Wednesday, July 22, 2009

Truth Behind Common Financial Advice and Conventional Wisdom

This is a guest post by Mr Credit Card from Mr Credit Card normally writes about credit card reviews, debt reduction topics and his site obviously has got tons of credit card offers. He has also put together a list of the best credit card offers and deals. Please check out his blog and subscribe to his rss feed. Today, Mr Credit Card is going to branch out and write about a topic that we should all be aware of. So here is his post

If you read the mainstream press and even most personal finance blogs, you will have come across many standard common advice. However, if you look deeper into these "standard advice or thinking", you will find that most of them are just not true or that it comes with a few caveats. Today, I am going to highlight some of these and hope that you will be more discerning whenever the mainstream press gives any so called "standard" advice.

The stock market always goes up in the long run - This common statement derived from studies in the US only from 1926 till present day. Some studies went further back to the late 1800s and came to the same conclusion. Based on this "empirical evidence", the common advice now had been to telling folks that in the 'long run', stocks are always the place to be. Problem with this analysis is that there are many assumptions that have been left out.

The first is that this study holds true only in the US because the United States. In countries like Russia (where communism happened in 1917, or parts of Europe, where there were 2 major world wars in the last century, or even in South America), this conclusion is simply nonsense. Germany went through hyperinflation in the 1930s and a change in currency. One that was pegged to gold and one that was not. South American countries went from being the richest nations in the world to one with massive debt problems in the 80s and 90s. If you were living in those countries, this 1926 US stock market analysis is meaningless when your country faces crisis of epic proportions.

Truth - It only went up in the US (and perhaps Britain) from the time frame of analysis. But bear in mind that the US has not been conquered in war in the last century. We have not had massive currency devaluations or flight of capital. Being careful of the definition of long run. There have been 20 year stretches where the US stock markets did nothing. So if you do not have a 20 year horizon or longer, be very wary about putting the bulk of your money in stocks.

US treasury bills and bonds are the safest investments - The US government treasury bills is considered the safest investments because the US government has never defaulted on its debt obligations. And hence, its historical yield is used in calculations. Because of such assumptions, academics have used the yields on treasury bills as the "risk free asset" (for those of you who study CAPM and stuff). However, there are some flaws to this assumptions.

But in the 1930s, President Roosevelt devalued the dollar by more than half when the dollar was re-pegged to Gold. In the 1970s, President Nixon took the dollar off the gold standard after the French President Charles DeGaulle wanted to exchange the French US Dollar Holdings for gold! In the 1950s, interest rates on long bonds was actually capped at 2+%!

Truth - While in many instances, US T-bills can be considered the safest assets, this only holds true if the US currency does not devalue massively. Today, we are seeing signs that countries like China are wary about their US Dollar reserves and also do not like the fact that the US Dollar's role as the international currency of choice means that we can get away with deficit spending. There is no guarantee that the dollar may lose it's reserve currency stature in future and if that happens, the US dollar will have depreciated a long way. Moral of the story is : have some of your other savings in other currencies and study how to keep your money safe. Perhaps, some gold investments would be good for you?

Reaching a retirement savings of a million dollars is a desirable goal - Another one of those myths that floats around the mainstream media. What puzzles me is that nobody questions this number at all. If a great retirement is your goal, I think that you will find that this number is really not enough. Why?

Using monte carlo analysis, it has determined that by withdrawing up to 4% of your retirement nest egg, you have a more than 85% chance of having your portfolio intact after 30 years. 4% of $1mm is $40,000 a year. And this is after tax money. Firstly, I doubt anyone can live with that amount in a high cost city like New York. Secondly, after factoring in health insurance and all other cost, there ain't much left!

What the mainstream media fail to tell folks is that planning for a career in "retirement" is more important than just "saving for retirement" itself. Afterall, savings can evaporate (ask anyone what happened to their 401ks in 2008). Your countries currency can become worthless (ask any middle Argentinian, or Russian). In the 30s, Germany went through hyperinflation.

Truth - With inflationary monetary policy as part of the western developed world for the last century, the whole million dollar is enough notion will face greater scrutiny sooner or later. You'll probably need much more to enjoy the same standard of living as you have now. If you are earning $100,000 a year today, based on 4% withdrawal rate, you'll need $4 million in retirement savings to have a good chance of achieving the same standard of living.

Small Deficits are OK - The US government has no problems perpetually running budget deficits (saying 3% deficit is OK!). All I can say is that if any household runs a budget deficit for too long, they will sooner or later have to file for bankruptcy. Well, I guess developed countries government like the US can run budget deficits for a longer time than most ordinary households. But sooner or later one's past sins will always catch up.

