It seems to me that for the most part blogs on investing focus on the successes of the investors. Generally these blogs make investment suggestions then trumpet successes. Failures certainly seem to be under-reported. In the opposite spirit this is the story of the worst investment I ever made.
Maybe it’s because of the movie but most people I know have heard of the Titanic. My investment was like the titanic in two ways. First, it set out with high expectations and unfounded certainty in the safety of the vessel, only to sink like a stone. Second, it was in the titanic. I invested in the Titanic
No, I’m not wildly old. An investor in the actual Titanic at least had the justification that they were investing in a working ship. Lay-investors probably couldn’t have known that the ship was going to sink (though I’d have liked to have met the man that managed to get short on the Titanic because he thought it was going to sink). What I invested in was the Titanic artifacts, and the salvage rights on the Titanic. You see, a company named Premier Exhibitions had acquired the Titanic artifacts and the salvage rights. These are the guys that do the Bodies exhibition among other things. Someone had signed a letter of intent to buy these assets for 189 Million ($3.78 per share). That deal fell apart due to financing, and as part of it a court set some restrictions on how a potential buyer had to care for the artifacts. However, the company was profitable (barely) At this point I made my first investment when the stock was trading for $2.69 per share, I invested a relatively small amount of capital (2.5%).
The march of doom
The price proceeded to fall from $2.60 to $1.60 because a major holder had partially liquidated his holding. This by itself wasn’t terrible news, it would simply give me an opportunity to buy more of the stock at a discount. (At least that’s what I thought at the time). So I ponied up another 5% of the portfolio. In 2014 the stock fell again. This time down to about $0.85 per share. This drop was different. It was due to the fact that the company was no longer profitable and that they had taken out a loan on poor terms. The company might not survive to realize the value of the assets. I reasoned that I had not invested in the company for its earnings, so that didn’t matter to me, and that shareholders would be driven to make a sale of the titanic assets happen before the company went under. Even if they sold it at a 50% discount I would come out ahead (so I figured). I therefore invested another 7.5% of the portfolio on the way down to $0.85 per share. (Everyone keeping track, we’re up to 15%, obviously this investment was worth substantially less than that now.) The same reasoning applied the following year when the stock fell to about $0.50 per share and I invested another 5% of the portfolio. Eventually my string of errors became obvious to me and I sold, part at $0.50 per share and part at $0.22 per share. (The stock did a 10:1 reverse split so in order to compare these values with current numbers available on a finance portal you need to multiply them all by 10). By the time I exited Premier Exhibitions had fallen a gut-wrenching 92%. If you add up all of my purchases and sales I managed to lose 55% of the money I invested, this was about 10% of my portfolio.
What went wrong
The joke I liked to tell at this point was, what do you call a company that falls 90%? A company that Adam loses 80% of his money on, invests more and proceeds to lose 50% of that money. As far as I can see it there were two large mistakes here. First was that an asset is only worth the discounted values of the future cash it generates. The titanic artifacts weren’t making Premier any money, who would pay $190 million for them? Depending on other people having a irrational attachment to the artifacts was the entire basis of the investment. It didn’t work out. Second, I was excited about this investment. I was losing money on it and I liked trotting it out as an example of me doing badly in the market. I thought that this would balance me out and not get overconfident. The problem was that every time I explained my reasoning, I was just pounding this wrong idea harder into my head. So I’d explain why I thought it was a good idea even though I was losing money, then go and invest another 5% of the portfolio in it! Charlie Munger explained this in a famous speech he gave in 1995:
And of course, if you make a public disclosure of your conclusion, you’re pounding it into your own head. Many of these students that are screaming at us, you know, they aren’t convincing us, but they’re forming mental change for themselves, because what they’re shouting out [is] what they’re pounding in. And I think educational institutions that create a climate where too much of that goes on are…in a fundamental sense, they’re irresponsible institutions. It’s very important to not put your brain in chains too young by what you shout out.
