Oh Those Wacky Rich People

For those of you who do not spend your waking hours prowling the blogs and newspapers (e.g. those of you with jobs) I thought I would summarize what I have learned lately.

1) The rich people who (used to) work on Wall Street are morons. Completely incompetent. All of them. “These people are idiots.” says Claire McCaskill, and she’s a senator, so she knows about groups of idiots.

2) Until recently, the idiots who worked on Wall Street, who most Americans associated only with making great piles of money without apparently doing anything useful, were nevertheless loved and trusted by all. There was never any envy or animosity. All that has changed now. “America doesn’t trust you anymore.” said Rep. Mike Capuano (D – MA) to a panel of Wall Street CEOs. And members of congress know a thing or two about not being trusted by America.

3) The really rich people who (used to) run Wall Street are particularly clueless. For years, they paid thousands of somewhat less rich people more than a million dollars a year because it amused them. Sorta like how some babies like watching mobiles. Obviously (see #1) there was nothing special about these workers, so they could have paid them a lot less. Now that the government is in charge, these banks will be run to maximize profit, so they will no longer pay anybody more than $500K a year. That’s not a bad salary for an idiot. Believe me, I know. It’s not like these people could just walk out and spin money for another employer or start a hedge fund or something. They’re idiots.

4) In these stressful times, comic relief is important for all of us, and what could be funnier than laughing at idiots? The New York Times has been making the most of this, with articles and opinion pieces that maximize the Wall Street idiot hilarity. Two weeks ago it was a side-splitting piece about how hard it is to live on $500K in NYC. Today we get one on what happens when the “Rituals of the Rich Meet the Realities of the Economy.” It turns out that those idiots indulge in such obscure rites as having their so-called “suits” put through a process called “dry cleaning.” Apparently, they still practice this behavior, but less often, much to the relief of the staff at Manhattan dry cleaners, who now have more time for reading and other hobbies.

5) Meanwhile, rich people outside Manhattan continue to reaffirm our faith in their judgement. A British bank, Barclays (not one cent of TARP money!) has introduced a Visa Black Card. For a modest $495 a year a person carrying this card will not only be able to buy all those things that a Visa card can buy, but will also get “24-Hour Concierge Service.” And the card itself is made of a carbon graphite substance, meaning it’s not mere plastic but really expensive plastic.

Suze Orman’s 2009 Action Plan, Part 1

I have only respect and contempt for Suze Orman.

On the positive side, it would be hard not to admire Orman’s talent and achievements. She is undoubtedly the most effective and popular personal finance guru in America today. Suze Orman’s 2009 Action Plan is her seventh consecutive New York Times bestseller. She has won two Emmys. Last year Time named her one of the 100 most influential people in the world. To put that last achievement in perspective, consider that the Pope did not make the cut.

Alas, this highly tuned and powerful machine is used to bring her vast audience fairly mediocre and amateurish advice. At best, what Orman tells her readers and viewers is pedestrian and obvious. At other times it is dangerously specific, assuming unstated facts about the reader’s situation. And once in a while it is just plain wrong. But wasting her abilities with weak content is not the chief reason I have contempt for her. She also has a righteous new-age shtick about courage and honesty which is not only grating, it is hypocritical.

Suze Orman’s 2009 Action Plan is her reaction to the current economic crisis. (Of course, given its success, I would expect an Action Plan to appear annually every January from now on, crisis or no.) It is one of many quickie books on similar themes that have appeared in the last few months. Orman’s was finished on November 19, 2008 and on bookshelves as a paperback by mid-January 2009. As would be expected, it is not very long and lacks much in the way of a coherent organization. The great majority of the book is in the form of an extended FAQ, with “situations” that could have easily been phrased as readers’ questions followed by short answers or “actions.”

The slim volume does contain a few longish bits of advice and explanation. One of these is the second chapter of the book, entitled “A Brief History of How We Got Here.” It is not merely brief (11 pages) but shallow as well, what you might expect from a bright high school student asked to summarize the economic situation based on accounts taken from one of our nation’s lesser tabloids. Admittedly, Wall Street and the economy are not Suze Orman’s fields of expertise, but this section betrays a remarkable lack of knowledge about how indeed we got here.

