Twenty basic rules for intelligent money management

post by James_Miller · 2015-03-19T17:57:22.558Z · score: 32 (37 votes) · LW · GW · Legacy · 55 comments

1.  Start investing early in life.
 

The power of compound interest means you will have much more money at retirement if you start investing early in your career.  For example, imagine that at age eighteen you invest $1,000 and earn an 8% return per year.  At age seventy you will have $54,706.  In contrast, if you make the same investment at age fifty you will have a paltry $4,661 when you turn seventy.
 
Many people who haven't saved for retirement panic upon reaching middle age.  So if you are young don't think that saving today will help you only when you retire, but know that such savings will give you greater peace of mind when you turn forty.
 
When evaluating  potential marriage partners give bonus points to those who have a history of saving.  Do this not because you want to marry into wealth, but because you should want to marry someone who has discipline, intelligence and foresight.
 
 2.  Maintain a diversified portfolio.

By purchasing many different types of investments you reduce your financial risk.  Even a single seemingly stable stock can easily fall by 70% in a single year.  In contrast, a broad investment portfolio is extremely unlikely to decline in value by such a gigantic amount unless something truly horrible happens to the entire world's economy.  As the saying goes, "don't put all of your eggs in one basket."

 
3.  Consider buying an index fund.
 
Index funds provide cheap and easy ways to acquire a diversified stock portfolio.  An index fund is a mutual fund that invests in every stock in its index.  So, for example, an S&P 500 index fund will purchase all 500 stocks in the S&P 500 index, which consists of the 500 largest publicly traded stocks in the United States. 
 

4.  Don't forget about foreign stocks.
 
To achieve optimal portfolio diversification you need to invest in foreign stocks.  The bigger a nation's economy, the more money you should put in its stock market.  You can buy index funds that invest in foreign stocks.  By investing in diverse foreign securities from many nations you will probably reduce the chance that your portfolio will suffer a sudden huge decline. 
 
 
5.  Don't try to out-guess the market.
 
Ordinary investors, and indeed even most professional investors, are horrible at figuring out which individual stocks will outperform the entire market.  For reasons I won't go into, economists have overwhelming evidence that without inside information not available to the general public an investor can't accurately predict which stocks will do well.
 
If you try to out-guess the market you might get lucky and earn a superior return.  But on average you will do worse compared to someone who holds a diversified portfolio.  Furthermore, by placing a large bet on a few stocks you will necessarily violate many of the other investing rules listed here and so will most likely pay a financial penalty.  True, it can be fun to take a chance and gamble on one stock.  But you probably shouldn't allow the excitement of gambling to infect your investment decisions.  If you want to gamble bet a few dollars on blackjack, but stick to a sound, diversified, investment strategy.
 
You may know people who brag about how they made a killing in the stock market by calculating which stocks would do well.  Keep in mind, however, that they might be telling you only about their profitable stock choices and not their losses.  Furthermore, even if someone has on average beaten the market, he probably just got lucky.  After all, although people do win lotteries, such winners don't really have any special abilities at guessing which lotto numbers will come up.
 
A few professional investors, such as multi-billion-dollar hedge funds, might well have means of earning superior returns by investing in just a few financial securities.   But if they do possess financial superpowers they won't share them with you for less than a lot of money.  Also, such investors probably earn their above-average returns by investing in exotic financial instruments, such as derivative securities, that you don't have access to.
 
 
6.  Don't take on "stupid" risks.
 
You may have heard that financial markets compensate investors for taking on risks. This is true, but it doesn't apply to stupid risks.
 
Imagine you work for a construction company.  You learn that the owner pays higher wages for employees who do work on the top of tall, unfinished buildings because such work is extremely risky.  Construction companies have to pay more to workers who undertake the most perilous tasks or else no laborer would be willing to do such dangerous work.
 
This week, say, you want to make a lot of money.  You understand that the construction company pays the highest wages to workers who do the most dangerous jobs.  So you intend to work on the top of the tallest skyscraper while drunk!  You figure that since this is extremely risky you should get a large bonus.  But of course management pays only for risks it needs someone to undertake, and they obviously don't need anyone to labor while under the influence.
 
Stocks on average pay higher returns than government bonds because otherwise everyone would buy the bonds and no one would take the risk of owning stocks.  Since markets need people to buy stocks, they must compensate those who do by giving them, on average, higher returns.  But the market doesn't need anyone to hold an undiversified portfolio.  If you do, you are taking on risks that benefit no one and so you won't get paid for it.  Holding an undiversified portfolio and expecting to get a high average return because of all the risk you are taking on is analogous to working on a skyscraper while drunk and expecting your employer to pay you a premium because you are increasing the riskiness of your job.
 
 
7.  Understand the dangers of actively managed mutual funds.
 
7(A)  On average, actively managed funds do worse than passively managed funds do.
 
