ETF Warnings

My previous post outlined two reasons why ETFs might be more attractive than traditional low-cost indexed mutual funds.  Here are some down-side risks to check for.

Does This ETF Suck?

This isn't a risk unique to ETFs - there are lots and lots of lousy mutual funds too.  But suffice it to say, the biggest risk with an ETF is that it isn't a very good one.  Check the expense ratio, and make sure the index makes sense for your investment goals.  There are actively managed ETFs, custom-indexed ETFs, high expense ratio ETFs - lots of weird stuff.

Brokerage Fees

ETFs are "more fair" (IMHO) than mutual funds because the cost of buying and selling the shares is out front where everyone can see it: you pay a commission to buy or sell an ETF, just like you would a stock.

But this means you have a fixed cost per transaction, and this changes things compared to a mutual fund.  For example, if your 401k normally buys a small amount of 4 mutual funds every pay period, that's 104 transactions a year.  At $12.50 a transaction, you've paid $1300 in brokerage fees.  If you contribute the IRS maximum ($16,500) that's a 7% commission!  Ouch!

Simply put, heavy dollar-cost averaging over a wide number of funds isn't going to be cost-effective with ETFs.  To use ETFs, you need to make contributions in fairly large chunks.

It should be noted that mutual fund buys are not really cost-free; the mutual funds that you can buy through your broker without a sales fee are subsidized by the mutual fund itself.  Example: I can buy any Fidelity mutual fund for free via my Fidelity account because Fidelity's mutual funds have an agreement with Fidelity's brokerage.  If I buy a Van Guard mutual fund I pay $75 - way worse than a trading commission.

Typically mutual funds that are free to buy will have a higher expense ratio - part of the expense ratio will go back to "mutual fund supermarket" brokers (like Fidelity, Charles Schwab, etc.) to offset buying costs.  There is no free lunch.  (One possible exception: Fidelity heavily subsidizes its own Spartan index funds to keep the expense ratios competitive with Van Guard.  So there may be some loss leader mutual funds.)

The bottom line is: your buying pattern may have to change to use ETFs, and there is a cost to not dollar-cost averaging, so look at the big picture and the details.

The Bid-Ask Spread

Since ETFs are traded, there is a bid-ask spread - that is, the price you sell at will always be a tiny bit lower than the price you buy at on the exchange.  That spread is the profit that market makers get for providing liquidity (that is, buying and selling whenever people want to keep the market working).

A healthy ETF should have high liquidity and thus a very narrow bid-ask spread.  For example, IVV (an iShares S&P 500 ETF) has a 1 penny bid-ask spread on an $85.51 share price - that is, the spread is really, really tiny.  If the ETF is less liquid, traded less often, has fewer shares, etc. you might see wider spreads.

If the bid-ask spread is too wide, treat this like an expense; you will lose the spread each time you buy/sell.  If an ETF were to have a 1% bid-ask spread, you'd lose 1% when you buy and sell.

(A one-time loss is not as bad as recurring fee like expense ratios, but it does warrant examination.)

Arbitrage Failure/Tracking Error

When you buy some shares of an open-ended mutual fund (most mutual funds are open-ended), the mutual fund manager goes out and buys some stock (or bonds or stuff) - in other words, crunch all you want; when you buy, the manager makes more.  To understand the problem of arbitrage failure in ETFs, we have to first ask: where to ETF shares come from.

When you buy and sell shares of an ETF, you are simply buying or selling existing shares on an exchange.  But...what if everyone wants shares of IVV (an S&P 500 index ETF) at once and there just aren't enough? What keeps the price of IVV from skyrocketing above the S&P index that it should track due to the outsized demand?

The answer is in the way ETF shares are born: in-kind creation and redemption.  ETF shares are created by someone coming to the ETF with the underlying stock or bind and saying "convert these stocks that make up the S&P into ETF shares".  The ETF takes the stock and holds onto it (that's what the ETF does) and issues brand new shares.  There are now more ETF shares in existence but the ETF now has more underlying stock to back them up.

Now when someone does an in-kind creation or redemption, he or she will make a profit or loss based on the difference between the ETF share price (as traded on the market) and the price of the underlying stocks and bonds that make up the ETF.  This is what keeps an ETF's price so close to its underlying value ("net asset value" or NAV).  

