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Posts from the ‘Personal Finance’ Category

Did You Like Being an Executive in Residence (EIR)

This is the fifth and final post of a multi-part series on being an Executive in Residence (EIR). The initial post outlining the full series can be found here. The previous post was “Challenges of Being an Executive-in-Residence (EIR)

As I’m writing this post, I’m feeling a bit sheepish as I promised the to finish this series last year. I was reminded last weekend that people are finding significant value in the series, largely because so few people actually write about being an EIR. In my previous four posts, I stayed objective and incorporate lessons from other EIRs that I’ve had the opportunity to both know and work with.

Despite the series, I still receive questions about my time as an EIR, and the most common question I still get is:

Did I like being an Executive in Residence?

For those who want the short answer, it’sYes, I did.

For the complete picture though, I’ll try to put into my own words why I liked the experience of being an Executive-In-Residence at Greylock Partners, and why I’m grateful for the opportunity.

My Three Top Reasons for being an EIR:

1. The Typical Benefits

As I wrote in my earlier post, “Should I be an Executive-In-Residence (EIR)?“, there are a number of benefits to being an EIR, and my case was no different.

The position gave me the opportunity to create, build and grow relationships.  While I was heads down at LinkedIn, it was often hard to do this well outside the company.  My time as an EIR definitely helped me go into my next role better reconnected into my professional (and personal) networks.

My time as an EIR also allowed me to both broaden & deepen knowledge about multiple markets. I had both the time and the connections to explore a wide variety of product categories and sub-sectors, and more importantly, learn more deeply about what strategies and tactics were finding success.

One of the most obvious benefits of being within a firm like Greylock Partners was the incredible visibility into the startup community. There are so many incredibly talented entrepreneurs and executives building new businesses, and being an EIR provides not only exposure to them, but the opportunity for deep & frank discussion & debate.

Lastly, at a venture capital firm you quickly discover what are the unique knowledge sets where others in the startup community find value.  At Greylock, I had the time and focus to both clarify both my thinking and content around product leadership and growth, two topics that continue to be in high demand.  The investment in thought leadership, that I was able to make during my EIR role has continued to pay dividends well beyond the relatively short time I spent in the role.

2. A Time for Self Discovery & Clarity

About six months into the role, I had the good fortune to experience one of those rare life events that gives you both the time and the catalyst to think deeply. In May 2012, my wife & I welcomed our daughter into the world, and I took a month off to both manage the chaos that comes with a new addition, and reflect a bit on next steps.  (For fans of my blog, this is when I wrote my piece on the Combinatorics of Family Chaos).

During that time, I came to a new level of clarity about what I was looking for:

  • Product. As someone passionate about product & design, it had to be a consumer product & service that I was passionate about.
  • Stage. I’ve had the good fortune to work for both startups and large companies at almost all stages.  That being said, there’s no question that I deeply enjoy the technology, product & strategy issues that come with hypergrowth.
  • Role. After a range of technology & leadership roles, I realized that I wanted the opportunity to help build and lead a company. I wanted to be the CEO.

Finding a company that fit the above felt a little bit like finding a needle in a haystack, but fortunately Silicon Valley turns out to be one of the better haystacks in the world, and the EIR role gave me time to find my needle.

3. Finding My Needle

In the summer of 2012 I met Andy Rachleff for the first time, through an introduction by Jeff Markowitz at Greylock. While I knew of Andy by reputation, we had never had the chance to meet in person. Wealthfront was not a Greylock investment at that time. I told Andy that I loved what Wealthfront was doing, and that I had opened an account almost immediately after it launched in December 2011. That being said, I told him that the only way to make Wealthfront succeed would be to find the right talent and the right growth strategy.

Over a few months we met and debated different ways to attract the right talent to Wealthfront and find a growth strategy that would succeed. One day, as I was discussing the company with my wife, Carolyn, she provided me with exactly the final clarity I needed.  She said, “It seems like you really like Wealthfront and want it to succeed.”

It was true. I not only liked the idea of Wealthfront, but I also liked the idea of a world where Wealthfront was successful. I signed on before Thanksgiving (Wealthfront had about $79M under management at that time), and formally joined after the new year. Andy wrote his own version of his decision to bring me on as CEO on the Wealthfront blog, but I credit the EIR role with the time, the relationships, the clarity and the opportunity to find my dream job.

Right product. Right team. Right role. Right time.

 

Behavioral Finance Explains Bubbles

Note: This post ran originally in TechCrunch on April 20.  As a courtesy to regular followers of my blog, I’ve reposted the content here to ensure that longtime readers have access to it.

“Bubbles are beautiful, fun and fascinating, but do you know what they are and how they work? Here’s a look at the science behind bubbles.” – About.com Chemistry, “Bubble Science

“Double, double toil and trouble
Fire burn, and cauldron bubble.” – Macbeth, Act 4, Scene 1

Given the incredible volatility we’ve seen lately in the Bitcoin and gold markets, there has been a resurgence in discussion about bubbles. This topic is always top of mind in Silicon Valley, especially given that the two favorite local topics of conversation are technology companies and housing.

Defining a market bubble is actually a bit trickier than it might first appear. After all, what differentiates the inevitable booms and busts involved in almost any business and industry from a “bubble”?

The most common definition of a speculative or market bubble is when a broad-based, surging euphoria or wave of optimism carries asset prices well beyond supportable value. The canonical bubble was the tulip mania of the 1630s, but it extends across history and countries all the way up to the Internet bubble of the late 1990s and the housing bubbles in the past decade.

WHAT DO BUBBLES LOOK LIKE?

Not surprisingly, there are a number of great frameworks for thinking about this problem.

In 2011, Steve Blank and Ben Horowitz debated in The Economist whether or not technology was in a new bubble. In those posts, Steve cited the research of Jean-Paul Rodrigue denoting four phases of a bubble: stealth, awareness, mania and blow-off.

bubble chart

(Source: Wikipedia)

HOW DO BUBBLES HAPPEN?

In 2000, Edward Chancellor published an excellent history and analysis of market bubbles over four centuries and a wide variety of countries called “Devil Take the Hindmost: A History of Financial Speculation.” In his book, he finds at least two consistent ingredients.

  • Uncertainty. In almost every bubble, there seems to be some form of innovation or insight that forces people to rapidly debate the creation of new economic value. (Yes, even tulip bulbs were once an innovation, and the product was incredibly unpredictable.) This uncertainty is typically compounded by some form of lottery effect, exacerbating early pay-offs for the first actors. Think back to stories about buying a condo in Las Vegas and flipping it in months for amazing gains. This creates the inevitable upside/downside imbalance that Henry Blodget recently framed as: “If you lose your bet, you lose 100%. If you win your bet, you make 1000%.” Inevitably, this innovation always leads to a shockingly large assessment of how much value could be created by this market.
  • Leverage/Liquidity. In every bubble, there is some form of financial innovation that broadly increases both leverage and liquidity. This is critical, because the expansion of leverage not only provides massive liquidity to fund the expansion of the bubble, but the leverage also sets up the covenants that inevitably unwind when the bubble turns aggressively to the downside. In some ways, it’s also inevitable. When a large number of people believe they’ve found a sure thing, logic dictates they should borrow cheap money to maximize their returns. In fact, the belief it may be a bubble can make them even greedier to lever up their investment so they can “cash out” the most before the inevitable break.

BEHAVIORAL FINANCE LESSONS IN BUBBLES

Bubbles clearly have an emotional component, and to paraphrase Dan Ariely, humans may be irrational, but they are predictably irrational.

There are five obvious attributes of components of bubble psychology that play into market manias:

  1. Anchoring. We hear a number, and when asked a value-based question, even unrelated to the number, they gravitate to the value that was suggested. We hear gold at $1,500, and immediately in the aggregate we start thinking that $1,000 is cheap and $2,000 might be expensive.
  2. Hindsight Bias. We overestimate our ability to predict the future based on the recent past. We tend to over-emphasize recent performance in our thinking. We see a short-term trend in Bitcoin, and we extend that forward in the future with higher confidence than the data would mathematically support.
  3. Confirmation Bias. We selectively seek information that supports existing theories, and we ignore/dispute information that disproves those theories. (This also tends to explain most political issue blogs and comment threads.)
  4. Herd Behavior. We are biologically wired to mimic the actions of the larger group. While this behavior allows us to quickly absorb and react based on the intelligence of others around us, it also can lead to self-reinforcing cycles of aggregate behavior.
  5. Overconfidence. We tend to over-estimate our intelligence and capabilities relative to others. Seventy-four percent of professional fund managers in the 2006 study “Behaving Badly”believed they had delivered above-average job performance.

The greater fool theory posits that rational people will buy into valuations that they don’t necessarily believe, as long as they believe there is someone else more foolish who will buy it for an even higher value. The human tendencies described above lead to a fairly predictable outcome: After an innovation is introduced and a market is formed, people believe both that they are among the few who have spotted the trend early, and that they will be smart enough to pull out at the right time.

Ironically, the combination of these traits predictably leads to these four words: “It’s different this time.”

