Monday, November 26, 2007


"Where observation is concerned,
chance favors only the prepared mind."

- Louis Pasteur

Who says you can't make money from personal finance books? A number of years ago, I used to buy a lot of financial books, and it has come to my attention that some of these used books are now worth more than I paid for them new - in some cases, a lot more. Using Amazon and eBay and other sources, I've determined that several of my old financial books are now worth more than $100 each, but the biggest jackpot is a 1991 book by Seth Klarman entitled Margin of Safety. An listing of the book shows prices from $1,125 to $2,399. My copy is in pristine condition and would appear to fetch more than two thousand dollars!

Margin of Safety has apparently become a collector's item because it's the only book Klarman ever published and it was never reprinted. For some hedge fund managers and others, it's also become a status symbol to be able to display the book on their coffee table.

It's a good book, but for $2,000, I think I'll take some notes and have it pay for next year's vacation. So take a look around on your bookshelves and see what you have. It might be worth more than you think.

Thursday, November 22, 2007

Thanksgiving Table

"Gratitude is not only the greatest of virtues,
but the parent of all the others."

- Cicero

I often feel that I complain far too much, and my biggest complaints usually involve work or money. This is unfortunate as I know in my heart of hearts that many people in other places and other times have never had it so good. As an exercise in gratitude, I decided to create a different kind of "Thanksgiving Table" this Thanksgiving morning.

I put all of my expenses in a spreadsheet, divided each of these expenses by my annual income, and then multiplied that by the number of minutes in a 40-hour work week. The result is how many minutes I must work each week to pay for each item. Furthermore, instead of complaining about "high taxes", I looked up the services I receive for the federal, state, local, and property taxes I pay, and substituted those in place of the taxes I paid. This was very enlightening. Lastly, for maximum impact, I started the clock ticking on Monday morning and arranged the items roughly in the order of Maslow's hierarchy of needs.

This exercise had nothing to do with comparing myself to anyone, so please don't take it that way. I'm well aware that there are millions of people in the world less fortunate than myself, and this post is in no way meant as braggadocio. I'm also aware that there are millions of people with more assets and/or income, and this exercise was also not meant to suggest that my financial situation is anything stellar. This article is not meant as a guilt trip for those readers who are rich, nor a put-down for those who are poor. This post is only a personal expression of gratitude and thanksgiving, but I do hope others will also find gratitude for their own situation, whatever that may be.

The bottom line is that I am truly humbled by how much I receive for such small effort on my part. I hope my complaining in 2008 is greatly reduced by meditation upon what I have discovered. Happy Thanksgiving to all!

Finish Time
9:00 AM
Before I start the clock ticking, I want to acknowledge that many of the best things in life are free and many of the things I enjoy cannot be bought with money: a loving family, good health, and a free country.
9:07 AM
Only had to work 7 minutes to provide the week's supply of clean water for drinking, cooking, and bathing. Sadly, this most basic of all needs is something many people on the planet don't have.
11:01 AM
By 11AM on Monday, there is enough food for my entire family, and frankly, we eat very well. If we had to, we could easily survive on half our food budget.
1:24 PM
Mortgage and all maintenance costs of our house and yard.
2:33 PM
Health insurance and out-of-pocket medical and dental expenses.
3:08 PM
This includes heating the house, as well as hot water and cooking.
3:12 PM
Local Police
Wow! 4 minutes of work to provide police protection for my safe neighborhood for the week.
3:16 PM
Fire and Rescue
And another 4 minutes to provide fire and rescue operations.
3:25 PM
For the whole family...
4:02 PM
As near as I can figure, this is what it costs me per week for national defense. Not nearly as much as I would have thought.
4:07 PM
5 minutes a week to maintain all levels of our judicial protection system.
4:11 PM
State Police
Additional police protection...
4:38 PM
Lights. Computer. Air conditioning. Everything you plug in.
10:17 AM
Social Security
As I have mentioned before, you will get back more than you probably expect.
10:50 AM
Of course I'm not eligible yet, but I've had several relatives that were provided hundreds of thousands of dollars of medical assistance after age 65. This is not to be taken for granted.
10:53 AM
Safety net for my job.
11:37 AM
Local Schools
This is one of the bigger expenses and is also a bargain. Less than an hour of work per week sends all my kids to local schools ranked in the top 5% of the nation. I have been in these schools many times. They are good schools with good teachers.
12:17 PM
Kids are not a recipient of the college subsidies yet, but hopefully will be one day.
12:18 PM
Incredible. One minute to provide for the library for the week. Our local library is huge and within walking distance of our house. My kids have been entertained for hours with literally thousands of books we checked out over the years.
12:24 PM
Sure beats hauling it to the dump and the recycling center myself every week.
1:25 PM
Soap, toothpaste, toilet paper, trash bags, etc. All the ongoing (non-food) consumables that keep the household running.
2:22 PM
Depreciation, insurance, gasoline, maintenance. The whole works for two vehicles.
2:27 PM
Combined federal/state expenditures of my taxes for this item...
2:42 PM
Taxes for local parks. Dues for neighborhood pool. Health club. Bicycles. Etc.
3:21 PM
Two cell phones. Land line. Broadband Internet.
4:08 PM
Eating out twice a week for the whole family. Often this is a fairly nice place. A luxury to be sure...
9:26 AM
Another indulgence...
1:47 PM
Gifts to charities and to others less fortunate than myself.
4:30 PM
Other Expenses
Things that I either don't care to track or to display to the world, plus taxes where I couldn't pinpoint where it was spent.
5:00 PM
Yes, it's a lot. A little over 40% of gross income, which is our target. Basically, Thursday and Friday wages of every week go to savings.

