Ignore Average Annual Return Rates: Geometric Mean V. Arithmetic Mean

Previous: Vanguard 500 VFINX Loses 20% of Your Money from 8 Years Ago

Protect yourself from slick marketing: This article explains the importance of the geometric mean and how to calculate it to read and report returns on investment (ROI) accurately.

Misleading "Average Annual Returns"

The average annual rate of return tends to overestimate your gains because it is an arithmetic mean (an average based on additive units) which is inappropriate for multiplicative products such as compounded interest.

Using the arithmetic "average annual rate of return" for stock performance is like trying to describe how tall you have grown in ounces or asking, "How many inches do you weigh?"

Simple hypothetical of a $100 lump-sum buy-and-hold:

Year - Investment - Return
0 ............ $100 ......... -
1 .............. $50 ...... (50%)
2 ............ $100 ...... 100%

• Average annual rate of return: (100 + (-50))/2 = 25%

You started with $100 and you ended with $100 but your $0 gain shows +25% average annual return.

Of course, you actually have 0% gain on your initial value after 2 years.

Use the Geometric Mean Instead

Ignore the arithmetic mean (average annual rate of return) and instead calculate the more helpful geometric mean (annualized rate) to find the factor that, if repeated, would result in your current/desired balance; for n years, the nth-root of the products of the rates-expressed-as-positive-growth-factors. For our example above that halved (*0.50) and then doubled (*2.00) in 2 years:

• The square-root of (0.50 * 2.00) = a factor of 1.00

So $100 * 1.00 = $100. The factor of 1.00 is equivalent to 0% interest, since you can multiply by 1 forever and still have the same number with which you started (in our example, 0% per year for 2 years). A factor of 1.12 would equal 12% growth (per time period). Note that 3 years would require the cubed-root, etc.

A shortcut is the nth-root of the last-year's-balance-divided-by-the-first-year's-balance. For our example:

• The square-root of (100/100) = a factor of 1.00

The shortcut shows that you can ignore all the "paper profits" ups and downs (unrealized gains and losses) of your stocks or home equity and concentrate on the end points of initial investment v. final cash-out (assuming no intervening hard cash inputs/withdrawals). The geometric mean simulates a consistent year-after-year interest rate so you can compare a volatile stock to something with steady progress such as a 5-year Certificate of Deposit (CD).

Use Geometric Standard Deviation

Ignore arithmetic standard deviation and use geometric standard deviation. That calculation is a bit more complicated (involving logs) but at least know how to read it. Unlike the arithmetic version which is reported as a quantity (e.g. 5% mean with standard deviation of 3% indicates a range of 2-8%), geometric standard deviation is reported as a factor (e.g. 1.05 mean with standard deviation of 1.03 indicates a range of 1.02-1.08, and the nth standard deviation is the nth power of the geometric standard deviation).

Always use the right tool for the job and do not let Wall Street or Madison Avenue tell you otherwise.

Geometric Mean Calculator for Annualized Returns on Investment (ROI)

Americans’ Net Worth in the Federal Reserve’s Survey of Consumer Finances (SCF)

What if a Quarter of Your Wealth Were Imaginary?

Net worth is a favorite topic in the buck-o-sphere (personal finance blog-o-sphere) and many people pounce on a government or media report to see how they stack up against their fellow Americans. You need to understand the source of the information and know how to read economic and financial reports correctly.

The Federal Reserve’s triennial Survey of Consumer Finances (SCF) and specifically its net worth numbers provide good examples on what to watch.

Time Lag

A report that comes out today might have no current data and instead be based on data from a few years ago. The 2003 SCF report used 1998-2001 data. The 2006 SCF report used 2001-2004 data. Most people will not see 2007 data until the 2009 SCF report.

Forgetting this point can lead to faulty decisions. One blogger recently linked to a 2003 article and compared his/her 2007 net worth to 2001 data.

Real (Inflation-Adjusted) V. Nominal Dollars

The SCF adjusts for inflation but its tables are not labeled as “real” dollars, making it too easy for the casual reader to assume nominal (un-adjusted) dollars. Further, the SCF uses a “current methods” adjusted CPI which assumes less of an inflation bite than the official CPI does.

How Do They Get People’s Financial Information?

The SCF is a survey, not a census. Like much government data, the results depend on “Gallup poll” types of problems such as sampling error, weighting, refusal to participate, and similar issues. The survey firm NORC conducts the survey of approximately 4,000 families to estimate the United States (a statistically significant sample). The accuracy of the Federal Reserve’s SCF depends upon the accuracy of Joe Sixpack’s financial self-knowledge when questioned by NORC.

