17. To Muni or not to Muni

I'm having a hard time deciding if a portion of my portfolio should be allocated to Municipal bonds. These bonds, issued by state governments and agencies are free from federal tax. If you buy bonds from your own state (Massachusetts, in my case), they're free from state tax as well (this is a pretty small peanut though; assuming 5% state tax and 5% annual growth, the state tax saving amounts to 0.25% annual gain.) If you're an AMT casualty, you should also make sure that the fund you choose avoids any AMT liability.

Once you do all that, you can get a fund whose income is tax free - about a 40% gain compared to treasuries. For example, a 3% annual yield in tax-free municipal bonds is equivalent to a 5% yield in treasury (or corporate) bonds.

Sounds simple, but of course it's not, for the following reasons:

• Lenders know that the yield is not taxed, and therefore offer lower interest
• It might be difficult to find a fund specific to your state, and even if you do, this will limit your diversification (bonds from one state instead of bonds from possibly all 50 states). Is it worth the extra 0.25% in annual yield? 
• Long-term muni bonds seem to have had (historically) a slight edge over intermediate-term bonds, but they carry higher risk. Are they worth the extra 0.2-0.3% in annual yield?
• Fees for muni bonds can be high: from 0.27% to 0.50% annually, and Vanguard funds have an additional $75 purchase fee (unless you have your account with them.)
• There are way too many options to choose from, and none of them is passively managed, meaning that none of them tracks the Barclays Municipal Bonds index. Coincidently or not, this also means that all of the funds I checked lag behind the index they track. 

The funny thing is that once you compare the returns of all these different options, they end up being about the same!

I focused on 5 funds: FTABX (Fidelity tax-free), FDMMX (Fidelity MA Municipal), FLTMX (Fidelity intermediate Municipal), VWLTX (Vanguard long-term tax exempt) and VMATX (Vanguard tax-exempt MA). If we forget for a second the state tax advantage of FDMMX and VMATX, looking over 10 years there's not much difference between them.

So what should I choose? FTABX since it had the best performance? VMATX since it's exempt from state taxes and has the lowest expense rate? FDMMX since it's also exempt from state taxes, but unlike the former fund has no transaction fee? FLTMX since it focuses on intermediate-term bonds, which should deliver lower volatility? Or VWLTX? Or VWUIR? Or... 

Or perhaps it doesn't matter, at the end of the day. The differences are small, and the ability of past-performance to predict the future is even smaller. I think I'll choose FTABX, because it has the lowest turnover ratio and it looks nice on the chart. Check with me again in 10 years to see if I could have made 0.375% more!

16. Friends Don’t Let Friends Get Into Finance

I recently heard that a group of friends of mine is busy working on a new startup, that will find and utilize inefficiencies in markets to perform micro-trading: buying and selling frequently, based on complex stochastic models of markets behaviors. I don't know if this can work or not. Secretly, I hope it can't. There's something inherently wrong, in my opinion, in investing your time and efforts in an endeavor whose sole goal is to take some percentage of market trades without putting anything back into the system. What is the contribution of their startup, besides (perhaps) making money for their customers? How does it help the economy, human prosperity, people's well-being, or any other ideals? In other words, what value do they create, as opposed to the value they extract from other traders?

This is the same group of people who created a successful hi-tech company 10 years ago, based on novel ideas of data protection and replication. Their product enables small business to protect their vital data against corruption and disaster, and gives a real, quantifiable value to their customers. They're very smart and very talented. Isn't this game a waste of their talents?

The same is unfortunately true for a lot of what's going on in the finance world. In the US, Finance grew to  be the biggest sector in the list of GDP components. But Finance is all about moving money from one hand to another, not about creating anything. Yes, some amount of finance is necessary: to help people and institutions raise money, protect and grow their savings, and to add liquidity to the system. But should it be more than 1-2% of the economy?

All these resources don't come for free. As Vivek Wadhwa points in his excellent post, Friends Don’t Let Friends Get Into Finance, the human resources invested in the Finance world come on the expense of academic research, technology development, science, medicine -- in short, all those boring productive disciplines that are not focused on getting some Wall St sharks rich quickly. Let me quote his last paragraph:

Paul Kedrosky says that the virus that infects scientists and engineers and causes them to go to Wall Street rather than create something of societal value is “economic Ebola”. He wants to be an “economic virus hunter”. Let’s all help him. Let’s save the world by keeping our engineers out of finance. We need them to, instead, develop new types of medical devices, renewable energy sources,and ways for sustaining the environment and purifying water, and to start companies that help America keep its innovative edge.