I strongly advise you to read the whole speech called “the psychology of human misjudgment”, it is available here.
So what did I learn? First, diversification is really important, simply because if you are making an error it protects you. I still outperformed the market during the 2013 to 2015 period despite losing 10% of the portfolio because of diversification. Second, I should probably limit myself to only investing a certain percentage of the portfolio in a specific stock even if “better” opportunities present themselves. This might help protect me from confirmation bias in the future. Anyone else have any horror stories about buying individual stocks? I can’t be the only one out there with a massive loser.
I love talking about politics, but in the past have found arguing about politics to be wildly unproductive. I’ve found that the easiest way to talk about politics in any situation is that rather than making a statement such as, X is bad/good, I instead prefer X will probably result in Y. In economics these two types of statements are referred to as positive and normative respectively. The problem with saying something like, “Bernie Sanders would make a bad president” is that you never actually make a testable prediction. How would you be proven unambiguously right or wrong? An argument like that could go on forever. Instead preferred is, “Bernie Sanders will not be the Democratic Nominee.” (Probably true) or “Bernie Sanders will not be elected president.” (Very probably true) or in the case of this article, “If Bernie Sanders is elected president, and he manages to get his education proposal passed in its current form tuition costs will accelerate or quality of education will decline.” Specifically the return on investment from the all-in cost of college measured as change in lifetime earnings will probably drop precipitously.
Bernie Sanders proposal is basically to make college at State institutions free to undergraduate students. Here is a fact sheet from the Sanders campaign. Here is the actual text of the bill. Basically the idea is to provide 2:1 matching funds to States for the purpose of making tuition at their public universities $0. This would be paid for by imposing a tax on stock, bond and derivative trades. Sanders claims this will generate $300 billion.
The supply/demand problem
The price system is a core part of the market economy. The law of demand is that, in general, if the price of good/service to the consumer is reduced more will be demanded. If more college is demanded how will that demand be satisfied? Supply must be increased. The law of supply says that more of a good will be supplied if the price to suppliers increases. Therefore, one of two things can happen. Either universities become more restrictive about whom they accept, or they supply more education at a higher marginal cost. This cost will now be born by State and Federal taxpayers. The fact sheet from the Sanders campaign claims that states must meet requirements to reduce “ballooning costs” in order to receive the matching funds. I can’t find anything in the bill to support this. The only thing I can find in the bill is provisions that ensure that costs will never stop going up. Specifically Title I, paragraph c, point 1: “a State shall— … ensure that public institutions of higher education in the State maintain per-pupil expenditures on instruction at levels that meet or exceed the expenditures for the previous fiscal year”. Cost is guaranteed by the bill itself to increase. Furthermore the other provisions which set out the requirements for states to get the matching funds also have the effect of driving up costs: 75% of instruction will be required to be provided by tenured or tenure track faculty. This simply costs more than the alternative. If you think that university costs are currently overpriced this plan won’t fix that problem. It simply shifts the costs from one group of people to another. This is a really bad way to allocate scarce resources. Speaking hyperbolically this will draw educated people into an industry of creating more Bachelor’s of Arts in Basket Weaving. While education sounds good and you might think that having a more educated populace will improve the economy, misallocation of scarce resources (in this case smart folk who could be educators or do something else) will do more damage to the economy.