Whose Net Worth?

The SCF’s “family” is technically the Primary Economic Unit (PEU) of a household. The SCF uses an unusual definition of “family” that includes single-person households. The PEU is a hybrid between other government definitions of family and households. The average US family is a bit over 3 persons and the average household is a bit under 3 persons.

“Age” is the age of “head” of “family” and the age of others in the PEU can vary from that, so 2 “40-year-old” households might have very different average ages (is the spouse 30 or 50?) and therefore have had different amounts of time to accumulate wealth.

What Counts?

The medians of many assets and debts are “conditional medians” that exclude zero to show a typical holding of a family that possesses the item in question (e.g., the median debt of debtors, not the median debt of everyone including debt-free people, which would lower the figure considerably).

The SCF counts a 401k but it ignores a defined-benefit pension (by the way, the proper absence of a defined-benefit pension from “net worth” is another reason why net worth is for measuring current wealth and is not very good at estimating future wealth). The SCF also ignores Social Security. The SCF appears to ignore tax liabilities.

Paper Profits

Net worth includes volatile asset prices (stocks, real estate) that can bubble or crash. Median unrealized capital gains ("paper profits") accounted for about 25-30% of median net worth for all but the youngest age group (under 35) in 2004 (before the 2005-2006 housing bubble apogee). Remember that about a quarter of median net worth is not real yet.

The only bad part about learning all this is that you might get upset more often when you see how other people misuse the SCF and similar statistics.

Vanguard 500 VFINX Loses 20% of Your Money from 8 Years Ago

Previous:
Beware Vanguard 500 Faulty Logic & False Performance Measures for Investments

Update 8/4/07: This article originally was based on Google Finance Beta's "10y" graph on 8/3/07 but the "10 year" graph did not cover 10 years (thanks, Google) so I re-adjusted the article for 8 years.

When Claims of +160% End at -20%

The Vanguard 500 S&P 500 index fund, often claimed to give a 12% return on investment (ROI) rate, closed today at $132.16, an excellent lesson in real returns.

Misleading "Average Annual Returns"

First, note that average annual return rates tend to overestimate your gains.

Simple hypothetical of a $100 lump-sum buy-and-hold:

Year - Investment - Return
0 ............ $100 ......... -
1 .............. $50 ...... (50%)
2 ............ $100 ...... 100%

Average annual rate of return: (100 + (-50))/2 = 25%

You started with $100 and you ended with $100 but your $0 gain shows +25% average annual return.

Of course, you actually have 0% gain on your initial value after 2 years.

Use the Geometric Mean Instead.

What if you put your $100 in the Vanguard 500 VFNIX 8 years ago?

If you expected 12% per year, you expect to find your $100 investment to have grown to $260 after 8 years, a 160% increase over your initial value.

De Ja Vu: "Hey, this is where I started!"

However, the Vanguard 500 spent the better part of the last decade in the V-graph pattern of our simple hypothetical: The VFINX share price was about $130 about 8 years ago and closed at about $132 today, which is about 0% growth after 8 years.

Real Negative Returns

If inflation were about 3% per year, then the Vanguard 500 performed as if it had been losing your money at -3% per year.

The real value of your initial $100 is now about $80. You lost 20% of your real money over the last 8 years.

Opportunity Costs

Some say, "Invest as early as possible!", but today you can buy VFINX at about the same dollar price (less in real terms) as 8 years earlier and have the same nest egg at retirement as the person who invested 8 years before you--and meanwhile your money could have been accomplishing other things for the past 8 years.

Some say, "Invest instead of paying off your mortgage!", but someone who had a windfall 8 years ago and chose to invest the lump sum in the Vanguard 500 instead of paying off a mortgage would have done even worse than the real 20% loss by adding the mortgage's real negative return to the VFINX's real negative return.

"In the long run, we are all dead." -- John Maynard Keynes

VFINX eventually will rise again and you can find other timeframes with higher returns on investment (ROI) but remember that certain investments or markets can be flat or worse for a decade. Even if Investment A beats Investment B in the long term (several decades), Investment B might beat Investment A in the short- or mid-term. You might have an immediate goal such as paying off a mortgage or other debt that can make you thousands of dollars richer than borrow-to-invest schemes when alternative investments are in--or are about to enter--the doldrums.

Always do the math for your specific circumstance and do not rely on optimistic promises.

