Modern Marvels of Finance

Much rhetoric today is focused against “Wall Street”, bankers, hedge funds, and speculators.  People are upset about the effects of the Great Recession, but are often misguided about the causes.  I submit the idea that the foremost cause of the Great Recession was the business cycle (or economic cycle).    If we are to blame the people and institutions behind the business cycle for the Great Recession we must also applaud them for the periods of growth between recessions.  To one degree or another we are all participants in the business cycle.

Of course, there have been behaviors ranging from ethical violations to fraud, particularly in the arena of mortgages and mortgage-backed securities, and (MBS) credit default swaps.

While there are flaws and imperfections in the US financial system, the accomplishments of the system deserve some attention.  The United States represents an economic marvel of the 20th century and 21st century financial achievements of the American financial system.  Like Rome, the United States incorporates the best of other systems.  The stock exchange did not originate in the United States, but the US and Europe improved upon it.  To the best of my knowledge, the index fund and the ETF both originated in the US.

Right now, today, US investors have access to:

  1. Low cost online brokerage accounts.   It is easy to find brokerage accounts that charge less than $8 per trade and have a list of commission-free ETF trades.  With effort, it is possible to find accounts with trades costing less than $5, or even lower.
  2. Free stock and ETF market data. (For example Yahoo! Finance and Google Finance).
  3. Superb ETF offerings. (SPY, VTI, SCHB, BND, VEA, VEU…)
  4. Excellent order fulfillment and pricing (with most brokers).

Just imagine a world without stock exchanges.  Could you imagine placing a classified ad or holding a garage sale to trade stock certificates?  Ludicrous, right?

The current US financial system is indeed a modern marvel.   English, Canadian, and  European exchanges have been similarly efficient and successful.  Other exchanges around the world are playing catch up, and doing so quickly.

The global world of finance is constantly evolving, but as of today the options available to US investors are quite spectacular.  We are wise to take advantage.

Only Half… of our Income?

I was having lunch and one of my friends said that something was troubling him.  He said that he worked out the numbers and, by his calculations, he needed to save 25% of his gross income for retirement.  And taxes took another 25%.  So, that meant he only got to use half of his income.  Only half!  Only half?   Were his calculations wrong?

My first reaction, was no, his computations sound about right.  But, I said, “Please tell me more. Maybe I’m missing something too?”

He explained that his projections were 8% return while he is saving, and then 5% while in retirement mode.  He explained that he had talked with his parents and other retired folks to estimate what their expenses are.

I asked him about how inflation factored into his calculations.  He said that he was estimating about 3-4% for inflation.

So, yes, his estimates made sense.  Knowing his age, and assets, etc, made me think that he had it about right.

So he confided, yeah, but I also have a mortgage and property taxes and insurance?  That takes, more, maybe another 30%.  So that leaves me with, like, 20%.  How am I supposed to do anything with that?!   My income is whittled down to almost nothing!

I could only sympathize.  Yes, I said.  You’ve sussed it out.  I hope that nonetheless you are enjoying your life.   Living responsibly for your future is not easy.  You and your family will, hopefully, thank you later.  The twin tyrannies, taxes and inflation, are the saver’s ever-present adversaries.  Facing them taxes the soul.  The intelligent saver faces them nonetheless, perseveres, and is better for it.

That was the best advice I could offer. It is the advice I give myself. It is unsatisfying, it is adult, it is realist. Are taxes and inflation such tyrants, such a drain? Historic facts say yes. It is the harsh truth. The wise face that truth, and succeed in spite of it. Best wishes, and hang in there. You can do it.

58,087 Pairs of Eyeballs

Number of visits (pairs of eyeballs) to balhiser.com so far, based on web analytics data.  (More technically, 58,087 absolute unique visitors.)  By web standards for a web-based business, that’s not much.  But it is a start.  And it is dramatically more visits than for my younger, sister-blog sigma1.com.  Of course I predicted that balhiser.com would only interest 1 out 10 people on the planet and sigma1 (Σ1) only 1 out a 100.  Still 58 K for balhiser.com is underachieving relative to those ambitious goals.

Visits, per se, doesn’t mean much.  Repeat visits say more.  And recurring visits say even more still.  Each seems about an order of magnitude less (one tenth) the previous.

Still, by those calculations I have, possibly, maybe, hopefully 500 or so regular or semi-regular readers.  Other data puts that estimate closer to 100.  Its not an exact science, at least not for a web analytics neophyte like me.  (I know an expert analyst, but can’t afford her expertise.)

Sadly, that means that balhiser.com is not currently getting enough traffic to get in the black, financially.  I do have a plan B.   Taking the 119 and counting financial blog posts and using them as raw material for an e-book.  (FYI, plan A is to keep blogging until, somehow, balhiser.com content gets picked up and syndicated, or keeps building momentum until critical mass or singularity occurs).