If the ETF share prices were ever selling for a lot more than the underlying stocks, some clever investor could buy the stocks and sell the ETF at the same time (making a profit).  To then recover the sold ETF shares, the investor simply converts the bought stock to ETF shares.  In other words, if the ETF trading price diverges from the NAV price, there is an arbitrage opportunity.  Arbitrage keeps ETF trading and NAV prices in sync, and that's why your ETF shares are always worth the value of the underlying assets.

Well, almost always.  During the recent market crisis, some ETF shares were trading at less than the value of their underlying assets.  How did this happen?  Vanguard explains here.

Basically if the NAV of an ETF share is below the trading price you don't want to buy (you'd be over-paying) and if the NAV of an ETF share is above the trading price you don't want to sell (because theoretically you should be able to get a better price).  In practice, you're most likely to see this with bond funds, where the market for selling the underlying assets (bonds) is (a) not very fast/transparent like a stock exchange and (b) tends to seize up periodically these days.

PEBKAC

ETFs introduce one last potential risk: you.  If you are the kind of person who might be tempted to day-trade your index funds, if  given the tools to do so, you might not want an ETF. Mutual funds are fairly clunky to buy & sell - they're terrible for day trading and speculating. ETFs don't have this weakness - you can short them, trade them every 3 minutes, and probably even buy them on margin.  If the temptation is too much, an ETF might not be a good idea.

Two Reasons to Consider ETFs

I am assuming that you already use low-cost indexed mutual funds, and assuming retirement planning (e.g. ignoring taxes).  Here are two reasons to use low-cost index-based exchanged traded funds (ETFs).  I am not arguing in favor of high cost ETFs (they do exist!) or some of the weirder indices (people make up indices and build ETFs around them all the time) - this is just a comparison of mutual funds vs. ETFs for things like the S&P 500.

WTF is an ETF?

Here are two articles explaining (or trying to explain ETFs).  But the basic idea is this: an ETF is like a public company whose business is to simply own the stocks (or bonds) in the index it tracks.  Since the company doesn't really have a business plan other than holding these stocks or bonds, the share value of the company is pretty much equal to the assets inside it.  Thus you can trade a single "stock" (the ETF shares) on an exchange instead of trading the 500 stocks that make up the S&P.  In other words, ETFs are sort of "meta-stocks".

How is this different from a mutual fund?

• In a mutual fund, when you buy & sell shares in the mutual fund, the mutual fund buys and sells the underlying "stuff" inside the fund to raise the cash to give you your proceeds when you sell, and then buys more stuff when you give them cash to buy.
  
• In an ETF, you actually buy and sell the ETF shares itself - the stocks inside the ETF don't have to be unbundled, sold separately, then rebundled each time a share of the ETF is sold.
  

This structure turns out to be good in two ways...

ETFs Often Have Lower Expense Ratios

When I went looking for a broad bond-index mutual fund a few years ago, I couldn't find anything cheaper than an expense ratio of 0.45.  For a bond fund, that's not very good - if I am only going to earn 3%, I don't want 15% (!) of my profits going to the managers.  You can find bond ETFs with expense ratios a lot lower - more like 0.11%.

There are a number of reasons why ETFs might have cheaper costs:

• The market is very competitive and very hot.
• The structure may actually be cheaper to work with.  When ETF shares change hands, only the ETF shares get sold, not the underlying instruments.*  So it is possible that ETFs are less costly to run.
• Mutual funds have this ugly property: if I sell all my shares and get out of Fidelity's Super-Actively-Managed-Wicked-Indexed-Cool-Kids-Fund (SAMWICK?!?) and you have shares, the fund pays the brokerage fee for the sale out of the fund.  But wait ... you own the fund and I don't.  You just paid my brokerage fees.  Sucker!
• By comparison, if I sell my ETF shares, I pay a brokerage fee to sell (like I would a stock). I pay my own costs.

On this last point, I would say the cost structures of ETFs are more fair - but it also means that the expense ratio of an ETF doesn't tell the whole story.  (Nor does the expense ratio of a mutual fund - more on that in the next post.)

The bottom line here is that if you are shopping for cheap indices to hold, the best deals seem to be in ETFs.  Van Guard has a nice set of low-cost ETFs wrapped around a number of indices -they are liquid (mostly), well funded, and have very low expense ratios.