See:
Never Prepay Mortgage? Housing Myths Part 1

Fact V. Emotion in Personal Finance: Do Not Confuse

Feel-Good Finance Folly

Lazy Man recently posted about taking the personal out of personal finance. He and the commenters made good points about how, if people need psychological or morale boosts, they should get boosts by seeing the benefits of the rational choice, rather than wallowing in the bliss of ignorance. I agree so far but there are important distinctions about which "personal" intrusions are bad.

Different valuations are inevitable.

First, people put personal values on items but I do not think that is what we mean by "psychological" irrationality. We cannot say, "You should have bought the whiskey that is on sale because it is clearly a better dollar-value than the milk." Basic economics says that the only reason people trade is because 2 people value the same item differently. You sell a book because you value the $10 cash more than the book--but you have to find a buyer with the opposite preference of valuing the book more than their $10 cash. If everyone shared your preference, you never would be able to sell. Without differential values/preferences/goals, there is no market.

The key is that everyone is rationally pursuing their different values and goals.

The Illusion of Progress:

Psychological irrationality is working against your goals, when you do not pursue/achieve your goals efficiently.

The problem is when someone wants to eliminate debt but pursues the goal irrationally. I do mean people who give lip service to fiscal health but clearly value other things more such as keeping up with the Joneses or refusing to admit a bad investment decision (although there are clearly psychological issues there). I mean people who fool themselves into bad decisions and think that they are gaining wealth efficiently when they are not.

Do not confuse difficult pricing with emotional irrationality.

Two people can look at "X risk level" and rationally decide differently based on their different personal risk averseness--but do not confuse that with 2 people with identical risk averseness who rationally decide differently because they disagree on what the risk level is. When 2 people disagree that the stock market will return 10%, that is not a difference of risk averseness, that is a mathematical dispute. Quantifying risk and estimating future prices is difficult but it is a mathematical job.

The anti-debt scolds might look emotional if stocks bubble--but the stock cheerleaders might look emotional if stocks crash.

See:
Never Prepay Mortgage? Housing Myths Part 1
The $200,000 Blunder: Housing Myths Part 2
Inflating Leveraged ROI Can Ruin You
-

Inflating Leveraged ROI Can Ruin You

Previous: Leveraged Investments: High ROI Is Not Always Best

The previous leverage article covered how the common method for measuring leveraged Return on Investment (ROI) can mislead you by underestimating the work and risk. Add overly-optimistic “magic” numbers to inflate ROI and this article shows how the combination of rosy estimates and ignored risk can trick you into a bad investment.

We will start with the same example as last time:
$250k: invest 100% cash (unleveraged) or 10% cash with 90% loan (leveraged)?

$250,000 [100%] paid in full in cash:
--$26,400 in rents - $3300 expense = $23,100 NOI
--$23,100 / $250,000 = 9.2% ROI

$25,000 [10%] cash down payment [plus $225,000 mortgage]:
--$18,879 in mortgage payments + $3300 expense = $22,179
--$26,400 in rents - $22,179 = $4221 NOI
--$4221 / $25,000 cash in front = 16.9% ROI

example from: Using Financing for Real Estate Leverage

Debt makes you 80% richer?

The example author concluded:

“As you can see, even though your risk increases with leverage, it might be a wise choice when you can increase your ROI by as much as 80% (16.9% is 84% increase over 9.2%) over the full cash in front option.”

The promised 7.7% spread (16.9 over 9.2) was not impressive enough so the author used a percentage of a percentage to make the pro-leverage number 10-times bigger (80%--Who doesn't want to earn 80%?). Almost doubling your ROI would be a good thing but let’s not get carried away too soon.

The pro-leverage conclusion depends on magic numbers.

How many rental markets have perfect 100% occupancy rates, i.e. no vacancies at all between tenants, and no missed payments? Here are some real-world rental occupancy rates/vacancy rates that I quickly found to see how the examples perform with real-life inefficiencies:

(Sorry if a long space appears before the table)

© 2007 HFF Market	Occupancy Rate (%)	Gross Rent Annual ($)	ROI Unleveraged (%)	ROI Leveraged (%)
Hypothetical	100.0	26,400	9.2	16.9
2001 Northeast	94.7	25,001	8.7	11.3
2001 US urban (inside MSA)	92.0	24,288	8.4	8.4
2001 US non-urban	89.6	23,654	8.1	5.9
2004-Sep. Texas 6 major markets	78.0	20,592	6.9	(6.3)
2003-Oct. Texas 6 major markets	77.5	20,460	6.9	(6.9)

Sources: Statistical Abstract of the United States, 2002, Community Connections

• In only one real-world occupancy rate did the leveraged ROI beat the unleveraged ROI.
• In one other case, leveraged ROI broke even with unleveraged ROI.
• In most cases, the leveraged ROI was worse than the unleveraged ROI.
• In 2 cases, the leveraged ROI is losing your money while the unleveraged ROI is still providing almost 7%.
• In the last case, the margin spread (+6.9% v. -6.9%) shows that it is the unleveraged ROI that is 13.8% points higher than the leveraged choice.