IT’S DIFFERENT THIS TIME

After two massive bubbles in the U.S. in less than a decade, many people question spotting bubbles ahead of time is so difficult. In every bubble, a number of people do correctly identify the bubble. As in the story of the boy who cried wolf, however, the truth is apt to be disbelieved. The problem is that in every market, there are always people claiming that prices are too high. That’s what makes a market. As a result, the cry of “bubble” is far more often proven wrong than right.

Every potential bubble, however, provides an incredibly valuable frame for deepening and debating the role of human psychology in financial markets. Honestly and thoughtfully examining your own behavior through a bubble, and comparing it to the insights provided by behavioral finance, can be one of the most valuable tools an investor has to learning about themselves.

First Day at Wealthfront & Disclosures

Tomorrow is my first day at Wealthfront, and I couldn’t be more excited.

WF Logo New

As many long time readers know, personal finance has always been a passion of mine.  However, now that I’m moving from this being a personal passion to a professional role, there are some important disclosures that have to be made.

First, it needs to be stated that Psychohistory is my personal blog and is not written in my capacity as COO of Wealthfront Inc.  Nothing on this blog should be construed as, nor is it intended to be, personal investment advice.  The content of this blog represents my own views and/or opinions and does not represent the views and/or opinions of Wealthfront Inc.

Second, I’ve added a Disclosure tab to this blog, to ensure that at any time, any new visitor will have quick access to this information.

Third, none of the historical content of this blog is being modified from its original.  Those articles were written for purely personal reasons, and are appropriate for the time they were published.  That being said, going forward, I’m only going to publish content related to personal finance and investing through the official Wealthfront blog.  Wealthfront has published a fantastic series of articles on a wide range of topics, and I feel privileged to be added as one of the contributing authors there.

I will continue to blog here about personal topics of interest, including product management, design, software development, Silicon Valley, startups, tech tips, science, and of course coins.

Can’t wait to get started tomorrow.

Joining Wealthfront

It’s official. As per the announcement on the Wealthfront Blog today, I have officially accepted the role of Chief Operating Officer at Wealthfront. I feel incredibly fortunate to be joining such an amazing team, with an opportunity to help build an extremely important company.

WF Logo New

From Human Capital to Financial Capital

One way to imagine your professional life is overlay of two types of capital: the building and growing of your human capital, and the transformation of that human capital into financial capital.

It feels like just yesterday that I was writing a blog post here about my first day at LinkedIn. At its heart, LinkedIn is building, growing & leveraging human capital throughout your career.  Wealthfront provides an answer to the second part of that equation – how to grow and leverage the financial capital that you accumulate throughout your career.

As Marc Andreessen put it, software is eating the world, and it is providing us a platform to bring the features and sophistication previously only available to the ultra-rich, and making it available to anyone who wants to protect & grow their savings.

Too many good, hard-working individuals today lack access to many of the basic advantages accorded to people with extremely high net worth.  With software, Wealthfront can bring features and capabilities normally available only to those with multi-million dollar accounts to everyone, and at a fraction of the cost.

Personal Finance as a Passion

For regular readers of this blog, the fact that personal finance has been a long standing passion of mine comes as no surprise.  What many don’t know is that this passion dates all the way to back to my time at Stanford, where despite one of the best formal educations in the world, there was really no fundamental instruction on personal finance.

In fact, upon graduation, I joined with about a dozen friends from Stanford (mostly from engineering backgrounds) to form an investment club to help learn about equity markets and investing together.  (In retrospect, the members of that club have been incredibly successful, including technology leaders like Mike Schroepfer, Amy Chang, Mike Hanson and Scott Kleper among others.)

A Theme of Empowerment

As I look across the products and services that I’ve dedicated my professional life to building, I’m starting to realize how important empowerment is to me.  At eBay, I drew continued inspiration from the fact that millions of people worldwide were earning income or even a living selling on eBay.  At LinkedIn, it was the idea of empowering millions of professionals with the ability to build their professional reputations & relationships.

With Wealthfront, I find myself genuinely excited about the prospect of helping millions of people protect and grow the product of their life’s work.

We’ve learned a lot in the past thirty years about what drives both good and bad behaviors around investing, and we’ve also learned a lot about how to design software that engages and even delights its customers.  The time is right to build a service that marries the two and helps people with one of the most important (and challenging) areas of their adult lives.

A Special Thank You

I want to take a moment here to voice my utmost thanks to the team at Greylock Partners.  My year at the firm has given me the opportunity to learn deeply from some of the best entrepreneurs, technology leaders and venture capitalists in the world.  The quality of the entrepreneurs and investors at Greylock forces you to think bigger about what is possible.  Fortunately, Greylock is also a partnership of operators, so they understand the never-ending itch to go build great products and great companies.

… And Lastly, A Couple of Requests

Since this is a personal blog, I don’t mind making a couple of simple requests.  First, if you have a long term investment account, whether taxable or for retirement, I would encourage you to take a look at Wealthfront.  I’d appreciate hearing what you think about the service and how we can make it better.

Second, and perhaps most importantly, we are hiring.  So let me know if you are interested in joining the team.

Apple & Dow 15000: Update

In February 2012, I wrote a blog post that indicted the Dow Jones Industrial Average for including Cisco in 2009 instead of Apple.  At the time, Apple had just crossed $500 per share, and that simple decision had cost the US the psychology of an index hitting new highs.

I was driving home on Sunday, listening to the radio, and it occurred to me how different the financial news would be if Apple ($AAPL) was in the Dow Jones Industrial Average (^DJI).

Of course, being who I am, I went home and built a spreadsheet to recalculate what would have happened if Dow Jones had decided to add Apple to the index instead of Cisco back in 2009.  Imagine my surprise to see that the Dow be over 2000 points higher.

Update: AAPL at $700

With the launch of the iPhone 5, we find ourselves roughly 7 months later.  For fun, I re-ran the spreadsheet that calculated what the DJIA would be at if they had added AAPL to the index in 2009 instead of CSCO. (To date, I’ve never seen an explanation on why Cisco was selected to represent computer hardware instead of Apple.)

Result: Dow 16,600

As of September 17, 2012, AAPL closed at 699.781/share.  As it turns out, if Dow Jones had added Apple instead of Cisco in 2009, the index would now be at 16,617.82.  Hard to think that hitting all new highs wouldn’t be material for market psychology and the election.

Anyone up for Dow 20,000?

Review: Quicken 2007 for Mac OS X Lion

This is going to be a short post, but given the attention and page views that my posts on Quicken 2007 received, I thought this update worthwhile.

Previous Posts

Quicken 2007 for Mac OS X Lion Arrives

Last week, Intuit announced the availability of an anachronism: Quicken 2007 for Mac OS X Lion.  It sounds odd at first, given that we should really be talking about Quicken 2013 right about now, but it’s not a misprint.  This is Quicken 2007, magically enabled to actually load and run on Mac OS X Lion.  It’s like Intuit cloned a Wooly Mammoth, and put it in the New York Zoo.

The good news is that the software works as advertised.  I have a huge file, with data going back to 1994.  However, not only did it operate on the file seamlessly, the speed improvement over running it on a Mac Mini running Mac OS X Snow Leopard is significant.  Granted, my 8-core iMac likely explains that difference (and more), but the end result is the same.  Quicken.  Fast.  Functional.  Finally.

There are small bugs.  For example, some dialogs seems to have lost the ability to resize, or columns cannot be modified.  But very small issues.

Where is it, anyway?

If you go to the Intuit website, you’ll have a very hard time finding this product:

  • It’s not listed on the homepage
  • It’s not listed on the products page
  • It’s not listed on the page for Quicken for Mac
  • It’s not listed in the customer support documents (to my knowledge)
  • It doesn’t come up in site search

However, if you want to pay $14.95 for this little piece of magic (and given the comments on my previous posts, quite a few people will), then you can find it here:

Goodbye, Mac Mini

I have it on good authority that Intuit is working on adding the relevant & required investment functionality to Quicken Essentials for Mac to make it a true personal finance solution.  There is a lot of energy on the Intuit consumer team these days thanks to the infusion of the Mint.com team, and I’m optimistic that we’ll see a true fully features personal finance client based on the Cocoa-native Quicken Essentials eventually.

Apple, Cisco, and Dow 15000

I was driving home on Sunday, listening to the radio, and it occurred to me how different the financial news would be if Apple ($AAPL) was in the Dow Jones Industrial Average (^DJI).

Of course, being who I am, I went home and built a spreadsheet to recalculate what would have happened if Dow Jones had decided to add Apple to the index instead of Cisco back in 2009.  Imagine my surprise to see that the Dow be over 2000 points higher.

In real life, the Dow closed at 12,874.04 on Feb 13, 2012.  However, if they had added Apple instead of Cisco, the Dow Jones would be at 14,926.95.  That’s over 800 points higher than the all-time high of 14,164 previously set on 4/7/2008.

Can you imagine what the daily financial news of this country would be if every day the Dow Jones was hitting an all-time high?  How would it change the tone of our politics? Would we all be counting the moments to Dow 15,000?

Why Cisco vs. Apple?

