Book Review: The Big Short

Coming off of one of the best books I have read in a while, Mustaine, I didn't think I would steam through another book so quickly. However, when I picked up The Big Short by Michael Lewis I was hooked instantly. The book is an incredible read that takes the reader on a surprisingly tangible trip through the subprime mortgage crisis.

Michael Lewis, most famous for his piece The Blind Side, which was recently turned into a major motion picture, does an excellent job of not only making what happened to our economy understandable but also entertaining. He does so by profiling a few interesting and important characters in the subprime mortgage meltdown. Although he does showcase some big name players and tell of their roles in how history played out, the real magic of his work comes from telling the tale through eyes of the few who saw it coming. Hence the title The Big Short.

The Big Short is not the story of the crisis, as the crisis is commonly understood. The failure of Lehman brothers and of Fannie Mae and Freddie Mac; the stock-market crash; the bail-out of Detroit; the fevered all-nighters pulled at Treasury and the New York Fed; the fears that the entire global financial system was on the brink of collapse -- little if any of that is in this book.

Instead, Lewis has found a different story -- one which he started mining for a spectacular cover story in the December 2007 issue of Portfolio magazine, and which has culminated in this book, over two years later. It's the story of what used to be called the "subprime crisis" before it metastasized into something much larger and more dangerous than that. And it's also, like all Michael Lewis tales, a human story, which takes us deep inside unique characters like Steve Eisman and Mike Burry.

Telling the story through the eyes of those betting against Wall Street's big hitters and the mortgage backed securities that eventually led to the chaos experienced in September of 2008 makes for a truly interesting perspective. It also allows Lewis to come off as less of an I know it all author who has forgotten that hindsight is 20:20. The story is told from the guys who can truly say 'I told you so' because the whole time they were putting their money where their mouths were.

Here are some notes from the book:

Prologue: Poltergeist:
- Predicted crash would occur almost 20 years ago in his first book Liar's Poker
- "If you'd gotten a few drinks in me and then asked what effect the book would have on the world, I might have said something like,'I hope that college students trying to decide what to do with their lives might read it and decide that its silly to phony it up, and abandon their passions or even their faint interests, to become financiers.'
- He kept waiting for a rebellion but it didn't happen

A Secret Origin Story:
-Steve Eisman was a nerdy badass
- "You don't even own stock in your company" said Eisman to the Japanese businessman. "In Japan it is not customary for management to own stock," said the businessman. Eisman noted that the guy's financial statements didn't actually disclose any of the really important details about the guy's company but rather than simply say that he lifted the statement in the air as if disposing of a turd. "This......this is toilet paper. Translate that!" he said.
- When asked about the pattern of upset he leaves in his wake, Eisman simply looks puzzled, even a bit wounded. "I forget myself sometimes."
- The big fear of the 1980 mortgage bond investor was being repaid too quickly not fear of not being repaid at all.
-"And the story they liked to tell was that 'we're helping the customer. Because were taking him out of his high interest rate credit card debt and putting him into a lower interest rate mortgage debt.' And I believed that story." Then something changed.
- None of his fellow accountants was able to explain why the traders were doing what they were doing. "I didn't know what I was doing," said Vinny. "But the scary thing was, my managers didn't know anything either. I asked these basic questions--like, Why do they own this mortgage bond? Are they just betting on it, or is it part of some larger strategy? I thought I needed to know. It's really difficult to audit a company if you can't connect the dots."
- Essentially a ponzi scheme. As long as they were growing the illusion was masked.
- Eisman wrote a report and trashed all the subprime mortgage originators. "Here is the difference between the view of the world they are presenting to you and the actual numbers." The subprime companies did not appreciate his effort. "He created a shitstorm," said Vinny. "All these subprime companies were calling and hollering at him: you're wrong. Your data's wrong. And he just hollered back at them, 'It's YOUR fucking data!"
- "You have to understand, I did subprime first. I lived with the worst first. These guys lied to infinity. What I learned from that experience was that Wall Street didn't give a shit what it sold."
- "The very first day we said, 'There's going to come a time when were going to make a fortune shorting this stuff. It's going to blow up. We just don't know how or when."

In The Land Of The Blind:
- Worst loans by Michael Burry's standards are interest only negative amortizing adjustable rate subprime mortgages
- "What you want to watch are the lenders, not the borrowers. The borrowers will always be willing to take a great deal for themselves. Its up to the lenders to show restraint, and when they love it, watch out." By 2003 he knew the borrowers had already lost it. By early 2005 he saw that lenders had too.
- You couldn't short the mortgage bonds
- Burry began buying corporate credit default swaps on companies he though may suffer from a real estate downturn but there was no guarantee these companies would go bankrupt and that is the only way he would get paid.
- He bought credit default swaps on subprime mortgage bonds in 2005 guessing in two years after teaser rates jumped his bet would pay off.
- The market didn't exist so Burry pitched Wall St. Only Deutsche and Goldman had any interest and no one saw what he was doing.
- He went from blogger to millionaire overnight because Gotham Capital was making money off his picks and offered him a million to open his own fund.
- White Mountain followed shortly after
- Volatility doesn't equal risk. "By and large the wealthiest of the wealthy and their representatives have accepted that most managers are average, and the better ones are able to achieve average returns while exhibiting below average volatility. By this logic a dollar selling for fifty cents one day, sixty cents the next day, and forty cents the next somehow becomes worth less than a dollar selling for fifty cents all three days. I would argue that the ability to buy at forty cents presents an opportunity, not risk, and that the dollar is still worth a dollar."
- He was turning away money after a few years. "He designed Scion so it was bad for business but good for investing."
- Charlie Munger said you can always predict how people are going to behave by looking at their incentives.
- "You can say everyone knows that. I think I've been in the top five percent of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther," said Charlie Munger.
- He went against the industry fee standard to properly align incentives
- Their decision making was one guy in a room pouring over publicly available information
- 2003 Bury called the real estate bubble. "You just have to watch for the level at which even nearly unlimited or unprecedented credit can no longer drive the housing market higher. I am extremely bearish, and feel the consequences could very easily be a 50% drop in residential real estate in the US....A large portion of current housing demand at current prices would disappear if only people became convinced that prices weren't rising. The collateral damage is likely to be orders of magnitude worse than anyone now considers."
- In 2005 when he first tried to convince Wall St of the credit default swaps for subprime mortgage bonds his first big problem was that they didn't share his sense of urgency
- He started buying and was amazed that no one on Wall St cared which funds he was shorting. It was like all subprime bonds were the same thing
- "Burry devoted himself to finding exactly the right ones to bet against. He'd read dozens of prospectuses and scoured hundreds more, looking for the dodgiest pools of mortgages, and was still pretty certain even then (and dead certain later) that he was the only human being on earth who read them, apart from the lawyers who drafted them."
- He even found a mortgage pool that was 100% floating rate negative amortizing so the borrower could not pay any interest and just have their loan grow and grow until default. Goldman sent him a congratulations for being the first to buy a credit default swap on it!
- He tried to start a fund to do only CDS but no one would pony up money
- The S&P was down 6.84% in 5 years and he was up 242% but no one believed him when it came to credit default swaps
- People wouldn't give him money but started prodding Goldman on how to do it themselves
- All the Wall St players started coming to him to buy back his CDS all at once
- He sold back to Deutsche and then saw an email that said "Greg Lippmann, the head subprime mortgage trader at Deutsche bank was in here the other day. He told us that he was short 1 Billion dollars of this stuff and was going to make 'oceans' of money. His exuberance was a little scary"

How Can A Guy Who Can't Speak English Lie?:
- Greg Lippmann of Deutsche went to pitch Eisman as if the CDS idea was his own
- Lippmann used a Chinese guy to give credibility to his numbers. "Eugene Xu was responsible for every piece of data in Lippmann's presentation. Once Eugene was introduced into the equation, no one bothered Lippmann about his math or his data. As Lippmann put it 'How can a guy who cant speak English lie?'"
- Eisman had two questions: 1. How does a CDS work again? 2. Why are you asking me to bet against the bonds at your firm?
- "When he walked in and said you can make money shorting subprime paper, it was like putting a naked supermodel in front of me. What I couldn't understand was why he wanted me to do it," said Eisman.
- Burry didn't know who was to be left holding the bag from Goldman and others if the CDS turned out the way he thought. He knew Goldman wouldn't have done the deals if the risk was on them.....turns out it was AIG
- Goldman had created Collateralized Debt Obligations (CDO) which just lumped together a bunch of the mortgage bonds to supposedly mitigate the risk but that already happened with the mortgage bonds
- The did CDO's to get shit bonds re-rated as AAA
- The CDO was, in effect, a credit laundering service for the residents of lower middle class America. For Wall St. it was a machine that turned lead into gold
- After a while they didn't need to do CDOs of mortgage bonds they did them on the CDS. This essentially created a market and money for banks out of nothing
- Ratings agencies didn't know how to rate these
- Lippmann although forced into the shorting of mortgage bonds by Deutsche realized it was a gold mine
- He couldn't convince others to short so he went to AIG to try and blow up the market so he could cash in

How to Harvest a Migrant Worker:
- Joe Cassano was the bullying prick CEO of AIG
- Gene Park asked people most closely tied to CDS what percentage of the loans were subprime. They were all saying 10-20%. No one knew it was 95%
- No one believed housing prices could fall nationally all at once
- Park convinced Cassano to stop insuring but they didn't unload what they had
- Lippmann went looking for others who agreed with his beliefs and ran into Eisman
- The simple measure of sanity in housing prices was the ratio of median home price to income. Historically in the US it ran around 3:1 by late 2004 it had risen nationally to 4:1. "All these people were saying it was nearly as high in some other countries. But the problem wasn't just that it was four to one. In Las Angeles it was ten to one and in Miami eight to one. And then you coupled that with the buyers. They weren't real buyers. They were speculators."

