The Guardian: “Toxic Debt Can Damage Your Wealth”

The Guardian: “A panel of top Wall Street bankers has recommended cigarette-style health warnings on complex financial instruments and suggests that ill-considered bonus packages may be encouraging financiers to take excessive risks”.

How didn’t I think of this before? In my opinion this is truly ingenious idea which is long overdue. The risk return equation is truly one of the most basic yet most misunderstood concepts in finance.

No return without risk is simple enough. But understanding risk is a whole other matter. What is investment risk, anyways? Is it the “value at risk” of an investment? Is it the volatility? Is risk lowered in long-term investments? All these questions have very complicated answers in finance and they are all correct in their own way. Some of these questions have been discussed in The Personal Financier and others will be discussed in the future.

The fact is that very few of us know what lurks behind complicated financial instruments. Even the professionals failed miserably in the last credit crisis surprised by the sub-prime lenders behind seemingly secure AAA bonds.

Are bonds truly less risky than stock? What about corporate bonds which have recently proved themselves ever so risky? Any sort of risk ladder, heads up or recommended investment term is blessed.

The Guardian reports that behind this initiative is an industry-wide group of senior Wall-Street executives chaired by Goldman Sachs managing director Gerald Corrigan. The panel was also critical of how pay deals are put together, saying incentives had "inadvertently produced patterns of behavior and allocations of resources" that were inconsistent with "the basic goal of financial stability". A very diplomatic way of saying risks didn’t really interest decisions makers.

Here are some ideas for possible warnings:

• MBS (Mortgage Based Securities) could cause severe loss of capital.
  
  


• ARS (Auction Rate Securities) may contain hazardous debt.
  
  


• Short term stock investments offer worse chances than roulette tables.
  
  


• Derivative investmetns have been proven to induce divorce.
  
  


• Quitting day trading greatly reduces serious risks to your portfolio.

I’d be very interested in some of your ideas for more warnings… I think I haven’t explored all the possibilities.

Image by: Dylan Boroczi

How to Invest Wisely In a Bear Market?

Bear markets present a challenge for any investor with the end never in sight. How do we invest wisely in a bear market?

Stocks are often hailed as the winning financial asset to invest in for the long term. While stocks offer great potential in return they also hold an equal level of risk. Bear markets serve as a good reminder of the risk-return tradeoff.

During the first half of 2008 stock markets worldwide have taken a relatively severe proverbial beating with major indices dropping %15-%25.

Still, a bear market is by no means a cause to give up on stock investments. It’s just another natural phase in the life-cycle of stock investments which are invested for the long-term.

Amongst my favorite investment methods is an investment technique which enables us to:

1. Gradually increase our exposure to the stock market.
   
2. Invest in a timely fashion which usually suits our monthly savings.
   
3. Enjoy stock returns while relatively limiting the risk we take.


4. Invest in bear markets as well without dwelling on timing the market.

Dollar cost averaging is a well known investment method which perfectly suits bear markets. Most of us are dollar cost averagers investing timely in retirement plans and other long-term savings.

Dollar cost averaging is basically buying a financial asset or a certain portfolio of financial assets in a fixed timely manner regardless of share price. When prices are low dollar cost averaging results in buying more shares of a certain financial asset or portfolio and while prices are high fewer shares are purchased. With Dollar cost averaging the average “initial” cost of the portfolio is updating either upwards or downwards with each purchase thus diversifying risk over time.

Naturally there’s a price to dollar cost averaging. Since the investment risk is reduced so is the potential return. Had we invested a lump sum instead the portfolio risk would be higher but so would be the potential return.

There is a lot of criticism directed at dollar cost averaging. Academic research has disproven this investment technique as preferable to lump sum investing. I believe that for a household investor, much like me, who manages to save some money here and there dollar cost averaging helps ease fears of sharp portfolio drops by easing into the stock market when times are rough.

