5&7 Plan

The idea is so simple, it is surprising that no one (that I have heard about) has proposed it.  One big problem the US government faces is the enormous pile of mortgage-backed debt held by Fannie Mae and Freddie Mac.  Another problem is that many “home owners” are underwater with their mortgages.  [How can you be a home owner if you have negative equity?]  Finally, the popping of the housing bubble continues to be a drain on the US economy.

The solution I propose is making interest on mortgage-backed securities tax free for five years.  This plan would immediately drive up the value of these “toxic” assets and drive down mortgage interest rates below historic lows.  This would provide a tremendous boost to Fannie and Freddie and even the Federal Reserve.  Increased demand for tax-free MBS would spur banks to issue more mortgages under easier terms, which would help prop up home prices.  Naturally, fewer home owners would be under water.

This would also be a boon for investors, giving them access to another tax-free asset class.  The incentive of tax-free MBS would be so powerful, it would threaten to take money away from tax-free municipal bonds.  To help offset this risk, part II of my plan would make long-term capital gains on municipal bonds tax free for seven years.  Like Cain’s 9-9-9 Plan, my plan would have a numeric title, the “5&7 Plan”.  (To avoid confusion with the 5-7 Pistol, the “&” symbol is used rather than a dash.)

The long-term capital gains provision gives investors an incentive to hold municipal bonds for at least one year.  The extra two years for municipal bond gains gives investors an added incentive to hold long-maturity municipal bonds.

The 5&7 Plan would expand the tax-free bond universe and introduce the concept of tax-free interest investing to a new group of investors… the middle class.  Typically only high-income earners benefit from tax-exempt bonds because they offer lower interest rates than taxable bonds.  Because high-income taxpayers face higher marginal tax rates, tax-free municipal bonds make sense despite lower interest rates.  If the 5&7 Plan becomes law, higher-yielding MBS will become lucrative to savvy middle-class investors.

I encourage the 2012 presidential candidates to consider adopting the 5&7 Plan.  I could see Romney offering the 5&7 Plan as a way of “cleaning up Newt’s Fannie and Freddie mess.”  Similarly I could see Gingrich pitching the 5&7 Plan as a way of “fixing the Democrat’s Fannie and Freddie problems.”  Finally, I could see Obama selling the 5&7 Plan as “an innovative way to clean up America’s mortgage crisis”.

If the 5&7 Plan gets enough press, it will revitalize the mortgage debate.  It will help turn the debate towards real solutions and away from political blame games.  And, if passed, 5&7 will energize the mortgage and housing markets in explosive ways compared to the tepid response all the other failed legislation of the past 3 years.  If you like the 5&7 Plan, share this link.  If you don’t, please share why.  I will publish all non-spam replies.  Let’s get the 5&7 debate started!

1. Your boss/company. Ask yourself first if you had a good year. If so, do some research on at you should expect to be earning.  Try starting with Glassdoor.  If you are not making what you want and are not moving in the right direction, consider moving to another company.  But, be sure to do through research and then line up a job (in writing) before giving your notice.

2. Politicians.  Are you getting reasonable benefit for your taxes?  Grade by region.  Here’s my grading:  City C, County B, State B+, Federal D.   If your grade is C or less, consider voting the bums out!

3. Social Security.  Ever work out the rate of return on your projected Social Security payments versus the amount you have and will put in.  Mine is about 0% return.  And that is *if* I ever get *any*.  Not much you can do about it, but something to consider when planning your own retirement…. What if I get nothing from Social Security when I retire?

4.  Investment Adviser.  How does my return stack up to A) The S&P500 total return (including dividends)?  B) A 100% bond profile such as Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX)?  If, overall, it is under-performing both, fire your adviser.  If it beats one… ask questions like why it didn’t do better.   If it beats both, ask “what risks are you taking with my money!”?  If you are your own investment adviser ask yourself the same questions.  And, if you decide to fire yourself, consider getting advice from someone reputable and sane like Vanguard.

