Final Four—Savings rate v. Tax optimization

Basketball hoop

Welcome to the second game of the Final Four of my investing strategies tournament.  Here we have Savings rate taking on Tax optimization.  In the first round, Savings rate beat Mortgage just on the sheer power that saving more money can have on the ultimate size of your nestegg.  Tax optimization squeaked by Starting early due to the enormous value created with minimal sacrifice by setting up the accounts to minimize your taxes.  As always, give the disclaimer a peek.  With that out of the way, let’s see who wins.

bracket-game 5


Reasons for picking Savings rate:

Savings rate is a simple but overwhelming force, maybe like Patrick Ewing when he dominated the Final Fours during his years at Georgetown (I don’t mean to call Ewing’s game simple, but you’ll see what I mean).  Ewing just owned the basket—any shot you put up he blocked, if you did get the shot up he got the rebound, when he got the ball you weren’t stopping him.  It all revolved around Ewing, and his dominance on the inside covered up for his shortcomings (outside shot, passing) as well as those of his teammates.


In the investing world, the sun really rises and sets with Savings rate.  Without any savings, you can’t invest so it really doesn’t matter what you do with things like Index mutual fundsAsset allocation, or Free money.

Also, unlike any other investing strategy, Savings rate can make up for any other mistakes you make along the way.  It’s a lot like Ewing protecting the rim on defense; if your guy beat you, you could be pretty confident that Ewing would bail you out by blocking his shot.  You could completely screw up Asset allocation and stuff all your money in a mattress—just crank up your Savings rateand there’s no problem.  Don’t participate in your 401k and walk away from the Free Money—save a little more and you’re okay.  You get my point.

Let’s use the same example of Mr Grizzly starting out at age 22, making $50,000 which will eventually rise to $100,000, and who wants to be a millionaire by the time he’s 60.  Let’s say he does everything right, plus he has a horseshoe growing out of his rear end, and over his investing career he averages a 10% return; he would only need to save about  3% of his income.  That’s probably a breeze.  Now, instead he has an average investing track record with returns of about 6%, he would need to save about 9% of his income.  So Savings rate was able to make up for his lack for tremendous luck.  Keep going down that path and let’s say he put all is portfolio in a local bank earning 1% interest, which I think we would all agree is a pretty terrible investing strategy, and he still becomes a millionaire so long as he saves about 24%.


Return Savings rate
10% 3%
6% 9%
2% 20%
1% 24%
0% 29%


So you can see that Savings rate can make up for all manner of investing sin.  Pretty much any other investing strategy has its limits to how far it can take you before you exhaust its benefits.  But of course there are no free lunches.  Increasing your Savings rate comes at a much higher cost than other investing strategies, namely all that money you’re saving means you can’t spend it on other things.  So when Mr Grizzly needs to crank up his Savings rate, that money has to come from somewhere—he passes up on that salmon fishing trip, or buying Mrs Grizzly some artisan honey from the farmer’s market, or getting some detangling shampoo for his coat.  We can debate whether those purchases are worth the money, but to Mr Grizzly they are (cut to Lady Fox nodding and pulling out a Pottery Barn catalog).  Sure, you can start by cutting away the layer of winter fat, but the higher you make your Savings rate the more you start cutting into muscle and eventually into bone.  That, my friends, is the rub with Savings rate.


Reasons for picking Tax optimization:

Taxes are to investing what water damage is to a house—unwelcome, can really ruin stuff if not attended to, and it gets into everything.  The tentacles of taxes traverse tremendous territory to touch your total transactions (I challenged myself to see how many “t-words” I could use in a sentence).  Seriously, taxes pretty much affect everything in investing.

There are the obvious big rocks, some of which we’ve already discussed, like a 401k and an IRA; using those accounts to defer taxes can save you hundreds of thousands of dollars.  Medium-sized rocks like 529s and tax-deductible interest on your mortgage can save you tens of thousands in taxes over a shorter time span.  Then there are tons of small rocks which can certainly add up—flex spending accounts and dependent care spending can save you thousands.  Add all that up and that’s a lot of clams (if you didn’t read yesterday’s post, I am trying to use as many slang phrases for money as I can).

And then you can get into the really obscure Tax optimization strategies.  “Loss harvesting” is when you sell investments at a loss so you don’t have to pay taxes on your winners.  “Dividend location” looks to put your high-dividend investments in tax deferred accounts like a 401k, so you don’t have to pay taxes on the dividends during your high-income/high-tax rate years.  There are millions of these little loopholes and strategies that allow you to pay less taxes.  A major part of the accounting industry is based on this fact.

Just to illustrate the point, I’ll share a story from Medtronic.  If you’re a high-compensation employee (I do not qualify, so I can’t take part in this) you can participate in the Capital Accumulation Program (CAP) which allows you to defer a portion or all of your bonus into a tax-advantaged account—think of it like an extra 401k without the match.  This is a veritable tax goldmine, and sadly very few of the people I talk to take advantage of this.  Let’s assume Mr Executive makes $300,000 per year, with $100,000 of that being his bonus; and assume that he’s working hard to build his nestegg, so after maxing out his 401k he saves $50,000 in his brokerage account.  That’s probably pretty close to the people I’m describing.

What Mr Executive could do but probably doesn’t is defer his entire bonus.  He’s already saving $50,000 per year and since he’s in a pretty high tax bracket, that’s probably pretty close to what his take-home would be on that $100,000 bonus.  However, by deferring his bonus he avoids paying the 40% on taxes now and only pays 5% in taxes when he pulls the money out in retirement.  If you do the math, that’s a potential savings of $35,000 ($100,000 x (40% – 5%)) on top of what he’s already saving.  When I ask executives why they don’t do CAP they tend to say they never thought of it or they didn’t understand it.  When I show them the math says they’re leaving at least $35,000 on the table, their eyes bug out and they need to sit down.

That’s just one example of the power of Tax optimization that is out there that goes largely unutilized, even by really successful people, even by those who have tax advisers helping them out.  And there are thousands of other examples like that out there.  That’s $35,000!!!  That’s a lot of money, even if you are pulling in $300k.

My point with this and the others is that in the US (and probably every other country) the tax code is super convoluted.  Add to that that when you’re making more and more money, you pay more and more in taxes, so the stakes start to get pretty high.  That’s a perfect recipe for hidden 1% coupons; some of them are easy to find, some a little hard, and some require serious digging—but they’re there.


Who goes on to the championship game?

Just like in the Elite Eight, I think Tax optimization pulls out a squeaker over Savings rate, 71-68.  While Saving rate has unlimited potential, it comes at a real cost of foregoing purchases today.  Tax optimization isn’t necessarily unlimited.  There are only so many wrinkles and loopholes you can take advantage of, but there are an awful lot of them and I bet you’d run out of time and energy before you’d run out of tax strategies.

bracket-game 6

But what tips the scale is that most of the Tax optimization gambits are free.   You’re already going to save for your retirement so why not do it with a 401k and not pay taxes on it right now?  You’re already going to save for your kids’ educations so why not use a 529 and not pay taxes on the appreciation?  You’re definitely going to need to pay for childcare so why not use a Flex spending account and do it tax free?  You and the family are going to get sick so why not use a Flex spending account for that, too?  None of those cost any more than you would have paid already, but you’re cutting Uncle Sam out of his 40% (legally, of course).

Thursday we will see who wins it all, Asset allocation or Tax optimization.

