Wise Money Decisions

I like Walter Updegrave’s Ask The Expert column on CNN Money.  His advice generally makes a lot of sense.

In March he got a question from a 28 year old with Roth IRA money in a 2045 target date retirement fund.  The reader’s account had been pummeled over the previous couple months and he/she asked whether he/she should do something different or just “suck it up” and keep investing (you can’t tell the reader’s gender from the column, unless “A.P.” is a non-gender neutral name that I’m not aware of).

Updegrave advised the reader that he/she shouldn’t “suck it up” because sucking it up is for sports not investing.  Then he used his next 828 words to give advice that can only be summed up as “suck it up.”

I’d like to add one important point to Updegrave’s advice.  There is no reason for the reader to be concerned about the ups and downs of a Roth IRA that is 30 years from its first withdrawal. 

In fact, the best thing that could happen to the reader is a stock market crash for the next 25 years, followed by a drastic upward climb just before he/she withdraws money from the account as the market takes up the slack of 25 years of under-performance. 

Why would that be better?  Because the reader would invest at attractive prices during the 25 years.  He/she would be worse off if the market steadily climbs during the 25 years.

It’s the same reason why I’m not bothered with the market’s awful performance the last few weeks.  After yet another horrible day today, it was announced the Dow is in recession territory at 10% below its all-time high from nine months ago. 

Music to my ears.  Every other long-term investor with a 5 year or longer investing horizon should be happy too. 

I just wish I had more money to throw in.

There have been reports of gas stations refusing to accept credit cards.  Here’s why:

Let’s say the credit card company charges the gas station a 2% fee.  A Honda Accord pulls up and buys 15 gallons.  When gas was $2/gallon, the Accord paid $30 for his gas.  The credit card company charged the gas station 60 cents for the transaction, or about 4 cents/gallon.  The station was left with a few cents of profit per gallon.

Now that gas is $4.50/gallon, the credit card company charges $1.35 for the same transaction, or 9 cents/gallon.  The higher fee pushes the station’s profit into negative territory.  The more the station sells, the more it loses. 

There’s an old Silicon Valley joke about the start-up that told its investors, “We lose money on each sale, but we make it up on volume.”  

To be fair, it’s not an old joke at all.  Before 2001 it wasn’t a joke so much as a business plan.  About that time people remembered their fifth grade math.  Multiply your sales revenue by a negative number, and you get a negative number. 

I hope you’re thinking, “But wait, even though the fee is higher, the station is making more per gallon and should be able to absorb the fee.” 

But alas, the station doesn’t make more per gallon.  The extra revenue is eaten up by oil producers, oil refiners, gasoline transporters, and government taxing authorities that are higher on the proverbial totem pole than the station. 

So what are the stations doing?  Some have stopped accepting credit cards.  Others are joining an effort to persuade the credit card companies to charge lower fees.

What should you, the mighty consumer, do?  Continue using your gas rewards credit card.  The station will make less from your patronage.  If that makes you feel bad, you can console yourself with the hundreds of reward dollars you’ll save each year. 

If you still feel bad, use your rewards dollars to buy Cheetos from the gas station. 

Ben Stein writes a biweekly column on the “Experts” section of the Yahoo Finance page. 

Ben Stein is an intelligent man (have you seen Win Ben Stein’s Money?  He’s a knowledge reservoir).  He also has the right big picture approach to investing. 

But yet I see his column as more ”celebrity” than “expert.”  Perhaps that’s just the point:  wise investing doesn’t require ”expert.”  Oh, and it doesn’t require “celebrity” either.  It requires clear thinking, a little know-how, and a lot of discipline. 

I like to read his column for a couple reasons: 1)  He has some wise things to say about investing, and 2) His celebrity undoubtedly brings in readers that wouldn’t normally read personal finance columns.  It’s interesting to see what kind of advice those people are getting. 

There’s a third reason.  Stanford Law School puts on a Jeopardy-like quiz show event as an annual fundraiser for a local legal aid society.  Ben Stein agreed to serve as the guest host for the 2004 event. 

