You know how this logic goes: “There are two kinds of people in this world…those who eat rubber cement and those who don’t.”
It’s the sort of tautology we love so much we can’t help but emblazon it across bumper stickers and t-shirts.
We’re a brilliant bunch.
So brilliant, in fact, that an entire cottage industry of dim-witted, dime-store, Internet-special finance “literature” has risen up to sate our need for prima facie “help” with our finances. And we actually read it. And maybe even follow it.
It’s not the good kind of finance. It’s the bad kind.
I see the links with the catchy titles, and I click just like you do.
I read the drivel. I shake my head. I wonder what in the F is going on. I refrain from flinging my laptop at the plate glass window across the room.
I’m glad those sorts of “resources” weren’t around during my formative years of financial planning. Or maybe they were and I just missed them.
Because here’s the real kicker: Some of the most damaging, utterly nuketastic advice/commentary out there sounds compelling at first blush.
It sounds kinda right. It makes me think… Is there a hole in my brain that caused me to miss this for so long? And then, a moment later, I wonder: What would I think of this if I didn’t actually know better?
So maybe, just maybe, we’ll see about making this sort of post a recurring trip. One where yours truly takes some of the rankest discharge from net-only “finance” and “economics” advice columns and invites them into the arena for a quick and dirty heel stomp to the face.
Now, before we get going here, let me add one thing. Not all financial commentary on the web is garbage. Some of it is brilliant. Some of it is altruistic, life-changing, world-enhancing econ gospel. And, really, that’s what makes separating wheat and chaff in this space so difficult sometimes: Some of the really good stuff – that econ gospel – sounds a lot like the bad stuff. But the difference is in the details.
Without further delay, here are two glistening piles of steamy slop guaranteed to not make you a millionaire. And how to fix their problems using real economics.
Bad: Invest Regularly, No Matter How Small the Sums
You’ve probably heard of this latte factor thing. The basic headline was this: If you invest the few bucks you would otherwise spend on a latte each day, you’ll be a millionaire in 30 years. Actually, according to the grand progenitor of el factor, you’d have something more like $2 million by retirement age.
Trouble lurks in the durn’d details, though.
The “factor” 1) used super aggressive estimates for what lattes actually cost, 2) assumed way-above-average annual market returns in stocks, 3) ignored taxes, 4) ignored fees, 5) ignored inflation, and 6) pretty much threw down a hailstorm of crap into peoples’ heads.
When corrected for at least some of its various computational lunacy, the latte factor would net someone more like $50k to $300k over 30 years of investing. Or around 2.5% to 15% of its promised figure.
If you happen to be one of those people who’s satisfied when you receive 2.5% of what you were promised, then you ought to stop reading right now and put in an application to serve as the next Dalai Lama. If you tend to wonder where the other 97.5% of what you were promised has gone, you may continue reading. (“There are two types of people in this world…those who prefer 2.5% and those who don’t.”)
The following table summarizes about the best you could do with the latte thing – a tad under $300k in total nut size, which still assumes zero taxes, zero transaction fees, Beverly Hills-priced coffee and investing your saved dollars all at the beginning of each year (i.e., every latte gets an entire year’s worth of return during the first year). As in, it’s still super-inflated lunacy.
But this isn’t about the latte factor. This is about what we can politely term “drivel runoff.” This is about rubbish-squared.
This is about an article ostensibly describing the power of this very-small-sum-investing idea. It built upon the soggy foundation of the latte factor. And actually managed to make it worse.
Here’s how. Instead of advocating that savers accumulate a relatively large sum, at least a monthly value of around $150 or so (like the latte factor does), before buying into the market, this super-special article proposed that investors buy in weekly, with $25 or so each go.
Okay, so your money gets into the market a bit faster, which is a good thing…
But the trouble is those pesky transactions fees that even the most discounted online brokerages charge. Let’s say you get a blue-light special on your brokerage fees each time you buy and pay only $5 a pop, which, according to NerdWallet, is about as low as small-scale investors can go. Right off the top, every single time you buy your weekly ETF or whatever, you’re losing 25%.
Around $7 to $9 per transaction is a more common commission rate. At those figures, you’re losing 28% to 36% before even going live.
At the end of a year, instead of having $1,300 of invested principal, you’d have only $832 to $975 in principal and a total result of around $900 to $1,060 (assuming an 8.4% average return and ignoring any effects of dollar-cost-averaging). Which would make investing in your mattress a much better option.
