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.

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.

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.

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 3.  Apple 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.

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.

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.

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.

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…

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.

  Morale 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.

As a side note, for an explanation on why I believe that deflation will be, at worst, short-lived in the coming years, my next blog post will delve into the reasons that I believe that significant inflation is coming.

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.

First, background:

• I’m using Quicken 2007 for the Mac, updated with the R2 updater and the R3 Certificate updater.  This is the most recent version.
• I’ve used Quicken since 1994 to keep track of my expenses and investments.  That’s right, this file has 15 years of meticulous data in it.
• Quicken for the Mac users at some level are masochists.  Circa-2000, Intuit decided that the Mac market wasn’t worth supporting, and effectively ended support for the product.  As Steve Jobs brought the Mac back, Intuit brought back support… but very little enhancement to the product.  Quicken 2007 is largely the same as the Quicken 1999 product, except far more rickety and long in the tooth.

OK, so here’s the story:

1. About 3-5 weeks ago, when downloading stock quotes, I got a very strange error.  It said something like “Unable to create INTC. Security already exists.”  (Of course it exists, I’ve been tracking INTC for more than 10 years…)
2. About 2 weeks ago, I quit and relaunched Quicken for some reason (my machine tends to stay up for weeks at a time.)  On relaunch, all of my “manually entered” stock quotes were gone.  After a brief panic, I restored a file from Time Machine from a week prior, and all was forgotten.
3. Periodically, I received that error when downloading stock quotes.
4. On Friday, I restarted Quicken and got a spinning beach ball.  I thought it hung, so I force quit it, and restarted.  Spinning beach ball.
5. No worries, right?  I have multiple backups.  I use Time Machine to get an older file.  I launch. Spinning beach ball.
6. Uh oh. Mild panic.  I tweet.  No one tweets back.
7. I go to the “Quicken Backup Folder”, which is created automatically in your Documents folder.  I select several of the backups, duplicate them, and try to launch them.
8. Good news, the file from November 12 actually works, but all security prices are missing.
9. Bad news, it’s missing two weeks of data!  A lot of manual re-entry of the last two weeks.  Not too bad though.
10. On Saturday, I quit Quicken and relaunch as part of a reboot.  Spinning beach ball.
11. Uh oh. Time Machine backups don’t work.  I tried five of them from the last three weeks.
12. Double Uh Oh. The only file that seems to work is that one from November 12.  But it gives me an error “Unable to save security”.  It works, but is missing all security prices. But it’s missing the two weeks of transactions.
13. A bit of panic here. I search Intuit boards.  No luck.  I post a question anyway, even though the community on the boards gives me no confidence of ability to help or desire to do so.
14. I delete Quicken 2007 and all preference files, and try to reinstall + updaters.  No luck.
15. Tweets return nothing, except strange semi-taunts like, “I hate Quicken too.”
16. Finally, I realize I may have to create a new file, then export/import all the transactions to create a new clean file.  Creating the file works.  Trying to export QIF and reimport into the new file leaves totally bizarre numbers and transactions.  Seriously, has QIF export ever worked in the past two decades?  Will it ever work?
17. Desperation.  I start seriously contemplating doing all my finances in Mint… except Mint doesn’t actually support managing accounts without online access that well.  I like Mint, but I use it differently than Quicken…
18. Hail Mary. The Quicken file isn’t really a file, it’s a Mac OS Package.  It’s a fancy name for a directory of files that is tagged to act like a single file for the Finder.  Looking inside, I find a data file for “Quotes” and a directory for “Quotes Details”.  I delete both.
19. Salvation.  I launch Quicken.  No beach ball.  Works beautifully.   All stock quotes are gone, but a quick click to download quotes fixes that.  I manually re-enter the few securities that don’t have ticker symbols.  Everything is wonderful again.

So, just to capture some trouble-shooting for you, here is what I saw:

• Launching Quicken with the corrupted file led to a spinning beach ball for over 30 minutes
• When it did finally load, it gave me an error “Unable to open file”
• There was a history of getting errors related to the downloaded stock quotes for securities

Solution was:

• Make a duplicate of your Quicken file (always, always have a clean backup)
• Right-click (or control-click) on the Quicken file.
• Select “Show Package Contents…” from the Finder.
• Double-Click on the “Contents Folder”
• Select the “Quotes” file and the “Quotes Details” folder
• Drag them to the trash, and empty trash
• Relaunch Quicken with the file

Thus, I am still a Quicken user, at least for a little while longer.  Intuit, if you are reading, please get Quicken 2010 (which has been promised for two years) out the door.  And make sure the import from Quicken 2007 files is *flawless*.

An article last week in the Wall Street Journal on investing in gold reminded me of a topic I had meant to cover this past summer:

What is the best hedge for a crisis?

The last two years have validated the fundamental premise of The Black Swan theory.  That premise is that, due to incomplete information and faulty statistical assumptions, the market generally underprices risk at the “tails” of the distribution.

In other words, while the outcomes of the market tend to look like a normal distribution, in reality, more “rare” events happen than would be predicted mathematically.

Given a potential fear of crisis, what is the best way to hedge?  What’s the best way to have some fundamental security in the face of these events?

For Nassim Taleb, the author, he has made his investment approach well known.  He keeps the vast majority of his money in cash, and periodically invests a small percentage in out-of-the-money puts on the market. In 2008, this made for extremely high returns (between 65% and 115%).

Unfortunately, this is such an extreme approach, it’s hard to recommend it as a general practice for anyone but the most stalwart intellectual and contrarian.

If you read any financial press, or listen to AM radio, you likely have heard a much more common refrain about a hedge against crists:  Gold.

Gold has historically been pitched as the ultimate hedge against inflation and crisis.  You can literally find websites that explain how to not only buy gold bullion, but how to effectively bury it in your yard in such a way that it won’t come up on satellite photos (in case the US Government chooses to confiscate it again, like FDR did in 1933.)  I’m not kidding.

Because fascination with gold goes back basically as long as recorded history, it’s rare to find new information on the topic.

This article in Seeking Alpha, however, caught my eye, as a rare piece that had something new to say about investing in Gold.

July 9: A Golden Hedge Against The Dreaded Dollar

This article highlights a well known point – that recently, when the market collapsed, gold actually collapsed with it.  In fact, if you look at the charts, in the past decade, gold and the market look like their moving together.  This makes it a terrible hedge, because good hedges are supposed to be decoupled.

In truth, GLD does appear to be a venerable contender for a portion of a well-diversified portfolio. Yet in a “black swan/perfect storm catastrophe” like the 3 month, systemic breakdown of 2008 (September through November), GLD dropped an astonishing -30%.  PowerShares DB U.S. Dollar Bullish (UUP) soared 20%.

What’s interesting, however, is that in these periods, a very surprising asset has done well: The US Dollar.  The author goes on to advocate for a split between the US Dollar Bullish ETF and Gold.

