College Savings and Compound Interest

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My littlest one turned four years-old last weekend1, and my eight year-old is taking a Texas-Public-Schools-3rd-Grade-State-Mandated-High-Stakes-Standardized-Test this week2, so you can probably guess what’s on this ex-banker’s mind:

That’s right! Good guessing!3

Time is quickly running out for me to save money for their college tuition.4

The only thing scarier than those scary scary clown head trash cans at my littlest daughter’s birthday party5 is the prospect of saving enough money for her college tuition.clown trash can

For my eight year-old, I’ve got just 10 years to go before C-Day, so I thought I’d share my current ex-banker thoughts with others, in the hopes that we can experience this horrific fear together.

Also, “saving for college” allows me to discuss my favorite topic (compound interest!) so that’s always a good enough reason by itself for a Bankers Anonymous post.

I see three big questions about college savings, with the most interesting one being #2.

Question #1: What college savings account or investment vehicle, if any, should I use?

  • Question #2: How much do I need to save, per month, to be totally set for college tuition payments when they arrive?  (Compound interest calculations coming up!  Yay!)
  • Question #3: What kind of investments do I need in my college savings account?

I’ll take these in order.

Question #1: What savings account or investment vehicle, if any should I use?

Open up a 529 College Savings account.

Ok, that was easy.

But, why a 529? Also, which one?

The first “why” is because you may get an income tax advantage when you make a 529 account contribution, depending on the state you live in.  When I lived in New York and paid New York state income tax, I enjoyed an income tax break on my contributions.  Now that I live in Texas, I get no state income tax advantage from 529 account contributions.6  So that may, or may not, apply to you.

The second ‘why’ is that any capital gains or investment income – which might be triggered when I sold stocks or earned interest on my investments – remain protected from taxation in that year, assuming I do not make withdrawals from my 529 account.  If I just held my college savings in a regular, taxable, brokerage account, I’d be required to pay taxes on capital gains or other income from my investments.  The result of this 529 account tax protection is that I can grow my money much faster than in a regular, taxable, brokerage account.

Ok, so that sounds good, but which 529 account should you open?  Probably you should start by investigating your own state’s offering7, precisely for that potential income tax break.  But if you live, as I do, in a state without an income tax, then you can consider other advantages, having to do with

a) Contribution limits – Some states allow higher contributions than others

b) Flexibility of investment choices – some states offer restricted types of investments

c) Cost of available investment choices – some states offer higher-cost plans than others

d) Convenience

I opened a New York state account for my oldest daughter because we lived there, then.  My youngest was born in Texas, but I opened a New York state account for her as well, purely for convenience sake. I prefer tracking both girls’ college savings information on a single website.

Question #2 – How much do I need to save, monthly, to have everything covered?

The College Board (The fun group that brought you the SAT, the PSAT the AP tests, and more!) has a couple of incredibly useful online calculators.

First, they can help you figure out how much of college’s cost you, as a parent, will likely have pay.   To try the calculator, go here.

This calculator asks some specific questions about your family situation, plus your income and savings, and then tells you how much the financial aid department of a college will likely expect you to contribute for your child’s annual college expense.

Beware, because [**Spoiler Alert**]

This number will be much higher than you want it to be.

I don’t think of myself as wealthy, and generally we don’t have much left over at the end of the month.  Which is why the expected contribution number from a typical financial aid department left my face feeling a bit tingly.

Is it getting warm in here, or is that just me? My editor-in-chief 8  thinks I’m either suffering from menopause or anaphylaxis based on these symptoms.  We’ll just have to wait and see. 

Next, the College Board has a great college savings calculator to tell you how far your current plan will go toward paying for college.  Before you go there, I’d like to warn you – the result is scarier than scary, scary, clowns.

First, you input the current cost of college, an assumed rate of tuition inflation, how many years your child will attend, and how much you will likely have to pay, which you may have some idea about based on the first online College Board calculator above.  Next, you input how much you’ve already saved, what you expect your annual investment returns will be, how many more years you have before your child goes to college, and how much you plan to contribute monthly, between now and then.

You input all of that, and then you have a heart attack immediately and die, because there’s Just. No. Way.

I personally can’t feel the whole left side of my face right now.

For example, let’s say I’ve managed to put aside $19,000 for my 4 year-old up until now.

Looking good, Billy Ray.

And let’s say I plan to invest $200 per month until she turns 18, and I can earn a 7% return on my investments, via my 529 account.

Feeling good, Lewis.

