Plenty of people leave shared housing behind forever after college.  I was not one of them.  For several years, I lived in a few places with different roommates:  some good, some not so good.  The last 2 roommates have been people I didn’t know so well before letting them move in, which can obviously cause problems.  It’s hard to judge how well you’ll do living with somebody if you don’t know them very well.  On the other hand, sharing a 2 bedroom apartment or renting out a spare bedroom in your condo (in my case) is the frugal choice.  I charged my last roommate $450 per month, including utilities.  Even allowing that my electric and gas bill was higher than it would have been, I was still netting at least $400 extra per month.  That’s enough to almost fully fund an IRA every month.  The alternative would be to turn my spare bedroom into a home office and take the deduction, which I calculate would come to about $100 per month in tax savings.  Clearly, the financials clearly point towards getting a new roommate, but I’m not so sure.  I really don’t need the money, but having an extra $400 per month to invest would help me reach my financial goals that much easier.  I’ve compiled a list of the pros and cons of having a roommate.

 Pros Of Having A Roommate

• Extra Booze Money!
• Split the work on household chores like cleaning, doing the dishes, etc
• Somebody to feed the dog while you’re gone
• Automatic drinking buddy

Cons Of Having A Roommate

• Lack of privacy
• Your roommate may not keep the common areas as clean as you’d like
• Some roommates are annoying
• It’s a pain tracking down late rent every month if your roommate is unreliable
• Noise

I’m leaning towards just turning the spare bedroom into an office and maybe brewing beer in the corner.  Actually, add that to the cons column:  you can’t brew beer in the house if you have a roommate. 

What would you do in my situation?

I hate to budget.  Budgets seem restrictive to me.  It’s totally psychological, but for some reason the mere act of making a budget makes me feel like I’m depriving myself, and nobody likes being deprived:  it’s depressing.  Inevitably, I would end up breaking my budget.  I wouldn’t go into debt, of course, but I would end up saving significantly less than I would have liked.  Budgets do not work for me.

Get Off The Treadmill

Modern Americans (most westerners, actually) are conditioned to spend.  From the moment we’re born to the day we die, we are bombarded by advertisements for goods and services nobody needs but yet nobody can seem to live without.  For me, budgeting doesn’t work primarily because it relies on my own will-power.  While I have plenty of will-power when it comes to some things, such as training for a marathon or finishing a project, it’s not so good when it comes to depriving myself of something I want when I know I have money in the bank to pay for it.  The solution?  Make sure I don’t have money to pay for it.

Artificial Scarcity

I’ve been doing this as long as I can remember, but apparently there is a name for it: artificial scarcity.  If you transfer money out of your checking account as soon as you’re paid, it’s not there to tempt you.  For most people, money in a checking account is “current spending” money while money in a savings or investment account is psychologically different.  Where most people wouldn’t think twice spending money out of a checking account, they would cringe at the thought of transferring money out of savings or selling a stock to make a purchase.  My strategy is simply to transfer a fixed percentage of my income to various money market and investment accounts as soon as my paycheck hits.  Having met my savings goal for the month, I simply spend whatever’s left.  That way, I never have to budget or track my spending because as long as I pay my credit card off every month with what’s in my checking account, I know I’ve met my savings goal.  If budgeting doesn’t work for you, and they don’t for many people, try something else.

This post is in response to the personal finance confession project started by Are You Going To Be This Way The Rest Of The Time I Know You (long name).  I ran across it over on Mrs Micah’s blog earlier today and thought it might be fun to share.  Admitting you have a problem is the first step to recovery, right?  Here goes:

My Personal Finance Confession

I don’t comparison shop.  Ever.  I am not a very frugal person in general.  Rather, my saving schedule is to create an artificial scarcity.  I transfer a certain percentage of my income into various IRA, money market, and brokerage accounts every month and spend freely with what’s left.  So long as my credit card is paid off every month, it means I’ve met my savings quota and I don’t worry about it.  this works very well for me most of the time, but it tends to backfire when I make large purchases that span multiple months.