5.  Your credit score.  Know your credit score (FICO score).  Guess what?  If it’s below 711, it’s below average! [Technically below "median", but let's not split hairs.]  720 used to be golden, but today 750 is the new golden score.  In some cases 770.  If your score is below where you’d like it to be, start getting financially fit.  And remember, success doesn’t happen overnight.  Success takes time.

Baseball before Moneyball

In a word: stats.  Baseball has statics for almost anything of relevance that happens on the field.  Finance has statics like expense ratio, yield, price-to-earnings ratio, total return, alpha, beta, R-squared, Sharpe ratios, and the Greeks (delta, vega, theta, rho)… just to name a few.  I  suspect most of my readers are more familiar with baseball stats like batting average, on-base percentage, slugging percentage, OPS, ERA, K%, BB%, GB, and the like.

Today’s blog will start with the simple concept of batting average.  In baseball batting average is the number of hits divided by the number of official at bats.  Since a typical baseball player can have 400 at bats per baseball season, there is a lot of statistical significance to his batting average for one year.

In contrast, a fund manager could be said to have about 4 at bats per season — one per quarter.  It would take a 100-year career to have as many “at bats” as baseball player has in one.  Even if you decided to count fund performance on a monthly basis, it would take 25 years to match a baseball season’s worth of data.

The most common financial definition of batting average counts a hit as outperforming the market (say the S&P 500) over a given time period, say 3 months.   An out is under-performing the market.  Generally a .500 batting average is analogous to the the Mendoza line in baseball.  Sadly, many fund managers and financial planners bat below .500.   And often those that do exceed .500 get there by early luck… luck which generally fades (back below .500) with time.

Just like in baseball batting average is not the most useful static in finance.  OPS (on base plus slugging percentage) is probably a better financial stat… if it existed.  Instead financial stats like Sharpe Ratio and alpha fulfill a similar role of financial performance measurement.  The problem with all these financial stats for measuring fund managers is there are simply not enough “plate appearances” to reliably measure a fund manager’s performance until his or her career is almost over!   It is only after a long financial career that the difference between skill and luck can be accurately sorted out… a bit late I’d say for investors looking to pick fund or fund managers.

There is a factor other than stats that financial and baseball matter share.  In a recent conversation someone mentioned that baseball is the only major sport where the player scores [directly].  In other words the runner himself (herself) scores by getting safely to home plate.   Basketball, football, and hockey require an object (ball or puck) to cross a threshold.  Football requires a ball + a player to score a touchdown, but a field goal does not directly require a player to fly through the uprights!  Only in baseball does the player himself score a run.

This analogy can be extended to the idea that the investor herself can be the only thing that matters (that scores).  At the end of the day it the investor who determines how successful she is at meeting her financial goals.  The Sabermetrics of finance may help her get there, but ultimately it is the investor herself who has a winning, losing, or World-Series-Championship financial season.

For example if a CD (Certificate of Deposit) is paying 6% it will double in 12 years because 72/6 = 12.

The rule of 72 can be used for decreases in value, such as inflation.  If inflation is 4%, money under a mattress loses 4% per year in value.  Because 72/4 = 18, that money’s value will be cut in half in 18 years.   So positive returns divided into 72 tell how long it will take your investment to double and negative returns how long to lose half its value.

The rule of 72 provides convenient illustration of how fees can effect an investment.  Let’s say you are considering two investments in your IRA managed by your brother-in-law Sam.  Option A is to buy and hold SPY, an index fund that has an expense ratio of virtually 0% (0.09% actually) or option B tracking the same index  but managed by the Sam’s company with a 2% expense ratio.  Sam says “Hey buy my index and I get a commission and a chance to win a boat.” Using the rule of 72 you see that 72/2 is 36, meaning Sam’s index will only be worth half of SPY in 36 years.  If you are 29 years old and want to retire at 65 (in 36 years) that’s half of your retirement money!  Tell Sam to find some other sucker to win his stupid boat.

Cost of 2% based on the Rule of 72

Finally you can use the rule of 72 together with inflation and expected return to plan your financial future.  If you expect a 7% (nominal) return on your retirement portfolio and 3% inflation, that’s a 4% annual return, so your money will double — in inflation-adjusted terms — in 18 years.  Now if inflation is 4% your real return is 3% and your real investment value will double in 24 years; that’s a whole 6 years longer.  Possibly 6 more years until you retire.  Add a 1% management fee and your real return drops to 2% and doubling time is now a whopping 36 years.  Yes, even a 1% fee can cost you 12 more years until you retire!

