Pondering Money

While reading Large Amounts Matter Too a quote from JD really got me thinking: “You rarely make financial decisions involving tens (or hundreds) of thousands of dollars.”    I agree people generally don’t spend huge amounts every day, but are the big opportunities really that rare?How many opportunities don’t we recognize?  Or just barely miss?  How many start small but turn into big wins over time?  Finally how many big wins are really summations of many small actions?

Unrecognized Opportunities

How can you take advantage of a big win unless you recognize it?  I’m very guilty of missing big opportunities.  I’m sure I missed at several million dollar opportunities.  I used the Mosaic Browser in ‘92 and I recognized that it was revolutionary compared with text based Gopher clients… but I didn’t recognize that the company to commercialize it would make a fortune and try to get in early with Netscape.. or even try to get some Netscape stock.

Missed Opportunities

I was at Stanford for most of the 1990es, ground zero for a lot of internet startups.  I knew people in the CS PhD program too.  Did I miss some chance encounter that would have put me as an early employee of either Yahoo or Google?  I wonder how many big opportunities we all just barely miss?

Small Seeming Big Wins

Some big wins seem are very small in the short term, but it the long term become huge.

• Choosing to Invest Early - When you choose to start investing early it may not feel like a big win, but consider if you invest $1 for forty years it becomes:
  • $21.72 @ 8% interest
  • $31.41 @ 9% interest
  • $45.26 @ 10% interest
• Investing with Index Funds - Saving a few percent in fees doesn’t seem like a big deal… unless you understand that interest rates really matter, and a 0.75% difference in fees could cost you over a quarter million dollars!  You also won’t waste time trying to outperform the market, especially if you don’t have the half million dollars to make it worth your time… even if you are the next Warren Buffett!
• Diversification - Instead of chasing after the latest hot sector you can own them all and let rebalancing automate buying low and selling high.

Big Wins that Require Small StepsSome big wins are really the result of a multitude of small steps.

• Investing - Most people save a bit at a time, small steps but those steps can lead to financial freedom over time.
• Successful Marriage - The I Do is just the start!  It takes a lot of small (and some large) efforts to really make a marriage work.  That has to be one of the biggest wins in terms of both happiness and finances.
• Practice - To be a master at anything takes years of practice- and those individual practice sessions are small actions with small effect but the sum is an incredible win.

Maybe the big wins aren’t really that rare, we just have to be more aware so we don’t miss all of them.  What do you think?

Dave Ramsey advises people to not contribute to retirement accounts while repaying credit card debt.  This advise seems sound because credit cards charge high interest rates and your investments may not make 10 or 20%.  But is this idea still correct when there is a company match, after all an immediate 50% or 100% return is pretty hard to pass up?

Your Choices

To simplify a bit I want to look at two choices: You could put $1000 dollars in 401K with a 50% match or you could take the $1000 pay 25% in taxes and put the remaining $750 toward your credit card.  After your credit card is paid off you take the monthly payment and contribute that much to your 401K and getting the employer match and a tax deduction.  Because of the tax break you can afford to contribute 25% more without lowering your income.  After five years which option earns you more?

And the Winner is…

It depends on the interest rates, but here is a graph that simplifies a lot of complex math:

It turns out that the expected interest rate on the credit card has to be a few percent higher than the expected interest rate from the 401K.    I tabulate the numbers below, an example if you expect to get a 6% return on your 401K investment then you should pay off a credit card that is 8.72% or higher.

What about 100% Match or 0% Match?

The results are the same- I was actually a bit surprised but the match % cancels out of the calculations.  The above chart does not depend on how much your employer matches- or if they match at all!

The Math

For anyone interested, I can send you a spread sheet with the calculations.  It’s a bit of a mess because the solution can’t be solved algebraically.  You make an initial guess and do repeated iterations that get an ever improving result.

Buying a stock on a hot tip is exciting, but it can be very expensive excitement don’t make the same kind of mistake I did…

Turning Back the Clock

In 2000 I sadly followed a hot tip and bought 15 shares of Sycamore Systems for about $1000. Pure speculation and not very wise on my part I was caught up in the irrational exuberance of the Internet bubble. It was pretty exciting, especially when the stock more than doubled!

What goes up…

The internet bubble popped sending stock prices through the floor. As it plunged I could have at least my original investment back… but I hung on, and on, and on… Hindsight is 20/20, so I know I should have sold, but who knew at the time that it really was the end of the bubble? Today, it’s a stock I’m likely to never sell. Don’t misunderstand, it isn’t that that it’s a wonderful investment. It’s that it is worth so little now (~$42.30) that it is worth more as a reminder to NEVER again buy a stock on a hot tip!

A Saner Alternative

What if instead I had bought $1000 of the S&P 500? Today it wold still be worth $760. Yes, that seems like a pretty big loss but when you include nine years of dividends I would actually be pretty close to break even… That’s even after buying at a truly terrible time to buy stocks!

Don’t Try This at Home

Being older and wiser, I’m not planning on repeating this folly. I’ve realized that I don’t need to get 100% yearly returns to reach my goals.   Slow and steady is far more likely to get me there- even if it is boring!  Please take my advise- forget the hot stock tips, buy low cost index funds and reap the rewards of owning a piece of capitalism.  The alternative is that you have your own $1000 reminder.

Even if you are the next Warren Buffett unless you have about half a million dollars you are still better off investing in index funds.  How could it be that the worlds greatest investor should still buy index funds?  Picking an index takes almost no effort and thus virtually no time, while finding superior stocks is a LOT of work!

Just Supporting Yourself is Costly

Let’s pretend that you are just as good as Warren at picking stocks.  But don’t fool yourself it will be a full time job for you- he didn’t become a billionaire by lounging around!  Since finding superior stocks will take all your time it must provide all of your income.  According to Berkshire Hathaway’s 2008 annual letter to the stock holders, their average compound annual gains are 20.3% which beat the S&P500 index by an impressive 11.4%.  If you can’t pay your salary from that 11.4% premium you would be better off with some other job and investing in a S&P500 index fund.   How much money do you need to invest to make it worthwhile?   Let’s just assume you are so good that you can do everything all on your own- no research staff, no special software, no special databases, just your time.  If your salary is $57,000/year, then you need $500,000 to invest to pay yourself and still match the returns of the S&P500!   Of course if you are that good at picking stocks you then go work for a mutual fund company earn a lot more than $57,000/year and invest in your own fund!

What About Dumb Luck?

I’m sure that someone reading this post will say- I didn’t need any work I picked stock XYZ and make an outrageous amount… That’s called luck, I’m happy for you but do you really think you are going to be lucky each and every year for thirty years?  If you really are that lucky forget the stock market- go to Vegas and win your fortune in a weekend it will be a lot more fun!

Reality Check

In reality we are almost certainly far less skilled than Warren Buffett, we don’t have millions to invest, we aren’t incredibly lucky, and we have far less resources than a mutual fund manager and the majority of actively managed mutual funds fail to beat the market.    Doe you still think it makes sense to try picking individual stocks?