This isn’t a foolhardy exercise.  The Dow Jones Industrial Average is changed very rarely, in order to promote stability and comparability in the index.  However, on June 8, 2009, they made two changes to the index:

  • They replaced Citigroup with Travelers
  • They replaced General Motors with Cisco

The question I explored was simple – what would have happened if they had replaced General Motors with Apple on June 8, 2009.  After all, Apple was up over 80% off its lows post-crash.  The company had a large, but not overwhelming market capitalization.  The index is already filled with “big iron” tech stocks, like Intel, HP & IBM.  Why add Cisco?  Why not add a consumer tech name instead?

In fact, there is no readily obvious justification for adding Cisco to the index in 2009 instead of Apple.

The Basics of the Dow Jones Industrial Average

Look, I’m just going to say it. The Dow Jones Industrial Average is ridiculous.

You may not realize this, but the Dow Jones Industrial Average, the “Dow” that everyone quotes as representative of the US stock market, and sometimes even a barometer of the US economy, is a mathematical farce.

Just thirty stocks, hand picked by committee by Dow Jones, with no rigorous requirements.  Worse, it’s a “price-weighted” index, which is mathematically nonsensical.  When calculating the Dow Jones Industrial Average, they take the actual stock prices of each stock, add them together, and divide them by a “Dow Divisor“.  They don’t take into account how many shares outstanding; they don’t assess the market capitalization of each company.  When a stock splits, they actually change the divisor for the whole index.  It’s completely unclear what this index is designed to measure, other than financial illiteracy.

In fact, there is only one justification for the Dow Jones Industrial Average being calculated this way.  Dow Jones explains it in this post on why Apple & Google are not included in the index.  To save you some time, I’ll summarize: they have always done it this way, and if they change it, then they won’t be able to compare today’s nonsensical index to the nonsensical index from the last 100+ years.

So what? Does it really matter?

It’s a fair critique.  Look, with 20/20 hindsight, there are limitless number of changes we could make to the index to change its value.  Imagine adding Microsoft and Intel to the index in 1991 instead of 1999?

I don’t think this exercise is that trivial in this case.  The Dow already decided to make a change in 2009.  They decided to replace a manufacturing company (GM) with a large hardware technology company (CSCO).  They could have easily picked Apple instead.

The end result?  People talk about the stock market still being “significantly off its highs” of 2008.  In truth, no one should be reporting the value of the Dow Jones Industrial Average.  But they do, and therefore it matters.  As a result, the choices of the Dow Jones committee matter, and unfortunately, there seems to be no accountability for those choices.

Appendix: The Numbers

I’ve provided below the actual tables used for my calculations.  Please note that all security prices are calculated as of market close on Monday, Feb 13, 2012.  The new Dow Divisor for the alternate reality with AAPL in the index was calculated by recalculating the appropriate Dow Divisor for the 6/8/2009 switch of AAPL for CSCO, and a recalculated adjustment for the VZ spinoff on 7/2/2010.

Real DJIA DJIA w/ AAPL on 6/8/09
Company 2/13/2012 Company 2/13/2012
MMM 88.03 MMM 88.03
AA 10.33 AA 10.33
AXP 52.07 AXP 52.07
T 30.04 T 30.04
BAC 8.25 BAC 8.25
BA 74.85 BA 74.85
CAT 113.70 CAT 113.70
CVX 106.38 CVX 106.38
CSCO 20.03 AAPL 502.60
KO 68.44 KO 68.44
DD 50.60 DD 50.60
XOM 84.42 XOM 84.42
GE 19.07 GE 19.07
HPQ 28.75 HPQ 28.75
HD 45.93 HD 45.93
INTC 26.70 INTC 26.70
IBM 192.62 IBM 192.62
JNJ 64.68 JNJ 64.68
JPM 38.30 JPM 38.30
KFT 38.40 KFT 38.40
MCD 99.65 MCD 99.65
MRK 38.11 MRK 38.11
MSFT 30.58 MSFT 30.58
PFE 21.30 PFE 21.30
PG 64.23 PG 64.23
TRV 58.99 TRV 58.99
UTX 84.88 UTX 84.88
VZ 38.13 VZ 38.13
WMT 61.79 WMT 61.79
DIS 41.79 DIS 41.79
Total 1701.04 Total 2183.61
Divisor 0.13212949 Divisor 0.146286415
Index 12874.04 Index 14926.95

Calculating the “alternate divisor” requires getting the daily stock quotes for the days where the index changed, and recalculating to make sure that the new divisor with the new stocks gives the same price for the day. It’s a bit messy, and depends on public quote data, so please feel free to check my math if I made a mistake.

Final Solution: Quicken 2007 & Mac OS X Lion

In July I wrote a blog post about a proposed solution for running Quicken 2007 with Mac OS X Lion (10.7).

Unfortunately, that solution didn’t actually work for me.  A few weeks ago, I made the leap to Lion, and experimented with a number of different solutions on how to successfully run Quicken 2007.  I finally come up with one that works incredibly well for me, so I thought I’d share it here for the small number of people out there who can’t imagine life without Quicken for Mac.  (BTW If you read the comments on that first blog post, you’ll see I’m not alone.)

Failure: Snow Leopard on VMware Fusion 4.0

There are quite a few blog posts and discussion boards on the web that explain how to hack VMware Fusion to run Mac OS X 10.6 Snow Leopard.  Unfortunately, I found that none of them were stable over time.

While you can hack some of the configuration files within the virtual image package to “trick” the machine into loading Mac OS X 10.6, it ends up resetting almost every time you quit the virtual machine.  I was hoping that VMware Fusion 4.0 would remove this limitation, since Apple now allows virtualization of Mac OS X 10.7, but apparently they are still enforcing the ban on virtualizing Snow Leopard.  (Personally, I believe VMware should have made this check easy to disable, so that expert users could “take the licensing risk” while not offending Apple.  But I digress.)

You can virtualize Snow Leopard Server, but if you try to buy a used copy on eBay, it’s still almost $200.00.  Added to the $75.00 for VMware Fusion, and all of a sudden you have a very expensive solution.  Worse, VM performance is surprisingly bad for a Mac running on top of a Mac.  In the end, I gave up on this path.

Enter the Headless Mac Mini

For the longest time, you couldn’t actually run a Mac as a headless server.  By headless, I mean without a display.  It used to be that if you tried to boot a Mac without a display plugged in, it would stop in the middle of the boot process.

I’m happy to report that you can, in fact, now run a Mac Mini headless.

Here is what I did:

  • I commandeered a 2007-era Mac Mini from my grandmother. (It’s not a bad as it sounds – I upgraded her to a new iMac in the process.)
  • I did a clean install of Mac OS Snow Leopard 10.6, and then applied all updates to get to a clean 10.6.8
  • I installed Quicken 2007, and applied the R2 & R3 updates
  • I configured the machine to support file sharing and screen sharing, turned off the 802.11 network, turned off bluetooth, and to wake from sleep from Ethernet.  I also configured it to auto-reboot if there is a power outage or crash.
  • I then plugged it in to just power & gigabit ethernet, hiding it cleverly under my Apple Airport Extreme Base Station.  It’s exactly the same size, so it now just looks like I have a fatter base station.

I call the machine “Quicken Mac”, and it lives on my network.  Anytime I want to run Quicken 2007, I just use screen sharing from Lion to connect to “Quicken-Mac.local”, and I’m up and running.   Once connected on screen sharing, I configured the display preferences of the mac to 1650×1080, giving me a large window to run Quicken.

I keep my actual Quicken file on my Mac OS X Lion machine, so it’s backed up with Time Machine, etc.  Quicken Mac just mounts my document folder directly so it can access the file.

Quicken: End Game

This solution may seem like quite a bit of effort, but the truth is after the initial setup, everything has worked without a hitch.  I’m hoping that once Intuit upgrades Quicken Essentials for the Mac to handle investments properly, I’ll be able to sell the Mac Mini on eBay, making it effectively a low cost solution.

For the time being, this solution works.  Mac OS X 10.7 Lion & Quicken 2007.  It can be done.

 

Proposed Solution: Quicken 2007 & Mac OS X Lion

Right away, you should know something about me.  I am a die-hard Quicken user.  I’ve been using Quicken on the Mac since 1994, which happens to be the point in time where I decided that controlling my personal finances was fundamentally important.  In fact, one of my most popular blog posts is about how to hack in and fix a rather arcane (but common) issue with Quicken 2007.

So it pains me to write this blog post, because the situation with Quicken for the Mac has become extremely dire.  Intuit has really backed themselves into a corner, and not surprisingly, Apple has no interest in bailing them out.  However, since I love the Mac, and I love Quicken, I’m desperately looking for a way out of this problem.

