Archive for November, 2006

The Hudson Institute has a good article on the spending profiles of Americans.

Interestingly enough:

Last year Americans in the lowest income quintile spent an average of $11,247 per person, according to the Bureau of Labor Statistics, compared with $15,843 for middle income quintiles, and $28,272 for the top quintile. The top group is spending only 2.5 times as much as the bottom group, and 1.8 times as much as the middle classes. This is not major inequality.

Tracking spending is vital because it is a better indicator of living standards than income and is a more reliable measure of our confidence in the future. Fortunately,

… a glance at per-person spending over the past 20 years shows that all groups are spending more in real terms. To humbly contradict the soon-to-be Senator Webb, everyone has grown richer over the past 20 years.

The lowest quintile is spending 14% more in 2005 than it was in 1985, the second quintile 16%, the third quintile 11%, the fourth 13%, and the top quintile is spending an additional 16%.

There’s no striking inequality there, especially since people don’t just stay in one quintile. Many have moved up to other quintiles in the 20-year time period as they get older and more experienced and marry other earners.

The Bureau of Labor Statistics data also provide a window on changes in our society. The bottom quintile is spending 120% more on audio and visual equipment and services, compared with the category of TVs and radios from 1985. The top quintile is spending only 31% more. Comcast and Netflix, take note.

Bank of America (with a horde of other banks on its heels) launched its Keep the Change promotion a year ago. Since then, 2.5 million people have been suckered into this folly. Unless you lack even the basest levels of discipline, this is a bad way to save. These days even checking accounts pay interest and there is virtually no reason for your money to languish in a savings account. Even if you do like to keep a rainy day emergency fund in cash, a money market account is a far better option for temporary savings.

Interestingly enough, the Keep the Change promotion was the cunning invention of IDEO (an outsourced design operation) after Bank of America approached them with a request for “ethnography-based innovation opportunities” (an alarming choice of words even if unintelligible). Apparently the target market was boomer-age women with kids.

Most people should have cash lying around in no more than 3 accounts:

1. A checking account [day to day cash needs]
2. A money market account or CD [ 3 – 6 month reserve fund for when disaster strikes ]
3. A brokerage account [ cash sitting in a money market fund waiting for deployment into your stock/bond portfolio ]

Stashing a few cents a day into a savings account which pays an interest rate below inflation is a recipe for the cat food you will be eating in your old age unless you take charge of your financial life.

I have long held the theory that every conversation, if pursued long enough, naturally and necessarily ends with a discussion about the existence of God and our purpose on earth. A few years ago a long lunch conversation reached this point, and an engineer concluded with the statement: “My God is a set of equations.” To which I replied, “What do those equations describe?”

These days it is fashionable among the intelligentsia to declare with newly-discovered transcendence that religion is a good enough thing (if done in moderation) and science is self-evidently worthwhile but we should never, ever confuse the two. The intersection of science and faith, rationalism and mystery, is best left to the final pages of an epilogue in a serious book on science, or to footnotes in a book on faith.

And yet equations are merely an abstraction of the physical world and the Christian faith claims to worship a Jesus who walked in history and a God who created the physical. Why then, have the last few decades produced an intellectual movement so devoted to a separation of faith and science?

In 1931 Godel published a paper which challenged the basic assumptions underlying mathematics and became a milestone in the history of logic and mathematics. I believe that the world is still coming to terms with the philosophical implications of Godel’s Theorem of Incompleteness. Others have better summarized his theorem but it proscribes the limits of axiomatic logic and shows that provability is a weaker notion than truth; in short, there is Truth that we can’t logically prove.

Nagel and Newman, in their classic book on the subject, Godel’s Proof, conclude with the comment:

Godel’s proof should not be construed as an invitation to despair or as an excuse for mystery-mongering.

That might be. But it does, I believe, suggest that if God is a set of equations, those equations lie in a realm of mathematics about which we haven’t even begun to dream.

Many people, after finally saving up a modest nest egg, are faced with the dilemma of what to invest it in. For those who don’t have any interest in spending the rest of their lives following stock tickers and listening to analyst conference calls, the following approach can be implemented extremely easily, is very cost effective, and should take less than 30 minutes each year to maintain.