Poor Long Term Performance Poses a Risk Even To Long Term Investors

The most common hypothesis is that the stock markets will eventually return to growth patterns and will break previous price records. This has yet to be the case with the Nikkei 225 and the S&P500 since the 1990’s and 2000’s respectively. Dollar cost averaging has helped small investor take part in the stock market while not risking their sole savings, other than retirement.

If we examine the two stock market indices I mentioned we’ll see that since January 2000 the S&P500 has generated a negative return of 11.2% (-11.2%) without inflation! The Nikkei225 performed much worse over the past two decades with a negative return of 66% (-66%!!), again without inflation, since January 1990.

The S&P500 since 1999:



The Nikkei225 since 1989:

Dollar Cost Averaging Help Reduce The Risk

Let’s examine what would have happened had we started dollar cost averaging in the worst of times for these two indices. Let’s assume a monthly investment of 1,000$ up to today. Out two portfolios would look something like this:

Even with the current crisis and with the S&P500 and Nikkei 225 losing approximately 15% since January 2008 the two portfolios significantly outweigh any lump-sum counterpart. The S&P500 portfolio actually manages to yield a positive return. Remember, we started dollar cost averaging in the worst possible time to begin investing (right before a big crash).

My goal in this post was to suggest what I believe to be a sound, less risky technique to start investing in the stock market, even if it is bearish. I’ve recently started buying a monthly share of the MSCI world index using dollar cost averaging. Naturally, I encourage each and everyone to regard everything with the appropriate reserve and carefully examine whether a stock investment is right for you. As always, consulting with a professional is recommended.

Related Posts:

• Long Term Investments Are Not Risk Free: The Fallacy of Large Numbers and the Past Decade in Us Stock Markets
• Diversifying your risk in the stock market
• Know your Portfolio - Three Simple Charts Can Make a World of Difference
• How to Protect Your Money From Inflation

How Many Olympic Medals Will Each Country Win in Beijing 2008? An Economic Approach

An economic research provides a simple yet powerful model for forecasting who will win the Olympic Games and why.

The Olympic Games are much more than a simple sports event. The international consensus around this multi-sport event is one of the rarest in our small yet divided world. I believe the Olympic Games are the only event in which more than 200 countries take place, proudly presenting themselves to the world competing equally under the same rules with matches and fights limited to the different events and with the Olympic spirit prevailing everywhere. I believe the most common question in everyone’s mind during this magnificent event is: Why can’t we all just get along?

I’m far from naïve. Politics have always and will always play a major part in such events but there is value to be had nevertheless. The cynics have their criticism of the Olympic Games and we will certainly get a decent dose of it in the upcoming days but hopefully nothing will ruin the festival that awaits us in Beijing this August.

Since this is a personal finance and economics blog I thought about presenting a very interesting economic aspect of the Olympic Games. Who wins the Olympic Games and why?

Economics has much more to contribute to this question than what might meet the eye. Researchers Andrew B. Bernard and Meghan R. Busse (of the National Bureau of Economic Research and Berkeley University) published a very interesting article in 2002 which tries to answer this question using an economic model.

In their research these economists examined the determinants of Olympic success at the country level. Not surprisingly a vast population as well as high per capita GDP were suspected as the main determinants of Olympic success.

The benefits of any economic model are its ability to generalize and produce quality results and conclusions from simplistic assumptions and behavior. The model the researches offered is no different. Through generalization the researches offered an answer to the question of how many Olympic medals countries should be expected to win.

Naturally, the researches assumed the following will serve as good determinants to the number of Olympic medals each country would win:

1. Population – Larger countries would have a deeper talent pool of athletes and greater chances of fielding medal winners and extraordinary talents.
   


2. Resources per person – Naturally population is not enough or China and India would rule supreme. The population model is adjusted with the parameter of per capita GDP. Wealthier countries have more resources, research and facilities required to develop top level athletes. Wealthier countries are also able to support more full-time professional athletes.

Two additional and more interesting parameters were:

1. Forced mobilization of resources by the government – Clearly the Soviet Union, at its time, and the Eastern Bloc countries had a share of medals 3% higher than average.
   


