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Tycoons, taxes, and the time-value-of-money

It is in your interest to pay the IRS as little as possible, as late as possible, while still avoiding penalties for underpayment -- unless you enjoy loaning Uncle Sam money for free.

The overenthusiastic taxpayer might decide to have his or her employer withhold nothing from his/her paycheck, and then make a big tax payment on April 15th. Unfortunately, the IRS is on to you – it penalizes taxpayers who paid too little in taxes over the course of the year. In fact, very roughly speaking, the IRS cares whether you've paid enough tax on a quarterly basis to cover your income that quarter.

However, the IRS has created various safe harbor provisions, under which one pays no penalty at all, so long as one has withheld some minimum amount of taxes over the course of the year.

Making use of these provisions is an additional, and entirely distinct strategy from minimizing your actual total tax burden.

Optimize by satisfying one of the safe harbor criteria stated below – pick the option that generates the smallest tax payment, and you’ll be able to avoid any penalty:

Safe harbor 1:If you have remarkable foresight, and can thus predict what your total tax burden will be for this year, pay exactly 90% of that amount and no more.

Safe harbor 2:If your prior year adjusted gross income (AGI) was less than $150,000, pay your prior year tax amount.

Safe harbor 3:If your prior year adjusted gross income (AGI) was greater than $150,000, pay 110% of your prior year tax amount.

Enhancements to this strategy, rapidly increasing in impracticality:

Enhancement 1: W-2 withholding is automatically smoothed over the entire year and avoids the quarterly check mentioned above. Thus, one could satisfy one's safe harbor contribution amount by having nothing withheld from one's paycheck until the last possible few pay periods, then have massive amounts of money withheld -- and not have to pay a penalty for making uneven quarterly tax payments. N.B.: This was certainly true in 2003, and to the best of my knowledge, is still true today.

Enhancement 2: Safe harbor #2 creates some interesting, but not-very-real-world-ish opportunities, where you have your employer pay you very chunkily on an every-other-year basis – eg, pay you minimum wage in year 1, then huge gobs of money in year 2, and then minimum wage again in year 3, huge gobs in year 4, etc.

Obviously, some wild-assed assumptions need to be made -- for starters:

-assume that you have sufficient savings to not worry about lean years.

-assume that there’s no risk that your employer will go under, or cheat you.

-assume that your employer’s tax rate and investment options for excess cash are no worse than yours (or at least are sufficiently close to your own) – this assumption is primarily intended to offset for the fact that your employer wants to deduct your salary to reduce its taxes as soon as possible, and to deal with your delayed receipt of funds that you could have otherwise spent or reinvested in year 1.

Result:

Year 1: You owe virtually no tax

Year 2: During the year, you only pay what you owed in year 1. Then, on April 15^th of the next year, you pay the rest of your humongous tax burden. You got yourself a huge free loan from the IRS!

Year 3: You owe virtually no tax

…and so on

There’s a huge additional assumption embedded in this fanciful example – after all, we live in a world of graduated taxation. There’s a high opportunity cost to having chunky income.

In your years of famine, you lose the benefit of a lower marginal tax rate – that is, you could reduce your total taxes by getting paid more in a famine year, and reducing your income in a feast year. One needs to make a great deal of money, or have some really awesome investments, or else really excellent uses for that money to surmount this problem.

Enhancement 3:One more obviously win-win scenario (from a tax perspective) for the feast/famine strategy, is if the employee works for an offshore hedge fund/private equity fund, and gets paid mainly in deferred compensation (which, unless Representative Chuck Rangel has his way, grows tax-deferred until actually received). Deferred compensation in this context basically means that your money grows tax-free in the fund until actually doled out.

Ignore issues such as:

A.The downsides to having a huge chunk of your wealth effectively invested in your employer (a la Enron), so that your wealth and income end up highly correlated due to mutual dependency upon your employer’s financial health

B.Whether you work for Paulson Capital circa 2007, or Bear Stearns’ subprime hedge funds circa 2008 – that is, whether investing in your own fund is worth it.

C.Whether your personal discount rate is higher than tax-adjusted expected returns, and so on (basically, whether you’d rather have $1 to spend today, or have $1 + returns on your fund in the future)

One objection might be that this set of assumptions is self-contradictory -- a person with such a long view would probably prefer to defer as much compensation as possible for as long as possible, period – lots of famine years, followed by a single feast year.

However, if someone is willing to defer most of his or her compensation, but does want to make sizeable withdrawals from time to time, it may make sense to do so in off years.

Viewing certain educational loans as FICO boosters, and low fixed APR for life balance transfers (Edit: New Strategy)

EDIT: See below for additional strategy

Most people tend to approach student loans through two typical lenses -- insist on paying them off ASAP, because all debt is bad -- and ignoring them as much as possible, because they're just student loan payments.

Neither approach is particularly elegant or optimal; though the first approach likely helps you reach financial stability sooner and is safer. I thought I'd point out a few little-known quirks of student loans that provide even better optimization strategies.

Some caveats:
I assume the all loans under discussion are Direct Loans from the government, and either subsidized (you don't pay interest for them while in school) or unsubisdized (interest accrues on your loan, but you don't need to pay it until after you leave school).

I also assume that whoever follows any of these instructions, will be perfectly rational w/respect to the managment and use of the resultant money. (In other words, the person won't buy more consumer goods because there's extra cash in the bank.) This person is unlikely to exist, but if s/he does, hopefully s/he is the kind of person who'd read my blog :)

There are also some scale issues -- I assume that your loan is large enough to make this workable. This is clearly the case for law student and doctors, say, or people attending expensive colleges (w/wealthy, but stingy parents) -- but at some point, if you only have a $500 loan, these strategies may not be appropriate. (Typical loans over 3 years for a law student, ~100k at even a 2nd tier, private school)

1.Typically, school loan rates are _lower_ than risk-free rates, though they also move in lagged tandem over time. The elementary strategy is either to bet that the risk-free spread over student loan rates will increase over time (and invest money you'd otherwise put towards repayment into a liquid savings account), or do a duration match w/the loan, using bonds, which may locks you in for up to 25-30 years. Only caveat is that consolidating through the US government takes your current rate and rounds it to the nearest .25% to get your fixed rate. In practice, the benefit is even greater (as is the risk), if you instead use your extra money wisely, but in riskier ways than just a savings account or T-bill.

