Dear, wonderful, devoted reader of this website,

By the time tomorrow’s article comes out, I’ll either be en route to the hospital or already be under general anesthesia off in la-la land while I’m getting my knee operated on (the same one which led me to my long, arduous journey to the Veterans Administration hospital to get a MRI). Whenever I publish an article, I normally do the usual social media rounds, posting the article on Twitter, Google Plus, and Facebook.

However, tomorrow, it’ll be kind of hard to do that, since I’ll be sucking in ether or whatever they’re going to use to knock me out while they dig around in my knee and scrape away torn meniscus and take a peek at my re-torn ACL.

So, if you happen to see tomorrow’s article, “What My Dog Wishes I Knew About Personal Finance” and think it’s any good, I’d really appreciate it if you could help me out and share it, since I won’t be around to do so. I even have little buttons at the end of each article that are supposed to make it a little easier to share. They look like this:

It’s so easy, yeah yeah…

If you don’t, no shakes. Hopefully, if you stick around long enough, you’ll find something which resonates with you!

If all goes according to plan, I’ll be back in the saddle, even if an immobile saddle, on Friday.

Thanks!
Jason

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ONE. TWO. NOT ENOUGH!

“Neglect of mathematics works injury to all knowledge, since he who is ignorant of it cannot know the other sciences or the things of the world.”
–Roger Bacon

If I told you that there were two investment possibilities, one of which had a 100% gain and one of which had a 1% gain, you’d probably immediately think that you should invest in the 100% gain investment. It’s natural to think that – higher percentages are better, right?

Let’s add some more details to the description above. The first “investment” was made by me sitting down at a slot machine in Las Vegas. I put in a quarter into a slot machine, pulled the handle (or pushed the button…I hate those new-fangled machines that don’t have arms), and, voila! I got fifty cents back (I also miss the actual coins being dropped into the container; the paper tickets just don’t have the same appeal)! Woo-hoo! A 100% return on my investment! I saunter away, shaking my fist at the “house,” embellishing my dominance.

The second “investment” was made by Bill Gates, who owns about 440 million shares of Microsoft. On the day I’m writing this article, his company is up about 1%, or around $0.30. He has made $130 million, on paper, since he got up this morning. He probably didn’t even notice. I doubt he’s calling up his broker to sell his holdings to “lock in his profit.”

So, now, which position would you rather be in? The person who made 100% or the person who made 1%?

We are faced with mathematical problems which integrate magnitude and relative growth all of the time in our personal financial lives, but, it turns out, Monkey Brain isn’t really that good at math.

Author Tim Harford recently wrote about this dilemma. He wrote about a study which showed that doctors made similar mistakes in choosing what tests to perform for cancer screening. Doctors were drawn to activities which detected cancer earlier, but failed to choose the ones which actually helped reduce incidences of cancer.

What’s the difference?

You want to focus on outcomes, not on process. In this case, if you detect an incurable cancer earlier, you may increase the five year survival rate, but you haven’t affected the overall outcomes one iota. Sure, there is value in earlier detection – getting your affairs in order, doing the things you really wanted to do, etc. – but the actual goal is the defeat of cancer itself.

Monkey Brain messes up these calculations all of the time; you don’t have to be a MD to fall for mathematical illusions. Let’s take a common example of what has happened to many people in the recent past.

According to Freddie Mac, between 1985 and 1999, an average 61% of refinanced mortgages led to an increase in loan balance of at least 5% while the average refinanced interest rate was 86% of the previous interest rate. In other words, Monkey Brain saw a lower interest rate, and instead of using the opportunity to decrease the term of the mortgage or use it as an opportunity to pay less in interest, he doubled down on the risk, pulling cash out. Monkey Brain was willing to pay more money later for a little money now – confusing interest rate with total interest paid.

What is the lesson here?

Do not be fooled by rates. Yes, oftentimes, rates going in the direction you want them to go is a good thing, but you also need to look at magnitude of the impact. A high rate change with a small magnitude impact isn’t really that meaningful.

Look for large total moves, not large percentage moves. Remember, the goal in financial planning is the overall impact. If you’re willing to dicker all weekend with your car salesman about a half a percent decrease in your auto loan but not willing to shop mortgage loan officers for a quarter of a percent decrease because you think the paperwork is “too difficult,” then you’re probably missing out.