Deficit spending has a nasty habit of being justified by something that is "really needed". We need to provide health care (very expensive) for the elderly. We need massive military spending. We are fighting two wars. We need to spend money on various programs.

But this mentality spills over to our individual's personal financial life as well. Many folks will say it is "OK" to put the plumbing repairs on the credit card, because we'll "pay it off soon"! Problem is that just like the federal government, most folks do not pay it off. Once in a while, certain "freebies" come along that make our debt load easier. In the case of the federal government, easy monetary policy allows US government debt to be issued at relatively low interest rates. The easy monetary policy has trickled down into the consumer world via promotions like 0% financing for cars, 0% balance transfer credit cards, or even low interest credit cards. For quite long periods of time, these easy monetary policies enabled the federal government and US consumers to "fund deficit spending".

Truth - Debt should be shunned at all cost. What starts as a small amount eventually becomes a habit that becomes very hard to kick.

Global Savings Glut by Emerging Countries Responsible for Global Imbalance - Here's another common economist rant. China, and the Asian emerging economies are savers (which everyone actually acknowledges is good). But they save too much! Because global trade is conducted in US Dollars, countries with trade surpluses have excess savings in US Dollars. And the dollars has to be invested somewhere. The most natural home is US treasuries (ie US government debt). Hence, even if the US is running a persistent budget deficit, savers abroad have no where else but to invest with us. The result for all that is that interest rates and mortgage rates remained low even though our debt picture shouldn't have allowed it.

So what do we tell China and the rest of the world's savers? Don't save so much. Introduce social welfare and health care so people do not have to save so much and they can "spend"! This is one of the worst advice I've heard. We have trouble controlling spending in medicare and social security and now we're telling savers to follow our vices!.

Truth - Truth is the problem is not with savings. It is with the fact that the world conducts it's commerce mainly in US dollars. Savings is the only way to wealth. Savings (just like an emergency fund) gives you cushion. China, for example, could pump billions into their economy without having to borrow from anyone! The good old US however authorized over $700 billion in spending (which by the way they printed!) and they actually have to borrow it from the financial markets. And that is the big problem with having debt. You have to keep issuing IOUs! China's billions was simply gotten by converting their US dollars reserves into Yuan! In personal finance, the same principals apply. When you have debt, whether it is a mortgage, a home equity line of credit or credit card debt, you are constantly on the treadmill trying to find a better card or loan with a better rate. Contrast that to someone who, for example, pays his balance in full. That person can actually use a cash back credit card or gas credit cards to earn cash rebates. Unlike the person having to pay down his or her balance, the person paying in full actually makes money!

Term Life Insurance is Always Better Than Whole Life - Here is another phrase that has been hyped up by the Suze Ormans of the world and literally the whole finance bloggers world. Everyone hates whole life. What nobody has ever properly explained is the cons of term life. So let's look at a few here:

Term life insurance ends after a term - proponents would claim that

1. You can save the money on whole life and invest the difference
2. You do not need insurance after 20 or 30 years cos you have saved enough
3. Term is more cost effective

Problem is nobody tells the downside. The first downside is that

1. The annual premium for term life goes up every year!
2. To maintain the same insurance, you have to keep paying premiums every year. When you are retired and have no "work income" but only portfolio income, monthly payments are a really pain in the B***. For whole life, once you have paid up, it really means you have paid up!
3. By the time you are 50 or 60, you may not have saved enough and your beneficiaries still need money from insurance if you pass away!
4. You have a disabled child and whole life or permanent insurance is the only way to fund it (after all, their needs are permanent!)

Truth - Term life may or may not be more suitable for you. It really depends on your particular situation.

I think I'll stop here. I hope this post makes you think harder and question common teachings and assumptions in the world of personal finance, or anything in fact.

Please leave a comment and tell Mr. Credit Card your thoughts.

1 comment:

  1. Choosing between Term or Whole life insurance certainly is a complex issue. The way I see it, life insurance shouldn't be used as a way to leave a legacy, it should be a way to cover immediate liabilities or debts until the family can deal with the unexpected loss in income.

    How long should that take? I don't know, a year at the most?

    If one has extraordinary circumstances, then of course extraordinary insurance would be required, like for disabled children or spouses. But for other folks, I would think enough to cover the bills for a year should be fine.

    The rest of the money could be put into investment vehicles that would be more efficient, and then you can use those as a legacy if you don't actually get to live to enjoy your retirement. Just my immediate thoughts-