-The money you save must be spent with utter care if you don't opt for either of the 2 previous options. This is the difficult part, to not feel like you have more money in the bank, ignoring the loan, and thus ratcheting up spending-- this is what economists (Ok, not econmists, just me) call illusionary marginal propensity to consume.

-If you _really_ want to lock in the trade, structure the savings vehicle you have to duration match that of the loan...30 years treasuries so you can't easily spend it!

2.Looking at subsidized loans -- here's the wonderful part -- as long as you enroll in at least 1/2 time a semester at a accredited college, they continute to pay the interest for you, so you're effectively holding down a HUGE 0% APR transfer for life (if you meet conditions, etc). If I were more rent seeky, and less easily guilted, I'd find the 2 cheapest accredited colleges in the country that allowed online only, or else sign up and flunk the classes if need be. I'd of course see if I could take out more student loans to do so :) EDIT: 4/30/06: To really spread out your expenses, keep in mind that after you stop taking classes, there’s a grace period of something on the order of 6 or 9 months – in effect, this may mean that you only need to take two classes every other semester to qualify.

3.Even if the loans are not subsidized...
Lock the loans in at the current low rate and you still then have the equivalent of borrowing at below money market rates in large size.

4.Either way, opt for the slowest acceptable payment plan possible (this can change later on since there is no prepayment penalty).

5.Tax effects
Can someone enlighten me -- if interest is taxed normally, does the interest accruing on unsubsidized loans while you're in school count as (negative) income for AGI purpose, insofar as it meets the student loan interest deduction? If so, that's another boost.

6.Credit scores:
Increasing average account age, having a particularly old account (since FICO inputs include the oldest account's age) -- these are all big plusses for one's score. Student loans can be carefully milked for FICO boosting as well as profit potential.

One ancillary benefit to your credit score is that the mix of types of accounts is another FICO input, and installment loans w/lo payments are generally considered plusses rather than minuses.

If you're a FICO junkie, don't pay off the student debt completely and then let the loan languish as a closed account on your credit report. Instead, try to get a deferral, or else make smaller payments whenever possible (which is usually fine w/colleges if you prenegotiate), and pay off the school loans as slowly as possible. I haven't ever seen a neg-am student loan, but not for lack of trying. (Note that I'm NOT sacrificing money forFICO, since the loan APR is presumably under riskfree.)

7.Extra 0.25% edge from making automatic debit payments on your loans
-- how sweet is that?!

Throughout, I'm assuming that if you've followed the previous steps, you are the utter master of your appetites. If you follow these instructions, so long as the rates lag the riskfree rate in the right direction, you'll have a hard to screw up solution that earns money, and will one day be the oldest installment loan tradeline (and perhaps oldest line period) on your credit report.

EDIT: Thanks to the poster who suggested that an alternative to 2 throwaway classes, might be classes that you have personal interest in, such as pottery for college credit, or college-level classes at a culinary institute that offers AA's or BA's...This is something I've considered in the past, but not something personally doable at present, given my schedule/exhaustion levels.

Chasing the Bank Accounts Bogey and Illusory Float, Addendum

First see my original post...


Another "free" checking service (that isn't useful enough on the margin to make me want to get one) from WaMu:

Adds free checks for life, free outgoing wire transfers (w/certain conditions), free Overdraft or Non-Sufficient Funds Fee Refund -- one per year (but they carry over), free ATM withdrawals (not as good as USAA -- WaMu doesn't refund you the external ATM machine's charge -- they just don't charge you themselves...)

Unnecessary distinctions between capital and income, and underestimating the impact of REIT yield crashes...

Inspired by comments on Miserly Bastard's latest post...

I'm sure many economists/personal financiers have commented ad nauseum on how for retirement, one shouldn't necessarily distinguish between income and capital -- instead, one should invest for total return.

There are caveats:
a)tax reasons for distinguishing between capital gains and income, of course (though for instance, long term capital gains are taxed less than interest (for most reasonably wealthy people) -- on the other hand, dividend taxation has been made consistent...). In practice, irrelevant if held in retirement accounts, and you aren't planning to rebalance for tax reasons.
b)mental bucketing/mental cost reduction (insofar as people tend to either spend too much if they can't clearly distinguish between "assets" and "income," and insofar as it makes it easier for people to spend the appropriate amount each year)

Beyond that, why the distinction between capital and income -- why wouldn't you just invest for total returns?

People look at a portfolio and think -- "Hey, my REIT's are yielding 8%, how much worse can they get?"

The thing is, when yields fall on REIT's, prices typically also fall.

I feel that lots of people erroneously believe that hi-yielding assets have a large safety cushion.

For instance:


Hey, I have an 8% yielding REIT that is $100 a share, and I own 1000 shares, so I'll make ~8k. Even if the yields fall to 4%, I'll still make 4k.

Here's the thing -- when yields fall, all too often rational market participants will revalue the REIT to meet the lowered cash flow stream.

So, if you're doing Monte Carlo analysis of how REIT yields (in % terms) crash in bad states of the world, and you think, "hey, at worst 8%->4%," you're ignoring the fact that the stock price probably went from $100->$65.

Thus, in $ terms on your original portfolio of 1000 shares:

a)your expected future income went from 8k to:
4% x $65 x 1000 =$2,600, which, in terms of your original portfolio, is an effective 2.6% yield
b)your immediate wealth today just went from $100,000 to $65,000, or -$35,000

How much people REALLY optimize on gas, and gasbuddy.com

I roughly agree w/Miserly Bastard's comments on how NY consumers are likely to optimize only on a macro level.

Active gas price optimization is likely irrelevant to most New Yorkers for any number of reasons -- I don't even have a driver's license.

