money on, down to the penny. If at the end of two months when you total up what you spend on each category, if you are not surprised, then I will agree with you that you don’t need a budget—you have an internal mechanism that works for you.

I have some friends who, at the time they did this two-month experiment, were approaching retirement. They paid off their credit cards monthly, contributed to 401(k)s, even had money left over at the end of each month to save. But they weren’t quite sure where their money was going and before they committed to retiring, they thought they should know.

It turned out wine was a much larger percentage of their spending than they expected. Whenever they ate out, which was regularly, they each ordered a glass or two of wine. They had wine most evenings at home—and they weren’t drinking “Two Buck Chuck.” Could they afford the wine? Yes.

When they considered the importance of drinking wine as compared to other things they wanted to do (travel more was one), they realized they could easily cut their wine budget in half and get nearly the same enjoyment from wine and free up money for other things.

I’d be interested in hearing about any discoveries you make.

~ Jim

Monday, May 17, 2010

Quality Service – It shouldn’t be so hard.

I’ll defer talk about budgets in order to discuss three recent experiences I’ve had. I am like a migratory bird, spending half the year in the Upper Peninsula of Michigan and the other half of the year in Coastal Georgia. Late last week I completed my migration to the north.

We’re off the grid and centrally located between multiple cell-phone towers, none of which provides us coverage. For several years I have had satellite internet provided by a well-known provider. When I went south, I put the internet on a vacation plan. I called them up several days before my return to give them a date to restart service. Turns out they can’t take advanced orders for the change back; I would have to call the day I wanted the service resumed.

So that’s what I did. When I tried to access the internet late the day of my northern arrival, it was no go. My computer could find the modem fine; there was some problem between the dish and the modem.

I drove 14 miles (30+ minutes) to where I can get cell coverage and reported the problem. It took several tries before the online technician (who based on her accent was probably in India) understood that I could not connect my computer to the modem and talk with her on the phone at the same time. She ran tests at her end, told me the problem was fixed and that if it didn’t immediately work to unplug the modem for 30 seconds, replug it and I would be good to go.

Not correct. Still no connection.

The next morning a provider to install satellite TV arrived on time for the scheduled appointment. He installed a new dish, gave me a new receiver, got to the point where he had to call the 1-800 number to activate the account and was stymied by the lack of cell phone coverage. Now I had anticipated this problem and emphasized that concern when I placed the order. The order taker said she understood and because of the lack of phone service she took me through my package choices and I determined what I wanted ahead of the installation.

The installer’s solution to the lack of phone service was to drive to his next appointment, promising to activate my account once he returned to cell phone coverage. Once he activated it, I’d have a couple of screens to click through and voilá – I’d be getting a picture.


An error message appeared. I tried rebooting the system and arrived at the screen requesting that I call the 1-800 number to activate the account.

So 14 miles and 35 minutes later I called each of these providers.

The satellite internet technician on the phone decided there was nothing they could do; they’d have to send a physical technician out. They would charge me for time and expenses. Keep in mind: The connection worked before they turned it off. It didn’t work when they were supposed to turn it on. I had all the same equipment, including the same laptop.

Oh, and I’d have to wait at least 24 hours to call back and be told a number I would then have to call to arrange an appointment.

The TV folks claimed I had made arrangements through a 3rd party, not through them (despite having their account number and installation number). The technician on the phone could do nothing. On a second call, when I reported the everyone-pointing-fingers-at-one-another scenario, she put me on hold while she talked with her supervisor. Finally, they said they would call me back within an hour to have a technician return to finish the installation.

An hour later no call; and I had to leave because my plumber had already passed me by (see third story below.) So I called the TV folks again to give them my partner’s phone number (she was driving north that day and would have cell coverage for several more hours.) All the TV phone guy could do was change the phone number attached to the contract; he had no access to the information from my previous call.

Now my plumber, Scott Oberlin, provided a different level of service. When I first called him to set up the appointment to reinstall the water softener we use to diminish the effect of iron ores in our well-water, he indicated he would either be out Friday, if his other work permitted, or first thing Saturday morning.