Final Four–Asset allocation v. Index mutual funds

Basketball hoop

Welcome to the first game of the Final Four of my investing strategies tournament.  Here we have Asset allocation taking on Index mutual funds.  In the first round, Asset allocation blew out Diversifying mostly due to the higher returns that younger investors can get by investing more in stocks early in their investing career.  Index mutual funds upset Free money on the strength of lower management fees that can apply throughout an investor’s career and across every account type.  As always, check out the disclaimer.  With that out of the way, let’s see who wins.

bracket-game 4

Reasons for picking Asset allocation:

Last round we saw how being too conservative with Asset allocation can really reduce the returns of younger investors who aren’t as heavily invested in stocks as they should be.  If you go to the other end of the investor’s time horizon, when he or she is older and nearing retirement, you can make equally harmful mistakes.

On one end of the spectrum older investors can become way too risky.  As the years tick by and people get closer to retirement, they begin to take stock (pun intended) of where they are probably a little more closely than they did in their 20s or 30s.  If they aren’t quite where they want to be, knowing that on average stocks have higher returns than bonds, one natural response is to allocate more of their nestegg to stocks to “catch up”.  According to generally accepted investing theory, this is the exact wrong thing to do—as we get closer to retirement you should be reducing your allocation of stocks to lower your risk, not increase it.  Here you’re stepping away from the world of investing and into the world of gambling.  Maybe you’ll get lucky and ride a bull market up to get your portfolio back to where you want it, but you’re definitely putting yourself at risk of hitting a market pothole and putting yourself further behind.

On the other end of the spectrum, they can become way too conservative.  Some people have the natural instinct to want to get completely off the investing train in retirement because they don’t want to have any risk, so they put all their money in bonds or cash.  This is understandable because they’re going to be depending on that nestegg, so it’s got to last.  But the problem is that even in retirement, many people still need the higher returns that stocks provide to balance out the relative safety of their bonds.  This is especially true in a world where people are living longer and it’s not unreasonable to expect retirement to last a few decades or longer.  And actually, that time element also makes the case for stocks being a significant part of your retirement portfolio—you have time to ride out the storms, just not as much time as you had before.

These are what make Asset allocation one of the harder investing strategies to get right, because it’s changing over time and there are shades of grey (at least 50 shades of grey).  Other strategies like Diversification and Free money are much simpler because your strategy is absolute.  Diversification—you should be diversified at all times.  Free money—you should get as much of it as you can at all times.  But with Asset allocation, the right thing to do gradually changes from being mostly in stocks during your early years, and then slowly switching to more bonds and cash as you start to near retirement, but never shifting completely to bonds.

There’s no strict rule on what your Asset allocation should be at different stages of life, but I always look at Vanguard target retirement funds as a bit of a guide (although I’ll write about some of my issues with these types funds in a future post).  With 40 years until retirement, right around when you’re first starting out, Vanguard suggests about 90% stocks and 10% in bonds.  Once you hit retirement Vanguard suggests 40% stocks and 60% bonds.  Notice that even in retirement a very significant portion is still in stocks.

Vanguard target date funds % in stocks % in bonds
2055 (40 years to go) 90% 10%
2035 (20 years to go) 85% 15%
2025 (10 years to go) 70% 30%
In retirement 40% 60%


So what does that all mean?  Well early on Asset allocation done properly can get you higher returns over the long run, historically about 3-4% higher than if you completely screwed it up.  Later on, it’s going to help protect you from any market crashes, market corrections, or general market zaniness that occurs.


Reasons for picking Index mutual funds:

We know from the Elite Eight round, that one of the major advantages of Index mutual funds is their lower management fees, which are on average about 1% less than actively managed mutual funds.  We also know from The power of a single percentage that saving 1% of your portfolio year after year can lead to some serious ducats (I’ve decided to use as many slang terms for money over the next few posts, so prepare yourself).  But we’re in the Final Four now so we need something more than that.

Not above a little chicanery, Index mutual funds is going to steal a page from Asset allocation’splaybook.  Often with actively managed funds, they keep a significant portion of the fund’s assets in cash so they can buy an investment when the opportunity presents itself.  Of course we know from above that holding cash over the long term leads to lower returns than holding stocks.  Index mutual funds are able to be almost 100% invested in stocks (or whatever asset class you want) because they aren’t picking investments so much as just following the index.  Just doing some simple math, if actively managed funds have 5% of their assets in cash, and over the long term stocks return 6% more than cash let’s say, that comes to a long term benefit of about 0.3% (5% x 6%).  That’s not going to change the world, but even those little bits compounded over decades can make a huge difference.

Index mutual funds is also copying Tax optimization.  When your mutual fund sells shares there are tax implications on that (death and taxes, baby).  That’s why you get that statement every year from your mutual fund telling you what you need to report to the IRS. The more frequently your mutual fund trades stocks, the more likely it is that you’ll have short term gains which are taxed at higher rates.  But with Index mutual funds, trading is minimized because the fund is only following an index like the S&P 500 which doesn’t change that often.  That leads to lower taxes which we know can add up to some serious cheddar (see, I did it again).

There are also people who argue that Index mutual funds do better than actively managed funds because they take the human element out of it.  This is pretty controversial, and if you believe in the theories from A Random Walk Down Wall Street, which I unabashedly do, then shouldn’t active managers do just as well as a passive index?  Hmmm, that sounds like fodder for another post.  People debate this all the time and I’m not convinced that this really drives the needle.

The final major benefit of Index mutual funds is that they’re super easy, especially compared to some of the more difficult investing strategies like Asset allocation.  You can go to a place like Vanguard (that’s where the Fox family’s money is) or Fidelity or a dozen other places and sign up for one of their index funds, then as Ron Popeil says, “you set it and forget it.”  That means you’re getting pretty incredible value for a relatively small amount of work.


Who goes on to the championship game?

Index mutual funds pulled out all the stops, but in the end Asset allocation was just too strong.  Index mutual funds will definitely help build your nestegg, probably juicing your returns 1% compared to actively managed funds and maybe even 1.5% if you’re feeling charitable.  That’s nothing to sneeze at, but we’re talking about punching your ticket to the Championship round here, people.

Let’s say you completely abandoned the idea of Index mutual funds and went totally with actively managed funds.  How bad would that be?  It wouldn’t be ideal (just my opinion and one not shared by my good friend Mike), but you’d be fine in the end.  Actually this is what millions of people do all the time and it tends to work out.

Compare that worst-case scenario to Asset allocation’s and you see why they won.  Screwing up early on and investing too much in bonds and cash instead of stocks can cost 3-4% on your returns.  That dwarfs what Index mutual funds bring to the table.  Screwing up closer to retirement can put your whole financial plan at risk.  Ask near-retirees who were to heavily invested in stocks before the 2001 or 2008 crashes what they think.  In the immortal words of Winston Zeddemore “I have seen s%$t that will turn you white.

bracket-game 5

With Asset allocation the stakes are just too high.  I have Asset allocation pulling away, 68-59.  Be sure to come back tomorrow to see who they take on in the final, either Savings rate or Tax optimization.

