2006 Stock Market Year In Review

With the last trading day of 2006 under our belts, it is time to take a look back at how the markets and my 401(k) portfolio performed this year.

Overall, it was a fantastic year for the markets, across almost every asset class. In fact, it would have been difficult to show a negative return in your portfolio this year. This was very upsetting to me. I'll explain why after I walk through some of the details.

70% of my retirement portfolio is invested in Large Cap stocks, with 50% in a S&P 500 Index fund, 10% in a large-cap growth fund, and 10% in a large-cap value fund.

According to Standard and Poor’s Website, the S&P 500 Index rose 13.62% in 2006 and showed a total return (factoring in both capital gains and dividends) of 15.8%. I use the S&P 500 Index as a proxy for the market as a whole, as do many other investors.

My S&P 500 fund showed a total return of 18% this year. I don’t exactly know why it outperformed the returns published on the S&P’s Website, since it is basically designed to track the S&P 500 and I would usually expect its returns to come out slightly lower than the S&Ps because of the fees the fund manager charges. The outperformance may be due to the fact that the fund managers were able to purchase securities at favorable prices, or some timing issue between when they added stocks and when the S&P officially added stocks to its index. Another reason could be that my plan’s Website has not yet completely updated its year-end figures.

Taking a closer look at the sectors that accounted for the S&P’s performance in 2006, the best performers were Telecommunications Services (+32.13%), Energy (+22.22%), and Consumer Discretionary (+17.23%). The weakest performing sectors were Health Care (+5.78%), Information Technology (+7.7%), and Industrials (+11.02%). When the third-worst performing sector in the S&P has double-digit returns for the year, you know it’s a good year for stocks.

2006 was a better year for value stocks than it was for growth stocks, as seen in the performance of my value stock fund (+18.5%) and my growth stock fund (+10%). Value and Growth stocks tend to perform differently as groups so I like to have exposure to both high P/E (growth) and low P/E (value) stocks in my portfolio.

As an aside here, the Wall Street Journal has another proxy for the market as a whole, and that is the Dow Jones Industrial average. I don’t think this is a great barometer for the market because it contains only 30 industrial stocks, but it is a popular gauge. Dow Jones publishes the Journal, so this is the index the paper focuses on the most. The DJIA was up 16% this year and closed near a new all-time high.

The biggest winners of the year were small cap and international stocks. Because I consider these two groups to be more risky than bigger, more well-established American companies, I have lower exposure to them. I keep 15% of my portfolio in small cap stocks, divided among two funds, one of which was up 15.5% on the year, and the other of which was up 7.9%.

12% of my portfolio is allocated to International stocks, with 7% in an international equity fund and 5% in an emerging markets fund. The emerging markets fund blew the doors off of the market this year, recording a 29.4% return. The international fund didn’t do too bad either, returning an even 21% on the year.

If you’ve been adding up my percentages along the way, you’ll discover that I have 3% left. I decided to put a small amount of my retirement money in a fixed income fund purely for the sake of diversification so that in the years when equities are in the red (and I know these years are coming!), I will be able to look at my portfolio and see that at least one of my investments is up. The fixed income fund underperformed my stock investments this year, returning 5%.

My combined rate of return on the entire portfolio this year was a solid 16.6%.

So, am I patting myself on the back for this 16.6%? Am I going to go out and have a party?

I most certainly am not. In fact, I'm pretty disappointed. To illustrate why, here’s a quote from Warren Buffett’s 1997 shareholder letter:

"If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period?"Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."

I'm definitely a net buyer, so I prefer sinking prices.

While it is a good idea to keep tabs on your investments and year-end provides a good time to take a deeper look at them, the only holding period return I care about is the time period between when I invested my money and when I cash it out. The market could be down 50% next year for all I know, but the reason I am putting my money into stocks is that I think they will end up as my best investment opportunity over the long haul. I hope to average 10% a year over the next 30-35 years, something I could probably never achieve with regular bank account interest, bonds, or other alternatives.

A few other random thoughts about the market this year:

-Most of the market’s gains came in the second half of the year, after the Fed stopped raising rates

-The price of a barrel of oil was up only a penny this year, closing at $61.05 vs. $61.04 at the end of last year. This compares with the $20 a barrel we had become comfortable with in the decade or so before 2004. I never thought I would live to see the day when people expressed relief that oil was “only” $61 a barrel. For most of my life (1986-1999), you could get a gallon of gas for $1.50 at the pumps. For the past few years we’ve been paying more like $2.50, which is a 67% increase that seems to my uneducated eyes like it’s here to stay. If you’re curious about gas prices, check out this website (zfacts.com).

-People seem to be looking for risk. One of the basic tenets of finance is that you get greater rewards if you take greater risks. Judging by how well the riskiest asset classes performed this year (emerging markets being the biggest illustration of this), investors are bidding up these risky assets in hopes of getting these big rewards. Don’t follow the crowd and throw a ton of money at these stellar performers. The other shoe will drop sometime.

-The housing market finally started getting some positive press towards the end of the year. A lot of it came from the National Association of Realtors (NAR), so that can be taken with a grain of salt, but some of the reports on housing starts and home prices have been downright rosy compared with what we had been hearing. Personally, I hope housing prices keep going lower, because I hope to be a buyer within the next few years.

That’s my year in review. I'll close with my wish for 2007:

LOWER SHARE PRICES!

Happy New Year!

The Best Place To Find a Notary

I have never used a notary before in my life, but I need one in order to roll over my old 401(k) plan into my new employer's plan. I thought this would be a huge hassle, but turns out it is only a small hassle. I just called my local Chase bank branch and they have a notary on duty today (Saturday). What great customer service!

Some guy on CraigsList wanted $50 to come and notarize something. I did some poking around and the most you can legally charge to notarize a signature in New York is $2. He must be claiming the $48 is his travel fee!

The point is, your first stop for notary services should be your bank's local branches. If you are paying someone to notarize something for you, look into what your state law says is the maximum fee they can charge.

Postscript: I just got back from Chase, and it was an extremely easy process. They were able to witness my wife's signature, notarize my document, and get me out of there in about 15 minutes. Now all I have to do is make some copies of the signed documentation, send it to the old employer's plan, and they will send me back a check for the amount in my 401(k). I will send this check to my new employer's plan along with instructions for where to invest the money (I am going to distribute it according to the same percentages I use for making my weekly contributions), and they will put it into my account for me. The result? One less account to worry about!

ING Direct's New Electric Orange Checking Account

Lately my online bank, ING Direct, has been dangling its new "Electric Orange" checking account in front of my face. Apparently I am one of a select group of 400,000 of ING Direct's most active customers that make frequent deposits and withdrawals, and they're giving me the opportunity to sign up for the account in January, a month ahead of the national rollout scheduled for February. I have been using the company's Orange savings accounts, its CDs, and even its investment accounts to a limited extent. This new offering is a paperless checking account that pays interest on the your balance according to the following schedule (effective 11/29):

Balance::::::::::::::::::: Interest Rate::::::::::::::::: APY

$0-$49,999.99::::::::::::::::::::::: 2.96%::::::::::::::::::::::::: 3.00%

$50,000-$99,999.99::::::::::::::: 4.94%:::::::::::::::::::::::: 5.05%

$100,000 or more :::::::::::::::::::5.18%:::::::::::::::::::::::: 5.30%

On the surface, this looks very promising, especially if you have a balance over $100,000. Most checking accounts do not pay interest, and to get a 5.30% APY on a checking account is unheard of, especially given the paltry 4.5% APY on ING's own savings account.

When I first saw this account, I immediately thought these were short-term "teaser" rates designed to get people to sign up, only to be ratcheted down a year from now.

Banks are really fighting to retain customers these days, and getting someone to set up a checking account at your bank, automating all of their bill payments through your bank, and basically getting them comfortable with you makes it much more likely that they won't switch. So I figured ING was throwing a teaser out so you would go through the trouble of signing up for another account.

Then I thought about some of the costs (to your bank) of having paper checks. These involve check processing, check imaging, possibly printing copies of your checks in your monthly statements etc... By giving you a paperless checking account, ING saves these costs and can partly pass this savings along to the consumer in the form of interest paid on the account.

Another thing that ING will potentially get from these checking accounts are fees for overdrafts, etc... that it can't hope to earn on a savings account. In addition, the account offers a bank card, and ING can collect some fees from these if you use an ATM that's not in the network.

Combined with the fact that ING doesn't have the overhead the brick and mortar banks have, all of these features allow ING to potentially make money from a checking account that offers such a high rate of interest.

So am I going to sign up for the account?