The tax problem
I can’t seem to verify the Sanders campaign’s numbers on the amount of money to be collected from the tax. As far as I can tell they just estimated the total dollar volume of transactions in the US multiplied it by the proposed tax rates, got something near $300 billion and called it a day. Fortunately, it appears as though the total cost of the program in the first year would be somewhat more than $70 billion. The main problem here is that trading volume in the US is assumed not to react to this new tax. Over 60% of trading volume in the US is high frequency trading. Most of those trading strategies flatly would not work if this tax was imposed. Therefore, volume would probably decrease substantially. My second testable prediction therefore is, in the first year the tax being in effect the program will collect less than $150 billion (obviously adjusted for economic growth from the date of the proposal to the year it actually gets implemented). Basically the tax interacts with stock trades according to the same laws that the subsidy interacts with higher education. The reduced proceeds lowers supply and the increased cost reduce demand. The question is what will be the amount of economic destruction (deadweight loss) caused by this tax? This gives my third testable prediction, the spread (defined as the difference between the bid and the ask) on stock trades will average at least 0.5%. Rather than having a bid of 31.56 and an ask of 31.57 we’ll have a bid of 31.50 and an ask of 31.64. This unfortunately means that the total cost to people buying and selling stocks won’t be 0.5%, but rather will be more like 0.75%, 0.5% for the tax and 0.25% for the spread*. In my view a tax that destroys at least $75 of value for every $50 of revenue is a bad tax.
I’m not saying all proposals to reduce the cost of higher education are bad. Don’t fall into the trap that politicians love to lay out. 1) A is a bad thing. 2) We must do something about A. 3) B is something! 4) Therefore if you oppose B you must like bad thing A. That being said its probably a bad idea to simply criticize something without offering a solution. My suggestion would be to restore regular bankruptcy treatment to student loans. Markets work best when the person risking the money is the same as the person making the purchasing decision. The job of a bank is to make sure that it weighs the risk of not getting repaid appropriately. When you take risk out of the equation for a bank, it ceases to behave responsibly. If the bank has skin in the game, its interests are aligned with the student. The bank then needs to make sure that the student is getting their money’s worth for the education, because if the student doesn’t get their money’s worth the bank doesn’t get repaid. In our current system the bank gets repaid no matter what, “education” and loans get foisted on young folk and taxpayers are left holding the bag. So goes my last prediction. If we go back to the system we used to have, where bankruptcy was an option for student loans, the rate of tuition increase will slow and the return on investment of a college degree will increase (again measured as a change in lifetime earnings).
*The spread is a zero sum game. The total spread is 0.5%. Someone pays that portion of the spread in each transaction. You may think that if you put a limit order in then you personally will be safe, however you have no guarantee to sell or buy at your limit price. The price could move in the other direction without you being able to make your transaction. I figure split the difference and say that a person pays half the spread on the round trip.
One question that comes up a bunch when you are starting to save seriously is whether to save in your work’s 401k plan or through your own IRA. We’ll talk about the difference between a Roth IRA/401k and traditional IRA/401k later but for now let’s assume we’re talking about traditional retirement accounts. The arguments will probably apply to both however.
The best advantage of a 401K is that you often get matching funds from your employer. Free money is free money. If your work offers a match and you aren’t taking advantage of it you’re commuting a worse financial crime than using high interest credit cards. It’s that bad. Stop eating out, cancel cable, do whatever you have to do to get the match. (Okay, don’t stop paying your mortgage.) (Do move into a cheaper place though). Another advantage is that since businesses are large institutions sometimes they can negotiate better deals on fees. Sometimes there are worse fees though and you should make a comparison so that you know. One of the last advantages is more restrictions. Generally in a 401(K) it’s harder to get your money out because you need permission. You won’t wake up one day and decide to buy a boat emptying your retirement to do it. You may think that only other people make mistakes like that, but that’s what they thought too, until it wasn’t.
The biggest advantage of the IRA is flexibility. You can choose almost any traded investment under the sun. You can hold gold or even real estate through an IRA. This is a huge advantage over 401(K) plans. Sometimes this means that you can find a better deal on an investment product like an index fund because you have more capability to shop around. You also have some more flexibility when it comes to taking your money out. Worse case scenario you pay regular taxes + 10%. You are never at the mercy of someone else telling you that you can’t have your own money. You might also find it a minor advantage that when you leave your job you don’t have to do any paperwork.