Problem: Mac OS X Lion (10.7) is imminent

Yesterday, I got this email from Intuit:

It links to this blog post on the Intuit site.  The options are not pretty:

  1. You can switch to Quicken Essentials for Mac.  It’s a great new application written from the ground up.  In their words, “this option is ideal if you do not track investment transactions and history, use online bill pay or rely on specific reports that might not be present in Quicken Essentials for Mac.” Um, sorry, who in their right mind doesn’t want to track “investment transactions”?  Turns out, at tax time, knowing the details of what you bought, at what price, and when are kind of important.  At least, the IRS thinks so.  And they can put you in jail and take everything you own.  So I’m going with them on this one.  No dice.
  2. You can switch to Mint.  I love Mint, and I’ve been using it for years.  But once again, “This option is ideal if maintaining your transaction history is not important to you.”  Yeesh.  For me, Mint is something I use in addition to Quicken.  Unfortunately, Mint is basically blind to anything it can’t integrate with online.  Which includes my 401k, for example.
  3. You can switch to Quicken for Windows.  Seriously? 1999 called and they want their advice back.  Switch to Windows?  Intuit would get a better response here if they just sent Mac users a picture of a huge middle finger.  By the way, to add insult to injury:  “You can easily convert your Quicken Mac data with the exception of Investment transaction history. You will need to either re-download your investment transactions or manually enter them.”

This is an epic disaster.  I’m not sure how many people are actually affected.  But the Trojan War involved tens of thousands of troops, so I’m going with Homer’s definition of “Epic”.

What’s the Problem?

There are really three issues at play here:

  1. Strike 1. Around 2000, Intuit made the mistake of abandoning the Mac.  Hey, they thought it was the prudent thing to do then.  After all, Apple was dying.  (The bar talk between Adobe & Intuit on this mistake must be really fun a few drinks into the evening.)  Whoops.  This led Intuit to massively under-invest in their Mac codebase, yielding a monstrosity that apparently no one in their right mind wants to touch.  From everything I hear, Quicken 2007 for the Mac might as well be written in Fortran and require punch cards to compile.  Untouchable.  Untouchable, unfortunately, means unfixable.
  2. Strike 2. Sometime in the past few years, someone decided that Quicken Essentials for the Mac didn’t need to track investment transactions properly.  I’ve spent more than a decade in software product management, so I have compassion for how hard that decision must have been.  But in the end, it was a very expensive decision, and even if it was necessary, it should have mandated a fast follow with that capability.  It’s a bizarre miss given that tracking investment transactions is a basic tax requirement.  (See note on the IRS above)
  3. Strike 3Apple announces the move from PowerPC chips to Intel chips in June 2005.  Yes, that’s *six* years ago.  Fast forward to June 2011, and Apple announces that their latest operating system, Mac OS X Lion, will not support the backwards compatibility software to allow PowerPC applications to run on Intel Macs.

Uh oh.

This is Intuit’s Fault.

With all due respect to my good friends at Intuit, this problem is really Intuit’s fault.  Intuit had six years to make this migration, and to be honest, Apple is rarely the type of company to support long transitions like this.  You are talking about the company that killed floppy drives almost immediately in favor of USB in 2000, with no warning.  They dropped support for Mac OS Classic in just a few years.  It’s not like Apple was going back to PowerPC.

If you examine the three strikes, you see that Intuit made a couple of tactical & strategic mistakes here.  But in the end, they called several plays wrong, and now they are vulnerable.

Intuit would argue that Apple could still ship Rosetta on Mac OS X Lion.  Or maybe they could license Rosetta to Intuit to bundle with Quicken 2007.

Apple’s not going to do it.  They want to simplify the operating system (brutally).  They want to push software developers to new code, new user experience, and best-in-class applications.  They do not want to create zombie applications that necessitate bug-for-bug fixes over the long term.  Microsoft did too much of this with Windows over the past two decades, and it definitely held them back at an operating system level.

A Proposed Solution: VMware to the rescue

I believe there is a possible solution.  Apple has announced that Mac OS X Lion will include a change to the terms of service to allow for virtualization.  If this is true, this reflects a fundamental shift in Apple’s attitude toward this technology.

The answer:

  • Custom “headless” install of Mac OS X 10.6.8, stripped to just support the launch of Quicken 2007.
  • Quicken 2007 R4 installed / configured to run at launch
  • Distribution as VMware image

OK, this solution isn’t perfect, but it is plausible.  Many system utilities are distributed with stripped, headless versions of Mac OS X.  In fact, Apple’s install disks for Mac OS X have been built this way.  A VMware image allows Intuit to configure & test a standard release package, and ensure it works.  They can distribute new images as necessary.

The cost of VMware Fusion for the Mac is non trivial, but actually roughly the same price as a new version of Quicken.  I’m guessing that Intuit & VMware might be able to work out a deal here, especially since Intuit would be promoting VMware to a large number of Mac users, and even subsidizing it’s adoption.

Will Apple Allow It?

This is always the $64,000 question, but theoretically, this feels like really not much of a give on Apple’s part.  They are changing the virtualization terms for Mac OS X Lion, so why not change them for Snow Leopard to0.

Can We Fix It? 

I’m a daily VMware Fusion user, which is how I use both Windows & Mac operating systems on my MacBook Pro.  If Intuit can’t work this out, I just might try to hack this solution myself.

In the end, I’m a loyal Intuit customer.  I buy TurboTax every year, and I use Quicken every week.  So I’m hoping we can all find a path here.

Feel free to comment if you have ideas.

 

 

Personal Finance for Engineers

Last Friday, LinkedIn had it’s monthly “InDay”, an event where the company encourages employees to pursue research, ideas & interests outside of their day-to-day responsibilities. (This is the same day that I run the regular LinkedIn Hackdays for the company.) This month, the theme was “personal finance” as a brief nod to the ominous due date for income taxes in the United States.

For fun, I volunteered to give a talk based on material that I’ve put together over the years called “Personal Finance for Engineers”

I cover the most obvious two questions up front:

  1. Why Personal Finance?  Personal finance is a bit of a passion of mine, and has been for almost twenty years.  It’s both amazing and shocking to me that you can attend some of the finest secondary schools and universities in this country, and still not get a basic grounding in personal finance.  More importantly, it happens to be an area with a huge signal-to-noise problem:  there is far more “bad” advice and content out there than good content.  And lastly, I believe that money matters are deeply important to the long term success and happiness of most people. (Let’s face it, money happens to be one of the top three causes of marital problems)
  2. Why Engineers?  The talk isn’t purely for engineers, per se, so this reflects a personal bias (I just empathize more with engineers more than other people).  That being said, engineers tend to make higher incomes earlier in life than most people, and thus face some of these questions earlier.  They also tend to have stock options, a fairly advanced financial instrument, as part of their standard compensation.  Probably most troubling, engineers also consider themselves exceptionally rational, which makes them more prone to human weaknesses when it comes to money.

It was very hard to decide how to condense personal finance into a 60 minute talk (I leave 30 minutes for advanced topics).  I decided to focus on five topics:

  • You Are Not Rational (Behavioral Finance)
  • Liquidity is Undervalued (Emergency Fund)
  • Cash Flow Matters (Spend less than you Earn)
  • The Magic of Compounding (Investment Returns & Debt Disasters)
  • Good Investing is Boring (Asset Allocation)

The deck is not perfect by any stretch, and I have a number of ideas on how to improve it.  There are some great topics / examples I missed, and there are some points that I could emphasize more.  I spend literally half the time on behavioral finance, which may or may not be the right balance.

The talk went extremely well.  We had well over 100 people attend, and stay through the full 90 minutes.  Surprisingly, I got more thank yous and follow up questions from this talk than any other that I’ve given at LinkedIn.  I’m strongly considering giving it again, perhaps at other venues, depending on the level of interest.

Let me know what you think.

Personal Finance: Refinancing a Residential Mortgage for 2011

One of my “To Do” list items for the end of 2010 was to investigate refinancing the mortgage on our house in Sunnyvale, CA.  As a sign of the decade, this actually is the third time we’ve looked to refinance our mortgage in about seven and a half years.  I was actually a bit surprised at the complexities involved, so I thought I’d share the results here on the blog.

Background

Our current mortgage is a “5/5 ARM” offered by Pentagon Federal Credit Union, a credit union that specializes in military families.  We completed that refinancing at the end of 2008, and I actually wrote a blog post about that experience if your curious about Pentagon Federal.  (Quick Summary: They are awesome, I highly recommend them for low rates on home & auto loans).

The “5/5 ARM” is an unusual program.  Like a normal 5/1 mortgage, it’s a 30-year loan with a fixed rate for the first 5 years.  Except, instead of repricing every year after that, instead, it only reprices every five years.  It reprices based on a rate tied to US Treasuries, and can rise no more than 2% at a time.

This means that if you get a mortgage at 5%, it will be 5% for years 1-5, and then can rise as high as 7% for years 6-10.  There is a cap of 5% on the total life of the mortgage, so if Obama turns out to be Jimmy Carter II and rates have to go to 20% in 2019, you’re protected.  All of this is fairly standard for high quality mortgages, except for the 5 year repricing schedule.

What makes this appealing is that the 5/5 rate tends to be the same as the 5/1 rate, so you are getting some extra stability effectively for free.  The only gotcha is that these are all FHA qualified loans, so they have to conform to their standards.  ($417K for normal mortgages, $729K in “high income” areas like Silicon Valley, 80% Loan-to-Value, etc).

The rate we got at the end of 2008 was 4.625%.  At the time, I thought that was the best rate we’d seen in 40 years, and it was good to grab.  Turns out, I was wrong about how low rates could go.

