February 2013 - Page 2 of 2 - Bankers Anonymous

February 14, 2013November 19, 2015

Part III – Compound Interest and Consumer Debt

Part III – Compound interest and Consumer Debt

Please see earlier posts Part I – Why don’t they teach this in school And Part II – Compound interest and Wealth

So in the last post I wrote about the the incredible power of compound interest, and the possibility it suggests about wealth creation over time.

Unfortunately, there’s also bad news.

On the debt side of things, how much does your credit card company earn if you carry just an average of a $5,000 credit card balance, paying, say, 22% annual interest rate (compounding monthly) for the next 10 years?

In your mind you owe a balance of only $5,000, which is not a huge amount, especially for someone gainfully employed. After all, $5,000 is just a quick Disney trip, or a moderately priced ski-trip, or that week in Hawaii. You think to yourself, “how bad could it be?”

The answer, including the cost of monthly compounding[1], is $44,235, or about 9 times what it appears to cost you at face value.[2]

I hate to be the Scrooge, but the power of compound interest transformed that moderate credit card balance of $5,000 into an extraordinarily expensive purchase.[3]

Compound interest: Why the poor stay poor and the rich stay rich

To take another example, let’s think of compound interest on credit cards for the average American household.

Let’s say you are an average American household, and you carry an average balance of $15,956 in credit card debt.

Also, as an average American household, let’s assume you pay an average current rate of 12.83%.[4]

Finally, let’s assume you carry this average balance for 40 years, between ages 25 and 65. How much did your credit card company make off of you and your extreme averageness?

Answer: $2,629,618.64[5]

So, in sum, your credit card company will earn from the average American household carrying a credit card balance for 40 years, $2.6 million. [6]

If you’re wondering why rich people tend to stay rich, and poor people tend to stay poor, may I offer you Exhibit A:

Compound Interest.

Now, your math teacher might not have done this demonstration for you in junior high, because he didn’t know about it. Mostly, I forgive him. Although not completely.

You can be damned sure, however, that credit cards companies know how to do this math. THIS MATH IS THEIR ENTIRE BUSINESS MODEL.

Which same business model would work a lot less well if everyone knew how to figure this stuff out on his own.

Hence, my theory about the Financial Infotainment Industrial Complex suppressing the teaching of compound interest. They don’t want you to learn how to figure out this math on your own.[7]

Please see Part I – Why don’t they teach this in school?

Part II – Compound interest and Wealth

Part IV – Discounted cash flows

Part V – Discounted cash flows – another example using annuities

Part VI – Conclusion and why everyone needs to know this math for the good of society

and Video Posts

Video Post: Compound Interest Metaphor – The Rainbow Bridge

Video Post: Time Value of Money Explained

[1] But importantly, excluding all late fees, overbalance fees or penalty rates of interest.

[2] We get this result using the same formula, although Yield is divided by 12 to account for monthly compounding, and the N reflects the number of compounding periods, which is 120 months. So the math is: $5,000 * (1+.22/12)¹²⁰

[3] Have you ever wanted to take a $45K vacation to Hawaii and pretend you’re a high roller? Congratulations! By carrying that $5K balance for 10 years, you did it! You took a $45,000 Hawaiian vacation. You’re a high roller! Yay!

[4] All of these stats taken from this great site on credit card statistics, which cites all of its sources.

[5] We express this again dividing yield by 12 to account for monthly compounding, and raising it to the power of 480 months, the number of compounding periods. Hence the math is $15,956 * (1+.1283/12)⁴⁸⁰

[6] I’m assuming for the purposes of this calculation that the debt balance stays constant for 40 years, but your household pays interest on the balance. In calculating this result, please note I have framed the question in terms of “How much does the credit card company earn” off of your household carrying this average balance for 40 years. Which is not the same question as “How much do you pay as a household?” Embedded in my assumptions, and the compound interest formula, is the idea that the credit card company can continue to earn a fixed 12.83% on money you pay them. Which I think is a fair way of analyzing how much money they can earn off your balance. Since there are no shortages of other household credit card balances for the credit card company to fund at 12.83%, I believe this to be the most accurate way of calculating the credit card company’s earnings on your balance.

[7] Here’s where, for the sake of clarifying sarcasm on the internet – which sometimes doesn’t translate well on the electronic page – I should point out that I’m (mostly) kidding about the suppression of the compound interest formula. Among the main reasons I started Bankers Anonymous was that the dim dialogue we have about finance as a society allows conspiracy theories to grow in darkness. Just as pre-scientific societies depend on magic to explain mysterious phenomena, I think financially uninformed societies gravitate toward conspiracies to explain complex financial events. As a former Wall Streeter who does not actually ascribe to conspiracy theories, I feel some obligation ‘to amuse and inform’ and thereby reduce the amount of conspiracy-mongering. So, I don’t really think there’s a conspiracy here. As far as you know. Or maybe, that’s just what I want you to think.