I had a classmate, a close friend, who was a huge Ben Stein fan.  It was a dream come true when she was asked to pick Mr. Stein up from the airport, chaueffer him to the Friday night event, and take him to his hotel afterward.

When I saw her the Monday after the event, I asked her how awesome it was to drive Ben Stein to and from the airport.  I was pleasantly shocked when she said she not only showed Ben around town, but she also hung out with Ben in Santa Cruz over the weekend!  An hour of Ben Stein stories followed.

Ever since then I’ve maintained a casual interest in all things Ben Stein.

His Latest Column 

The latest Ben Stein column is short and sweet.  As usual there is not necessarily any unique insight or deep analysis, but there is a big picture idea that hits the proverbial nail on the head: 

Years ago, I received a letter that asked a brilliant question. The writer essentially wrote, “I read many business publications including the well known ones like Business Week and The Wall Street Journal. I observe that not only are they often at odds with one another. But they often have columnists within each publication who vehemently disagree. Moreover, they often turn out to be mistaken in their observations and predictions. How then do I know who to believe and what I should read to know the truth?”

The man’s question haunts me. The older I get (I am now 63 and feel every hour of it), the more clearly I see that much of what is in the media and in the financial media about investments, in particular, is simply nonsense.

I couldn’t have said it better myself.

I came across this article from Jack “the Mortgage Professor” Guttentag discussing the difference between wholesale and retail mortgage prices. 

Guttentag has formed an alliance of sorts with Amerisave, an online mortgage broker.  I read just about everything Guttentag has ever written before I got my first mortgage.  His writings convinced me to limit my search to Amerisave or another up-front mortgage lender that would guarantee their fees.  I ended up going with Amerisave.  I’m glad I did, despite a small mistake made by Amerisave that would have cost me $300.  After a few months of prodding and a quirky turn of events I finally got Amerisave to make good on the $300.  I’ll post about my Amerisave experience sometime soon.

Back to the article.  Now Guttentag has teamed up with Amerisave to provide wholesale mortgage price information on his website.  Without the Amerisave data on Guttentag’s site it is difficult for retail mortgage borrowers to obtain wholesale data.  By comparing wholesale data with the retail data quoted by brokers or lenders, the retail borrower gets an idea of the broker’s or lender’s markup.

The most interesting thing about the article is the data Guttentag gives about the average difference between mortgage rates for:

• Conforming and non-conforming loans.  Before the so-called sub-prime crisis the difference was 0.278%.  A few months into the crisis it had risen to 0.745%.  That extra half percent for a non-conforming loan is a big deal for those of us in high-cost areas.  Note that Guttentag’s article was written before the new higher conforming loan amount was approved.  I would expect there would still be a difference, but it occurs at a different loan amount (up to $729,750 depending on where you live) rather than the previous limit of $417,000.
• Full-doc and No-doc loans.  Difference was 0.525% before the sub-prime crisis and 1.022% after.  Ouch.
• Good credit and not-as-good credit.  Before the sub-prime crisis a FICO score of 620 cost you 0.3% on your loan compared to a 720 score.  Five or so months into the crisis the lower credit score cost you 1.37%.  Ouch.  Even worse, loans were no longer offered to borrowers with 620 scores after the first five months.

The numbers show that bad credit is much more costly than getting a non-conforming loan or a no-doc loan.

What to do with this information?  First, figure out what is the new conforming loan amount for your area.  If your loan amount now qualifies whereas it didn’t before, you should watch rates to see if it makes sense to refinance.

Second, do a full-doc loan if you’re able.  For most people the only difference between getting a full-doc and a no-doc loan is convenience.  It takes a little more time and organization to get everything together for the full-doc loan.  Getting the no-doc loan is easier, but an extra half percent on your mortgage is a hefty price for convenience, especially if you have the mortgage for many years.

