Chris's Thoughts on Money
I find benefit in
telling people what I think, so this material is up purely for my
own selfish reasons. Enjoy (or not : ).
Saturday, May 1, 2004
I'm a huge fan of talking to kids about money (actually,
I'll talk an adult's ears off about money, too, if given half a chance
-- I once lectured Matt
Pietrek and his girlfriend on the topic for an hour over pancakes
[sorry, guys...]). When I was growing up, the training I got in school
about money management has how to write a check, i.e. how to be a good
little consumer. I also learned the basics of compound interest, but not
as related to anything real, e.g. buying a house or saving for
retirement. Most of what I didn't learn in school, I also didn't learn
from my parents because one of them (who managed to buy high and sell
low during the recent market correction) isn't any good at money
management and the other was very private about such things (although
has been opening up on this topic recently).
Me, I go the other way. While they know not to talk about it outside
of our immediate family, my kids know how much my wife and I make, how
much we spend month to month, how we're saving for their college
education, how we're saving for retirement, the investment property I've
purchased with my money-savvy brother-in-law (whose parents also refused
to talk money with him), etc. The Sells brothers have their own
allowance that goes up annually on their hire date aka their birthday. I
act as their bank, keeping track of their income and expenses in an
Excel spreadsheet as they deposit and withdraw money, limiting them to a
single week's "advance" on their allowance (giving them the choice of
spending what they've got now vs. saving for what they want in the
future). In the future, I plan on letting them maintain their own
balance sheet (subject to random audit), like my Mom let me maintain
mine on a paper check register (I guess I did learn a little something
from my parents -- come to think of it, the way I award allowance is
just like my Mom, too -- way to go, Mom! : ).
Anyway, as open as I am about our money and as much as I bring it up with
them in an attempt to stamp the consumer culture out of my children
before it takes hold, there are still more things to be done, as I
learned this morning on
"the mint," a web
site dedicated to what kids should know about money and how teachers and
parents can help. Check it out.
BTW, I've recently come to the conclusion that a parent paying for
their child's college education is a sucker's game, as it drains much
needed funds out of the parent's own investments when it should be
enjoying the magic of compound interest. Instead, grandparents should
pay for college, letting each generation have another 20-30 years of
compound interest before skimming off the top for college. The problem
with this, of course, is that it requires one generation to pay for both
their kids and their grandkids to shift into this new thinking
(assuming, of course, that the parents can pay for their kid's college
at all, which isn't a given with our current consumer-oriented society).
I plan on being that bridge in my family, i.e. I plan to pay for my
kids' and my grandkids' college education. I also plan to have myself
cryogenically frozen, putting half of my money into a trust for myself
when I'm rejuvenated, leaving the other half for my wife. Neither of
these has anything to do with this subject, but I thought I'd stick them
on the end here anyway. : )
Discuss
Sunday, June 29, 2003
Chris's Notes on
Stock Options For Dummies, Alan R. Simon, Wiley Publishing, Inc., 2001.
I recommend this book for folks that need to know the details of their
company's stock options, although the details aren't interesting enough
or important enough to warrant a book of this size, especially given how
worthless most company's stock options are these days.
I bought this book when I was too stupid to recognize it as a book
about a company's stock options instead of about publicly traded
options. In general, the strategy that I've developed if I ever get the
opportunity to exercise company stock options is as follows:
- Exercise stock options as soon as possible, paying taxes as
appropriate
- Hold stocks for at least one year to reduce taxes on gains from
normal income tax rates, e.g. ~30%, to the long-term capital gain
tax rate, 15%, using 0 as the basis and subtracting the taxes
already paid in step 1
Doesn't seem like enough for an entire book...
Sunday, June 29, 2003
Chris's Notes on
The Instant Millionaire: A Tale of Wisdom and Wealth, Mark Fisher, New
World Library, 1991. I recommend this book for folks that are
willing to believe that the act of willing something to happen hard
enough will make it happen.
On the one hand, I've solved many an engineering problem by simply
letting my subconscious know that it needed solving. On the other hand,
I've never been able to successfully wish for something to happen. The
question is whether you view this book as channeling your subconscious
energies into finding ways of making your dreams of financial
independence come true or whether you view it as a fairy tale.
Sunday, June 29, 2003
Chris's Notes on
All the Math You Need to Get Rich: Thinking with Numbers for Financial
Success, Robert L. Hershey, Open Court Pub Co, 2001. I recommend
this book for the basics it covers, the slim size, the exercises and the
approachable text.
