Market capitalization doesn't matter because share prices don't matter

There is a tendency in financial journalism to refer to a company's market capitalization as what the company is "worth," or its "value." This tendency is most pronounced when people describe a private company raising capital, for example describing Uber as "worth" $62.5 billion. These valuations are arrived at by comparing the price paid to the share of the company purchased: if $3.5 billion in cash buys you 5.6% of the company, the company must be "worth" $62.5 billion.This is absolutely preposterous. Market capitalization doesn't matter because share prices don't matter.

Share prices tell you at what price shares recently changed hands

When the stock market closed this afternoon my shares of Mattel were quoted at $25.76. As there are 342,045,279 shares of Mattel outstanding, the company's market capitalization is about $8.81 billion.From this, your Bloomberg talking head will conclude that Mattel is worth $8.81 billion. This is false.

You cannot buy Mattel for $8.81 billion

It is true that if you want to buy 100, 1,000, or even 10,000 shares of Mattel, you could probably do so for about $25.76 per share. On average 4 million shares change hands every day, so there are always a lot of people trying to sell their shares (although you still have to compete against all the people trying to buy them as well).If you try to buy 100,000 shares of Mattel, you're going to find that there just aren't that many people willing to sell shares at $25.76 each. The price is going to inch up as you exhaust the shares available at each price point. And as the price inches up, the market capitalization, which is simply the multiple of the number of shares outstanding and the last price a share changed hands at, will also increase.If the market capitalization were the "value" of the company, this process would be increasing the value of the company. But it obviously isn't increasing the value of the company: it's a mechanical process of paying more and more money to people depending on their willingness to part with their shares.If every single market participant had some price they were theoretically willing to sell their shares at, the final share you purchase, the 342,045,279th share, will be the final price quoted on the market, perhaps at $50, $100, or $1,000, giving your toy company a market capitalization of $342 billion. But "the market" doesn't "value" Mattel at $342 billion — that calculation is purely an artifact of the last price the stock traded at.

You cannot sell Mattel for $342 billion

The same process would work in reverse if you tried to sell your 342,045,279 shares of Mattel. You might find an eccentric willing to buy the first share for $1,000, but after that you'd quickly find yourself offering your shares for less and less money in order to entice reluctant buyers. The final share you sell might fetch you as little as $25.76, resulting in a market cap of a mere $8.81 billion, despite the fact that you received much more than that as you sold some shares for $1,000, others for $50, and others still for $30.

There are shares that are unavailable at any price

The Vanguard 500 owns 5,070,147 of Mattel, and they aren't for sale. As you bid up the price of Mattel on the public markets, there is no one at Vanguard authorized to cash in on your lunacy. Since Mattel is in the S&P 500, Vanguard will hold its shares all the way up and all the way down.You will never buy Mattel on the public markets while Vanguard, Fidelity, Blackrock are sitting on shares that their index funds are legally bound to hold.

What is a company worth?

The point of this exercise is not to say that it's impossible to value companies, or that there's no such thing as value, or that market capitalism itself is some kind of hoax. It is only to say that a company's market capitalization is not the value of that company, because it's not the price of that company.It is perfectly reasonable to ask what a company is worth, and it's perfectly reasonable to express that value in dollars. So here's my crystal clear answer about what a company is worth:"Somewhat more than its average price across the entire business cycle."That is what a company is worth because that is what it would cost to acquire the company — that's the price of the entire company, not just 1/342,045,279th of it. When you want to buy a company, you make an offer for all the shares, so that shareholders willing to accept a lower price don't get stiffed while those willing to wait sell you the last share for $1,000. Everybody gets the same price, and that price is "somewhat more" than the average price of the stock.

Conclusion

It is good that we have deep and liquid capital markets, because they allow people to be practically certain they can buy and sell their shares at some price. But using share prices as a measure of the value of a company confuses the froth for the ocean. Companies can be valued, they can be bought, and they can be sold, but publicly traded share prices on a given day are absolutely irrelevant to those enterprises.

The boring reason you might take out student loans while getting a free education

Last week I wrote about the simple path anyone can follow in order to go to college for free (and explained why I think almost no one takes it).Some commenters objected to the fact that in passing I mentioned the benefits of the income-based repayment option for loans made directly by the federal government, claiming that an education paid for with such loans wasn't "really" free.This seems like a deliberate misreading of my post, but since several people made the same objection, I thought I may as well explicitly clarify the issue.