Looking_good_billy_ray

Also, assume a private 4 year college costs $50,000 per year today, the college cost inflation rate is 5%, and I plan to pay 90% of that from savings.

I have an estimated shortfall of $276,399.

Randolph, this isn’t Monopoly money we’re playing with.

Some of you clever readers may just be smirking because your little darling will likely either get a ton of scholarships or else attend a state college, no?

Well, the bad reality is that state college isn’t that affordable these days either.

The average 4-year in-state tuition cost, according to the College Board, will set you back $21,477 this year.

If I have zero savings for my 4 year old, but I manage to invest $200 per month, starting now, and she attends an average cost in-state college, I’m still $107,582 short, 14 years from now.

The answer to the question “how much should I be saving per month to be totally set for tuition” is provided by the College Board calculator, just under the shortfall number.

I’m sorry about this, but as you know: Compound interest is powerful.

After you recover from this shock, you’re ready to move on to question #3.

Question #3 – How should you invest your child’s 529 Account?

This one’s easy, and frequent Bankers Anonymous readers will not learn a single, damned, new thing from me here, because the answer is unchanged from previous, similar questions about how to invest for the long run.

Hopefully you noticed, from playing around with the college board’s calculator, that you need a fairly high rate of return on your investments from now until college to even have a chance of closing the gap between your current savings and how much you’ll owe for your child’s college, every year, for four years.

Now, since returns have to be high, you have precisely one choice for how to invest: 100% equities.

Let me further clarify, in a way that will again make me sound like a broken record for careful readers: You need to invest your long-term savings for college in a highly diversified low-cost (probably indexed) mutual fund, invested in stocks only.

Why 100% equities?

Why not bonds or other safe investments?  Two reasons.

The first reason is low returns.  For the vast majority of us, we can’t afford to invest in bonds over the medium to long run.  An intermediate-term bond fund will return somewhere between 0.5% and 2.5% right now, and that’s just not going to cut it.

The second reason is that – on a probability-adjusted basis – you will get more from investing in equities.

Here are the relevant facts to back up my assertion, as well as a cool graphic of these statements 9

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Stocks vs. Bonds given a time horizon

If you have a 5-year investment horizon, you will be better off entirely in stocks, rather than bonds, 70% of the time.

If you have a 10-year horizon – as I do – you will be better off entirely in stocks rather than bonds, 80% of the time.

If you have a 15-year horizon – as I do with my youngest daughter – a 100% stocks portfolio10 outperforms a 100% bonds portfolio 90+% percent of the time.

Is that guaranteed?  Of course not

Probabilities are not the same as guarantees,11 so of course the bet you make on investing in 100% equities in your child’s 529 account could go wrong.  But making the other choice – including bonds in your portfolio – is a low probability bet.  By investing in bonds you are implicitly saying “Probabilities be damned! I don’t care about history! This time is different!”12

Look, I play poker with the neighborhood dads, so I know that low-probability bets sometimes work out.  But I also know it’s kind of stupid to make low-probability bets.  Trust me, because I’ve been losing $20 a week on a regular basis to these guys, testing this hypothesis, since I’m not a strong poker player.

You can decide to weigh down your kid’s college savings account with bonds, and you may be under the illusion that this is ‘prudent’ because they’re bonds and “bonds = safe.”  But it’s not prudent, any more than it’s prudent to bet with jack seven off-suit.

Low probability bet
Low probability bet

Would I advocate investing in 100% equities if my kid is going to college next year?

Well, this gets trickier. Stocks still beat bonds in most years, so if you want to play the odds – and if you have some kind of cushion – you could reasonably keep the account in stocks. Most of the time – on a probabilistic basis – this would be a winning choice.

But I realize this seems a bit extreme, so with one year to go I’d probably take next years’ tuition (potentially only 1/4th of your position) and plunk it into a risk-free investment, like a money market fund13, and leave the rest exposed to stocks. Remember, 3/4ths of your account has more than one year to remain invested.  Each additional year invested increases the probability that stocks beat bonds.14

Tick Tock Tick Tock

For my wife and me, that loud ticking we hear is not the biological clock anymore, but rather the college financial clock.

For anyone in our demographic15 who checked the College Board calculator,16 I’ll now sum up the only other good pieces of advice I can think of related to saving for college.

  1. Open up a 529 Account for each kid. Like, right now.  Stop reading blogs and do this immediately. Really. Did you do it yet? How about now?
  2. Set up an automatic withdrawal from your bank account, so you don’t have to make a choice about contributing every month.  Because if you have to make the choice every month, the money might not be there.  Even $25 per month in automatic withdrawals is better than nothing.  Increasing that $25 monthly contribution over time, once the account is open, will be much easier than you think.