Index funds are passively managed because the funds don't try to guess which stocks will do well.  In contrast, actively managed mutual funds do try to identify stocks that will outperform the market.  Most actively managed mutual funds, however, do much worse than broad-based index funds such as S&P 500 index funds.  
 
7(B).   Actively managed mutual funds have high fees.
 
Mutual fund fees have a tremendous impact on long-term investment performance.  Imagine that the market goes up by 8% a year.  One mutual fund charges fees of .2% a year; another charges fees of 1.5% per year.  Pretend that you invest $1,000 in both funds.  After thirty years you will have $9,518 in the first fund but only $6,614 in the second.
 
Mutual funds often charge high fees to pay expensive MBAs to pick stocks.  But MBAs are not on average, any good at out-guessing the stock market.  So when you buy a high fee mutual fund you are wasting money on MBAs.
 
Index funds often have the lowest fees because these funds don't try to out-guess the market and so don't need to hire expensive (and useless) stock guessing MBAs.  Still, some index funds do charge high fees and so should be avoided at all costs. 
 
7(C).  Survivorship bias artificially inflates the mutual fund industry's past performance.
 
Let's say I start 100 mutual funds.  Each fund will randomly select a few stocks to invest in.  Almost certainly at least one of my funds will get lucky and earn a high return.  After a few years I will identify the one that did the best and market this fund to consumers.  I will quietly close down the other 99 funds.  When attracting customers for my one surviving fund I will claim that its fantastic past performance proves I'm an investment genius.  Of course, since all my stock picks were random I have not demonstrated any investment skill.  If you evaluate only the mutual fund that survives it will indeed appear that I'm an investment wizard.  But such "survivorship bias" corrupts the evaluation.
 
Mutual funds that do very poorly shut down.  Consequently, if we just take the average past returns of mutual funds that exist today we would get an estimate of performance that overstates the overall investment skills of the mutual fund industry.
 
 
8.  Don't engage in much stock trading.
 
When you trade a stock you pay a fee.  And as a previous investment tip explains, in the long run fees decimate investment performance.  Furthermore, when you trade stocks that are not in a tax-preferred plan (such as a 401(k) plan) you often pay extra taxes.
 
 
9.  Invest in tax-preferred vehicles such as 401K plans.
 
The U.S. government gives tremendous tax benefits to those who invest in certain tax-advantaged vehicles such as 401(k), 403(b), or IRA plans.  (Restated:  The U.S. government imposes a "stupidity tax" on investors who don't take advantage of tax preferred plans.) These plans have yearly contribution limits, so a wise investment strategy is to put as much as the government allows into the plans you are eligible to contribute to.
 
 
10.  Avoid credit card debt.
 
High interest rate credit card debt is financial cancer.  Each month you should pay off your full credit card balance to avoid such financial sickness.  If you can't, however, call your credit card company to negotiate a better rate. 
 
Credit card companies love customers who (a) have lots of debt, but (b) make only their minimum payment each month.  If you are such a customer then call your credit card provider and tell it that because of the high interest rates it charges you want to transfer your balance to a card from another company.  Chances are your credit card provider will offer you a lower rate to keep you as a customer.  The credit card industry is highly competitive.  Use this to your advantage if you can't pay off your total balance each month.
 
 
11.  Always take full advantage of matching contribution pension plans.
 
Some employers will match a worker's contribution to his retirement account.  These matching plans always have some upper limit after which the employer will no longer match contributions.  For example, an employer might deposit fifty cents into your 401(k) account for every dollar you put in as long as you have put in less than $6,000.  After you have put in $6,000 your employer won't match any additional money you put into your retirement account.
 
You should always take full advantage of matching pension plans because they offer the best rate of return of any investment.  For example, with the 50% plan described above you get an immediate and risk free 50% return on your investment.  Putting less than $6,000 in this hypothetical plan is the equivalent to telling your employer that it should keep some of the money it was prepared to give you.
 
Many employers don't offer matching contribution pension plans.
 
 
12.  Be cautious about investing in your employer's stock.
 
Companies love for employees to buy lots of their stock because such stock-owning laborers care more about the company's profitability.  But it's financially perilous to buy your firm's stock because if the firm goes under you lose not only your job but also part of your savings.
 
Some companies, however, offer significant financial enticements to employees who do buy their stock.  If these enticements are large enough you should seriously consider giving in.  But understand that by buying your company's stock you are taking on significant risk.
 
 
13.  Remember that your home is a very risky asset.
 
 It's temping to think that your home is a much more solid investment than your stocks because you can actually touch your home.  But as with individual stocks, the value of a single home can fall rapidly .  This is especially true if you have a mortgage. 
 
Imagine, for example, that you buy a $400,000 home and pay for it with $40,000 in cash and a $360,000 mortgage.  So you have a $360,000 debt on a home worth $400,000, meaning that you have $40,000 in home equity.  Now assume that the value of your home falls by 10% and becomes worth $360,000.  Since you still owe $360,000 on the home, your equity in it has fallen to zero!  A 10% fall in the value of your home has obliterated your home equity. 
 