The article shows this chart, which tracks gold and the US dollar over the past two years:

The insight here is not that you should split your “crisis” holdings between Gold and the Dollar.  Most Americans are already heavily weighted in dollar holdings.   The insight is simply that gold actually doesn’t cover you in all crises, despite the protestations of the gold bugs.

Indeed, I would like to see this relationship going back over the past century, to see what possible approaches might make sense:

• A balanced approach?
• A reciprocal trade where you sell into strength of one, and buy the other?
• Relationships between various mixes of gold & dollar to hedge a stock portfolio?

My guess is that a dollar-denominated fixed income allocation (Treasuries) would look similar to dollar bullish, and would fit a more traditional view of asset allocation.

WSJ: Breaking Down the Obama IRA

It’s been a while since I’ve written a personal finance-related post, but this move towards fixing our retirement savings policies in the United States is the most promising since 2005.

Here are the basics of the Obama IRA, at least, based on current information:

• Companies with 10+ employees will have to start offering payroll deduction service to contribute to a “Universal IRA” account.
• Employees would be automatically enrolled at 3%
• Employees can set the rates higher or lower
• Employees would get a few specific options:  Series I Savings Bonds, Money Market, Stable Value.
• At approximately $3000 – $5000, the amount would migrate to a Target Date Maturity Fund

That’s it on details.  There are a few things I like about this plan:

• Broadly available. Most people would be covered under this plan.
• Opt-out. The libertarian side of me loves the fact that people can choose their own contribution limits.  The behavioral economist in me loves the fact that the default state is set to opt-out, so that inaction leads to some savings for everyone.
• Low cost. The structure of the plan ensures low cost options for both employers and employees.  Today, far too much hard earned money is literally wasted through hidden and exorbitant fees charges by retirement plans and mutual funds.
• Simple investment options. Most people do not need a wide variety of options to provide a good, default retirement vehicle. This one keeps it simple.

Things that I don’t like:

• 3% is too low. There is absolutely no possible way that a 3% contribution is going to help provide for retirement in a meaningful way, at any income level.  Most “opt-out” advocates currently recommend starting at 3%, but automatically increasing at a rate of 1% per year until they hit 10%.
• Why tie this to employment at all? These plans should be available to anyone, particularly self-employed who don’t have the sophistication to set up more advanced vehicles.  In fact, imagine the option at tax-time to direct your refund towards your retirement account.
• Create an open market for running these accounts. Define the “plain vanilla” investment types.  Cap the expense ratios that can be charged.  Allow any private firm to offer these plans.  USAA, Vanguard, etc will compete for this large pot of assets ($100B+ per year at current estimates).
• Add an Immediate Annuity option at retirement. One of the biggest problems people have with 401k & IRA plans today is a lack of sophistication on how to turn a lump-sump into income that will last the rest of their lives.  It’s a version of the lottery-winner problem.  Offer a standard conversion for these accounts into a combination of a partial sum, an immediate annuity, and longevity income insurance to guarantee that you will have a certain amount of income until you die.  That’s what people really like about traditional pensions & social security.
• Exempt these accounts from Social Security Means Testing. By means testing Social Security, we’ve already created a perverse incentive where incremental income in retirement can be taxed, at some levels, at more than 100%.  Give these accounts a boost by exempting income from these accounts from income tax calculations in retirement.  Otherwise, we’ll continue to penalize the ants who save for the winter vs. the grasshoppers who spend through their spring & summer months.

The plan isn’t perfect, and there is ample opportunity for the current Congress to complete mess it up.  But conceptually, the Obama IRA is starting to move in the right direction.  Ironically, it shares some of the goals of the privitization of Social Security – shift the nation towards providing for retirement through individual savings & investment rather than through transfer payments.

I’m working on a follow up post that outlines what I believe would be a better direction for retirement savings, since it’s clear that the previous concepts of pensions, social security, and the 401(k) all have significant weaknesses.

Why I love Timber as an Asset Class (November 10, 2006)

Since then, from time to time, the article has been referenced in investment blogs and journals.  For example, I am still getting hits to my blog based on the following article on Seeking Alpha:

• Considering Timber as an Asset Class (Seeking Alpha, December 2008)

Last year, I was flattered to see a quote of mine show up in Nuwire Investor:

• Timber: A Renewable Resource (Nuwire)

What I didn’t realize at the time I wrote this blog post in January 2008 was that my entire interview was actually posted online.  That’s right. You can read the whole thing in all of its glory:

• Timber Interview: Adam Nash (Nuwire, May 2007)

How embarrassing.  I remember doing this interview over the phone in March 2007 from a conference room from the Toys building at eBay.

Still, it’s a matter of public record now.  So enjoy, if you are curious.  I still do love timber as an asset class.

John Batelle has fairly representative coverage on his blog.  His post cites coverage from Adam Lashinsky at Fortune (a personal favorite as a journalist) with a fairly typical dig on the issue.  Here’s the actual quote:

One last item of note. Google is offering employees the opportunity to exchange underwater stock options for newly priced options due to the stock price having been hammered. (The only catch in the exchange is that employees will have to wait an additional 12 months before selling re-priced options.) The stock price is  currently around $300, compared with $700 in late 2007. The number of shares eligible for exchange is about 3% of the shares outstanding, and the exchange will result in a charge to earnings of $460 million over a five-year period.

One must re-phrase this last bit in English: Google is transferring almost half a billion dollars in wealth from shareholders to employees, and for what ….? Motivation and retention, says Google. This a well known farce, as old as the Valley, which tells itself first that it offers generous stock options as a form of incentive and then, when share prices plummet, moves the ball so its employees, whose incentives apparently didn’t work (as if the stock price were under their control) can be re-incentivized. Retention? Would someone please tell me where the average Google employee is going to go right now?

To be clear, there have always been people who have a significant problem with employee stock option repricing, and with good reason.  Theoretically, options are supposed to align employee interests with shareholders.  In an ideal world, the employee wins if the shareholders win.   Repricing, therefore, breaks this model, because, after all, no one reprices the shares purchased by outside shareholders when the stock tanks.

Somewhere in the post-2000 bubble hangover, this criticism went from being a common argument to conventional wisdom.  Accounting standards were changed to require the expensing of employee stock options, and stock option repricing became largely verboten.

I rarely see anyone in the financial press explaining anymore why, in fact, there are very good arguments for stock option repricing.  So, I’m going to take a quick crack at it here.  Even if you disagree, it does a disservice to not reflect both sides of the argument fairly.

First, and foremost, it’s important to note that, while options are intended to help align employee interests with shareholders, stock options, in fact, do not do this in all situations.  The problem is the inflection point in the curve.

This is a simple chart that shows the intrinsic value to an employee of a stock option with a strike price of 50 at different stock prices.  Notice the blue line, which is stock, actually reflects a 1:1 ratio of value.  If the stock is worth $10, the employee gets $10, etc.  For the stock option, however, there is a “break” in the line.  Below $50, the employee gets $0.  Above $50, the employee gets $1 for every $1 of stock price increase.

In general, employee stock options are granted at the strike price of the stock roughly on the date that they join.  So, the assumption is, this aligns the employee with gains after they join.  In theory, it’s even better than stock, because if the stock drops, they get no value for gains made before the date of their join.