For example, Orman explains that in reaction to the low interest rates of the middle of this decade, the “too-smart-for-their-own-good minds of the financial sector” “bundled the prime and sub-prime mortgages into one investment, called a Credit Default Obligation (CDO).” Actually, CDO stands for Collateralized Debt Obligation, prime and sub-prime mortgages are generally segregated (not that that helped) and CDOs became the standard method for structuring mortgage bonds twenty five years ago. How CDOs were invented is described entertainingly in Michael Lewis’ bestseller Liar’s Poker (1989) which until recently I had thought everybody involved in finance and over the age of 40 had read.

The Orman view on what went wrong in the global economy begins and ends with American house prices and mortgages. That is like blaming a warehouse fire on faulty wiring without mentioning that the building was full of fireworks and that the sprinkler system failed. But no matter. 2009 Action Plan is for consumers, so limiting the explanation of what went wrong to consumer-oriented factors is not the worst thing imaginable. Orman ends the chapter by summing up that “the mortgage crisis is the most vivid example of how dishonesty and greed leads to financial destruction” and exhorts her readers to become honest with themselves about their own finances.

That’s a sentiment with which it is certainly hard to disagree. Truth and candor is a recurring theme of Suze Orman’s, both in this book and elsewhere. It would be much more convincing if Orman was herself more honest about how her advice about houses has changed over the past few years.

2009 Action Plan tepidly endorses buying a house, saying that “over time a home can be one of the most satisfying investments you can make” (p. 147) and clarifies that your house “will, on average, rise in value at a pace that is only one percentage point above inflation.” (p. 154.) I have no objection to either of those points, but isn’t this the same Suze Orman who called home buying “one of the best known investments” (The Laws of Money, 2003 & 2004, p.131) just a few years ago? In 2009 Action Plan Orman is repeatedly strident about not taking out a loan from your 401(k) or tapping your IRA for any reason short of dire emergency, and yet in The Courage to Be Rich (1999 & 2002) she suggests doing both to raise money for a house down payment (p. 223.) In 2009 Action Plan Orman condemns adjustable rate mortgages and says that a 30 year fixed is a “requirement” for home buyers (p. 148.) In The Courage to Be Rich she discusses both flavors of mortgage favorably and lists reasons you might be better off with an ARM. (p. 254.)

There is no shame in having been much more enthusiastic about houses a few years ago. As far as I can tell, all personal finance writers urged their readers to buy houses in the Good Old Days, and Suze Orman was actually more cautionary than most. And circumstances have indeed changed in the meantime. But for a person who lectures continually about the importance of honesty and speaking the truth about money, would it be too much to expect a modest mea culpa? Wouldn’t her criticism of the “dishonesty” of those who borrowed too much to buy more house than they could afford be more persuasive if she conceded that the chorus of personal finance advisers, Suze Orman included, egged them on?

[Click to the second half of this review here.]

What to Expect from the Stock Market

Just about all mainstream personal finance writers advise making stocks the centerpiece of your investment plan. Most will quote a reassuring average market return over a reassuringly long period and make the argument that for sober long-term investors such as yourself, stocks are the place to be. But few writers explain what that long term average return really means and what expectations you should draw from it.

The first thing to understand is that you cannot expect to actually get that average return in any given year. Get Rich Slowly has a guest post by Carl Richards that patiently makes this point with the use of an elaborate animated presentation. His data has an average return of 10% over eighty years and shows that only twice in that time did the actual market return for a year fall between 9% and 11%. I would hope that this is a nearly obvious point to all stock market investors, but I know better.

Moreover, I worry that by saying that the market has good years and bad ones, but that the long run average is high, people are led to believe that as long as they can stick it out through the ups and downs, after twenty years or so they will get the promised average return. This is not necessarily so. Those long run averages are not that much more predictable than individual years.

To illustrate, I will run some numbers of my own. Yale’s Robert Shiller has a website with the S&P 500 index returns annually back to 1871 as well as some other useful stuff such as inflation rates. It turns out that, sure enough, the average return for the US stock market, as measured by the S&P 500, was 10.08% per year over the 138 years from 1871 to 2008 inclusive.