More Control Over Buying and Selling

The way the two-step buying process of a mutual fund (step 1 - buy the fund; step 2 - the fund buys more "stuff") is implemented in the US is really lousy: I put a buy order in during the day, then the market closes, then they recalculate the fund price, and then they buy for me at the new price.*  In other words, there is a huge delay in order execution.

That didn't bother me three years ago, but times have changed, and the market jumps up and down several percentage points in a single day.  And that's where another feature of ETFs is handy: the ability to execute trades faster and place limit orders.

Since an ETF is traded like a stock, all of the things you can do with a stock are available on the ETF - in particular, you can place a limit order, saying "I would like to buy 1000 shares of this ETF when and only when the price dips below $50 a share".  You set the limit order and walk away, knowing that if the ETF falls in value (altering the balance of your portfolio) the limit order will (hopefully) kick in and change your asset allocation back to where it should be.

(In my experience limit orders don't work as perfectly as you might hope - I don't know what kind of mechanism is behind the execution process, but exchanges aren't perfectly continuous - there will be a limit to the precision of order execution.)

Similarly, if you place a market order on an ETF, it's going to go through pretty fast.  So in volatile times, with an ETF at least you know what you're buying.

ETFs also have some potentially negative features, and they're a bit more subtle than an ETF's features.  I will cover them next.

* The mutual fund situation is worse - since the NAV is calculated after hours, you only know the NAV if you buy after hours - but if you do that, they wait an entire market cycle.  So you basically never know what you're getting unless you calculate NAV yourself right before the close of market.

Isolating the Wrist

Plenty of people have written plenty of blog entries about Ultimate Frisbee, and, being a typical perennial rec-leaguer (read: not that good) I'm not really qualified to write squat about Ultimate frisbee.

But - I did manage to "fix" my back-hand throws over the last year (more or less) and, being a big nerd with no coordination who doesn't "get" any sporting activity naturally, I can write about how I did it, because the process was deliberate, intentional, and took a while.

I think you could identify a number of important elements to throwing a frisbee - spin is always at the top of the list, as well as the relationship between the disc and its flight path, how the disc is oriented at release, etc.  In my case what I was missing most was wrist isolation.

When you throw a frisbee, the wrist has a special role: many muscle groups are providing forward velocity, which will make the disc go faster (and thus farther before it falls out of the sky).  For a short throw, the elbow and shoulder might be involved; for a longer throw the whole body might rotate.

But the wrist is the only part of the body that can make the disc spin.  Why is that?  Well, the bigger the muscle group, the slower the rotational speed it produces.  I can snap my wrist almost instantly, but I can't rotate my hips 90 degrees that fast.

Thus the key to a frisbee throw is to "save" the wrist snap until the very last instant possible.  If you snap your wrist too early one of two things happens:

• Your wrist has rotated as far as it goes and the throw isn't over.  Or more likely...
• Your wrist rotates more slowly than it can so as to rotate at the same speed as bigger muscle groups.

I suspect that many attempts at "big" throws go wrong because the thrower synchronizes the wrist and another muscle group.

For my forehand, snapping my wrist at the last second just sort of happens - I don't know why. But for my back-hand, one of the keys to rehabilitating it was to learn to delay the wrist snap until the last minute - it was an issue of coordination.

What finally got my head in the game was to think of the arm movement and wrist snap as two distinct steps.  The exercise I do is to first step across to 10 o clock with the arm swinging as part of the movement, and then, only once my arm actually gets to the throwing position, snap my wrist to throw, as if throwing without any arm movement at all.

(A number of websites suggest first throwing wrist-only to isolate muscle groups - I think this is a good suggestion.  The next step then is to be able to move the arm and not lose the independent wrist control.)

Yet Another Way to Fund Housing

In a previous post I suggested that housing could be funded via equity instead of debt, an idea inspired from other economists and twisted slightly.  It's a somewhat impractical idea - at best the equity stake in a house owned by those other than the occupant would be split into tiny pieces and combined to make a "housing equity index"-style investment.  (The goal of slice and dice here is to emulate stock index funds and insulate passive investors from the occasional idiot home owner who destroys his own equity.  The goal is not to create tranches to change the risk curve like a CDO.)