No.

Why?

Number one, I still harbor suspicions that these rates are a little "too good to be true" and that they will come down to more normal levels after the introductory period is over.

Number two, Chase has already retained me pretty well! I have all of my bill payments set up through that bank's checking account, and I don't relish the idea of redoing all of my payees.

Number three, one of my 2007 goals is to simplify my finances, and I don't think adding another account is a good way to do that.

And finally, even though I don't use them very often, I still use paper checks at least once a month to pay my rent. I like the flexibility of being able to put one into a birthday card or send money through the mail with a paper check. In ING's defense, the checking account does offer an option where you can enter in some information online, and it will generate and mail a check to your recipient, but I'm not entirely comfortable with that process. Chase does something similar but I had them send a check to my brother one time and it took forever. Plus, you can't easily stuff one of those into a birthday card.

The rates are attractive right now, but in this case the negatives outweigh the positives for me. The last thing I need is another account, another piece of plastic with my account numbers on it, and more statements coming to my house.

You can read more about Electric Orange on ING Direct's Website.

POSTSCRIPT: I reevaluated the ING Direct Electric Orange account in May of 2007 and I opened one. See this post for my rationale (its about half way through the post). To make a long story short, it yields the same amount as a 1 year CD, and I had enough cash savings to get the highest offered rate, which is 5.25% APY as of June 2007.

Buffettology by Mary Buffett

Buffettology was among the first investing books that I read way back when I was a 19 year old college senior, and it remains one of the foundations of my investment philosophy.

Mary Buffett was Warren Buffett's daughter-in-law for 12 years and wrote this book following her 1993 divorce from Warren's son Peter (for the sake of clarity, I will refer to Ms. Buffett as "Mary" and Warren as "Buffett" from here out). It gives her "insider" perspective on on Buffett's investing style and offers a fairly in-depth look at how she thinks he makes his decisions.

The book is broken into two main parts- "The Art of Basic Buffettology" and "Advanced Buffettology."

If you think the stock market is about ticker symbols, three week moving averages, relative strength, reading analyst reports, buying, selling, and momentum, then anything you hear from or about Buffett will seem counterintuitive.

Mary lays this out right at the beginning of the book "Warren had little use for typical Wall Street banter. He didn't seem to care which way the Dow Jones Industrial Average went, and he certainly had no use for all the soothsayers and their predictions. In fact, he acted as if the entire stock market didn't exist. He never looked at a chart, and if anyone tried to give him a stock tip, he would usually shut him or her off... He seemed to care only about the individual businesses he was interested in owning."

From the book you will quickly learn that Buffett takes a business perspective to investing. He doesn't think of buying stocks like the way many people think about buying them. He understands that they represent an ownership interest in a business, and evaluates whether or not he wants to own a piece of that business.

Of particular interest in the first half of the book is Mary's treatment of the general kinds of businesses Buffett likes to invest in. According to Mary, Buffett divided businesses into two basic categories - commodity type businesses and excellent businesses.

The commodity-type businesses "offer the least for future growth of shareholder value," and they share some or all of the following characteristics: low profit margins, low returns on equity, absence of brand-name loyalty, the presence of multiple producers, the existence of substantial excess production capacity in the industry, erratic profits, and profitability almost entirely dependent upon management's abilities to efficiently utilize tangible assets. Buffett stays away from these kinds of businesses, she says, because price competition generally reduces profits, and in the event that the business does earn some profits, "the capital is usually spent upgrading plant and equipment to keep abreast of the competition."

The excellent businesses, on the other hand, have something called a "consumer monopoly" going for them. When a company produces products with "some distinctive attributes that are particularly attractive to buyers, who then form an attachment to a company and the products it sells," that company has a consumer monopoly.

Mary lists nine questions to help determine if a business is an excellent one:

"1) Does the business have an identifiable consumer monopoly?
2) Are the earnings of the company strong and showing an upward trend?
3) Is the company conservatively financed?
4) Does the business consistently earn a high rate of return on shareholders' equity?
5) Does the business get to retain its earnings?
6) How much does the business have to spend on maintaining current operations?
7) Is the company free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does the managment do at this?
8) Is the company free to adjust prices to inflation?
9) Will the value added by retained earnings increase the market value of the company?"

The second half of the book is called "Advanced Buffettology" and takes a more quantitative look at some of the Buffett tools such as projecting rates of return, forecasting future earnings, and playing the short term arbitrage game. To wrap it up, Mary presents a few case studies of stocks that Buffett has actually purchased, and walks through his most likely rationale for making the investments that he did.

Coupled with a reading of Buffett's shareholder letters, this book makes an excellent introduction to the investing style of Warren Buffett. Mary lays it all out in short, distinct modules that make it very easy to pick up the book, spend 10-20 minutes reading, then put it down to come back to at another time.

Since Buffett has never written a book himself, we may never get a perfect insight into how he selects and values stocks. However, I think it is an extremely worthwhile exercise to try to figure it out using the materials available to us. If you are interested, I would recommend picking up a copy of this book and adding to your knowledge of The Oracle of Omaha.

Yearend Financial Tips from Bankrate

Just passing this along...Bankrate.com has a great roundup of financial tips from seven experts for 2007. There should be something here for everyone. I was particularly impressed with the Tax Adviser's roundup, because it did not include a suggestion to "sell your losers!" Kudos to bankrate on some more great info!

Bankruptcy Adviser: 7 steps to a fresh financial start

Mortgage expert: 7 smart mortgage moves for '07

Debt Adviser: 7 moves to get debt-free

Dr. Don: 7 personal finance ideas

Tax Adviser: 7 moves for tax-filing season

Real Estate Adviser: 7 tips for home buying or selling

College Money Guru: 7 steps to save for college

It's That Goal-Setting Time of Year Again

The week between Christmas and New Year's always seems to be a slow one at work, making it an opportune time to take a step back from your life, look at where you've been, where you're going, and maybe set some goals for the upcoming year.

I was just over at Consumerism Commentary reading this post linking to stories about other bloggers' 2007 goals. I had a good time looking at people's goals and realizing how similar they are to mine, and to basically everyone I know. I recommend taking a look at some of these, you just might find some inspiration there.

We all seem to want to exercise more, we want to spend more time with our families, and we want to improve our financial security. I've achieved a few goals in the past and the best advice I can give is to make it a priority, figure out the pitfalls in advance (ie- what are the things that have prevented me from doing this in the past), and start small. If you want to start a new exercise routine or something, be fully aware that the first few weeks are going to be the most difficult, but they are also the most important. The inertia of not exercising, not saving, and not spending time with your family is a powerful thing and you have to hit it like a wrecking ball.

I always make it a point to get into the office at least a few days in the week between Christmas and New Years (if possible) because, since it is usually so slow, it gives you the perfect opportunity to clean up your workspace by throwing out a bunch of old documents and files. It's also a great week to devote a day or an afternoon to the big picture thinking you might otherwise never get the chance to do. For more on big picture thinking and how it can help you, check out this post I wrote.

If you haven't already done so, why not take some time this week to set some goals for next year? The following are some links to help you jump-start your thinking:

mindtools.com
topachievement.com
about.com

Stupid Year-End Tax Advice

Of all the year-end tax tips I see bandied about in the popular financial press, the one that I disagree with most is the advice to sell stocks in your portfolio that have declined in value in order to generate tax losses that can offset capital gains you might be reporting for that year.

I cringe whenever I see an article entitled "10 Year End Tax Tips" or "Seven Ways To Cut Your Tax Bill Next Year," because nine times out of ten, the writer suggests that you "sell your losers."

This advice shows up here (allbusiness.com), here (quicken.com), here (taxprofblog.com), here (turbotax.intuit.com, which presents the advice a little bit more responsibly), here (about.com), here (csmonitor.com), here (taxguru.net), here (money.cnn.com), here (money.aol.com) and in basically every single year end tax planning guide you will ever come across. These year-end tax tip articles usually have the same incestuous few bits of advice that, although they might be helpful in some situations, generally aren't worth the paper or pixels they're printed on.

So why do I call the particular suggestion of selling losers "stupid advice?" Because you should always base your decision to buy or sell a stock on the price of the stock and your estimate of the company's future prospects, not on how the other stocks in your portfolio have performed.

If you own shares of a company, and the value of your investment falls below where you purchased it, you need to reevaluate your investment. Is the company still performing how you thought it would? Has there been a negative change in the fundamentals of the business or its industry? Has the stock simply fallen out of favor? Are investors getting scared? You sell your stake in the company when the fundamentals have changed and your original reasons for buying it no longer apply, and this shouldn't be something you wait until the end of the year to decide on.