Your total returns would be a nosebleed -30% (or worse).
When the markets swoon by 30%, people jump from bridges and balconies. And so, to be fair, FL’s kicking this steaming mound of “help” out of the ring into the black abyss.
But for the love of all that’s green, you can abso-effing-lutely not ignore transaction fees. They’ll kill your returns if you’re not careful. Transaction fees are a leading reason why day traders and other “active” investor types lose out to the passive indexed gains in the market.
Before getting to my proposed rule-of-thumb for determining appropriate transactions fees, I’ll mention there are some places where you can execute trades at a cost lower than $5, but most impose minimum balances or other financial hurdles. My BofA/Merrill brokerage account, for instance, charges me $0 per trade for up to 100 trades a month, but only because my balance is over their $100k threshold for white glove treatment; at lower balances, commission charges are at least $5. So, for purposes of the rest of this discussion, I’ll assume that you can’t avoid transaction costs when buying and selling stocks. If you can, go ahead and buy stocks as often as you want.
Good: Invest Like A Genius (And Maximize Your Total Returns)
Okay, onward and upward: What does real, actual, reasoned economics and finance, math and science tell us about transaction fees? Quite a lot, it turns out.
Here’s how we’ll organize the discussion. We’ll ask two questions that are almost certainly rattling around in your cabesa right now. And then we’ll answer them with the stuff that’s rattling around in mine.
First, what’s the FL-Approved approach to determining an appropriate transaction fee rate?
And, by extension, how much do you need for each equities purchase to invest like a genius?
So glad you asked. Roughly 3%. And at least $167.
That is, as a rough guideline, your transaction cost for purchasing equities should be a maximum of 3% of the initial invested sum.
And, assuming a $5 transaction cost, you should invest in increments of no less than $167. If your commission rates are higher, say $7 or $9, you’d want to invest in increments of at least $233 or $300, respectively.
The reasoning here is simple. A few predicates:
You should (almost) never hold equities for less than 1 year. Doing so makes you a deadbeat trader rather than a Luchadorian investor. And it opens you up to a mountain of incremental taxes. So, for purposes of this discussion, we’ll assume you hold your stocks at least 1 year.
For most investors, dividends and long-term capital gains are taxed at 15%. (Yes, you only incur cap gains taxes upon a sale, while divvies get taxed all along. But, for purposes of roughing out our 3% Rule, this issue is immaterial.)
The average annual long-run geometric real return to U.S. stocks is about 8.4%.
If we begin with $100 and assume the investment is held for a year before being sold, we end up determining that anything above a 3% transaction fee rate will, on average, leave us with a negative return on our investment. Which is just bad business.
Here is a rundown of the calculation.
Begin with $100 and immediately deduct $3 for a 3% transaction cost. Our initial principal goes to $97.
Adding 8.4% to that principal leaves us with about $105.15 after one year.
We owe 15% taxes on the $5.15 in gains and divvies, or about $1.22.
Our net value after one year is thus $103.93.
So, if we sell after a year and a day and incur another 3% transaction charge, we’re left with $100.80 in real value. That provides a small gain, to be sure. But not a loss.
Hence one derivation of our 3% Rule: Anything more than 3% of transactions fees for an equities purchase or sale is best avoided. Always shoot for less than 3%.
Yes, by the above reasoning you notice that, if your holding period is longer than 1 year, you can afford higher commission rates. Which is true.
But you’d only want to invest in smaller increments (i.e., go with a higher commission rate) if you’re going to be compensated with higher returns as a result. You get higher total returns by being in the market earlier. So, we can incorporate “opportunity cost” into the analysis for another derivation of our 3% Rule.
When we do, we take into direct account the opportunity cost of delaying equities purchases. That is, we consider the forgone gains from market exposure “lost” as a result of delaying purchase in order to accumulate greater principal. Conclusion: For most people most of the time, if your transaction fee is 3% or less, you should invest right away; if it’s more, you should delay until added principal drives it down to 3%. I wrote the logic all out and then, like a thousand words later, decided it wasn’t worth belaboring the point. It’s kinda math-y and doesn’t really change the conclusion that our 3% Rule works for most people most of the time.
Here’s the summary: If your investable sum implies you’ll pay a commission rate over 3%, you are more likely to obtain a better overall rate of return by delaying investment until you have accumulated more principal to drive your commission rate down to 3% or less. That is, the “savings” accrued by accumulating greater principal (and thus driving down the commission rate) will usually more than compensate you for the forgone gains in the market. Below 3%, you’re probably better off getting into the market.