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February 13, 2013January 30, 2014

Part II – Compound Interest and Wealth

Compound Interest Math Formula – The Most Powerful Math in the Universe

Please see my earlier post, Part I – Why don’t they teach this math in school?

For the sake of blowing the lid off this vast cone of silence, here’s the compound interest formula:

Future Value = Present Value * (1+Yield)^N

This is the formula you use if you want to see how money grows over time, to become “Future Value.” Present Value is the amount of money you start with. That could be $100, such as in my examples below, or likewise a series of $5,000 IRA investments each year. Present Value is whatever you’re starting amount of money is today.

Yield is the interest rate, or rate of return, you get per year. Usually expressed as something like 5.25% or 0.0525.[1]

N is the number of times you ‘compound’ the yield. In its simplest form as written above, if you compound annually, N is the number of years your money compounds.

Example of the power of compound interest: Early investment for retirement

When do you use this formula? You use it when you want to know how much your $100 invested today, or this year, will grow over time.

To offer you an extreme example, using the compound interest formula:

What if you invested $100 today, left it invested for the next 75 years, and you were able to achieve an 18% annual compound return? How big an investment does your $100 become?

The answer is $24,612,206.

Can I interest you in $24 million? Without working?

As I say that out loud, I feel like a late-night infomercial guy. And that feeling makes me want to take a shower. But the money and the pitch is nothing more than compound interest math.

I happen to believe there’s quite a few 20 year-olds who:

a) Could put their hands on $100 today for the purpose of investing in a retirement account, and

b) Would like, at the end their life, to boast a net worth of $24.6 million[2]

I know all you realists out there will say that 18% annual compound return for 75 years is a fairy tale, and of course I can’t disagree with you.

But I’m doing a magic trick here for the sake of making a point, so would you please suspend disbelief for just a moment and revel in the magic? The point is not to argue about what reasonable assumptions may be, rather the point is to show why knowing how to do compound interest math could be a life-changing piece of information.

At the very least, its a tool that every citizen should be armed with. Thank you.

To be slightly more realistic, but equally precise, with a series of other assumptions:

If you’re 20 years old now and you let your money grow for the next 50 years, at 12% yield, your $100 invested today becomes $28,900. That’s also an amazing result.

Try it and find the Future Value for yourself, by inputting into the formula

Future Value = Present value * (1+Yield)^N

PV = $100

Yield = 12%

N = 50

Heck, having your money grow like this sure beats working for a living.

These facts are so amazing, I think, that they might induce a 20-year-old to forgo his XBox purchase this year, and invest the money instead in stocks, in a retirement account.

What about putting your money away in your IRA, $5,000 per year from age 40 to age 65, earning 6% return on your money every year? Would you like to know what kind of retirement you will have at age 65? Compound interest can tell you precisely the number.[3]

You’ll have $290,781.91[4]

And all of that becomes possible if we have some insight into the inexorable growth, the most powerful force in the universe, the one math formula to rule them all, compound interest.[5]

Please see Part I – Why don’t they teach this in school?

Part III – Compound interest and Consumer Debt

Part IV – Discounted cash flows – example of pension buyout

Part V – Discounted cash flows – using the example of annuities

Part VI – Conclusion and why everyone needs to know this math for the good of society

and Video Posts:

Video Post: Compound Interest Metaphor – The Rainbow Bridge

Video Post: Time Value of Money Explained

Addendum by Michael, added later: It turns out one of my high school math teachers not only does teach compound interest, but he included it in his math textbook, linked to here:

[1] I fear many of us learned how to convert a percent into a decimal in sixth grade, but not how to do anything useful with it.

[2] Yes, I hear you cynics, that this is in nominal dollars, and $24 million won’t buy them then what it buys today. But would you just stop being cynical for a moment, and appreciate the magic of compound interest? Thank you.

[3] If your assumptions are correct, of course.

[4] To achieve this calculation, you’ll have to add up 25 separate amounts, in a spreadsheet. The first amount, invested at age 40, compounds the most times and is expressed as $5,000 * (1+.06)²⁵. The second amount, invested at age 41, compounds as follows: $5,000 * (1+.06)²⁴. The third amount is $5,000 * (1+.06)²³, all the way until the 25^th amount, which is simply $5,000 * (1+.06).