Finally, establish good credit.  If you don’t have much of a credit history, begin to establish one by getting a credit card.  If you have a bad credit history, make the decision to change your credit habits.  It will take time to build a good credit file and raise your score, but it will pay for itself many times over.

A month ago I wrote about the $2/bag skycap fee at American Airlines.  At the time I thought American was out ahead of the industry, charging more than everybody else just like with the $15 fee for checking a first bag.

But it turns out Delta is one up on American.  I flew Sunday morning out of Salt Lake City and paid $3/bag to skycap.  The gentleman at the skycap helpfully pointed out that the $3 goes to Delta and not to him, just in case I didn’t see the sign that said the $3 fee didn’t include a tip. 

So I paid him another $1/bag, for a total of $16 to check 4 bags.

Was it a lot?  Yea. 

Was it worth it?  Probably not. 

But it saved my pregnant wife and me a short walk carrying a lot of bags, an extra wait in line at the check-in counter, and the risk of missing our flight (we had arrived late at the airport, as always). 

Maybe it was worth it.

But the story doesn’t end there.  My $16 bought me a precious piece of knowledge worth oh so much more than $16.  The skycap guy pointed out that had I checked in online I could skycap my bags for no fee.  I wasn’t sure I heard right so I asked him to clarify.  Apparently it’s true.  If you check in online before you leave for the airport, you can check your bags at the Delta skycap for no fee.  Be a nice guy though and still pay a tip of at least $1/bag.

I usually check in online.  I didn’t this time because I was at my brother’s house and his printer was broken so I couldn’t print the boarding passes.  Maybe I’ll see if I can bill through the $16 to him.  Just kidding Rob.

I mentioned the broken printer to the skycap guy, and he said you don’t even need to print out your boarding pass.  Just check in online and skycap your bags for no fee. 

I am operating under the assumption that it only works with Delta, until I hear of other airlines doing the same.  If you are aware of other airlines’ policies, please leave a comment.

ABC has an article on their website titled, “They Earn $200,000 and Pay No Taxes: Find Out How These Rich Folks Avoided Paying Any Income Taxes.” 

The title is provocative and seems to be an attempt to appeal to a “class warfare” or “class jealousy” mindset.  What can be more unfair than wealthy people getting away with paying no taxes while the rest of us are stuck paying our fair share?

However, as I read through the article I discovered it’s all bark and no bite.

Here’s the story in a nutshell.  Each year the IRS releases aggregated data about federal tax return filings.  In 2005 (the most recent data available) there were nearly 7,400 returns that showed adjusted gross income (”AGI”) greater than $200,000 but reported no tax liability. 

How can someone earn $200,000 and have no federal tax liability? 

Two ways, according to the article.  First, in response to Hurricane Katrina Congress made rule changes to encourage charitable giving during the last few months of 2005.  The 50%-of-AGI limit on charitable deductions and the overall limit on itemized deductions was lifted for charitable donations made between August 27, 2005 and January 1, 2006. 

Second, in 2004 Congress began allowing taxpayers to claim a full, 100% credit for foreign taxes paid against the Alternative Minimum Tax.  Previously the credit had been limited to 90% of federal tax liability.

To sum up, there are a few thousand wealthy people that, in response to law changes made by Congress, decided to increase their charitable giving in latter 2005 or were allowed a full 100% credit (instead of the previous 90% credit) for foreign taxes paid.

It’s hardly the kind of unfairness that leads to revolution, or even hastily written letters to Congressmen.  As hard as I try, I just can’t imagine Patrick Henry getting upset about laws that encourage charitable giving.  And I did try.

There is a long list of things in our creaky old tax code that one could rightfully complain about.  Laws that encourage charitable giving or allow a credit for foreign taxes paid are not at the top of that list.

One of the unanticipated blogging difficulties I’ve had is deciding what to do when I’m traveling or on vacation.  I faithfully read a handful of blogs and it’s always a disappointment when there’s no new post.  I don’t like the idea of being the source of that disappointment for someone else.  I would like to let my readers know not to expect posts for a week or two. 