First Round: Mortgage versus Savings rate

Basketball hoop

After a thrilling contest between Index mutual funds and Free money yesterday, we are now pitting Mortgage against Savings rate.  As always, I am not an expert on these matters.

bracket-game 2


Reasons for picking mortgage:

For most families, their Mortgage payment on their home is the single largest expenditure they have.  Also, due to its nature as a commodity, it’s also one of the easiest places to really save a lot of money pretty painlessly.  For a lot of products there’s a trade off between price and quality.  A BMW 325 owner could pay $20,000 less and drive a Honda Civic, but there is a trade-off, either real or perceived, between those two cars.  Sure you’re saving a lot of money, but you’re also getting not nearly as nice a car.

Mortgages are very different because money is a commodity, so there’s no difference.  If you get a Mortgage from Bank of America it acts pretty much identically as the Mortgage you get from Roundpoint (incidentally, the Fox family used to have our mortgage with BofA and now we’re with Roundpoint).  Money is money so here you want to go with whoever can give you the lowest rate (there are some features that might be important like prepayment penalties or ability to refinance within a certain period of time, but in my experience those are pretty rare).

Here we’ll use the Grizzly family as an example; they owe $400,000 on their home.  One of the easiest ways to save money on a mortgage is by refinancing when interest rates go down.  In the past few years, rates have been at historic lows and that means Mortgage interest rates have been similarly low.  Let’s say the Grizzlys got their mortgage 8 years ago with a rate of 6%, but now they can refinance at about 4%.  That alone would reduce the interest payments over the life of their mortgage about $175,000!!!  That’s an incredible amount of money for going through a process that takes maybe a month from beginning to end, and probably about 5 hours of work on your part.  As easy as this is, there are millions of homeowners out there who haven’t done this yet.

You can move a little up the difficulty spectrum and save even more.  Some Mortgages are sold with “points” which is basically prepaying interest; for example you might pay an extra $5000 when you get your loan and for that you would have an interest rate of 3.5% instead of 4.0%.  Points aren’t very well understood and because of that a lot of people tend to stay away, but if you are planning on staying in your house for a long time, they can be the best money you ever spent.  Using that above example, paying the $5000 to get the lower interest rate would net you a savings of about $35,000 over the life of the loan.

Kind of the opposite of points are adjustable rate mortgages (ARMs).  Instead of a 30-year fixed loan (the interest rate stays constant for the 30 year life of the loan) you could get a 5-year ARM where the interest rate is fixed for the first 5 years of the loan and then adjusts based on market conditions for the remaining 25 years.  The benefit of these is ARMs tend to be about 1% less than fixed rates, but the major concern is that rates could rise after the 5 years is up and that could increase the cost of your Mortgage.  In my opinion ARMs make sense if you don’t think you’ll be in your home for very long.

In fact the Fox family got a 5-year ARM when we relocated to North Carolina.  In the here and now we enjoy a rate about 0.8% lower than if we got a 30-year-fixed (our rate is 2.2% and it would have been about 3% with a fixed).  That’s worth about $300 each month.  Rates have been rising, so in 2020 when the ARM starts to float (rates can move) we can either pay a higher rate (remember, we’re still ahead of the game so long as rates stay below 3%), refinance to a fixed mortgage and pocket five years of monthly $300 savings, or just pay off the entire mortgage.  We’ll see.

  What it does?
Refinance Take out a new loan at a lower interest rate to decrease the amount of interest you pay
Buy points Pay more in closing costs to get a lower interest rate
ARM Get a lower interest rate that is fixed in the beginning but then becomes adjustable (usually after 5 years)


So all these seem to be pretty big numbers, especially since you aren’t really giving anything up to achieve them.  But they aren’t going to be quite that big because interest on mortgages is tax deductible, so saving $100,000 in interest on the life of your mortgage may only put you ahead $60,000 because of the tax deduction.  On the other side of the spectrum, you might end up with significantly more if you took those savings and invested them.  Either way, your Mortgage is a great way to pad your nestegg.


Reasons for picking savings rate:

Savings rate is probably the most fundamental element of investing.  You can’t really invest until you have saved some money to invest with (Gee Stocky, thanks for that tremendous insight into what we already know).  And certainly, the more you save, the more you can invest, and the larger your nestegg will become.  But how much can saving more really move the need?

savings rate

The impact can be pretty staggering.  Over a 38-year period, from 22 when most of us enter the workforce, until we turn 60 and hopefully retire, if you invest $100 per month (assume a 6% return) you will end up with about $175,000!!!  It’s not that $100 isn’t a lot of money (it definitely isn’t chump change), but that seems pretty incredible that such a modest amount every month can lead to such a large number at the end of the run.  Over those 38 years, you would have invested a total of about $47,000, and because of investing returns you would have ended up with about 4 times that amount.

And the math works so if you save $200 per month, you end up with about $350,000; $1000 per month, you end up with $1.75 million.  Ladies and gentleman, say “hello” to the power of compounding.


Who wins?

Mortgage gives it a good fight, but in the end Savings rate is able to generate numbers that are so much bigger.  Also, while refinancing at a lower rate is a pretty sure-fire way to save money with your Mortgage, the more complicated maneuvers like buying points or using an ARM do entail some risk which could cost you serious dollars if you move too early or too late.  On the other hand, there is really no way that saving more can hurt your nestegg.  In the end Savings rate crushes Mortgage 65-51.

Come back on tomorrow to see the final match of the first round, Starting early against Tax optimization.


bracket-game 3

First Round: Asset allocation versus Diversification

I’ve got my tickets to the Regionals in Charlotte, thanks to my neighbors Mr and Mrs Nittany Lion.  In honor of that I am kicking off the investing strategy tournament to determine which is the single best investing strategy if you could only pick one (which fortunately isn’t the case–you can pick all these).  As always, I am not an expert.  So without further ado, we’ll start with the contest between Asset allocation and Diversification.


Reasons for picking Asset allocation:

Asset allocation is picking the right mix of stocks, bonds, and cash which maximize your investment returns while also limiting that chances that you hit a bad patch of time which cripples your portfolio beyond recovery.  The basis of the concept of asset allocation is the fact that as your expected investment returns increase, so does its volatility.

So for example, cash (or money market accounts) are the least volatile investments around where the chances of you losing money are nearly zero, but they also offer the smallest return at about 1-2%.  On the other end of the spectrum are stocks which historically have averaged about an 8% return, but where about one-third of the years you lost money.  Bonds are between those two, both in terms of returns and risk of losing money.

In my experience screwing up Asset allocation, especially among young investors, is one of the most common missteps.  The conventional wisdom is that you want to take more investing risk when you’re younger because you have more time to “recover” from any market downturns (as was the case with me in 2001 when I was just starting out).  That means that typically (and of course, each individual is different) younger people should allocate more to stocks than bonds or cash.  However, so often I talk to younger investors who have a significant chunk of their 401k in bonds or worse yet, cash.

Why is this so bad?  Well, over a period of decades, the investment horizon when you’re in your twenties or thirties, you end up leaving a lot of money on the table.  Using historic averages, if the 25-year-old you invested your 401k in stocks and your twin invested in bonds, when it comes time to hang up the spurs, it’s no contest—you’re so far ahead of your twin.  Remember that historically, stocks have returned about 8% while bonds have returned 5% and money markets (cash) have returned about 2%.  Just doing some really simple math, the historic difference between stocks and bonds has been about 3%–that adds up to huge differences over an investing career (remember from “The power of a single percentage” how big a difference 3% can make?).  Who knows if it will be like that in the future, but based on history that could lead to hundreds of thousands or even millions of dollars over time.

