Andrew Feinberg has an interesting article on Kiplinger, Boiled Shrimp and the Sunk-Cost Fallacy, dealing with our tendency to throw good money at an investment that has gone bad.

I know dozens of friends, clients and acquaintances who under perform the market largely because they can’t part with their losers. If they buy a stock at $50 and it falls to $30, the last thing that they think about is selling. They focus on their sunk cost of $20 per share and all they want to do is get even. The fact that the stock may have plunged from $50 to $30 for a very good reason doesn’t interest them. They can’t sell because they have a large sunk cost and because they believe that, by not selling, they are somehow avoiding the loss.

Now, when this $50 stock reaches $5, they really, really can’t sell. Now it’s even more painful than before. The sunk costs are greater. The wounds to the ego are greater. And besides, math illusion enters the picture. Almost everyone thinks it is easier for a $5 stock to double than it is for a $25 stock to do the same. (That’s actually not true — low-priced stocks under perform every other kind of stock — but people intuitively believe it anyway.)

But what is an investor to do? Cut your losses and run!!

But the reason economists call it the sunk-cost fallacy is because your future attempt to enhance the value of your portfolio should be independent of what has occurred in the past. It is perfectly irrelevant that JDS Uniphase (JDSU) once traded for $150. The only interesting question is whether the stock is a buy or sell here at $3.59 per share. (Focusing on the $150 price is called anchoring, and it is yet another bane of investors.)

He gives a real good real world example:

You buy two nonrefundable movie tickets in advance. In between your purchase and the time of the show, you discuss the movie with 12 people you know well. Each tells you that you will loathe the movie, that it is the cinematic equivalent of Chinese water torture. Would you go see it anyway because you’ve already spent $24? A behavioral finance expert would say you shouldn’t. Why compound your financial loss by spending two or more hours of your life being unhappy? Why not do something more enjoyable instead? Why throw good money — in this case your enjoyment of life, which is what money sometimes helps you buy — after bad?

Reminds me of the story of the guy who tossed a $20 bill down the outhouse hole — when asked why he said he had dropped a dollar but had to make it worth going after.

An article in the Fort Wayne News-Sentinel reports on a Junior Achievement poll stating that one of every 10 teenagers uses credit cards and that some are as young as 13! I wonder if the kids are paying their own bills or if mom and dad are paying most of these?

According to Junior Achievement and the Allstate Foundation, it would take a teen making minimum payments nine years and almost $2,000 in interest fees to pay off a $1,000 card balance at an 18 percent annual interest rate.

Since it takes 10 years to clear your credit once it has gone bad, is it any wonder that so many people under 25 file for bankruptcy?

Survey Highlights

• Only 10.3% of respondents indicated that they own credit cards, but as teens grow older, incidence of credit card ownership consistently climbs. Among teens ages 13-14 only 5.0% reported owning credit cards. At age 17, the percentage of ownership climbs to 9.8% and then doubles again to 19.6% for teens 18-or-older.
• Only 4% of students reported being victims of credit card fraud.
• Of teens owning credit cards, 83.6% reported paying the balance in full each month. Only 0.7% admitted to occasionally skipping payments. The minimum payment is made by 15.7% of teens.
• The most frequently charged item is “clothes,” with 67.1% of teens making this purchase with their credit cards.
• Teens are not reluctant to use the Internet to make purchases. Results indicate that 59.3% of teens have made online purchases with their credit card.
• Do teens make huge purchases on their cards? Not according to the I-Poll results. Nearly three-fourths (73.8%) charge $100 or less per month. Included in this percentage is the 44.8% who charge less than $50.
• Almost a quarter of all teens (22.7%) pay for less than 15% of their own expenses. Those self-sufficient teens who pay 76% or more of their expenses represent only 20.1% of students surveyed. As teens grow older, they take responsibility for paying a greater share of their expenses.

If you are tired of getting offers for credit cards in the mail you can opt-out simply by going to the web site http://www.optoutprescreen.com or by calling (888) 5OPTOUT.

We are always being warned that these offers, in the wrong hands, are prime material for identity thieves to use to perpetrate their deeds. So, if you don’t want to be shredding 10 offers a week, you can now opt-out. If, on the other hand, you are looking for a better deal on credit card interest rates or looking for 0% balance transfers then you might want to continue getting these offers.