But my mother would be aghast if I broadcast to the world that my house is uninhabited and undefended for the next two weeks. 

It’s not like I own anything valuable.  Let me put it this way.  Do you remember a few years back when the grand prize for all contests was a 60-second shopping spree at some store in the Midwest?  Well, if I sold you a 60-second shopping spree through my house for $100, I’d likely come out ahead. 

But even so, why let 0.000023% of the world know that I’m out of town?

So if you have any bright ideas how to handle the blogger’s travel dilemma, I’d be happy to hear about it.

Now we return to our regularly scheduled programming…

The Wife points out a great way to save on rent:

Japanese Woman Caught Living in Man’s Closet

Tokyo - A homeless woman who sneaked into a man’s house and lived undetected in his closet for a year was arrested in Japan after he became suspicious when food mysteriously began disappearing.

Police found the 58-year-old woman Thursday hiding in the top compartment of the man’s closet and arrested her for trespassing, police spokesman Hiroki Itakura from southern Kasuya town said Friday.

If I’ve said it once I’ve said it a hundred times.  Don’t steal food from the guy whose closet you’re staying in.

There’s a well-written article in the New York Times on the growing debate over market-weighted vs. fundamental-weighted indexes.  The author Joe Nocera has done an exceptional job distilling a complicated topic into an easy-to-understand article.

If you have 5 minutes you should read the New York Times article.  If you only have 30 seconds here’s the 30-second version:

The world has been using market-cap weighted indexes.  The weight of each company in the index depends on its market capitalization.  Bigger companies have a greater weight in the index. 

Some believe that traditional market-cap weighted indexes overweight overpriced companies and therefore result in subpar returns.  Over the last few years there has been a growing movement that advocates the use of fundamental measurements (e.g. earnings, dividends, etc.) to determine each company’s weight in an index.  They have developed not only dozens of indexes, but also dozens of funds following such indexes.  They argue that the new funds generate superior returns over traditional market-cap weighted funds.

Robert Arnott, an advocate of fundamental-weight indexing: “It was very clear what was wrong with the index was that the weight was linked to the price.  If the price was wrong the weight was wrong.”

Opponents of the new movement complain that it’s not true indexing because it doesn’t seek to obtain the market return.  They claim it’s nothing more than a clever marketing scheme for what amount to actively managed funds. 

John Bogle: “The market return is the market return.” 

Bruce Greenwald, Columbia University finance professor: “It is a crime that they are marketing this as some kind of new theory they’ve come up with. All they are doing is dressing up a simple, well-understood practice.”

Supporters of the new movement (in no particular order):

• Robert D. Arnott
• Nobel laureate Harry Markowitz
• Charles Schwab
• Jeremy Siegel, well-known Wharton economist

Supporters of the traditional market-cap weighted indexes (in no particular order):

• André Perold, finance professor at Harvard Business School and a Vanguard director
• Vanguard founder John Bogle
• Burton Malkiel, author of “A Random Walk Down Wall Street”
• Clifford Asness, co-founder of AQR, a large quantitative hedge fund
• Bruce Greenwald, Columbia University finance professor

My Thoughts

I need to research the issue before I come to any firm conclusions.  But I’ll offer a few thoughts.

I sympathize with the view that traditional cap-weighted indexes can become skewed when stock prices are out of balance.  Also, I’ve long thought that a 500-company or a 3000-company market-weighted index is overkill when the top 20% of the index drives 90% of the index’s movement (that’s not a criticism of traditional cap-weighting, just a pet peeve). 

I like the idea of indexing based on something other than market capitalization.  However, fundamental indexing has the potential to introduce a great deal of subjectivity.  The whole point of index investing is to minimize the need for subjectivity. 

To the extent an index is based on subjective measurements, it seems like nothing more than a clever marketing strategy for active management (for now we’ll leave aside the fact that there is already some amount of subjectivity in many popular market-weighted indexes, including the S&P500.  Topic for another day). 

