What should stocks cost?

As you may have heard, US stocks are expensive. You may even think you know what that means. Personally, I have no idea.I buy organic milk. Organic milk costs more than milk from corn-fed antibiotic cows. In other words, it's "more expensive."I buy t-shirts made by union workers in downtown Los Angeles. They cost more than t-shirts made in Southeast Asian child labor mills. They're "more expensive."But when I buy US stocks by making contributions to the Vanguard 500 fund I hold in my IRA, I don't know what the point of comparison is supposed to be. You can tell me the Russian stock market has a lower price/earnings ratio than the US stock market, but Apple isn't listed on the Russian stock market; it's listed on the US stock market. You can tell me that the price/earnings ratio of the US stock market used to be lower than it is today. But I don't live back then, so I can't pay the historical low price, or even the historical average price, for US stocks. The only price I can pay is today's price. Is today's price "expensive?" Compared to what?

Stocks, flows and stocks

Say you happened to enter the workforce in March, 2009, and started directing monthly contributions into an IRA invested entirely in the Vanguard Total Stock Market Index Fund. Every single one of those purchases in the last 8 years has been "expensive" compared to your original purchase: you've received fewer shares per dollar contributed to the fund. Why would anyone pay $58.19 for a share that's identical to the one they used to pay $16.43 for?That being the case, you might arrive at a sensible conclusion: "there's no way I'm paying that much for a mutual fund share that I used to be able to buy for $16.43. I'm not going to buy a single share more until the price falls to something more sensible."But that leaves you with an obvious dilemma: all those other lunatics are willing to pay you $58.19 each for shares you purchased starting at $16.43. If you're not willing to pay such a ridiculously inflated price, and are waiting for prices to fall, why not unload your shares now and hold onto the cash, "dry powder" for when the market finally comes to its senses?

What should stocks cost?

There is a very fashionable line of inquiry that asserts that the historical average Shiller CAPE ratio of "about 15" is a kind of dividing line between an "expensive" and a "cheap" stock market. Does that mean stocks should cost 15 times their inflation-adjusted 10-year average earnings? I don't know anyone who would agree with that. For one, it means any company that has run a loss on average over the last 10 years is worthless. Whatever you think about Amazon's business model, clearly the warehouses, technology, and patents they own aren't worth nothing.You're free to say that I'm being ridiculous, and that while an individual company's "correct" share price can't be calculated so mechanically, the correct price of an entire market can be, averaged as it is across so many different companies.But if it's ridiculous to use such a mechanical calculation for an individual stock, it's equally ridiculous to use it for the stock market as a whole, which is of course composed entirely of those individual stocks.

Why own stocks?

No one would ask "how much should a car cost?" without first asking "do I need to buy a car?" No one would ask "how much should a coffee machine cost?" without first asking "do I need a coffee machine?" But plenty of people are willing to ask "how much should stocks cost?" without first asking "do I need to own stocks?"The reason I own stocks is in order to have a broadly diversified, inflation-protected income stream denominated in my home currency. Stocks will not make me rich (nothing will make me rich), but owning a very broad swathe of US stocks will give me access to the overall profits of the publicly-traded US economy.

Publicly-traded securities are a weird thing to own if you have other options

The great democratization of the stock market in the latter half of the 20th century, spurred on by the adoption and growth of 401(k) and IRA accounts, has obscured a much older and more fundamental truth: people invest in securities when they are out of other things to buy.After all, cobblers did not historically own stocks: they owned shoe stores. Blacksmiths did not own stocks: they owned smithies. Even lawyers didn't own stocks: they owned law firms. The idea that ordinary people, and even professionals, should own stocks instead of investing in themselves or their businesses is a relatively new phenomenon.That's worth remembering when deciding whether to buy stocks or not, however much stocks cost. If you have credit card debt accruing 21% interest, you should pay it off before buying stocks no matter how cheap stocks are. If you have a business idea that needs capital, you should pour capital into it before buying stocks.Of course, most people today don't own their own businesses. They're employees, they're paid a more-or-less fixed wage, and they have to decide how to save their excess income. My point is that when determining what to do with that excess income, the past performance of a given market is largely, if not entirely, irrelevant. You should decide whether or not you need to own stocks before the question of whether stocks are "expensive" or not can even begin to become relevant.

Demographics, inflows and outflows

Finally, I want to mention a topic that some people seem to believe has unusual explanatory powers: the question of demographics and market flows. The simplest version of this theory goes that aging Americans today, who have accumulated a vast treasure trove of assets, will begin to sell off those assets as they enter and proceed through retirement, forcing down asset prices and crushing the US stock market, impoverishing their children and grandchildren who are still investing in that market.This is an excellent theory with absolutely no logic behind it. A senior citizen who sells a share of Berkshire Hathaway at $245,000 in order to spend $245,000 in the US economy has liberated $245,000 in idle capital (from the person they purchased the share from) and converted it into $245,000 in consumption. The fact that the sale puts marginal downward pressure on the share price of Berkshire Hathaway is offset by the marginal increase in expenditures by the seller, raising the market's overall earnings.Now, it is certainly true that the across-the-board aging of the US workforce needs to be offset by increased immigration and births by people living in the United States in order to ensure the continued prosperity of the country, but the conversion of capital assets into cash, which is then spent on consumption, cannot on its own have a large negative effect on the earnings of US companies. Their decreased share prices will be precisely mirrored by increased earnings when that cash is spent.

All-in margin account rates at Robinhood and IB

I've written elsewhere about the Robinhood app and Robinhood margin accounts (branded as "Robinhood Gold"). One issue raised on the Saverocity Forum was that Robinhood's margin interest rates were high compared to those offered by Interactive Brokers, generally considered one of the cheapest sources of margin credit for retail investors.I looked into it, and there are a couple moving pieces I think are worth mentioning. I'm not thrilled by the pricing disclosure of either site, so if there's something I'm missing I hope readers with more experience will chime in.

Robinhood Gold's flat margin lending APR

Robinhood's margin lending product is unorthodox, and presumably they hope to make some profits on the confusion induced from that weirdness, but the basic premise is simple: you pick the amount of margin credit you want Robinhood to extend, and you pay a flat fee for it whether you use it or not.I can pay $120 per year for $2,000 in "Gold Buying Power," i.e. margin credit, on the Robinhood trading platform. That works out to a 6% APR, although any unused Gold Buying Power doesn't reduce the amount paid. If you only use $1,000 of your $2,000 limit, you'll end up paying 12% APR, for example.Since Robinhood doesn't charge for domestic ETF and stock trades, that gives you a flat margin lending APR that you know in advance (as long as you use your entire margin credit line).

Interactive Brokers' layers of fees and interest

The thing said, both by Interactive Brokers and by their defenders, is that their margin lending rates are much lower than their competitors. This is true. Using their margin interest calculator, the same $2,000 margin credit line that would cost $120 per year at Robinhood would cost just $48.20 at Interactive Brokers.But Interactive Brokers, unlike Robinhood, doesn't offer commission-free trades. Not only that, but if you don't earn Interactive Brokers $10 per month in commissions, they'll charge you the difference!That means you are guaranteed to spend $120 per year — the same 6% APR Robinhood charges on a margin line of credit of $2,000 — plus your margin interest, in order to take advantage of Interactive Brokers lower margin interest rate.

Of course there's a breakeven point

Interactive Brokers' margin lending rate is so much lower than Robinhood's that even with the fixed overhead cost of $120, you quickly reach the breakeven point between their service and Robinhood Gold: at $3,342 in margin, to be precise. By the time you got to Robinhood's next threshold of $4,000 in margin (costing $240 per year) you'd save $23.60 with Interactive Brokers' $120 annual fee and $96.40 in interest.

Which service to use depends on both your needs and expectations

Interactive Brokers, as far as I can tell, is a profitable company that is able to leverage its scale to offer lower costs to its customers.Robinhood, as far as I can tell, is a deeply unprofitable company trying to seize as much market share as possible while it's still being pumped full of cash by its early-stage investors, hoping to eventually raise prices and become profitable.None of that matters to you, per se: your securities are insured on either platform, whether one or both eventually goes bust. What might matter to you is that in order to get and retain market share, Robinhood might keep its margin lending rates lower longer than Interactive Brokers does. If that's the case, then Interactive Broker's interest rate might creep up high enough to make Robinhood the cheaper source of margin credit, once you take Interactive Broker's flat monthly fees into account.

No, you still shouldn't buy the dividend

Finance, like many professions stocked with men trying to impress each other, has accumulated a plethora of cliches like barnacles on the hull of a ship. Among the hoariest is the admonition, "don't buy the dividend." Since I, personally, love dividend-paying stocks, not because of their "outperformance" or their "value" but simply because they pay dividends, I decided to check whether or not "buying the dividend" really is a bad idea.

Why buying the dividend shouldn't work

In a stock market that has already perfectly priced in every participant's expectations of the future, you might expect share prices to be stable as well. Not so! In fact, in such a market each day share prices should increase by the discounted value of their dividend payments until the final day when owners are eligible to receive that dividend. The next day (the ex-dividend date), the share price should fall by the amount of the dividend, before starting to gradually rise up until the next eligible payment date.This is, in fact, what you see in mutual funds whose net asset value is calculated at the end of each day. The mutual fund's value is the sum of the shares it holds and the cash dividends it has accumulated for distribution; upon distribution, the cash value falls to (or near to) zero and the net asset value of the fund likewise falls. Shareholders receive the difference in cash, which they can reinvest or keep, thus leaving the account value unchanged.