If you based all of your financial decisions purely on lowering your tax bill, I could give you some great year-end advice. Tell your employer to stop paying you for your work. This will put you in a lower income tax bracket (the 0% bracket, to be more specific) and ease next year's tax burden. Then take all of your income-generating investments, liquidate them, and put the proceeds into a 0% checking account. This will reduce the interest income you have to pay. Also, try to contract a serious disease or injure yourself so you can deduct all of those huge medical bills.

Hopefully you realized the previous paragraph was me being sarcastic, but the point that I am trying to make is that you should not base your investing decisions purely on the tax consequences because in many cases, the tax benefit of offsetting some capital gains would be more than offset by the future performance of the stock. You are taking a very short-term view when you sell a loser to offset gains, and I would argue that if you're going to make short term bets on stock prices, you might as well go to the nearest casino and at least get some free drinks while you gamble your money away.

In some cases, the advice to sell losers might make sense. If you haven't been paying attention to your portfolio all year (and if you haven't, why are you investing in individual stocks in the first place?), this might give you a reason to reevaluate your holdings. If you're on the fence about selling a stock due to its business prospects, all else equal this consideration might push you over the fence.

Finally, I am not a tax advisor, so you should check with yours before making any decisions with the intention of lowering your tax bill. The preceding was just my sound, educated, correct opinion and does not necessarily reflect the views of the personal finance industry, the blogosphere, or the world as a whole.

Organize Your Work With a Notebook in 2007

One of the recurring themes of this blog is that the best way to get richer is by increasing your income. For most of us, the best way to do this is by doing our current jobs better and getting the raises and bonuses we deserve. This post walks you through a system I use to organize my work and manage my time on a daily basis. It has done wonders for my organization and recall, has been a real timesaver, and I think it has contributed to improving my performance.

The system is incredibly low-tech, and consists of nothing more than an ordinary spiral 8.5' x 11' notebook that I use to take notes on virtually everything I do. If you walk by my desk, you will always find one of these books right next to my computer, open to a page with the date on top.

Each day I get into work about a half hour before everyone else. This gives me some good quiet time to plan my day. I usually start by flipping a new page in the notebook, writing the date on top, and making my to-do list, which I sometimes populate while reading my emails and flipping through the previous days' pages.

Then I keep my notebook with me throughout the day so I can write things down and cross off my "to-dos" as I get through them. When I said "virtually everything" goes in my notebook, I meant it. Some examples include:

• Each time I make or receive a phonecall related to a work project, I write down the person's name and number along with a summary of the important points.

• Each time I come across a word or a concept that I don't understand, I make a note to research it when I get some down time.

• I bring the notebook into every meeting I attend, where I list the attendees and my notes on the important discussion topics.

• If I get some particularly important handouts at a meeting, I scotch tape them into the notebook so I can easily reference them at a later time.

• I have multiple sets of usernames/passwords, and I keep them on a certain page of the notebook, disguised so that someone who found the book would not know how to use them.

• If I accomplish a task that wasn't on my to-do list, I make a note of it.

• If an idea comes to me in the course of working on something, I immediately write it down so I don't forget it.

• If a new employee joins the company and they are introduced to me, I write down their name and department, and possibly a few other details about them (where they used to work etc...) because those are the kinds of things that tend to immediately fly out of my head right after I've met someone new.

• If I write down something important that I will need to come back to over and over again, I go over it with a highlighter so that I can easily find it. One example of this is a procedure I run through quarterly to access data from a website and format it for a certain report.

• I often write a brief postmortem after I’ve completed a project or solved a problem. Sometimes when you get an answer, it sticks in your head for a short period of time, then leaves. When the question comes up again, you have to reinvent the wheel and figure it out all over again. If you’ve written it down, you can just go back to your notes instead fo doing extra work.

The single notebook system is a great way to make sure that I'm not always searching for materials, that I don't forget things, and that I can recall phone conversations from years ago. I can't count the number of times where this system has helped me out. For example, just the other day I was in a meeting where we were discussing a certain transaction we did some months back, and nobody could remember the dollar amounts involved. I simply flipped back to the day I called someone about the transaction and pasted into my notebook was a summary Excel table I had made with all of the relevant details. This made me look extremely efficient and organized.

It is also a great place to keep phone numbers. I find that I often lose business cards, napkins, post-it notes, and various other scraps of paper that people use to jot down phone numbers. When they are taped or stapled in my notebook, all I have to remember is the approximate date I had the conversation, and I can immediately find them.

Another great thing about having this notebook is that it comes in extremely handy around annual review time, especially when I am asked for a list of my accomplishments throughout the year. Reading through my notebook at the end of the year is a great way to get all of my accomplishments fresh in my mind before heading in to a performance review.

I make sure to put the book away in a drawer at the end of each day so the cleaning staff doesn’t accidentally toss it. And when I go on vacation I usually try to lock it in a drawer to make sure someone doesn’t walk off with it.

This technique is also a great one for the disorganized college student (which I was during my first couple of semesters at college). If you keep one binder or notebook for each class, bring it to every class, and keep all of the materials together, you will never lose anything. You are also much less likely to forget due dates for assignments.

If you want to improve your organization at work, I highly recommend you try using a notebook. Once you stick with the system for a few weeks, it becomes second nature to keep your notebook by your side and should lead to a noticeable increase in your productivity.

You can adapt the system any way you want but I would say the three keys to making it work are:

1) Starting each new day on a new page
2) Putting the date on top of each page
3) Resisting the urge to take notes anywhere else (like a post-it or the back of an envelope)

Best of luck with this, and I'm always happy to hear if this helped, if you do this differently, or have any additional tips on how to be more organized at work.

Update On 401(k) Rollover

As part of my ongoing effort to streamline my finances, I have been working on rolling my previous employer's 401(k) plan into my current employer's plan. I have been able to access my previous employer's plan via the internet in the years since I left that firm, but I think it would be more efficient for me to have all of my 401(k) retirement money in one place.

The first thing I did was request forms from both my old employer and my new employer. They arrived at my house today but to my dismay it looks like the process is going to be a little more complicated than I expected.

The basic idea behind the rollover is that you get your old employer's plan to send you a check for the value of the account, made out to your new plan. You then submit that check to your new employer's plan within 60 days, and it goes into your 401(k) with no negative tax consequences.

I figured it would be fairly easy to do because it was just a matter of filling out and mailing forms.

However, my former employer's rollover application has a bit of a kicker in it- they want my wife to sign a "Waiver of Joint and Survivor Annuity" saying basically that we are giving up our right to get the balance paid to us via an annuity. A signature is fine, but they also want her signature notarized! This means that I have to find a state appointed notary, get that person, my wife, and myself into a room, have my wife prove her identity to the notary, sign the document, and have the notary stamp it.

I think this is a ridiculous step, and adds another unnecessary hurdle to the process of me moving my own money.

I don't know if this is common for most husband and wife combos, but we both leave for work at about seven in the morning and I don't get home until seven in the evening on average. This makes doing something like going to a notary (or doing anything together during normal business hours) a pain in the rear end.

According to the forms though, it has to be done.

If you're planning on rolling over your 401(k) and you're married, plan for this step.

Peter Lynch's One Up on Wall Street

One of the first books I ever read about investing was Peter Lynch's One Up On Wall Street.

For those of you who have never heard of Peter Lynch (wikipedia), he ran Fidelity's Magellan fund from 1977-1990 and put together one of the most enviable fund manager records of all time. The fund showed a CAGR of approximately 29% during his tenure, and he only underperformed the S&P twice.

The first 80 pages alone are worth the price of this book, and if I taught a course in investing, I would be sure this section (Part I: Preparing to Invest) was required reading. The ideas in these chapters form the foundation of a sensible investment philosophy.

Chapter 4, Passing the Mirror Test, has a particularly useful exercise for anyone who is thinking about investing. Lynch suggests that you stop, look at yourself in the mirror, and ask these three questions:

1) Do I own a house? Lynch suggests that you buy a house before you invest your money in the stock market because, "in 99 cases out of 100, a house will be a money-maker." The way he sees it, a house is rigged in your favor. You can acquire one for 20% down (without having to make the cash call like you would with a stock bought on margin), the leverage you use increases your returns, and the interest on the loan is tax deductible. In addition, people generally do more research when they buy a home than when they buy a stock, which further increases the chances that the investment will turn out well.

2) Do I Need the Money? I think this is the single most valuable piece of advice someone will ever give you about investing. Lynch says the formula for figuring out what percentage of your assets should be put into stocks is simple: "Only invest what you could afford to lose without that loss having any effect on your daily life in the forseeable future."