Best of luck!

Please see related posts on:

Interview with College Advisor Part I – The insanely rising cost of college

Interview with College Advisor Part II – is the 4-year college financial model broken?

New York Times on funding your 401K Account vs. 529 Account

And related post: Stocks over Bonds – The Probabilistic View

And related post: Ask an Ex-Banker: Should I open an IRA?

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You want to see something really scary? Check the College Board Calculators

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  1. Kiddie Park, established in 1925! A Merry-Go-Round from 1925! Scary, scary, clowns!  Oh my!
  2. First, take the Pre-Test! Then the Practice Test! Then the Real Test! Oh my!
  3. As Dora the Explorer would say.
  4. My wife and I like to jokingly append “–should they choose that path,” whenever we discuss our daughters going off to college, but the fact is that’s our chosen path for them and they can deviate from it at their peril. I’d like to see you just try it, kiddo.
  5. Everything you need to know about my view on little kid birthday parties was captured recently by Drew Magary at Deadspin.com.  We have got to do something about the Big Birthday Industrial Complex.
  6. In a news item that may or may not be directly related to this fact, my local urban school district boasts 7% college readiness among its graduates.  I will now light myself on fire.
  7. Here’s a nice website for getting starting comparison shopping for 529 accounts.
  8. aka wife.  Also, she’s an MD
  9. Courtesy of David Hultstrom at Financial Architects LLC.
  10. Hopefully the following is obvious, but just in case it’s not: When I say 100% stocks I mean a highly diversified mutual fund, not an individual stock or even a small group of stocks, or a single stock sector.  When I say bonds I really mean a AAA-rated bond fund of, say, intermediate duration.  Not junk bonds or emerging markets or anything else interesting and high-yielding.
  11. As my close, personal friend, Nate Silver would say.  (I wish.)
  12. “This time is different” is one of those investing No-Nos as a justification for making an investment decision. “This time is different” is a fine gambling notion (for investing in individual tech stocks, for example, or buying into a venture capital fund) but is not a fine investing notion.
  13. Why a money market fund and not a bond fund?  Because a bond fund, with only one year to go, could actually lose money as well – in a rising interest rate environment – so only a money market fund guarantees you zero volatility of results.
  14. Incidentally, investing today for your kids’ college next year is NOT the way to do this. Sorry if you are reading this with a 17 year-old breathing down your neck. 529 accounts have little to offer in this case, and compound interest can’t help you much either.
  15. Meaning, you’re going to pay for some kid’s college some day.
  16. And if you haven’t yet used the calculators, have a swig of whisky and then seriously you should go check them, it’s the right thing to do.

Why The Wolf of Wall Street Is Total Crap

Wolf-of-wall-streetI have been harsh in the past about some things William D. Cohan has written about Wall Street, specifically in this review of his book about Goldman Sachs, and this view on Fabulous Fab’s criminal conviction for just doing his job as a CDO structurer.

However, I really appreciated his Op-Ed in this weekend’s New York Times about the Wolf of Wall Street movie versus the reality of Wall Street.  Cohan nails it.

The Wolf of Wall Street depicts a Hollywood version of a dark corner of the finance world – boiler rooms – that bears little resemblance to the actual Wall Street.

My colleagues generally worked too hard, had too much pride in their fancy educational pedigrees, and too much ambition to get ahead in a culture that actually punished irresponsible behavior to do the stuff that Leonardo DiCaprio’s character does in the movie.

I’m not saying there weren’t jerks – of course there were – but the point was you didn’t want to get identified inside the firm as a jerk.  It was a very bad career move to get known for bad behavior.

That’s the real truth, but it obviously makes for far less exciting cinema than cocaine, prostitutes, and scamming people on purpose.

 

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Video: Russian TV on Bankers’ Stressful Lives

I did an interview recently for RT London, which I gather is sort of Putin’s version of a Russian CNN or Qatar’s Al Jazeera. Just more sensational.

They wanted to cover what they call a recent string of high-profile banker suicides.  I have zero reason to think bankers commit suicide in higher numbers than any other profession, and if I had to guess, the rate of depression or suicide probably reflects prevailing rates in other high stress areas.

But of course, stressful jobs have different effects on different people.  Below is my 15-seconds of skype video fame on RT London TV.

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Interview: Lars Kroijer (Part II) – On Having An Edge In The Markets

Please see earlier podcast Interview with Lars Kroijer Part I – on the importance of Global Diversification

And my earlier book review of Lars Kroijer’s Investing Demystified.