It's possible to go to college tuition-free

The second step I explained was to "Select institutions that promise to meet full demonstrated financial need." If you've established FAFSA independence, and have a low income and assets during the period the FAFSA covers, meeting your full demonstrated financial need will cover your tuition and fees. Here's the description of the California Blue and Gold Opportunity Plan:"If you are eligible, your systemwide tuition and fees will be fully covered by scholarship or grant money."That means no tuition, no fees, no loans.

Grant aid covering room and board is taxed as ordinary income

When your grant aid (scholarships, fellowships, and any other grant that doesn't need to be repaid) exceeds the amount your college charges in tuition and mandatory fees, the difference is taxable as ordinary income on line 7 of IRS Form 1040.Maybe this is a good policy and maybe this is a bad policy, but the logic behind it is simple: the car you use to drive to work isn't deductible as work travel, the meals you eat every day aren't deductible as work meals, and your house or apartment payments aren't deductible as work lodging just because you happen to have a job. The IRS isolates your expenditures directly connected to your business or job from those incidental to it, so even if you live in the same city as you work, your rent isn't a work expense.The same logic applies to the taxability of grant aid in excess of tuition and fees: you have to live somewhere, and you have to eat something, so grant aid covering room and board doesn't cover "educational" expenses, it just covers expenses you'd have to pay anyway, and is therefore taxable income, not untaxed educational assistance.

Colleges don't want to waste their grant aid

This makes colleges and universities extremely reluctant to spend their scarce grant aid covering room and board because the same amount of money goes further when distributed tax-free to cover other students' tuition and fees. For a student in the 10% income tax bracket, $10,000 in grant aid only covers $9,000 of living expenses while it covers $10,000 in tuition and fees.

Don't take out student loans if you don't want to

If you want to save up money before going to college, or if you want to work enough while enrolled in order to cover your room and board out of current income, then you don't have to take out student loans or any other kind of loan in order to sleep and eat.

But if you take out student loans, take out federal direct student loans

On the other hand, if you don't have enough money saved up to pay for your room and board out of pocket, or if you don't want to work enough hours while enrolled in order to cover your room and board, then federal direct student loans offer impossibly low interest rates and impossibly generous repayment terms.

An investment strategy doesn't work just because you, personally, find out about it

One of the most important things you can learn as you study finance and investing is that the markets do not care about you. This is, on the one hand, terrific news: if the market cared about you, you might find it an angry and vengeful, rather than benign, master. The flip side is that your personal development as an investor has absolutely no effect on prices in the market.It's that second lesson that people have difficulty accepting, but is most valuable to learn well, if you're able to.

There are lots of great investment strategies

Standardized databases of share prices and company financials make it trivial for professionals to identify strategies that, when applied to historical prices, outperform buying and holding a broad US market index fund over time.My favorite example of these data-mining strategies is so-called "momentum" investing, which is supposedly based on the observation that asset classes that have recently increased in price tend to continue doing so while asset classes that have recently fallen in price likewise tend to continue falling.When I make fun of this strategy its advocates get the mistaken impression that I think this observation is false. I think no such thing.Another popular investment strategy is so-called "value" investing, which, depending on the level of complexity of the strategy, may involve buying assets taking into account their price, quality, leverage, or any number of other factors, based on the observation that, if properly selected, such assets tend to perform better over long periods of time.This is a perfectly reasonable observation, and one that may prove to be true in the future as well, although it's famously hard to make predictions, particularly about the future.

Different investment strategies produce price appreciation at different times

I was listening to an interview with Jack Bogle, who said something that didn't seem like it could possibly be true: the Vanguard Value Index Fund (VIVAX) and Vanguard Growth Index Fund (VIGRX) have had identical performance since the funds began. The Value fund returned more in dividends than price appreciation, while the Growth fund returned more in price appreciation than dividends, but each experienced the same total return.It turns out this isn't quite literally true, but it's darn close. Since inception on November 2, 1992, VIVAX has returned a cumulative 791.58% and VIGRX has returned a cumulative 721.96%. That's pretty close for a 25-year investment horizon!But now let's look at the performance over shorter periods. In the past year, Value somewhat beat out Growth:In the past 5 years, Value again has a small edge:In the past 10 years, Growth has a large edge:Keep in mind that we know that since inception, the funds have had virtually identical returns (yes, 0.5% over 25 years adds up, but it doesn't add up THAT much):So which performs better? It can't be the case that "over 10-year time horizons Growth consistently outperforms Value but over 25-year time horizons Value consistently outperforms Growth," because every 25-year time horizon consists of multiple overlapping 10-year time horizons.What we can say for sure is that "over some time horizons one will outperform the other, but over very long time horizons the difference probably isn't worth worrying about."