Accidental Capitalists:
- A smaller number of people, more than ten, fewer than twenty, made a straightforward bet against the entire multi trillion dollar subprime mortgage market and by extension the global financial system. In and of itself it was a remarkable fact: The catastrophe was foreseeable, yet only a handful noticed.
- The few who saw it coming could be traced back to Lippman, except Mike Burry
- "I loved the concept of shorting a bond because your downside is limited. Its an asymmetrical bet." Said Paulson. He was shocked how much easier and cheaper it was to buy a credit default swap than it was to sell short an actual cash bond even though they represented the exact same bet.
- Charlie Ledley got a hold of Lippman's presentation
- He and a few buddies began buying options they viewed as mispriced and built their own fortunes in a short time
- They eventually got Wall St to sell them CDS
- "It took us weeks to really grasp it because it was so weird. But the more we looked at what a CDO really was, the more we were like Holy shit, that's just fucking crazy. That's fraud. Maybe you cant prove it in a court of law. But its fraud." - Charlie Ledley
- They were even buying the AA tranches of the CDS and they were the first to do so because they realized they were no better than the BBB but cheaper
- "A lot of people when we called them said hey why don't you guys buy some stocks? They couldn't believe that these young guys wanted to buy not just CDS but CDS's so esoteric that no one else had bought it."
- They didn't realize yet that the bonds inside their CDOs were actually credit default swaps on the bonds, and so their CDO's werent ordinary CDOs but synthetic CDOs or that the bonds on which the swaps were based had been handpicked by Mike Burry and Steve Eisman and others betting against the market. In many ways they were still innocents.

Spiderman At The Venetian:
- Eisman met Wing Chau a CDO manager and thought he would be hurting with the housing prices falling because the CDO managers had filled the void left by AIG. But the CDO managers were selling to Institutional Clients. Everyone was passing the risk.
- "He 'managed' the CDOs. But managed what? I was just appalled that the structured finance market could be so insane to allow someone to manage a CDO portfolio without having any exposure to the CDOs. People would pay up to have soomeone 'manage' their CDOs as if this moron was helping you. I thought, you prick, you dont give a fuck about the investors in this thing." - Eisman talking about Wing Chau a CDO manager
- Chau's real job was to serve as a new kind of front man for the Wall St firms he "hired"; investors felt better buying a Merrill Lynch CDO if it didnt appear to be run by Merrill Lynch.
- After the dinner Eisman grabbed Greg Lippmann and said "Whatever that guy (Chau) is buying, I want to short it." Lippman took it as a joke but Eisman was serious. He wanted to specifically bet against Wing Chau. "I want to short his paper. Sight unseen."
"Usually when you do a trade you can find some smart people on the other side of it. In this instance we couldnt. Nobody we talked to had any credible reason to think this wasnt going to become a big problem. No one was really thinking about it." Cornwall Capital guys
- People believed the collapse of the subprime market was unlikely precisely because it would be such a tragedy.
- Eisman, "In Vegas it became clear to me that this entire huge industry was just trusting in the ratings so they didnt have to think about it."
- "You know how when you walk into a post office you realize there is such a difference between a government employee and other people? The ratings agency people were all like government employees." - Vinny
- "That was the moment when we said, 'Holy shit, this isnt just credit. This is a fictitious Ponzi scheme." - Vinny
- "There were more morons than crooks but the crooks were higher up." - Vinny and Eisman
- Eisman got back from Vegas and increased his shorts by $250M

The Great Treasure Hunt:
- Charley traded with Morgan Stanley and literally overnight they said they couldnt do CDS anymore.
- In a portfolio of 30 million Charley and Cornwall Capital owned 250 million and were disappointed they didnt own more
- Charley even went to the SEC but they didnt get it and never investigated
- "We always asked the same question. Where are the ratings agencies in all this? And I'd always get the same reaction. It was a physical reaction because they didnt want to say it. It was a smirk. They were just assuming home prices would keep going up," Eisman said.

The Long Quiet:
- Mike Burry had 1.9 billion in CDS and he shouldve been recieving money as the market took its lumps but since he was one of the only players Wall St was setting the market price of his shorts
- So he started asking to buy at the prices they were telling him his shorts were worth but of course they wouldnt sell him any more. It was BS.
- "One of the oldest adages in investing is that if youre reading about it in the paper it is too late. Not this time."
- Burry's investors all wanted their money back including partner Joel Greenblatt. When he locked up their funds from withdrawal they started organizing to sue.
- Wall St stopped responding for a few days then all called at once saying they wanted to ensure the value of his shorts were fair. They were getting in on the shorts themselves before the crash.
- "When I first started shorting these mortgages in 2005 I knew full well that is was not likely to pay out within two years. And for a very simple reason. The vast majority of mortgages originated in the last few years had a rather ominously attractive feature called the teaser rate period. Those 2005 mortgages are only now reaching the end of their teaser rate periods and it will be 2008 before the 2006 mortgages get there. What sane person on Earth would confidently conclude in early 2007, smack dab in the midst of the mother of all teaser rate scams that the subprime fallout will not result in contagion? The bill literally has not even come due." Burry
- "Nobody came back and said, 'Yeah you were right.' It was very quiet. It was extremely quiet. The silence infuriated me." Burry

A Death Of Interest:
- Howie Hubler of Morgan Stanley is profiled as the stereotypical trader with the blinders on
- "It was more than a little weird. There was a lot of angst about it. It was sort of viewed as, These folks dont know what theyre talking about. If losses go to ten percent there will be, like, a million homeless people." Losses in Hublers group would eventually go to 40%.
- "They kept saying That state of the world cant happen!"
- "It is one thing to bet on red or black and know that you are betting on red or black. Its another to bet on a form of red and not to know it."
- "They werent lying. They genuinely failed to understand the nature of the subprime CDO
- Howie went on vacation and never came back. The losses left behind were 9 billion, the largest in Wall St history for a single trader
- The last buyer of subprime mortgage risk had stopped buying
- Cornwall began to worry Bear Stearns would go out of business and would be unable to pay up so they sought buyers of their CDOs.
- UBS offered 30 points up front. That means Cornwall's $205M in CDS were now worth $60M (30% of $205M) when it cost them only $1M to buy them
-"It's the first time were seeing any prices that reflect anything close to what they're really worth. We had positions that were being valued by Bear Stearns at six hundred grand that went to six million the next day." Charlie Ledley
- Mike Burry also started to make a killing. In a portfolio totalling $550M he maid $720M in one year
- "Even when it was clear it was a big year and I was proven right, there was no triumph in it. Making money was nothing like I thought it would be," said Mike. To his founding investor, Gotham Capital, he shot off an unsolicited email that said only, "Youre welcome." He'd already decided to kick them out of the fund and insist they sell their stake in his business. When they asked him to suggest a price, he replied, "How about you keep the tens of millions you nearly prevented me from earning for you last year and we call it even?"

