Word.

Did that get some attention?  I hope so.  The conclusion that realtors should rent comes directly out of urban economics, an understudied and ignored branch of modern economics.  But while it is a cute fact you’d expect to see in Freakonomics, it wasn’t there.  I wanted to take some time to explain this counterintuitive fact, and then use this to maybe reshape the question of renting or buying.

One of the reasons why we hear that we should hold a balanced portfolio is that, for whatever reason, it reduces our exposure to risk.  If our eggs are in one basket and that basket drops, we have a mess.  So by diversification, we’re not so S.O.L. if one of the baskets drops.

But that isn’t necessarily true.  If, for instance, basket 1 and basket 2 tend to drop together, then we haven’t really diversified as much as we might suspect.  In the classic portfolio of stocks and bonds, those two tend to trend in opposite directions, so that’s one way of diversifying away risk.

Real Estate is a part of our overall investment portfolio.  In fact, it is typically the biggest chunk for most households.  If I look at my Net Worth estimate, about 40% is our estimated house equity.  So we should consider our house part of our investment portfolio.

Now, let’s assume you are a realtor.  When house values rise, realtors tend to make a lot of sales and thus money (this is a fairly well established relationship in urban economics).  When house values decline, realtors tend to make few sales.  There’s a lot of economics behind these simple statement but I’m going gloss over them.

Since portfolio theory tells us to diversify, and since a realtor’s income and home values are very much related, diversification indicates that the realtor should RENT to mitigate risk.  Now how about that for some counterintuitive fun!  The person selling your house should be renting theirs, if they’re properly diversifying.  HA!

How does this tie in to DiNK readers?  For one, the buying vs. renting decision is often thought about in terms of interest rates, time frames, and available down payment.  But in addition, whether or not your income is related to house prices should ALSO be a consideration, and this is NEVER mentioned in buy vs. rent guides.  Of course, this would imply that a foreclosure specialist should own their home, since their business goes up when house values go down.

Anyways, I hope that adds a wrinkle to the buy vs. rent debate.  Can you determine whether your income varies alongside house prices?  Sort of.  Government employees tend to have income that is little related to house prices.  Some banking, investment, and local business owners income may be quite related to house prices.  It is worth considering.

And if you do buy, ask for a realtor who rents.  They get it.

In econo-speak, we refer to this as a “sunk cost.”  A sunk cost, once paid, cannot ever be returned.  It is something bought from a store with a no return policy.   Yet, what is often seen is that we do not ignore sunk costs when we should.  It’s our psychology being the enemy of ourselves again.  We’ve paid, something (time, money, emotion) into whatever it is, and rather than cut ties and bail.

A great example here is say, a purchase of a stock that didn’t quite pan out.  Rather than buck up to the loss, its quite commonplace to see an investor hold onto a mal-performing stock in the hopes that one day they’ll break even

If it was a bad judgement call to buy, and then becomes a bad stock to hold, what possible logic exists to justify its continued presence in our portfolio.  I don’t see sunk costs talked enough in the personal finance world.  Perhaps because they’re uncomfortable to discuss.

The best action is to act like a poker player who has bought into a tournament.  Once his seat has been purchased, that cost is sunk.  It is gone. The only possible recovery is to win, place, or show.  Poker players tend to switch up strategies once play starts to find something that works with their table, their cards, their hands.  The sunk cost of the entry fee is ignored by the good poker players, they recognize that money is already forfeit.

Keeping a bad credit card, a bad stock, 401k, etc, because you want to break even, stops one from playing the good hands that come along, because one is too focused on getting back from those bad hands

Here’s a good link on this subject:  Sunk Costs

Perhaps the easiest thing to do with personal finance habits is to “One and Done” them.  This is probably one of those rare times where “One and Done” is a good thing.

For many folks, money maintenance is tough, and our own psychology often acts against us.  This session sets up a basic automatic system that’s going to limit the ability of ourselves to harm ourselves.

Most folks have some basic automation of their personal lives, and its catching on more and more since online computing makes this easier.  For instance, our 401K contributions are automatically taken from our paychecks.  We’re going to take this and move a few steps out.

For myself, when I look at my checking account, that’s what I can spend guilt-free.  Doesn’t matter if its on a movie, a new shed, WWE PPVs, etc.  I can blow all of it frivolously or I can be a miser.  By restricting choice I’ve inexplicably freed myself at the same time.

While automation may change over time (hopefully we earn more, and invest more!),  by establishing an out of sight, out of mind, we’ll lower the investment/investor gap.
See you all tonight.

Thought for the weekend.

So I have these savings, and they might be in a checking account, an IRA, a 401K, stocks, bonds, gold silver, alien futures, what have you, but are these all just savings?  Not from my perspective.