Why buying the dividend might work

One reason why buying the dividend might work is that, in general, stocks are very volatile but tend to go up in value over time. Let's take a stylized example: there are roughly 63 trading days in each quarter. A stock that pays a dividend of $1 per quarter, according to the logic above, should rise in value about 1.6 cents per trading day, before falling $1 on the ex-dividend date. If the stock typically moves $2 up or down on any given trading day, but moves up 60% of the time and down 40% of the time, then 40% of the time the stock will drop $3 on the ex-dividend date (the normal volatility of $2 plus the decreased intrinsic value of $1) while 60% of the time the stock will similarly gain $1. Since in either case you get to keep the $1 dividend, your expected value should be $0.40 per share.

Why it would be nice if buying the dividend worked

The reason why it's worth asking whether buying the dividend works is that it would be a way of capturing the dividend yield of a stock with very little exposure to its underlying risk — just four days per year in the case of a stock that pays dividends quarterly. In an extreme case, if a stock's price was completely indifferent to its dividend payout schedule then the stylized case above would have an expected value not of $0.40 per share, but rather $1.40 per share: the $1 dividend plus the $0.40 expected value of a single day's ownership.You could quickly jump from one stock to another and use the same money over and over again to buy as many dividends as possible each quarter, or you could put the money in a high-interest savings account the 246 trading days of the year your stock of choice isn't about to go ex-dividend.

But buying the dividend doesn't work

Anyway, since I take money literally, I decided to see whether buying the dividend does or doesn't work. My methodology was simple, since a purely mechanical trading strategy like this needs purely mechanical rules:

• I took the 52 companies on this list of S&P 500 "Dividend Aristocrats."
• I sorted them by their nominal dividend payout, on the grounds that the highest nominal payouts will appear most clearly in the stocks' historical price data.
• For the top ten stocks ranked by nominal dividend payout, I looked at the last 4 dividend payouts. This usually meant going back 4 quarters, but in the case of annual or biannual dividend payouts I looked back further.
• For each of the top ten stocks, I looked at the opening price on the last day investors were eligible for the dividend, and the opening price on the ex-dividend date.

To implement this strategy, you would place a market buy order before the market opened the day before the ex-dividend date, then a market sell order before the market opened on the ex-dividend date. You'd be exposed to one day of market volatility, either positive or negative, and receive each company's dividend. Here's what I found:This is just about as close to a random walk as you're gonna get in the real world:

• 5 of the 10 companies showed a profit buying the dividend and 5 showed a loss.
• 21 of the 40 datapoints showed a profit and 19 showed a loss.
• 3 of the 10 companies showed a profit on 75% of datapoints.
• 5 of the 10 companies showed a profit on 50% of datapoints.
• 2 of the 10 companies showed a profit on 25% of datapoints.
• Interesting, none of the companies showed a profit on all four of their datapoints.
• On the other hand, the entire loss of the strategy is accounted for by a single company: Sherwin-Williams. With that company's dividends excluded, the strategy flips to a positive $1.63 return!

Conclusion

I think the best way to think of this strategy is as a negative-expected-value gamble but with only a modest house edge. To take an analogy from craps, it's like making a come bet on every roll once a point has been established: you'll lose money over the course of an evening, but you'll win a little bit back every time you seven out, which helps take the sting off.

What would you do if the risk-free rate was 7%?

While it's a cliche to say that investors have short memories, I'm frequently surprised to realize just how short most people's memories are:

• I'm old enough to remember when the United States was running a budget surplus and the chairman of the Federal Reserve endorsed a tax cut because of the risk of the debt falling too low.
• I'm old enough to remember when mortgages were so easy to obtain that "flipping houses," literally just waiting for local real estate prices to increase before selling a piece of property onward to the next speculator, was treated as a legitimate business enterprise.
• And I'm old enough to remember when PayPal offered a money market account paying over 5% APY on your entire balance.

I do not know if we will ever see such a high interest rate rate environment again. To get there from here would require 4 years of economic growth with a 1 percentage point rise in rates each year, 2 years of economic growth with a 2 percentage point rise in rates each year, or 1 year of economic growth with a 4 percentage point rise in interest rates this year. I don't think that will happen, and indeed I don't think the United States will ever experience 5% APY interest rates again.But what if it did?

 

What is the point of investing?

This is a post that I've thought about writing in a number of different ways, and that I suspect I will write in a number of different ways. The fundamental question I'm interested in is this: what is the point of investing? Is it to achieve lifetime spending goals, with a margin of safety based on the risk of an unexpectedly long lifespan? Or is it to accumulate as much money as possible?Establishing an objective is essential if you're to identify what behavior is most likely to achieve your objective. This may sound trivial, but is in fact absolutely essential to the entire enterprise of investing. Consider the following two scenarios:

• A person making $25,000 per year wants to retire in 30 years with $1,000,000 in savings;
• A person making $1,000,000 per year wants to retire in 30 years with $1,000,000 in savings.

The first person needs to save 57% of their income compounded at 5% per year for 30 years to achieve their goal. The second person needs to save 10% of their salary compounded at 0% per year for 10 years to achieve their goal.There is no reason for the second person to take any risk at all with their savings: They can easily achieve their savings goal through mechanically adding to their savings each year from current income.

Don't scoff at the risk-free rate of return

 Today, the risk-free rate of return is about 0.91%. That's the rate of return that you're guaranteed, in inflation-adjusted dollars, by buying a 30-year TIPS bond today.That's very low!On the other hand, it's guaranteed to keep up with inflation, and a million dollars is a lot of money. It seems perfectly reasonable to me that the first million dollars a millionaire earns should go into a 30-year TIPS bond that's guaranteed to keep up with inflation. That way, in 30 years, they'll still be an inflation-adjusted millionaire no matter what happens.On the other hand, the first saver above can't settle for a 0.91% APY real yield. Saving the same 57% of their income as above, after 30 years they'll have just $496,000 in savings, over 50% short of their goal. "Clearly," that saver needs a more aggressive investment portfolio, including domestic equities, international equities, emerging markets, real estate, and whatever else you think belongs in a "balanced, diversified portfolio" or whatever today's nostrum is.But what if the 30-year real yield on TIPS was 5%? Of course if the risk-free rate were that high, you'd have to assume stocks were badly beaten down, the world was in a state of depression or war, and blood was in the streets — the perfect time to invest in an aggressive portfolio. But why? If your goal can be achieved with less risk, what is the purpose of taking on more risk?There are many possible answers. Here are a few:

• To spend more in the present. If you can exceed your investment goals by taking on more risk, you can reduce your savings and spend more out of current income. This is sometimes referred to as "lifestyle inflation," a term that always makes me chuckle.
• To increase your margin of safety. Remember we're talking about inflation-adjusted dollars here, but certainly you may decide over the course of your investing career that one million dollars really isn't enough to retire on, what with the increasing cost of prescription drugs, the war on health insurance, the deportation of our low-wage nursing home workers, etc. If you think you can accumulate $1.25 million, why not do so in order to be on the safe side?
• To pass down a larger estate to your heirs. Many people want to leave their partners and dependents a heap of money after they find out what happens next. If that's your goal, then your investment portfolio might be perpetually focused on earning a rate of return above the risk-free rate.

What will you do if you achieve your financial goals ahead of schedule?

Pick a large-capitalization stock today and you'll find someone has written an almost identical cliche about it:

• "An investment of $1,000 on Berkshire Hathaway's estimated 1964 stock price in 1964 would have generated over $9.98 million."
• "if instead of paying $2,495 for a Macintosh in 1984 and customers put that money into Apple stock, their shares would now be worth $715,943, or more than $710,000 after fees."
• "if you would have invested $5,000 in Walmart stock (WMT) at the beginning of 1976 and reinvested all your dividends into more Walmart stock, 30 years later you would have over 5.4 million dollars today."

These are literally just the first three companies I thought of. My question is, what if you do buy the Berkshire Hathaway, Apple, or Walmart of tomorrow and see your investment soar beyond your wildest dreams? Should your goals change as your net worth does? Maybe $1,000,000 sounds like a lot of money, but if you reach that amount of savings at age 40, maybe you'll decide that a million dollars actually isn't cool — a billion dollars is.

If the risk-free rate of return were 7%, your financial advisor's charts would be correct

Google "benefits of compound interest" (I did) and you'll find some inspiring charts about the value of your account, smoothly sailing upward over time as the interest on your interest makes you wealthy beyond your imagination (not to mention right on schedule). And then if you zoom in close enough, you'll see some fine print tucked away somewhere reading "assumes a 7% annual return."Assumptions, as I like to say, are fun. But what if the risk-free rate of return really were 7%? What if you could lock in those inflation-adjusted returns for years or decades? What purpose, then, would a diversified, well-balanced portfolio of stocks and bonds serve?

Conclusion

All of this brings me back to the question posed in the title: what would you do if the risk-free rate were 7% APY? Would you save less? Would you retire earlier? Would you chase riskier assets in pursuit of a "risk premium" you don't need? Or would you sit back and actually watch your assets climb your financial advisor's compound interest graph?

 

What is, or might be, a pension crisis?

A spectre is haunting the United States — the spectre of pension crises. Since "the pension crisis" is on the lips of policy-makers around the country, I think it is well worthwhile taking a moment to discuss what is, what might be, and what is not a pension crisis. For additional details I recommend this recent Haas Institute paper on public pensions.