Two Men In A Boat:
- "Being short in 2007 and making money from it was fun, because we were short bad guys. In 2008 it was the entire financial system that was at risk. We were still short. But you dont want the system to crash. Its sort of like the floods about to happen and youre Noah. Youre on the ark. Yeah youre okay. But you are not happy looking out at the flood. Thats not a happy moment for Noah." - Eisman
- Frontpoint's fund went from $700M to $1.5B
- "What, the entire American population woke up one morning and said, 'Yeah I am going to lie on my loan application'? Yeah people lied. They lied because they were told to lie."
- Sept 18 2008 all hell was breaking loose
- Eisman sold all his CDS back to Lippmann two months earlier. They were now back to stock market investors and shorting all the banks. On the 18th minutes after opening they were up $10M
- "There wer no bids in the market for anything. There was no market. It was really only then I realized there was a bigger issue than just our portfolio. Fundamentals didnt matter. Stocks were going to move up or down on pure emotion and speculation of what the government would do." Danny
- They were a subsidiary of Morgan Stanley
- "I'm thinking, Weve got the world by the fucking balls and the company we work for is going bankrupt."
- Mike Burry and Scion earned invesors a 490% gain in 3 years but all his investors were pulling their money out
- He shut down his fund and vanished
- Eisman ran into Merrill's CFO Jeff Edwards and said "You remember what I said about those risk models of yours? I guess I was right huh?"
- "I felt bad about it. It was obnoxious. He was a lovely guy. He was just wrong. I was no longer the underdog. And I had to conduct myself in a different way." Eisman
- "The investment banking industry is fucked. These guys are only beginning to understand how fucked they are. Its like being a scholastic, prior to Newton. Newton comes along and one morning you wake up: 'Holy shit, I'm wrong!" Eisman

Everything Is Correlated:
- The worst part of the crisis is that everyone came out rich. All the guys who called it and they guys on the wrong side of the bet. Even those who ran their companies bankrupt
- "What are the odds that people will make smart decisions about money if they dont need to make smart decisions--if they can get rich making dumb decisions" The incentives on Wall Street were all wrong; theyre still wrong."
- Handouts by the government
- "There's no limit to the risk in the market. A bank with a market capitalization of one billion dollars might have one trillion dollars' worth of credit default swaps outstanding. No one knows how many there are! And no one knows where they are!"
- Michael Lewis has lunch with an old associate who basically created the credit default swap. He is a former king of Wall St. Lewis says he is thinking about doing a book on the subprime, revisiting his old Liars Poker days. Wall St guy says, "I think we can agree about this; Your fucking book destroyed my career and it made yours."

Buffett Bites

I have followed Warren Buffett since college when I took my first real investments class. He has been revered by many, but also accused by many as being old fashioned and past his prime. However, as the accusations keep coming the one constant is that his company Berkshire Hathaway has continued to outperform most other inhabitants of this earth. He has consistently outperformed the competition all while sticking to a few simple and honorable principles. It is funny when I look back at my blog and see how many times I have mentioned his name and the many more times I have cited advice which parallels the Buffett maxims because I actually spend very little time managing my investments. But I guess the lack of time I put into investments is symbolic of the approach that I take. If you don't have the time to dedicate to extensive research then you are probably better off just investing in index funds, investing for the long haul, and gladly taking the gains that the broad market enjoys over time. This is a classic Buffett nugget of advice for passive investors worldwide and it is one I have heeded. Here are a few other Buffett bites of wisdom from the MSN Money homepage:

Stay liquid. "We will never become dependent on the kindness of strangers," he wrote. "We will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity. Moreover, that liquidity will be constantly refreshed by a gusher of earnings from our many and diverse businesses."

Buy when everyone else is selling. "We've put a lot of money to work during the chaos of the last two years. It's been an ideal period for investors: A climate of fear is their best friend. . . . Big opportunities come infrequently. When it's raining gold, reach for a bucket, not a thimble."

Don't buy when everyone else is buying. "Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance," Buffett wrote. The obvious corollary is to be patient. You can only buy when everyone else is selling if you have held your fire when everyone was buying.

Value, value, value. "In the end, what counts in investing is what you pay for a business -- through the purchase of a small piece of it in the stock market -- and what that business earns in the succeeding decade or two."

Don't get suckered by big growth stories. Buffett reminded investors that he and Berkshire Vice Chairman Charlie Munger "avoid businesses whose futures we can't evaluate, no matter how exciting their products may be."

Diversify your portfolio. Most investors who bet on the auto industry in 1910, planes in 1930 or TV makers in 1950 ended up losing their shirts, even though the products really did change the world. "Dramatic growth" doesn't always lead to high profit margins and returns on capital. China, anyone?

Understand what you own. "Investors who buy and sell based upon media or analyst commentary are not for us," Buffett wrote.
"We want partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand and because it's one that follows policies with which they concur."

Defense beats offense. "Though we have lagged the S&P in some years that were positive for the market, we have consistently done better than the S&P in the 11 years during which it delivered negative results. In other words, our defense has been better than our offense, and that's likely to continue."

Timely advice from Buffett for turbulent times.

The Decade From Hell For Investors?!

Time Magazine has called it the "decade from hell". CNBC recently ran a one hour special entitled The Bubble Decade detailing ten years of boom and bust cyles. Politicians have foreshadowed apocolyptic financial doom around every corner. Has it really been that bad of a decade for investors? I would argue no if you are a long term buy and hold investor that invests primarily in low cost index funds, and apparantly I am not alone. Forbes recently published an article by Richard A. Ferri detailing the relatively solid decade most disciplined long term investors had.

We all agree that US stocks were not a fun ride, but that is not the most important question. Rather the questions to ask are these: How did you perform over the past decade, and how did a diversified portfolio of index funds perform over the same period?

Index fund investors who remained disciplined and stuck to a simple strategy of diversification and rebalancing fared pretty well.

Ferri goes on to give actual 10 year annualized returns for a few different asset allocations. Mostly broken up by percentage of stocks and bonds. All of his examples acheived at least a 3.1% return. Not great? Well that may be true but he makes a good point.

All the portfolios outperformed the CPI, and that means all portfolios made money in real terms. Since this is true, was the first decade of this millennium really an investor's hell? Not as I see it. Yes the volatility was unnerving at times. Yes, the performance of US stocks was well below its historic average. However, a diversified and disciplined index investor weathered the past decade just fine.

I would go a step further in that we do not know what the future holds. What if the next decade sees a great rise in the annualized return of the market. Then the disciplined investor who continued to invest in index funds throughout the "decade from hell" was actually not experiencing hell at all....they were merely buying on sale! Although this decade was undoubtedly hard on some who were approaching retirement or needed a large portion of their savings, the reality is the majority of people out that not only have an investing time horizon that is long enough to recover, they may actually thrive. I would also be interested to see what the alternative to the disciplined investor looked like in the past decade. What was the 10 year annualized return for the guy who listened to the 'experts', the guy who took the stock tip from his neighbor, the woman who paid hefty commissions and fees for someone to manage their money? How did they fair? My guess is much, much worse....

Braving The Storm: Screw Financial Experts, Stay The Course

I was perusing through Yahoo Finance while eating my lunch today and wasn’t really paying that much attention to what I was looking at. As I was skimming the headlines I almost started laughing at what I saw. Here are some headlines that I found all on the same site! Disclaimer: This post is not to bash Yahoo Finance. I like Yahoo Finance. It is merely to prove a point.

Stocks Rise as Profits at Banks Provide Boost- AP

23 states report higher unemployment in September- AP

Oil falls to around $78 as inventories weigh- Reuters

The Days Of 'Buy and Hold' Are Over, says John Mauldin- Tech

John Mauldin: Tax Hikes Will Kill the 'Recovery’, Which Isn’t Real Anyway- Tech Ticker

Housing Prices: Expected to Drop More in the Next Year?

Stimulus Push Is On, Even If It Isn't Called That

Recovery in Luxury Goods Still Out of Reach

Holiday Shopping Season Gets Early Start

Foreclosure Epidemic Reaching More Expensive Homes

Is the economy recovering? Recovered? Slumping? A Farce? Are we on the brink of another crash? With headlines like the ones above who knows what to believe? With an onslaught of daily information more prevalent now than in any time in history it is important to filter through the minutia to take what information you need while trashing the rest. Do I read articles like the ones above? Yes. But I do so more to stay familiar with the general positions of the articles than I do to develop an investing strategy. If you cannot brave the storm of financial and investing information that is thrown your way it is easy, as illustrated by the headlines above, to run in 50 different directions at once without accomplishing the life goals that are the reason you are investing in the first place. Here are a few things that I try to remind myself when I am doubting my strategy, feeling restless, feeling impatient, etc.:

1. Remember your life goals – You should already be enjoying your life. You should also want to make it better. You should be investing to make your ideal vision of life a reality and to secure your financial future. If your vision of a great life is based on values and those values are aligned more on the family, friends, experiences side of the house as opposed to the Lamborghini, having six pools, and a castle side then you don’t need to drastically earn massive amounts of wealth tomorrow. Live your life today and make gradual improvements over time with your financial decisions furthering those goals.