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In this discussion with author Lars Kroijer we talk about the main assumption of his book Investing Demystified – which I happen to completely endorse – which is that ‘beating the market’ lies somewhere between highly unlikely and impossible. The goal for individuals should be, instead, to earn market returns. Common behaviors that most investors do, like

1.  Paying extra management fees to an active portfolio manager, or

2. Stock picking yourself in order to ‘beat the market’

is a fool’s game, and will ultimately prove unnecessarily costly.

Later in the interview I asked Kroijer to describe his earlier book, Money Mavericks.

 

Lars:                Everyone’s got sort of their angle. My angle is really to start with asking a question of the investor, which is; do you have edge? Are you able to beat the markets? I don’t even make that call for you but I try to illustrate it is incredibly hard to have edge, and that most people have no shot in hell whatsoever of attaining it. Incidentally, that means that people like you are I are not necessarily hypocrites because it’s entirely consistent with our former lives to say we worked in the financial markets; we’ve bought and sold products, and as well informed as anyone. So if we didn’t have edge, edge doesn’t exist.

You could say I’m a hedge-fund manager, and I sold edge for a living, and I certainly thought I had it. But that doesn’t mean that most people, or even that many people have it. I start with the premise in this book of saying do you have it. Then I go on to explain it’s really bloody hard to have it. If you don’t have it, which most people don’t, what should you do?

Essentially, this is a book written for my mom. It kind of is. You wouldn’t believe, but as a former hedge-fund manager, every time I talk to my mom, who’s a retired schoolteacher, she’d always say which stock should I buy. I’d say mom, you could buy an index. And she’s like no, no. Then she’d say stuff like Dansker bonds have done so well, I should be buying it. And I’d be like no, don’t do that. She’s certainly not alone in that position.

Michael:          I completely agree with you, and when I think about how your book lays out four simple rules, starting with the one that you should be exposed to the broadest, most global index portfolio, and I have not done that, in terms of I am US-centric and small-caps centric, so I don’t have the broadest exposure. On the other hand, there is no gap between what you advocate, in terms of can you beat the market, and the way in which I invest, which is always I assume from the get-go ‑‑ and this is why that part of it resonated with me ‑‑ so clearly I, like you, say you can’t beat the market. The goal should not be to beat the market. The goal is to expose yourself to the appropriate allocation to risky markets, appropriate to your own personal situation. And then get the market return.

Lars:                You want to capture the equity-risk premium.

Michael:          The entire finance-marketing machine is about can you beat the market. Beating the market is a complete fool’s game. I think it’s particularly interesting, the other reason I wanted to talk to you, is because you’ve worked in the hedge-fund world, you’ve been a hedge-fund manager, an advisor to hedge funds. I worked on Wall Street. I founded my own fund, and it’s all about that theory that you can, in a sense, have an edge in the market. Yet, the more you know about how it actually works, the more extremely bright people, with the highest powered computing power and the most cutting-edge ideas ‑‑ and you think about the power they had, and we had, and the chances of any retail investor or in fact any of those investors themselves beating the market, or as you say, having edge, is just impossible.

Lars:                Add to that they’re at a huge cost disadvantage, informational disadvantage, analytical disadvantage. It’s so unlikely, and this is why always start with you’ve got to convince people they can’t. That’s actually probably the toughest thing. You’re fighting not only against conventional wisdom, but you’re also fighting this almost innate thing we have, that you somehow have to actively do something. You somehow have to pick Google or whatever.

You have to have a view, and you’re smart, you’re educated, doing something to improve your retirement income, or whatever you’re doing. What you and I are advocating is essentially do nothing. Admit you can’t. I think that rubs a lot of people the wrong way.

Michael:          You need to bring humility to the situation. I cannot do better than the market. I can do the market but I can’t do better. It’s a very hard, humble approach, but in my opinion and in your opinion it’s the correct approach.

Lars:                Yeah. And I also think we’re extremely guilty of selective memory. We remember our winners. That adds to the feeling. It’s a bit like when you ask guys whether they’re an above-average driver. 90% will say they’re above average.

If you ask stock pickers whether they do better than average, 90% of stock pickers would say yes, even more than that. I think there’s a lot of that, a huge degree of selective memory. It’s a shame because I think it really hurts people in the long run.

Michael:          It makes conversations along the lines of what you mentioned with your mother conversations with me and other friends and retail investors in stocks ‑‑ hey, I’ve got this great new stock. I’m such a bummer when I talk to them because I say really? I don’t know what to say.