If you do opt-out, you can always sign back up by calling the number or going to the web site again.

In the 5th chapter of The Automatic Millionaire, Bach discusses the necessity of putting money aside in case of emergency; whether the emergency be a job loss or medical bills. He calls this the “sleep well at night” factor. Most people live paycheck to paycheck and many families depend on 2 paychecks to make ends meet. He credits his grandmother with telling him when he was younger, “when the going gets tough, the tough have cash.” We may not be able to prevent bad things, such as a job loss, fire or flood damage, or becoming disabled, from happening to us but we can protect ourselves financially by having a cushion of money available (and, although he does not mention it, appropriate insurance).

Bach sets up 3 rules for setting up your emergency fund. First is to decide how big a cushion you need. He recommends having at least 3 months worth of expenses set aside (note this is not 3 months worth of income). Although he says more money can be put in this emergency fund, I disagree. Your regular investment account can be tapped after three months. This emergency fund is to give you liquidity in case of emergency. Your regular investments should be earning a better return than your emergency fund and should be accessible within 3 months of the emergency, if needed.

The second rule is not to touch the emergency fund. This money is for true emergencies. He compares it to a fire extinguisher that should be used only in case of fire not every time you think you think you smell smoke. He describes a real emergency as something that threatens your survival — not just your desire to be comfortable.

The final rule is to put this emergency fund money in the right place. The money needs to be earning a decent return and regular savings accounts and suitcases in the back yard just won’t cut it. He suggests shopping for the best money market rates at regular local banks as well as at online banks or to use government I-Bonds. He gives a list of online banks that would be worth looking into and does warn that some banks have minimums required to open a money market account but many will let you open an account with a smaller amount if you have money direct deposited into it. The problem I see with the government I-Bonds is that they have penalties for early withdrawal, so investigate these carefully before using them.

In the course of his discussion he suggests putting at least 5% of your salary away each month towards this rainy day fund. There is no discussion if this 5% is in addition to the 10% minimum he suggested for your retirement fund or if it is done in lieu of retirement planning until the fund is built up. Again, I think his emphasis is so much on the “Automatic” in the title, that he is not really worried about making a coherent, step by step plan.

Along this same vein, Bach mentions, almost as an afterthought, that you should not ignore your credit card debt while building up this emergency fund. Instead he says you may want to set aside just one month’s worth of expenses until you are able to get your credit card debt paid down. I think that Dave Ramsey is more on track in this area, just $1,000 set aside until you are able to get those pesky credit cards paid off.

I just saw that the Personal Finance Course offered at the University of Utah has been put up on the web. The site has the class syllabus, overheads used in class, and a spreadsheet that contains just about every form and calculation you might need.

HatTip: savvy saver for pointing to this Personal Finance class.

Over at Seattle’s Rain City Guide, Eileen wrote about the fun of owning multiple companies and the necessity of keeping the tax man happy. She brought up some things I never thought about such as having to have one of your companies charge sales tax to each other when they are both working on the same project! She just went through an audit and it sounds like it was a painful process.

For example, if I own two companies, a construction company and a company that buys property, subdivides, remodels, build new, etc., and if an employee from the construction company builds for the venture company, then I must charge sales tax to myself!. Yes, I know the LLC’s and the Inc.s are their own entities, but it never occurred to me that I’d have to charge myself sales tax and give it to the state even if I’ve already paid sales tax at the point of sale. Similarly, if I bring my computer from home (or office furniture or ANYTHING and GIVE it to one of my companies, I must again pay sales tax. I own the computer, I own the company, I paid sales tax when I bought the computer. However, the state wants it’s $ so they consider that I sold the computer and therefore must pay sales tax.

Another example. If the construction company pays an architect for plans for the venture company, then I must charge tax and pay it to the state, even though architects are a service industry and don’t incur sales tax. I could elaborate but it’s just more of the same. Reminds me of my restaurants I had in the 80’s. I had a similar audit and because I gave free meals to my employees(100 of them at $2/day for 5 years), I had to pay sales tax to the state on those FREE meals. Go Figure.