2. Think long term – Massive amounts of wealth are rarely made over night. Those that are made overnight are even more rarely made in the market. Chances are that person is not going to be you. A long term consistent approach to building wealth is never dead (as claimed above) because as investment vehicles, strategies, and laws change, a long term investment horizon can absorb the unforeseen consequences of the changes and will likely beat many of the speculators on the way back up. Time and asset allocation are the biggest determinations of success that you have. Run any compounding interest model and be amazed at the power of time! Besides all that, long term investing is a hell of a lot more relaxing.

3. You only suffer losses when you sell – When you operate on a long term investing horizon it’s much more difficult to pull the trigger at the wrong time. If you don’t like your unrealized gains just wait longer. When you operate your investment scope on days your time frame to make a wise decision (or to guess wisely) is measured in minutes or seconds. When you operate in terms of decades your time frame to make wise decisions is measured in days, months or even years. By stretching the scope of your vision you have effectively error proofed your decision making ability. And if you do make a decision that looks bad in hindsight you likely are only cutting into unrealized gains and not original principle.

4. Building wealth isn’t always sexy – An average person can accumulate large amounts of money over time simply by investing in a total market index fund or a life cycle fund. Will you outperform the market? No. Will you be able to talk hot stock tips with your neighbor? No. Will your life resemble a scene out of Boiler Room? No. Should you give a shit? NO! Who cares. Investing is the one ‘sport’ where being average, as in mirroring the market, will put you ahead of a great deal of investors whose potential gains are getting chipped away through fees, emotional decisions, and the next big fool proof investing strategy that doesn’t work. Don’t compete against others, compete against the goals you have set for your life.

Landlord Chronicles - Lessons in Real Estate Investing

It has been a while since I updated you all on my first rental property progress. Part of the reason is that I have been busy with the move and whatnot, but another part of it is that I really didn't have much good news to report until now. In my last post on my landlording journey I spoke a bit about how networking helped me, and in my initial post I spoke about how my primary concern was marketing. Well it is safe to say that since those posts I have gone through a lot of experiences and have learned quite a few lessons along the way.

One of the biggest lessons I learned was about negotiation. I spoke previously about how when I got the news that I was moving and I realized that I was going to become a landlord my primary concern wasn't laws and leases, but marketing. Well I think that was the right strategy; to an extent. In fact I think my wife and I did an awesome job marketing. Over the past two months we showed our place over a dozen times and got calls about it almost daily. This was with an entirely free marketing campaign. We used a military housing site, craigslist, postlets.com, and a few signs and flyers. The problem was that I wasn't thinking ahead. I wasn't thinking of step two. I was only thinking of getting as many people in the door as possible and hoping that one would seal the deal. When I was taking a professional development class for Air Force Contracting we watched a cheesy movie about a couple of brothers and their quest to buy a minor league baseball team. The movie was hilariously bad as far as acting goes, however it had amazing lessons on negotiation. It talked about setting anchors and having BATNA (best alternative to a negotiated agreement) and a reservation price or the lowest amount you would settle for.

Well obviously I didn't turn my education into action after watching this movie, because I would have saved myself a hell of a lot of stress and trouble had I discussed these things with my wife at the outset. At the beginning we had time on our side and a pretty nice condo to offer. As time went on we had more and more people walk away and we had to lower our price more and more. I set my anchor fairly high asking for $1700 a month in rent. We had a nice young couple come on day two who were extremely interested in the place. They wanted to negotiate rent and me being the rookie that I am, told them that the property had just been put on the market and I wasn't going to budge on the price yet. Well multiple showings later and a few years of my life lost to stress and we eventually ended up getting $1575 a month in rent. As time dwindled away the BATNA that I never set was becoming more apparent. My BATNA was me floating a mortgage in New Jersey while paying rent in Boston. Not a very good BATNA. I did the right thing by setting my initial anchor high at $1700 a month, however my wife and I had never discussed a reservation price. If we had, we likely could have gotten the first couple in back in May instead of showing the place to multiple other people for the next few months. In fact, there is a chance that I could have gotten more in rent had I been willing to budge and give a little while we were asking $1700, or even $1650.

This brings me to my next lesson learned which is the the power of the market. The market will bear only what the market will bear. Because I listed my condo at $1700, does that mean I am going to get $1700? Obviously not. With the rental market as soft as it is, many renters were willing to sacrifice what my condo had to offer, quality, in order to seek out a cheaper rental. Even though I was a little disappointed with the amount of rent I ended up getting, I really do have to say that it is reasonable given the size and location of my condo and the other condos available out there. Although this lesson is not entirely new to me, it certainly is different when your monthly cash flow is on the line. Easier said than done.

In order to avoid writing a real estate investing novel I will break up some of these lessons learned and add to them at a later date.

Another Athlete Investing Lesson

I don't know what it is about hockey players getting scammed all of sudden but it seems like this is a growing trend. Not too much detail yet in the article, but it goes back to a few central themes here at Badskiblog. Keep it simple. Invest in what you know and understand. Invest in people you trust. And if you don't understand what the people you trust with your money are investing in, don't let them invest in it. I spoke about these very lessons in a post a few weeks back where a bunch of other hockey players were scammed out of some money. Check it out here.

Former Detroit Red Wings star Sergei Fedorov says a man entrusted to manage his money during the past 11 years swindled him out of $43 million.

Federov, who played the last two seasons in Washington, won three Stanley Cups with the Red Wings. (Jamie Sabau / Getty Images)
In a lawsuit filed Thursday in Wayne County Circuit Court, Fedorov says Joseph Zada of Grosse Pointe Shores also broke a promise to repay him $60 million by April 20.

The suit says Zada "acting in concert with others" and "intentionally lied to Fedorov" whenever he asked about the money.

There was no answer Thursday at a number listed for Zada in Grosse Pointe Shores.

Fedorov, the 1994 NHL MVP and three-time Stanley Cup winner with the Red Wings, has signed a two-year contract with a Russian club of the Kontinental Hockey League. He has also played for Anaheim, Columbus and Washington.

It's sad this had to happen to a guy like Federov. He has been great for the game and is a class act. I just imagine what I could do with $43 million dollars. In fact, if Federov had done relatively little and sat on the sideline over the course of those 11 years stuffing his $43 million under his pillow, and then invested it in a money market fund that earned an average annual return of 4% his money would have grown to a cool $66,196,524.42. Vanguard's Prime Money Market Fund has averaged an average return of 6.27% since its inception. Although this ignores the effects of inflation it certainly beats losing $43 million over that same period. Imagine if he had merely bought a total market index fund? With all the time athletes spend on the road they could read enough personal finance and investing books to become dangerous, or at least to be able to claim responsibility for losing their own money instead of paying someone else to do it for them. Live and learn I guess.

The Death Of Buy And Hold....Only Idiots, Salesmen, and/or Idiot Salesmen Need Apply

I read a very good post on My Money Blog the other day regarding the death of the buy and hold strategy. You can see the article complete with spreadsheets and graphs here. This is a must read for beginning investors.

A regular reader Don sent me a post entitled Long Term Buy And Hold Is Still Bad Advice. Okay, fine, everyone and their mom has been telling me this recently. But I read it, and it was such a bad analysis that I had to rebut it here. I think Mish writes a lot of useful and thought-provoking stuff on his popular blog, but he really missed a big error here.

The sky is falling! Oh wait, there’s a little fine print.

TC is ignoring dividends

Let’s bold that. The analysis and data above completely ignores the dividend return of the S&P 500. This is like buying an investment property and ignoring the rent payments coming in. What? There are checks coming in every month from the tenants? Nah, let’s not cash those.

The post goes into a lot more depth and explanation but the example above is one that you will likely hear again in one form or another. I have been hearing that the buy and hold strategy is a poor strategy a lot lately as well. I think it is an idiotic argument at best, especially for the everyday average Joe investor. Even if our traditional view of the market has changed or is now ‘wrong’, taxes and the fees associated with the markets have not changed. If you consistently buy and sell, fees and taxes will eat you alive. Unless you either have the skill (questionable at best) or through blind statistical luck end up being a rock star fund manager/investor it is nearly impossible to overcome taxes and fees over time let alone beat a low cost index fund. If you want to take those odds be my guest, just send a copy of your W-2 to me as to remind me what not to do while your at it. The way I see it, I have no choice but to be a buy and hold investor. I have accepted that I cannot time the market, I cant predict the future and I don’t have increased skill or access to information. The only logical thing for me to do is to control what I can control, like how much I invest and into what asset allocation I put that money into, and to keep on trucking. Anybody who tells you differently is either selling you something, is dumb, or unfortunately is both selling you something and dumb.