Pensions are a mechanism to save money

Today, in the throes of this supposed crisis, pensions are treated as an unaffordable luxury extracted by lazy employees from their unwitting employers.This is dangerous nonsense.Consider the following stylized example: the going rate to employ a firefighter is $60,000 per year. You could, of course, pay the firefighter $60,000 per year. Or you could pay the firefighter $30,000 per year and offer $30,000 in pension benefits. The firefighter still receives $60,000 per year, but your out-of-pocket expenses are just $30,000 per year. Pensions are a way to save organizations money by deferring their payroll expenses into the future.Of course, the firefighter would only be willing to make this deal if she were assured that she'd receive the value of that $30,000, with a reasonable rate of return, in future income. An organization guaranteeing a 5% rate of return, but assuming a 7% actual rate of return on its investments, is able to save money on its current payroll expenses by deferring them into the future at a discount. This is the iron logic of pension accounting.

Public pension funds are a convenient but unnecessary expedient

The current conversation around the pension crisis revolves around the ratio by which pension funds are "fully funded," that is to say, able to pay out all the benefits they're obligated to provide.But pension funds themselves have nothing to do with the underlying mechanics of pension obligations. This is illustrated most clearly by the largest US pension fund: the Social Security trust funds.All the money paid in Social Security taxes in excess of the current payouts of the program are used to purchase Treasury bonds, which are assigned to the Social Security trust funds. The demand for those Treasury securities by the Social Security trust funds decreases the market rate of interest the United States is forced to pay on its debt obligations.It is true that excess Social Security funds could be used to purchase other securities, like stocks or commodities. But using the excess funds in that manner would mechanically decrease the demand for US Treasury bonds and increase the interest rate paid on government borrowing. The increased earning on the Social Security trust funds would be offset by increased debt interest that has to be paid off by American taxpayers. Again, this relationship is mechanical, not ideological in any way.

State pension funds are one answer to a particular question

State pension funds differ from the Social Security trust funds in two related ways:

• they have no control over their tax base;
• they have no control over their currency.

Since people can move freely between the states, each individual state has a peculiar problem: you may pay a teacher to educate children in 2016, but if that child moves out of the state by 2046 he won't be available to provide tax revenue to pay his teacher's pension.Similarly, while the United States can print money to pay the obligations of the Social Security Administration, individual states have to find dollar tax revenue from the taxpayers currently living within the state's jurisdiction.State pension funds are one answer to those problems: the money saved on public salaries in the present (see above) are saved in investments outside the state, so that funds will be available to pay future pensions regardless of the economic conditions of the state itself when those obligations come due. Note that in our stylized example above, the money saved at 7% is less than the future value of the pension paid at 5%, creating a concrete, real-time payroll saving for the public entity involved.It is worth stressing at this point that this is not the only answer to this question! States could, like the Social Security trust funds, simply take pension "contributions" (the decreased payroll expenses of their public employees) and invest them in infrastructure, in lower taxes, in education, in health care, or in absolutely anything else they feel like investing in.

Private workers are right to demand pension funds

A different situation exists in the private sector, where even the most well-established firms can collapse in ignominy from something as significant as a major economic transformation or as trivial as a crisis of governance. Relying on the continued existence and profitability of your employer for both your current and retirement income is a dangerous gamble, so it makes perfect sense for private employees to insist that their pension funds be invested and managed independently of their employer.However, this is correctly understood as an insurance policy, not an intrinsic characteristic of pensions. Apple has never declared bankruptcy since its founding in 1976. It could have promised its earliest employees pensions after 25 years of employment (say 2001) and been able to easily pay those pensions out of current cash flows without ever starting or running a pension fund. Meanwhile it could have used the difference between what it paid its employees and what they were worth to finance ongoing investment in the company, just as the Social Security trust funds do for the United States of America.An independently management pension fund is an insurance policy against bankruptcy, nothing more and nothing less. Perpetual entities like the United States and California have no intrinsic need for such an insurance policy.

What is a pension crisis?

Hopefully all the foregoing illustrates what a pension crisis isn't, and cannot be: a pension crisis cannot be that a pension fund isn't "fully funded," and it cannot be that taxpayers are unwilling to pay higher taxes in order to pay their pension obligations. That is a perfectly reasonable preference of taxpayers that should nevertheless be ignored, because they have already received the services which entitle pensioners to their retirement income.A pension crisis is properly understood to be when the resources available to an entity, whether public or private, are not sufficient to pay the pension obligations that entity has incurred. It does not matter whether it is pleasant or unpleasant to find the resources to pay those obligations; it matters whether it is possible. If it is possible, then there is no crisis. If it is not possible, then there is a crisis.The preferences of current taxpayers as to whether their taxes should be raised or lowered are immaterial to this discussion once the original services have been rendered and the obligations have been incurred.

Where does your marginal dollar go?

On Twitter the other day I had a short exchange with Noah at Money Metagame about a question that I find fascinating: what do you do with your next dollar in income?

Budgets are fine but don't aid ongoing decision-making

For a little bit of context, here are my recurring monthly expenses:

• Rent
• Phone
• Internet
• Blog subscription service
• Google business account

I also have a few recurring annual expenses:

• Credit card annual fees
• Website hosting fee

Finally I have recurring weekly investments:

• IRA contributions
• Solo 401(k) contributions

All together these expenses add up to something like $1,604 per month (I can't be bothered to crunch my credit card annual fees but those would add a few hundred dollars per year, perhaps adding up to as much as $50 per month).So in a very concrete sense, it's important that I earn, on average, $1,650 per month in order to meet those recurring expenses out of current income, i.e. without incurring additional debt.When personal finance gurus tell you to create a budget, they are normally hectoring you to use that budget to restrain your spending. For me, the more interesting question is the one I posed to Noah: once your income meets your budgeted expenses, what do you do with each additional dollar you earn?After all, it's true that if my income fell I could move to a cheaper apartment, or buy slower internet service, or make smaller IRA contributions. But when my income rises, it's less obvious what I should do.

I don't care what you do with your marginal dollar, but it's worth thinking about in advance

Noah had an immediate answer to my question: "Yeah, retirement accounts are maxed already. The marginal dollar gets swept into a brokerage acct ~monthly"Noah is trying to achieve his goal of early retirement by making additional contributions to a taxable brokerage account with his marginal dollar, which is perfectly reasonable. But it's not the only thing you could do with a marginal dollar of income:

• Pay down debt. Student loans, mortgages, car loans, installment loans and any other kind of debt without a prepayment penalty costs less the sooner you pay it off. By using your marginal dollar to pay down those debts you can get a risk-free rate of return that may exceed your other investment opportunities (note: many people will tell you that your risk-free return when paying down mortgage debt should be discounted by the amount of the mortgage interest tax deduction, but those people are part of the problem and should be ignored, if possible).
• Increase your budget. If your income regularly exceeds your budgeted expenses, you can increase your budgeted expenses by moving to a bigger apartment, buying faster internet, or signing up for more expensive credit cards. That would bring your budget up to your income, and minimize the question of the marginal dollar.
• Build up cash savings. Many people think that having a cushion of cash savings is important in order to prepare for or withstand unexpected events. If you're one of those people, then your marginal income can be directed into a high-interest rewards checking account in order to maximize the interest you earn on your federally-insured savings (I personally use Consumers Credit Union due to the high maximum balances and easy-to-meet monthly requirements).
• Buy more/better/sooner stuff. One popular option for people who see irregular bursts of income is to buy stuff. This is so popular that it has become a kind of cliche around tax season when people receive tax refunds and quickly use them to upgrade older appliances or buy new ones.
• Invest. This was Noah's answer, and involves moving his marginal income each month into a brokerage account to hopefully speed his progress towards early retirement.

This is a subject of frantic and unnecessary moralizing

I have attempted above to present the variety of things you could do with a marginal dollar of income as even-handedly as possible, but different readers are likely to attach different moral valence to each one. To one reader paying down debt is obviously a higher priority than upgrading a television set, while to another saving for retirement is clearly superior to moving to a more expensive apartment.My primary concern is that if you don't have an idea of what you would do with a marginal dollar of income, you're exceedingly unlikely to spend it in the way you really want to. Spending a few minutes with a notepad thinking about where you'll put your next "spare" $1,000, $5,000, or $10,000 doesn't mean you'll spend it more wisely according to somebody else's idea of personal responsibility, but might make it marginally more likely that you'll spend it in a way that you'll feel good about once it's gone, whether it's gone into a savings account, a television, an index fund, or a trip to Vegas.

The effects of late-career Social Security contributions

I've written before (and expect to write more) about the Social Security Administration, which is both the primary source of disability insurance for low-income workers and one of the lowest-cost guaranteed retirement savings vehicles available to all workers in the United States.I want to address a few curious issues that arise with late-career Social Security contributions, since for a variety of reasons they're handled somewhat differently than the contributions you make throughout most of your working life.

Delaying retirement versus delaying Social Security benefits

First I need to untangle two slightly different questions. In my experience personal finance journalism focuses primarily on the benefits of delaying claiming Social Security benefits. The numbers differ very slightly depending on your birth year, but the general principle is that if you claim Social Security retirement benefits prior to your full retirement age your retirement benefit (what I calculated in this post) is reduced according to the following formula:

"a benefit is reduced 5/9 of one percent for each month before normal retirement age, up to 36 months. If the number of months exceeds 36, then the benefit is further reduced 5/12 of one percent per month."