Why Did I Want to Refinance

Looking up rates on the internet can be very confusing.  The reason is that few sites offer a comprehensive average of rates, and more importantly, the ones that do tend to ignore complexities around terms like the number of points paid.  When you hear rates on the radio for a 3.875% 30-year fixed mortgage, you are hearing the interest rate that assumes a massive amount of up-front payment and some stricter-than-average terms.

I was exclusively looking for the “perfect repricing”:

  • No money down
  • Monthly payments drop
  • Interest rate drops
  • Total amount paid over life of the loan drops

You might be wondering why I would think this was possible.  Well, in 2004 and 2008, it was.  It turns out in 2010, there is no real free lunch.

Based on advertisements, and some spreadsheet calculations, it seemed like there was a real opportunity to achieve the above with current rates.  I was seeing advertisements for rates as low as 3.5% on 5/1 ARMs, which would not only drop our payment by hundreds of dollars per month, but literally would save us tens of thousands over the life of the loan.

Where Rates Are Now

This was my first surprise – it’s not that easy to get a great rate, even with great credit, with zero points.  It’s not that there aren’t great rates out there – there are, but the plain vanilla, no catches, no points and rock-bottom rate days seem to be behind us.

To evaluate options, I checked the following sources:

  • Internet searches at sites like bankrate.com
  • Quotes from big banks, like Wells Fargo and Bank of America
  • Quotes from credit unions, like Stanford Federal Credit Union and Pentagon Federal
  • Brokers like Quicken Loans

First, the Big Disappointment with Pentagon Federal

Pentagon Federal has a current price (as of 1/2/2011) on a 5/5 ARM of 3.5%.  Yes.  Awesome.  I was ready to just refinance and be done.

I should have known that there was a flaw with PenFed.  Sure, they offer great rates.  Sure, they offer clean terms.  But it turns out that there is one ugly fee that they do charge, and I was about to get caught in it.

On top of regular closing costs, title search, etc, Pentagon Federal charges a 1% origination fee when you refinance an existing Pentagon Federal mortgage.  So, for example, on a $500K mortgage, this would be an extra $5K.  Up front.  Not interest.  Not deductible.

I argued with them about it.  I escalated.  I tried sweet talk.  Nothing worked.  They admit that this is an incentive for me to leave Pentagon Federal.  They admit that it is bad for the customer.  They are not interested in changing it.

Strike 1. No worries, it’s a big internet out there, isn’t it?

Don’t Bother With These

Just don’t even bother wasting time with Bank of America, Wells Fargo, or no-name shops on the Internet offering mortgages.  You put in a bunch of time and effort, fill out forms, submit applications, etc.  The end result is underwhelming.

Countrywide, I actually miss you.

It’s pretty clear that the big banks really aren’t feeling the need to push to get people with great credit scores to refinance with them.  Whatever was driving the banks to want to “take your business” from other banks is clearly pretty weak.  I was actually a bit surprised, since I tend to think of a mortgage as a way for a bank to take a “loss leader” approach to getting a valued customer.

The Easy Orange Mortgage and Bi-Weekly Payments

ING Direct is the oddball in the group.  Since they originate their own loans and do not syndicate them, they set their own terms.  They have rates based on a $500K size and $750K size, and a variety of terms.  Definitely worth checking out, because some of their mortgages are best in class.

For example, their under $500K 5/1 is at 2.99%, with reasonable closing costs.

I spent quite a bit of time in Excel working on the options offered by ING Direct and their Easy Orange mortgages.  They offer both regular and “bi-weekly” versions.  In fact, most banks now seem to offer bi-weekly options for their loans.

If you are unfamiliar with the concept, a bi-weekly mortgage involves making a payment of 1/2 of the normal monthly payment every 2 weeks.  Since you pay more frequently (effectively you pay an extra month’s payment every year), you end up paying off your mortgage faster and with less interest.

Unfortunately, this largely seems to be a gimmick.  Technically, you can send money in early to almost any legitimate bank, and they’ll apply the early payment to principal without penalty.  Mathematically, it’s very hard to see the benefit of these type of programs once you price in the amount of cash you’d accumulate outside of your mortgage if you just put that extra payment in the bank.  Even with 0% interest, in the first ten years, there is almost no measurable benefit to bi-weekly payments at current rates.  (By the way, here is a cool website that let’s you calculate bi-weekly options without building a spreadsheet.)

As a last note, I did discover that ING has a lot of terms that are left open that could turn ugly.  For example, their Easy Orange mortgages are designed as balloon mortgages.  So in 10 years, the rate doesn’t adjust – you literally owe the entire remainder of the loan.  This is fine, if you are allowed to refinance at the time.  But ING does not guarantee you will be able to.   So, this is a great loan if you plan on selling your house before the term is up, and a bad loan if you don’t want to be caught in a situation where you have to.

Close, But No Cigar

I was very impressed with the level of effort that Quicken Loans put into helping me, even though in the end, I didn’t use them.

At first, I was somewhere between annoyed and amused when I got a phone call the next day after submitting my application.  On Day 2 when they had called 3 times, I was ready to be annoyed.  I decided to call back and let them know I wasn’t interested, but when I got them on the phone, they impressed me with the breadth of their knowledge about different options, and I was convinced they could help.

So I told them – find me a 3.5% 5/1 mortgage out there with zero points, and I’ll go with them.  I pointed them to PenFed, but didn’t tell them about the 1% fee I would face.  They went to work.

The next day, they found a few options, and I got a call from the Director of their team.  She wanted to clarify a few things in terms of income and home value, to evaluate all options.  In any case, she seemed sincerely interested in the business, which is more than I can say about any of the traditional banks.

They got close.  They found a 5/1 mortgage with $6600 up front costs and a 3.875% rate.  They also found a 5/1 at 3.5% rate, but that required $11.3K up front.  While both of these mathematically were good options compared to the 5/5 I have, I was disappointed at the size of the up front cost.

Strike 2. What’s left?

Final Decision

Fortunately, while searching the internet, I came across some great discussion boards about Pentagon Federal.  Thinking that in a world of cheapskates, I could not be the only one complaining about refinancing with Pentagon Federal.  And I was right, in a way.

In the end, I discovered 2 things:

  • There really aren’t many other mortgage options that are better than Pentagon Federal for what I was looking for.
  • Pentagon Federal has a repricing program that is documented on their website, but that they never actually promote.

Here is the program.  If your mortgage conforms to these requirements:

  • Conventional Adjustable Rate Mortgage (ARM loans) are eligible. All other types
    of loans are not eligible.
  • Loan must be 100% owned by PenFed. The loan, or any portion of the loan, cannot have been sold, or committed to be sold to Fannie Mae, or any other public or private investor.
  • No late payments showing on first mortgage payment history over last 12 months.

If you meet the terms, they will reset your mortgage to the current rate for a fee of 1%.

Now, you may be wondering why I’d be excited about this.  After all, wasn’t the 1% fee the problem with refinancing with PenFed in the first place?

The answer is simple – a 1% fee on top of normal closing costs of $3000+ is prohibitive.  A 1% fee in lieu of closing costs is pretty attractive.  No points.  No title search or insurance.  No paperwork fees.  Nothing.  Just 1%, flat.

They reset your mortgage at the current rate, give you another five years before the next repricing, and they leave your mortgage term as is.  So, since our mortgage currently completes in 2038, it would keep that completion date.

The result: lower monthly payment, lower total costs of the mortgage, dropped interest rate.

Swing and a Hit. Not perfect, but definitely the best option.  So we went for it.  Only took a phone call – no application, no paperwork.

Final Thoughts

The average duration of a home mortgage in the US is between 7-8 years, which tends to mean that mortgage rates correlate strongly with the 7-Year Treasury rates.  In the past six weeks, the rates on US Treasuries have moved up quite a bit, likely in anticipation of an economic recovery, inflation, or both.

In any case, the decision to refinance is based on a huge number of factors, not the least of which is how long you plan to stay in your current home, and how secure you feel about your current job / income stream.

But if you’ve been thinking about refinancing, and you’ve just procrastinated, I’m hoping the info above will be useful.

Personal Finance: How to Rebalance Your Portfolio

One of the prudent financial housekeeping chores that people face every year is rebalancing their portfolio. Over the course of the year, some investments outperform, and others underperform.  As a result, the allocation that you so carefully planned at the beginning of the year has likely shifted.  If left unmanaged over the years, individuals can end up with profoundly more risk or worse performance than expected.

Rebalancing your portfolio annually tries to address this issue by forcing you to sell asset classes that outperformed in the previous year, and purchase those that underperformed.  In practice, I try to rebalance the week before New Years as a way of “cleaning up” going into the next year.  While most academic research points to rebalancing as healthy every one to three years, I find that annual rebalancing provides the following benefits:

  • Forces you to see how your investments performed for the year
  • Forces you to learn which asset classes actually did well during the year, and which didn’t
  • Forces you to re-assess the appropriate “asset mix” for your risk tolerance and financial situation
  • Forces you to revisit which investments you are using to represent each asset class (mutual funds, ETFs, individual securities, etc)
  • Forces you to actively engagement with your portfolio, and reset your balance to the appropriate mix

I’ve just completed my rebalancing for 2011, and I thought I’d share some of the process here, in case it’s useful to anyone whose New Year’s Resolution is to be more proactive about their finances.