This sounds good in theory, but we know that it has real problems, on both the upside and the downside.

On the upside, most stocks go up every year.  (Yes, I know.  In 2009, it’s hard to remember that.)  If the stock market itself goes up 7% every year, then an employee will see real returns on their stock options for just “matching the average”.  In fact, they can actually see real material gains over long periods even by underperforming their benchmark index.

However, since shareholders also enjoy that benefit, it tends to only get complaints when you see incredible gains by executives with huge option packages.   No one likes to see an outsized pay package for undersized performance.

On the downside, however, the problem is much more severe.  Let’s say our stock example from above drops to $25, a price that the company hasn’t been at for 3 years.  The good news is that shareholder alignment works, to a point, as advertised.  Not only are shareholder gains for the last 3 years wiped out, but so are the option grants for employees who joined in the last 3 years, and even any other employees who received grants in the past 3 years.

That part seems fine… at first.

Where does the company go from here?  Now we need to talk about the principle of sunk cost.  Sunk costs are costs that cannot be recovered, and therefore should be ignored when making future investment decisions.  (More rigorous explanation on Wikipedia).  For stocks, it’s important to remember the stock market does not care what you paid for a stock.  It has no memory.  The question for a shareholder (barring external effects like taxes, etc) is purely where you think the stock will go from here.

But now we see that the employee is no longer aligned with the shareholder!  From $25, most shareholders would love to see a gain of 20%, which would take the stock to $30.  But for employees, a $30 share price and a $25 share price mean the same thing:  $0.

Worse, if employees leave the company, and get a job at a new company, they will get option prices at today’s stock price.  In fact, if the employee quits the company, and then is rehired back, they would actually get their options priced at today’s stock price.

In a world of at-will employment, this is a big problem.  True, as Adam Lashinsky pokes at, most employees won’t be able to find a new job so fast.  But many of the good ones can.  And they will.  Because your competitor can actually come in with in a simple, fair market offer for the employee, and beat your implicit offer of zero.  Even if they don’t do it today, these problems tend to persist for long periods of time, and employees have long memories.  You may find that your best talent starts leaving, and then you get snowball effects because great talent is hyper-aware when other talent leaves.

So what is a company to do?

In a perfect world, the company would have a very tight and accurate evaluation of their best talent, and would target “retention compensation” proportionally to their people based on their value.  This would both minimize the risk of flight, and would also help “re-align incentives” for the gains going forward.

Unfortunately, the mechanics and accounting of repricing makes this fairly prohibitive.   As a result, it tends to be an all-or-nothing option.

The truth is, repricing stock options can be one of the best things to realign employee incentives going forward.  It resets the vesting period, basically treating employees like new employees.  The employees do not get to go back in time and recover their equity compensation for the past three years.  The new vesting period basically wipes out the history.  They literally no longer own the rights to the shares – they have to re-earn them.  In fact, if the employee quits the next day, they will take no stock with them, even if they worked for the company for three years.

As a result, stock option repricing actually re-aligns employees more closely with shareholders than nay-sayers give credit for.

Last thoughts

While I am explaining the reasons why repricing stock options makes sense, there is still the significant problem of “repeat abuse”.  If employees believe all options will be repriced for all drops, then you end up with a moral hazard, where you might actually want to drive down the price, get your options repriced, and then recover easy gains.  True, the market is fairly hostile to repricing due to the accounting charge, so it’s unlikely this would happen, but it’s still a real concern.

As a result, my recommendation would actually be that companies faced with this situation actually use the opportunity to not reprice stock options, but move to actual stock-based compensation.  Both have an accounting charge, but actual stock-based compensation serves three purposes:

• The new stock grants can be better targeted to employees based on performance and value
• The new stock grants have immediate value, serving as a kind of retention bonus
• The new stock grants align the employee with shareholders going forward in both up and down markets

So while I do believe that repricing stock options gets a “bum wrap” in the financial media, I also believe that there may be potentially better compensation alternatives, particularly for public companies.

• We will never see an end to Ponzi schemes, because they work.
• This exposes some of the flaws in the fund of fund approach to hedge funds.  Picking a manager is almost impossible, adding a level indirection truly is. (courtesy Dave Swensen)
• The level of scandal for absconding with billions is historic.  The number of charity dollars, particularly from the Jewish community, is truly shocking, and likely deserves its own, new circle of hell (for those Dante fans).
• There is no punishment that can fit this crime.  The impact will literally be felt by millions.
• This failure will likely be used as a scapegoat and excuse to permanently damage the hedge fund industry in ways that may materially harm our markets for decades. (knee-jerk, political grandstanding regulation)
• We still haven’t heard the worst of it.

Now, among friends, I’ve joked that while I’ve heard the expression “death by a thousand cuts”, this situation seems to be a good opportunity to actually test that theory out.  (yes, dark humor)

For my birthday, my brother actually forwarded me this Youtube video, and I couldn’t stop laughing.  So I’m posting it here, since it seems to have a shockingly low view count.

Enjoy.

Since I haven’t commented much on personal finance topics lately, this seemed like an opportune time. 

Quick set of definitions, if you aren’t familiar with the topic:

• ETF:  Exchange Traded Fund.  These are funds that are similar to mutual funds, except that they are traded like stocks.  For the most part, they are index funds with extremely low expenses.  In the last five years, there has been an explosion of index-based ETF funds, ranging from the plain vanilla US Stock Market to indexes only for water companies.
• Inverse ETF:  This is a fund that makes money based on the opposite direction of an index.  Example: An S&P 500 bear ETF, or inverse index, would attempt to give you a positive 20% return in the case that the S&P 500 dropped 20%.
• Double/Triple ETFs:  A double (or triple) ETF attempts to give you double (or triple) the returns of a given index.  For example, a double oil fund would attempt to give you a 20% return in the case that oil rose in price 10%.

The original discussion Elliot & I had was back in 2007, when we were comparing two hypothetical portfolios:

• Portfolio 1:  100% invested in the S&P 500
• Portfolio 2: 50% invested in cash, 50% invested in double S&P 500 ETF

At first blush, it might seem like Portfolio 2 is the winner.  After all, with Portfolio 2, it would seem that if the stock market were to drop more than 50%, Portfolio 2 would allow you to keep 50% in cash safe and sound.  If the stock market returns more than negative 50%, then the portfolio seems to offer exactly the same return as Portfolio 1.

The trick, however, is the nature of the double ETF itself.  Double ETFs are not perfect instruments – because they simulate returns using derivative contracts, they try to match their promised returns on a daily basis.  (I’m assuming here, by the way, that the simulation of returns is perfect.  In real life, these funds have an additional problem of tracking error due to the nature of the way they are implemented.)

So if on Day 1 the S&P 500 goes up 1%, the double ETF tries to return 2%.  I say “tries” because it’s rarely perfect.  If the next day the S&P 500 drops 2%, the double ETF should drop 4%.