I bought my current car new in 2004 (I know I know, but I was just out of college and didn’t know what I know now).  My car-buying process was basically do some cursory research on various automotive sites such as Edmunds and Autotrader to get an idea of how much I should pay.  I then went to the nearest Toyota dealer, told them what I wanted and what I was willing to pay, and bought it on the spot.  I realize I probably could have gotten a better price by playing a few dealerships against each other, but I suppose I’m just too lazy for that.  I usually can’t bring myself to do much comparison shopping for big-ticket items I don’t care much about, like a car.  Once I get to an acceptable price, I usually pull the trigger even if I know I’m leaving a little money on the table.  Of course, if it’s for a big-ticket item I enjoy, like a guitar, I will spend endless hours obsessing over ever tiny detail, but most consumer products just don’t interest me all that much.  I guess it’s a good thing I don’t buy many of them.

It’s embarassing.

Last week, I wrote that from a modern portfolio theory perspective, stocks actually become more risky with time (Obi-Wan Kenobi was right).  Because even small differences in returns can have monumental consequences to the eventual size of your nest egg, every little bit counts.  Mutual funds with high expense ratios are an unnecessary and outright harmful drag on returns.

The main reason I like index funds is their rock-bottom expense ratios.  Low expenses means you keep more of your investment returns to compound for you over the years.  A cost drag of just 1% (about average for an actively-managed fund vs a low-cost index fund) can amount to a nearly 50% hit to your next egg over 40 years.  That’s huge.

A Reliable Predictor Of Future Returns

In an attempt to isolate factors most likely to lead to superior portfolio returns, a 2002 study by the Financial Research Corporation analyzed 10 potential predictors of future performance.  The conclusion?  Low expenses are the one and only reliable predictor of future success.  That is, mutual funds with low expense ratios tended to have above-average returns relative to their peers while funds with high expenses tended to have below-average returns.  Statistics such as Morningstar ratings, alpha, beta, and manager tenure all had dubious value in predicting future winners.  The solution?  Allocate at least 80-90% of your portfolio to low-cost index funds.  If you insist on trying to beat the market, limit this to a small percentage of your overall wealth.

First off, let me announce that apparently I’m a “known spammer”.  A few weeks ago, a spammer sent out tens of thousands of spam emails from bogus email accounts using my domain.  Consequently, it looks like I’ve been placed on Akismet’s “spammer” list even though I had nothing to do with it and no way to prevent it.  I’ve noticed my comments on blog posts have been getting caught up in the spam filter, so if you’re reading this and run a blog, I would appreciate if you could put me on your white list.  Otherwise I can’t post comments.  Thanks!

Carnival of Personal Finance

Thanks to Mrs Micah for including my post The 8 Levels of Passive Income in this week’s Carnival of Personal Finance #158.  It’s sad to admit, but I used to watch Buffy The Vampire Slayer when I was younger.  Buffy was hot!  This week’s carnival was a monster, but here are a few of my favorite posts.

Is It Frugal Or Stealing by Passive Family Income.  Have you ever ordered water at a fast-food restaurant and filled your cup with something else?  That looks a lot like stealing.

When To Sell Your Dividend Stocks by Dividend Growth Investor.  Knowing when to sell a stock is usually much more difficult than knowing when to buy.

Should You Blog Anonymously? my My Small Cents.  I don’t feel comfortable revealing any personal financial information outside of broad portfolio allocations.

Do stocks get less risky with time?  That’s actually an interesting question and the answer, as with most things, is “it depends.”  For most of our investing lives, it’s been beat into our head by the more responsible financial gurus that stocks are for the long term.  That is, if you value your wealth you don’t buy a stock hoping it will go up tomorrow.  Rather, you buy a broadly diversified portfolio of stocks and hold them for years if not decades.  Over 20 years, we’re told, the stock market has never lost value.  This is true.  But does that necessarily mean stocks become less risky with time?

Not According To Modern Portfolio Theory

It is absolutely true that stocks become less risky in an absolute sense.  That is, you probably aren’t going to lose money in the market over a 20 year period in nominal terms.  Your account balance will at least be larger than it was at the start.  That’s a good thing and for most people, that’s probably good enough.  They, quite rationally, look at risk as the chance of permanent loss. 

But modern portfolio theory measures risk differently.  To the portfolio manager, risk is simply the degree to which returns differ at the end of any given period i.e. risk is volatility of returns.  In portfolio theory parlance, this is measured by standard deviation.  If returns are more or less normally distributed, there is approximately a 66% chance that next year’s result will fall within one standard deviation of the average return (arithmetic mean, in this case) and a 95% chance it will fall within two standard deviations of the average. 