I do have lots of 2nd hand observations that seem consistent w/the optimization side of this post (people living under different working/driving conditions) -- lots of my friends who live in small towns in MA and have ~1 hour drives to work, plus more driving for work, and have horrendously large gas bills -- they definitely do seek to price-optimize in a extreme fashion (perhaps to an inoptimal degree, even taking into account the large and negative beta of their wealth to gas prices, at least compared to most New Yorkers).

I also know a surpisingly large number of frugal Asian parents who do engage in this sort of behavior, but that may not be particularly generalizable to the overall population (though a roughly proportional % of the non-Asian people I know who are that age, also engage in such behavior, albeit in a smaller sample than my already small and self-selected sample).

Part of my argument is a bit circular, like many efficient market arguments -- consumers are efficient enough -- that is, sufficient numbers are optimization prone beyond what would be rational for them, or else truckers and taxidrivers are the equivalent of arbitrageurs. A further financey take: gas station owners don't price discriminate in favor of such drivers to the degree that would be needed to really negate their competition inducing effects. I definitely see certain stations w/huge cab populations in Manhattan, but that might be a demonstration of extreme price sensitivity, network effects such as drivers wanting to socialize, perks such as clean and free bathrooms, geographical oddities, etc

As a result, when prices go up, the average consumer _doesn't_ need to pay lots of attention. As a note for the noneconomist, "although the term "discrimination" has negative connotations, "price discrimination" is merely a technical term meaning differentiation in price to increase efficiency."

I also think that Gasbuddy.com indicates that at least some people care enough about micro-optimization to make the info publicly available for free, and others access it. Gasbuddy allows you to search by zip code for various gas prices – people actually go to the trouble of posting live observations (surprisingly frequently).

One theory is that when prices go down, the "parent from the WW II generation" category of consumer is more likely to become lax in optimization, making arbitrage bounds sufficiently broad despite the "arbitrageur" taxi and truck drivers, that gas stations can lag in price (as per my original post)

MB's original comment:

"I dont think that most consumers price-shop for gasoline, except at a very macro level.

What I mean is that there is a certain point where consumer preferences are indistinguishable between price points. For instance, consumers cannot notice the difference between $2.33 a gallon and $2.34 a gallon, unless the information is presented to them simultaneously and truly all other factors are held equal (e.g., gas stations across the street from each other).

As a practical matter, most consumers won't know the difference between how much gas costs on the upper west side vs. downtown, even though price discrepancies probably exist. Only the most saavy consumers of gasoline (e.g., NYC cabbies), can probably make price distinctions for gasoline between filling stations in a local area, and even then, they probably rely on proxies for price information such as the "reputation" that a particular station or brand may have as offering lower prices. (Think Wal-Mart's brand proxy of "Everyday Low Prices" as a substitute for actual price information).

Only at the very macro levels can consumers distinguish between price differences in gas stations, such as "it is cheaper to fill up in Jersey than in the city, so I better tank up before the tunnel."

Reference points, and their relevance to personal finance

A lot of my friends work on Wall Street, and often get ridiculed for casually saying stuff like "My bonus was only X, but Biff got 3X!" (Actually, that's an utter lie -- my friends on Wall Street are far more likely to be named Adil, or Moishe.) They, and people like them, get pilloried in the press for making such claims on 6, 7, 8 or even 9 figure amounts when there are millions of people barely able to subsist on their limited incomes. Sadly, their anger and unhappiness are probably attributable to core psychological issues that lock in everyone from hedge fund traders in NY to poor students in CA to small farmers in IA.

A caveat about Wall Street -- the very nature of trading jobs argues for either picking someone else off, or being picked off yourself on virtually every trade -- the signal sent by smaller bonuses is basically your boss telling you, we're paying you just enough to make you somewhat unhappy, but we know you're not good enough to go elsewhere. In fact, I would suspect that the equilibrium bonus strategy is just that -- pay enough so the trader is somewhat unhappy, but unwilling to take on the switching costs of looking for a new job. Thus, the complaint is not so much that compensation is inadequate for one's lifestyle (well, actually, there are a lot of spendthrift traders making trades, like buying cartel-ized, obnoxiously large diamonds rings that lose 95% of value immediately after purchase, in essence doing trades that they'd kill themselves for making on the job -- unless girls that materialistic are still someone worthy of partnering with/they're thinking of it as a blatantly mercenary trade to get access to her trust fund/she needs it as a signal for the bitchy, elitist people she has to interact with at work, etc), but that one is getting picked off on a huge trade (basically, most of one's personal PNL -- profit and loss -- for that year).

But back to reference points -- there was a survey of college students that basically demonstrated that the vast majority would rather make $50,000 when everyone else working with them made $25,000, than make $100,000 when everyone else made $200,000. (Implicitly, the rest of the economy, purchasable goods per $ of your money, stayed the same, though I'm not sure if all interviewees realized this.) Also, multiply all those numbers by some factor 1/X to get the actual survey. (For more on behavioral economics in a relatively easy-to-read format, check out Colin Camerer's paper, page 16 for reference points in particular.)

Before you lambaste these Ivy-degreed idiots, think about it -- do you measure your happiness by comparing your lot to that of your ancestors 500 years ago, or people living without electricity and telephones in rural 19th century America? Do you actively think about how much better off you are than people starving in Biafra? If people on average did so, then also on average, people's happiness should be rising roughly proportional to pre capita GDP growth (which is ex-growth via population increases), deducting some amount for how much more hurried their lives are due to work, knocking some more off for greater income inequality levels, number of hours worked on average (which in many countries, has gone down significantly over the last few hundred years), etc. Nope -- surveys demonstrate that without fail, people instead seem to look at coworkers, neighbors, friends, when judging personal happiness levels. This applies across history, ethnic groups, countries, even different zip codes w/radically different median income levels. Even if they resist trying to keep up w/the Joneses, people still feel worse for not doing so, whether the Joneses are Park avenue socialites, or mobile home dwellers.

