Amex Paying Customers $300 to Go Away

There’s much buzz in the blogosphere (e.g. here, here, and here) about the latest from American Express. They have offered certain of their customers $300 if they will close and pay off their credit card accounts by April 30. (Are there other businesses that will pay me not to do business with them? I could use the money.)

What is going on here? Amex is letting the accounting tail wag the business dog. They feel pressure to reduce their book of consumer debt. Investors are very worried about financial companies that are overly leveraged with too many (possibly bad) loans to consumers. Bribing some customers to beat it addresses this problem because it will reduce both the total that Amex is owed and the total that its customers could borrow. Amex may also be targeting customers with low credit scores or other characteristics of which investors are particularly leery.

Does this make good business sense? Not even close. Imagine separating credit card customers into two categories. Group A is made up of those willing and able to pay off their balance in 60 days in exchange for $300. Those in Group B are either uninterested or unable. Everything else being equal, with which group would you rather continue to do business? Amex has concocted a scheme that efficiently and expensively drops the customers it need not worry about and keeps the ones that might have trouble paying what they owe. Brilliant.

Does this mean that the people who run Amex are idiots? Not necessarily. They are probably acting rationally and making what are, from their point of view, sound economic decisions. Wall Street wants them to improve their balance sheet and will pay them to do this, in the form of a higher stock price and lower borrowing costs. From this, the managers of Amex can do the math and work out that paying some customers, even relatively good ones, to get lost is profitable. The fact that this ought not to be the case, that the markets should not be rewarding Amex for doing something that actually harms itself, does not enter into the calculation.

This scheme may not be the ideal implementation of the lose customers to improve balance sheet strategy, e.g. I have trouble believing that offering everybody the same $300 is optimal, but it’s not a sign that the folks at Amex have lost their marbles. It is, however, a sign of the times. We currently live in a world where the appearance of improving a balance sheet outweighs the substance of shrinking a business.

More on ETF Fees

I’ve been meaning to do a follow up on the costs of ETFs vs. open-end index mutual funds. My post from February 5 on why ETFs should probably not be the mainstay of your investment diet has inspired interest (much to my surprise it continues to be one the most popular posts here) and a little bit of controversy.

To summarize what I said three weeks ago, the pecking order of low cost for investors is: open-end index mutual funds (best), ETFs, and then open-end active mutual funds (worst.) You will often see ETFs touted as being low cost, and relative to active funds this is certainly true, but the typical investor will do even better in an old-style index mutual fund.

For a change of pace, I thought I would gather some actual data to make my point. Yahoo Finance has a useful list of the largest ETFs. Let’s look at the five biggest, which together account for about a third of all the money in ETFs.

One of the five, at number 3, is a special case, the streetTracks Gold Trust, which strictly speaking is not really an ETF at all. It represents simply the ownership of gold bullion, and Yahoo informs us that it is not registered as an investment company under the 1940 act, which means that it is not a mutual fund. Apparently as a side effect of this, Yahoo does not list an expense ratio for it, so it’s not clear what the fees are. I am going to set this one aside, but I cannot resist remarking what a sign of the times it is that gold is in the top 5.

Numbers 1 and 5 are virtually identical S&P 500 ETFs, the giant SPDR Trust (SPY) and the Pepsi to its Coke, the iShares S&P 500 Index (IVV). Yahoo tells us that the expense ratio, i.e. annual fee charged by the manager, for these two is 0.08% and 0.09% respectively. Fidelity has a pretty big S&P 500 fund, the Spartan 500 (FSMKX) which charges 0.10% and, for investments over $100,000, the Spartan Advantage 500 (FSMAX) which charges 0.07%. Even a precision freak like me will concede that all these tiny numbers are practically the same.

Number 2 is the iShares MSCI EAFE Index (EFA) which charges 0.34% in fees. You can get the same thing from the Vanguard Developed Market Index (VDMIX) which charges only 0.22%.

And at number 4 we have the iShares Emerging Markets Index (EEM) which charges an impressive-in-a-bad-way 0.72%. Vanguard will charge you 0.37% for it’s Emerging Stock Index Fund (VEIEX) or only 0.25% if you have more than $100,000 in the Admiral version (VEMAX). Note that both Vanguard funds have a 0.25% transaction fee to invest or sell.