Rebalancing is actually a very simple process – it’s kind of surprising that basic financial tools like Mint and Quicken don’t actually help you do this.  Whether you’ve never rebalanced or your rebalance every year, there are fundamentally five steps:

  1. Assess your current investment portfolio, broken down by types of assets
  2. Calculate the percentage of your portfolio in each asset class
  3. Calculate the difference in dollars for each asset class in your portfolio from your ideal mix
  4. Finalize the list of investments you will use to represent each asset class
  5. Make the trades necessary (buys and sells) to bring your portfolio into balance

This can all be done within an hour, with the exception of making the trades.  Those can spread over days, potentially, since certain types of securities (like mutual funds) take time to execute (typically 24 hours).

Step 1: Assess your current investment portfolio

Believe it or not, this can actually be the most time consuming part of the process, especially if you have accumulated accounts over the years and haven’t ever used any sort of tool like Quicken to pull your portfolio together accurately.

A few ground rules on how I think about portfolio allocation:

  • I’m a big believer in the research that shows that most of your long term investment return is based on asset mix, not security selection.  This means I do not spend time picking individual stocks, bonds, or dabble with active mutual funds in general.
  • I use very broad definitions of asset classes.  For example:  “US Stocks” vs. “International Stocks” vs. “Emerging Markets”.   These tend to correlate with the standard definitions used broadly to define popular investment indexes. Technically, with sophisticated software and data, you can do very fine-grained breakdowns.  I don’t bother with this, as the resulting differences are statistically marginal vs. the effort / complexity involved.

Fear not, because with tools like Microsoft Excel or Google Docs, this has become much, much easier.  All you need to do is:

  • Make a spreadsheet with the following columns:  Security Name, Ticker, Shares, Share Price, Total Value, % of Total Portfolio
  • Fill in a row for everything you own, regardless of account

The second part is very important, if you want to avoid the “mental accounting” that leads people to invest differently in one account versus another.  If you’ve worked at multiple companies, you may have multiple 401k, IRA, college savings accounts, and brokerage accounts in your name.   Obviously, reducing the number of accounts you have is helpful, but sometimes its unavoidable.  Maybe you have a Roth IRA, a regular IRA, and a 401(k) with your current employer.

This becomes important because certain accounts may have limited access to different types of investments.  For example, your Vanguard IRA might only let you buy Vanguard funds (not such a bad thing), while your 401(k) at work might limit you to some pretty meager options.  When we get to Step 5, we can take advantage of multiple accounts to get the right balance by buying the best investments in the accounts with the best access to them.

Here is an example screenshot of a simplified list of investments that I bet wouldn’t be that unusual in Silicon Valley.  This person has some Vanguard index funds that they purchased prudently the last time they looked at their portfolio, combined with some stocks they purchased based on TechCrunch articles.  (I wish I were kidding).

You can see immediately that this small amount of accounting can actually help organize your thinking about what you own, and force you to remember why you own it.

Notice, I do not recommend putting in columns showing how well an investment performed historically.  For rebalancing, you only care about the here and now.  The past is just that – the past.  Performance data will likely just add emotion to a decision that, when made best, should be purely analytical.

Step 2: Calculate the percentage of your portfolio in each asset class

The hardest part about this step is defining what you are going to use as “an asset class”.   There is no one right answer here – I’ve seen financial planners break down assets into literally dozens of classes.  I’ve also seen recommendations that literally only use two (stocks vs. bonds).

The great thing about asset classes is that you can always break down an existing bucket into sub-buckets.

For example, if you decide to have 30% of your money in bonds, and 70% in stocks, you can then easily make a 2nd level decision to split your stock money into 50% US and 50% international.  You can then make a third level decision to split the international money 2/3 for developed markets, and 1/3 for emerging markets.  In fact, for some people, this is a much easier way to make these decisions.  Do whatever works for you, but be consistent about it.

Personally, I’ve gotten quite a bit of mileage using the following break downs:

  • Stocks
    — US Stocks
    — Large Cap
    — Mid Cap
    — Small Cap
    — International Stocks
    — Developed Markets
    — Emerging Markets
  • Fixed Income
    — Standard
    — Inflation Protected
  • Real Assets
    — Commodities
    — Real Estate

You can see in the screenshot above, calculating these buckets is fairly simple.  You just total up each group, and then divide it into the portfolio total.  So in the example I provided, the individual has 11.5% of their money in fixed income.

As the size of your assets increase, more sophisticated breakdowns are likely warranted.  But for the purposes of this blog post, I think you get the idea.

With mutual funds, this can be tricky.  For example, did you know that the Vanguard Total Market fund is 70% Large Cap, 21% Mid Cap, and 9% Small Cap?  (I got this data off etfdb.com).  In order to solve this problem, I actually create a separate column for each asset class.  I then put the percentage for each fund in each column, totaling to 100%.  I then multiply those percentages by the amount invested in each fund, giving me an actual dollar amount per asset class.

Step 3: Calculate the difference in dollars for each asset class in your portfolio from your ideal mix

This is the step where your self-assessment turns toward action.  How far are you off plan.

The hardest problem here is the implied problem: what is your ideal mix?

There are quite a few rules of thumb out there, and more than enough magazines and books out there to tell you what this should be.  Unfortunately, all of them are over-simplified, and none of them likely apply exactly to you.  At minimum, it’s a whole separate blog post to come up with this.  Fortunately, if you pick up the 2011 planning issue from Smart Money, Kiplinger’s, or Money magazine, you’ll probably end up OK.

But let’s say our individual in question is a 30-year old engineer who believes in the rule of thumb that they should take 120 minus their age, put that in stocks and the remainder in bonds.  Let’s say also that they’ve read that their stock investments should be split 50/50 between the US & International, with at least 10% of their overall portfolio in Emerging Markets.

That would leave our hypothetical engineer with the following breakdown:

  • 90% in Stocks
    — 45% US Stocks
    — 35% Developed Markets
    — 10% Emerging Markets
  • 10% in Bonds

Based on the numbers from the first screenshot, they would create an spreadsheet table like this:

This shows that our hypothetical engineer needs to rebalance by selling US Stocks, Emerging Markets, and Bonds.  The extra money will be re-allocated to international stocks in developed markets.

Step 4: Finalize the list of investments you will use to represent each asset class

Most people skip this step, but that’s a real missed opportunity.   Once you decide how much money to allocate to a given asset class, it’s worth a bit of thought about what is the best way to capture the returns of that asset class.  For example, is owning Google, Apple & Goldman Sachs the best way to capture the returns of US Stocks?  I’m not a professional financial planner, so you shouldn’t take my advice here.  But my guess is that you’ll be hard pressed to find a professional who believes that those three stocks represent a balanced portfolio.

We live in an unprecedented time.   Individuals with a few hundred dollars to invest can go to a company like E*Trade, open an account, and for $9.99 buy shares in an ETF that represents all publicly traded stocks in the US, for an annual expense of 7 basis points.  That’s 0.07%, or just $7 for every $10,000 invested.  That is an unbelievable financial triumph.  Previously, only multi-millionaires had access to that type of investment, and they paid a lot more for the privilege than 7 basis points.

Personally, I’m heavily biased towards using these low cost, index based ETF shares to represent most asset classes.  In fact, E*Trade let’s you mark any ETF for “free dividend reinvestment” under their DRIP functionality.  As a result, you get all the benefits of mutual funds with lower annual costs!  It takes some research to find the best ETFs, and in some cases, standard no-load mutual funds are a better option.  (Once again, I’m not a professional, so do your own research on what secrurities make sense for you.)

The biggest exception to this is with 401(k) plans, where you have limited choices on what types of investments you can make.  In these cases, I evaluate all of the funds in the 401(k), find those that are “best in class”, and purposely “unbalance” the 401(k) to invest in those.  I then make up for that lack of balance with my investments outside the 401(k).  For example, let’s say your current 401(k) has excellent international funds, but poor US funds.   you can skew your 401(k) to international funds, and make your US investments outside of the 401(k) where there are better options.

For our hypothetical engineer, let’s say that he’s decided to stick with Series I Savings Bonds for his fixed income, and uses the Vanguard ETFs to represent the different stock classes.

Step 5: Make the trades necessary (buys and sells) to bring your portfolio into balance

It seems like this part should be simple, but it can be surprising how many complications arise.  For example:

  • Sometimes the model says to sell $112 of something.  The trading costs alone make that likely prohibitive and unlikely to be worthwhile.
  • Share prices change every day, and your model leaves you short a few dollars here and there.
  • The model doesn’t take into account commissions for trading
  • Some funds have fees
  • Some transactions have tax consequences
  • Some investments can only be purchased in one account, not another
  • Some investments cannot be bought in a given account (like a 401k)

As a result, there is no advice that will apply to everyone.  Taxes alone make this the time when you may have to consult a professional.