Can you feel that $225k of debt making you 80% richer yet?

Leveraged Investments: High ROI Is Not Always Best

A recent leveraged-investment discussion revealed that people can calculate a high Return on Investment (ROI) from borrowing by not counting the debt principal as a cost and (in one case) not counting the debt interest as a cost.

Consider a choice to invest $250 cash v. $250 debt:

Investing cash to earn 10% earns 10%.
Investing debt at 5% interest-cost to earn 10% earns net 5%.

However, it is common to claim that debt gives the higher ROI.

Free money, for the asking, no strings attached, no debits

Financial analysts can claim that debt gives the higher ROI by not counting the debt principal as part of the investment, yet counting the net returns from debt (your ROI sprouts from "nothing"). The argument is that the debt is "not your money," although a credit check of your name would not agree completely and at the very least the argument ignores the legal liability, risk, insurance requirements, effect on credit score, credit score's effect on other loan rates, etc.

Infinite ROI, infinite profits

Excluding the debt principal from the initial value of an investment certainly can raise the apparent ROI. However, that argument suggests that 0% downpayment gives you infinite ROI when we all know that, for any given dollar amount of investment, you would be poorer by borrowing more of it and richer by borrowing less of it (as in the "Consider a choice" above, and the example below).

Wait, there is no such thing as a free lunch after all

While a high ROI seems efficient, at some point you want to maximize your profits in dollars rather than percentage points. You cannot buy lunch with percentage points. You need dollars.

Look at your real estate profits here in Net Operating Income (NOI):

$250,000 [100%] paid in full in cash:
--$26,400 in rents - $3300 expense = $23,100 NOI
--$23,100 / $250,000 = 9.2% ROI

$25,000 [10%] cash down payment [plus $225,000 mortgage]:
--$18,879 in mortgage payments + $3300 expense = $22,179
--$26,400 in rents - $22,179 = $4221 NOI
--$4221 / $25,000 cash in front = 16.9% ROI

example from: Using Financing for Real Estate Leverage

The NOI trend gives you an idea of your hard-earned money that you keep by putting a larger downpayment on your mortgage (although this is a rental example).

These types of examples are very common to extol leveraging but you can see the trend that the more you pump up the ROI, the less money you make.

Cocktail-party bragging rights to the higher but leveraged ROI will cost you $18,879.

How high an ROI do you want?

(PS: The NOI informs you that the leveraged ROI is inflated because it ignores that you left $225k cash idle and (apples to apples) the actual leveraged ROI here is only 1.7% ($4221/$250k), or 0.9% ($4221/$475k) if you include the $225k mortgage to discount for debt risk.--Note added 7/25/07, last updated 7/30/07)

-

Leveraging multiplies scale, volume, and risk but I will leave that for a future article. Alternate uses for the same money (opportunity costs) such as stocks or arbitrage are separate choices and each can be leveraged or not leveraged.

Next: Inflating Leveraged ROI Can Ruin You

See also:
Never Prepay Mortgage? Housing Myths Part 1
The $200,000 Blunder: Housing Myths Part 2
Home Mortgages Are Bad Investment Tools? Housing Myths Part 3
Homeowner Profits Ignore Huge Costs: Housing Myths Part 4

Beware Vanguard 500 Faulty Logic & False Performance Measures for Investments

The Vanguard 500 S&P500 index fund is popular in the buck-o-sphere (PF blogosphere) and bloggers often cite its historical annual rate of return of 12% since inception in 1976. However, besides the usual caveat that past performance is no guarantee of future performance, too many people ignore another vital factor. The Vanguard 500's real performance is not nearly as stellar as many believe.

Confusing Nominal V. Real (Inflation-Adjusted) Returns
& Confusing Today's Inflation Rates V. Past Rates

Dough Roller recently remembered earning more than 10% on Certificate of Deposit (CD) during the high inflation of the 1970s/early-1980s. Indeed, consumer prices rose 13.3% in 1979.

Forgetting to count inflation--and forgetting that past inflation was quadruple current official rates--will cause you to overestimate historical investment performance. The Vanguard 500 averaged 12% annually since mid-1976 but double-digit inflation makes a 12% return pitiful. A fund with 12% growth during 12% inflation is no better than a fund with 3% growth during 3% inflation.