2. Hosting - Interestingly enough host counties were seen to win an additional 1.8% of medals beyond the average predictions. Hosting countries have the home advantage and they spend less on each participating athlete.

Another interesting anecdote examined by the researchers was the affect of large scale boycotts on the Olympic Games. The numbers were corrected for two large scale boycotts of the Olympic Games in 1980 and 1984 (These games where held in Moscow and Los-Angeles).

The researchers examined data from the years 1960-1996. The model for 1996 produced the following graph: It’s pretty amazing what a relatively simple economic model can achieve. Forecasts for Sydney 2000 were also pretty accurate. The following table shows the estimated vs. actual medals won by leading countries:

Medal predictions for Beijing 2008 keep the USA far ahead with approximately 50 gold medals (11 more than China) and with 100 medals overall. China is next with around 40 gold medals and 90 overall. Russia, Britain and Germany are all in the top five with Australia at the sixth place.

It would be very interesting to see what the model would forecast for 2008. Unfortunately I don’t have the data currently available to run it. Still, as the major determinants haven’t changed (even though their distribution has, greatly) I do believe the major results are still relevant. One distinct exception is in fact China which has certainly mobilized its resources towards winning an astounding number of medals (currently estimated at 90).

Small Cities and Net Worth, Misconceptions, and Hanging on to Gas Guzzlers? @ The RoundUp

The customary weekly roundup

I hope you have found my new initiative helpful and interesting. The following are some of the more interesting reads from top business papers:

• Shipping Costs Start to Crimp Globalization @ NY Times – Gas and oil price levels are significantly reducing the attractiveness of imports in favor of local goods. Sounds much more natural, doesn’t it?
  
  
• Ditch the Gas Guzzler? Well, Maybe Not Yet @ NY Times – Interesting points being made. Still, I say ditch it.
  
  
• China’s dash for freedom @ The Economist – The Olympic Games and China discussed. An interesting and more controversial opinion expressed regarding the influence of the Olympic Games on China’s rise.

On to carnivals:

The Money Hacks Carnival #23 was hosted by Can I get Rich on a Salary. My favorite posts from this edition include:

• Money In The Bank - How Much Of It Is insured? @ Your Finish Rich Plan – Very relevant these days.
  
  Small Cities Better at Growing Net Worth @ Free Money Finance – A very interesting and sometimes counter-intuitive point.

The Carnival of Personal Finance #163 was hosted by You Need a Budget. Here are my carnival picks:

• Common Misconceptions about Government Statistics @ Amateur Asset Allocator – A very important post.
  
• Dealin’ with the devil @ Funny about Money – Great writing. A recommended read.

The Festival of Frugality #136 - Summer School Edition was hosted by Student Scrooge. I’ve found these the most interesting:

• Get 100+ MPG with scooters @ Gather Little By Little – I’ve only recently written a post on the matter myself and I’m glad to see scooters are really kicking in.
  
  
• Consider Dumping Your Newspaper In Favor of Your Iphone @ EnviroHumanImpact – I actually canceled my newspaper subscription two weeks ago in an effort to reduce the amounts of paper lying around the house and to save some money. I’m having trouble getting used to paperless mornings. I don’t think I’ll last long but rationally speaking this is a sound advice.

More from fellow personal finance bloggers:

• The 'Experience-Stretching Hypothesis' @ The Financial Philosopher
  
• Lost Money: How Money Drains Add Up To $175,000 In 10 Years @ The Digerati Life
  
• How to Do a Bond Ladder @ The Financial Blogger
  
• How to Give Money to Charity @ Brip Blap
  
• Finance Fiesta

More than a Third of British Citizens are Only 11 Days Away from Financial Ruin: On The Importance of Good Financial Planning

How long could you last on $1,100?

A recent survey by the Yorkshire Building Society reported by the Daily Mail indicates 36% of British citizens could survive financially for only 11 days should a personal crisis occur such as losing a job or getting too ill to work.