Unfortunately, it turns out that the math for doubling daily returns does not necessarily lead to a long term result that matches the long term double of the index.

An easy example of where this breaks is to take a huge increase followed by a huge drop.

Let’s say you put $1000 into the S&P 500, and $1000 into the double S&P 500 ETF.

On Day 1, the index goes up 40%.  Great news!  Your $1000 in the S&P 500 is worth $1400.  Your $1000 in the double S&P 500 ETF is now $1800, expected, for a 80% gain.  Everything is as expected on Day 1.

On Day 2, the index goes down 40%.  Bummer.  Your $1400 in the S&P 500 is now $840.  Your $2000 in the double S&P 500 ETF is now $360.  Wow.  That’s bad news.

You can see the problem.  Technically, over two days, the S&P 500 dropped 16%.   But the double S&P 500 ETF dropped 64%.  Most people assume it would have dropped 32%, which is double the two-day return.  This is the issue with percentages – the product of a series of percentage changes will not equal the product of a series of 2x those same percentage changes.  (Covered in Calculus D at most schools, for those in a nostalgic mood).

If you are skeptical, you might be thinking: “Well, Adam just picked the extreme example.  Of course a one day 40% move wipes you out. Most stock market moves are small, so the error is small.”

Unfortunately, this isn’t the case either.  A long series of small moves can lead to large errors as well.

Let’s assume a stock market where every day is either up 2% or down 2%.  In this case, we’ll go up twice for every down.

Let’s say you put $1000 into the S&P 500, and $1000 into the double S&P 500 ETF.

After thirty days of +2%, +2%, -2% (10 times), here is what you are left with:

You’ll have $1214 in the S&P 500, for a 21.4% gain.  But you’ll have $1457 in the double S&P 500 ETF for a 45.7% gain.  In just thirty days, you’re off by 6.6% (in gains).  In this case, it’s a good thing, but obviously in a market like the one we’ve been having over the past six months, it can be a very bad thing.

In fact, over the long term, the errors can be fairly extreme, and whether they are to your benefit or not is based purely on the size and ordering of the volatile movements.  The only way to get ride of the errors is to have an absolutely equally distributed, linear progression of the market in one direction.  And let me be the first to say that we will never actually see that happen.

So, what’s the takeaway here?  Simple.

The errors in inverse and double/triple ETFs grow rapidly based on volatility.  In low volatility markets, they can be used for a short period with expected results.  Like options and other derivatives, however, their tracking errors make them poor choices for long term allocation or investment.

They do make interesting options for speculative bets in the short term, especially in situations where:

• You want to keep liquidity (ie, cash available)
• You want to limit your downside to 50%

But watch out for those error rates…

When will we ever be able to refinance at 40-year lows again?

Silly me, the answer turned out to be about five years later, in late 2008.  Since our rates were about to float, and not trusting the bank to keep the rate reasonable, we decided to lock in rates for at least another five years.  In the process, we evaluated almost every web-based pricing agent, several internet deals, and one professional mortgage broker.

The winner: Pentagon Federal Credit Union

To get a mortgage, you must join the credit union.   You can do this for free if you or a family member served in the armed forces and has proof.  Otherwise, you can sign up to join the National Military Family Association for $20.  Yes, that’s right.  $20.

I’ve been extremely happy with the service.  In fact, when we originally engaged with them, the rates on a jumbo 5/5 mortgage (a unique mortgage they offer that resets every 5 years based on US Treasury rates) were at 5.375%.  They have dropped twice since then, and they allowed us to reset at their current price of 4.625%.

Yes, I know there is probably a better deal out there.  But I also know that most are worse.

In any case, they are worth checking out.  Their rates are updated daily.  Low closing costs.  They depend on Fannie Mae for securitization, so it’s really a good deal if you have a good credit score and fit within guidelines.  No points for loans under 70% LTV.  0.50 points for loans between 0.70% and 0.80% LTV.

If you find a better deal out there… don’t tell me.  I’m happy enough as is.  I may ask for you help again in 2014.

Or, at the rate we’re going, if rates plummet to 100 year lows in 2009, we might refinance again.

3% mortgages?  That’s the magic of deflation…

Investors around the world are stuffing their money into a mattress — otherwise known as the U.S. Treasury-bond market.

Fund managers, corporate treasurers, hedge funds, banks and central banks want to show their constituents, or bosses, their portfolios are bulletproof as year end approaches. Even with all the government’s steps to shore up the credit markets, investors aren’t taking any risks. Instead, they are willing to pay a premium, rather than collect one, to ensure they have in 2009 what they have now.

That means that someone is paying $100.00 for the priviledge of  getting back $99.99 at the end of the term.

This may sound ridiculous, unless you think of it in plain English:

“I’m willing to pay the US Government one penny to keep my $100.00 safe and sound for this duration.”

In a world of fear and deflation, this statement starts to make sense.  Hell, you might even pay more than $0.01 for that security in some cases.

Deflation is a very weird financial state.  For most people, it’s completely counter-intuitive. It’s a world where cash today is worth less than cash tomorrow.  It’s a world where commodities (like gold, silver, oil, food) get cheaper over time nominally, not more expensive.  It’s a world where you don’t buy today, because tomorrow the same product will be cheaper.

In fact, the only large segment of the population at this point who likely have an instinctive feel for deflation are people tied to high technology, primarily hardware like hard drives and semiconductors.  They’ve spent 30 years dealing with the fact that their products will be cheaper tomorrow than today.  They’ve even created high return businesses in effectively a deflationary environment.

I’m not going to go into detail about all aspects of deflation in this post.  But I did think it was worth explaining why 0% bonds might make sense.

Think about the dangers for keeping cash:

• Someone could steal it.  So you have to secure it.
• It can get physically destroyed (fire, pets, small children)
• You can invest it, but those investments may lose money (stocks, bonds, commodities, you-name-it)
• You can put it in a bank, but they may go bankrupt.  (you are protected up to $250K, but you may not get it immediately)

When people are afraid, and liquidity is rushing out of the system, 0% guaranteed by the ultimate “too big to fail” institution in the world can sound pretty good.

Now, I doubt this makes sense for individuals with dollars measured in thousands.  With those numbers, you can get 3+% on a CD, guaranteed by the FDIC.  But for institutions with millions or billions, how do you protect your cash?  Seriously.  It’s not a trivial problem when you think about it.

And no, you can’t just “go to gold”.  Even gold drops in nominal value during deflation.

Mathematically, if a country is undergoing 5% deflation per year, that means that $1000 of gold will only cost $950 in a year.   From that point of view, 0% percent interest + 5% deflation = a 5% real return on your capital, adjusted for inflation.

Yes, it seems like a monetary phenomenon from Bizzaro’s home planet, a square world where people say “goodbye” when they come and “hello” when they go.

But that’s what we’re flirting with right now, as it seems like literally $20 Trillion in nominal value may have disappeared off the planet.

The silver lining, however, is that you can make money in a deflationary market, if you re-orient your thinking.  Sell your products quickly, for cash.  Money now is worth more than money later.  Prioritize products that buyers cannot postpone.  Inventory turnover is key.