Before you "beat the market," at least beat inflation.

"Beating the market" compares your fund relative to other funds, which could mean that your fund lost a lot while other funds lost even more. This is small consolation, since schadenfreude will not pay your bills.

You need real, after-tax gains to buy food in retirement.

Use real rates of return (not nominal rates of return) to get a more accurate measure of historical performance. This lesson applies to any investment.

See also:
Vanguard 500 VFINX Loses 20% of Your Money from 8 Years Ago
Destroy Your Retirement Nestegg with Happy Thoughts
Never Prepay Mortgage? Housing Myths Part 1

Destroy Your Retirement Nestegg with Happy Thoughts

Magic Numbers:
Pick One . . . Whichever One Makes You Happy

My recent article about investing vs. paying off your mortgage, Never Prepay Mortgage? Housing Myths Part 1, has a bigger lesson for the subprime mortgage and Collateralized Debt Obligation (CDO) mess.

“Prove” anything by picking the magic number.

My article noted how a 2001 Fool.com article predicted a 12% annual return on investment (ROI) for an S&P500 fund but in early 2007 the 10-year average was only 7.7% (even using "Bull's Math" (optimistic Wall Street math)).

The second mistake is forgetting what an average is.

The problem for your retirement nest-egg is that a return to 12% annually does not fix the predicament. To average 12% after a decade of 8%, you need the next decade to provide over 16%. However, we are coming due for a recession (cycles are inevitable) and a steady 16% for a decade seems unlikely. Moreover, if a coming particular year does “only” 12%, you need another year at 20% to average a 16% decade to make up for the first decade’s 8%. If the S&P500 returns a modest 8% in a future recession, we might need the S&P500 later to return 25% simply to average 12% in the 21st Century.

“Experts” apparently made this mistake in financing the housing bubble.

Experts at an early-2006 conference on home-equity-loan securitization assumed a worst-case scenario of +3% asset (home) appreciation per year. It seems as if they assumed the worst stress-test condition to be the long-term trend rate of residential real estate appreciation, barely treading water with inflation (if we continue 2-3% core inflation).

The bigger they are, the harder they fall.

The glaring error is assuming that the price basement will be the historic average, rather than the lower numbers that created the average. +1 and -1 average to 0. It is mathematically impossible for every year to be either average (0) or above average (+1). Some years must be below average (-1) to make the average. If you then had a few years at +10 (far above average), you cannot assume that your future floor will be 0 (the average) because now you need a few years at -10 (far below average) to return the average to 0.

The big problem ahead

Standard & Poor's (S&P) and Moody's are reducing the ratings of mortgage securities, which is like telling a new owner, after the purchase, that his/her "6-pack" of soda only has 5 cans, his/her "30mpg" car only gets 20mpg, or his/her "3-bedroom" house only has 2 bedrooms.

The valuation errors contributed to the housing bubble by (1) overestimating the profit in home-mortgage sales, (2) thus overselling the financing product, (3) thus causing the inflation of too many dollars chasing too few assets (the home, necessary to cash the profit on the home-mortgage product), (4) thus contributing to the asset bubble, (5) but also underestimating the risk, (6) thus underdiscounting/overpricing securitized debt/CDOs, (7) thus sticking buyers/investors with insolvent lemons, (8) and the double whammy of evaporating home equity and evaporating securities equity creates yet to be seen ripples in pension/retirements funds, consumer spending, employment, Federal Reserve monetary policy, stock market performance (+25% or -10% for the S&P500?), and the economy writ large.

See also: Beware Vanguard 500 Faulty Logic & False Performance Measures for Investments

“Savings” Pitch Tricks You into Overspending

More Dark Alchemy:
“News”=Advertising
“Saving”=Spending

Free Money Finance cited a finance article about 15% of US households with $0 net worth. The article is a perfect example of tricking you with slick sales marketing that masquerades as news.

First, however, look at the faulty analysis:

• The article cites 15% of households with $0 net worth but is on thin ice when it converts households to individuals—unnecessarily (what is wrong with simply saying "1 out of 7 households"?).
• The 2.6 persons per household includes babies and college roommates.
• The logical flaw is the article's assumption that a $0 household has 2.6 persons each with $0 net worth. Each household member can be wildly different from one another—think if your roommate were Casey Serin.
• Besides, since about 15% of households are led by a “householder” under 30 years old, 15% of households with $0 net worth is not “shocking” (as the author asserted).