The problem with this scheme is that the equity holders of the house would either have a say in how the house is managed (an annoying intrusion on home owners) or have no say (which means their capital is at risk).  This new scheme tries to work around this by keeping ownership with the occupant.

Derivatives As Insurance

Derivatives are like the force - they can be used for good or evil.  A legitimate use of derivatives is to offset one risk with the exact opposite risk.  For example, an airline (which is hurt by rising fuel prices) can use derivatives to cheaply set up an investment that goes up when fuel prices rise.  The result is that the airline's net exposure to fuel prices is smaller, which means the airline isn't as at risk to fuel price changes.  This use is a "hedge".

By comparison, derivatives can also be used to speculate - I can buy those same derivatives without being an airline - if fuel prices go up, I win my speculative bet - if they go down, I lose my money.

Derivatives that are used as a hedge are sort of like "insurance" - they provide compensation to the buyer when bad things happen.  If I buy a put option on the S&P, I have bought insurance against the stock market falling.  If the market falls (and I lose money from my stocks) the party who wrote the put will pay me - my insurance payout.  The cost of buying that put option was like a premium.

It should be noted that a derivative contract can be insurance to both parties!  If an oil company writes insurance on fuel prices going up and sells it to an airline, this is good for both parties. If fuel prices go up and the oil company has to pay out on the insurance, that's okay, they're printing money because fuel is expensive.  If fuel prices go down, they get to keep the premiums just when they need it.

(I mention this because A.I.G. has just cost us tons of money by writing insurance policies that came due using derivatives.  A.I.G.'s mistake was not writing the insurance - it was writing insurance that they didn't have the money to pay out.  What they did is equivalent to me starting to write insurance on an earthquake in California.  If it happens, I don't have the millions of dollars to pay out claims.  Maybe I could get a bailout and $165 million in bonus money...)

A New Kind of Home Insurance

So here's my scheme: home depreciation insurance.  The home owner agrees with a third party to:

• Pay the third party if the home price goes up and
• Receive money if the home price goes down.

This effectively lowers the market swings.  If I have a $400,000 house and buy a $200,000 depreciation policy, then if my house price falls by 25% I am only out $50,000, not the full $100,000.  (The other $50,000 "lost" is a loss for the third party.)  If the house goes up by 25%, I only gain $50,000, not $100,000.

In other words, I have given up some of the up-side of owning a home to avoid some of the down-side.  Given that a home is a single asset that is more expensive than most Americans savings, this improves the balance of the home-owners portfolio (which is normally over-weighted in non-diversified real-estate).

Homes are bought with leverage (e.g. I buy a $400,000 home with only $80,000 of my own money), to use the financial lingo.  Leverage (borrowing money to buy more of something that changes in price) amplifies the change in value of whatever you buy.  So our use of mortgage financing is making us all more susceptible to housing market price swings, relative to our personal income, savings, etc.  Depreciation insurance is an attempt to counter-act this problem, by letting the home owner "sell" some of the risk to a third party.

Who would be on the other side of the equation?  I can think of a few possible parties:

• Real estate investors who want exposure to house price appreciation but don't want to have to manage a rental property.*
• Pension fund managers who want to balance a series of asset classes that are unrelated (e.g. stocks vs. bonds vs. houses) to optimize return on volatility.
• Home owners who would consider buying a second home as an investment but don't want to buy less than a whole house worth of exposure.

* Buying a rental property to speculate in real-estate is a little bit tricky - the tenant and land lord have opposite incentives financially.  By comparison, in an owner-occupied house the owner and occupant are one in the same, so there is no conflict.  In other words, if you buy part of the appreciation of someone else's owner-occupied home, you don't have to be as worried that they'll scratch the hell out of the new wood floors.

What's A Bonus Anyway

I heard a commentator on the radio say "people know what a bonus is but they don't know what a credit default is". The commentator was getting at why we all have our shorts tied up over the A.I.G. bonus payout, but I think he is wrong; we (the American people) apparently don't know what a bonus is in the finance industry either.

