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Archive for January, 2006

The pitfalls of “full-service” brokerages are becoming more widely understood by younger investors. However, many investors still don’t understand the problem too well, so a word of warning about full-service brokers is in order.

They Make Money, Even if They Squander All of Yours

The largest problem with full-service brokers aside from the fees, which we’ll get back to, is the simple fact that their interests are not aligned with yours. They make money primarily by getting you to trade. For them, it doesn’t matter if your net worth increases or decreases. What matters is how often, and usually how much, they can get you to trade. Unfortunately, this runs contrary to your goal of increasing your net worth. Every time you trade, you have to pay a commission. And it’s a hefty commission, believe me, if it’s a full service broker. Worse still, each time you sell a stock that appreciated, you have to pay taxes. To top it off, the tax rate is higher if you hold your stock or fund for less than a year. Here’s an example from my own life:

Back
in the go go days of the late 90’s when I was at a tech company, I decided it was time to start investing. Everybody else was making millions and I wanted in on it.

Unfortunately, I went about it in the worst possible way. I procured the services of a full-service broker. He told me to buy some 3COM, so I did. I put $2500 into it. Like many other stocks around that time, it tripled! I was making money! My broker then suggested that I “move out of that position to lock in my profits”, so I did. I bought two other tech companies. One tanked, but the other did pretty well. When he suggested that they were both “played out” and that I move my money again, I did. This time, one
stock stayed pretty steady and the other one increased in value.

With my three bagger from 3COM, I knew I was way up. But the thing is, I wasn’t. In a year when the NASDAQ went up by 37%, I only came out up
16%. Why? Trading costs. When I bought the 3COM, I paid a %3 commission, or $75. When I sold it, I paid another $200. It cost $200 more to buy my next two stocks. I had to pay nearly $200 more when it was time to sell them, though it was a bit less since the value of my portfolio had declined a bit. I had to pay another 3% in commissions to buy replacements for those stocks. Within one year, I spent over $800 in trading fees on what had started as a $2500 investment. No wonder I didn’t beat the market.

Full-Service Brokers Charge Way Too Much

Let’s put this into perspective. I was paying 3% per trade. That means 6% if I sell one stock and buy another. Over the past 100 years, the major stock market indexes have returned 10%-12% per year. With my previous broker, simply selling out of one stock per year and buying another would cut this rate in half. In other words, instead of $10,000 becoming $228,923 over 30 years, it would only become $41,161. If you were foolish enough to trade multiple times per year with such a broker, as I did, you’d lose money, even from market-beating investments. Admittedly, my broker was an exceptionally bad deal, and full-service brokerages have had to lower fees to compete with the ever growing number of discount brokers. However, make no mistake. You will pay dearly if you chose a traditional brokerage.

I know that many people feel they need a broker. It may seem that there’s no way you could possibly take care of your investments on your own. But do you really want to pay someone who’s financial interests are opposed to your own? Another consideration is that most of the money traded on Wall Street is traded by large, traditional institutions. They can’t all beat the market. What you pay for your broker doesn’t mean that you’ll enjoy superior returns. In fact, considering fees and taxes, you’ll almost certainly do worse than if you chose stocks at random, or better yet bought a low expense-ratio index fund.

Use Discount Brokers

After reviewing my finances and realizing how much my broker was costing me, I did some research online and learned about the then new discount brokerages. By not offering a traditional brick and mortar office, they save a great deal of money. They don’t tell you what to buy; you have to decide that for yourself. All orders are completed over the web or the phone. At that time, Scott was offering $7 trades, Ameritrade $8 trades, and E-trade charged $15 per trade. Each offered a friendly web interface, with a variety of features and research tools. In the end, I chose Ameritrade and I’ve saved a great deal as a result.

One of the most painful experiences I had upon coming back from Taiwan, was learning of my Grandmother’s financial situation. Nearly all of her money is at Merrill Lynch, and she’s paying both hefty fees after each transaction and she has money in funds which charge over 2% per year. Worse still, some of their funds even include 12b-1 fees. 12b-1 fees are basically how they make you pay their advertising costs. My grandmother already lost nearly half of her retirement due to the accounting scandal and ensuing crash of Qwest. It really, really pains me to see her paying more money than I made last year for “full-service” financial advice. Helping her get moved out of a full service brokerage, out of managed funds, and into index funds with a discount brokerage is a top priority for my current visit to Colorado. Here are links to some of the more popular services: Ameritrade, Sharebuilder, E-trade.

Last night, I continued on my mad geeking spree. Robb, Lisa, Aubrey and Warren came over and we played Magic the Gathering. Geez, it’s been a long time since I played that game. It was pretty fun, though. Warren had never played before, so to save time we each made decks out of 10 random cards of each color, 7 lands of each type, and 5 artifacts. For the first game, we played with the whole deck. After that, we pruned our decks down (but kept the 40 card minimum rule). Somehow Warren completely wasted us, punk that he is.