How To Twist “Savings” To Trick You into Overspending

• The author claims “shocking” news to scare you into “saving” more.
• Even more importantly, the pitch actually gets you to spend more money.
• There is no mention of debt reduction. The author ignores the most basic method of increasing net worth (reducing debt), and also ignores basic savings, and skips straight to investments and advertises specific mutual-fund and stock picks.
• Swallowing his advice means that you probably will be paying fees to someone, probably while paying interest (on unpaid debts) and taxes elsewhere along the way.

The Old Borrow-To-Invest Scheme Again: Who Profits?

It is no surprise when someone advises you to do something that would profit him/her (e.g. to buy a mortgage, student loan, insurance, investment, or anything). The strange part is that people continue to fall for it.

If you pay off debt early, the bank gets less profit off you and the stock market does not get to profit off that money either. It is no surprise when the banking and investment industries (including “free” websites that make money off the stock-market culture) urge you to invest instead of paying off debt; they make money off you coming and going.

When your “impartial” friend makes that same recommendation, you might find that you can trace his/her conviction to advice from the investment industry.

Cast a Jaundiced Eye on the Old Spend-To-Save Advice

Investments are great vehicles for surplus funds but do not confuse true surpluses with amounts above minimum debt payments.

You might do all the math specific to your situation and occasionally find a circumstance where borrowing to invest will (1) profit you as well as (2) profit others—but make sure that #1 is indeed part of the result.

Do Not Inflate Net Worth: Ignore Taxes at Your Peril

Hat Tip: Ed provoked this post.

Part of series: Biggest Net Worth Mistakes: Is Your Net Worth Accurate or Useful?

Do not deceive yourself by inflating your net worth.

Yes, it is difficult to estimate some items but it is better to underestimate your wealth and later be pleasantly surprised than to overestimate and lay a trap for yourself.

The taxman cometh.

People often leave taxes and regulatory costs off their liability list but you can be sure that the government will ignore such creative accounting and will not forget to take its slice ("But look, my blog says I don't have a tax liability because I typed it that way.").

Remember what "net worth" is.

Net worth is a snapshot of what you would have if you liquidated now. If liquidating your IRA now would incur a 35% income-tax rate plus 10% penalty, then the accurate net worth of your IRA now is about half of what your account statements say.

To say that you would not liquidate now and things will be different later is to ignore net worth. If you use a non-net-worth measure, do not call it net worth.

It is better to understand the limitations of a measurement than to cook the books.

Even if you somehow accurately predict a $1 million nest egg for retirement and dismiss your tax liability on it as "only" 10%, leaving the tax liability off your books is a $100,000 error.

To estimate what your net worth will be decades from now is a very difficult endeavor because you would have to guess at fluctuating IRA and home values, variable inflation rates, uncertain future income and saving rates, and the competing compounded interest/returns of both investments and debts.

That difficulty is why it is easier to estimate your net worth now with all liablities from current tax brackets and current laws.

Is the American Dream Dead? Debunking the Pew Charitable Trusts' Economic Mobility Project

The recent Pew Charitable Trusts Economic Mobility Project’s claim that the American Dream "may well be shifting" (about sons not doing as well as their fathers) has been spreading through the mainstream media like a rash and Flexo at Consumerism Commentary asked me to explain my skepticism so here is my quick impression:

It is always a good idea to go to the original report and check the “methodology” section, often buried in the footnotes, to see how the report created the results.

We start with Pew’s own numbers:

Real Income of Men Age 30-39

1964 $31,097
1974 $40,210
1984 Missing
1994 $32,801
2004 $35,010

• The “falling behind” media headlines highlight the 2004 v. 1974 comparison but comparing 2 isolated data points is notoriously dangerous and you can see even from the short chronology above that the long-term trend shows an increase while 1974 is an “outlier” (aberration that deviates from the trend). The 1994 figure is also lower than 1974 even though during the 1990s the media told us ad nauseum how the 1990s was the greatest economy in history. The 2004 figure is higher than the 1994 figure so why isn’t the current decade greater than the greatest?
• The “falling behind” media headlines highlight the comparison to a 1974 baseline but 1970s baselines are frequently misleading. If you ever want to “prove” decline, the 1970s is a good place to shop because of a peculiar set of economic convergences at that time. The numbers often appear to show the 1970s as a worker’s paradise even though this was the Archie Bunker decade of stagflation, an energy crisis, price controls, gas rationing, and a high Misery Index.
• The report calculates income oddly, considering the topic of economic progress. The report’s idea of “income” excludes non-cash employer-provided benefits such as health insurance and retirement benefits but it does count government welfare checks. In other words, if your dad collected a lot of welfare, the report counts that as doing well. In Pew’s world, being on the dole is better than having health insurance or a pension.