Meanwhile if you wait to claim until after your full retirement age your retirement benefit is increased by 8% per year you delay initiating your benefit.That's not what I'm talking about. As opposed to delaying claiming Social Security retirement benefits, I want to address issues arising from delaying retirement, which is to say continuing to contribute to Social Security in the last decade or so of your working life.

If you have reported earnings in fewer than 35 years, continuing to work will increase your benefit

Social Security retirement benefits are calculated based on your highest-earning 35 years, including years in which you earned nothing, so the addition of earnings up to 35 years will always increase your retirement benefit since it reduces the number of zeroes dragging down your average earnings.For very-low-income workers there is a minimum retirement benefit, but very few workers both qualify for retirement benefits and are eligible for only the minimum benefit so I'll set that special case aside for now.

If you have reported earnings in 35 or more years, continuing to work may or may not increase your benefit

One of the most important things to know about how Social Security benefits are calculated is that they're on the basis of your wage-inflation-adjusted earnings. While up to $118,500 in 2016 earnings are subject to Social Security taxes, that's the inflation-adjusted (according to their calculations) value of just $39,600 in 1985 earnings (to pick the year of my birth at random).There's a natural intuition that late-career workers earn more money than early-career workers, and so their increased earnings should increase their average 35-year earnings and drag up their retirement benefit.But that is only true if their increased earnings outpaced the Social Security Administration's wage-inflation gauge.Now, obviously many people do, in fact, earn higher inflation-adjusted wages later in life than they do earlier in life, due to experience and seniority if nothing else. The key point here is that continuing to work after receiving 35 years of credit only increases your benefit according to the inflation-adjusted difference in your income.Suppose a late-career worker with 35 years of credited income and whose income is above the taxable maximum of $118,500 has 1985 earnings not of $39,600 but instead half that, just $19,800. Using Social Security's inflation adjustment, that works out to $56,628 in 2015 dollars. An additional year of crediting $118,500 in earnings to Social Security will definitely increase the worker's retirement benefit, but by a fairly modest amount. To calculate it, deduct the annuity purchased by the $56,628 "rolled off" the worker's earning history and add back the annuity purchased by the $118,500 added to the worker's earning history (this exercise is left to the reader).

If you like your Social Security retirement benefit, you can keep it

Obviously most people treat their Social Security retirement benefit as something that happens to them. You work all your life, then you decide whether to start claiming at 62, at your full retirement age, or at age 70.But late-career people who have already accumulated 35 years of Social Security earnings credit have other choices. They can keep working in their current profession and, if their wage-inflation-adjusted income is higher than their lowest lifetime earning year, marginally increase their retirement benefit.Or they can do something else. This blog is independently financed, with an emphasis on independence. If your domestic labor income isn't earning you a higher old-age pension, maybe you should consider something else. Start a business, travel, make a difference in the world. Your Social Security benefits will be waiting for you.

We must decide: shall people be financially ruined by medical costs?

Since we now have a preliminary Congressional Budget Office report on the effects of the American Health Care Act, the Republican replacement for the Affordable Care Act, this seems like as good an occasion as any to address the importance of medical insurance to the construction of an economy of entrepreneurs and entrepreneurship.

Since World War II, most workers have been covered by employer-based health plans

Employer-based health insurance became widespread for a simple, stupid reason: health insurance premiums were deemed deductible from the employer's income as business expenses, but not treated as taxable income by the insurance beneficiaries. This meant, just as a dollar of tuition scholarship goes further than a dollar of room and board scholarship, employers had a huge incentive to pay their employees in the form of health insurance, rather than wages.Those group plans also provided some basic protections to the insured: community rating, so sicker workers couldn't be charged more for their plans, family coverage, so spouses and children would receive insurance through the worker's plan and, after 1985, the right to COBRA continued coverage under a group plan (with the worker paying the entire premium without employer cost-sharing).To be as clear as possible about this: there is no intrinsic advantage to offering health insurance through employers. The only reason this system exists is because wage controls during World War II could be evaded by employers who extended tax-free health insurance to their employees, and then the perpetuation of that tax regime in the following decades.

The pre-ACA individual health market was completely dysfunctional

Before the passage of the Affordable Care Act, the health care market did not adequately serve individual health insurance customers. Travel back in time with me to 2008, when the following problems were endemic among individual health insurance plans:

• Individual underwriting. If you were sick, you could not get coverage. If you had ever been sick in the past, you could be denied coverage or have your earlier condition excluded from coverage. If you forgot you had been sick in the past and didn't mention it on your application, you could suffer retroactive rescission if you became sick in the future, losing your health insurance just when you needed it most. If you were a woman, you could be charged more for the same plan.
• Lifetime limits on coverage. If you were healthy, you might get a health insurance policy with a lifetime or annual limit on coverage, so after paying your deductibles and copays, and exhausting your plan's lifetime or annual limit, you'd be left paying all your remaining bills out of pocket. This made medical bankruptcy a fact of life for many Americans.

The Affordable Care Act gives everyone access to comprehensive health insurance

Everyone picks and chooses what they want to highlight in the Affordable Care Act, or Obamacare, so I'm going to tell you I think of as the principle benefits of the Affordable Care Act:

• Employer health insurance becomes more comprehensive (this wasn't the biggest problem pre-ACA, but it's an improvement);
• Low-income people get access to Medicaid;
• The individual market is subsidized and regulated so all plans have community rating, guaranteed issue, no annual or lifetime caps on coverage, and affordable premiums.

This framework isn't perfect (if it were up to me, subsidies would be universal and paid for with modestly higher income taxes), but it is exquisitely good at what it does, and what it does is provide universal health insurance.You are free to quibble with the "value" of that insurance, free to complain about high co-pays and deductibles, free to complain about limited provider networks.But that is not the point of health insurance: the point of health insurance is to keep people from being financially ruined by medical bills, as they regularly were in the decades leading up to the passage of the Affordable Care Act.

Why would we limit entrepreneurship to the young, single, healthy, male and married?

Before the Affordable Care Act was passed, of course people did leave their jobs to start businesses. And if they were young, healthy, and male, they may even have been able to afford individual health insurance. If they were married, they could remain on their spouse's health insurance plan. If their business grew fast enough and profitable enough, they could start a group plan to insure themselves and their employees.That is not going to be enough. We need a society that doesn't just permit, but encourages entrepreneurs and entrepreneurship. And we are never going to have that society if leaving your employer to start a business exposes you to catastrophic medical debt.We know what the world looked like before the passage of the ACA. It was a world in which people would do anything to keep their jobs and access to health insurance; when they would take any job in order to keep access to guaranteed employer-based health insurance.That system never worked well, but it may have worked well enough in a world of lifetime employment for white-collar and blue-collar workers alike and in a world of relatively restrained medical costs. That's not the world we live in anymore.Access to comprehensive, affordable health insurance is the only way we can build the society of entrepreneurs and entrepreneurship that we must, in fact, build.I do not know if the Congressional Budget Office is right that 24 million people will lose coverage under the Republican replacement plan. But I do know exactly what a world looks like without access to comprehensive, affordable health insurance, because that's the world I grew up in and which I, unlike your cable TV anchor, remember perfectly clearly.

Over There: Investing in Germany

Today I'm introducing a new feature I'm very excited about. It's extremely common in financial journalism and even in popular culture to see vague references to "how things work" in some other country, whether it's refugee policies in Denmark, the health insurance marketplace in Singapore, or employment law in France.Since, as readers know by now, I have an unfortunate literal tendency, I'm always left wondering, "how do things really work over there?"That's the origin of this new feature: I'm going to be taking a closer look at how people go about basic tasks under totally different regulatory regimes than the ones we have in the United States.As a heads up, I'm definitely going to get a lot of stuff wrong. But that's because I'm trying to take a closer look than the superficial glosses you get from the Associated Press. Also, Russian is my only second language, so a lot of this is going to be based on Google Chrome's built-in translation feature. With all that out of the way, let's get to the first installment: investing in Germany!

Do Germans invest?

There are two slightly different questions here. Germany is a market capitalist economy, and virtually all of its large companies are publicly listed on its stock exchanges, primarily the Frankfurt Stock Exchange and its two trading venues, Xetra and Börse Frankfurt.German companies also sponsor American Depository Receipts which allow Americans to purchase shares in companies like Volkswagen (VLKAY on the over-the-counter market). These are slightly different from US-listed shares of international companies like Deutsche Bank (DB on the New York Stock Exchange).All of this is to say that unlike, for example, Cuba or North Korea, large German firms are in principle organized for the creation and distribution of profits to their shareholders.However, the question of whether Germans themselves invest is somewhat trickier. In 2010, Bloomberg wrote that:

"Only 6 percent directly owned stocks in the first half of 2010, according to Deutsches Aktien­institut (DAI), a shareholder lobby association, whereas stock ownership for the French is 15 percent and 10 percent for the Britons. Only 9.4 percent of the German population owned shares of mutual funds in the first half of 2010."

In 2013, the Economist wrote that:

"only 15% of Germans own shares directly, while a partly overlapping 21% own mutual funds."

In 2015 the Financial Times reported:

"Only 8.4m Germans, or 13 per cent of the population, held shares or equity funds in 2014, according to Deutsches Aktieninstitut, a lobby group — down a third since 2001."

So the simplest answer seems to be that most Germans do not own shares in German companies, or in any other country's companies.