It’s never a good idea to let Monkey Brain do math. When you’re faced with rates compared to magnitude, stop for a minute and think about the total implications of your decision. Otherwise, Monkey Brain will think he’s getting more bananas than he might otherwise be getting.

If you want to read more about the importance of numeracy in your financial life, check out my U.S. News & World Report article about math.

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Mental accounting in a picture

“I try not to be surprised. Surprise is the public face of a mind that has been closed.”
–Bernard Beckett

In my previous company, when we started out, we flew by the seats of our pants. Not so much flew as skidded across the runway, trying desperately to reach launch velocity or whatever it is that they call it which allows planes to take off before they crash into the trees or berm at the end of the runway. In the first couple of years, we called ourselves “involuntary non-profits” (not to anyone who might have actually wanted to spend money with us, mind you) because we were trying to be profitable, but we weren’t succeeding.

Then, suddenly, we got a big contract.

If you have read the comic strip Peanuts, you know what I’m talking about when I say that we did the Snoopy dance. We went from 3 guys and 3 computers to 11 people almost overnight. Pretty soon thereafter, we got a check for a sum of money that I couldn’t even fathom. I dutifully cashed it, paid our people, and went about planning.

Things went well for quite a while. We were finally able to pay ourselves a salary, and life was good.

Then, at the end of the year, I went to our accountant to have him prepare our taxes.

Gulp.

We were a limited liability company who chose partnership tax treatment. That meant that all of the profits and losses of the company flowed through to the personal income taxes of the three owners. For the first year, this was great because we had tax losses. Of course, we didn’t make any profits, which was another issue altogether, but from a tax perspective, it was great. In year two, though, we had profits.

This meant that each of us got a big, fat K-1 showing all sorts of income which we hadn’t actually seen go into our pockets.

We weren’t prepared. There wasn’t enough money in the corporate kitty to pay our taxes because we were very aggressive about paying our vendors as soon as we got bills. That was good from the perspective that our vendors loved to work with us, but it was bad from the perspective that our wives were mad about a very significant tax bill that we all had to eat until the company could pay us back.

It took us quite a while to pay ourselves back from that planning fiasco. It wasn’t like we didn’t know that there would be taxes, but we didn’t plan ahead. Monkey Brain was running our corporate books too. It was that same surprise that people feel when Christmas suddenly arrives and they didn’t budget to buy presents.

Yes, you have to budget for taxes when you’re a partnership.

It took us a while to get a system that worked, but we finally got there, and now, when filing season comes, we’re not left gasping for air at the bill, because we already have the money set aside to pay for it.

Here’s what I do.

First, at the end of each month, I set aside a percentage of profits equal to my effective total tax rate (federal + state + local where applicable). That money gets distributed and put into a separate tax payment checking account. If there’s no profit that month, then I start a running tally until there’s a cumulative net profit. Once there’s a positive number, tax payment money gets distributed. Every three months, I make my estimated tax payment to Uncle Sam and to other tax authorities as necessary.

Yes, paying taxes is a pain. It’s a necessary pain. It’s a lot better than having to explain to your wife that you need to raid (or raze) the emergency fund because you need to pay taxes and that the company “owes” you. We were very fortunate that our company was a viable and going concern and was profitable enough to pay us back. I suspect a lot of small business owners are not that fortunate and wind up with a double whammy – losing the money they invested and the money that they owed in taxes.

Save yourself the hassle. Set aside the money every month so it’s there when you need to pay taxes. Being in the hole because of that tax bill was one of the biggest thorns in my side for a couple of years. Avoid that pain, because it festers in the back of your mind like a sunburn in the middle of your back – irritating and unreachable.

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Ask, and ye shall receive!

I recently received a question from one of the subscribers to the 52 Week Financial Game Plan that seemed like an excellent topic to share with all of you.

This person asks:

Jason,
As I read more and more on the topic of financial planning, it seems there are 2 factions. One faction is the adviser that manages/advises mainly on matters concerning investments ( IRA’s, retirement etc.). The other seems to be the nuts and bolts kind of guy……answers questions on insurance, budgets, everyday financial concerns and such.

Can you get both in one, or, at least to get started, with regards to advise, should these two different interests be handled by one adviser or separated ?