Of course, you probably read A Random Walk Down Wall Street, so maybe you’re saying, “but when you invest in stocks you’re only getting a higher return because you’re talking on more risk.”  There’s no such thing as a free lunch, and right you are.  That argument is exactly why Asset allocation is so important.  If you were 60 years old and getting ready for retirement, it probably wouldn’t be a good idea to risk losing a big chunk of your portfolio by investing the majority of your money in stocks.  But if you’re 20 or 30 years old, then you can invest in stocks to get the higher return knowing you’re at less risk of a catastrophic loss because you have three or so decades to ride out any storms.


Reasons for picking Diversification:

Diversification is the strategy of picking multiple investments so that you can reduce the volatility of your portfolio.  When some of your investments are down, others will be up.  This is really Investment 101 stuff, and I don’t think you’ll find many legitimate investors who would not say it’s a good thing.  But if you think about it, how much is Diversification really doing to help you achieve your financial goals?

The fact of the matter is that Diversification does not increase your investment returns, on average (“on average” is a critical phrase here).  If that’s true, then why does everyone make such a big deal about Diversification?  Because by diversifying with several stocks you even out the highs and lows that would occur with a single stock.  As an example let’s look at investing in an S&P 500 index mutual fund which is considered highly diversified, and compare that to investing in a single stock.  Here I picked Catepillar because from 1980 to today, it and the S&P 500 had largely the same performance (they were both up about 2300% over those 38 years).

Over that time both investments had their ups and downs, but the difference was that Caterpillar’s ups were much higher and its downs much lower.  Since 1980 (38 years), the S&P 500 index had eight negative years with its worst year being 2008 when it was down 39%.  It also had 13 years where it had a return of 20% or better with its best year being 1995 when it was up 39%.

Now compare that to Caterpillar over the same time, remembering that over the entire 38 years they both had total returns fairly similar to each other.  Caterpillar had 17 years with negative returns, the worst being 2008 when it fell 55%.  On the other side, it had seven years where returns were over 55% (16% better than the best year of the S&P 500 index), with the best year being in 2010 when it increased 90%!!!

So think about that.  If you decided not to diversify and put all your money in Caterpillar back in 1980, you would have ended up in pretty much the same place as your twin who diversified with the S&P 500 index, but you would have had a much crazier ride.  2008 would have sucked for both of you, but much more so for you than your twin.  Also, almost half of your years would have been negative (15 out of 34 years) where it was only about 7 out of 34 years for your twin.  Of course, that would have been offset by some real “bumper crop” years (I had to get a farming analogy in) like 2010 when your portfolio would have almost doubled.  No one is complaining about a year like that, but it that a good thing?

Even recently, with Caterpillar you would have had 2014 and 2015 which were down over 10%, but that was made up in 2016 and 2017 which were both up over 60%.  Meanwhile, the S&P 500 was trudging along at double digit gains.  Holy Cow!!!

How do you plan for something like that?  Pre-2010 you were probably figuring you’d have a moderate retirement, and then 2010 rolled around and life all the sudden got a lot sweeter.  Exact same story after 2015.  Just look at the graph—far and away the most common annual return for the S&P 500 index was the 0-20% bucket; for Caterpillar the returns were all over the board and the most common was -20% to 0%–a loss!!!

And of course, I picked Caterpillar because over the 38 years it was pretty close to the S&P 500.  Remember that if you picked a single stock randomly from a broad index like the S&P 500, you would expect the stock to do just as well as the index, because the index is just an average of a bunch of those stocks.  And it’s true that on average a single stock will do as well as an index, but what if I randomly picked United Airlines which went bankrupt just like many, many other companies do every year (there’s no real chance that the value of the S&P 500 would go down to zero in a similar way)?  Or if I picked Medtronic (one of the greatest companies ever) which outperformed the S&P 500 some 8x?

My personal preference with investing is that I want as much predictability as possible, and that is even tough to come by when you’re highly diversified; when you aren’t diversified, there’s no chance.  Maybe if you like those types of thrills that putting everything into a single stock brings, you may want to think about BASE jumping or free diving.

But assessing it honestly, Diversification does not lead to higher returns on average.  It just reduces the crazy swings up and down.


Who wins?

Asset allocation wins this one pretty easily, 86-59 (I just made that up to look like a basketball game score, but it seems about right).  Diversification definitely helps smooth things out, but Asset allocation can undeniably increase your returns which translates to real money.

bracket-game 1

So Asset allocation moves on to the Final Four.  Make sure you come back tomorrow to see Free money take on Index mutual funds.

Investment returns on our solar panels

If you are a loyal reader, you’ll remember that two years ago this month we made a 5-digit purchase.  Foxy and I installed solar panels on our new North Carolina house.

Two years later, let’s look at how that “purchase” has performed as an “investment”.  To save you the suspense (Hey, I appreciate you’re busy and may not have the time to read this whole post), I’ll give the investment a solid mediocre to slightly below mediocre—about a 4% return.


Sweet, free electricity

We bought an array of twenty 265-watt solar panels.  At the time, when we were talking to the sales guy and we factored everything in—the number of sunny days in our area, the pitch and direction of our roof—we thought we were going to be getting about 550 to 600 kWh each month.  As it turns out, we’ve averaged slightly less than 530 kWh per month.

That’s a bit of a miss that translates to real money.  With our electric utility in North Carolina (Duke Energy), when you factor in taxes, fees, and everything we pay about $0.10 per kWh.  Quick math shows you our panels save us about $53 each month.  However, that’s 20 to 70 kWh less than we thought, and that translates to about $2 to $7 less per month that we are getting than we expected.

That said, we’re generating a lot of “free” and green electricity each month.  As you would expect, our electricity varies widely with the seasons—higher in winter because of the furnace and summer because of air conditioning and lower in spring and fall.  If you average everything out, we use 1,100 kWh each month, so those panels are addressing about half our usage.  That actually seems pretty decent.


By the numbers

But you know me—words like “pretty good” and “decent” don’t cut it when we’re talking about real money and investments.  Let’s dive into the nitty gritty to see how this works has an investment.

The whole set up cost $17,700, however our net cost was significantly less.  For paying in cash we got a $1,100 discount.  We also played credit card roulette, and that knocked our price down another $1,400.  Finally, the biggest discount was the federal tax credit; solar panels allow for a 30% tax credit so that knocked another $5,700 off (we only got that when we filed out taxes the following year).  Net all that out, and our panels cost $9,700.

For a $9,700 “investment” we got our electricity bill reduced by about $53 each month.  If you do the math, that’s right at 4.0% return.  If you’re curious, without the $1,400 credit card roulette the return would have dropped to 2.8%.

A 4% return isn’t very good.  It’s a far cry from the 20%-ish annualized return the stock market has blessed us with these past two years, so that’s a bit of a miss.  However, that’s not entirely fair to compare something like solar panels to the stock market.

Probably a better comparison would be a bond—we pretty regularly use electricity and those solar panels pretty consistently generate 530 kWh each month (the highest we get is in June at about 800 kWh and the lowest is in January at about 200 kWh).  That 530 kWh is worth $53 each month, so that “feels” a lot more like a bond.  Given the warranty on the solar panels is 25 years, I think it’s safe to assume we’ll continue to get that electricity generation for a really long time.

So we bought a $9,700 bond that pays us a monthly dividend of $53—a 4% return.  That’s where I’ll give it a solid “decent”.  In this market, 4% is a fairly decent return for a government or corporate bond: long-term Treasuries are yielding about 2-3% and investment grade corporate bonds maybe 4-5%.  We’re right in that mix, so that’s okay I guess.  Of course, I would have liked more (and thought we were going to get more), but that’s the way it is.