There are some tiers here. First thing, you need to put enough in the 401k to get the maximum match. Just do it, you think you’ll miss the money but you won’t. Sell anything that somebody will pay a buck for, go back to the article on ways to make money you haven’t tried.
Now there is a corner-case where you might not want to take the match. If the 401(K) plan is really bad and charges 2% more in fees annually than the investment you could make in your IRA and you are certain you’ll be in this position for the next 32 years. Then, and only then, invest in the IRA for the first year before getting the match in the second year and so on. That’s because the additional 2% in fees you don’t have to pay compound to a doubling over ~32 years. This is such a ridiculous scenario I feel dumb even suggesting it, but it goes to show how crazy the scenario has to be for you to skip the match.
After you’ve gotten at least the match it becomes a lot closer of a decision. If you think you’re an investment expert, you should probably just go with the 401(K). You need the restrictions because if you need this question answered for you and you think you’re an expert you’ll probably lose all your money. It’s a blessing that your 401(k) has some basic guardrails. Take advantage of them. If you’re very even tempered and are willing to read a bunch of textbooks on the subject of investing you’ll probably be better off with the IRA. Keep in mind that you still need to be careful. You’re in competition with professionals and you’re turning the bumpers off.
If you’re contributing more than the limit of your preferred one just try to max out both. Tax shelters are awesome. Use them. People constantly complain about the tax shelters the rich use and the reality is that they pale in comparison to the tax shelters the middle class has access to. Plan carefully enough and someone making $40,000 per year could pay zero income tax. Use your tax sheltered space!
Step 6: Register a Business Name
This is sometimes called a DBA (stands for “doing business as”) name. This turned out to be flatly easier than I really anticipated it to be. The SBA webpage has links to different state webpages. The one for Colorado, which I’ll be using as an example is here. Click on the “File a business document” link.
Finally in order to register my sole proprietorship I need to click on the “Trade Name” link.
Here we are at yet another screen. Makes you wonder how many forms there must be to have this many layers of this many options…
Now that we’re onto the form you’ll notice that we’re going to get charged $20. A surprisingly reasonable fee in my view. To be entirely honest I thought this was going to be somewhat more expensive. The form starts out straightforward. What’s your address etc. You’ll need to know what you want your “trade name” to be. The question here is, “what is the name of your business”. Hopefully you can answer that by now. There’s an additional section I found interesting though. The “delayed effective date”. Why would I want this?
This could be useful if you were converting a sole proprietorship to some other form of entity that was taxed a little differently. By filing with a delayed effective date you can make sure that the business takes its new tax treatment exactly on the first of the year or something useful, so that you don’t have to file an extra form for one year. Additionally, sometimes States get swamped with new business filings. If you wait until you need the business created then choose for it to take effect immediately you may have to wait longer for confirmation. If you file in advance and choose the delayed effective date you can control what day it begins on because you’ll be at the front of the line.
Step 7: Get a Tax Identification Number
To apply for an EIN (employer identification number) you have to go to this webpage. You can also do it by mail, but honestly, how crazy would you have to be? (Very). Judging from this questionairre I’m actually not required to get an EIN. I think I’ll go ahead and do it anyway, maybe I’ll end up hiring a secretary or something.
Fortunately the process is pretty simple. We do need to keep track of the Doing-Business-As name that we signed up for in Step 6. All-in-all this turned out to be more intimidating than it was difficult. Looking at all this I start to wonder how hard it would actually be to hire an employee.
Reading is simply the easiest way to cram a lot of new information into your skull. I’m a little skeptical that it does quite as much good if you end up reading exactly what everyone else is reading. With that in mind here are three books I bet you haven’t read.
Early Retirement Extreme by Jacob Lund Fisker
This is a fundamental reworking of how you view personal finance. I have always summarized the argument as, if you are an environmentalist libertarian you only need to work for five years. Jacob points out the massive waste and fragility of consumer society. He points out that if you’re willing to live in a house the size of your grandparents, drive a car as often as they did, and prepare your own meals in an efficient fashion you can probably save 80% of your income. You then invest this savings as you wish over five years, after which you are financially independent and no longer need to work. The book details a philosophy and grounding theory for the whole framework. It reads like a technical manual for quickly achieving financial independence, which it basically is.