But, lesson learned and I’m now cutting paychecks out of 4 different companies. Four sets of W-2’s, etc for each employee. Yuck

The restaurant example also floored me! I would never think that I would have to pay sales tax on something I gave my employees! The taxman though wants to get his cut any way he can!

There are some credit card terms that can be especially problematic that you should be on the look-out for:

• Two-Cycle Billing
  Think you paid off your credit card? Think again. More and more credit card companies are using what is called “Two-Cycle Billing” which penalizes customers who occasionally carry a balance If you didn’t get the full balance paid last month, but paid it off this month you would expect not to have to pay any finance charge this month. Not so. With the two-cycle billing system, if you do not pay your balance in full last month, you will have an interest charge this month for the amount that carries over, even if you pay it in full this month.
• Universal Default
  Universal default means that your credit card company can raise your interest rate if you’re late on another credit card or bill. In other words, if your credit-history takes a hit, so will your interest rate.
• Over-Limit Fees
  If you have maxed out your credit card but continue to charge, don’t expect the charges to be declined. No, your credit card company is more than happy to charge you an over-limit fee of $30 or more each time you go over your credit limit.
• Close Early on Due Dates
  Many credit card companies now consider your payment late if it arrives on the due date after a certain time of day, not withstanding the fact that the mail never arrives before that time. Late payments will incur a late charge and can, of course, jack up your interest rate.

I was just reading a post over about budgeting over at lifehacker.com and was amazed at some of the comments. The number of posts by people in their 20s who have outrageous student debt and low paying jobs really floored me. Most were complaining that it is impossible to set aside 10% of your income every month, let alone the 20% the article suggests. But the numbers in this comment really floored me:

Hrm. I’m a college student and I’m not getting rich by any means. I also live at home, and work part time. That said, I pay for all of my own expenses (including what amounts to slightly more than my board and utilities costs), and I save 20% of whatever I bring in in a given week. No matter how big or small said check is.

I started a Roth IRA when I was 19 with $600. I’ve grown that in value to ~$1500 in three years. I haven’t contributed anything to it since.

I’m also up to my ears in student debt: $132,000. So I guess that makes me worse off than most all things considered…

So he is still in school, but has already chalked up $132,000 in student debt! What kind of a job would you need to be able to get to make that kind of expense ‘justifiable’? The reason I ask is there are other comments like this one:

Most people I know have college degrees and make $10-15/hr in lower-level white-collar jobs. They need a reliable vehicle to get to work, because for most of the US, this is a car culture. Most people I know are relatively maxed-out without frivolous spending; they might be able to manage 10% if they never ate out (including fast food), did not eat organic, and never went anywhere. Most people are not able to hack a lifestyle quite that austere, especially with stressful, low-paying, and unsatisfying jobs. (Should they quit? Sure. Can they? Not realistically.) So I don’t think we’re necessarily talking about the guy with the BMW whose girlfriend has the Louis Vuitton bag… we’re also talking about the guy who just wants to go see a first-run movie once every few months.

The comment author might need to reevaluate the definition of ‘reliable car’. A 3 year or 4 year old Ford Focus is a reliable car. A new or newer Toyota Camry is a splurge.

Richard Jenkins has an thought provoking article on MSN Money, A simpler way to save: the 60% solution. Jenkin says that after 20 years of doing regular budgets he has found that when money gets tight it is becafuse his committed expenses exceed 60% of his income. Much like how a bank determines how much house you can afford as a percentage of your income, Jenkin realized that when his regular, committed expenses exceed the 60% mark, he began to run into financial trouble. Lets look at how Jenkin defines his system.

Committed expenses include taxes, insurance, charity, regular bills, and basic living expenses such as food and clothing. I wonder how to include clothing as a regular expense. My family may go months between expenses for clothing. Under my current budget system I set aside a dollar amount each month that is held in reserve until needed, but that does not sound like what he means as a ‘committed’ expense, but more like the next category, “irregular expenses”.

Jenkin describes “irregular expenses” as a short-term savings fund that can be transferred to checking as needed. This fund is designed to pay for things like vacations, home and car repairs, furniture, and new appliances. From his description these all seem like big ticket items, but I wonder if other expenses would go in here? My AAA Motor Club renewal? Clothing? Haircuts?