Intel has made billions turning over products that drop in value 1% a week in some cases.  It can be done.

After all, isn’t gold supposed to be a safe haven in times of financial depression and panic?  And if these aren’t times of financial depression and panic, what are?

After all, every country in the world is busy running their printing presses to fund bailouts and fight deflationary forces.  Gold should be on its way up, not down.

If you want to see a good article on the topic, there is some nice coverage here on Marketwatch

Gold futures hit a historic high above $1,000 an ounce a few days after Bear Stearns was taken over by J.P. Morgan Chase & Co. on March 14. But in the recent round of crises triggered by the collapse of Lehman Brothers Holdings Inc. gold has fallen to below $700 for the first time in 13 months. The metal has so far lost nearly $170 this month.

The reason, according to analysts at the World Gold Council, is that the latest bout of the credit crisis has been deeper and more far reaching. Funds were forced to sell desired assets such as gold to meet margin calls, while weakness in European economies lifted the U.S. dollar, which then pushed dollar-denominated gold prices lower.

This decade has seen an amazing boom in investment tolerance for non-traditonal asset classes.  People freely talk about how different new investment assets have a “low correlation” to the stock market.  Real estate, commodities, rare coins, art, collectibles, long/short funds, you name it.   As a result, across the world, trillions of dollars are now factored into different asset classes, prudently distributed to minimize risk and maximize reward.

This would all be fine except for one thing.  And it’s the one thing that more than anything led to LTCM’s demise.

That one thing is that all of these great measures of risk are based on historical records.  And as all mutual fund prospectus readers know, “past history is not necessarily indicative of future performance.”

You see, you can take two things that historically have not been correlated.  Asset A & Asset B.  But the minute that an investor owns both A & B, there is now a correlation that didn’t exist historically.  The investor is that correlation.

If Asset A goes down, and the investor needs to sell something, they may now turn to Asset B for liquidity.  And that means selling pressure for Asset B, based on nothing but the asset price of Asset A.  Voila, correlation.

Gold didn’t used to trade like a stock in an ETF that anyone could buy.  It was expensive, hard to store, and was distributed through inefficient, clumsy channels.  It was diversified from other investment classes because it couldn’t be bought & sold easily like stocks or bonds.

Now, buying a Gold ETF is trivial, and can be done for less that $10 a trade with very little spread.  In fact, many commodities can.

All of a sudden, in this market, people are realizing that the investors are the correlation.  And that correlation is much stronger than historical analysis would suggest.

Not to get to gloomy, but re-reading my August 2007 post, I caught this somber realization:

What’s worse, those historical models lead investors to believe that they have less risk on their books than they do have, which leads rational investors to introduce leverage into their portfolios.  That means when the risk shows it’s ugly head, the results get magnified by the leverage of loans.

That’s what happened to LTCM.  Their models were excellent, but they were based on historical correlation.  The minute some of their investments turned the wrong way, their incredible leverage forced pressure in previously uncorrelated investments.  What’s worse, other investors, smelling the “blood in the water”, discovered this new-found correlation, and pressed trades against them.

So, this scares me a lot, at least intellectually.  There are very good reasons why major investors like hedge funds and other asset managers can’t share their up-to-the-minute holdings.  That means, however, that no one really understands this type of “co-investment risk” that is building in mass across the markets.  Unfortunately, the only way I can imagine to properly handle this risk would be to have a universal monitoring set up to accurately reflect this new type of correlation from mass “co-investment” across assets.

Ugh.

It’s called:

Don’t Buy Stuff You Can’t Afford

Scene: a typical American kitchen. A husband (Steve Martin) and wife (Amy Poehler) are puzzling over their finances.

Wife: Oh, I just can’t get these numbers to add up
Husband: Like we’re never going to get out of this hole.
Wife: Credit card debt, does it ever end?
Salesman: [entering from who-knows-where] Maybe I can help.
Husband: We sure could use it.
Wife: We’ve tried debt consolidation companies.
Husband: We’ve even taken out loans to help make payments.
Salesman: Well, you’re not the only one. Did you know that millions of Americans live with debt they can not control? That’s why I developed this unique new program for managing your debt. [Holds up book] It’s called, “Don’t Buy Stuff You Cannot Afford”
Wife: Let me see that. [Reading from book] If you don’t have any money, you should not buy anything. Hmmm … sounds interesting.
Husband: Sounds confusing.
Wife: I don’t know honey, this makes a lot of sense. There’s a whole section here on how to buy expensive things using money you’ve “saved”.
Husband: Give me that. And where do you get this “saved” money?
Salesman: I tell you where and how in Chapter 3.
Wife: OK, what if I want something but I don’t have any money?
Salesman: You don’t buy it.
Husband: Let’s say, I don’t have enough money to buy something. Should I buy it anyway?
Salesman: No.
Husband: Now I’m really confused.
Salesman: It’s a little confusing at first.
Wife: What if you have the money, can you buy something?
Salesman: Yes.
Wife: Now, take the money away. Same story?
Salesman: Nope. You shouldn’t buy stuff when you don’t have the money.
Husband: I think I’ve got it. I buy something I want, then hope that I can pay for it. Right?
Salesman: No. You make sure you have money, then you buy it.
Husband: Oh, then you buy it! But shouldn’t you buy it before you have the money?
Salesman: No.
Wife: Why not?
Salesman: It’s in the book. It’s only one page long. The advice is priceless and the book is free.
Wife: Wow. I like the sound of that.
Husband: Yeah, we can put it on our credit card.
Announcer: So, get out of debt now. Write for your free copy of “Don’t Buy Stuff You Cannot Afford”. And, if you order now, you’ll also receive, “Seriously, If You Don’t Have the Money, Don’t Buy It” along with a twelve month subscription to “Stop Buying Stuff” Magazine. Order today.

You can watch the video here.

Genius.  Pure Genius.  I feel like I’ve actually had this conversation with people before.

LifeHacker: How to Create Your Life Plan

The article points to a blog post by Michael Hyatt, CEO of Thomas Nelson Publishers.  The post from Michael is extremely detailed about the system he’s used for the past five years to guide his life (not just career, but life) on a quarterly basis with the help of his executive coach.

Here is the intro:

I have met very few people who have a plan for their lives. Most are passive spectators, watching their lives unfold a day at a time. They may plan their careers, the building of a new home, or even a vacation. But it never occurs to them to plan their life. As a result, many end up discouraged and disillusioned, wondering where they went wrong.

But it doesn’t have to be this way. You can live your life on purpose. It begins by creating a “Life Plan.” This won’t insulate you from life’s many adversities and unexpected twists and turns, but it will help you become an active participant in your life, intentionally shaping your own future.

I remember some of these exercises from the management and leadership curriculum in the IEEM (now MS&E) track at Stanford, but never with this much richness or detail.   It’s a fairly personal and exposed post in many ways – impressive in some regards to see this kind of transparency from an executive.