I would add to that my opinion that every billion dollars earned by a hedge fund or an Investment bank is a billion dollar taken away from private investor, pension funds, enterprises, factories and every other part of the economy responsible for our growth and success.

The big question is how to cure this "economic Ebola". Any ideas?

15. Q&A

Today I'll respond to a few questions that readers have asked me since I started the blog. Got more questions or feedback? Add them as comments below.

Q: How do you pick a mutual fund?

A: Let's start with how not to pick a mutual fund: looking at past performance. Morningstar and other publications have a rating system that takes into account past performance over short and long term, and gives funds high ratings if they beat their peers in the same investment class.

What they don't tell you is that the best funds of one year are often below average the following year. In fact, on average, 5-star funds will underperform in following years! This amazing result, confirmed again and again in research, is due to multiple reasons:

• Fund managers who bet on a sector and win (say, Internet stocks in 1999 or Real Estate in 2002), will stay with this sector when it loses steam and comes crashing back to Earth
• Since on average all the stock funds do the same (a bit less than the index), the return-to-the-mean phenomenon will mean that good years are often followed by less-than spectacular year
• Only a tiny fraction of lucky managers (0.1%) manage to beat the index consistently over long periods. Everyone else will have to balance their good years with bad years. 

So how do I choose my funds? I first zoom in on the sector I want to cover (say, US market or Muni bonds or International stocks). I look for funds with high diversification. I then narrow the selection to low-cost index funds, and look for low turnover. In some cases (such as Muni bonds) this is more difficult due to tax issues, but in general I end up with a few options that have more or less the same performance. Sites like Fidelity and Morningstar make this sorting easy. 

Q: When is a good time to buy a mutual fund?

A: The answer to this question is always the same - "Now". You can't predict the market. Maybe in hindsight, you'll enter right before a crash. Or maybe you'll enter right before a boom. But your best bet is not to enter at all - just be in the market all the time, keeping your preferred stock/bond ratio, and investing in small amounts any savings you have. I do not recommend sitting on a pile of cash and trying to time the market - this is way to risky.


Q: How to split the pie?

A: This depends on your level of risk tolerance, your investment horizon and how well you sleep at night. I'm a pretty aggressive/adventurous guy, and my split is 80/20 (stock/bonds). Others go with a more balanced 70/30 or even 60/40. I wouldn't recommend less than 60% in stocks for people under the age of 60. A good test of your risk tolerance is to ask yourself how you'd sleep at night if the stock portion of your portfolio drops by 25%. Note that with a 60/40 split, this means only 15% drop in your total portfolio, while with a 80/20 split this amounts to 20%. Try to run the numbers in your head - if you're going to lose sleep on a big drop, increase the bonds ratio. If you can see the longer time horizon and stick with the plan, go with a more aggressive approach. The one thing you don't want to do is to change the pie allocation in response to market events.


Q: What are your main DOs and DON'Ts?

A: There are so many of them... check my earlier posts for the essentials. You can start with Dilbert's advice.


Q: What is the mathematical background for these recommendations?

A: This is a little too much to cover here, I'll try to cover it in more details in a few weeks. But the basis is the following: while stocks have given, on average, the highest returns, they also carry with them the highest risks. It turns out that for any given return you wish to achieve, there's a certain mix of stock and bonds that can be predicted to achieve this return (based on historical averages) while minimizing the risk. For example, a 50/50 stock/bond portfolio with no rebalancing has gained 8.6% over the last 60 years, with a risk (standard deviation) of 12.2%. The same portfolio, with annual rebalancing, has gained 9% annually - or 25% more over the life of the investment. Moreover, the risk for the latter portfolio, as measured in standard deviation, is 25% lower (9.3%). In other words, more rewards, less risk. Achieving the same gain without rebalancing would have required you to increase the stock ratio and take even more risk.

The reason is that a balanced portfolio enables you (or rather, forces you) to sell stocks when they increase in value and buy more of them when they lose value - "sell high, buy low." Ferri's "All about asset allocation" gives many more details and graphs. In particular, the numbers I'm quoting here are from table 3-3.

14. What is insurance good for? Part 2

A friend of mine from NYC, a handsome teacher by day who doubles as a construction worker by night (long story), asked me recently about long-term care insurance. Indeed, long-term care can be pretty costly, and many people need it for a prolonged period towards the end of their life.

