Looking into Financial Rules of Thumb

I recently ran across this site carrying information, pet peeves and rules of thumb about financial advice. After reading through it, and in the spirit of economic understanding as well as last Monday’s comments about how there is always someone out to con us, I thought I would add my two cents.

One of the questions asks how much life insurance a person should buy. The writer was confused and concerned because the answers differed depending on which expert you ask. “Some say your policy should cover five times your annual income. Others say ten times. And Suze Orman recommends 20 times annual income needs.”

The real answer, of course, is that it depends.  Some people need no life insurance. Just as homeowners insurance is designed to cover a financial loss and inconvenience of losing a house to fire or a tornado, life insurance is designed to cover loss of income for some period of time until those who remain behind can work out other solutions. “You only need it if other people — like a spouse or children — would face financial hardship when you die. If you don’t have kids, if your spouse has a good income, or you have substantial savings, then life insurance isn’t a necessity."

He goes on to say: “Even if you do need life insurance, you probably don’t need to carry as much as your insurance agent is willing to sell you,” and recommends checking a site called the Life Insurance Needs Calculator. This calculator still needs to be taken with a grain of salt, but from what we learn here it’s pretty clear that life insurance for a child is unnecessary – the probabilities are low and the financial contribution is zero. So those inexpensive offers sent to grandparents in the mail border on being scams.

A second comment in the article that I took some exception with was the identification of inflation as a “silent killer of wealth.” This is a pretty common theme from financial experts. And it is true that if a person invests $100 modestly at a rate about 3%, ten years later he will have over $130 but the buying power on average will be a little less than when he started out.  It’s really a breakeven strategy at best. People may feel richer but they are no better off.

To earn more than the inflation rate though, requires putting some of the principal at risk. (A 10-year CD from Discover Bank, where you never lose your initial investment, is paying only 2.7%.) To beat inflation over time one must invest in the stock market (or similar instrument more risky than a bond or CD) and ride the roller coaster hoping to hit a peak and not a valley when the money is needed. Advisors help their customers do that, but as we know, past performance does not guarantee future returns.

But not to worry – there is another side of the story. This article reminds us that buying power is not easy to calculate. It gives a list comparing prices of numerous items including: bicycles, stoves, home entertainment systems, slow cookers, gas grills and more, for 1979 and 2015 not only in terms of dollars (for inflation), but also in terms of number of hours of labor required by an average worker to earn that amount.  In all cases there is a steep decline in required labor – and the product quality is much better.  For example, a vacuum cleaner went from 15 hours to 2.3 hours with a vast improvement in the machine itself.

To compare to 1979 is one thing.  If the list used 1959 instead, a microwave wouldn’t even be on it. I read in another source that 100 years ago it would have taken almost 11 months of average wage work to buy a refrigerator compared to a just few days today! That’s why almost no one owned one then and almost everyone owns one now. That’s perspective!

Help With a New Year's Resolution

People want to save money (for education, for retirement) but find it difficult and sometimes scary.  Is putting money in the stock market the same as gambling?  Let’s take a look.

Here is a story from 2015 reporting that Americans spent $70 billion on lotteries the prior year, “more than $230 for every man, woman and child in [the 43] states where the lottery is legal.”  This amount varied from $36 in North Dakota, to nearly $800 per capita per year in Rhode Island.  (It could have something to do with access to high-paying petroleum jobs in North Dakota while the Rhode Islanders might catch a glimpse of all the rich people’s yachts and want to join them – or maybe not.)

To update the information a bit, I found a  CNN Money piece from last year giving the total lottery spending of $80 billion.  That would move the current average closer to $260 per person per year.

I’ve written about lotteries before, about what a bad deal they are, how the states consider them voluntary taxes, how you get better odds from casinos and how they generally prey upon the poor.  This is well reported on the news and should not surprise anyone.  But the bets are small and seem affordable even if the odds are terrible.  You can get rich quick but are much more likely just to be making a weekly donation to your state’s tax revenue.