After I made my first call to the internet folks, I also called Scott to let him know I had screwed up draining the water last fall and had a leak in a ¾” ball valve, which I hoped he could fix. I left a message and crossed my fingers.

With my second trip out the next day, I called Scott to confirm that my message was understandable (a plumber I am not) and find out when I might expect him. He had gotten the message, had the part he would need and he expected to arrive early afternoon, unless his boss gave him another in-town assignment. Ten minutes later he called back—he would be delayed, an emergency call had just come in, but he’d be out by late afternoon.

In fact the emergency didn’t take as long as he expected and so he was ahead of schedule. He stopped when he saw my car parked at the side of the road (“This your phone booth?” he asked.) I gave him keys to the house while I was waiting for the return call that didn’t arrive from the TV people. When I got home he was mostly done with the work.

The differences? Scott never overpromised. From the beginning he knew his Friday schedule was not under his control. He hoped to get to me that day, but if he couldn’t, it would be first thing Saturday morning. When his plans changed, he immediately contacted me. He’ll get my business again.

We’ll see what happens with the internet and TV people. I want their services, but they both have competitors who might be more interested in servicing me. I’ll let you know how this works out.

~ Jim

Friday, May 14, 2010

The Worst Insurance Gap?

In Monday’s post I talked about how many people have the wrong amount of life insurance – either too much or too little. Today I want to suggest that many people are woefully underinsured for disability benefits.

There are two major differences between the risk of dying and the risk of becoming disabled. First, when you die (once your estate pays your funeral expenses, etc.) you have no ongoing costs. When you are disabled, your living expenses continue and may even increase. Second, life insurance pays in one lump sum, whereas disability insurance pays monthly benefits for the duration of your disability (often subject to a number of years or age limitation).

Terms in bold are defined after the main post. Let’s start with those who have a group disability policy sponsored by their employer. Upon total and permanent disability such policies typically provide 50-60% of your pay once the elimination period is satisfied. If you get benefits from any other source, they offset your group disability policy benefits. For example, if you qualify for Social Security disability benefits, that amount is subtracted from the benefits paid from the group policy. Also, if you are injured and successfully sue someone, your group benefits may be adjusted to reflect payments you receive as a result of the suit.

So where are the gaps?

First gap – the elimination period. Usually long-term disability (LTD) policies require you to be disabled for six months. Many companies have short-term disability policies to cover the elimination period. However, other companies force you to rely on sick time and your vacation, which for most of us won’t come close to lasting six months. Unless you cover this gap, you may have your own “donut-hole” for disability.

Second gap – Once you qualify for disability benefits your income declines by 40-50%, but your expenses do not decline nearly as much. Sure, while you’re on disability you’ll receive most of your benefits tax free, you no longer have Social Security taxes withheld and you can eliminate job-related expenses. Conversely, other expenses may increase because of your disability, such as co-pays for medical insurance. The net result is usually an overall decrease in expenses, but not enough to match the 40-50% decrease in income.

Third gap – your benefit is frozen. If you qualify for Social Security benefits, they will increase over time to reflect changes in the CPI; but benefits from a group LTD policy are not adjusted for cost-of-living increases. If you earned $60,000 when you became disabled and the benefit is 60%, you’ll receive $36,000. If you are 35 when you became disabled, even at a modest inflation rate of 2% per year, thirty years later that $36,000 has a buying value in today’s dollars of less than $20,000. The result is you must life on income equivalent to only a third of what you were earning.

Fourth gap – Many policies reflect on the base pay portion of your compensation. If you receive overtime, shift differential, bonuses and sometimes commissions, they may not be included in the definition of compensation, in which case the 60% benefit is not of your total income, but 60% of part of your income.

Fifth gap – The definition of total and permanent disability may exclude your situation. Many policies initially define total and permanent disability as the inability to physically or mentally perform the job you were in. Under many policies the definition tightens after two years, so to remain disabled you must be incapable of performing ANY job. Depending on the policy, your benefits might stop or decrease to reflect earnings differences between your old job and one you are now able to do.