There is a bit of an ace in the hole that makes this a bit brighter.  That 4% assumes that electricity rates stay at $0.10 per kWh, which is where they’ve been the past two years.  Electricity rates have historically risen in the 2-3% range (although they didn’t this year specifically, I believe, because I invested in solar panels and the investing gods wanted to humble me).  If you assume a 2% electricity rate inflation that return bumps up to 5.6%.  That seems a little bit better.

As an aside, when I run for government office I am going to propose a nice little tax break financed solely by increasing electric rates.  Between solar panels and LED lights, we can definitely reduce our electricity usage with minimal sacrifice.  I cringe when I see incandescent light bulbs at someone’s house or in a store.  A 5-watt LED bulb can generate the same brightness at a 60-watt incandescent bulb.  Over the 20 life of an LED bulb, there is a electricity savings of about 1,000 kWh ($100).  In case you’re curious, that’s a 251269% return (I’m not kidding, that’s a real number) on investment just changing your old bulbs to LED bulbs.


The intangibles

So as an investment I think the solar panels are a bit mixed.  We’re getting 4% with the chance that it increases a bit.  It’ll never be anything magical that rivals the stock market.

However, there is another piece that is important—the “green” perspective.  In these two years, our solar panels have generated a total of about 12,000 kWh of pretty much pollution-free electricity.  Given that Duke Energy still generates most of it’s electricity from coal plants, that has a positive carbon footprint.

Using back of the envelope math, that’s about 7 TONS of carbon dioxide that isn’t in the atmosphere.  Basically, we’ve offset both of our cars, plus two of our neighbors’ cars.  I don’t know how you personally value that, but that’s what you’d have to do to make the solar panels make sense in your head as a good investment.


The other day Foxy Lady and I were chatting about home improvements (she desperately wants a pool), and the solar panels came up.  She asked me what I thought about the decision.  I thought for a few seconds and said I regret doing it.  The electricity generated was a bit short of what I had hoped, and the return was therefore below expectations.

I do think solar panels are the wave of the future.  Right now, unless you are totally green, the federal tax incentives are a must for them to even be a consideration.  You never know when they will end, and back in 2016 I think I had a bit of “get on the bus before it leaves” mentality that made me pull the trigger maybe sooner than I should have.

I know panel prices have gotten better (more kWh per panel) and prices have fallen, so I think if I was able to do it at current prices the return might be a bit better, but it’s still going to be in the 5-6% range.


Driver-less cars impact your decisions now

I don’t think there’s any doubt that driverless cars are going to change the world.  They’ll be safer, cleaner, more efficient, eliminate/reduce traffic jams, and on and on.  The future looks bright . . . but what does that have to do with today?

The big question isn’t if but when.  A few years back Google and Uber and GM and everyone else were figuring out prototypes, and putting them on the road in a very limited way.  They told us not to get too excited—driverless cars wouldn’t become mainstream until way in the future: Think 2030 or 2040 when they became standard fare.

Yet that seems to have inched significantly closer.  Tesla today has driveless cars.  GM claims it will sell cars without steering wheels and pedals in 2019—THAT’S NEXT YEAR PEOPLE!!!

But back to the question at hand: what does that have to do with today?


Buying a car has big financial implications

Purchasing a car is a big deal that can greatly impact your personal finances (finally, Stocky, you’re getting to the point).  Getting that right or wrong can mean hundreds of thousands or millions of dollars.  Let’s really simplify the world to two scenarios:

  1. The Stocky method: You buy a car new, finance it at the teaser rate, and drive it until it goes to heaven.
  2. The Ocelot method: You lease a car and then turn it in after 3 years.

Certainly there are other options (1a—you buy a three year old car and drive that into the ground), but let’s just look at these two.

As you would expect, from a financial perspective option #1 wins big time.  A “typical” car like a Honda Accord costs about $22,000.  You could buy it for $2,500 down and then take advantage of 1% APR financing so you’ll have monthly payments of $332 for the next 5 years.  Or you could lease it for $2,500 down, and then pay $200 per month for the next three years; after which you turn the old car in and start it all over again.

Cars are engineered incredibly well, so let’s assume the car you buy lasts 24 years (I am the proud owner of a 1998 Toyota 4Runner).  If you run the numbers, buying a car comes out ahead to the tune of about $90,000.  That’s astounding considering the original purchase is only $22,000.

Bear in mind that’s $90,000 per car each time you make a purchase/lease decision.  For a married couple, it comes to about $800k over their investing horizon.  Remember that the average American has a net worth of about $80,000.  Heck, if you didn’t save a dime in your 401k or do any of the other stuff we talk about, just the car purchase decision could fund your retirement.

Of course, it’s not a perfect comparison.  The major advantage of a lease is you get a new car every three years—that’s a safer car, a nicer car, plus the option to change the car as your situation changes.  But $800,000 is $800,000 after all.

The point is that financially it makes a lot more sense to buy a car than lease.


Driverless cars completely changes the car purchasing decision

Let’s bring this full circle now.  We’re on the brink of driverless cars changing everything.  Once they come out, you’d be crazy not to go with that option.  In fact, I think car insurance will make it much more expensive not to use driverless cars, and before too long human-driven cars will be banned (the same way horse carriages are banned on highways today).

We’re definitely in the kill zone.  Foxy and I are wondering how much longer the 4Runner has—I say many more years but I think she secretly tries to put sugar in the gas tank to kill it when I’m not paying attention.

If we had to get a new car today, what would we do?  Normally it’s a no-brainer: you buy a new car and drive it forever.  However, for that decision to make sense you have to drive that car for years.  Actually, the breakeven point is at about 8 years.  Is there any doubt that by 2026 we’ll have really good driverless cars?  At the rate things are going, we’ll have them in 8 months, not 8 years.

Futurists make a really exciting debate about what the future of cars will look like.  Personally, I think ‘Lil Fox and Mini Fox will never own cars.  Rather they’ll subscribe to a service similar to your cell phone: for $300 per month you get your 16-mile work commute (with up to 2 other commuters, 2 minute max wait time) plus 500 miles of other driving in a 4-person sedan (with up to 100 miles in a minivan or SUV).

That will fundamentally change things like car insurance, garages (both at home and parking structures), and a million other things.  And I bet it’s a lot sooner than we think.  Bear in mind, 5 years ago, everyone was saying driverless care are decades away; now GM says it’s a year.

In the meantime, we have to still get to work and pick up groceries and take the kids to baseball practice today.  How does all this impact what you want to be a sound financial decision if we have to get a new car today?


The verdict—lease your next car

While this pains me to say, I think the best financial move for your next car is to lease.  Who would have thought I would ever type those words?

If you buy, in 10 years or so you’ll be just getting ahead on your financial decision, but you’ll be sooooo behind the times plus be a bit of a hazard on the road.  Imagine hanging out with your friends as they take selfies and you pull out your Blackberry.

Going all in with stocks


With the recent craziness in the stock market, I’ve chatted with friends about how much of their portfolio should be in stocks.  Actually the conversation goes more like:

THEM:  I am about 50% stocks, 50% bonds.  How does that sound?

ME:  50% stocks and you’re 41 years old, and you have a good job?!?!?!?  Are you crazy?  That’s way too conservative.

THEM:  But I don’t want to be too risky.