Lars:                The alternative is to say you don’t know what you’re talking about, which is not an all together pleasant thing to say. It’s not how you make friends. Certainly not when you’re moving to a new town, like you did.

Michael:          I’ve written about this on my site before, but essentially when somebody talks about individual stocks, to me what I’m hearing is I went to Vegas. I put money on 32 and 17 on the roulette wheel. Look how I did. I just don’t know how to respond to that. That’s fabulous, you hit 17 once. I don’t know what to say.

Lars:                This is conventional wisdom because to most other people that person will sound smart and educated. They will say here’s why I found this brilliant stock and here’s why it’s going to do great. Most people in the room will consider that person really smart, educated, and someone who’s got it. They’ll sound clever about something we all care about, namely our savings. And you think if I could only have that, I’d want that. It’s tough to go against that.

This is why I think the biggest part of this book is if I could get people to question that. Maybe even accept they can’t beat the market. Then that would be the greatest accomplishment. I think a lot of the rest follows. I haven’t come up with any particularly brilliant theory here. It’s sort of academic theory implemented in the real world and that’s pretty straightforward.

Michael:          It cuts against the grain of what I call on my site “Financial Infotainment Industrial Complex,” which is there’s a lot of people invested in the idea that markets can be beaten, that individual investors can play a role.

Lars:                Think of how many people would lose their jobs?

Michael:          Yeah, it’s an entire machine around this idea. It’s very hard to fight against that. It’s very boring to fight against that. I joked about it in my review; your book is purposefully hey, I have some boring news for you. Here’s the way to get the returns on the market and sleep better at night.

Lars:                I sort of compared going to the dentist. You really ought to do it once in a while and think about it. I completely agree with you. I mentioned in the book ‑‑ when I thought about writing this book, it was one of these things that slowly took form, but there’s this ad up for one of these direct-trading platform websites. And there was a guy who was embraced by a very attractive, scantily dressed woman. He was wearing Top Gun sunglasses, with a fighter jet in the background. It said something like “Take control of your stock market picks.”

I thought fuck; are you kidding me? Really? Whoever falls for that, I’d love to sell them something.

Michael:          Oh yeah, they’d be a great mark.

Lars:                You also hear a lot about the quick trading sort of high-turnover platforms. It’s something like 85-90% of the people on there will lose money. You have a lot of these companies, their clients, 85-90% will lose money.

It’s almost akin to gambling. You can argue is it gambling, which is a regulated industry in a lot of countries, for good reason, because it costs you a lot of money. And I think certain parts of this circus is the same. But it’s very tough to regulate, and I’m not saying you should. But it could cost a lot of people a lot of money.

I feel very strongly about this. I’m not saying edge doesn’t exist. I’m saying it’s really hard to have it. And you’ve got to be clear in your head why you do, and what your edge is.

Michael:          I have not read [Kroijer’s previous book] Money Mavericks but give me a preview so when I do read it, what am I going to get?

Lars:                It’s a very different book. Money Mavericks is essentially the book of how someone with my background, a regular kid from Denmark ends up starting and running a hedge fund in London, and all the trials and tribulations, humiliations and all that you go through in that process. I thought when I wrote it lots of things have been written about hedge funds, and a lot of it’s wrong. Namely this whole idea that we’ll all drive Ferraris and date Playboy Bunnies and do lots of cocaine.

I thought very little was written from a first-hand perspective, someone who’s actually set up a fund and gone through the fund raising and trying to put together a team. And the humbling failures, and successes, so I thought let me try to write that. I did. I found myself enjoying the process of writing it, which I guess was part of the reason I did it. But then it got published, and it ended up doing really well.

I was actually kind of pleased about that because I thought it’s very nonsensationalist. We didn’t make billions, we didn’t lose billions. No one defrauded us and we didn’t defraud anyone. So those are the four things you normally think about when you think of hedge funds.

Michael:          If you’re trying to sell books, yes.

Lars:                Yeah, so this is none of that. It’s just a story of some guy starting a hedge fund, how it all worked out, all the little anecdotes. I was really pleased that resonated. In fact, the best feedback I got was from people in the industry who were like yeah, that’s exactly what it was like. I’m sure you would appreciate it because you’d have lived a lot of it. Begging for money.

Michael:          No, that’s my second [imaginary] book. My first [imaginary] book is personal finance. My second book is gonna be that experience, your books in reverse.