The example above shows the destructive power of inflation and why even a 1% annual inflation underestimation can be a big deal.  For tax payers that means tax brackets (based on the government’s CPI-U) gradually form an increasingly tight straight-jacket around your take-home pay.  For Social Security recipients this means cost of living adjustments that simply don’t keep up with real world expenses.

The rule of 72 is a powerful tool for financial estimation.  The rule of 72 is not perfectly accurate, but it is generally pretty close to the target.  It is, however, easy to use and can be used to explain financial concepts to people that aren’t that “mathy”.  It is a great way to start explaining finance to kids; while being a tool powerful enough that is also used by Wall Street pros.

Investing in Rental Property

I have been a rental property manager (landlord) for just over two years now.   I’ve learned many things; two stand out:

1. Residential real estate can be a great investment.  Rental real estate can provide steady cash flow, excellent asset diversification, favorable tax treatment… all with modest capital gains potential.
2. Rental real estate can be a real pain to manage at times.  Both tenants and repairs cause headaches.

I currently own one rental property through my LLC.  Because of item #2 above, I’ve recently turned over the property management to property management company.  This choice will probably reduce net revenue about 10-12%, but will help take much of the stress out of finding and screening new tenants and dealing with repairs and tenant issues.  If things work out well, I will consider purchasing a second rental property.

In my local real-estate market it is reasonable to expect about 5-6% net income on a fully-owned rental property.  And over a 30-year period I conservatively estimate 1.5% appreciation.  Further since real-estate prices are a large competent of cost-of-living and inflation, real estate makes a good hedge against real inflation.  Finally, just as property values tend to go up, so do rental rates.  Simply put, residential real estate is the best long-term inflation hedge I’ve found.

The flip side of rental property is the eventual likelihood of landlord/tenant issues ranging from breaking the lease, to late or unpaid rent, to property damage, to eviction — just to name a few. Vacancies without rent can really take a bite out of your cash flow.  Properties can drop in value, and marketable rental rates can fall dramatically.

Somewhat of a wild card is the tax treatment of rental properties.  In the “pro” side are depreciation of the structure which can be deducted, and the fact that “passive income” like other investment income is not subject to Social Security tax.  On the “con” side is that fact that nothing can offset “passive income” except passive losses (and vise versa).  Owner’s of rental real estate (or at least their accountants) will become very familiar with IRS Schedule E of their income taxes.

Rental real estate is not for every investor.  Personally I wouldn’t recommend buying rental real estate until you have a minimum of $250,000 net worth.  Managing a rental property can be time-consuming and challenging.  Alternately, finding a good property management company is also a real challenge.  And unlike infomercials and “Rich Dad Poor Dad” author Robert Kiyosaki suggest, real estate is not a financial panacea.  However, for some higher net-worth individuals, rental residential real estate is worth considering as part of their investment portfolio.

I’ve been reviewing which topics and blogs have been the most popular.  Computing beta was the most popular topic, followed by my CBOE visit, then financial baseball.  Popular searches were what CPI stands for, bitcoin inflation, entrepreneur jobs, possible investments and living below your means.

Some analytics stats are better than last year, some are worse.  The most improved stat was time per visit which is up 70% to 2 minutes and 6 seconds per visit.

Finally, the financial blog has passed 150 blog posts.  This blog post will be #156.

There were several interesting articles, and a few that did not strike my fancy… involving MACD and other technical analysis methods.  Overall I found it a worthwhile read.

First and foremost I found the reference to CPI-U and shadowstats.com to be the most exciting aspect of “Futures”.  I have long been a casual follower of ShadowStats (SGS) and I was pleased to see in print what I have seen online.  What Wall Street and many economic statisticians understand is that the government-reported CPI (specifically the CPI-U) has become a bogus indication of inflation.  CPI-U  remains relevant because of it is tied (directly or tangentially) into many things such as Social Security benefit changes, COLA and TIPS.  CPI-U is a “headline number”, but many on Wall Street use their own inflation models.  These Wall Street models routinely show CPI-U to understate actual inflation.