What is the alternative?  If everyone took their (average) $260 per person and put it into a conservative investment portfolio, the results would add up surprisingly well.  After 10 years such a fund could have grown to over $3,600 per person or about $11,000 for a family of three.

To get those numbers I used a theoretical mix of real index mutual funds with 62% invested in stocks, 32% in bonds and the rest in a money market fund.  This is a very conservative and reasonable mix for a younger person (30-45).  It is also highly diversified and automatic by virtue of being an index fund.  When I looked up the returns for that mix over the last 10 years, the rate was 6.1% compounded annually.  Remember, that 10-year period includes 2008 when the stock market was seriously tanking and 2017 when it was soaring.  There was much variability, which can be scary, but the overall trend over long periods has historically been positive.

The question is whether it’s smarter to invest your money at those pathetically poor lottery odds – 10,000 to 1 on a simple pick 4 card or about 290 million to 1 for the Power Ball – or to actually have (in your pocket, so to speak) $11,000 for your family.  Making the right decision shows strong behavior in critical thinking and discipline.

Other sources of potential savings with no downside include homeopathic remedies.  After I mentioned them in an essay before Christmas, a reader sent this link to CBS with this excellent summary.  “The market for homeopathic ‘medicines’ has grown to $3 billion, according to FDA. These remedies are often sold next to bona fide treatments like Tylenol and aspirin despite little evidence they actually succeed at treating anything at all. In fact, homeopathic products have sometimes been ripped from shelves due to deleterious side effects, as when more than 100 people lost their sense of smell using products with zinc gluconate in 2009, or when a brand of teething tablets was linked to seizures and death in infants and children.”  Throw in another $28 billon spent on nutritional supplements and we are looking at the potential for big bucks in your own account, not gambled away on the lottery or outright thrown away on ineffective medicine.

Burning Your Way to the Top

Personally I am skeptical of motivational speakers for the same reason I am skeptical of sellers of energy bracelets or any other magical solution.  In general, they get people all fired up about success in their personal or business lives and then send them back to the same old routine with the same old co-workers or family, who are not fired up.  Soon the enthusiasm wears off.  I have seen this over and over.

When the entire team is sent to one of these events to climb rope ladders and swing from trees, for example, forced to work together to solve some artificial and usually physical problem, they experience the same sort of half-life of enthusiasm.  They return to work to face the same business problems that are totally unrelated, except by a major stretch of the imagination, to those artificial problems encountered during the “field trip.”  With these more typical problems in more familiar surroundings and no one accountable for continued reinforcement, the spirit from the outdoor exercise quickly wanes. 

These types of events usually rely heavily on hype and endorsements from selected feedback forms filled out immediately afterward when the feelings are still fresh.

It didn’t surprise me at all then when I saw the headline back in June:  “More than 30 burned during famous motivational speaker's hot coal walk.”  Ambulances took five of the participants who were more seriously burned to Parkland Hospital Burn Center in Dallas.  “Members of Dallas Fire-Rescue also asked that a Dallas Area Rapid Transit (DART) bus be used as a staging-area for between 30 and 40 people who were less seriously hurt.”

The theory is that doing what you think is impossible, that is, walking across a bed of hot coals, leads you to face other challenges that seem impossible or, as they put it, to “conquer the other fires of your life with ease."  The organization’s statement says that there were only a few minor injuries out of 7,000 firewalkers.

Of course anyone who thinks walking across hot coals is impossible needs to do just a little research. This site tells about the history and science of fire walking.  Fire walking is really “no more impossible than putting your hand in a hot oven without getting burned.  It has to do with the heat capacity of the coals and the temporary insulation provided by the soles of the feet especially if the soles of the feet are wet from sweat, which they may be from the nervous energy of facing such a challenge.  “Thus, even if the coals are very hot (1,000 to 1,200 degrees), a person with ‘normal’ soles won't get burned as long as he or she doesn't take too long to walk across the coals and as long as the coals used do not have a very high heat capacity.”