High Frequency Traders

Interesting article on high frequency traders.

It is now generally understood that high frequency traders (HFTs) are dominating the equity market, generating as much as 70% of the volume.

HFTs are computerized trading programs that make money two ways, in general. They offer bids in such a way so as to make tiny amounts of money from per share liquidity rebates provided by the exchanges. Or they make tiny per share long or short profits. While this might sound like small change, HFTs collectively execute millions of trades a day, making it an extremely profitable business.

I have had a theory that part of the reason we have so much volatility in the markets these days is the increased use of electronic trading programs. Hedge funds electronically buy and sell once the market hits their set point. I haven’t been following the market all that long and to be honest I don’t even watch it that closely but it does seem like every other day the market is drastically shifting up or down. I think it might be because many of these HFT’s aren’t really acting with any logical thought behind them, they are merely just milestones that are being met that trigger a predetermined action. Couple the high frequency traders with the market information overload that is shoved down every investor's throat everyday and I am amazed the market isn't more volatile! Some of the points in this article are scary to say the least.

There’s a lot to worry about:

1. HFTs provide low-quality liquidity

In the old days, when NYSE specialists or NASDAQ market makers added liquidity, they were required to maintain a fair and orderly market, and to post a quote that was part of the National Best Bid and Offer a minimum percentage of time. HFTs have no such requirements. They have no minimum shares to provide nor do they have a minimum quote time. And they could turn off their liquidity at any time. When an HFT computer spots a real order, the HFT is not likely to go against it and take the other side. The institution is then faced with a very tough stock to trade.

2. HFT volume can generate false trading signals

This can cause other investors to buy at a higher price, or sell at a lower price, than they would otherwise. A spike in HFT volume can cause an institutional algorithm order based on a percentage of volume to be too aggressive. A spike can attract momentum investors, further exaggerating price moves. Seeing such a spike, options traders can start to build positions, which, in turn, can attract risk arbitrage traders who believe there’s potential news that could affect the stock.

3. HFT computer servers are faster than other trading systems

Because most HFT servers are co-located at exchanges, they can beat out institutional or retail orders, causing them to pay more or sell for less than they should have for a stock.

Then there are the “what if” problems that could be created by HFTs:

1. What if a regulation like the uptick rule were enacted?

Volumes could implode and stocks that appeared highly liquid could become extremely difficult to trade with wide spreads and no depth in the quote.

2. What if a “rogue” algorithm entered the market?

Many HFTs are hedge funds that enter their orders into the market through a “sponsored access” arrangement with a broker. Many of these arrangements do not have any pre-trade risk controls since these clients demand the fastest speed. Due to the fully electronic nature of the equity markets today, one keypunch error could wreak havoc. Nothing would be able to stop a market destroying order once the button was pressed.

Gives new meaning to the term “mutually assured destruction”?

Investing Lesson - A Case Study

This article was featured on ESPN the other day, and although it is a sports article it teaches a valuable lesson about investing. The article talks about some current/former NHL players that are suing a developer for blowing their investment pool on lavish parties to entice higher profile and higher paid MLB players. Although the set up reeks of a classic Ponzi scheme, that's not why I chose to post this article. I chose to post this article not only because hockey is near and dear to my heart, but also to serve as an illustration of what happens when you violate one of the principle laws of investing basics.

A golf resort developer duped nearly two dozen NHL players out of $25 million, blowing the money on gratuitous parties that were attended by former Yankees players Roger Clemens and Reggie Jackson, according to a lawsuit filed Thursday.

The New York Post reported in Friday's edition that 19 former and current NHL players filed suit against Ken Jowdy, alleging they invested the money with the Las Vegas-based golf-course mogul to develop two luxury resorts in Mexico -- a project they say is seven years behind schedule.

One of Warren Buffett's favorite quotes is "Never invest in a business you cannot understand." I always try to remember that. I think that, in true Buffett fashion, his simplistic mantra is so insightful and all encompassing. In this scenario I would expand it to say don't invest in people you don't understand. If you aren't quite sure of someone's character or your gut is telling you don't invest, then don't. I am sure it is easier said than done and if it was me who made the mistake I'd be on BadskiBlog writing what I learned from the negative experience but simply put don't get blinded by the money or the prospect of making money.

Instead, according to the players, Jowdy squandered the money on "lavish parties" to impress the likes of Clemens, Jackson and banned hits king Pete Rose, among others, who Jowdy hoped would eventually buy real estate in the planned resorts.

The lawsuit seeks the return of the $25 million they invested and $15 million in damages.

Former New York Rangers and Islanders defensman Bryan Berard and one-time Islanders captain Michael Peca were hit the hardest, each losing $700,000 in the deal, according to the filing in Los Angeles County Superior Court.

"It's particularly uncomfortable for all," Berard told the Post. "He's taken our money without telling us, and it's supposedly all gone."

Other players involved in the alleged scam include: Chris Simon, who played for both the Rangers and Islanders; former Rangers Greg deVries, Steve Rucchin and Rem Murray; former New Jersey Devil Turner Stevenson; and Sergei Gonchar of the Stanley Cup champion Pittsburgh Penguins.

Sadly I don't think these guys will ever get a dime back. Everyone has the 'right' to enter into a poor agreement and it looks like that's what these guys did. The funny part is that if the $25M had been put in even a modestly aggressive asset allocation of low cost index and mutual funds they likely would have made, by all conventional definitions, a ton of money. When the majority of these guys were playing and in their money making primes was when the S&P was putting up a 10 year annualized return of roughly 19%. Instead of making money incredibly complicated they should have kept it simple and used the advantage they had, which was large amounts of money to invest with. A sad story but a great learning experience for the rest of us.

Stocks: The Lost Decade

The article from BusinessWeek below is very interesting. I have included the entire article below. I would love to hear some dialogue in the comments about what all you BadskiBlog readers think about this article.

There are still six months left in this decade, but it is not too soon to start drafting its obituary. Howard Silverblatt, senior index analyst at Standard & Poor’s, is already looking at the decade’s stock market legacy. It’s ugly. The S&P 500 is down 39.22% from Dec. 31, 1999 through Monday’s close.

“We need a 63.79% advance just to break-even for the decade,” Silverblatt says. That’s not going to happen by Dec. 31. “The last negative decade was the 1930s, -41.77%,” according to Silverblatt. Annualized, stocks lost 5.12% so far this decade; in the 1930s decade of the Great Depression they lost 5.26%.

When this decade started, the talk was about sure-thing tech stocks and worries that the Y2K software bug would set the world back to 1900. The computer clocks entered the new millennium. The tech stocks broke down within 90 days.

Some people said we should call this decade the oughts, for the two zeroes. The term didn’t catch on. Looking back, it is clear that the real oughts of the 2000s were that we ought not to have paid so much for internet stocks and that we ought not to have paid so much for big houses with granite counter-tops.

Now we know that it was a lot easier, and cheaper, to fix the Y2K bug before a calamity than to fix the stock, housing and credit markets after. To our regret, we were more skeptical of computer programs than the “efficient” markets we wanted to make us rich. Nerds win. Pigs lose.

When I read this article a part of me wants to cringe. I have done all of my investing during this decade, so to read the sobering statistics above is troubling to say the least. Hopefully you can tell from my posts that I am an optimist. Continuing with the optimist mentality, I have saved what I consider a significant amount in the second half of this decade considering my first two years of investing were during college and the last three have been starting out living on my own. Even with all those losses I still feel as though I have been successful in accumulating wealth. If you keep more than you spend and invest for the long term it doesn’t matter what your return is. Sure it sucks that stocks are down but it is only a matter of time until you reach your goals, even if you are taking a paper loss. Who knows the next decade could be a 10% annualized gain decade. You cannot time the market and you cannot control the return that the overall market bears. So control how much you save and let time value of money work its magic while you accumulate wealth.

Personal MBA Update

Personal MBA Update: The Bogleheads Guide To Investing by Taylor Larimore, Mel Lindauer, and Michael LeBoeuf - I present you with yet another update along my Personal MBA journey. If you haven't read about the Personal MBA you can check it out here. I finished The Bogleheads Guide To Investing the other day and I must say it was pretty good. A lot of investing books are either get rich quick shock value investing scams or they are so boring and mind numbing that you fall asleep throughout the whole book without learning much of anything. This book provided a wealth of knowledge surrounding what I call "mindless investing" while still remaining viable from an entertainment standpoint. It is mindless in the sense in that they don't teach you be a day trader using intricate default credit option swaps or something. They preach low cost diversified mutual fund/bond fund investing based around a long term buy and hold strategy.