I can't say it any better myself. The stock market is not magic. If you need to pay for something within the next five years or so (such as a new house, college tuition for a kid, etc...), do not put that money into the stock market because there is no guarantee that it will be there when you need it.

3) Do I Have the Personal Qualities it Takes to Succeed? Lynch says that this is the most important question of all. The personal qualities he lists as necessary for success in the market are "patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit to mistakes, and the ability to ignore general panic... It's also important to be able to make decisions without complete or perfect information... And finally, it's crucial to be able to resist your human nature and your 'gut feelings.'"

After setting out this foundation, Lynch moves into Part II - Picking Winners. He takes the reader through a process they can use to discover undervalued stocks on their own, and continually stresses that people should exploit any edge they have to identify promising companies. He says to stay on the lookout for things that are happening at your company, stores that seem crowded, prices that are going up, products that are in demand, and you might notice something before Wall Street does. For example, "You don't have to be a vice president at Exxon to sense the growing prosperity in that company, or a turnaround in oil prices. You can be a roustabout [ed note: whatever that is], a geologist, a driller, a supplier, a gas-station owner, a grease monkey, or even a client at the gas pumps."

Once you've located an opportunity, Lynch walks you through the next steps in the research process, from looking up the financials, to calling the company for more information, and ultimately, deciding if it is worth buying.

I'm not a fan of picking your own stocks, unless you are really willing to put some time into doing the research. If you do choose to get into this, however, this book would make an excellent addition to your shelf.

As an added bonus, it is extremely easy to read. There are no boring parts, and Lynch has a somewhat light-hearted style.

Lynch followed this book up with "Beating The Street" where he went more in-depth about specific stocks that he selected and why. If you liked this book, "One Up On Wall Street" would make a logical next read.

My Spreadsheet Will Never Make Someone Smile

The other day I was on the train with some friends- all professional types with degrees and fancy-sounding jobs and things. A guy got on and started playing some Beatles songs on his guitar.

Maybe it was the fact that it was the Christmas season, maybe it was the little kids on the car that got up and danced, or maybe it was just the fact that the guy was good and he got really into it, but at the end of the song, everyone in the car applauded.

During one of the songs, my friend leaned over to me and whispered "That guy's job is so much more important than any of ours."

I agreed with him to an extent. As good as I might be at pushing around numbers in a spreadsheet, I am never going to get a spontaneous round of applause for it. I am never going to cause kids to get up and dance, and I am never going to make people smile.

I do take pride in my work though. I hope to be able to use it to support a family of my own one day. The money I make is only a means to an end, and I’m reminded of this end every time I go to a funeral. No, I’m not talking about death. I’m talking about having a positive impact on the people around me. About being a good husband, brother, son, uncle, and friend.

Maybe the fact that I like to leave work early on Fridays to play Wiffleball with my nephews will get me one or two less promotions in my lifetime. Maybe coming home to have dinner with my wife will make me fall behind on some things at the office. Maybe (almost definitely) I will never be the CEO of my company but you know what? That’s fine with me, as long as I don’t have to give up those other things.

The US Income Tax Headache

According to an opinion piece in yesterday's Wall Street Journal:

Americans who earned more than $1 million in adjusted gross income paid $178
billion, or an average of $740,000 per filer, in income taxes in 2004. That's up
about one-third from 2002, the year before the Bush tax cuts in marginal
income-tax and dividend and capital gains rates. The wealthiest 1% of tax filers
paid a remarkable 35% of all individual income-tax payments that year.

It is no secret that the rich pay the vast proportion of the income taxes in the US, and I think this is a good thing. Our tax system is graduated in such a way that the more you make, the higher a percentage of your income you pay to the IRS. This in effect forces those who have been rewarded by our society with riches to subsidize services for (and yes, even handouts to) those who do not make as much money.

Is the system perfect? I think the answer to that question is "definitely not." but I it is at least closer to good than it is bad.

My biggest problem with the current system is the complexity involved. The rules, the forms, the deductions, the instructions, the carryovers... it makes my head spin every year.

Another problem with our system is the alternative minimum tax, which was put in place to catch rich people, but due to neglect over the course of the past few years, is ensnaring more and more middle class tax payers.

I have heard a lot of different proposals for changing our tax system over the years, and of all the ones I've heard, I think the flat tax is the way to go. The hours I have put into doing my taxes over the years could easily have been put to some more productive use. So could the money I spent the one time I had a tax advisor prepare them for me. Don't even get me started on that ripoff. They charged me PER FORM, and it took about 10 minutes for them to do. My bill ended up north of $200.

I would prefer a graduated flat tax where everybody who makes a certain income pays a certain rate. This way we would be able to keep the system fair, and tax the rich more than we tax the poor.

Yes, tax preparation firms like Jackson-Hewitt and H&R Block would be very upset if we instituted a flat tax, but I would be thrilled.

There are some downsides to the flat tax as well, which you can read about in the Wikipedia article, but I think the simplicity of the system would far outweigh the negatives.

Beat the Average Raise

I read an article in the Wall Street Journal today that referenced a Mercer Human Resources Consulting survey that said the average annual pay raise this year was going to be in the 3.6%-3.7% range.

The key word there was average. This is further reinforcement for the idea that you need to perform well at your job. You want to give your boss a reason to give you an above average raise.

So this year has already pretty much passed you by. Were you a mediocre performer this year? Did you do just enough to get by with outbeing fired? Are you going to get your usual 4% raise this year?

If you answered yes to any of the above questions, and you want to earn more money so that you can achieve your financial goals, you need to make a change. If you do a 180, you will be able to laugh when this same survey comes out again next year, and says the average raise is going to be 4%.

A lot of people have asked me how to make a change at work and break the yolk of mediocrity. I don't claim to be an expert at what you do, but I will offer you a few suggestions on how you might get started:

1) Ask your boss. During your annual performance review (if you are fortunate to have one), ask your boss what it will take to be labled a high performer next year. Chances are he will be able to tell you a few things, but not all bosses are prepared to give you enough feedback.

2) Answer your company's questions. Pay attention at meetings and when senior management speaks. Are there questions that keep coming up each month that nobody seems to know the answer to? Are they wondering how one competitor keeps taking all of your sales? Are they wondering why certian projects consistently come in under-budget while others come in over? I don't know what your company's questions are, but if you keep on the lookout for them, you will definitely begin to notice them. Take your best shot at answering them. Even if you don't come up with a solution, if you find some new insight, your boss will appreciate that.

3) Get some training. Do you always find yourself asking a coworker for help creating an Excel spreadsheet? Does someone else always get assigned to work on projects because of their knowledge of MS Access? There are plenty of classes and books out there designed to improve your skills in these areas and others. Maybe your company will even pay for them!

4) Watch the star performers. Is there someone in your group who is your boss's "go-to" person when they have important projects to work on? If that person isn't you, you need to observe the go-to person and how they work. Do they get in much earlier than you? Do they have better contacts within the company than you have? What do they do that is different, and how can you gain their skills?

5) Read. Reading is one of the most underrated ways to improve your performance. The more you read about your company and your industry, the more ideas you take in, the more you are able to speak intelligently about important current events, the smarter you will be perceived. Don't take this to the extreme, however. We've all worked with the low-level brown-noser who reads an article or something and attemts to impress everybody with their knowledge. Usually this ends up working against them because people resent anyone who tries to flaunt their knowledge. A sincere effort to better educate yourself on your company and your industry will pay huge dividends down the road.

My lowest raise was something like 7.5%. Admittedly I am still young and haven't had the chance to really settle into a career yet, but I intend to do everything possible to keep my streak of above-average raises alive!

You can check out the Journal article here:

http://online.wsj.com/article/SB116658391005855379.html?mod=home_whats_news_us

Simplify Your Finances

A few posts ago I told you about where I keep my money. When I sat down to do that exercise, I realized that my accounts had a sort of scattershot feel to them. I have an Ameritrade brokerage account I opened up way back in 1998, I have a Chase account for the bills, I have 2 credit cards, a couple of store credit cards, a TreasuryDirect Account, an old employer's 401k, an ING direct account, my wife's accounts, etc...

These accounts are fine for their purposes, (allthough I really think ING Direct has been lagging in terms of the interest rate on its orange savings account) but way in the back of my head, there was this thought: Wouldn't it be great if I could just simplify all of this and put it into one account? I had this dream of one password, one login ID, and one screen where I can go every once in a while to check everything out.

