Lightbulbs and Lattes

Sometimes we confuse the number of visible acts we make working at something with the progress we actually make towards our goal. Let me explain what I mean with a story about what our leaders in Washington have been up to.

Did you know that Congress voted to ban the familiar incandescent light bulb? More than a year ago? It’s true. Starting in 2012, no more 100 watt bulbs and by 2014 none of any wattage. Clever of them to pass something that doesn’t take effect for 5+ years. The small number of folks who really care are happy, and everybody else won’t even notice until after what must seem like an eternity to the guys inside the beltway.

And people will notice. Although the law does not, strictly speaking, ban the incandescent bulb, it only mandates energy efficiency standards that amount to a ban, the bottom line is that consumers will have to replace the familiar old bulbs with compact fluorescents. And earnest green hype aside, CFLs are not the same. The light they give off is a little bluer, they cost about six times as much (twenty times as much if you want to use a dimmer switch) won’t fit in all existing fixtures, and, let’s face it, look dumb. Oh, and also they contain mercury so are bona fide toxic waste. Not only can’t you recycle them, putting them in the trash is illegal in many places.

So what’s the benefit for this inconvenience? Why, we reduce greenhouse gas emissions, of course! By how much, you ask? Good question. For that I will have to do actual research, as none of the news articles seem to cover that. According to the EPA, burning fossil fuels to generate electricity accounts for 38.9% of CO2 emissions in the US. And according to the Energy Information Administration (which is a real government agency, even though it sounds like I made it up) residential use of electricity is 37% of the total, so 14.4% of CO2 is due to the electricity we use in our houses. And how much of electricity used at home is for lighting? Only 8.8%. To put that in perspective, 13.7% goes to the kitchen refrigerator. 3.5% is for stand-alone freezers. The total percentage of our national CO2 output due to household lighting is 1.27%.

And how much of this 1.27% will we eliminate by doing away with Edison’s greatest work? That’s not so clear. But let’s get real, even cutting it in half isn’t going to move the CO2 needle much. Banning stand-alone freezers would probably be just as effective and much less annoying. There is even the argument to be made, which I don’t buy, that switching to CFL will not reduce CO2 emissions at all because CFLs don’t give off heat, so people will burn more oil and gas heating their houses.

This is bad policy. Even if you accept that looking to take out CO2 from the 14.4% of it that goes to household electricity makes sense, then looking at the 8.8% of that that goes to lighting is nuts. So when this law kicks in people will rise up and protest and force its repeal? I doubt it. Most people really like the idea of saving the planet and the fact that this particular way is a little bit of a sacrifice just makes it that more attractive. The best part is that it is so everyday. You get to remind yourself that you are saving the planet every time you see that funny looking bulb in your living room.

What this has to do with personal finance is that it is exactly the same dynamic as the idea that you can save your way into wealth by giving up a minor daily expense or two. Give up the lattes at Starbucks and you will be rich when you retire. The fact that the math doesn’t really work doesn’t stop millions of people from embracing the principle. Its attraction isn’t so much that you save money but that it’s something tangible that you can do starting tomorrow and everyday. As with the light bulbs, it is as if progress towards the actual goal is less important than maximizing the number of noticeable acts in the right direction.

Meanwhile, I’m buying light bulbs to stash in my basement. Look for them on eBay in 2014.

Predicting Stock Market Returns

Amongst the nice things about blogging is that you get to write your own headlines. I imagine that Jason Zweig isn’t all that happy with his editor’s “hed” for his column today in the Wall Street Journal. It reads “Why Market Forecasts Keep Missing the Mark.” I was a little disappointed, but not really surprised, to find that the column doesn’t really address that good question at all.

So I will try. How hard could it be?

Market forecasts, such as “the Dow will be up 14% in 2009″ are doomed to failure because the market is impossible to forecast.

That was easy.

Some things are forecastable. The weather, for example. Or how many votes a candidate will get in an election. You can look at certain data, do a little math, account for a special factor or two, and presto, a useful estimate of the near future.

But for other things you really can’t create a useful estimate. The score in the next Super Bowl. The next roll of the dice. It is not that you are stupid or lack data. And it is not that you don’t understand what is going on. You can say some useful things about these unforecastable future events. The Steelers are heavily favored. Seven is the most likely dice roll, and fourteen just ain’t gonna happen. But these are not predictions, they are statements about likelihoods and probabilities.