What do we know from this? We know that funds invested in the market on December 31, 1870 and held through December 31, 2008 would have made an average of 10.08% a year. We do not know what the average returns for the next 138 years will be. 10.08% is a pretty solid guess, and in fact is almost certainly the best guess we’ve got, but it’s still just a guess. There is no “true” expected stock market return, even over long periods of time. Setting market return expectations is not science, just thoughtful estimation based on what has happened in the past.

To get a better feel for how volatile even long term averages can be, consider the 80 year period that Richards uses. The 80 year average return for the period ending in 2007 was 11.52%. But move it forward a year to end in 2008 and you get only 10.46%. That is a big difference considering those two periods are 98.75% identical.

And 80 years is a lot longer than the typical person will be invested in the stock market. For most, there is a critical twenty years or so from middle age to retirement when the nest egg does or doesn’t grow. And the returns for twenty year periods are all over the place.

As it happens, the best twenty year period in the stock market since 1871 was recent enough that a lot of us remember it well. From 1979 to 1998 the market averaged 17.32% a year. One dollar invested at the end of 1978 grew to $24.41 by the end of 1998. At the opposite extreme, 1929-1948 averaged only 3.00% a year. The $1 invested at the end of 1928 became only $1.80 by the end of 1948.

There aren’t a lot of people still around who remember the stock market in 1929-1948. But your parents or grandparents might be able to tell you about the period 1962-1981. The market went up an average of 6.57% per year, which doesn’t sound so bad until you find out that inflation averaged 5.50% over the same period, leaving stock investors with an average real return of only 1.07%.

If you are like me, in your mid-forties and heading into the intense period of investing for retirement, the big question is will the period 2009-2028 be more like 1979-1998 or 1962-1981? Nobody knows.

There were 118 twenty year periods ending from 1890 to 2008. The average twenty year period had an average annual return of 9.22%, but a forth of those periods had returns worse than 7% and a fourth beat 11.5%. And you only get to do this once. Consider the difference in circumstances of a person born in 1933, who turned 45 in 1979 and enjoyed fat returns on his way to retirement in 1998 at 65, with somebody born in 1916 whose nest egg went nowhere in the twenty years before his retirement.

What can you do about this? In the most direct sense, nothing. Diversification will help some, but not by as much as you might like. Bad decades for the stock market tend to be bad decades for bonds and real estate too. The truth is that this is one of the many things in life that are beyond your control.

But you can take it into account when doing your financial planning. If the difference between 8% and 10% returns over the next twenty years is the difference between a comfortable retirement and hoping your kids can support you, you need to reconsider your plans. Expecting 10% a year from the stock market over the long run is reasonable, but counting on it is foolish.

Frugal Friday the 13th of February

It was a quiet week on the frugal front. It seems like every blog had the same Valentine’s Day hints. The most common tip for saving money was to ignore the holiday entirely, but failing that, you could celebrate it late, when the candy goes on sale.

There was some mention of Lincoln on the occasion of his 200th birthday. There was no mention of Charles Darwin, a reasonably important figure in some places, who was also born on February 12, 1809. That Darwin doesn’t rate in Frugal Nation isn’t that surprising. According to The Economist, only 14% of Americans believe that humans evolved over millions of years. The scientifically minded can take heart in the fact that the trend is actually up. In 1982 only 9% believed in human evolution.

Of course, to the frugal, Lincoln is closely associated with that enduring symbol of saving really small amounts of money, the penny. Free Money Finance had an informative post of facts about the penny, including that 63% of Americans think we should keep using them. That’s actually not that high, if you think about it, and shows that at least 37% of Americans are insufficiently frugal. Imagine how much worse it would be if it was widely understood that it costs 1.2 cents to make a penny. (It takes a special kind of government to mint coins at a loss.)

According to Coinstar, which supplied the penny facts to Free Money Finance, the average American household has $90 in coins lying around. Based on the handy converter on their home page, that’s about half a gallon of change. What to do with this hoard of metal disks is of course a concern for the frugal. Dawn at Queercents suggests that you put it in a tin container rather than a glass one. Seeing the money will make you want to spend it. She also suggests other clever ways of hiding money from yourself, including inflating the values of the checks you write in your check register so that your balance is actually higher than you think it is. This has inspired me to convince myself that I belong to a high-end gym and to record imaginary large monthly checks for the membership fee. I think this will work as long as I don’t notice that I am not losing weight.