The next category is “fun money” to spend as you see fit, for comic books, eating out, music, your hobbies, etc. Jenkins allocates 10% this category, but for our family that would be extremely excessive. I doubt we spend more that 5% in this category each month. Possibly this is because with 6 kids still at home there are too many regular, committed, expenses to be able to afford much more.

This leaves us with 20% of our income. Jenkin has half of the 20% in to retirement savings account such as a 401k, IRA, or whatever account you use to save for retirement. The remaining 10% is put into long-term savings (or debt reduction if you have unpaid credit card balances). This money is being set aside for future car purchases, major home fix-ups, and other investments.

So, in reality 10% is truly being saved for retirement and the rest is either being spent or being set aside to be spent. 10% towards future big ticket items, 10% towards personal spending money, 10% towards irregular expenses, and the remaining 60% goes towards regular monthly expenses. The key is watching that you don’t make too many commitments and exceed your threshold for monthly expenses.

I like the simplicity of this plan, but am afraid it may only work for those who, like the Jenkins, already have budgeted for quite awhile and already have their cash flow under control.

The real secret to building a budget that really works isn’t tracking what you spend, any more than counting calories is the secret to losing weight. The key is creating a sustainable structure for your finances, one that balances spending and income and that leaves enough room to handle the unexpected.

David Bach gives the third of his secrets to financial security in this chapter of The Automatic Millionaire. The first two were 1) Pay Yourself First 10% of your pretax income and 2) Make it Automatic. The third secret is to Buy a Home and Pay It Off Automatically. Bach gives reasons you should buy a home, reasons you should pay it off, and reasons you should do it automatically.

He begins by saying that the first landlord you should become is your own. Turning some statistics on their head to say what he wants, he points out that since homeowners are 31 times richer than renters you should become a homeowner so you can be richer. He gives 6 reasons why your first step should be to buy a home: forced savings, leverage, OPM - Other People’s Money, tax breaks, pride of ownership, real estate has been a great investment.

He then discusses paying the mortgage off early either by using a biweekly payment plan or by sending in extra money with each payment. I have never understood the biweekly plan. Unless the homeowner is paid biweekly, where are they going to get the money to make the extra payment and how do you budget for it? Much more reasonable to pay extra with each payment. Also, earlier in the chapter Bach talks about the advantage of using leverage and OPM as positive reasons for buying a home, why is he now advocating paying the home off early rather than investing in more real estate?

And finally he advocates setting up your mortgage payment to be paid automatically by your bank each month so that you don’t have to think about it and you won’t be tempted to send in just the regular payment instead of the extra.

In this next-to-the-last chapter of The Automatic Millionaire, the author, David Bach, deals with what most personal finance writers place higher on the list, paying off your credit card debt. Bach states that Automatic Millionaires do not do debt, they only borrow to pay for things that appreciate in value, like a home.

After going through some pretty sad statistics on credit cards, Bach sets up a couple of steps for getting rid of your credit card debt:

Stop Carrying Credit Cards
You cannot get out of a hole if you keep digging. Recovering alcoholics do not carry a flask with them, just in case, neither should you. I don’t know that you need to destroy all your credit cards, but I do agree with the author that there is no need to carry them around with you.

Renegotiate Your Interest Rates
Here the author gives some advice on how to negotiate with your credit card company to get a lower interest rate. I have done this, and don’t call without ammunition — know what good deals you can get, because the first thing they offer you will not be their best offer.

Consolidate Your Credit Cards to the Lowest Rate Cards
Actually part of the above step, as you are talking to your credit card company, ask them if they also have a ‘deal’ for transferring balances, and let them know you are asking all your credit card companies for their best deal. Be careful of any fees for balance transfers, although if it reduces the interest rate a $50 one time fee may not be a bad deal but $0 is better.

Devote Half of Your “Pay Yourself First” Money to Paying off Credit Card Debt
Here again Bach deviates from the standard personal finance advice. Most writers have you pay off all your credit card debt before starting your retirement fund. Bach’s proposes using half of the 10% you are setting aside for your “Pay Yourself First” money to pay off your past. He contends that people need the emotional satisfaction of building for the future while paying down their debt.