[5] Thank goodness Sauron didn’t get his hands on the formula FV = PV*(1+Y)^N, or else the hobbits would have been so screwed. Ancient legend has it in the Silmarillion that Sauron actually did acquire the compound interest formula, but he interpreted the mysterious algebraic symbols as high Elvish, a language he could not read at the time. Speaking of which, does anybody else want to use compound interest to become a Silmarillionaire? Um, not so funny? Ok, you’re right, but don’t worry, I’ll be here all night folks. Don’t forget to tip your waitress. And try the fish.

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February 13, 2013January 9, 2014

Part I – The Most Powerful Math in the Universe Goes Untaught

On Teaching Compound Interest and Discounted Cash Flows

“The most powerful force in the universe is compound interest”

– Albert Einstein[1]

“Tomorrow and tomorrow and tomorrow,
Creeps in this petty pace from day to day
To the last syllable of recorded time”

This Spring I began teaching Personal Finance to a group of bright college students, and we recently wrapped up a section on compound interest and discounted cash flows.

What I’m trying to get across to these undergraduates is that all of the key financial choices they will make in their lives – all of their future decisions about consumer debt, retirement, insurance, purchasing a home, tax preparation, and investing – will be much, much better decisions if they deeply understand compound interest and discounted cash flows.

What are these concepts for?

The compound interest formula tells these students, and any of us who use it, exactly how quickly, and to what ultimate size, money grows in the future.[2]

Discounted cash flows reverses the process, and tells us what the present value would be of any given cash flow or series of cash flows that occurs in the future.[3]

I’ve realized over the course of the last few weeks, however, that I’m trying to convince these students of the absolute centrality of an idea that 95% of them have never heard of before walking into my class.

Not only this, but also 95% of the people my students will meet in their life never have heard of compound interest and discounted cash flows, and therefore will not have the slightest idea how profoundly it affects their lives and their personal financial choices.

Picture me in front of the class jumping up and down and waving my arms wildly (metaphorically of course), trying to get them to believe me.

And yet, why should they believe me when I appear to be the first (and possibly insane) person to ever argue this case?

I’m afraid that after they leave my class, the Financial Infotainment Industrial Complex will never again reveal the importance of compound interest and discounted cash flows to personal finance decision-making.

Why isn’t this taught as a requirement of Junior High School Math?

I was a strong math student in junior high and high school.[4] I received a solid foundation in algebra, geometry, trigonometry, and calculus. Of these, algebra has frequently proved useful, but none of the others apply to my life or career.

Compound interest and discounted cash flows, however, dominated my professional life as a bond salesman and hedge fund investor, and I make use of insights from them in my personal financial life all the time.

And yet, nobody taught me compound interest or discounted cash flows in school. I’d be willing to bet that almost all of you reading this didn’t get taught these concepts in school. That knowledge had to wait until I started as a bond guy at Goldman. This, despite the fact that you only need junior high school level math – basically algebra and the concept of ‘X raised to the power of Y’ – to understand and use compound interest and discounted cash flows.

The fact that school taught, and I spent years learning, complex but ultimately very niche mathematical skills, combined with the fact that nobody taught the essential mathematical skills of personal finance (and Wall Street finance for that matter) really gets up my nose when I think about it.

More than gets up my nose, it puts me in a suspicious frame of mind.

Why would these essential skills not be taught to every junior high school student, and then re-taught to every high school student, and then elaborated on for every college student? Because that’s how important this stuff is. And how relatively unimportant trigonometry, geometry and calculus skills are for most citizens.

I’ve only come up with a couple of possible explanations, as I explain below, but please chime in with your own theories.

1. Math teachers, as a group, do not understand the role of compound interest and discounted cash flows in personal finance.

I fear this is true. I’ve become friends with a few of my high school math teachers as an adult and with one I’ve discussed the power of compound interest as a math concept and as a personal finance concept. Later in his career, long after I took his class, he taught compound interest as part of his lessons on mathematics skills known as ‘sequences and series.’

In these later days he emphasized to his students that if he had really understood compound interest – as a young man – as well as he does now, his working and his retirement years would look totally different. Could somebody please tell the Professional Math Teachers Association (or whoever is responsible for this stuff) that this is really the key concept, and I mean, for everything?

2. The Financial Infotainment Industrial Complex wants to keep us down. I’m afraid I’m coming around more and more to this explanation. Nothing else makes sense.

I mean, seriously folks, calculus: Not relevant (for most people.) Compound interest: relevant (for everyone.)