For those who don't know Mr. Bogle is the founder of Vanguard, the company that largely ushered in the new era of investor class through low cost passively managed index funds and online services. It's not often that investment books advise the majority of people to invest in index funds and total market index funds, especially when the company can profit from other investor behaviors like constant buying and selling and investing in actively managed funds with high expense ratios. It definitely says something about what Mr. Bogle and Vanguard stands for. The book preaches financial literacy and prudent do it yourself investing that is well advised for the majority of people out there.

I would definitely recommend the book to anyone who is interested in investing. I have read a lot of investing books and I still took away a lot from this book while touching up on the basics, and I think the novice investor would get a look at the broad topic that is investing as well. Here are the notes that I took while reading this book:

- Our financial markets are essentially closed systems in which an advantage garnered by a given investor comes at the disadvantage of other investors in the same market. As a group we investors are inevitably average, so beating the market is a zero sum game. After deducting investment costs its a losers game.
-Understanding that contrarian wisdom is the first step toward investment success
- "Choose a sound financial lifestyle. Start early and invest regularly. Know what you're buying. Preserve your buying power. Keep costs and taxes low. Diversify your portfolio."
- "In reality there is perhaps no one of our natural passions so hard to subdue as pride. Disguise it, struggle with it, beat it down, stifle it, mortify it as much as one pleases, it is still alive, and will every now and then peep out and show itself: you will see it perhaps often in my history; for even if I could conceive that I had completely overcome it; I should probably be proud of my humility." - John Bogle
- "Do not value money any more nor any less than its worth; it is a good servant but a bad master." Alexander Dumas
- "Drive in banks were established so most of the cars today could see their real owners." - E. Joseph Grossman
- Take 100 young Americans starting at age 25. By 65 one will be rich and four will be financially independent. The remaining 95 will reach the traditional retirement age unable to self sustain the lifestyle to which they have become accustomed.
- What is your financial lifestyle? The borrowers, the consumers, and the keepers
- 1. Graduate from the paycheck mentality to the net worth mentality 2. Pay off credit card and high interest debt 3. Establish an emergency fund
- Its not how much you make its how much you keep
- "Adding time to investing is like adding fertilizer to a garden: it makes everything grow." - Meg Green
- Late Actor George Raft explained how he blew about $10M this way: "Part of the money went to gambling, part for horses, and part for women. The rest I spent foolishly." All good wealth builders have one thing in common: they spend less than they earn.
- Nothing decreases your future net worth more than a new car every few years
- "When a man with experience meets a man with money, the man with the money gets the experience, and the man with experience gets the money"
- "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years." - Warren Buffett
- Treasury issues are exempt from state and local taxes
1. Find a bond fund that matches your investment time horizon 2. Don't time interest rate hikes 3. Match your risk tolerance
- Bond vs Bond fund page 37
- "Ive found that when the markets going down and you buy funds wisely, at some point in the future you will be happy. You wont get there by reading, 'Now is the time to buy'." - Peter Lynch
- 10 advantages to investing in mutual funds: 1. Diversification 2. Professional Management 3. Low Minimums 4. No loads or commissions 5. Liquidity 6. Automatic reinvestment 7. Convenience 8. Customer service 9. Communications and record keeping 10. Variety
- ETFs basically mutual funds that trade like stocks on an exchange and are priced continuously throughout the day. Not good for buy and holders due to the brokerage costs
- "Control your destiny or someone else will." - Jack Welch
- Inflation stats on page 49 and table on page 51
- TIPS have real rate and rate adjusted for inflation 1.2+3=4.2 or 1.2+4=5.2% adjusted twice annually IRS taxes both rates
- Lower the tax bracket the higher the return - place in a tax deferred account
- I bonds are already tax deferred and TIPS aren't
- "You don't really need to begin saving for retirement before you reach 60. At that point simply save 250% of your income each year and you'll be able to retire comfortably at 70." - Jonathan Pond
- Factors for retirement:
1. The amount we save 2. Our current age 3. The age at which we plan to retire 4. How many years we will expect to live 5. Whether we plan to leave an estate 6. The expected rate of return 7. The rate of inflation 8. Whether we expect an inheritance 9. Other sources of income in retirement
- "There is a crucially important difference about playing the game of investing compared to virtually any other activity. Most of us have no chance of being as good as the average in any pursuit where others practice and hone their skills for many many hours. But we can be as good as the average investor in the stock market with no practice at all." - Jeremy Siegel Professor of Finance at U of Penn Wharton School
- Index funds beat 80% of all actively managed funds for one simple reason: rock bottom costs
- Page 81-86 quotes
- "The most fundamental decision of investing is the allocation of your assets: How much should you own in stocks? How much should you own in bonds? How much should you own in cash reserve?" - Jack Bogle
- Efficient market theory and modern portfolio theory
- Asset Allocation has greater impact on financial performance than anything Studies on page 92-93
- 1. What are your goals? 2. What is your time frame? 3. What is your risk tolerance? 4. What is your personal finance situation?
- "Never buy anything whose price you cant follow in the newspapers - and you shouldn't buy anything that is too complex to explain to the average 12 year old." - Jane Bryant Quinn
- "Bulls make money, bears make money, but hogs get slaughtered"
- Quotes on pages 105-107
- "The shortest route to top quartile performance is to be in the bottom quartile of expenses." - Jack Bogle
- 1926-2004 stocks returned 10.4% - 3.3% avg cost and its 7.1% nearly a third lost to expenses
- Page 117-118 quotes
- "The profound impact of taxes on fund returns is a subject too long ignored." - Jack Bogle
- Keep turnover low, use tax efficient funds in taxable accounts, avoid short term gains, buy shares after the distribution date, sell before the date, harvest losses
- "Of all the expenses investors pay taxes have the potential for taking the biggest bite out of total returns." - The Vanguard Group
- Invest in 401K to match amount, Roth to max, 401k to max, additional funds to tax efficient funds
- "Diversification is a protection against ignorance" - Warren Buffett
- Correlation for any two investments range from +1 to -1
- Over the past decade Morningstars five star equity funds have earned an average 5.7% against a 10.3$ return for the Wilshire 5000.
- Since the 1960's the average return of the top 20 mutual funds in each decade was less than the market index return in the next decade
- If you think timing the stock market is difficult timing the bond market is impossible. Of 14 bond timing systems tracked for the last five years only one beat a simple buy and hold strategy
- Wall st and financial media have a symbiotic relationship - The media wants readers viewers listeners and most of all Wall St's advertising dollars. Wall St also wants readers viewers listeners and most of all your dollars. Unfortunately these dollars come straight out of your investment returns.
- Pg 166-7 quotes
- "Economists report that a college education adds many thousands of dollars to a mans lifetime income -which he then spends sending his son to college." - Bill Vaughan
- Windfalls of money: Deposit the money in a safe account for at least 6 months, set a realistic estimate of what it can buy, make a wish list, get professional help
- "I helped put two children through Harvard-my brokers children." - Michael LeBoeuf
- "When someone buys or sells an investment the broker makes money and the brokerage house makes money, and two out of three ain't bad."
- Fee only advisers are the best they use a percentage of AUM assets under management
- "Foolproof systems don't take into account the ingenuity of fools." - Gene Brown
- Rebalancing is the act of bringing our portfolio back to our target asset allocation after market forces or life events have changed the percentage of our various asset classes
- use expansion bands to determine the need to rebalance +-5% example
- Rebalance in tax deferred accounts first because there is no tax consequence
- In 1980 only 6% owned mutual funds and today over half do. This increase has created an increase in the amount of noise out there
- There are only two ways to outperform the market: 1. Choosing superior investments 2. superior market timing
- Research shows the ability to do either consistently is so rare that it may as well be chalked up to chance
- Create simple diversified asset allocation plan, invest a part of each paycheck in no load index funds, rebalance when necessary and stay the course
- Investment pornography refers to excess advice and information but it is actually somewhat flattering. Real pornographers deliver what they promise!
- "I'd compare stock pickers to astrologers but I don't want to badmouth astrologers." - Eugene Fama
- There has never been a 15 year period when stocks lost money. That is all you need to know.
- 1. All forecasting is noise 2. Listen to the helpers ignore the hustlers 3. Be a skeptic and do your homework
- Investment experts fall in 3 categories:
1. Those who don't know what the market will do and know they don't know
2. Those who don't know what the market will do but they believe they do
3. Those who don't know what the market will do and get paid to pretend they know
- "Rich people plan for three generations. Poor people plan for Saturday night." - Gloria Steinem

Real Estate Investing: A Dialogue Amongst Friends

Here is another interesting back and forth (mostly forth on my part) between a friend and I. This friend is extremely smart, an awesome dude, and a very entrepreneurial person. Throughout the existence of BadskiBlog I have preached that there is no one set investment advice. That is why it is so important to know your goals and your strategy for achieving those goals. Because it is those goals that will dictate which investing advice you will take, and which you will leave for the next guy. Just because my friend and I do not have the same world view on this topic does not mean that I am right and he is wrong or vice versa. I would argue that we are both right given our goals and investing strategies. I have included my friends contributions in italics

http://finance.yahoo.com/real-estate/article/107122/Is-Your-Home-a-Good-Investment?