The report has much more to question (a 30-year generation instead of a 20-year generation, the international comparisons, etc.) so feel free to see for yourself and post comments.

Best-Worst Financial Measures: How To Track Your Financial Independence and Security

Five Cent Nickel's recent post shows that he and the rest of the buck-o-sphere (personal finance blogging) are still crackling over net worth and practical wealth so here is further elaboration of my thinking:

How To Track Your Financial Independence and Security

The first step is to choose your lifestyle (do not let a lifestyle choose you--take control of your life). The best financial measure depends upon your exact purpose. If you are planning to sell your million-dollar mansion and move into a $100k condo, then you want to track both those prices. Even so, it might be more prudent not to count the difference as wealth until the money is in your bank account. If, however, you plan to stay at your current consumption level without wrenching changes (e.g. you will stay in the same place or a similar-value residence for the rest of your life), then ignore your home value, ignore your treasured collection of collectible Star Wars action figures, and ignore anything else that you would not cash-out.

Measures to ignore:

• Net worth
• Income (general): Any income recommendation such as “80% of pre-retirement income” is nearly worthless because it ignores expenses (costs/outgo)—and expenses are the whole reason that you need income.
• Gross Income: Guidelines about what percentage of gross income to spend on Item X are nearly worthless because (1) taxes and deductions vary widely so net income varies widely, and (2) the value of “$100” of Item X can vary greatly by how much is asset value versus interest or related fees.
• Net income: Even “25% of net income” for Item X can mean very different things to different people depending upon other regular bills (medical costs, etc.). Further, income can vary and future income is less certain than past income (savings are your residual past incomes).

What to measure:

Financial security = liquid wealth divided by total expenses
e.g., divide by monthly expenses to see how many months you can go without income.
Remember to amortize infrequent expenditures (automobile purchase) into a monthly budget.

Expenditures are key

The critical value is your minimum necessary expenses, relative to available wealth (i.e. savings, not income). In other words, compare past surplus income to future costs; past income v. future outgo. You want to maximize your past, surplus, accessible income (savings/liquid wealth) and minimize your expenses.

Next: Give Yourself a Raise: Best Saving Is Not Spending

Practical Wealth V. Phantom Wealth: Time Your Money

Time Is Money

Timing Is Everything

"Biggest Net Worth Mistakes: Is Your Net Worth Accurate or Useful?" covered how "net worth" and assets can trick you into the illusion of financial health (phantom wealth). Instead of net worth, use realistic measures of accessible wealth to rate your fiscal health. Too many people ask the "How much?" question but forget the crucial "When?" question.

Liquidity: WHEN you have money is as crucial as HOW MUCH.

Try calculating your wealth in the standard money measurements of liquidity to measure how much buying power you actually have at different time horizons, from immediately through the medium and long terms: Make your own personal M0 (“M zero”), M1, M2, and M3:

• M0 = Cash.
• M1 = M0 + checking or other “demand” accounts.
• M2 = M1 + savings accounts up to and including insured CDs (<$100,000).
• M3 = All money.

Compare cash with obligations at each time horizon (week, month, year, before age 59 1/2, etc.--including any withdrawal penalties). What if you lose your job, get sick, wreck your car, or have a house fire? You should have cash for small or likely or short-term events, scheduled liquidity for medium-term events, and use available credit or insurance only for the biggest, unexpected, unaffordable events.

Working Capital a.k.a. Operating Capital

Current Ratio = current assets divided by current liabilities

"Current" means liquid, liquidatable, or due within a time period. A potential pitfall is that, with a time period such as "this year," current assets include expectations of future income: Beware of relying on Accounts Receivable, including future wage paychecks, because they are not "a bird in the hand." If you have been opting for overtime pay recently, that precedent is no guarantee that you always will be able to choose your take-home dollar amount. Do not count your chickens before they are hatched.

Liquidity Ratio = liquid assets divided by expenses
Assume your income suddenly becomes $0. How long would you last? A typical recommendation is a 3-6 month buffer, and the self-employed or irregularly-employed are more likely to keep even bigger buffers for longer lean times.

Accurately Rate the Liquidity of Your Non-Money Assets

Rate the realistic time horizon for liquidating the asset (Week? Month? Year?) before you include it in your appropriate "time horizon" assessment of wealth.