Consumption creep is made even more difficult to resist because the average person also references himself or herself for comparison -- that is, we examine recent consumption levels when internally deciding how happy we should be. How many people, after getting out of college and getting a good job, still gorged themselves on free food every chance they got (not realizing that given their income levels, they should have been considering the health effects/maybe even the poor quality of most catered food)? And how many of that set of people, end up spending the bulk of their salary on fast cars, cool gadgets, and expensive food just a few months later?

Some people do resist reference-point based consumption, and I commend them for it. As much as possible, I try to do so by deliberately not ratcheting up my spending, trying to ignore conspicuous consumption, even avoiding knowledge of certain categories of consumption that I'd never previously known about or considered, and so on -- I may have it easier than most people, since I've always been an appreciated of iconoclasm (at least w/regards to consumption and common wisdom, and not necessarily broad social norms -- well, OK, maybe a fair number of social norms as well). Either that, or as my girlfriend puts it, while I may appreciate many luxury goods and many of the nicer things in life if they were free/cheap, I have insanely low minimum thresholds for almost anything (optimization along the lines of 1.Is it healthy 2.Is it tolerable physically 3.Is there anything cheaper that satisfies 1 and 2?).

Perhaps my only luxury is food, but even there, I avoid alcohol (which greatly caps total restaurant spending unless one is a sumo wrestler), I focus on tastiness rather than trendiness, and deliberately and gradually dole out visits over long timeframes to the famous, expensive restaurants that I could afford to go to, and instead go to what in my opinion are equally good, occasionally even better, but underrated restaurants. I add value, or at the very least, self-perceived value by becoming a quasi-regular at the least flashy/most welcoming restaurants that are above a high threshold of quality, and reap the benefits in the form of tasting menus that feature things not even remotely hinted at on the menu (or else, this strategy might also suffer from lack of novelty).

Short of radical steps, like
-moving to Buffalo County in South Dakota, home of the Crow Creek Indian Reservation, which had the lowest median income in the US (at $17,003)
-telecommuting to your original job since a)jobs in that zip code are clearly limited, and b)you want to avoid seeing the consumption of your coworkers
-from time to time, resetting your references by deliberately eating very bland/disgusting but healthy food for several weeks at a time (not that high end restaurants will be very relevant if you're living in the poorest area in the country)
one can still take less radical, but effective steps to limit consumption creep.

Sure, every blogger always says, you should just save more money and spend less, and so on and so forth. The behavioral economist would probably ask people to come up with actions today that bind your future self to such actions -- that is, make it very difficult to spend, even if you wanted to do so at some point in the future. Such innovations in the field of retirement accounts, for instance, will probably make a huge difference in total welfare of numerous individuals over the next 50 years.

I think the essential evaluation is frank and hardheaded evaluation of just how forward looking you are, how disciplined you are, and how overall, how much delayed/discarded gratification you're willing to take on. One person might be able to get 0% APR for 12 months credit cards, remember all the fine print, spend no more than s/he would otherwise, and eke out a nice implied 5% return on the money. Another person might get the same deal, spend crazily, forget a payment, not realize that this rachets his/her APR up to 20%, and also forget that the card doesn't provide free money -- just a roughly 5% implicit return (depending on how quickly it gets maxed out). Whenever you see a cool idea or gimmick, make sure to think about the net effect of that object on your entire finances, and not just think about it in isolation. If coupons end up making you buy far more perishable foods than you should, they're not saving you money. Overall, if you do things that make it more difficult to spend (eg, keep credit cards for your credit score, but always leave them at home unless there's a special promotion you need one for), you'll probably win out over the long run (unless your response to temporary deprivation is consumerist binging thereafter...).

Satisficing more and optimizing less for gas prices

A quick and light comment -- there are innumerable studies that examine gasoline wholesale and crude oil prices and asymmetric price move relationships betwixt the two. I'm not interested in bringing those up. Instead, I'm focusing on your everyday filling station.

I recently read a paper that proposed a behavioral economics explanation (w/empirical analysis) for why pump prices rise with wholesale gas prices, but lag significantly when gasoline prices are falling. It seems fairly plausible that people are loss averse, and therefore, they search vigorously for the best possible deal among filling stations, sometimes even driving further than would be optimal given gas prices, especially when prices are in the process of rising. I suspect people have a mental benchmark for the "proper" price of gas, and the upwards moves in price are all losses relative to that benchmark price (which only very gradually shifts up as gas prices continue to rise, but tends to lag actual prices).

However, when prices begin to fall, the consumers' mental benchmarks make them feel as if they're gaining money as prices fall -- and as a result, they don't search as diligently for the best deal.



Not sure what to do with this, except maybe:
1.Don't search too hard for the cheapest gas when prices are up -- the filling station market is likely fairly efficient because of the way most people behave.
2.Spend more time searching when prices are falling, because stations can get away w/less competitive prices when people are not feeling loss aversion and hence, search less diligently. (To some degree, if prices fall enough, you'll be spending the same amount of effort to save fewer $'s, as the average tankful of gas gets cheaper and cheaper.)
3.Overall, free ride the efforts of others -- search hard when others don't, and search less when others do.
3.Pick up a 5% gas rebate Discover or Citi credit card.

Then again, I don't even have a driver's license because I live in NYC...

A quick fyi -- if you're not interested in tradesports.com and other betting exchanges that let you take on 20 million kinds of risk (but may potentially have legal issues for US residents, though no enforcement has yet occured to my knowledge), check out hedgestreet.com for cool (though maybe not very efficient/liquid) CFTC approved mini-mini futures and options on stuff like drug presecription price cost moves, housing indices (though the Chicago Mercantile Exchange is now offering these in non-retail size for the first time), and gas costs.