So it is with the stock market. (And for that matter, the bond market, commodity markets, etc.) Occasionally somebody will throw out a prediction like “the Dow will be up 14%” but nobody, the speaker included, expects it to be taken very seriously.

Sober predictions about the stock market are really estimates of the so-called expected outcome, the probability weighted average of all possible outcomes. E.g. seven is the expected outcome of a roll of two dice. The most common way to come up with an expected outcome for a year in the stock market is to average historical performance. Depending on which years are used, and which indexes, the answer is usually something like 10-12%.

So a personal finance pundit will tell you to expect 10% average annual returns in the stock portion of your investment portfolio. That’s a reasonable thing to say, but I think that too many people, possibly including the pundits, misunderstand what it means.

Imagine that on January 1, 2006, based on being told to expect 10% annual returns in the stock market, you invested $100. With the help of Microsoft Excel, you work out that you should have $672.75 on January 1, 2026. But over the next three years the investment actually goes down, so your January 1, 2009 balance is $81.88. Now what is your expected 2026 value?

Way too many people would say $672.75 or something like it. They think that the 10% number they were given was a forecast of what was actually going to happen over twenty years, rather than an estimate of the expected outcome for each year. Put another way, they think that the market has a memory, that it will remember it had some bad years and make up for it in the future, in order to return to the “normal” long-run average.

Well, sorry kids, it just don’t work that way. The 10% number may still be sound as an annual estimate. Assuming it is, then 17 years at 10% compounds to 405.44%. Starting with $81.88, the expected value on January 1, 2026 is now $413.86. Sorry ’bout that.

Frugal Friday

Fridays sometimes put me in a certain mood. I thought I might highlight a few frugality tips from this week in the blogosphere:

Free Money Finance asks can you pay for a Costco membership by eating free samples? That is, if roaming the store and snarfing up food samples can substitute for a meal, would that savings be enough to cover the annual membership fee? I’ve read this post several times now, and I really think it’s a serious question.

The Frugal Mom Blog has a list of even more amazing ways to save money on food. My favorite is saving the wrappers from your sticks of butter to grease baking pans. If you baked enough, I estimate that you could save the equivalent of an entire stick of butter in a year. Now that’s real money.

The Frugal Duchess had two posts listing ways to watch the inauguration for free, assuming you do not own a TV. The answer is that you could have watched it on any one of several obvious websites, e.g. or (You may not have a TV, but you’ve obviously got high-speed web access, right?) Also, it turns out that it was on every TV in every public area in the nation. Come to think of it, a post listing ways to manage to spend money watching the inauguration would have been more interesting.

Rounding out the week’s insights, The New York Times’ Frugal Traveller reports that Cape Cod is cheap to visit in January. How true. In a similar vein, I will add that admission to Fenway Park is much cheaper on days that the Red Sox are not playing.

The Great Life Cycle of Risk Aversion Fallacy

If there is a single bit of established personal finance wisdom that is most popularly accepted and most wrong, it is what I call the Life Cycle of Risk Aversion. I have to name it myself because it is so widely assumed to be so obviously true that hardly anybody even notices it.

The Life Cycle of Risk Aversion is the idea that as you get older you should take fewer risks in your investment portfolio. When young, you should invest aggressively in stocks and similar exciting things. As you age, you temper your investments gradually into bonds and the like, until in retirement you have an all-boring portfolio.

This unspoken assumption of retirement planning is so pervasive that right about now you are probably wondering if I am really crazy enough to challenge it. Before clicking away, imagine the following “thought experiment.”

Suppose you are 25 years old and your great-uncle leaves you a very strange bequest. You get a million dollars, but only to be used for your retirement in 40 years. The terms of the will say that you must hire a money manager and, although you can talk to him all you want now, once he gets the money no communications are allowed until you are 65, when you get full control over the money.

What instructions would you give the manager before he sets off on his 40 year mission? Would you, for example, tell him to invest aggressively at the start but taper down to conservative investments in the final decade? If that makes sense to you, consider that investment results are multiplicative. The returns from each of the forty years are equally important to the final value of the portfolio. (Annual returns of +10%, -5%, +22% and -3% will always result in a four year return of +23.7% no matter what order they came in.) So as far as you know, starting out risky and ending safe has exactly the same expected result as starting safe and ending risky.

If risky-start-safe-end doesn’t make sense as a plan for this blind investment plan, then why would it make sense as generic advice to those saving for retirement? Well, of course, it doesn’t.