Because of the math-y-ness and the ability to more or less summarize in a single paragraph (above), I nixed to more formal discussion. (Disclosure: There are lots of (reasonable) assumptions built into this 3% Rule idea. Quants will find exceptions. Which is why I say it’s a good guideline for most people most of the time.)
Moving on to the next steamy pile…
Bad: An Optimally Allocated Portfolio Means You Don’t Feel Market Fluctuations
Ok, so we got pretty heated beating the bejeezus out of that latte-factor-no-whip-double-stupid-flop-sweat idea and its little sidekick.
We’ll use round 2 as an opportunity to cool down.
This second piece of flotsam comes at us from a 20-something financial advice column directed at young investors working (I’d guess very slowly) toward seven-figurehood.
The summary headline of this piece of financial proclamation runs as follows: When the stock market takes a dive, if you’re properly allocated, you don’t see the downturn in your accounts.
Now, for an octogenarian or someone who hates building long-term wealth, this is approximately correct. For a 20-something worker drone with no imminent plans to cut the paycheck cord and who’d like to retire sometime this millennium, this is as bad as drinking Dran-O for constipation.
Why? If you’re not seeing market downturns, bros and babes, then you’re not seeing market upswings, either.
This is a certain truth: there ain’t no free rides on the market express.
As a practical matter, for virtually all 20-somethings, seeing no movement in your portfolio during market downturns means you’re terribly allocated. You don’t have anything close to enough stocks in your tiny nut.
Good: Invest Like A Luchador (And Maximize Your Nut Size)
It’s been said, and I agree, that the best thing for a young investor is a long and savage bear market until just before retirement. This makes your new investment dollars go farther. It makes each dividend payment worth more. It keeps you financially disciplined as time passes because you’re not softened up by the mirage of wealth.
If you’re a 20-something investor, you should want to feel market volatility more than a grizzly feels a porcupine mid-bite. Downturns should get vicious and dirty and nasty all over your portfolio like it’s some backwoods outhouse that even Sasquatch wouldn’t brave.
You’re by default allocated much too heavily into slow-growth vehicles like cash and bonds and houses and gold. Which will help you get “rich” just in time to pay for a pair of new titanium knees and a heart transplant.
Outta the ring, Miss Allocation.
The right way to allocate for young investors? In an upcoming post I’ll outline my formula for optimal allocation for all types of Luchadorian investors. For now, though, here’s what we know:
A bit of real estate provides good utility, tax benefits for high earners and a diversification benefit to a stock-heavy portfolio. But young investors are likely to have too much exposure to real estate. It’s not a strong grower over the long term and it can be a drag on “labor mobility” or your ability to move for a better job, a particularly important consideration for youngsters.
Government bonds are lethal, with low yields and high prices. Select fixed income from corporate bonds (or, for high earners, municipals) can be useful as a small component of the portfolio.
Some cash kept on-hand for emergencies, opportunistic rebalancing and “special situations” is useful for young investors. Cash holdings shouldn’t be much more than a “safety net” figure, and cash shouldn’t be held in deadly CDs or no-yield checking accounts; opt for high-yield online savings accounts instead.
As a general guideline, if you’re a young investor, you should have at least 75% of your investable assets in equities.
Why do I stoop, you ask, to heel stomp bad finance advice stupidity into oblivion?
Shouldn’t I stick with novel concepts and high-value analysis for the discerning and top-drawer readership attracted to posts that use terms like “flop-sweat”? Do I really need to scrape the underbelly of the web to find bad financial analysis in order to talk about good economics?
I do this because it’s so easy to be seduced by sound bites like: “become a millionaire by ditching coffee” or “my portfolio doesn’t ever lose value.”
They’re attractive from about 50 feet away. But get close and – whoa – it’s worse than trying to look at Jean Pierre-Paul’s fireworks hand without feeling sick.
I do this because finance and economics are shrouded in a kind of fear-based exile from most peoples’ everyday lives. So when they see something that, on its face, makes sense or gives a simple answer to a thorny problem, they go with it. They don’t tend to get into the details. And they get burned by the silly advice.
I do this because I believe that, if the level of financial fluency goes up, we all become much better off – me included. In that sense, I do this out of personal self-interest. Your healthy, wealthy, life-awesome future helps me almost as much as it helps you. Plus it’s fun.
Luchadores, what’s your favorite wrong-headed but popular financial advice?
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