When I did my first job for Austin, I was paid by the job - I received my payment in two lump sums (one part-way through and one upon completion) based on showing the progress of my work.  I would describe this as "deferred compensation":

• The amount of payment was predetermined.
• The work was done significantly before I received the money (this project took over a year of part-time work).
• The amount of payment was unrelated to the quality of the work.  Either the work was acceptable and I got paid, or it wasn't and I wasn't considered done.
• We had a binding contract enforcing this agreement - had Austin decided not to pay me for my work, my recourse would have been to sue for my due compensation.

That sounds a lot like the A.I.G. "bonus" situation: money promised earlier to employees based on a contract that is now enforceable.  (I can only assume that if the contract was not enforceable that Liddy would have done the easy thing and not paid the employees in the beginning.)

By comparison I received a traditional "bonus" at the end of a different project - it was simply a one-time extra payment, the amount specified by Austin, after finishing my work, as a way for Austin to reward me financially for work that he was "extra" happy with.  That's what we all know of as a bonus.

Now don't get me wrong, I am in favor of not paying the bonuses.  But...not because I think the employees don't "deserve" them for ruining the economy.

I am for not paying the bonuses because, as a tax payer, I now own A.I.G., and as an owner of a financial institution, I think that:

1. The compensation of finance employees is way, way too high.  Simply put, I feel that we bought a company with overpaid employees and we should use every technique we can as an owner to reduce salary!  Call me the Frank Lorenzo of financial services!!*
2. We bought A.I.G. not out of profit motive but to preserve the stability of the financial system. To that end, retaining the legacy employees should not be a goal.  If a side effect of cutting costs is to shed the old employees, I am okay with that.

Of course, there is one very dangerous situation: if employees who know A.I.G.'s "positions" (what derivatives A.I.G. owns/sold/is invested in) quit, can they then try to profit by trading against A.I.G.?  I can only hope that they have some kind of non-compete clause in their contract.  (If not, what on earth was A.I.G.'s management doing?)

* This is why I don't like the idea of congress taxing the bonuses to death - I am in favor of strong ownership by all businesses as a way to protect investor value - including the nationalized ones.  When we the people own a bank, we need to be careful not to let politics run operations, but that doesn't mean we have to be taken as suckers by management.  What drives me nutty about A.I.G.'s bonus payout is that it doesn't strike me as driving a hard bargain.

The Worst Finance Book Ever?

I didn't think I would find a source of financial advice worse than CNBC, but I was wrong. "Conspiracy of the Rich", at least in its present form, should be retitled "Robert Kiyosaki gives you financial advice that is somewhere between negligent and completely destructive to your financial health, while advertising his other books and trying to push your buttons."  Kiyosaki has one good point: we (Americans) are terribly uneducated, financially speaking.  Reading his book will only make the problem worse.

The book is available for free online (if you have an email address you don't mind giving up) - it is very possible that the page numbers I quote will have changed; I don't intend to spend any more time reading it.  Here's just some of what horrified me in the introduction:

"The old rule of diversification tells you to buy a number of stocks, bonds, and mutual funds. Diversification, however, did not protect investors from a 30 percent plunge in the stock market and losses in their mutual funds." (p. 7)

Either this is a gross straw man, or Kiyosaki doesn't understand what diversification means. Diversifying into a broad index of stocks rather than one or two stocks protects you from a particular stock doing something particularly bad. Diversification means that you don't get totally wiped out when Bear Stearns goes down. Diversification among stocks does not protect you from the entire market going down, and no investment advisor with more than 3 brain cells would ever say it does.

Diversification across asset classes protects you from strong movement in one asset class, sometimes. Investors who held both stocks an bonds saw less of a dip than investors entirely in stocks. For a thorough and correct discussion of the capital asset pricing model (which is at the heart of modern portfolio design) see A Random Walk Down Wall Street; for a discussion of why things sometimes still blow up, see Fooled By Randomness.

At the heart of the issue with stocks is not diversification, but volatility. Stocks as an asset class have a history of sometimes getting killed, and now is no exception. The issue at hand is risk tolerance, e.g. if your investments lose half their value, are you going to be okay?

In the end, diversification is a zero-sum game at best. If you are evenly diversified, when one asset class goes down, the other goes up. You lose money in one place and make it in another, but you don't gain any ground. You are static." (p. 8)

This is wrong too for two reasons:

1. Diversification lowers the volatility of your portfolio. If an investor diversified into bonds and lost only 15% when everyone else lost 30%, I can assure you the investor who lost only 15% will be happier than the one who lost 30%. When looking at investments, the "expected" (average) return is not the only thing you care about, and it's probably not even the most important. Diversification makes the worse case a lot less worse, which is hardly "static".
   