How do Germans save?

This may seem like a striking conclusion because one cliche about the economic geography of the European Union is that "frugal Northern Europeans" subsidize "profligate Southern Europeans." And it turns out that Germans do have a relatively high savings rate — they just don't use their savings to purchase shares of private companies. Instead, they deposit them in a range of savings vehicles, the most distinctive of which is the "Riester-Rente," which gives eligible participants a state subsidy for deferring a certain percentage of their income in qualified savings vehicles.Let me be frank: the Riester-Rente sounds like a bureaucratic nightmare. This seemingly-knowledgable website describes the conditions as follows:

"If a beneficiary accesses the Riester assets before the age of 60 (remark: for contracts concluded from 2012 onwards: 62), cancels a Riester contract, or dies without qualifying heirs (i.e. a spouse or children for which children allowances / “Kindergeld”are paid), all government benefits (subsidies and tax savings) so far must be repaid in monthly installments (“förderschädliche Verwendung“). Therefore, Riester contracts are usually not cancelled before retirement. Beneficiaries spending their retirement outside of the EU/EEA also have to repay the benefits as described above."

It appears to me that the majority of German savings takes three primary forms: payroll tax contributions to the state pension system; contributions to a Riester-Rente and other private pension schemes; and deposits in bank savings accounts.

What are the options for a German to invest?

Germans do have access to a number of brokerages which allow them, if they choose, to purchase shares in private companies. You can tell by the websites of these brokerages that they are targeted primarily at foreign exchange and options gamblers, but this appears to be a completely legitimate brokerage firm that allows Germans to purchase shares on Xetra, Euronext, and US stock exchanges (and also shows the prices they charge and the prices of their competitors).Since German brokerages allow purchases on US exchanges, I assume it is possible for them to purchase the same extremely-low-cost Vanguard ETF's that are available to us (though I'd love if a reader had additional insight on this question).

How would I invest, as a German?

I think this is a fascinating question that US-based financial journalists spend exactly zero time thinking about. For example, we often talk about "home-country" bias in the United States, but what is the proper locus of home-country bias for a German investor to exhibit? Is her home country Germany, Northern Europe, the Eurozone, or the European Union?I think if I were a German socking money away each month in my brokerage account, and I could only use exchange-traded funds, I'd try to come up with something like this:

• 50-60%: iShares MSCI Eurozone ETF (EZU);
• 20-30%: Vanguard Total Stock Market ETF (VTI);
• 5-15%: Vanguard FTSE Pacific ETF (VPL);
• 5-15%: Vanguard FTSE Emerging Markets ETF (VWO).

Remember, this portfolio will be Euro-denominated in my German brokerage account, and all my dividends will be distributed in Euros, so I'd want to start with a strong Euro-denominated tilt in the portfolio. Adding the United States total stock market would give me access to the largest market economy in the world, and then I'd want some "just in case" exposure to the Pacific and emerging markets.

What about taxes?

It appears to me (Wikipedia, KPMG) that all dividends, capital gains, and investment income are subject to a 26.38% tax (technically a 25% tax plus a 5.5% surcharge on that tax).However, it appears that 801 Euros in capital gains are completely exempt from taxation each year, and if your income tax rate is below 25% you are entitled to the a refund of the difference between your income tax rate and the 25% withheld from your capital gains and dividends.This all sounds quite complicated but I believe it is much simplified by the fact that most Germans don't own shares so never have to calculate the refund they're owed on their withheld capital gains.

Have Germans been domesticated by their welfare state, or have they domesticated their industrial state?

While researching this post I kept coming back to the same quandary: Germany notoriously enjoys one of the most competitive and profitable industrial and manufacturing bases in the world, but Germans themselves seem to reap virtually none of the rewards through claims on the stream of income their factories and businesses generate.The accumulation of wealth in the form of shares is treated as a fringe activity, while pensions, health care and education are treated as entitlements. Would making wealth. as opposed to financial security, more widespread lead to the same fractures in German society we see in the United States? I didn't come here with any answers, but now you know everything I know about investing in Germany.What would you like to see in the next edition of "Over There?"

 

What do you think you are doing when you diversify investments?

Over the last year or so, I've read 20-30 books on investing, including short handbooks like The Index Card and somewhat more technical volumes like Jack Bogle's Common Sense on Mutual Funds.The thing virtually every book I've read on investing has in common is a recommendation that part of a portfolio be invested in bonds, and it took me a long time to understand why.I finally did come to a few conclusions on this score, which I shared in this modestly interesting thread on the Saverocity Forum.I'd like to take a slightly different approach to the same question, through the prism of some financial independence bloggers who are kind enough to share their actual investment portfolios online (or at least what they claim to be their actual investment portfolios). These aren't bloggers I necessarily follow myself, but are rather bloggers who seem to have a general attitude towards investing that reflects mine: invest as much as possible in funds that cost as little as possible.

The White Coat Investor

Here's the latest investment portfolio shared by the White Coat Investor blog:

• 75% Stock
•    50% US Stock
•       Total US Stock Market 17.5%
•       Extended Market 10%
•       Microcaps 5%
•       Large Value 5%
•       Small Value 5%
•       REITs 7.5%
•    25% International Stock
•       Developed Markets 15%
•       Small International 5%
•       Emerging Markets 5%
• 25% Bonds
•    Nominal Bonds (G Fund) 12.5%
•    TIPS 12.5%

Physician on FIRE

Here's the latest investment portfolio shared by Physician on FIRE:

JL Collins

I'm a bit confused by how JL Collins describes his holdings, but I think he claims to be currently holding:

• 75%-80% VTSAX (Total US Stock Market)
• 25% VBTLX (Total US Bond Market)
• 5% "cash"

What benefits might diversifying investments conceivably provide?

If you happen to be a fan of these bloggers, trust me when I say I'm not trying to "criticize" these investment decisions. In an era of comprehensive historical market data and cheap or free backtesting data, I'm sure these portfolios have a higher (lower?) Sharpe ratio (or whatever) than my portfolio, and if that's what you want then you can build such a portfolio yourself, or copy one of theirs.But unless you know why you're constructing your portfolio in the way you are, it seems to me vanishingly unlikely such a portfolio is the straightest path towards achieving your investment goals.Of course, there's no sense in talking about "diversifying" a portfolio unless you have a portfolio in the first place, so I'll use as a "baseline" portfolio the Vanguard Total Stock Market Index Fund, VTSAX, a fund that all three of the bloggers above use as their largest single holding. Why might a well-informed investor/blogger deviate from that portfolio?

• The belief that another asset class will provide a higher return on investment. This appears to be the logic behind the White Coat Investor and Physician on FIRE portfolios, with their addition of small-cap, mid-cap, and value funds to the core VTSAX holding. The investors appears to believe that such funds will generate higher returns than the market-cap-weighted total stock market index.
• The belief that an additional asset class will provide a more stable account balance. I don't know why an investor would be interested, in general, in the stability of their account balance, but it is a fixture of financial writing that this is something people are, in fact, deeply interested in. This is how JL Collins explains his bond holdings: "Bonds provide income, tend to smooth out the rough ride of stocks and are a deflation hedge. Deflation is what the Fed is currently fighting so hard and it is what pulled the US into the Great Depression. Very scary" (emphasis his).
• Tax-loss harvesting. As Physician on FIRE explains, "Some of the complexity comes from tax loss harvesting, which results in me holding four funds in the taxable account, rather than two." In other words, he does not believe that his added diversification will improve returns and he doesn't believe it will lead to a more stable account balance, he diversifies solely for the purposes of not having substantially similar funds in his taxable account so he can trade them against one another for tax reasons.

If you want to diversify, first figure out why

After all the research I've done into investing, I was personally shocked to learn this, so don't be surprised if it's a shock to you as well: diversification doesn't increase long-term returns. Diversification only increases long-term risk-adjusted returns, which is to say, returns adjusted for volatility in your nominal account balances. If you don't care about your nominal account balances, diversification away from equities is a pure drag on your investment performance.You may, in fact, be the kind of investor that cares deeply about your account balances, in which case, frankly, I don't have any recommendation besides a heavy allocation to cash (here's a great resource for high-interest checking accounts you might consider).But if you're a long-term investor who doesn't care about your nominal account balances, you should diversify away from broad market indices only with caution and only when you have good reasons for doing so.

Why do we tax corporate profits?

There is a periodically-fashionable argument in the United States that a key obstacle to economic growth is the "double-taxation" of corporate earnings: once at the corporate level, and a second time when profits are distributed to shareholders and (eventually) reported on their individual income tax returns.This argument is typically made by people who, for ideological or self-interested reasons, want to eliminate either one tax or the other: either tax corporate profits but not dividends and capital gains, or tax dividends and capital gains but not corporate profits.In fact, this so-called "double" taxation is a very sensible answer to a very particular problem.

The corporate tax rate is relatively flat

Many people use as a shorthand for corporate profit taxation the maximum corporate profit tax of 35%. This is not strictly speaking true since like the personal tax code the corporate income tax is somewhat progressive. However, for large corporations it's true that profits are taxed, in general, at a marginal rate of 35%.

The federal income tax is relatively progressive

Unlike the relatively flat corporate tax rate, the federal income tax on qualified dividends and long-term capital gains is quite progressive. No federal income tax at all is owed on such income for taxpayers in the 10% and 15% federal income tax brackets, and the federal income tax tops out at 20% for taxpayers in the top income tax bracket (there is an additional Medicare surcharge I'm ignoring for simplicity's sake).