I know that Quicken or Microsoft Money do this, but to tell you the truth, I see financial programs like that as yet another step in the process, and I don't feel like I need any more links in my chain!

This got me thinking more broadly about simplifying my finances, but I never really had a chance to organize my thoughts. Fortunately, the great Jonathan Clements over at wsj.com had a chance to organize his thoughts, and I was happy to come across his "Getting Going" column as I was browsing on wsj.com today. The column, entitled "Give Yourself a Present: Simplify Accounts" (subscription), laid out his thoughts on simplifying the various accounts you use to do business. He throws out these seven ideas for simplifying your accounts, with the goals of making it easier for you to track your finances and for those of us that think about such things, making it easier for your heirs to find and divvy up your money when you give up the ghost.

1) "Get a Life" - Clements recommends you invest in a lifecycle fund (investopedia.com) to avoid having to rebalance your portfolio as you age. This way you only need to invest your retirement nest egg in one single fund, rather than trying to diversify into an international fund, a large cap index fund, a smallcap fund, etc...

Personally I am not a big fan of the lifecycle fund because I take a perverse pleasure in allocating my own retirement dollars. However, for someone looking to cut this step out of the process, or someone not very financially inclined, I think a lifecycle fund is a fantastic idea.

2) "Playing Favorites" - here he got to what I alluded to earlier. Clements thinks it might be a good idea to keep all of your investment money at one firm. Why have a fidelity 401(k), an ameritrade taxable account, and a Roth IRA at your local bank? Why not find a place that gives you a single source to sock away all of that money.

Clements stresses that you should still diversify where the money gets invested, just not the bank/brokerage/financial firm you use to do the investing.

3) "Make it Automatic" - When I saw the name of his third tip, I became extremely worried that Clements was going to suggest using direct deposit for your paycheck. I think is the cheapest piece of financial advice out there. I think this has officially moved from the realm of financial advice to common sense. Bloggers can stop blogging about it. People can stop writing books about it. We know. We know. Direct deposit your paycheck.

But true to form, Clements doesn't offer you the same old recycled financial advice. He goes a step further and notes that many utilities are now offering automatic bill payments that get deducted from your checking account every month. You still get to view the bill, but you don't have to go through the payment process.

This is something I am considering, but I'm not convinced. I like to look at my utility bill every now and then because six months ago, for the first time in my life, I started getting my own utility bill (I previously lived with my parents after college, then in an apartment where utilities were included in the rent payment). I think the process of paying the bill gives me a good excuse to actually look at it, so for now I'm sticking with the online bill payment function I have set up with my Chase account.

4) "Counting Cards" - Clements has a pretty interesting idea here. He says people should consider carrying only one credit card and only using it in case of emergencey. Instead, he suggests that you run all of your purchases through a debit card, particularly if your bank offers a cash-back feature.

This isn't the idea for me, though. I am extremely responsible with my credit card payments, and I run as many purchases as possible through my card so I can earn me some frequent flyer miles! Plus, my bank doesn't offer cash back on debit card transactions. If your bank does, though, you might consider it.

5) "Cashing out" -nothing inspiring from Clements here. He pretty much just says you might want to make bigger, less frequent withdrawals from the ATM. This hopefully helps you to budget and to avoid paying fees when you have to use a non-network ATM in an emergency.

6) "Charitable thoughts" - This is an idea I like. Clements recommends focusing on 1 or 2 well run charities and giving your donations to them. If you itemize deductions (which I don't, mainly because I rent and my charitable givings are not bigger than the standard deduction), it makes it much easier to go back and find your one or 2 big checks vs. hunting and pecking around for email confirmations and slips of paper.

I give money to a certain charity every week. I have often considered instead giving this in the form of one lump sum on an annual basis. When I do eventually start to itemize, I might start doing this.

7) "Dodging trouble" - Clements recommends thinking twice about putting money into more complicated investments such as limited partnerships and purchases of rental real estate. These come with a load of paperwork, tax considerations, landlord considerations etc...

I don't know what to tell you here. If you find a once-in-a lifetime limited partnership (such as the Buffett Partnership back in the 1970s) or a great rental property and know what you're doing, you might as well go for it. Then again, you could end up losing a lot of money. I don't think simplifying accounts is a big factor when deciding whether or not to invest in assets like these.

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Unsolicited Plug: The Wall Street Journal seems to have been placing more emphasis on personal finance as of late. I used to think of it purely as a source of business news, but more and more I am finding it has a bunch of handy articles on personal finance. Clements is a regular in the WSJ and is one of my favorite personal finance columnists because he really eschews the sensationalism you get from other personal finance folks like Suze Orman (she gives some good advice but she is a little too much for me) or the EVER FABULOUS DONALD TRUMP AND ROBERT KIYOSAKI!!

For some reason I can't mention a Trump project WITHOUT PUTTING IT IN CAPS, THE MOST LAVISH, THE MOST ELEGANT, THE MOST FANCY ADVICE IN THE WORLD- TRUMP ADVICE!

Clements seems like he's basically a guy you wouldn't mind having a beer with, but he is plugged in on many finance topics. He understands the limitations of investing, and he is definitely intelligent and conservative. If you listen to Clements, I'm confident you won't be steered in the wrong direction.
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After giving this some additional thought, I decided that I am going to make cleaning up my accounts one of my 2007 goals. I am going to start by rolling over my previous 401k plan into my current employer's plan and work from there. Why don't you think about doing the same thing?

As always- if you want to discuss this further, offer me some advice, or just toss me some old fashioned comment spam- feel free to talk back in the comments section below this post.

Could The Great Depression Have Been Averted?

I had the opportunity to study the Great Depression while I was in grad school, and I put the meat and potatoes of a paper I did on the topic here in case you're interested in my take. I didn't do a fantastic job of keeping my citations in order, but I'm sure if you take the time to do it, you can fairly easily double-check the facts below.

The depression interests me. Our generation has never seen anything like this. The closest we got were the few years after the internet bubble burst circa 2000. That, coupled with the 2001 terrorist attacks, didn't even come close to the kind of broad scale havoc the depression wreaked on the people who lived through it.

I know we have our fail-safes in place. We have the triggers that close the markets down if a panic sets in, we have a more activist Federal Reserve, we have the FDIC etc... but has it all ever really been put to the test? Hopefully nothing like that ever happens in our time.

Anyway, this paper revisits the Fed's role around the time of the Great Depression and at the end I have the audacity to look in the rear view mirror and say if the Fed had acted differently, things might not have turned out as bad as they did.


The Goals of the Federal Reserve in the 1920s

The Federal Reserve System (also referred to as the “Fed”) was formed in 1914 to serve as the United States’ central bank. Its primary goal was to give the US government some measure of control over the money supply in order to dampen the impact of financial crises on the economy. Before the Fed was created, the government had little to no control over the money supply, which was tied to the gold standard.

In the 1920s and early 1930s, the Fed’s leaders said their primary purpose was to serve as “a system of productive credit.” This meant it existed to lend money to member banks for “productive” purposes involving only agricultural, industrial or commercial pursuits and not for what it called “speculative” or investment purposes. In this way, the Fed operated in what was for the most part a passive manner. In theory it could affect the money supply by setting interest rates to encourage or discourage bank borrowing, but it was up to the discretion of the banks whether or not they would borrow money from the Fed. The Fed shied away from use of its more active tool- open market activities, for reasons we will later discuss.

Another main goal of the Federal Reserve during this time period was to maintain the gold standard, keeping gold reserves on hand to collateralize the US dollar. By law, the Fed was required to maintain reserves equal to the value of at least 40% of the outstanding reserve notes, as well as 30% of deposits held at the Fed.

Reasons for Pursuing These Goals

The reason the Fed would have pursued these goals was the prevailing economic wisdom of the time. Most of the industrialized world had been on the gold standard for 200 years[1], and it was seen as the proper way to run an economy. With banks having experienced periodic liquidity problems in the past, the Fed wanted to be sure it could serve as a “lender of last resort” should a panic create the need for banks to return money to depositors beyond the level of their reserves. Monetary theory as we know it today was undeveloped during the period.

What the Fed Could Have Been Doing

An alternative goal the Fed might have pursued would have been to work at increasing aggregate demand and keeping the economy at full employment with low inflation. These are the Fed’s goals today, and would have meant taking a more active role to stimulate or restrain the economy via the money supply. At times, this would have meant more aggressively employing open market operations.