To be clear, there are many reasonable circumstances in which a person might want to reduce risk as they got older. A 55 year-old who has done well in his investments and is on an easy glide path to retirement might not want to jeopardize that to possibly make more money than he really needs. Alternatively, the same guy who has done poorly might want to reduce his risk so as to hold on to what he has left and fund at least a modest lifestyle.

If those two examples of rational risk reduction in late middle age have you convinced that maybe I am wrong, consider that a desire to increase risk in both those situations could be equally rational. The richer 55 year-old could decide to swing for the fences, reasoning that either he can live large in his golden years or, at worst, even if he loses half his kitty he can still be pretty comfortable. The poor 55 year-old might reason that he has some serious catching up to do and he is willing to accept the risk of possibly having to live off Social Security.

The point is that how much risk you should take on has a little to do with how much money you have got, a lot to do with your level of risk aversion, and just about nothing to do with your age. And risk aversion, even though it can be described with fancy math, is ultimately simply a personal matter of psychology. There is no logical argument to make that the 55 year-old who wants to increase risk is wrong, and therefore no reason to advise 55 year-olds in general to reduce risk in their investments.

So why is this universally accepted wisdom? My theory is that it is because in the late 20th Century, when this idea took over, risk aversion was well correlated with age. Folks born in 1915, who came of age in the depression, were much less willing to invest in risky things than those born in 1945, who in turn were considerably more cautious than my cohorts born in 1965, who learned about investing in the ‘80s and ‘90s.

If present trends continue, I expect that my kids’ generation will be much more risk averse than mine. So in a decade or two personal finance blogs (and books, if they still exist) will drop the idea that you should reduce risk as you get older. Or, possibly, they will come up with a reason why you should take on risk in mid-life but not before or after, to accommodate the inclinations of the various generations in their readership.

Never Sell a Used Car

Yet another blog post from the personal finance mainstream that I must grudgingly acknowledge is good and useful. This one is on the advantages of driving a car until it is an inert pile of rust, rather than trading it in for something new. Get Rich Slowly guest blogger Joel Berry describes the financial benefits of driving a 1995 Geo Prizm, which has got to be just about the least impressive set of wheels imaginable.

That you should always buy cars used rather than new is a common and cliched bit of advice. Like many cliches, it is generally true. But I have always been amazed that the relatively obvious corollary, that you should never sell a used car, is rarely mentioned.

The crux of the matter is a bit of insanity that we all take for granted without reflection. New cars lose something like 25% of their value the moment they get an owner and continue to depreciate rapidly over the next year or two. Step back and think about this. The physical attributes of the car do not change when it is driven off the lot and generally do not deteriorate very much at all in the first years. So why does the market price for the car plummet?

There are basically two explanations. The first is that people are crazy. They will pay good money for the new car smell. Or they think that a newer car will attract members of the opposite sex. Much as I am biased in favor of any explanation based on the mental deficiencies of my follow man, I do not think this is all that is going on.

There is an inherent information asymmetry in the used car market. The owner of a car knows its true condition while the buyer does not. So the market price for a particular used car is based on the average value of similar cars for sale, not the specific value of the car in question. An owner considering selling a car will compare what he knows the car really to be worth to what he could get if he sold it. If it is worth more than the going rate, he holds on to it, if it is worth less, he sells. Which means that the used cars for sale tend to be the bad ones, which in turn reduces the average selling price, which means even fewer good cars are for sale, and so on. This is from a truly seminal paper published in 1970 called The Market for Lemons: Quality Uncertainty and the Market Mechanism.

On any rationally objective measure, used cars are cheap as compared to new ones. Moreover, and this is the point that most personal financial advisers miss, the average value of used cars that are for sale is far less than the average value of similar cars that are not for sale. So unless you have a real clunker, that car in your driveway is almost certainly worth more to you than you could get if you sold it.

It would be hard/impossible to get real numbers, but I am of the opinion that you take a bigger hit selling a used car than you do buying a new one, at least on a percentage basis. The optimal car strategy is to buy two- or three-year-old used cars and drive them until they are scrap metal. Which is what the experts recommend. But the real benefit is on the back end, not the bargain you get up front. Given the choice, and here is where I part company with the established wisdom, buying new and driving the thing until it stops running makes more sense than buying youngish used cars and selling them again when they are not so young.

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