Use the DOLP Method to Pay all Remaining Credit Cards.
This is Bach’s cute acronym for “Dead on Last Payment” since he is going to have you cancel each card after it is paid off. No matter this may hurt your credit. The actual ‘method’ of this system is to divide each card’s balance by the minimum payment for that card and pay the card with the least number of remaining payments off first with your extra cash. He does not mention snowballing the minimums together as you pay them off like most other writers.

Automate Your Credit Card Payments.
His final step is, of course, to make this all automatic by having your credit card companies auto-deduct the payments from your checking account each month or using bill payer option with your checking account. I don’t think I would want to give my credit card company access to my checking account but would have no problem setting up automatic payments from my checking account to the credit card companies using the bill payer option. It especially makes sense to set it up so that the minimums come out each month, then you can send in any extra to pay them off early.

In order to increase my net worth I am investigating rental property. I know nothing of being a landlord and so have begun my research on the internet and at my local library. I am not 100% sure that I have the temperament to be a landlord but I am interested in investigating the possibility. I also know some people who own rental property and will pick their brains as soon as I learn enough to know what to ask.

So far I have found three web sites that look to have quite a bit of information. Here are the sites I have investigated so far:

• FatWallet Investment Forum - especially the 1600 messages in the “Investment / Rental Property” thread.
• MrLandlord.com - “where rental owners ask landlording questions and get answers and tips from other landlords”.
• Creative Real Estate Online - “Financial Independence through Education”

The books that I have checked out of the library include the following:

• The New No-Nonsense Landlord by Richard H Jorgensen
• Landlording: A Handymanual for Scrupulous Landlords and Landladies Who Do It Themselves by Leigh Robinson
• The Landlords Handbook by Daniel Goodwin, Richard Rusdorf, & Barbara McNichol
• Simply Essential Landlords Kit with CD by Timothy Madden
• How to Find and Manage Profitable Properties by Robert Irwin
• Property Management for Dummies by Robert Griswold
• How to manage apartments for maximum cash flow and resale value

As I go through the books and websites I will post my impressions.

I listened to Paul Merriman of Merriman Capital Management give his ‘The Ultimate Buy-and-Hold Strategy’ workshop online. He makes a very good argument for diversifying your portfolio through no-load mutual funds. I found that Merriman’s article on this subject has also been updated, showing how a series of simple concepts can benefit patient investors. This update to the strategy also incorporates the five intervening years of returns and adds a new portfolio to the mix.

He recomends putting your ‘investment plan’ into writing so that it is mechanical and you are able to remove emotion from the buy/sell process. My summary of the strategy is designed to help me ‘think-through’ his advice and write my thoughts as I do so.

According to Merriman, the average investor is unable to successfully use market-timing strategies. His investment firm decided to seek out a buy-and-hold strategy that could be be used to increase investment returns and reduce risk.

In theory, a “perfect” investment strategy would be cheap, easy to implement and risk-free. It would make you fabulously rich in about a week. Tax-free, of course. We haven’t found that combination, and we don’t expect to. But the Ultimate Buy-and-Hold Strategy is the best real-world substitute that we’ve found.

This strategy is designed to produce higher returns at a lower risk with minimal transaction costs.

The Ultimate Buy-and-Hold Strategy uses no-load index funds to create a sophisticated asset allocation model with worldwide diversification and the addition of value stocks and small-cap stocks to a traditional large-cap growth stock portfolio.

This strategy is not available through a single mutual fund but can be built using a combination of low-cost index funds. It is definitely not a short term strategy but, as the title of the strategy suggests, is a buy-and-hold strategy for the long term. The strategy promises there will be times your portfolio will not ’shine’ but, based on historical data, this strategy should produce good returns on a long-term basis while minimizing downside risk.

The Ultimate Buy-and-Hold Strategy is not based on anything that happened last year or last quarter. It’s not based on anything that is expected to happen next quarter or next year. It makes absolutely no attempt to predict what investments will be “hot” in the near future. If that is what you want, you won’t find it here.

But if you want superior long-term performance from a buy-and-hold approach, the Ultimate Buy-and-Hold Strategy is the best way I know to get it.