“Nevertheless, some people do get burned walking across hot coals, not because they lack faith or willpower, but because the coals are too hot or have a relatively high heat capacity, or because the firewalker's soles are thin or he doesn't move quickly enough.”  In other words, the motivation is about getting moving and keeping moving, not about whether or not you get burned.

But doing a little research is critical thinking, and most people these days tend to skip it.  So the practice continues with people spending their own time and hard-earned dollars ($4995) to get this (often temporary) psychological boost.  This speaker, just one of many confidence builders available, has over 2.8 million followers on Twitter.  But wait!  If this stuff works, why do you need to be a follower?  I guess the effect really is temporary and you need a booster shot for continuing to do what you think is impossible.  Or perhaps followers must check to see if the guru has come up with another secret or magic formula since you last attended, a secret that you can’t miss out on for fear of losing your edge!

These rah-rah gatherings might very well work for some people, probably the few that stick with it.  But I believe long-term motivation comes not from a seminar, but from within.  So one week of your time plus $5000 and the possibility of burned feet seems like a big investment for a questionable reward.  Needless to say, I’m still skeptical.

Your House is NOT an Investment

Recent news reported the 100 hardest hit cities where the mortgage crisis lingers.  Homeowners are “stuck in loans for more than their home is worth.” This situation of “negative equity” or being “underwater” ranges from 22% to 56% in these metropolitan areas with Hartford, Connecticut the highest.  It’s not only an East Coast issue, though, the problem is shared by cities like St. Louis, Milwaukee and Seattle.

One problem is that people have been led astray by the realtor’s and financial advisor’s propaganda about the “American dream.”  There is no shame in renting.  In fact where there are commonly two categories on credit applications and other paperwork:  rent or own, there should probably be three:  rent, own, or buying.  This would remind us that anyone paying a mortgage does not yet own the house, as many who went through a foreclosure now understand.  And those who are “underwater” right now are less well off than renters, since they are making monthly payments but can’t easily “break the lease” if a better opportunity arises or call the landlord to take care of maintenance problems.

A house should not be considered an investment.  This only encourages Americans to buy more house than they need and, in some cases, more than they can afford.  Advisors tell us that it is an investment, using the leverage of borrowed money, not our money, to purchase an asset that will appreciate.  We have little at stake, but get to keep all the appreciation in value.

But investments are risky.  Sometimes they don’t appreciate.  Sometimes, though rarely, houses lose value.  This has been the case lately.  “After bouncing back smartly in 2012 and most of 2013 following the 2006-09 real estate crash, the housing market began slowing last fall.” That’s eight years of turmoil, and the investment at risk is the roof over your head (and your family).

In the whole housing-as-an-investment game, some have been lucky and some have been very unlucky.  When we retire, we still need a roof over our heads.  So when it’s time to cash in our investment, we get the often impractical advice to downsize or move to an area of lower housing prices or take out a high-cost reverse mortgage.  Wouldn't it make more sense to live in the right house in the first place with retirement savings in more accessible assets?

The Magic Money Tree

I wrote about this issue over a year ago, but this recent article gives me an opportunity to reinforce the idea.  Data from a Bankrate.com survey shows that truly free checking accounts are becoming less common and that other banking fees are increasing as well.  The cause, of course, is the well-intentioned efforts of our government to play hero by protecting us from those evil bankers.

What a large number of Americans don’t seem to understand is that there is no magic money tree to fund programs, pay insurance claims or make up for business losses brought about by regulations.  The money in our economy moves within the system and does not appear out of thin air.  When shoplifting increases, the store loses in the short term but eventually finds a way to pass losses along to their customers in the form of slightly higher prices, otherwise they go out of business.  If the local government workers get a raise in pay or benefits, our taxes increase or some other expense must be cut.  If regulations on credit cards change in the name of consumer protection, the banks figure out other ways to make up for it.  We are all part of that system, and actions within the system can usually be traced back to our money.  This reduction in “free” checking and increase in other fees is a typical example.