I might be cheating with this one, maybe you have heard of it. If you have or haven’t pick it up again as it’s a fast read. It was originally published in the 1920’s and details the advice of the so-called Richest Man in Babylon. It probably doesn’t have any advice you’ve haven’t already heard in some form or another. It does drive home precisely how you should think about money. An exchange early in the book goes thusly:
Then he looked at me shrewdly from under his shaggy brows and said in a low, forceful tone, “I found the road to wealth when I decided that a part of all I earned was mine to keep. And so will you.”
Then he continued to look at me with a glance that I could feel pierce me but said no more.
“Is that all?” I asked.
“That was sufficient to change the heart of a sheep herder into the heart of a money lender,” he replied.
“But all I earn is mine to keep, is it not?” I demanded.
“Far from it,” he replied. “Do you not pay the garment- maker? Do you not pay the sandalmaker? Do you not pay for the things you eat? Can you live in Babylon without spending? What have you to show for your earnings of the past mouth? What for the past year? Fool! You pay to everyone but yourself. Dullard, you labor for others. As well be a slave and work for what your master gives you 12 to eat and wear. If you did keep for yourself one-tenth of all you earn, how much would you have in ten years?”
Basically everything you need to know about the standard theory of personal finance is in this book. Everything else is execution.
Reviving the Invisible Hand By Deepak Lal
This is an economics book which details why free markets are effective and how the fall of the first liberal economic order under the British empire caused a whole host of problems. It also covers the benefits of the current second liberal economic order under the United States. The book is full of all sorts evidence about the nature of capitalism and why things like free trade are so important. It covers almost every facet of classical liberal thinking. The citations often take you to economic papers which will get you well versed in the literature if that’s your thing. It is otherwise a completely indispensable book if you are currently a socialist. Nothing is more important in finance and investing than trying to figure out what’s actually going on compared to what you wish was going on. If you don’t have at least a cursory understanding of what your opponents actually think rather than some nonsensical straw men you’re going to have a bad time. If you already view yourself as a classical liberal it is still probably worth reading because of the sheer volume of information. I thought myself well versed on the subject and I couldn’t go a chapter without learning something really useful. One example stands out, “Why is an above market return on invested capital not a sign of market failure?”
What’s the most reliable way to identify an amateur at a poker table? I’ll give you a hint, it’s not the guy making mistakes. It’s the one who gets loudly angry at him for making mistakes, when he loses in an unlikely fashion he just can’t stand to keep his mouth shut and just has to explain at length why he shouldn’t have lost and why the other guy made such a big mistake. In poker, you want your opponents to make mistakes, why would you explain what they did wrong? The reason is that the amateur’s sense of self-worth is wrapped up in winning each hand. If he* loses, to soothe his ego he has to explain why he made the “right” decision and the other person made the “wrong” decision. He* has traded his ego for future profits. I hope that I’m not showing off my amatuerishness doing precisely the same thing here.
I read this (If You Have Savings In Your 20s, Something’s Wrong) article. Please take a moment and read it, or at least the opening few paragraphs. I suppose if the author, Lauren Martin, decides to use all of her savings eating out, buying clothes and going out at night, all the better for me. The dollars she spends wind up (in a very small part) going into my pocket. In a sense this is a perfectly fair transaction. She works at a magazine which earns money in part by selling advertisements for companies I own (like t-mobile), through a broker (looks like google ad services) that I own, then spends that money at businesses that I own. I’d be willing to bet that she hasn’t gone a day without somehow giving a little bit of money. How do I achieve this feat? Well, I contribute to a 401(K) type plan (here’s what she had to say about those):
When you care about your 401k, your life is just “k”
When you’re 40, you’re not going to look back on your 20s and be grateful for the few thousand you saved. You’re going to be full of regret.