2. The investor who lost only 15% has more money, and now is in a much better position to exploit low stock prices than the investor who lost 30%.

Which brings me to the next quote:

"Rather than diversify, wise investors focus and specialize. They get to know the investment category they invest in and how the business works better than anyone else." (p. 8)

and later

"Don't diversify."

This is where Kiyosaki goes from simply wrong to dangerous. Telling an investor not to diversify is, to me, about the same as saying "why don't you bet your entire house on this hand of black-jack. It's a really, really stupid thing to do. It is astounding that he would put this in a personal finance book.

Of course, when you read what comes next...

"During this current financial crisis I took a few hits, but my wealth remainded intact. This is because my wealth is not dependent upon market valuesgoing up or down (a.k.a. capital gains). I invest almost exclusively for cash flow.

"For example, my cash flow decreased a little when the price of oil came down, yet my wealth is strong because I still receive a check in the mail every quarter. Even though the price of the oil stocks, capital gains, game down, I'm not worried because I receive cash flow from my investment. I don't have to worry about selling my stocks to realize a profit."

In other words, Kiyosaki invested in oil stocks, but he didn't lose his wealth when those stocks tanked, because he doesn't consider them to be part of his wealth. If this doesn't seem like the stupidest thing you've ever read, you need to read a book on basic accounting.

Now there is a grain of truth to this. If you have enough money to buy an investment that pays cash periodically and you never need that money back again, you only care about the cash it pays. But this strikes me as making a small fortune on wall street by starting with a large fortune. Let's imagine that Kiyosaki's oil stocks pay a 4% dividend. (That is a rich dividend, by the way!) If he doesn't count the principle (the stocks themselves) but only his cash flow, he will BREAK EVEN on the investment in just over 17 years. In other words, in order to truly ignore the value of the stock, he needs to hold the stocks for 17 years.

Of course, this ignores two huge problems: companies can cut dividends - they can go out of business. All sorts of things can go wrong. A bet that his dividend will stay at 3-4% for 17-24 years uninterrupted is a bad bet to take. The second problem is that there is an opportunity cost. Kiyosaki could have put his money in 2% TIPS (those are inflation-protected government bonds). In those 17 years, his TIPS will probably have doubled his money while he has only made up what he spent on the stocks with his oil stocks.

This is all a fancy way of saying that all investors with half a brain care about what happens to the principle, that is, the money they put in to start the game. It's too big of a chunk of money to ignore. There is no investment that pays such good cash flow that the principle is moot.

But my favorite is on page 10:

"The problem is that very few people know what derivatives are. To keep things simple, I explain derivatives by using the example of an orange and orange juice. Orange juice is a derivative of an orange - just like gasoline is a derivative of oil, or an egg is a derivative of a chicken. It's that simple: If you buy a house, a mortgage is a derivative of you and the house you buy."

Kiyosaki is correct about only one thing in that paragraph: apparently very few people know what derivatives are - and Kiyoaski is not one of them. I do know what a derivative is, and it's not that. A financial derivative is not a "processed" product like orange juice to oranges. A derivative is like a calculus derivative - an investment whose value is based on the change of a property of another investment.

(A stock option is a derivative - its value is based on how much a stock's value goes up - or down, depending on the type of market. A mortgage is not a derivative - it is a non-recourse loan. Fortunately web sites like investopedia can help.)

"Some of these new derivatives had exotic names such as collateralized debt obligations, or high yield corporate bonds, a.k.a. junk bonds, and credit default swaps." (p. 10)

Of the financial instruments on that list, only credit default swaps are actually derivatives. (A credit default swap's value goes up and down depending on the credit worthiness of a bond, that is, how likely is it that the bond is repaid.)

I think this quote from page 5 says it all: 

"Most people cannot tell a good financial advisor from a con man." 

Kiyosaki is 100% correct about that -- ironically it's why he may be able to sell this book.

Bob Vila is Tired of Getting Mugged

James Kwak has a great post about the AIG bonus money.  (The Baseline Scenario is one of my favorite econblogs...)  I'm not usually a fan of grandstanding and populist outrage winning out over pragmatism, but the AIG bonus situation is so outrageous that even I'm pissed off.