Lars:                I think you’d enjoy it. That resonates with a lot of people, including what you also would’ve experienced, this whole undertone of anyone can start a hedge fund; I’m going to quit my job and raise 50 million dollars. I’m going to build a track record and then raise another couple of hundred million. Then I’m going to be rich and happy. The number of times I’ve heard some version of that makes me want to puke. When you’re actually doing it you realize how incredibly hard it is.

Michael:          Very stressful.

Lars:                It impacts your health, your life, your family, all of that. Then that’s before you try to make or lose money.

Michael:          You actually have to do it, get a return that people are happy with, and they’re happy to stick with you. Does your fund exist still?

Lars:                No, it’s just my own money. I had incredibly fortuitous timing. I returned all capital in early ’08. But no skill, it was for mainly my own reasons, sanity, health, and family. I’ve been lucky.

Michael:          As we always say better lucky than good. That’s more important.

Lars:                For me there was a big part of that. I thought let’s quit while you’re ahead. To be honest, I have yet to wake up one day where I miss it. I get to wake up one morning where I wish I was heading to Mayfair to turn on to Bloomberg and be at it.

 

Please see related podcast Interview with Lars Kroijer Part I – on the importance of Global Diversification

Please see related book review on Investing Demystified by Lars Kroijer

 

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Interview: Author Lars Kroijer (Part I) – on Global Diversification

Lars_kroijer

In the first section of this interview with author Lars Kroijer we talk about his idea, from the book Investing Demystified, that we should all seek portfolio exposure to the broadest segment of global equities – essentially all 95 stock markets in the world.  In the second part of this interview we talk about the opposite – namely the dangers of concentrating all of your investment portfolio within, say, your home country.

 

Michael:          I’m talking to Lars Kroijer, [/Kroy’-er/] the author of Investing Demystified which I’ve reviewed on the Bankers Anonymous site. First things first, I read your book and I agree with a ton of it, the theory. And then I thought about my own portfolio, and I thought I’m two-thirds the way towards what you’re saying. By that I mean I invest in index-only Russell 2000 index funds. Talking about my retirement portfolio. I halfway embraced what I think is – in shorthand – an efficient market hypothesis. But I’m not entirely there, so tell me about why I’m doing it wrong.

Lars:                It’s an interesting place to start because you are doing it less wrong than most people in the world would be. You being an American investing in a very broad US index, you are already invested in a very large portion of the world-equity portfolio. What I would normally tell people is you need to invest cheaply and extremely broadly in equity indices for your equity exposure.

Now what does that mean? That means all equities traded in the world.  I think there are 95 public equity markets in the world today, and you should be invested in all those in proportion to their values. You’re only invested in one, the US one, but that’s the biggest one by a very large margin. So failing to invest abroad is less of a sin than it is for someone who is based in Denmark, where I’m from, that represents only 1 or 2% of the world-equity markets. Where I’d tell you you’re going wrong is you should diversify beyond the US, and you’re not doing that.

danish_flag
Only ~1 % of global equities in Danish stock market

Michael:          So I’m a complete hypocrite on this front. I worked in emerging markets so I professionally, on Wall Street, worked in non-US markets. Whenever I speak to friends, I say, “If you’re completely exposed to the US, you’re doing it wrong.” And nobody who grew up in any other country but the US would probably ever dare to be so bold as to only invest in their own country. It’s an irony.

Lars:                It’s interesting you say that, if I could just interrupt you there; you look at institutional investors in the UK or in Denmark, really any country in the world, and a lot of them will have exposure to just their own domestic stock markets, for lots of terrible reasons.

I’m saying that is generally a mistake, but in your case, it’s less of a mistake than if you lived in Denmark. If you lived in Denmark you would only have exposure to 1% of the world equities, where in the US it’s more like 35-40%. When I tell people to go buy the world-equity portfolio, you already have 35-40% as opposed to in Denmark you’d have 1-2% of that, so that is a big difference.

Michael:          Getting extremely practical, how many different positions in either ETFs or mutual funds do I actually need to buy if I’m going to get some kind of efficient frontier of global equity exposure?

Lars:                You can do just one.

Michael:          There’s a single ETF?

Lars:                The reason I’ve refrained from endorsing just one specific security is because I’m hoping that world-equity markets is a race to the bottom in terms of fees product. Right now, that might be called MSCI All Country World. Personally I don’t care what the index is called because what we’re after is the broadest, cheapest exposure. If someone comes up with a cheaper, better index, that’s even better. If an index-tracking product is cheaper and better, that’s even better. But you can buy the MSCI All Country World in one ETF, iShares will do that, DB Trackers will do that, Lyxor will do that. Vanguard does a version of it.