Once on the road, what is the function of an adviser? Do you see it as that of a physician, checking in from time to time and providing a check up, getting you back on the straight and narrow when need be, or someone actively reaching out when they sense a concern?

To which I replied:

Mr. or Mrs. X–

I’d offer a slightly different take on your division. To me, there are two types of advisors:

1. The person who wants to invest your money for you, take a % of your invested assets each year, and for whom the financial planning is ancillary. The financial planning is a loss leader for the assets under management fee that he will get every year from you. There’s a big discussion going on in the financial planning industry about the role of financial planning as it relates to getting people to invest their assets with the financial planners. The planning runs from “invest your money with me! Goodbye!” which you’ll get at any of the strip mall “financial advisory” firms (you can probably figure out the names of the firms to whom I refer). They’re giddy when you buy 5.9% front loaded mutual funds and then pay 1-2% of your assets each year on the back end. The other end of the gamut are the firms who will still take some percentage of your assets under management each year, but will go through an entire financial planning process with you, covering estate planning, tax planning, financial management, and the like, minus teaching you about investing, since that’s what they want you to think they can do better.
2. The person who won’t manage your money and will do the entire gamut of financial planning, to include teaching you how to invest your own money. This is what I do, so I have an obvious bias, which I’ll explain shortly. In general, these people either don’t want to deal with the hassle of the regulatory requirements associated with having a broker-dealer relationship and investing your money for you (which is not insignificant) or they don’t feel like managing someone else’s money is in the best interest of their clients.

I fall into the latter of the latter categories. There are few of us out there (I feel like a wizard in Middle Earth – strange and rare) because, honestly, there’s just not a lot of money in it. An average engagement with me will cost around $2k (give or take), and even though I’m a lot cheaper than someone who’s charging a percentage of assets under management, due to cost deferral and the fact that Monkey Brain doesn’t have to ever stroke a check for the services, it’s easy to pretend that the costs aren’t there and that I’m actually more expensive than the investment advisor who’s charging you that percentage of your assets that he “manages.” Therefore, there are few people who a) have the strong convictions about what they do like I have, and b) have the financial wherewithal to have a comparatively low income from what they do (which I do, thanks to both my own prudence and to selling a company), since this route is not as lucrative as taking 1% of their client’s money every year. My goal is to teach my clients what they need to know, and then, unless they just want a check up, or their life circumstances change (“you mean Bill Gates was my illegitimate uncle and I’m inheriting everything from him?!?”), they shouldn’t need to come back.

Thus, the decision really comes down to a tradeoff of time for money. If someone REALLY wanted to, they could scour the Internet for every piece of relevant information that is out there, or take the CFP core courses, and get a pretty significant portion of the knowledge I possess. There are a ton of DIYers out there who spend a lot of time on Bogleheads and other similar forums and sites doing just that. Or, they can have the teaching tailored to their needs and pay for the education.

Now, back to why I think model #2 is superior.

1. Conflict of interest. If I’m managing your assets, then I have an incentive to grow those assets as much as possible. Sounds good in theory, but in reality, it means that I’m encouraged to take inappropriate risks, which, more often than not (discussed below), wind up not working out the way that they were supposed to on paper, and you wind up with even less. Once you’re down some, I’m encouraged by prospect theory to try to win it all back – effectively a Martingale system for investment management.
2. Nobody can systematically and consistently outperform the market in a replicable manner. Statistically speaking, investment performances are more and more a function of luck than skill (see my article “Do You Have to Be Lucky to Beat the Market?” for more). As a result, you’re paying what could wind up to be a significant portion of your potential net worth to someone to, from a probability standpoint, underperform the market.

Therefore, with regard to your question about the fees you paid, you have to ask yourself two questions:

1. If I simply went with an appropriately allocated index strategy, what would my returns have been compared to the returns I received?
2. What guarantees that I’ll continued to receive the same investment performance, relative to an appropriately allocated index strategy, year over year?

Unless you simply do not have the time because you’re pursuing activities which have a higher value to you than the few hours a year necessary to manage your own portfolio or you do not have the cognitive ability to do said management, I see no reason why you (or anyone) should be paying someone to invest your money for you and run a high probability risk of underperforming the market.