In the 20s, however, the Fed was generally wary of open market purchases, which it believed would serve to fuel “inflationary speculation, not increasing output of goods and services.” Keynes was only first beginning to publish his theories in the early 20s, and the idea of such active tinkering with the economy by a central bank had not been embraced. Even the most liberal Fed board members were generally opposed to open market purchases. As the case stated, they saw such purchases as a kind of “shotgun approach” and believed it would take more careful aim to respond to the problems they faced.

Factors responsible for the collapse of the money supply between 1929 and 1933

A number of factors were responsible for the collapse of the money supply during this period, when M1 fell 25%, from $26 billion to $19.5 billion.[2] These included:

An “internal drain” from bank deposits to currency. Following the stock market collapse in 1929 and the ensuing lack of faith in the financial system, there was a wave of bank failures in the fall of 1930, noticeably among smaller regional banks that had loaned to now-insolvent farmers. With the realization that bank deposits could disappear if banks failed, there was an increasing public desire to hold currency, and a rush to empty bank accounts. Since banks did not hold enough money to reimburse every depositor, these bank runs led to further bank failures. The resulting drop in deposits served as an “internal drain” on the money supply. With fewer deposits on reserve, the banks could loan out less money, due to their required reserve ratios.

An “external drain” of foreigners’ dollar deposits and gold from the US. Following Great Britain’s departure from the gold standard on October 21, 1931, worldwide attention turned to the United States. Worried that a financial crisis could hurt dollar investments in the United States and possibly bring about the demise of the gold standard there too, foreigners began to convert American bank deposits into gold.

As foreigners took money out of American bank accounts and redeemed dollars for gold, Fed gold reserves began to dwindle, falling over 15% between September 31 and October 28 of 1931. If outflows continued, the Fed would not be able to maintain the 40% gold reserve level required to support the value of its outstanding notes. In order to stem the gold outflow, and in response to increasing pressure from France in particular, the Fed raised bill buying and discount rates in October of 1931. The move did slow the outflow, but as is typically the case, higher interest rates also served to contract the money supply. This added further to the collapse.

The Fed’s avoidance of open market purchases. Though the lack of reliance on open market purchases was not in itself a cause of the declining money supply, it was a tool that could have been used to prevent the collapse. As described on page 6 of the HBS case, New York Fed Governor George S. Harrison “argued for more open market purchases” in 1930, but he was overruled by the heads of most of the other Fed banks, who felt that low bill buying rates (which had been reduced to 2% in 1930 and 1.5% in 1931) made credit easy to obtain, making further purchases undesirable.

Despite easy credit, borrowing from the Fed shrank by 83% between July 1929 and September 1930, highlighting the fact that interest rate adjustments were a passive tool. Lower rates as they might, the Fed could not force banks to borrow, and banks’ unwillingness to borrow served to keep the money supply from growing. The only way to “force” money into the system would have been through open market purchases, over which the Fed had complete discretion.

Did Monetary Forces Cause the Great Depression?

Due to the complexity of the US economic system, I would be hesitant to pin the great depression on monetary forces alone. However, I think that monetary forces played a large role in causing the depression, and greatly contributed to its length and severity.

The beginning of the great depression was associated with a deflationary trend that began in 1929. This deflation can be explained by the contraction in the money supply that began in 1929, due to reasons previously discussed. Deflation had a negative effect on the US economy by reducing consumer demand. Noticing that prices were falling, consumers delayed current purchases. This dropoff in demand led businesses to produce less and lay off workers, causing unemployment to jump from 3.2% in 1929 to 25.2% in 1933.

Bank failures were another large contributing factor to in the great depression, and it seems that the vicious circle of runs on bank deposits causing banks to fail and fueling further runs on banks could have been averted had the money supply been adequate to cover Americans’ desire to hold currency. When the first groups rushed to hold currency instead of savings deposits, the money supply failed them. Losing savings, or hearing about others losing savings, served to darken the spirits of consumers in a manner that economic statistics cannot adequately measure, compounding the other factors that weakened the economy at the time.

The contracting money supply also served to reduce income, and according to Keynsian theory, income determines consumption. This dropoff in consumption, combined with decreasing business output caused GDP to drop from $822.2 billion to $602.3 billion during the period.

It would take until 1936 for GDP to return to the $820 billion levels seen in 1929. I would argue that, had the Fed intervened in a more effective manner to prevent the collapse of the money supply over that critical 1929-1932 period, the impact on the economy would have been mitigated, and there is a possibility that “The Great Depression” would now be known only as “The Depression.”

[1] Siegel, Jeremy. “Stocks For the Long Run.” McGraw-Hill, 2002. p. 186.
[2] Godon, Robert. “Macroeconomics.” Pearson Education, 2003. p. A2.

Determinants of Portfolio Return

I was playing around with this calculator (moneychimp.com) and noticed that the constant annual growth rate of the stock market from 1950 through 2005 was about seven and a half percent. If you add in dividends, the total return of the stock market over that period worked out to about 11% or so. This kicks the pants off of the returns you can expect from investments such as money market accounts, or even bonds for that matter.

So why would a young person like me (28 years old and probably 40 years away from retirement) put their retirement money into anything besides stocks? Some people argue that you can improve your overall returns and lower your risk if you put 10-20% of your retirement funds in bonds. My bond allocation is much lower - more like 5%. This is mainly because I am so young and I am not a very risk-averse investor. I believe that the stock market will continue to outperform bonds and cash over the long run, so I am willing to put more of my retirement savings into stocks.

There was a famous study published in 1986 called "Determinants of Portfolio Performance" by Brinson, Hood, and Beebower. They concluded from a study of a bunch of portfolios and how they performed over time, that over 90% of a portfolio's long term performance is explained by asset allocation, rather than stock selection. This means it is about nine times more important for you to decide what percentage of your portfolio you will allocate to stocks, bonds, and cash (t-bills) than for you to decide what specific investments in those categories to invest in.

So don't go crazy looking at a bunch of different mutual funds. If you're my age and 20% of your retirement money is in bonds, and 80% is in a few good mutual funds with low fees (such as index funds or ETFs), then you're on the right track. All of the fluff and advertising done by all of the mutual funds is generally nothing but smoke and mirrors. When you get down to it, investing can be an extremely simple task, once you've learned the basics. You don't even have to dip into a single balance sheet or income statement if you don't feel so inclined. Just invest in index funds and spend your time with your family, at your job, or unwinding with a good book.

The Gap Between Rich and Poor

According to a new survey put out by Bloomberg and the LA Times, Americans see the widening gap between rich and poor as a serious national concern. A few of the key observations:

-What the "poor people" think about the gap: according to the results of the poll, 84% of people earning less than $40,000 a year say the growing gap is a "serious problem", and over 50% say it is "very serious."

-What the "rich people" think about the gap: more than 60% of those who earn more than $100,000 a year said it was a serious problem.

-Bloomberg also added that "the portion of national income earned by the top 20 percent of households grew to 50.4 percent last year, up from 45.6 percent 20 years ago; the bottom 60 percent of U.S. households received 26 percent, down from 29.9 percent in 1985, according to the Census Bureau"

-The average pay of corporate CEOs rose to 369 times that of the average worker last year, compared with 131 times in 1993 and 36 times in 1976

You open up a can of worms when you discuss issues like this. On the one hand, I'm very much in favor of capitalism and free markets. On the other, I sometimes feel like there are people in the United States who are monopolizing the country's wealth and opportunity. These are the people who inherit their wealth and do not have to work for it.

Yes, I think one of the perks of making it big in the United States should be the ability to provide the very best situation for your kids. But I also think Warren Buffett's philosophy that he wants to leave his children "enough money that they can do anything, but not enough that they can do nothing" is a better approach than handing billions of dollars to someone who never really worked a day in their life.

I do think there should be a gap between rich and poor though. It gives people something to aspire to. It represents the American dream. Should it be as large as these numbers show?

I don't think so.

Investing in Treasury Bills

I'm as patriotic as the next guy, but one thing I don't like doing is paying the government more of my money than I have to. This was part of the reason why I first got interested in investing in treasury bills - they are tax free at the state and local level.

What are treasury bills?

When the US government wants to borrow money for a short period of time, it does so by issuing short-term debt instruments called treasury bills. A lender (which could be you!) pays the government some money and 3, 6 or 12 months later the government pays that money back, with interest.

Unlike a regular bond or savings account, you don't receive interest on your treasury bills until they mature. This is similar to a zero coupon bond. A simplified example to illustrate this with numbers- let's say 1-year treasury bills are yielding 5%. You could buy a $10,000 treasury bill for $9,500 (a discount), and one year from now, you would receive $10,000 back from the US Treasury, $9,500 which is the return of your principal, and $500 of which is your interest ($10,000 * 5%).