Most small businesses don’t grow to medium-sized businesses.  And many medium-sized business fail to grow to big businesses.  However, many big businesses started out as small businesses.  Two examples, Microsoft and Hewlett-Packard, immediately spring to mind.

If, somehow, against the odds, balhiser.com (and Balhiser LLC) become big business, this blog will detail the financial and other aspects of its early ascent.

If not, it still may provide lessons learned and other insights for a) other small business owners and entrepreneurs, b) people interested in personal and business finance.

Options Investing

Some readers have expressed interest in options investing blog topics.  So I’ll pontificate a bit about options investing.

I view options as generally “zero-sum” hedging tools.   When I buy and sell (mostly sell) options my first thought is not making money on the options trades.  My main goal is transforming and reshaping my portfolio.

In my IRA portfolio option trades cost me about $8.00 each.  Since IRA accounts generally cannot be margin accounts, I have only 4 basic ways to play options: 1) write covered calls, 2) write cash-covered puts, 3) buy calls, 4) buy puts.

The tactic I’ve applied in my IRA is a basic covered-call approach applied primarily to SPY.  In a nutshell, I started by buying 100 shares of SPY and selling a single at-the-money call 2 or 3 months out.  That call option either expires worthless or I buy it back just before it gets exercised.  I then repeat every couple months; selling 4-5 option contracts a year.

The primary advantage of this approach is that it provides extra return during sideways markets and softens market dips.  The trade off is missing out much of the upside return during bull markets.  Setting the option strike price near the stock price eats into portfolio upside, but gives larger option premiums.  Choosing a higher strike price, more out-of-the-money, allows you to retain a larger share of market upside but provide you a smaller premium.

The other factor to keep an eye on is implied volatility.  The most common way to track implied volatility is via the VIX.  When the VIX is higher, you can expect to get more money for the calls you “write” (create and sell a call option).  I prefer to sell call options when the VIX is 18 or higher.

So if you are interested in dabbling with options I recommend starting with selling covered calls on a highly-liquid ETF like SPY.  Real time bid/offer quotes are almost essential and allow you to make limit order trades.  I recommend starting near the option midprice when selling a covered call.  For example if the Jan 2011 SPY 125 call has an ask/offer of 2.16/2.20, you can started by offering your call at 2.18. [Depending on the exchange, your brokerage account, and the price you may only be able to bid in $0.05 increments; in other cases you can price options in penny increments.]

To make things a little more confusing, most options are quoted with a 100x multiplier.  So that means that an option quote of $2.18 actually sells for $218.00.  Each option contract transacts 100 shares of the underlying security (the “underlying”).  So exercising one SPY 125 call contract requires paying $12,500 in order to buy 100 shares of SPY at $125 per share.

Year-End Portfolio Tax Planning

With only a few weeks remaining in 2010, now is a great time to make any tax-planning adjustments.

Step 1 is determining your general current capital gains and gross income situation.   Do you have carry-forward tax losses?  What are your current 2010 realized net short-term and long-term capital gains?   What are your unrealized capital gains?  What is your 2010 “ordinary income” situation looking like?

Answering these questions gives you a starting point for year-end tax planning.

For example, if you have big long-term capital gains because you sold a bunch of company stock to make a down-payment on a vacation property, you make ask yourself, “is paying 15% tax on these gains a good deal, or do I want to try to offset them with a few capital losses?”

Or, you may ask the inverse question…  “I have a bunch of unrealized long-term capital gains;  Should I sell now and realize them for the ‘bargain price’ of 15% tax?”

Some of these financial questions are tough to answer.  That is why I pay my CPA $80/hour to help me answer them. [This is a bargain price; my previous CPA was $150/hour.  Finding a good one for $80/hour was a godsend!]  If your struggling to answer them, I’d encourage you to set up an appointment with your CPA, or if you don’t have one a local CPA.   Bring your best answers or guesses, and you might be surprised how much they can enlighten you in one short hour.

A little year-end tax planning could save you $500, $1000, possibly several thousand dollars.  If you have to pay $80, $100, or even $250, for this I’d say its money well spent.

Portfolio Construction ETFs

Just a quick chart, globally-exposed ETF building blocks with VTI, JNK, IGOV, and  EFA.

GRAPH:  Possible portfolio construction pieces

And on the short-side, ETFs: BIL, BWX, IEI, IEF, ISHG, ITE, and TLO.

GRAPH: Possible short-side (deconstruction) pieces

These ETFs are building blocks I’m considering for a long-short portfolio.  As you can see it would be a US-equity-long,  global-equity long, high-yield (junk bond) long, USD (United States Dollar) short portfolio.

I’m also very interested in call option writing to blunt some of the equity exposure, whilst still remaining equity-long.

What Election 2010 Means for Your Finances

Simply put, the House will go to a Republican majority.  The Senate is likely to maintain in Democratic hands, though by a small margin (say 51/49, with independents caucusing Democratic).