Discovering a strategy is a big deal for you but the market doesn't care

So we've established that there are a lot of different strategies, many of them work fine, but they work fine over different time horizons.The problem is that you can't personally implement a strategy until you, personally, find out about it. There are three possibilities for when you might find out about a strategy:

• at a random time, with an equal possibility of the strategy outperforming in the near future or underperforming in the near future;
• at a particularly auspicious time, with a higher probability of the strategy outperforming than underperforming in the near future;
• at a particularly inauspicious time, with a higher probability of the strategy underperforming.

It seems obvious to me that you are most likely to find out about a strategy at a particularly inauspicious time to begin implementing it, because the financial media spends an overwhelming majority of its bandwidth covering strategies that have worked in the most recent past, while reversion to the mean is the most powerful force in the financial universe.

Make changes to your investment strategy deliberately and implement them gradually

One solution to this problem of timing is to never make changes to your investment strategy.That's a pretty good plan!But there really are genuinely bad investment strategies out there, so I don't want to prejudge how good or bad your existing strategy might be. If it's really bad, for example if it comes with high fees, high turnover, or both, then you should certainly not feel wedded to it for eternity. But the last thing you want to do is hop from one strategy to another just because you, personally, happened to find out about it.So let's say I'm a relatively new investor who knew he should invest with Vanguard, and after poking around their website discovered that over the past 25 years Value had slightly outperformed Growth, and therefore decided to make his regular weekly IRA contribution to VIVAX.After a few years, imagine I stumbled across this blog post and discovered that what I thought was a secret to squeezing additional returns from my investment is just a historical artifact and there's no reason to believe Value will enjoy that same 0.5% advantage over the next 25 years, and that really I should just be holding the Vanguard 500. What should I do?My argument is that the worst thing I could do is instantly exchange my entire IRA balance from VIVAX to VFINX, since that is allowing the fact that I, personally, just found out about an investment strategy to influence my decision. But I made my discovery at a completely arbitrary time, and my Value investment is just as likely to outperform as underperform the Vanguard 500 over the next 5 or 10 years!There are two perfectly reasonable things I could do, however:

• Change the investment of new money. I could make a switch in my automatic investments from investing in VIVAX to investing in VFINX, and simply let my Value investment ride. Maybe it will slightly outperform, maybe it will slightly underperform, but it will represent a relatively small amount of my final portfolio 10 or 20 years from now.
• Gradually shift my VIVAX investment over to VFINX. In addition to changing my automatic investment settings, I could set up an automatic exchange between Value and the Vanguard 500 in order to, over 1, 3, or 5 years, completely replace my Value shares with Vanguard 500 shares. This would allow me to possibly take advantage of any Value outperformance while, over time, correcting a relatively minor mistake.

The worse your initial investment decision, obviously the sooner you'll benefit from correcting it, but the fact is most reasonable investment strategies work fine over long enough periods of time. If you find yourself in a hole, you should certainly stop digging, but if you find yourself jumping from one hole to another every 3 or 6 months, then your problem is, unfortunately, likely much more serious than your investment strategy.

Why I make $18,500 every year

While the income tax code is packed full of adjustments and credits for "reservists, performing artists, andfee-basis government officials" and those engaging in "domestic production activities," the only income tax benefit a low-income self-employed person can deliberately trigger is the retirement savings contribution credit.By saying someone can "deliberately trigger" the credit, I mean to exclude things like the earned income credit, which requires you to calculate it based on both earned income and adjusted gross income and claim the lower amount, and the student loan interest deduction, which you can only trigger by going back in time and taking out student loans.The retirement savings contribution credit isn't like that: it's calculated exclusively based on your adjusted gross income, which means you can deliberately trigger it by lowering your adjusted gross income below the cutoff point.

What's the cutoff?

In order to receive the maximum credit, your AGI must be no greater than:

• $18,500 if your filing status is single, married filing separately, or qualifying widow(er);
• $27,750 if your filing status is head of household;
• $37,000 if your filing status is married filing jointly.

What's the credit worth?

The maximum credit allowed by law is $2,000 if your filing status is married filing jointly, or $1,000 for all other filers.However, the retirement savings credit is very poorly designed. Specifically, it is capped at the sum of lines 44, 45, and 46 on Form 1040.

• A single filer with an AGI of $18,500 only owes $818 in taxes on line 44;
• A head of household with an AGI of $27,750 and a single dependent owes $1,033 in taxes on line 44;
• A couple that's married filing jointly with an AGI of $37,000 and no dependents owes $1,628 on line 44.

The more dependents you add, the lower your line 44 taxes will be and the lower the cap on your retirement savings contribution credit.