Self-insuring whenever possible – not necessarily for those in the know, after all…

Large segments of America, for one reason or another, may be underinsured. This may be attributable to a number of root causes, such as extreme poverty or social strictures – for instance, the Amish prefer to engage in implicit community insurance (which is likely underfunded). Nonetheless, the common financial mantra is that on average, people generally overinsure themselves against certain particularly salient risks (travel insurance that protects against dying in a plane crash, for instance), and have a tendency to overinsure in general. So, the supposedly sophisticated investor turns his nose up at mutual funds in favor of private equity, hedge funds, and commodities, and turns down all but the most vital of insurance, in favor of self-insurance whenever possible. This is not entirely incorrect -- I certainly minimze many forms of insurance, and make my deductibles as high as I can tolerate. However, I’d argue that the extra shrewd may, under certain circumstances, find ways to pick up insurance and not feel like Mr. Main Street after all.

I break this post into three segments, two of which, I and III, are nothing new:

I.Why insurance is probably overpriced and oversold – people reasonably familiar with human psychology, behavioral economics, and/or the insurance industry can skip this.

II.Why the shrewd investor who can afford to self-insure, may still want to seek out insurance under certain conditions.

III.A primer of the underlying concepts that are needed to understand how insurance works – _really_ nothing new here for people who’ve taken Econ 101/202, except my summary/excerption of some wikipedia concepts.


I.A qualitative description of how insurance works, and why people frequently buy too much of it – see below for a more detailed intro.

People buy insurance because they dislike taking large risks, even if on average, they’d make a profit if they could take on such risks over and over (roughly speaking, this makes them unwilling to take on bets with positive expected value). Making a profit in this fashion isn’t always viable for a single individual, such as when you buy a single extremely expensive machine for one’s business. Say there’s a one-in-a-thousand chance that if the machine breaks, you’ll have to replace it – but because you can’t afford to do so, you’ll go bankrupt. Instead, you buy insurance against breakage, which costs you far less than the replacement value of the machine. However, you are charged a premium by the insurance company that’s enough to make them a profit. How do both parties end up with a win win scenario? Well, the insurance company wins because they _can_ play the game over and over again by insuring lots and lots of people in situations similar to yours, and thus, they’re not worried about a single broken machine bankrupting them (as long as the machines don’t all break at the same time). And, they charge a high enough rate that on average, they make money and you lose money in the 999 cases where your machine doesn’t break – and even if one in a thousand machines breaks, they still make just enough money off the elevated premium on the other 999 machines to more than break even. You of course don’t mind the fact that you’re paying that extra slice because you now won’t go bankrupt (at least from the machine breaking, anyway).

Here’s the thing – for smaller amounts at risk, you typically don’t want to buy insurance. After all, if you self-insure for small amounts that you can afford to absorb yourself, you get to pocket the premium. In some cases, this may be simply impossible, such as when one engages in a lucrative, one-time activity that also has a high risk of limb amputation (not exactly a repeatable game, at least for values >4 or so).

Nonetheless, people frequently fail to properly understand this critical expected value-vs-risk principle that ought to drive decisions about insurance, and as a result, they buy excessive amounts. There are a number of reasons for this, and a few examples follow.

Insurance is an intensely quantitative business, and the average person is nowhere nearly as mathematically sophisticated as the pricing actuaries working for BigLifeInsuranceCo (arguably, insuring for this reason may be a valid choice to outsource to a specialist). Furthermore, in many insurance segments, people who set foot in insurance offices have to contend with an intensely broker-driven, sales-oriented business. Finally, people have a tendency to overestimate particularly salient risks – even though the probability of dying in a plane crash is miniscule, people inevitably and repeatedly shell out big bucks for practically worthless crash insurance.

The average person may not want to cancel his or her health insurance policy, but typically, by raising deductibles just short of the pain point, one can make oneself much better off financially. I could go on, but I haven’t even gotten to the actual focus of my commentary – namely, that while most people fail to realize that they should self-insure whenever practicable, many smarty-pants fail to realize that they may be even better off seeking out specific forms of excess insurance.

II.Why financially sophisticated, quantitatively comfortable, fairly wealthy people may still want to buy more insurance than they think they should:

1.Perhaps the insurance industry is similar to the airline industry (which has made barely any money/arguably has made no money (net of direct government subsidies) over the course of their history), and thus, you can rip them off. On an empirical basis, this is probably not true, except perhaps in certain sub-industries in certain states. A weaker claim that might hold -- in certain highly competitive markets where insurers are competing on price for market share, they may in the short run price below the level of acceptable long-term profits. Signs of this may involve intensive ad bombardment, desperate insurance salesmen, geckos, etc.

2.Take advantage of principal-agent problems:
Brokers are typically not also owners, and they are frequently incentivized to produce up-front business and premiums – in poorly run insurance companies, they may be able to fudge risk, or else get paid while the going is good, and then skedaddle. If a contract is expected to pay w/very low probability, and stretches over a long period of time, it is hard for managers in a poorly run organization to overrule a broker who sells you insurance too cheaply. I’m not arguing for wink-wink, nudge-nudge agreements w/your broker. However, it is possible that while broker-driven insurance businesses overall may have more fingers in the profit pie, leaving less for the consumer, a consumer with good negotiation skills going to an improperly incentivized broker-driven insurance business may be able to get a legal steal. GEICO tries to deal w/this problem by backloading commissions, and reducing emphasis on volume – probably not a good place to test this theory.

3.Maybe Johnny can time the market, after all:
Examine historical behavior of E & O (errors & omissions) insurance pricing for executives in large, publicly traded companies. In a rising bull market, where there is little incentive for investors, regulators, journalists, and insurers to rock the boat, and the most incentive for executives to conceal material information or engage in abuse accounting, the historical levels of errors and omissions may seem to have fallen to a new low. Yet, it is at these frothy times that actual levels of liability are rising to all-time heights – so that insurers w/poor memories may lower and re-lower premiums on the assumption that liabilities have reached a permanently low plateau – not realizing that in fact, they are about to get slammed. Even if you’re not an executive, it may pay off to avoid/seek out similarly over/undervalued forms of insurance during bull markets and economic upturns, or vice versa.