Here’s the deal.  U.S. Bonds today, while “safe”, simply do not keep up with inflation.  Their performance in taxable accounts is even worse.  The same holds for money markets and savings accounts.  This knowledge is part of the inside baseball of finance, that I like to call financial baseball.  For the investor that wants to keep up with inflation, this “inside knowledge” pushes them towards riskier investments including stocks (and stock ETFs), junk bonds, and international stock and bond investments.  The bottoms line is that investing is either more risk-prone or inflation-ravaged… or a combination thereof.

I will divulge that I have been much less vigilant with my spending habits this year.  Since my girlfriend and I have stable, high-quality jobs and our financial strategies have been reasonably successful, it has been easy to indulge a bit.  One indulgence has been adopting two wonderful rescue dogs.  We spoil them, and they eat a lot.  I figure they collectively cost $4000/year.  We enjoy their company greatly so the price, while steep, is worth it to us.

I used to be a master of savings.  Now I am merely pretty good living below my means.  I still have the extreme saver know-how, but I am no longer living the extreme-saver lifestyle.  I am living the disciplined saver lifestyle.  I say this because I am sensative to the fact that my finance blog readers are in a wide variety of financial positions.  I am a strong believer in living below your means, especially in your accumulation (savings) years.

I always found a job, because a) I needed the money for college, b) I was willing to take what I could find.

Now that I am a professional I have steady work.   I’ve also continued to be an entrepreneur as I worked.  If I was laid off and couldn’t find work I’d like to believe that I would continue to pursue my entrepreneurial effort.  I’d take part-time work (like I did during my school years) to pay for the basics.

I write this after having returned from an internet entrepreneurial group meetup.  I get to meet and reacquaint with other entrepreneurs at varies levels in the entrepreneurial process, from “haven’t a clue, just getting started” to “been self-employed for 20+ years”.

If your are unemployed, I’d encourage you to consider what job you would like to create for yourself.  Sure, keep applying for “regular” jobs to, and if a good-enough one comes around, take it.  In the mean time apply yourself to developing your own small business.  I recommend something with low start-up costs, and something that you have a passion for.  You may find yourself developing new and valuable skills in the processes…  Discover talents you didn’t know you had.

You may, just may succeed in creating a wonderful business.  Even if you don’t, you will learn more about yourself, your talents and what you really like (and don’t like).  So when you do land that cushy corporate job, you will have a better idea of how to shape your career.  Even after landing that job, you might find yourself dabbling in entrepreneurial enterprises.

Marijuana Plant in Pot

As a non-user of marijuana, I find it interesting and unfortunate that many other non-users are opposed to marijuana legalization.  My  argument starts fiscally.  Illegal marijuana is a net cost to society.  It finances crime syndicates both in the US and particularly Mexico.  Illegal marijuana also poses several direct fiscal burdens:

1. Law enforcement costs to arrest and pursue marijuana use and sale cases.
2. Expenses to incarcerate marijuana transporters, sellers, buyers and users.
3. Cost of taking employed users away from their jobs and family.

Conversely, legalized marijuana provides fiscal benefits:

1. Decreased law endorsement expenses.  Law enforcement can focus on under-age (under 21) marijuana crimes.
2. Decreased incarceration expenses.   Freeing non-violent users (and sellers) from prisons will save tremendous sums of money.  Further not incarcerating such people in the future saves money.
3. Otherwise law-abiding individuals will retain jobs.
4. Tax revenue can be collected on legal marijuana.

That is just the beginning of my supporting argument.   Think of the other “Freakonomic” effects of marijuana criminalization:

1. Drug violence in the form of turf wars and transportation route protection (esp. at border crossings).
2. Financial support of other illegal enterprises, such as human smuggling and weapon smuggling.
3. Lack of quality controls (regulations) leading to contaminated (with pesticides) and laced marijuana leading to sickness, disease and occasional death of consumers.