ME:  You have a lot of safe investments that you probably don’t even know about.  The investments you can invest in stocks you should so you can get the higher return over the long term.

THEM:  ??????


So here is what I am talking about–the hidden cash in your portfolio.

We know that you need to balance risk and return in our investments.  This is most clearly done when we choose our mix of stocks (more risky, higher average returns) and bonds (less risky, lower average returns).  As an investor gets older they want to shift their asset allocation towards less risky investments because their time horizon is shortening.  We all agree with this.  So where is this hidden pot of gold I’m talking about?


Let’s look at the example of Mr and Mrs Grizzly.  They are both 65 years old and entering retirement.  They worked hard over the years and socked away $1 million that will see them through their golden years.  They do some internet research and learn that a sensible asset allocation in retirement is 40% stocks and 60% bonds, so they invest $400k in stocks and $600k in bonds.  Knowing the long term average returns are 8% for stocks and 4% for bonds, they expect their $1 million nest egg to generate about $56,000 per year ($400k * 8% + $600k *4%) , knowing that some years it will be more and some years it will be less.   So far so good, right?

1 m

THEY ARE LEAVING MAYBE $20,000 PER YEAR ON THE TABLE.  That’s a ton of money.  How can this be?  They seem to be doing everything right.  The answer is they are being way too conservative with their asset allocation.  They shouldn’t be investing $600k in bonds and $400 in stocks; stocks should be a much higher percentage.

Waaaaiiiiiiiittttttttt!!!  But didn’t we agree that about 60% of their portfolio should be in less risky investments?  Yes, we did.  Are you confused yet?


Hidden cash

Here’s what I didn’t tell you.  Mr and Mrs Grizzly have other investments that act a lot like bonds that aren’t included in that $1 million.  Both Mr Grizzly and Mrs Grizzly are eligible for Social Security with their monthly payments being $2000 each.  If Mr Grizzly (age 65) went to a company like Fidelity and bought an annuity that paid him $2000 each month until he died (doesn’t that sound a lot like Social Security), that would cost about $450k.  So in a way, Mr Grizzly’s Social Security payments are acting like a $450k government bond (theoretically it would be worth more than $450k since the US government has a better credit rating than Fidelity).  And remember that Mrs Grizzly is getting similar payments, so as a couple they have about $900k worth of “bond-ish” investments.

Also, Mr and Mrs Grizzly own their home that they could probably sell for $300k.  They don’t plan on selling but if they ever needed to they could tap the equity in their home either by selling it or doing a reverse mortgage.  So in a way, their house is another savings account for $300k.

If you add that up, all the sudden the picture looks really different.  They have about $950k of Social Security benefits that have the safety of a government bond.  Plus they have that $300k equity in their house.  That’s $1.25 million right there.


Investing your portfolio

So now let’s bring this bad boy full circle.  Remember their $1 million nest egg they were looking to invest?  Look at that in the context of their Social Security and house.  Now their total “assets” are about $2.25 million.  If you believe that the Social Security and house kind of feel like a bond, just those by themselves account for 55% of their portfolio.  If on top of that if you invest 60% of their $1 million nest egg in bonds, they have over 80% of their money in bonds, and that seems way too high.

2 25 m a

On the other hand, let’s say they only put $100k of their nest egg into bonds and the rest into stocks, after you include their social security and home, they’d be at about 60% bonds and 40% stocks.  Isn’t that what they were aiming for the whole time?

2 25 m b

Wow.  It took a long time to get there, Stocky.  The punchline better be worth it.  Remember that with $600k in bonds and $400k in stocks, they had an expected return of about $56,000 per year.  However, if they have $100k in bonds and $900k in stocks, because stocks are more volatile but have a higher expected return, they can expect about $76,000 ($900k * 8% + $100k *4%).  THAT’S $20,000!!! 

But aren’t they taking on a lot more risk to get that extra $20k?  Remember, there’s no such thing as a free lunch.  For sure, but if you look at it in the context of their Social Security benefits and their home, they have a fair amount of cushion from “safe investments” to see them through any rough patches in the stock market.


I wrote this post to show that people really need to take account all the financial resources they have.  In the Grizzly’s case, it was their Social Security benefits and their home.  Others of you may be getting a pension (Medtronic is generous enough to offer the Fox family one) or a second home or a dozen other things like that.

When you take those cash flows into account, all the sudden it seems a lot more reasonable to invest the rest of your money a little more heavily in stocks which you know over the long haul will give you a better return.

Market dips are awesome?!?!

Holy crap!!!  The last week of the market has been insane.  We’ve seen the largest point drops in the history of the Dow—1175 drop on Monday and 1033 drop on Thursday, although neither ranked within the worst 50 drops in percentage terms.  This is crazy, yet why would I possibly think that this is a good thing?  Over the past 6 trading days, the market is down about 7%.  Yowza!!!

I am, and most of you are, long term investors.  The money I am investing in the stock market is meant to be spent years, or more likely decades, from now.  Sure, what happened right now sucks and maybe is scary (although I think it’s actually the opposite).  That should be comforting because, although we’ve taken a huge body blow, the good news is that we have a really long time to recover.


Dollar cost averaging

OK, that might explain why it’s not so bad, but how could it possibly be good?  If you can take a Pepto and keep your head, this is actually a great time to be investing, be it regular contributions to your 401k and IRA or just regular stock purchases.  If you were excited to buy stocks two weeks ago when the market was frothing, you should be even more so now that stocks are “on sale” at 7% off.

Sure, that might make sense philosophically, but how does that work in real life.  Let’s look at my nephews Risky Fox and Safey Fox.  Risky Fox invests $10 every day no matter what happens.  His twin Safey Fox cut a deal with the investing gods where every day the stock market goes up an equal amount.  Both twins started investing on January 1, 2000, and each has invested $10 every day for those 18 years.  They both start when the S&P 500 was at 1455 at the start of the millennium and they both end last Friday when the market was at 2,620.

Those 18 years have had crazy bull markets and crazy crashes—the dot-com bubble and it’s popping in 2001, the Great Recession of 2008, and the Trump run of 2017.  Those are the big ones but there have been mini-crashes and corrections too like August 2011 and January 2016.

Through all of that Risky invested $10 through thick and thin, no matter where the market was, high or low.  In her bizzaro alternative universe, Safey invested $10 every day , knowing each day the market went up a small but consistent amount (0.0129% each day if you’re curious).

Who ends up ahead?  It would be a pretty stupid column if it was Safey . . . of course it was Risky Fox.  Each invested $45,560 over those 18 years.  Safey ends up with $62,011 which isn’t bad.  But Risky ends up with $89,773, about 45% more.

How does such a thing happen?  In 2001 the dot-com bubble popped and stocks fell 45% over three years.  Throughout all that Risky kept plugging away, investing his $10 each day, but now he was getting stocks at a huge discount.  Stocks recovered after a few years and that looked like a great buying opportunity in hindsight.  Then in 2008 the Great Recession his and stocks fell about 55% in a little over one year.  Again, Stocky keeps investing and when stocks bounce back, he looks like a genius for having kept faith and picking up stocks at a substantial discount the whole time.

And just to prove it isn’t a unique thing, if you did the same Risky/Safey experiment for the 1970s, 1980s, and 1990s, you get similar results.  The 1960s and 1950s have Safey coming out ahead, but by a much smaller amount.