A home is inherently risky because it's an undiversified asset.  Mortgage debt magnifies this risk.
 
This doesn't mean you shouldn't buy a home.  The favorable tax treatment of mortgage interest makes it worthwhile for most adult Americans to be home owners.
 
 
14.  Learn how your financial advisor gets paid.
 
People respond to incentives.  If, for example, your stock broker receives a fee every time you make a stock trade then he may well advise you to make more trades then you should.  If your real estate agent gets paid the same whether you buy after looking at five or twenty-five houses then she has an incentive to get you to make a quick home buying decision.
 
 
15.  Buy life insurance if your family relies on your income or time.
 
If your family relies on your income you owe it to them to buy life insurance.  No one likes to think that he could die but, alas, all men are mortal.  If you rely on your spouse's income make sure that he/she has life insurance.  A husband should get life insurance before his wife becomes pregnant in case the worst happens.  Homemakers who don't earn any income but have dependent children should still buy life insurance because if they die their spouses may have to hire someone to do many of the tasks that the homemaker had previously done.
 
 
16.  You and your spouse should have disability insurance.
 
You might well impose a greater financial burden on your family if you become seriously disabled than if you die.  If you die you stop bringing in income, but you also (after your funeral) stop consuming.  If, however, you can't work because of a disability, you not only won't be earning money but you will also require a significant amount of financial support from your family.  To (partially) protect your family from this burden you should purchase disability insurance.  Most people get such insurance through their employer, so speak to your company's human resources department about getting disability insurance.
 
 
17.  As you approach retirement consider putting much of your new savings into safe government bonds.


Sudden falls in the stock market have a greater impact on those close to retirement than on younger investors who can ride out the inevitable ups and downs of the market.  So as you approach retirement you should consider putting much of your new savings into safe government bonds.  
 
 
18.  Women usually live longer than men and so need to save more for retirement.
 
Since women live about six years longer than men do, they will on average need more money to finance a comfortable retirement.
 
 
19.  Keep in mind that you might live a lot longer than your grandparents will/did.
 
Over the next forty years scientists might develop many successful anti-aging treatments.  Because of the possibility of such technologies, a forty-year-old alive today has a non-trivial chance of still being alive one hundred years from now.  So when deciding how much to save for retirement take into account that you might spend a heck of a lot more time in retirement than any of your grandparents will/did.
 
 
20.  Determine how much people in your job make.
 
Your employer knows how much people in your position are paid.  If you don't you're at a disadvantage in salary negotiations.  Many people are uncomfortable discussing salaries with co-workers.  Overcome such discomfort to find out if you deserve a raise.


 Originally published on Google's Knol

 

55 comments

Comments sorted by top scores.

comment by Vaniver · 2015-03-19T18:15:56.757Z · score: 12 (14 votes) · LW · GW

When evaluating potential marriage partners give bonus points to those who have a history of saving. Do this not because you want to marry into wealth, but because you should want to marry someone who has discipline, intelligence and foresight.

A more immediate consideration here is that money is (I believe) the most common cause of fights in relationships, and agreeing about money before you get into the relationship should help avoid that.

comment by James_Miller · 2015-03-19T18:22:17.642Z · score: 9 (9 votes) · LW · GW

My mom use to work as a marriage counselor and told me that money issues are indeed the biggest cause of serious marital fights.

comment by Lumifer · 2015-03-19T18:42:27.720Z · score: 3 (3 votes) · LW · GW

Cause or subject?

comment by James_Miller · 2015-03-19T18:43:50.681Z · score: 6 (6 votes) · LW · GW

Cause

comment by [deleted] · 2015-03-19T19:08:02.070Z · score: 0 (2 votes) · LW · GW

Hey.

You suck.

comment by 2irons · 2015-03-27T15:38:56.992Z · score: 6 (6 votes) · LW · GW

My wife had a poor history of saving when we first met while saving and planning ahead financially are one of my strongest areas of discipline. However I think our differences were as much a function of circumstance and nurture as anything innate. Overall I think she wins hands down on discipline, intelligence and foresight vs me.

Because of this core discipline, intelligence and foresight– over time she’s moved far closer to my spending and saving habits having seen their value (and in turn I’ve loosened up, and would still acknowledge it'd probably be optimal for me to do more of that. Time and willpower are often cheaply purchased.)

Of course we have to go on the limited signals we have but remember saving is just a proxy for what we’re really after.

As an aside, I am a portfolio manager – managing circa $2bn of fixed income assets, so fees feed my family – but I wholeheartedly agree retail investors generally do much better by investing in passive funds and avoiding fees.

comment by Epictetus · 2015-03-20T07:52:37.288Z · score: 1 (1 votes) · LW · GW

Attitudes about money are easy enough to overlook at the start and differences can remain quiescent until some crisis forces them to the surface and then all Hell breaks loose. It's probably good advice in general to look at the sorts of things that have been known to cause problems further down the line and get them sorted out as soon as possible.