On the face of it, the policy looked reasonable. The insurer is a big, stable company (John Hancock), and the hefty premium ($50,000) is still small compared with the expected expenses ($5,000 a month for 8 years = $480,000). Also, the insurance had an early withdrawal options (life insurance and cash value). What not to like?

As it turns out, a lot.

When you consider this kind of policy, here are a few questions you should ask yourself. 

• Do I trust it that the insurer will be there in 40 years when I need it? Probably yes, John Hancock is a big, established company. On the other hand, so was AIG.
• Do I have more important things to do with $50K now (such as putting a downpayment on a house)?
• What alternatives do I have? Investing $50,000 for 40 years with a balanced portfolio can yield $350,000 to $750,000 (these numbers correspond to 5% to 7% annual gain - plug in your own estimate of market performance, bearing in mind that historical averages are 9%). 
• Is this benefit going to guarantee my long term care cost? The answer is no - the benefit is capped at 6 years, and the monthly payment ($6,458) might not be enough in 40 years. In fact, it's highly likely it will not be enough. 
• What if I need the money for other needs, such as a costly operation? This insurance has a "face value", but it's equivalent to a minuscule return of 2% annually. 
• What's the insurance benefit if I never use the benefit, say, if I live to 105 without any need for help, then die within a week? Again, the benefit turns into a pretty mediocre life-insurance (equivalent to investing the money with 2% annual interest). 

But the biggest drawback of the policy is this beast called Inflation. People tend to forget about it, but over long periods of time (40 years in our case), an average inflation rate of 3% can wreck havoc in these kind of policies. Indeed, assuming 3% annual inflation rate, the guaranteed payment of $6,458 shrinks to just $1,980 in today's dollars. And a few years of 70s style high inflation will erase most of the value of the policy. Are you willing to take this risk?

The funny thing is that insurance is supposed to reduce risk. You take insurance to cover yourself against unlikely, catastrophic events. An ideal insurance will have a high deductible, small premium, and guaranteed coverage against an expensive, unforeseen disaster (read more about it in part 1 of this blog.) This is exactly NOT what's offered here.

The insurance my friend was offered is more similar to buying 40 year treasury bonds with 2% and keeping them intact. Any period of high inflation during the coming 40 years will erase your investment. Remember, long-term bonds, as well as long-term fixed rate investments are dangerous, volatile and potentially disastrous investments. Especially now, when the Fed is printing money as fast as they can, the long-term interest is low in historic terms, and the national deficit is running circles around the moon, assuming that there will be little to no inflation in the coming 40 years and committing to it is a very high risk move.

My advice to my friend was to put $50K in a well balanced investment fund (such as FFNOX or other index funds). You gain the flexibility - the money is in your hands, and you can use it any time. You're better protected against inflation (since a well balanced portfolio on average beats the CPI). And if you need the money for long-term care, you can end up potentially with more than the insurer's guarantee of  $465,042. If you don't need long-term care, the money stays in your hands, and not in Mr Hancock's pockets.

Think I got it right? Got it wrong? Your comments are welcome!

13. What is insurance good for? Part 1

I recently decided to cancel my comprehensive car insurance (leaving only the liability and mandatory insurance) and my personal property insurance. Together, these will save me about $1500 a year. I still have life insurance and long-term disability insurance through my workplace. Am I over-insured or under-insured?

If you ask any insurance agent, he'll tell you I'm under-insured. Of course, their job is to sell you as much insurance as possible. But when is it right for you to buy insurance and when are you throwing away your money?

To clarify the problem, let's take an example. Suppose you buy a mug at the store for $10, and they offer you an insurance: $5 a year against any damage, with no deductible. In other words, if you drop and break the mug, you'll get a replacement mug for free. Are you interested?

Sounds a bit ridiculous. You can certainly afford to buy a new mug if needed. The benefit of the insurance is insignificant, and though the cost is low, after 2 years you've already paid the entire cost of the mug. If the chances are you'll keep the mug for more than 2 years before you break it, this deal is bad for you.

What are the problems with this proposal?

First, statistically, it is biased towards the insurer. This would always be the case, but it's more obvious in this example. After all, insurance companies are there to make money. They have expenses - management, commissions, agents, buildings, processing, etc. And after paying all these expenses, they still need to make a profit. So of course, on average, they'll charge you for the insurance more than what, on average, it's worth for you. Again, this will always be the case. To make things worse, if you're a careful driver, living in a good neighborhood, in good health etc. then you'll be subsidizing a lot of people who have a much higher risk of using the insurance.