Getting around the cap

As I said, the credit is capped at the sum of lines 44, 45, and 46. Line 44 is your income tax calculated from the income tax table, and line 45 is the alternate minimum tax, so there's not much you can do about either of those.What you can control is line 46, the "excess advance premium tax credit repayment," which is the amount of Affordable Care Act premium subsidy you received during the tax year in excess of the amount you ultimately ended up being entitled to.If you purchase health insurance on the ACA marketplaces, you can request a monthly premium subsidy in excess of the amount you're eligible before, thus paying a lower monthly premium throughout the year and incurring an "excess" advance premium tax credit. You can then repay that "excess" out of your "excess" retirement savings contribution credit, which would otherwise be wasted, since you can't roll your retirement savings contribution credit forward to future years or apply it to previous years.

Adjusting your income

If you're self-employed, adjusting your income so it's at or just below the earnings cutoff is easy. After calculating your taxes as normal, determine by how much your adjusted gross income exceeds the cutoff, and contribute the difference to a traditional IRA or as a pre-tax contribution to a 401(k).Note that there's no reason to contribute additional money to a pre-tax account once you've lowered your AGI to the cutoff, so any additional retirement contributions should be made to after-tax Roth accounts, where earnings won't be subject to capital gains or income taxes.

Is it worth it?

I like to say nothing worth doing exclusively for tax reasons is worth doing, and the retirement savings contribution credit illustrates the point nicely: if the credit is worth triggering, it's worthwhile because saving for retirement is worth doing!Obviously, the more your unadjusted income exceeds the cutoff by, the heavier a lift it is to trigger the maximum credit. In 2016 my income was about $22,500, or $4,000 above the cutoff for the maximum credit, but leaving me eligible for a $200 credit. Contributing $2,500 raised that to $400, and contributing $4,000 raised it to $1,000 (I had an excess premium credit repayment in 2016 so I was able to claim my whole credit).An $800 return on a $4,000 contribution was a no-brainer for me. On the other hand, a single filer with an income of $58,500 would have to make $40,000 in contributions to trigger a $818 credit, getting just 2% of their contribution "rebated" in the form of a retirement savings contribution credit. That may or may not still be worth doing, but it's a much smaller nudge and such a person would need to look closely at their tax situation before making a decision.Finally, note that this whole discussion is completely separate from the question of pre-tax traditional versus post-tax Roth contributions, since the tax savings are realized in cash the year the contribution is made, not in the form of deferred or up-front income taxation of the contribution amount.

Of course there's going to be a major market selloff. From what level?

Since this is the first bull market during which I've been invested in the stock market, it's been interesting observing my emotions as US stocks have marched steadily higher. My investments are completely passive and I don't have any interest in acting on my emotions, but I understand where the impulse to react hourly or daily to market events comes from.I don't really care about the value of my investments, except that I'd like to buy them as cheaply as possible, but one thing that serious investors seem to obsess over is the magnitude of decreases in the value of their portfolio. Diversification, according to this logic, isn't expected to increase your absolute returns, it's expected to increase your "risk-adjusted" returns. In this logic, adding bonds to a portfolio doesn't increase the return of the portfolio, it decreases the portfolio's volatility.Since the stock indices are regularly posting all-time highs, and publicly traded companies are trading at higher valuations than their historical averages, people obsessed with protecting their portfolio from decreases in value fret about the inevitable coming collapse in stock prices.I am likewise certain there will be a sharp decrease in stock prices, I just don't plan on doing anything about it.The reason is simple: I know there will be a sharp drawdown in stock prices, but I don't know what the starting point of the drawdown will be. I think there are two interesting ways to describe this problem.

Retrospective

If the selloff begins tomorrow, we know the starting point of the drawdown. Vanguard 500 Admiral Shares, my main investment, closed today at $217.34. That lets us calculate the post-drawdown low:

• a 10% drawdown would reduce the value to $195.61;
• a 20% drawdown would reduce the value to $173.87;
• a 50% drawdown would reduce the value to $108.67.

The interesting thing about these values is that we actually know the price history of the fund, and can easily determine the last time the fund traded at those prices (or slightly below, since it's a mutual fund with prices calculated just once daily):

• VFIAX closed at $192.87 on November 4, 2016;
• VFIAX closed at $172.43 on February 12, 2016;
• VFIAX closed at $106.49 on October 7, 2011.

If you were certain that a 50% drawdown would start tomorrow, the obvious thing to do would be to sell everything, wait for the fund's value to fall to $109 or so, then buy back in. You'd thereby double your share count and future income stream compared to the buy-and-hold status quo.