Michael:          I was going to ask: I use Vanguard because of their brand name, and low cost, passive mutual fund investing.

Lars:                They’re very good.

Michael:          They have this global, total world-equity exposure. Are there another half-dozen US fund companies who also –

Lars:                Yeah all the large ETF providers will have it.

ETF

This idea that you have your house, your education, your pension, all your assets come together and really are correlated to the same thing, which is typically your local economy. So one example I have in my book is imagine you’re a London-based real estate agent and you have your own flat. And you have a pension with the real estate agents, and then on top of that you own a couple of real estate related stocks in the UK.

Now, you are really long in London real estate market and that’s crazy to do that in your investment portfolio when you’re already so long in the rest of your investment life. This is yet another reason you’ve really got to stay diversified in your investment portfolio. Even sometimes your future inheritance is going to be in the same stuff: your parents’ house, your spouse’s job, dependent on the same local economy, your future job prospects dependent on the same local economy. Don’t have your investments in that same area.

This argument actually works better outside the UK because you can apply it to ‑‑ instead of London real estate I say Denmark. So very easily don’t have your equity investments in Denmark because you’re already long in Denmark. I think that’s a hugely important part of why these kind of diversified products really make a lot of sense for a lot of people. And why I think it’s a great shame that people tend to have their equity investments and investments generally so close to where their other assets are. They really all can go badly wrong at once, and that’s exactly what you should avoid.

Michael:          We know from the 2008 crisis that all risk assets correlate almost to one. In extreme downturn – everything that is a risk asset goes down all at the same time. That was a very scary reminder of that. There is nothing that is at all risky that doesn’t drop in value in a crisis.

Lars:                You’ve got to diversify. Then you could also look at if you’re a Greek investor, your real estate, your future pensions, your house, your job, all that would go belly up at the same time. Meanwhile, the rest of the world was fine. Imagine you had Greek government bonds as your low-risk asset. If you’d also had the Greek equity market as your equity exposure, you really would’ve been toast. Don’t do that. You’re not getting additional expected returns to reward you for that.

I think that’s an area that’s very important that people don’t talk enough about. That frustrates me. Again, people don’t want to listen to it because there’s little money in telling someone to buy the world-equity index. No one is interested in that.

Michael:          As an emerging-markets guy, it’s clear to me that anybody with any kind of net worth in any of these countries which has experienced typically a currency devaluation or nationalization or national political crisis, anybody generationally who grew up in that who has any net worth, always has a significant portion of their assets in Europe or the US or hard currencies. But in the US we don’t have an experience of having our credit – of course it’s been downgraded in the US but it’s not been junk status.

Our currency has never devalued wildly or unexpectedly. People are quite complacent about the idea of our exceptionalism. I’ve often said ‑‑ you said you wrote this book in a sense for your mom. I’ve often had conversations with my mom along these lines of do you know that most US investors have never considered that their house, job, currency exposure, government credit exposure is all US based? With almost no diversification. And we’ve gotten away with it up to this point, but it doesn’t mean we will in the future. It’s imprudent but as you say, people continue to do it because it’s either complicated, seems hard, boring, or not enough people are telling them to look elsewhere.

Lars:                No one is really incentivized for you to do that. No one makes money. The CFAs or financial planners don’t make money from this. What we’re talking about is not a good thing for the financial-planning industry either.

Michael:          It’s a much lower fee situation.

Lars:                Much lower fees, and paid by the hour kind of stuff.

Michael:          For the typical ‑‑ my orientation is the US investor ‑‑ the typical US investor, it will sound like madness when you say exposure to every equity market such that two-thirds of your money will be exposed to non-US will sound very aggressive to the US market. It doesn’t sound aggressive to me. It sounds like an obvious, logical outcome of the efficient-market hypothesis, just get the broadest exposure. But it will sound aggressive. You mean you’re going to put 65% of your net worth in non-US?

Lars:                You’re going to own Indonesian stocks? Where’s Indonesia?

Michael:          It sounds very aggressive. It sounds less aggressive to anybody who doesn’t live in the US, because they’re used to that.

Lars:                That’s right, I couldn’t agree more. This book actually shouldn’t but it’s going to be an easier pitch outside the US because you’re already likely to have exposure to non-domestic securities or at least you’re going to be accepting of the possibility that you should.

Michael:          In currencies and government exposure, and all of that.