I graduated from high school with all kinds of wonderful math grades
(I finished all of my high school math a year early and had to attend a
calculus course at a nearby college in my senior year), but managed to
get out without a firm grasp of some simple ideas. Specifically, I never
learned why it is that when I make a fixed house payment, the actual
amount that goes to the interest and to the principle varies each month.
The reason this is (as I'm sure all of my readers already know) is
because the interest is only paid against the outstanding principle that
remains on the total loan each month. It's just like compound interest
in reverse (an idea that I always did understand).
I haven't been reading this book cover to cover (I already know how
fractions, scientific notation and fractions work), but this one fact
alone makes this book worth the price. Plus, it makes a wonderful
reference (this is where I got F=P(1+R)^N used in
The "Average Return" Myth). The
world needs more short, focused, well-written books.
Sunday, June 29, 2003
Chris's Notes on
The Motley Fool Investment Guide: How The Fool Beats Wall Streets Wise
Men And How You Can Too, David Gardner, Tom Gardner, Fireside, 1997.
I don't recommend this book for anything but an example of the hubris
that was rampant during the Internet bubble and a few chapters that hold
the reader's hand making the markets seem approachable.
In general, I recommend
Peter Lynch's Learn to Earn for the hand holding instead.
Sunday, June 29, 2003
Let's say that you have $1000 to invest. The first year, you invest
it and get a 25% return, so you leave your money invested. The next
year, the market doesn't do as well and your return is -15%. What's the
average rate of return over the two years? You way think that it's 5%,
that is, (25% + (-15%))/2. Let's do the math for 25% and -15%:
- Using simple interest, after 1 year, $1000 + $1000 * 25% = $1250
- After 2 years, $1250 + $1250 * -15% = $1062.50
Here we're using Interest = Principle * Rate * Time calculation for
yearly aka simple interest (I = PRT and Time is 1 year). Taking the
numbers the other way, i.e. -15% the first year and 25% the next year,
yields the same result:
- After 1 year, $1000 + $1000 * -15% = $850
- After 2 years, $850 + $850 * 25% = $1062.50
In fact, the result is the same no matter in which order that the
rates come or how many there are:
Table 1: From Good to Bad
|
year |
return |
total |
|
0 |
0 |
$1,000.00 |
|
1 |
25% |
$1,250.00 |
|
2 |
15% |
$1,437.50 |
|
3 |
5% |
$1,509.38 |
|
4 |
-5% |
$1,433.91 |
|
5 |
-15% |
$1,218.82 |
Table 2: Starting Bad to Good
|
year |
return |
total |
|
0 |
0 |
$1,000.00 |
|
1 |
-15% |
$ 850.00 |
|
2 |
-5% |
$ 807.50 |
|
3 |
5% |
$ 847.88 |
|
4 |
15% |
$ 975.06 |
|
5 |
25% |
$1,218.82 |
Table 3: A Mixed Bag
|
year |
return |
total |
|
0 |
0 |
$1,000.00 |
|
1 |
25% |
$1,250.00 |
|
2 |
-15% |
$1,062.50 |
|
3 |
5% |
$1,115.63 |
|
4 |
15% |
$1,282.97 |
|
5 |
-5% |
$1,218.82 |
This result surprised me. I found it unintuitive that no matter how
the rates vary over time, it doesn't matter if they come first, last or
in between. I expected large losses up front to swamp later gains or
early gains to make up for late losses, but the change of the underlying
principle amount evens things out, e.g. a smaller percentage drop later
is against a larger principle if there have been early gains.