In our hypothetical case, our engineer would:

  • Sell their stakes in Apple, Google, Goldman Sachs, and Teva
  • Decide to leave their Series I Bonds alone – not worth the trouble.  Take the extra money out of the developed markets stake.
  • Purchase / Sell shares in the Total Market, Ex-US, and Emerging Market ETFs to meet their new allocation goals

The following table shows how to use a spreadsheet to calculate the different trades (buys in Green, sales in Red):

Last Thoughts

I’ve been doing some version of the process above for at least fifteen years at this point, and it’s never failed to help me with my financial planning.  Of all the benefits described, annual rebalancing gives me the confidence to withstand the day-to-day gyrations of the markets, with the confidence that at the end of the year, I’ll get a shot to rebalance things.

There are a few “temptations” that I’ve noticed could lead someone astray:

  • Changing the “ideal asset mix” year-to-year based not on financial research, but based on what’s “hot” at the moment.  For example, if you find yourself saying that Gold should be 10% of your portfolio one year, and then the next year it’s “Farmland”, you’ve got some popular investing psychology drifting into your process.
  • You pick arbitrary “hot stocks” to represent asset classes.  This can lead to a double-whammy, you not only pick a bad stock, but you also miss out on key gains in your selected asset class.
  • Splitting hairs.  Don’t stress about small dollar amounts, or potentially, asset classes when your portfolio is small.  I remember investing the first $2500 I ever made from a summer job, and I got a little carried away with the breakdown.  In general, you can get pretty far with just the “Total Stock Market” and “Total Bond Market”.

This was a really long blog post, but hopefully it will prove useful to those who are interesting in balancing their portfolios, or just curious on how other people do it.  In either case, please comment or email if you find mistakes, or have additional questions.   Happy to turn the comment section here into a useful discussion.

The Incentives for Inflation Going Forward

In my last blog post, Lessons from the Masters of Deflation, I alluded to an upcoming article on why I expect heavy pressure towards inflation in the United States in the coming years.  I don’t think I’m at all unique in this projection – there are currently a huge number of economics and financial analysts that expect significant inflation in the coming years in the United States.  The rationale is almost universally the unprecedented expansion of the money supply by the Federal Reserve.  With over $2 Trillion on the balance sheet, and the acquisition of debt of questionable value, it’s easy to look at the incredible growth in M2 (a measure of money supply) and project out inflation once the economy recovers.

My rationale for significant inflation in the future is not actually based on these facts, although I don’t dispute them per say.  The rapid deleveraging of our economy argues for short term deflation.  The massive and hastily executed fiscal stimulus and monetary expansion argues for long term inflation.

I’m going to argue instead that you should just follow the incentives.  It is fairly obvious that a vast majority of Americans will benefit in the short term from a significant devaluation of the dollar.  If you believe that this country’s politics (and economics) tend to follow the majority opinion, then it seems like just a matter of time before we talk ourselves into policies that lead to inflation.

For the sake of argument, let’s assume that we could conjure up an instant 25% devaluation of the dollar. In this world, everything that costs $1 now will cost $1.25 tomorrow. Let’s look at some of the large groups of Americans that will benefit from this type of massive devaluation:

  • Homeowners.  A dominant majority of American households are homeowners, and almost all of them carry weighty mortgages.  More importantly, by some counts, almost 20% of those mortgages are underwater.  Inflation to the rescue!  In this world, every $400,000 house is now worth $500,000.  But of course, the mortgages themselves don’t grow, since they were written in the past.  Debtors love inflation, because they get to pay off old debts.
  • Federal Government. This is a two-fer.  First, most of our taxes aren’t indexed to inflation.  Want to keep that promise to tax only people making over $250K?  Devalue the dollar, and now more people will cross that threshold.  Capital Gains taxes?  Booyah, those aren’t indexed to inflation.  Now everyone whose stock just keeps pace with the devalution will owe taxes to boot!  Besides increasing revenue, the devaluation makes it easy to pay off bond holders of those trillions of dollars of debt, since they are all denominated in dollars.  With benefits like these, why stop at a 25% devaluation?  Let’s go for 100%!
  • Consumers in Debt. The average American has thousands of dollars in debt.  Assuming that wage inflation approximates price inflation, consumers can benefit from seeing increased nominal wages, and then paying off debts that were made before the devaluation.

Sense a common theme here?  Debtors.  The United States is a nation of debtors.  Individual households are in debt.  State governments are in debt.  Homeowners are in debt.  The Federal Government is in debt.  Debtors, in the short term, love devaluation because it means they get to pay off old borrowing with inflated currency.  On average, we are in debt, which means, on average, we’re incented to devalue the dollar.

In fact, you could argue that Japan, a nation of savers, has been stuck in a deflationary spiral precisely because, as a nation of savers, they benefit on average from seeing their saved Yen go farther at the market.  Of course, the younger Japanese don’t see those benefits, but thanks to aging demographics, they are outnumbered by older generations who saved massive amounts of wealth.

Yes, I know I am grotesquely oversimplifying the ramifications for all parties involved once an inflationary spiral takes hold.  And believe, me, I do not believe that this is a good outcome for the country (or the world economy).

Of course, I am a saver, so I would be biased against inflation…

Lessons from the Masters of Deflation

You can’t open a decent newspaper these days without coming across an article warning of impending deflation.  (Yes, I know.  How many people still open a decent newspaper?) Deflation, the Bizarro twin of inflation, has been a major concern for the United States since the financial crisis unfolded in 2008, and fears of a Japan-style lost decade emerged.

We’re now two years into the unfolding drama, and fear of deflation has resurged in the past few months as the sovereign debt crisis in Europe has led to a spike in the value in the dollar, a potential for weakening global demand, and the threat of a double-dip recession.  While I personally don’t believe we’ll see an extended period of deflation given the current monetary & fiscal incentives in our country (a blog post on this topic is coming), I do think a few years of borderline deflation may still occur.

From today’s Wall Street Journal:

The old bogeyman of deflation has re-emerged as a worry for the U.S. economy. Here’s something else to fret about: After studying more than a decade of deflation in Japan, economists have slowly realized they have no idea how it works.

Every time you see a piece on deflation, you find references to Japan.  This is not unexpected – Japan is the second-largest economy in the world, and it wasn’t too long ago that many highly educated people thought that it would usurp the US role as the dominant western economy.  This is really the only large-scale modern example of deflation – to find another you have to revisit the 1930s, and too many elements of our system have changed for those analogies to be completely helpful.  In fact, I see some pieces stretch back into the 1890s at times.

Unfortunately, Japan has been a wreck of an example.  They pursued massive borrowing and Keynesian stimulus, running their national debt to over 200% of GDP.  In fact, the most notable thing that they’ve achieved is setting incredible new records for the potential debt a country can take on without completely imploding.  This is similar in some ways to new records being set for over-eating.  Impressive, scary, and not something that inspires you to try it yourself.

However, if you want to understand deflation, and more importantly how to handle deflation, you need to turn to the true masters of deflation.  That’s right, living in our midst, there are huge multi-billion dollar economies that have not only survived a deflationary environment for forty years, they’ve thrived in it.

I’m talking, of course, about the children of Moore’s Law: our high tech industry.  Moore’s Law (circa 1975), loosely put, predicts that the number of circuits that you’ll be able to put in a semiconductor for a fixed cost will double every two years.  This is the equivalent of saying that the price of a circuit will drop by 50% every two years.

That’s deflation of 22.47% per year.  Put that in your pipe and smoke it.

But the industry has thrived, and looking at the financial structure of high tech companies, you can learn a lot about the topsy-turvy logic of deflation and how individuals can cope.

  • Debt is Bad. For decades, high tech companies have resisted the traditional financial wisdom of adding leverage to their balance sheets.  Why?  Theoretically, leverage is one of the key ingredients in Return on Equity, a primary measure of financial performance.  The answer is, when it comes to deflation, debt can kill you.In an inflationary environment, being a lender is tough.  There is a risk that inflation will eat of the gains (or more) of the interest you are charging.  If I loan you $10,000 at 5%, and inflation jumps to 8%, I’m losing 3% on the deal.   $300/year lost purchasing power is tough, but imagine that being $3B on a $100B loan portfolio.  This is because as a lender, my return is the interest rate I charge MINUS the inflation.In a deflationary environment, roles are reversed.  As a lender, I’ll lend you money at 0%!  After all, if deflation increases the value of a dollar by 3%, then I effectively make 3% on a 0% loan.  My return as a lender is the interest rate PLUS the deflation.  But the borrower has the other end of the deal.  Not only do they have to pay the interest, but they have to pay it with higher value dollars in the future.  Ouch.