I got my chance to gloat though, and it was a big one. You see, Warren’s Taiwanese. He moved to Colorado before middle school, and ended up living a couple blocks from me. We both went to the same high school and college. By the time I got to know him, a little in highschool and a lot better in college, his English was already great and he didn’t need ESL classes anymore. I do remember him reading Chinese books every now and then, though. Anyway, I still had some old Chinese study materials at my family’s house, from my last visit a couple of years ago. Warren noticed my flash cards and picked up a few stacks and started going through them, much like I did when I noticed them after getting here last week. Here’s the thing, though: he couldn’t read about 20% of them, and I knew them all. He couldn’t read my 國語日報, either. I could read about half the articles.

Yeah, baby! I knew my writing would be better, but I never imagined my reading would be, too. Ok, I have to admit I’m far from literate, his listening is still better, and his English and Taiwanese are perfect, but still! So what if he hasn’t lived in Taiwan or used Chinese in school since he was a little kid? I beat a Taiwanese person at something Chinese related and I’m going to cling to my moment of glory forever! Yeah, I got wasted at our geeky card game, but I’d rather have the Chinese. It means my 3 years of livin’ in “the ‘wan”haven’t all been in vain.

It’s been two more wonderful days of hanging out with old high school friends and serious geeking out. On Friday, I went over to Dan’s place with Chris (another high school buddy), Aubrey, Matt and Robb. Since Dan and Chris have never been too keen on being photographed, I decided not to put their picture up on my blog. They taught me how to play a card game called “Munchkin“, by Steve Jackson Games. In role-playing lingo, a “munchkin” is a selfish, greedy bastard who doesn’t care about helping the group but just wants to get as much loot and experience as possible. In the card game, “Munchkin”, each player takes on the role of just such a greedy, selfish bastard.

Everyone takes turns drawing from a stack of “door” cards. That represents kicking down a door in a dungeon. Sometimes there will be a monster. You can fight them on your own or get someone to “help”, for which they will almost certainly insist on a share of the treasure. The first one to get his or her character up to level ten wins. This means that people in your “group” helps only when they can gain from it, and everyone will screw you over to keep you from getting to level 10. On top of this, the rules are intentionally vague and exploitable, leading players to bicker over convoluted interpretations of them. I got wasted because Matt, figured out a way to abuse the rules in such a way that allowed him to pick up the entire treasure deck and basically become invincible. All in all, its like role-playing in middle school, but a whole heck of a lot funnier.

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This year my father gave my Grandmother an investing book. It’s called The Little Book That Beats the Market, by Joel Greenblatt. I’d already read about Greenblatt before. His investment firm has averaged a jaw-dropping %40 in annual returns for over 20 years. Needless to say, I was more than a little curious what he had to say. I ended up reading the whole book yesterday, and figured I’d report on what I read.

The Little Book that Beats the Market is aimed at beginning investors. It starts with very clear explanations about the nature of investing in general and investing in stocks in particular. I can’t say I’ve seen too many books that would be as clear to the layman. Then the book goes on to tout its “magic formula” for beating the market. It’s a mechanical investing approach that involves buying stocks based on ROC and P/E. Being an academic, he used “Earnings Yield”, which means E/P instead of the commonly used P/E. The method does indeed have an impressive track record that is based neither on data-mining, nor on “survivorship”. The method has a great rationale, too: buy companies that generate lots of money when you can buy them at deep discounts. All in all this is a great book for a novice investor and I’m really glad my Grandmother has it.

Still, I’m somewhat skeptical of mechanical investing. Despite the book’s arguments to the contrary, I’m pretty sure that if the “magic formula” really is that good, then more and more institutions will start to use it. After that, the returns would have to dry up pretty quickly since it’s impossible for everyone to beat the market. Basically, what I’m saying is that right now there’s a pricing inefficiency. As always in the case of pricing inefficiencies, the first to find them can make a lot of money, but it disappears once enough people are aware of it. The Little Book that Beats the Market was just published this year (2006). If you don’t mind betting your savings on an algorithm and you want to make money from the “magic formula”, now is the time. It may not be that useful anymore in a couple of years.

Note: Joel Greenblatt used EBIT/(Net Working Capital + Net Fixed Assets) to calculate ROC, and EBIT/Enterprise Value to calculate Earnings Yield. He ranks all the stocks above a certain market cap based on ROC, and then he ranks them all by Earnings Yield. After that he adds the two rankings together to get a grand ranking. For example, a stock ranked #4 in terms of ROC and #732 in terms of EY would have a total rank of 726. Another stock ranked #50 on both lists would have a total rank of 100, and thus be the better buy. His system is to rank all the companies above a given market cap, and then buy the top 30, hold them for one year, sell them, and then buy the new top 30 ranked companies of that year.