On the surface, it feels a little strange to see this type of micro-management of your entire life.  Of course, I’m not sure it makes sense to expect your goals to be fulfilled without both a clear definition of your goals, and a strategy & execution to get there.  After all, it’s what I hold Product Managers accountable for, right?

Can you manage your life the way you manage a product?

Definitely worth a read and at least 15 minutes of consideration…

Vanguard announces share split for three exchange-traded funds

June 04, 2008 – Vanguard announced today a two-for-one split of shares of Vanguard® Total Stock Market ETF (VTI), Vanguard Emerging Markets ETF (VWO), and Vanguard Extended Market ETF (VXF). The conventional shares of the funds are not affected by this split.

The share split entitles each shareholder of record at the close of business on June 13, 2008 to receive one additional share for every share of the ETF held on that date. The additional shares are expected to be distributed to shareholders on June 17. The shares will trade at the new split-adjusted prices beginning June 18.

I need someone to explain this one to me.  After all, splitting a stock does absolutely nothing for the fundamentals of the stock.  You might argue there is some emotional, momentum-based advantage when go-go growth stocks do it, but this is an index fund.  And a Vanguard fund to boot!  I just can’t imagine the Vanguard trustees chasing momentum money, or expecting momentum money to flow to an index fund just because it’s splitting.

There is that old argument that you want to keep share prices low so “small investors” can buy a “round lot” of 100 shares… but that logic went out the door with odd lots and discount brokers about 30 years ago.

So why did they do it?  Are they trying to capture small investments under $100 with the ETF?  Brokers like E*Trade already offer free dividend reinvestment on ETFs, which allows you to buy partial shares.

Anyway, if you own any of these funds, note it in your calendar, Quicken, etc.

Weird.

I’m going to try to be careful here not be too specific about any candidate or their plans.  I felt, however, that this topic was non-obvious enough that it was worth commenting on, despite the danger.  I can only hope that these comments might reach the ears of all three of the currently viable candidates…

Please don’t raise capital gains taxes in this environment

Or at least, please don’t raise them without also indexing gains to inflation.  It’s not a serious problem when inflation is extremely low for long periods of time, but it could be very very bad if we are, in fact, heading into an environment with a weak dollar and higher prices.

Why?  Because the capital gains tax today is based on nominal gains, not real gains.

Not clear on why this is a problem?  Here is an example:

Let’s say you bought a stock in 2009.  It’s a good stock, but not a great one, and it returns roughly 10% per year for the next 7 years.  In fact, by 2016 the stock has doubled, exactly, from $10 per share to $20 per share.  Since you bought 1000 shares, you’ve just turned $10,000 into $20,000, for a $10,000 gain.

That sounds good, and you might be thinking, “Well, with a $10,000, why should I begrudge the government $2,000 or even $2,800 of that gain?  After all, it’s this great country that has made that type of gain possible.”

Here’s the problem.  Let’s say inflation over the next 7 years is higher than it has been.  5% instead of 3%.  Well, then actually $10,000 in 2016 doesn’t buy what it did in 2009.  In fact, it takes over $14,000 2016 dollars to buy the same car that $10,000 did in 2009.

But the tax man doesn’t care.  The IRS still calculates your gain as $10,000, not $6,000.  So $2,800 might be 28% of your nominal gain, but it’s 47% of your real return, after inflation.

Ouch.

It gets worse.  If inflation manages to soar to around 8%, which it did in the 1970s, then actually that $2,800 tax becomes more than your entire real return.  At 8.1%, in fact, your real return becomes negative – you end up paying a real tax of over 100% of your inflation-adjusted gains.

Double-Ouch.

That’s pretty much what happened to people in the 1970s.  And it really did have a drastically negative effect on capital investment and tax collection, because rich people basically decided to either avoid capital investments, or they decided to postpone taking gains.  (Little known fact, but capital gain tax revenue has increased since we lowered the rate to 15%… a combination of better market performance and likely some acceleration of people taking gains.)

Now, in the 1980s and 1990s, this wasn’t such a big deal, because we both lowered capital gains tax rates and we killed inflation.  Or, at least, we wounded it.  When inflation is low, and the holding periods are relatively short (under 10 years), you could argue that the inflation “tax” automatically adjusts the 15% up to something higher, but manageable.

So, I think that leaves us in a policy bind, since it’s very likely we’re headed for higher inflation in the next 10 years.  In fact, you could argue that cutting the capital gains tax commensurate with the increase in inflation and the average holding period might make sense, if the goal was economic neutrality.

One solution would be to index capital gains for inflation.  It’s a sticky problem, because it means that taxpayers would have to have a table of “multipliers” to apply to any investment, based on the year of investment.  You would also likely have to exclude shorter holding periods to avoid trading scams, and have some sort of wash-sale like rule.  But this is all doable.

If you see another path around this problem, I’d love to hear it.  Right now, it feels like inflation is going to take a serious whack at capital investment if we’re not careful.

For a while, Paul Krugman was making more and more sense to me.  It had me worried, because I remember distinctly feeling more and more alienated by his commentary in the past 5+ years.  But since I don’t follow him that closely, the reasons why were fading from memory.

This article snapped them back into clarity.  Oh boy, is this column off-base.

I think the point of his column here was to effectively claim that there is no social security crisis, that social security is doing just fine, and that the arguments against it are contradictory and specious.  I’m not really sure, though, because the point of the column kind of wanders.

In any case, he is right about one thing: the arguments against the stability of social security do contradict each other.  Unfortunately, what is good for the goose is good for the gander… Krugman’s arguments seem to also contradict themselves.

The fundamental argument that is correct, unfortunately, is that Social Security is going to start doing some serious damage to the Federal Budget, starting around 2018.

Krugman is correct that there is, in fact, a Social Security surplus, engineered as part of the Federal tax changes made in 1986.  This surplus, however, is not saved in any sort of marketable assets.  Instead, these trillions of fictional dollars have already been spent as part of the regular annual budget (yes, even after that we still run a deficit), leaving in their place special US Treasuries, redeemable in the future by the US Government.

What Krugman misses here is that US Treasuries are just an IOU that the US Government is writing to itself.  US Treasuries are in fact a great asset to invest in for every single entity other than the US Government. It’s as if you decided to buy a car today by lending yourself the money.  Yes, it is that silly.  Guess what happens when the right hand goes back to the left hand to get payment on that loan?

Allan Sloan sums the argument up well in the March 2008 issue of Fortune Magazine:

How can I say that, given Social Security’s $2.3 trillion (and growing) trust fund? It’s because the fund owns nothing but Treasury securities. Normally, of course, Treasury securities are the safest thing you can hold in a retirement account. But Social Security’s Treasuries won’t help cover the program’s cash shortfall, because Social Security is part of the federal government. Having one arm of the government (Social Security) own IOUs from another arm (the Treasury) doesn’t help the government as a whole cover its bills.