2000 to 2018

























And never lose sight of the fact that what Safey is doing is impossible.  The market doesn’t work like this.  This just shows that what Risky is doing, something we all “have” to do, really isn’t all that bad.

It’s similar to asking if you can get from point A to point B faster by walking with your feet or flying with your wings.  You can get there with your feet most of the time more quickly, but even if that wasn’t so, none of us have wings.  The whole point is that buying through market down turns (or walking with your feet) does pretty well, even when compared to some fantasy construct.



Ultimately, this is a lesson of faith.  When we were in the depths of the Great Recession, Warren Buffet famously professed his faith in the US economy.  He turned out to be right and made tens billions (billions with a “B”) along the way.

There’s no proof that markets will always go up (predicting the future of human behavior is always impossible), and at the end of the day it’s a matter of faith.  If you believe in capitalism then you believe that stocks will always go up.  I do believe in capitalism so I do believe that stocks will always go up.

That’s what makes the little experiment with Risky and Safey work.  Even when things look horrible, like it did in the dot-com bust and the Great Recession, if you have faith in capitalism you’ll look at the downturn as a temporary turn that will ultimately return to rising prices.  You can see this by looking at a long term stock chart of US stocks: they have an unrelenting upward march through all sorts of markets over 100 years.  Or you can look at the data that shows that historically consistently investing in stocks has never lost money over a 20-year horizon.

S&P 500 since 1950

That brings us full circle.  We’ve been bashed in the face the past 6 trading days.  Stuff like this happens.  I have total faith in capitalism which means I have total faith that things will recover.

When people have asked me what I think will happen/what I think they should do, I tell them to keep on keeping on.  Keep investing in your 401k, keep putting away money in the 529 and your IRA.  It’s probably a lousy time to withdraw a ton of money for a beach house or some other massive expenditure, but beyond that, what’s going on in the stock market really shouldn’t be impacting you at all.

BOOM—Top 5 impressions of Dow’s 1150 free fall

Yowza.  Yesterday was a crazy day.  There’s an ancient Chinese saying: “you are lucky to live in interesting times.”  Definitely the past couple days the stock market has been interesting.

Yesterday I got cocky and wrote a post on the 666 point fall on Friday.  I was a bit aloof, and the investing gods love nothing more than to humble people like that.  So in a weird way, I take some of the responsibility for the 1175 point drop yesterday.

Seriously though, let’s take a look at what’s going on.  Here are my Top 5 impressions of what happened, and what it all means.


  1. Biggest point drop in a day

Yesterday’s 1175 point drop for the Dow was the largest of all time.  Living in interesting times, right?  But at a 4.1% decrease (I’m going to be using S&P 500 for percentages just because it’s a broader market and the data is easier to get), yesterday was about the 30th biggest drop since 1950.

A top 30 (or bottom 30 depending on how you want to look at it) is notable given there have been over 17,000 trading days since 1950.  However, top 30 means that on average, something like this happens about every other year or so.  Maybe not so special.

Remember the last time we had a drop this big?  Of course you don’t.  In August of 2011 there was a -4.5%.  Actually, August 2011 was a crazy month—there were FOUR days with percentage drops greater than the one we had yesterday.  Think about that for a second.  The month of August 2011 was a major rollercoaster with a lot of ups and downs.  Stocks were down 5.7% for the month.  But we don’t remember that at all because it was just a blip.  Just.  A.  Blip.

That’s how I think we’ll remember this one.  There are never guarantees, but this stuff happens all the time in investing during your 60+ year investing career.  Get used to it.


  1. See the horrors of automated trading

Look closely at the daily chart right around 3pm.  It took a super-steep nosedive, at that point falling to about 1500 points.  But then, nearly as quickly it recovered about 500 points.  That a huge swing in about 10 minutes.

What caused that: Automated trading.  Computers saw all the selling around them and were programmed to sell too.  However, what should be very comforting is that humans (and other computers with different programming) saw that and realized that the selling was overdone.  They stepped in and started buying.

Computer algorithms are a newer phenomenon in the market.  I did a post of how they lead to much more volatility (written the last time the market went really crazy).  However, while volatility may rise, it really doesn’t have any long-term impact on returns.

But the lesson here is realizing that a lot of what goes on is driven by thoughtless, emotionless computers that don’t really realize if there is an “overreaction”.  As a human who has perspective, that means you can keep your cool when that stupid machine thinks it’s all going to hell.


  1. How bad are things really?

This is important.  What has fundamentally changed since a week ago when stocks were at an all-time high?

Really not much.  There was a jobs report that showed wages had crept up a bit.  On top of that Janet Yellen has stepped down as Chairwoman of the Federal Reserve, and is being replaced by Jerome Powell.   Yellen was seen as fairly dovish on inflation, tending to keep rates lower for longer to spur higher employment.  Powell is a bit more hawkish and is seen as more likely to raise rates more quickly to fight inflation.  That goes to the whole thing we were talking about with the Fed yesterday.

Beyond that, which I think is a bit of a Red Herring, there aren’t any fundamental economic problems that are causing this.  In 2008 the mortgage crises exposed the rotten foundation of the banking industry; in 2001 the internet bubble popped and exposed massive accounting frauds; in the 1970s OPEC exercised considerable cartel power (something that I wrote about here as unlikely to occur again).

That’s a quick rundown of all the major stock market disasters of the past 60 years.  I don’t think there are any fundamental issues like that which we are uncovering to cause that to happen now.  Rather, while we remember those three listed above, just like August 2011 there are a dozen mini-disasters that turned out to be much bigger bark than bite.  I think that’s what we’ll have here.


  1. What I think is going to happen

Making predictions on the stock market is a sure way to look stupid, but I’ll do it anyway.

I think we’re definitely in for a wild month.  I bet today (Tuesday 6-Feb-2018) the market will be up 200 points, then down 300 and another 500 the next two days.  We’ll have a ton of volatility for the rest of the month, and we’ll end February down 4.8%.  For the year, I will stick with my prediction from December 2017, and I think we’ll be up 5%.

What am I basing that on?  A lot of gut, and that’s never a good thing.  The market has had an unprecedented run.  These things can’t last forever, and the market does take “breathers” (sometimes called corrections).  I think that’s what we’re going through right now.

However, the fundamentals are strong.  The tax break is a big boon.  Even more important, the tax break and a lot of other things are spurring innovation.  Money is being deployed in R&D instead of sitting in banks in Ireland and Switzerland.

Being as involved as I am in the medical device space, I know tremendous innovation is happening.  Diabetes is on the brink of being cured by Medtronic; bear in mind in the US we spend about $250 billion (read that again, a quarter TRILLION) to treat that.  Think of all the benefits that will follow.  Also we’re on the brink of having driverless cars which that alone will create well over a trillion dollars in sales and societal benefit.  Those are just two of probably a dozen you could rattle off.  Bottom line, I think things are really good right now.


  1. How this should impact your portfolio

It shouldn’t.  Definitely this shouldn’t scare you off into selling your portfolio.  There’s a famous saying in the stock market that says “You should be scared when others are greedy, and you should be greedy when others are scared.”

A week ago stocks were flying high and everyone was greedy.  As it turns out we should have been scared, but hindsight is 20/20.  Now that everyone is scared, we should be greedy.