Be very cautious in counting non-money assets because their ownership is "sticky" (resistant to change). The stickiness might be due to legalities such as a car title, or regulations such as car inspection (it is grandfathered but would fail a new inspection), or transfer costs such as a sales tax. Both time-to-sell and sales-price can change with events, such as a CNN expose on how your car model is a death trap.

Even more importantly, emotional attachment is another form of stickiness that confuses investment with consumption.

How To Borrow Money Wisely: Do's and Don'ts

The best loan is the one not taken but if you must:

Do the Whole-Household Worst-Case Scenario

• Spot logical fallacies. Forget expert recommendations or the plan that "most people" choose. They are not you. Do the numbers make sense for you?
• Forget eligibility limits of maximum loans, which are enticements to "overbuy" the lender's product (overborrow). What you could borrow is irrelevant. Stick to what you need and nothing more.
• Demand the disclosure of all payments over the lifetime of a loan (avoid the trap of low installments that add up to far greater final cost, especially through negative amortization).
• Check the bottom line of total costs, including combined interest rates, fees, surcharges, taxes, or required insurance. A favorite trick is to say things such as "5% more" or "5% over" and people hear "5%" even though the total interest might be 10% or higher.
• Question all assumptions (e.g. adjustable rates "estimated" to rise very little). Forget what "probably" will happen according to the optimistic salesperson ("You can always refinance later."). What "could" happen on the downside? Spot oxymoronic, tricky weasel phrases such as, "At worst, it probably won't go higher than . . . ." Probable is not the same as possible.
• Consider not only "worst case scenario" with that isolated loan but consider a combined worst case for your entire household (all current liabilities plus possible future medical emergencies, employment interruptions, etc.).
• Review all final written terms at the moment of closing. Do not rely on what the proposal was yesterday and especially do not rely on verbal assurances.
• The first thing to do with final papers is to check the last few pages, because a favorite trick is to pack surprises at the end of a stack of papers for when you are tired, bored, running late, and deeply "invested" in a long process (surprisingly, even people who spot a problem will succumb to a "too late" feeling, which of course is the intent of the trick).
• Take as much time as necessary to understand the final terms. The rushed sell is one of the oldest tricks so do not be intimidated. A broker in a hurry should have gotten up earlier that day or can return tomorrow. The broker will warn of dire consequences but Rule #1 of business deals is, Be willing to walk away. Feel free to make people wait for your signature--because that quick scribble represents years of your life.

Avoid Debt “Anti-Scam” Scams

Everyone Wants To Believe in the Tooth Fairy and the Free Lunch

People who get themselves into debt problems often do so by wanting to see the best and ignoring red flags so they can sign on the dotted line and get instant stuff. When considering a contract or loan, there is a temptation to ask the right questions but accept dodgy answers that do not add up, so you rationalize that you “did your part” and any later problem will not be your fault. That is a self-deception because you are the one who will be left holding the bag.

Debt Relief: Out of the Frying Pan, into the Fire

People who get themselves in debt trouble are unfortunately likely to repeat the same mistake for the same reason by desperately wanting to believe that some debt-relief expert can provide a painless way out of a debt problem. Some companies charge up-front fees but offer no success guarantee. Some companies offer to take care of everything (sending the mortgage payments, negotiating with banks) but—as you discover too late—did not do so.

You are ultimately responsible and you suffer the consequences so the sooner that you accept responsibility and stop wishing for the too-good-to-be-true short-cut, the sooner you can establish a solid financial foundation.

How To Protect Yourself from Fraud: Avoid Preferred Providers

I previously warned about avoiding "preferred provider" lists for home-buying services (the ones that a realtor or mortgage broker might push on you): The recent student loan financial scandal reminds us that the warning applies in all your financial plans. In the student loan scandal, schools or their agents took kickbacks to push high interest rates or other bad terms on students. Today's NPR reported that 90% of students accept school's "preferred lenders" recommendations instead on shopping for themselves.

I will repeat the rule:

A "preferred provider" is preferred by the person making the recommendation--i.e. it benefits him or her but not necessarily you.


Important: This is not just about criminal fraud.

The fundamental lesson goes beyong legalities so do not trust the government to protect you either. Anyone who thinks that stopping the specific fraud in student loans will end the danger is missing the whole point:

The recommender's self-interest might be an illegal kickback but it also could be a perfectly legal and unregulated benefit such as easier paperwork for the recommender even if it costs you more.

This rule applies to everything including medical treatments and prescriptions.

The bottom line: Do your own homework.

Do not expect anyone to care more about you than you do.

Next: Danger: Preferred Providers Conflict of Interest