Many corporate distributions are untaxed

While relatively few low-income taxpayers receive any qualified dividends or long-term capital gains, there's another class of entities that receives a vast quantity of dividends and capital gains: untaxed endowments and foundations.Harvard University's $35 billion endowment pays no taxes whatsoever on any dividends it receives from its extensive portfolio or on any capital gains it realizes on its investments.However, its investment portfolio is still taxed: what critics call "double" taxation of both corporate profits and capital gains in fact results in the only form of taxation Harvard's endowment is ever subject to!

Corporate profits are taxed twice, but differently

In reality, we have two taxes sitting on top of each other: a relatively flat corporate income tax on profits as they are realized and before they are distributed to shareholders, and a relatively progressive personal income tax that is applied only to distributions and capital gains realized in taxable accounts, and completely untaxed for the endowments and foundations that hold a great many shares.Today's tax on corporate profits has a floor of 35% (for distributions to untaxed shareholders) and a ceiling of 59.6% (for distributions to high-income shareholders in taxable accounts). Referring to that as "double" taxation misses the point: it's a relatively progressive taxation scheme, based primarily on ability to pay.A world with only a corporate income tax would be a world with a flat tax on corporate profits, without respect to ability to pay: low-income shareholders would pay the same tax rate as wealthy shareholders.A world with taxes levied only on profits distributed to shareholders would be one where corporate profits distributed to tax-exempt shareholders and to those with shares held in tax-advantaged accounts avoided taxes completely.Instead, we levy one tax on corporations based on the profits they choose to distribute to shareholders, and a second tax is levied on shareholders based on their ability to pay.This system may not be (in fact, is certainly not) ideal, but it is a concrete solution to a real problem: with many shares held in different structures, including tax-exempt, tax-advantaged, and overseas accounts, profits are taxed in multiple different places to ensure they are, in fact, taxed at all.

The many flavors of investing activity

I've heard a lot of talk lately about the issue of investors and investment advisors who claim to be investing "passively" but are really just actively managing low-cost index funds. One reason this issue is interesting is that most research into the superiority of index investing seems to ignore it completely.For example, when Jack Bogle says the passively-managed Vanguard 500 index fund has to outperform all actively managed large cap funds after taxes and fees, he's making a very specific (very true) claim: that a dollar invested at the start of a period in the Vanguard 500 will outperform (after taxes and fees) the average performance of a dollar invested in every actively managed fund. If all passive investors together earn the performance of the market minus fees, then all active investors together must also earn the performance of the market, minus taxes, fees, and trading costs. This is mechanically true, not an ideological argument of any kind.On the other hand, the relative performance of the same dollar is completely unknown if you're buying into the fund every time it goes up and selling every time it goes down, or vice versa. Even though you're investing in a passively-managed index fund, if you're actively trading it's impossible to predict your relative performance compared to "passively" buying and holding an actively managed fund!With that in mind, here are 3 kinds of activity that are guaranteed to change your performance relative to the market, one way or another.

Active fund selection

Say that you are committed to investing exactly $1,000 each month in a low-cost, passively-managed index fund. However, each month you decide from scratch which fund to invest in. Some months you think the domestic stock market's overvalued and you invest in a total international stock fund instead. Other months you think the domestic stock market's got a lot of upside potential so you buy in there instead. Other months you see that below-investment-grade bond yields have ticked up and buy $1,000 of that fund instead.I suspect if you really feel compelled to introduce some kind of activity into your investment decisions, this is the most defensible: you're consistently adding the same dollar amount to your investments each month, you're investing in low-cost, passively-managed index funds, and you'll end up either modestly underperforming or modestly overperforming a truly passive approach.You still shouldn't do this, but I find the impulse completely understandable.

Active timing of buying decisions

An approach that is much more likely to see you underperform over time is timing your buying decisions. There are a number of ways you might execute such a "strategy." In a single-fund portfolio, you might wait until the price/earnings ratio drops below some fixed number before buying, or you might wait until some arbitrary drawdown from the fund's high point before adding additional funds.The two biggest problems with this approach are the certainty of missing out on dividend yield and the likelihood of jamming yourself due to tax considerations.For the first point, consider that the Vanguard 500 at its current price yielded 1.89% in dividends over the last 4 quarters. I am absolutely positive that the Vanguard 500 will experience at least one 10%, 20%, and 50% correction in the next decade, but I am completely agnostic as to whether they will occur tomorrow or 10 years from today, which means I'm completely agnostic about the level from which the drawdown will occur, which could easily be 11%, 25%, or 100% higher than today.The second point is even more devastating if you're making contributions to a tax-advantaged account with annual funding limitations. Say you can make 2017 contributions to your IRA on any date between January 1, 2017, and April 16, 2018. You would obviously like to make your purchase on the date within that period when your contribution will purchase the most shares possible. The problem is that each day that elapses is a day when you're unable to make your purchase, even if it turns out to have been the cheapest entry point. When April 16 comes around, you're forced to make your contribution, even if it's the absolute most expensive point during the year, and you'll meanwhile have missed out on 5 quarterly dividend distributions.

Active selling decisions

The absolute worst kind of activity you can introduce into your account is selling activity. I do not consider this to be because of tax consequences, because I think tax consequences are utterly irrelevant for most investors and wildly overblown even for the small group of investors they do affect.The problem with selling activity is that it requires you to be right twice: you have to correctly guess when the price of a fund will drop, and exit before it does so, and then you have to correctly guess when it is at or near its bottom in order to reenter before it rises again (or guess when some other fund will start to rise).The one kind of selling that makes any sense is rebalancing from appreciated assets to less-appreciated assets within a tax-advantaged account. For example, a 50/50 domestic/international portfolio may naturally change its weight to 60/40 if domestic stocks drastically outperform international stocks. I don't think you should do that, but I understand the logic behind it if you have some reason to be invested in a 50/50 portfolio to begin with.

What is a passive investment portfolio?

There are two ways to construct a truly passive investment portfolio:

• Make regular, identical purchases of a fixed asset allocation, and never change it.
• Make a single purchase of a fixed asset allocation, and never change it.

As an example of the first, you might contribute a fixed dollar amount to a single domestic index fund every week or month. As an example of the second, you might make a single purchase of a fund or set of funds and never buy or sell them again.Both choices have their advantages and disadvantages: the first will give you access to the range of asset prices across several business cycles, allowing you to buy in at the average value of each asset class. The second gives you access to more dividend distributions by making your contributions up front, but locks in your cost basis at the moment you make your single initial investment decision.While both are fine, I believe only a tiny minority of investors are capable of pursuing either option. If, like most investors, you aren't able to behave completely passively, you need to decide what kind of activity to introduce into your portfolio.

• Actively selecting passively-managed low-cost funds that you'll hold forever is unlikely to present much of a drag on your portfolio, since you'll be fully invested at all times in whichever funds you ultimately pick.
• Actively timing buying decisions isn't a great idea, since you'll find yourself with investable cash on the sidelines while you could have been accumulating shares that provide a stream of future income.
• But actively selling shares is virtually guaranteed to make you underperform basic market indices all year, every year.

A final option is to "top up" underperforming investments with each new additional investment, so rather than selling off overperforming funds in order to buy underperforming funds you might make larger contributions to the underperforming funds until they return to their "ideal" allocation. This is still market timing, but perhaps the most harmless of all forms of market timing if you insist on introducing activity into your portfolio — which, to be perfectly honest, you probably will.

Affordable Luxuries #1: candles, chocolate, car washes

Some people like luxury European automobiles, high-end kitchen ranges, and very old wine. As far as I can tell, these things are all outstanding, but they have one thing in common: they're expensive.When I say "expensive," I don't mean they're not worth every penny — just that they cost a lot of pennies.So as a person who doesn't have a lot of pennies, I thought I'd introduce this occasional series, Affordable Luxuries. These are things that are amazing, quality-of-life enhancing, and cost less than a bottle of 1961 Right Bank Bordeaux.

Candles

Remember candles? You probably saw them last at your 13th birthday party, but they still make them, and they're terrific! Ikea sells 100 GLIMMA tealights for $3.99, so go ahead and buy a hundred or two. You'll also want to pick up some candleholders, but those are pretty cheap too, and last forever.Once you have a bunch of candles you paid next to nothing for, you can light them for any occasion, or no occasion at all. And then you'll be the kind of person who eats dinner, watches TV, or reads the newspaper by candlelight, and you'll feel great about it.

Chocolate

Unlike candles, you probably know about chocolate, and may even eat it fairly regularly. But it turns out really, really good chocolate is widely available in the United States, and is completely affordable. A bar of Green and Black's organic chocolate retails for around $5 (though I've seen it cheaper).On the one hand, that's somewhat more expensive than a bar of Hershey's milk chocolate. On the other hand, it actually tastes like chocolate, and will last you a good long while.I personally prefer the 85% Dark Cacao bar, but don't take my word for it: they're $5, try them all!Eating really good dark chocolate isn't like eating cheap milk chocolate. My recommendation is to break off a small square, stick it in your mouth, and then just wait as it melts and the flavors consume you. Feel free to do this with candles flickering in the background (see above).