Prospective

The historical data, I think, illustrates one problem with this logic. What if, on October 7, 2011, you knew there would be a 50% drawdown, but you didn't know it would take until February 16, 2017, to arrive? You'd sell everything, thinking you were protecting your portfolio's value from falling to $53.25, while in fact you were "protecting" yourself from 5 years of quarterly dividends and a share price sitting exactly where it was that morning!I was joking about this question on Twitter the other day: "If the S&P 500 increases by 0.5% every trading day for the next 6 months, how long before it's 20% lower than today?"The point is, when deciding whether to buy or sell a security today, it's essential to consider how future price increases protect you from from future price declines. A security that doubles in price is insured against a 50% drawdown, which would merely bring it down to a price that you already decided was worth paying.People normally phrase this in reverse: "it only takes a 50% drawdown to wipe out a 100% gain." But it's equally true to say "a 100% gain protects you against a 50% drawdown." Likewise a 25% gain protects you from a 20% drawdown and an 11.11% gain protects you from a 10% drawdown.

Conclusion

Look: if you know the date the drawdown begins and ends, you should sell the day before it begins and buy the day after it ends.But if you only know, as I do, that there will be a massive drawdown at some point in the future, but you don't know, as I don't, when it will be, then selling off investments in anticipation of it is merely selling yourself out of a stream of dividend income.If, on the other hand, you want to lock in your gains in order to start a business that's more profitable than your current investment strategy, that's a different story entirely.

Where is the next crisis hiding?

Capitalism has always been subject to periodic crises. It's now very fashionable to refer to "Minsky moments," but you don't need any training in economic theory to observe that, as a matter of fact, these crises regularly occur, causing a drastic fall in asset values, an economic slowdown or recession, or both.Once you accept that the certainty of another crisis in global capitalism, you get to play the much more entertaining game of guessing where it will emerge. So, let's play!

Credit

The first rule of crises of global capitalism is they're never exactly the same as previous crises. That means we're exceedingly unlikely to see a crisis in poorly-underwritten mortgage-backed securities.But the credit space is big, which means there are plenty of places for a crisis to hide! I'm particularly intrigued by "exchange-traded notes," the unsecured cousins of exchange-traded funds. It's easy to imagine sudden changes in asset prices causing the banks underwriting such notes to face a sudden liquidity crisis, since unlike exchange-trade funds, they don't (usually) own the underlying assets. There have been a number of articles recently about the growth in subprime auto lending. This is an attractive area to look for the next crisis of capitalism because it "rhymes" with the subprime housing crisis that triggered the 2008 global financial crisis. Unfortunately, for just that reason it's unlikely to be the culprit next time. Such a crisis would be easy to imagine, with an otherwise-benign negative shock to economic activity leading to layoffs in the lowest-paid service sector. When lower-income workers lost their ability to pay their car loans, the starter interrupt devices installed by lenders would keep them from finding new work or spending money, creating another shock to economic activity. If the holders of subprime-loan-backed securities were burned and refused to fund new loans, the credit crisis could quickly grip the entire economy. As I said, unfortunately I doubt this is the crisis we'll see next.

Commodities

While people traditionally think of oil as the classic commodity causing economic shocks, with the United States as the global swing producer of oil, it's unlikely to be the cause of the next crisis, whether or not OPEC is successful in reining in production.It may sound strange, but I think cotton is as plausible a source of the next crisis as any. This isn't because the world is highly dependent on cotton products, as it is on oil, but because the world economy, particularly the developing world, is highly dependent on the processing of cotton. A catastrophic cotton blight (apparently there's no other name for this disease besides "bacterial blight of cotton") in the United States or another major cotton-growing country could have a minor shock in the exporting country but a major shock in countries dependent on the textile industry. Developing economy failure to service external, dollar-denominated debts is an excellent excuse for a crisis of capitalism.If you don't like my cotton blight theory, substitute your own preferred "low-level manufacturing input" commodity and find the crisis that's right for you. 

Global Supply Chains

South Korea and Japan are two of the largest trading partners of the United States, and both, unfortunately, are on the bad side of a nearby nuclear state led by a pathological narcissist (I mean Kim Jong-un, this time). Due to the lengthy supply chains US corporations have built around the world, and the interlocking insurance contracts on ships, factories, currencies, and commodities, war in East Asia could easily spiral into a crisis of capitalism.Also, did you know there's a global shipping crisis? I have no idea what the implications of this are, which makes it an excellent candidate for crisis of capitalism.