For a real world example, take Vanguard’s Total Stock Market Index Fund (VTSMX).  Over the past few years, it’s had a mean return of 8.6 %and a standard deviation of 9.15% which means there is about a 66% chance next year’s return will be between -0.55% and 17.75% and a 95% chance next year’s return will be between -9.7% and 26.9%.  Not bad odds.  What this means for long-term investors, though, is that due to the long-term affects of compounded returns, the variability of outcomes can be monumental.  Over 40 years, $10,000 will turn into $361,100 at 9% per year but over $537,000 at 10% per year, a difference of almost 49%!  And that’s only a 1% per year difference.  Run the numbers with 2 or 3% and the differences are truly mind-boggling.  From a portfolio perspective, the volatility and thus risk of these returns are very high so in a very real way, time actually INCREASES the risks of the stock market.  The real-world takeaway from all this is that investment costs matter!  Even differences of as little as 0.5% per year can have a dramatic impact on the value of your portfolio at retirement.  If you don’t believe me, run the numbers yourself.

Doing my usual rounds reading various personal finance blogs yesterday, I discovered the IRS has raised the business mileage deduction to 58.5 cents per mile, up 8 cents per gallon over the past year.   Obviously, as a small business owner or somebody who spends a lot of time driving for work, you’d be a fool not to deduct as much as the IRS allows.  But I got to wondering…with the current budget deficit and our dependence on foreign oil what it is, should this mileage exemption even exist?

Double Dipping

From an accounting standpoint, it’s important to match revenue with the expenses required to generate them as much as possible.  If generating revenue for your business requires driving a motor vehicle, depreciation of the vehicle must be accounted for to arrive at an accurate profit figure.  No arguments here, but I have to wonder if a mileage deduction is the best way to accomplish this.  A mileage deduction basically subsidizes driving and encourages excess gas consumption (and the resulting environmental pollution).  With gas at $4 per gallon, this strikes me as a silly thing to incentize.  It’s also unnecessary.  Instead of allowing a per mile deduction, business owners should be required to depreciate their vehicle (or a portion thereof if used for business only part of the time) according to more traditional straight-line depreciation schedules and deduct the price of gasoline directly.  By allowing a per mile deduction, the government is effectively subsidizing the cost of operating a motor vehicle far beyond the point where the true residual economic value of the asset has reached zero.  A business owner who continues to drive a motor vehicle beyond its average life span is effectively driving for free on the taxpayers’ dime.  Such deductions actively encourage waste at a time when we should be focusing on conservation.  Many would argue that ditching the mileage deduction would unfairly penalize small businesses and discourage economic growth and they have a point.  But I would argue the existence of the deduction to begin with has unfairly penalized the general public in the form of lower air quality and higher gas prices for decades now.  And it has to stop sometime.  There’s no time like the present.  The tax code should not encourage harmful behavior.

Legendary value investor Benjamin Graham once said “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”  Now more than ever, Benjamin Graham’s wise words must be remembered.  Just because a stock goes down after you buy it doesn’t mean you made a poor decision.  Similarly, just because it went up doesn’t mean you’re a genius.

With stock prices falling daily, many bargain hunters who have bought financial stocks of late are being ridiculed as fools.  “Never catch a falling knife,” they say.  “Cut your losers and let your winners run,” they smugly remind you as if it’s an immutable law of the universe.  When financial stocks seemingly inevitably sink lower, those same people will point and say “I told you so.  If you’d listened to me, you wouldn’t have lost 10%.”  That may be true in hindsight, but nobody knows the future.  Unfortunately, the $2.99 crystal balls at Target are for novelty purposes only.  This sort of thinking is a perfect example of the bandwagon fallacy I talked about yesterday.  You are neither right nor wrong because everybody else agrees or disagrees with you.

Contrarians Win In The End

At its core, Graham’s value investing is a contrarian strategy.  Popular industries or companies rarely make good investments, rather, it is the downtrodden, rejected, and industries with a questionable future  that are likely to hold the best bargains.  Value investing requires self-confidence and a strong resolve to buy and hold companies everybody else is publicly lambasting.  Let’s face it, banks are essential to not only the modern economy but to civilization itself.  World governments will not allow the system to collapse and are willing to pay whatever price is necessary to enforce their will.  Today’s investor in financials are likely to be extremely generously rewarded over the long term.  All it takes is the courage to act when the world is screaming at you otherwise.

According to the aptly named logicalfallacies.info, a logical fallacy is, quite simply, an error of reasoning.  Logical fallacies abound in everyday life:  everybody from college professors to politicians, businessmen, and scientists unknowingly commit these errors of reasoning on a daily basis.  The financial media is not exempt from this.  Following are logical errors the financial media in particular is most prone to making.