When you figure it as a single formula, Future Value = Principle *
(1+Rate1) * (1+Rate2) * (1+Rate3) * (1+Rate4) * (1+Rate5) or F =
P*(1+R1)*(1+R2)*(1+R3)*(1+R4)*(1+R5), the independence of the order
makes more sense, since multiplication is commutative, i.e. it doesn't
matter in what order you do it:
f = p* (1+r1)* (1+r2)* (1+r3)*(1+r4)* (1+r5)
f = $1000*(1+25%)*(1+15%)*(1+5%)*(1-5%)* (1-15%) = $1218.82
f = $1000*(1-15%)*(1-5%)* (1+5%)*(1+15%)*(1+25%) = $1218.82
f = $1000*(1+25%)*(1-15%)*(1+5%)*(1+15%)*(1-5%) = $1218.82
Having varied rates like in Tables 1-3 in a stock or stock mutual
fund investment isn't uncommon (as we've just seen during and after the
Internet bubble). On the other hand, if you compare this a fixed yield
(like a bond) with our "average rate of return" of 5%, you'll see a
different result:
Table 4: Small But Fixed Rate of Return
|
year |
return |
total |
|
0 |
0 |
$1,000.00 |
|
1 |
5% |
$1,050.00 |
|
2 |
5% |
$1,102.50 |
|
3 |
5% |
$1,157.63 |
|
4 |
5% |
$1,215.51 |
|
5 |
5% |
$1,276.28 |
With a fixed interest rate, we can simply our calculations somewhat
using Future value = Principle * (1 + Rate)^Number of compounds. So,
$1000 at 5% for 5 years is:
f = p*(1+r)^n
f = $1000 * (1 + 5%)^5
f = $1000 * (1.05)^5
f = $1276.28
Any way you calculate it, not only does the boring, fixed interest
rate bond out-perform the variable rate even for the same average rate
of return, but clearly our average rate of return calculation isn't very
useful. We're not really getting 5% year to year on our varied stock
rates of return, or they'd show the same results as the bond. Instead,
if you reverse the formula for Rate, we get:
r = (f/p)^(1/n) - 1
r = ($1218.82/$1000)^(1/5) -1
r = 1.21882^(1/5) -1
r = 4.037%
This gives us a annualized rate of return:
Table 5: Annualized Rate of Return
|
year |
return |
total |
|
0 |
0 |
$1,000.00 |
|
1 |
4.037% |
$1,040.37 |
|
2 |
4.037% |
$1,082.37 |
|
3 |
4.037% |
$1,126.07 |
|
4 |
4.037% |
$1,171.52 |
|
5 |
4.037% |
$1,218.82 |
Taking this further, because the future value of an investment is the
same whether you consider a fixed rate of return or a variable rate of
return, for any principle, you can calculate the fixed rate of return by
deriving from this formula (assuming r0 is the fixed rate of return and
r1-r5 are the variable rates of return):
p*(1+r0)^n = p*(1+r1)*(1+r2)*(1+r3)*(1+r4)*(1+r5)
Further, because principle plays the same role on each side of the
equation, you can remove it:
(1+r0)^n = (1+r1)*(1+r2)*(1+r3)*(1+r4)*(1+r5)
Solving for the annualized rate of return from the variable rates of
return gives you this:
r0 = ((1+r1)*(1+r2)*(1+r3)*(1+r4)*(1+r5))^(1/n) - 1
Applying it in our example:
r0 = ((1+25%)*(1+15%)*(1+5%)*(1-5%)*(1-15%))^(1/5) - 1
r0 = (1.25*1.15*1.05*0.95*0.85)^(1/5) - 1
r0 = 4.037%
So what happens when we increase the variability, but leave the
average
rate of return the same? The variability adjusted return gets smaller:
Table 6: Extended Variability
|
year |
return |
total |
|
0 |
0% |
$1,000.00 |
|
1 |
25% |
$1,250.00 |
|
2 |
-15% |
$1,062.50 |
|
3 |
5% |
$1,115.63 |
|
4 |
15% |
$1,282.97 |
|
5 |
-5% |
$1,218.82 |
|
6 |
5% |
$1,279.76 |
|
7 |
-25% |
$ 959.82 |
|
8 |
40% |
$1,343.75 |
|
9 |
-30% |
$ 940.62 |
|
10 |
35% |
$1,269.84 |
Notice that we're still got an average rate of return of 5%,
but increasing the variability gives us an annualized rate of return of
2.42%.
On the other hand, extending the same average without
increasing the variability looks like this:
Table 7: Extended Time, Variability Unchanged
|
year |
return |
total |
|
0 |
0% |
$1,000.00 |
|
1 |
25% |
$1,250.00 |
|
2 |
-15% |
$1,062.50 |
|
3 |
5% |
$1,115.63 |
|
4 |
15% |
$1,282.97 |
|
5 |
-5% |
$1,218.82 |
|
6 |
25% |
$1,523.53 |
|
7 |
-15% |
$1,295.00 |
|
8 |
5% |
$1,359.75 |
|
9 |
15% |
$1,563.71 |
|
10 |
-5% |
$1,485.52 |
In this case, when the variability remains unchanged, the annualized rate of return remains unchanged at 4.037%. In other words, as
the variability increases, the annualized rate of return gets further
away and lower than the simple average rate. On the
other hand, as the variability decreases, the annualized rate
approaches the maximum value of a fixed rate of return, i.e. zero
variability.
So, while it's comforting that so long as your investment doesn't go
to zero, it doesn't matter when the highs and lows come, it's somewhat
unintuitive that the average rate of return is not what you want to use
to calculate the rate of return that you're actually getting. In fact, the
annualized rate of return will always
be lower than the average rate as variability increases.
Sunday, June 22, 2003
In general, I suspect all members of the financial education market,
from authors to radio talk show hosts and everyone in between. When I
obtain financial independence, I don't plan on teaching anyone but my
own friends and family. Why would anyone do otherwise except to fleece
the public?