I have a two-bucket approach to my financial investment strategy

Bucket 1: Solid, Steady, and Passive

Bucket 1 includes my IRA and 401K.  Both are index funds.  The IRA points to two foreign index funds, and the 401K is your standard 401K lifecycle fund.  Contributions are automatically deducted.  I don’t ever see what’s going on in this bucket.  I know its there.  I know it will be fine 30 years down the road.  This bucket keeps me financially secure later on

Bucket 2: Crazy, Fluid, and Active

Bucket 2 includes my stocks, bonds, and a commodity index fund.  I’m more active here.  I do research.  I buy.  I rarely sell but I am active in monitoring it.  And it is in this bucket that I want to take my shots.  I want to beat my index investing, or at least try.  But I’m not going to pay others to do it.  If I lose this bucket, I still have Bucket #1.  So its guns ablazing in Bucket #2.

I like the two bucket approach.  I want to actively manage, but I don’t want to tinker with my 401k.  So I am able to battle my own psychology and win.

And how is the bucket approach doing?  Bucket #1 has recovered from the economic crash and has about a 5% real return annualized over 5 years so far.  It is doing what it needs to do.  Bucket #2 has been awesome!  I started Bucket 2 in June 2008.  That was a heck of a time to start!  But, Bucket#2′s return, despite some big misses in some assets, has annualized returns of 15%.  I’ve even got one stock that’s been a whopper, 320% return in just a year!

The two bucket approach I think works well for defeating the psychology of wanting to mess with things when times are bad and good, and gives my financial brain exercise.

How would you organize a bucket strategy?

]]> http://coffeecents.wordpress.com/2010/03/24/a-two-bucket-approach-to-financial-investing/feed/ 2 coffeecents http://branthansen.typepad.com/photos/uncategorized/2008/04/13/buckets_and_stuff.jpg http://coffeecents.wordpress.com/2010/03/24/tuesday-recap/ http://coffeecents.wordpress.com/2010/03/24/tuesday-recap/#comments Wed, 24 Mar 2010 13:21:20 +0000 coffeecents http://coffeecents.wordpress.com/?p=92 ]]> So one thing I was left wondering about after Tuesday’s session was that, how do we get the folks coming to the meeting to express themselves more?  If there are any suggestions on how to get folks to open up, that would be helpful.

We spent time talking about goals (except for Brian, who was WORKING!)  I’m left to wonder how much time we spend planning out our time and how much we float with the wind instead.  I do think its semi-realistic to have an idea of what personal success is for yourself at a young age, though perhaps expressing it requires some truely deep introspection.

One comment not in the powerpoint was that, there are sick days, then there’s an idea of a fiscal fitness day, and I spoke about also taking off personal days, time spent with oneself to realign the goals and checkpoints and destination.

Well, next week will be much more mathy and finance related.  I could make session 2 better if I knew of more awesome resources of goal-setting and financial planning / career / cause finding.
Thoughts?

Tonight, we’ll be veering off, slightly, talking about money, and talking more about planning and goal-setting. There’s still plenty of money talk to be had.   There’s a few more readers now, which is nice, and I’m excited to be hosting tonight’s session.

I think the important statement of tonight is that achieving goals isn’t a passive “Secret”  (bleh).  It’s active management and maintenance.  This applies not just to say, writing a term paper or finishing a work project, but also to our money management, our future plans, etc.

Some comments about the PowerPoints : They’re designed to guide myself and Jay and Brian and the discussants on the topic, but I really try to not follow them too much.  Chalk and talk teaching is quite passe.  We want to be interactive.  You’ll still get plenty from them, but it pays to be there in person.

Unit 2 can be downloaded here

One good question came from the crowd.  I’m terrible with names so I forget this young lady, but she is a sophomore and asked about when she should start budgeting.  She assumes that her income situation will change very much upon graduation and wondering just how useful starting now would be.  That’s a question I hadn’t thought of.  My response was that it was the habit of budgeting that was more important than having an awesome budget, if she was in the habit of budgeting before graduating and jobs and that stuff, it would be that much easier.  Jay from budgetsaresexy stopped by as well, and added that there’s no such thing as a “normal” month in budgeting anyways.

Hung out a bit with Jay and Brian (mynextbuck) afterwards.  One interesting observation.  Brian was a trust fund baby,  Jay came from a middle class background, and I came from lesser means, but here we all were talking about personal finance and learning from each other now.  And we’d all come to very similiar conclusions and philosophies on frugality and money management (though we each differ, the theme is the same).  It was cool hearing Brian and Jay talk about what I was discussing but bringing an entirely different perspective to a similiar point.  Having them added a good bit of value to the discussion, awesome to have them.

You can download a read-only copy of the first unit’s powerpoint here.

I hope to be able to put up video of this event and the ensuing discussion.

Aside from personal finance bloggers, we don’t really talk about money, how we manage it, what our problems are, etc, even with very close family and friends.  I think that’s a big part of the problem plaguing personal finance education today.  The old chalk and talk system is passe.  I think an introductory system that gets folks talking about how they did this or that, and sharing ideas, will improve education of personal finance and break down the social taboo barrier of talking about money.