Sixth gap –Group LTD benefits usually stop at age 65. Social Security disability benefits continue, but unless you had enough squirreled away when you became disabled to support yourself after age 65 (and that seems unlikely), you’ll need to keep saving during your disability. How are you going to do that when your income has been substantially cut?

These six gaps were based on the assumption you participated in an employer-provided LTD plan. If you’re not covered by a group LTD plan, Social Security may be your sole coverage unless you purchase private insurance.

If you do have a group LTD policy, now would be a good time to find out what benefits you actually have. It’s too late to check the small print when you’ve already fallen off the ladder putting Santa on the roof next winter.

You can find disability calculators on the internet to help you determine the size of your gap, but to use them you need a good idea of your expenses.

Next up: Pros and Cons of a budget.

~ Jim


CPI: Consumer Price Index – the catch-all name for a series of indices that attempt to measure the changing cost of a basket of consumer items.

Elimination Period: The period of time between the onset of the disability and when benefits start. Policies have elimination periods for two reasons. Many employers provide different (sometimes greater, sometimes lesser) benefits for short-term disability. The elimination period prevents duplication. Also, most disabilities don’t last a long time, and using an elimination period substantially decreases the cost of the policy.

LTD: Long-term disability. (See Total and Permanent Disability definition below.)

Total and Permanent Disability: The disability policy will define this or some similar term. It is very important to understand what is covered. Some policies require you to be unable to perform the normal duties of ANY occupation in order to meet this definition.

Wednesday, May 12, 2010

Types of Life Insurance

In the previous article I suggested most of us have the wrong amount of life insurance. That said, many of us may have the wrong kind as well. Currently you can buy four major types of life insurance: Term Life, Whole Life, Universal Life and Variable Life. They are not totally separate species so they interbreed and produce subspecies like Universal Variable Life.

Term Life     This is the pure insurance form. For a specific number of years (the term) you pay a specific dollar amount to purchase a specific face amount of life insurance. If you pay your premiums and you die during the period, the insurance company pays the full face amount. Terms can be as short as one year and as long as twenty. During the term period the life insurance company can’t cancel the policy or raise their rates, even if you are on death’s door. Each year we age, life insurance becomes more expensive because more people in our age-cohort are expected to die. Consequently, whenever the term is greater than one year, the rate you pay is an average rate to cover the whole term. You pay a bit too much in the early years and are getting a break in later years. On average the insurance company is still making money.

Whole Life     Think of this as term insurance that lasts your “whole life.” AS with term insurance, for whole life policies the insurance company can’t cancel the policy as long as you continue to pay premiums on time, it pays off whenever you die and your premium remains constant.

Because the premium will last your whole life (usually they stop when you reach a defined age, like 100) the amount you pay in the early years far exceeds the cost of pure insurance. To make that attractive, the policy calls for investment of the “excess” premium in a Cash Value Account. The cash value account grows, often based on arcane formulae related to the insurance company’s investment earnings and typically has a low minimum guaranteed interest rate. Over time, the policy may pay dividends that you can apply to reduce the premium or (preferably from the insurance company’s standpoint) increase the amount of life insurance.

Starting to get confusing right? Whole Life is a combination of Term Life and an investment product. Depending on interest rates, tax policy, and a host of other characteristics it can be a good investment or a bad investment, but it is important to realize it is an investment. Life insurance companies understand this and they pay their brokers a lot more commission to sell you a Whole Life policy than a Term Life Policy.

Universal Life     Think of Universal Life as a life insurance policy with the extra advantage that you can make additional contributions to the Cash Value Account, which will earn market interest rates based on the insurance company’s investments in bonds and (often) mortgages. You can apply returns on the Cash Value Account to reducing future premiums, building up extra cash values or purchasing additional insurance.

As you can see, this product moves farther away from pure insurance and more toward an investment. Under current law, tax advantages are available, but periodically as Congress looks for ways to cut deficits, these tax “loopholes” come under fire.

Variable Life     For the first three types of life insurance, the amount of insurance remained fixed, unless you use policy dividends to purchase additional insurance. Variable life changes that dynamic. You pay premiums that are invested in investment vehicles you choose from a selection that includes stocks and bonds. Your Cash Value Account can decrease as well as increase and the amount of life insurance you have in effect depends on the value of the account. This product is mostly an investment tail wagging the life insurance dog.