The second reason you would not want to buy this insurance is that the potential loss is not catastrophic for you. If you become disabled and cannot work for the rest of your life, or if you crash into a parking lot full of brand new Mercedes-Benz cars, the damage will be high, and it may ruin you financially. For these events, and only these, insurance is a prudent step. For anything that you can afford (such as, in my case, losing the value of my old Passat or buying new clothes and furniture), insurance is a casino bet that is tilted towards the house.

The third reason is that the mug insurance is too costly. A good insurance will have high deductible and low cost, and this mug insurance has no deductible at all.

To sum up, these are the questions you need to ask yourself when you're offered insurance:

• Is the insurance going to protect me against a catastrophic event that might ruin me financially, or against an affordable damage that I can pay for out-of-pocket without much hassle?
• Is the insurance going to cover all my expenses or does it have a low limit that will still leave me exposed?
• Does the insurance have a deductible high enough to lower its cost?
• What is the alternative to the insurance? How else can I invest the money?
• What are the chances I'll need this insurance? What will happen if I don't have it?

As another example, consider extended warranties. Every year I'm offered to buy warranty for the major appliances in my home. Each costs between $100 to $300. If I bought them all, I would spend about $1500 annually on insurance. Yes, they do break from time to time, but I never paid more than $500 in any given year to fix them. Again, the math is unquestionable - trust the actuaries to charge high enough premiums to make the house win.

Next week, on a real case analysis for a friend of mine who needed to weigh a much more costly insurance plan: $50,000 for long-term care.    

12. Math Break: The impact of taxation

What is the benefit of letting your savings grow tax free?

Of course, if you never need to pay taxes on your savings, the benefit is obvious. For example, with a 401K program, you invest money pre-tax (i.e., put the money before any taxes are taken from it), and if you withdraw it in retirement (after the age of 59.5), the withdrawals are tax free as well. Even without the matching contributions most employers offer, this is a no-brainer good plan. The first order of the day for anyone who can save money is therefore to max out their 401K.

With a Traditional IRA, things are trickier. You can contribute pre-tax money (if you're below certain income thresholds), but you need to pay taxes when you withdraw the money. And Roth IRA is kind of the opposite: you contribute post-tax money, but the withdrawals are tax-free.

<rant>I find it crazy to have all these different retirement programs available in the tax law, each with its own peculiar rules, and to top it all, complex rules for conversion between plans. And this is before we add other more exotic plans such as Roth 401(K), 529 and others I know little about. Wouldn't it be nice if we had just one plan whose benefits combine all of the above? One pool of savings that can be used in retirement, or for college, or for buying a house?</rant>

Financial advisers will often tell you that you gain more from letting your savings grow tax free, even if you pay taxes at the end. As a mathematician, I wasn't sure there's a real benefit. After all, if you start with, say, $10,000 and expect a gain of 50% over 10 years and taxes of 35%, why should the order matter? After all:

$10,000 * 1.5 * 0.65 (50% gain first, then 35% tax) 

is the same as

$10,000 * 0.65 * 1.50 (pay taxes first, then add the gain).

In math terms, multiplication is commutative - the order of the terms will not change the result. 

And in fact, in some situations this is exactly the result - both kinds of IRAs will give you absolutely no benefit if you invest under these "vanilla" criteria. 

However, for most of us, IRA plans do have a real benefit, as a result of the following factors:

• Your tax bracket when you withdraw the money is typically lower than when you save the money.
• If you invest in mutual funds in a taxable account, you'll have an annual tax bill even if you don't sell them since they have annual distributions
• If you buy bonds directly, when they mature you'll have a tax bill
• And of course, if you change your investment - sell some shares and buy others - you'll have a tax bill.

In other words, the only way that my math above would deem IRA plans worthless is if you use them to buy stocks (not mutual funds) and keep them until retirement without ever selling them, and then sell them when you're still employed with the same tax bracket (or higher.) This is unlikely for most investors.

Which leads us to the next question: suppose you're a typical investor investing in mutual funds (and I hope that means Index funds!) What is the gain from delaying paying taxes or from letting the money grow tax-free?

Let's take for example a traditional IRA and compare it with a taxable account. In this example the IRA is fully invested in bonds, which are taxed as income. Let's also assume that your tax bracket remains constant (if it's lower when you withdraw the money, we already know the benefit). Let's fix your income tax at 35%, and assume a net annual growth of 5% (by net I mean net of inflation - it just makes the calculations easier). Suppose that you start with $10,000 and invest them for 30 years.