4.Even if insurance companies on average extract profits from risk averse individuals in a given industry, you can still beat the markets. There's an asymmetric information and/or adverse selection issue -- if you have private information about your bad genetics that on expectation, make your health far worse than that of someone with your publicly available health profile (eg, cholesterol gets disclosed to insurance companies, but certain genes do not, except insofar as your agent asks you about family disease histories), then definitely get the cushiest reasonably priced insurance plan possible. (The corollary to this is that the insurance industry probably has to price even more aggressively overall to compensate for this, making insurance for the average person that much worse a deal.)

5.Another argument by anecdote:
Most law firms don't vary the pricing of insurance policies by individual worker -- yes, you can choose different plans, but except for various subsidies that may go up if you're a secretary vs an associate vs a partner, everyone pays the same marginal amount for switching to the PPO from the HMO. In this scenario, even if you are publicly sickly, as long as pricing overall for the entire firm is close enough to fair, you can again free ride by opting for the cushiest policy. Unless your firm is tiny, I doubt your increased medical costs will drive up firmwide costs enough to impact you much. The lesson here is to seek out other examples of artificially fixed price insurance if you’re way above the norm for risk, and to avoid such insurance -- or else seek it through non-fixed-price sources. (As always, every argument I makes only definitely applies if all else is held equal. Even if you’re remarkably healthy, and your company does not explicitly subsidize your health insurance, you still may not be able to save money by going out on your own, because the company’s greater ability to negotiate rates for a big bloc of insureds comes into play.)

6.An observation:
Some insurance companies are actually willing to take on expected value negative bets. They're willing to bet that they can reinvest your upfront premiums so that on average, they'll be ahead when, at random intervals, various policies need to pay out.

Caveat: once events take place in the future (rather than just multiplying probabilities by outcomes for lots of present events), one could argue that I could manipulate this argument by using different discount rates. I'd point out that lots of insurance 10-K's show that by (presumably liberal) assumptions, the cost of their float (the money they get up front) is still negative. As a cynical/rational person, I'd assume that other than Buffet’s, most companies are overly optimistic in reporting expected losses on policies, so if anything, the cost of float to them is even higher. (Whether this translates into skinnier premiums for you, or fatter bonuses for brokers is a different story.)

Insofar as the companies that are most willing to believe that they can successfully reinvest your money before your policy pays out, are easily identifiable, try to do more business with them. Hopefully, their greater shrewdness (if their belief is justified) doesn’t hurt you when they price your business, and their idiocy (in case they overvalue their investing skills) doesn’t extend to bankrupting the firm.

7.Another low-payoff variant:
Say that you’re a housewife/househusband (and a fairly inactive one with a nanny at that, so you’re not providing implicit unpaid/untaxed economic services to the household). If you can sign up on your spouse’s company health plan, despite the coinsurance for out of network visits common to most plans, because of the low opportunity cost for your time, you can use the plan far more than the average person. This is unlikely to make much money, however, and if anything, probably just argues for your being more active an economic contributor to household income. More generally, when you have low opportunity costs (and don’t plan to change that fact) – it may make sense to buy of certain types of insurance – assuming that you have the money to do so.

I should probably generalize my comment in point #6 to all strategies that depend upon seeking out poorly managed insurance companies: such strategies leave you worse off to some degree because such companies are also the most likely to go bankrupt and leaving you holding the bag. Any savings you can get must be carefully weighted against such risks, and you may want to consider some fairly crappy hedging by purchasing long-lived put options on the fairly crappy company you buy insurance from, or else avoid implementing these suggestions entirely. I post these mostly as a set of thought-provoking comments, and do not anticipate that the average individual will do anything different -- hopefully, he or she will walk away a little better informed.



III.A brief overview of a few insurance-related concepts:
My loose description of loss aversion, which may be another significant factor that causes people to pay too much for insurance.
Say people are irrationally sensitive to the way a particular set of choices is framed, so that two things w/identical effect -- losing $X vs failing to get an $X bonus, where all else is held equal – are treated very differently simply because they are described, or framed differently. Another rough example of this is when someone is asked “How much money will you accept to double your cancer risk,” vs “How much would you pay to halve your cancer risk, assuming that it were actually twice as high as it is right now,” not realizing that giving different answers would be inconsistent. (To be closer to correct, I’d also have to also state for the second scenario, that the respondent had just been made wealthier by the amount of money given in the response to the first question, etc.)
Expected Value, courtesy of wikipedia:

In probability theory (and especially gambling), the expected value (or mathematical expectation) of a random variable is the sum of the probability of each possible outcome of the experiment multiplied by its payoff ("value"). Thus, it represents the average amount one "expects" to win per bet if bets with identical odds are repeated many times. Note that the value itself may not be expected in the general sense; it may be unlikely or even impossible. A game or situation in which the expected value for the player is zero (no net gain nor loss) is called a "fair game."For example, an American roulette wheel has 38 equally possible outcomes. A bet placed on a single number pays 35-to-1 (this means that you are paid 35 times your bet and your bet is returned, so you get 36 times your bet). So the expected value of the profit resulting from a $1 bet on a single number is, considering all 38 possible outcomes:



which is about -$0.0526. Therefore one expects, on average, to lose over five cents for every dollar bet.
Risk Aversion, from an interactive economics tutorial:
This use of the expected value is based on the Law of Large Numbers, which is a statement about what happens when a game is repeated over and over and over again. If a game can be repeated many times, good luck and bad luck tend to wash out.
What happens, though, if the game isn't going to be repeated over and over? What if it's only played once, or a few times, in your life? What if the stakes are very high, so that you are gambling with something that you really do not want to lose? That's when risk aversion comes in.
Risk averse means being willing to pay money to avoid playing a risky game, even when the expected value of the game is in your favor.
N.B.: This post was originally inspired by the intended post of a comment on http://miserlybastard.blogspot.com, where the blogger mentions self-insurance only tangentially – unfortunately, I ended up sticking my comments onto a different post of his about Social Security -- my bad.

How to satisfy your urges without losing your appetite

I refer, of course, to stock picking -- which, for the average private individual, is a huge waste of time and money. I'm not going to rehash the thousands of studies proving this, nor will I dwell on the fact that in most cases, the time spent doing due diligence on a stock, even if at all capable of adding edge, would have been more risk/reward profitable if spent on work (or flexible independent contracting if you work for a fixed salary w/little upside for performance).