Furthermore, the level of effort to manage a $1 million portfolio is not twice as much as the level of effort to manage a $500,000 portfolio, so why do people who pay others to manage their money get charged twice as much?

By the way, I did not even include commission-based front-load mutual fund salespeople, because they’re not worth me wasting my breath on. Spend money with them and you’re lighting it on fire.

You’re darn right, I’m biased.

What do you think? Sound advice or am I blowing smoke? Tell us your thoughts in the comments below!

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Who wants five blades when you can have six?

“Give away the razor. Sell the blade.”
–Every MBA professor for the past fifty years

“IT CHEAP!”

That’s my Monkey Brain’s favorite saying. He knows that the soft spot in my heart is finding something on sale or something cheap. This is one of the few places where Monkey Brain and I have our interests aligned. We both like low prices.

However, Monkey Brain has trouble doing math. He isn’t familiar with the term Total Cost of Ownership, sometimes known by its acronym TCO. Monkey Brain often confuses cost and value. Actually, he doesn’t really care about value. He just cares about cost. Lower cost means he can go out and buy more things!

There are many instances where it benefits the seller to attempt to hide additional costs associated with a low up-front price. As M.I.T.’s Xavier Gabaix and Harvard’s David Laibson show, marketers have no incentive to educate customers about hidden fees because the uneducated customers will pay them, and educating the customers just shows them how to avoid the additional costs.

Let’s look at a couple of examples.

How many times have you checked in at an airport and been behind someone who expresses surprise, disgust, and then resignation at a checked bag fee? The person in front of you probably saw that the airline had the lowest fare, booked it, and went merrily to the airport, forgetting (or being ignorant of) the checked bag fee that is rampant throughout the airline industry. The airline has no incentive to remind this customer of the fee beforehand, lest he pack a carry-on and the airline lose the checked bag revenue.

The same holds true for hotels. Many hotels, particularly business hotels, still charge a wifi fee, even though guests could walk down the street and get free wifi for the cost of a cup of coffee at a café. Why do they do this? They charge the fee because they know that there is an inconvenience to packing up your laptop, heading down to the café, buying a cup of coffee, and then using the wifi. What if you need to surf the web at 3 AM? Good luck finding that open café. Hotels realize that there are people who will pay for the “convenience” of in-room wifi, and the inconvenience is not enough to get others to switch to a different hotel. Educated consumers will find alternatives, but it’s in the hotel’s interest to capture a reservation and then, once the guest is there, show the sign for the $19.99 wifi fee.

Monkey Brain sees the low initial costs and reaches out for them like a pile of bananas. Monkey Brain doesn’t like to do the additional work and searching to determine what something will truly cost. He sees the first price and becomes anchored to it.

Here’s how to fight the impulse to think that the first price is the best price:

• Do a little more digging. Look at the website and also look on a search engine such as Google or Bing for additional fees. It’s worth spending the time up front before you’re mentally committed to a purchase to determine the total cost of ownership. Otherwise, you’ll feel mentally committed, the perceived switching costs will be too high, and you will just pay the fees. If you have a printer at home which eats ink cartridges, you know this feeling.
• Reframe the cost away from the “sticker price.” Because of the anchoring bias, we mentally affix the first price we see to whatever it is that we’re buying. We have to fight this bias – the marketers want us to think of the low price first. That’s why car dealers advertise prices and then mention, in hurried and low voices, “tax, tag, title, and add-ons.” They want you to anchor on that base price and not deviate.
• Don’t make the purchase right away if you don’t understand the total cost. It’s easy to become emotionally involved in a decision, and, as research has shown, you cannot concurrently have analytical and emotional thoughts. Want to read more about the conflict between emotional and analytical thinking? Subscribe to my 52 week Financial Game Plan and it will be a part of the series you receive!

Monkey Brain likes low numbers when it comes to price, but he doesn’t like to think about other numbers which are involved. That’s why it’s important to step back, evaluate, and properly think about the total cost of a purchase. If you can avoid add-on fees, then marketers will actually subsidize your purchase with the purchases of the unsophisticated Monkey Brain buyers.

Have you ever bought something you thought was inexpensive only to find out it cost a lot more than you expected? Tell us about it in the comments below!

This article appeared in the Finance Carnival for Young Adults. Thanks for hosting and choosing this article!

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