You’ll regret the experiences you didn’t take, the people you didn’t meet and the fun you didn’t have because you were too worried about a future that came and went.
I’m not quite sure what kind of world it would be if the difference between me saving 10% of my income and saving 0% of my income caused me to miss out on a lot of experiences, people, and fun. Honestly, I find that the first dollar I earn is really important to me, the second dollar is less so, but the last dollar I earn? It isn’t critical to my happiness, people may find it hard to believe, but I don’t miss my 401k savings.
Now I’m inclined to think this is all okay. I don’t need to consume everything I earn right now to be happy, evidently this girl does. We’ve found an agreeable arrangement where I provide my capital to businesses which are required to keep Lauren happy. In return I get to earn a profit on that capital. Fair deal, right?
They want us to save because it provides us with a safety net, but that’s exactly why we shouldn’t. Their need for us to have a safety net is just a giant metaphor for the difference between our parent’s generation and ours.
The only problem that I have with this is that I don’t honestly believe that Lauren has thought this all the way through. She seems to think that money represents safety. It can. If you have a nest egg you are more capable of dealing with problems as they come, but that’s not the real reason. You buy insurance for safety. If you lose your job, that’s what unemployment insurance is for. If you get sick, that’s what health insurance is for. If you become disabled, disability insurance. If you die, life insurance. These are important things to have, and you often need a little savings to supplement them. However, it is not the reason that we save.
The Real Reason to Save
Freedom is the real reason. Savings give you options. Options that folks that won’t save don’t have. A little savings gives you a few options. If you save up six months of expenses that’s six months of your life that you can do anything you want with. I had a close friend that also has the savings bug. I’ve not seen her deprive herself of the company of friends or eating out in my memory. Nevertheless she managed to save some money. Last year she quit her job to go study a language in Europe for six weeks. According to her it was an irreplaceable experience. Someone who spends every last dime doesn’t have that kind of flexibility in their lives.
What if you save more money?
Six months of expenses is enough to allow you to quit your job and not worry. You’ve got plenty of time to find another one. What if you save more though? The 4% rule is a common rule in early retirement the basic idea is that if you only spending 4% of your invested capital annually you will probably never run out of money. You could spend the same amount (adjusted for inflation) every year and more likely than not end up with more money by the day you die. That means to quit your job (permanently) you just need to save up 25 times this year’s expenses. (Granted that’s a massive amount). It also means that if you save up 6 years of expenses, you would only need to cover nine months worth of expenses out of a year. You could take a 3-month sabbatical to somewhere new every year, forever. If you save up 12 years of expenses, that’s only half the year you need to work. The profits from all the 20-somethings in the world spending their every last dime “enjoying life” really add up, don’t they?
I couldn’t enjoy my life because I was too busy worrying about my bank statement. I was too busy watching my savings instead of savoring my youth.
Lauren really hits the right sentiment here. This is a personal finance blog. We think about bank statements here, but we think about them so that we don’t have to worry about them. Savoring life is deeply important. Fortunately, it’s possible, even advisable, to do that with less money. Ultimately, I think the approach of Thoreau (28 when he went to Walden) rings truer to me than Lauren’s. He said:
I went to the woods because I wished to live deliberately, to front only the essential facts of life, and see if I could not learn what it had to teach, and not, when I came to die, discover that I had not lived.
Thoreau kept a very careful account of all the money he spent over the two years at Walden pond, it works out to roughly $870 in today’s dollars, I guess he didn’t need to spend money to enjoy life. My suspicion is that he had the more memorable time.
* Yes, I know I’m using the male pronoun here. There is a simple reason. I’ve never once in my life seen a female poker player behave this stupidly. Perhaps I’m being sexist. If someone can provide me an example of one woman they’ve ever seen do this I’d be happy to edit into the he/she construction.