Thursday, November 15, 2007

Reframing The Question

"We may consider ourselves lucky when, trying to solve a problem, we succeed in discovering a simpler analogous problem."

- George Polya, How to Solve It

In his book entitled Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing, Hersh Shefrin poses the following question:

The Dow Jones Industrial Average closed 1998 at 9,181. As a price index, the Dow does not include reinvested dividends. If the Dow were redefined to reflect the reinvestment of all dividends since May 1896, when it commenced at a value of 40, what would its value have been at the end of 1998? In addition to writing down your best guess, also write down a low guess and a high guess, so that you feel 90 percent confident that the true answer will lie between your low guess and your high guess.
I took a wild guess: 40,000. For a low and a high, I chose 20,000 and 60,000. This turned out to be totally wrong - not even in the right ballpark. The correct answer is 652,230. (!)

Apparently I am at least in good company, as the author goes on to state that "virtually nobody finds that the true answer lies between his or her low and high guesses." The author cites this as an example of overconfidence. People generally overestimate their knowledge and abilities, and thus they are frequently surprised by events.

While I think it's a very interesting example, I really felt that the question itself was a much better example of framing than overconfidence. It turns out that the human brain does not work very well with exponential functions like compound interest, so it's not really too surprising that the average person has no clue where the Dow index would be 100 years after inception.

So I propose that we state the problem a different way:
From 1896 through 1998, what has been the annualized total return of the Dow, including reinvested dividends? Again, pick a low and high number that makes you feel 90% confident the true number lies in the interval.
This is a much easier question to answer than the first. You might very well have heard the long run average return for stocks reported as 12%, or 9%, or 10.5%, or various other numbers, depending on the time period and the index involved. You might also have heard that 5% or 6% or 7% plus inflation is a good ballpark number. You might also intuitively know that GDP growth + inflation + dividend yield is a reasonable proxy for long term returns, and you might calculate something like 10% that way. Personally, I've also read that the worst 30-year period for the S&P 500 returned 8%.

So it was fairly easy for me to pick 10% as my guess and 13% and 8% as my high and low. Now let's resolve the original question using the new answers.

Average guess = 40 * (1.10 ^ 102) = 666,982
Low guess = 40 * (1.08 ^ 102) = 102,632
High guess = 40 * (1.13 ^ 102) = 10,376,647 (!)

Interesting, right? First, note that the guess for the average is very, very close to the right answer. Second, note the bounds that are produced by 8% and 13%. Hardly anyone would pick those numbers the way the original question was framed. But in the second framing of the question, you only had to include 10% in your interval. I'll bet a fair number of people would get the question right that way. In fact, I'm nearly certain that the percentage of correct answers would be dramatically better if the question were asked the second way.

Can we learn anything practical from this exercise? I think so. If nothing else, try to reframe questions that appear confusing. A person can very easily be duped by salespeople in the financial arena - not necessarily because they are gullible or uninformed, but because statements and questions are (often deliberately) framed to make it appear that your interests are being served when in fact they are not.

Never let a car salesman or a mortgage broker reduce everything down to a monthly payment and nothing else. Your brain will tend to think you are getting a good deal the way the information is presented. Similarly, don't try to attempt variants of the Dow question above. For example, don't say to yourself: "It looks like I spend about $50K per year. After about 30 years of inflation, that would probably be...oh...I don't really know...probably about $70K." You are likely to make severe financial errors this way. Instead, reframe the question and ask yourself what is a realistic yearly inflation rate given everything you know. Then use a tool (such as a financial calculator, Microsoft Excel, or even a compounding table) and solve the original question. If you choose 3.5% per year, for example, then your original estimate of $70K was less than half the actual number!

Personal finance is hard to master because it involves knowledge, insight, and personal discipline. At the very least, make sure your decision making framework is on a level playing field by insuring that you frame your financial questions in a way that you can realistically make good choices.