Coming up next: Part II – Compound interest and Wealth

Part III – Compound interest and Consumer Debt

Part IV – Discounted Cash Flows Formula

Part V – Discounted Cash Flows – another example, using annuities

Part VI – Conclusion, and why we need this math as a society

——Addendum by Michael to this post:

One of my high school math teachers (and my high school advisor!) responded to my post by pointing out that not only does he teach compound interest, but that its part of the math textbook he wrote. How about that? I can’t resist linking to his textbook on Amazon, as my way of atoning for casting aspersions on math teachers.

[1] Albert Einstein frequently gets credited with this wise statement. A quick interwebs search suggests Einstein didn’t necessarily say this, as the first mention in print is found circa 1983. But Einstein could have, and should have, because it’s true.

[2] To get started on your own learning journey on compound interest, I recommend beginning by watching a video here, with my favorite, Salman Khan. If you enjoy that, continue the process with videos on present value #1, present value #2, and present value #3

[3] A nice place to start on discounted cash flows is Salman Khan’s video on present value #4 (and discounted cash flow). Khan doesn’t go far enough on discounted cash flows, or as far as I’m going to go in this series of blog posts to follow, but he at least gets us started, which is more than I can say for almost anyone else available for free out there.

[4] I didn’t pursue math in college, beyond one statistics class required for my concentration, which was Social Studies. Shout out to the 0.0005% of readers (I chose an arbitrary but statistically insignificant number) who will recognize my major and salute me for it, rather than assume I spent my college years doing what the rest of you did in Social Studies in middle school – memorizing state mascots.

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February 6, 2013February 12, 2013

Rating Agency Pet Peeve

While I’m on the topic of ratings agencies, I need to get this off my chest. I hate it when I read from the Financial Infotainment Industrial Complex that “X markets moved today in response to a ratings downgrade of Y.”

Here’s a hint for anyone who follows financial news but who has never worked in the industry: Markets never move in response to a rating agency change.

Never.

Ever.

Markets move in anticipation of news, months or weeks ahead of a change in credit quality. Often the ratings agencies observe a market move which prompts a query on their part, and possibly the rating agencies often have an inkling of the change in credit quality on their own.

But the ratings agency review process itself also takes days or weeks. Which, in the continuous feedback loop of world markets, may itself prompt a market response.

Markets are forward-looking, anticipating credit quality changes, as well as ratings agency changes. Markets never respond to credit ratings changes.

Want to spot a journalist who doesn’t know what he’s talking about?

Look at the one ascribing a market move to a rating agency change.

End rant.

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February 5, 2013February 7, 2013

Busting the Rating Agency

Yo everybody 5-0! 5-0! The cops are here!

The US Justice Department filed a lawsuit yesterday against Standard & Poors, for its role in over-rating mortgage bonds, CDOs, and other securities in the years 2004 to 2007, securities which later proved to be weapons of mass financial destruction – the initial catalysts of the Great Credit Crunch.

When I read the story this morning, I suffered an involuntary eye-roll, the type I discourage in my daughters.

If a fraud was committed in those years, the rating agencies, frankly, are not the prime suspects here.

If the Wall Street mortgage bond market was the greatest financial frat party of all time, in the years 2002 to 2008, the rating agencies were the freshman pledges. We needed them for continuity, and because they provided a reason to host a party. But look, nobody really respected them. They did what Wall Street told them.[1]

But then the party went horribly awry. Somehow the upperclassmen frat brothers are way too smart to still be at the scene.

Now, with the frat house furniture stolen, the neighbor’s cat shaved and duct-taped, the Dean’s house toilet-papered, and the entire kitchen and basement burned black, the police have shown up and seized all the stupid pledges they found passed out in the back garden.

Yes, the pledges were at the party. And yes, they kind of knew it could all go wrong somehow,[2] but not really. They weren’t really in on it. They didn’t have the upside that the Wall Street firms had. They were just trying to appeal to the big frat brothers, who might someday invite them to be part of the inner circle.[3]

So, I rolled my eyes this morning because the cops can definitely bust Standard & Poors, but it begs the question of “Why?”

Who Killed Fund Performance? We All Did!

Essay Review of “Murder on the Orient Express – The Mystery of Underperformance”

Once in a while I read something which crystalizes for me – with data and arguments better than I could hope to make – what I already suspected but hadn’t yet put into words.

Charles D. Ellis writes in Financial Analysis Journal[1] a research-based critique of the Financial Infotainment Industrial Complex’s myth of investment manager outperformance.

Using the literary conceit of Agatha Christie’s Murder on the Orient Express, Ellis plays detective Hercule Poirot to uncover everyone’s guilt – investment managers, investment consultants, fund executives, and investment committees – when it comes to paying unnecessary fees to managers who inevitably underperform ‘the market.’