Some wonder why stores, banks or insurance companies don’t just take it out of their “obscene” profits.  The answer is fundamental to investing.  If you are willing to settle for a low return on your money you choose a low-risk investment.  Put it in the mattress for absolute safety but no return.  Put it in an FDIC-insured bank account for a small amount of interest.  The more risk you take, the more return you deserve, because sometimes the risk doesn’t pay off.  That’s why stocks, investments in businesses, usually return more than bonds, which are merely loans to companies.  Usually government bonds pay less than corporate bonds for the same reason.  In general, if you buy shares of a company that drills for oil or flies airplanes you take on more risk than if you buy shares of a company that delivers electricity to your house.  If your friend wants you to invest in a new invention or to start a new business, you expect a much higher return.  (Hint: If anyone tells you of a high-return investment that's "a sure thing," you can bet it's a scam.)

As companies face new threats, their risk increases so they owe their investors a higher return.  Threats may be the possibility of increased lawsuits, new government regulations, or merely facing the unknowns of being first to enter a new market.  They shouldn't permanently take these losses out of profit, which represents a return on overall investment, because the risk is higher, not lower, and their investors deserve a higher, not a lower, return.  They are not just being greedy or evil.  The result, however, will often be that we, the consumers, pay more for the same product or service as an indirect result of that added risk.

 Perhaps politicians understand this and are just trying to fool us when they take credit for a new law or mandate to protect us, but let’s give them the benefit of the doubt and assume that they don’t get it either.

Down with Home Equity Loans

Driving past a local bank recently, I was surprised (perhaps even mildly shocked) to see a sign reading: “Put your home equity to work for you.”  What could they be thinking?  Well, the banks are thinking that they can make a loan and collect fees and interest.  The customers are likely not thinking very clearly.

There are still so many people with zero or even negative home equity, owing more than the value of the house, “upside down” or “under water” from the Great Recession.  They believed the line the banks (and realtors) fed them about putting almost nothing down and counting on the market to push the prices up steadily.  When the bubble burst they were left holding the bag.  Some walked away and some were evicted but many lost their houses.

Now, before the economy has fully recovered, banks are at it again.  The advice you get from bankers, realtors and financial advisors serves their purposes,  not yours.  It produces interest, fees and commissions.  A house is not a good investment.  It’s usually hard to sell, so you can’t get your money out right away for emergencies.  It doesn’t always appreciate.  The tax deduction is less of a benefit than most people understand (see The Myth of Home Equity, March 5, 2012).  The government only helps you pay a portion of your interest and you still pay more than you borrow.  Finally, when you do sell it, you still need some place to live!  That means you have to buy another house that has been going through the same market changes.  Unless you are a speculator, timing the market, or willing to put a lot of time and energy into a fixer-upper, you have to be very lucky to come out ahead.

Those advisors continue to call it an investment, buy a house bigger than you need (paying interest and sales commissions) and count it as retirement savings or keep cashing in your home equity to invest in the stock market (paying more sales fees) where it will grow more quickly or, worst of all, take the money out and reward yourself with a nice vacation – “You owe it to yourself; you’ve worked so hard, etc.”

Well call me old fashioned, but my advice is build up that equity and don’t even think of it as equity or an investment.  Think of it as having a roof over your head that no one can take away from you.  When the market goes up, good.  When it goes down, too bad, but at least you don’t have a bank or collection agency knocking on the door.  You’ll never be able to afford your neighbors' luxuries or exotic vacations, but you won’t have their headaches either.  This behavior is not possible for everyone.  I understand there are exceptions and personal situations.  But when you drive by the sign tempting you to “Tap your home equity,” I think you will be a lot happier in the long run if you just keep driving.