Post Hoc Fallacy

The full latin term “post hoc ergo propter hoc” literally means “after this therefore because of this.”  Commission of this particular logical fallacy in the financial media is quite common and usually takes the form of “the Dow fell today on higher oil prices” or “the market rose on low inflation.”  While at first glance it may indeed seem logical that higher gas prices would put downward pressure on the Dow, it’s far from a foregone conclusion.  It is entirely possible for both oil to go up and the Dow to go down.  Similarly, just because the Dow just happened to go down on the same day oil went up doesn’t mean one caused the other.  In most cases, day-to-day fluctuations of the stock market are statististically meaningless and don’t require an external explanation.  It’s just noise.  Of course, that’s not to say the market wasn’t actually down on higher oil prices, but there is simply no way to know that for sure.  But financial journalists would be out of a job if they simply told the truth.  Imagine tomorrow’s headling:  “market fluctuations.”  Not nearly as compelling as blaming it on oil prices.  People hate oil prices.

Bandwagon Fallacy

The bandwagon fallacy is commited when an implication is made that the rising popularity of an idea is proof of its truth, or at least a compelling reason why it should be accepted as true.  Anybody who remembers the late 90’s tech boom will recognize this fallacy in action.  As valuations for tech companies that had never earned a single dime became more and more astronomical, several prominent industry analysts declared it was the dawn of a “new economy” and that traditional valuation metrics no longer applied.  They then pointed at rising prices as evidence their logic was correct.  Humans have shown themselves to be quite susceptible to herd behavior and well, we all know how that turned out.  Beware the bandwagon fallacy.

Gambler’s Fallacy

The gambler’s fallacy, which is the assumption that short-term deviations from probability will be corrected in the short term, can have devastating consequences for investors.  For example, it is tempting for financial journalists and even experienced investors to ask “how low can it go” after a bout of falling stock prices.  “Stocks have fallen 10 days in a row now,” you might tell yourself.  “They are due for a rebound tomorrow.”  Not so.  Daily stock returns are what’s known as independent trials, meaning yesterday’s return has no bearing on tomorrow’s result.  As anybody who bought bank stocks recently will tell you, things can always get worse before they get better.  Certainly the market is likely to revert to the mean in the long term, but as economist John Maynard Keynes once quipped, “the market can remain irrational longer than you can remain solvent.”

Some of you may have heard of the Permanent Portfolio (PRPFX), an unorthodox mutual fund that bears more resemblance to a modern university endowment (such as the famous Yale endownment) than a traditional retail mutual fund.  What’s so unusual about it?  For starters, the fund has only half its assets in traditional mutual fund asset classes like stocks and bonds.  The other half is invested in gold, silver, real estate, Swiss francs, and commodities.  In other words, this is a fund you’d expect to do very well during periods of inflation.

Like any good portfolio, the managers of the Permanent Portfolio don’t attempt to predict future returns of various asset classes.  Rather, they maintain a fixed allocation diversified broadly between uncorrelated asset classes.  According to the fund manager, the Permanent Portfolio’s target allocation consists of:

• 20% - Gold
• 5% - Silver
• 10% - Swiss Franc Assets (governemnt bonds, interest-bearing accounts, etc)
• 15% - US and Foreign Real Estate and Natural Resource Stocks
• 15% - Aggressive Growth Stocks (high beta, fast growers)
• 35% - US Treasury Bills, Bonds, Notes, and other dollar-denominated assets

Over the decade ending March 31, 2008, the fund returned 9.38% per year before taxes with a standard deviation of just under 7%.  This compares quite favorably with the overall US stock market’s 5% return and standard deviation upwards of 9%.  Viewing the fund’s 10 year chart, it’s clear the fund did not participate in the great bull market of the late 90’s and the resulting bust.  In fact, most of its outperformance can be attributed to its stable performance after the tech bust and the recent gold and commodities bull market.

Although quite tax-efficient (it’s managed with an eye towards tax efficiency), the expense ratio is a somewhat pricey 1.11% so I wouldn’t want to allocate the majority of my portfolio to it.  On the other hand, its low correlation with stocks and bonds make it a good diversifier.  Futhermore, the fund is an excellent hedge against inflation and adverse geo-political events.  I could easily see allocating 10-20% of my portfolio to the fund.