So from this sample, based only on management fees, you might conclude that ETFs are mostly the same, or sometimes just a little worse than open-end index mutual funds. But with ETFs, you still have more costs to consider. ETFs trade like stocks, which means that you need to pay money to buy them and sell them. You will pay your broker a commission, you will pay the bid-ask spread, and you will pay both of these things twice, on your way in and your way out. These additional costs (shouldn’t be) huge, but they do count and are more than enough to tip the balance in favor of old-school index mutual funds.

As I wrote in the previous post, ETFs do have their role. There are things you can do with them because they are stocks that you cannot do with an open-end fund, such as buy on margin and sell short. And there are some peculiar things that actually are cheaper as, or even available only as, ETFs. Gold might be an example, if only I could work out what that ETF charges. The Nasdaq Composite ETF (QQQQ) is another because there are so few open-end funds that bother tracking it. You might also just enjoy trading your ETFs more than investing in open-end funds. But if you want to know which will, in the long run, make you more money, the answer is open-end mutual funds, not ETFs.

IRAs: Roth and the Other Kind

Poke around the blogosphere and personal finance punditocracy and you will find lots of positive references to Roth IRAs and virtually no nice things said about its dull older brother, the traditional IRA. If you didn’t know any better (and why would you?) you might assume that the younger and hipper Roth IRA was the way to go. After all, it is the cool new thing and the latest in retirement savings technology. Here’s a rundown of the differences and why you are likely to want to go with the unhip kind after all.

IRAs come in two basic flavors. There is the traditional old-style IRA, in which you put pre-tax money, i.e. your contributions are tax deductible, and then later in life pay taxes on your withdrawals as if they were income. And there is the relatively newer type, a Roth IRA, in which contributions are post-tax, i.e. not deductible, but withdrawals are tax-free.

Which is for you? Obviously, you want the one that will wind up making you more money. To tee that up, consider the following.

Tom Traditional and Robbie Roth have identical incomes, and so pay identical tax rates, and they both have $3,000 a year of that income that they wish to put in an IRA. Obviously, each picks the type that matches their name, so Tom puts in the full $3,000 each year and Robbie puts in $2,250 after paying taxes of 25%. The years pass, and they make identical investment decisions until they retire on the same day. Tom’s account is, of course, larger but he needs to pay 25% taxes on anything he takes out, while Robbie can withdraw tax free. Here’s the big question: after Tom pays taxes on his withdrawals, who has more money to spend?

The answer, which seems to surprise a lot of people, is that they have exactly the same amount of money. Assuming the tax rate going into the Roth is the same as the one coming out of the traditional, the financial benefit of the accounts is exactly the same. Fire up Excel and run the numbers yourself if you don’t believe me.

So why do the advocates of saving seem to universally prefer Roths? It’s not about numbers, it’s about conceptual appeal. Saving is about sacrificing now for a benefit in the far-off future. With a Roth, you pay taxes now so you can not pay taxes later, and that has a big attraction to the savings crowd.

Symbolism aside, there are good reasons to choose one type of IRA over the other. Primarily, which one is better depends on the tax rate you pay now and the one you will pay when you are retired. Tom and Robbie came out equal because they always paid 25%. If the tax rate had been 25% when working but only 15% during retirement, then Tom would have wound up ahead because he would avoid the 25% and only pay 15%. Conversely, if the rates were 25% while working and 35% when retired, then Robbie would be better off.

Occasionally you see the pro-Roth argument that given the fiscal problems the government has now and is likely to have in the future, tax rates will inevitably rise. That sounds perfectly reasonable, but it is worth reflecting that the same thing could have been said for the past 30 years and so far it’s been wrong. Predictions of what Congress will do in future decades is hardly a sound basis for your retirement planning.

On the other hand, predictions of how much money you will be making in retirement, and so which tax bracket you will be in, are more practical. If you have a Roth, you are betting that your income, and your tax rate, will be higher in retirement than it is now. That’s some bet. (You do understand that in retirement you won’t have a job, don’t you?) Furthermore, choosing a Roth over a traditional is doubling down the bet on your own future prosperity. If you wind up being a rich retiree, you’ll be happy you have a Roth because you won’t pay high taxes on the withdrawals. But if you wind up a poor oldster you’ll wish you’d picked traditional, because you’d have more money, even after paying the (lower) income taxes on what you take out.

There are other factors to consider when choosing between the two types of IRA. (There’s a nice rundown here and here.) But they are all secondary to the tax rate issue and some of them are pretty esoteric. In the big picture, what matters are tax rates now and when retired. And for many, if not most, people that means that an old-school traditional IRA is a better choice, even if it lacks hipness and the frugal appeal of paying more now for a benefit far in the future.

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.

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]