The Joneses Are Your Enemy

Photo by: Chapek Sergey

Probably the most self-destructive thing that a person can do for their financial future is to pay undue attention to what those around them are doing.  Obviously this has limits, but using your friends, family or neighbors as benchmarks for “success” can manifest itself in many ways and almost all of them can sabotage your financial progress.  You should always remember that what a person presents as their situation can be very different from their true situation.  Let’s look at some ways the Joneses can sabotage you.

Status Symbols

Typically when talking about “keeping up with the Joneses” we’re referring to buying status symbols.  Maybe your neighbor bought a new BMW, and it sure looks nice.  Or maybe you’d like to host the football watching party sometime, but your TV just doesn’t match up to your friends’.  These types of situations can inspire us to make purchasing decisions that may provide a short-term high for a lot of pain.

Almost all status symbols are depreciating in nature.  Your car and that new TV are going to lose their value over time.  The more purchases like that you can avoid the better your financial future is going to be.  This isn’t really very tricky, and most of us are aware of this, even if we don’t always follow through.

Debt

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Should You Ever Leverage Yourself?

Photo by: fairlightworks

The typical American is leveraged.  They have borrowed money to buy things.  This is not necessarily bad in and of itself, but if you start to think of your household as a business, you may stop and question whether the leverage you’ve taken on makes sense.

What is Leverage?

Leverage is the use of debt to magnify the outcome of an investment.  Say, for example, you are a company, and you trade widgets.  On each shipment you can buy widgets in one location for $10 and sell them in another for $12.  If you only had $100, you could only do this in shipments of 10 widgets and make $20 per shipment.  However if you could go and borrow $10,000, you could buy shipments of 1000 widgets and make $2000 per shipment.  Even after you paid back the party that loaned you the money, along with any interest, you would have made considerably more money per shipment.

Appreciating Assets

One of the most compelling reasons for an individual to leverage themselves is to buy an appreciating asset.  An appreciating asset is one that gains value over time.  The most common form of this in recent history has been real estate.  Leverage, in the form of a mortgage, is very common for an individual buying a house. (more…)

Should You Be In the Stock Market?

Photo by: mvhargan

I often hear people tell me that they’ve stopped contributing to their retirement account because they don’t think the stock market is going to go up.  It seems many of these people assume that a retirement account and the stock market are one and the same.  Most plans have many options, and nearly 64% have actively managed bond funds as an alternative.1

The fact that many people don’t even know what their options are in their retirement accounts suggests to me that they probably shouldn’t have been in the stock market in the first place.  Many people were initially sold on stock market-based retirement account options by claims that the stock market returned 8%, or 11%, or whatever their advisor was telling them. They put their finances on autopilot and never looked back.  At least they never looked back until 2008.

The Risk Premium

The philosophical rationale for why stocks should outperform “safe” investments, like government treasuries, is something called the risk premium.  In theory, if equities did not outperform safe investments, then rational actors would cease to buy the equities. The prices would decrease to a level where there would be an adequate risk premium.

This theory was put to the test during the recent financial crisis when, at the nadir of stock prices, there essentially was no risk premium for the previous thirty years.2  Since then, stocks have rebounded a good deal and the risk premium has returned. However, it points out an important fact: the risk premium is only likely in the long term and is not guaranteed.

Risk Tolerance

Because of the wild variability of the risk premium, the value proposition of equities decreases as you get closer to an expected retirement date.  Once you have a near-term window for beginning withdrawals, the amount of time your returns have to “average out” decreases, and your exposure increases.  As you get closer and closer to retirement, equities should become a smaller and smaller portion of your portfolio. (more…)

1. PSCA.org – 51st Annual Survey of Profit Sharing and 401(k) Plans [↩]
2. Bloomberg.com – Bonds Beat Stocks in ‘Earth-Shattering’ Reversal: Chart of Day [↩]

Some Thoughts on “Dollar Cost Averaging”

Photo by: Rob Lee

The term “Dollar Cost Averaging”, or DCA, can have many different meanings.  Oftentimes when referring to “Dollar Cost Averaging,” people actually mean “Automatic Investing.”  DCA typically refers to investing over a period of time an amount you could have invested initially.  So for example, if you had $10,000 to invest, instead of putting it all in now, you invest it over a period of several months in equal dollar amount increments.  Automatic Investing on the other hand is simply taking a set amount out of your income and investing it every month.  This is what the majority of people think of as Dollar Cost Averaging.

The Theory

Proponents of DCA claim that it reduces risk, because you tend to buy more shares when prices are low and fewer shares when prices are high.  This argument makes some sense in an oscillating market that isn’t moving overall in any particular direction.  One question remains, however: why would you want to be investing in an oscillating market that isn’t trending in one direction?  Typically most people’s faith in investing in stock markets is that over time they go up.  If the market is on average going to move upwards, why am I holding back investing a portion of my investment?  On average this simply means I’m going to get a higher price.

The Worst-Case Scenario

If we think about this matter anecdotally it seems intuitive however that by holding back some money to invest we’re reducing our worst-case scenario.  Suppose for example that we invest all our money today and tomorrow the stock drops precipitously.  We’ve avoided that risk.  At the same time however, what if the stock rises sharply and never returns to our original price.  While we may be reducing our worst-case scenario somewhat, we’re also risking leaving a lot of money on the table.  Still there seems to be some merit to increasing your exposure over time. (more…)