    Moral of the story: In a deflationary environment, you do not want to owe debt. This is why deflationary environments lead to massive deleveraging.   You do not want to be caught holding a check denominated in low value today dollars, and forced to pay it back with higher value tomorrow dollars.
  • Don’t Buy Today What You Can Buy Tomorrow. This is something that any avid purchaser of computer equipment knows.  You pay a lot for the privilege of buying computing power today.  I guarantee you, it will be cheaper 6 months from now.  Want a 2TB hard drive?  Just wait a few months for significant discounts.  Want that Mac Mini?  It will be cheaper (or faster) in a year.  Same item, same condition, same quality – lower value in the future.  That is what deflation looks like.In a deflationary environment, on average items will cost less in dollars in the future than they do today.  So if you don’t need it now, you should wait.  In fact, you are paid to wait.  Literally.  High tech companies know this – they don’t source components until they absolutely need them to put in boxes.  High tech consumers know this.  Want to buy a 42″ LCD TV?  Wait a year, I promise you that exact same model, brand new in the box, will be a lot cheaper.This may not seem weird to you, but think about it for a second.   It’s not normal.  In order to keep the box the same price, most consumer products companies literally shrunk what they are offering you, or raise the price.   In high tech, they regularly have to double what they give you every two years, just to keep the price the same!  This is also why high tech companies are desperate to unload inventory as soon as possible… within days.  When I was at Apple, we moved our days of inventory on the books from eight week to just under two days!  Dell at the time was at six days.  Just six days of inventory!  That’s how you handle deflation.

    Moral of the story:  If you don’t absolutely need it now, wait. In inflationary environments, we buy now to avoid paying a higher price in the future.  In deflationary environments, the later you buy, the cheaper it is.  So don’t buy it unless you need to use it, immediately.

  • Success Depends on Increasing Value through Innovation. We take this for granted now in the high tech industry, but let’s face it:  high tech is unique.  If the internal combustion engine followed Moore’s law, we wouldn’t be worried about oil usage right now because we’d all be getting over 1M miles to the gallon.What people don’t realize about Moore’s Law is that it isn’t some government regulation.  There is no one handing out 2x performance every two years that high tech companies can just cash in periodically.  Literally hundreds of thousands of brilliant people, across a range of disciplines, degree programs, and commercial ventures are constantly ahead of the curve, inventing the technologies that will deliver that incredible curve.It’s a trap, in a way.  The innovation that makes the deflationary environment a fact is also the path to surviving it.  If you miss the next step on the curve, you’ll find that your products quickly are only worth half as much, and your more innovative competitor will still be collecting full price.

    This is tough to handle at an individual level.  In an inflationary environment, everyone gets some form of raise to “adjust for inflation”.  In a deflationary environment, everyone should get a pay cut to “adjust for deflation”.  However, since employees, managers, unions and even governments hate to see this happen, you tend to see layoffs instead.   It’s a vicious productivity war.  If you want earn the same paycheck next year, and deflation is running at 3%, you have to be 3% more productive to make that math work for the business.   At the company level, you need to see companies that can deliver productivity gains every year at a rate above deflation, just to tread water.

    Moral of the story:  There is no coasting in a deflationary environment, no rising tide that lifts all boats. Inflation may be an illusion of more money, but it’s an illusion that people emotionally depend on.  Deflation forces people to come to terms with a basic economic fact – if you aren’t able to make more with the same cost next year, you’ll likely be worth less next year.

I’ve obviously oversimplified a fairly complicated macroeconomic situation in the comments above.  However, I’m hoping that the insights provided will be helpful to those of you who have trouble visualizing what deflation might look like, in practice.  If there is interest, I may put together another post on what types of investments perform best in a deflationary environment.

Accredited Investors: Fixing the Dumb Money Problem

We’re now days away from the potential passage of significant financial reform, and a particular issue in the bill caught my eye.  This excerpt is from Businessweek:

Currently, a person must have a net worth of $1 million or an annual income of $200,000 if single or $300,000 if married (and filing jointly) to be an accredited investor. The senator’s proposed bill doesn’t say what inflation adjustment will be used to convert these numbers, established in 1982, to today’s dollars. But if we use the Bureau of Labor Statistics inflation calculator to adjust these figures on the basis of the consumer price index, then the annual income requirements for accredited investor status would become $449,000 if the investor were single and $674,000 if the investor were married, while the net worth requirement would become $2.25 million.

This is exceptionally bad news, if it passes, on multiple fronts.  To explain why, let’s review some of the basics.

What is an accredited investor?

Investing in public securities, like stocks and bonds, is heavily regulated.  There is a long standing legal concept, dating back to the 1930s, that individual investors need to be protected from nefarious money raising capitalists.  However, a special exception was carved out for the rich, under the auspice that sufficiently wealthy investors have enough education and resources to protect their own interests.  Thus, for private companies that wish to raise capital from private investors outside these large regulated facilities, there is a concept of an “accredited investor”.

Accredited investor qualifications have changed over the years.  Currently, there are two ways to qualify as an individual:

  • You are single and make $200K/year, or you are married and make $300K/year as a household
  • You have over $1M in liquid assets

When do you need to be an accredited investor?

You need to be an accredited investor to invest money in angel investments, hedge funds, certain private partnerships, and other high risk / unregulated investments.  For example, if Mark Zuckerberg came to you in 2005 and offered to let you put $25,000 into thefacebook.com, you’d need to be an accredited investor to do so.   (BTW If you can go back in time and do this, I highly recommend it).

Who is this going to hurt?

This is really going to hurt two groups – entrepreneurs and individual investors.

Entrepreneurs are going to be hurt by the severe limitation of who they can potentially raise money from at the angel stage.  As the Business week article points out:

Updating Reynolds’ estimate of the share of the adult population who are accredited investors to the 2008 adult population as reported in the Statistical Abstract of the United States, there were 5 million to 7.2 million American adults who were accredited investors in 2008…

Adjusting the income and net worth requirements for accredited investing to those proposed in the Dodd bill would reduce the number of accredited informal investors to 121,000 to 174,000 people.

So if this passes, we are talking about a massive decline in the number of potential angel investors in a new business.  Potentially a 98% decline, if the numbers above are accurate.  Outside of web 2.0 companies in Silicon Valley, raising angel funding is not trivial as it is.  Reducing the pool of investors here is massively disadvantageous to most entrepreneurs.

Individuals are also hurt here – that same 98%.  These are people who make a lot of money – $200K/year individually or $300K/year if married.  Imagine yourself as the founder of a cool web company, which sells to Google for $10M.  Your cut is about $1M after taxes.  Your friend is starting a new company, and you want to make a $50K investment.  You can’t because… the government says you aren’t rich enough?  Really? (I guess you are rich enough for a top tax bracket, just not rich enough to make investment decisions.)

Why do they think this is a good idea?

The amounts to qualify as an accredited investor haven’t been changed in a very long time.  Originally, these amounts were incredibly large, but they were never indexed for inflation.  I don’t think anyone ever envisioned millions of Americans qualifying.

Given the recent scandals around hedge funds and related ponzi schemes, these changes are an attempt to “protect” the public from people who would trick them into investing into shady schemes and poor investments.  The assumption is the same as the original one in 1933 – that in order to be sophisticated about investments, you need to be rich.

Alternatively, you could argue that we just don’t care that much if “rich” people lose their money, but that normal people, even those earning $300K/year, need to be protected from charlatans and rogues who would trick them into unregulated investments.

A better solution: make accredited status earned by knowledge, not income or assets.

We are learning the wrong lessons from the recent financial crisis and scandals.  If anything, recent events have demonstrated that dumb money is bad in large amounts, whether it is aggregated from a bunch of small investors, or funded by large rich investors.

We know from clear evidence that lottery winners, professional athletes, movie stars, and other wealthy people can still be incredibly financially ignorant.  Just because a retiree has accumulated $2M over a lifetime does not mean that they have significant financial education, or that they understand how to evaluate a hedge fund for legitimacy.  We also know that there is significant danger in this money being lost, stolen, or even worse, leveraged and invested in ways that can exacerbate bubbles.

My thesis is as follows:

  • Just because someone has a high income and/or significant wealth, does not mean that they have significant financial education, or will appoint/hire people who have significant financial education.
  • Depriving entrepreneurs and individuals from the opportunity to fund new businesses is completely unfair, and likely counter-productive to goals of encouraging new business formation and entrepreneurship.

My proposal would be as follows:

  • We introduce a new form of license / test that gives you “accredited investor” status for a fixed number of years (3-5 years).
  • We do increase the accredited investor limits – in fact, we eliminate them over time.

Look, we force people to repeatedly take a test to prove that it’s safe for them to drive.  It’s not a big stretch to insist that people who believe they are capable of making unregulated investments have the proper education.

The advantages of this program are clear:

  • Meritocracy.  This allows for anyone with the will to research and learn the ability to become an accredited investor.
  • Education.  This allows the government to ensure that all accredited investors, regardless of wealth, are aware of relevant financial and legal issues around investments.  This would help prevent charlatans from taking advantage of people.  For example, the test could ensure people are aware of their rights, of recent financial returns, of warnings signs, and of recourse for reporting fraud.
  • Self-funding. The government could charge a fee to take this test to help fund the license and potential even some enforcement resources.  It could also charge a licensing fee for institutions that want to offer classes around the license.
  • Centralized verification.  This would ensure that every accredited investor is easily verifiable.

As always, very interested in thoughts and feedback from those familiar with the issue.

Update: Good news.  It looks like some amendments have made it through on the Senate bill that restore much of the status quo.  That means the primary damage will be avoided.  Maybe now there is an opportunity over the next four years to take a different approach to qualifying accredited investors.

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