Tonight I was able to borrow my uncle’s car and drive up to Boulder. I got to see my old roommate and running partner Matt, Mike, and Warren. Warren went to high school with me, but I didn’t really get to know any of these guys well until college. Still, they all ended up becoming great friends, especially Matt who I probably hung out with more than anyone else I knew in college. Matt’s wife Nicole (another old friend of all of ours) was there, too. She wasn’t feeling too well, so we didn’t chat much. I made a horrible blunder calling their baby “he” when it was a she. It probably had something to do with the downright evil way Matt used her for part of his Halloween costume last year. Hopefully nobody’s feelings were hurt!
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We all went out to eat at a nearby Mexican restaurant, and had a pretty good conversation. It spanned everything from the morality and ethics question on my blog a few posts ago to eugenics, twin studies, and imbalances in sports betting. I meant to ask Mike why the heck he’s back in school going for an undergrad EE after already having earned an M.A. in Physics from UC Santa Barbara, but I forgot. He got married recently, and he’s been setting up a pretty neat charity in Guatemala. Warren’s got a drive failure analysis job that jets him back and forth between Boulder and Singapore. It sounded pretty cool. After dinner we went back to Matt’s place for some more chatting, and catching up. He had a neat stack of Rubick’s cubes there- a 2×2, a 3×3, a 4×4 and a 5×5. Having already solved the 3×3, I figured the 2×2 would be trivial. It really wasn’t. I got one layer solved pretty quickly, but I didn’t manage the right sequence to rotate the pieces on the bottom. I’ve got to pick up some of those.

Tonight, I saw my old friends Aubrey, Lisa and Robb again. I’ve known Aubrey since middle school. Along with Jason and Dan, he was a constant member of my “group” since before our voices changed, before we were interested in girls and before we realized how unyielding reality is. In high school, several other friends including Robb and Lisa joined us as companions in role-playing, video gaming, fencing, martial arts, CCGs, board games and just about anything else we were involved in. Unlike many other groups of friends, most of us stayed friends through college and after. Heck, Aubrey and I even bought a house together when we were 20 and rented it out to our friends… We used to throw parties all the time. Some were big, with 30-50 college buddies, but my favorite ones were smaller. Things weren’t perfect, of course. But all in all, high school and college were good times.

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It was both a great and a terrible feeling to see everyone again. On one hand, it was great to hang out. Lisa and Robb moved into a new house and have kept stable jobs after they got married, and now Aubrey’s studying bio-chemistry of all things, but they’re all pretty much the same as when I left. Aubrey is still one heck of entertaining conversationalist, Robb still has half-assembled computers on his living room floor, and Lisa is the same personable gal she’s always been. We all went out for Beau Jo’s pizza, had a lot of laughs, talked of old times and got caught up with each other. Tomorrow, I’ll see some of my best friends from college- Matt (who also lived in our house), Nicole (who ended up marrying Matt), and Mike. It will be a blast for sure.

And the bad part? Well, I guess seeing everyone has forced me to look at exactly how much following my dreams costs me. The whole time I’m in Taiwan saving up money, and later studying, I’ll be away from the friends who will be my friends for the rest of my life. I have an interesting job and I’m learning new things everyday. I know I’d be restless if I lived here now, but that doesn’t make it any easier. I think Neil Peart said it best,

It’s cold comfort
To the ones without it
To know how they struggled
How they suffered about it
If their lives were exotic and strange
They would likely have gladly exchanged them
For something a little more plain
Maybe something a little more sane

We each pay a fabulous price
For our visions of paradise
But a spirit with a vision is a dream
With a mission.

One thing I’ve really missed about Colorado is the weather. Because of living so close to the mountains, it’s really, really erratic. Yesterday was warm enough to wear shorts, but there was still snow on the ground from last week. It will probably be cold again next week, but for now it’s sunny and warm. Did I mention I’ve missed the snow? If only my old dog were still here to play in it, too…

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For many years I’ve felt a special hatred towards China Airlines, the kind of hatred normally reserved for murderers, rapists, the RIAA and Microsoft. Two years ago I decided to stop flying China Air once and for all. At that time, they compared with Singapore Air as follows: Singapore Air had monitors in front of every seat, and nice headsets to go along with them; passengers could watch movies on demand or play video games during their long flights. China Air had a shitty little headset which usually only worked for one ear, and five or ten radio channels that all sucked. Movies were only available in the larger screens dispersed around the cabin and passengers couldn’t choose which ones to watch. Singapore Air had a very safe track-record. China Air racked up more accidents, injuries and deaths than just about any of their competitors. Singapore Air had mildly uncomfortable seats. China Air had torture devices re-labeled as seats. Singapore Air had decent food. I literally threw up after one China Air meal. I’m sure you get the idea.