That said, I wouldn’t try to time the market either.  A friend, Mr Snow Leopard, has a bit of cash sitting on the sideline and we were chatting about this and what to do.  I said if it was me, I would invest in equal installments over the next three or so months.  I know that goes against my analysis on how to invest a windfall, but I think things are so crazy right now, I wouldn’t feel comfortable putting all the chips in on one hand.  I’m going with my heart over my head, but oh well.

I think we’ll definitely be in for a rocky ride and I think there are going to be a few of these really good buying opportunities interspersed with glimpses of optimism.  Either way, DEFINITELY DON’T PANIC AND SELL OUT.

Fed rate hike spooks Wall Street

Last Friday there was blood flowing down Wall Street.  The Dow suffered its 6th largest point drop in a single day, falling 666 points (que Iron Maiden).  Being a top 10 worst day seems like it’s important, but that really overstates things.  The Dow is so high now, at 26,000, that a 700-odd point drop really isn’t that big.

If you look at the list of the Top 20 biggest point drops, this one ranks at #6.  But in percentage terms it’s lowest on that list.  In fact, since 1950 there have been about 200 or so drops in percentage terms this bad.  That comes to about 2-3 per year.  So let’s not get too freaked out.

Also, let’s keep in mind that the stocks are up 3% so far for the year.  That’s really good, and no one would normally complain about that after just a month.  But it’s human nature to complain, so that’s what we do.

OK, I’m a little calmer.  But it’s still worth trying to figure out why the drop happened.  Most economists look to the Federal Reserve as the culprit.  Or more precisely the idea that inflation is steadily rising and that will prompt the Fed to start raising interest rates.  You know my feelings on inflation in general, and specifically I predicted a few weeks back that over the long term we would have really low interest rates.  Either way, new ideas on inflation weren’t what spooked the market, but the idea that the Fed would start raising interest rates.

That begs the question, how do interest rates impact the market?  And that’s really French for Why is the Fed so important.


How does the Fed impact the economy?

Let’s imagine a really simple economy.  There are ten companies named A and B and C all the way down to J.  Just like in real-life, not all companies are created equal, with some being much more profitable than others.  Here A is the most profitable (maybe like Apple) while J is the least profitable (maybe like JC Penney).

Interest rates will play a big part in the profitability of these firms.  As interest rates go up, the amount they spend on interest for all their debt goes up as well.  Because A is so profitable, it would only start to lose money if interest rates went really high, up over 10%; however J is much more vulnerable and will become unprofitable if interest rates go over 1%.  All the other companies have a similar situation as shown in the graph.

So this is where the Fed comes in.  Let’s say the Fed sets the interest rate at 6%.  Firms A, B, C, D, and E are all profitable even when the interest rates are that high; but firms F, G, H, I, and J are not.  Because of that things won’t look good for firms F-J.  Maybe it’ll be so bad that they’ll go bankrupt or maybe they’ll lay off people or put a hiring freeze on.

At 6% interest, you have five firms that are doing well (A-E)—growing, hiring more people, expanding, etc.—and five that aren’t (F-J).  And at 6% the economy is performing at a certain level.  But what would happen if the Fed lowered the interest rate from 6% down to 5%?  One more firm (F) would be profitable, and in general it would benefit all the firms.  The profitable ones would be doing even better, and the unprofitable ones wouldn’t be quite so bad off.  And that would lead to a strong economy: more “stuff” would be produced and more people would be employed.

So there is very clear relationship that lower interest rates led to a stronger economy.  Having a strong economy is one of the Fed’s goals, so that begs the question, “Why doesn’t the Fed push rates all the way down to 0%?”

This is where it starts to get interesting.  It’s my favorite topic: Inflation.  Remember that the Fed’s first job is to control inflation.  Let’s look at the Fed’s decision to move interest rates from 6% to 5%, but now look at it with an eye towards inflation.

In our pretend world, let’s assume at 6% interest rates the economy is doing well.  Things are growing and unemployment is fairly low.  When interest rates go to 5%, firm F will become profitable so they’ll want to hire some people—makes sense.  But remember that unemployment is low, so F is going to need to tempt people who are already working for A or B or C or whoever to come work at F.  How does F do that?  They pay them more.

F starts to pay people more, but A doesn’t take this lying down, so A starts paying more.  This wage increase trickles through the economy.  But A and B and even F need to make money, so the increase in compensation they’re paying to their employees gets passed along to consumers in the form of higher prices.  When prices start rising, that’s INFLATION.  And controlling inflation is the Fed’s #1 goal.  So that creates the difficult balance for the Fed—they want the economy to do well but not so well that it triggers inflation.

So there you go.  You just completed a course in “Introductory Macroeconomics”.


What’s going on today?

Now that you have that little lesson under your belt, how does that relate to what’s going on with the Fed right now?  Currently, the Fed has interest rates at about 1.5%.  That’s really low, but actually over the past couple years the Fed has been raising interest rates from when it was at 0%.  Obviously that’s super low, so shouldn’t the Fed be worried about inflation?

Remember the circumstances of how interest rates got that low.  At the beginning of 2008 the economy was going strong and the interest rate was at over 5%.  But then the financial crisis hit, blowing up the banking industry, and sending the world economy into a very sharp recession.  A ton of people lost their jobs (unemployment went up) so prices stayed flat or even started to fall a little bit.

With all this going on, the Fed threw a life raft to the economy in the form of near 0% interest rates.  In the intervening years, the economy has rebounded and unemployment has fallen, but inflation has remained pleasantly low.  This is kind of the best of both worlds for the Fed—the economy is strong and there’s no inflation.  The two things they have to balance are both in happyland, so they have kept interest rates low.

But what keeps them in the news is “the specter of inflation on the horizon.”  If you follow this stuff (like I do) in the past few months, every time inflation numbers come out, everyone looks at those and tries to predict what the Fed will do.

Every time this happens the market swings like a pendulum.  If rates are going to go up, the stock market gets crushed because firms will be less profitable (as we saw on Friday and in the little illustration above).  If that changes and we think rates are going to stay low, the market shoots up like a rocket.


What does it really mean when the Fed changes interest rates?

With all of this, are we just a bunch of idiots?  Should we really be so happy if the Fed is keeping rates low, and should we be so bummed if the Fed raises rates?

As the parent of two boys who one day may start sponging off Foxy Lady and me, I think the parent-child relationship is a good analogy.

Imagine you have parents (the Fed) who have a grown child (the US economy).  Times are tough for the child (the economy is doing poorly) so the parents help out (the Fed lowers interest rates).  The good scenario is that the child starts doing better to the point where he doesn’t need his parents’ help (the economy strengthens so it can withstand higher interest rates).  The bad scenario is the child becomes dependent on his parents’ help and is never able to make it on his own.

In this analogy the parents reducing the amount of help they give (the Fed raising rates) is a good thing, isn’t it?  It means that the kid is getting things on track and is standing on his two feet.  For this reason, I actually think it’s a good thing if the Fed raises interest rates because it means that the economy is strong enough that it doesn’t need insanely low interest rates any more.  Yet the markets react in the exact opposite direction.

I get it.  Just as the kid would be bummed if the parents said, “Hey pal, since you’re starting to make some money now, we won’t be sending those monthly checks”, the companies are bummed that they can’t borrow money so cheaply.  But that isn’t sustainable.

I chalk this up to yet another of a million examples of how the stock market acts in a goofy manner in the short term.  And another reason why I NEVER try to time the market.  I just keep my head down and invest for the long term, regardless of what is going on with interest rates.  But watching everyone hang on the Fed’s every last word does make for perverse entertainment.