If, like me, you kind of suspected all that, but wanted to see it demonstrated in black and white, I recommend the article. If you want the Cliff’s Notes version, hey, that’s why you come to Bankers Anonymous!

The Problem

As Ellis points out, everyone wants to own funds with investment returns in the top quartile; this is statistically impossible for more than 25% of investors in any year.

The further grim reality is that 60% of mutual funds underperform their benchmark every year, and that number climbs to 80% underperformance over a 20-year period.

Most troubling of all, Ellis cites research[2] which concludes that 24% of funds underperform their benchmark, 75% of funds match their expected market returns with no alpha[3], and 1% of funds actually offer risk-adjusted superior net returns, after costs.

So about 1% of actively managed funds are really “worth it.” Think you can pick that 1%?[4]

Ok, that’s the problem. Who’s to blame? Everyone in the Financial Infotainment Industrial Complex.

Investment Managers

How are they to blame for underperformance?

They choose time horizons in their marketing materials specifically to show outperformance, ignoring those years which would show either ordinary market returns or underperformance
They ignore the proliferation of thousands of highly trained experts in every aspect of investment finance who ensure that almost nobody has an edge on anybody else.
They actively market their products precisely at the moment following short-term outperformance, despite their knowledge that performance almost always reverts to the mean in the medium-to-long-run.

Investment Consultants

How are they to blame for underperformance?

Consultants get paid to retain clients, by not meaningfully underperforming the market. Consultants achieve this aim by emphasizing the importance of diversification, thereby ensuring that no single fund can noticeably impair the client’s portfolio, nor can any single fund make a meaningful contribution to alpha.[5]
Consultants inevitably recommend funds with recent outperformance – which limits the pool of funds – and ignores the mean-reversion inherent in most managers’ performance over time.

Fund Executives

How are they to blame for underperformance?

Fund executives often add a layer of extra fees by insisting on ‘separate accounts’ even when investing in long-only stock funds, when it makes little sense.
Fund executives typically are at an information and experience disadvantage when dealing with their counterparts at investment manager firms. So they fail to ask pertinent questions or push back when necessary. I’ve frequently observed the psychological barrier that prevents less experienced financial professionals in the room from asking the right question. Investment managers know this and depend on this. Traditionally we think ‘fear and greed’ drive the market and that’s still true. But the ‘fear of appearing foolish’ drives the fee structure in many parts of the investment management world.

Investment Committees

How are they to blame for underperformance?

Investment committees, like fund executives, usually act at an information and experience disadvantage when reviewing investment managers.
Most investment committees have limited time and resources to do proper due diligence. As a result, they tend to focus on recent past performance, which has little predictive power for future results, and suffers from the mean-reversion problem of markets and strategies.[6]
Investment committees mistake their role, imagining that it consists of investment decisions rather than governance decisions.
Investment committees stick with historic policies long past their “sell-by date,” because of the group-think inertia.

The result

The logical result of the “Murder on the Orient Express” discovery that “everyone is guilty” is that managers of pension funds and endowment tend to pay too much in fees for investment management.

The Financial Infotainment Industrial Complex continually reinforces the idea that outperforming managers may be discovered at any time and that the goal of investment managers is to ‘beat the market.’

But when you pay extra to ‘beat the market,’ you end up, in the long run, paradoxically underperforming the market by, at least, the amount of your fees.

[1] What? You’ve let your subscription to Financial Analysis Journal lapse? Well, thank goodness you have me to point this paper out to you then. Here’s the Scribd link to the paper.

[2] Laurent Barns, Olivier Scaillet, and Ruiss Wermers, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas.,” Journal of Finance, vol 65, no. 1 (February 2010): 179-216.

[3] Sorry to get all Greek-lettery on you. “Alpha” means “performance above your benchmark” in investment terms. “Beta,” if you’re curious, means correlation to your benchmark. Beta is easy to achieve, and it’s what most mutual funds do despite claiming to deliver alpha. Getting alpha from an investment manager over time is hard, and rare.

[4] That sounds like a rhetorical question, but there actually is a correct answer. The answer is “no.”

[5] It’s not in Ellis paper, but this point reminds me that ‘diversification’ often prevents significant wealth creation. I’ve written this before, but truly wealthy people who made the money in their own lifetime, inevitably have extreme concentrations of risk in only one or two assets or businesses. Concentration of risks creates alpha, diversification creates beta.

[6] Ellis points out that research supports only the predictive power of recent performance for the bottom decile of managers. The worst 10% tend to maintain underperformance due to high fees and limited capability.

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