What else?

Oh gosh, I haven’t touched on the ability to borrow from your Cash Value Account and the myriad ways that affects your death benefit, or future premiums, or how some policies allow you to automatically increase coverage at certain periods in time and … There is nothing simple about life insurance products once you move away from Term Life. That’s how insurance companies try to differentiate themselves and brokers justify their commissions. If everything were transparent insurance companies would have to cut their profits to compete on costs and service. Well, that’s a rant for another day.

From the previous post we saw that our insurance needs do not remain constant over our lifetimes. Only by great luck will one policy be a good fit all of your life. Many people end up cancelling their Whole Life or Universal Life or Variable Life policy because they don’t meet their needs. This is an expensive proposition because you’ve paid your insurance broker much of his commission from the first years’ premiums.

If you need life insurance, buy term. If you want investments, choose the best one. Sometimes, because of tax advantages, an insurance product may be the best investment vehicle. Sometimes. My money is mostly sitting in mutual fund companies.

As you can guess, your local insurance broker isn't sponsoring this blog.

~ Jim

Monday, May 10, 2010

How Much Life Insurance?

I would be willing to bet that most people either have too much or too little life insurance. Before you read this post, what’s your gut feeling about the level of your life insurance?

I also want to note that I don’t sell insurance, am not affiliated with any organization that does, and frankly couldn’t care less who you buy insurance from. I’m only interested in helping you understand how to determine the right amount.

Term Life insurance (the pure form, not with some accidental death and dismemberment benefit and not where you are investing in the policy by paying more than for pure insurance) only pays off if you die. Life is a binary proposition. You are either alive or you are dead. (Again, we’ll ignore the missing person cases where things are in limbo for a few years.)

Here’s the thing: actuaries (and I used to be one of them) are pretty adept at estimating what percentage of a large group of people will die at each age. What they can’t do is tell which ones. (Although there is a rumor some Sicilian actuaries have the inside track – it’s a joke—pause for groans.)

Dying, however, is not necessarily a financial risk.

I am an example of someone who does not need life insurance. I have sufficient assets to cover all my debts and take care of funeral related expenses. My children are grown and no one is counting on me for their living expenses, or college education. (At least they shouldn’t be.) In fact, some charitable organizations would benefit from my death.

I could purchase life insurance to increase the size of my estate, but if I do, I’m not buying insurance; I’m buying future gifts for my favorite people or charities. I’m making a choice to invest in a bet on when I die rather than give them the money directly for them to invest. That’s not eliminating any financial risks of my untimely death.

When I first started working, I was in a similar position regarding life insurance to where I am now. The modest life insurance policy I got as a benefit from my employer more than covered my obligations. However, as soon as I had my first child everything changed. With that blessed event, my death was no longer just my bad fortune. My death would eliminate a future income stream that I expected to use to take care of my child through college and take care of my wife during the time she couldn’t earn full wages because she was taking care of our child. The ante increased with child number two.

I think at that time my employer-provided policy was three times my pay. It was woefully inadequate. To do a quick estimate of how much life insurance you might need, figure out a year’s worth of living expenses for all your dependents. Multiply that by the number of years you need to support your dependents and then add on college expenses (if you were planning on paying for them), credit card debt, student loans, etc. (not your mortgage payment because that should be part of your annual support number.)

Fancy Dan investment folks will want to develop present value numbers that recognize the time value of money and future cost increases and all kinds of stuff to make your head spin.

This isn’t an exact science and the method I’m suggesting implicitly assumes your dependents can invest the money to earn the same rate costs will increase in the future.

Here’s a simplified example:

Alice and Joe have two children, ages 8 and 6. They both work and each earns $40,000 per year. After taxes and savings they spend $60,000 per year or $30,000 from each paycheck. If either of them dies, they want the surviving family members to maintain their same lifestyle.