Please note that I am NOT advocating the use of marijuana, in the same way (as a non-smoker) that I do NOT advocate the use of tobacco!  I avoid both because of their negative health effects.

However, I do use alcohol.  I like microbrew beers, fine Scotch, and assorted other libations.  I have done some research and have learned that 1-2 alcoholic drinks per day is an overall  health-enhancing activity.

I liken marijuana prohibition with alcohol prohibition in a few ways.  For example, both have lead to increases in organized crime and related violence.  And both reduced sales tax revenues.   Further, both moratoriums have lead to poor quality products… such as blindness induced by the lacing of ethanol with methanol during Prohibition.

Now I switch gears to the ethical arguments.  I have seen a loved one die of cancer and cancer-induced starvation.  Cancer and chemotherapy frequently leads to nausea and vomiting.  These are miserable symptoms and lead to weakness and premature death.  The 70-something person I refer to was a vital, strong and healthy person before cancer struck.  He could do manual labor in his 70s that 30-year-olds would struggle to do.  And his mental faculties were also razor sharp.   Nonetheless his cancer deprived him of the ability to eat and retain food.  This reduced his weight from a trim 165 pound pre-cancer 6’1″ frame to a sad 110 pounds.  I personally believe, based on my research, that marijuana would have helped his appetite and nausea, which would have greatly improved his *quality* of life.

There you have it.  Financial and ethical arguments for the legalization of marijuana.  Note, I don’t couch the arguments in terms of medical marijuana… I speak in general terms.  I have had friends and dare I say colleagues who have used marijuana.  Some of whom have retained great talents and intellects.  On close inspection I have seen their short-term memory impaired in a manner similar to that produced by overindulgence in alcohol.   In my college years I have “babysat” many an alcohol overdose “patient” including one time we had to call 911.  Conversely, I never had to “babysit” a marijuana OD person.  My research confirms that anecdotal evidence.  Cliff Notes version: “Alcohol OD bad, marijuana OD… virtually impossible.”

It makes no sense to make marijuana illegal.  Tobacco and alcohol are arguably more dangerous… but society has wisely seen clear to regulate rather than prohibit their sale and use.  Marijuana should be no exception.

I’m happy to say the Ivan Account has beaten the S&P500 slightly so far this year.  I haven’t crunched the numbers, but I’d wager it has also done so with less volatility than the S&P500.  The best thing though is that I can channel my financial energy and emotion through this account, while leaving my other, larger nest egg largely untouched.  Plus making low-cost, tax-deferred IRA trades is fun. Bonus!

Even if the Occupy Wall Street movement has a financial focus, the term “Wall Street” is just too overloaded.   And that is assuming the folks gathered there are focused on financial institutions and markets.  Some are protesting the Federal Reserve, others the Government, others corporations, others still capitalism.  Most are upset about our crappy US economy.

I think much of America looks at the financial world as a mysterious black box, or as a series of opaque entities tied together in a labyrinth only a few now how to navigate.

Some view this financial black box as useful.  They invest in mutual funds, stocks, bonds, and ETFs.  They take out mortgages and buy insurance.  They trust their investment advisers, or go it alone and trust in themselves.

Others view the financial black box as a “wretched hive of scum and villainy”.  Some from this group are part of Occupy Wall Street.

I have many good things to say about the version of “Wall Street” that I use.   However, I am critical of many parts of Wall Street that I don’t use.   Number 1 on my sh– list are many (not all) financial advisers and stock brokers.  All too often they put people into funds that are commission-laden, undiversified, and unsuited to the needs of their clients, just to make a lot of extra bucks for themselves.  Number 2 on my list are financial analysts (many, not all) whose job seems to be pumping up investments for their proprietary trading beneficiaries.

Nonetheless there are many good things about “Wall Street” and US  markets in general.  Vastly lower commissions on (online) trades, decimal pricing, lower spreads, low-cost ETFs and mutual fund (esp. index and enhanced-index funds).  Free stock quotes and online research.

Back to Occupy Wall Street.  I might as well join (though not support per se) with some virtual protests.