Furthermore, if you are someone working in finance with a legal edge (informational, or wrt. investing skills), you're probably better off investing the time in work and trying to increase your bonus.

Nonetheless, people will still stockpick -- and don't get me wrong -- I enjoy stockpicking for my personal portfolio. Telling people not to stockpick and invest in virtual stockpicking contests instead, is like telling a non-compulsive but bad poker player to quit playing for money because the house/his opponents always win. There is a large component of inherent enjoyability in taking risks, but how can you do so in the stock market w/o having your face ripped off, as Michael Lewis put so piquantly? (Just as real mafiosi have been observed imitating the Sopranos, sometimes I wonder if the people in finance that I know who use that expression are quasi-ironic, perhaps indirectly imitating a relatively rarely used expression popularized by Liar's Poker, or dead serious...)

One way is to reduce the risk of bad investing. If you can restrict your attention to a set of stocks that will likely do better than others on average, you can have your fun (and your full wallet too). Of course, if markets were perfectly efficient, you wouldn't be able to do this regardless.

This is where Joel Greenblatt's recent book comes in. For a short and enjoyable read, check out the hokily titled The Little Book That Beats the Market (co-authored with Andrew Tobias).



Details below:

It essentially claims is that if you asset allocate to baskets of stocks with low P/E (a value stock trait) but hi ROE (calculated w/a little more care than I take here, so that it is actually return on capital, not equity), over the long run, you’ll eke out a decent edge over the market, based on statistical evidence over large groups of stocks over longish time periods. He basically says only intelligent, non-hyperbolic things throughout the book, and mentions topics like how to rebalance portfolios tax-efficiently. (I typically find that one of the top signs of investment crankdom is a writer who tells you to ignore the effects of capital gains/losses when trading. If in fact you have a collection of stocks w/high return and high risk, but little dividend generation, you can selectively sell big losers to offset capital gains, as well as $3,000 of regular income a year w/carryforward.)

Furthermore, Greenblatt makes a decent point about why this effect would exist in the first place and then continue to persist, even after discovery, by appealing to a broad set of behavioral biases that make it unlikely that the effect will disappear. I’m mangling the argument by compressing it, but roughly speaking, he argues that this effect kicks in over long periods, is smaller in large-cap stocks, reflects genuine and persistent risk-aversion preferences among most individuals, also appeals to investor tendency to rank welfare by reference points (investing in a bubble is better than not doing so, because not making money when others do is very painful, and losing money when everyone loses money isn't very painful), and such tendencies drive market movements in ways that are difficult to "arbitrage" away.

Similar arguments are used in mainline finance academia to explain the persistence of value beating growth, despite the disclosure of said effect. For the quant in me, he reduces the chance that this is data-miney by creating baskets of all stocks broken up by decile ranking (using his low P/E and high ROC metric), and showing that over many years, each decile does progressively better than the next by discernable amounts. He also acknowledges various potential problems upfront, such as whether most of this effect is found in small, untradeable penny stocks, survivorship bis, etc.

Performance of Magic Formula (universe of 3500 largest US stocks, choosing top 30, rebalancing once a year) vs S&P:
Over 1988-2004 (yes, this conveniently excludes 1987), all annualized:

• 30.8% w/formula12.3% over universe of equally weighted, 3500 stocks
• 12.4% S&P 500 (equal vs market weighted)
• 22.9% larger cap (top 1000 stocks by market cap) w/formula
• 11.7% larger cap (equally weighted index of top 1000 stocks by market cap)

Best of all, he offers an automatic screener for _utterly_ free on his website that allows you to choose a minimum market cap, and then picks out the top 25-100 stocks meeting his criteria. If nothing else, limiting your fundamental analysis efforts to that universe should prevent you from systematically losing to the market, unless you somehow have biases that always allow you to pick the underperforming stocks from the Greenblatt set -- which may still outperform the market. (It is also fairly difficult to argue that you can systematically bad stocks, as this implies that you can systematically refuse to buy stocks that you like, and instead only buy stocks you dislike, for a market-beating edge.) In essence, if you believe stock picking has alpha, and that you can try to grab some of that alpha, or even if you get utility from stock-picking, despite believing that the house always wins -- at least selecting from the Magic Formula's top picks, you make it less likely that you’ll tank your returns.

If I were writing an academic rebuttal, there are millions of things I could bring up, such as whether this strategy is properly risk-adjusted (he claims yes, and I roughly believe his arguments), whether 17 years is a large enough sample, etc -- and yes, these are all things that I worry about. Nonetheless, I am inclined to believe in this strategy.

I usually hate testimonials, but knowing that lots of people like something is more valuable than not knowing it (even if it is to avoid things that your dentist tell you to invest in, for instance). Hedgies love Greenblatt (they also love raising new money in a record-breakingly starved for alpha markets, so take this with a huge hunk of rock salt)– he’s one of the founders of Gotham Capital, which returned outside investor money on the order of 10 years ago after achieving 50% annualized returns, and since 1985, has had 40% returns. He is still very rich/not looking to maximize cash flow for time spent on writing this book. Specifically respectable people in the hedge fund industry seem to almost uniformly respect him (despite huge differences in investing approaches, etc), and many successful hedgies revere his first book as well (which is focused on special situations investing).

On a more personal note, once I have a Greenblatt set, I research and screen on some additional criteria. Meta-criterion: Select effects that you have a strong prior belief in, and at least some statistical/academic evidence for as well. For instance, in descending order:

1.Pick small caps, or even micro micro caps.
2.Look at insider holdings, and more importantly, sales and purchases -- Smartmoney has a free, clever tool that graphically depicts purchases and sales, and also gives insiders a letter grade.
3.Choose stocks w/minimal analyst coverage.
4.Choose stocks w/low $ price per share (a weak argument)
5.Choose stocks near all time lows -- as always, make sure that this is not caused by expectation that the firm is about to bankrupt, etc (weaker argument)
6.Pick up stocks opportunistically, say, by buying the biggest intraday downmoving of the Greenblatt screened list, assuming that a 10-K release didn't just give new E for the PE, and RO"C", both of which could screw up the screener (data is pulled once a day) . (Weakest...OK, starting to really get out there now...)
...and so on.