This year's bonus represents approximately 50 cents for every American.  That's not a lot of money...I just found two quarters the cats knocked off my desk, so clearly this isn't killing me. I think what is most offensive to me about the bonus money situation is that it took us (Americans, participants in our own financial system) such a blatant abuse to get our blood boiling. 

Apparently wall street doesn't just have to treat us like crap to piss us off, they have to do so after they completely trash the economy.

• If the economy is growing and wall street steals from us, we don't care.
• If the economy is growing, but wall street is stealing from us faster than the economy is growing, astoundingly we still don't care.
• Only if the economy crashes and burns hard and then they steal more from us do we get grumpy.

If there is a lesson for Wall Street CEOs and fund managers, it is this: take all you can during a boom - no one is paying any attention.

The problem is one of leverage.  $165 million is a lot for a small group of people.  But it is not much for the entire population of the US.  It's hard to say "I really want my 50 cents back"...it doesn't feel right.  And this is the problem with all of the ways that wall street takes our money: they take a little bit from us and it adds up to a lot for them.

Actually, it only seems like a little bit.  Consider one of my favorite rants: the lousy mutual funds that get passed off as savings vehicles for employee 401Ks.  If you are like my wife and get stuck with a lousy selection of 401K funds there's basically nothing you can do - don't use the 401K and you lose the tax incentive to save.

Consider the effect of a 1.1% expense ratio on your funds vs. a 0.1% expense ratio.  To make this simple, assume you invest $1000 in stocks when you turn 22, and then just leave it until you are 65.  What will your real (inflation-adjusted) result be when you retire?

If you invested in the cost-effective mutual fund, you have $11,763.22.  Not bad - for $1000 in principle you made $10,000 in returns!

But what about the 1.1% fund?  Should we be angry that the fund managers are syphoning off 1%?  1% doesn't sound like much.  But...in the same scenario, you end up with...

...$7,822.50.

Ouch.  33% of your returns are gone!  If you read a prospectus that said: we will take 33% of your retirement money, would you ever accept that?

So...perhaps we should be outraged about 1%.  Perhaps we should be outraged about $0.50. Because it starts to add up.  But more importantly, because the mindset that lets people syphon their 1%, their $0.50, is wrong and it's toxic.

Media Bias? Follow The Money

My views on media bias have changed from the days I used to work in commercial radio - the media business has changed too.  But this rant is directed at my favorite fish in a barrel, CNBC. Here's a taste of CNBC headlines:

• Bounce of The Century!
  
• Market Tips: Get Your Cash into This Rally
• Pros Say: Cash is Now the Riskiest Bet
• Hirschhorn: 5 Reasons to Get Back Into the Market

This from a network that was touting non-directional "absolute return" CDs.

I claim that CNBC's bias is toward advocating things that are bad for your financial health.  Market timing, active trading, complex, hard-to-understand investments with opaque fee structures, what's the connection here?

The answer is the advertisers...Charles Schwab, Fidelity, E-Trade, and off we go.  Wall Street makes its money in a number of ways, but the main way is by taking a piece of the action, often whether or not the outcome of the action is any good.  Examples:

• Investment banks take a fee for issuing bonds in a leveraged buy-out, even if the bought out company then craters under the weight of its own debt.
• Credit cards take 2.5% to 3.5% of everything from merchants, and then hit shoppers with 20% or more on an overdue balance.
• Mortgage brokers take a fee up front for a completed mortgage even if the home owner defaults.  The broker might take a bigger fee if the home owner takes a higher interest rate, regardless of whether this is good for anyone involved.
• Mutual funds take 1% of your money every year, whether their investments go up and down.  If they run up trading costs by trading like crazy, you pay that too.
• Hedge funds take 20% of the profit they make with your money.  They don't eat 20% of the losses.

So what is CNBC's bias?  I think it is to advocate strategies that create a "cut" for their advertisers.  If it wasn't they might say something like:

• Pick an asset allocation that makes sense for your financial goals.
• Build a portfolio using the cheapest vehicles that meet the asset requirements.
• Rebalance periodically, and let it sit.

And hrm...if you do that, you don't really care whether this is the bounce of the century, do you?