Here’s why the trust fund has no financial value. Say that Social Security calls the Treasury sometime in 2017 and says it needs to cash in $20 billion of securities to cover benefit checks. The only way for the Treasury to get that money is for the rest of the government to spend $20 billion less than it otherwise would (fat chance!), collect more in taxes (ditto), or borrow $20 billion more (which is what would happen). The spend-less, collect-more, and borrow-more options are exactly what they would be if there were no trust fund. Thus, the trust fund doesn’t make it any easier for the government to cover Social Security’s cash shortfalls than if there were no trust fund.

I think Krugman does a real disservice here by pretending that this fact is some sort of charade cooked up by people who want to privatize social security.  The fact is that social security, in its current structure, is part of the general budget.  It has no marketable assets beyond those US Treasuries, which the US issues at its discretion anyway.  The US has no sovereign wealth fund in marketable assets.  That means in 2016/2017 or so, we’re going to start having to pay the piper.  According to the Social Security Administration, the tab will be $96B in the red in 2020.

Sure, we can fund it with higher taxes.  Or lower spending.  Or both.  But it’s going to start hurting as soon as it goes negative.

There are a lot of potential solutions here – but none are easy, and none erase the fact that we effectively spent our $2.3 Trillion surplus before we were supposed to.  We’re going to have to pay it back, one way or another, or we’re going to have to radically rethink Social Security.

So, my apologies Mr. Krugman, but we do, in fact, have a Social Security crisis and a general budget crisis in the making.  And it’s going to be in the next decade, not in 2042.  My generation is going to end up paying a lot more for a lot less, assuming we even have a claim on assets at all when it’s all said and done.

However, I’ve seen pitifully few articles that actually explain the details of what the Federal Reserve did, and why it was so revolutionary for the almost 100-year old institution.  Sure, I’ve seen commentators refer to a “$30 Billion Bailout” of Bear Stearns, especially in the context of populist rhetoric that this somehow would justify spending $30 Billion to bail out homeowners who are under-water on their mortgages.  But this isn’t really a bailout.

Well, the April 7th issue of Business Week actually has a decent article on the topic, and I recommend it to those who are seeking to understand what, exactly, the Fed did.  (Hard not to like the cartoon, also):

A few facts to glean from the article:

First, the Federal Reserve action, although structured like a loan, actually seems to behave mathematically more like equity:

So far, few people have focused on what exactly the Fed is getting in exchange for supplying $29 billion to JPMorgan Chase. That’s a bit surprising because whatever the deal is, it’s far from a standard loan. The strangest twist is that even though the money goes to JPMorgan, that firm isn’t the borrower. So the Fed can’t demand repayment from JPMorgan if the Bear assets turn out to be worth less than promised.

What’s also odd is that if there’s money left after loans are paid off, the Fed gets to keep the residual value for itself. That’s what one would expect if the Fed were buying the assets, not just treating them as collateral for a loan. Vincent R. Reinhart, a former director of the Fed’s Division of Monetary Affairs and now a resident scholar at the American Enterprise Institute, said in an interview on Mar. 26: “The New York Fed is the residual claimant. That doesn’t look to me like a loan. That looks like equity.”

More detail follows down the page:

Here’s how it works: A Delaware-based limited liability company will be set up to receive, upon completion of the merger, $30 billion in various Bear holdings, such as mortgage-backed securities. The Fed will lend $29 billion to that company, which will pass all the money along to JPMorgan, Bear’s new owner. JPMorgan itself will lend $1 billion to the Delaware company. The company, managed by BlackRock ­Financial Management, will pay back the loans by gradually liquidating the assets. As a protection for the Fed, it gets paid back fully before JPMorgan gets back anything on its loan. The other sweetener for the Fed is that if there’s money left over even after ­JPMorgan gets repaid, the Fed gets it all.

From an economic perspective, this complex arrangement is functionally identical to a purchase of the Bear portfolio by the Fed—one that’s financed in small part by the subordinated $1 billion loan from JPMorgan. But the Federal Reserve Act doesn’t seem to provide for the Fed to make such equity investments. That doesn’t trouble the Fed because it argues that the $29 billion is indeed a loan—or, to use the antiquated language of the Fed’s founding legislation, a “discount” of a “note.”

This is an important point, because if the history of liquidity-impacted portfolios like LTCM are any indication, it’s very likely that an orderly disposal of the Bear Stearns assets could actually net gains in the long term.  More importantly, since JP Morgan takes the first $1B in losses, the Fed actually gets a bye on the first 3.3% of net loss on the portfolio, if it exists.

Now, you could argue that the Fed has put $29B of taxpayer dollars at risk, and that is true in a sense.  But the value of that risk is not the $29B number thrown around, but a complex calculation of the actual expected gain/loss here.  As I mentioned, historically, these type of crunch-induced crisis portfolios actually net out positively when given the time to unwind outside of a panic situation.

The fairest criticism I’ve seen of this action to date is the result of the raised offer from $2/share to $10/share by JP Morgan, which will not only keep Bear Stearns credit holders whole, but will also net common shareholders something of a windfall.  You could argue that shareholders should have received nothing, and that credit holders should have born the first risk traunche of the portfolio.

The problem with this argument is that it assumes that any other deal could have been workable and accepted in the limited timeframe caused by the run on Bear assets & liquidity.  These situations always seem calmer from hindsight, and beg for Monday-morning quarterbacking, but the truth is, they are negotiated in the heat of panic, and the almost audible sound of an approaching, falling knife.

Morgan Stanley has teamed up with Van Eck Global to launch currency exchange-traded notes offering exposure to the Chinese renminbi and the Indian rupee. The Market Vectors – Chinese Renminbi/USD ETN (NYSE Arca: CNY) and Market Vectors – Indian Rupee/USD ETN (NYSE Arca: INR) are the first exchange-traded products to offer exposure to those two currencies. They launched today on NYSE Arca.

The notes are designed to go up in value when the named currency appreciates against the U.S. dollar, and down when the dollar strengthens. The ETNs are underwritten by Morgan Stanley, and Van Eck is the marketing agent. The notes charge 0.55% in annual fees.

Full details are on Yahoo Finance.

The securities are already live and trading.  Here is a quote for the Market Vectors – Chinese Renminbi ETN (CNY), here is a quote for the Market Vectors – Indian Rupee ETN (INR).

There are a few details that are worth noting.  ETNs, or Exchange Traded Notes, are a relatively new innovation in indexes, and as a result, there are some grey areas around their long-term tax treatment.  Both notes do not actually own the currency.  Instead, you are buying a promise, from Morgan Stanley, that they will pay off a return on investment that matches the return on investment of an index that is tied to the currency.  Got it?  Yes, it’s two levels of indirection… almost like a HANDLE to the currency.  (Bonus points to old-school Mac developers who get the reference.)

Here are three caveats from the article:

First, unlike most currency products, they earn interest based on the U.S. Federal Funds interest rate … not local interest rates.�(Although they are currently similar.)

Second, these ETNs do not pay out interest income – instead, it is added to the share value of the note.�That creates a problem for investors, as the IRS has said that investors must pay taxes each year on this notional interest … even though they won’t realize the gains until they sell the note.