Hyperinflation/seignorage

People have been predicting hyperinflation since the first stimulus package passed in 2009, when conditions made it virtually impossible for hyperinflation to appear: unemployment was nearing post-war highs and there was a global flight to safe assets like US Treasuries. Under those conditions virtually no amount of government spending could have resulted in hyperinflation, and indeed, we saw barely any inflation at all for years.Today, on the other hand, Treasury yields are finally inching up (3.01% on 30-year bonds!) and unemployment is starting to look like it might be low enough for wages to begin accelerating.Also today, we are faced with unified Republican control of Congress and a long-standing agenda to lower the long-term deficit by...cutting taxes.Also today, we are faced with a president completely devoid of ideology but with a commitment to spend more money on the military and a deathly fear of cutting any program that might hurt his already-abysmal poll numbers.A stable US government, printing the world's reserve currency and playing a pivotal role in every global institution can run almost unlimited deficits indefinitely (although it probably shouldn't).An unstable US government untrusted by allies and easily manipulated by rivals is likely to face higher obstacles to financing deficits in the long term. Meanwhile, having discovered the trillion dollar coin option under the Obama administration, Trump will face almost irresistible pressure to exercise it should he run into any trouble financing his "agenda."Whether the US government floods the economy with cheap money in order to keep congressional Republican promises to cut taxes, or the US government faces much higher interest rates on the world market, or Trump just orders Mnuchin to mint the damn coin you have three promising options for a crisis of global capitalism.

Conclusion

See, didn't I tell you this would be fun?Where do you think the next crisis of global capitalism is hiding?

529 plans are a scam used by the rich to transfer wealth between generations

529 plans are special accounts authorized by their eponymous section of the Internal Revenue Code, "sponsored" by the states and administered, with some exceptions, by Upromise Investments.I am going to tell you five facts about 529 plans:

• Depending on the plan, you can contribute up to $511,758 in after-tax income per designated beneficiary (some states have much lower caps);
• Contributions are excluded from your taxable estate;
• You can designate yourself as a beneficiary;
• You can open plans in multiple states;
• Plans are inherited tax-free.

Knowing all that information, the only possible conclusion you could reach was that this is a scam to transfer wealth between generations tax-free.Now, it happens to also be true that this scam was foisted on the American people with "college affordability" branding. Taking money literally means looking through that branding and seeing how these plans work mechanically.

Contributions are made after tax and appreciate tax-free

In this way, 529 plans are similar to Roth IRA's. However, Roth IRA's have strict limits, including an annual cap on contributions. It's possible to game those limits by "contributing" improperly-valued or hard-to-value assets (Mitt Romney's IRA had a value over $20 million when he ran for President, leading some to speculate he had done this), but they are at least a gesture at limiting the cost to taxpayers of shielding the assets of the wealthy from capital gains taxes.529 plans have contribution limits set by the plan administrators to approximate the "maximum cost" of attending college in the sponsor state. That amount can be contributed to the account all at once, and in fact if the investments in the account go down in value, even more money can be added.

Contributions are treated as federal gifts to the beneficiary

Most articles about 529 plans go to great pains to explain the annual tax-free gift limits ($14,000) and the lifetime gift tax exclusion ($5,450,000).This is nonsense. You can designate yourself as the beneficiary of your own 529 plan, and "There are no tax consequences if you change the designated beneficiary to another member of the family."

529 plans are inherited tax-free

When a 529 plan owner dies, the account gets a new owner but since the value of the plan is treated as part of the beneficiary's estate, it's not taxed. At all.You might ask, "Ah hah, Indy, now I've got you! That means that if the beneficiary dies unexpectedly the 529 plan will be taxable as part of their estate!"Nope. The owner just gets to designate a new beneficiary.

I'm sure the IRS doesn't love it when people do this

That's what lawyers are for.If you think "maybe the IRS will frown on this scam" stops wealthy people from leveraging the language of the tax code to the maximum extent possible, I've got a $916 million deduction to sell you.It would be trivially easy to identify and penalize the people taking advantage of this scam. The IRS budget has been cut 17% since 2010. Maybe estate tax avoidance is an enforcement priority for the IRS. Maybe they sometimes catch people doing this. Maybe the wealthy know that shielding $2 million is "safe" and shielding $10 million is "risky." The federal estate tax rate is 40%, making that a "mere" $800,000 in taxes avoided.

What about restrictions on withdrawals?

Are you talking about "qualified education expenses?" Forget about it.First of all, contributions are always free to withdraw. There's no tax or penalty if the value of the account is the same as the value contributed or below. Since the wealthy are using these plans as tax shelters, not investment vehicles, contributions could just be left in cash for simplicity's sake.Second of all, paying for education expenses for future generations is largely the point of intergenerational wealth transfers; I gather it's the central conceit of "Gilmore Girls."