Well, this year I had no choice. Since I went home to see my family during the New Year, just like every other freaking Chinese guy and his idiot step-cousin, I couldn’t be choosy about airlines. After realizing I was stuck with China Air, I felt total despair. This time wasn’t so bad, though. They had the same snazzy movies on demand & video game set-up as Singapore Air has had for a long time. The food wasn’t so bad, either. All in all the flight was quite tolerable. It wasn’t perfect, though. Crowded China Air Flight When I arrived at the airport, they asked if an isle seat would be ok. I said sure, but that a window seat would be even better if they could arrange it. Stupid me. They gave me a window seat, right next to the wing. If I pressed my face against the window, I could sort of make out some stuff way in front of us, but that was it. To make matters worse, the seats were so cramped that I couldn’t sit normally. Since there was no room for my knees, I had to sit with them splayed out to the sides- frog style. Needless to mention, passing people was almost impossible. To make matters worse, an old woman who seemed to be in her 70’s was sitting next to me. Since she couldn’t stand up very easily, I had to contort myself and pick up one foot at a time with my hand to stretch in such a way as to pass her. I felt like a real scum every time I had to go by her like that to get to the bathroom.

All flight announcements were “trilingual”, but the English was so bad I honestly couldn’t make half of it out, even after hearing the same announcement in Chinese. On the good side, the service from the flight attendants I got was the best I’ve ever experienced; they even talked to me in Chinese after they realized I wanted to use it. All in all, I give the flight a 4/10 and I’ve decided that China Air isn’t nearly as bad as it used to be. Next time I have to fly home, if it’s at least $10/flight hour cheaper, I’ll fly China Air instead of Singapore Air.

I’ve been actively participating in some discussions about the Japanese whaling issue over on Darin’s blog. I don’t want to discuss the ethics of hunting endangered species, nor do I want to get into the complex legal background of the issue. What I’m more interested in is this question: Do right and wrong depend upon culture?

In other words, could hunting endangered species be “wrong” in western countries, but “right” in Japan? Could inflicting pain on dogs to cause them to release chemicals that make them taste better be “right” in Korea, but “wrong” in Australia? Could creating absurd quantities of greenhouse gasses be “wrong” in Europe, but “right” in America? My feeling is that if something is “wrong”, it’s wrong regardless of culture. Maybe the things I listed above are all “wrong”, but only a little bit so.

Think about slavery. Would anybody actually defend slavery as just part of the “culture” in the southern states of the US 150 years ago? Could anybody defend the concentration camps and gas chambers in Nazi Germany, or the chemical and biological toxins experiments the Japanese performed on the Chinese during World War II as “culture”? Obviously, some things that large numbers of people think are ok, or at one point thought were ok, are still wrong. It’s my contention that relative ethics are no ethics at all. Still, boundary cases, such as cases in which one thing is good for an individual’s rights and another is good for society in general, require that conflicting values are weighed against each other. Obviously not all people and cultures will put the same weight on the same values. What are your views? Should you ignore what happens outside of your own culture and let other cultures decide what is right for themselves, or should you stand up for what you think is right?

Today, I was hanging out with my old buddy and co-worker Mike W. for the first time in about half a year. I have to admit he was something of my archetypical ideal of a spendthrift. He earned at least 50% more money than a normal family of four, but he didn’t save much. He ate out at expensive restaurants, and even ordered 400台幣 meals to wolf down between classes. I made occasional remarks in the office about the glories of living below one’s means, but nobody really seemed to agree with me. He did have really cool tech toys…

And today? He showed up at our friend Martin’s place and was all fired up about investing. He was talking about various funds he bought into last year, catching up on his IRA, and even whipped out an investment book in the middle of our conversation and started showing me data on the performance of stocks versus commodities and bonds over the last 200 years.

Martin countered that while investing nuts like myself and now Mike might make some money at it, we’ll be spending our time on it, too. It was a good point. I started to talk about how I don’t really spend that much time, but then Mike had the perfect answer:

Right now, the only thing making me money is my work. But in 20 years, my money will be making me money. Do you really want to have to rely on your work to make you money indefinitely? What if you’re doing that 20 years down the road and you break your right arm? What will support you then? What about when you’re just too old to work?

I absolutely love that line of reasoning. I agree that while your net worth is low, it doesn’t make sense to spend too much time on investing. I’d probably have more time if I’d just bought an index fund and took all of the time I spent investing and spent it working instead. For me, it is something of a hobby. Still, once you have enough money, it really is worth a significant chunk of your time. Think of it this way: how much time do most people spend comparison shopping for things like computers or TVs? How much money will that save them? Then ask yourself how much their entire retirement savings is worth, and how much it’s worth to plan it effectively.