This approach is suitable for people who a) have saved at least $5,000 and b) are aged 10-60. If you are older than 60 you should probably adopt a more conservative approach. If you have less than $5,000 you should spread your investments over fewer funds else trading fees will dampen your returns considerably.

At a high level, you allocate your investments as follows:

60% stocks

20% real estate

10% bonds

10% commodities

There’s no real magic to this. It just depends on how risky you want your portfolio to be. If you already own a house, I would probably halve the real estate section and increase the rest.

Then the allocation to stocks I break down as follows:

60% US stocks

40% International stocks

That is a good mix given the increased participation in the global economy of the rest of the world and helps guard against currency fluctuations of the dollar.

The US stocks I break down as follows:

33% Large cap stocks

33% Medium cap stocks

33% Small cap stocks

The international equity allocation I break down into:

50% Emerging markets (South Africa, China, India, Brazil, Russia etc.)

50% Developed markets (Europe, Japan, etc.)

For the bond allocation, I recommend a broad-based bond index fund (a mix of long-term and short-term bonds). For real estate you can only really invest in commercial real estate (office buildings, shopping centers, apartment complexes). You then round out your portfolio with an allocation to commodities: oil and precious metals.

Putting that all together works out to the following target portfolio (with ticker symbols and fees of representative index funds in brackets):

12% Large cap US stocks [ VV, 0.07% ]

12% Medium cap US stocks [ VO, 0.13% ]

12% Small cap US stocks [ VB, 0.10% ]

12% International : Emerging market stocks [ VWO, 0.25% ]

12% International : Developed markets stocks [ EFA, 0.35% ]

20% Commercial real estate [ VNQ, 0.12% ]

10% Bonds [ AGG or VBMFX, 0.20% ]

10% Commodities [ IGE, 0.48% ]

If anyone finds a comparable fund with lower expense ratios, please leave a comment and I’ll update this list. For instance, in the emerging markets I have substituted VWO for EEM. The former has fees of 0.25% versus 0.75% for the latter. It should be possible to create a portfolio with a blended fee of 0.14% or less.

I generally prefer the exchange-traded funds as it makes it easier to keep all your investments in one place. I recommend E*Trade for a good blend of low fees, ease of use, and reasonable service. The disadvantage is that you have to pay a fee each time you trade whereas at Vanguard you can add money whenever you feel like without paying a broker fee.

Arranging the list in order of decreasing risk would give:

12% International : Emerging market stocks [ VWO ]

12% International : Developed markets stocks [ EFA ]

12% Small cap US stocks [ VB ]

12% Medium cap US stocks [ VO ]

12% Large cap US stocks [ VV ]

10% Bonds [ AGG or VBMFX ]

20% Commercial real estate [ VNQ ]

10% Commodities [ IGE ]

In the long run, the more risk you take, the higher your returns. The key term is “in the long run”. That’s why as you approach retirement you gradually make your portfolio less risky and weight it more and more towards bonds and fixed income securities. There is plenty of evidence that asset allocation is far more important in determining your eventual return than picking the exact stocks or countries to invest in.

The Barclays iShares web site (www.ishares.com) is the best thing since sliced bread and has pretty much everything you need to get started. Most of the funds are index funds which can be traded through an online brokerage like E*Trade.

Always try to find the funds with the lowest fees. High management fees are a vastly underestimated destroyer of long term wealth. You will always pay higher fees for international stocks and the more esoteric funds. You should definitely never pay more than 0.50% in annual fees. The highest fees are for emerging markets funds and specialty funds which should be around 0.45%. The lowest cost funds, like standard S&P 500 index funds, have fees below 0.1%. Fees tend to come down in the long run so keep reevaluating your choices. Always read the entire prospectus for any funds that you invest in so that you know what you actually own.