529 plans were a bad idea, are a bad idea, and will always be a bad idea

"The problem" is not high contribution limits, it's not being able to designate yourself as a beneficiary, it's not tax-free inheritance, it's not being able to change beneficiaries, it's not being able to make penalty-free withdrawals of contributions, it's not limited IRS resources."The problem" is that it's a bad idea to allow people to shield their assets from taxation when sold or transferred.This has nothing to do with college affordability because 529 plans have nothing to do with college affordability, just like HSA accounts have nothing to do with health care affordability and the mortgage interest tax deduction has nothing to do with housing affordability.They are all just branding used by the wealthy to shield their income and assets from taxation.The only question is, how long are we going to put up with it?

The Federal Reserve wants you to sell everything and start a business (Congress doesn't)

It's treated as a platitude that interest rates are at "historically low levels," that the Federal Reserve has just begun tightening US monetary policy, that it anticipates raising rates only slowly in the coming years. But treating these facts as background noise, instead of a concrete fact of everyday life with important implications, is a real misunderstanding of the current situation.

Why does the Fed manipulate interest rates?

The Federal Reserve has a number of policy levers it uses to meet its "dual mandate" of price stability and full employment: the rate it charges banks to borrow directly, the reserve requirement (this used to be a much more important policy lever), and in the current environment the quantity and duration of bonds that it buys and holds.But all of these policy levers have a single goal: the management of the supply of money. The Fed also houses a lot of other regulatory functions, but the management of the money supply is the key way it tries to affect the economy's output.If money is plentiful, the logic goes, like any other commodity it will become cheap, and more kinds of economic activity will be worth doing if money is cheaper, causing economic output to accelerate. If money is scarce, fewer kinds of economic activity will be profitable and economic output will decelerate or even reverse.

The Fed wants your assets to be overvalued and low-yield

The persistently low interest rates of the last 8 years or so have often been said to have perverse effects on a number of industries. Insurance companies that are required to hold super-safe assets to pay for future liabilities have become less profitable, for example. But many of the effects of low interest rates are not perverse at all: they're working exactly as designed.Consider what happens when the interest rate on deposits drops from 5% APY to 0.01%. People who were previously able to earn a 5% risk-free return are suddenly forced to decide whether they'll accept a lower return at the same risk, the same return at a higher risk, or whether it is worth saving at all. All three outcomes serve the Fed's purposes: those who leave their money in super-safe securities provide lower-cost financing to people who want to borrow it; those who "chase yield" by investing in riskier securities paying the previously safe return decrease the cost of borrowing for riskier and speculative investments, making them worth pursuing where they may not have been before, and those who decide it's not worth saving at all boost economic output by spending more of their income.Meanwhile, for those invested in the securities markets, there's a surge in asset values. Safe bonds that have to pay nothing in yield trade close to their face value. Publicly traded companies are able to borrow huge sums at low costs to buy back their shares. The allure of high stock valuations causes firms to publicly list their shares to raise money and pay off early investors.

Investors are stubborn and boring

I have recited the above facts because they illustrate just how weak the Federal Reserve's control over the real economy really is. The Fed wants you to invest your savings in riskier assets, or even better, borrow money to buy a house, a car, a yacht. But a perfectly rational, arguably much more rational, reaction to a lower return on your savings is to save even more. If you think you're going to earn half as much on your savings, you need to save twice as much to retire with dignity (or a speedboat, or whatever else you want to retire with). This is part of the process the financial press calls "deleveraging," but is really just a natural response to low returns on savings and high debt costs: aggressively saving and paying down debt.

The Fed wants you to sell everything and start a business

That's all well and good, but it ignores the key fact: the Federal Reserve has orchestrated these high asset values for one and only one reason. The Federal Reserve wants you to sell all your highly-appreciated assets and start a business.Jack Bogle has a concise formula for the returns you should expect on your equity investments: the starting dividend yield, plus earnings growth, plus (or minus) the speculative return. Over a long enough investing horizon you can pick your own speculative return (sell when the price/earning ratio is high), so your expected return should depend on the first two factors. A dollar added to your equity investments today should be expected to earn 4-6%.The Federal Reserve wants you to look at your assets and think, "is there anything I could be doing that would generate a higher return than 4-6%?" If so, they want you to sell all your highly-appreciated assets, take the money, and go do it.