Guys,

See above link. Part of this discussion is why I am not big on buying homes unless you plan to live there for a long time....

Love Forever,

BK

Reese,
I just posted a blog post on the index yesterday. I think what the article fails to address is that the majority of the benefits of
being a property owner aren't Annual Return. And that return is skewed by not taking into account Cash on Cash return. If you buy $10K worth of stock, how much is that stock worth at that moment? $10K.....not a trick question. If you buy $10K worth of property how much is that property worth? It could be worth $100K or even $200K depending on financing. So if the price of that $100K property appreciates by the 1.5% the article claims after factoring the CPI then it would be worth $101,500.00. Not a great return. But you have to look at cash on cash return. You only put in $10K of your own money. $1,500 is a much more significant portion of $10K than $100,000; it's actually a 15% cash on cash return.

Leverage can work the opposite way as well but how many houses go out of business? Not many. And as I always say with both stocks and property, you only lock in losses if you sell.

After you look at the income potential from renting out a property, the tax advantages, and the control you have over the present value of your investment I think that property is a really good investment.

I do however agree completely with Reese that some people shouldn't own homes unless you live there for a while. The situation I am in getting moved to Boston has put me in a tough spot with my condo. However, I feel that I have the business sense and the stamina to become a landlord and continue building equity in my property. Each person's situation is different. Good read.

Is Drinking An Investment?

Today a friend stopped by for a drink and to BS for a bit. After he left I got to thinking about two topics that rarely intersect; alcohol and personal finance. There are a million finance pundits and gurus out there who preach the uberfrugal approach to personal finance and want you to live on tuna and wonder bread. To these finance "experts," anything that does not directly improve your net worth is a financial sin and therefore must avoided at all costs. Something like buying a case of beer everything month is viewed as an unnecessary expense and nothing more. I am stepping on my virtual soapbox today not to advocate drinking, but to challenge that lifeless view on personal finance and propose a slightly refracted viewpoint on the subject.

I am not a scientist, but I imagine that the devastating effects of alcohol abuse can affect all human beings regardless of race, religion, gender, etc. It is the same non discriminating factor that makes alcohol so dangerous that also serves as the source of my argument that even drinking can be an investment. All kinds of people drink. Having a drink serves as common ground and a social expression across the globe.

Our lives revolve around social connections. We are social creatures that thrive on interaction with other human beings. Having a drink serves as a common action or reason to meet up. How many times have you said to even your best of friends, "we should get together to talk tonight." A little awkward especially for males. Getting together to have a drink is the lowest common denominator excuse for getting together for no reason other than to converse. Through communication we build relationships that not only open the doors for opportunities in the future, but make our lives enjoyable and worth living in the first place.

Is it that far of a stretch to say that having a beer is not only the farthest thing from a waste of money, but an investment into the quality of your life and the expansion of your social network? I can here the anti alcohol police coming at me from a mile away, but alcohol is not the point. The point is that the traditional approach to how you spend your hard earned dollar is typically a linear thought process that realistically just isn't that simple. You can substitute the alcohol with dinner, running, racquetball, or anything else that is an expense financially yet an investment socially. Being a guy that loves business and finance yet hates numbers and math I find that the status quo advice is often way too calculated. Let's blur the lines, lets get a little fuzzy, lets talk about the art instead of the science. If everything was linear or a calculation then it would just be "the way." The fact is as humans our lives are based on emotions, on our worldview, on biases, on the information at hand, on relationships. Invest in things that make you a better person to be around and things that facilitate your interaction with other people. Not only will it make your life more enjoyable, the intangible benefits are bountiful as well.

Investing: A Dialogue Amongst Friends

Below I have included a cleaned up email exchange between some friends and I. It all starts with an article that argues against the buy and hold strategy and continues on to touch on a variety of topics. Some of the advice is tailored more towards those in the Air Force because these friends happen to be in the Air Force, however there are some great points for everyone. I have separated each email with a line. Hope you enjoy.

http://finance.yahoo.com/special-edition/active-investor/buy_hold_rip;_ylt=A9G_b88TCfZJavgAihhsLKJ4
Bades, Reeser - I'd like to read your blogs concerning this article...don't let me down!
Franky
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I might have to tackle that one in the BadskiBlog. A few quick thoughts: The guy makes some good points. I have read other books that reference the study in which the 10 best and worst days are removed. The point is noted but I don't really think it enforces his point that buy and hold doesn't work. I think it contradicts it. As long as you were in the game over the life of the study those outliers would not extremely affect you and would only serve to give you an overall gain of 8% or whatever it was. I also think that articles like this one are meant to get readership and stand out in a fairly boring topic. At the root of all the investing madness there lies an asset that you purchase that someone else is willing to buy. The value which they place on that asset is what fluctuates. One can argue in this article that just because something has occurred in the past is no guarantee that it will continue to occur in the future. Great. Point taken. But I think it is even crazier to assume that things have changed so much that people are not willing to buy assets in pursuit of a better return than the "hide your money under the bed" strategy. Regardless of all of these arguments, what other option do you have? Do you pull out completely? Do you become a day trader? Do you resort to a life of crime? I still believe in the buy and hold strategy because psychologically it forces me to put away and save money. Even though I have a net loss over the last 3-4 years I am better off than I would be spending my money and clothes, cars, food, and beer and anyone who says differently is likely profiting from that advice or lying to himself/herself.
Badski
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Agreed. Buy and hold forever is still the way to go. If you are going to jump in and out of the market, do so with no more than 5% of your total portfolio.

Depending upon your tolerance for risk (mine is high), a good mix for young people like us with good jobs and a steady stream of income is 80% stocks, 10% bonds, 10% cash or cash equivalents. If you don't want to have $1M when you retire, go with 50% stocks, 30% bonds, 10% REITs, and 10% cash.

If you can, keep a good amount of cash in a savings account. You don't want to have to sell stocks or bonds to pay for something like a car repair, down payment, etc. Call the banks and negotiate your APY--you'd be surprised how easy it is. Shoot for 2-2.5%...rates are terrible right now.

How much cash should you keep? 10% of your overall combined gross income. My gross income is ~$47K X 2 for the wifey = $94K. I keep around $10K in a savings account. Don't keep a lot of cash in a checking account because you're probably getting about .20% interest.

If you haven't already set-up a Roth IRA with USAA call them today and begin the process--takes ~20 min. You can deposit up to $5,000.00 per year in your account. You will pay taxes up front, but it will grow tax free until you begin withdrawals at age 59.5.

In order of precedence:

1. Roth IRA
2. TSP (operates like a traditional IRA with higher limits)
3. Traditional IRA

Revisit this order if the military ever matches contributions in the TSP (it does for civilians)

What to buy in your Roth IRA:

1. USAA S&P 500 Index Fund, symbol: USSPX
2. USAA or Vanguard municipal or corporate bond funds

What not to buy:

1. Any mutual fund
2. Common stocks

Index funds have very low expense ratios. ~.15-.30%. Mutual funds run anywhere from 1.5-3.0%. Basically you are paying some jackass who knows no more than you do to lose your money.

Use the features at USAA and set-up a monthly deduction so you never even see the money. It will dollar cost average every month.

If you have a lot of cash and don't know what to do with it, try CDs (2.5-4.0% depending on the term) or municipal bonds (tax free both State and Federal).

Final thoughts (my opinion): The American dream is no longer about owning a home. Buy a home only if you've done (1) a ton of market research, (2) plan to live there a minimum of 5 years, 7-10 years is better, and (3) your credit score allows you to negotiate a great fixed rate mortgage--NEVER get an ARM. Don't look at renting as throwing your money away...it's simply a sunk cost of living the dream as an American warrior.

Feel free to contact me if you have questions about what you should be doing.