Finally, ETNs are debt instruments, which means investors are exposed to the credit risk of the underlying bank. Morgan Stanley seems sound, but the current market environment could give people pause.

This is an interesting option, but likely only appropriate for tax-protected accounts.  Personally, I still have a soft spot for Everbank, and it’s currency-based bank notes, CDs, and money market funds in different world currencies.

Credit to Paul Kedrosky’s Blog.

Slice the $270m JPMorgan just agreed to pay for Bear Stearns any way you want to and still it’s a horrible end for a storied brokerage firm. To end up paying $0.25 on the dollar for the company’s $1 in headquarters real estate, in effect, and to do it in equity, no less, is an embarrassment beyond embarrassment for people collectively incapable, at least until now, of being embarrassed.

Tragic, tragic stuff, and, we can only hope, a bottom, even if one we bounce along for some time,  to one of the worst periods in modern financial markets. But trust me, there is nothing in it for anything to be proud of, other than removing much of the Bear-specific counterparty risk that would have taken everyone in the financial market out in a major way during trading tomorrow.

Here is the NYT piece, from tomorrow’s newspaper, tonight, online.

Here is the PDF of the investor presentation.

Wow.

It’s becoming fashionable in circles to doubt the Fed.  I’ll be posting a book review of “Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve” soon, and I’ve seen a lot of commentary doubting Mr. Bernanke.  All I can say at this point is that it is way too soon to be counting out the Fed.

They can’t work miracles, of course, but the power of almost unlimited resources is significant, if wielded properly.

The most fascinating aspect about central banking is it’s amazing foundation on the irrational and the immeasurable.  In the end, it’s more about confidence than anything else.  By convincing the markets that you will solve the problem, you create the confidence that increases liquidity and solves the problems.  You can’t be predictable, because, like in warfare, predictability leads to people thinking steps ahead and countering your actions.  Like a great General, you have to be unpredictable enough to instill fear and uncertainty in those who would fight against you, and through that uncertainty, ironically you win.

So you want uncertainty, but only the type that destabilizes those that would bet against you.  You want to reduce uncertainty around the likelihood of Fed success.

Got it?

If the juxtuposition sounds funny, blame it on the fact that I read the Greenspan book and a biography of George Washington all within a two week period.

Anyway, at times like this, it’s good to remember that the guy we have at the helm, at this time, is someone whose fundamental academic expertise is the mistakes made in the 1930s Great Depression, and the mistakes made in Japan in 1990s.  A quick reference from Paul Krugman:

What you probably should know is that Ben Bernanke, in his capacity as a professional economist, spent a lot of time worrying about Japan’s experience in the 1990s. (So did I.) What was so disturbing about Japan was the way monetary policy became ineffective; by the later 1990s the short-term interest rate was up against the ZLB — the “zero lower bound.” This is alternatively known as the “liquidity trap.” And once you’re there, conventional monetary policy can do no more, because interest rates can’t go below zero.

Krugman also points out that today’s TED spread indicates a mixed message – confidence seems better slightly, but not significantly.  That could be an indicator that the weight of uncertainty.  Still, in his own words, yesterday’s move was a big slap in the face for the credit markets.

I can’t wait until the weekend when I have time to dig into all of this further.

A significant number of my personal acquaintances purchased homes (newer, larger) within the last several years. Inevitably, they were also convinced that financing via an 80/20 first/second mortgage setup was the way to go. Doing so is “financially smart,” because it allows them to avoid paying private mortgage insurance.

It’s an idea that works … until it doesn’t. Consider this Baltimore resident’s story, for instance:

Baltimore Sun: “Some Lenders Block Refi Ability”

He needs to refi out of his nasty ARM first mortgage — he’s lucky, in that he does have decent equity in his home — but his second-mortgage holder won’t agree to a re-subordination.

Under any circumstances.

I think the 80/10/10 is more common here in the Bay Area, or at least was, back in 2003/2004.  The 80/10/10 is  80% first mortgage, 10% HELOC, and 10% down payment.  No mortgage ensurance, and you get a HELOC which can be useful if you need to tap assets for some reason.

This is a pretty good example of how liquidity in a market like mortgages which isn’t centrally brokered can quickly jam up.

I’ve also seen stories lately of banks literally calling due their HELOC loans with fairly short notice.  Seems to be tied to people who are underwater on their houses (debt is greater than value of house). Not a good thing if you don’t have the liquidity to cover the outstanding balance, or if you were depending on your HELOC as an emergency fund.

Another lesson on why, in the end, liquidity can be one of the most important aspects of personal finance.   People tend to focus on rates of return, which of course, is a good thing to focus on.  But when you need money, it’s amazing how rates of return give way to the simple ability to tap assets for cash.

Earlier this month, Vanguard shaved its fees on four of its popular ETFs. Those were:

• Growth ETF (AMEX: VUG), from 0.11% to 0.10%.
• Value ETF (AMEX: VTV), from 0.11% to 0.10%.
• Small-Cap Growth ETF (AMEX: VBK), from 0.12% to 0.11%.
• Small-Cap Value ETF (AMEX: VBR), from 0.12% to 0.11%.

Also, the new Europe Pacific ETF (AMEX: VEA) wound up the year at 0.12%. The fund opened last July and was expected to assess expenses of around 0.15%.

“We originally estimated an annualized expense ratio at higher levels,” said Rebecca Cohen, a Vanguard spokesperson. “But after the year closed out, expenses wound up being less than originally estimated.”

While relatively tiny moves, the latest changes further distances Vanguard’s ETF lineup from the pack. It also brings to 18 the number of different ETFs that Vanguard has cut expense ratios on within the past four months.

The flurry of cost-cutting leaves Vanguard with an average expense ratio at 0.16%. Through year-end 2007, Lipper data showed an average ETF in the U.S. with an expense ratio of 0.53%.

“As ETFs grow in size, they generally become more efficient to run,” said Vanguard in a statement.

As a shareholder-owned company, Vanguard says its “policy has always been to pass the savings from those efficiencies through to investors. The new expense ratios reflect the lower costs of managing these products.”

This is why I am such a loyal customer of Vanguard and Vanguard financial products.  Their entire brand promise is around minimizing management costs for investors, and as a result, they proactively reduce rates constantly.  Unlike other institutions that use low fees as a short term “loss leader” to bring in assets, Vanguard genuinely strives for the lowest costs structure, and passes those savings on to their investors.

The idea that you can now buy an index of small-cap, domestic, growth companies for 11 basis points a year is just amazing.  11 basis points!  That means if you had $10,000 invested, the annual overhead cost would be just $11.   And that’s for a fairly focused index – I believe the broad based US domestic stock index ETF from Vanguard is down to just 7 basis points!

When at all possible, I tend to go with the Vanguard index ETF/Fund.  In fact, since many brokerages (like Fidelity) charge exorbitant commissions on the Vanguard funds,  you can now just buy the ETFs like any other stock.  Pay a cheap commission once, and pay cheap expenses for decades.

Hard to beat a great product with a great cost from a great firm.  Hard to beat.