Car Washes

I don't know about you, but I didn't go to a car wash between age 17 and age 30. But it turns out they still exist, they're great, and they're completely affordable!For $10-15, you can have the entire exterior and interior of your car cleaned. Dusty dashboards wiped, muddy interiors vacuumed, mirrors polished till they shine. I promise you will not recognize your car after it's been professionally washed.If you're lucky you can still find a carwash that lets you ride through inside your car, which is even more fun and doesn't cost anything extra. Bring a friend if you want to recreate your favorite car wash makeout scene from early-80's TV and cinema.You can also do this with chocolate (see above), although I recommend against bringing lit candles into the car wash.

Self-employment tip #1: use your EIN for everything

I am working on a project for my beloved readers that has quickly spiraled out of control and is taking me much more time to complete than even I had contemplated. But one key point that I've learned is that as a self-employed person, you should use your Employer Identification Number, or EIN, for absolutely everything connected to your business.This may sound obvious, so I want to explain exactly why this has turned out to be so shockingly annoying.

The IRS prefers you use your Social Security number

On form W-9, the one independent contractors and self-employed people submit to their clients, you're asked for your "Tax Identification Number," which is either your Social Security Number or your Employer Identification Number:As the form helpfully explains, "However, for a resident alien, sole proprietor, or disregarded entity, see the Part I instructions on page 3."Turning to page 3, we see:"However, the IRS prefers that you use your SSN."Why does the IRS prefer that you use your Social Security Number? In order to make your life as difficult as possible.

You cannot deposit employee withholding using a personal EFTPS account

I spent 3 hours today trying to figure out how to deposit federal tax withholding for employees until Twitter user and American hero @utahshane explained: "@FreequentFlyr You're on a personal EFTPS login. Need to be on a business version to se 940, 941, etc."Since I am still boiling with rage right now, I'm going to explain how frustrating this is through gritted electronic teeth:

• EFTPS, the electronic system sole proprietors and employers are required to use to make quarterly estimated tax payments and deposit tax withheld from employees paychecks, is completely undocumented. This is the EFTPS "Help" page. This is the official IRS publication on EFTPS. This is the Payment Instruction Booklet. None of these documents explain that if you enroll as an individual you are unable to deposit taxes withheld from employee pay. None of them explain how the system actually works.
• Here is what EFTPS thinks you "Need To Know:"
• One of the things EFTPS DOESN'T think you need to know is that only certain account types can make certain kinds of tax deposits, and which account type you should enroll in.
• Finally, here are the three options you're given when enrolling:
• Is a sole proprietor a business or an individual? On the one hand, you receive business income. On the other hand, we've established on IRS documents elsewhere that "the IRS prefers that you use your SSN." If any information was provided in advance about the different account types, it would be easy to decide. Instead, you're left to flip a coin.

I want to make clear that I did not "accidentally" or "mistakenly" set up my EFTPS account as an individual. I randomly set up my account as an individual because the IRS provides no guidance or instructions whatsoever about how you should set up your EFTPS account.

Why isn't this easy?

Since I'm seething with rage you probably don't want to ask me any question beginning with "of course you're supposed to enroll as a business." As I said above, this is one tiny corner of a larger project I'm working on for you, and it took me hours of searching IRS documents, forums, and finally begging for an answer on Twitter before I found the answer to this one tiny question.Do we want people to start businesses or not? Do we want people to hire employees or not? If we do, this simply cannot be the way we organize the most basic government functions, like collecting and paying employment taxes!

Yes, you can pay to do this

Of course you can buy payroll software, hire a payroll firm, or sign up for an "exciting new" option like Zenefits to take care of this kind of payroll administration for you.But what does it say about our system of market capitalism that we erect barriers to hiring that even reasonable people (with plenty of time on their hands) are unable to surmount without paying third parties to handle them?One very strong tendency in American life I fight against is the impulse to treat starting a business as some kind of risky, complicated endeavor you should only undertake when you're already rich and comfortable. When we say as a culture that the first thing you should do when you start a business is pay strangers to manage your payroll, we're confirming that impulse and saying that starting a business isn't for you or people like you.Much, much more on this subject to come. But for now, just remember: fuck the IRS and their preferences, and use your EIN for everything connected to your business.

You can pay someone to harvest capital losses for you, but why would you?

A current fad in the world of personal finance and investing is so-called "tax-loss harvesting." If you're not familiar with the concept, tax-loss harvesting refers to the perfectly true observation that up to $3,000 in capital losses can be deducted from ordinary income each year, and it's one of the biggest selling points of "robo advisors," the automated investing services that manage accounts on your behalf.Due to my unfortunate literal tendency, I had the apparently unprecedented idea of checking whether this is actually worthwhile. This isn't rocket science: we need only compare the value of a $3,000 reduction in ordinary income to the cost of maintaining an account with one of these services.There are a number of automated advisory services, so for simplicity's sake let's take a look at the big three: Wealthfront, Betterment, and FutureAdvisor. Purely from the generosity of my spirit I'm going to give each service the benefit of the doubt and assume that they really will achieve $3,000 in capital losses each and every calendar year.

What are $3,000 in capital losses worth?

In the United States we have 7 marginal income tax rates, and since the $3,000 in capital losses will be deducted from your income at the margin, the value of the loss depends on your marginal income tax rate:

• 10%: $300
• 15%: $450
• 25%: $750
• 28%: $840
• 33%: $990
• 35%: $1,050
• 39.6%: $1,188

For an automated advisory service to be worth paying for, the amount paid to the service must be lower than the value of the tax-loss harvesting the service provides. Since automated advisory services charge based on the amount of money they manage, this creates the curious situation where the value of the service goes up the higher your marginal tax rate and goes down the more money you hold with them.What we can easily identify is your breakeven point, where you begin to pay more in advisory fees than you receive in reduced income tax liability.

Wealthfront

Wealthfront has a 0.25% annual advisory fee and claims to provide tax-loss harvesting services to every client, regardless of account balance, and manages your first $10,000 invested for free. Assuming they're able to realize $3,000 in capital losses on accounts of any size, the breakeven points for someone in each marginal income tax bracket are:

• 10%: $130,000
• 15%: $190,000
• 25%: $310,000
• 28%: $346,000
• 33%: $406,000
• 35%: $430,000
• 39.6%: $485,200

Betterment

Betterment charges the same 0.25% annual advisory fee as Wealthfront, but doesn't exempt the first $10,000 from fees so the breakeven points are identical to those above, less that $10,000 amount.

FutureAdvisor

FutureAdvisor charges 0.5% of assets under management each year, which means you'll pay more in advisory fees than you earned in reduced income tax liability at the following account values:

• 10%: $60,000
• 15%: $90,000
• 25%: $150,000
• 28%: $168,000
• 33%: $198,000
• 35%: $210,000
• 39.6%: $237,600

What about offsetting capital gains?

It's also true that capital losses can be used to offset capital gains. While only $3,000 of capital losses can be used to offset ordinary income, an unlimited amount of capital losses can be used to offset realized capital gains.This leads me to the rather embarrassing question I'm forced to ask: why do you have capital gains?Last year the Vanguard 500 (VFIAX) distributed $0 in capital gains.Last year the Vanguard Total International Stock Index (VTIAX) distributed $0 in capital gains.Same with Emerging Markets, Europe, and the Pacific.If you're recording large capital gains each tax year you definitely have a problem, but that problem isn't going to be solved by automated tax loss harvesting, that problem is going to be solved by getting — and staying — in some low-cost Vanguard index funds. That's true whether you have invested $100,000 or $1,000,000. Constructing a portfolio that spins off capital gains each year and then paying somebody to offset them with capital losses isn't a second-best, third-best, or fourth-best option.It's literally the worst option.

Go ahead and roboinvest if you think they know something you don't

I do not have any reason to believe that backtesting is an interesting or useful way to build a portfolio. But I do believe backtesting is an extremely popular way to build a portfolio, and I'm sure these and the many other automated investing firms are great at it. So if you, like many investors, believe that backtesting is an interesting and useful, and hopefully profitable, way to build a portfolio, I don't see any reason not to invest with one of these automated investing services.If you're right, and these model portfolios outperform buying and holding some low-cost Vanguard funds, then you win twice: you outperform us lazy, skeptical investors and you make a little money each year harvesting capital losses.If you're wrong, then the good news is that you're not alone, but the bad news is you're paying out of pocket each year for the privilege of underperforming.

Why should retirement savings be financed out of current income?

If there are two axioms that financial graybeards treat as indisputable, they are:

• Americans don't save enough money for retirement;
• and the government needs to do more to encourage retirement savings.

With respect to the first axiom, we're treated to serious-looking charts about the "retirement savings gap" and told how few people are taking advantage of workplace savings accounts. It seems to me that this is a complete misunderstanding of the problem, which is that people are assigned a task they have no training or competence for, and that modestly raising Social Security benefits would be a much more straightforward way to ensure retirement security. But if you prefer this "personal responsibility" routine I won't argue with you here (we can get into it in the comments if you like).My problem is with the second suggestion, that the government encourages retirement savings. It does no such thing. On the contrary, government policy is currently engineered to actively hinder people from accumulating adequate retirement savings.