This, of course, assumes that potential partners are plentiful...

comment by Lumifer · 2015-03-19T18:21:04.558Z · score: -2 (4 votes) · LW · GW

If we are going there, even better advice is just the traditional "Marry someone rich" X-/

comment by Vaniver · 2015-03-19T19:15:44.909Z · score: 4 (4 votes) · LW · GW

If we are going there, even better advice is just the traditional "Marry someone rich" X-/

This prevents some fights about money, but not others. Matching spending habits and interests probably does more to minimize conflict than just having more to fight over.

comment by jimrandomh · 2015-03-20T00:48:47.396Z · score: 9 (13 votes) · LW · GW

This is good advice iff you are a middle-class person who expects the world to remain as it is, and whose greatest desire is to avoid ever falling into the lower class. But from a different perspective, some of it seems questionable. There are two main assumptions threaded through this: that your personal discount rate is less than or equal to the market's risk-free rate of return, that you expect to retire in old age, and that you think nothing will happen first to render your savings moot.

In particular - while there are loopholes for getting your money back after putting it into a 401k, if you ignore the loopholes and just look at the central use case of not withdrawing until you're 60, then putting money into a 401k is about as good as setting it on fire.

comment by Epictetus · 2015-03-20T07:21:02.788Z · score: 8 (8 votes) · LW · GW

There are two main assumptions threaded through this: that your personal discount rate is less than or equal to the market's risk-free rate of return, that you expect to retire in old age, and that you think nothing will happen first to render your savings moot.

Financial strategy always depends on your expectations. If you expect civilization to collapse, then you may want to invest in guns and MREs. If you expect society to move beyond the need for money, then any money you have left after that point is wasted.

The question then becomes: is it worthwhile to hedge against other outcomes? You're paying a price in exchange for protection from some outcomes. On the other hand, not hedging means that those outcomes will screw you and you'll have to improvise. For example, maintaining enough in savings to last the next 6 months can help if you lose your job, but it's money that could be spent on other things.

It seems to me that it's reasonable to expect some form of the modern financial system to exist in 50 years, and for those with a decent income it's not too odious to build up a decent nest egg over the course of 40 years.

comment by Vaniver · 2015-03-20T13:16:22.007Z · score: 1 (5 votes) · LW · GW

The question then becomes: is it worthwhile to hedge against other outcomes?

Yes, but it's very different to say "you should hedge against the case where you get a medical disability and the Singularity doesn't happen" and "you should do what would have put you in the best position today." My parents, both looking at retirement shortly, maxed out their retirement accounts and got significant benefit from doing so; I have a similar disposition and financial situation but 2015 looks very different from 1985. It is not enough for me that I won't be taxed on the money after 2048 once I start to draw it down; the cost in flexibility from not being able to invest it in a Bitcoin-like opportunity is really high.

So it seems to me that any subsidy that beats the penalty (in the US, I believe you pay the tax you would have paid plus 10%) is worthwhile because it's still free money (even if you pay the penalty), but beyond that it may be better to buy disability insurance (or something similar) than do pure retirement saving.

Two related articles: Saving for the long term, Why is it rational to invest in retirement? I don't get it.

comment by Weedlayer · 2015-03-20T18:59:38.372Z · score: 6 (6 votes) · LW · GW

Do you feel confident that you could recognize a Bitcoin-like opportunity if one did appear, distinguishing it from countless other unlikely investments which go bust?

comment by Vaniver · 2015-03-20T20:52:33.306Z · score: 2 (4 votes) · LW · GW

Do you feel confident that you could recognize a Bitcoin-like opportunity if one did appear, distinguishing it from countless other unlikely investments which go bust?

When I have thought that there was a narrow time window during which long-run predictable effects were mispriced, I have been correct 3 out of 3 times (but didn't follow through at all once, or completely another time, for various logistical reasons). Obviously, I haven't successfully recognized every such opportunity, but it seems like I'm good enough at recognizing gold when I come across it that when I think I've found gold it makes sense to bet on that belief. I tell people to expect that sort of thing roughly once every five years; this is emphatically not a claim that I can look at the market and make a good pick every day.

They're also not all at the scale of Bitcoin. The smallest of the three was when I correctly predicted the point of maximum pessimism during the Deepwater Horizon spill to within a week, which was worth about a 50% gain as the price returned to normalcy.

comment by Epictetus · 2015-03-20T17:38:28.794Z · score: 1 (1 votes) · LW · GW

Yes, but it's very different to say "you should hedge against the case where you get a medical disability and the Singularity doesn't happen" and "you should do what would have put you in the best position today."

Of course. The future will be different from the present. Strategies that work today may not be viable tomorrow (just look at CD rates from the early 80s and contrast with today). However, if you assign a reasonable probability to the United States maintaining political and economic stability, and for money still being important, then some level of saving for the future seems to be a safe bet.