Why invest in treasury bills?

There are three reasons why I invest in treasury bills - yield, safety, and the fact that interest on treasuries is tax-free at the state and local level.

The yield on treasury bills has fluctuated over time, just like all interest rates have. In recent times, the yield on the 13-week T-bill (commonly referred to as the "3 month" or "90 day" T-bill) bottomed out around .8% in June of 2003, following the federal reserve's unprescedented rate cuts during that time period. However, we have had some rate hikes since then, and the yield has climbed to around 4.8% more recently. Compare that with yields on similar short term vehicles such as money market accounts and CDs and you'll see it is in the ballpark, and definitely more than you would earn in most bank savings accounts.

Treasury bills are considered the safest financial instrument you can invest in. In fact, many analysts refer to the T-Bill yield as the "risk-free rate" because it is the closest thing to a sure return an investor can get in today's world. The thinking here is that the US Government is a rock-solid creditor- the treasury can just print more money if it doesn't have enough to pay you back.

How to Invest

Unlike corporate bonds, treasury bills/bonds are very easy for the average investor to get into. All you have to do is go to www.treasurydirect.gov and open up a personal account.

I've had an account on this site for about 9 months now, and though I will say there is a bit of a learning curve at first, I have gotten used to the way the T-bill market works. I'll give you a runthrough of one trade I did a few months ago to show you a little bit about how the process works.

On Tuesday December 12, I decided to take $10,000 from my ING direct account and invest it into a 26-week (6 month) treasury bill. This is part of my down payment fund, so i knew I wouldn't need it for at least 6 months. At that time, 6 month bills were yielding somewhere around 4.8% vs. my ING Direct account yielding 4.6%.

Treasury bills are sold via auction, and according to TreasuryDirect, 6-month treasury bills are auctioned every Thursday. The way this process works is basically a bunch of big institutional buyers (called competitive bidders) put in bids to buy treasury bills, and the Treasury awards them all at the one highest rate needed to sell all of the securities. The smaller buyers like you and me (called noncompetitive bidders) receive the securities at that rate without having to do anything.

So, I put in my $10,000 order on Tuesday.

When Thursday December 7 came around, I checked my account and saw that the security was issued to me. I paid $9,755.31 for the 6 month treasury, and I will get back $10,000 on June 7, 2007. This nets me $244.69 in interest over 6 months, which works out to a 4.84% yield (vs. the 4.5% APR I was earning at ING Direct).

I headed over to my ING Direct account and saw that the funds had been taken out.

When tax time comes around next year, I won't have to pay taxes on this interest on my NY State and City filing. Assuming my tax rate is about 22%, this results in me keeping $53.83 of the $244.69 that I otherwise would have been paying to New York!

In Summary

Treasury bills should be another tool in your short-term investing toolkit. Sometimes it makes sense to invest in treasury bills, but you have to compare their yield, as well as the tax benefits, to your alternatives. As with any investment option, be sure to do your research before putting your money to work for you!

(note: this is not to be construed as investment or tax advice, it is just my own experience)

Warren Buffett's Shareholder Letters

If you've never read Warren Buffett's shareholder letters, I suggest you head over to this page (Berkshirehathaway.com) and check them out.

Buffett is the 2nd richest man in the world (behind Bill Gates) and made his fortune primarily from investing in stocks. I first encountered him while doing an independent study in college and his investment philosophy has formed the basis for my own.

His basic philosophy is that businesses have an intrinsic value that an investor can compute. If the business fundamentals are right, the market is offering to sell you an ownership interest in the business (stock) for less than the intrinsic value and a margin of safety, and you have done your research, you should invest in the company.

I will cover some of Buffett's principles in some future posts, but for now I suggest you head over to the site above and poke around. Some people have said that a thorough reading and study of Buffett's letters is the equivalent of an MBA in investments. I wouldn't go that far, but I think it would definitely make for a fantastic self-study course.

If you have the time and the finance savvy, then you can take your chances picking stocks. If you work a day job, you will do much better putting your retirement fund into mutual funds... in particular, low fee index funds. That's where I keep the bulk of my retirement savings.

Admit it... you've peeked

So you're going over to the ATM to get some cash and you notice the little white strip of paper someone forgot to take.

If you're like me, you look.

You want to know how much is in their bank account.

I'm usually surprised, because in my experience, the amount is usually something around $900 or so. I guess people are pretty good about keeping money out of their lousy no-good fluffy legged pencil necked zero interest checking accounts!

Where I keep my money

I have received some interest in blogging about my own personal finances and I am happy to oblige.

Background on my situation

First of all, I'm married, so everything is mine and my wife's and that has led to some duplicate accounts. I am basically in charge of where we put it, because I have so much fun doing it!

We are currently renters, but we hope to buy a house sometime in the next few years. We are not rushing into anything, and are doing our best to save money for a down payment. Unfortunately, house prices in the NYC area are RIDICULOUSLY expensive, especially for a young couple just starting out. I can't underscore that enough. In fact, the small house we currently live in (we rent the 1BR apartment on the 2nd floor), an hour commute from Manhattan, would go for approximately $750,000 based on comparables in the area.

We are debating if we want to stay in NYC for the long term. My wife is from a small town in PA, and we are considering relocating there, but for now both of our jobs are here in NYC and we like where we're at. I might do another blog post on our moving considerations if there is enough interest.

The reason I give you all this back story is it explains where we currently have our money. What we do with our income right now is we spend about 40% of it each month and save the rest in relatively liquid, but high-yielding short term assets. When I look at my net worth, I divide it into four general categories:

1) Retirement accounts - all mutual fund 401k investments
2) Money available for down payment - high yield savings, CDs, T-Bills
3) Emergency fund - 3 months living expenses that we do not touch
4) Illiquid assets - we have 2 cars so I list the resale value of one of these here, as well as some other small assets we have that can't be easily turned into cash

Where We Keep Our Money

ING Direct. We currently have about 25% of our assets in an ING Direct savings account, and 25% in ING CDs laddered out about a year and a half.

My current employer's 401k. I divide this money amongst an Index fund (50%), a growth stock fund (20%), an international fund (10%), a smallcap fund (10%), a value stock fund (9%) and a fixed income fund (1%).

My former employer's 401k. This is a chunk of money I socked away from my first job in a Fidelity 401k plan. This money is about half of what's in my current employer's plan, and I have it allocated in the same way.

Her current employer's 401k. Similar allocations to mine.

Her pre-marriage bank account. A regional bank in PA. We leave it in there so she still has an account in her name, so she can get money out of the ATM when we visit her parents etc... There is not much in there.

US Treasury Bills. This is something new I have been experimenting with. With the Fed raising interest rates lately, yields on T-Bills have been rising (in fact we're currently sitting at a strange period in our financial history when shorter term bills are yielding more than longer term bills, which is known as an inverted yield curve.) The reason I started putting some money into T-Bills is something I noticed as I was filing my State and Local tax return last year. Interest on government issued securities is tax free at the state and local level. With NYC's high taxes, I think this makes t-bills just as attractive, if not more attractive, than my ING Direct account. I have this linked to my ING direct account so I can buy the bills with ING money, and when the bills mature, they go right back into the ING account.

Chase checking and savings accounts. Her entire check is direct deposited into this account every two weeks, and we live off of just that. We use their online billpay to take care of our bills, and we try to keep as little as possible in the low-interest savings account attached to the checking account. Fortunately, I am able to transfer some money out of this account every few months into our longer term savings account at ING.

TD Ameritrade Brokerage Account. This is a liquid account since I can sell the stocks if I want to buy a house or something, but it is not money I need. I would never invest money I might need within the next 5 years in stocks, especially individual stocks. I own two stocks in this account, and I trade pretty infrequently, but I am a big investing buff, so this provides me with an outlet to hopefully make some money off of my stock picks.

Final Thoughts

I guess there are a few key themes I'd like to highlight from this overview:

1) We live off of one paycheck. My wife's paycheck is actually a little more than we need to pay our usual bills every month and my paychecks all go into the ING account and from there they occasionally take a detour into a treasury bill.

2) We are putting our down payment fund in very safe, liquid investments. Hammer this into your brain: money you will need within 5 years does not belong in stocks. While they offer above average returns over the long run, they could get killed in the short term, putting you at the mercy of the market.

3) We are maxing out our 401K contributions and putting them all into stocks. Hammer this into your brain: if you have more than 30 years until retirement, put a large portion of your retirement savings into stocks. This is not to say that there is no debate on this point. In fact, noted financial guru Robert Kiyosaki recommends against putting so much of your net worth into your 401k plan, but that is a discussion for another post.