It will be 10 years before child 1 is out of the house and each year the family will be $30,000 short, for a total of $300,000. The second child will be in the house an extra 2 years at (say) $6,000 a year. (An extra $12,000). You want each child to attend college and you’d like for them not to have to take student loans since you won’t be there to help them out afterward. If you die, private college may be out; but even at a decent public college, tuition, room and board, a car, books, fees, etc. adds up to a bundle. You figure $20,000 per year (so $10,000 for each parent) for eight years (Totals $80,000).

Grand total = $392,000. Put another way, each parent should be carrying insurance of almost ten times their gross pay.

What other things might you consider in determining the life-style risk? If the surviving parent will have to cut back on employment to take care of children, life insurance will have to pick up the slack. You may be subsidizing elderly parents and need life insurance to cover that need.

You know your personal situation better than I. The good news is that pure term insurance, guaranteed renewable for 10 or 15 years is very affordable. A 35-year old healthy male can get a $500,000 policy for a little over $20/mo.

The internet has lots of calculators to help you define how much insurance you need, and can also be used to price insurance. I suggest you go explore them. Maybe in a future post I’ll check a bunch of them out and let you know which ones I like.

So, do you have the right amount of life insurance?

Next up, different kinds of Life Insurance.

~ Jim

Friday, May 7, 2010

Understanding Personal Financial Risk

Another word for risk is uncertainty. Financial folks often talk about “risky assets.” By that they mean assets that do not come with a guaranteed return. If you dive into investment textbooks you can find formulae to measure risk based on volatility of returns, standard deviation of returns, variance of returns, ratios of those statistics relative to expected return and so on and so forth. Lots of measures but they all have to do with how uncertain the return is.

For individuals all the mathematical equations in the world miss a very large point about real risk. You are only one person, and you only get one result, not a array of possible results.

Let’s take a simple example of what I mean by real risk. You are contemplating investing in a stock that in one year will be worth either $0 or 1,000 times as much as it is today with a return of your investment to boot. There is a 50/50 chance of each result and to make this bet you have to put up everything you own, but no more than $10 million. A math guy would tell you that your expected rate of return is 500%.

I don’t know about you, but I’m not worth $10 million, so I would be investing everything I had. I’m retired and if I lost it all, I would be in very deep trouble. You could change the 1,000 multiplier to 10,000 or even 1,000,000 and I still could not afford to take the gamble. It is too risky for me because if I lose I’m wiped out and do not have a viable way to recover any semblance of a decent standard of living.

Bill Gates, however, could hop on this investment with little thought (other than to make sure the deal is really as represented.) While he wouldn’t want to lose $10 million, the loss is less than .02% of his reported assets1 — a drop in the bucket. If you are rich enough that you can easily afford a $10 million loss, this is a great deal.

If I were 23 years-old again with most of my working years in the future, I’d make that bet in a heartbeat. Sure, I only had a net worth of a few thousand bucks, but at that age I’d gladly risk all of it (say $5,000) to earn $2,500,000.

When we look at financial risk as an individual, we can’t just look at it as a financial wonk would. We have to consider what it means to us if the investment pays off and what happens if it doesn’t.

In the next few posts we’ll consider some specific aspects where this perspective is helpful in making personal financial decisions.

~ Jim

1 Forbes Magazine 2010

Wednesday, May 5, 2010

Fixed Costs and the Not-for-Profit

Most not-for-profit organizations (not to be confused with not profitable organizations) rely on three sources of funding: endowment income, corporate contributions and individual contributions.

To focus on the fixed costs aspect of this topic, let’s say the organization is a church with no endowment. It won’t receive corporate contributions, and so it must rely on individual contributions (and a few fund raisers) for its income.

And just for fun, let’s say a generous member decides to make a one-time gift of $20,000.

What could the church do with such a gift?

They could start an endowment fund, not touch the principal and use the income from the fund each year. They could pay off a chunk of the mortgage on the church building, or remodel the church kitchen. The uses are endless, but I’ll bet large amounts of money that among the alternatives, a great groundswell will arise for using the money to pay staff. The proposal might take the form of increasing staff wages or benefits; it might instead focus on increasing hours worked.