But if the index is based on something more objective, like earnings (and nothing else), I don’t have the same objection.  Note that one of the fund companies mentioned in the article uses earnings to weight their indexes, while the other uses a combination of earnings, dividends, and other fundamental variables.  There’s little or no subjectivity in the former, but a lot of subjectivity in the latter.

I love innovation and new financial products.  I don’t use most new products but I like that they’re available for research and for possible use if I decide it’s a good fit at some point.  I plan to watch the fundamental index funds for a while and see if they make sense for me. 

Bill Miller is a well-known stockpicker.  He is chairman of Legg Mason Capital Management and oversees some $35 billion.  Although not as famous as Warren Buffet, his reputation is on par with Mr. Buffet when it comes to picking stocks.  No less an authority than CNN Money proclaims him “the greatest money manager of our time.” 

Bill Miller is most famous for beating the S&P500 index 15 years in a row with his mutual fund Legg Mason Value Trust (LMVTX). 

During the streak there were several years that saw his fund underperforming the S&P500 leading into the final months or even the final weeks of the year.  But somehow he always ended the year with a miraculous finish to beat the S&P500 and grasp victory from the jaws of defeat. 

Nearing the end of 2006 he was in a familiar position: losing to the S&P500 with the year coming to a close.  There was a lot of media attention on whether this was the end of the streak. 

If memory serves me, he performed well at the end of the year.  But the deficit was too much to overcome and the streak ended in 2006.

What Does Bill Miller Prove About Active vs. Passive Management?

(Reader warning:  In the interest of space I’m about to make some generalizations.)

With the rise of index investing over the last 30 years there has been an ongoing debate about whether investors are better off choosing actively managed mutual funds or passively managed index funds. 

Supporters of passive management have compiled an impressive body of evidence indicating that passive management is likely to outperform active management over short periods of time, and even more importantly it is highly likely to outperform active management over long periods of time. 

Supporters of active management cite Bill Miller as proof that actively managed funds can outperform passive funds over long periods of time.  After all, Bill Miller did just that.  He beat the (mostly) passive S&P500 index for 15 years.

So who’s right?  Does Bill Miller prove that active management can beat passive management?

Evidence is Different than Proof

First, it’s important to remember the difference between proof and evidence.  Bill Miller might be evidence of some proposition, but not necessarily proof.  We have evidence of a Big Bang, but we haven’t proved it.  We have evidence of the Loch Ness Monster, but we haven’t proved it. 

If someone tells you that Bill Miller is proof that active management works, the proper response is that he might be evidence, but he’s not proof. 

Now that we all know the difference between evidence and proof, we can discuss whether Bill Miller is evidence that active management works. 

(For ease of use I’m going to use a shortcut.  When I say “does active management work” I’m really saying “can an active manager consistently outperform a passive approach over long periods of time.”   Similarly, when I say, “is active management better than passive management” I’m really saying, “can an active manager consistently outperform a passive approach over long periods of time.”)

Point

Supporters of active management see Bill Miller as evidence that active management is better than passive management. 

Counterpoint

However, supporters of passive management would rightfully argue that the existence of a single active manager that beats the S&P500 index for 15 straight years is a strong piece of evidence that active management doesn’t work. 

Passive management supporters recognize that there may be an occasional “lucky” fund manager that beats the index over a long period of time.  They would argue that with hundreds or thousands of fund managers in the world there ought to be more Bill Millers through simple random chance.  The index doesn’t have to beat all managers over a given time period, it simply has to beat the vast majority.  They would say the dearth of Bill Millers supports their argument that active management doesn’t work.

Point

Supporters of active management would argue that 15 years is simply too long for someone to beat the index by chance.  He must have special insight that allows him to do it year after year.

Counterpoint

Supporters of passive management would respond that 15 years may not be sufficient time for the index to prove its superiority over all other investing approaches.  (For some reason when I write the last sentence I picture Chris Farley saying, “All other tropical storms must bow before El Nino“). 