It is not enough for me that I won't be taxed on the money after 2048 once I start to draw it down; the cost in flexibility from not being able to invest it in a Bitcoin-like opportunity is really high.

It depends on the person. If you're the sort to be active with your money and seize opportunities, that's one thing. If you're the sort to spend money on frivolities, then tossing a certain portion into a retirement fund isn't a bad idea.

comment by Lumifer · 2015-03-20T18:26:25.353Z · score: -2 (8 votes) · LW · GW

If you're the sort to spend money on frivolities

LOL.

“I spent half my money on gambling, alcohol and wild women. The other half I wasted.” ― W.C. Fields

comment by [deleted] · 2015-03-20T20:04:25.963Z · score: 0 (0 votes) · LW · GW

A.J. Simpson says that you're an untrustworthy person.

comment by [deleted] · 2015-03-20T20:00:54.545Z · score: 0 (0 votes) · LW · GW

Are you Weedlayer?

comment by [deleted] · 2015-03-19T22:18:40.355Z · score: 5 (7 votes) · LW · GW

Generally good piece, but I have a few points:

Maintain a diversified portfolio

Completely agree. In fact, I think this is more important than points 3), 5), and 7). Evidence indicates that the asset classes chosen for a portfolio wield greater influence than the investments chosen within each asset class.

https://personal.vanguard.com/pdf/s324.pdf

The bigger a nation's economy, the more money you should put in its stock market.

Exposure to a country’s stock market is not equivalent to exposure to its economy…

http://www.businessinsider.com/sp-500-foreign-revenues-2013-2013-5

Equity diversification without trying to “out-guess the market” may best be achieved by a market capitalization-weighted world equity fund.

The U.S. government gives tremendous tax benefits to those who invest in certain tax-advantaged vehicles such as 401(k), 403(b), or IRA plans.

Roth IRAs are also an interesting option. Maybe you grouped them in “IRA plans”.

You and your spouse should have disability insurance.

This depends. Affluent individuals might be able to use savings, and the U.S. government offers some disability insurance through Social Security.

Disclaimer: This is not investment advice, don’t listen to me I’m crazy, etc.

comment by is4junk · 2015-03-20T19:14:25.845Z · score: 4 (4 votes) · LW · GW

Brokerage accounts (fidelity/etrade) are better then bank accounts in every way (in the US). Use them with a margin account to safely maximize your investments. The margin account will basically function as an overdraft / short term loan at very favorable rates. Reasons:

  • direct deposit in to your brokerage account - all surplus money should be sweeped in to an index fund (SPY or global equiv)
  • You can have a ATM card and do all your checks through them usually for free
  • they all have bill pay service for free
  • depositing checks - they can be mailed in
  • Even if you don't invest the money it will automatically be in a money market account earning you interest
  • investment interest payments (on the margin) can be tax advantaged unlike credit card payments

I didn't have a bank account for over a decade. There is no reason to think about checking and savings being separate things.

Concerns about margin account being scary are only that way when you margin a substantial fraction of your account. If you are under 10% and invest in stable index funds you won't have a worry.

instead of investing in SPY consider Berkshire Hathoway (brk) for the tax advantages - (Warren Buffet doesn't like to pay taxes). I'd look at costco's sharebuilder if you can't afford to buy 1 share.

comment by JenniferRM · 2015-04-04T18:28:03.650Z · score: 6 (6 votes) · LW · GW

This seems like awesome advice that I have never heard before. Do you think it might be dangerous for some people? Like is it a "you must be this tall to ride this ride" kind of thing?

Also, it seems like it might help to have this made actionable by talking about the steps someone would take to convert their financial service provider setup to this. Do you have a good method for picking a broker? If someone was not very financially savvy (like they didn't know what a brokerage even was exactly) what should they do right after reading here to start on the path to setting things up this way?

comment by [deleted] · 2015-03-20T19:56:35.717Z · score: 0 (0 votes) · LW · GW

Hey.

You suck.

comment by Zubon · 2015-03-20T13:40:36.092Z · score: 4 (4 votes) · LW · GW

Easy way to fight akrasia with respect to saving: when your income increases, put half in savings. Do so through automatic paycheck deductions like a 401(k) to avoid needing to think about it. If you are currently getting by well enough, you don't strictly need that extra money, and the way to avoid unthinkingly frittering is away it to unthinkingly save it. If you get a 2% raise, increase your withholding by 1%. You still get a bit of a raise, and your savings increase.

This assumes "you are currently getting by well enough." If you have debts, paying down the debt is your savings. The interest rate on your credit card balance is higher than anything you can get through investing; stop the bleeding.

comment by [deleted] · 2015-03-20T12:40:48.280Z · score: 4 (4 votes) · LW · GW

It.. feels like I've read this before.

"20 reasons/ways/books/movies/facts you should..."