How to Do Great Work - Hamming's Take Part II

Continuing the series on Richard Hamming's "You and Your Research" and how it can help you become a fantastic worker and therefore increase your income. The full text of the speech (which you can read instead of these blog entries) is available as a .pdf here.

Accept ambiguity - Hamming says that "Great scientists tolerate ambiguity very well." He says that doing great work requires a delicate balance between believing in the idea well enough to go forward, and doubting it enough to notice errors. I have often engaged in this balancing act while working on bigger long-term projects at work. What this says to me is that, if you have an idea and you get some data or a result that disputes it, don't let that anomaly crush your idea, rather let it refine the idea, or guide you to a new one.

Be emotionally committed - Hamming speaks of the power of being so committed to a problem that it works its way into your all-powerful subconscious, which has an amazing ability to solve problems. "...when you have a real important problem you don't let anything else get the center of your attention - you keep your thoughts on the problem. Keep your subconscious starved so it has to work on your problem, so you can sleep peacefully and get the answer in the morning, free." This quote speaks to two points. The first goes back to drive and dedication. Working hard on something for a long period of time will ensure that it becomes the center of attention. The second is the amazing ability of our subconscious. Your mind can do some amazing things while you sleep.

Work on important problems - "If you do not work on an important problem, it's unlikely you'll do important work." Hamming admits that this is an obvious point, but says he noticed in his experience that the average scientist spends all his time working on unimportant problems. From what I've seen, the average worker also spends all of his time working on unimportant problems. To a certain extent, you have control over what you're working on. If you don't have control over what you're working on at the moment, do a good job with the work you're given and you will eventually get that leeway.

Hamming also had what he called "Great Thoughts Time." Every Friday during and after lunch, he would only discuss great thoughts, such as "What will be the role of computers in all of AT&T?" By setting aside a specific time to think about great thoughts, he made sure he didn't get caught up in the little things. I know that Bill Gates does something similar, but instead of Friday afternoons, he gets it all done in one "Think Week" every year. You can read about think week in this article. This think time also gives him a chance to take a step back and examine whether or not the stuff he is working so hard on every day is really the right stuff to be working on.

Work with the your door open - Hamming made this observation- "I notice that if you have the door to your office closed, you get more work done today and tomorrow, and you are more productive than most. But 10 years later somehow you don't quite know what problems are worth working on; all the hard work you do is sort of tengential in importance." This seemed counterintuitive to me at first. It seems like all of the interruptions I get throughout the day (unfortunately I work in a cubicle and don't have the ability to close my door) are nothing but disruptive. However, Hamming's point is that you have to know what's going on around you, and keeping yourself open to the occasional interruption is one way to do this. In the short run it seems like a pain in the butt, but over the long term, you get to learn things about your organization and the world around you. Important things.

Sell your work - Hamming spoke about how selling does not always come naturally to a scientist who makes a discovery. "The world is supposed to be waiting, and when you do something great, they should rush out and welcome it. But the fact is everyone is busy with their own work. You must present it so well that they will set aside what they are doing, look at what you've done, read it, and come back and say, 'Yes, that was good.'"

He says there are 3 important ways to sell: write clearly and well, give formal talks, and give informal talks. If you're like me, the idea of giving talks makes you shudder. It made Hamming shudder also, at first. But given some time and practice, he became much more comfortable making these talks (the equivalent of presentations people give at my company).

So that's pretty much everything I took away from reading the text of Hamming's speech. Hopefully you had a chance to read it and take away some ideas and/or inspiration from it. Let me know if I missed anything important, if you think I got anything wrong, or if you have another take on this.

How to Do Great Work - Hamming's Take

I read widely and often find pieces of personal finance inspiration in fields outside of finance.

One of my favorite non-finance bits of inspiration is a transcription of a speech given by Richard Hamming, a mathematician who was highly respected in the fields of computer science and telecommunications. He was one of those scientists whose research led to a number of things being named after him: Hamming code, Hamming matrix, the Hamming window, Hamming numbers etc... Needless to say, he was one of the greats, and made contributions that I don't even pretend to understand (not being a scientist myself), but I know earned him a great deal of respect.

The title of this particular speech was "You and Your Research" and in the talk, he attempted to give his answer to the question "Why do so few scientists make significant contributions and so many are forgotten in the long run?"

He then goes into what separates great scientists from the average scientist, and I think the lessons apply to separating great anythings from average anythings. Financial analysts, marketers, human resources people etc...

Being great at what you do at work goes a long way towards increasing your income, which is without a doubt the most important thing you need to do if you want to become wealthier than you are today. When you go to your boss for a review at the end of the year, if you can put a record of great accomplishments in front of him, you are going to make it easy for him to offer you a raise, or risk losing you.

I'm going to break out what I learned from reading this document over the next couple of posts because there was just too much good insight in there to limit it to one. I highly recommend you read the entire text here (direct link to a .pdf document at cs.virginia.edu).

So what's the secret to setting yourself apart from the pack?

It's not all luck - Hamming argues that some people don't even set out to do great work, because they believe all of the great breakthroughs were the result of luck. He contradicts this thinking by giving examples of scientists who did a number of things in their lifetimes and says that luck might have played a part in their accomplishments, but, quoting Pasteur, concludes that "luck favors the prepared mind."

It takes courage - Hamming says that courage is another thing that distinguishes great scientists. He says "Once you get your courage up and believe that you can do important problems, then you can." I notice this a lot in my line of work. The people who do better work in finance are the people who don't hide when they come across something they don't understand. They believe that they can understand it, and they work to do so. Just because something at work is complex, does not mean you cannot figure it out and do it. If you hide from big words and difficult tasks, someone else is going to do them and get paid for them as well.

It does not take ideal working conditions - "What most people think are the best working conditions, are not," Hamming said. This wasn't a particularly great insight to me. I remember the book "On Writing" where Stephen King said he wrote his first few novels in a cramped closet in the back of a laundromat. Apple Computer started in a garage...the list goes on and on. You don't need the ideal working conditions to do great things, so stop complaining about your quirky mouse, your squeaky chair, and your coworker who is always making personal phone calls.

It takes drive - Paraphrasing a colleague, Hamming said that "Knowledge and productivity are like compound interest. Given two people of approximately the same ability and one person who works ten percent more than the other, the latter will more than twice outproduce the former. The more you know, the more you learn; the more you learn, the more you can do; the more you can do, the more the opportunity"

I think that is worth reading again. Go back and let that sink in. If you're the type of person who does this, print it out and post it someplace where you can see it. I think this quote speaks to those of us who get caught up reading sports stories at work, or not putting in the hours we need to when we need to. Quite simply you have to work hard in order to do great things.

One other thing he adds to this topic is the fact that you must intelligently apply your drive. As hard as you might be working, if you aren't working on the right thing, you are just spinning your wheels. Sometimes it takes a great deal of awareness to be sure you're working in the right way on the right thing because you can get caught up in the moment. In the next post I'll get into what I think Hamming's solution for this particular problem is... it involves setting aside time for thinking some form of what he calls "Great Thoughts."

Get rich by increasing income, not cutting expenses

I've seen a lot of personal finance advice thrown around on a lot of different websites/blogs/books that focuses on the little things. For example, people are advised to re-use teabags to save money, clip coupons, make coffee at home instead of buying it on the way to work, and other tips that I would put in the general category of "being frugal."

This advice definitely has its place. Being frugal will allow you to save more money in the long run. If you can cut your expenses dramatically, you can definitely become richer (from a financial standpoint).

However, I think people sometimes tend to focus too much on the expense side of the equation. Instead, they need to focus on the income side. I would argue that it is dramatically easier and will make a more significant change in your life if you increase your income than if you cut your expenses by a small amount.

Don't get me wrong, I think most of us have a good $100 a month we can squeeze out of our budgets, and I recommend that we all take the time to identify this $100 and eliminate it. However, once you wring the big stuff out of your budget, your opportunities for cutting costs are very slim. You can cancel your cable television, get a cheaper cell phone plan, sell your old junk on eBay, give up the Starbucks habit, but eventually you come to a point where you're splitting hairs. Once you find yourself washing out sandwich bags, I recommend you stop your intense focus on being frugal and instead shift your efforts towards maintaining your expenses and especially on growing your income.

So how do you grow your income?

This answer is different for every person reading this blog. I hope to shed some insight into this in future posts (I have more than doubled my income since I first started working in 1999). If you're in my position, you will want to make yourself a better employee. If you're a small business owner, you might want to look for ways to increase sales, add new value for your customer, or something else along those lines.