Staff salaries aren’t exactly fixed costs. Salaries and benefits can be reduced. Staff positions can be eliminated or have their hours cut back. Salaries in particular are referred to by economists as “sticky downward.” That is to say, there exists a great reluctance to reduce nominal salaries. When times are good salaries go up, but when times are bad they do not go down as quickly. Given bad enough and long enough times, salaries will decline.

Back to our $20,000 largess. Let’s say we’re in a more reasonable interest rate environment than today and can expect to safely earn 5% on our money. The $20,000 will spin off $1,000 a year. The church could afford to increase salary and benefits by $1,000 bucks because that’s the income the $20,000 will generate each year. Income and Expenses would increase by the same amount.

Big whoop. This won’t satisfy anyone.

However, applying any greater amount of the one-time largess to the sticky downward costs of employee compensation means the church is eating into the $20,000, and at some point the well will run dry. When it does, the church needs to find a new source of funding or enter a painful (and often hurtful) process of cutting compensation and/or hours.

In a church that is growing and needs additional staffing to help it grow, it could be reasonable to spread the $20,000 out over (say) four years. This method implicitly challenges those who are getting the additional compensation to add enough value to the church that at the end of the four years congregants will in the course of normal business be kicking in an extra $5,000 to keep the higher staffing levels. However, if that is the case, it is important to not take increased contributions as they come in and apply them to something else.

If they do apply increases in contributions in years 1-3 to something else, they’ll find themselves in the same position I did in 1984 with my fixed costs rising substantially through a number of individually reasonable decisions. [See: earlier post ] In the church example, at the end of four years the $20,000 is gone, and for the next year they need to replace $5,000 of income.

This scenario crops up a lot in churches under various guises. Sometime it is a one-time unrestricted contribution as in the scenario just discussed. Sometimes it’s a surplus from a previous year. Sometimes it is money pledged to match increased contributions.

The last case is a bit trickier. The assumption is that when parishioners increase their pledges because of a special match, they will maintain the new, higher level of giving in the future. For many people that is the case (contributions are somewhat sticky downward) and so applying those higher pledges to increased fixed costs can be (mostly) justified.

However, the generous match is a one-time offer and churches should treat it as such—at least that’s my opinion. What’s yours?

P.S. Happy birthday to my dog, who turns 10 today.

Monday, May 3, 2010

Fixed Costs and the Housing Market

In 1987 the privately held company I worked for sold out to a much larger corporate competitor. I was in a mid-level position and required to own a certain level of stock. I voted against the acquisition. I thought I would have more opportunity with the smaller company where I had been promised a particular higher position a year hence.

Didn’t matter, the old guys (and it was almost entirely guys back then) had the shares and they voted their wallets and we sold out. (Oh, they officially called it a merger—they usually do—but when one side controls all the subsequent decisions, it’s a merger in name only.)

The good news was that I made a hefty profit on my stock, and didn’t have to maintain any level of ownership in the acquiring company. As a result I had some free cash.

Interest rates were high (in the 9-10% range), the stock market had been on a tear and one of my friends and I decided the best thing we could do with some of the money was pay off our mortgages. Not everyone agreed. We had another co-worker and friend who thought the best approach was to use the stock sale windfall to trade up in houses. He figured he'd use the money as a down payment, combine that with the profit he had in his house (the housing market was booming then) and get a really big, expensive house.

His analysis showed that he could afford the mortgage, with the additional down payment, it would only increase 25% from current levels, and with raises and expected bonuses he could cover the increase.

But, he didn’t think about (1) the additional real estate taxes (2) the increase in property insurance costs (3) additional maintenance costs that come with a bigger house, and (4) the house he wanted was farther away from work, so his commuting costs and time would both increase.

Lastly, he would have no cushion. If the business had a bad year and bonuses declined he was in trouble—and our business was cyclical.

During that whole time I joked with my finically conservative friend that if I took on that much risk, I couldn’t sleep. He said, if our other friend took on that much risk, he couldn’t sleep.

Given that, we sat our friend down and talked him out of his proposed house purchase. Back in 1987 our friend was “out there” on the risk frontier.

Twenty years later, huge portions of the United States shared his risk tolerance and we narrowly avoided a depression as a result.

~ Jim