1. I want a full, independent, and complete audit of the the Federal Reserve and the US Treasury [no I am *not* a Ron Paul supporter].
2. I want all shareholder initiatives that pass to be legally binding.
3. I want, at a minimum, the right as an index ETF or mutual fund to have my portion of shares be abstain votes (e.g. the fund manager may not vote *my* shares).
4. I want (and this is a stretch!) no exit packages for failed CEOs.  I’m fine for paying for real success, but I am not fine with paying for failure.  If a new CEO wants a financial exit package of more than zero dollars, I want a CEO with more self confidence.
5. I want the government to get out of the bailout business.

If any of you Occupy Wall Street (or Occupy XYZ) folks want to use my protests, be my guest.

I try to stay out of politics on this blog, but I feel compelled to comment about gross fiscal negligence.  I accept the argument that US GDP as a percentage of global GDP is susceptible to decline.  As an US citizen I see no reason to accelerate the decline.  For elected officials to do just that is negligent, naive, or fundamentally hostile to the general welfare of the United States.

The fact that the US has been so successful from 1945 to present is a testament to something unique and special about our whole socioeconomic system.  The fact that we have righted or ameliorated our past social mistakes while improving our economic quality of life is remarkable.

Why our President is so hostile to basic economic factors is shocking.  Historically massive US National deficits siphon capital from the private sector.  Federally-manipulated low interest rate actions (QE1, QE2) sap safe investment opportunities from senior citizens, while fueling speculation in gold, silver, and commodities ranging from oil to corn to aluminum.   Putting the hammer down on domestic oil and natural gas production, particularly off-shore, puts another deep bleeding gouge into the US GDP.   Presidentially-dictated EPA mandates on coal plants put US electrical production in limbo.  Crony-capitalism (or faux capitalism) puts basic free enterprise on notice to be politically correct as a first priority.

I have been silent too long.  I avoid social political issues, but I must address fiscal political issues.  This is my first salvo.

Here I am, Joe investor, watching the markets whipsaw like mad.  I braced for impact in my oh-so-slow way and mitigated perhaps 10% of the damage, but my investments have been generally damaged too.

Maximum caution lies not on either side of the coin, but on the edges.  100% “safe” investments are not safe in the same way that 100% aggressive investments are not safe.  Safety should be measured in terms of the following risk factors 1) situational 2) statistical (non-monetary)  3) inflationary (monetary).

In the midst of worldwide and US market turmoil there has been similar chaos in the fledgling currency called bitcoin.  It is so “new” that my spell checker suggests “bitchiness” or “bit coin” as alternatives.   Meanwhile I’m thinking of a very small exposure to bitcoin as an alternative to precious metals or commodities.

I should disclose that I have I have an emotional connection to bitcoin.   Bitcoin has aspects of finance, technology, and financial engineering that are intriguing to me.  So please consider this factor as I continue to write.

Bitcoin is all that fiat money is not… Bitcoin is finite!   The number one rule I am painfully learning about ANY fiat currency is that it is potentially infinite.  (Unbounded, if you will.)  The fiat currency “presses” are only bounded by the constitution and discipline of the political systems that underlie them.  And these very systems have show over historically documented periods to be ultimately undisciplined. Simply put: lack of monetary discipline leads to economic calamity leads to runaway inflation.

That is one factor that is engineered against in the bitcoin ecosystem.  The bitcoin “printing presses” are inherently limited to 21,000,000 bitcoins.  Further some bitcoins will be forever lost into the digital black hole.

I am not here to say that there are not flaws with bitcoin (BTC).  Just that very few have been discovered yet, and those are very minor so far.  I am saying that bitcoin also has unprecedented advantages: 1) digital portability, 2) relative anonymity, 3) potentially fee-less transfer, 4) agent-less security, 5) inflation-resistance.  I love all of these factors, especially resistance to inflation.

I am here to say that the business cycle is real.  There are booms and busts.  And there is government meddling with the business cycle that, in the long run, only magnifies booms and busts.  And that bitcoin is one possible antidote.  That said, I am sticking with stocks, bonds, ETFs, etc in a not-so-contrarian manner.  I just happen to be mining a few bitcoins on the side.  Not familar with bitcoin mining?  Google it!