Case 1: Tax-free Growth: After 30 years your taxable account is worth 10,000 * 1.05³⁰ = $43,219. You need to pay 35% tax on the gain ($33,219) which leaves you with $31,592.

Case 2: Taxable account: Every year, starting with A, your account grows to A*1.05, but then you need to pay taxes on the gain, A*0.05. This leaves you with A*1.05 - A*0.05*0.35 = 1.0325*A. After 30 years, your account will be worth 10000 * 1.0325³⁰ or $26,104. This is about 18% less.

The difference won't be as dramatic when the taxes are lower - as is the case with long-term capital gain. But if you're buying and selling stocks all the time (a bad idea in any case), your tax bill will quickly eat your gains.

What is my bottom line?

1. Tax-free growth is good. Maximize your 401(K), and if you can open an IRA or a Roth IRA, maximize your contributions to these channels as well.
2. For asset allocation, try to put tax-inefficient investments (such as bonds) into your 401(K). A second choice is long-term aggressive growth funds. 
3. For your taxable accounts, focus on low-turnover index funds. They will minimize your annual tax bill, and when you finally sell your investments at retirement, you'll enjoy all the years of nearly tax-free growth, and, most likely, a lower tax bracket. 

  

11. Entitlement

Where I work, EMC, there's a cool little shop near the cafeteria which sells memorabilia with the EMC logo. You can get an EMC mug there for about $6. My boss recently bought a bunch of mugs and gave them to some of the people in his team, just for the heck of it since he's such a great guy.

If you're one of the lucky guys who got a mug, for how much would you sell it? Remember, they sell them at any time at the cafeteria for $6. Think for a second and write down the number.

Now switch hats. Suppose that you did not receive a mug. How much will you be willing to pay one of your peers to buy his or her mug?

Let's look at these numbers - it makes sense that the average selling price and the average buying price will be the same. After all, they both represent the value that people associate with the mug. Why would people who have a mug associate a different value than people who don't? If at all, people who have the mug should price it low - since the only way they can convert it to cash is through undercutting the cafeteria.

Turns out this is not the case.

In a similar experiment done a few years ago, mug owners were willing to sell it for an average of $5.75. In other words, they, on average, assigned the value of $5.75 to the mug they just got. However, people who don't own the mug were, on average, willing to pay only $3.25. In other words, they assigned a much lower value. Somehow, owning the stupid mug increased its value in the eyes of the owners, even though they had owned it only for a few minutes and hadn't had time to develop any deep feelings. This makes no sense.

I can recognize this from my behavior. I wouldn't buy an old broken iron for a buck, but when I had one, I didn't want to sell it for less than $20 (I ended up donating it.) There are clothes that I have in the closet that I wouldn't buy now even if they were virtually free, but wouldn't get rid of now that I have them. Why is owning
something makes us assign a higher value to it?

Behavioral economists have found this phenomenon to be consistent: a sense of entitlement, or ownership, will raise the value of whatever you have. You won't buy an old clunker for $5,000, but you'll certainly not sell your clunker for less than $8,000. In a restaurant, you won't eat a salty overcooked lukewarm bowl of soup, but if you made it, you won't throw it away and finish it all. If you get a ticket to a show that has a $100 list price you'd rather go and watch the show even if you don't like the band, instead of giving it away or selling it for the $5 it's actually worth to you.

People associate a different, higher value to items that they own. We get attached too easily to what's ours. We also have the tendency to use our cost to estimate the value. This can be especially bad when it comes to investments.

You bought 1000 Microsoft shares for $40 a piece. Now the stock trades for $25 a share. Do you hold? Do you sell? Do you buy more? How much is the stock worth to you?

The objective truth is that the stock is worth $25, no matter how much you paid for it (except for tax purposes, which we'll neglect for the sake of this discussion.) But perhaps you feel deep inside that the stock is worth $40, and you need to wait until the market realizes that it owes you $15 a share and correct its mistake. It is as silly as it sounds, but we all do it.

It's difficult to get over this. One way of coping is to go through the following mental exercise: your shares are worth $25,000. Suppose you sell them and now you have $25,000 in cash. Would you invest it in Microsoft given the current stock price, or invest it elsewhere? If the answer is "elsewhere", sell. If the answer is "Microsoft", hold.

And if you're not sure?

In that case, perhaps you should do what the experts do and switch to index funds.