Researchers examined income and expenditure patterns among British citizens and come to alarming conclusions. The survey indicates 36% of British citizens have less than 500 Pounds in savings to use as an emergency (Approx $1,100).

The current economic climate apparently leaves people with little choice regarding their financial conduct. More and more people are living on a “financial tightrope” as the Daily Mail puts it due to rising commodity levels and inflation and the growing impact of the current economic slowdown or recession.

The typical person, according to the survey, has 52 days before running out of financial resources. The average monthly expenditure of the average British citizen amounts to 1,445 pounds which are approx. $3,300.

Source: The Daily Mail

Many of the people surveyed indicated they will sell their home should a crisis occur. Relying on selling your home as a last resort is a very poor option as we’ve witnessed only recently. In a crisis real-estate prices tend to respond rather quickly plummeting down due to lack of demand.

In another recent survey by the ASEC Americans reported they saving habits and progress. According to the survey more than two-thirds (71%) report that they "have sufficient emergency savings to pay for unexpected expenses like car repairs or a doctor visit."


Good financial planning is about smoothing both consumption and living standards over one’s life

Solid financial planning aims to smooth consumption over a life time. As crisis come out of nowhere, annoyingly unannounced, good financial planning should utilize precautions to smooth out such a crisis as losing one’s job or becoming too ill to work. There are several tools which help smooth out such a crisis:

#1 Budget for the unexpected

Unexpected expenditures are a fact of life. Budgeting for these unforeseen expenditures each month is a great way of tackling them. Set aside 2%-3% of your entire budget for unexpected expenditures (aside from savings). This method has two distinct advantages: You won’t be surprised and hard pressed when you suddenly need a new car battery and more importantly should frequency and volume be surprisingly low you’ll be able to save that amount, increasing your emergency fund (step 2).The temptation to consume these funds is great. However, keep in mind that on average these expenses will occur eventually.

#2 Set up an Emergency Fund

Much has been said and written on emergency funds and their importance should be clear by now. It’s a method of expecting the unexpected and a very important pre-emptive measure towards more pressing times. Should nothing surprising happen you’ll have a healthy saving generating solid interest.

I believe an emergency fund should last for at least a couple of months of debt and mortgage payments as well as solid living. Everyone knows that decisions made under a lot of stress are usually bad decisions (I already addressed the faulty logic of selling your home as a last resort).Great articles on emergency funds can be found at The Digerati Life, The Simple Dollar and Get Rich Slowly.

#3 Get Insurance

Accidents, disability, mortality and longevity (surprising but true) all significantly or totally hinder our ability to maintain the level of comfort we have been used to. These events are unexpected in nature but have a certain probability of occurrence. Accidents and disability significantly change our lives, mortality is self-explaining and longevity has the risk of turning us into a liability on our children’s lives.

There is no real way to budget for these occurrences. What do we have left in our arsenal of pre-emptive measures? Insurance.

Insurance is basically transferring our specific risks to the community for a premium. For a certain premium which is carefully calculated according to the risk of a certain occurrence we can assure ourselves and our families a steady and good life even should the unfortunate happen. Disability Insurance, life insurance and retirement planning are all integral parts of planning for unexpected expenses in the “life” level.

All of the precautions and preemptive measures mentioned naturally cost money. That is what good financial planning is all about. Save when you’re able to finance possible hardships. Too many people live on a much higher level than they can actually afford. With an upcoming economic slowdown in Great Britain as well many people will unfortunately learn this lesson the hard way.

I believe its much easier compromising for 15% of your monthly income (that’s how much you need to put aside totally) than to face financial ruin.

Related Posts:

• Budgeting for Unexpected Expenses


• The Problem of Accounting and Budgeting For Cash Expenses


• How to Save Money by Analyzing Your Budget: 4 Basic Tools


• How to Make Saving More Rewarding and Tangible: 5 Practical Tips


• How to Save by Making Credit Card Payments More Real and Tangible: 5 Practical Tips

Images by: Phil Moore