After some time and effort I realized what I'm reading is probably situational or more like professional-to-professional, rather than professional-to-beginner or in simplier terms, it doesn't convince me simply because I cannot see the reasons behind it.

comment by korin43 · 2015-03-19T19:07:32.491Z · score: 3 (3 votes) · LW · GW

As you approach retirement consider putting much of your new savings into safe government bonds.

This is "safer", but it introduces new problems. Since your investment has lower expected returns, you need significantly more money saved up. The S&P 500 has historically returned around 10% per year over 25 year periods, and has almost never returned less than 5%[1]. Right now, as far as I can tell, government bonds return 1-2% depending on their length. With 5% expected returns, you need 20x your expenses saved up, but with 2% you need 50x, and with 1% you need 100x. Most of these are probably possible for high income/low expense Lesswrongers to save up, but I'd expect that we have higher value things to do with 30x our expenses than to hold onto it in case of very unlikely personal risks.

It is possible to live for a long time while withdrawing more than you earn. For example, with 5% expenses and 2% returns, you would last about 26 years[2] before running out of money. Considering point #19 though, guessing how long we're going to live seems like a pretty big risk too.

[1] http://financeandinvestments.blogspot.com/2015/01/historical-annual-returns-for-s-500.html

[2] http://ideone.com/0K2Uhd

comment by [deleted] · 2015-03-19T19:54:56.014Z · score: 0 (2 votes) · LW · GW

You are comparing the historical return of one asset class to the prospective return of another.

"Apples and Oranges"

comment by korin43 · 2015-03-19T20:03:29.964Z · score: 1 (1 votes) · LW · GW

How else would you compare them? The values I chose are meant to be the expected returns. For bonds I chose the listed rates, since those are (I think?) guaranteed, so historical rates would be meaningless. For stocks I chose the historical rates since that's all we have. Did I use the wrong rates for bonds somehow?

comment by [deleted] · 2015-03-19T21:36:07.769Z · score: 1 (1 votes) · LW · GW

Stocks: It is difficult to predict future returns, but I would at least calibrate my expected returns based on inflation expectations. Research indicates that equity expected returns and expected inflation move together…

http://www.federalreserve.gov/pubs/feds/1999/199902/199902pap.pdf

…and if expected inflation is lower than average (which I think it is)…

http://www.tradingeconomics.com/united-states/inflation-cpi

http://www.tradingeconomics.com/euro-area/inflation-cpi

…then, all else equal, current expected stock returns should be lower than historical stock returns.

Bonds: I agree with you that the yield to maturity for high quality government bonds is the best estimate for their expected returns, I would just make sure the maturity matches the time horizon. For a 25 year time horizon, I look at bonds that mature in 25 years.

Disclaimer: this is not investment advice.

comment by emr · 2015-03-24T20:55:28.010Z · score: 1 (1 votes) · LW · GW

On outguessing the market: With only public information, can someone (expect to) determine better times to invest into diversified funds? Specifically, is it a good idea to use the "being greedy when others are fearful and fearful when others are greedy" heuristic?

comment by James_Miller · 2015-03-24T21:45:29.946Z · score: 1 (3 votes) · LW · GW

No because hedge funds would already be doing this, and you would have to think you were better at it than them.

comment by gjm · 2015-03-25T02:20:34.324Z · score: 1 (1 votes) · LW · GW

You could alternatively think that hedge funds don't have enough trading volume to shift the prices so far that the heuristic stops working. Imagine a market composed of a thousand idiots, one hedge fund, and you, each participant having roughly equal resources. If all the idiots make some mistake, the hedge fund will get there before you and profit from it, but unless it's leveraged 1000:1 (which would be ... brave) there are likely still profits for you to take by exploiting the same mistake.

In reality there are a lot of hedge funds and some of them have an awful lot of money, but they're still no more than ~1% of the market.

comment by Vaniver · 2015-03-24T21:54:18.148Z · score: 0 (0 votes) · LW · GW

No because hedge funds would already be doing this, and you would have to think you were better at it than them.

Consider funds that close out their positions by the end of every day. They're implicitly being as fearful as possible (in a world with just cash and stock), which is not obviously the optimal approach to long-run timing.

comment by James_Miller · 2015-03-24T22:23:53.943Z · score: 0 (0 votes) · LW · GW

Even if most funds did this, it would only take a few attempting to take advantage of this to eliminate any profit opportunity for non-hedge funds.

comment by Vaniver · 2015-03-24T21:22:09.104Z · score: 1 (1 votes) · LW · GW

Specifically, is it a good idea to use the "being greedy when others are fearful and fearful when others are greedy" heuristic?

I would say "yes, but." Really, the value comes from predicting a change before anyone else does it--saying "ah, the greed has spread as far as it can, and so now the only possible place for us to go is back towards fear, and that will happen all at once" or "ah, the fear has spread as far as it can, and so now the only possible place for us to go is back towards greed." (In my experience, fear is more contagious than greed.)