Lars:                That’s why all the best FX (foreign exchange)  traders are all Argentine. They grew up ‑‑ my college and business school roommate is from Bolivia. He said the one time in his life his mom ever hit him was when he was a kid and he’d gotten some US dollars. He had to run down to the bank and exchange them. Or he had some bolivar or whatever it’s called. He ran down and exchanged the US dollars. He came across a [soccer] pitch and a bunch of guys were playing football,  so he played football for two hours and then he went to exchange it. The amount of money that had cost in the currency…

Michael:          Poor kid.

Lars:                You learn about inflation real quick.

Michael:          Tough lessons about inflation.

Please see related post, a book review of Investing Demystified, by Lars Kroijer.

 

Please also see related podcast post, Interview Part II – Do you have an ‘edge’ when it comes to investing?  We doubt it!  Also, a description of  Kroijer’s previous book Money Mavericks: Confessions of a Hedge Fund Manager

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The Efficient Market Hypothesis: The 7 Levels of Nate Silver

Nate_SilverOne of the most important, but controversial, ideas of investing is the ‘efficient market’ hypothesis.

I say important, because it provides a great starting point for approaching investing and markets humbly, as well as for approaching the Financial Infotainment Industrial Complex with a healthy dose of skepticism.  Most investors would be better off if they understood and believed in the efficient market hypothesis.

I say controversial because extreme – or rigid – versions of the efficient market hypothesis can be either disproven or mocked or shown to be untrue in a variety of ways.

Why is this on my mind?

In the next few days I’ll be posting a podcast interview I did a few months ago with author Lars Kroijer, whose book Investing Demystified builds on the basic idea that very few of us actually have an ‘edge’ in the markets. As a result, we would be better off adopting a simple, low-cost approach to our investments.

Reviewing that podcast interview reminded me of my favorite presentation of the efficient market hypothesis, from Nate Silver’s The Signal and The Noise.

Silver doesn’t accept the discredited rigid definition of the efficient market hypothesis, but rather builds a series of increasingly accurate versions through steps 1 through 7.  I read this portion of the Silver book to Kroijer, so I thought I’d just post the transcript of our interview here, as a preview to the upcoming podcasts:

——————————

Michael:          My favorite version of the efficient-market hypothesis was written by Nate Silver in The Signal and the Noise. Have you read that book?

Lars:                No.

Michael:          Do you know who he is?

Lars:                The New York Times guy? [More recently, ESPN, of course]

Michael:          Yeah and Fivethirtyeight.com where he does political forecasting. He’s an interesting thinker and I really recommend the book. But he has a statement of the efficient-market hypothesis that matches his view of the world, which is a probabilistic view in which you end up saying things much less certainly about the future, but maybe more accurately, because the future itself is uncertain. He has seven levels of the efficient-market hypothesis, which I just want to read to you, because it’s really fun.

Level 1:  “No investor can beat the market.”

Okay, that’s very strong, very simple.

Level 2:  “No investor can beat the stock market over the long run.”

That’s a bit, more qualified.

Level 3:  “No investor can beat the stock market over the long run, relative to his level of risk.”

Okay, that’s more sophisticated.

Level 4:  “No investor can beat the stock market over the long run, relative to his level of risk, and accounting for transaction costs.”

Okay, makes sense.

Level 5:  “No investor can beat the stock market over the long run, relative to his level of risk, and accounting for transaction costs, unless he has inside information.”

Makes sense.  The second-to-last one is:

Level 6:  “Few investors can beat the stock market, over the long run, relative to their level of risk, and accounting for the transaction costs, unless they have inside information.”

Finally, the most complete version of the efficient-market hypothesis, which makes sense to me.

Level 7: “It is hard to tell how many investors beat the stock market, over the long run, because the data is very noisy. But we know that most cannot, relative to their level of risk, since trading produces no net excess return, but entails transaction costs. So unless you have inside information, you’re probably better off investing in an index fund.”

Lars:                I like that.

Michael:          He’s a good writer and he has an awesome way of talking about how do we understand the future in a probabilistic way. It’s a sophisticated way of talking about the different levels of extreme efficient-market hypothesis, versus a more – probably correct – nuanced way.

Lars:                I think unfortunately the way it’s sort of been very roughly done in theory, it’s sort of been discredited.

Michael:          If you go to the extreme version, you can discredit it, I think.

Lars:                So no one will really look at it today. It’s not something widely discussed. One of the reasons being is that not many people are really all that interested in discussing it widely. I like what he’s talking about.

 

Please see related post book review of The Signal and The Noise, by Nate Silver

The Signal and The Noise

Please see related post book review of Investing Demystified, by Lars Kroijer

Investing Demystified

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