One slightly tricky part is balancing your asset allocation across your retirement/non-retirement/tax-deferred accounts. Thanks to the complexities of the US tax code there is no way around having three or four investment accounts. A good rule of thumb is to have the investments which pay dividends in the tax-sheltered accounts and the high-risk, high growth assets in the taxable accounts.

Finally, once you have got your asset allocation set up, you need to rebalance it once or twice a year. Since the various funds grow at different rates, eventually your carefully assigned percentages will be all out of whack. One solution is to add your latest contributions to whichever fund is the furthest off at the time. That way you end up investing new money in the funds which have performed poorly recently (buying low). At the beginning of each year, you can spend 30 minutes rebalancing your portfolio to make sure you remain on target. Resist the temptation to go with the latest fad sector. Investing is a long term discipline.

One last comment:

Your investing will dramatically improve if you read a few solid books that lay the theoretical groundwork for choosing where to put your hard-earned cash. I have read scores of books on investing and I would say that the ones that have most shaped my investing philosophy and have enabled me to outperform the S&P 500 for over 15 years are:

1. Reminiscences of a Stock Operator by Edwin Lefevre
2. The Intelligent Investor by Benjamin Graham
3. Common Stocks and Uncommon Profits by Philip Fisher

Buffet describes his investment philosophy as 80% Benjamin Graham and 20% Philip Fisher. Reminiscences is a classic that has stood the test of time because it so accurately describes the emotional traps that lay in wait for the investor.

Advanced Topic

Finally, there is an excellent website, Asset Correlation, which dynamically calculates a correlation matrix for the major asset classes. It is important to check that you are suitably diversified if you decide to tweak my recommended asset allocation.

I am an engineer at heart. Now, however, I work in the world of finance. I once asked why engineers in start up companies earn so little despite creating so much of the value. My partner’s answer was disturbing. Engineers, he said, want credit for being smart and that’s what we give them. Everyone else wants money, and that’s what they get.

I have another theory too. I have observed that engineers in private companies often have no idea how much of a company they own. They know how many stock options they have, but they have never thought to ask how many shares there are in the company. I once encouraged an engineer to ask the HR manager what fraction of the company she was being granted with her options. She was told that that information isn’t typically divulged and was advised to treat her options like a lottery ticket. I haven’t bought a lottery ticket recently but I understand that they’re only worth a dollar or so!

If you work for a private company, here’s how you can estimate the economic value of your stock options.

First, you need to answer the following questions (ask your friendly CFO for the answers):

1. How many shares are outstanding
2. What was the share price of the last financing
3. How much common stock is outstanding
4. How much preference there is in the company and if there is any multiple
5. Whether the preference has participation.

Ideally, all this information is contained in a one page document called the “cap table” but the company probably won’t just hand it over to you.

What you really want to know is how much preference there is ahead of you. Basically, it works as follows:

Assume there have been 3 financings, series A, B and C. Those 3 financings are all preferred stock and will get paid out before any of the common stock (which is your options). So, as an example, let’s assume that the following financing’s happened:

A: $ 8M
B: $11M
C: $16M

The total is $35M. This is the preference which is “ahead of your options”. Thus, if the company is sold for $50M, the investors in Series A, B, C will first be paid out their $35M and then the remaining $15M will be split amongst the common stock. This is why you need to know what percentage you are of the common stock. Typical %’s of the total stock are

• CEO: 6-8%
• VP: 1-2%
• Dir: 0.5 – 1%
• Eng: 0.2-0.5%

Sometimes, though, the investments are structured with what is called a “multiple” (1.5x, 2x etc). For instance, a 2x multiple on all 3 rounds of investment would mean that there is actually $70M ahead of you, in which case, the company will have to be sold for $70M before the common stock will start to get paid out since the investors will first get double their money before any of the management team and employees get anything.

The other term often specified is something called “participation”. If the preferred stock has full participation, then, (assuming the 2x multiple) after the first $70M is paid out to the investors, what is remaining is then split between the common stock as well as the preferred stock.

If you’ve read this far and know engineers in a private company who can’t answer the question: “How much will you make if your company is sold for $150M?” then please refer them to this article. There’s no need to unionize. But there is a need to demand information.