But always disagreeing with the herd is reversed stupidity, not intelligence.

comment by Lumifer · 2015-03-27T16:23:12.119Z · score: 0 (0 votes) · LW · GW

Yes, with caveats.

Caveat 1 is that your implied model is continuous growth of the underlying investment (say, the US stock market represented by S&P500) with more-or-less constant trend. Given this, you should buy if you think the current price dropped below the long-term trend (e.g. 2008) and sell if you think the price rose above the same trend. If this model is correct, the trading strategy will work (we're ignoring risk for the time being). But if the model turns out to be wrong, well then...

Caveat 2 is that you're implying that you have a considerably longer time horizon than other market participants. Hedge funds might play a similar game, but they have to deliver returns to investors and a hedge fund which just bleeds money for months and years with nothing but a promise that someday it will redeem itself will not last long. There are investment entities which can take a very long-term view (e.g. sovereign funds), but they are not the rule.

comment by 2irons · 2015-03-27T16:05:00.523Z · score: 0 (0 votes) · LW · GW

I think you can win using this strategy - but it requires a lot of patience. Certainly years - with the possibility of decades. You'd have to be sure of your strategy and sure of your belief in your strategy, changing tact when offside is the worst thing you can do if you are playing a deep value game.

It remains a winning strategy because of that cost.

comment by AnthonyC · 2015-03-23T01:34:11.080Z · score: 1 (1 votes) · LW · GW

Basic question: if every stock, bond, and government debt investor started actually believing the obvious advice and buying index funds and holding for the long term, where would the stock prices themselves come from?

comment by James_Miller · 2015-03-23T03:21:23.683Z · score: 4 (4 votes) · LW · GW

The stock market would fail if everyone just bought index funds. But this can't happen because as the percentage of people holding index funds approaches 100%, there would be high profit to finding undervalued stocks.

comment by Nornagest · 2015-03-23T05:53:35.615Z · score: 1 (1 votes) · LW · GW

The main thing that bothers me about the Boglehead program is the usual Goodhart's law deal: the more popular index funds become as a form of low-risk exposure to markets, the worse I'd expect them to perform as indices, and the less stable I'd expect them to be. I'm not sure what to actually do about this, though, or if it's even a problem worth worrying about.

comment by Aharon · 2015-03-24T07:17:14.543Z · score: 1 (1 votes) · LW · GW

I agree, and I think we can already observe the consequences: For example, since exchange traded funds have become more popular, their number increased from 276 to 3.906, and not all of them are passively managed any more. I don't know about the situation in the US, but in Germany, one of the largest direct banks incentivizes buying ETFs that are indexing risky underlying things (for example, one ETF follows the development of pension-funds in emerging markets). It does so by having lower trading costs for incentivized funds.

I think on a private level, one can still find index funds that are actually useful. On a global level, there are some worries that ETFs might contribute to a potential future crisis.

comment by Lumifer · 2015-03-23T15:49:20.642Z · score: -2 (2 votes) · LW · GW

a form of low-risk exposure to markets

That's a nice oxymoron right there :-)

comment by DanielLC · 2015-03-21T21:03:16.854Z · score: 1 (1 votes) · LW · GW

7(A) On average, actively managed funds do worse than passively managed funds do.

I have heard this before, and I'm still confused about it. They would need to do all the work of obtaining good evidence entangled with reality, and processing that evidence coherently, just to anticorrelate that reliably. Why aren't there actively managed funds that hire people with MBAs and ask them which stocks to buy, and then do the opposite of whatever they say?

I have a few theories. One is that short selling is difficult, so you can't make money as easily by predicting a stock price dropping as you could by it rising. As a result, predicting it dropping pays less, and is easier to do. Actively managed funds can therefore predict it, and use this to consistently lose money.

Another one is that actively managed funds are more open to embezzlement, and that a few companies claiming they bought different stocks after the fact managed to drive down the average enough to make it statistically significant.

There's also the whole thing about the market not being quite efficient. If you can outperform the market, you can use the same strategy with more money in order to make more money, up until you start trying to buy and sell enough stock that you actually change the market. As a result, the people who are best at predicting the market will control it, and it will be efficient. But it has to be just inefficient enough to pay them enough to keep doing it. The same amount of money would have to come from other people trying to predict the market and failing. As a result, an average person would have a small expected loss that goes to those people, and if the actively managed funds are just hiring average people, they'll lose money.

comment by CronoDAS · 2015-03-21T21:12:18.796Z · score: 5 (7 votes) · LW · GW

Short answer: Actively managed funds do worse because they have more overhead - money managers cost money, and, on average, they don't bring in more money than they cost.

There's also the whole thing about the market not being quite efficient. If you can outperform the market, you can use the same strategy with more money in order to make more money, up until you start trying to buy and sell enough stock that you actually change the market. As a result, the people who are best at predicting the market will control it, and it will be efficient. But it has to be just inefficient enough to pay them enough to keep doing it. The same amount of money would have to come from other people trying to predict the market and failing. As a result, an average person would have a small expected loss that goes to those people, and if the actively managed funds are just hiring average people, they'll lose money.