Meanwhile, there will be a lame-duck House and Senate sessions.  The biggest item this Congress will face is expiring tax cuts.  There are two ways this can go.   1)  A compromise is reached before year-end where cuts under a certain number (say $400,000) are retained.  2) No compromised is reached and the tax cuts sunset.  Forced to bet, I’d predict option #2 happens.  If this occurs, this sets up an interesting 2011 where the President’s veto pen and the Senate are the checks against a strong Republican push to retain the Bush tax cuts.

In 2011 the status of income taxes, inheritance taxes, dividend taxes, and capital gains taxes is up for vote.  The strong Republican shift in the House will put more attention on these issues in 2011.  The minority status of Republicans in the Senate will make it challenging for Republicans to put significant changes on President Obama’s desk.  The biggest wildcard will be how President Obama will deal with this dramatically changed legislature.

In summary, I predict that the next 2 years will be marked by gridlock on many fronts.  I predict that the Bush personal income taxes will be retained for those with incomes $200-250K or less… I’ll hazard that even up to cuts for this with incomes up to $500K will be retained.  The fate of dividend tax cuts it less certain.  I suspect that the 15% rate will be retained for those with incomes up to $500K.  I suspect that capital gain rates will lapse to the higher pre-Bush levels.  These are my best guesses.

Computing Beta, Again

The beta computation saga continues.  I came up with a modified version of the example beta computation method from:

http://faculty.babson.edu/academic/Beta/CalculateBeta.htm

I incorporated a couple modifications (specific to Excel 2010):

  • Install the “Analysis Toolpak” Add-in:
    • File->Options->Add-ins->”Go…”->”Analysis Toolpak”
  • Data->”Data Analysis”->Regression
  • You will have the option of “R Square”.  You will have a couple coefficients, the first (top) is alpha, the second (bottom) is beta.

The “Babson Method” is equally effective.  Take your pick.  Beta and “R square” together are more useful than beta alone. Remember that a low R-square (say <0.5) means that (historic) beta is not particularly useful for explaining the movement of the stock or asset in question.  Moreover either method also supplies a (historic) alpha… a measure of that assets excess return versus the benchmark.

Like any backward-looking analysis, historic alpha, beta, and R-square provide ways to look a that asset’s past.  One hopes that they provide some measure of an asset’s future… this may or may not prove to be the case.

I still see a minor factor that makes either method slightly imperfect…. the lack of accounting for total return.   The basic method don’t account for (re-invested) dividends.  However this is fairly easily remedied by factoring in dividend payments into the asset returns.  It is likely that there are other refinements to be found.

Making Personal Finance Personal

Previously I started blogging about the very different approaches my parents took with respect to money and investing.  In this blog post I continue that discussion with a story of how I became even more passionate about investing.

My parents divorced not long after I started attending college.  Because of the way divorce law works, my Mom received the majority (perhaps two-thirds) of the family assets plus a fairly significant monthly alimony payment.  Over the next ten years Dad rebuilt his financial life, benefiting from the remarkable 90’s bull market and intelligent investing.  Over that same period, Mom’s financial fortunes floundered.  I witnessed both financial journeys as a powerless spectator.

The sad irony is that Dad, the savvy investor, was willing to listen to my investing ideas, whereas Mom stubbornly refused almost all of my investing advice.  I saw Mom make one bad investing decision after another.  She put the house on the market but could not sell it because her asking price was about $100K too high.  She loaned money to business partners without a written contract… money that was never paid back.  Most upsetting to me:  She let her investment adviser, Sam W., manage her IRA, losing money with highly under-diversified utilities stocks and funds in the midst of this tremendous bull market.  The contempt and disappointment I feel towards Sam still lingers with me to this day.  That Mom blindly trusted this man, who likely had little interest in her well-being, and shunned her son’s financial advise left me with stunned disbelief.

I was interested in investing from the time I learned about compound interest at around the age of 9.  I was fascinated by the math of computing compound interest monthly, daily, hourly, continuously.  I was intrigued by the concept of companies, shareholders, stock exchanges, and business.  But it was in watching and living the real-world consequences of my parent’s good and bad investing actions, that my lifelong passion for investing was forged.

These experiences are probably why I am so driven to help people avoid making big financial blunders.  I’ve seen and felt the effects of load funds and self-serving financial advisers.  I’ve seen the impact of poor diversification.  I’ve seen the tears of losing a home, losing a business… due to poor financial choices.

I’m often looking for ways and words to become more persuasive.  I’m looking for ways to help people build interest and confidence in shaping their own financial destinies.  I’m working to develop tools to simply and explain the financial world.  I’m working to create this financial education blog which will someday become part of a personal finance book.

Finance is my passion.  This passion is often hard for people to understand.  Perhaps this blog article will help people understand.  Probably some of my readers share a passion for personal finance and investing.  If you have a similar passion, I hope you will consider sharing your financial stories that shaped your financial lifestyle.