The strategy’s success is based on investing in a diverse set of asset classes rather than trying to buy or sell at exactly the right time or choosing the right stocks or mutual funds.

The truth is this: Your choice of asset classes has far more impact on your results than any other investment decision you can make. I know this flies in the face of a lot of conventional wisdom and of almost all the marketing hype that comes out of Wall Street, so I want to repeat it. Your choice of the right kind of assets is far more important than exactly when you buy and sell those assets. And it’s much more important than finding the very “best” stocks, bonds or mutual funds.

In the next post on this subject we will look at building the ‘ultimate’ portfolio.

Paul Merriman of Merriman Capital Management recently presented his ‘The Ultimate Buy-and-Hold Strategy’ workshop online. The presentation makes a very good argument for using no-load mutual funds to create an asset allocation plan that will beat the market over the long haul and with less risk. Merriman’s article on this subject has been updated, giving the same details as the workshop and showing how investors can implement this strategy.

The first portfolio that Merriman presents is the industry standard 60/40 ratio of equities and bonds; providing growth from the equities while the providing stability and income from the bonds. This is the way most pension funds, insurance companies, and other large institutional investors traditionally allocate their assets.

According to the author, this portfolio produced a compound annual return of 10.4 percent between January 1970 through December 2005, a period which included three major bear markets and had a standard deviation of 11.6. Standard deviation is a statistical way to measure risk. The lower the standard deviation, the more predictable and less volatile the investment. This long-term return of 10.4 percent with a standard deviation of 11.6 will be used by the author as the benchmark against which he measures the Ultimate Buy-and-Hold Strategy.

Hundreds of thousands of investors would be better off with Portfolio 1 than they are with their current investments, which offer too little diversification and too much risk. If they did nothing more than adopt this simple mix of assets, which is easily duplicated using a couple of no-load index funds, these investors would be more likely to achieve their long-term investment goals than they are now.

Therefore, I believe Portfolio 1 is a relatively high standard from which to start. In my view, anything worthy of being called the Ultimate Buy-and-Hold Strategy must beat Portfolio 1 in two ways. It must be expected to produce a return higher than 10.4 percent and have a standard deviation lower than 11.6.

The next article will look at the make up of the bond portion of the investment portfolio before looking at how to allocate the equity portion to attain “The Ultimate Buy-and-Hold Strategy”.

Laura Rowley, Yahoo! Finance columnist, asked readers for their best ideas on how to raise money-smart kid](http://finance.yahoo.com/columnist/article/moneyhappy/6038) and reproduced some of her favorites. She introduces the idea of saving money by waiting six months to get “Over the Hedge” from Netflix for $2.50 instead of seeing it now at the theater for $8 or more per person at the theater:

Imagine this was a stock: If you could confidently predict it was going to drop 94 percent in six months, wouldn’t you wait and buy low?

Here are a couple of the reader’s comments that caught my attention:

At the end of every year, whatever our nephew saves and invests — in stocks — we match. That includes Christmas money, birthday money, and anything else he manages to save up. We started last year and bought him a few shares of Disney (DIS) since that’s what he wanted to buy. It worked. We have him reading to tell us how the stock is doing, how much it goes up and down. Next December, he’s thinking about eBay (EBAY). He has from Christmas until the second week of January to decide where his “401(k)” is going. — Rebecca A. Gushue

I really like the idea of matching my kid’s long-term savings. Right now the kids get $10 on the 5th and 20th of the month (dad’s payday) which is divided up between spending, savings, and tithe. I would like to see part of that savings go towards long term savings and this would be a good way to encourage it.

I encourage my kids to live in an eBay world, where closets of unused sports gear can be turned back into cash. It also shows them depreciation when they say, “That cost me $100, and all I got for it was $10!” I also point out car commercials and teach them about leasing vs. buying, new vs. used. I invest in real estate and often take my kids to the closing. I explain what it means to pay rent vs. receive it. I think that it’s important for kids to understand the process and not to be afraid of investing. — Mark Adams

Hmmm. Might have to have them go on eBay to check out some of their recent purchases…..

HatTip to: Blueprint for Financial Prosperity