And then, having said that, I realize that every single book I've
written, I wrote because I had a burning story to tell; I couldn't not
write it. My motivation to write novels is grounded in my need to take
my writing into a completely different direction w/o the requirement of
generating an income stream. So it's likely that at least *some* of the
folks in the financial education market are in it for love, but how can
you tell which ones?
Further, it's not generally true that "them that know, don't
tell."
I know that I know how to write real software and how the technologies
that form the topics of my writings and teachings really work, so at the
very least, I'm the exception to that rule. However, there are an awful
lot of exceptions, like all of my friends in the Windows developer
education industry, so I reject the rule out of hand for at least a
significant percentage of participants in any given field of education
(certainly a significant percentage of them conform to the rule, of
course, and those are likely to out number the ones that are the
exception).
However, all of us in the Windows developer education industry make
our living on education, not on the technology itself. We've chosen
education because it's more lucrative then being a practitioner. (This
may help explain why elementary school teachers choose their field: can you
think of a place that they can make more money on basic readin', 'ritin'
and 'rithmatic than as a teacher?)
So, if it's the case that education is more lucrative than practice,
why should I buy someone's financial book, since they've obviously
decided that selling me a book is more profitable than practicing what
they're preaching. Further, the real-time markets have the built-in
handicap that when a technique for really making money is widely put
into use, the market adjusts for it, bringing the returns for that
technique back in line with the market as a whole. If I discovered a new
way to make real money, publishing how it works is the last thing that I
want to do. Definitely, those kinds of books, like The Motley Fool's
Investment Guide, are not what I want to put my trust into.
Things I find I can trust more are books that inspire me, like Rich
Dad, Poor Dad, or change the way I look at things, like Fooled by
Randomness, or help me to establish a foundation of knowledge, like
Investing for Dummies or Learn to Earn. These are books that don't
promise to make me rich (except the Rich Dad, Poor Dad books, but I've
learned to discount that promise : ), but that help me align my brain
cells so that I can take control of my own financial health.
So, all of this boils down to "Be a skeptic" from the Epilogue to
Effective COM, furthering my belief that the ability to learn how
one system works, e.g. COM, can be effectively translated into learning
how another system works, e.g. investing. And so what's my motivation
for this writing and others like it? It's purely selfish, I assure you.
Writing something clarifies my thinking and posting it gets me access
to, and feedback from, like-minded folks that can help clarify my
thinking even more.
Sunday, June 22, 2003
Chris's Notes on
Cashflow Quadrant: Rich Dad's Guide to Financial Freedom, Robert T. Kiyosaki and Sharon L. Lechter, Warner Books, April, 2000. I
recommend this book for the way it twisted my head around.
There aren't any "how to" details in this book, but it still had some
pretty valuable ideas in it that really changed my thinking and inspired
me about what's possible:
- There are four main ways to make money: as an employee, being
self-employed, running a business and investing.
- Our society has trained the middle and lower classes that
success looks like getting a good job and being a good little
consumer. I'd long recognized the cycle of get into college->get a
good job->save for your kids' college education->they do it all over
again for their kids, but I didn't know what alternative I had.
- The alternatives, according to this book, are running a business
and/or investing. Specifically, this book really pushed running a
business to fund investments, mostly for the tax benefits. My own
thoughts are that having a business to fund investments is the
absolute right thing to do. However, having a business that
generates extra money to invest is easier said than done. If that's
your plan, you should go away and do that first, then figure out the
investing thing later in your leisure by the pool.
- Folks that run their own business or invest have a reasonable
chance for financial independence, whereas employees and the
self-employed do not.
- Financial independence has a specific definition: having more
passive monthly income than your monthly expenses. Only when's it's
passive income, i.e. you don't have to do the work to generate the
income, do your finances allow you to pursue whatever activities you
want, regardless of their income generating abilities, e.g. write a
novel or home school your kids.
In general, I really like the way that Kiyosaki writes, although it's
very marketing-style, so it turns me on and off at the same time. What I
like is that he writes in a very personal way, talking about his two
fathers, one trapped in the rat race like most of us and the other who'd
learned how to become financially independent. He uses examples of his
fathers' behavior to illustrate his points and talks a lot about how be
changed his own thinking to break himself out of the cycle.
On the other hand, it seems like his major business is selling
financial education-related materials to fuel his own wealth, so right
away you have to suspect his motives. Also, his books are light on
details, although he's happy to use them to point you at other produces
that he or his partners have produced for more information. That's not a
business model that respects the needs or intelligence of his audience.
Still, if you ignore that and look for the ideas, I find his writing
useful.