This makes sense. It's like playing poker at a raked table: the "average" return of playing poker at an unraked table is zero dollars, because every dollar that someone wins is also a dollar that someone loses, but at a raked table, the house gets a cut of each pot, so the "average" return is negative. Similarly, every dollar of "above-average returns" earned in a market has to have a corresponding dollar of "below-average returns". However, actively managed funds are like playing in a raked game: the money managers have to get paid, so they have to do better than average in order to earn "average" returns for investors.

comment by DanielLC · 2015-03-21T23:02:11.337Z · score: 0 (0 votes) · LW · GW

Actively managed funds do worse because they have more overhead

It's not clear here, but when I first heard this they made it pretty clear that it was doing worse selecting investments. The extra overhead was an additional problem.

comment by Davidmanheim · 2015-03-22T03:59:46.592Z · score: 1 (1 votes) · LW · GW

You are correct; one simple reason is that they tend to under diversify, and make correlated bets, which undermines the benefits of diversification.

comment by DanielLC · 2015-03-22T06:09:00.037Z · score: 0 (2 votes) · LW · GW

Under-diversifying increases risk without a commensurate increase in reward. It does not decrease reward, so it would not result in actively managed funds doing worse on average.

comment by Davidmanheim · 2015-03-22T20:28:22.798Z · score: 0 (0 votes) · LW · GW

So under-diversified portfolios will under perform...

If I can invest in either of two portfolios, where one is LogNorm(1.25, 0.5), and the other is LogNorm(1,1), which should I prefer? They have the same mean, but my expected return over time still is dominated by one that has a lower standard deviation. (Try it in excel.)

comment by gjm · 2015-03-22T20:44:23.061Z · score: 0 (2 votes) · LW · GW

If you're looking at long-term results, you don't really want the (arithmetic) mean of short-term results, you want the geometric mean (or, equivalently, the arithmetic mean of logarithmic short-term results). So the first of those portfolios is unambiguously better if what you care about is typical long-term performance.

comment by DanielLC · 2015-03-22T22:51:51.029Z · score: 0 (0 votes) · LW · GW

We're not arguing about what's a good idea. We're arguing about what could cause actively managed funds to do worse on average. I suppose it's possible that the statistic I saw was calculated using a geometric mean, or even a median.

comment by Davidmanheim · 2015-03-22T21:49:13.854Z · score: 0 (0 votes) · LW · GW

Exactly.

If you look at the single period mean, it will not represent the portfolio return. That's why the expectation of an RV in a single period is insufficient information for looking at the return, and why we want to reduce volatility, and preserve expected.

comment by James_Miller · 2015-03-21T21:20:15.583Z · score: 0 (0 votes) · LW · GW

Good answer.

comment by Epictetus · 2015-03-21T21:56:12.403Z · score: 4 (4 votes) · LW · GW

Think about it this way: investors buying index funds are doing about as well as the market. Active traders who beat the market do so basically at the expense of other active traders who do worse. The aggregate performance of all active traders won't beat the market. However, there are extra expenses (overhead, fees, etc.) to active trading, so we actually expect active traders to perform worse.

The second issue is taxes. A passive investor gets to pay the long-term capital gains tax after the stock is sold. Someone who actively trades is getting hit with a short-term capital gains tax (paid every year), which is considerably higher and will positively murder one's compound interest rate.

comment by AnthonyC · 2015-03-21T12:07:22.080Z · score: 0 (0 votes) · LW · GW

An excellent list, agreed on all points.

On homes: yes, assuming you buy with a mortgage, these are short-term risky, but they are also long-term safe. This also means they are short-term high-expected return and long-term lower return. On average home prices rise at just slightly above the inflation rate (in my area a little faster right now, about 3%). So when I bought a $335k house with 5% down (<4% interest, 30 yr mortgage), that means my equity (initially ~17k) rose by close to 80% in the first year. Factor in closing (read: transaction) costs and it's still an expected 50% return. But that will fall to 3% over 30 years once my equity rises to 100%. And in my case, the mortgage payment + taxes was already hundreds of dollars less than my previous rent (and the mortgage payment will never go up), interest and property taxes are tax deductible, and my state has programs to significantly reduce the costs of PMI. I stared at a lot of spreadsheets before pulling money out of my brokerage account to buy a house.

comment by James_Miller · 2015-03-21T14:55:46.491Z · score: 2 (2 votes) · LW · GW

Yes, but don't forget to put the expected costs of home repair in the spreadsheet (repair costs are implicit in rent).

comment by AnthonyC · 2015-03-22T15:23:51.108Z · score: 1 (1 votes) · LW · GW

Very true. I did. I forgot to mention that; The rule of thumb people give seems to be to assume you'll spend 1% of the home's value per year on maintenance. I assumed 2%, on the assumption that at first there would probably be lots of little things cropping up and I have no handy skills at all.