Forget everything you know about retirement savings

It is a very tempting trap when discussing issues of general familiarity to anchor the discussion on programs and policies that already exist. In other words, if I tell you IRA contribution limits are too low, the easy impulse is to say they should be raised. If I tell you taxes on distributions are a drag on performance the easy impulse is to cut or eliminate those taxes.I want you to momentarily put aside everything we already know about the system of tax-advantaged retirement accounts in the United States while I show you two charts. This is a chart of the growth of an account that has $5,500 added to it each year and that compounds at an annual rate of 5% APY for 40 years:This is a chart of an account with the same $220,000 in contributions made in the first year and allowed to compound for 40 years at 5% APY:Obviously I haven't picked these numbers at random. Someone who begins working at age 25 and contributes the maximum $5,500 every year until they retire at age 65 will have contributed $220,000 over the course of 40 years.The current policy, in other words, of the US government is that you should save $220,000 for retirement but, by contributing it out of current income each year, you should only retire with 41% of the assets you'd have if you'd invested the full amount in your first year.Now you tell me, is the US government encouraging Americans to retire with adequate resources, or discouraging them from it?Even worse are the so-called "Catch-Up" contributions which allow individuals over the age of 50 to make additional contributions to their retirement plans. That's right, you're supposed to "catch up" by making contributions as late as possible, when the money will do the least good by having the least time to appreciate and compound!

This is a system of labor subsidies, not retirement subsidies

All you need to know about Individual Retirement Accounts is laid out clearly by the IRS:"For 2015, 2016, and 2017, your total contributions to all of your traditional and Roth IRAs cannot be more than:

• $5,500 ($6,500 if you’re age 50 or older), or
• your taxable compensation for the year, if your compensation was less than this dollar limit." (emphasis mine)

A year in which you make nothing, or less than $5,500, is effectively excluded from the number of years you can make contributions to so-called "retirement" accounts. If your belief is that elderly Americans don't have adequate income in retirement, why would your solution be to punish those with spotty or incomplete work histories by reducing the amount of retirement assets they are permitted to appreciate tax-free? If you suffer unemployment or imprisonment early in your life, you're forbidden from making contributions in the very years they would be most valuable in retirement!The game becomes even more obvious when you see how these programs interact with one another in practice:

• you have to have taxable income to make an IRA contribution;
• if your AGI is low enough to qualify you can receive a Retirement Savings Contribution Credit;
• but the Retirement Savings Contribution Credit can only offset taxes owed — it's non-refundable and thus cannot actually increase someone's retirement savings.

A modest proposal: burn it down and start over

Here is my two-part plan. Feel free to share it far and wide:

1. Eliminate from the tax code all of the following provisions and programs, and any other "retirement" scheme you can think of: 401(k), 403(b), SEP, SIMPLE, Solo 401(k), IRA.
2. Create a single tax-advantaged account with the following features: a lifetime cap of $200,000 (indexed to inflation) in after-tax contributions, starting at age 18, which compounds tax-free and with tax-free withdrawals of any amount at any time.

That's it. I do not think that people are very good at saving for retirement (which is why we need to strengthen Social Security), but for those with the talent or inclination to do so, this would allow them to shield a substantial, fixed amount of money from the drag of annual taxes on distributions, which they're welcome to use in retirement or for any other purpose.Here are four conceivable objections (besides the obvious "I'm taking advantage of my 401(k) and I don't want you to take it away." That's not an objection, that's greed. Go sit in the corner):

1. Rich people will make $200,000 contributions on the day their kids turn 18. Yep, I'm not thrilled about that either, but I don't care enough to punish everyone the system will help by trying to monitor or prevent it. Also, rich people don't trust their kids, so I suspect this problem will be less serious than it seems (unlike the 529 problem, which is real and serious, because parents maintain ownership and control of accounts). The impulse to impose high fixed costs on everyone in order to prevent abuse by a tiny minority is a serious and endemic problem in American politics, which you often see in discussions about preventing "abuse" of the welfare state.
2. By not earmarking funds for retirement, people will make early withdrawals to cover non-retirement expenses. Yep. Fortunately, most people will not max out the $200,000 contribution limit, so even if they "waste" $10,000 of it by making a contribution and withdrawing it shortly after, they still have $190,000 before they hit the cap. This is an insignificant problem that will affect almost no one.
3. Employers should be involved in some way. No, they shouldn't. That's anchoring on our current bizarre system where large employers have a competitive advantage over small employers because they can afford to administer large retirement schemes. If you want to make regular contributions from your paycheck, set up direct deposit. Involving employers in the administration of government programs is a tendency we need to beat back at every opportunity in order to build a society of entrepreneurs and entrepreneurship.
4. There should be a way to make pre-tax contributions. No, there shouldn't. A pretax contribution by a high-income person costs the taxpayer more than an identical contribution made by a low-income person, forcing taxpayers to pay more to subsidize the retirement security of the wealthy than the poor! That's the perverse logic of pretax contributions (it applies equally to so-called Health Savings Accounts).

Conclusion

Since man is a social creature, the way we think about things is often constrained by the way we talk about things. That's why people think Individual Retirement Accounts are about saving for retirement, 529 plans are about making college affordable, and Health Savings Accounts are a good way to pay for healthcare.As I explained in my introductory post, I have an unfortunate literal tendency which leads me to take things as they actually are, not as people pretend they are. And what we have now is a system rigidly engineered to obstruct those saving for retirement from taking advantage of the most powerful tool in their arsenal: the time for the power of compound interest to work miracles on their behalf.The correct way to address problems is to address the problem. When people were unable to get health insurance because of pre-existing conditions, we passed guaranteed issue. When lifetime caps on benefits left people without health insurance coverage, we banned lifetime caps on benefits.But when people were suffering from income insecurity in retirement, we pretended to address the problem by building a system of expensive and complicated labor subsidies. That system will never work because it was never designed to work.It's time to start over, and do it right this time.

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.

Free Business Idea: Mailstream, Your Home Away From Home

There are lots of people who enjoy their jobs, who find that their jobs give their life meaning, or who think that wage labor is the natural order of the universe and that it's their duty to be employed by somebody else.On the one hand, I'm not in the business of judging other people's priorities. On the other hand, the obsession with "employment," with laboring for someone else, has consequences that I do care about very much: air conditioner factory employees who choose to vote for someone who promises to "bring back their jobs" have helped bring us to the present crisis, while I believe a society of entrepreneurs and entrepreneurship might be more resistant to these kinds of reactionary appeals.I don't think everyone should be an entrepreneur, but I do think more people should be entrepreneurs than currently are, and that situation is made worse by the ways we talk about work. When someone is laid off, we have programs to retrain her for a new job, but no programs to retrain her to run her own business, let alone provide startup capital. You can get trade adjustment assistance to go back to school, but not to create your own job.That's why I'm introducing this periodic feature, which I'm calling "Free Business Idea." I have 2-3 ideas for new businesses each week (sometimes each day!), but I already like what I'm doing, and am not too interested in starting a new business. If you don't like what you're doing, but don't have a business idea, feel free to take one of mine — they're free!

Mailstream: Your Home Away From Home

Moving is a pain in the ass. Moving overseas is even worse. Mailstream is the answer.If you've ever lived overseas, you probably know what I'm talking about. None of your banks, credit cards, or insurance companies will deliver to you overseas, so you need to find somebody stateside to have your mail delivered to, or risk missing something important. If you've got an accommodating parent or sibling, you might use their mailing address, and if you know something important is coming ask them to watch for it.But what if something important comes that you don't know to warn them about? A tax notice in a plain envelope, a replacement credit or debit card, a check from a class action settlement, a jury duty summons, the list is endless!And what if you don't have anyone whose address you can use? No parents, no siblings, no address at all in the United States?The solution is Mailstream: Your Home Away From Home.Mailstream is a physical address where all your mail is delivered, opened, scanned, and made available to you online within 2 business days of delivery. When you log onto Mailstream from anywhere in the world, you can view each piece of mail and decide whether to keep or toss each physical item (digital copies are stored indefinitely).Every 30 days, all the physical items you've decided to keep are packaged and sent to you anywhere in the world by your choice of carrier (availability depending on destination country). You can also request expedited shipment of any items that might be time-sensitive.Mailstream has a simple fee structure:

• a flat monthly fee (with a discount when you pay for a year in advance);
• a shipping and handling fee for your 30-day international shipment (waived if you decline to receive any physical mail during the 30-day period);
• and an express shipping and handling fee for any deliveries you request expedited.

Nuts and bolts

To implement this free business idea, you'll need a storefront address and a moderate amount of storage space. To start with you can probably handle all the work yourself and simply use a Dropbox account to upload and share each client's Mailstream, with subfolders clients can drag "keep" and "destroy" mail to.Once you have some more clients you might consider hiring someone to design an online interface for clients and an interface for you to use to easily sort physical and digital copies to make your life easier. You could even license the software to other Mailstreams for an additional source of revenue!Mailstream will be most appealing if you set it up in a state with no individual income tax: Alaska, Florida, Nevada, Texas, Washington, Wyoming, or South Dakota. That's because the federal government shares federal income tax data with the states, and your clients might be subject to state income tax liability if they use a Mailstream in a state that levies a tax on income.On the other hand, each state should have a Mailstream to help people maintain their state residency, and you'll have plenty of customers even in states that do levy income taxes: students, people on temporary assignments abroad, etc.You should consult a lawyer to draw up your user agreement so it covers a few key points:

• every single piece of mail has to be opened before being repackaged, so Mailstream doesn't find itself mailing contraband internationally. Mailstream won't mail any fruits, vegetables, organic matter, or pornography;
• Mailstream isn't liable for destroying anything the client accidentally elects to destroy instead of keep;
• if a client's payment is overdue their mail won't be opened and will be marked return to sender.

You can surely come up with a few more exigencies you'd want clients to agree to.

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.