Love Always,

BK
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Greese,
Agree with everything you said with the exception of real estate but I think we both would agree that we are giving advice based on our own goals and dreams which may not be everyone else's. That is why I lean towards real estate and you don't, yet we agree on 99% of everything else. Good advice dude. Hope all is well boys.
Badski
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Hey boys, I haven't been in the last couple days, but have enjoyed reading the emails so far. Not gonna lie, still haven't gone through the resumes yet, but did read some of Greeser's and Ski's financial advice. I definitely think that even though everyone has different goals one thing should remain very clear...Only 2 out of every 100 or 2% of American's over the age of 65 are able to retire WITHOUT any assistance from Government or other support from children/families etc. The question is...What are you going to do about it? I'm not banking on the Government to help me out when the time comes. If you read the fine print in your Air Force "contract" nowhere does it say that even if you retire that they have to continue paying your "retirement benefits." Therefore, X amount of years from now, even that retirement salary you may suck up 20 years for can go away. Just food for thought when considering your future financial situation.

Devo
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Do either of you know much about Dave Ramsey? If so, what do you think? I bought his book and it's pretty good. He basically says to pay off all your debt right away and you'll have tons of money to invest after that. In theory, you can probably make more money without paying off your debt so quick, but in practice, it never really works that way... http://www.daveramsey.com/etc/cms/baby_steps_2867.htmlc?ictid=Useful_Tools
http://www.daveramsey.com/
Medy
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My parents follow Dave Ramsey's advice and listen to his show. I know a little about what he preaches and what he is all about. In my mind I think he targets people who are struggling a little bit more than you and I but he has some good advice. The one thing I really like about Dave Ramsey is his snowball debt approach. He believes that you should tackle your smallest debt...like a $400 loan on a TV for instance and pay that off first regardless of the interest rate. Once that is paid and you free up lets say $40 a month that was going towards your TV you pay that towards your next lowest debt which lets say is a student loan of $5000. Once you pay that you take the $40 a month from the TV and the $100 a month from the student loan and roll that over towards your credit card debt of $10000 dollars. Many gurus attack the fact that you aren't paying off your highest interest rate first and therefore it is costing you more to pay off your debt that way. But I like how he acknowledges the psychological side of saving and investing which is so often overlooked. These people need success not optimization. The freed up cash rolled into the next debt will be more powerful for them than optimizing paying the least amount in interest. I think the premise behind Dave Ramsey is undeniable. If you have no debt and save you will be well off. However for someone like myself who has developed good financial habits and is committed to investing and learning, avoiding all debt isn't really the best strategy for me in some areas, specifically real estate investing. I also think it is unreasonable for most people to make major life purchases like a car, house, etc without taking on some debt. Concentrating on paying off that debt and perhaps ignoring investing while you are younger is going to have you miss out on some critical wealth building years and the power of compounding interest. Like I said I think his premises are sound from the limited amount I know, especially for people who aren't as disciplined with their money, just don't forget that investing while you are young is extremely important as well.
Badski
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Agreed Badski. Some people need to tangible success in order to tackle their debt. However, from an investment perspective you should first pay off your debt with higher interest rates.
BK
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The more I learn about investing the more I learn to give the political answer of "it depends". Everything depends on who it is. There are some true time tested principles but if you cannot carry them out for whatever reason then whats the point. An example is that right now I have a huge surplus of cash in a money market fund. By all investment guidance and my age group I have way too much money in there. However, for my current situation and goals it is the right amount for me. I need some liquid cash for my next property, the market crash made me realize I did not have enough cash on hand for emergencies, and I to this date have never sold any of my investments. So I knew that I needed some more cash on hand for different life goals and preferences that others may not have. Little did I know that I have actually had a better return on that then my investments but that is besides the point. Now that I have built up that cash fund I am taking advantage of a market that as a whole is on sale! If you take responsibility for everything you do and keep investing and saving you are doing the right thing even if most people will tell you you can do better.
Badski

Money Tips - Asset Allocation

Welcome to another post in the series known as Money Tips. So far we have addressed that being rich is a mentality and keeping more than you spend, that you must have a budget to know where you are, and that you must have goals and a strategy to get to where you want to be. All that is great but what exactly do I do? Well the next step is to design an asset allocation that will allow you to most effectively reach your goals.

What is asset allocation? Asset allocation is exactly what it sounds like. It is determining how you are going to apportion your invested capital to manage risk and realize gains. Think pizza. You can get all pepperoni, or half pepperoni half sausage. How are you going to cut your investment pie? Asset allocation is merely exercising the age old adage of not putting all your eggs in one basket. The concept is the same.

As I have said before, your asset allocation should be based on your financial goals and where you are at in achieving those goals. For that reason I am not going to go too far into depth on what the appropriate percentages of various investment vehicles and/or asset classes are, although feel free to contact me if you want some free advice. Instead I am going to cover some simple, yet key concepts of what to consider when determining your asset allocation.

Risk - How much risk are you willing to take? Only you can answer this question. However, here are some things you might want to consider. First off, what are you investing this capital for? For instance if you are investing in a Roth IRA for your retirement, your risk tolerance may be lower than the risk you are willing to bear for the extra money you got back at tax season that you want to play with. Another thing you should consider is how quickly you need access to the capital. Someone who is close to retiring will be much less willing to incur risk than a 20 something saving for their retirement. Lastly you need to do a little gut check. How conducive is your personality and overall demeanor to dealing with risk? The goal is to keep putting money in, not panicking and constantly buying and selling.

Reward - What kind of return do you need to realize in order to achieve your financial goals? How long do you have to achieve those goals? Different asset classifications have different historical returns. Below is a chart showing some historical returns of various asset classes. The numbers may be a bit different from other sources due to different time periods and assumptions but the overall disparity between the classes is fairly indicative of most statistics.


Now that you have analyzed your goals and current situation you should have a decent idea of what type of risk/reward trade off you are willing to accept. Let's use my retirement portfolio as an example for some other things you should be thinking about. So I am 26 years old. Lets assume that I want more than a million dollars in my retirement by the time I am 65 (here is a retirement calculator you can play with that may help you determine how much return you need, how much you need to save, etc. to reach your goals). I know that I am fairly tolerant of risk and I have a long investment horizon to reach my goals. Why don't I just invest all in small cap US stocks? The answer is volatility. Although small cap US stocks may have a 12% return over a period of years it may have a -40% (probably this year!) in any given year. So what, isn't that just part of the risk you accept in the market? Yes, but what if half of your portfolio lost 40% and the other half was an asset class that gained 40%? You would be even. Or better yet what if the other half of your holdings gained 50%? You get the idea. This concept is called correlation. How correlated are the historical performances of your holdings? The goal is to reduce variation of return by diversifying your holdings to achieve a constant, steady, and most importantly greater return than if you did not diversify your assets. So in my case I know that I want to achieve the most return possible for a long term timeline. I will not be concerned with the day to day activities of the market, yet I want to be diversified enough so that a scenario much like the current market doesn't destroy me. Don't get me wrong, the current state of the economy has done some major damage to most people's portfolios including mine, however Mint.com is showing that my current asset allocation is outperforming the NASDAQ, S&P 500 and the Dow. The moral of the story is that it could be worse!

So my asset allocation will be distributed mostly amongst equities, a small portion of bonds, REIT's, and Precious Metals and Minerals funds. Within my equities I am diversified between foreign and domestic, as well as small, mid, and large cap stocks. I am trying to not get too in depth or too technical, because I am not writing a book here and there are plenty out there that do a better job than I do of explaining and recommending asset allocation models. The point is that you should be diversified appropriately based on your goals, risk/reward tolerance, and your timeline.

Here is an example of what an older person's asset allocation may look like. Since they have a much shorter time frame to retirement their goals and risk/reward tolerance will be much different than mine. And therefore their asset allocation looks much different as well. This person is likely concerned with preserving the capital they have while protecting it from inflation. Hence, the larger concentration of bonds and cash equivalents. The current state of the economy surely gave a rude awakening to many baby boomers on the lessons of asset allocation, as many of them who had large portions of their portfolio in stocks have lost significant amounts of their retirement.

Hopefully this post has served as a guide to know what you don't know. It is far from all encompassing but hopefully it gets the gears turning. If some of this is new to you don't feel bad, feel empowered and start educating yourself on the topic. I recommend reading "A Random Walk Down Wall Street" and "The Art of Portfolio Investing and Management: A Proven 6-Step Process to Meet Your Financial Goals" both of which are on my bookshelf on this blog. Once I re balance my Roth IRA and make my asset allocation excel sheet look pretty again I will post more in depth analysis of my portfolio. I would love to open up discussion and get tips from others as well. Keep checking in for more Money Tips posts, and if you are interested in writing a guest blog for my Guest Bloggage installment write me a comment or email me.