I should probably make it clear that this is a way to get your stockpicking jollies and probably not get shafted, not an argument for "this is how you can beat the market by 100% every year if you follow my whiz-bang patented pick tips!"

A sampling of basic and not so basic retirement account strategies

Please note that as you descend down this list, I move further from the practical toward the theoretically interesting but impractical, and potentially even illegal (ie, stuff I'd never do, never want someone else to do, and have no legal opinion on -- not that ANY of this should be construed as investment advice/legal advice -- but that I feel is cool to come up with). Furthermore, many of these are only appropriate for sophisticated and hyperrational investors with high risk tolerance.

1.Most obviously, tax-shield any security that throws off a lot of income. Any normal asset that you can hold w/o realizing gains or income, is essentially being held in a virtual tradtional IRA (albeit w/o the initial deduction), so putting it in your IRA to replace another asset in your IRA has little marginal advantage. (I assume throughout that people already know the difference between a Roth and a Traditional IRA, etc.)

2.If you have a large batch of securities, all of which are high risk and return and not that correlated, hold them outside your sheltered accounts (assuming #1 holds, and that this risk/return is almost entirely due to capital gains). You can selectively sell the big losers to realize tax losses, while holding the winners for as long as possible (though you may have portfolio rebalancing issues and have to sell winners).

Rationale: Because the asset class has high returns and high risk, you expect individuals assets within that class to be wide-ranging in returns -- some stocks collapse in value, some triple. Sell and realize capital losses on the stocks that collapse, but hold onto the ones that shoot up in value to defer taxation.

3.Borrowing from your 401k: When you borrow from your own 401k, there is typically a small adminstrative fee, along with interest on the loan; however, this interest is paid to yourself. As long as you take the borrowed money and sink it into long holding period/no income assets, and your 401k doesn't happen to offer private equity deals, etc, that are unavailable outside, you can essentially benefit from slightly overcontributing to your 401k (albeit not using pretax dollars). The marginal benefit is fairly small -- after all, the 401k assets can be churned w/o taxes, but if you were going to put money into long holding period assets outside the IRA anyway...

Entering speculative territory...

4.Consider that over the long time horizon, even risk averse individuals may (justifiably) care more about raw expected returns than risk-adjusted returns when looking at their retirement accounts. (In financespeak, Sharpe ratio is less important here.) If so, hold indexed, low-fee, but high risk (and hopefully, return) stuff. One example is Bridgeway's Ultra Small Company mutual fund.

5.Assuming that you believe in stock market premia going forward, and also want broad market exposure, there are some crappy Rydex index mutual funds and ETF's that expose you twofold to the S&P, but charge high fees. The only advantage to these is that if you wish to reserve your valuable retirement account slots, they do prevent you from continually realizing gains like futures do -- and you also avoid being stopped out w/S&P futures. I'd probably never buy them.

6.For the iron-stomached: blindly rolling S&P futures in your IRA, which allow you to take on what is effectively leverage (but is actually a performance bond, thus allowing you to trade it in your retirement account), raising your expected return drastically without ridiculous Rydex fees.

6.If you don't want to worry about being stopped out/wiped out by your futures in a really big downmove (and then being unable to catch the upmove unless you overcontribute immediately to your IRA), buying S&P options might be a slightly less crappy alternative. Transaction costs are higher, and option volatility may get more distorted than futures indices can get abnormally backwardated/or contango'd, but you can tailor your purchase to a maximum loss level -- namely, the cost of the options.

7.Be aware of self-directed IRA accounts, which allow you to invest in virtually anything -- personal loans, real estate (albeit w/o borrowing), but be wary of their ridiculously high fees.

8.Consider whether overcontributing to an IRA occasionally makes sense -- even after penalties, sometimes there is a large investment opportunity that is expected to rise sharply in value, but is fairly granular. Buying real estate before a bubble bursts, and selling at the perfect time might be one example. (In practice, that given example might not be perfect -- one might be able to strucure a real estate deal so that your self-directed IRA buys a slice of the equity, for instance.)

9.THIS MAY VIOLATE securities laws, or else just be ridiculously risky to implement, so don't do it unless you get legal advice first and are very risk loving. If you do get formal legal opinion on the matter, please let me know. Say you have a Roth IRA brokerage account. Pick a really, really low volume/low price/low market cap penny stock and buy lots of it in your IRA over a period of weeks, so that the price doesn't get driven up. At this point, put in a large limit buy order from outside your IRA that drives up the price substantially (again, very doable w/certain highly illiquid stocks, hence the spam that touts them to you). Simultaneously, sell the shares in your IRA. Done properly, you incur some transaction cost, but basically sell (mostly) to yourself, and in theory could easily increase the amount of money in your IRA 10-fold. Of course, 20 million things could go wrong, and you could just end up with craploads of delisted penny stock inside and outside your IRA account.

I mention the legal risk because an analogous, but not equivalent transaction would involve a self-directed IRA, and your selling a valuable house to your own IRA entity for $1. This is unlikely to result in IRS approval. When one trades penny stocks on the open markets, there is some duty on the part of the marketmaker (insofar as there is one for your penny stock), and less onus on you, to value the stocks "properly." Again, this MAY STILL be utterly illegal. For that matter, selling your IRA owned property to your non-IRA self, is typically a prohibited transaction. There are lots of such rules surrounding self-directed IRA transactions, so don't take the non-advice of some random guy on the web unless you enjoy audits and litigation!!!

Possibly acceptable variants on the $1 house scheme might involve your selling of non-publicly traded real estate to your IRA at the bottom range of acceptable market value (I don't know if selling in this direction is illegal as well). I'm also ignoring Unrelated Business Income Tax, and a whole host of other things that come part and parcel with buying real estate in your IRA.

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