There may be a lucky active manager that beats the index for 15 years.  But continue for another few years and the lucky manager will eventually revert to the mean. 

I Got to Thinking…

There’s no question that Bill Miller has handily beaten the S&P500 index for 15 years.  But what has he been up to since the streak ended?  Unfortunately not much.  He has been beaten up the last couple years.  If this were a prize fight he’d be down for the count.

As a supporter of passive management I thought to myself, “If the last couple years have pulled down Bill Miller’s average return to that of the index, then passive management has once again proven its superiority, Bill Miller gets his comeuppance, and order reigns in the universe.”  After all, why should 15 years be the right testing period?  Why not 17-and-a-half?  Or twenty?  Or more? 

If the passive supporters are right, then the longer the testing period the more likely Mr. Miller should revert to the mean.

The Numbers

I gathered the numbers for SPY and for Bill Miller’s fund Legg Mason Value Trust.  I chose SPY because it’s the most well-known index fund that tracks the S&P500 and because it has data stretching back through most of Mr. Miller’s streak.   

SPY started trading in January 1993 so I started my comparison there.  By that point Bill Miller had already beaten the index for a couple years.

I’m not going to describe my methodology in detail since most of my readers want the bottom line without the details.  If you’re one of the chosen few that likes the details, post a comment and I can describe more in the comments.

From January 29, 1993 through the end of the streak in December 2005, Mr. Miller outperformed SPY quite spectacularly:

LMVTX:   13.7% annual return
SPY:        9.5% annual return

Miller’s numbers would look even better if I could include the first 2 years of the streak (SPY didn’t start until January 1993). 

Slightly more of Miller’s returns came through dividends.  Including the effect of taxes and taking into account the reinvestment risk would help close the gap a bit, but Miller still comes out far ahead. 

By the way, if you’re thinking, “Big deal, it’s just a few percent difference” then repent now.  A few percent is a big deal when compounded over several years.

Now let’s include the numbers for 2006, 2007, and 2008 through May 15 (from Jan 1993 through May 2008):

LMVTX:   10.74% annual return
SPY:          9.1% annual return

Including the last two-and-a-half years causes a slight decrease in SPY’s performance, but a staggering decrease in Miller’s performance.  Miller seems to be reverting to the mean.

Finally, I calculated the performance for an investor investing in LMVTX vs. SPY assuming a 25% tax on dividends.  SPY partially makes up the gap after-tax because a smaller share of its return comes from dividends.  The results (from Jan 1993 through May 2008):

LMVTX:   10.0% annual after-tax return
SPY:        8.8% annual after-tax return

If you’re like me, you appreciate the tax deferral opportunities of a fund with a low dividend yield.

(Although coming up with different numbers, Moneywise also concludes that SPY makes up ground on LMVTX once tax effects are thrown into the mix.)

Final Thoughts

Bill Miller earned his keep over the last 15 years as he thoroughly trounced the S&P500.  However, SPY is making up lost ground over the last 2.5 years.  It hasn’t caught up to Miller yet.  Only the future can tell if or when it will. 

In my view the existence of a single Bill Miller is strong evidence that active management can’t consistently beat passive indexing over long periods of time.  If active management worked (in other words, if active managers could consistently outperform the index) then there would be many Bill Millers that consistently beat the index year after year. 

Think about it.  The index has vanquished the vast majority of active managers over the years, but it doesn’t get any headline love from the media.  But when an active manager beats the index for 15 straight years it makes headline news in the financial section of the New York Times.  We’re still talking about it years later.

It ought to make you think twice before you pick an actively managed mutual fund.

Finally, if you believe that it’s just a matter of picking the right manager, you still face difficulty of identifying those managers ahead of time.  It’s once thing to marvel at Bill Miller’s outstanding returns over the years, but it’s quite another thing to identify the next Bill Miller without the benefit of hindsight.

Post Script

The New York Times (registration may be required) has this interesting graph showing Miller reverting to the mean after jumping out to an early lead in the late 1990’s and early 2000’s.