Congress is fighting the Fed

It's impossible to read anything about personal finance without arriving at the conclusion that "personal finance" is just a barely-concealed code word for minimizing your taxes. I make no secret of the fact that I detest this genre. Anyone who's afraid of paying taxes is afraid of making money.Nonetheless, there are concrete ways that, through the tax code, Congress works directly at cross-purposes to the Federal Reserve in order to encourage you to hang onto your highly appreciated assets instead of selling them, and continue working at wage labor instead of starting and building your own business.

• By taxing appreciated assets that are held for less than a year at a higher rate than appreciated assets that are held more than a year, Congress encourages you to wait to sell your appreciated assets, instead of selling them right away to start a business, as the Fed would prefer;
• By encouraging assets to be deposited in so-called "retirement" accounts, like 401(k) and IRA accounts, Congress chooses to penalize people who sell highly-appreciated assets in order to start a business;
• By excluding income on capital from FICA (Social Security and Medicare) taxes Congress encourages holding securities instead of starting your own business, which would be subject to self-employment taxes.

You can fight back (with the Fed on your side)

Those are serious obstacles, and Congress should do away with them if they want to create an economy of entrepreneurs and entrepreneurship (this will be a recurring theme on this blog). But they have given you a few tools to fight back if you are ready to take the Fed up on their offer.

• Roth IRA contributions (not any earnings or appreciation of those contributions) are penalty-free and tax-free to withdraw. That means a $10,000 contribution that has since doubled in value to $20,000 gives you $10,000 in capital to start your business, with $10,000 in earnings that can only be withdrawn under penalty.
• Up to $10,000 in withdrawals of Roth IRA earnings are allowed penalty free for a first-time home purchase. That means if your business involves owning a home in some way, you have penalty free access to up to $10,000 in capital appreciation.
• You can finance your business out of retained earnings. If you have investments in a taxable account, instead of reinvesting dividends and capital gains distributions, you can take them as cash. If you properly use low-cost Vanguard index funds for your investments, those distributions are very likely to be treated as long-term capital gains, giving you lower-cost access to capital.

Conclusion

It's a mistake to treat Federal Reserve policy as irrelevant to your personal finances. The Federal Reserve is on a crusade to stimulate economic activity by making the returns on the secondary markets unacceptably low to ambitious, entrepreneurial spirits.If you are such a spirit, it's time to get the message and get on board.

Welcome to Independently Financed

Just what the world needs, another personal finance blog

Personal finance journalism as an industry has a problem: it's too often directed at the people who need it least. It shouldn't take more than a moment's reflection to realize that low-income renters need good personal finance advice much more than salaried homeowners, but personal finance journalism treats the problems of the latter with the kind of gravity usually reserved for the High Holy Days while neglecting the former.While different opportunities are available to people in different circumstances, good personal finance practices are good no matter how much money you make or how much wealth you have, and I'm going to cover opportunities available up and down the income spectrum. If you get bored reading about opportunities only available to low-income people, you'll have a sense of how the rest of us feel reading about your stock options.

 

This is advice

If you've ever read finance, tax or investing articles written by professionals you know the line that inevitably appears at the top, bottom, or middle, and sometimes all three: "this isn't advice, your situation may vary, consult your own advisor about your specific situation." Those bloodless articles leave feeling like I've been eating rice cakes: I'm pretty sure it's food, but what's the point?Screw that. I'm not a lawyer (and I'm definitely not your lawyer), but if I think something's a good idea, I'll say so. If I think something's a bad idea, I'll tell you not to do it.

This is political

I belong to the radical fringe movement that believes the main problem facing poor people is a lack of money. There are other theories, of course: maybe it's out-of-wedlock childbirth. Maybe it's low high school completion rates. But as for me, I think what makes poor people poor is not having enough money.With more money, poor people are more able to be engaged with their families, communities, and country. If we're going to hang onto our representative system of government, it has to serve the needs of all its citizens, and that requires political engagement from all its citizens. Not having enough money is a serious obstacle on that front.So I hope I can help there, as well.

About me

I have an unfortunate tendency to take things literally. I believe this must be a defect arising from my childhood and causes me no end of grief, but it does come in handy when discussing money since money is one of the few things in the world that benefits from being taken literally. The difference between a literal 6% return on your investments and a hypothetical 6% return on your investments, for example, makes all the difference in the world to your economic security.I also have a modestly popular blog about travel hacking. Travel hacking and personal finance are closely related, and in fact many travel hackers are also enthusiasts for financial independence. I have written a number of articles on personal finance on that blog, but decided that it was time to create a separate space so my travel hacker readers aren't bored by my views on personal finance, and vice versa.

Welcome!

I'm thrilled to finally have a blog hosted on Saverocity. Stay tuned to this space (and check out all the other Saverocity blogs) while we get things set up, and I hope you'll come back soon.