Speaking of losing weight, Frugal Living Tips suggests saving on food bills by foraging for things to eat in the woods. Not only will you save money, you will lose weight because of the exercise you will get and because you will find so little to eat, especially in February.

And finally, Tip Hero has a post about saving what must surely be many small copper disks with Lincoln on them by making your own half and half for your coffee. The recipe given is one quart light cream to one quart milk. No word on what to do if you need less than half a gallon of the stuff, but you can use that glass bottle you used to store loose change in.

Phil Town’s Rule #1, Part #5

[This is the final part of a multi-part review of Phil Town's book Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! If you haven't already, you might want to read Part 1, Part 2, Part 3, and/or Part 4 first.]

Does anybody really believe that they can buy a book containing a sure-fire formula for riches? I do not mean conceding that it is remotely possible, I mean truly believing that Town’s book, or one of its thousands of competitors, will disclose a magic technique to the reader. I am sure that there are a few out there that are that gullible, but I don’t buy the idea that Town’s large readership is made up entirely of such folk.

So maybe my efforts to demonstrate that Rule #1 does not work were a waste of time. If Town’s audience does not really expect his scheme to make them rich, then why bother showing that it will not? Moreover, if we accept that there are very few people out there who are both in the habit of reading books and naïve enough to think that reading a particular one will make them rich, how do these books become bestsellers?

For me, the most meaningful revelation from Rule #1 is just how impractical it is to carry out what Town advises. I expected that his formula for picking stocks would not work in the sense that the stocks picked would not do particularly well. I did not expect that it would not work in the sense that it would barely function, that it would be so hard to use it to pick stocks at all. And you might think that this kind of not working would be a big problem for the sales of the book. A scheme that is easy to operate but does not pick winning stocks at least has the virtue that it could take a year or two before the readers realize it is defective. A scheme that is more or less inoperable from the start would, you would think, be noticed right off and become a hindrance to climbing the bestseller lists.

The flaw in that logic is that it assumes that readers actually attempt to follow Town’s advice and discover it is defective. But just as the vast majority of Town’s readers does not, in the cold light of day, really think that his scheme will make them rich, the vast majority also does not bother to try to follow it. Why would they? They know deep down that it will not work, so why put in the considerable effort required to shatter the illusion that it might work? Which then begs the question, why buy the book at all?

Because Rule #1, like nearly all books (and seminars, for that matter) is, ultimately, primarily a form of entertainment.

Consider television cooking shows, a genre that dates back to the earliest days of the medium. Although nominally instructive, it is clear that almost all viewers will never cook the elaborate dish that the host prepares. They watch not to so they can follow the instructions, but because it is entertaining. If you are into food, watching a skilled chef prepare and discuss a dish is fun. You can, at least in the abstract, imagine yourself preparing and even eating it, and that is enjoyable for many. I know people who buy and read cookbooks on the same basis.

Or consider cowboy hats. Putting one on has no chance of turning you into a cowboy. But it helps with the fantasy of being one. (In reality, it is probably not a great job: long hours, low pay, lots of big dumb smelly animals, and no Internet access.)

The fantasy that goes with Rule #1, and other books like it, is that you will read them and become rich. That any modestly intelligent reader knows, at some level, that this is really unlikely, does not diminish their appeal. A person can read the book and imagine becoming rich just like the ordinary people in the inspirational stories included in the text. That some of the instructions are, in fact, impractical is unimportant. They only need to seem practical to somebody who will never attempt them. Just as the host of a cooking show can get away with using obscure ingredients or a tricky technique requiring years of practice, Town can get away with vague instructions that do not produce the desired result.

So in a narrow sense, I am willing to forgive these books for being as bad as they are. They fill an entertainment role for some, and, apparently, do it well. The problem is that personal finance is still an area that American adults need to master. After you are done watching the celebrity chef prepare Cajun crawfish stew, somebody still needs to cook dinner.

[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]